Monday 25 September 2017

Macro and Credit - Rescission

"Perfection of planned layout is achieved only by institutions on the point of collapse." -  C. Northcote Parkinson, British Historian

Looking with interest at the decisions taken by the Fed at its FOMC meeting to start unwinding its bloated balance sheet, when it came to selecting our title analogy, we reacquainted ourselves with the term "Rescission" from contract law, (not to be confused with "Recession" yet). In contract law, "Rescission" has been defined as the unmaking of a contract between parties. "Rescission" is the unwinding of a transaction. This is done to bring the parties, as far as possible, back to the position in which they were before they entered into a contract (the status quo ante). One could opine that "Rescission" is typically viewed as "an extreme remedy" which is rarely granted, but in the case of the Fed, it was a unanimous decision to hold the federal funds rate between 1.00% and 1.25% and begin the process of shrinking its balance sheet by October hence our chosen analogy for this week's conversation.

Before we go into more details of this week's conversation, we would like to make a support appeal on behalf of our surfing friends in Saint Martin. They lost everything when hurricane Irma levelled their island. While we do have a tip jar on the blog page, for those of you who enjoy our free weekly musings, we would be extremely grateful if you could be helping out in providing financial support for the reconstruction of Saint Martin's surf club facilities given they really need a new boat. These facilities have been effectively wiped out. Jean-Sebastien Lavocat, a great windsurfer and surfer, is running the place. In 23 years of existences the surfing club of Saint Martin has generated numerous young surfing champions including current top French number three Maud Le Car. He really needs your support to continue to do so. You can make donations at the following address: Solidarity with Windy Reef. Please give them a hand. As well, the natural reserve area where the surf club is located, needs financial support. You can also donate on the following page: "Réserve Naturelle St-Martin Vs IRMA". After Irma please participate in the restoration of the last natural sites of the island of Saint Martin! Thanks again.

In this week's conversation, we would like to look at the Fed's low inflation mystery, in relation to the fall of productivity in the US, yet another nail in their Norwegian Blue parrot aka the Phillips Curve. Another wise wizard from the BIS, namely Claudio Borio has delivered another blow to the outdated model used by the central banking "cult members".

  • Macro - Low inflation mystery? The Fed is gone fishing.
  • Credit - Beware of rapid credit expansion
  • Final chart - "Broken" asset investment in Developed Markets

  • Macro - Low inflation mystery? The Fed is gone fishing.
Given the colloquial meaning of "Gone Fishing" relates to a checkout from reality, as well as being unaware of what's going on, Janet Yellen's latest comment on the low inflation mystery is another indication of their lack of understanding of why their Phillips Curve model is clearly past its due date we think. 

While in various recent musings we have been pounding this Norwegian Blue Parrot, which is still resting for the Phillips Curve "cult members", we couldn't resist to bring back this subject following the support coming from Claudio Borio, Head of the BIS Monetary and Economic Department in his most recent discussion on the low inflation issues entitled "Through the looking glass" published on the 22nd of September 2017.  
"Central banks must feel like they have stepped through a mirror, and who can blame them? They used to struggle to bring inflation down or keep it under control; now they toil to push it up. They used to fear wage increases; now they urge them on. They used to dread fiscal expansion; now they sometimes invoke it. Fighting inflation defined a generation of postwar central bankers; encouraging it could define the current one.
What is going on in this topsy-turvy world? Could it be that inflation is like a compass with a broken needle? That would be a dreadful prospect – central bankers’ worst nightmare. And what would be the broader implications for central banking?
In my presentation today, I would like to address these troubling questions. I will do so recognising that “in order to make progress, one must leave the door to the unknown ajar”, as Richard Feynman once said. We should not take for granted even our strongest-held beliefs. That, of course, means that I will be intentionally provocative.
I will make three key points – putting forward two hypotheses and drawing one implication.
First, we may be underestimating the influence that real factors have on inflation, even over long horizons. Put differently, Friedman’s famous saying that “inflation is always and everywhere a monetary phenomenon” requires nuancing (Friedman (1970)). Looking back, I will focus mainly on the role of globalisation; but, looking forward, technology could have an even larger impact.
Second, we may be underestimating the influence that monetary policy has on real (inflation-adjusted) interest rates over long horizons. This, in fact, is the mirror image of the previous statement: at the limit, if inflation were entirely unresponsive to monetary policy, changes in nominal rates, over which central banks have a strong influence, would translate one-to-one into changes in real rates. And it raises questions about the idea that central banks passively follow some natural real interest rate determined exclusively by real factors, embodied in the familiar statement that interest rates are historically low because the natural rate has fallen a lot. Here, I will provide some new empirical evidence to support my hypothesis.
Finally, if these hypotheses are correct, we may need to adjust monetary policy frameworks accordingly. As I shall explain, that would mean putting less weight on inflation and more weight on the longer-term real effects of monetary policy through its impact on financial stability (financial cycles). Incidentally, the stronger focus on financial stability would bring central banking closer to its origins (Goodhart (1988), Borio (2014a))." - source Claudio Borio, BIS
Of course, we would argue that, if indeed, one is to make progress, one should be ready to reassess the validity of its framework such as the sacrosanct Phillips Curve. We were pleasantly surprised to read in the excellent speech from one of the BIS maverick economists, that globalization was put forward as one of the reasons for the lack of responsiveness of the Phillips Curve framework, which for some is simply resting like a "Norwegian Blue parrot":
"The one I find particularly attractive is that the globalisation of product, capital and labour markets has played a significant role. Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening-up of other emerging market economies? This added something like 1.6 billion people to the effective labour force, drastically shrinking the share of advanced economies, and cut that share by about half by 2015. Similarly, could it have remained immune to the technological advances that allowed the de-location of the production of goods and services across the world? Surely we should expect the behaviour of both labour and firms to have become much more sensitive to global conditions. We know that workers are not just competing with fellow workers in the same country but also with those abroad. We know that, for a given nominal exchange rate, the prices of two tradable goods that are close substitutes should track each other pretty closely. And we know that exchange rates have not been fully flexible, as the authorities have been far from indifferent to exchange rate movements. In other words, we should expect globalisation to have made markets much more contestable, eroding the “pricing” power of both labour and firms. If so, it is quite possible that all this has made the wage-price spirals of the past much less likely.
More specifically, one can think of two types of effect of globalisation on inflation. The first is symmetrical: assuming something akin to a global Phillips curve, one would expect domestic slack to be an insufficient measure of inflationary or disinflationary pressures; global slack would matter too. The second is asymmetrical: one would expect the entry of lower-cost producers and of cheaper labour into the global economy to have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge." - source Claudio Borio, BIS
As we pointed out earlier in September in our conversation "Ouroboros", these are the reasons why the Phillips Curve is broken we think:
"For us, there are three main reasons why the Phillips curve is a Norwegian Blue parrot, simply resting in a Monty Pythonesque way:

  1. Demographics: as population ages, there are more pressure on aggregate demand and total consumption. 
  2. Globalization: real wages have come under pressure thanks to offshoring of labor in different parts of the world, leading to good solid wages jobs in the industrial sector being replaced by low qualification low paying jobs in the service and hospitality sectors.
  3. Technology: As per Henderson's work and recent progress in technology, pressure on prices as been appearing thanks to the Experience curve. The fight between Amazon and the retail sector comes to mind we think about it. Technology has been holding down costs overall and facilitated rapid price competition in some sector (internet on retail).
This is why we think the Phillips curve is obsolete, for structural reasons." - source Macronomics, September 2017

Obviously our hypotheses have been given some much appreciated boost from none other than the wise and respected Claudio Borio from the BIS. We will not delve into more details of Claudio Borio's speech, but, in our opinion, it is a must read, particularly for the Phillips Curve "cult members". As Richard Feynman once said, and as pointed out by BIS Head of Monetary and Economic Department, in order to make progress, one must leave the door to the unknown ajar. Unfortunately, for many it seems, the door is closed. For them, the Phillips Curve is simply "resting".

The pace of wage inflation is influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 - 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase, that simple. We already discussed the issue of US productivity in June 2016 in our conversation "Optimism bias":
"In our book, "secular stagnation" is not only due to the burden of high global debt levels but, as well by the evident slowdown in productivity labor growth, which is clearly impacted by the "rise of the robots". This does not bode well for the stability of the "social fabric" and with rising populism in many parts of the world." - source Macronomics, June 2016
As we pointed out to Kevin Muir author of the Macro Tourist in our conversation "The Dead Parrot sketch", a business owner is a "deflationista" at heart because he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. Also it is worth mentioning French economist Jean Fourastié's work relating to real wages, real prices and in particular around productivity. In our last conversation we indicated that when it comes to the Phillips curve, the deflationary bias of capitalism and the Experience Curve should not be neglected in addition to the globalization factor:
"As we move towards the end of an economic expansion in the US, productivity has been falling, and jobs have been mostly created for lower skills workers, hence the lower wages conundrum weighting on inflation expectations." - source Macronomics, September 2017
When it comes to productivity issues, it seems to us that the Fed is unaware of what's going on, namely, that they've "gone fishing". On the issue of low productivity, we read with interest Bank of America Merrill Lynch's Economic Weekly note from the 22nd of September entitled "Productivity growth is a procrastinator":
  • "The US economy is currently in a low productivity regime, averaging just 0.6% growth since 2011.
  • The near-term outlook appears dim due to headwinds from unfavorable demographic factors and weak capital investment.
  • Broad adoption of new IT goods and services could generate better productivity growth. But a regime shift is likely a long-term story.
Productivity growth down in the dumps
Labor productivity growth has been abysmal. Since 2011, it has averaged less than 1% and the trend is pointing down, as it came in flat in 2016. As we wrote last week, low productivity growth is likely one of the factors holding down wage gains and one of the catalysts that led some FOMC participants to revise down their longer-run dot in the latest SEP projections. In this note, we break down productivity growth into its three major components—labor quality, capital deepening and multifactor productivity—and ponder the near-term outlook.
Not all hours are created equal
Labor quality measures the effect of shifts in the age, education, and gender composition of the workforce. One can imagine that total output will vary given a workforce with a certain set of education, skills, and experience. Contribution of labor quality to productivity growth has varied over time as the composition of the workforce has shifted (Chart 1).

Labor quality took a dip in the late 60s to the 70s as a surge of young inexperienced workers (Baby-Boomers) entered the job market, lowering the experience level of the overall workforce. But as those workers gained experience and entered their prime-working age (when they are likely to be the most productive), the labor quality of the workforce increased, leading to greater productivity gains. Additionally, we saw the skill level of the workforce rise as a greater share of workers obtained higher degrees, helping to usher in an era of high productivity growth.
Today, the forces affecting labor quality are mixed (Chart 2).

