Macro and Credit - The Twain-Laird Duel

"All you need in this life is ignorance and confidence, and then success is sure." - Mark Twain

Watching the mesmerizing new heights reached by US equities in conjunction with US rumblings and looming threats of trade wars being felt, with ECB supremo Mario Draghi vainly trying to offset the weak dollar rhetoric coming from Treasury Secretary Steven Mnuchin's weak dollar recent stance, when it came to selecting our post title analogy, we reminded ourselves of the famous duel that opposed American writer Mark Twain with fellow country man James Laird. This was one of the most prominent duels in American History:

"While living in Virginia City, Nevada, sharp-witted satirist Mark Twain was up to his usual pot stirring, writing such outrageous editorials for The Territorial Enterprise that locals dubbed him “The Incorrigible.” When Twain wrote a piece erroneously accusing a rival paper, The Virginia City Union, of reneging on a promised pledge to charity, the publisher of the paper, James Laird, made such a stink over the false accusation that Twain challenged him to a duel. Twain’s second, Steve Gillis, took Twain to practice his shooting, only to find that the man’s pen was truly mightier than his pistol; Twain couldn’t hit the side of a barn. Filled with fear, Twain collapsed. As Laird and his men were making their way over, Gillis grabbed a bird, shot his head off, and stood admiring the corpse. Laird’s second asked, “Who did that?” and Gillis responded that Twain had shot the bird’s head off from a good distance and was capable of doing it with every shot. Then he gravely intoned, “You don’t want to fight that man. It’s just like suicide. You better settle this thing, now.” The creative ploy worked, and the men reconciled. Tom Sawyer would have been proud." - source The Art of Manliness

One could opine that in similar fashion to Mark Twain, when it comes to its inflation target, Mario Draghi cannot hit the side of a barn as well. Then again, as history as shown us, many times, sometimes you don't want to fight central bankers, because often their creative ploys work, whatever it takes, until they don't but for now that's another story.

In this week's conversation, we would like to look at the recent rise in the trade war rhetoric, the weakness in the US dollar and what it entails from an allocation perspective.

Synopsis:

• Macro and Credit - Trade and currencies, gloves are coming off
• Final chart - Pension rebalancing? Re-hedge this...

• Macro and Credit - Trade and currencies, gloves are coming off

We won't continue to blow our own trumpet, but as a reminder, in January 2017 in our conversation "The Woozle effect" we indicated our contrarian stance, namely that we were willing to stand against the US long dollar crowd and that we would rather be overweight Emerging Markets (EM) equities over US equities. Obviously with the continuation of the same trend in early 2018 with a weaker US dollar, we continue to advocate being overweight Emerging Market Equities over US equities from an allocation perspective. 

The recent "war" of words between US Treasury Secretary and Mario Draghi, tempered somewhat by the US president as of late has already revealed clearly that when it comes to being in a tight spot, the ECB is in a much more difficult position than the Fed when it comes to winding down its QE program. 

Also in our January conversation "The Woozle effect" we indicated the following:

"Equities pundits like to focus on the asset side, such as the impact of corporate tax rate mentioned above, we credit pundits tend to focus on the liability side which means that rather than focusing on the corporate tax relief effect we would rather side with our friend Michael Lebowitz from 720 Global from his latest note "Hoover's folly" from the 11th of January and focus on Global Trade risk, Hoover's style:

"Ramifications and Investment Advice

Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.

If actions are taken to impose tariffs, VATs, border adjustments or renege on trade deals, the consequences to various asset classes could be severe. Of further importance, the U.S. dollar is the world’s reserve currency and accounts for the majority of global trade. If global trade is hampered, marginal demand for dollars would likely decrease as would the value of the dollar versus other currencies.

From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

Investors should anticipate that, whatever actions are taken by the new administration, America’s trade partners will likely take similar actions in order to protect their own interests. If this is the case, the prices of goods and materials will likely rise along with tensions in global trade markets. Retaliation raises the specter of heightened inflationary pressures, which could force the Federal Reserve to raise interest rates at a faster pace than expected. The possibility of inflation coupled with higher interest rates and weak economic growth would lead to an economic state called stagflation. 

Other than precious metals and possibly some companies operating largely within the United States, it is hard to envision many other domestic or global assets that benefit from a trade war." - source 720 Global, Michael Lebowitz, Hoover's folly, 11th of January 2016

This makes perfect sense and as we indicated earlier on, we have become more positive on gold / gold miners in late December for that very reason. As we pointed out in our November conversation "From Utopia to Dystopia and back" the trade attitude of the next US administration is the biggest unknown, and the biggest risk we think." - source Macronomics, January 2017

Weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand. 

We also added 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." - source Macronomics, January 2017

In numerous conversations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Furthermore, in our recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. Protectionism, in our view, is inherently inflationary in nature. To preserve corporate margins, output prices will need to rise, that simple, and it is already happening. 

Productivity in the US has been eviscerated. We feel we are increasingly moving from cooperation to "non-cooperation", a sort of "deglobalization". 

It is a theme we approached in January 2015 in our conversation "The Pigou effect" when we quoted the books The Trap and The Response from Sir James Goldsmith published in 1993 and 1994. Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015:

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.

“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

Real wage growth has been the Fed's greatest headache and probably the absence of it has been of the main reasons behind President Trump's election. This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, 22nd of July 2014

The recent "Twain-Laird Duel" between US Treasury Secretary and the ECB clearly shows that there is a heightened risk for global trade thanks to a domestic agenda given low productivity and the consequences the "off-shoring" of labor has had on local communities as warned by Sir James Goldsmith in his great books. On the subject of global trade we read with interest Barclays Economics Research note from the 26th of January entitled "Trouble with trade?":

"Global trade at risk?

Protectionism and its adverse effect on the global trade system has been one of the key concerns in a 'Goldilocks' environment of favourable economic developments and rallying financial markets. The aggressive rhetoric on trade of the US started to turn into action this week, as President Trump's approved 'safeguard' tariffs on imported solar panels and washing machines. Later Secretary Mnuchin and Commerce Secretary Ross indicated at the World Economic Forum in Davos that further such trade measures could be forthcoming, while also criticising the WTO in principle. President Trump's speech at Davos struck a generally conciliatory tone on trade, but also lacked any specificity to meaningfully alleviate concerns. In parallel, the NAFTA re-negotiations entered their sixth round this week, with growing risk of collapse, as the US will present its response to Mexico and Canada's suggestions this Monday

Could this be a turn for the worse in global trade? Pessimists can point to the fact that an already quite 'globalised' world in the early 20th century experienced a collapse of trade openness as a consequence of war and protectionism in 1914-1945; it took many decades to regain such openness, and only since the early 2000s have global trade levels reached new highs.

However, several reasons (beyond the absence of a world war) speak against such gloom: first, leaders from Europe, Canada, China and elsewhere in EM continue to underline their commitment to openness and multilateral cooperations; the UK's apparent growing desire for a 'soft' Brexit could also be seen in this light. Second, undoing global trade has become ever more difficult: as it has transformed from an exchange of final goods between nations into a complex trading network of intermediate goods that cross borders as part of corporations' global value chains. Protectionism would, thus quite immediately backfire on an economy with as many global corporations as the US, likely affecting equity market valuations, etc.

We continue to believe the US administration will want to avoid deterioration into a trade war. However, the coming months will show whether this view could be too sanguine; markets will watch for the next steps in: NAFTA negotiations, additional trade actions by the US (eg, on steel and aluminium) and potential retaliation measures by China, as well as a possible turn of the US towards challenging its KORUS deal with Korea and a looming fight over the refusal of the US to grant China 'market economy' status in the WTO. 

