Tuesday 29 November 2016

Macro and Credit - From Utopia to Dystopia and back

"For other nations, utopia is a blessed past never to be recovered; for Americans it is just beyond the horizon." - Henry A. Kissinger
Hearing about the passing of Cuban leader and revolutionary Fidel Castro also an accessory ambassador to the Rolex brand, and given the continuous rise in government bonds yields, while thinking about what should be our title analogy, we thought about the current situation. Our current situation entails we think a reversal of the 1960s utopian revolutionary spirit towards a more populist and conservative political approach globally. Also, it seems as of late that there has been somewhat since the Trump election an opposite movement in the financial sphere from financial dystopia aka financial repression from our central bankers towards utopia aka a surge in inflation expectations leading to large rotations from bonds to equities and rising "real yields". Also, another reason from our chosen title is the recent UK bill requiring internet firms to store web histories for every Briton's online activity. The most famous examples of "Dystopian societies" have appeared in two very famous books such as 1984 by George Orwell and of course Brave New World by Aldous Huxley. Dystopias are often portrayed by dehumanization, totalitarian governments, environmental disasters or other characteristics associated with cataclysmic declines in societies. Dystopia is an antonym for Utopia after all, used by John Stuart Mill in one of his parliamentary speeches in 1868. Dystopias are often filled with pessimistic views of the ruling class or a government which has been brutal or uncaring. It often leads to the population seeking to enact change within their society, hence the rise in what is called by many "populism". What is important we think, from our title's perspective is that financial repression goes hand in hand with dystopia given that the economic structures of dystopian societies oppose centrally planned economy and state capitalism versus a free market economy. One could infer that central banks' meddling with interest rates with ZIRP, NIRP and other tools is akin to a dystopian approach also called financial repression. Right now we think that on the political side, clearly, the pessimistic views of the ruling class has led to upsetting the outcomes of various elections this year such as Brexit and the US election thanks to "optimism bias" from the ruling class. So all in all, Utopia has led to political Dystopias, creating we think inflationary expectations for now and therefore leading to euphoria in equities or what former Fed supremo Alan Greenspan would call "irrational exuberance" when effectively, it is entirely rational given market pundits expect less "financial repression" to materialize in the near future but we ramble again...

In this week's conversation we would like to look at what to expect in 2017 from an allocation perspective, while since our last conversation there has been some sort of stabilization in the rise of "Mack the Knife" aka King Dollar + positive real US interest rates, it appears to us that the first part of 2017 could get complicated.
  • Macro and Credit -  Erring on the wider side
  • Final chart - Gold could shine again after the Fed

  • Macro and Credit -  Erring on the wider side
As we have pointed out in recent musings, credit investors since the sell-off in early 2016 did not only extend their credit exposure but, also their duration exposure, which as of late has been a punishing proposal thanks to convexity particularly for the low coupon / long duration investment grade crowd. While total returns have still been surprisingly strong in the second part of 2016, particularly in High Yield in both Europe and the US, the "beta" players should be more cautious going forward. 

We think that the goldilocks period for credit supported by a low rate volatility regime has definitely turned and slowly but surely the cost of capital is rising. 

For instance, in the US while the latest Senior Loan Officer Opinion Surveys (SLOOs) has pointed to an overall easing picture as of late as per our previous conversation, in the US, Commercial Real Estate is already pointing towards tightening financial conditions as indicated by Morgan Stanley in their CRE Tracker note from the 18th of November:
"CRE Lending Standards Tighten For the Fifth Straight Quarter in 3Q16
•The Federal Reserve’s Senior Loan Officer Opinion Survey showed CRE lending standards continued to tighten in 3Q16, marking the fifth straight quarter of net tightening.

•Overall, standards tightened at a stable pace, with 29.5% reporting net tightening compared to 31.3% in 2Q16. Large banks have been tightening more than other banks, but the 3Q16 release shows that large banks’ tightening pace has slightly slowed.
•Tightening has been most pronounced in multifamily loans, and in 3Q16 other banks upped their tightening pace in this category.

•Loan demand continues to strengthen but has decelerated quarter-over-quarter: only 5.8% reported a net increase in demand compared to 12.0% in 2Q16. Demand is stronger for construction loans relative to the other two types.

•Our studies have shown that tightening lending standards and/or decreasing loan demand tend to lead to declining CRE property prices.
- source Morgan Stanley

While we have tracked our US CCC credit canary issuance levels as an indication that the credit cycle was slowly but surely turning, the above indications from the US CRE markets is clearly showing that the Fed is about to hike in a weakening environment, should they decide to fulfill market expectations in December. Obviously while the market is clearly anticipating their move and has already started a significant rotation from bonds towards equities, the move from Dystopia to Utopia and Euphoria will have clear implications for credit spreads in 2017, and should obviously push them wider we think. 

This thematic is clearly as well the scenario being put forward by most of the sell-side crowd when it comes to their 2017 outlook for credit. For instance we read with interest Morgan Stanley's take on the macro backdrop for credit for the US entitled "From Cubs to Bears":
"We are cautious on US credit for 2017: Across the spectrum, credit markets will likely finish 2016 with the best returns in many years – certainly better than we anticipated. If we had to boil the rally from February-October down into two factors, we think the recovery in oil/energy explains the first half, and the massive global reach for yield driven by low rates and easy central bank liquidity explains the second. In our view, fundamental risks are still very elevated, and while sentiment has become bullish around the impact of a Trump presidency, any way we look at it, credit is moving out of the 'sweet spot'. Specifically, the days of ultra-low rates, ultra-low volatility, and ultra-easy Fed policy are in the rear-view mirror. All while valuations are considerably richer than this time last year – not a great setup for 2017.
More specifically, our cautious call on US credit is based on three key points, which we expand on in the first section below:
  1. A less benign environment: We would not underestimate the impact central banks have had on markets. Now, eight years into a cycle, we expect inflation to rise, the Fed to hike quicker, and the dollar to break out. Fiscal stimulus helps growth, but there are clear offsets, like tighter financial conditions. This is a backdrop where mistakes are more likely and costly.
  2. Fundamentals are weak, late-cycle risks have risen, and the Fed could push us to the edge quicker: Markets anticipate defaults one year in advance. Lower defaults in 2017 are in the price. Rising defaults in 2018 are not.
  3. Credit is priced for a benign environment as far as the eye can see: IG spreads adjusted for leverage and HY default-adjusted spreads have rarely been tighter. In addition, higher Treasury yields make the 'reach for yield' argument for US credit much less compelling.