On one hand, the share of the prime-age workers is declining as Baby-Boomers begin to retire and the Bureau of Labor Statistics projects that the trend will remain flat over the next decade. On the other hand, a greater share of workers are obtaining college degrees or higher and the trend looks broadly positive. In the long run, a more-educated labor force should pay dividends for productivity growth. However, in the near term the “Silver-Tsunami” effect will likely be a bigger countervailing force, keeping the contribution of labor quality to productivity growth below levels experienced in the 90s and 2000s.
You got to spend money to make money
Capital deepening or capital intensity is the amount of capital investment in relation to labor input. More machinery or equipment should make a worker more efficient, which should translate to more output per hour. Prior to the Great Recession, capital deepening contributed on average 0.9pp to labor productivity growth. Moreover, we experienced a big surge in capital investment at the turn of the century as businesses invested more in information and communication technology during the IT revolution. Since then, the pace of capital investment has slowed. The Great Recession played a role in holding down business investment, but during the current recovery, the pace of net stock of capital investment growth has remained well below prior trends (Chart 3).

Recently, businesses have placed investments on hold, as they wait to see if Congress passes corporate tax reform. Moreover, in the industrial sector, capacity utilization remains well below pre-recession levels and overall capital formation is only modestly outpacing depreciation, lessening the need to invest heavily in new equipment and machinery. All told, given our expectations for nonresidential fixed investment to grow at a tepid pace over the next several years, we see little prospects of a strong pickup in capital deepening.
Multifactor productivity: the magic elixir for growth?
Multifactor productivity (MFP) measures the output per unit of capital and labor input. In essence, it measures the overall production efficiency of the economy. The driving force of MFP is hard to pinpoint. In fact, empirically MFP is usually estimated as the residual of the production function. But the right combination of labor and capital can lead to significant productivity growth similar to what we experienced during the IT boom.
Although productivity growth at the aggregate remains weak, certain sectors have benefited from adoption of new technologies (Table 1).

For example, the oil and gas industry experienced a surge in MFP growth due to new drilling methods such as “pad” drilling, which allows rig operators to drill groups of wells simultaneously. Additionally drillers have found further efficiencies by developing fracking methods, which reduce the amount sand and water needed to drill wells. The IT-producing and service industries such as “computer and electronic products” and “computer systems design and related services” industries continue to see productivity gains from faster processors and algorithms and the adoption of cloud computing technology. In the retail world, ecommerce has led to a surge in the share of retail activity at non-store retailers, while job growth has remained limited, boosting productivity growth in the sector. In fact, according to the BLS, labor productivity growth for non-store retailers has averaged 5.6% over the last five years, well above the aggregate pace.
Innovation in robotics and artificial intelligence, adoption of big data and machine learning analytics raise the prospects for productivity gains. However, broad diffusion of these technologies will likely take years if not decades, implying that the hoped for rebound is likely a long-term story. We could see some incremental increase in the meantime, but a full regime shift seems unlikely.
A word on mismeasurement
It’s possible that there are some mismeasurement issues in the data. The skeptics of low productivity growth usually argue that prices for IT products used to deflate nominal expenditures are too high given the quality improvements, implying more real output and greater productivity. The jury is still out, but the preponderance of evidence suggests that mismeasurement issues were around prior to the slowdown in productivity growth and there’s little evidence to suggest it has exacerbated. One area where we see potential measurement issues is profit shifting of US corporations abroad, distorting the way corporate income is reported, which leads to wider trade deficits than the official measure. According to Guvenen et. al., adjusting for this mismeasurement would add 0.1pp annually to productivity growth for 1994-2004 and 0.25pp for 2004-2008, mitigating some of the productivity slowdown.
Adding it all up
The prospects of returning to a high-productivity regime and seeing better potential growth in the near term seem limited. In fact, the risks are likely skewed to the downside to our already low estimate for potential growth of 1.7%. Demographic trends are unfavorable and businesses appear to be in a “wait and see” mode on capital spending. Multifactor productivity remains an unknown factor: the trend doesn’t look too promising, but broad diffusion of new IT products could lead to some modest productivity gains in the short run before seeing greater gains once potential is fully realized. Until then, we remain comfortable with our call for productivity growth to stay subdued and for growth to hover around 2% over the next several years." - source Bank of America Merrill Lynch
As we pointed out, productivity has been falling, and jobs have been mostly created for lower skills workers. On top of that, business owners have been more creative in keeping costs under control and not only due to "globalization". Overall, low inflation should not be a mystery for the Fed:

  • if they had read the work of French economist Jean Fourastié, 
  • if they had taken the globalization factor pointed out by Claudio Borio at the BIS 
  • if they had taken into account BCG's Experience curve impact (a company’s unit production costs fall by a predictable amount - typically 20 to 30 % in real terms - for each doubling of “experience,” or accumulated production volume). 

What we called recently in one of our musings the "Amazon factor" is effectively today' application of the Experience curve in the sense that it is the ability to produce existing products more cheaply and deliver them to an ever-wider audience (or what BCG calls "shaping demand with successive innovations").

That's about it for our "Macro" bullet point. For our credit point below, we would like to point out the brewing instability coming from rapid credit expansion, as it might be the case, that, from a Financial Stability perspective, at least the Fed is getting nervous on that front.

  • Credit - Beware of rapid credit expansion
As we pointed out in our previous conversation, the work of Claudio Borio from the BIS, has been very interesting when it comes to pointing out the risks for Financial Stability including rapid credit expansion. As a reminder, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS 
A common sign of brewing instability has always been rapid credit expansion. The "controlled demolition" analogy we used in the past when discussing the threat of the Shadow Banking sector in the Chinese economy was a clear illustration that the Chinese authorities were clearly aware of the risks. So far they have managed to dampen the issues at hand. It is always critical to assess rapid credit expansion to gauge rising instability in our current credit world. On this subject we reminded ourselves of September 2016 paper by Matthew Baron and Wei Xiong, Quarterly Journal of Economics, entitled "Credit Expansion and Neglected Crash Risk":
"By analyzing 20 developed economies over 1920–2012, we find the following evidence of overoptimism and neglect of crash risk by bank equity investors during credit expansions: (i) bank credit expansion predicts increased bank equity crash risk, but despite the elevated crash risk, also predicts lower mean bank equity returns in subsequent one to three years; (ii) conditional on bank credit expansion of a country exceeding a 95th percentile threshold, the predicted excess return for the bank equity index in subsequent three years is -37.3%; and (iii) bank credit expansion is distinct from equity market sentiment captured by dividend yield and yet dividend yield and credit expansion interact with each other to make credit expansion a particularly strong predictor of lower bank equity returns when dividend yield is low." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics
As pointed out by the BIS work, rapid credit expansion can have severe consequences on the real economy. The recent Great Financial Crisis (GFC) was an illustration of out of control credit expansion in the housing markets with global dire consequences:
"The recent financial crisis in 2007–2008 has renewed economists’ interest in the causes and consequences of credit expansions. There is now substantial evidence showing that credit expansions can have severe consequences on the real economy as reflected by subsequent banking crises, housing market crashes, and economic recessions, (e.g., Borio and Lowe 2002, Mian and Sufi 2009, Schularick and Taylor 2012, and L´opez-Salido, Stein, and Zakrajˇsek 2016). However, the causes of credit expansion remain elusive. An influential yet controversial view put forth by Minsky (1977) and Kindleberger (1978) emphasizes overoptimism as an important driver of credit expansion. According to this view, prolonged periods of economic booms tend to breed optimism, which in turn leads to credit expansions that can eventually destabilize the financial system and the economy. The recent literature has proposed various mechanisms that can lead to such optimism" - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.
As we have discussed recently, in credit booms such as the ongoing one, credit quality is deteriorating, which is the case when it comes to US Investment Grade. The deterioration of credit quality forecasts not only lower future corporate bond returns but, will also have an impact on the recovery value. In their very interesting paper, Matthew Baron and Wei Xiong look if credit expansion predicts a significantly higher likelihood of bank equity crashes:
"We find that one to three years after bank credit expansions, despite the increased crash risk, the mean excess return of the bank equity index is significantly lower rather than higher. Specifically, a one standard deviation increase in credit expansion predicts an 11.4 percentage point decrease in subsequent three-year-ahead excess returns." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.
Their analysis demonstrates the clear presence of overoptimism by bank shareholders during bank credit expansions, which of course not a surprise given this phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. You might already be wondering where we are going with this but, we think that right now, loose financial conditions are leading to rapid credit expansion which is probably a concern for the Fed relating to Financial Stability. On this subject we read with interest Société Générale Market Wrap-up note from the 19th of September entitled "What the macro number tell us about borrowing" which indicates that leverage is rising now in Europe as well:
"Market thoughts
In “Leverage is rising in Europe too,” we used two bottom-up data series of leverage, built from the companies in the iBoxx euro-denominated IG and high yield indices, to show how European companies were getting more risky. Do the macro figures back these conclusions up?
The Banque de France published its latest update on the financing of the corporate sector on 12 September. The year-on-year growth rate of loans to non-financials remains just under 5%, more or less unchanged from where it has been since mid-2015 (as Chart 1 shows).

The growth rate is broadly in line with the levels seen in mid-2011, ahead of the euro crisis, but less than half the peaks in 2001 (ahead of the 2002 bear market) or 2007/8 just before the US-led global financial crisis. The level of borrowing is not striking, but the composition is more noteworthy. While borrowing for short-term needs is now stable year-on-year, and borrowing to finance property investment has dipped, the borrowing for other forms of capital investment is running at 7% per annum, well above the 2011 peaks.
This suggests that companies are borrowing to invest, and explains some of the rise in balance sheet leverage noted in our earlier study.
Seen at a pan-European level, however, the trend looks far less significant. Chart 3 shows the growth in borrowing from the ECB for corporates and households (with the latter split into consumer credit and house purchases).

