Sunday, 3 September 2017

Macro and Credit - Ouroboros

"History is about loops and continuums." - Mike Bidlo, American artist

Reading with interest a summary of the paper co-authored by top-ranking Philadelphia Fed economist Michael Dotsey indicating "no evidence for relying on the Phillips curve", we felt indeed that our latest musing title had been more than appropriate We were amused to see a Monty Pythonesque title from Bank of America Merrill Lynch title when it comes to the Phillips curve: "The Phillips curve: it’s not dead, it’s sleeping" on this subject. Of course this relates perfectly to the Norwegian blue parrot we mentioned in our previous conversation:
- source Bloomberg

You might already ask yourselves why we choose "Ouroboros" as a title analogy. The Ouroboros is an ancient symbol depicting a serpent or dragon eating its own tail. Via medieval alchemical tradition, the symbol Orobouros entered Renaissance magic and modern symbolism, often taken to symbolize introspection, the eternal return or cyclicality especially in the sense of something constantly re-creating itself (like credit cycles). It also represents the infinite cycle of nature's endless creation and destruction, life and death (creative destruction à la Schumpeter comes to mind). The first known appearance of the ouroboros motif is in the Enigmatic Book of the Netherworld, an ancient Egyptian funerary text in KV62, the tomb of Tutankhamun, in the 14th century BC. Also, the alchemical textbook, Chrysopoeia (gold making) of Kleopatra contains a drawing of the ouroboros representing the serpent as half light and half dark, echoing symbols such as the Yin Yang, which illustrates the dual nature of all things, but more importantly, that these opposites are not in conflict. No matter how many tricks (ZIRP, QE, NIRP) used by our modern alchemists, aka central bankers, they cannot alter cyclicality of credit, that simple. Let's be very clear about that. When it comes to our assessment of the credit cycle, it's getting late in the game, and capital preservation is becoming essential. This means starting moving to higher grounds credit quality wise we think.

In this week's conversation, we would like to look at the importance of wages for signs of inflation as we discussed last week. In our previous conversation we indicated that we thought that real wage growth mattered for inflation expectations. Could we be wrong? We will also look at the unintended consequences in liquidity thanks to regulation and the Volcker rule.

  • Macro - Real wages growth? The "deflationistas" have won the war.
  • Credit - Credit Supply is cyclical, so is liquidity...
  • Final chart - Japanese support for credit - The boys are back in town

  • Macro - Real wages growth? The "deflationistas" have won the war.
As we pointed out in our previous conversation, we indicated that the most important point for a rise in inflation expectations had been real wages growth. We also posited in our conversation "Perpetual Motion" in October 2014 that real wage growth would indicate the US would be reaching "escape velocity":
"In fact the Fed's conundrum can be seen in the lag in wage growth given nominal wages are only up 2% yoy whereas real wage growth remains at zero. Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, October 2014
Obviously the latest disappointing Nonfarm payroll for August, still point towards weak real wage growth and it isn't the time for clamoring victory for the Fed. 

In our previous musing we pointed out the amazing work of Jean Fourastié on the subject of real wages, real prices and productivity (which in our humble opinion should have been worthy of a Nobel prize). True capitalism is inherently "deflationist" when it comes to prices. While any aspiring economist and/or central banker should get acquainted with the work of Jean Fourastié, same goes with the work of BCG's founder Bruce Henderson seminal work on the Experience Curve.

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. On the subject of the relationship between inflation and wages we read with great interest Wells Fargo's take from their note from the 31st of August entitled "Do Wages Still Matter for Inflation?":
"Executive Summary
Wage growth has garnered increasing attention in the heavily watched monthly employment reports. The scrutiny reflects the emphasis many Fed officials have placed on the critical link between slack in the labor market and inflation. With wages accounting for a significant share of costs in most industries, it makes intuitive sense that rising labor costs would soon develop into higher inflation. The reality, however, is that wage growth tells us little about future inflation. If anything, the relationship runs the other way, with inflation leading wage growth.
The limited influence of wage growth on inflation reflects the changing structure of the U.S. economy. Technology is making it easier than ever for consumers to compare prices, intensifying price competition. At the same time, globalization has diminished the role of the domestic labor market with a larger share of goods consumed imported from overseas. Finally, the inability of many firms to adjust prices frequently generates the need to set prices in anticipation of future costs, making inflation expectations a more significant driver of inflation than wages.
Watching Wages for Signs of Inflation
The PCE deflator has only briefly brushed the Fed’s 2 percent target since the start of the
expansion (Figure 1).

