Friday 24 February 2017

Macro and Credit - Pareidolia

"It is discouraging how many people are shocked by honesty and how few by deceit." - Noel Coward, English playwright, composer, director, actor and singer

Watching with interest the continuation in rising asset prices and the relentless tightening in credit spreads, while monitoring our rewarding gold and silver miners exposure and itching to dive into US long bonds, we reminded ourselves for our title analogy of Pareidolia. Pareidolia is a psychological phenomenon involving a stimulus (an image or a sound) wherein the mind perceives a familiar pattern of something where none exists. Most people have never heard of "Pareidolia". But nearly everyone has experienced it. Anyone who has looked at clouds, the Moon and spotted faces or animal forms has felt the pull of "Pareidolia". Pareidolia can be extremely evocative particularly for people having "blind faith" or who are inclined in believing in "miracles" (such as the ones "pulled" by our central bankers). Put it simply, "Pareidolia is the human ability to see shapes or make pictures out of randomness. Pareidolia can be considered a subcategory of Apophenia being the human tendency to perceive meaningful patterns within random data. 
You are probably already asking yourselves where we are going with this, for us it is pretty simple. The much vaunted "Trumpflation" trade which has been put on meaningfully by many pundits, leading to some very distorted and crowded positions (short US Treasuries for instance) appear to us to be a case of "Pareidolia". The idea that the US economy can be "reflated" meaningfully at a rapid pace by the new US administration is an "optical illusion".

While last week me mused around the "Hypomanic" state of the markets and its pervasive elevated euphoric mood and the potential for equities to impact the tightening mood in credit which so far has prevailed, in this week's conversation we would like to cogitate more on the state of the credit cycle, some thoughts on Gold, and the risk of an equity drawdown. Rest assured a correction is most likely to happen in the US in the near future, regardless of the prevailing "Pareidolia" mantra.

  • Macro and Credit - Fooled by "Pareidolia"?
  • Final charts - Credit growth? appearances can be deceiving?

  • Macro and Credit - Fooled by "Pareidolia"?
In our previous conversation we wondered if in 2017 a US equities sell-off could for a change lead credit wider. We also mused around the impact a global rise in core inflation could potentially lead to, when it comes to a "sell-off". Since our last conversation we have seen some interesting developments in credit, namely that the tightening movement has been relatively impressive in the credit space as reported by DataGrapple in their blog post from the 23rd of February providing a good example of "Hypomania" in credit land:
"The credit market felt firm throughout the session. Credit indices would have closed a tad better across the board were it not for a late day wobble following a rapid increase of 4bps to 75bps of the OAT/BUND spread towards the close. The most striking feature of the session was actually the collapse tighter of a number of Crossover names. It is not often that 5 constituents of iTraxx Crossover (ITXEX) tighten in excess 30bps for completely unrelated reasons, while the index is left unchanged. SELNVX (Selecta Group BV) closed 100bps tighter at 700bps after an article published in the Italian press mentioned Argenta – an Italian vending machine operator – could be up for sale and that a merger with SELNVX followed by an IPO of the newly created entity would be on the table. DRYMIX (Dry Mix Solutions) closed 45bps tighter at 139bps, after a refinancing of the company’s debt was announced paving the way for an orphaning of the entity. WINDIM (Wind Acquisition Finance) closed 38bps tighter at 262bps after releasing good numbers and saying that they are happy with their current structure. Without many names widening significantly - New Look was the odd one out -, that was enough to send the basis of ITXEX back to its recent wides despite the absence of any sharp move of the market as a whole, which is fairly unusual." - source DataGrapple
Indeed, it is not often we do see such large movements for an index comprising 75 equally weighted single company credit default swaps. Given we have recently been fairly vocal on our contrarian stance relating to the Trumpflation trade, it seems to us that investors have been blinded by their "Pareidolia". On the subject of this phenomenon and the related "blind faith" of investors, we read with interest Morgan Stanley's recent Cross-Asset Dispatches note from the 20th of February entitled "How Likely Is a Major Equity Drawdown":
"We look at what key indicators say about the likelihood of a recession or a major equity sell-off over the next 12 months. On current readings, the likelihood averages ~20%.

We often hear "a large sell-off is unlikely, based on the levels of 'X'". We decided to test that:
A 15%+ correction for the S&P 500 within 12 months occurred around ~20% of the time when a wide variety of indicators were at the same levels they are now. That's close to average, but higher than options markets imply.
Don't forget, the probability of a 15%+ drawdown over ANY 12-month period is 18%:
We think investors underestimate the unconditional probability of a major drawdown (defined here as a 15%+ decline from current prices within a year).
What's worrying?
Year-over-year changes in oil, real yields and the level of jobless claims are all consistent with a 30%+ probability of a 15%+ drawdown over the next 12 months.
What's comforting?
The level of credit spreads and yield spreads and strong PMIs suggest that this drawdown risk is much lower than normal (in the single digits).
Investment implications – own the tails, hedges in credit: We believe that 2017 has larger-than-appreciated tails on both sides of the distribution. Calls on the S&P 500 are our preferred way of expressing underpriced animal spirits. On the downside, we think credit hedges are attractively priced, and 'lock in' one of the asset classes most relaxed about large drawdown risk.
Investment implications – own the tails, hedges in credit:
We believe that 2017 has larger-than-appreciated tails on both sides of the distribution. Calls on the S&P 500 are our preferred way of expressing underpriced animal spirits. On the downside, we think credit hedges are attractively priced, and 'lock in' one of the asset classes most relaxed about large drawdown risk.
Exhibit 1:
Oil, UST real yields and equities are flagging higher-than-average risk of a large equity sell-off over the next 12 months, while credit spreads remain relaxed
- source Morgan Stanley

Of course the worrying part is of interest to us, not because we suffer from a "pessimism bias" but, mostly because rather than going for the "optimism bias" and "Pareidolia", our contrarian stance pushes us towards "realism bias". 

To that effect, when it comes to the "barbaric relic" aka gold, when it comes to using Continuous Jobless Claims (Z-score 6months - 183 days and data non revised) as an input to generate "alpha" in relation to gold as an asset class, we find of interest that since the 22nd of January 2004 until the 17th of February, this simple input would have generated 0.76 of alpha according to the tool DecisionScreen:

- source DecisionScreen

What is as well very interesting is the sharpe generated by this simple trading rule over one year, we get a sharpe of 1.48 for a cumulated excess return of 23%:

- source DecisionScreen

Obviously as you can see from the tool above, when jobless claims rise, it is bullish for gold. The "barbaric relic" is still a buy. We also indicated dear readers our move towards a positive stance towards the asset class by the end of December 2016 if you remember our previous musings.

Also from a "realistic perspective" relative to gold, we read with interest Mish Shedlock's recent take on  the relation between gold and rate hikes in his post "Rate Hike Cycles vs. the US Dollar: Rate Hikes Bad for Gold?" from the 23rd of February:
"Gold Does Well in These Environments
1. Deflation
2. Hyperinflation
3. Stagflation
4. Decreasing faith that central banks have everything under control.
5. Rising credit stress and fear of defaults
Gold Does Poorly in These Environments
1. Disinflation (1980 to 2000 is a perfect example. There was inflation every step of the way but gold got clobbered).
2. Increasing faith in central banks’ ability to keep things under control (Mario Draghi’s “Whatever it takes” speech triggered a prime example)
Gold does worst in periods of prolonged disinflation and in periods of rising faith in central banks." - source Mish -
So while we don't have rising credit stress and fear of defaults à la 2016, the potential for stagflation should not be discarded with the increasing risks of a global trade war down the line. In that particular case, to repeat ourselves, a slowdown in global trade would evidently be bullish for gold.

But moving back to the subject of the credit cycle and being fooled by "Pareidolia", we keep telling you that we are slowly but surely moving towards the end of the cycle. From the latest Fed Senior Loan Officer Survey and in particularly Commercial Real Estate, to other segments of US consumer credit, but also other parts of the world, there are more signs that the "credit impulse" has been weakening as of late. When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. On that specific subject, we read with interest JP Morgan's special report from the 22nd of February entitled "Global credit cycle: Divided and sluggish":
  • Globally, the growth of private nonfinancial credit is slowing in a major departure from the past few business cycles.
  • In the DM, credit gains have firmed modestly but banks have recently stopped easing lending standards, giving some caution.
  • The private sector in EM ex China has been deleveraging since mid-2015. The process is broadening and there is no sign this headwind to growth is about to dissipate.
  • EM real GDP growth recently has stabilized as other factors offset the drag from credit. Our economists anticipate some pickup in 2017. Potential downside risks likely would be related to the Fed, US trade and tax policy, or China.