Adding everything up, we do not think this is the point in the cycle to reach for yield, and most of our recommendations are up-in-quality as a result. And we note that better growth does not always equal better returns. In the second half of cycles, negative excess return years come more frequently than you might expect, and we expect to see one in 2017.
Moving Out of the Macro 'Sweet Spot'
The US economic environment is becoming less supportive of credit markets. Our economists forecast US GDP to grow at 1.9% in 2017, 0.3pp higher than the baseline, given our expectations around fiscal stimulus. Why not a bigger number? First, it is important to remember that the underlying headwinds to growth that have driven a subpar expansion for eight years have not gone away just because Trump was elected. Second, our economists assume that a material tightening in financial conditions offsets some of the benefits of fiscal stimulus. For example, we now expect the Fed to hike twice in 2017 and three times in 2018, the dollar to rally by 6%, and 10Y Treasury yields
to hit 2.75% in 3Q, (2.50% at year-end), very different from our prior forecasts of low rates and ultra-accommodative Fed policy. These risks may rise further later in 2017, if markets begin to worry that Yellen will be replaced with a much more hawkish Fed chair. Third, right now investors seem to be focused on all the benefits from stimulus, but downplaying the risks to Trump's policies that were so concerning in the run-up to the election. It doesn't take much for sentiment to swing back in the other direction or for current lofty expectations around fiscal stimulus to disappoint.
Either way, there is much greater potential variability around our forecasts, given all of the unknowns. For example, in our bear case where we assume Trump takes a hard line on trade, GDP growth is hit by 0.6pp, even assuming material tax cuts and infrastructure spending.
~2% growth by itself is manageable, but unlike earlier in this cycle, the Fed is not adding stimulus, but instead withdrawing liquidity. And remember, even with fiscal stimulus, the Fed is still tightening into a much more anemic growth environment than inpast rate hike cycles (Exhibit 3), significantly later in the cycle, and with profits growing considerably slower.
Due to this subpar recovery, markets have become very dependent on central banks, and when the liquidity spigot turns off, credit has consistently had problems. In fact, over the past two years, the Fed has struggled to get in even one hike a year. We would not dismiss the impact on markets if the Fed has to step on the brakes more quickly, given how much central bank policy may be supporting valuations, given the starting point on growth, and with the US economy much later in a cycle than when the Fed has begun hiking in the past.

In addition, less easy liquidity could become a global theme next year. Our economists expect the ECB to announce tapering at its June meeting, and a shift in the BOJ's 10Y yield target in 4Q17 – very different from the risk-supportive environment from central banks immediately post Brexit.
Lastly, even with this rate rise, the market is still only pricing in ~1.5 hikes in 2017 – thus risks are asymmetric. If growth disappoints, the Fed has little ability to release a verbal dose of monetary stimulus like this past year, when rate hike expectations quickly dropped from 3 to almost 0. Alternatively, if this is the year where inflation starts rising, there is plenty of room for rate hike expectations to rise. In addition, with IG and HY spreads 37bp and 204bp tighter vs. when the Fed hiked last December, credit markets also do not have the same shock absorber as last year." - source Morgan Stanley
The last point is particularly true given that the second half rally saw credit investors piling on more duration and more credit risks, meaning more instability in credit markets at the time where "Dystopia" has been fading in financial markets. As we pointed out in our previous conversation, we think the market is trading ahead of itself when it comes to its expectations and utopian beliefs. Like any good behavioral therapist we tend to focus on the process rather than the content and look at credit fundamentals to assess the lateness of the credit cycle. 

There is no doubt in our mind that we are moving towards the last inning of the credit cycle and there has been various signs of exhaustion as of late such as our CCC credit canary issuance indicator or as above tighter lending conditions for CRE which is trading at elevated valuation levels, but on these many points we agree with Morgan Stanley's take that fundamentals are clearly showing signs of deterioration in the credit cycle that warrants caution we think:
"Elevated Fundamental Risks Late in the Cycle
Markets are very late cycle, according to our indicators, and even compared to this time last year, fundamentals are weak. To provide a few examples on the first point: The Fed is expected to continue hiking, and looking at the shadow fed funds rate, has already tightened policy by a similar amount as in past cycles. Lending conditions have tightened (measured by the % of banks tightening C&I, CRE, auto, and now consumer loans), and leverage is very high. Margins, M&A, and auto sales look like they have possibly peaked. In addition, leading economic indicators have rolled over, employment has slowed from the peak in early 2015, and productivity has declined. Along similar lines, looking at our cross-asset team’s indicator, the US may have entered the 'Downturn' phase of the cycle earlier this year.
The deterioration in corporate balance sheet quality also indicates elevated cycle risks.
For example, as we show below, leverage is at or near record levels across credit markets. In addition, the leverage increase has been broad-based (outside of financials), and the ‘tail’ in the market has grown substantially. For example, the highly leveraged tail has doubled since 2011 in high yield (two-thirds of this tail is ex-commodities) and 30% of the IG market is levered over 4x today, compared to only 11% in 2010.

This deterioration in credit quality should not come as a surprise – low rates and ultra-easy liquidity for eight years have had negative side effects. What should be concerning is that, historically, the sharpest rise in leverage tends to occur in recessions when earnings collapse. Hence, the fact that leverage is this high in a growing economy means that it will likely peak at a much higher level than in the past when a downturn finally hits. We would also note that leverage is not the only area of concern, with interest coverage and cash/debt also trending lower in most markets.

