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! 

Macro and Credit - Unobtainium

"Progress is impossible without change, and those who cannot change their minds cannot change anything." - George Bernard Shaw

Watching with interest the significant compression in credit spreads thanks to "Le Chiffre" aka Mario Draghi going "all in", which to some extent, is putting pressure on Haruhiko Kuroda and the Bank of Japan, to raise the stakes once more in this global game of liar's poker, given their respective ability in reaching their inflation targets and both their repeated failures, we reminded ourselves for our chosen title analogy of "Unobtainium", being any fictional, extremely rare, very costly, or impossible material, or (less commonly) device needed to fulfill a given design (inflation) for a given application (QE+NIRP). The word "Unobtainium" derives humorously from unobtainable (inflation) followed by the suffix -ium, the conventional designation for a chemical element. 

What we also find of interest in our chosen title is that there is a cryptocurrency named Unobtainium, which uses Bitcoin's source code with some modifications to the monetary policy. UNO aka Unobtainium is a SHA256 Proof of Work cryptocurrency unique for low inflation, scarcity, a fair launch and distribution. Just 250,000 Uno will ever be mined over 300 years. Unobtanium is merged mined with Bitcoin, resulting in a secure high-difficulty blockchain that is 3x faster than Bitcoin. Uno is rare not only in the number coins issued, but also in it's fair launch and distribution. Uno was not pre-mined. There is no POS inflation. On that matter we find it very amusing to read about the proto-currency known as RSCoin in recent column by Ambrose Evans-Pritchard on the 13th of March in the Telegraph in his article entitled "Central banks beat Bitcoin at own game with rival supercurrency" as a better alternative to Bitcoin and it's smaller rival "Unobtainium":

"The RSCoin is deemed more likely to gain to mass acceptance than Bitcoin since the ledger would remain exclusively in the hands of the central bank, with the 'trust' factor of state authority. It would have the incumbency benefits of an established currency behind it....RSCoin may be irresistible for central banks. Dr Danezis said it is allows them to turn the money tap on and off with calibrated precision, and lets them track the sort of counterparty liabilities that nearly blew up the financial system during the Lehman crisis. "There would be instant visibility. They could react very quickly in an emergency, " he said.
Ultimately it could achieve some of the objectives of 'narrowing banking' proposed by Adam Smith, or the Chicago Plan put forward by US economists in the 1930s - but never enacted - to transfer control of money creation from private banks to the state. Arguably, this would make the financial system safer and less prone to boom-bust cycles." - source The Telegraph, Ambrose Evans Pritchard, 13th of March 2016

We find it particularly hilarious that RSCoin is deemed more likely to "mass acceptance" thanks to the 'trust factor of state authority'. To paraphrase Hayek's 1988 book, one could argue that RSCoin will not likely be more successful than Bitcoin because having the "trust factor" of the central bank would be a "fatal conceit", but we ramble again...

On a side note, before we move on our weekly musing, we find as well very entertaining that China and its Popular Bank of China (PBOC) are thinking about the implementation of a "Tobin tax" given one of our latest musing was the "reverse Tobin tax". This was reported by Bloomberg on the 15th of March in their article "China Tobin Tax Riles Analysts as Citi Warns of Foreign Exodus":

"China’s central bank has drafted rules for a tax on foreign-exchange transactions, a plan that still needs central government approval, people with knowledge of the matter said on Tuesday. The initial rate may be kept at zero to allow authorities time to refine the rules and to deter speculators by letting them know that there is a system in place, said the people, who asked not to be identified as the discussions are private. 

The People’s Bank of China has been fighting to drive out traders who take advantage of the difference in the yuan’s rates at home and abroad. The PBOC drove the currency’s offshore borrowing costs to records in January, increasing short-selling costs, and instructed banks on the mainland to restrict sending yuan overseas. 

