Saturday 28 January 2017

Macro and Credit - Two Generals' Problem

"It is impossible to suffer without making someone pay for it; every complaint already contains revenge." -  Friedrich Nietzsche
Watching with interest, the trade war narrative escalating thanks to the new US administration and reciprocal tweets between president elect Donald Trump and former Mexican president Vicente Fox relating to the Mexican wall to be erected, in true MMMA fashion (Macro Mixed Martial Arts) reminded us for our title analogy of the Two General's problem. The Two Generals Problem is a thought experiment meant to illustrate the pitfalls and design challenges of attempting to coordinate an action by communicating over an unreliable link. It applies to any type of two party communication where failures of communication are possible. The problem we chose as a title analogy highlights the importance of "Common knowledge", which we have used in the past as an analogy about potential outcomes for credit crisis. 

The Two General's problem is also known as the Two Generals Paradox, the Two Armies Problem or the Coordinated Attack Problem. We find of interest that it was the first computer communication problem to be proved to be unsolvable in the face of arbitrary communication failures, thus providing a base of realistic expectations for any distributed consistency protocols. In regards to realistic expectations, with the latest US GDP in Q4 rising only 1.9% and below the expected 2.2%, one could argue that given the heavier debt load which has been accumulated in recent years, some would be wise to review their growth expectations in the light of US growth being lower for longer but we ramble again. 

But, moving back to our analogy, the problem is as follows: Two armies, each led by a general, are preparing to attack a fortified city. The armies are encamped near the city, each in its own valley. A third valley separates the two hills, and the only way for the two generals to communicate is by sending messengers through the valley. Unfortunately, the valley is occupied by the city's defenders and there's a chance that any given messenger sent through the valley will be captured. While the two generals have agreed that they will attack, they haven't agreed upon a time for attack. It is required that the two generals have their armies attack the city at the same time in order to succeed, else the lone attacker army will die trying. They must thus communicate with each other to decide on a time to attack and to agree to attack at that time, and each general must know that the other general knows that they have agreed to the attack plan. Because acknowledgement of message receipt can be lost as easily as the original message, a potentially infinite series of messages are required to come to consensus. The thought experiment involves considering how they might go about coming to consensus. In its simplest form one general is known to be the leader, decides on the time of attack, and must communicate this time to the other general. The problem is to come up with algorithms that the generals can use, including sending messages and processing received messages, that can allow them to correctly conclude:
"Yes, we will both attack at the agreed-upon time."
Allowing that it is quite simple for the generals to come to an agreement on the time to attack (i.e. one successful message with a successful acknowledgement), the subtlety of the Two Generals' Problem is in the impossibility of designing algorithms for the generals to use to safely agree to the above statement. The first general may start by sending a message "Attack at 0900 on August 4." However, once dispatched, the first general has no idea whether or not the messenger got through. This uncertainty may lead the first general to hesitate to attack due to the risk of being the sole attacker. To be sure, the second general may send a confirmation back to the first:
"I received your message and will attack at 0900 on August 4." 
However, the messenger carrying the confirmation could face capture and the second general may hesitate, knowing that the first might hold back without the confirmation. Further confirmations may seem like a solution - let the first general send a second confirmation: 
"I received your confirmation of the planned attack at 0900 on August 4." 
However, this new messenger from the first general is liable to be captured too. Thus it quickly becomes evident that no matter how many rounds of confirmation are made, there is no way to guarantee the second requirement that each general be sure the other has agreed to the attack plan. Both generals will always be left wondering whether their last messenger got through. Since the protocol is deterministic, the general sending that last message will still decide to attack. We've now created a situation where the suggested protocol leads one general to attack and the other not to attack - contradicting the assumption that the protocol was a solution to the problem.

You are probably already asking yourself, where we are going with this analogy, but, it appears to us that the tweeting protocol of the new US president of the United States is not the solution to the trade problem of his country. On another note, while in our analogy and example a protocol is deterministic, regardless of the generals at the Fed, so is the credit cycle.

  • Macro and Credit - The credit cycle is deterministic
  • Final chart -  High Yield priced to perfection is not a good sign

  • Macro and Credit - The credit cycle is deterministic
While central bankers and in particular the Fed has been attempting in recent years to avoid pitfalls and failures to communicate appropriately their actions through a deterministic communication protocol, regardless of their numerous communication attempts, something still remains and it is the credit cycle. On numerous occasions we have looked back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube which we introduced in our conversation "The Night of the Yield Hunter":
- source Rcube

Although arguably, long government bonds appear to be a poor proposal at this very moment, particularly in Europe since the election of US president Donald Trump. There will come a point where US long bonds will get enticing again, particularly with such a consensus short base on the US 10 year Treasury Notes. What appears to us clearly "mis-priced" from our perspective is volatility. Risks are more and more asymmetric in 2017, therefore one should seek asymmetric payoffs in this context.

As shown by the latest US GDP in Q4 rising only 1.9%, if growth disappoints in Q1, as it did in 2016, the Fed has little ability to use a deterministic protocol, in a year where pundits are focusing more and more on inflation expectations. As we pointed out in our November conversation  "From Utopia to Dystopia and back":
"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." - source Macronomics, November 2016
In a market where both US High Yield and European High Yield are "priced to perfection", we will be very wary about what credit spreads will be doing in the coming weeks. To repeat ourselves, there is no doubt to us that we are moving towards the last inning of the credit cycle. On that subject we read with interest Nomura's take from their Japan Navigator note number 702 from the 23rd of December:
"Sharp JGB market sell-off is the first sign of a credit crisis
From the perspective of a 10-year credit cycle,  financial markets have entered a third-year period that represents the last stage of expansion, and thus are approaching a credit crisis (Figure 3).
We would view a sharp JGB sell-off as the first sign of the credit crisis, and believe that the JGB market entered the bearish cycle in mid-2016.
In the current 10-year cycle, we believe a credit crisis will stem either from China’s property market or the US corporates market. Both of these markets have inflated to alarming levels. The Fed became aware of the risk of an asset inflation bubble in the corporates market in 2013, exiting QE3 and implementing two hikes. Despite these efforts, the market continues to inflate on investor flows from the Euro area, Japan and China, where central banks remain ultra-easy (Figure 4).