Corporate borrowing is not only growing less quickly than household borrowing, but the year-on-year growth rates have decelerated recently.
On balance, then, the macro data is rather less alarming than the bottom-up figures, which do show that leverage is rising. As we noted in our earlier study, however, this could be because of the increase in high yield borrowing and issuance in euro-denominated debt from issuers outside the eurozone. The bank lending figures themselves are more likely to be biased towards domestic borrowers." - source Sociéte Générale.
While on balance the macro data seems less alarming, there is no doubt that leverage is creeping up and that covenants are being loosened, even in Europe, which seems to indicate rapid credit expansion in some instances. No surprise some central banks including the Bank of England are wary about these developments. As shown in a recent article by the Wall Street Journal, leverage loans are coming back at a rapid pace, as indicated in their article from the 24th of September entitled "Leveraged Loans Are Back and on Pace to Top Pre-Financial Crisis Records":
"Lending to the most highly indebted companies in the U.S. and Europe is surging, a development that investors worry could pressure financial markets if the global economic expansion starts to fade.
Volume for these leveraged loans is up 53% this year in the U.S., putting it on pace to surpass the 2007 record of $534 billion, according to S&P Global Market Intelligence’s LCD unit.
In Europe, recent loans offer fewer investor safeguards than in the past. This year, 70% of the region’s new leveraged loans are known as covenant-lite, according to LCD, more than triple the number four years ago. Covenants are the terms in a loan’s contract that offer investor protections, such as provisions on borrowers’ ability to take on more debt or invest in projects.
Toys ‘R’ Us offered a reminder of the risks of piling on debt when the company filed for bankruptcy protection on Monday. The toy seller’s chief executive said in court papers that Toys ‘R’ Us had been hampered by its “significant leverage.” Its $5.3 billion in debt included a large number of leveraged loans and high-yield bonds" - source Wall Street Journal
Given in the US a third of loans to private-equity backed companies this year are leveraged six times or more, according to LCD’s calculations of companies’ debt to earnings before interest, tax, depreciation and amortization and despite 2013 guidelines from U.S. regulators, including the Fed, on loan underwriting stating that leverage of more than six times "raises concerns for most industries", you probably understand why the Fed is envisaging "Rescission" from its generosity, and draining some of the alcohol out of the credit punch bowl. In similar fashion, credit expansion and loose covenants have become more aggressive in Europe as indicated in the Financial Times on the 20th of September in their article "Aggressive term in Stada bond sale causes outcry":
"Analysts and investors are crying foul at an aggressive term in the bond sale backing the €4.3bn buyout of Stada, which they say creates a new way for the drugmaker’s private equity owners to strip cash out of the business.
The €825m high-yield bond deal is being sold alongside a €1.95bn syndication of leveraged loans, in order to finance Bain Capital and Cinven’s acquisition of German generic drugmaker Stada. The acquisition is the largest leveraged buyout of a European-listed company in four years." - source Financial Times
European companies are indeed getting more risky. This another indication of the lateness of the credit cycle, even in Europe, although one could argue that US is ahead of Europe when it comes to its rapid credit expansion phase as pointed out by JP Morgan in their note from the 20th of September entitled "Age isn't everything -  Gauging the DM business cycle":
"The US looks modestly more vulnerable
On balance, most indicators suggest that the DM as a whole is not close to its next recession, despite having returned to full employment. While this case can be made for the DM as a whole, the picture is more mixed for the US—the economy farthest advanced in its cycle. Our US team’s recession risk tracker places the risks of a recession in the next twelve months at a relatively low at a 1-in-4 chance. However, the risk profile rises sharply to a 3-in-4 chance at the two to three year horizon.
Two factors appear to differentiate the US from other DM economies. First, falling productivity growth and weak pricing power has led to a significant decline in corporate profit margins from the highs. Some of this margin compression owed to the hit to the energy sector in recent years. With oil prices having bounced from the severely depressed levels in early 2016, and also with productivity growth having recovered, US corporate margins are staging a bit of a recovery. Still, with labor markets continuing to tighten, the pressure will be for some compression in US corporate margins.
Second, there has been a large increase in nonfinancial corporate credit with debt/asset leverage at the 85th percentile of its nearly four decade average. It is important to recognize that our US recession probability model does not account for the fact that rising corporate leverage and falling margins have usually been accompanied by other late cycle pressures that push interest rates up. With US interest rates low and the Fed unlikely to tighten policy significantly over the next year, forces magnifying problems due to tight labor markets and lower corporate margins do not look likely to intensify soon. Still, US shocks generate powerful reverberations through the rest of the world, and it is important to track the factors generating US vulnerabilities alongside our assessment of DM risks in the aggregate." - source JP Morgan
One thing for sure, the Fed might be in "Rescission" mood when it comes to its balance sheet and the credit punch bowl, the US Yield curve is still not buying their "Jedi tricks" as it is getting flatter even after the latest FOMC. So overall credit is becoming stretched and productivity is remaining low in the US. Meanwhile business investment remains very low as well in this unusual "recovery" cycle as per our final chart below.

  • Final chart - "Broken" asset investment in Developed Markets
Although the Fed is lost in "inflation" translation, and with the ongoing low productivity seen so far in this cycle, there has been as well a notable imbalance such as the downward trend in business investment. Our final chart comes from JP Morgan report quoted above and displays the trend in Fixed asset investment in Developed Markets (DM):
"With regard to imbalances, there are few signs of an overstretched durables spending cycle. Even accounting for a downward trend, the level of outlays for business investment remains relatively low by historical standards (Figure 18).

Similarly, DM spending on housing and motor vehicles remains low relative to GDP or to population growth. At the same time, household balance sheets are quite healthy even if corporate balances are beginning to look somewhat stretched. 
It is difficult to be precise about the timing of recessions,which are inherently coordination failures among millions of economic actors. The historical record on slack underscores a wide range of outturns once full employment is reached, and there is sufficient evidence to suggest that the typical vulnerabilities associated with recessions are not currently present. However, as vulnerabilities rise, they can be amplified by unforeseen shocks, often coming from financial or commodity prices. It is worth noting that every US recession (except one) was preceded by a material increase in oil prices and every oil market disruption (except one) was followed by an economic recession (“Historical Oil Shocks,” J. Hamilton, 2011). The fact that oil prices have witnessed a spectacular supply-led collapse since 2014 and continue to struggle is encouraging in this regard. While the direction of causation is widely debated, it is arguably the interaction between the various vulnerabilities noted above, along with tightened economic conditions, with financial and commodity prices that becomes the catalyst for recession." - source JP Morgan
As we pointed out last week, for a bear market to materialize, you would need a buildup of inflationary pressure that would reignite the volatility in bonds via the MOVE index. We also pointed out in a previous conversation in similar fashion to JP Morgan that past history has shown that what matters is the velocity of the increase in the oil prices. 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. No need to press the "panic" button yet, but it is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation. The Fed might be in "Rescission" mode when it comes to its bloated balance sheet, the US Yield curve remains oblivious to its Jedi tricks and continues to flatten. This does indicate that "Rescission" could eventually lead to "Recession" in 2018, but that's another story...

"Expansion means complexity and complexity decay." - C. Northcote Parkinson, British historian.
Stay tuned !

Monday 18 September 2017

Macro and Credit - The Two Who Stole The Moon

"Three things cannot be long hidden: the sun, the moon, and the truth." - Buddha

Watching with interest the continuation of the beta trade in conjunction with new record highs in US equities, we listened with great interest to the interview on Bloomberg of the always wise real Gandalf of central banking namely William White from the OECD. In this must see interview, the former great wizard of the BIS goes through the "end game" and the current state of affairs. Given recent discussions in the central banking world of helicopter money and also the growing discussions about universal basic income, while thinking about our title analogy, we reminded ourselves of the 1962 Polish children's film based on  Kornel Makuszyński's 1928 story "The Two Who Stole the Moon". The film stars the Kaczyński twins, two of the country's future political leaders of Poland incidentally. Despite having been known to Polish children for many generations, the film gained renewed fame in the 2000s because it starred two of the country's future leaders: Lech Kaczyński, who served as President of Poland from 2005 until his death in a 2010 plane crash, and his identical twin brother Jarosław Kaczyński, the Prime Minister of Poland from 2006 to 2007, Chief of Office of the President of Poland from 1990 to 1991, and current chairman of the Law and Justice party. The twins were thirteen at the time. The story of the film we are using as a title analogy is about two twins, Jacek and Placek who are two cruel, greedy and lazy boys whose main interest is eating, eating anything, including chalk and a sponge in school. One day they have the idea of stealing the moon; because, after all, it is made of gold:
"If we steal the moon, we would not have to work""But we do not work now, either...""But then we would not have to work at all".
After a few small adventures, they really manage to steal the moon. Immediately a gang of robbers notices the little thieves and captures them. The two regain their freedom, and one of the twins devises a plan to enter the "City of Gold". The plan works, but when the robbers try to collect the gold, they turn into gold themselves. The twins escape and then run home and promise to help their parents with their work as farmers. In similar fashion, our central bankers have been stealing the "printing press" and the idea of "helicopter money" or universal basic income is doom to fail given as posited by Adam Smith:
"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased." - Adam Smith
No matter how our central bankers or bitcoin followers would like to play it, even after "stealing the moon", as the Polish children story goes, the twins ended up having to work with their parents as farmers, labour being the first price, the original purchase, but we ramble again...

In this week's conversation, we would like to look at the financial conditions versus the upcoming update of the Fed's dot plot.

  • Macro - Losing the dot plot
  • Credit - US Investment Grade - putting the brakes on leverage
  • Final chart - The only easy day was yesterday

  • Macro - Losing the dot plot
In our previous conversation "Aleatoricism", we discussed how immune the US yield curve has been to the Fed's "Jedi tricks" given the on-going flattening stance and the recession predictability of an inversion of the US yield curve. A very important point mentioned we think was that with a December hike, the threshold for a 69.2 percent chance of a recession during the next 17 months (average lead time) according to the study we quoted and made by Wells Fargo would be reached. Their framework has predicted all recessions since 1955 with an average lead time of 17 months, therefore one wants to be extra careful in 2018 for any signs of slowdown/recession. What is of interest and in continuation to our last conversation relating to the Fed's dot plot with the upcoming update is that the Taylor rule has fallen about 20 bp since the June update. Financials conditions matter particularly when looking at the Taylor rules used by the Fed. On this subject we read with interest Deutsche Bank's Fed Notes from the 13th of September entitled "Can loose financial conditions save the Fed's dots?":
"With an announcement to begin tapering balance sheet reinvestment viewed as nearly a done deal at next week’s FOMC meeting, focus will be on any signs of a shift in the Fed’s views about the expected policy rate path as represented by the “dots.” While the recent string of soft inflation prints argues for some downgrade to the dots, one key question is how much, if at all, loose financial conditions can counterbalance disappointing inflation and support the Fed’s rate hike expectations.
Taylor rules and financial conditions
Financial conditions have eased considerably in recent months. After bouncing around near zero just prior to the US election – a level indicating that financial conditions were broadly neutral for growth – our high-frequency financial conditions index (FCI) rose to its highest (i.e., most growth-supportive) level in several years in August (Figure 1).

Our FCI has declined slightly over the past month but continues to indicate that financial conditions are loose, signaling solid growth in the coming quarters.
As our FCI has risen, traditional Taylor rules, which do not account directly for financial conditions, have fallen sharply. In recent years, the predicted fed funds rate from a Taylor rule espoused by Chair Yellen in a March 2015 speech has implied a fed funds rate above the Fed’s actual policy rate. However, the recent decline in measures of the neutral fed funds rate, or r-star, and recent soft inflation, have led to a collapse in the prescribed fed funds rate towards the actual policy rate. Indeed, after peaking near 2% at end-2016, the fed funds rate implied by Yellen’s preferred rule has fallen to near 1.2%, just above the current effective fed funds rate (Figure 2).

And the predicted fed funds rate from this Taylor rule has fallen about 20bp since the Fed last updated their dots in June.
Does the easing in financial conditions alter this story? In previous work, we constructed an FCI-augmented policy rule to quantify how movements in financial conditions would affect fed funds rate prescriptions from traditional Taylor rules. In that work, we converted the level of our FCI into a fed funds rate equivalent at each point in time, and then incorporated this value into the Taylor rule that
Yellen mentioned.
According to this FCI-augmented Taylor rule, loose financial conditions in recent months have consistently added between 30 and 50bp to the typical Taylor rule prescriptions (Figure 3).