Central banks: managing great expectations

Central banks this week acted broadly according to expectations. Facing market expectations for a more rapid policy normalisation and related appreciation pressures on their currencies, both the BoJ's Kuroda and the ECB's Mario Draghi tried to downplay expectations for policy change. However, both did so with limited success, as they did not deny the robust growth and data-dependence of their future actions. Thus, as long as the favourable economic trends persist, the BoJ and the ECB may struggle to reverse the market's growing anticipation of policy normalisation. We continue to expect the BoJ to shift its yield target in Q3 and the ECB to end QE in September, followed by a first depo rate hike in December.

Next week's meeting of the Fed - whose new chairman Jerome Powell was confirmed this week by Congress - should be relatively uneventful as well. The FOMC statement should remain largely unchanged, with the next hike expected only for March. The FOMC members' assessment will take note of recent developments: Q4 GDP growth at 2.6% was below consensus, but accompanied by strong durable goods orders, broadly confirmed the economy's robust expansion; the sharp USD depreciation contrasts with rising yields and ever highly equity market records; and the more aggressive trade policy moves and continued domestic political tensions (even if the government shut down has been ended this week at least temporarily) mean higher uncertainty.

Watching Wages

More quietly but no less importantly will be the monitoring of inflation and wage growth developments in core economies. This week’s December core CPI print failed to strengthen, suggesting the need for wage growth and higher service prices for more sustained inflation. Next week’s annual wage outlook survey should be a decent predictor for the actual Shunto wage negotiation outcomes in March. Amid a growing labour shortage, the outlook for Japanese wages should finally improve in Germany where unemployment is also at record low levels, the powerful 'IG metal’ trade union has threatened nationwide strikes, as the fourth round of wage negotiations has not satisfied their demand for a 6% wage increase. Again this could possibly signal the beginning of some upward pressure on wages.

For the same reason, attention will be on US core PCE (December) on Monday (we expect 1.5% y/y), as well as on next Friday’s labor market report. Besides some expected improvements in the monthly NFPRs from last month (to 175,000), we expect the pace of m/m wage growth to be unchanged at only 0.3%.

It will show whether some US companies' recent verbal commitment to increase investments, hire more worker and increase wages will be reflected in these aggregates" - source Barclays

Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing...

Could the word "stagflation" makes a return? We wonder given corporations which have spread their supply chains across the world in the last ten years could be impacted seriously via a rising cost bases due to protectionism. After all, "globalization" means the world is more connected than before, so are stock markets around the world, and we are not even talking about the ETF "interconnection" risk here (another subject yet an important one).

But moving back to the US dollar, we still think, when it comes to its relationship with oil, that it was the primary driver of the collapse in oil prices in 2014. The sudden vicious surge in the US dollar was an exogenous shock which impacted the oil market. The US dollar has been in the past as well problematic for oil prices when recessionary forces caused a safe haven surge in the US dollar in 2008, leading to oil prices collapsing as per the below FRED chart:

- source FRED

While some pundits would argue that correlation doesn't mean causation, the weakness in the US dollar in 2017 has translated in a surge in oil prices with a continuation of the theme in early 2018 it seems. The risk is that if the Fed reads the US dollar weakness as a sign of the global economy’s heating up too fast with a higher risk of inflation in the future (particularly in the US), then it could shift in a hawkish direction because the dollar weakness goes hand in hand with even looser financial conditions and financial stability matters a lot for these guys. This would mean that the Fed might feel it is once again behind the curve. Yet it seems many investors have not factored in a possibility of more rate hikes coming compared to what is being discounted. This is indicated by Deutsche Bank in their Global Fixed Income Weekly note from the 26th of January entitled "Exogenous currency shock and monetary policy":

"A weaker USD supports easier financial conditions in the US. In turn, easier financial conditions will support growth and inflation. Therefore, one can back the implied “rate cuts” from the currently extremely very loose financial conditions. The work done by our US economics team suggests that the improvement in financial conditions observed since December is equivalent to 15-20bp of Fed fund easing. In other words, to compensate for easier financial conditions, the Fed would need to add close to one additional hike.

- source Deutsche Bank

Also, many pundits have put into the forefront a risk of a repeat of a 1987 event in the making. On this subject we read with interest Nomura's Matsuzawa Morning Report from the 25th of January entitled "Similarities between the strong commodities/weak USD trend and Black Monday":

"Yesterday, USTs and Bunds softened (bear steepened), USD and equities weakened, commodities strengthened and inflation expectations increased. This combination provides a relatively clear message, namely that the Fed is beginning to fall behind the curve. If the US administration takes FX measures favoring US trade, the Fed would lose its freedom with monetary policy and faith in the USD could begin to crumble. This would be a relatively dramatic denouement. We can look back to Black Monday in 1987 and the Tequila Crisis in 1995 for examples. Ultimately, USD did not stop weakening until the G7 issued a joint statement and carried out coordinated interventions. At the same time, the implications for US rates and global rates could be the exact opposite, depending on economic sentiment at that point. In 1987, rates surged globally, but in 1995 they plummeted. Stronger-than-expected economic growth in 1987 led to calls for rate hikes but, in 1995, substantial Fed rate hikes over the previous year sparked fears of an economic slowdown. Opinions will differ on which of these scenarios mostly closely approximates our current situation, but we believe the 1987 scenario is a closer fit. EM equities continued to rise yesterday, demonstrating resilience in the face of higher US yields and weaker USD. Moreover, despite stronger EUR, Europe’s PMI has reached the highest level during the current phase.

We cannot be sure whether the current phase will play out as dramatically as it did in 1987 and 1995, but investors holding USTs will face a trial in the near term, in our view. If the US administration and Fed fail to address weak USD and higher inflation expectations, the support line of 2.75% for 10yr UST yields would lose its significance, and the bear steepening could accelerate (due to higher risk premiums). The outcome with the least damage would be for the Fed to turn hawkish at an early stage, curb inflation expectations, and encourage USTs to bear flatten. We will be watching the end-January FOMC statement and incoming Fed Chair Jerome Powell’s testimony before Congress in mid-February for any hints as to the approach the Fed will take. However, if the US administration continues to take action to weaken USD, the Fed’s efforts alone would not be enough to alter this course. This would create a difficult position for Japan and the EU, which face strong currencies, and for their central banks, for the opposite reasons. They must consider a QE exit given robust economies, strong commodities and higher inflation expectations, but they must also take into account the deflationary pressures arising from strong currencies (Note 1). As a result, the ECB and BOJ would find themselves unable to take action, which could encourage investors to pull their money out of the US and seek refuge in Japanese and euro area bonds instead. However, this flow would reverse as soon as the weak USD begins to wind down, accelerating upward momentum for global yields.

Note 1: In 1987, the Bundesbank gave a greater weighting to strong commodities and higher inflation expectations than to a strong currency and ramped up its rate hikes accordingly. This was one of the triggers for Black Monday. In contrast, the BOJ left its policy rates at a historical low (for that time), creating the most massive stock and real estate bubble since WWII." - source Nomura

In this new Twain-Laird Duel, it could be argued that both the ECB and the Bank of Japan have been effectively cornered. If some feels there is a 1987 risk to the current trend, some others think the period is more akin to the 1994-1995 period which showed significant pressure on bond prices with rising yields. This is what Deutsche Bank has argued in their FX Special Report note from the 25th o January entitled "Yes, it all makes sense":

"The lead market commentator of the Financial Times this morning writes that the dollar sell-off has “stopped making sense”. Viewed with the post-crisis lens of activist central banks and exceptionally tight correlations between FX and rates the dollar is entirely out of line with fundamentals. Take a step back to the 1990s and 2000s however and things look a lot less unusual. Back then, the correlation between US yields and the dollar was very weak. FX market drivers were influenced by the complex interaction of macro variables, politics and valuations. The deviation between rates and FX was the norm, rather than the exception (figure 1).

