Macro and Credit - Volition

"The true test of a leader is whether his followers will adhere to his cause from their own volition, enduring the most arduous hardships without being forced to do so, and remaining steadfast in the moments of greatest peril." - Xenophon

Looking at the dizzy heights being reached in equities with uninterrupted flows into US Investment Grade with yet another warning coming from the wise wizard from the BIS, namely Claudio Borio in the latest quarterly report, when it came to selecting our title analogy, we reminded ourselves of the term "Volition" from psychology given our fondness for behavioral economics. Volition or will is the cognitive process by which an individual decides on and commits to a particular course of action such as the normalization process undertaken by the Fed. It is defined as purposive striving and is one of the primary human psychological functions. Volition means the power to make your own choices or decisions. As an example of the classical concept of volition, comes from Eliezer Yudkowsky while discussing friendly AI development and "Coherent Extrapolated Volition" in 2004. The author came up with a simple thought experiment: imagine you’re facing two boxes, A and B. One of these boxes, and only one, has a diamond in it – box B. You are now asked to make a guess, whether to choose box A or B, and you chose to open box A. It was your decision to take box A, but your volition was to choose box B, since you wanted the diamond in the first place. Now imagine someone else – Fred – is faced with the same task and you want to help him in his decision by giving the box he chose, box A. Since you know where the diamond is, simply handling him the box isn’t helping. As such, you mentally extrapolate a volition for Fred, based on a version of him that knows where the diamond is, and imagine he actually wants box B. In developing friendly AI, one acting for our best interests, we would have to take care that it would have implemented, from the beginning. The question one might rightly ask is relating to the volition of the Fed, is it really for our best interests? One might wonder.

In this week's conversation, we would like to look at the volition of the Fed in its normalization process and the potential upcoming impacts in 2018 should the Fed, once again be behind the increasing flattish curve.

Synopsis:

• Macro and Credit - When the going gets tough
• Final chart -  The Fed can't escape Newtonian gravity

• Macro and Credit - When the going gets tough

Back in April 2017 in our conversation "Narrative paradigm" we argued that when it comes to credit market the only easy day was yesterday. Given the significant role of beta thanks to cheap credit and the "carry play" supported by low rates volatility, it becomes increasingly difficult for us to be supportive of at least the European beta play with the level touched by European High Yield. We also indicated recently that we were expecting a significant pick-up in M&A activity in 2018. This means that some investment grade issuers could experience some sucker punches in the form of blowing out credit spreads in 2018 hence the need of reaching out for your LBO screener à la 2007. A raft of M&A transactions in 2018 would clearly reinforce the view of the lateness in the credit cycle. In terms of change of narrative and in continuation of the "synchronicity" we mentioned in our previous post, the Fed's volition should not be taken lightly.

Also, regardless of the economic narrative put forward by many, including November payrolls rising by a seasonally adjusted 228K and beating expectations of 200K, leaving the unemployment rate in the US to 4.1%, rising wage pressure remains relatively absent. On top of that, surging consumer confidence and modest income growth should trigger much stronger loan demand in our "credit book". One could argue that the credit impulse in the US is tepid at best, no offense to the volition of the Fed. This is indicated by Wells Fargo in their Interest Weekly note from November 29th entitled "Mixed Credit Trends Among Businesses and Consumers":

"In the ninth year of the current economic expansion, credit standards point to a varied, but stable, outlook. Recent data suggest business lending demand has fallen, while consumer demand has seen modest gains.

Banks Optimistic (Yet Cautious) Approach to Lending

Banks continue to relax lending standards on business, commercial and industrial (C&I) loans and mortgages, as banks’ willingness to make loans has gained some stability. A slowdown in banks’ willingness to lend is customary with late cycle expansion. As seen in the below graph, banks’ willingness to extend credit follows a cycle-like trend.

At the start of an economic expansion, banks appear very willing to extend credit. But as the cycle matures, they become less willing to extend credit, and, in turn, tighten their standards in a cautionary nature.

