Tuesday 25 July 2017

Macro and Credit - The Butterfly effect

"The foolish are like ripples on water, For whatsoever they do is quickly effaced; But the righteous are like carvings upon stone, For their smallest act is durable." -  Horace

Watching with interest the retreat in government bond yields, thanks to overall dovishness from our "Generous gamblers" aka central bankers including recently ECB's Le Chiffre (Mario Draghi), leading to renewed inflows into High Yield and equities in the US making new records in the prospect, with a continuation of the bull market in complacency, we reminded ourselves for our title analogy of the much used "Butterfly effect" narrative. While the "Butterfly effect" is the concept that small causes can have large effects and was initially used in weather prediction, in chaos theory, the sensitive dependence on initial conditions in a nonlinear system such as financial markets can lead to large differences in a later state of a credit cycle. The name was coined by American mathematician, meteorologist and chaos theory pioneer Edward Lorenz.

Our chosen analogy is also a veiled reference to US Treasuries Butterfly, given we think it is showing us that the US economy to some extent is tracking Japan. The butterfly spreads formed by the gaps between short, medium and long term US Treasury yields has been narrowing with Japan as of late:
- source Bloomberg 

In this week's conversation, we would like to look at what continues to provide inflows and support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan". 

  • Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets
  • Final charts - Financial conditions? The punch bowl is still plentiful.

  • Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets
Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. 

While 2016 was a record year in terms of foreign bond purchases by Japanese Lifers, 2017 was more tepid thanks to European elections risk, but according to Nomura in their JPY Flow Monitor note from the 21st of July, Insurance companies bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row:
"Insurance companies: Insurance companies kept purchasing foreign bonds in June, but momentum remained relatively weak (Figure 1). They bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row. They tend to be net buyers of foreign bonds in June, and the amount of net purchases was not significant (see “JPY: Season of seasonality”, 2 March 2017). Their investment in JGBs slowed to JPY171bn ($1.5bn). We expect lifers to keep purchasing foreign bonds, as major lifers’ investment plans suggest JGB yields will remain unattractive (see “BOJ review: Waiting longer for tailwinds”, 21July 2017).
Banks: Banks were net buyers of domestic and foreign bonds in June for the second month in a row (Figure 2).

They were large net sellers of bonds in April, but as seasonality shows, they resumed purchasing bonds in May and June. Foreign bond investment has slowed from May, but the FX impact was limited, in our view.
Pension funds: Trust banks, which manage pension funds’ money, kept purchasing foreign securities in June for the third month in a row (Figure 3).

The pace of net purchases slowed to JPY132bn ($1.2bn) though. Pension funds were also net buyers of domestic equities for the first time in five months. They bought JPY236bn ($2.1bn) of domestic equities, the biggest amount since August 2016. They were net buyers of JGBs too (JPY411bn or $3.7bn). The GPIF’s latest portfolio data up to end-March showed the fund’s portfolio is closer to its target portfolio. However, it accumulated short-term assets at a high level, and the president of the fund said the accumulation of short-term assets is to enhance available capacity for the next investment. Diversification from short-term assets into portfolio assets should continue for the time being as European political uncertainty has diminished. We expect pension funds to be dip buyers of foreign bonds and equities." - source Nomura
Not only for Japanese Lifers, but also for retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years as per Barclays JPY Monthly Flows noted from the 20th of July:
  • "Japanese institutional investors continued to buy foreign bonds, but net outflow slowed down from last month. By investor type, banks and trust banks remained net buyers of foreign bonds. Meanwhile, life insurers continued to purchase foreign bonds. Foreign equity investments also decreased slightly in June, led by banks and bank trust account. Weekly data indicates that a net purchase of foreign bonds by Japanese investors turned positive again in the first week of July amid yield curve steepening globally since the end of June. Regional breakdown of foreign bond flow shows that Japanese investors turned net buyers of US, German and French bonds in May (Figure 1).

  • Among retail investors, toshin funds remained popular while net issuance of foreign-currency-denominated uridashi bonds decreased somewhat in June. In bonds, INR- and RUB-denominated uridashi bonds continued to attract solid demand from investors. As for toshin funds, BRL-denominated funds increased for the first time since January this year and TRY- and INR-denominated funds continued to tick higher. Margin FX investors reduced their net long positions in USDJPY and AUDJPY notably and increased their short EURJPY and GBPJPY positions.
- source Barclays

Clearly, for Japanese retail investors, it has all been in recent years about low bond volatility and "king dollar". We continue to believe that when it comes to global flows, Japan matters and matters a lot. Japanese yen is indeed the source of the carry trade on a global basis and this has very significant implications from a tactical perspective when it comes to foreign bonds overall. Since the implementation of NIRP in 2016, Japanese Lifers went into "overdrive" in their purchases of foreign bonds. No surprise therefore that, when it comes to the "Butterfly effect", Bondzilla's appetite has been increasing at a rapid pace. 