Currency moves over the medium-term ultimately boil down to one thing: flows. If inflows into an economy pick up the currency strengthens and vice versa. Looked at from a flow perspective, the dollar bear market makes complete sense. The US basic balance – the sum of the current account, portfolio balance and foreign direct investment flows - peaked last year and is on a steadily declining trend (chart 2).

The European basic balance, in contrast, is shooting up (chart 3).

Can this continue? In our FX outlook for the start of the year we argued that the answer is yes: US asset valuations are at record highs so it will be difficult to find the marginal buyer of dollar assets in 2018. US twin deficits are widening driven by fiscal stimulus at the wrong point in the macroeconomic cycle pushing the US current account deficit even wider. And the US is reengaging with a weak dollar policy similarly to the 1994-95 period. “Words” in the world of FX do matter – the big turn in the dollar cycle in 1985 was driven by the Plaza accord, and in 1995 by Treasury secretary Rubin’s initiation of a strong dollar policy. The US tax reform does not make a difference because corporates already hold the bulk of their offshore earnings in dollars and there was nothing preventing them from converting into dollars in previous years anyway.

What about Europe? Europeans have spent trillions of euros recycling their current account surplus abroad over the last few years, a phenomenon which we have previously termed “Euroglut”. This flow drove EUR/USD all the way down from 1.40 to parity. As a result, Europeans are exceptionally overweight foreign assets. In the meantime, Europe’s current account surplus has swelled to 400bn EUR a year. As these European outflows begin to normalize, even a small change makes the Eurozone basic balance look a lot more positive. Add the shifting political dynamics in Europe and we have the perfect cocktail for continued euro strength.

Turning points in the medium-term dollar cycle are often marked by material geopolitical events (chart 4).

We would argue the medium-term bear market in the dollar started with the inauguration of President Trump and President Macron in the US and France, respectively, last year. It has coincided with a structural shift in the relative flow dynamics between the US and the rest of the world. We continue to target 1.30 in EUR/USD for this year." - source Deutsche Bank

From cooperation and globalization to un-cooperation and "deglobalization" through "trade war"? One might wonder if indeed there is a definite change of narrative that could lead to a new "Twain-Laird" Duel. So far the "inflationista" camp is racing ahead, but given lackluster productivity growth in the US, automation, robotization and globalization and demographic headwinds, do all this mean that the "deflationista" camp has lost the battle and the reflation trade remains the "trade du jour"? We wonder, but so far, the trend in yield is up and is your friend. We'd rather be neutral on the duration front for now and wait for more clarity from the upcoming FOMC, making us more Laird than Twain on this occasion and not willing to fight these men for now.

• Final chart - Pension rebalancing? Re-hedge this...

Last week saw for the first time outflows in 5 weeks for Investment Grade funds as reported recently by Bank of America Merrill Lynch Follow The Flow note from the 26th of January entitled "Blame the tail" with a sizable outflow but, according to them there were only a handful of funds to blame for this event taking place. Higher outflows would be tied to renewed bond volatility than current rates levels according to them. Also, we would argue that as we are moving into the end of an extended credit cycle it would be wise for some investors to become more defensive credit wise and we would continue to expect some sort of rotation from US High Yield towards US Investment Grade. In fact their report indicated that High Yield fund flows remained into negative territory, recording 11th consecutive week of outflows. Yet, our final chart from Deutsche Bank US Fixed Income Weekly note from the 26th of January entitled "Easier financial conditions warrant higher short rates" indicates that we could see significant rebalancing or re-hedging needs from the pension community:

"Dramatic equity outperformance relative to fixed income such as that experienced thus far in 2018 can produce very large re-hedging needs. For example, at the time of writing the SPXT had outperformed the Bloomberg Barclays US Aggregate index by just over 7%, which produces an implied “static weight flow” of $87 billion out of equity and into the bond market. This demand is likely to remain a short term impediment to term premium recovery, and should continue to flatten the long end of the Treasury curve and steepening of the swap spread curve. This acute demand has been the third of our four key themes.

Note, however, that punitive hedge costs for yen based investors have the opposite effect, as the yield of hedged Treasuries over JGBs is at or near historically low levels. With these investors likely to look elsewhere for yield, it is pension demand at the moment which is the “swing factor” slowing term premium recovery. What reduces pension demand? Equity stabilization, or more generally tighter financial conditions. Ironically, the Fed will likely have to continue to hike rates to stabilize equities and provide an ultimate release for the long end." - source Deutsche Bank

With US 2 Year treasury now yielding 2.13% it remains to be seen at what level investors will start parking cash again and start paring back on their equity exposure and other risky credit such as high yield. For the time being in similar fashion to Twain and Laird, the duel seems to have been postponed but we ramble again...

"Prophesy is a good line of business, but it is full of risks." -  Mark Twain

Stay tuned !

Macro and Credit - The Lindemann criterion

"We're just a bubble in a boiling pot." - Jack Johnson

Looking at the acceleration of inflows, with record flows piling into Investment Grade, Emerging Markets (EM) and equities, when it came to selecting this week's title analogy, we reacquainted ourselves with the "Lindemann criterion", being the first theory explaining the mechanism of melting in the bulk. An attempt to predict the bulk melting point of crystalline materials was first made in 1910 by Frederick Lindemann. The idea behind the theory was the observation that the average amplitude of thermal vibrations increases with increasing temperature. Melting initiates when the amplitude of vibration becomes large enough for adjacent atoms to partly occupy the same space. The Lindemann criterion stated that melting is expected when the vibration root mean square amplitude exceeds a threshold value. Quantitative calculations based on the model are not easy, hence Lindemann offered a simple criterion: melting might be expected when the root mean vibration amplitude exceeds a certain threshold value (namely when the amplitude reaches at least 10% of the nearest neighbor distance). In similar fashion, melting up might be expected with such strong inflows into various asset classes. As we have repeated in numerous conversations, you can expect the credit amplifier to reach 11 in true Spinal Tap fashion.  On a side note Lindemann model is based on harmonic forces, which never give way, whereas melting must involve "bond breaking". This is another serious defect of the model. Furthermore numerous experiments carried out at high pressures indicate that the Lindemann model does not estimate adequately the pressure dependence of the melting temperature, but,  the predictive success of the Lindemann melting criterion lent support to the belief that melting could be a gradual process, beginning within the solid at temperatures below the melting point. 

In this week's conversation, we would like to look at cycles in credit in conjunction with what is happening in US Consumer Credit as well as boiling markets and bubbles.

Synopsis:

• Macro and Credit - The credit boiling frog
• Final charts - Fund flows have a tendency to follow total returns

• Macro and Credit - The credit boiling frog

Whereas the heat continues to be "on" when it comes to fund inflows and in particular for Investment Grade credit, one might wonder from a "Lindemann criterion" approach, when could we reach the boiling point in this on-going "melt-up" phase. Some pundits have even called this phase "euphoria" given the strength of the start of the year performance wise in various asset classes including equities. 