Nevertheless, the FCI-augmented Taylor rule has also fallen considerably. After peaking at around 2.25% in February 2017, with core PCE inflation near 1.9% and the Laubach-William’s measure of r-star around +0.1%, the FCI-augmented Taylor rule has fallen nearly 60bp to 1.69%. It has also fallen by about 5bp since the Fed last updated their rate expectations at the June FOMC meeting. In other words, loose financial conditions are only able to partially offset the decline in the fed funds rate predicted by traditional Taylor rules.
Do Fed officials care about financial conditions?
There is correctly some skepticism about how important financial conditions are for the Fed outlook. Some officials, such as NY Fed President Dudley, clearly put meaningful weight on financial conditions. But financial conditions are less of a focus for other Fed officials, and in fact, the traditional Fed view has been that financial conditions and financial stability considerations are typically better dealt with via supervision and regulation tools, not monetary policy.
In this context, it is important that the FCI-augmented rule can also be interpreted as capturing a forward-looking element to monetary policy expectations. Financial conditions provide an important signal about economic growth in the upcoming quarters (Figure 4).

In turn, FCIs provide information about future developments in the Fed’s dual mandate – full employment and 2% inflation. Fed officials that are less inclined to place significant weight on financial conditions may therefore still want to consider the impact of financial conditions on growth, the labor market, and inflation when setting their expectations for rate increases in the coming quarters. That is, current loose financial conditions can provide some support for a view that growth will remain solid, the labor market will continue to tighten, and inflation should rise from current low levels.
Financial conditions alone unlikely to save the dots
Recent soft inflation prints have been a critical driver of the decline in Taylor rule predictions for the fed funds rate. As such, a rebound in the inflation  trend in upcoming months would produce a meaningful increase in rule-based prescriptions. This Thursday’s US CPI print could also be critical for the September dots. A stronger print that is in line with our expectations and consensus, could give the Fed some confidence in their central narrative that inflation should rebound and return towards the Fed’s 2% objective after recent weakness.
We will detail our expectations for the dots more precisely in a September FOMC preview note later this week. But while loose financial conditions are likely to help keep rate hike expectations stable for some key Fed officials, like Dudley, the conclusion from our analysis here is that financial conditions alone are unlikely to be enough to save at least some Fed dots from falling." - source Deutsche Bank
US CPI came out at 0.4% month-on-month and 1.9% year-on-year, which was above expectations of 1.80%. It's too early to expect a rebound inflation towards the Fed's 2% target we think. On that point we disagree with Deutsche Bank. Deutsche Bank in their Japan Economics Weekly note from the 25th of August entitled "The decline in labor share touched a very important point relative to our Norwegian Blue parrot aka the Phillips Curve when it comes to wages and productivity relative to the end of an economic expansion:
"Financial markets think that a strong economy tightens the labor market, driving wages up, but people who are hired closer to the end of an economic expansion phase have lower productivity and are hence paid lower wages. Thus, the preconception that the rise in per-capita wages accelerates in an economic expansion is doubtful." - source Deutsche Bank
This is exactly what we have been saying when discussing recently the Phillips curve, the deflationary bias of capitalism and the Experience Curve. As we move towards the end of an economic expansion in the US, productivity has been falling, and jobs have been mostly created for lower skills workers, hence the lower wages conundrum weighting on inflation expectations.

Also, when it comes to including Financial Conditions in the Taylor rules, this is a subject we discussed in our conversation "An Extraordinary Dislocation" given we would prefer the Fed used a Wicksellian Differential:
"Before we start our usual Macro and Credit musing we would like as a reminder to discuss Wicksell Differential and the credit cycle (linked to the leverage cycle). Wicksell argued in his 1898 book Interest and Prices that the equilibrium of a credit economy could be ascertained by comparing the money rate of interest to the natural rate of interest.  This simply equates to comparing the cost of capital with the return on capital. In economies where the natural rate is higher than the money rate, credit growth will drive a positive disequilibrium in an economy. When the natural rate of interest is lower than the money rate which is the case today (rising Libor), the demand for credit dries up (our CCC credit canary are being shut out of credit markets) leading to a negative disequilibrium and capital destruction eventually. In a credit based global macro world like ours, the Wicksellian Differential provides a better alternative estimation of disequilibrium than the more standard Taylor Rule approach of our central bankers. At the Bank for International Settlements since 1987, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS 
So when we hear Janet Yellen at the Fed saying the following:
  "Asset values aren’t out of line with historical norms." -Janet Yellen, 21st of September 2016
We reminded ourselves that Wicksell used just the housing sector to illustrate his theory. Excess lending dear Mrs Yellen, always lead to "overinvestment". Just because the Taylor Rule used by the Fed doesn't include asset prices, it doesn't mean in our book that asset values are not out of line of historical norms
Why is the Wicksellian Differential so important when it comes to asset allocation? Either profits increase due to an increase in the return of capital and/or a fall in the cost of capital (buybacks funded by a credit binge)." - source Macronomics, October 2016
Of course the Wicksellian Differential is an ex-post measure, so, it isn't that helpful for investors as a predictor (or the Fed but still better than a crude Taylor rule).

The leverage ratio and the rate of profit or changes in general price level or output per worker are much better factors to take into account for designing a predictive tool. We also pointed out in our previous conversation the importance of the Fed's quarterly Senior Loan Officer Opinion Surveys (SLOOs) in terms of credit impulse and credit availability guides for the US credit markets. As we pointed out last week, we do monitor as well the shape of the High Yield credit curve through its proxy the CDX High Yield CDS index. We also look at the ability of the CCC rated US High Yield segment's ability in tapping the credit markets as a sign of tightening financial conditions:

- source Bank of America Merrill Lynch

Overall the market is pretty much open still for the CCC rating bucket (the Energy sector and Healthcare being the most prominent sectors in the US), yet for the last 12 months, the trend of the market has been somewhat a tad tighter as per the above graph.

What is of interest to us is the importance of comparing the cost of capital with the return on capital from a Wicksellian Differential perspective hence the importance of tracking the evolution of the cost of capital as pointed out by Wells Fargo in their Interest Rate Weekly note from the 13th of September entitled "Evolution of the Cost of Capital Over the Business Cycle":
"Equity capital is one factor in financing economic growth and yet the cost of equity capital varies over the business cycle.
Top Line Growth: The Reward for Capital Investment
Nominal GDP growth provides a starting point to judge the top-line growth opportunities for business and thereby a measure of incentives to balance against the cost of capital.
As illustrated in the below graph, nominal GDP growth provides evidence of a linear downward trend over time.

This downward trend in growth signals that nominal GDP growth is not a mean-reverting series. This observation stands against the claim that somehow nominal growth and capital returns will come back to some average value over time.
The Price-Earnings Ratio: Another Non Mean Reverting Series
Commentators frequently argue that equity price-earnings ratios are either above or below some average value and that this difference indicates the equity market is under or overvalued. However, as illustrated by the below graph, an average value can be calculated for any time series, but that does not indicate that the behavior of that series will return to some average value. Mean-reverting behavior for a series cannot simply be assumed. 

In fact, the P/E ratio is not mean reverting. There have been significant shifts in the series in October 1987 (downward) and in October 1991 (upward) and then down again in July 2002. In fact, the P/E ratio is dependent on the behavior of several economic fundamentals such as expected nominal growth and interest rate polices as well as regulatory changes and exogenous shocks that alter the risk/reward calculus. The P/E ratio is not independent of the economic cycle and, instead, a product of the many forces of the economic cycle.
CAPE Ratio: Another Product of Economic Fundamentals
Cyclically adjusted price/earnings (CAPE) is another measure to judge the pattern of equity finance costs relative to a recent past (bottom graph). This series, as well as the P/E ratio itself, is subject to many exogenous forces that result in a pattern of behavior that reflects the influence of economic, political and regulatory forces.
The CAPE ratio is not mean-reverting, thus there is no single number that is the standard of value. Second, the CAPE ratio is subject to several shocks that shift the behavior of the series (Sep. 2001, Oct. 2008, Nov. 1998) such that the ability to judge the cost of equity finance relative to the recent past will have to adjust to the many structural shifts in the CAPE series.

Since the 1970s, the CAPE ratio does evidence peaks prior to a recession but the series also provides evidence of declines such that the CAPE ratio does not appear to provide a reliable leading indicator. Instead, the CAPE ratio itself is an endogenous part of the economic cycle and is a function of ongoing changes in economic activity as the business cycle matures." - source Wells Fargo
Of course there have been so many articles relating to lofty valuations in many various asset classes from the usual perma-bear crowd, which will be right in the end. But, what matters we think, is the potential change in the central banking narrative. For us, as we pointed out in various musings, for a bear market to materialize, you would need a buildup of inflationary pressure that would reignite the volatility in bonds via the MOVE index. This would create the necessary conditions for a change in the direction of markets. In our recent musings, we pointed out that in the on-going credit "Goldilocks" scenario, already expensive asset classes would become even more expensive, going to 11 that is, in true Spinal Tap fashion.

On another note, whereas the first part of the year saw a significant rally in Emerging Markets equities thanks to  US dollar woes and our correct January call, we are wondering if indeed the US dollar is not due for a bounce, should some tax reforms be passed by the US administration.

When it comes to credit and the lowering of quality we have witnessed in US Investment Grade, leverage in recent years has been going up thanks to buybacks and M&A. As of late there seems to be a pause at this stage, which is "credit friendly".

  • Credit - US Investment Grade - putting the brakes on leverage

The latest rafts of earnings report, in conjunction with the SLOOs we mention, have shown us that Financial Conditions are still loose. Richer equity valuations have somewhat dampened the appetite of CFOs in pursuing buybacks as well as M&A for the time being. When it comes to the current stability of credit spreads, this is a welcome respite given leverage is higher in the US than in Europe as indicated by Société Générale in their Market Wrap-up note from the 29th of August entitled "Where US leverage is rising the most":
"US balance-sheet leverage has risen
Chart 1 shows the change in US debt/equity. The weighted average is shown in blue; the median is shown in brown. Both have risen since around 2013, and while the weighted average is not quite back to 2002/3 levels, the median is within a whisker of these points.
How did we get here? Chart 2 shows the breakdown of the median leverage numbers by industry. Two sectors – Real Estate and Utilities – have seen only modest increases. Other sectors have risen more sharply, and the biggest rise has been in Mining & Energy, still the sector with the lowest overall leverage.

US income-sheet leverage has also risen 
Chart 3 shows the weighted average of US net debt/EBITDA;

Chart 4 shows the median level. Of the two, Chart 4 is more worrying.

The weighted average level of income-sheet leverage is nowhere near the 2001 peak (let alone the late-2008 peak) and has been declining since early 2016. The median figure keeps climbing and is now close to the 2002 peak.
Looking at net debt/EBITDA by sector confirms the concerns with the median figures. Chart 5 shows that leverage has dropped slightly in the Mining & Energy sector but continues to rise in the Consumer and Industrials sectors, while Telco leverage has been flat.