Among the biggest Tobin tax concerns cited by analysts is that the levy would sap market liquidity. One gauge of the ease of trading the yuan -- the currency’s bid-ask spread against the dollar -- was about 0.05 percent on average in March, versus 0.01 percent for the dollar-yen rate, according to data compiled by Bloomberg Intelligence." - source Bloomberg

As a reminder from our conversation, the Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system which ended on August 15 of 1971. Also we would like to point out, that this additional precautionary measure from the PBOC, does seem to us overstretched as we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"It seems to us that speculators, so far has not been able to  gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals." - source Macronomics, 1st March 2016.

For us, this announcement from the PBOC is posturing and ambitions to deter further speculation and prevent speculators to gather together, ensuring in effect that renewed attacks will be postponed and inflict sufficient damage to the "short crowd". It seems to us that, shorting the yuan is indeed a very costly "Unobtainium" for now. End of our side note.

In this week's conversation, we would like to look at inflation expectations and what it means in terms of allocation and credit given the significant tightening move seen in recent weeks.

Synopsis:

• Macro and Credit - Is inflation really rearing its ugly head?
• Macro and Credit  - The bond yield curves are now fully inelastic
• Final chart: Demography is destiny

• Macro and Credit - Is inflation really rearing its ugly head?

Back 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", and of course it has worked again like a charm in 2016:

"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 jumped after a renewed dovish Fed, 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...). 

We continue to 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?

What we also find of interest is that some have argued that with inflation supposedly "rearing its ugly head", US Treasuries are vulnerable in this situation. No doubt the dovish stance of the Fed is going to wreak havoc on the short end of the curve, but we do think the very long dated part of the curve (30 years) still offer some good carry and roll-down in a growing NIRP world (yes we are still long, very long US duration as well, if you'd like to ask). 

But when it comes to "inflation" and "Unobtainium", we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine":

"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, July 2014

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 towards the $40 mark, we do not think it is such a surprise to see a rise in inflation expectations in that context. This latest rise in inflation expectations could after all be transitory as well as the sudden rise in oil prices, particularly in the light of the tight relationship between the US dollar and oil prices. We think that the latest dovish stance of the Fed all has to do with their concerns relating to the "velocity" of the US dollar and the "unintended consequences" a too rapid rise of the "Greenback" could have on Emerging Markets (EM).

When it comes to the assessing the transitory nature of the rise in inflation expectations, we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 18th of March entitled "Yellen: The lady doth protest too much" where they disagree with the impact of the change in oil prices moves on inflation expectations we mentioned above:

"Key takeaways

• The Fed's dovish commentary on inflation is getting stale very fast.

• The evidence for a pick-up in wage and core price inflation is not just a couple data points, but is broad based.

• Markets are only beginning to come to terms with the reality of a steady upward move in inflation.

Our core disagreement with the Fed 

Once every year or two a significant gap develops between our thinking relative to the Fed. For example, early last year, we were struck by the Fed’s apparent complacency about the strong dollar. Fed officials seemed to dismiss the dollar, arguing that the US is a relatively closed economy and a strong dollar could be viewed as a vote of confidence in US growth rather than as a shock to US growth. That view seemed increasingly out of touch given both the size of the dollar move and the fact it continued to strengthen in the face of very weak US data. The Fed did not capitulate until March when they acknowledged the weaker outlook and moved out the expected timing of the first hike.
Today, a similar sized gap in thinking has emerged; this time around the outlook for core inflation. Despite stronger data, the FOMC continues to question whether core inflation is really picking up. “Inflation is expected to remain low in the near term …but to rise to 2% over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” Asked about the pick-up in core inflation during the press conference, Chair Yellen vaguely talked of volatile components. The forecasts were similarly dovish: even though year-over-year core has already jumped from 1.3 to 1.7% YoY, the median forecaster continued to look for 1.6% inflation this year and the median forecast for next year actually dropped from 1.9% to 1.8%.