As pointed out recently on Twitter by our good friend Tiho Brkan when it comes to the credit boiling frog bullet point analogy, for us there is no real value left in European High Yield to say the least:

"For the first time (possibly ever?) we have European Junk Bonds yielding less than European equities.

You have to hand it to the ECB. They really a did a terrific job bailing out the whole continent. Not a single bankruptcy was allowed!" - source Tiho Brkan - Twitter feed

No wonder flows have been very strong into equities in Europe as pointed out by Bank of America Merrill Lynch in their Follow The Flow note from the 19th of January 2018 entitled "Turbo-boosted flows":

"Inflows into IG, EM and equities continue stronger

The reach for yield continues for another week. IG, equity and EM debt funds have had a great start of the year. IG fund flows have tripled (3wks YoY); flows into equities have moved from marginally flat to $6.4bn, and flows into EM debt have more than doubled. Nonetheless, flows into HY funds have flipped to negative, on the back of rising idiosyncratic risk. With spreads continuing tighter in the IG space and rates vol remaining close to the lows we see no reason for flows to stop in the IG space.

Over the past week…

High grade funds, continued to record inflows their fourth consecutive week. The monthly December data also reflected the calm of the holiday season with the second smallest inflow of 2017 – second to January. High yield fund flows remained on negative territory recording their 10th consecutive week of outflow. Looking into the domicile breakdown for last week, as chart 13 shows, European-focused HY funds were the main source of outflows, but the US-focused and globally-focused funds also recorded withdrawals. Monthly data for December showed a 2nd month of outflows.

Government bond funds recorded an inflow erasing last week’s outflow and a strong inflow during the month of December as well. Overall, Fixed Income funds flows remained sizable – and positive – for the fourth week in a row. As for the month of December, inflows –despite being the smallest in 2017 due to seasonality - confirmed the overall inflow trend that was seen throughout the year.

European equity funds continued on their positive streak for a third week, with inflows accelerating. Last week inflow was the largest in 36 weeks. However, in December the asset class recorded a large outflow – the largest in 14 months." - source Bank of America Merrill Lynch

As long as rates volatility remains muted, there is no end in sight for the "goldilocks environment" and the Investment Grade TINA (There Is No Alternative) trade supported by the Japanese investment crowd at least when it comes to US credit markets. As we pointed out last week when it comes to US TIPS being enticing and rising risks of inflation surprises, back in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves if indeed the game was turning and if we should switch camp from the "deflationista" towards the "inflationista" camp. Flow wise, what we are seeing is large swath of investors piling into the "inflationista" camp and investors as pointed out by Reuters in their article from the 18th of January entitled "Investors scoop up U.S. inflation-protection bonds":

"Investors on Thursday pounced on $13 billion worth of U.S. bonds that offer them protection from faster wage growth and costlier goods and services as their longer-term inflation outlook rose to their highest in almost a year.

Overall bidding for these 10-year Treasury Inflation Protected Securities was the strongest at an auction in over 3-1/2 years with investors buying nearly 90 percent of the supply.

"The allocation into the (TIPS) asset class has been strong," said Michael Pond, head of global inflation-linked research at Barclays in New York. "It's all related to the pickup in global growth."

Barclays' Pond said the run-up in TIPS may be overdone in the short term. "Evaluation is getting a bit stretched," he said." - source Reuters

TIPS focused funds have reached "boiling point" to the tune of $68.01 billion of inflows in the asset class in the week ending the 10th of January according to Lipper. As the Lindemann melting criterion has shown us, melting is indeed a gradual process. Have we reached the boiling point yet? Could we be on the cusp of a vicious bear market as anticipated daily by the perma bear crowd? One thing for certain, as we pointed out again last week, you need core US CPI to tick up significantly for a bear market to materialize for our equities friends. We do not think we have reached that point yet. Financial conditions continue to remain loose which makes this credit cycle particularly long and extended.

Not all credit cycles are the same and business cycles as well tend to be different across sectors over time. On that subject we read with interest Wells Fargo Interest Rate Weekly note from the 17th of January entitled "Cycles in Credit, Economics and National Finance":

"Business cycle trends differ across major sectors; while some series are mean-reverting, others are shifting over time. Careful analysis leads to a better understanding of ‘normalcy.’

The Bank Credit Cycle: Mean-Reverting

The Federal Reserve reports a bank’s willingness to make loans on a quarterly basis as part of the Senior Loan Officer Opinion Survey. Such a qualitative measure is telling of lender expectations and is often consulted to predict the coming credit conditions in the market. A bank’s willingness to make loans is a stationary series, which contains no structural breaks. That is, the series acts in a predictable nature, allowing one to refer to it as a benchmark to assess lending practices over a business cycle (below chart).

At the beginning of an expansionary period, as banks are very willing to extend credit, the series rises. Once reaching its peak, a bank’s willingness gradually decreases until turning negative during a recessionary period. That said, it would appear that willingness has peaked in the current expansion, which is in line with our assessment of the business cycle being in the late stage.

Elevated Household Debt: Not Back to “Normal” Ratio

Debt as a percentage of GDP serves as a good measurement of indebted households relative to the size of the economy.

However, analyzing averages can be significantly misleading. As seen in the middle chart, after rising exponentially in the prior expansion, household debt as a percent of GDP never returns to its “average” trend, as portrayed in the 1991-2000 expansionary period. Despite decreasing significantly from its peak prior to the Great Recession, household debt still remains quite elevated, stabilizing around 77 percent. As this series is not mean-reverting, it does not follow a cyclical trend, and the behavior of the series in this cycle is distinct compared to prior expansions. The recent deleveraging is likely attributable to increased caution as households acquired large amounts of debt during the previous expansion, which led to a sharp increase in the debt burden.

Unusual Behavior of Profits

Corporate profits as a share of GDP appear to follow a cyclical pattern in which they gradually increase, peaking late in an expansionary period, before steadily declining during a recession. However, pre-tax corporate profits are non-stationary, and thereby are a less predictable series. Although profit growth as a percent of GDP appears to follow a traditional peak to trough trend, there have also been various structural breaks within the series leading to highly irregular and quite misleading judgements based on prior trends. Although this might not be very surprising, the larger decline being in the 2001 recessionary period seems unusual (bottom chart).

The greatest decline in corporate profits would be assumed to have occurred during the Great Recession, as we saw dramatic movements in a bank’s willingness to lend as well as households acquiring record amounts of debt. That is, one might suspect a similar case of dramatics in the decline of profits during the Great Recession; however, the drop was more significant in 2001." - source Wells Fargo

When it comes to the US economy, US consumer credit matters a lot. We continue to monitor that space given any weakness in US consumer credit could be an additional sign the US economy is reaching a turning point. Also in our October 2017 conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves what could make the credit cycle turn once we have reached boiling point:

"When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion. " - source Macronomics, October 2017

From a Lindermann criterion perspective, measuring the level of indebted households matters and in particular the use of Consumer Credit and in particular non-revolving credit we think. In regards to the results from big US banks we read with interest the Financial Times article from the 21st of January indicating a surge in credit card losses:

"US banks suffer 20% jump in credit card losses

Rising soured debts raise concerns about the financial health of middle America

The big four US retail banks sustained a near 20 per cent jump in losses from credit cards in 2017, raising doubts about the ability of consumers to fuel economic expansion.