The Consumer and Industrial sectors are among the most cyclical in the index, so if the economy turns down and EBITDA starts to decline, we should expect these leverage ratios to jump much more sharply.
Income-statement leverage has also been rising in the Real Estate and Utilities sectors, which we show separately in Chart 6 to make both charts more legible. 
US cash-flow leverage is up as well
Finally, we turn to interest coverage, our cash-flow leverage indicator. Charts 6 and 7 show the weighted average and median levels of the indicator across the IG and HY universes.

Net interest coverage, which we plot in reverse to make these charts comparable to the preceding ones, has been falling, but this fall has stabilised on an average basis and is declining in median terms. This is comforting, but remember that interest coverage is probably going to be the last leverage indicator to flash warning signs.
It’s worth noting moreover that the worsening in interest cover since 2010 has largely been limited to two sectors – Mining and Real Estate. In addition, real estate interest coverage remains high in absolute terms:
Conclusion: reasons to worry about the cyclicals 
What should we conclude from these numbers? Balance-sheet leverage and income-sheet leverage are both near the top of their historical ranges, so both are giving warning signals. A drop in EBITDA and net income would lead to historical highs both in income and cash leverage. This, combined with relatively tight spreads, should make investors more defensive on the US credit market.
The sectors where we are most wary are first Mining & Energy and second the Consumer and Industrial sectors. The problems of the Mining & Energy sector are well known; by contrast the cyclical Consumer and Industrial sectors are probably more vulnerable than investors realise. Telecoms are also showing higher leverage and could be challenged if interest rates rise and refinancing conditions become more difficult. The most defensive sector is certainly Utilities, with Real Estate fairly defensive too in comparison to historical leverage levels." - source Société Générale
As we are slowly but surely moving towards the end of this long credit cycle, we do agree that it is time to start building up defenses and move up the quality ladder, yet there is no denying that we are currently seeing some respite not only through better SLOOs but also with CFOs tempering their appetite for increasing leverage in the US as indicated by Bank of America Merrill Lynch Situation Room note from the 13th of September entitled "Spending less on stocks":
"Spending less on stocks
With even the late reporters 2Q results in by now, data from US non-financial high grade issuer cash flow statements shows that companies have again reduced spending on both share buybacks and acquisitions during the quarter (Figure 1, Figure 2).

This spending has been trending down as a share of free cash flow as well (Figure 3).

The decline is notable because buying your own or other company equity is typically the biggest drivers of leverage for the high grade market (Figure 4).

The reason for the decline is likely a combination of richer equity valuations as well as better growth globally that allows companies to deliver EPS growth without resorting to financial engineering. Finally, robust supply volumes in the first half despite decelerating cash needs supports our view that issuance was front-loaded this year.
Aggregate data for our universe of high grade issuers shows expenditure on net share buybacks declining from $84bn in 4Q-16 to $73bn in 1Q and $64bn in 2Q. Similarly spending on acquisitions fell from $99bn in 4Q-16 to $72bn in 1Q and $62bn in 2Q." - source Bank of America Merrill Lynch.
Although this is a welcome respite, US Investment Grade spreads benefit from a bigger interest rate buffer than European Investment Grade spreads, so if and when the ECB decides to taper its purchases the impact will be different. But, given the cyclical exposure to US Investment Grade, slower growth would probably have a more meaningful impact in the US thanks to the leverage difference. We might not be heading for the bunker yet and don a kevlar helmet, but, we are keeping a close eye on 2018 for potential signs of exhaustion in the credit and business cycle.

  • Final chart - The only easy day was yesterday
Whereas Financial Conditions matter for Taylor rules as per our macro bullet point, it remains to be seen how accommodative the Fed is going to be at its next FOMC meeting, whether it will keep a somewhat dovish stance or adopt a more hawkish tone, relative to its worries about Financial Stability, meaning they would start indicating they are about to drain some alcohol out of the credit punch bowl they have been serving for so many years. After all, in our book the Fed is the "credit cycle". Our final chart comes from Bank of America Merrill Lynch and displays the National Financial Conditions Index from the Chicago Fed, as goes the saying, the only easy day was yesterday, for tomorrow, we are not too sure:
"The best high level metric that reflects these benign conditions is the Chicago Fed’s National Financial Conditions Index seen in Chart 3. It’s tightened ever-so-modestly in the past month, going from -0.88 to -0.85. But the long term perspective shows that we are still in record territory as far as easy financial conditions. A slightly lower level of - 0.898 was observed in June 2014, but we have to go all the way back to August 1993 to the all-time low of -1.0 – not very far from where we are today; it was six months later, in early 1994, that a dramatic and disruptive hiking cycle began, but those were different times. Financial conditions don’t really get much easier than they are today.
With that in mind, the question is whether the Fed is ready to shift the framework at next week’s meeting, and deliver a more hawkish message than markets expect. As one gauge of the market’s dovish view of the Fed, there is currently a 53% probability assigned to a December rate hike (up from about 20% a week ago, but still well below 100%), and there is still about a 75 bp spread between what the market thinks for YE 2018 versus the Fed’s last dot plot. As we noted last week, this disconnect seems to represent a source of near-term risk for securitized products spreads; it’s the #1 reason we think spreads are more likely to widen than tighten in September-October. With financial conditions as easy as they are, and with a 10yr breakeven inflation expectation of 1.85% (in other words, pretty close to 2.0%), the Fed seems to have a great opportunity to deliver a hawkish message. Obviously, though, hawkish has not really been the MO for the Yellen Fed, so it seems reasonable to assume a “balanced” outcome is most likely.
If the Fed is dovish next week, securitized products spreads will probably tighten, but modestly. If the Fed confirms the market view, and December hike probability is still at about 50% a week from now, spreads will likely remain range-bound. If the Fed is hawkish, and hike probabilities increase materially, we expect spread widening. We think there is some asymmetry around spread widening potential relative to tightening potential, so we retain our defensive posture for September-October. If it’s a dovish Fed next week, we’ll give up on the defensive posture. If it’s hawkish, and spreads begin to widen, we will eventually look to add on spread weakness. Longer term, for fundamental and technical reasons, we remain constructive on securitized products." - source Bank of America Merrill Lynch
The major big question we have these days is relative to the direction of the dollar. Will it continue to "break bad" or are we due for some important rebound which would have implications for the rally seen so far this year in Emerging Markets equities? We wonder but, we are not lazy enough to go and steal the moon just yet...

"Don't tell me the moon is shining; show me the glint of light on broken glass." -  Anton Chekhov

Stay tuned ! 

Monday 11 September 2017

Macro and Credit - Aleatoricism

"An investment in knowledge pays the best interest" - Benjamin Franklin

Like any good behavioral psychologist, we watched with interest the debt ceiling theatrical drama unfold positively, not being surprised of the outcome given we tend to focus on the process rather than on the content. Given we have seen the Fed consistently lower their dot plot forecasts to meet market expectations, when it came to selecting our title analogy for this week's musing we decided to go for "Aleatoricism". Aleatoricism is the incorporation of chance into the process of creation, especially in the creation of art or media, or central banking one would opine. The word derives from "alea", the rolling of a dice. Aleatoric methods have been used in artistic composition for thousands of years and were popularized in the early 20th century by the Dada movement. Leonardo Da Vinci once said:
"Look at walls spotted with various stains or with a mixture of different kinds of stones. If you are about to invent some scenes, you will be able to see in it a resemblance to various different landscapes adorned with mountains, rivers, rocks, trees, plains, with valleys and various groups of hills."
In similar fashion, one could look at the Fed's dot plot and with Fischer resigning wonder if indeed they do matter anymore, or are just an artistic creation given  markets are acting like the Fed will only hikes approximately once between now and Dec 2018 when their Dot Plot showed 4 hikes:
- source Bloomberg

The median forecast still had the central bank making three quarter-point increases in 2018; the end-2019 rate was seen at 2.9 percent, a slight change from 3% from their March projections. One might wonder if indeed we have a case of "Aleatoricism". Interest-rate projections for 2018 and 2019 are becoming less reliable guides to future policy with the likelihood of a complete revamp of the Fed’s Board of Governors next year. With the Fed officially entering its blackout period, where officials no longer make public appearances or grant interviews, one thing we are certain is that the US yield curve is immune to their "Jedi tricks". We continue to hold a flattening stance, and while we have missed the opportunity to reach more the long end of the curve we will happily do so and increase our duration exposure accordingly. After all, New York Fed president William Dudley took a less hawkish stance than previously on Friday when he admitted that the call on further rate hikes was up in the air. This is in our book is clearly "the rolling of a dice" but we ramble again...

In this week's conversation, we would like to look at the predictability of the US Yield curve in forecasting US recession, without having it inverted as the economic and credit cycle matures. 

  • Macro - Yielding to the predictability of the US Yield curve
  • Credit - US High Yield - Beware The Ides Of September
  • Final chart - Is the "Buck" breaking bad?

  • Macro - Yielding to the predictability of the US Yield curve
As we pointed out in our August conversation "Gullibility", the US yield curve has been immune to the old tricks played by the Jedis at the Fed. While the Fed's dot plot might be a case of "Aleatoricism, it certainly isn't the case when it comes to using the US Yield curve as a recession predictor, with its ongoing flattening stance. Same goes with credit curves. In our book a flattening of the US High Yield curve (we use the US CDX High Yield CDS Index implied curve as a proxy), is a predictor for growing pressure on credit, which is generally a leading indicator for equities as shown in late 2015 before the early sell-off of 2016. For instance, as of late, we have been closely watching with interest the rise in the front-end of the curve as displayed by ICE CMA:
- source ICE CMA

No need yet to panic on the above, but it is certainly worth monitoring going forward, as another indicator you need to track. The next CDS roll for CDS indices will mark the launch of new credit index series (series 28 in Europe and series 29 in the US) and the introduction of new "on-the-run" single reference contracts (bearing a December 2022 maturity rather than the current June 2022 "on-the-run" maturity) and is only a couple of weeks away as a reminder.