That said, government bond markets began to sell off in summer 2016, which we view as their pricing-in of the ECB’s and BoJ’s hawkish shift, suggesting the excess liquidity-driven rally has entered its final stage.
What will follow the US’ protectionism and isolationism
In our opinion, the Trump administration’s potential failure in its protectionist strategy is the biggest downside risk for bond yields in 2017. We believe the new administration is unlikely to seek a diminished equilibrium via a weaker USD and higher tariffs, as included in President-elect Trump’s campaign pledge, but instead use these measures as bargaining chips to win concessions from others in expanding domestic demand and opening markets – in short, it will likely seek an expanded equilibrium.
However, if the Trump government fails in its attempt, it could actually implement these bargaining chip measures, thus exporting deflation to other economies, in our view. We would also be concerned about a scenario of another Brexit as a result of isolationism gradually taking hold in the Euro area. If this materializes, we would expect substantial risk aversion, but we see little risk of any such scenario at this point.
We view China’s higher inflation as not only a downside risk in the bond market, but also a factor that could lead to a global credit crisis. If China’s CPI inflation rise above 3% (which we consider an optimal level) in 2017, we would expect fairly aggressive PBoC tightening, which could lead to the bursting of China’s property market bubble. In this materializes, we believe the last stage of the global credit cycle would be brought forward.
Medium-term scenario
• We believe the bearish cycle that started from the US presidential election (Trump risk-on rally) will end its first stage in December-February. In March-May, markets will likely test room for flattening as: 1) concerns over an increase in US fiscal spending under the Trump administration subside; 2) the US criticizes other countries’ weak currency policies; 3) the likelihood of three Fed hikes by end-2017 is questioned; and 4) investors begin their FY17 investments. We believe yields marked just before the 20-21 September BoJ meeting (20yr yields of 0.45%) will serve as a resistance point.
• We expect the Trump risk-on rally to enter its second stage before summer 2017 due to concerns over: 1) the US prompting other countries to increase fiscal spending; and 2) global higher inflation stemming from China. The BoJ could adopt an even more flexible approach to its quantitative target, or could abolish it in April-July 2017. As concerns over BoJ tightening increase, we believe 5yr, 10yr and 20yr yields could rise to positive levels, exceed 0.10% and rise to 0.80%." - source Nomura
In recent musings we pointed out that tightening financial conditions were already showing up in the US in Commercial Real Estate (CRE). This is a segment we will be particularly monitoring in conjunction with its synthetic CMBS proxy the CDS CMBX index and in particular series 6 which comprises the highest retail exposure with 37%.

Furthermore, if indeed we are moving towards somewhat a repeat of 2016, namely "risk-off" and a US Q1 GDP print at 1%, then obviously, it makes sense to put our contrarian boots on again we think. From a USD/JPY perspective, what has been driving the currency pair as of late has been the beloved "Mack the Knife" aka King Dollar + positive real US interest rates. On the subject of USD volatilities, we read with interest Bank of America Merrill Lynch's note from the 19th of January from their FX Vol Trader series entitled "USD vols are relatively overvalued":
"Enamoured by Trump
Since Trump was elected, markets have focused almost exclusively on the US. As an example, USDJPY has recently been driven almost entirely by US rates rather than the Japan story of easing and reform (Chart 1).

This has resulted in USD vols trading at a significant premium to non-USD pairs. In the case of EURJPY vs USDJPY vols, the former is now trading at the cheapest levels relative to the latter in the past decade (Chart 2).

While we see the possibility of the USD continuing to rally, we do see this dislocation in vols as an opportunity to fade the spread.
Vols mostly underperforming
Despite the recent USD correction, vols in general are underperforming on both a high and low frequency basis. Curve flatteners seem the optimal way to position for vol consolidation, given steep curves, while being hedged against event and headline risk of short-term volatility spikes." - source Bank of America Merrill Lynch
While the Japanese story has not been in the driving seat of the recent price action for the USD/JPY currency pair, we think it is important, not only to track as we have indicated the foreign investments from Japan's GPIF, Lifers and Mrs Watanabe to determine the outcome for government bond yields in the coming months, but, there are as well some implications from Japan's Current Account surplus as highlighted by Deutsche Bank in their recent Japan FX Insights note from the 13th of January entitled "Implications of Japan's C/A surplus":
"No need to regard Japan's C/A surplus as yen-bullish when US economy is expanding
Japan's current account (C/A) surplus has held at around an annualized ¥20trn. With recent yen weakness, there is a possibility of the trade balance and international tourism balance, compounded by a further rise in UST yields, contributing to an increase in the primary income surplus. However, we do not necessarily agree with the view that this will soon result in yen appreciation. C/A-related flows are a relatively small part of overall FX flow, so we do not expect this to be a dominant factor for the medium term JPY movements.
In the past, the USD/JPY has often tended to strengthen in phases when imbalance between the US-Japan C/A balances has expanded.

The US trade deficit has been prone to expand due to higher imports when US domestic demand outperforms major trading partners on the back of a booming economy. However, the robust US economy supported a rise in rates and asset prices, which energized fund inflows to the US and pushed up the USD.
Cyclically, it has been observed C/A cycle leading the USD/JPY by 1.5 years. Rather than supply-demand causal relationship, however, this can be explained by the cyclical phenomenon that the C/A balance changes with reflecting the economic cycle while the USD/JPY moves in line with the economic cycle with 1.5 years lag. So, we think the key focus should be the economic cycle.

We have maintained that the most important factor in the direction of the USD/JPY in this phase has been the strength of the US economy. The USD/JPY fell from above 120 toward 100 when the US economy slowed early in 2016, despite the BoJ using a negative rate policy to encourage the yen lower. In this process, no small number of market participants attributed the stronger yen to an expansion of Japan's C/A surplus.
However, the yen's weakening under the Trump market was not the result of the Japanese C/A balance falling into deficit. No critical turning point for USD/JPY can readily be grasped if the theory that "yen appreciation is due to a C/A surplus" (which may appear correct at first glance) is taken at face value. It is clear that the Trump market is the result of cyclical expectations of higher rates and a reacceleration of the US economy driven by aggressive fiscal measures.
Comprehensive forex supply/demand analysis incorporating factors such as trade balance, C/A balance, and investors' foreign securities investment trends is also often seen as a means of determining the yen exchange rate, but this is likely virtually useless in grasping market dynamism. This only reveals the degree of pressure that can gradually emerge when the market is in a lull. As seen in developments after Trump won the presidential election, market moves dramatically alter the composition of supply/demand." - source Deutsche Bank
So if indeed, the consensus for stronger growth is wrong again when it comes to the US 1st quarter GDP and we do get a repeat somewhat of 2016, then obviously, it seems to us that we could see a spike in FX volatility and somewhat renewed pressure on the USD/JPY currency pair and a potential strengthening of the Japanese yen versus the US dollar in short order. 

Although the consensus trade is still being long the US dollar, when looking at the credit cycle, we think we do sit an important fault line when it comes to real yields and inflation expectations. This could also have implications for the long USD crowd and our recent positive stance on gold miners. On that specific point we read Nomura's most recent Japan Navigator note number 705 from the 23rd of January:
"Inflation expectations continue to rise even without large stimulus spending
Next week, a 40yr JGB auction will be held, and trade and CPI data will be released. Expectations for the US substantially increasing fiscal spending under the Trump administration have apparently faded, and concerns over Fed hikes have fallen. Despite this, risk-on momentum remains in place and inflation expectations continue to rise
(Figure 1).

We attribute this to the strength of macro data in the US and China, and Treasury Secretary designate Steven Mnuchin’s comments aimed at easing concerns over a weak-USD policy under the Trump administration. Chair Yellen does not seem to be laying the foundation for a March hike but has been suggesting that the decision will be data dependent.
The UST market rallied on short covering, but stopped rising after regaining only one third of the ground lost since the US presidential election, which suggests investors expect the bearish cycle to continue. We believe risks in the UST market are skewed towards the downside until the January jobs data are released (early February) and Chair Yellen testifies before congress (mid-February).
In the yen rates market, while JGBis are slow to rise due to concerns over the 7 February supply, nominal JGB yields are likely to rise and the curve is likely to steepen on improved growth expectations and higher inflation expectations (Figure 1), in our view.
Super-long JGB rates are approaching levels just before the BOJ intervened with an increase in its purchases of super-long JGBs on 13 December (20yr rates of 0.65%). However, we believe investors may well not buy by assuming a support at this level, as the bank reduced its purchases of these bonds to previous levels only 10 business days after. We believe the BOJ is unlikely to target super-long JGBs at these levels, but intervened just because the curve steepened too sharply.
Assuming the short and intermediate tenors of the JGB market stabilizes and yields rise in a consistent manner, we believe the BOJ would intervene at yields higher than the market assumes (20yr rates of 0.8% or higher and 40yr rates of 1.0% or higher, seen before the excessive flattening in March 2016). 
Reasons why USD should strengthen under Trumponomics
Weak USD in the first stage of the credit cycle, strong USD in the last stage half
In this section, we look at the relationship between the credit cycle and US government policies.
In the early stage of the credit cycle, monetary policy tends to be accommodative and USD to weaken (Figure 2).