You might be wondering where we going with the reference to the Butterfly effect and the importance of Japan but for US credit markets, Japan matters as well and matters a lot. Back in March 2017 in our conversation "Outflow boundary", we indicated the following:
"The big question, as we await the allocation decision from our Japanese friends, if there will be enticed again by foreign bonds like they have in recent years. The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment." - source Macronomics, March 2017
For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments.  

One thing that appears clear to us is that USD corporate credit in recent years has been supported by a large contingent of foreign investors in particular Japan. Reading through UBS Credit Strategy note from the 21st of July entitled "Where are we in the credit cycle?" we were pleasantly surprised that indeed, Bondzilla the NIRP monster is "made in Japan" and it is as well a critical support of US credit markets:
"Our deep dive analysis isolates Japan as the critical support for US credit"

- source UBS

Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk. 

The latest dovish retreat from our "Generous gamblers" (Fed and ECB) has created a "Rebound effect" as posited last week in the sense that is has not only prolonged the goldilocks state in credit markets with spreads tightening further for a longer period in this credit cycle, but, equities wise, it has provided additional strong support as well. Summer 2017 has led to record stock indices and all time spread tights in many instances. For now it seems it is "carry on" and we are indeed in the final melt-up of this last inning of the credit cycle risky assets wise. For many it continues to be the most hated bull-market in history. So far it seems our gamblers are reluctant in removing too early and too fast the credit punch bowl. For the moment the credit love boat is still sailing strong during this summer lull and unless we see some exogenous factors coming into play, it is difficult to see what could be a catalyst for a reversal before September where the Fed and the ECB could decide to tighten the financial conditions spigot as per our final charts.

  • Final charts - Financial conditions? The punch bowl is still plentiful.
As we have seen recently, the Butterfly effect from the hawkish comments from Le Chiffre aka Mario Draghi led to a mini-tantrum in the Euro government bond space. Obviously the recent tone down in the rhetoric from both the Fed and the ECB has led to a continuation of "goldilocks" for risky assets thanks to record low volatility. Given the current financial conditions on both side of the Atlantic, it remains to be seen if our "Generous gamblers" will maintain further their dovish rhetoric in September. Our charts below come from Nomura and displays the US and Euro area financial conditions and comes from their recent Japan Navigator notes:
"Euro area and US policymakers are likely concerned about riskier asset rally;

Japanese policymakers may welcome it
This week 40yr and 2yr JGB auctions will be held. Japanese CPI data will be released.
The FOMC meets.
This week’s ECB announcement and market reaction have strengthened our conviction that the global yield upcycle that started from the euro area in late June has faded. We believe bond markets will move substantially only in September, when the Fed and ECB are likely to tighten policy, but only if riskier asset markets remain bullish despite Fed and/or ECB action. During this period, yields are likely to trade in a fairly narrow range, with risks on the downside, in our view. Riskier asset markets may strengthen and prevent yields from rising, but they tend to destabilize in the summer, particularly because US growth expectations are unlikely to rise.
UST yields have begun to fall. Although the market had become bearish owing to momentum from the euro area government bond (EGB) market, it lacked bond-negative factors (Figure 1).

There have been fairly strong concerns over US growth and inflation, and August data will likely be interpreted with scepticism – at the very least, a single month’s worth of data are unlikely to dispel these concerns, in our view.
We believe the ECB and Fed will look to tighten policy further if the output gap continues to improve and the riskier asset rally continues, even as they express concern about slow inflation growth, in our view. However, the Fed and ECB are unlikely to have an opportunity to jawbone until the Jackson Hole symposium in late August. Although the BOJ has emphasized its dovish stance, we believe it has basically the same stance as the Fed and ECB, and is unlikely to adopt an easing stance again as long as the output gap continues to improve. However, if JPY strengthens on risk aversion this summer, the market’s easing expectations may rise again, if only temporarily.
Compared with the Fed and ECB, the BOJ appears more tolerant about an increase in JPY carry trades and a riskier asset rally, and appears to be concerned about how much it can increase its JGB purchases further, rather than ETF buying, in our view. That said, if the BOJ revises its policy framework in such a way as to (erroneously) cause risk aversion, the negative impact on the appointment of the next governor should be substantial. Therefore, we do not expect policymakers to change the upper end of the target 10yr JGB yield range (0.11%) in the near term." - source Nomura
There you go, for now the ECB and the Fed have been mindful of the "Butterfly effects" in risky asset markets, hence the tone down of the rhetoric and insisting on a gradual process in removing the proverbial punch bowl, while the Bank of Japan (BOJ) has so far been in a holding pattern, ensuring in effect that investors in Japan as well continue to play out the low volatility leveraged "carry" play into overtime. No wonder the "Butterfly effect" is made in Japan, maybe it's related to the famous Opera play Madame Butterfly by Giacomo Puccini where the hero was so excited to marry an American that she had earlier secretly converted to Christianity or like Bank of Japan to central bankers' current religion we wonder. It didn't end well for Madame Butterfly in the end but we ramble again...

"See, the night doth enfold us! See, all the world lies sleeping!" - Giacomo Puccini

Stay tuned !

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