“People are using their cards to get from pay cheque to pay cheque,” said Charles Peabody, managing director at the Washington-based investment group Compass Point. “There’s an underlying deterioration in the ability of the consumer to keep up with their debt service burden.”

Recently disclosed results showed Citigroup, JPMorgan Chase, Bank of America and Wells Fargo took a combined $12.5bn hit from soured card loans last year, about $2bn more than a year ago.

Banks have ramped up lending, wooing customers with air miles, cashback deals and other offers. The number of open credit card accounts in the US is forecast to reach 488m this year, according to Mercator Advisory Group, a rise of 108m from post-crisis lows in 2010.

Yet borrower delinquencies are outpacing rising balances. While still less than half crisis-era levels, the consultancy forecasts soured credit card loans will reach almost 4.5 per cent of receivables this year, up from 2.92 per cent in 2015."  - source Financial Times

Low inflation and loose central bank policies have indeed played a critical role in moving asset prices towards the boiling point and the ongoing "melt-up" but the narrative is slowly but surely changing as we pointed out on numerous occasions. 

Nonetheless, the most predictive variable for default rates remains credit availability. Senior officer loan survey leads default rates (SLOOs) so it is important to track them. When it comes to consumer credit, as the credit cycle matures, it is becoming essential to monitor what is happening for Credit card ABS we think.  As displayed by Wells Fargo in the below chart in their Credit Card Surveillance Report from the 19th of January, credit card ABS issuance has been increasing in 2017 but it is still relatively tame compared to the years prior to the Great Financial Crisis (GFC):

- source Wells Fargo

While securitization of US consumer credit is comparatively tame compared to what happened before the GFC, US consumer debt surged by the most in over 2 years to $3.8 trillion and jumped by 8.8% in November, the most in two years, to $3.83 trillion, according to the Federal Reserve. Clearly in the coming months US Consumer Credit should be on everyone's radar in conjunction with SLOOs we think.

As per our bullet point the credit frog is slowly but surely heating up for sure as per the Lindemann criterion but, we do not think yet we have reached the boiling point yet in credit we think.

For our final charts we have always thought tracking flows matter, particularly this year the ones coming from Japan given their support for US Credit as a whole. 

• Final charts - Fund flows have a tendency to follow total returns

When it comes to flows the most cited linkage according to CITI is trailing returns. Our final charts come from CITI's European Credit Weekly note from the 19th of January entitled "How durable is the fund flow frenzy" and display fund inflows as a percentage of AUM (Assets Under Management) versus total returns for both US Investment Grade and US High Yield:

"Fund flows have a tendency to follow total returns, both on the way up and on the way down. The relationship holds in IG (Figure 7), in HY (Figure 8) and in equities, and while sometimes coincident, the return series quite often seem to lead at turning points.

This relationship is clearly sending a positive signal at the moment. While it left us very worried in early 2016 (after investors had lost money on almost every asset class in 2015), 2017 returns were almost universally positive. If investors simply chase trailing returns, there is very little reason for them to withdraw their money at present.

Admittedly there are a few wrinkles. In such a risk-on environment seems odd that investors are quite so keen on IG (both outright and relative to trailing returns), and quite so cautious on HY (likewise). It might just be an overhang from the losses of 2015, when investors clearly ended up regretting their enthusiasm for HY in 2010-14.

Something similar is apparent in equities: last year’s $200bn inflow to mutual funds and ETFs – a mere 1% of total holdings – seems relatively paltry when markets are returning 15+ percent. Again, it may just be that investors have been unable to regain the love of the asset class they displayed during the 1990s (Figure 9).

But we would be much more convinced of private investors’ ability to take over from central banks as the main driver of risk assets this year if we saw more elevated and sustained inflows to both HY and equities. Perhaps those are on the verge of showing up, but there is an alternative interpretation which points in the opposite direction.

Cash is king

Just as last year’s outflows from HY funds did not seem to have much negative impact on their performance – perhaps because IG or other investors were crossing over into HY – so we find we get the best understanding of fund flows when we consider the big picture, rather than looking at each asset class individually.

Specifically, we like to look at inflows to all risky (or “long-term”) assets together – IG, HY, govies, EM, equities and alternatives, in mutual funds and ETFs – relative to total inflows into money market funds and deposits. How much of people’s saving is going into risk assets relative to what they a simply trying to keep safely in cash?

This combined flow also exhibits a strong relationship with equity returns, with recent strong inflows at first sight almost exactly where they “should be” (Figure 10).

When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash.

But look more closely, and another pattern is visible. In each cycle, as the economy emerges from recession, with risk assets priced cheaply and deposit rates low, investors start by doing the vast majority of their saving in risk assets (1992-3, 2003-4, 2009-10). Then as the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off, before the cycle starts again (Figure 11).

In addition, both the red and blue lines have exhibited a long-term downward trend. The move in the blue line could just be the relative growth in deposits across cycles. But an alternative interpretation – consistent with investors’ relative reluctance to buy both HY and equities – is that as markets have become more obviously expensive, it has taken steadily lower deposit rates just to prevent them from hoarding cash.

One way or another, the past year’s shift into risk assets, so late in the cycle, is extremely unusual. Even the late 1990s sees nothing like it. It is the exact opposite of what one would normally expect as deposit rates rise. And yet this year needs to see an even bigger such shift if private investors are to absorb the $1tn global hole left as central banks reduce their purchases.

Perhaps the strong start to the year will encourage just such buying on the part of investors. And in €, at least, negative deposit rates will continue to be an incentive for a good while yet. But despite the recent drop in correlations, our instinct remains that markets remain deeply interlinked across both assets and across geographies – meaning that the Fed’s rate rises have significance even in €, and the ECB’s and BoJ’s reductions in purchases have relevance for $ investors alongside the Fed. So while the signal from recent fund flows is undeniably positive, it will take more than just a good few weeks at the start of the year to convince us that 2018 as a whole will see a continuation of this raging bull market." - source CITI

As we posited at the start of our conversation, from a Lindemann criterion perspective, melting up might be expected with such strong inflows into various asset classes, particularly in credit. That simple. Melting is indeed a gradual process, particularly for our credit frog but it seems our central banker are using a pressure cooker, which is interesting because by pressurizing the vessel, they are able to produce much more heat than the boiling point of water, and still have water (inflows) present but we ramble again...

"When the water starts boiling it is foolish to turn off the heat." - Nelson Mandela

Stay tuned ! 

Macro and Credit - Bracket creep

"Declining productivity and quality means your unit production costs stay high but you don't have as much to sell. Your workers don't want to be paid less, so to maintain profits, you increase your prices. That's inflation." - W. Edwards Deming

Watching with interest the latest US CPI posting its biggest gain in 11 months to 1.8% in a US economy plagued by "fixed income" (lack of wage growth) and "floating expenses" (healthcare and rents), when it came to selecting our title analogy we reminded ourselves of the term Bracket creep, particular following the landmark tax reform passed on Christmas Eve to replace the 30-year-old, complex U.S. tax system. Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation. Given most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple.

In this week's conversation, we would like to look at rising inflation expectations and what it entails from a US TIPs and other linkers perspective as well as what are Japanese friends are up to from an overall flow allocation.

Synopsis:

• Macro and Credit - The return of the inflationistas
• Final chart - The "Bid 'Em Up Bruce" stage is now

• Macro and Credit - The return of the inflationistas

While inflation has been the elusive piece of the puzzle for many of our dear central bankers around the world, the latest print of core US CPI is marking the return of the "inflationista". This obviously should be welcomed good news for the members of the FOMC, but be careful what they wish for. As we indicated back in June 2015 in our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation. Also remember that in the headline CPI, rental prices represent 25% in the calculations and overall housing 42%. We will eagerly watch rental prices in the coming weeks and months. Back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008 as a reminder.