This is because inflation tends to head lower in that period due to a carry-over from the recession. In contrast, in the last stage of the credit cycle, Fed policy tends to be tightened and USD tends to strengthen.
However, we see little relationship between US fiscal policy and the credit cycle. A new administration’s stance on fiscal policy tends to be a reversal of its predecessor’s. In addition to political reasons (i.e., refuting the previous administration’s policy), the new government tends to face constraints in terms of the fiscal and current account balances.
The US may seek to increase fiscal spending, tighten monetary policy and strengthen USD under Trumponomics
Assessing Trumponomics in terms of the credit cycle, we note: 1) the new administration takes office in the last stage of the credit cycle; and 2) Former President Obama took fiscal austerity measures. The first point suggests USD would strengthen and the second point makes an increase in fiscal spending likely under the Trump administration.
However, the unemployment rate and other indicators show that the US economy is beginning to face supply-side constraints, and Fed policymakers and others say larger stimulus spending is unnecessary. Despite this, we believe the new administration will substantially increase fiscal spending as President Trump intends, at least in the first one to two years, because; 1) he won the election by calling for the need to stimulate growth, primarily via increased fiscal spending; 2) Republicans control the presidency and both houses; and 3) the fiscal and current account deficit look fairly small, leaving room for a further deterioration (Figure 3).

Reasons why USD remains supported even though the current account deficit increases
As the US currently faces supply-side constraints, an increase in demand brought about by tax cuts and infrastructure investments would likely translate into increased imports, and – contrary to President Trump’s intention – an increase in trade and current account deficits, which may weaken USD. 
However, USD historically begins to weaken several years after the current account balance begins to deteriorate (Figure 3).

This is because the current account balance tends to deteriorate in the last stage of the credit cycle, when tighter monetary policy, higher UST rates (i.e., relative to other government bond yields) and higher US domestic growth (relative to other economies) prompt higher investments into the US.
There is also a lag of about one year between the reversals in the movement of the UST-JGB yield differential and USD/JPY (Figure 4).

As the UST-JGB yield differential is still widening, we believe USD/JPY is unlikely to begin falling in the near term.
Judging by their comments, we believe President Trump and Treasury Secretary nominee Mnuchin will not look to improve US exporters’ competitiveness via macroeconomic policies (e.g., by guiding USD weaker, as seen in President Reagan’s second term and President Clinton’s first term). We believe the Trump administration is likely to use a weaker USD and higher tariffs merely as bargaining chips to win concessions from others. Instead, the new US administration will look to prompt its trading partners (governments, corporates) to increase investment into the US.
Higher investment into the US may lead to higher production in the US and an increase in US exports to others, but USD would likely remain supported while capital continues to flow into the US." - source Nomura
Interestingly, we agree with Nomura that, in the last stage of the credit cycle, Fed policy tends to be tightened and USD tends to strengthen. This overall has clearly had an impact on global financial conditions. But, if indeed the current account balance in the US deteriorates, then the US dollar should weaken as it generally happens in the late stage of a 10 year credit cycle, hence our contrarian stance versus the bullish US dollar crowd. The credit cycle is therefore deterministic we think.

So, overall, you might garner from the above our defensive stance and our "risk-off" feeling but, one thing that do makes us feel nervous is indeed the overall complacency in high yield where it seems as per our final chart, that the market is nearly priced to perfection.

  • Final chart -  High Yield priced to perfection is not a good sign
Since the beginning of the year credit has continued to perform and in particular High Yield. As we indicated earlier on in our conversation, the second half rally of 2016 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. Right now, we think that "Dystopia" has been replaced by "Euphoria" and the current levels reached by high yield, make us think that indeed, the risk/reward for the asset class appears to us particularly poor following a very good 2016. Our final chart comes from Société Générale's Credit Strategy Weekly note from the 20th of January and entitled "It's starting to get trickier". It displays how pricey High Yield relative to Investment Grade (IG):
"We're even more worried about High Yield
In the editorial of last week’s Credit Weekly, we argued that European high yield markets were too ebullient. Clearly, market participants disagree. This week in Europe, government bond yields rose to within a whisker of their December peaks (at 40bp on the Bund), equity markets corrected (slightly) lower, but European high yield spreads continued to tighten. While IG spreads in Europe were broadly unchanged, high yield spreads tightened another 5bp.
Note that the recent moves have brought the relationship between IG and HY markets in Europe to very rare levels. Chart 1 shows the spread ratio (HY/IG) and the spread differential (HY-IG) since the financial crisis. We have smoothed the data to reduce the impact of monthly rebalancing. Note that the spread ratio is closing in on the lowest levels since 2012, while the spread differential is at the lowest levels since the mid-2008 widening. High yield is very expensive indeed.
Beta, not supply, has driven the markets tighter this year. The risk here is that the mood may well sour. Indeed, we think it will, given the shakier tone in other markets and the political risks in evidence this week with Theresa May’s Brexit speech and ahead of the French leftwing primaries. We still recommend reducing risk in portfolios despite the rally seen in the year to date." - source Société Générale
While in recent years the "printing protocol" and "wealth effect" of various central banks has been seen as a solution to a global debt problem, it appears to us, in contradiction to their assumption, when it comes to GDP growth, the protocol they have used was clearly not the solution to the problem but we ramble again with our unsolvable Two Generals' Problem.

"An ignorance of means may minister to greatness, but an ignorance of aims make it impossible to be great at all." - Elizabeth Barrett Browning, English poet

Stay tuned !

Saturday 21 January 2017

Macro and Credit - The Ultimatum game

"Never accept ultimatums, conventional wisdom, or absolutes." -  Christopher Reeve, American actor
Looking at the United Kingdom under the guidance of Prime Minister Theresa May moving towards "hard BREXIT", we decided this time around, when it comes to selecting our title analogy to go for the "Ultimatum game", which is a game in economic experiments. In this game, the first player (the proposer) receives a sum of money and proposes how to divide the sum between the proposer and the other player. The second player (the responder) chooses to either accept or reject this proposal. If the second player accepts, the money is split according to the proposal. If the second player rejects, neither player receives any money. The game is typically played only once so that reciprocation is not an issue.  Given our fondness for behavioral economic and psychological accounts, our title analogy and the aforementioned experiment suggest that second players who reject offers less than 50% of the amount at stake do so for one of two reasons. An altruistic punishment account suggests that rejections occur out of altruism: people reject unfair offers to teach the first player a lesson and thereby reduce the likelihood that the player will make an unfair offer in the future. Thus, rejections are made to benefit the second player in the future, or other people in the future. By contrast, a self-control account suggests that rejections constitute a failure to inhibit a desire to punish the first player for making an unfair offer. The ultimatum game is important from a sociological perspective, because it illustrates the human unwillingness to accept injustice. The tendency to refuse small offers may also be seen as relevant to the concept of honour. The extent to which people are willing to tolerate different distributions of the reward from "cooperative" ventures results in inequality that is, measurably, exponential across the strata of management within large corporations. Some see the implications of the ultimatum game as profoundly relevant to the relationship between society and the free market, with Prof. P.J. Hill, (Wheaton College, Illinois) saying:
"I see the [ultimatum] game as simply providing counter evidence to the general presumption that participation in a market economy (capitalism) makes a person more selfish."
Given the rise in inequality in conjunction with populism, there is a rising drift between the have and the have not, which is leading for some politicians to somewhat embrace or envisage rebalancing Wall Street towards Main Street in order to avoid capitalism's own demise. As of late we find of interest that, as we posited in our previous musing, the cozy relationship between politicians and central bankers is waning as illustrated by rising criticism coming out from German leaders and directed towards the ECB. But, moving back to "Brexit" and the "Ultimatum game" currently being set in motion, as we posited in our conversation "Optimism bias" from June 2016 from a game theory perspective we indicated at the time:
"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016
While having correctly guessed in 2016 both Brexit and the US election (which earned us some nice bottles of wine from "optimistic" friends), given the English common law system is UK's best export (Singapore, Hong Kong, etc.) as well as its best business friendly feature, we do think that the United Kingdom benefit from first mover's advantage to that respect. Why so?