Nevertheless, most FOMC members remain confident that inflation will move higher from here. In the Committee’s most recent economic projections published in June, the median estimate for where inflation would end the year was 1.6 percent and 1.7 percent for headline and core inflation, respectively, while both measures were projected to end 2018 at 2.0 percent (Figure 2).

Although those estimates will likely come down a tick or two following recent months’ softness, the path remains upward and is a key factor in the Committee’s baseline outlook to further raise interest rates over the next year.

The FOMC’s confidence that inflation will head higher over the next year and a half hinges critically on the assumption that as resource slack is absorbed, upward pressure on prices follows. While resources include both labor and capital, the link between slack in the labor market and inflation garners more widespread attention. As unemployment declines, firms need to pay higher wages to attract and retain workers, and those costs in turn generate the need to raise prices. Over the past couple of years, the unemployment rate has fallen to where it is now below many estimates of full employment, while inflation—headline or core—has remained stubbornly below 2 percent. The result has been to closely watch wage growth as a sign of future inflation.
Wage growth has remained frustratingly low for workers and policymakers alike. After increasing only about 2 percent a year in the early years of the expansion, average hourly earnings began to strengthen in 2015. The uptrend has fizzled by multiple wage measures this year, however, and wage growth remains weak by historic standards (Figure 3).
There are some signs that higher pay may be in the offing. Job openings are at an all-time high, underemployment is shrinking, and the share of small businesses raising compensation is hovering near cycle highs (Figure 4). But even if we see stronger wage growth, will it lead to more inflation?

Wages as a Driver of Inflation: Not What It Used to Be
The relationship between labor market slack and inflation, known as the Phillips Curve, has had its share of critics over the years as it appeared to break down completely (as in the 1970s) or at the very least weaken in recent decades. Nevertheless, Fed Chair Janet Yellen has made comments over the years indicating she is a subscriber of the Phillips Curve and that short-run fluctuations in labor market slack affect inflation. As indicated in the most recent FOMC meeting minutes, however, doubts seem to be emerging among more FOMC members about the link between labor market slack, wages and inflation. Research by Federal Reserve economists has found that the impact of labor costs on inflation has diminished in recent decades.
A simple regression of our own shows that an increase in wages is associated with a smaller rise in inflation than in previous decades. For this we look at the “nominal” component of wage growth, or average hourly earnings growth minus labor productivity since productivity drives real wages. While a one percentage point rise in the year-over-year rate of productivity-adjusted average hourly earnings was consistent with a 0.4 percentage point rise in CPI inflation from 1985 to 2000, that relationship has fallen by half since 2000. Moreover, when determining if in recent decades changes in wage growth cause changes in inflation and are not simply associated with these, we find no statistically significant support. If anything, inflation drives wage growth.
Domestic Labor Costs Only Part of the Story
For most businesses, labor represents a sizable share of costs. This is particularly true for service sector industries, where labor compensation accounts for at least 30 percent and often more than half of input costs. Why then do wages provide so little information about inflation if labor is such a big input cost? Labor conditions have increasingly taken a backseat in inflation dynamics in recent years as the U.S. economy has evolved. Technology has changed the way consumers shop and the way in which businesses offer goods and services. At the same time, globalization has opened up new sources of labor beyond the domestic workforce. And while workers may think about future inflation when negotiating wages, businesses are also thinking about future inflation when setting prices.
Technology: Holding Down Costs and Facilitating Price Competition
Technology seems to have infiltrated every corner of life so it is not a leap to believe it has affected inflation. Technological improvements have always held down inflation by improving the production processes or lowering the input costs of existing goods and services. By making it cheaper to produce products, firms can raise margins without increasing prices. It’s tough to argue, however, that technology in this way is playing a bigger role today in holding down inflation given the weak rate of productivity growth in the last decade. Instead, competitive forces unleashed by new technology have been pointed to as a recent factor holding down prices. The internet has made it easier than ever for consumers to compare prices of goods and services. Nowhere though has competition been more intense than in the retail sector as e-commerce has grown to nearly 10 percent of sales. Yet while increased competition should pressure margins, margins for retailers have held up over the past decade as the shift to online sales has limited the need for costly brick and mortar stores (Figure 5).