The growth of global private credit is slowing, maintaining a downtrend that took hold in 2014 (Figure 1).

This slowing is a major departure from the past few business cycles, when credit accelerated in the latter phase of the expansion. The dynamic underscores the significant structural forces damping credit growth. Demand for credit remains subdued in the wake of the global financial crisis. Additionally, global banks are becoming less willing to extend new credit. DM banks had been easing standards but stopped doing so in the latest quarter. EM banks have been tightening
standards since 2011 (Figure 2).
Beneath the global surface, the most striking feature of the credit landscape remains the sharp dichotomy between the DM and the EM. The DM private sector underwent a lengthy deleveraging phase from 2010 through 2014. However, DM credit growth has exceeded nominal GDP growth since 2015 and reached an estimated 3.3% in 4Q16. Taken at face value, the credit cycle has swung from being a significant headwind for DM economic growth to a modest tailwind. However, with DM banks turning more cautious, this could cap the recovery in credit growth or even reverse it.
The process is moving in the opposite direction in the EM and the dynamic is sufficiently powerful that it has dominated gains in the DM. EM private credit growth slowed to an estimated 9%oya in FX-adjusted terms in 4Q16, half the peak rate from early in the expansion (Figure 3).

Moreover, China’s double-digit gains strongly influence the EM aggregate. In the EM ex. China, credit growth has receded to just 6.0%oya. The private sector in EM ex. China has been deleveraging since mid-2015 (Figure 4).

These credit dynamics represent an ongoing headwind for EM growth, similar to what happened in the DM from 2010 to 2014. Nonetheless, it is encouraging to see that EM real GDP growth recently has stabilized due to positive offsets from EM policy support, easier financial conditions, rising commodity prices, and stronger DM growth.
Consistent with our previous analysis, this note focuses on broad private nonfinancial credit, which includes bank loans and corporate bonds, as well as other forms of financing. Up through 3Q16, our data are based on statistics provided by the BIS and the central banks (for background, see “The elephant in the room: Taking stock of the surge in EM private debt,” September 2, 2015, and “EM debt overhang is larger but its growth pace is slowing,” J. Goulden and A. Wong, September 30, 2016). We then generate estimates for 4Q16 using data on domestic bank credit, which accounts for the majority of total credit. The data for the EM cover only the subset of countries encompassed in the J.P. Morgan global economic forecast, as shown in Table 2 below.
Leverage cycle slowly turning up in DM
DM private credit contracted in the early days of the economic expansion. When credit growth resumed in 2011 the pace was slow and below that of nominal GDP as households and corporates worked to lower their indebtedness and banks struggled to shore up their balance sheets. A further acceleration in credit took hold in 2014 and beginning in 2015 credit growth moved above nominal GDP growth (Figure 5).
To be sure, any added support for consumer or corporate demand from increased leverage has been modest compared to the 1990s and 2000s cycles. The DM leverage ratio increased 1.7%-pts of GDP per annum on average from 1Q15 through 3Q16, a little more than half the pace from 2002-07.
The recovery in credit growth varies across the DM (Figure 6).

The pickup has been focused in the corporate sector (Figure 7), especially in the US, and so far has not translated into increased capex.

On the contrary, DM capex growth weakened progressively since 2014, falling below zero over the four quarters through 3Q16 (Figure 8).

It appears that many businesses, particularly in the US, used the money they borrowed for stock buybacks or M&A, or else they saved it. After having boomed in the previous cycle, household credit stagnated from 2009-12 as households in the US, the UK, 
By region, credit growth has recovered most strongly in United States, reaching about 4.6%oya in 4Q16—about 1%- pt above nominal GDP growth. By comparison, credit growth was more restrained in the Euro area, the UK, and Japan at 1.8%oya, 3.7%oya, and 1.8%oya, respectively.
We can gain insights into the bank credit cycle, and thus the broader flow of credit, through the quarterly surveys of senior loan officers conducted by the major DM central banks and the Institute of International Finance. These surveys provide information about the supply and demand for bank loans that we show in the form of net percent balances (“PB”).
The latest surveys, which compare banking conditions in January 2017 with those in October 2016, indicate DM banks shifted to a neutral stance on credit standards following an extended easing phase (Figure 11).

This shift includes the US, the Euro area, and the UK, though not Japan. In aggregate, DM banks stopped easing business credit standards in late 2015. They shifted to neutral for consumer credit standards in the 1Q17 survey. This shift in bank behavior is typical of late-cycle expansions and needs to be watched. In these phases, excesses in household or business balance sheets  often occur, or in real estate markets. In addition, these periods normally are characterized by tight monetary policy. Against this backdrop, it is not entirely clear why the DM banks are acting this way.
The relationship generally fits this pattern looking at the available history. The DM originations proxy is positive (the demand PB is positive while standards are neutral), implying DM loan growth should be increasing. This had been the case until DM loan growth stabilized in recent quarters, when it began to undershoot the model’s projection (Figure 12).

Note that since the current-quarter originations proxy tends to lead changes in %oya loan growth, it currently points to a significant pickup in DM loan growth this year. However, since the DM proxy has been over-predicting loan growth for about a year, we would temper its projection." - source JP Morgan
From a "Pareidolia" perspective, one would assume a significant pick up in loan growth, in particular in relation to an expansion in PMIs overall, but as stated by JP Morgan, their DM proxy has been over-predicting, meaning that, in similar fashion to the much vaunted "reflation" play, it can be highly deceptive. It might be a case of us being fooled by "Pareidolia" at this stage of the credit cycle. After all us human beings have a tendency to perceive meaningful patterns within random data. 

Clearly as we pointed out last week, in a state of "Hypomania" and at this stage of the cycle, there is a tendency for excesses (real estate prices, subprime auto loans, etc.) to build up meaningfully. For instance, we have been monitoring the weakening demand for credit but in particular Commercial Real Estate given the latest Federal Reserve Senior Loan Officer Survey has shown that financial conditions have already started to tighten meaningfully in that space. This has been confirmed by Wells Fargo in their note from the 22nd of February entitled "CRE Credit: Fed Concerns, Tighter Standards and Less Demand":
"CRE Credit Availability and Demand WaneThe slowdown in transaction volumes coincides with survey measures reporting weaker demand for CRE loans. According to the Federal Reserve’s January Senior Loan Officer Opinion Survey, CRE loan demand has fallen. Lenders reported weaker demand for multifamily and construction loans on net in the fourth quarter, while nonfarm nonresidential loan demand was relatively unchanged (middle chart).

On the supply side, lending standards for CRE loans continued to tighten across the board in the fourth quarter, marking the sixth-consecutive quarter of net tightening (bottom chart). The Fed survey noted particularly “significant” tightening for loans secured by multifamily properties and construction land development loans, with a net 33.3 percent and 25.0 percent of firms, respectively, tightening standards. Meanwhile, a more moderate 13 percent of banks reported tightening standards for nonfarm nonresidential property loans. The survey data suggest that bank lenders are proving themselves more cautious/selective, consistent with indications that the sector is at a mature stage in the current cycle.

The slower pace of foreign investment in U.S. CRE, and tighter lending standards for CRE loans, should provide some relief to Fed officials that have sounded caution over credit risks associated with the elevated level of CRE pricing." - source Wells Fargo
This brings us to the relationship between credit and more importantly the credit impulse and growth. Credit growth has always been the necessary condition for economic growth. On that subject we read with interest Wells Fargo's Interest Rate Weekly note from the 22nd of February entitled "Credit and Growth: A Partnership Not Opposition":
"Growth and Debt Finance
As illustrated in the graph below, there is a close link between economic growth and domestic nonfinancial debt growth.

This pattern reflects an interaction that works both ways. Economic growth prompts creditors and debtors to accept more debt as the expectation of growth, and thereby the increased financial rewards to creditors and debtors, improves. In turn, the availability of credit opens up opportunities for entrepreneurs to pursue prospects for growth.
During the most recent economic expansion, the very modest pace of debt growth has been associated with a period of subpar real economic growth. In part, this pattern may reflect the emphasis on financial regulation to avoid risk-taking that may have put a damper on financing any idea that carried a perception of risk.
The Specific Issue of Private Credit
During the current economic expansion, the pace of private credit growth to the consumer and business sectors has been particularly weak relative to prior economic expansions (middle graph).