"Common law as a foundation for commercial economies
The reliance on judicial opinion is a strength of common law systems, and is a significant contributor to the robust commercial systems in the United Kingdom and United States. Because there is reasonably precise guidance on almost every issue, parties (especially commercial parties) can predict whether a proposed course of action is likely to be lawful or unlawful, and have some assurance of consistency. As Justice Brandeis famously expressed it, "in most matters it is more important that the applicable rule of law be settled than that it be settled right." This ability to predict gives more freedom to come close to the boundaries of the law. For example, many commercial contracts are more economically efficient, and create greater wealth, because the parties know ahead of time that the proposed arrangement, though perhaps close to the line, is almost certainly legal. Newspapers, taxpayer-funded entities with some religious affiliation, and political parties can obtain fairly clear guidance on the boundaries within which their freedom of expression rights apply." - source Wikipedia
 "Assurance of consistency" - try to have this in France. It is totally the opposite. As per our previous conversation: 
"The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them." - source Macronomics, January 2017
Hence our long term more favorable view for the United Kingdom and the Common Law premia that needs to be taken into account when it comes to assessing the prospect for the country and its currency we think. 

Furthermore, the Ultimatum game is clearly being played out by president elected Donald Trump with US corporations in his quest to "make America great again". Again, the ultimatum game is profoundly relevant to the relationship between society and the free market economy. As we posited in our conversation "The Great Wall of China hoax", global rise in populism, came hand in hand with lowering the living standards of the average American, and hearing the inaugural speech from president elected Trump on the 20 of January makes it clear to us, that this will have a significant impact on allocations as the Ultimatum game will be starting in earnest:
Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response": 
"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith 
So you already might be asking yourself where we are going with all this, well, we have long argued the following as per our conversation "The Grapes of Wrath" back in October 2016:
"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.
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. Also 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.
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"." - source Macronomics, October 2016.
While the inaugural speech of the newly elected President Trump did focus on bringing jobs back to America and making America first, on that subject we read with great interest our former esteemed colleague David Goldman's take in his latest column published in Asia Times entitled "Donald Trump, American hero" and his take on "productivity":
"The problem is how to protect Americans. The global supply chain is so closely integrated that it is hard to discourage some imports without doing real damage to American industries. The border tax proposed by House Republicans would prevent corporations from deducting imported inputs as costs for tax purposes. For industries like oil refining, that would create enormous distortions, while providing windfalls elsewhere. My own preference would be to use selected tariffs for products that benefit from government subsidies overseas, which is entirely permissible under World Trade Organization rules.
Ultimately, no government can protect American workers unless productivity growth resumes. American productivity growth has fallen to zero for the first time since the stagflation of the 1970s. Without productivity growth, American living standards will fall, irrespective of whether the government pursues protection or free trade. I have argued elsewhere in this publication that reviving military and aerospace R&D is the key to productivity growth." - source David Goldman, Asia Times,  20th of January 2017
There lies the crux of the problem, to make "America great" again, you need CAPEX growth and more importantly, "productivity" growth.

In this week's conversation, we will look at jobs, wages and the difference between Japan and the United States, in relation to the "reflation" story or "Trumpflation".

  • Macro and Credit - The wage / productivity paradox
  • Final chart - International trade and Nash equilibrium

  • Macro and Credit - The wage / productivity paradox
While we recently used Japan as a base case when assessing the negative impact low rates have had on real estate assets, leading some becoming nonperforming in our recent conversation  "The Great Wall of China hoax", what has been plaguing Japan since they have reached effectively full employment is indeed the outlook for wages. Without wage rising, there is no way Japan can truly break its deflationary spiral and the Bank of Japan create sufficient inflation. This is clearly indicative of the malaise of the Japanese economy. On that subject we read with interest Nomura's take in their Japan Economic Weekly note from the 13th of January 2017 entitled "Outlook for wage rises remains bleak":
"Employers and employees deaf to government's calls for wage rises
No sign of a pickup in the rate of wage rises from New Year events
Prime Minister Shinzo Abe has taken the opportunity provided by New Year events such as those organized by Japan's economic associations to reiterate his calls for companies to raise wages. However, we see no sign from the response of either employers (and their associations) or employees (and their trade union representatives) of any pickup in the rate of wage rises at this year's spring wage negotiations. Any discussion of what is happening to the Japanese economy, inflation, or market factors such as interest rates will have to assume for the time being that there will be no marked increase in wage rises.
Deep-seated reluctance of employers to increase fixed costs
While Japanese business leaders share Abe's positive attitude towards wage rises in general terms, they appear to be slightly less enthusiastic when it comes to putting this into practice. A good example of this is the frequent inclusion by Sadayuki Sakakibara, Keidanren chairman, of the provisos "companies that enjoyed earnings growth last year" and "on an annual pay basis" when expressing his desire for wage rises. We see this as reflecting a deep-seated reluctance by business leaders to increase fixed costs. With companies facing increasing uncertainty, they may well be more reluctant to increase the base pay of their regular employees as this would amount to an increase in fixed costs.
The unions are also cautious about demanding wage rises
A certain reluctance of some trade unions to demand wage rises also appears to be an impediment to a pickup in the rate of wage rises. We think that the cautious attitude of the trade unions probably reflects the less optimistic view that companies now have of their growth prospects as well as the increasing uncertainty they face and that workers and their trade union representatives may tacitly prefer the stability of a job for life to a bigger increase in base pay (see our 21 October 2016 Global Research report Why is wage inflation so low despite a shortage of labor? - The ''base pay wall'' facing the Japanese economy).
Limits to how far working practices can be reformed without freeing up the market for regular employees
In view of the attitude of employers and employees, the only way to overcome obstacles to speeding up the rate of wage rises would be to free up the market for regular employees to make the cost of employing full-time employees a variable cost. Similarly, safety nets such as vocational training and greater provision of unemployment benefits would be needed to overcome the concerns of workers and trade unions about freeing up the labor market for full-time employees. It seems that, as freeing up the market for full-time employees touches on the system of lifetime employment that forms the cornerstone of Japanese employment and working practices, it is off limits for those seeking to reform working practices such as the present government." - source Nomura
Indeed, the cornerstone of the Japanese employment system has long been lifetime employment and a clear impediment in freeing up the market. There is no way the Bank of Japan on its own can fill its inflation mandate without the government stepping in and playing out the "Ultimatum game" with Japanese business leaders. When it comes to the "Ultimatum game" and reflationary policies in the United States, we think that the recent raft of corporations folding under the pressure exercised by Donald Trump is clearly a sign that the new US administration is clearly being serious on its willingness to focus on America and Americans. Obviously this will have significant implications in terms of allocations. Put it simply as displayed by our friend Cyril Castelli from Rcube, rising wage pressures imply lower profit margins:
- source Rcube

End of the day, earnings revisions matter, as they are according to our friend, the best leading indicator for expected cash flows momentum. Negative earnings revisions always imply weakening cash flows and inversely. Also, "Mack the Knife" aka King Dollar + positive real US interest rates is tightening financial conditions globally. Cheap dollar funding has been exported to many Corporate Emerging Markets as highlighted in recent studies completed by the Bank for International Settlements (BIS). 