The upshot is prices for core consumer goods have been falling for the better part of the past 15 years (Figure 6).
The service sector has not been immune to competitive pressures either. The recent drop in the cost of cell phone services offers a relevant example. However, part of the decline since the start of the year is traceable to quality adjustments made by the Bureau of Labor Statistics (BLS). When the quality of a product improves, the BLS imputes the value of the improvement and downwardly adjusts the product “price” to account for the fact that while the listed price may be unchanged or higher, consumers are getting a better product.
Globalization: Not Just a U.S. Labor Market
Of course, the decline in core consumer goods prices has coincided with increasing global trade. The start of the North American Free Trade Agreement (NAFTA) in 1994 and China’s entrance to the World Trade Organization in 2001 both opened up significant sources of global labor. In 1992, only about one-third of U.S. consumer goods were imported from overseas, but that share has grown to about 55 percent today (Figure 7).

Although goods only account for one quarter of the core CPI, global price dynamics have had a significant, albeit small, impact on U.S. inflation. With foreign-made goods accounting for a larger share of consumption, the cyclical state of the U.S. labor market has lost importance in price setting.
Expectations: Firms Get Ahead of Cost Pressures
Inflation expectations play a more crucial role for inflation than wages. Expectations of future inflation affect firms’ decisions in price setting. As price changes can be costly in their own right, many businesses change prices infrequently. The stickiness of prices generates the need for businesses to make assumptions about future costs, including labor.7 As a result, price changes can precede wage growth, rather than wage growth leading to inflation. While a Granger- Causality test as previously noted shows wages do not drive inflation, the same test shows that inflation expectations are a significant driver of realized inflation.
Conclusion: Don’t Look to Wages for Early Signs of Inflation
The payroll figures and unemployment rate have typically been the focus of the closely-watched Employment Situation report each month, but increasingly those figures have taken a backseat to average hourly earnings. Market participants have been closely watching wage growth for signs of inflation in order to anticipate future policy decisions by the FOMC. Despite the emphasis placed on labor market conditions as a as a driver of inflation, average hourly earnings contain little information about inflation. Changes in wage costs are often already anticipated by businesses, meaning there is not much new information contained in them from an inflation perspective. Moreover, the ability and need to raise prices has been altered by technology and globalization, making the state of the domestic labor market less important.
We continue to watch wage growth as a source of household income and, therefore, spending power. In conjunction with aggregate hours worked, average hourly earnings remain a useful guide of near-term income for consumers (Figure 8).

As a signal of future inflation, however, the emphasis on wage growth appears misplaced."  -source Wells Fargo
Why wage growth has remained frustratingly low for workers and policymakers alike? You have the answer, there are structural changes at play. Therefore using a Norwegian Blue parrot aka the Phillips curve in the expectation of changes in the inflation outlook is at best misplaced by the FOMC, at worse plainly wrong because of the inherently "deflationist" bias of capitalism with innovation, technology and globalization. The model might have been working in a less open world but in today's globalized world, it's just not working anymore, it's not "resting" put it simply, it's broken.

If the PhDs at the Fed had closely studied both Fourastié and Henderson, they would have stopped making wrong assumptions and discarded their obsolete models as pointed out by our friend "Polemic" recently who runs the excellent blog "Polemic pains" in relation to the Phillips curve:
"Real problem is it is used for local policy using local employment/inflation when really, with globalisation, its inputs are global not local. Take UK, falling unemployment doesn't mean labour supply diminishes.. just suck in more from Europe/RoW. So wage inflation stays low but number of employed rises. Then screw it all up again with FX rates flying around altering actual wages for migrant labour relative to their spending location and it gets really confusing. I guess it will only work if free migration of labour is stopped so we no longer have a 'spare tank' of labour that sits outside the Phillips curve measure of unemployment" - source Polemic, 24th of August 2017
Exactly. It might be fun using it locally but in a globalized world, it is just isn't working anymore dear FOMC. That's the main issue with your Norwegian Blue parrot. If indeed everyone is focusing on real wages for a change in inflation expectations, then obviously we are wrong like so many others and the US will not reach that easily escape velocity. Also, the FOMC should look more closely to the Experience curve as it refers to the ability to produce existing products more cheaply and deliver them to an ever-wider audience. Could we call this the Amazon factor? We wonder.