When it comes to the US Yield curve being a recession predictor, its reliability over time is certainly not a case of "Aleatoricism". What is of interest to us all, is the recent question asked recently by Wells Fargo on the subject in their note from the 8th of September entitled "Do We Need to Wait for a Yield Curve Inversion to Predict a Recession? No":
"Others have seen what is and asked why. I have seen what could be and asked why not." – Pablo Picasso
Be Mindful of Elevated Recession Risks in 2018-2019
Predicting recessions is one of the most important elements of decision-making in the public and private sector. As such, a different set of policy tools is needed during a recession than that used for an economic expansion. The yield curve (spread between the 10-year Treasury and federal funds rate, for example), in particular the inversion point of the yield curve, is thought to be a very good predictor of a recession. An inverted yield curve has led all recessions since the 1969-70 recession. Furthermore, the Federal Open Market Committee (FOMC) has raised the federal funds target rate (fed funds rate) twice in 2017, which has brought the inverted yield curve topic (and the impending risk of a near-term recession) back into the spotlight. Other analysts are raising questions surrounding the yield curve’s effectiveness in predicting recessions. Presently, the fed funds rate is “recovering” from a historical low level (zero-lower bound) and, as such, the yield curve may not invert in this cycle as it has in the past. That is, the yield curve stayed in the positive territory (did not invert) during the 1954-1965 period and that era experienced two recessions (1957-1958 and 1960-1961 recessions).2
In this report, we propose a new framework that identifies a threshold between the fed funds rate and the 10-year Treasury yield (we call it FFR/10-year threshold). In a rising fed funds rate environment, the threshold is breached when the fed funds rate touches/crosses the lowest level of the 10-year Treasury yield in that cycle. When this occurs, the risk of a recession in the near future is significant. Our framework has successfully predicted all recessions since 1955 with an average lead time of 17 months. Furthermore, our framework predicted several recessions before the yield curve inversion point and, therefore, serves as a more effective tool in predicting recessions. That is, with our framework, we do not need to wait for the yield curve to invert to predict a recession.
Why is our analysis important for decision-makers? In the current monetary cycle, the lowest 10-year Treasury yield was 1.36 percent (hit on July 5, 2016) and the current fed funds rate is 1.25 percent. We are forecasting one more rate hike by the FOMC (December 2017), and, if we are correct, the fed funds rate will be 1.50 percent, thereby surpassing the lowest level of the 10-year Treasury (1.36 percent) and thus breaching the threshold. Historically, when the threshold is met, there is 69.2 percent chance (average probability) of a recession within the next 17 months  (average lead time). Therefore, in the December rate hike scenario, the chances of a recession in 2018 through mid-2019 are elevated.
Summing up, our proposed framework (FFR/10-yr threshold) produced 13 signals since 1955 and 9 of the 13 signals are associated with recessions (there are only 9 recessions in that time period, thus, we did not miss any recessions) with an average lead time of 17 months. The remaining four signals are connected with changes in the monetary policy stance (moving from rising fed funds to cutting interest rates) with an average lead time of 8 months. Typically, during long economic expansions, monetary policy will shift due to a “mid-cycle softening” and the FOMC will reduce interest rates to boost the economy. This phenomenon occurred in the 1960s, 1980s and 1990s. Therefore, our proposed framework did not produce a single misleading signal (neither false positive or false negative). Given the robust performance of our framework, we suggest decision makers to watch for a recession during 2018 and mid-2019 (17 months from December 2017, in the case of a rate hike).
The Inverted Yield Curve: A Song of Policy Tightening and Recessions
The yield curve (spread between the 10-year Treasury yield and fed funds rate) is one of the most cited recession predictors. In fact, the yield curve is the part of the Conference Board’s index of leading economic indicators (LEI). In particular, the inverted yield curve has led the last seven recessions (all recessions since the 1969-70 recession), Figure 1.

That is, the yield curve inverted before each of the last seven recessions (although with a wide range of 8-23 months lead time).
Most studies in the past have utilized the spread between the 10-year Treasury yield and fed funds rate as the yield curve, and we followed that tradition (for more detail see Adrian et al. (2010)). There are several benefits of using the yield curve based on the 10-year Treasury and fed funds rate. First, Bernanke and Blinder (1992) utilized the nominal level of the fed funds rate to measure the monetary policy stance, and thereby we include the policy stance in the yield curve. Second, moments in the 10-year yield reflect financial market participants’ expectations about the economic outlook and the monetary policy stance.

For example, typically, investors seek higher yield in an inflationary era and take refuge in Treasuries when fears of a recession rise (lower yield), all else equal. Therefore, our measure of the yield curve represents both the policy stance and market expectations.
Third, Adrian and Estrella (2009) utilized the fed funds rate to identify monetary cycles, which are good predictors of recessions and another competitor of recession prediction methods. The fourth and final method, our FFR/10-year threshold framework, also utilizes the fed funds rate and 10-year yield to predict recessions. Therefore, all three methods of recession prediction utilize the fed funds rate and 10-year yield and, thereby, we can compare performances of these methods to find which approach is most effective in predicting recessions.
Typically, an inverted yield curve suggests that the financial markets are not very optimistic about the near-term economic outlook and seek “safety” of their investment by buying 10-year Treasuries, which creates higher 10-year Treasury demand and reduces the yield, all else constant. The fed funds rate, on the other hand, is set by the FOMC and, usually, the FOMC takes time (lag effect) to change the stance of monetary policy (transitioning from a dovish tone to hawkish one). The lag response from the FOMC is because the FOMC utilizes realized data along with its forecast to set the monetary policy stance. Therefore, in the case of an inverted yield curve, the 10-year yield drops below the fed funds level because changes in the economic outlook influence both financial market expectations and monetary policy.
Is This Time Different for the Inverted Yield Curve to Predict Recessions?
As mentioned earlier, the inverted yield curve has predicted the last seven recessions but missed the 1957-1958 and 1960-1961 recessions. That is, the yield curve remained positive (did not hit the inversion point) during the 1954-1965 period. Furthermore, the misses associated with the 1957- 1958 and 1960-1961 recessions (false negative) raises questions about the yield curve’s effectiveness in predicting the next recession. This begs the questions: are there some potential factors which may prevent the yield curve to invert in this cycle similar to the 1950s/mid-1960s episodes? Likewise, is there an alternative method for recession prediction that is more effective than the yield curve?
We believe that the yield curve’s effectiveness to predict the next recession may be different than the last seven recessions and may repeat the 1957-1958 and 1960-1961 recessions’ experiences. That is, the yield curve may not invert and, thereby, be useless in predicting the next recession. There are several major reasons to support our view. First, the fed funds rate is recovering from the lowest level (from 0-0.25 percent range) in our analysis, which covers the January 1954- July 2017 time period. Furthermore, the fed funds hit the 0-0.25 percent range on December 2008 and that was the lowest level since July 1958 (0.68 percent). In addition, before December 2008 there are only two episodes of below 1 percent fed funds rate and both of them occurred in the 1950s (several months in 1954 and a few months of 1958 observed below 1 percent fed funds rate) and the yield curve did not invert in the 1950s (1954-1959). Since both the 10-year yield and fed funds rate remained positive in our sample period (1954-2017), a historically lower level of the fed funds rate may pose a hurdle for the yield curve to invert. For instance, the 10-year yield dropped below 2 percent for the first time (in our sample period) on September 2011 (1.98 percent) and never dropped below 1 percent in our analysis. The fed funds rate, on the other hand, hit the zero-lower bound on December 2008. By the same token, in the 1954-1965 period, the lowest fed funds rate was 0.63 percent (May 1958) and the lowest 10-year yield was reported as 2.29 percent (April 1954). It is important to note that, in the pre-December 2008 era, the lowest level of the fed funds rate and 10-year yield were reported in the 1950s and the yield curve did not invert during the 1954-65 period (and missed two recessions). Therefore, the recovery from the historically low-level of the fed funds rate may alter the yield curve’s effectiveness in predicting the next recession compared to the last seven recessions—we may not see an inverted yield curve before the next recession.
Second, the current and near-term economic outlook, in particular inflation expectations, may not be ideal for a faster pace of monetary policy tightening (faster fed funds rate hikes, for example). That is, the dual mandate (maximum employment and price stability) of the FOMC dictates that officials consider the labor market/inflation expectations (in addition to other factors) in setting the monetary policy stance. For example, Taylor (1999) suggested that the fed funds rate responds to economic variables (unemployment and inflation rate, for example), even in the periods when the FOMC was targeting some other variables (i.e. money growth and/or reserves targets). Furthermore, Romer and Romer (2002) concluded that inflation expectations, typically, play a crucial role in setting the monetary policy stance. Therefore, the economic outlook may influence the fed funds rate in a way to slow any pace of federal funds rate.
Echoes From the 1950s 
In our view, the current economic outlook, in particular realized and expected inflation, is more in line with the 1954-1965 period than the last seven recessions (1969-2007 period). For example, the FOMC’s inflation target is 2 percent (the PCE deflator is the preferred inflation measure of the Fed) and the PCE deflator is just 1.22 percent for the May 2012-June 2017 period (Figure 3).

Furthermore, the PCE deflator (year-over-year [YoY] percent change) stayed below 2 percent for the May 2012 to June 2017 period (with the exception of two months: January/February 2017) and it is the longest stretch in the past 50 years. In addition, before 2012, the last time the PCE deflator stayed below 2 percent for over five years was between January 1960 and January 1966 (slightly more than six years). It is worth mentioning that the PCE deflator series only goes back to 1960, and we utilize CPI (YoY) for the pre-1960 period. The CPI (YoY) was below 2 percent for the November 1952 and July 1956 period (with an average of just 0.41 percent) and between November 1958 and January 1966 (with an average of 1.28 percent). The possible consequences of the lower inflation of the 1950s and early 1960s is the lower fed funds rate as the rate dropped below 1 percent, the first time ever in our analysis, in 1954 and then in 1958. On the other hand, the PCE deflator hit the 2 percent target on February 1966 and then stayed above the 2 percent line for the next 30 years, and the fed funds rate never dropped below 3 percent during that time period.
Silvia, Iqbal and Bullard (2016) identified low-inflation episodes (where a low-inflation episode is defined as six consecutive months of PCE deflator below 2 percent) using the 1975-2016 time period. Out of eight total episodes identified between 1975 and 2016, three of them occurred in the 2008 2016 period. Between November 2008 and July 2017 (last data point at the time of this writing), the PCE deflator was below 2 percent for 85 of 105 total months (with an average of just 1.33 percent). Therefore, inflation rates since the Great Recession are at historical lows, on average. The unemployment rate, the other focus of the FOMC, took almost nine years to drop below the pre-Great Recession era (Figure 3 above). That is, the unemployment rate dropped to 4.3 percent in May 2017, just below the 4.4 percent rate registered in May 2007. Historically low inflation rates, along with a slow decline in the unemployment rate, are associated with a historically low fed funds rate (dropped to zero-lower bound on December 2008 and stayed there for the next six years) and several rounds of quantitative easing, which boosted the Fed’s balance sheet to around $4.5 trillion (a historically high level). All of these factors, in our view, are supportive of a slower pace of fed funds rate hikes in the near future. The FOMC has also announced its intentions to reduce its balance sheet starting in 2017. Furthermore, a lower fed funds rate was unable to invert the yield curve in the 1954-1965 period, although that period experienced two recessions. Therefore, we need to look for methods, other than the simple yield curve, to accurately predict the possibility of the next recession.
A Probit Model Using the Yield Curve to Predict Recessions
One method that utilizes the yield curve to predict recessions involves building a probit model and employing the yield curve as the predictor variable of the model (Figure 4).

The probit model (or any standard econometric model) needs a longer data history for estimation purpose. Therefore, we started forecasting recessions since 1980 (use 1960-79 period for estimation). The probit model has predicted (50 percent probability as a threshold) all recessions since 1980 except the 1990-91 recession. Furthermore, due to the lack of data for the pre-1950 period, we are unable to check the probit model’s accuracy regarding the 1957-1958 and 1960-1961 recessions (these recessions were missed by the traditionally calculated inverted yield curve). Thus, the probit model may not be the answer. Therefore, we move forward to utilize another tool, monetary cycles, to try to predict recessions.
- source Wells Fargo

It seems apparently that not only the Fed's Phillips Curve model is outdated, but waiting for an inversion of the yield curve to predict a recession going forward might not be working this time around. 