Yet as posited by Wells Fargo in their Economics Group from the 12th of January in their note entitled "CPI: Beyond the Headline, Inflation is Strengthening", consumer prices are it seems indeed edging up:

"Consumer price inflation edged up 0.1 percent in December despite a fall in gasoline prices. Reversing last month’s weakness, core inflation rose 0.3 percent and is up at a 2.5 percent pace over the past three months.

Gasoline Savings Going Elsewhere

Inflation cooled in December with the Consumer Price Index (CPI) increasing 0.1 percent. That followed a 0.4 percent gain in November.

The tamer increase stemmed from a pullback in energy costs as gasoline prices fell 2.7 percent over the month. That overshadowed a modest rise in energy services (electricity and utility gas). It was not until late in the month that unusually low temperatures led to a jump in natural gas prices. Although not quite halfway through the month, spot prices for natural gas are up about 6 percent from their December average. Therefore, we suspect energy services could provide an even larger lift to headline inflation next month.

For December, food prices rose 0.2 percent. That marks the largest increase since July and suggests that more stable prices for food commodities and rising labor costs for food services workers may be reasserting some modest upward pressure on the sector.

Core Inflation Rebounds

Core inflation bounced back after a weaker-than-expected reading in November. Excluding food and energy, prices were up 0.3 percent. Core goods prices posted a rare increase and moved 0.2 percent higher.

Leaner auto inventories after last year’s natural disasters spurred demand to replace vehicles and slower production growth more generally has given some support to prices. After falling from February to September, new and used vehicle prices have risen the past three months, including the largest monthly gain in December in more than six years. A 1.0 percent jump in prescription drug prices also pushed core goods inflation higher. Stronger core inflation was also driven by services. Shelter costs advanced an above-trend 0.4 percent in December. Rent of primary residences and owned residence both rose more than in November, while lodging costs partially reversed last month’s drop. Costs for medical care services also rebounded after a sharp decline in physician services in November.

Getting Back to the Fed’s Target

Inflation has been the darkest cloud hanging over the Fed’s efforts to normalize policy. Over the past year, inflation has risen 2.1 percent, a touch lower than November’s 12-month change and noticeably below the pace set earlier in the year. Yet the recent trend looks stronger. Over the past three months headline inflation is up at a 2.6 percent annualized pace. Similarly, core inflation, which is up 1.8 percent on a year-ago basis, has risen at a 2.5 percent pace over the past three months. This should help to allay some FOMC members’ fears that inflation is stuck at undesirably low levels. We expect to see a noticeable pick up in the year-over-year change by this spring. Although that will stem in large part from base effects following weakness last year, the trend remains upward." - source Wells Fargo.

Back in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves if indeed the game was turning and if we should switch camp from the "deflationista" towards the "inflationista" camp:

"Given China's most recent uptick in its PPI to 6.9%, we are indeed wondering if this is not a sign that we should change allegiance slightly towards the "inflationista" camp and start fearing somewhat the possibility of the return of the Big Bad Wolf aka inflation. We will be monitoring closely this latest China "inflation impulse". China's rising costs via exports could boosts inflation expectations in the US. These higher inflation expectations in the US would mean a steeper yield curve with a rise in long-duration yields overall and it would lead to higher rates volatility down the line. A bear market needs a wolf and this wolf would materialize in a return of inflation we think." - source Macronomics, October 2017 

As pointed out by Christopher Cole from Artemis Capital in his must read note "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. But flow wise, as we have pointed out in numerous conversations, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" so far. It seems the bond kings such Bill Gross and Jeff Gundlach as of late have picked up their side and are steering towards the "inflationista" camp whereas Dr Lacy Hunt, from is latest  quarterly note for Hoisington continues to sit tightly in the "deflationista" camp it seems. One might therefore wonder where we stand.

Also, in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:

"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", but that was because of the following:

"If the policy compass is spinning and there’s no way to predict how central banks will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up."

Given it seems that US inflation expectations are moving upwards it seems, one could argue that the compass in the US has somewhat stopped spinning hence the move in US breakevens and TIPS, in conjunction with the continuous support for Gold Miners (yes we are still long and we have been adding...). 

We like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment? 

At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument. We highly recommend our friend Kevin Muir aka The Macro Tourist post on a refresher on how breakeven works: "BREAKEVEN REFRESHER LESSON" for those not familiar with the concept. 

We would also like to add that if indeed the rise of inflation expectations is a global phenomenon, then our UK friends have an advantage with Gilt Linkers given they do not have an embedded deflation floor so, they should outperform US TIPS on a relative basis. 

Also, as all eyes are looking at the significant surge in oil prices in recent months as per our March 2016 conversation "Unobtainium":

"A very interesting 2015 paper by the Bank of Israel (Sussman, N and O Zohar 2015, “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015.) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area. Therefore, given the recent significant surge in oil prices, we do not think it is such a surprise to see a rise in inflation expectations in that context." - source Macronomics, March 2016

Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach of the "inflationistas" for the long end of the curve. We live in a world in which the public sector has never been so indebted (The world's global debt just reached $233 trillion in 3Q 2017). Demography is as well playing its part in rendering the US Yield curve "inelastic" therefore the volatility of the US yield curve is clearly in the front-end of the curve. We continue to witness a bear-flattening of the US Yield curve with the Japanese investment crowd and in particular Lifers continuing to be dip buyers. This is confirmed by Nomura from their JPY Flow Monitor report from the 12th of January entitled "Net buying continued but at a slower pace":

"Lifers sold foreign bonds, but seemed to maintain its recovery trend

Investment by life insurers, which are prominent medium- and long-term investors, remained lackluster. They were net sellers in November at JPY234bn and in December at JPY124bn ($1.1bn). Higher FX hedging costs for US bond investment may slow their foreign bond investment, but we do not believe that the recovery trend has ended, (see “US curve flattening and Japanese lifers”, 7 December 2017). Barring another resurgence of geopolitical risks, we believe there is a good possibility that lifers will resume their net buying at a high level due to pent-up demand. The recent rises in US and European yields should encourage them to consider foreign bond buying. Lifers’ FY17 investment plans show that the structural shift away from yen bonds and toward foreign bonds continues (see “JPY: Lifers upgrade EUR/JPY forecast”, 25 October 2017). Despite this, at JPY1834bn, lifers’ cumulative foreign bond investment from April through December 2017 is below the average since FY05 (JPY1959bn; Figure 3).

When it comes to unhedged investments, If USD/JPY trades below 112, this would trigger demand to buy USD on dips (sell JPY), in our view. Major lifers forecast USD/JPY in a core range of 109-115. According to major lifers’ H1 FY17 financial statements, their hedged ratio was 58.0% at end-September 2017, down slightly from end-March (60.2%), but this level was still high (see “JPY: Modest decline in lifers’ hedge ratio”, 24 November 2017). With the Fed raising rates, higher hedging costs should push lifers into reducing their hedged ratio (thus creating pressures pushing up USD/JPY). Lifers still have substantial room to unwind FX hedges, which should keep USD/JPY steady." - source Nomura

With government bond yields ratcheting up, this means more buying at some point FX unhedged from the Japanese investment crowd and still a strong demand for US credit given it is still a TINA trade (There Is No Alternative). When it comes to the on-going "bear-flattening" of the US yield curve, yes,  one could see a rebound with some tactical steepening in the 2s10s part of the curve as pointed out by Nomura in their FX and Rates Trade Ideas note from the 11th of January:

"In the US strategy outlook for 2018 (see link), we listed several reasons why we do not expect a full flattening of the US curve, or an inversion any time soon. It is inconsistent, in our view, for curves to pancake at this time given outright levels of rates are low (versus prior periods), global QE is fading, debt issuance is rising and the economy is growing. We expect these and other factors driving the US curve to result in sharp countertrend moves at times in 2018. We envision some bull and/or bear steepening factors ahead.