Here we take a closer look at the gap between the FOMC and our own thinking. We think the Fed’s views are stale in several respects. We also argue that the FOMC is more willing to allow inflation to overshoot the 2% target than they are suggesting. Looking ahead, we think this meeting outcome will be the high point for Fed dovishness this year and we reiterate our long-standing call for hikes in June and December. 

It was a new day yesterday 

A key Fed concern is that weakness in oil prices will pass through to the core over time. However, most studies find very weak or nonexistent pass through. The worst of the oil price drop now appears behind us: prices seem to be finding a floor, with Brent up about 40% from its 20 January low. As base effects fall out of the data, headline inflation should continue to converge to the core (Chart of the day above).
The Fed is concerned that the strong dollar will continue to drive import prices lower as the lags play out. Presumably they are also concerned that if they are too hawkish the dollar could surge again. In our view, the period of rapid dollar appreciation is fading into history (Chart 1).

As a result, consumer import price deflation has already slowed sharply. For much of last year, consumer import prices were falling at 1.3% YoY, but the rate of decline has now dropped to just 0.2%. In our view, this is a major factor in the recent pickup in core goods price inflation. 

Yellen and company seem skeptical about any pick in wage growth: “in the aggregate data, one doesn't yet see any convincing evidence of a pickup in wage growth. It's mainly isolated to certain sectors and occupations.” She also pointed to the pickup in the participation rate as a hopeful sign. In our view, the evidence of a pickup in wages is compelling. The growth in average hourly earnings in the last 12 months is higher than the prior 12 months for seven out of 10 major industries. Overall compensation growth has accelerated relative to a year ago for all the major compensation gauges except the employment cost index. A lot of second-tier measures, such as surveys from the Fed, have also picked up modestly. 

At her press conference Chair Yellen was asked why she was skeptical about the recent inflation numbers. She said, “I see some of that as having to do with unusually high inflation readings in categories that tend to be quite volatile without very much significance for inflation over time.” We agree that there are a few special factors in the numbers, but not enough to cancel out the inflation signal. The Fed has developed “trimmed mean” measures of core inflation that strip out all volatile items rather than somewhat arbitrarily eliminating all food and energy items (Chart 2).

The trimmed CPI measure is still up at a solid 2.5% annual pace in the last two months and on a year-over-year basis has been accelerating since May 2015. A similar story applies for the trimmed PCE: it is rising at a 2% annual pace in the last two months and has been drifting higher since last January. In our view, these are trends, not noise. 

The one dovish aspect of the Fed view we agree with is the risk of inflation expectations unhinging to the downside. Measuring inflation expectations is difficult. Survey measures have an upward bias and market-based measures can be heavily distorted by technical factors. Nonetheless, after six years of weakness in wage and price inflation it would be surprising if inflation expectations for real people had not fallen. We believe confidence in the Fed’s inflation-creating ability surely is under pressure and is already impacting wage and price setting. Despite this headwind, however, wage and price inflation is already starting to pick-up. This suggests the economy is already at full capacity.

Living in the past 

This brings us to our final point. Chair Yellen has been adamant that the Fed has not changed its inflation target: it is still 2% and it is still symmetric; they are just as concerned about above-target inflation as below-target inflation. We are skeptical. In our view, there is a very strong economic case for “really risking” overshooting the target. Recall that the reason the Fed’s target is 2% rather than zero is that the Fed wants to minimize the risk of deflation and avoid hitting the zero lower bound for the funds rate when fighting recessions. Recent experience argues strongly for a higher inflation target:
• the Fed and other central banks have been stuck at zero for many years,
• inflation has been chronically low
• inflation expectations have fallen below the Fed’s target
• and the equilibrium real rate has probably dropped.
With the benefit of 20-20 hindsight we think the Fed would have adopted a higher target: say 3%, instead of 2%. The problem is that resetting the goal would require a very complicated debate at the Fed, raise concerns about a slippery slope (if 3%, why not 4%?) and would likely subject the Fed to even bigger political attacks. In our view, the politically correct answer is to keep the target, but err on the side of overshooting and then wait for the inevitable recession to knock inflation back down to target.
The bottom-line of all of this, in our view, is ongoing upside risks to inflation breakevens as the markets recognize the Fed can create inflation after all." - source Bank of America Merrill Lynch