Could the monetary cycles be more useful in predicting the next recession and avoid "Aleatoricism"? Wells Fargo in their very interesting notes try to give us some clues on this very subject:
"The Game of Monetary Cycles: Is Recession Coming?
Adrian and Estrella (2009) identify monetary cycles and suggest that monetary cycles are good predictors of economic activities, as these cycles are typically associated with business cycles.11 Adrian and Estrella (2009) concluded that there have been 14 monetary cycles since 1955 and that a monetary cycle ends when the fed funds rate peaks. Moreover, the end of a monetary cycle is a prediction for an upcoming recession. According to the NBER, however, there have been nine recessions since 1955, which indicates that not all monetary cycles are associated with recessions as there were 14 monetary cycles in the same time period, see Table 1 and 3 for results.
For example, the first monetary cycle ended on October 1957 but the recession start date is August 1957 (missed by two months). Similarly, January 1980 is the recession start date but the monetary cycle end date is April 1980 (missed by three months). Monetary cycles predicted the rest of the recessions with a lead time range of 1-16 months. Although monetary cycles have predicted several recessions (and missed the 1957-1958 and 1980 recessions), the real time effectiveness of the monetary cycles is a big question mark. Why? In our view, the monetary cycle approach to predict recessions is a backward-looking method, and that is because of the way a monetary cycle is defined. For example, Adrian and Estrella (2009) said that a monetary cycle ends when either one of the two criteria is met: (1) the fed funds rate is higher than at any time from the 12 months before to nine months after and is at least 50 bps higher than at the beginning of this period, or (2) the fed funds rate is higher than at any time from six months before to six months after and is 150 bps higher than the average at these endpoints. Basically, the peaking of the fed funds rate is the ending of a monetary cycle; in other words, the peaking of the fed funds rate is a prediction for the upcoming recession.
However, life is not that simple as we have to wait for at least six months (2nd criterion) to confirm whether the fed funds rate has peaked six months ago. Why does that matter? It matters and, to some extent, changes (reduces) the real time effectiveness of monetary cycles to predict recessions completely. For example, the first monetary cycle end date is October 1957 and that cycle missed the recession by two months (the recession start date is August 1957). However, in reality, we have to wait for at least six months (using the 2nd criterion, which has a shorter waiting period) to determine the fed funds rate’s peak point. That is, in April 1958 we were able to declare that the October 1957 was the peak month for the fed funds rate (end of a monetary cycle) and then we can make a recession prediction. But, April 1958 is also the end date of the recession, and therefore, in real time analysis, the monetary cycles missed the 1957-1958 recession completely. What we are suggesting is that the monetary cycles method’s lead time to predict recessions should be longer than the waiting period of 6-9 months to gain financial benefits (predict recessions) from this approach. For example, using real time analysis, monetary cycles have missed all of the recessions in the 1955-1989 period as the lead time for all these recessions is less than six months (Table 1). Monetary cycles did predict the 1990-1991 and the Great Recession as the lead time was 16 and 15 months, respectively. The lead time for the 2001 recession was eight months and that could be considered a miss using the first criterion to define a monetary cycle (at least nine months are needed to confirm the fed funds rate peak).
Therefore, in our view, monetary cycles are effective recession predictors, but the method is backward-looking. Furthermore, in real time analysis, monetary cycles are only able to predict recessions in the post-1990 era. We need a method that effectively predicts recessions in real time so decision-makers have enough leeway to prepare policies for the upcoming recession. We will now discuss the final method, our proposed method. We believe this approach is more effective in predicting recession than the other methods discussed so far in this study.

In similar fashion to the monetary cycles, looking at default rates is backward-looking when trying to assess the state of the credit cycle. Looking at the deterioration of financial conditions through the prism of the credit impulse as well as the Fed Quarterly Senior Loan Officer Opinion Survey (SLOOs) appears to us much more relevant:

- Lending conditions - source Bank of America Merrill Lynch

US C&I Loans last three months: 31st of August 0.7, 31st of July 0.2, 30th of June 0.6. Since the beginning of the year and relative to 2016, the trend has been weakening hence our more cautious tone we have been having relative to the credit cycle.

If the Norwegian Blue Parrot aka the Phillips Curve is simply "resting" and if waiting for the US Yield Curve to invert would be akin to waiting for Godot, then again you might be wondering what kind of framework would enable you to predict an upcoming recession. Wells Fargo in their very interesting note is coming up with an interesting proposal we think:
"A New Framework to Predict Recessions: The FFR/10-Year Threshold
We have discussed the limitations of the yield curve (inverted yield curve and the probit/yield curve modeling) and monetary cycles’ approaches to predict recessions. In addition, one major challenge in this monetary cycle is that the fed funds rate’s recovery from the lowest level, along with a low inflation environment, may block inversion of the yield curve similar to the 1954-1965 period. Therefore, we need a framework that is more effective in real time recession forecasting than the yield curve/monetary cycle methods. The framework should also be able to predict recessions accurately in different economic regimes such as lower inflation/fed funds rate regimes (the 1954-1965 period and the era since the Great Recession, for example), higher fed funds rate/inflation (the 1970 to mid-1980s time period) and in the moderate inflation/fed funds rate time periods (the 1990-2007 time period, for instance). We believe our proposed framework would predict recessions accurately in all those economic regimes.
Our framework identifies a threshold between the fed funds rate (FFR) and the 10-year Treasury yield (10-year). The crossing of the threshold is an indicator for an upcoming recession. We labeled the framework as the FFR/10-year threshold to predict recessions. The threshold is best explained by the following description: in a rising fed funds rate period, when the fed funds rate crosses/touches the lowest level of the 10-year yield in that cycle, then that is a prediction for an upcoming recession. For example, the Fed started raising the fed funds rate in December 1954 (fed funds rate increased from 0.83 percent to 1.28 percent) and the 10-year yield hit 2.61 percent (lowest level in that cycle) on January 1955. Furthermore, the fed funds rate crossed the lowest level of the 10-year yield on April 1956 (fed funds rate was 2.62 percent) and, thereby, signaled an upcoming recession. The recession start date is August 1957 (a 16-month lead time for our framework’s prediction), (Table 2). It is worth mentioning that both the yield curve and monetary cycles’ methods were unable to predict the 1957-58 recession.
Before we discuss the effectiveness of the FFR/10-year threshold, we raise a few questions to highlight the intuition behind the threshold method. Why is the rising fed funds rate the starting period for the threshold method? Why is the lowest level of the 10-year Treasury yield in a cycle matter? Why is the threshold (FFR crossing/touching the lowest 10-yr) approach a good recession predictor? The rising fed funds rate, outside recessions, is a sign of a change in the monetary policy stance and, typically, the Fed starts raising interest rates when the economy enters expansion. Naturally, a recession comes after an expansion phase and therefore a rising fed funds rate environment is a better policy stance to utilize in recession predictions, which is the objective of the threshold framework. The 1980 recession is an exception as the next recession (the 1981-1982 recession) started within a year of the ending month of the 1980 recession. Therefore, a rising fed funds rate represents a change in the monetary policy stance and the FOMC’s expectations about the strength (expansionary phase of a business cycle) of the economy.
By the same token, the 10-year yield’s lowest level in a cycle serves as an inflection point in the market’s expectations about the economic outlook and monetary policy stance. That is, market participants are not looking for a refuge/safety in Treasuries, which reduces the Treasuries’ demand and consequently a rise in the yield, all else equal. Furthermore, financial markets are also expecting a better economic outlook (perhaps the beginning of an expansionary phase) and a change in the policy stance (rising fed funds rate) in the near future. Basically, both policy makers and market participants are expecting a better economic outlook/expansion phase and, therefore, the rising fed funds rate and lowest 10-year yield level are inflection points and help to predict recessions.
Looking Beyond the Absolute Length of an Expansion 
While it is true that the end of an expansion phase is the beginning of a recession, the length of expansions vary significantly as the longest expansion in our analysis lasted for 10 years. The current expansion is the third longest at the time of this writing, September 2017. Therefore, attempting to predict a recession based on an expansion’s start date and current length is not a useful exercise. Moreover, we are looking for a threshold that will help us to predict recession, in real time, in a timely matter. For example, the threshold for the yield curve approach is the inversion point and peaking of the fed funds rate is a benchmark for the monetary cycles. However, the lower fed funds rate along with a low inflation rate may prevent an occurrence of an inversion point in this cycle similar to the 1954-1965 period. We have to wait for 6-9 months to declare a peak month of the fed funds rate to predict recessions in the monetary cycles’ analysis and the waiting period reduces the effectiveness to predict recessions significantly, as mentioned earlier. Therefore, our proposed threshold of FFR crossing/touching the lowest 10-year point is effective in real time recession prediction. There are several reasons for this unique ability that will be discussed.
First, a lower fed funds rate may prevent a yield curve to invert, but our method does not incorporate an inversion point in predicting recessions. Second, there is no waiting period to declare whether the threshold has been met, unlike the monetary cycle method, which is largely backwards looking. Moreover, we can also predict the possible timing of the threshold point, which we show in a latter part of the study. Third, we do not impose a specific value of the 10-year yield as a benchmark (2 percent 10-year as a threshold, for example) because different economic regimes (higher or lower inflation and/or stronger or weaker recoveries, for instance) would produce different lows/highs of fed funds rates and 10-year yields in a business cycle. Therefore, using the cycle low yield for the 10-year, accounts for the heterogeneity of business cycles. Another reason for not using a fixed level for either the 10-year yield or the fed funds rate as a threshold is that the effect of a rising fed funds rate on 10-year yield varies depending on the cycles. For example, the FOMC raised the fed funds rate from 1.00 percent to 5.25 percent during the June 2004-June 2006 period and the 10-year increased only by 37 bps (from 4.73 percent to 5.11 percent) during the same time period; Greenspan labeled it as “interest rate conundrum.” In sum, the accuracy of our proposed framework would not be affected by the fact that the fed funds rate is recovering from the zero-lower bound, or by a low inflation environment or by the fact that the relationship between the fed funds rate and 10-year has changed overtime.
The final and fourth reason is that the FOMC can raise the fed funds rate up to a certain level and, typically, when the fed funds rate peaks, that is an indication that the expansion is close to its peak, and a recession is in the neighborhood. Furthermore, historically, (Table 2 and 3) when the fed funds rate crosses/touches the lowest level of the 10-year, in a monetary cycle, that is an indication that fed funds rate’s peak is approaching. Therefore, meeting the threshold is a prediction for the upcoming recession.
Now we discuss the accuracy of our proposed method, with the results reported in Table 2. Since 1955, our framework predicted all recessions with an average lead time of 17 months, with a range of 6-34 months. It is important to note that our method is the only approach discussed in this study that did not miss any recessions in the sample period. This means that it is more effective than the yield curve and monetary cycle approaches. Furthermore, our framework has a better lead time than the yield curve to predict recessions for all recessions except the 1969-1970 and 1981-1982 recessions where both approaches have the same lead time, Table 2.
The Exception to the Rule: Recessions versus Changes in the Monetary Policy Stance
Sometimes there is an exception to the rule, and thereby our framework produces four calls that are not associated with recessions. It is worth mentioning that our framework is the only approach (discussed in this study) that did not miss any recession since 1955, whereas the yield curve missed two recessions and produced three calls, which were not related with recessions, Table 2 and 3. Similarly, the monetary cycle method missed two recessions and five of its signals are without a recession, Table 1 and 3. Does that mean that our framework produces false positives? In our view, the answer is no. Although four of the 13 calls are not associated with recessions, those four calls are connected with changes in the monetary policy stance (from raising/unchanged fed funds rate to cutting interest rates). For example, the framework produced a recession call on December 1964 (threshold met) and the Fed started reducing the fed funds rate on December 1966 (24-month lead time). The Fed reduced the rate from 5.76 percent to 3.79 percent between November 1966 and July 1967, Table 3. Similarly, the remaining three calls  (August 1984, February 1995 and July 1998) are followed by changes in the monetary policy stance, see Table 3 for details.
Put differently, four of the 13 calls are associated with a change in the monetary policy stance with an average of eight months lead time—with a range of 1-24 months. Another reason not to declare these four calls as false positives is that, during long economic expansions, the Fed has reduced interest rates to “boost” the economy from a “mid-cycle slowdown.” Furthermore, the 1960s, 1980s and 1990s experienced some of the longest expansions on record and, thereby, changes of monetary policy stance during those expansions.
Summing up, our framework has produced 13 recession calls since 1955, and nine of those are associated with recessions. Therefore, whenever our framework produced a recession call, there was a 69.2 percent (9/13) chance of a recession within the next 17 months (average lead time).
Why Our Analysis Matters for Decision-Makers?
The FOMC raised the fed funds rate on December 2015, the first time in the post-Great Recession era, so the first condition of our framework is fulfilled—in a rising fed funds rate environment. The 10-year yield hit 1.36 percent on July 5, 2016, which is the lowest level in this cycle, Figure 5. Therefore, two conditions of the threshold framework are accomplished. The current level of the fed funds rate is 1.25 percent, which is lower than the 1.36 percent 10-year yield.15 As mentioned earlier, our proposed framework is not only good in a real time analysis but also is a forward-looking approach. That is, we are forecasting one more rate hike by the FOMC in 2017 (December), and, if that happens, then the fed funds rate will be 1.50 percent in December 2017. Therefore, in the case of one more rate hike, the threshold will be met in December 2017 as the cycle low for the 10-year is 1.36 percent (lowest daily closing yield on July 5, 2016, and 1.50 percent for the monthly average of July 2016, still the lowest level in this cycle). Therefore, starting in December 2017, again in the case of a rate hike, there will be a 69.2 percent chance of a recession during the next 17 months (average lead time).
Final Thoughts: Be Mindful of Elevated Recession Risks
We have proposed a new framework using the fed funds rate and the 10-year yield to predict recessions. Our framework has predicted all recessions since 1955 with an average lead time of 17 months. Furthermore, we are forecasting one more rate hike in 2017 (December), and, in the case of a rate hike, the threshold will be met. Therefore, starting December 2017, there is an increasingly elevated probability of a recession in the coming years. It is important to note that, at present, our official call is for continuously moderate growth in 2018-2019 (around 2.5 percent GDP growth rate) and this framework suggests a downside risk to our forecast. Therefore, we are not making an official call for a recession over the two-year forecast horizon. Instead, decision-makers may want to watch 2018 through mid-2019 for potential slowdown/recession. But, be mindful of the analysis we have performed in this report, we will be watching incoming data closely to determine whether conditions that could lead to a recession/slowdown starting late 2018 are developing. We would encourage decision-makers to do so as well." - source Wells Fargo
If indeed, the Fed goes for another hike in December, then again the recessionary path could be starting from that point at least from a high probability threshold and not due to "Aleatoricism". The Wells Fargo analysis is interesting in the sense that it shows that macroeconomic frameworks need to be reassessed and one must not take for granted that what has been working, will continue to work  the same like the Phillips Curve though the Phillips Curve debate is still raging.