In an environment of higher rates and better growth, as markets are seemingly anticipating, could leverage come down? We think it is possible, but unlikely. First, better growth should, if anything, encourage more aggressive corporate behavior, which is why historically, the biggest declines in leverage come after a credit cycle. Second, we would not dismiss the underlying headwinds to a big pickup in earnings at this stage in the expansion, especially if the dollar rallies 6% as we expect. Yes, corporate tax cuts could help, although even there we need to wait for the details – if tax cuts are paid for in part by getting rid of tax preferences and there is a tighter noose around what is considered domestic income, the aggregate benefit may be lower. But bigger picture, weak productivity and rising wages are a few of the many headwinds to profitability that probably aren't going away. Lastly, even if leverage does drop modestly, higher rates are an offset when thinking about future defaults. Ultimately, we think the damage has been done looking at fundamentals, and better growth, higher rates, as well as faster rate hikes if anything, push us to the cycle edge more quickly. We note that the later years in an equity bull market when growth is strong are often not bullish for credit. For example, in 2000, HY excess returns were down 16.3%. 
Assessing credit quality in aggregate, we think the fuel for a default/downgrade cycle is clearly present. And with banks tightening lending standards now across C&I loans (albeit only modestly per the latest survey), CRE, and autos, and no longer easing for consumer lending, this credit cycle is actually playing out as one would expect in a long, slow default wave. Yes, the defaults so far have been predominantly commodity focused, but in our view, it is normal for the problem sector to drive the stress early on.
The key question of course is one of timing – when do default/downgrade risks start to spread beyond commodities in a bigger way? In our view: Sooner than most think. We discuss our default and downgrade expectations in more detail in the forecasts section below. But in short, default rates will likely drop in 2017, which we think is in the price, with the HY energy sector 955bp tighter since the wides in February.
However, according to our numbers, defaults will start rising again in 2018, likely peaking in 2019. Without going into the details, we base our assumptions on the lag between when the indicators we track have turned historically and when defaults have subsequently spiked, as well as the status of those metrics today.
If our estimates are correct, this default wave will last ~4.5 years in total (having begun in 2016), similar to the 1999-2003 cycle. And we think there are logical reasons to assume a prolonged cycle. For example, the prevalence of cov-lite loans and somewhat elevated interest coverage will not make overall default volumes lower, in our view, but could mean defaults take longer to materialize. In addition, if a recession occurs while rates are still generally low, the tailwind of falling yields will not be there this time around, which could slow the bounce off the bottom.
Last and most importantly, if defaults start rising again in 2018, the market should price that in next year. As we show below, years when defaults rise more than 2%, spreads tend to widen by 283bp on average the year prior, as the market prices in those risks. Or said another way, the fact that defaults will drop in 2017 should have little bearing on spreads in 2017.
As a result, the only way to rationalize today’s valuations is to assume a benign default environment for several years, which we believe is a low probability. Looking back in time, we only have one good example of when defaults rose temporarily due to one sector and then subsequently dropped without a near-term recession. That took place in 1986, yet even then, defaults only fell for two years, and subsequently rose into the 1990 recession. Also we would note the Fed was not hiking at the time, but instead cut rates by ~200bp in 1986 to cushion the blow – very different from today." - source Morgan Stanley

Furthermore, a continuation in the rise of "Mack the Knife" aka the US Dollar and real rates, then again US earnings could come under pressure and financial conditions will no doubt get tighter and hedging costs for foreign investors pricier, which could somewhat dampen foreign appetite from the like of the Japanese investor crowd and Lifers in particular, leaving in essence very little room for error when it comes to credit allocation towards the US, hence we would favor quality (Investment Grade) and low duration exposure until the dust settle, meaning some sort of stabilization in current yields gyrations from a US allocation perspective.

Obviously for Europe, in terms of credit, the story is slightly different given the on-going support from the ECB but clearly the risk lies more into a rise in political "Dystopia" rather than financial "Utopia" given the on-going deleveraging process of the European banking sector. To that effect, whereas there has been a very significant rally in the European banking sector when it comes to equities as of late in conjunction with the US sector thanks to less "Dystopia" and rising yields, we still favor high quality European financials credit in the current environment. Even European High Yield is more enticing thanks to lower leverage than the US. To illustrate the "japanification" process in Europe and the reduced "credit impulse" largely due to peripheral banks being capital impaired thanks to bloated balance sheets due to nonperforming loans (NPLs), we would like to point out once more to the difference in terms of deleveraging between Europe, the US and Japan when it comes to their respective banking sector as highlighted as well by Morgan Stanley in their European Credit Outlook note from the 28th of November entitled "As Good As It Gets":
"In our base case, we expect bank credit to outperform non-financials because valuations are less distorted, technicals remain supportive, fundamentals at the system level continue to improve (albeit at a slower pace) and regulatory pressures on the sector are easing. The earnings squeeze on account of negative rates and flat curves is also likely to ease, at least in some parts of the system, on account of recent moves in bond yields. Moreover, the possibility of ECB purchases (while lower now) is still an important source of optionality.
Banking on favourable technical and valuations: 
Delving into some of the factors listed above, we note that the positive, but subdued, lending impulse has been a favourable set-up for bank credit. It has helped to ease concerns of financial conditions and at the same time has kept the supply technical supportive. As shown in Exhibit 28, net issuance
of senior unsecured paper and covered bonds from European banks are barely positive. The need for funding is modest and the avenues are many, with the ECB still an attractive alternative to bond markets. Against this backdrop, we expect senior bank supply to remain muted in 2017. Another important factor that informs our view is regulations. As our bank analysts have been highlighting for some time now (see The Potential for MREL, September 23, 2016), MREL is likely to be supportive for bank debt. They believe that non-preferred senior/'Tier 3' will be the MREL of choice for most banks, increasing structural protection for opco seniors and far lower needs to issue senior debt." - source Morgan Stanley
We hate being "party spoilers" for our equities friend and their "optimism bias" but, in the current deleveraging and "japanification" process, we'd rather go for financials credit wise thanks to the technical support and lower volatility of the asset class compared to equities. No matter how strong the rally has been as of late in equities, for credit there is a caveat, you need to pick your issuer wisely in Europe. Europe is still a story of subdued credit growth given that the liquidity provided by the backstop of the ECB has not meaningfully translated into credit growth for the likes of Portugal and Italy and in no way resolved the Damocles sword hanging over the Italian banking sector and their outsized NPLs issue.