Since both the business and consumer sectors are major contributors to economic growth and job gains, then it is not a surprise that the overall pace of economic growth and job gains have been modest, at best, during the current cycle. This is particularly apparent by the big drag of credit during the first few years of this expansion.
This interaction of private credit and spending imparts a pro-cyclical pattern to both economic activities which, if not carefully monitored, creates an abrupt halt to both when perceptions of risk and economic growth opportunities are altered.
Household Net Worth: A Balancing Act
During the latest downturn, the hit to real estate values was very evident in the steep drop off in household net worth as illustrated in the bottom graph. Each prior recession (1981-1982, 1990-1991, 2001) was associated with a decline in the growth of net worth but not to the extent experienced in the 2007-2009 period. Each recession, including 2007-2009, was associated with a decline in the growth rate of consumer spending.

Once again the link between financial/real asset values and consumer spending emphasizes our view that credit growth and economic growth are closely linked and that this link must be considered by public policymakers.
Current economic policy proposals favor faster growth and easier financial regulation. If thoughtful actions are taken, then faster growth can be achieved within a reasonable risk-taking environment." - source Wells Fargo
Unfortunately, where we disagree with Wells Fargo is that easier financial regulation will not lead to faster growth thanks to faster credit growth (credit impulse) at this stage in the cycle. When it comes to perceiving some form of "reflation" thanks to better credit growth on the back of a stronger credit impulse, we believe our final chart and conclusion below do point out towards yet another case of "Pareidolia".

  • Final charts - Credit growth? appearances can be deceiving?
When it comes to economic growth, private credit matters and matters a lot as we have been discussing to some extent in our conversation. For our final chart we would like to point out to yet another chart from the quoted JP Morgan report relating to the credit cycle. The chart displayed shows indeed that, when it comes to the growth of private credit, appearances can indeed be deceiving such as encountered through "Pareidolia" effects:
"Appearances can be deceiving. The growth of private credit exceeds nominal GDP growth and the debt/income ratio has climbed rapidly since 2012. This sounds similar to what happened in the late 1990s and the 2000s. However, this characterization belies the lopsided nature of the cycle. In the DM, credit growth remains muted and the leverage ratio barely has increased from the lows of a few years ago (Figure 18).

Globally, the EM have accounted for most of the expansion of private credit and leverage. Yet, in the EM, credit growth has been sliding, both outright and in relation to nominal GDP.
In our interpretation, for the DM, the credit cycle gradually has shifted from being a stiff headwind to a modest tailwind. One question is whether even this modest degree of support might be fading. DM credit growth recently has leveled off near 3%. With inflation normalizing, this pace is barely above that of nominal GDP. Moreover, DM banks have unexpectedly turned more cautious. US banks are tightening lending standards while Euro area and UK banks have turned neutral. This shift in the credit supply, especially if it extends  further, could halt the recovery in credit growth or even reverse it.
For the EM, we believe the credit cycle has been damping economic growth. This belief is based on the rapid deceleration in EM credit, especially outside China, to where the majority of the EM countries encompassed in our economic forecast are now deleveraging. From the standpoint of credit supply, the weak banking sector interfered with the transmission of monetary policy. From the standpoint of credit demand, the desire of DM households and corporates to shed debt damped the recovery in consumption and business investment. We think these same dynamics are occurring in the EM. Moreover, the number of EM countries that are deleveraging continues to increase and there is no sign in credit data or in the IIF bank lending conditions surveys that the underlying supply/demand dynamics driving the deleveraging are abating.
EM credit dynamics have damped economic growth but they have not generated recessions, much less a crisis. This is consistent with recent experience in the DM, where the extended deleveraging phase from 2010 to 2014 did not prevent GDP growth but acted as a powerful headwind. In previous research, we found that deleveraging typically occurs during economic expansions, not during recessions (see “A constrained global credit cycle,” October 14, 2016). However, most episodes of significant deleveraging occur during the early phase of economic recoveries, as with the DM during this cycle. In the relatively brief history of our EM data, which extend back about 20 years to just before the Asian financial crisis, a significant number of EM countries delevered nearly all the time except during economic recessions (Figure 19).

However, the more intense phases of deleveraging followed major economic downturns (again, as happened in the DM in the 2010s). In this sense, the current shift toward deleveraging in the EM is unusual." - source JP Morgan
Could it be that the pattern of "deleveraging" in both EM and DM is simply a case of "Pareidolia"? We wonder...

"It is only hope which is real, and reality is a bitterness and a deceit." - William Makepeace Thackeray, English novelist

Stay tuned ! 

Sunday 19 February 2017

Macro and Credit - Hypomania

"Knowledge is marvelous, but wisdom is even better." -  Kay Redfield Jamison, American psychologist

Looking at the unabated records being broken in US equities markets, with the S&P 500 having had 47 consecutive trading days without a 1% move, we reminded ourselves for our chosen analogy title of the mood state of "Hypomania", well known in psychiatry. Hypomania (literally "under mania" or "less than mania") is a mood state which is characterized by persistent disinhibition and pervasive elevated (euphoric) with or without irritable mood but generally less severe than full mania (Tulip mania...). In 19th century psychiatry, when mania had a broad meaning of craziness, hypomania was equated by some to concepts of "partial insanity". Looking at financial markets today, one would ask if we have indeed reached that threshold to some extent in this long credit cycle. What we find of interest is that the state of "Hypomania" may occur as a side effect of pharmaceuticals prescribed for conditions/diseases other than psychological states or mood disorders such as the "opioids" like QE dear to our central bankers. We find interesting that as of late Fed's Harker said that opioid abuse is one cause of low labor participation by prime-age men. Maybe the Fed's opioid abuse is also the cause of stock market melting up thanks to "multiple expansion" due to record buybacks funded by cheap credit leading therefore to a "hypomanic" state of affairs? We wonder.

In those instances, as in cases of drug-induced hypomanic episodes in unipolar depressives, the hypomania can almost invariably be eliminated by lowering medication dosage (tapering), withdrawing the drug entirely (stop QE for good), or changing to a different medication if discontinuation of treatment is not possible. The funny thing with "Hypomania" is that it may also be triggered by the occurrence of a highly exciting event in the patient's situation, such as a substantial financial gain or recognition. In other words, "Hypomania" can be associated with "narcissistic personality disorder". The DSM-IV-TR defines a hypomanic episode as including, over the course of at least four days, elevated mood plus three symptoms OR irritable mood plus four symptoms, one of which being foolish business investments but we ramble again...or are we really? Because if indeed "Hypomania" can be associated with "narcissistic personality disorder", one has to wonder where we are currently located on Brean Capital Head of macro Strategy Peter Tchir's Maslow's Hierarchy Of Credit Bubble:
- source Brean Capital

If indeed, credit investors are showing traits of "narcissistic personality disorder", then it validates even more our "Hypomania" title analogy and the fact that the credit cycle is slowly but surely moving into the final inning number 9 (or 9 years?) Place your bets accordingly.

In this week's conversation we will be wondering whether or not we could be facing an inflexion point, namely that a correction in equities might start to weight on credit and in particular High Yield, currently "priced for perfection".

  • Macro and Credit - 2017 - Credit leads equities, but could equities lead credit in 2017?
  • Final charts - US Consumers yet to feel "Hypomaniac"

  • Macro and Credit - 2017 - Credit leads equities, but could equities lead credit in 2017?
While clearly the equities markets in the US have been in a state of "Hypomania" as of late, so far the environment has been pretty supportive of credit spreads, and not only thanks to the ECB's buying spree. But, while credit has always been leading equities, one could wonder if this time around a sell-off in equities could impact credit spreads this time around, contrary to what we have seen in 2016 where the widening in credit spreads in the energy sector finally had an impact on equities at the beginning of the year.