It seems to us that Bank of America Merrill Lynch is focusing on the content, like any good behavioral psychologist we prefer to focus on the process. If indeed, the Fed has recently preferred a slowdown in the "velocity" of the surge in the US dollar for obvious external EM concerns, hence its dovish tone, what has also been a concern has been the overall global tightening of financial conditions. What is also of interest is that the surging dollar in recent years and falling US treasury yields have happened in conjunction with falling commodity prices and particularly a sharp drop in energy prices. This has therefore reinforced the possibility of coordinate actions from central banks which could have happened given the US dollar has dropped as much as 3 percent since the G-20 meeting held in Shanghai which ended on February 27. Whereas the Fed's latest dovish tone aims at somewhat lessen the impact of a rapidly surging US dollar, clearly to us the ECB's ambition of purchasing corporate bonds, is a clear demonstration of its willingness in suppressing a surge in credit spreads and a flattening of the credit curves which would in effect trigger a rise in the cost of capital and funding for banks and other players, and trigger a renewed credit crunch in Europe in the process. Not only has the US dollar fallen relative to other currencies, but in Europe credit spreads have fallen very rapidly to much lower levels thanks to the ECB "credit put".

When it comes to wage inflation, which would entice us to validate the "recovery" mantra, we believe wage inflation remains "Unobtainium", an impossible material as posited by Zero Hedge in their article from the 18th of March entitled "Feeling Underpaid? This Is What Wage Inflation Around The World Looks Like" which is pointing to the similar Deutsche Bank report we read with interest "Inflation Sensation - a global inflation monitor" from the 16th of March. If US inflation is indeed rearing its ugly head, then the jury is still out there when it comes to monitoring wage inflation in the US:

"Wage developments are striking across the G10. While there are tentative signs of producer and consumer price disinflation bottoming in some countries, wage growth remains particularly weak. This may be because wages are a backward looking indicator of inflation pressure, but it may also be a sign of second-round effects influencing price-setting behaviour." - source Deutsche Bank

What seems so evident to us is that Central banks such as the ECB are pouring oil on the fire as they have trying to push long-term rates down after having succeeded in pushing short term rates to zero. 

In Europe, it is clear that the ECB's policy is having no lasting effect on prices and inflation. It is because the ECB can create all the money it wants, but it cannot command it to flow "uphill", in wages, hence the "Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hands:

 - graph source Deutsche Bank

As we pointed out in our recent conversation "The Monkey and banana problem":

"Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. This negative feedback-loop, doesn't stop the frenzy for bonds and the "over-allocation process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP. This push yields lower and bond prices even higher" - source Macronomics, February 2016

The results of the "Unobtainium" process is that money flows into Wall Street and less so into Main Street as a result. The latest decision by the ECB is putting the demand for credit products into "overdrive" while in no way the most recent TLTRO is altering the credit profile of ailing Italian banks and their balance sheets bloated by Nonperforming loans (NPLs). "Liquidity" via funding at zero cost doesn't resolve "Solvency". But, yes, the rally in credit has legs for the time being.

The "Unobtainium" process followed by our generous gamblers have not only enticed even more speculation downhill, in the government bond markets but now in the credit markets where we still favor quality and in particular US Investment Grade (for carry purposes...). All of this brings us to our next point, namely that bond yield curves behavior have changed dramatically.

• Macro and Credit  - The bond yield curves are now fully inelastic

Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach for the long end of the curve particularly because, we agree with Louis Capital Markets latest points made in their most recent cross asset note from the 16th of March entitled "How does it end?":

"Last week there was also a huge move on long term Japanese rates. The 10 year Government bond yield appears now to be well anchored in negative territory. How is this possible? In what world do we live? 