  • Credit - Credit Supply is cyclical, so is liquidity...

When it comes to "Orobouros", as we pointed out at the beginning of our conversation, no matter how many tricks (ZIRP, QE, NIRP) used by our modern alchemists, aka central bankers, they cannot alter cyclicality of credit, that simple. If they do not believe us in similar fashion to the many points we have made when it comes to the state of their Norwegian Blue parrot, they could indeed look at the work of Bo Becker and Victoria Ivashina (link above) and their working paper from 2011 published at Harvard Business School:
"Theory predicts that there is a close link between bank credit supply and the evolution of the business cycle. Yet fluctuations in bank-loan supply have been hard to quantify in the time series. While loan issuance falls in recessions, it is not clear if this is due to demand or supply. We address this question by studying firms’ substitution between bank debt and non-bank debt (public bonds) using firm-level data. Any firm that raises new debt must have a positive demand for external funds. Conditional on issuance of new debt, we interpret firm’s switching from loans to bonds as a contraction in bank credit supply. We find strong evidence of substitution from loans to bonds at times characterized by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. The bank-to-bond substitution can only be measured for firms with access to bond markets. However, we show that this substitution behavior has strong predictive power for bank borrowing and investments by small, out-of-sample firms." - source HBS, Bo Becker and Victoria Ivashina, 2011
The provision of credit is highly pro-cyclical in the sense that not much new credit is issued during recessions. As shown in Europe with the "credit crunch" in 2012 thanks to the collapsing of loan books leading to disintermediation, from loans into new bonds issues, to paraphrase Bastiat, there is what you see, and what you don't see. In their paper Bo Becker and Victoria are showing that credit is pro-cyclical because banks have not been willing to lend (supply shift = Economics 101). In very simple terms, the contraction in bank credit supply has been offset by bond issuance on a grand scale. They conclude their paper by adding that a strong predictor of overall contraction in credit is when firms cannot tap into the bond market, hence the importance of monitoring the weaker part of the bond market namely the CCC bucket.

Obviously there have been other impacts than loan contraction in Europe when it comes to dis-intermediation and bonds issuance. At least in the US the impact of financial regulation and Volcker Rule has had an impact on liquidity. This is particularly important we think with the rise of passive investing and the growing use of ETFs in the fixed income space. This of course will have serious implications when the markets turn, particularly when one takes into account the "liquidity" factor. On this subject we read with interest Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 25th of August entitled "When the tide goes out":
"When the tide goes out… the unintended consequences of financial regulation are revealed. High grade corporate bond trading has doubled over the post-crisis years (Figure 1).

However, because the size of the market tripled that means the overall market has become less liquid - due to a number of post-crisis changes - including financial regulation and most prominently the Volcker Rule, but also less leverage in the system. For example, while annual trading volumes in the HG corporate bond market were 135% of the size of the market back in 2006, we estimate that statistic is tracking only 86% for 2017 (Figure 2).
However, counterintuitively in this environment, market-based measures of liquidity – such as off-the-run/on-the-run spread premiums are back to pre-crisis levels. This is true for bid/ask spreads as well, although we are no fan of them as measures of liquidity as we have no information on the true cost to trade more than just a small block of bonds. Moreover quality data on bids and asks naturally is concentrated in what is liquid and trades. In contrast liquidity almost by definition has to be measured where there is liquidity risk, which in many market environments is not quoted actively by traders.
Market based measures are back to pre-crisis levels because of the unique post-crisis environment of extremely low global yields that has led to an unprecedented reach for yield in US HG corporate bonds. In recent years, yields have dropped so much that investors have been forced to enhance yields by reaching into normally illiquid off-the-run names and maturities, which naturally compresses the off-the-run/on-the-run liquidity measures. That means liquidity is OK because dealers are happy to use their  lean balance sheets to not only buy liquid on-the-runs that turn over quickly, but also normally illiquid off-the-runs because there is an army of investors waiting to buy them in short order.
In other words, in the post-crisis years the unprecedented reach for yield engineered by global central banks has likely mitigated the unintended consequence of financial regulation, which is diminished liquidity in the corporate bond market. This means everything is OK until it is not. Only when interest rates go up significantly, and we get large outflows, will we see just how illiquid the corporate bond market can be in the new regulatory regime. Initially liquid names and maturities would likely underperform as investors have to sell what they can. Then later when investors find they can no longer sell the vast majority of bonds they own – the off-the-runs – at meaningful prices we get a big widening in liquidity measures. This could get ugly, we think.
Rates vs. liquidity
To illustrate, Figure 3 shows our preferred measure of market liquidity - the percentage difference between credit spreads on 9-year and 10-year bonds (adjusted for the on-the- run curve).