From our perspective when it comes to "Hypomania", greed and the potential for a sell-off or the start of a bear market, we reminded ourselves of our 2014 conversation "Equity bear markets tend to coincide with high global core inflation":
"High global core inflation as a risk-off signal
Individual country inflation series are noisy, but the average across G10 economies has been stable in the 1-2% range, and has exhibited clear cyclicality. Bear markets for US equities have usually coincided with high global core inflation. We believe inflation based carry will remain attractive until inflation increases globally and we would expect currencies to mean revert when this occurs.
High inflation leads to mean reversion for currencies
Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with high global inflation suggests that inflation can be used as a carry filter. More generally, we would expect currencies to mean revert during periods of risk-off, which may or may not be negative for carry strategies. Our analysis suggests that a strategy of mean reversion towards 5 year averages would have performed well during the last two periods of high inflation. Is there a fundamental link that makes this robust? 
Inflation matters when inflation is high
Central banks have historically been much more concerned with fighting inflation than deflation, so that high inflation is likely to result in greater attention being paid. Increased attention on fundamentals could drive currencies towards fair value. Behaviourally speaking, high inflation may tip the psychology of the market towards accepting the inevitability of some nominal currency depreciation. This shift in psychology might result in greater reluctance to buy expensive currencies." - source Bank of America Merrill Lynch / Macronomics, June 2014
At the time we also mused around a phenomenon we saw in 2008 in relation to core inflation in the US:
"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:

 - source

Given January CPI rose 2.5% y-o-y, the strongest gain since early 2012 (core CPI up 2.3% y-o-y), and with Janet Yellen taking a more hawkish tone recently in the latest FOMC, one might be wondering if indeed the current "Hypomania" and global rising core CPI will not lead to some sort of "accident" in the not too distant future (like a rate hike in March...). Clearly the inflationary "build up" is putting stress on the QE infinity camp. We indicated in our recent conversations as well that the cozy relationship between central bankers and politicians was as well coming under renewed pressure (Germany). So overall, there is no doubt to us that we are seeing a dwindling support for central bankers. The QE backstop is slowly but surely fading on top of the buildup of inflationary pressures globally.

So of course, as anyone else we are watching inflationary pressure building up very closely. On this subject we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 10th of February entitled "The day of max inflation":
"The day of max inflation
WTI oil prices have more than doubled since reaching the low close of $26.21 a year ago on 2/11/2016 (Figure 1). This means that, if oil prices remain stable, headline inflation is peaking (at least locally) today. However, because economic data is reported on a delayed basis – and only monthly, not daily – we should continue to see oil prices driving up headline inflation numbers above core when reported for January (next week) and February.

- source Bank of America Merrill Lynch

As we pointed out as well in 2014, in our conversation "The Molotov Cocktail", past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years.

In this "Hypomania" environment we reminded ourselves of the wise words of Dr Jochen Felsenheimer from asset management XAIA which we quoted back in September 2011 in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!":
"in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. efficient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth." - Dr Jochen Felsenheimer
From our September 2011 conversation we also reminded ourselves this quote from Dr Jochen Felsenheimer's letter:
"In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer
Given the risk of a surge in trade wars with the new US administration, where it becomes interesting is that in our global competing systems, it seems we are moving away from "cooperation". This could of course have nasty consequences to say the least, for global trade, and would therefore continue to be bullish for gold (hence our late December positioning on gold miners as a reminder). As we pointed out on numerous occasions when discussing gold matters, has been the return of the Gibson paradox which we mused about in our October 2013 conversation:
"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics
Real interest rate is the most important macro factor for gold prices. US real rate has been the main driver for gold prices moves in recent years; while academic papers (Barsky, Summers, 1988) have given theoretical support. Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. You might be wondering what has led four our switch to our positive stance towards gold/gold miners at the end of December 2016, it all had to do with real rates as indicated by Bank of America Merrill Lynch in their Inflation Strategist note from the 14th of February entitled "Breakevens go overboard over border tax":
"Imports to CPI to breakevens: a perfect pass-through?

That a border tax has been interpreted as a stagflationary shock is apparent when one looks at the inflation market since the markets attention shifted to it post the Dec hike. Roughly about 11% of CPI is tied to imports using input-output tables. A 20% border tax would push 1y inflation up by 220bp immediately with a follow through impact of 40bp on 5y breakevens. It is no coincidence that since the December Fed hike, 5y breakevens went up 30bp, 5y real rates went down by 50bp and the DXY was weaker by 3% – a classic stagflationary shock priced in by the markets.
However, in our view it is too optimistic to expect the market to price in a perfect passthrough to breakevens without the any currency adjustment. Our analysis has shown that a border tax of 20% could be wiped out by a 25% likely rally in the dollar. Also, likely if a border tax were, implemented, it would be delayed and staggered over several years, making the impact on very front-end breakevens unclear. Ultimately, as highlighted in detail here and summarized in Chart 2, we see the border tax adjustment proposal largely playing out as a higher dollar and flat-lower breakeven trade.

Recent price action proves real rate a better short
To us, last week’s price action post the euphoria, proves exactly why real rates offer a better protected short than breakevens. While the upside may not all be captured in a rate selloff, any unwind of the Trump trade is far more likely to hurt breakevens than real rates. Consensus was expecting four hikes over the next two years even six months ago, when the odds were favoring a gridlocked Congress, a continued Yellen Fed and no fiscal stimulus. This suggests that the unwind of the post-election euphoria is likely to manifest as an unwind of the reflation trade as opposed to the unwind of the Fed hike trade, in our view. We maintain our short real rates recommendation across the curve."- source Bank of America Merrill Lynch
We agree with the deflating Trumpflation trade, and we also agree with Bank of America Merrill Lynch's recommendation for "shorting" real rates. There is of course an explanation around this which was very clearly put forward by David Goldman in Asia Times on the 17th of February in his article "A mistery solved: Why real yields are falling despite higher growth":
"Economists often think of real yields as the “real interest rate,” or baseline rate of return, in a macroeconomic model. From this standpoint the low level of TIPS yields is a mystery: when economic growth is rising, the real interest rate should rise. The expected short-term interest rate has been rising as the Fed sets about normalizing rates, and the rising short-term rates affect real yields. The fall in TIPS yields in the face of Fed tightening and stronger growth presents a double challenge to the conventional wisdom.
The conventional way of looking at real yields ignores the way markets treat risk. Government debt (and particularly the government debt of the United States) is not just a gauge of economic activity, but a kind of insurance. If the world comes crashing down, you want to own safe assets. Investors hold Treasuries in their portfolios not just for the income, but as an insurance against disaster. And TIPS offer a double form of insurance: If economic crisis takes the form of a big rise in the inflation rate, TIPS investors will be paid a correspondingly higher amount of principal when their bond matures. That explains why TIPS yields sometimes are negative: investors will accept a negative rate of return at the present expected inflation rate in return for a hedge against an unexpected rise in the inflation rate.
The yield on TIPS has tracked the price of gold with a remarkable degree of precision during the past 10 years, as shown in the chart below. Gold tracks the 5-year TIPS yield with 85% accuracy. That’s because both gold and TIPS function as a hedge against unexpected inflation.
During the past year, for example, we observe that the relationship between gold and the 5-year TIPS yield has remained consistent, while the relationship between the expected short-term rate (as reflected in the price of federal funds futures for delivery a year ahead) has jumped around. There are lots of local relationships between federal funds futures and the TIPS yield, but the overall relationship is highly unstable." - source Asia Times - David Goldman

The rest of his article, is a must read we think. but if indeed there are rising inflation expectations, then it makes sense for real yields to continue to fall, which can be assimilated to the cost of the insurance for "unexpected outcomes" is rising. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations is going up.

So moving back to how inflation can play out ultimately on credit spreads, it is most likely through a sell-off induced in equities which could be triggered by a "preemptive hike" by the Fed in March. On this subject we read with interest Bank of America Merrill Lynch Credit Market Strategist note from the 17th of February entitled "Equities not rates":
"Equities not rates
As highlighted by this week’s tightening of credit spreads amidst increasing rate hiking risks (Figure 1), higher interest rates and inflation are not the biggest near term risks to our bullish view on credit spreads.

With the continued rally in equities instead we are getting to the point where we are most concerned in the near term about scenarios that lead to a correction in stocks (Figure 2) – especially if interest rates decline materially in sympathy. Two leading candidate scenarios for this include US policy risk – including most prominently, but not limited to, disappointments around tax reform – and developments ahead of the French election.
Border adjustment tax
The key uncertainty in US tax reform is the border adjustment tax (BAT) from House Speaker Ryan’s blueprint. As we have argued, should the BAT – against our house view – be included, chances are that tax reform gets delayed significantly, as the scheme creates many losers that will push back (and winners – but losers tend to complain more than winners cheer), both domestically and internationally. As much of the recent rally in risk assets hinges on tax reform such delays could be troublesome. Perhaps we will know more on or before February 28th when President Trump addresses a joint session of congress.
To see this note that from an international trade perspective taxing imports, but exempting exports, is the equivalent of imposing an import tariff and giving out an export subsidy. There are three key effects of this. First it creates winners and losers domestically (see: Equity Strategy Focus Point: Death and tax reform 29) which again, as we have seen, translates into pushback against the plans. Second it creates losers and winners internationally as well. Potential losers and winners include countries that are net exporters to (Figure 3) and importers from (Figure 4) the US, respectively. Because the US is running a large trade deficit in goods and services ($490bn in 2016) of course there are more losers than winners abroad. That ensures significant pushback against the BAT abroad as well and the risk of trade war.