When it comes to Japan, clearly as indicated by Nomura, the Japanese wage paradox is weighing heavily on inflation, when the country is getting close to full employment (which is not the case in the US regardless of the much vaunted 4.7% unemployment rate put forward by the Fed).  Japan has been a productivity laggard for many years. Japan's labor market is a two-tiered market. There is one group of Japanese workers, called "seishain" which has retained its privileged, old-style jobs comprising job security, benefits and regular raises while the other group is made up of low-security, low-pay, low-benefit, dead-end jobs. These individuals have very little chance of ever jumping up to the "seishain" track. In similar fashion, if someone digs deep into the BLS, one can argue that the US employment market has been facing similar issues since the Great Financial Crisis (GFC). 
On the Japanese conundrum, we read with interest Bank of America Merrill Lynch's take from their Japanese Economics Viewpoint note from the 19th of January entitled "Jobs, wages and the BoJ":
"The biggest medium-term macro surprise?
We believe that the re-acceleration of wage growth could provide one of the biggest macro surprises for Japan in 2017. Investors appear to be increasingly coming around to our view that the Japanese economy is due for a solid, 1.5% pick-up in 2017, up from 1.0% in 2016. However, skepticism around the potential for higher wage growth—the key to Japan’s reflation efforts—runs deep.
Tackling Japan’s wage paradox
The doubts may be warranted, given that wage growth has remained stagnant over the past few years despite the unemployment rate plunging post-bubble lows and business surveys pointing to record tightness in the labor markets. We think the relative weakness of the wage indicators reflects both cyclical and structural factors. On the demand side, the slowdown in the economic recovery after the 2014 tax hike reduced wage pressures. On the supply side, the reserve of lower-paid, part-time and “non-regular” workers meant that there was still some “invisible” slack in the labor sector.
Approaching full employment
However, 2017 could mark an important inflection point as both demand-side and supply-side factors drive the economy towards full employment. We forecast the unemployment rate to drop to 2.9% by the end of 2017, and 2.7% by the end of 2018, from 3.1% today. There is already evidence that remaining labor market slack is quickly diminishing. Moreover, demographic headwinds will begin blowing much harder in the coming years, resulting in tighter labor supply.
Wages growth to double in FY17, reach 2% in FY18 
The FY2017 Shunto spring wage negotiations are unlikely to result in significant base pay increases. But we still see the combination of tight labor supply and stronger demand lifting nominal per worker wages to around 1.4% in FY2017, and close to 2% in FY2018, up from the 0-0.5% pace of the past three years. Adjusting for job growth, we see nominal employee compensation holding steady between 2-2.5% and real employee compensation of around 1.2% over the next two years. This should support consumption.

But patient BoJ to keep rates on hold
Our optimism on the outlook for labor markets and wage growth underpins our above consensus inflation forecasts. We see Japan-style core inflation rising 1.2% in FY17 (0.9% on a CY basis), and 1.5% in FY18 (1.4% on a CY basis). If our forecasts are correct, the risks of early BoJ policy normalization, including rate hikes, may become an important theme in the markets in the second half of this year.
However, we remain of the view that the timing of BoJ “lift-off” remains far away and that the central bank will keep its rates targets under its Yield Curve Control (YCC) framework unchanged through FY2018. Running a “high pressure” economy is the best shot the BoJ has at re-anchoring inflation expectations and reducing future deflation risks." - source Bank of America Merrill Lynch
Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years.

As put forward by Bank of America Merrill Lynch's note, there is a disconnect between job growth and wages in Japan:
"Disconnect between job growth and wages
Investors are often perplexed by the disconnect between Japan’s headline wage data and the relative strength of its labor market indicators. As of November 2016, Japan’s unemployment rate stood at 3.1%, down from 4.1% at the beginning of the Abenomics recovery phase (November 2012). Meanwhile, the job-offers-to applicant ratio has been climbing steadily, reaching the highest level since 1991 (Chart 2). 

Various business surveys also point to record labor market tightness. The employment conditions indices in the Bank of Japan Tankan reflect deep labor shortages, especially among non-manufacturing SMEs (Chart 3).
Despite robust job growth, total cash earnings data in the Ministry of Health, Labour and Welfare’s Monthly Labour Statistics (MLS) have been disappointingly weak. This measure, which tracks nominal wages on a per worker basis—picked up in the initial phase of the Abenomics recovery but has recently weakened and is stuck at around 0.4%, while hourly wage growth is tracking around 1% (Chart 4).

Digging into wage growth by component, the slowdown in 2015-16 was in part due to a collapse in bonuses (which is linked closely with corporate profits) (Chart 5).
But more importantly, the combination of aggressive fiscal tightening, coupled with a downturn in the global export cycle caused Japan’s economic recovery to stall, reducing cyclical wage pressures.
That being said, structural factors may be in play as well. Over the years, wage growth— in both per worker and per hour terms--has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

Part of this reflects a trend rise in lower paid, “non-regular” workers, which include various forms of part-time and temporary employment (Chart 8).

The main split in Japan’s dual labor market is defined by job status. “Regular” workers generally work full time, are directly hired by the employer, and receive bonuses along with a wide range of employee benefits.1 While regular workers enjoy an upward sloping wage curve, reflecting regular, seniority-based pay promotions, the wage curve for non-regular workers is virtually flat, resulting in a huge pay gap—average lifetime income for non-regular workers is about 60% of “regular” workers’ levels (Chart 9).
Please note that due to differences in classification of workers between the MHLW Monthly Labor Statistics and the Ministry of Internal Affairs’ (MIA) monthly Labor Force Survey (which does not cover wage data), from here on out we focus on employment and wage developments of part-time workers, which are a decent proxy for the broader “non-regular” category.
Based on MLS data, the part-time employment doubled from around 15% in March 1990 to about 30% today (Chart 8). The good news is that the pace of increase in the part-timers’ employment share has been slowing, with the rise limited to a relatively modest 1.6ppt between Q3 CY2012 and Q3 CY2016. But even such a small drag represents a powerful drag on headline per worker wages since part-timers receive lower pay and work fewer hours by definition (Chart 10).