Banks have reported increased competition from other bank and nonbank lenders, which in part, has led to the easing of standards. Continued loosening of lending standards of C&I and mortgage loans points to sustained confidence in the current state of the expansion. However, banks continue to tighten standards on credit card and auto loans, which may signal some caution in the consumer sector as the economic cycle ages.

Slowly Growing Consumer Demand for Loans

With an unemployment rate of just 4.1 percent, and in an environment of modest income growth and surging consumer confidence, theory would suggest robust loan demand. Loan demand, however, remains muted, pointing to a change in consumer sentiment towards debt. Credit card demand has remained unchanged, while we have seen a recent uptick in auto loan demand (below graph).

The rise in demand for auto loans is likely attributable to rebound effects in auto-sales due to damage from the recent hurricanes in Texas and Florida. Consumer demand for mortgage loans has slowed, which is expected to reverse as existing home sales edge higher off a recent slowdown.
Without an increase in income growth, loan demand should continue to increase modestly. Our forecast calls for an uptick in disposable personal income in Q2 2018, due to the effects of the proposed tax reform, followed by a slowdown in disposable personal income growth through the last year of our forecast (2019). Such slowing in income growth suggests consumers may increasingly turn to borrowing to fund their consumption habits in the future.
Demand for business loans remains weak, yet increased strength in business investment suggests that firms have turned to other sources of funding to fuel capital spending (below graph).

The loosening of lending standards, coupled with our positive outlook for business investment, should drive C&I loan demand higher in the near future. However, as the cycle continues to mature, we project equipment spending to slow, likely resulting in a reduction in business demand looking further ahead. The current credit climate insinuates stability within lending practices as growth continues in the ninth year of the current economic expansion."  - source Wells Fargo

While the Fed's volition is to continue with its hiking cycle, financial conditions remain loose and the lack of pressure on wages means that consumers are increasing their leverage through consumer loans in an environment where there is increased competition for business from other players. There are two ways we think the first part of 2018 could play out, "Goldilocks" or "Stagflation" with a sudden rise in inflation expectations that would provide support for a bond bear market narrative with rising interest rates volatility. This is of course without taking into account rising geopolitical risk aka the dreaded "exogenous" factors. We sidestepped various political "exogenous" risks in the first part of 2017 with various elections taking place in Europe in particular. It remains to be seen what will be the trigger of the return of volatility which has so badly wounded many large global macro funds in recent years thanks to its absence. As far as interest volatility is concerned it is at the lowest level in more than 20 years as displayed in the below Wells Fargo chart from their 2018 US Corporate Credit Outlook published on the first of December:

- source Wells Fargo

It won't last rest assured as it is getting late in the game we think and we are already seeing a "synchronized" change in the central banking narrative. Yet some "beta" players continue to be oblivious to the change in the central banking rhetoric. It doesn't mean that the "Goldilocks" environment won't last a little bit more in 2018 for credit, but, we think you should start thinking about playing "defense". This is why back in July we recommended to tactically going for duration again particularly in credit. This has been paying off nicely in 2017 (MDGA - Make Duration Great Again) as indicated by Bank of America Merrill Lynch Credit Market Strategist note from the 8th of December entitled "Year of Duration":

"Year of Duration

That 30-year corporate bonds, which we define in the following as 15+ years, have performed well in 2017 (+11.48% YtD) is no surprise. After all we expected “equity-like” 8-9% total returns in our 2017 outlook piece (see: 2017 US high grade outlook: Let’s do the twist 21 November 2016) on the back of a 27bps decline in 30-year corporate yields (actual: -48bps YtD, Figure 1).

However the surprise has been that credit spreads and Treasury yields were almost equally responsible for this decline in yields (25bps tightening in spreads and 30ps decline in 30-year Treasury yields as of yesterday, Figure 2).

This positive correlation between credit spreads and Treasury yields for such large moves is noteworthy and counterintuitive, but not unseen in the post-crisis years.

How did duration become king?

There are many reasons corporate yield curves are flattening so much including first and foremost that the Fed plans to hike rates actively in an environment of weak inflation data (Figure 3, Figure 4).

This was highlighted by today’s mixed jobs report for November where, although headline nonfarm payrolls were strong at +228k (vs. +195k consensus, Figure 5), average hourly earnings grew only 2.5% YoY (vs. 2.7% expected, Figure 5).