Below, we show the average 10-year bond yield for developed countries and it stands at an all-time low, below 1%. We live in a world in which the public sector has never been so indebted. However, it can borrow money at a rate that has never been so low.

Economic textbooks are filled with details of the term structure of interest rates and the message of the bond yield curve. Below right we show that these academic books should be used now for lighting fires because the historical relationships have fully broken down. Since 2009, we have faced a long lasting capitulation towards the idea that one day long term bond yields will recover their pre-crisis levels. Thus, while the slope of the bond yield curve was negatively correlated to short term rates, it is now fully inelastic: short term rates have been stuck to 0% since 2009 and long term bond yields have moved from 3% to 1%.

The fact that long term bond yields confirm that even in the long term the situation will never normalise poses two questions. Firstly, do bond markets fundamentally misunderstand the economic situation or are they correct in their expectations? The problem is that central banks, who decide the level of short term rates, have remained unclear about what will be the next “normal situation”? The case of Sweden, one of the first countries having experienced deeply negative rates, is worth mentioning. We show below the dynamic of the core CPI, of wages, of Employment and we add the main refinancing rate into the mix as well. The  first chart below shows absolute data and the second one, it is a z-score (in standard deviations around the mean).

Sweden: Key Economic Data  

We see that in Sweden, the employment situation has normalised, the core inflation rate has normalised, the wage dynamic is a bit weak but interest rates have never been so low in economic history. Why has the Swedish central bank decided on such a policy? Or to put it in another way, what is required to put rates back above 0%?

The Fed will meet in two days. We believe Fed Board members remain very uncomfortable with the current situation. We will not repeat what we have said for many months now, that slacks in the economy no longer exist and that inflation is back to trend. The problem is not the US economy, the problem is the US$ leverage in the emerging world and the declining EM currencies. The question for Fed members is clearly subjective. Should they grant more time to EM countries to make their adjustments or should they reload their monetary policy tool because the US economic cycle is reaching maturity? These are two different questions and up to now, Fed members have refused to choose, leaning however a little towards the first solution.

Our stance remains the same, because we are bullish on the US economy, we do not understand how 5y×5y forward USD rates can trade below 3%." - source Louis Capital Markets

Apparently, the Fed has chosen to throw a lifeline to EM countries and to give them more respite by tampering their "normalization" process, but as far as our "inflation expectations are concerned and in relation to "Unobtainium", when it comes to the US we remain "data dependent" and it remains to be seen if the US has indeed reached "escape velocity" when it comes to "wage inflation". We do not share the same optimism as LCM on that matter and believe the rise in "inflation expectations" to be for the time being a temporary phenomenon. Yet, if indeed the slope of the bond yield curve which was negatively correlated to short term rates, is now fully inelastic from a strategy perspective, we believe being long US TIPS (given their embedded deflation floor), long gold miners and long US long bonds still represent a relatively attractive "allocation". What is as well interesting is that the short-end of the US yield curve is prone to more volatility in similar fashion than long-dated Japanese and German government bonds have become as well significantly volatile thanks to NIRP. 

The volatility of of the US yield curve is clearly in the front-end of the curve as indicated by Bank of America Merrill Lynch in their Situation Room note from the 16th of March entitled "Marking the Fed toward the market":

"Marking the Fed toward the market 

The main story at the conclusion to the March FOMC meeting was that, by lowering the dot plot to two rate hikes this year, the Fed chose to mark their view on the near term path for the Fed funds toward market expectations. In other words, the Fed acknowledged, what the market has suspected for a long time, that it will be difficult for the Fed to hike rates in an environment of global weakness and deflationary pressures. Hence the big bull steepening move in the Treasury curve with 2-year yields 10.9bps lower while 30-year yields were comparatively little changed (-2.0bps). 