The idea is that on-the-run 10-year bonds are issued and traded actively and are liquid. Then liquidity declines over time and they become off-the-runs. We use the 9-year maturity point for that, as the bonds have not become too illiquid for pricing to be somewhat accurate.
We plot this liquidity premium over time against interest rates to show the normal environment, which we saw for example around the US downgrade and European sovereign crisis in 2011, where there was an inverse relation. In such risk-off environment, Treasuries rally and liquidity dries up. But fast forward and starting in 2015, there has been a strong positive correlation between interest rates and the liquidity premium. The reason for this shift is very simple – as we described above – that interest rates had declined so much that further declines force investors to reach for yield in off-the-runs, while with increasing rates they are able to return to on-the-runs. Hence, the big decline in interest rates has compressed the liquidity premium to pre-crisis levels.
Why, you may ask, did investors not compress the liquidity premium back in 2H12/1H13 when interest rates were also low? Well remember that the dominant investor reaching for yield in US HG corporate bonds nowadays is the foreign investor. Back then, there was still some yield to be had in foreign fixed income (Figure 4) and foreign investors did not have to reach for yield in US corporate bonds (Figure 5).

Of course, with the collapse in foreign interest rates that has changed, and over the past few years foreign investors have had no choice but to buy US corporate bonds. To make things worse, the cost of dollar hedging has risen sharply for foreign investors, due in part to all the foreign buying of US fixed income (Figure 5).

Combined with the decline in US yields that means foreign investors are that much more pressed to reach for yield in off-the-runs." - source Bank of America Merrill Lynch
Obviously when it comes to "liquidity" and credit, when it comes to the supportive "bid", you need to pray the ECB but more importantly the Bank of Japan have your back with their NIRP and QE policies when it comes to "liquid" US credit markets that's a given as per our final chart.
  • Final chart - Japanese support for credit - The boys are back in town
As we pointed out in many musings, the bid in US credit has been "Made in Japan". Back in July in our conversation "The Butterfly effect" we indicated that Japan had been heavily supporting US dollar flows but US credit as well. At the time we indicated:
"Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk." - source Macronomics, July 2017.
And even with prolonged US dollar weakness they have been wrong, no offense to their credit team. When it comes to Fixed Income flows, we keep saying this but, matters Japan and matters a lot. For instance we read with interest Bank of America Merrill Lynch Liquid Insight note from the 23rd of August 2017 entitled "Japan's outward portfolio investment resurging; diverging implications":
"Key takeaways
  • Japan's outward portfolio investment is resurging led by banks' buying of US and French bonds.
  • The rapid increase partly reflects a reversal of earlier unwinding, adding to structural demand for non-yen assets.
  • Expect Japan investors to dip buy USD, continue buying AUD & NZD. EUR/JPY demand to remain subdued unless, until a deeper dip
Japan’s outward portfolio investment resurging
Although it may have gone unnoticed as the market has much to focus on elsewhere, the return of Japan’s outward portfolio investment since May has been notable. The purchase of foreign securities by Japanese investors hit a seven-year high on a 13-week base at ¥13.4tn in July (Chart of the day). This came after a period of net selling in the spring when we thought Japanese investors were resorting to a “wait-and-see” stance due to heightened external risks. We explore diverging implications across relevant markets." - source Bank of America Merrill Lynch
When it comes to the support provided by the Japanese investment crowd, which where there in force in 2016, particularly with Lifers, it remains to be seen how long these guys are going to stay in town. Just ensure you have a good view of the credit saloon's revolving doors, because when it comes to "liquidity", as Mark Yusko, Morgan Creek's CIO put it, it's a feeble creature:
"Liquidity is a coward, it only exists when you don't need it..." - Mark Yusko
In the current "Ouroboros" credit game, liquidity seems indeed to be plentiful particularly in the passive investment game, it remains to be seen, if it will be present when the tides goes out...

"The only relevant test of the validity of a hypothesis is comparison of prediction with experience. " -Milton Friedman

Stay tuned!

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