Third, the BAT issue is particularly sensitive as about two thirds of the US trade deficit is with just one country – China – which creates a particularly high risk of retaliation. In terms of possible responses, to mitigate the impact of a US border BAT for example China could choose to devalue the Renminbi against the dollar, which is very deflationary globally through commodities (Figure 5) and would bring back the memories of some of the biggest sell-offs in risk assets we have seen the past couple of years (Figure 6).

There are many reasons why the Trump administration might want to implement a BAT scheme, including that it creates significant revenue to help mitigate the impact of lowering the corporate tax rate. This is because the net effect of the border adjustments is effectively to tax the trade deficit by the new corporate tax rate – for example, a 20% tax on a $500bn trade deficit translates into $100bn in new tax revenue annually. Hence, taking out the BAT creates the need to find $100bn annually elsewhere, which may constrain the ability to lower tax rates." - source Bank of America Merrill Lynch
The conjunction of all these factors in an environment where "Hypomania" has reigned supreme, makes us particularly more nervous as we move towards March and a potential rate hike on the back of a stronger than expected January CPI and retail sales data. We also note that from a flow perspective, there have been some significant inflows into High Grade funds and ETFs as put forward as well in Bank of America Merrill Lynch's note:
"Flows refocus on stocksInflows to US equity funds and ETFs reached $13.13bn this past week (ending on February 15th) – the highest weekly inflow in two months – compared to a $1.95bn inflow the week before and $8.81bn inflow for the week ending on February 1. The pickup in inflows is consistent with the recent stock market rally. At the same time inflows to bonds moderated to $5.06bn from a high $8.04bn inflow in the prior week, mostly due to lower inflows to high grade." - source Bank of America Merrill Lynch
We don't think that "Hypomania" is warranted when the reliance in "opioids" is fading. On top of that, as we pointed out in our previous conversation, the latest Federal Reserve Senior Loan Officer Survey shows a weakening demand for credit overall, with Commercial Real Estate feeling the brunt.

  • Final charts - US Consumers yet to feel "Hypomaniac"
Whereas in the financial sphere, "Hypomania" is clearly running high, the US consumer it seems is less "euphoric". If indeed it is "Hypomania" for Wall Street, Main Street seems much more prudent as per our final charts from Bank of America Merrill Lynch in their Inflation Strategist note from the 14th of February entitled "Breakevens go overboard over border tax" displaying a decline in December in Consumer Credit which is consistent with declining Credit and Auto loan demand reported in the Senior Loan Officer Survey (not to mention rising delinquencies in subprime auto loans as of late...):
"In wait and see mode
While most often the Federal Reserve Senior Loan Officer Survey is closely monitored for color on bank lending standards, the most striking aspect of Monday’s report was weak loan demand across the board (see: Situation Room: The French Connection 06 February 2017). Perhaps this is due partly to rising interest rates, which would make sense for mortgages. However, one would certainly expect that development to play a smaller role for consumer loans and business loans. Tuesday’s Fed Consumer Credit expansion of $14.6bn in December (Figure 9), the lowest since June, is consistent with the sizable contractions in credit card and auto loan demand reported in the Senior Loan Officer Survey (Figure 10).

For more timely data the Fed’s weekly H.8 data allows us to come up with good estimates for January 2017 bank loan growth. We estimate that in January US banks experienced only a 0.6% annualized increase in consumer lending, down from 5.3% in December and the lowest reading in two years (Figure 11).

Furthermore C&I lending remained weak in January at 0.9% (Figure 12).

While bank profitability stands to benefit from higher NIMs as interest rates go up, nothing yet suggests animal spirits – in fact US consumers and businesses appear presently stuck in wait-and-see mode." - source Bank of America Merrill Lynch
So if indeed US consumers are closed to being "maxed out", then if the Fed is ready to pull the "hike trigger" in March, things could become interesting in "Hypomania" land we think. Can you spell "Policy Mistake"? Because we can...

"Mistakes can be corrected by those who pay attention to facts but dogmatism will not be corrected by those who are wedded to a vision. " - Thomas Sowell, American economist

Stay tuned!

Saturday 11 February 2017

Macro and Credit - The Carrington Event

"Faith may be defined briefly as an illogical belief in the occurrence of the improbable." -  H. L. Mencken, American writer

Watching with interest US stocks markets reaching new record levels, while investors are pondering what are the risks coming up in the horizon such as a potential trade war initiated by the Trump administration, China credit bubble bursting, an end of the euphoria in US High Yield, upcoming European elections in Holland, France and potential elections in Italy, we reminded ourselves for our chosen title analogy of the 1859 Carrington Event, a perfect solar superstorm and arguably the most underpriced risk in the world. At 11:18 in the morning on September 1st 1859, English astronomer Richard Carrington in his observatory saw two patches of intensely bright and white light breaking out as he wrote in his report "Description of a Singular Appearance seen in the Sun". The massive solar flare had the energy of 10 billion atomic bombs and hit our planet a couple of hours later wreaking havoc to the nascent global telegraph system. Today such natural "Electromagnetic Pulse" (EMP) disaster would inflict considerable damages to critical infrastructures around the globe. Extreme solar storms pose an existential threat to all forms of high-technology and create widespread power blackouts, disabling everything that plugs into a wall socket. According to NASA from their 23rd of July 2014 article entitled "Near Miss: The Solar Superstorm of July 2012", a similar storm to the Carrington Event of 1859 would exceed $2 trillion or 20 times greater than the costs of a Hurricane Katrina according to a study by the National Academy of Sciences. We find it interesting that the more technology and connected we are the more fragile we have become, the thesis of Nassim Taleb's "antifragile" theory. Furthermore as per our long fascination with "Rogue Waves" and risk, depicted in our February 2016 conversation "The disappearance of MS München", what apparently seemed to be an oddity in terms of probabilities, isn't in terms of frequencies as discovered by scientists studying the phenomenon to their dismay. In similar fashion, a solar superstorm appears to many people to be an extremely rare type of event with a low probability. It isn't. As per NASA's article to paraphrase Taleb, we are fooling ourselves with randomness: 
"In February 2014, physicist Pete Riley of Predictive Science Inc. published a paper in Space Weather entitled "On the probability of occurrence of extreme space weather events." In it, he analyzed the records of solar storms going back to 50+ years. By extrapolating the frequency of ordinary storms to the extreme, he calculated the odds that a Carrington-class storm would hit Earth in the next ten years. The answer is 12%. "Initially, I was quite surprised that the odds were so high, but the statistics appear to be correct", says Riley. "It's a sobering figure"." - source NASA
To paraphrase Donald Rumsfeld, while in financial markets today they are known unknowns, when it comes to solar superstorms it represent an unknown known, yet simply ignored by so many.  Such an event, if it hits Earth would cost several trillions of dollars, with a potential lasting recovery time given we are much more reliant on technology these days. Therefore we are way more vulnerable to these types of "rare" event than in the past, same goes with financial markets. Central banks meddling with assets prices have rendered the system much more "interconnected" therefore much more fragile and unstable. Globalization as well, has rendered economies much more entangled than in the past.

You might be wondering where we are going with our analogy. It seems to us that 2016, the many pundits that made the case for catastrophic events for BREXIT and Trump election got not only the outcome wrong, but also got the results wrong when it came to predict the impact on financial markets. In the case of 2016 we had "bad news" (on the back of "fake news") leading to "good news" for financial markets, we are wondering if in 2017 will not be "good news" (on the back of "real news") leading to "bad news" for financial markets.

In this week's conversation we will look at if indeed the "Trumpflation" story is not losing some steam and also what it entails in terms of allocation.