Overall as "Dystopia" is fading, marking a return of bond volatility, we would be surprised to see a continuation of the strong rally seen in the second part of 2016 for credit markets in 2017. Whereas we have not seen signs of clear stabilization for "Mack the Knife" aka King Dollar + positive real US interest rates, hence our neutral stance for the time being on gold, in our last chart, we would like to point out that gold could shine again following the Fed in December.

  • Final chart - Gold could shine again after the Fed
Whereas Gibson's paradox, thanks to  "Mack the Knife" has reversed meaningfully during the month of November, we could have a surprise rally after the Fed's decision in December according to our final chart from Deutsche Bank's "Mining Chart of the Week" note from the 25th of November:
"After five of the last eight US interest rate hikes, gold has rallied
The gold price has declined 7% so far in the month to reach a nine-month low on expectations of a US rate hike in December and improved sentiment that recessionary risks are fading with hopes of a Trump-led fiscal stimulus. The precious metal now looks less shiny; but what’s next? History teaches us that gold can rally after the Fed has hiked. As we show on this week’s chart, since 1976, in five instances out of eight, gold rallied with rising Fed rates.

Reading through the Chart
We find it interesting that even in an environment of flat/rising US GDP growth and rising interest rates, gold can rally – this happened in 1977-78, 1993-95, and 2004-06." - source Deutsche Bank
Whereas investors have been anticipating a lot in terms of US fiscal stimulus from the new Trump administration hence the rise in inflationary expectations and the relapse in financial "Dystopia", which led to the recent "Euphoria" in equities, the biggest unknown remains trade and the posture the new US administration will take. If indeed it raises uncertainty on an already fragile global growth, it could end up being supportive of gold prices again. As a bonus chart we would like to point out Bank of America Merrill Lynch's chart highlighting the relationship between gold and global trade from their Metals Strategist note from the 21st of November:
"Trade is an unknown
Trade, the other cornerstone in US President-elect Trump’s plan, has been discussed contentiously. In our view, measures that would restrict global trade would do a lot of damage to economic activity. Against this backdrop, we note that trade has been subdued anyway, and this may not change imminently given developments including a shift in economic activity from DM to EM has run its course for now. Of course, this raises uncertainty over the strength of global growth, which is supportive of gold (Chart 67).
Having said that, we believe a wholesale crackdown on US and global trade cannot be in the interest of the US president elect and we are cautiously optimistic that outright trade wars may not be the core agenda for 2017, so we track developments in this area mostly as a bullish unknown for gold." - source Bank of America Merrill Lynch
Whereas the markets and US voters have so far embraced the utopian idea that the new US Administration could make America great again, it remains to be seen if this state of euphoria is warranted.

"The euphoria around economic booms often obscures the possibility for a bust, which explains why leaders typically miss the warning signs." -  Andrew Ross Sorkin

Stay tuned ! 

Wednesday 23 November 2016

Macro and Credit - Critical threshold

"If you wish to be a success in the world, promise everything, deliver nothing." - Napoleon Bonaparte
Watching with interest the violent rotations in fund flows with Emerging Markets debt funds recording a $6.64 (-1.9) billions of outflows last week, the largest ever in terms of $AUM thanks to "Mack the Knife" (King Dollar + positive real US interest rates) while financial-sector funds experienced as well some monster flows to the tune of $7.2 billions, in effect validating somewhat our "macro reverse osmosis" discussed again in our previous conversation, we reminded ourselves for this week's chosen title as an analogy the definition of "critical threshold". Critical threshold is a notion derived from the percolation theory, which by the way ties up nicely when it comes to fluid movements and osmosis and refers to a threshold, that summons up to a critical mass. Under the threshold the phenomenon tends to abort, but, above the threshold, it tends to grow exponentially hence the risk for osmosis and flows to become at some point excessive, which would mean deflation bust and defaults for some. In cases the phenomenon is not sudden and take times to operate (such as a gradual surge in the US dollar) we would have used a critical phase or phase transition as a title for this week's musing but not this time around given the violence of the moves we have seen as of late.

In this week's conversation we would like to look at the violent flows rotations and what it entails in terms of critical threshold and risks as we move towards 2017 given the on-going killing spree of "Mack the Knife" on gold and US Treasuries and EM as well.

  • Macro and Credit -  Is reverse osmosis finally playing out?
  • Final chart - The dollar is their currency but our problem for 2017

  • Macro and Credit -  Is reverse osmosis finally playing out?
While last we week we reacquainted ourselves with our reverse osmosis macro theory relating to the acceleration of flows out of Emerging Markets, the latest raft of data relating to flows of funds clearly points out to a buildup in "Osmotic pressure" and a risk to break through the "critical threshold" and a significant "margin call" on the huge US dollar shortage that has been building up. On our twitter feed in fact we recently joked that the Fed was not behind the curve, but, that the curve was behind the Fed (watch the flattening...). The acceleration in the rise in US yields and in particular real yields have accelerated as of late, putting additional pressure on gold, Emerging Markets alike. If indeed the dollar rally continues to run unabated then, in continuation to our previous conversation, there is no doubt in our mind that trouble will be the outcome for the leveraged "macro tourists" carry players in the Emerging Market space. When it comes to trends, we do follow funds flows as indication of rising instability. To that effect, we read with interest Deutsche Bank's Weekly Fund Flows note from the 21st of November 2016 entitled "The great unwind?":
"Expectations of a looser US fiscal policy added fuel to the reflationary fire, triggering a bond sell-off across regions and classes on the one hand while also arranging for a strong return of equity inflows on the other hand. investors moved away from bonds at the highest weekly pace since the taper tantrum in 2013, as rising inflation expectations prompted outflows in both credit and sovereign bond fund categories, with US mandates bearing the brunt. In tune with the market, last week’s post-election flow data also saw a renewed appetite for DM equities as the reception of Trump's plans on tax cuts and infrastructure spending resulted in the highest weekly inflows for US equity funds since Dec’14 (see chart below).