There are many other reasons for flattening yield curves including Treasury’s refunding announcement, where they committed to meet any increased issuance needs using shorter maturities (see: On funding and refunding), the ongoing shift in Europe out of cash and way out the curves (see: QE is dead, long live NIRP), macro risks, etc.

Re-iterate 10s/30s spread curve flatteners

Unusually - and a testament to extreme investor need for both yield and duration – we have seen the 10s/30s corporate spread curve (non-fin, commodities) flatten 8-9bps this year, despite the fact that the 10s/30s Treasury curve has flattened 22bps. More broadly this environment of both flattening Treasury and spread curves has been in place since spreads began tightening in early 2016 (Figure 7). However, the past six months has seen little flattening of the spread curve – but the lack of steepening is actually very impressive as the Treasury curve has flattened 27bps over the same period of time. Needless to say if the Treasury curve continues to bull flatten our recommended non-banks spread curve flattener will not work. We are probably even now reaching levels where further bull flattening actually leads to steeper spread curves. Our house view (see: Global Rates Year Ahead) remains that the Treasury curve is too flat and eventually will re-steepen, which should be very favorable for our spread curve flattener trade. The trade also works with higher interest rates as long as the curve does not flatten.

- source Bank of America Merrill Lynch

As we concluded back in early June in our conversation "Voltage spike", the MDGA trade (Make Duration Great Again) has made a very good come back as indicated by the ETF ZROZ we follow, which delivered a 10.53% return so far this year. For 2018, we continue to favor style over substance, quality that is, over yield chasing from a tactical perspective. As well in another conversation of ours in June this year entitled "Goldilocks principle" we indicated:

"The relentless flattening of the US yield curve shows that in the current inning of the credit cycle, and with a Fed determined in continuing with its hiking path, from a risk-reward perspective, we believe long duration Investment Grade still offers support to the asset class and not only from a fund flows perspective with retail joining late the credit party. On another note the "Trumpflation" narrative has now truly faded to the extent that the deflation trade du jour, long US Treasuries (the long end that is) is back with a vengeance, while inflation expectations has been dwindling on the back of weaker oil prices (after all they still remain "expectations" from our central bankers perspective). " - source Macronomics, June 2017

Our call has been vindicated as well as our contrarian stance against the "bullish" dollar crowd. We continue to believe we will see further weakness ahead for the US dollar in 2018. If we do see additional pressure on the leverage play thanks to the carry trade due to central banking's volition, then one should expect a rise in the Japanese yen we think. As well we continue to see value in the long end of the US curve. Also while gold prices have been weaker recently, the recent pullback as for goldminers looks to us enticing, particularly in the light of a growing risk in "exogenous" factors. If credit options are cheap, gold/gold miners options are "cheaper" as well from a convexity reward perspective in 2018. When it comes to the bull run in credit spreads it has not yet ended and probably will last longer than many might expect, until we hit 11 that is on the "credit amplifier" in true Spinal Tap fashion. We do not see any value left (apart from playing the "dispersion" game with active credit management) in European High Yield at these levels. What is left is "carry" and clearly not enticing enough for us from a risk reward perspective in 2018. We would rather continue playing the US Investment Grade long duration play when it comes to credit allocation. What about US equities being priced to perfection and US High Yield? Given the strong correlations of both asset classes (close to 1 regardless of what some pundits would like to tell us), it is all a matter of "earnings" and they have been so far holding fairly well.