On average, the continued shift towards part-time employment has subtracted about 0.5ppt from growth in total cash earnings per worker (Chart 11).
Had the part-time share stayed neutral, per worker wages would be tracking closer to 0.8%YoY—about double the headline figure.
Reasons for optimism
The popular view in Japan seems to be that the Phillips curve is dead and that the weakness in wage growth will remain entrenched. There is also a strong belief that the secular shift in non-regular/part-time employment is unlikely to be reversed any time soon, keeping wage pressures contained. We disagree, and believe that growth in total cash earnings per worker will pick-up from around 0.5% in FY16, to around 1.4% in FY17, before rising to around 2% in FY18." - source Bank of America Merrill Lynch
The reason we have to disagree with Bank of America Merrill Lynch and their reason for optimism comes from our discussion from June 2013 in our post "Lucas critique":
"Robert Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:
"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.
For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia
So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  
In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia
In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.
The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia 
As we posited at the time, when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it on Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion.

On this occasion, we think's Bank of America Merrill Lynch's optimism is indeed leaning towards naivety because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property. As per our conversation "The Great Wall of China hoax" like in Japan, at some point low-yield assets such as real estate become nonperforming.

Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":
"He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.
“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg
So if the "old" like in Japan still predominates the economy, we have a hard time believing the Bank of Japan will be able to control economic outcomes and it appears clear to us that their monetary policies have truly become ineffective.

In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that mattes in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again.

Finally for our final point and given our chosen title, we would like to look at a simplistic international game.

  • Final chart - International trade and Nash equilibrium
Given we started our conversation mentioning a game relating mostly to BREXIT, we thought we would end this conversation by looking at the known unknown of what the new US Trump administration stance will be when it comes to international trade. To that effect, our final chart or diagram, comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 20th of January and entitled "The times they are changin' "and looks at international trade from a game theory perspective:
"International Trade game
Consider the following simplistic game of International Trade. Suppose there are two countries that can each choose between the two policies “Free Trade” and “Protectionism”. Because international trade in most circumstances boosts global growth it follows that protectionism is growth negative. Put differently, while in isolation a country can boost economic growth by playing the “Protectionism” card, the associated costs to the other country outweigh these gains. There are four possible outcomes (Figure 2). 

One equilibrium is that both countries agree to play “Free trade” (NW corner of figure), where we say that both have GDP of 10 (arbitrary units). Suppose now that Country 1 unilaterally plays “Protectionism”, in which case the outcome in the short term is the SW corner of the chart where this country boosts GDP by 2 to 12 at the expense of Country 2 that sees a 3 decline in GDP to 7. Note that world GDP declined by 1 as protectionism is distortive and thus creates inefficiencies.
However, the SW corner is not a sustainable equilibrium as Country 2 stands to benefit from playing the “Protection” card as well – i.e., retaliate – as they can increase GDP by 2 at the expense of country 1. That moves us to the SE corner – the “Trade Warfare” outcome - where each country has GDP of 9, a loss of 1 from the “Free Trade” equilibrium. Hence there are only two sustainable equilibria in this international trade game – “Free trade” in the NW corner, if both countries agree and commit, or trade warfare in the SE corner if they do not.
What this means is that the new administration’s intentions to restrict international trade are almost certainly negative for US economic growth in the longer run. Of course what prompted the coming US pushback against imports is that, even though trade boosts the economy, there are winners and losers. Thus we are unable to say unambiguously that the country is better off in utility terms just because that is the case in dollar terms." - source Bank of America Merrill Lynch
If the second country rejects protectionism, like in our case of the Ultimatum game, then neither countries receives any money, and this dear friends means to us lower global trade which is indeed bullish gold, in the end (hence our  recent positive stance), but we ramble again...

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Stay tuned!

Friday 13 January 2017

Macro and Credit - The Woozle effect

"When everyone is thinking the same, no one is thinking." - John Wooden, American basketball player and coach
Watching with interest more fake news such as more stories surrounding evidence by citations of Russian involvement in US elections and fake prices, leading to some violent market gyrations as in Bitcoin, given our last musing around the thematic of hoaxes, we decided that for this week's title analogy, we would stick with the theme. The Woozle effect, also known as evidence by citation, or a woozle, occurs when frequent citation of previous publications that lack evidence misleads individuals, groups and the public into thinking or believing there is evidence, and nonfacts become urban myths and factoids. More importantly, "The Woozle effect" describes a pattern of bias seen within social sciences and which is identified as leading to multiple errors in individual and public perception, academia, policy making and government and markets as well (herd mentality). A woozle is also a claim made about research which is not supported by original findings. Given the creation of woozles is often linked to the changing of language from qualified ("it may", "it might", "it could") to absolute form ("it is"), we found interesting that the "Trumpflation story" has suddenly morphed from "it may" to "it is". To some extent, the Woozle effect is yet another example of confirmation bias we think. People tend to interpret ambiguous evidence as supporting their existing position. A series of experiments in the 1960s suggested that people are biased toward confirming their existing beliefs. Later work re-interpreted these results as a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. In certain situations, this tendency can bias people's conclusions. Explanations for the observed biases include wishful thinking and the limited human capacity to process information. Another explanation is that people show confirmation bias because they are weighing up the costs of being wrong, rather than investigating in a neutral, scientific way. Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor decisions due to these biases have been found in political and organizational contexts but, also in financial markets. As we have often indicated in our past musings, our contrarian stance comes from our behavioral psychologist approach given we would rather focus on the process of the woozles rather than their content. In our last musing, for instance we indicated we had turned slightly more positive on gold and gold miners alike. We must confess we have been adding in late December.

In this week's conversation we would like to discuss our contrarian stance surrounding "Mack the Knife" aka King Dollar + positive real US interest rates and why we think that eventually "Trumpflation" could morph into "DeflaTrump", meaning a lower dollar thanks to that 30s model we discussed as of late,  namely that populism and discontent means we are potentially facing a global trade war with the rise of protectionism.

  • Macro and Credit - All the promises we've been given...
  • Final chart - The central bank "put" has been weakening

  • Macro and Credit - All the promises we've been given...
From a Woozle effect perspective, we find it very interesting how easy weighing up the costs of being wrong leads to overconfidence.

We might sound a bit philosophical in these early days of 2017 but, we do share Jim Chanos and Steen Jakobsen, that we are going to see some tectonic shifts.

These shifts will have some significant consequences in terms of allocations rest assured. You might be wondering why we have entitled our bullet point this way? Well as goes the lyrics for an Electro House song we like "All the promises we've been given", government and central bankers have been very good at promising:
"All the promises we’ve been given
All the fires that we’ve feedin’
All the lies that we’ve been livin’ in
Wouldn’t it be nice if we
Could leave behind the mess we’re in
Could dig beneath these old troubles return
To find something amazing" - The Presets - Promises

This is somewhat the "Trumpflation" story playing out. Unfortunately, we cannot leave the mess we are in thanks to so many years of lax policies, lies and fires which our central bankers have been feeding. But, there is more to it. and at this juncture, we would like to remind ourselves with our November 2013 conversation entitled "Squaring the Circle" in which we tackled the paramount issue between "explicit guarantees" and "implicit guarantees":
"We quoted Dr Jochen Felsenheimer in our conversation "The Unbearable Lightness of Credit" in August 2012, let us do it again for the purpose of the demonstration:
"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"
We will not discuss the issue of implicit guarantees and explicit guarantees from a credit valuation point of view as we have already approached this subject in our conversation quoted above. The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them. Obviously our great poker player "Mario Draghi" at the helm of the ECB has played with his OMT a great hand but based only on "implicit guarantee". That's a big difference." - source Macronomics, November 2013
And this is the great swindle politicians have been pulling selling entitlements based on "implicit" guarantees rather than "explicit" ones. Let us explain, the developed world is awashed in unfunded liabilities, therefore "it may" has for so many people clinging to their pension benefits has become "it is". The woozle effect in that case is that many think that what is in reality clearly "unfunded" is "funded". It isn't. 