1. Bullish front-end factors: The front-end has quickly discounted the 2018 hiking path. US momentum looks solid but any sort of miss in US data could prompt a front-end rally. The front-end has also built up a sizable short base as seen in Figure 1.

2. Curve correlation factor: The curve versus the level of rates (Figure 2) is shifting quickly from the prior bull flattening/bear steepening regime.

Thus, those expecting the long end to outperform on any sort of risk-off (which is a common rationale we hear from investors long 10s plus) is misplaced, as 2s would now rally more in a risk-off.

3. Bearish long-end factors: As seen in Figure 3, one reason why the curve flattened in 2017 was 10-year rates were stuck in a range, while the Fed was hiking short-end rates.

This year will be unlike last year because Fed QT in ongoing, US tax reform passed (and deficits/debt loads are likely to expand) and global QE buying is slowing.

4. Curve momentum factor: We take the 3-month moving average of the curve as an indicator of momentum and take the rolling 1-week change to gauge its speed. As seen in Figure 4, the US curve momentum has hit its limit and is due for a rebound.

We recommend investors go short 10s on the curve (2s10s) and the broader butterfly in Q1 2018. For the 2s10s UST trade, our first steepening target would be half the flattening seen since November 2017 (roughly 15bp above current levels) before we re-assess." - source Nomura

While we might see indeed some rebound in the 2s10s part of the US yield curve, the continuation of the velocity in the "bear-flattening" of the US Yield curve which has started a while back is depending on renewed appetite from "Bondzilla" the NIRP monster "Made in Japan" we think.

But moving back to the attractiveness of US TIPS, we do think that, from an allocation perspective, they are of renewed interest. On that subject we read with interest another Nomura note, their Inflation Insights from the 11th of January entitled "Tip(s)-toeing into the US BEI pool":

"Avoid jumping but gradually wade into BEI waters

The macro case for adding long US inflation positions has strengthened with higher price pressure from the recovery in world trade, which has been a driver of higher commodity prices, especially for oil. These higher input costs coupled with what still remains a relatively accommodative global monetary stance (keeping real rates contained for now) is leading to wider TIPS breakevens inflation (BEI). Yet, this has been an orderly move and there are few relative value disruptions to take advantage of (i.e., cash/swap basis and curve disruption). A long US BEI position is therefore mostly a directional macro trade. 

We recommend investors stick with the macro trade, with limited risk and an oil hedge. We get long 5y breakeven rates at 1.95%, targeting 2.20% at the end of February (20bp net of negative carry) and pay for some oil price protection. We expect core inflation to strengthen in December. However, we would not hesitate to take losses if the December print meaningfully surprises to the downside. Globally we still prefer long euro BEIs.

US TIPS breakevens showed a strong performance into and out of year-end

The US 5-year breakeven inflation rate performed remarkably well into and out of yearend, increasing by about 15bp since mid-December 2017 (about 12bp net of the negative inflation carry). This is a solid performance that contrasts with the lack of movement between October and December. Inflation carry should remain negative in February, pushing forward breakeven rates higher at an increasing pace given the magnitude of the negative carry and the low number of days in the month (Figure 1).

The inflation carry profile therefore accentuates the skew to long breakeven positions into the CPI number on 12 January: a substantial positive surprise is needed for long positions to perform, while a small negative surprise would be enough to postpone long positions by a month. Note that our US economists’ forecasts for the December headline CPI are in line with both consensus and short-term inflation markets, although their forecast on core is higher (see US CPI Preview: A Potential Jump in Core).

Timing aside, the medium-term outlook for US TIPS BEIs appears favorable

As we highlighted in the TIPS section of Fixed Income Insights: 2018 Themes - US Strategy Outlook, “while valuation did not argue for a massive TIPS BEI long, the US may be the first place to benefit if the ‘reflation’ trade 2.0 is driven by Trump administration’s tax plans and fiscal stimulus”. Beyond the hurdle of short-term carry implications, various factors are forming a positive framework for US inflation valuations.

Global inflation is picking up and that should be supportive BEI wideners

The first positive technical stems from the behaviour of our Global Inflation Factor (GIF, a factor extracted from internationally-set prices such as commodity prices and manufacturing prices obtained from manufacturing surveys, which remain a large fraction of world trade). As the right chart in Figure 2 shows, global inflation picked up at the end of last year.

Furthermore the strong momentum on the price of manufacturing goods is further supported by the recent strength in energy and food commodity prices. Goods price momentum is particularly visible in Europe and is reflected in the right chart in Figure 2. The chart scaling shows this is why our favored long so far has been in euro inflation wideners. Yet, stronger momentum on commodity prices favors US TIPS breakevens, despite some discrepancy between wholesale and retail gasoline prices, probably due to margin changes after the weather-related disruptions of last year.

Valuations are balanced and not only driven by the hope of reflationary policy

The second factor supporting a long US inflation breakeven trade is a more balanced valuation framework/background. The left chart in Figure 2 shows this dynamic. In a reestimated version of a statistical model developed by Fed researchers (see IFDP notes, Dec.2016, "drivers of inflation compensation: evidence from inflation swaps in advanced economies", M.Rodriguez and E.Yoldas), the model is estimated over the 2008-2016 period, then projections are simulated since September 2016.

We find the large discrepancy that occurred between their model and actual inflation valuations that built up after the US Presidential election very informative. It validates our view at that time of some re-building of the specific inflation premium. Note that the risk premium captured by the model is generic and pertains to risk aversion, not inflation specific forces. Inflation valuations after October 2016 seem to have priced in too promptly the impact of expected reflationary policies, particularly on the fiscal side.

One year later, the US tax reform package has finally been voted on and passed. Yet, the fact that the discrepancy between the trajectory of breakevens and the fundamental factors (as implied by the model) is now small suggests there is room for upside that is motivated by expectations beyond just fiscal policy. We think the backdrop for US inflation is therefore much more balanced than was the case at end-2016 after the election.

The issue of timing and carry limits our exposure and enthusiasm

Investors should still scale into BEI wideners, as there are a few issues associated with an unconditional bullish stance on US inflation. We have already described the first issue in terms of seasonal carry not being ideal. There is also the issue of the near-term inflation profile which, according to both economists and markets, will not be very supportive.

As Figure 3 shows, year-on-year inflation is expected to fall between now and the end of Q1 2018, reaching a low of 1.8% in February 2018.

This year-on-year inflation downtrend should occur despite the robust core inflation rate forecast by our economics team at of 0.20% /month between December 2017 and December 2018, which is higher than average core inflation over the past two years. Some negative surprises on inflation are definitely not out of the question, although our economists see upside risks to the next core inflation print (see Economics Insights - US: December CPI Preview).