As we move towards Autumn, the real season that is, not the credit cycle season in which we believe we are, there are indeed interesting seasonality factors for credit markets and in particular US High Yield of interest as per our next credit bullet point.

  • Credit - US High Yield - Beware The Ides Of September

Summer might be over as we move towards autumn, but, when it comes to assessing the credit cycle, we clearly think we are way part Summer and most likely in Autumn from our perspective. On the subject of seasonality and credit, we read with interest Barclays US High Yield note from the 8th of September entitled "Autumn Years":
"Seasonality in market conditions is often tracked as a way to measure the extent to which technicals drive returns. September, in particular, poses seasonal headwinds for high yield investors. As shown in Figure 1, it is the only month that has produced an average negative return and has ranked among the top quartile of best-performing months in only four times out of the total 33 observations considered.

This trend has persisted in recent years, with September the worst-performing month in 2014 and 2015.
While we are skeptical of any investment strategy that relies purely on return seasonality, we believe the drivers of the calendar effect can provide a useful guidepost. We first note that one significant factor has been a seasonal uptick in September gross issuance, which has, in turn, weighed on returns for the month. Figure 2 shows the month-over-month increase in supply is highest in September, with supply more than doubling following a slow August.

We do not expect an increase in supply of the same magnitude this year, considering that high yield markets priced roughly $20bn in August despite a litany of volatility-driving headlines. But a sizable forward high yield calendar and the tight pricing of recent deals suggest roughly $25-30bn in September supply. Furthermore we expect to see more opportunistic issuance considering currently attractive financing yields. Our expectation is that new supply will be well absorbed and that refinancing will account for a bulk of the calendar through year-end; but beyond September, we do not believe incremental supply will produce a drag on returns.
We find that the increased supply in September is often not met y increased demand from retail investors. Fund flow seasonality shows that retail sentiment has historically been softer leading up to September, with funds registering outflows in August followed by only modest inflows in September (Figure 4).

That said, US high yield valuations have remained largely intact despite the $12bn in year-to-date outflows registered through last week. Therefore, we are not overly concerned about a seasonality driven weakening of retail sentiment, but recognize that it could be a factor that prevents the market from tightening in the face of higher supply. In the event that volatility spikes meaningfully and outflows increase, we expect this to be counterbalanced by less opportunistic issuance." - source Barclays
Despite Labor day, and the seasonality factor pointed out in Barclays note, we do agree that flows matter and particularly in High Yield with the retail feeble crowd playing the beta game through ETF exposure. We note that last week inflows to US High Yield jumped to $1.1bn following the previous week's $258mio gain, the most since July and the third largest inflow year to date according to Bank of America Merrill Lynch US High Yield Flow Report from the 7th of September. Yet, year-to-date total returns were down a bit during August, but to a still-impressive 6.1% through August 31. Within developed markets, this is the 2nd best performance and only trails the S&P’s +11.9% return. The beta game is still the trade du jour for many. We do think that at this stage of the credit cycle, you should continue moving higher the quality spectrum and on that note we agree with Bank of America Merrill Lynch's take from their High Yield Strategy note from the 6th of September entitled "Labor Day letdown in credit":
"Where does this leave us?
Moving forward, we remain cautious on high yield. Although earnings growth remains strong and issuer fundamentals continue to improve, in our opinion the macro landscape remains concerning. With US and North Korea relations heading in the wrong direction, the Fed on a normalization path, and all eyes on Washington as it faces a multitude of uphill tasks for the remainder of the year, we think too many risks still persist. Consider the amount of spread investors earn per turn of leverage in HY, which declined from 85bps to 83bps last quarter (Chart 2).

This is below the historical median of 111bps and suggests that investors are currently taking on more risk for lesser compensation. However, high yield spreads have proven resilient in the face of macro uncertainty for the first half of the year. We could therefore envision a scenario where the FOMO (fear of missing out) attitude extends into 2018, with high yield clipping coupon through December. But not before enduring a few speed bumps along the way." - source Bank of America Merrill Lynch.
Sure there is still plenty of punch being served at the credit party but it doesn't mean you need to get yourself drunk beyond reason by playing the beta game a little bit too long we think. What matters once again is the velocity of credit, the rate of change of credit availability.

  • Final chart - Is the "Buck" breaking bad?
While our contrarian stance served us well in early 2017 as per our conversation "The Woozle effect" given we told you that we were not part of the long US dollar crowd at the time:
"If indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar
It appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier."  - source Macronomics, January 2017
Of course we were right...But the most important question is about the US dollar aka the "Buck" and if it is on course to "break bad". Our final chart comes from Nomura FX Insights note from the 6th of September entitled "The dollar's seven-year feast-famine cycle" and displays the dollar cycle:
It’s all too easy to get caught up in the short-term dynamics of currency markets and miss the big picture. Alternatively, if one did see the big picture, it’s too easy to erase the pre-2008 period as the “old normal” and believe that the financial markets are now driven by new forces. This ahistorical perspective forgets that every decade is characterised by some new paradigm that impels us to believe the old rules no longer apply. Today the new paradigm is secular stagnation or balance sheet constrained growth models. In the 2000s, it was the disruption caused by China, the 1990s saw the dot-com boom, the 1980s saw Reaganomics, and the 1970s saw stagflation.
Through all of this the US dollar has tended to follow a cycle where it enjoys many years of gains followed by many years of declines. On average the dollar trends tend to last about seven years (Figures 1). The number seven seems almost pre-ordained. The Bible talks about seven years of plenty and seven years of famine (Genesis 7:2). There are the seven chakras in various Indian traditions. Then we have the seven-day week, the seven metals of antiquity and the seven endocrine glands. It’s perhaps easy to see why chartists in currency markets have been known to use the moon cycle or sunspots in forecasting the dollar.
Admittedly, seven is an average. Dollar trends can be longer or shorter, but importantly there are fundamental causes for this dollar cycle. The crucial point is that the business cycle which most investors focus on tends to be much shorter than the dollar cycle. The combined expansion and recession phases of the US have typically lasted six years, while the full dollar cycle – both the uptrend and downtrend – has lasted 14 years. That means business cycle or monetary policy explanations alone will not be adequate in predicting dollar trends. Instead, forces such as relative price levels, terms of trade, current account dynamics and capital flows need to be included to provide the context for multi-year turns in the dollar. Taken together, they indicate that the dollar is currently at the early stages of a multi-year decline. This could see the euro eventually reach 1.40 or higher and USD/JPY fall towards 90 or lower."  - source Nomura
We don't know if it as case of seven years of bad luck for the US dollar or an imaginary curse or another illustration of "Aleatoricism", but we do know that when it comes to the US Yield Curve and the credit cycles it does follow patterns much more precise than the Fed's dot plot, that's a given no matter how good their "Jedi" tricks.

"Luck is a matter of preparation meeting opportunity." - Lucius Annaeus Seneca

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