  • Macro and Credit - 2017 - From optimism bias to realism bias 
  • Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends

  • Macro and Credit - 2017 - From optimism bias to realism bias 
2016 for "credit" performances was a story of "bad news" leading to "good news", with the first part of the year plagued by the widening in the energy sector thanks to oil woes and spilling over to equities. Clearly the second part of the year saw a dramatic reversal of fortunes with US High Yield and in particular the energy sector leading the way, while investors extended both their credit exposure and duration exposure. While 2017 continues to see a rally in both US equities reaching new height and credit continuing its strong pace thanks to very significant inflows. This is particular the case for fixed income which is clearly seeing no sign of the "Great Rotation" story playing out, from bonds to equities that is. In fact, what is of interest is that this "great rotation" is happening with significant inflows into High Yield, most likely out of Government bond funds. As we have commented before on numerous occasions, we believe we are moving into the last inning of the credit cycle and at this stage we do not think High Yield could easily repeat its 2016 feat.
When it comes to "reaching for yield", whereas 2016 saw an extension of both credit risk and duration risk, 2017 so far is seeing somewhat a more defensive play when it comes to duration, but in terms of credit risk, High Yield has been seeing some significant flows as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 10th of February 2017 entitled "Reach Higher (yield), go Shorter (duration):
"No losers; everyone benefitting so far
Rising rates are not deterring investors from allocating more into fixed income funds. In fact last week’s inflow into the asset class was the strongest in 28 weeks. Inflows were strong mainly in the higher yielding part of the market, i.e. HY and EM debt funds, but also into high grade ones; predominantly on the short-dated part looking for a “shield” against rising rates. In other words investors are seeking high-yielding instruments and shifting into low-duration IG to protect against rising rates. Rising uncertainty is also favouring flows into commodity (particularly gold) funds.
Over the past week…
High grade funds continued on a positive trend for the third week in a row. The weekly inflow was also the highest in six weeks. High yield funds saw inflows for the tenth consecutive week, and the latest inflow was the largest since March ‘15. Looking into the domicile breakdown, the inflow last week came largely from US domiciled and globally-focused funds. Nevertheless the European-focused funds inflows improved from the previous trend.
Government bond funds had their third week of outflows despite rising rates. Money market funds weekly flows were positive after three weeks of outflows. Overall, fixed income funds recorded an even stronger week of inflows than the previous one, the highest in 28 weeks and the seventh positive in a row. The asset class is rapidly approaching the $20bn mark of inflows YTD. European equity funds flows were positive for a third week but with marginal volumes.
Global EM debt fund flows continued on the positive trend for a second week; and the latest inflow was the highest in 28 weeks. Commodities funds flow remained positive for a fourth week in a row, with the inflow pace going up again.
On the duration front, inflows continued in short-term IG funds for the eighth week in a row. Note that last week’s inflow was the highest since July ‘14. Mid-term funds’ flows flipped back to negative territory after last week’s strong inflow. On the other hand, flows into long-term funds moved back to positive after two weeks of outflows." - source Bank of America Merrill Lynch
Given such powerful flows as of late, it is hard to see what could be the catalyst that will finally derail this long in the tooth credit cycle. We are wondering what could potentially be the Carrington Event for credit. In the meantime, the rally runs unabated thanks to solid macro data and reasonable earnings for the time being. As we indicated earlier one, we wonder if 2017 will not be the reverse of 2016, namely that we will have a solid first half and probably a more difficult second half of the year. It is very difficult to assess what lies ahead with so many political events lining up for the year. In this context, we have raised our cash levels, and continue to play the gold mining theme while we are waiting for more clues from the Japanese crowd before being enticed again towards US Treasury notes. On the subject of tail events, we read with interest Bank of America Merrill Lynch Relative Value Strategist note from the 9th of February entitled "Always looking on the bright side of life":
"The anti-climax of tail events
In our view, the biggest financial misjudgments in 2016 were not about underestimating the probability of certain political events. We believe the larger error, in hindsight, was overestimating the immediate severity of the market’s reaction should they come to pass. So while we had two unexpected outcomes in Brexit and the US election results, both of which were viewed negatively in their respective run-ups, the aftermath has been quite anti-climactic in our view. The market has chosen to focus on the bright side of things, building up policy proposals that it favors like lower taxes and fiscal stimulus, while casting aside those like border adjustment taxes and renegotiating trade deals that could be detrimental to asset prices. While this may eventually prove to be the right call, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way.
As it stands, there seems to be widespread optimism that tax reform, deregulation and fiscal expansion this year will spur strong growth and inflation in the US. While this may eventually prove to be true, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way. This speaks to some complacency in our view, with not enough weight being given to medium-term policy uncertainty. 
Uncertainty is high. Stay liquid. Be hedged.
In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and favor CDX HY over indices referring cash bonds, as the basis is unlikely to compress much further." - source Bank of America Merrill Lynch
As per our last conversation, we would side again with Bank of America Merrill Lynch in regards to favoring the liquidity of CDX HY over cash bonds particularly in the light of the compression seen so far in US High Yield since the beginning of the year (European High Yield as well has had a solid run):

But, nonetheless, a barbell strategy of quality investment grade including short duration High Yield, could still represent an attractive investment proposal, particularly in the light of continuing widening in European Government bonds and the convexity risk for long dated investment grade securities.
"Stay liquid: long CDX HY over HY cash
In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun – SPX is down 0.5% in the last two weeks, while IG is 2bp wider. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and prefer CDX HY over indices referring cash bonds.

The CDS-cash basis is unlikely to go much higher
The CDS-cash basis has reverted towards its pre-2015 levels. The BAML HY index, H0A0, now trades just about 50bp wider than CDX HY (Chart 1). (Note it was 38bp wider until IHRT was removed from HY27 post default.)

As Chart 2 shows, the IBOXHY cash index has consistently outperformed its CDX counterpart for a year now. We think there is limited upside to this now i.e. the basis is unlikely to compress all the way back to 2012 levels thanks to some amount of liquidity premium embedded in high yield cash bonds after the events of the last two years.
Liquidity, liquidity, liquidity
CDX HY offers a better value, liquid long here than HY cash in our view. In the event of a macro shock, the synthetic index might initially underperform cash, but if the weakness persists, bonds will eventually catch-up. More importantly, we think the level of uncertainty regarding policy and the prospect of a flare-up following this period of extremely low volatility demands a higher allocation to liquid products.
Hedge against rate risk
This switch to CDX or a positive basis trade (long CDX, short cash spread) will also perform well as a hedge against a sharp rate rise, should one materialize.
US equities outperformed European equities while volatility continued to decline in both
markets (Table 4). Equity vol in the US currently stands at 11 vol points, near the lows
seen over the past 10 years:

 (Click to enlarge)
- source Bank of America Merrill Lynch

What is of interest to us in the case of US High Yield is the very slow deteriorating trend as shown per the Q4 Fed Senior Loan Officer Survey which has been recently released. On this subject we read with UBS latest Global Credit Strategy note from the 7th of February entitled "Has US High Yield priced too much good news?":
"Has US high-yield priced too much good news?
One of the most critical questions that portfolio managers face when investing relates to what is priced into the market. We have tackled this question before. One year ago, we highlighted to investors that it was not attractive to short US high-yield, as spreads near 850bps implied a US recession was imminent, while underlying fundamental data suggested otherwise. Fast forward one year, and we are in a very different world. US high-yield spreads sit at 400bps, only 43bps above cycle tights in July 2014. US highyield has returned a superb 21.2% over the last 12 months, one of the strongest rallies ever outside of a post-recession recovery. The key question for investors: Is there still room for US high-yield to rally?
It’s certainly possible. In our recent client meetings, we have heard the strong current of institutional pressure dragging active managers into the market to stem client outflows and reduce what has been an exceptionally difficult period of active manager underperformance vs. the broader index (Figure 1). We think this theme is dwindling as cash balances are falling, but it cannot be discounted from extending further . In addition, if developed market central banks remain dovish (i.e. only 2 Fed hikes in 2017, ECB keeps Taper talk to a minimum, BOJ keeps 0% 10yr JGB yield target), we believe that would be a positive near-term for setting the marginal price of credit.
However, it is becoming impossible to ignore downside fundamental and political risks that are more elevated than when high-yield last traded at such levels. Bank and nonbank lending standards are not easing, credit card and auto loan delinquencies are rising, bank C&I loan growth has stalled, and more protectionist sentiment is being underprized in our view as a macro risk. We believe investors should protect gains at current levels, with both high-quality (BB) and low-quality (CCC) high-yield credit at expensive prices. We suggest investors own junk credit through CDX to protect against illiquidity risk in cash bonds. Investors can also bet on a widening Cash-CDX HY basis as a downside hedge with very attractive risk-reward characteristics. Lastly, we reiterate our 2017 preference for US investment-grade credit and leveraged bank loans over US high-yield.
We believe the main conclusion that investors should take away is the following: While US high-yield has rallied to near cycle peaks, fundamental data highly correlated to US high-yield has not followed suit. Today’s release of the Q4 Fed Senior Loan Officer Survey highlighted a net 0% of banks tightening standards on small firm C&I loans, marginally worse than the -1.5% of banks easing conditions in Q3 (Figure 2). While 0% is not terrible, we need to remember that in the sweet spot of the cycle, a net -5% to -10% of banks typically ease conditions. It should be rather disappointing to bullish investors that one of the strongest high-yield rallies in history has been unable to induce banks to ease standards on CI loans.
Even more important than the headline number, we found only a net 7.4% of banks tightened spreads on C&I loans (average across large and small firms). This reduction of spreads is very modest in light of the massive spread tightening seen in the high-yield bond market. In context, this reading is worse than that experienced in Q2’98 and Q2’07. Put simply, banks are not passing on the decrease in market funding costs to their customers, at least not to the same extent as in the high-yield bond market. Given that these two lending indicators empirically lead both high-yield spreads and default rates, we keep our year-end forecasts for HY credit spreads, default rates, and total returns unchanged (YE 2017 HY spread: 570bps, 2017 HY Default Rates: 3.6%, 2017 HY total returns: 0.1%). For more details on our overall credit forecasts, please see our 2017 outlook pieces. In addition, the rather mixed performance of the lending survey was not limited to C&I loans; a net 23.8% of respondents tightened standards on CRE loans, a net 8.3% tightened on credit cards (worst post-crisis) and 7.3% tightened on auto and other consumer loans (worst post crisis) (Figure 3).