If such stimulus in combination with reduced business regulation were to lead US GDP growth higher (as our US economists expect), we could finally see a normalisation of flows whereby money rotates out of over-allocated bond funds ($1tn of inflows since 2009) and into DM equities ($400bn of inflows since 2009). Last week’s bond-to-equity pull was strong in the US, and if rates continue rising this should go on.
Meanwhile another rotation seems to be in the making, as a rising dollar accompanied by fears of trade renegotiation spelled panic over emerging market fund flows. The run for EM bonds, which already looked increasingly  tired the past two weeks, took a big hit with highest redemptions since Jul’13 (see chart below) and the highest outflows in dollar terms since 2004.

EM equity fund redemptions also climbed to a one-year high. We remain particularly worried about intensifying EM capital flight on the back of a stronger dollar, and think EM redemptions are likely to continue." - source Deutsche Bank
If indeed when it comes to "credit" we look at the "credit impulse", in order to gauge the strength of economic growth, when it comes to flows and financial markets we like to look at Deutsche Bank's liquidity pulse, being the standard deviation from the mean of the relative between the current flow (4-week average as % of NAV) and the average size of flows in the last 13 weeks to get a better idea of the "critical threshold". Below are a couple of charts relating to equities and pointing towards a rotation from EM to DM with US equity funds talking the bulk of the flows:
- source Deutsche Bank

Whereas so far US equity funds have been receiving most of the inflows whereas EM has been on the receiving end of the "reverse osmosis" theory, given the surge in "Mack the Knife", it looks to us that once again a weakening Japanese yen against the dollar should go hand in hand with a surge of the Nikkei index, currency hedged. particularly in the light of the liquidity pulse which has yet to surge meaningfully.

When it comes to bonds and flows it is a different story as the velocity in the surge of US yields has translated into outflows from bonds funds and particularly EM funds towards equities for the time being:
- source Deutsche Bank

If indeed the pressure from "Mack the Knife" continues to build up, then obviously "de-risking" will be de rigueur, which should lead to additional significant outflows. So all in all not only we should be seeing additional capital outflows from EM under pressure but, in the financial sphere, if the trend is indeed your friend, there is further pain ahead in this "Great rotation" currently playing out. Furthermore, while there has been some additional pressure in the High Yield space seeing $3.8 billion of outflows, marking a third straight week of leakage for the asset class. A continuation of both a flattening of the yield curve and a surge in the US dollar will eventually start hurting credit and spreads could start widening at some point. As pointed out from a recent BIS paper entitled "The dollar, bank leverage and the deviation from covered interest parity" (H/T fellow blogger Nattering Naybob) we quoted recently on our tweeter feed:
"The highly significant coefficient on the US dollar index is -0.49, which implies that a one percentage point (aggregate) appreciation of the dollar is associated with a 49 basis point decline in the growth rate dollar-denominated cross-border bank lending. The estimated coefficient for lending to banks is even larger in absolute value (-0.61), implying that the decline is even stronger for interbank lending." - source BIS
In their long report the BIS indicated that a strengthening of US dollar has adverse impacts on bank balance sheets, which, in turn, reduces banks’ risk bearing capacity. An appreciation of the dollar entails a widening of the cross-currency basis and a contraction of bank lending in dollars. So all in all, our "exuberant" equities friend should be wary of outflows, the surge of "Mack the Knife" and a flattening of the yield curve, because in our book, once you've passed the critical threshold, there is more pain ahead with contraction of credit and consumption, if our murderous friend continues its rampage. If you forgot what a global credit crunch looks like, then you should be concerned by the devastation that can bring in very short order a US dollar shortage. 

When it comes to the aforementioned "risk bearing capacity for banks" think about rising hedging costs because as per the below chart from a Nomura note from the 17th of November entitled "Japanese investors' foreign bond buying (Oct 2016)", since late October, USD/JPY basis has been widening again. So, dear investors you can not only expect rising hedging costs going forward but a higher cost of capital, which entails credit spreads widening at some point:
"USD basis costs fell after the adoption of new MMF regulations in the US, but …
We attribute the rise in USD basis costs until early October to new MMF regulations, which were implemented on 14 October. The valuation method for prime MMFs (primarily investing in commercial paper issued by corporates) held by institutional investors was revised in such a way that these instruments could incur losses.
This likely prompted a shift from prime MMFs to government MMFs (which invest more than 99.5% of their funds in cash, government bonds, and government bond repos). This made Japanese banks USD funding via commercial paper more difficult. USD Libor also rose on expectations that USD funding would become tighter for Japanese banks, which led to a widening of USD/JPY basis.
Once the new regulations were implemented, the tightening of USD funding materialized, and USD/JPY basis began to narrow. Since late October, however, USD/JPY basis has been widening again. Moreover, USD Libor may rise if a Fed rate hike at the December FOMC meeting becomes more likely, which could translate into higher currency-hedging costs, in our view." - source Nomura
USD libor, dear friends, will rise if the Fed hikes in December FOMC meeting (100% certainty according to market pundits). This will accentuate even more currency-hedging costs. So what could be the consequences given Japanese Lifers and their investment friends have been large buyers in 2016 of foreign bonds, this could lead Japanese investors to look back into domestic issues or switch some of their appetite towards cheaper alternatives such as Euro denominated bonds longer than 10 years.

As a reminder from our July 2016 conversation "Eternal Sunshine of the Spotless Mind", Bondzilla the NIRP monster has been 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"." - source Macronomics, July 2016
Unfortunately for the "macro tourists" out there, playing the leveraged carry trade, if there is something that carry players hate most is bond volatility! It is therefore difficult for us to envisage some stability in the Emerging Markets space until US interest rates stabilize. We have yet to see some sort of stabilization.