While everyone is focusing on the asset side of the "Trumpflation" story (lower corporate taxes, cash repatriation, etc.), no one has really been focusing on the liability side, which could have some important implications. What has been weighting so much on bond prices since the US election has been once again the Japanese investors crowd. Again what we indicated back in 2016 in our conversation "Eternal Sunshine of the Spotless Mind", still holds in 2017, namely that you want to track what these investors are doing flow wise:
"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
On this subject we read with interest Bank of America Merrill Lynch's Japan and FX Watch notes from the 12th of January entitled "Japanese investors sell foreign bonds after US election":
"Surplus structure keeps yen in check
Japan's Ministry of Finance today released the November international balance of payments and a preliminary portfolio investment report for December. Japan’s current account stood at a ¥1.8tn surplus in November to match the recent trend (Chart 3).

We are seeing a gradual recovery in Japan’s real exports, which seems in line with the positive cyclical trend in global manufacturing. Oil imports have stabilized, but remain low. Outward direct investments exhibit structural strength, but the yen’s significant depreciation since the summer suggests “tactical” large-scale purchases of foreign companies (eg, Softbank buying ARM) are probably behind us for the time being (Chart 4).
The BoJ’s yield curve control has widened the yield gap between foreign and yen rates, which should support Japan’s thick income surplus. Overall, the surplus structure marginally stabilizes the yen’s move especially as Japanese investors first reacted to the US election by selling foreign bonds (Chart 2).
Trump shock led to foreign bond sale
In December, Japanese banks and lifers sold ¥1.48tn of foreign bonds, the biggest sale since June 2015 amid the Bunds tantrum. This is in line with our view given the rise in volatility in the US and the likely loss from the move in rates after the election. Details are yet to be reported, but we would assume this is a continuation of November where most of the sales happened in the US rather than Europe (Table 1).

Given our core view in the US remains bearish duration while the BoJ’s monetary policy helps keep JGB yields relatively low, this likely leads to some repatriation of Japanese money to the JGB market, which explains the rise in JGB purchases at both banks and lifers in November.
Pensions rebalance into bonds, out of equity
In Oct-Dec, trust accounts–represented by pension accounts–sold domestic and foreign equities and bought JGB and foreign bonds (JGB data up to November) (Chart 6).

In our view, the GPIF portfolio is close enough to its target that large moves in financial markets would lead to rebalancing activities where appreciating assets are sold and depreciating assets are bought, reducing market volatility at margin.
Flows may keep USD/JPY basis from widening for now
Meanwhile, foreign investors net-sold ¥123bn of JGBs in December. This most likely resulted from quarterly redemption of JGBs as a data from the JSDA, which excludes redemptions, shows foreign investors were net purchasers for a 29th straight month in November. We argued that tightening in USD/JPY basis spread is unlikely to become a trend, but a combination of cautious Japanese investors in foreign bond investment (and some repatriation into JGBs) and demand from foreign investors for JGBs will keep the USDJPY basis off the high seen in November for a while." - source Bank of America Merrill Lynch
So, from a "flow" perspective, no matter what the latest woozle is, namely the "great rotation" from bonds to equities pushed forward by many pundits, when it comes to Japan, not only the voracious foreign bid from Japanese investors has tempered it's pace, but if indeed, Japanese are more cautious about their foreign allocations, then indeed this will put some additional upward pressure on sovereign bond yields we think.

For the time being, the dollar woozle is still working its way, being the largest consensus trade around for many pundits, also for the likes of Deutsche Bank from their FX Blueprint note entitled "King Kong Dollar" from the 12th of January:
"King Kong Dollar
The most prominent theme in our 2017 FX blueprint is that a Trump presidency changes everything. The US economy is the 800-pound gorilla in the room – policy shifts are too important to not matter for global FX. Our overall assessment is that Trump will be highly supportive of the dollar. Whether this mostly happens against the low-yielding EUR and JPY or EM FX will depend on the policy mix that is delivered: greater emphasis on growth and the euro and yen will suffer most; greater trade protectionism and EM, particularly Asia, will bear the burden. Either way, the broad trade-weighted dollar should strengthen, with a Trump administration coming at a convenient time for our medium-term bullish view. First, the greenback has finally entered the ranks of a G10 FX top-3 high-yielder, an important driver of dollar appreciation in the past. Second, a rally that is front-loaded to the beginning of a Trump presidency fits in nicely with the mature stage of a typical 7-10 year dollar up-cycle.
It is tempting to only talk about President-elect Trump, but currency drivers run beyond the US. From Brexit to European elections and China’s ongoing battle with outflows, politics and de-globalization stand out as the broader FX drivers of 2017. In most instances, particularly in Europe, idiosyncratic stories provide further support to a bullish dollar view. In other cases, local drivers allow for useful diversification against dollar longs, with ZAR, RUB and IDR standing out in particular. 2017 promises to be another exciting year for FX.
Looking for the dollar catalysts
We see Trump’s Fed appointments and corporate tax reform as the most important drivers of the dollar in 2017. Four out of seven board nominations are due this year, including Yellen’s replacement. These are likely to lean hawkish and entirely reshape the Fed. Corporate tax reform may well mean lower rates, but far more important would be an imposition of a “border tax” –potentially the biggest shift in global trade since Bretton Woods and leading to a big US competitiveness gain. Beyond America’s shores, idiosyncratic drivers point to a stronger dollar against both the JPY and EUR. In the Eurozone, negative surprises in either the French or potential Italian election open up existential risks. Even if all goes well, the beginning of ECB taper could accelerate record portfolio outflows: wider spreads (and redenomination risk) and more volatility in bunds should further lower demand for European assets. Japan stands out for the opposite reasons: political stability will allow the BoJ to continue targeting JGB yields unhindered, further increasing policy divergence with the US. We expect EUR/USD to break parity and USD/JPY to approach its all time-highs this year.
It’s all about Trump’s tax policy
While most attention is focused on US fiscal stimulus, we think corporate tax reform stands out as the biggest positive driver of the dollar in 2017. Lower tax rates, border adjustments and a tax holiday on unrepatriated earnings all matter. Border adjustments would impose a 15-20% tax on all US imports while exempting export income from taxation. The policy would amount to a 15% backdoor competitiveness gain for the US economy. A mechanical application of trade elasticities would imply that the US basic balance would go back to the highs seen at the start of the
century (chart 1).

A tax holiday and shift to a territorial system of taxation would allow more than $1 trillion of dollar liquidity and $200bn of annual future earnings to be brought back to the US. Most of this cash is already in USD: but the withdrawal of offshore liquidity will maintain widening pressure on cross-currency basis pushing offshore dollar yields higher. Corporates are likely to use the liquidity for buybacks and dividend hikes which together with corporate tax cuts would encourage equity inflows and further support the dollar. With foreigners not having invested in US equities for the last five years, there is plenty of potential for foreign buying of the S&P (chart 2).