The Q4 Senior Loan Officer Survey also asked two sets of special questions regarding the future outlook for 2017 lending standards and delinquencies. The results here again are mixed, but mixed is not good enough with prices so high. On the former, it is true that a net -16.4% of banks expected lending conditions to ease for C&I loans to small firms, assuming economic activity progresses in line with consensus forecasts. This is the most bullish reading in the SLOS survey for credit investors and if it came to fruition could indicate the credit cycle is restarting. However, at the same time, a net 10.5% of banks expected to widen spreads on small firm C&I loans over the next year. This expected level of spread widening is empirically inconsistent with the forecasted easing in lending conditions, given the strong correlation between the two (Figure 2). To put in context, 10.5% of banks widening spreads is consistent with late 1999 and 2007 levels.
Significant numbers of banks indicated continued tightening for CRE (23.6%) and consumer loans (0% credit cards, 5.1% auto loans next year) as well in 2017. The outlook for delinquencies was also rather mixed. C&I loans only saw a small improvement, with a significant fraction of banks expecting rising NPLs in credit cards and auto loans (Figure 4).

This weakness in the consumer area remains a key source of concern. Our recent Evidence Lab primary survey on the US consumer suggested that rising post-election optimism was balanced out by households stating they were more likely to default on a loan over the next 12 months. Bottom line, there is clear potential for winners and losers post-election, rather than all winners.
The divergence of spreads relative to fundamentals goes beyond bank lending. Non-bank liquidity continues to tighten, largely flying under the radar of most investors. This has continued to tighten since we wrote our initial warning piece on the credit cycle in 2015 (Figure 5).

Non-bank trade credit (i.e. the financing of working capital) in particular continues to struggle, as improvement in the CMI trade-credit index has been modest and highly focused on better-quality names. (The favorable component of this series is currently at 60.8, the highest since July 2015). More stressed firms are under pressure however, with the unfavourable component of the CMI index at 49.5 in January, in contraction territory. The divergence of high-yield spreads versus weaker trade credit is now gaping. Figure 6 highlights that high-yield spreads are tightening rapidly at a time when the usage of collection agencies to collect on unpaid debt continues to grow.

When high yield spreads were at similar levels in 2014, the prospect of collection agencies was not even a remote concern. The CMI Index highlighted that retail names in the service sector were facing the most pressure, consistent our preference for underweighting this sector in US HY.
Another hole in the rally is how high-yield spreads have decoupled from underlying bank C&I loan growth (Figure 7).

Despite the well-publicized increase in consumer confidence and business optimism post the US election, bank C&I loan growth has stalled. We think this is not normal for an economy that is expected to hit mid 2% to 3% growth rates in 2017. In fact, the current growth rate of bank C&I loans is more consistent with levels seen just before recessions. Historically, high-yield spreads lead loan growth, as banks take time to restructure old loans and new firms wait to see evidence of consumer spending before borrowing anew. But this is typically an argument made after a recession. It is difficult to reconcile why bank loan growth has slowed already, since it is now generally established that the prior increase in credit spreads and funding costs did not impact US real GDP broadly to a meaningful extent. Could non-bank financing be crowding out bank financing to skew these numbers lower? This may matter somewhat, but many small US businesses with no access to capital markets must rely on bank financing if they wish to expand their businesses. Bottom line, we need to see loan growth picking up again.
Lastly, we believe there is significantly more political risk than many investors are appropriately pricing. We see the prospect of future protectionist policies from the new administration has the potential to be a key headwind, and our conversations with clients suggest this is not being taken seriously enough. A September 2016 paper by now Commerce Secretary Wilbur Ross and National Head of Trade Council Peter Navarro indicates a desire to reduce the US trade deficit meaningfully. The authors wrote in this report that “Those who suggest that Trump trade policies will ignite a trade war ignore the fact that we are already engaged in a trade war.” On the concept of tariffs, Mr Ross and Navarro wrote that “tariffs will be used not as an end game… Trump will impose appropriate defensive tariffs to level the playing field.” The authors believe that deregulation, lower taxes, lower energy costs, and a strong US bargaining position would offset any price increases and retaliation from increased protectionism, leading to a boom in US growth. However, we view any aggressive move to reduce the US trade deficit near-term via perceived protectionist measures would likely create considerable volatility in financial markets." - source UBS
You probably understand by now why our bullet point is entitled "From optimism bias to realism bias". It is important at this stage of the credit cycle to keep a heavy dose of realism. As we mentioned as well in numerous conversations we are tracking closely US Commercial Real Estate (CRE) particularly in the light of significant tightening financial conditions as depicted in the most recent Senior Loan Officer Survey. 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%. As a reminder in our February 2016 conversation "The disappearance of MS München", we discussed the significant headwinds for the retail sector and in particular series 6 for the CMBX index due to its larger retail exposure. We recently read with interest from an article from Matt Scully in Bloomberg from the 9th of February entitled "Deutsche Bank Says Next Big Short Is on CMBS as Malls Suffer":
"Analysts at Deutsche Bank AG, one of the biggest underwriters of bonds tied to U.S. commercial mortgages, say now it’s time to bet against the securities.
The bonds are vulnerable because they are supported in part by leases from retailers, a lagging part of the economy, wrote Ed Reardon and Simon Mui in a note this week. A combination of bankruptcies and closures could lead to faster-than-expected mortgage defaults for stores and malls, as long-term pressure from internet competitors wears many companies down, the analysts wrote.
Deutsche Bank recommends that investors bet against two series of indexes of commercial mortgage bonds: one from 2012, and another from 2013, a trade that amounts to shorting the underlying securities. Those indexes have larger exposure to malls than their more recent counterparts.
The lender famously recommended betting against real estate before. Before the financial crisis, traders led by Greg Lippmann shorted residential mortgage bonds, which helped the lender weather the global banking meltdown. His efforts were portrayed in the book and movie “The Big Short.”
Falling Index
In this week’s note, Deutsche Bank advised buying credit default protection on the parts of CMBX indexes that are a single step above junk, known as the BBB- tranches. Morgan Stanley recommended betting against portions of those indexes last week. The BBB- rated portion of the 2012 Markit CMBX price index, known as the series 6, has been falling since the end of January.
That index traded at 90 cents on the dollar on Wednesday, compared with 95.2 cents on the dollar on Jan. 27, according to data compiled by Bloomberg. The price has dropped as wagers on the index have climbed in recent weeks, reaching $2.3 billion at the end of last week, according to Depository Trust & Clearing Corp. data.
Deutsche Bank was the biggest underwriter of commercial mortgage bonds in 2012 and 2013, selling about a fifth of the deals, according to trade publication Commercial Mortgage Alert. Buying default protection on the CMBX indexes from those years amounts to betting against many of the bonds the bank sold during that period.
Commercial mortgage bonds that the bank underwrote have performed worse than those of many rivals, said Don McConnell, a senior portfolio manager at Bank of Montreal’s BMO Global Asset Management in Chicago, who helps manage $15 billion of taxable bonds. Of property securities that are delinquent, 40 percent were underwritten by Deutsche Bank, the highest of any lender, even though it is the second-biggest underwriter, he said. JPMorgan Chase & Co., the biggest underwriter, accounts for 10 percent of delinquencies.
Failing Malls
More losses may be coming. The Hudson Valley Mall went into foreclosure last year after Macy’s Inc. and J.C. Penney Co. left the mall. The mall liquidated last month at a $42 million loss to investors -- by far the largest realized loss since the CMBS market restarted in 2010, according to Morningstar Credit Ratings. Sears Holdings Corp.’s credit rating was recently cut further into junk territory after sales in stores open at least a year fell 12 to 13 percent during the holidays.
“Big mall loans have outsize losses for investors,” said Morningstar analyst Edward Dittmer. “We expect the stores like Sears, Macy’s and Penney to close more stores later this year and next year, and as they close, there will be knock-on effects that lead to other mall tenants leaving. This can start the cycle of blight.”- source Bloomberg