Also, we believe that the most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line for stretched EM dollar denominated leveraged players. Right now, when it comes to the US, the latest Senior Loan Officer Opinion Surveys (SLOOs) point to some easing as of late as indicated by Bank of America Merrill Lynch in their HY Wire note of the 21st of November entitled "Don't be a hero":
"We use three main criteria to forecast HY default rates: the Senior Loan Officer Opinion Survey (SLOOS), credit migration rates, and real rates in the economy. When combined, these three inputs have an 85% correlation over the next 12 month trailing default rate at any given point in time. This makes sense because looser lending conditions, a higher proportion of upgrades, and lower real rates all make it easier for an issuer to secure funding and hence maintain balance sheet liquidity. For Loans we use a two factor model - rates don’t have a meaningful impact on the asset class, especially since they are floating in nature.

"Our HY model is most sensitive to the lending standards as reported by senior loan officers on a quarterly basis- a measure that has declined from a relative high of 11.6% in April of this year to 1.5% today (Chart 18). The survey reflects the ability of medium sized enterprises (annual sales greater than $50mn) to get funding from regional banks. Since HY issuers fit this criterion, this survey is also well correlated with their ability to tap the bank lending market. Another way to assess issuer access to funding is by tracking the proportion of risky companies that have been able to tap the HY capital markets on a trailing 12-month basis. While this too has a high predictive power of defaults (Chart 17), it doesn’t add enough incremental explanatory power to justify adding an additional variable. Further, the lead time of the risky issuance model is less consistent than the lending survey. Hence we choose to rely on SLOOS for the purpose of our model. Just like for bonds, SLOOS is a good indicator of the level of default rates for loans a year later. However, in the case of loans, the default rates are more sensitive to the asset class’s migration rates than the lending survey, quite the opposite of bonds.
Another interesting point to note about the SLOOS report is that it does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. On the other hand, it undershoots when defaults are driven by idiosyncratic events in individual sectors such as what we witnessed in the 2015 commodity bust. Our forecasted default rate for 2015 thus happened to be lower than the realized headline default rate but higher than the ex-commodity rate" - source Bank of America Merrill Lynch
The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years has ended.

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). With rising interest rate volatility, one would expect leveraged players, carry traders and tourists alike to start feeling nervous for 2017.

Also, rising rates can easily curtail the US consumer which would ultimately disappoint earnings growth and sales as the ability to use cheap funding wane with rising interest rates, meaning less potentially less buybacks regardless of the US repatriation factor vaunted by some pundits. This leads us to our final chart as in the end, for us Europeans, the US dollar might be their currency but our collective problem in 2017 we think.

  • Final chart - The dollar is their currency but our problem for 2017
The continuation of a surging US dollar and a flattening of the US yield curve could represent a significant headwind for 2017. This is as well indicated in the final chart we selected from Bank of America Merrill Lynch HY Wire note of the 21st of November entitled "Don't be a hero" displaying the USD appreciation versus YoY EBITDA growth (ex-Energy):
"Given the strengthening dollar, a fall in earnings growth and a pickup in treasury yields, we’re concerned that unless sales growth accelerates meaningfully in 2017, ex-Commodity fundamentals may disappoint relative to 2016. And although we were becoming emboldened by what appeared to be stronger revenue growth in Q3, as more companies report we are finding that unfortunately our optimism may have been misplaced; sales growth for Q3 now stands at just 3.7% whereas 11 days ago it was 8%." - source Bank of America Merrill Lynch
If optimism is somewhat misplaced, it could well be that our eternal equities optimists friends could be somewhat getting ahead of themselves in their "reflation" wishes. But that's another story as for now it's rally time in the equity world and we don't want to be the party spoilers for now.

"In politics stupidity is not a handicap." - Napoleon Bonaparte
Stay tuned!

Wednesday 16 November 2016

Macro and Credit - When Prophecy Fails

"Experience is the only prophecy of wise men. Alphonse de Lamartine," - French poet
Looking at the dislocation and violent bond market gyrations that followed our second "prescient" call (following our correct Brexit call) on Trump being elected in the US as indicated in our conversation "Empire Days" which by the way earned us two nice bottle of wines thanks to our friends being plagued by "Optimism bias", we decided to steer towards "behavioral psychology" for our chosen title analogy this time around by referencing the classic 1964 book of social psychologists Leon Festinger, Henry Riecken and Stanley Schachter where they deal with the psychological consequences of disconfirmed expectations. While we have already used "Cognitive dissonance" as a previous title, this book was very importance in the sense that it published the first cases of dissonance. The chief reason for us selecting the above title reside in the fact that not only did the US election was a case of disconfirmed expectations and of course "Optimism bias" but, the resulting wakening of "Bondzilla" the NIRP monster led to the reversing of Gibson paradox given the sudden rise in real yields that lead to not only a bloodbath in the bond space but also a vicious sell-off in both gold and gold miners, with silver not spared either. As a reminder about Gibson paradox from previous conversations: When real interest rates are below 2%, then you get bull market in gold, the reverse also works. There has never been an episode in history when Gibson's paradox failed to operate. Real interest rate is the most important macro factor for gold prices. Also the relationship between the gold price and TIPS (or “real”) yields is strong and consistent. Gold and TIPS both offer insurance against “unexpected” (big and discontinuous) jumps in inflation. The price of gold normally falls along with the price of TIPS (which means that TIPS yields rise). So to conclude, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates and the aforementioned "sucker punch" delivered in a very short order. So while many noses have been bloodied in recent days following Trump's victory, our contrarian and behavioral posture tells us we think the market might be trading way ahead of itself given the uncertainties relating to what the policies which will be implemented by the new US administration. When it comes to disconfirmed expectations and its inflationary bias as of late, we are still awaiting to see additional pressures coming from wages before we embrace the recovery mantra. Nonetheless we have been gradually de-risking our early 2016 barbell position significantly (long US long bonds / long gold miners) in favor of cash in US dollar terms waiting for the time being for the dust to settle and the fury to abate before dipping back our toes.