The big risk out there is, as we pointed out the return of the "Big Bad Wolf" aka inflation. This would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant repricing on the way. Inflation is our concern numero uno and this would we think be the trigger for higher volatility. This is as well the view of Deutsche Bank from their Asset Allocation note from the 4th of December entitled "What to make of volatility at 50-years lows":

"In our view the leading candidate for a shock that would lead to a sustained increase in vol is a sharp increase in inflation

As noted above, exogenous shocks have historically played a significant role in increasing and sustaining vol at higher levels. Shocks in general of course tend to be inherently unpredictable. Our economists forecast is for a gradual rise in inflation. But in the current context a sharp increase in inflation sticks out as a leading candidate for a shock that raises volatility in a sustained manner in 2018 given the extent to which it is priced in and the likely reaction of monetary policy:

• Slow inflation priced in. The slowdown in US inflation beginning in March this year had large impacts across asset classes and looks to be priced in (The Growth-Inflation Split, Sep 2017).
• Few expect a sharp pickup in inflation. The market and FOMC narrative around low inflation with widespread buying into structural declines and a breakdown of traditional relationships looks to have gotten carried away (Six Myths About Inflation, Oct 2017). This suggests few are expecting a sharp pickup in inflation.
• Four fundamental reasons to expect inflation to move up. First, the lagged impacts of inflation to the growth slowdown during the dollar and oil shocks points to a pick up. Second, the labor market continues to tighten and in our reading there is no reason to believe the traditional Phillips curve has broken down, just swamped by other factors. Third, the direct drag from the past appreciation of the dollar should begin to pass through. Fourth, idiosyncratic factors together have had a strong negative run but tend to mean revert over time. Acting in concert, the four factors clearly have the potential to create a sharp move higher in inflation.
• A sharp pickup in inflation is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle. Fed hiking to keep inflation in check has been a—if not the —leading driver of recessions historically. Market expectations of Fed hikes are currently of course far below the Fed’s guidance and a sharp pickup in inflation is likely to entail a significant re-pricing. We don’t see Fed rate hikes from current low levels as ending the cycle any time soon (Is Unprecedented Monetary Policy Easing Creating Secular Stagnation? Jul 2016). But we do see faster rate hikes against the backdrop of a sharp pickup in inflation as having the potential of raising and sustaining vol at higher levels as concerns about the end of the cycle grow." - source Deutsche Bank

Make no mistake, inflation is the "Boogeyman" for financial markets. From the long interesting report from Deutsche Banks, three graph stand out when it comes to heightened risk for large "sigma" events in 2018 given how coiled the volatility spring is:

- source Deutsche Bank

No matter how high your "interval of confidence" is, your VaR model is looking/asking for trouble, particularly your "liquidity" hypothesis. It is time to build some cheap "convexity" defenses as we posited above, not to mention the need for your LBO screener with rising M&A risk and the sucker punches they can deliver to your Investment Grade portfolio à la 2007. Just some thoughts for 2018.

When it comes to the relentless flattening of the US Yield curve as a harbinger for rising recession risk in a classical macro way, we read with interest Deutsche Bank's take from their Global Market Strategy note from the 1st of December entitled "The Fed, the Curve and Risk Assets in the Great Rate Normalization about the recession risk transmission:

"Recession risk transmission

The sharp curve flattening has given renewed life to worries that recession risks are on the rise. Given the flattening, our recession probability metrics – one using the outright slope of the 1s10s yield curve, and one that adjusts the 1s10s curve for the level of 1s – both suggest that November’s flattening was worth a ~6pp increase of the probability that a recession will begin in the next 12 months.

Holding all other inputs equal (the u-rate vs nairu, aggregate hours worked growth, core CPI ex-shelter, and the change in oil prices) puts the probability of a recession beginning in the next 12 months at 16.4% on the unadjusted model, and 26.4% when we adjust the curve for the level of front-end rates. This is still low.

The parallels between the current environment and the Greenspan conundrum are inevitable given the apparent insensitivity of long-end rates to the Fed’s hiking cycle – particularly in the context of a balance sheet unwind that many expected to put sustained steepening pressure on the curve. There is no “conundrum” in our mind – the Fed is simply hiking into a very low neutral rate, with no evidence that inflation is set to materialize to allow them to move faster. This cycle is following a somewhat similar path, however, to the mid 2000’s cycle from the perspective of recession probability.

Now 2 years into the current cycle, the recession probability is at a similar spot to mid-2006 (which was just months away from being within the 12 month window to the start of the great recession).