In February 2017, the 1-year inflation swap rate was about 2.35% and effective inflation over the period consistent with the swap rate was 2.13%, a 20bp shortfall mostly due to the unexpected fall in inflation (mostly from transitory factors but real drivers of inflation nonetheless) between February 2017 and June 2017. A quick glance back at forecasts back in February 2017 shows an underestimation of inflation by up to 60bp for some months. The reason for the underestimation is not yet fully apparent (see Special Report - Why Does the Fed Appear Insensitive to Soft Inflation Data?), and we have pointed to evidence of less-anchored inflation expectations in Inflation Insights - Reality check. The persistence of uncertainty on the inflation mechanism in the US, acknowledged by the Federal Reserve, suggests some caution is warranted on outright long US inflation stances.

Sharing between real and inflation components of yields

Keeping inflation anchored is a key condition for smooth monetary policy normalization. 

Any sort of increase in nominal interest rates that would be accompanied by falling inflation compensation would in fact entail a much tighter real stance via higher real rates pushing up overall yields. This would risk putting the economy on a very volatile path.

A key part of our analysis has been to favour inflation markets where the fostering of expectations was supported by low real yields, and this is why we have favored the euro market, where 2-year real rates are now close to their historical lows (Figure 4).

Short-term real rates in the US have increased much more rapidly which, by contrast, makes the increase in inflation valuations very dependent on economic optimism, not on policy accommodation. The stabilization in real yields suggests this element of vulnerability of the long US inflation trade is less acute now than a few weeks ago.

Still, it remains the case that the increase in inflation compensation is highly dependent upon a modest path in the recovery of real yields (see Inflation Insights - A tale of two modes).

Trade Idea: Scaling into long US 5-year TIPS breakevens

Oil prices are rising, valuations are balanced, the next CPI print is likely to surprise markets to the upside: there are many reasons to go long US inflation despite the negative seasonals.

The focus in the rally has been on cash instruments rather than derivatives, which is consistent with EPFR data showing strong inflows into TIPS ETF based funds. Also, in the latest BEI rally, the 5-year point has outperformed the 10-year point probably due to higher oil prices. Yet as during previous rallies, the 5-year breakeven rate relative to 3- year and 7-year has not outperformed, see Figure 5.

As a result, the case for relative value on the US inflation curve is limited, in our view.

The case for long US breakeven inflation exposure is therefore mostly a macro trade, with few elements of relative value selection that could “enhance” the trade. Longs need to fight less than ideal carry profiles, prospects of volatile oil prices and the Fed’s hiking path ahead. We cautiously go with the macro arguments by scaling into a long 5y TIPS breakeven trade with limited risk exposure (limited notional and some oil price hedges)." - source Nomura

Indeed it is a "macro" trade. We like these. We would also like to repeat what we have pointed out in our conversation "Hypomania" in February 2017 relative to rising oil prices given the relationship with recessionary pressure in the US. 

"As we pointed out as well in 2014, in our conversation "The Molotov Cocktail", past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years." - source Macronomics, February 2017.

As well there is a very important relationship between "gold" and "Tips" when it comes to their reaction to the velocity in rising inflation expectations as we indicated in last year's conversation:

"There is of course an explanation around this which was very clearly put forward by David Goldman in Asia Times on the 17th of February in his article "A mistery solved: Why real yields are falling despite higher growth":

"Economists often think of real yields as the “real interest rate,” or baseline rate of return, in a macroeconomic model. From this standpoint the low level of TIPS yields is a mystery: when economic growth is rising, the real interest rate should rise. The expected short-term interest rate has been rising as the Fed sets about normalizing rates, and the rising short-term rates affect real yields. The fall in TIPS yields in the face of Fed tightening and stronger growth presents a double challenge to the conventional wisdom.

The conventional way of looking at real yields ignores the way markets treat risk. Government debt (and particularly the government debt of the United States) is not just a gauge of economic activity, but a kind of insurance. If the world comes crashing down, you want to own safe assets. Investors hold Treasuries in their portfolios not just for the income, but as an insurance against disaster. And TIPS offer a double form of insurance: If economic crisis takes the form of a big rise in the inflation rate, TIPS investors will be paid a correspondingly higher amount of principal when their bond matures. That explains why TIPS yields sometimes are negative: investors will accept a negative rate of return at the present expected inflation rate in return for a hedge against an unexpected rise in the inflation rate.

The yield on TIPS has tracked the price of gold with a remarkable degree of precision during the past 10 years, as shown in the chart below. Gold tracks the 5-year TIPS yield with 85% accuracy. That’s because both gold and TIPS function as a hedge against unexpected inflation.

During the past year, for example, we observe that the relationship between gold and the 5-year TIPS yield has remained consistent, while the relationship between the expected short-term rate (as reflected in the price of federal funds futures for delivery a year ahead) has jumped around. There are lots of local relationships between federal funds futures and the TIPS yield, but the overall relationship is highly unstable." - source Asia Times - David Goldman

The rest of his article, is a must read we think. but if indeed there are rising inflation expectations, then it makes sense for real yields to continue to fall, which can be assimilated to the cost of the insurance for "unexpected outcomes" is rising. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations is going up." - source Macronomics, February 2017

The recent surge in both US Tips, gold and gold miners are a consequence of the rapid surge in "inflation expectations" hence the interesting case for going both long gold/gold miners and US TIPS in that particular context we think, while there might also be a seasonal factor too it given we witnessed a similar situation in December 2016. There is a well continued weakness in the US dollar which is positive for Emerging Markets equities relative to US equities from an overweight allocation perspective. Right now risk assets continue to push higher, this in conjunction with rising inflation expectations should trigger a more hawkish change of narrative from central banks. As we pointed out in our final post of 2017, "Rician fading", once the tax deal was a done deal, US corporates with more clarity ahead could resume/start some M&A typical in the late stage of the credit cycle game in the first part of 2018.

• Final chart - The "Bid 'Em Up Bruce" stage is now

 As a tongue in cheek reference to the mighty Bruce Wasserstein aka "Bid 'Em Up Bruce",  the M&A legend, our final point of this conversation highlights another sign of late cycle behavior, namely corporate M&A. This final chart displays M&A in the corporate sector since 1999 relative to the credit cycle seen since 1999. It comes from Nomura Japan Navigator note from the 9th of January entitled "Equities move on factors other than yields and exchange rates":

Unlike the pattern over the past three years, 2018 began with substantial risk-on momentum. China’s short-term money rates stopped climbing, allaying market concerns, and commodities and EM equities gained upward momentum. The closing of positions out of concern that the year would start with the anomaly of a risk-off flow and the winding down of selling for a loss ahead of the implementation of US tax cuts also played a role, in our view. In addition, the passage of the US tax cut legislation provided an opportunity for investors and companies to resume investments once uncertainty had been dispelled. We view corporate mergers and acquisitions as a key engine of growth during the latter part of an economic recovery, and had been concerned about their lackluster pace despite the strong credit market in 2017 (Figure 2). This should pick up now.

At the start of the year, many economists and analysts set out the major themes for the year, regardless of their probability, and we expect corporate M&As to become a market theme, at least temporarily. This year, in our view, while the stock market will place more weight on the corporate sector’s capital investment and M&As, we think the rates and FX markets will focus on policy changes by central banks, with the start of monetary tightening by the BOJ and ECB clashing with the end of Fed rate hikes. We think this explains the disjointed movements across markets." - source Nomura

Is this cycle different when it comes to late cycle behavior such as heightened M&A activity? We do not think so, and it is a consequence as well of the "Bracket creep". Get your LBO screener ready folks...

"The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation." -  Vladimir Lenin

Stay tuned!