In this week's conversation we would like to revisit our July 2015 theme of "Mack the Knife", also known as the Greenback in conjunction with US real interest rates swinging in positive territory hence the pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation. Of course what is happening in the Emerging Markets space is of no surprise to us given we mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:
"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 
Wave number 1 - Financial crisis 
Wave number 2 - Sovereign crisis 
Wave number 3 - Currency crisis
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"
Real interest rate and US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple.

  • Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife
  • Final chart - People are trading on hope: Higher growth or higher inflation?

  • Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife
For us, Mack the Knife = King Dollar + positive real US interest rates. 

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013
The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2016 after the US elections in very short order) started once again the biological process of the buildup in the "Osmotic pressure" we discussed at the time:
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.
More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been China with the acceleration in capital outflows put forward by many pundits and displayed in the below chart from Bank of America Merrill Lynch from their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go":
"Asia: It’s complicated
We expect weaker Asian currencies vs USD. In addition to the higher US rates channel, Asia is very exposed to US trade protectionism and will rely on rate cuts, weaker currencies and domestic fiscal policies to offset those risks. We like short KRW and SGD vs USD, and we remain short CNH against a narrow CFET basket as outflows are expected to continue (Chart 2). A complicating feature will be the greater scrutiny on USDCNH and whether President elect Trump will come true on his election threat to charge 45% punitive tariffs on Chinese exports to the US." -source Bank of America Merrill Lynch
Nota bene: Hypertonic
"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia
As a reminder and what is playing out again is what we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs China). So, all in all, the likely Fed hike in December in conjunction with USD strength will once again result in additional capital outflows which are leading not surprisingly to textbook bigger CNY depreciation from China.

When CNY / USD depreciation expectations continue to rise or USD strengthens, you can expect once again more pressure on capital outflows if other macro factors remain relatively stable. Emerging Markets including China are in a hypertonic situation; therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield (ETF JNK and outflows) and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates) hence our propensity in this kind of situation to raise significantly cash levels in US dollar terms.

Our reverse osmosis process theory from a macro perspective can be ascertained by monitoring capital flows. On the subject of monitoring for the purpose of the exercise, we read with interest Nomura's latest Capital Flow Monitor from the 14th of November entitled "EM Pressure Index Update":

  • EM central banks (excluding China and the OPEC countries) continued to buy reserves in foreign currencies to the tune of $37.7bn in October vs. $12.0bn the prior month, led primarily by strong purchases from Hong Kong (around $25.3bn). This is the eighth consecutive month of net buying by these EM central banks. Of these 20 EM central banks, two sold reserves, nine bought, and nine did not intervene.
  • After adjusting for FX valuation and coupon payment effects, we estimate that China sold FX to the tune of $11.2bn in October, after having sold around $29.8bn in September.
  • EMFX pressure rose moderately: Our Global EM FX Pressure Index (excluding China and the OPEC countries) continues to deteriorate. The main contributors to the pick-up in pressure are the South Korea, Indonesia, Israel and Russia, in that order of significance. This was partly offset by lower FX pressure in the Philippines, Mexico (MXN appreciated significantly in October), and Brazil.
Global EM FX Pressure Index
The Global EM FX Pressure Index combines information on EM central bank reserve dynamics and EM FX price action.
EM FX price action is measured by the monthly percentage change in EM currencies against the USD. Reserve dynamics are measured by EM central bank intervention (in USDbn) scaled by the money base. EM central bank intervention is estimated to be based on changes in the level of FX reserves, adjusted for valuation effects. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
The methodology above is developed by the IMF
  • EMFI pressure rose in October: Our Global EM Fixed Income Pressure Index, which combines information on cross-border flows into EM local bonds and price action, indicates a significant increase in pressure. The absolute pressure level was high in October relative to history.
Global EM Fixed Income Pressure Index
The Global EM Fixed Income Pressure Index follows a similar methodology and combines information on cross-border flows into EM local currency bonds and EM local currency bond price action.
EM local currency bond price action is measured by the change in bond prices, computed based on the monthly change in 10yr sovereign yields and a 7yr duration assumption. Cross-border flows are acquired from various local sources; most of them are estimated based on changes in foreign holdings of local currency bonds. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
Estimates for the current month are made based on flow data from Mexico, India, Indonesia, Hungary, South Africa, and Turkey. A revision will be made (in the following month) once data from Colombia, Brazil, Malaysia, Korea, Russia, Poland, Israel, Thailand, and the Czech Republic are released.

Pressure on EM bonds rose in October
  • EMFI pressure rose: The index fell to -1.2% (a significant rise in pressure). As indicated in Figure 2, this level of pressure is low compared to historically.
  • Bond flow: EM local bond markets saw an estimated outflow of $4.3bn, compared with an inflow of $9.1bn of inflows in September and $2.0bn of inflows in August (based on a consistent sample of six countries that have reported for May: Mexico, India, Indonesia, Hungary, South Africa, and Turkey).
  • Price action: Of the 19 EM countries we track, two countries saw their sovereign yields fall, while 17 rose (Figure 9). Russia (+54bp) and Turkey (+33bp) saw their sovereign yields rise the most, while Brazil (-19bp) and India (-2bp) saw their yields fall the most. Yields in the advanced economies rose, with US 10yr yields up around 23bp, Japanese only up 4bp, and eurozone up an average of 35bp, led by Italian bonds.
- source Nomura

From our monitoring perspective and our interest in dwindling currency pegs with Egypt being the latest one to throw in the towel, given that we won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September 2015 conversation and with the additional points made in our conversation "Cinderella's golden carriage", we might have had once again our timing wrong in 2016 as far as the HKD is concerned. But, when it comes to dwindling currency pegs and with our own prophecy failing so far to materialize in 2016 we would like to remind you the trend for currency pegs so far. When it comes to our 2016 "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop if Mack the Knife continues his run unabated:
-source Société Générale