- source Deutsche Bank
Like any woozle, while the above narrative is enticing, we are not buying it. Equities pundits like to focus on the asset side, such as the impact of corporate tax rate mentioned above, we credit pundits tend to focus on the liability side which means that rather than focusing on the corporate tax relief effect we would rather side with our friend Michael Lebowitz from 720 Global from his latest note "Hoover's folly" from the 11th of January and focus on Global Trade risk, Hoover's style:
"Ramifications and Investment Advice
Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.
If actions are taken to impose tariffs, VATs, border adjustments or renege on trade deals, the consequences to various asset classes could be severe. Of further importance, the U.S. dollar is the world’s reserve currency and accounts for the majority of global trade. If global trade is hampered, marginal demand for dollars would likely decrease as would the value of the dollar versus other currencies.
From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.
Investors should anticipate that, whatever actions are taken by the new administration, America’s trade partners will likely take similar actions in order to protect their own interests. If this is the case, the prices of goods and materials will likely rise along with tensions in global trade markets. Retaliation raises the specter of heightened inflationary pressures, which could force the Federal Reserve to raise interest rates at a faster pace than expected. The possibility of inflation coupled with higher interest rates and weak economic growth would lead to an economic state called stagflation. 
Other than precious metals and possibly some companies operating largely within the United States, it is hard to envision many other domestic or global assets that benefit from a trade war." - source 720 Global, Michael Lebowitz, Hoover's folly, 11th of January 2016
This makes perfect sense and as we indicated earlier on, we have become more positive on gold / gold miners in late December for that very reason. As we pointed out in our November conversation "From Utopia to Dystopia and back" the trade attitude of the next US administration is the biggest unknown, and the biggest risk we think. In this previous conversation we showed in our final chart that gold could indeed shine after the Fed and guess what it has:
"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." - source Macronomics, November 2016
So if indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar. This is a point put forward by Nomura in their FX Insight note from the 5th of January entitled "The weak dollar revolution could be tweeted":
"Weak dollar policy is a natural extension of protectionist policies
Clearly, the one area of trade policy that has been so far little discussed is FX policy. In a detailed interview on 30 November 2016, soon-to-be Treasury Secretary Steve Mnuchin evaded a pointed question on whether he supports a strong dollar. Instead, he responded:
“I think we’re really going to be focused on economic growth and creating jobs and that’s really going to be the priority.” (CNBC, 30 November 2016).
FX policy cannot be ignored in trade policy. A weak currency can be effective in giving domestic industries an advantage over foreign industries. Indeed, this has generally been the policy of emerging Asia economies from China to Thailand. Their substantial growth in FX reserves since the Asia crisis in 1997 is testament to a concerted policy to curb strength in their currencies. For Donald Trump, at a fundamental level, any appreciation of the dollar would offset some if not all of any import tariffs introduced.
As for the practicalities of introducing a weak dollar policy, the Plaza Accord of 1985 under a Republican administration is the last such example. However, it was coordinated with key trade partners and monetary policy was moving in a supportive direction. Replicating such an Accord would be a gargantuan task. The other precedent of sorts is the Nixon shock – again under a Republican administration. This was a unilateral move and involved both a currency devaluation and the imposition of import tariffs.
However, the better reference points may actually be emerging markets. They have pursued weak currency policies without coordination and often at odds with domestic monetary policy. Admittedly, the presence of capital controls makes it easier to separate FX and monetary policy (thereby overcoming the so-called Triffin dilemma).
The success of their policies has often hinged on the scale of their interventions whether through direct currency intervention or sovereign wealth fund purchases of foreign assets. One study featuring 133 countries over the past 30 years found that such state-directed outflows were a significant positive driver of the current account (i.e. pushed it into surplus)9. An IMF study featuring 52 countries (13 advanced and 39 emerging) from 1996 to 2013 found that currency intervention had a larger and more significant impact on exchange rates than interest rate differentials10.
It should be noted that Japan, which has been the most active G7 intervener in currency markets, has typically engaged in sterilised intervention. That is, intervention that would not affect domestic money supply (and so not impact monetary policy). Studies have shown that Japanese intervention has at times been successful even though it was sterilised. Moreover, one study by former Deputy Vice Minister of Finance for International Affairs, Taktatoshi Ito, showed that FX intervention over the 1990s, which was predominantly uncoordinated with other countries, resulted in a profit of JPY9 trillion ($75 billion). This showed that the MoF was buying USD/JPY at the lows and selling at the highs11. Therefore, there could be nothing to stop the US engaging in FX intervention to weaken the dollar. " - source Nomura
It appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier.

What appears to be clear to us is that the Woozle effect from a central banking perspective has been fading as shown below in our final chart.

  • Final chart - The central bank "put" has been weakening
What has clear in recent months has been rising signs of the Woozle effect fading when it comes to central banks credibility. With rising populism, which in recent ways has been driven by central banking interventionism, there are growing indications that the cosy relationship between politicians and central bankers is getting tested. Our final chart comes from Bank of America Merrill Lynch European Credit Strategist note from the 9th of January entitled "Yielding to populism" and displays how the central bank "put" has been weakening:
"Yielding to populism
We expect to return frequently to the theme of “populism” as 2017’s big narrative. For credit investors, populism doesn’t have to be all bad news. As our US credit strategy colleagues have highlighted, potential Republican tax reform could be very beneficial for some parts of the US market. In Europe, though, we worry that populism will manifest itself in two bearish ways this year: a weaker ECB “put” (read: weaker credit technicals), and rising political risk, which we believe is not reflected in European spreads.
Thus, while Euro corporate bonds have nudged tighter in the first week of 2017, with reach for yield behaviour still evident, we think Euro spreads stand to end the year wider. We look for the Euro high-grade market to finish the year 15bp-20bp wider than today’s levels, and for high-yield spreads to end 50bp wider (applying some tweaking to our Nov ’16 forecasts given the big high-yield tightening in December).
Draghi’s populist moment
In our view, Dec 8th 2016 should be seen as a game changing moment for Euro credit markets. We think the ECB yielded to another form of “populism” – namely pressure from a hawkish governing council to step away from the negative yield era, given undesirable side effects. So from April this year, ECB monthly QE buying will decline from €80bn to €60bn.
But we think that Draghi’s actions highlight a bigger story: namely that the central bank “put” (or influence on the market) is already showing signs of weakening. Chart 1 shows cumulative central bank asset purchases including EM FX reserves (which we think should be viewed as another form of QE buying). Note the peak in September last year, due to declining EM FX reserves (such as China). 

But in 2017, we know that the ECB is set to tone down its asset buying, and we also expect the BoE to stop buying gilts and corporate bonds once their respective targets have been reached (which we estimate to be in February ’17 and April ‘17, respectively). A weakening influence of central banks therefore means a weakening of the very strong technicals that have been asserting themselves on European fixed-income markets."
- source Bank of America Merrill Lynch

From a credit tightening perspective, we think you ought to monitor US Commercial Real Estate (CRE) because as reported by UBS in their latest US Credit Strategy Outlook for 2017, CRE nonperforming loans are likely to rise for the first time since 2010 and monthly CMBS deliquency rates were up 6 bp to 5.23% Y/Y in December. Bank loan officers have started to tighten lending standards since the first quarter 2016. US CRE is therefore something you want to keep a close eye on 2017. If the equity crowd are indeed the eternal optimist and suckers for the Woozle effect, the credit crowd is often the eternal pessimist, but then again, regardless of the narrative, as indicated above, in a world stifled by very high debt level, both duration risk and credit risk have been clearly extended meaning that price movements like we have seen in the Energy sector in 2016 are larger. When things will turn nasty at some point, recoveries this time around are going to be much lower, so forget the assumed recovery rate of 40% when you price your senior CDS but, that's a story for another day...or year...
"Every swindle is driven by a desire for easy money; it's the one thing the swindler and the swindled have in common." - Mitchell Zuckoff, American journalist
Stay tuned!
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