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 !

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