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been". We also note from Nomura's research piece that when it comes to intervention by country and capital flows, once again Hong Kong Monetary Authority (HKMA) had to step in significantly in October:
- source Nomura

What has been happening of course for Emerging Markets and yield hunters alike is that central bank's meddling with interest rates (ZIRP, QE, NIRP) drove traditional investors seeking mid-to-high single digit yields out of investment grade/ crossover credit into high yield, leveraged loans and emerging market debt to satisfy their yield appetite. The problem, however, is some of these "macro tourists" underappreciating exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle will eventually turn in earnest (not yet the case according to the latest US Senior Loan Officer Survey showing some easing as of late) annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range as we have seen earlier on in 2016 for the energy sector. Yet, it seems given the significant returns delivered in the second part of the year to the High Yield sector, that some of these "macro dimwits" have not learned their lesson, given that not only they have increased their credit exposure, but, they have also extended their duration exposure at the same time! Hence the on-going bloodbath. As a reminder, in the current low yield environment, both duration and convexity are higher; therefore price movements lower for bonds are larger.

In August 2013 in our conversation "Alive and Kicking" we argued the following:
For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":
"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 
However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 
Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson
It seems to us the central bank "deities" are in fact realizing the dangers of using too much "overmedication" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space and Emerging Markets bond funds alike. Even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in bond funds given that the Fed's role is supposedly one of "financial stability". We will not delve again into our views relating to positive correlations and large standard deviation moves as we have already tackled the subject in February in our conversation "The disappearance of MS München" conversation. We commented at the time that the fate of the attack of the Yuan and in effect the attack of the HKD peg could be analyzed through the lens of the Nash Equilibrium Concept:
"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfillingIf at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think.

When it comes to the much feared Mack the Knife and Asia, Bank of America Merrill Lynch in their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go" looks further into the dominating risk from a rising US dollar:

"Does dollar strength dominate everything?
The sharp reversal higher in risk assets following the Republican clean sweep has raised the question of whether reflation optimism (driven by the end of gridlock and expectations of US fiscal stimulus) could support Asia FX over the coming months. We are skeptical, at least vs the USD. As we have argued, the biggest implication of a Republican clean sweep is a stronger USD and higher US rates– this should lead to higher USD/Asia, even if trade-weighted FX performance remains more sensitive to risk.
US tax cuts – this time is different for Asia
Historically, large US tax cuts have been followed by a widening of the US current account deficit driven by higher imports (Chart 9).
This supported Asia export growth and exchange rates, especially during the Bush tax cuts of 2004 (Chart 10).

However, this time could be different, partly because the US household spending has been shifting towards non-tradable services. More importantly though, Trump’s policy platform itself is geared towards reducing dependence upon foreign goods and services.
Trade policy risks
While the prospect of draconian trade restrictions is still uncertain under a Trump Presidency, some risk premium is likely to be factored into Asia FX. There will be particular focus on the trade policy stance towards China. China is currently far from meeting the existing US Treasury criteria for currency manipulation, primarily because it has not engaged in RMB weakening intervention. It will be important to watch if the US Treasury amends these criteria under the new Administration. Another issue would be China’s expectations to be granted market economy status on 11 December 2016, fifteen years after its WTO accession, and the negotiations around this. A key risk is if China chooses to weaken its currency more quickly ahead of these events and the new Administration taking office." - source Bank of America Merrill Lynch
In the current context, from an allocation perspective, we are neutral on gold and silver until we see more stabilization in the move in real rates. While many have been jumping on the "equity" bandwagon, if indeed there is further weakening of the yen relative to the USD then again, the Japanese Nikkei should benefit so what is not to like in going long Nikkei hedged in either USD or Euro? Also, the strengthening of the HKD, should benefit Chinese shoppers and Japan from a "retail" perspective. This is already a subject we discussed in our conversation"Cinderella's golden carriage" in December 2015 as  tourists amounts to more than 12% of  Hong-Kong to GDP:
"So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again." -source Macronomics, December 2015
As we stated before, if Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think. While our "prophecy" failed in 2016, if the trend continues, who knows how long Hong Kong can hold the line.

When it comes to failing prophecies and high expectations, particularly of the inflationary type and the market trading ahead of itself our final chart below is highlighting once again the gap between equity investors (the eternal optimists) and fixed income investors (the eternal pessimists). 

  • Final chart - People are trading on hope: Higher growth or higher inflation?
While the Fixed Income crowd continues to be trounced by rising real rates and surging inflation expectations we do believe that the market is trading way ahead of itself and speculating already on what the new Trump administration will be able to deliver. The significant rise in interest rate volatility in conjunction with real rates means that not only fixed income in general and emerging markets in particular are getting slammed, but, it means once more that Gibson's paradox is at play at the moment hence our neutral stance for the time being and cautiousness. Our final chart from Deutsche Bank's Torsten Slok Chief International Economist and illustrates the different trajectories of volatility between rates markets and equities:
"Fixed income markets and equity markets are following completely different narratives after the election. Rates markets are focusing on higher inflation and what it means for rates across the curve, including the risk of the Fed falling behind the curve. Equity markets, on the other hand, are focusing on higher GDP growth, and equity markets don’t seem to worry about the risks of an overshoot of inflation and the Fed falling behind the curve. These different ways of looking at the election outcome have opened up a huge gap between rates volatility and equity volatility." - source Deutsche Bank
Indeed, mind the gap, because if volatility continues to surge in rates markets, we have a hard time believing it will not eventually spill-over to equities. We shall see if the inflationary prophecy materializes itself in the coming months. For the time being, like any good behavioral therapist, we'd rather focus on the process of a rising US dollar rather than on the prophetic content of the policies which will be followed by the new US administration.

"In the computer field, the moment of truth is a running program; all else is prophecy." -  Herbert Simon, American scientist
Stay tuned!

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