While CMBX Series 6 saw it prices recover somewhat following the volatile first semester of 2016, the recent price action in conjunction with the weaker Senior Loan Officer Survey does suggest that there is indeed more pain coming for the sector and it is already playing out in this particular CMBX series. This as well documented in Bank of America Merrill Lynch's latest Securitized Products Strategy Weekly note from the 10th of February;
"Recap & relative value
With benchmark conduit spreads unchanged, no private label deals pricing and only one conduit transaction in the marketing process, the majority of this week’s conversations remained focused on the retail sector. Over the past two weeks short-risk interest in lower-rated CMBX6 tranches surged (Chart 45), fueled by a consensus among some hedge funds that retail and regional mall problems will accelerate in the coming months.
As a result, lower-rated CMBX6 tranches, which are collateralized by about 37% retail exposure, have borne the brunt of the pain (Chart 46), falling by as much as 3.5 points since the beginning of the month.
Although retail sector problems will likely continue to unfold over the coming months and years, it is important to understand what sparked the recent selloff. Over the past two weeks there has been some negative retail-related news (Wet Seal, LLC, filed for bankruptcy on Feb 2, Hudson’s Bay Co. approached Macy’s about a takeover, etc.) and the recent broader-market risk-rally stagnated as evidenced by range bound equity markets and falling 10-year Treasury yields and breakevens (Chart 47).
Ultimately, however, we think the recent move lower in the CMBX wasn’t based on new, fundamental information. Despite the selloff among lower-rated CMBX6 tranches over the past few weeks the underlying cash reference obligations have held in extremely well: there has been little client selling and cash bond spreads have barely moved. As a result, the BBB-minus and double-B cash/synthetic spread differential gapped sharply negatively (synthetics underperformed the similarly rated cash bonds) and (Chart 48) and are now testing, or through, their tightest historical ranges.

This isn’t to say that problems don’t exist. The regional mall space is likely to consolidate over the coming years, which may put pressure on some of the loans collateralized by these assets. Aside from those investors that are using lower-rated CMBX6 tranches to hedge their long-risk books (as some distressed investors do), in order for the “short CMBX6.BBB- or CMBX6.BB” trade to work successfully for an investor that is selling risk outright, the retail sector would need to experience a significant, large shock that has systemic implications to serve as a catalyst. The most commonly mentioned catalyst by many investors would be a near-term bankruptcy of a large retailer. Among retailers, Sears tends to be one that many investors focus on, given the company’s broad-based regional exposure in regional malls and the difficulties that it has experienced over the past few years.
Over the past few weeks, however, no new negative announcements have been made by the company that could have sparked renewed downward pressure on the CMBX. In fact, the company today issued a press release in which it announced it initiated a restructuring program targeted to deliver at least $1 billion in annualized cost savings in 2017. This is not to say that all is fine: although 4th quarter earnings were better than expected, total comparable store sales for the fourth quarter declined 10.3%, comprised of a decrease of 8.0% at Kmart and a decrease of 12.3% at Sears Domestic.
Ultimately, there are several independent “variables” that need to play out simultaneously for an outright short-risk CMBX6 trade to work as well as many hedge fund investors hope it will. In all likelihood, we think this is unlikely to happen. Instead, we think lower-rated CMBX6 tranches will trade in a wide range over the upcoming months and be exposed to potentially significant price fluctuations – both higher and lower – as investors react to headlines. At this point, following the magnitude of the recent move, which began at the end of January (Chart 49), we think the lower-rated CMBX6 tranches are over-sold and could rally as investors get short squeezed.

Given the lack of material, significant fundamental news, this week’s move seems largely technically driven. Over the past few weeks we’ve analyzed the regional malls collateralizing the CMBX6 and last week looked at loss severities for mall loans that were liquidated last year (Regional mall rhetoric has become too negative). One additional data point that we didn’t discuss, but which we think is important, relates to the timing between when loans first show signs of stress and when they were ultimately liquidated. Although this may not matter for investors shorting CMBX6 as a trade, it is important to investors shorting the index outright, since losses would need to be crystalized in order to receive a payout. On average, for the loans liquidated in 2016 that were collateralized by regional malls, it took approximately 48 months between when loans first began to show signs of stress and when they were ultimately liquidated" - source Bank of America Merrill Lynch
So, while no doubt, when it comes to the retail sector there is blood in the water and sharks are starting to circle, it appears to us that in this particular case "someone" is effectively "talking his book". While some pundits might eagerly follow the "Optimism bias" course of action with that "short" trade idea, we would rather side with Bank of America Merrill Lynch and play the "Realism bias" given the potential for the enthusiastic punters to get "short-squeezed" in very short order on that move.

For our final chart and when it comes to being more a "realist" the recent significant widening in French yields have been explained by many pundits by the sudden rise in the political risk in French from seeing Marine Le Pen getting elected at the next presidential election in France. For us, as we have been explaining in numerous conversations, when it comes to European government yields, you seriously need to track the flows from Japan.

  • Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends
In 2016, in numerous conversations we have indicated the importance of tracking Japanese flows from the Government Pension Investment Fund (GPIF), their Lifers friends and Mrs Watanabe playing it through the famous Uridashi retail funds. We believe that in 2017, following Japanese flows is paramount when it comes to assessing yield movements in European government bonds. While the political rational might be enticing for some, for us it is simply a question of flows, or lack thereof, from the voracious 2016 Japanese investors which have been on a diet as of late. Our final chart comes from Bank of America Merrill Lynch Japan Rates and FX Watch note from the 8th of February and displays the cumulative purchase of European sovereign bonds by Japanese since 2012 (JPY trn):
"FDI and portfolio outflow offset current account surplus
Today Japan's Ministry of Finance (MoF) released international balance of payment statistics for December and a preliminary portfolio investment report for January (based on reports from designated institutions). The seasonally adjusted current account surplus was ¥1,669bn, somewhat lower than in November (¥1,780bn), but still a high level. The current account surplus for CY2016 was ¥20.6trn, and direct investment deficit of ¥14.6trn cancelled out most of this. The ¥30.5trn deficit in portfolio investment is sizable, but a significant part of this portfolio investment should have been hedged. This pattern of investing surplus funds overseas and using the profits to fund the home country reflects Japan’s status as an aging developed country. Also, due to the rising number of foreign visitors to Japan, a surplus of ¥1,339.1bn was recorded in the travel account, the largest such surplus since 1996.
The Trump shock’s aftereffects and Europe’s political risk
The rise of US yields following the US presidential election appeared to settle down around the beginning of 2017, but Japanese investors continued to sell a net ¥1.62trn of foreign bonds in January. Banks were the main sellers. They were net sellers of ¥1.97trn in one month. Life insurers, who had been net sellers along with banks in the previous month, switched to a net purchase of ¥159.8bn in January. Details of flow for January have not been released yet, but we do know from December figures that the net sale of US Treasuries was ¥2.39trn that month, the largest since May 2013." - source Bank of America Merrill Lynch
So if indeed in the Land of the Rising Sun, the sun is in fact setting on their appetite for European sovereign bonds, then no doubt you might get your equivalent of a Carrington Event and solar storm in European bond land we think. It might simply be that "Bondzilla" the NIRP monster might have a serious case of "bond" indigestion after his epic fest of 2016, but we ramble again...

"The world is divided into two classes, those who believe the incredible, and those who do the improbable." -  Oscar Wilde

Stay tuned !

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