The risks presented by a flattening yield curve have a clear transmission mechanism to broader conditions as the Fed’s balance sheet shrinks. Before the Fed began to pare its balance sheet we discussed why a steep curve is important to a successful QE unwind – if the curve flattens too much, banks will have no incentive to hold securities over cash earning IOER, meaning non-banks will likely be the marginal buyers of securities no longer owned by the Fed, and deposits will leave the system. This in turn carries meaningful risks to loan growth, which had caught a fair amount of attention given the slowing earlier in the year. Our financial conditions index suggests that C&I growth should be accelerating, though that has not really materialized yet.

The lagged relationship between C&I loans and the Senior Loan Officer survey points to a pick-up in loan growth, but only into the ~5% y/y range, not the double digit range of years past. This has failed to materialize, however, and is a going risk amid the Fed’s balance sheet wind down.

It is still sufficiently early into the Fed’s balance sheet unwind that banks’ reaction function is hard to gauge – securities holdings have risen since the end of September, while cash holdings have been more or less stable and deposits have shown some recent volatility but might still be on an upward trend. So the limited evidence does not yet suggest that this is posing an imminent risk to the economy, but the flatter the curve gets, the more likely banks are to eschew securities for cash, increasing the risk that deposits leave the system, and banks have to pull back on lending."  - source Deutsche Bank

There you have it, no matter how strong the "volition" of the Fed is, the exercise is difficult to execute. While there is no imminent threat to the positive narrative from a fundamentals perspective, the relentless flattening of the Us yield curve is difficult to ignore on top of rising geopolitical exogenous factors. We could easily entertain a blow out of oil prices on the back of exogenous factor in an already tensed Middle East, which would no doubt spill into the inflation expectations surprises on the upside and lead to some repricing and heightened volatility. As we pointed out in our bullet point, when the going gets tough...volition or not.

In our last conversation, we pointed out that "volatility" conundrum was not a paranormal phenomenon, and no matter our strong the Fed's volition and "Forward Guidance" (or imprudence), what the US yield curve is telling us is that no matter how strong the Fed's volition is, they cannot escape Newtonian gravity:

"When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward." - source Macronomics, November 2017 

Our final chart below points towards the gravitational pull the Fed is facing.

• Final chart -  The Fed can't escape Newtonian gravity

No matter how strong the spells of the "wizards" at the Fed have been in recent years as pointed out by the wise wizard of the BIS aka Claudio Borio, the Fed's volition is one thing, Newtonian gravity is another. Our final chart comes from Bank of America Merrill Lynch's Weekly Securitization Overview from the 8th of December entitled "The gravity of the yield curve" and displays the 2Y10Y versus the US unemployment rate:

"Given the magnitude of recent yield curve flattening, we revisit our framework where we look at the 2y-10y spreads relative to the unemployment rate back to 1989 (Chart 1).

The flattener has moved more slowly than we anticipated back in 2014, dropping by about 50 bps per year over the last 4 years. Given where unemployment already is, and expectations that it will move lower in the year ahead, we see a strong gravitational pull lower on the curve. Moreover, given that the Fed likely has 4-5 rate hikes in store over the next year (including December 2017), while inflation readings remain low, dropping an additional 50 bps on the curve over the next year seems very achievable, particularly after the 30 bps drop in the 2y-10y spread in the past six weeks.

We note that flattening is not the house call: BofAML rates strategists believe the curve will steepen due to easier fiscal policy, higher deficits, and a higher inflation expectation and the Fed will require higher 5y-10y yields as a precondition to flattening or inverting the curve. We recognize that the flattening process has already taken longer than we expected a few years back, due to multiple “dovish” Fed hikes or pauses, and we acknowledge the potential for what we think would be steepening detours along the way.

Newton's law of gravitation resembles Coulomb's law of electrical forces, which is used to calculate the magnitude of the electrical force arising between two charged bodies. Both are inverse-square laws, where force is inversely proportional to the square of the distance between the bodies. In similar fashion, the relationship between the US 2Y10Y and the US unemployment rate could be seen as inverse-square laws when it comes to the ongoing flattening stance of the US yield curve but we ramble again...

"A man of genius makes no mistakes; his errors are volitional and are the portals of discovery." -  James Joyce

Stay tuned!