As a result the likelihood of a hawkish monetary policy mistake derailing the US economy declined significantly and VIX dropped 11.0% as stocks rose 0.6%. Less economic uncertainty in turn is positive for credit spreads, while the decline in interest rates is negative. However, with longer term interest rates holding up well the net effect is positive and supportive of our bullish outlook for HG credit as well as the Treasury curve steepening move supports our view that the 5s/10s spread curve flattens. Sector wise today's Fed moves are more positive for industrials than banks, although relative valuations and last weeks's ECB moves mitigate that." - source Bank of America Merrill Lynch

Whereas the rally in the US Investment Grade has been significant, the ECB's latest "generosity" package has lead to a rush towards credit spread products, enticing investors to renew the "beta" game in the process, namely reaching for yield and credit risk in the process. If indeed the short end of the European government bond market has become irresponsive thanks to NIRP and has plunged most of European short term bonds into negative territory, the consequences of yield curves becoming "inelastic" is pushing punters towards the only "less perceived risky"decent game in town namely investment grade credit. This is validated by the flows seen in Europe as shown in Bank of America Merrill Lynch chart below from their Follow the Flow note from the 18th of March entitled "Front-running” the ECB…":

"…as investors rush to buy corporate bonds 

We have seen it in the past. When the ECB announced the government bond buying program, inflows accelerated into the asset class. With the help of the ECB, credit flows broke free from a long period of outflows. Last week’s positive inflow into high-grade and high-yield funds was the third consecutive and the biggest in 53 weeks.

This considerable shift in momentum was mainly thanks to a decisive shift in high grade. The asset class recorded its first inflow in ten weeks and the biggest for more than a year. High yield funds enjoyed another - the fourth in a row - week of inflows.

Elsewhere in fixed income, government bond funds recorded another outflow during the previous week.

Money market fund flows were also in the negative territory, recording a fourth consecutive outflow – the longest streak since March ‘15.

To the contrary outflows continued from equity funds. The asset class has suffered outflows for the last six weeks, which now sum up to $15bn. This is the longest period of outflows seen in equities since October ’14." - source Bank of America Merrill Lynch

The outflows from equity funds do not surprise us. This what we pointed out in our recent conversation "The Monkey and banana problem":

"The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box): When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock" hence the reach for bonds." - source Macronomics, February 2016

No doubt that the "European investor monkey community" is fearful of another "electric shock", so for now they'd rather play the "reach for bonds", ditching equities in the process. The beauty of the Skinner box...or from "Unobtainium" (Main Street) to "Obtainium" (Wall Street), but, we are ranting again...

This leads to our final point and final chart, that no matter how hard central bankers try to generate "Unobtainium", demography matters, end of the day, no matter how big your "printing press" is.

• Final chart: Demography is destiny

As we have pointed out, like many others before us, when it comes to the trajectory of bond yields and inflation expectations, demography matters. This is the point we made in our February 2015 conversation "The Pigou effect" relating to our long term deflationary stance. 

You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:

Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price!

"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."

The problems facing Europe and Japan are driven by a demographic cycle not a financial cycle. This once again illustrated in our final chart and table from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 18th of March:

"Demography is destiny 

The big picture
We borrow this week’s title from Dr. Joseph Coughlin of the MIT AgeLab, who was a featured speaker at this week’s BofAML Residential Mortgage and Housing Finance Conference. For financial markets, the key demographic reality is that populations across the globe are aging, some more rapidly than others. BofAML Chief Investment Strategist Michael Hartnett noted this in the recent piece, BofAML’s Transforming World Atlas: Investment themes illustrated by maps.Table 1 shows, by country, the percentage of populations that are 65 years old or over, as of 2015 and projected for 2050.

Japan is seen as the world’s leader in age, both now (26%) and in 2050 (37%). Europe (Germany, Italy, Spain) is not too far behind. The US, currently at 15%, is next, although countries such as China and Brazil will age more rapidly over the next 35 years and overtake the US in terms of the percentage of people above 65 years old. Not surprisingly, as populations age, productivity and consumption patterns change, with deflation conceivably an associated phenomenon. The bond market experiences of Japan and Germany relative to the younger US are perhaps illustrative. Chart 1 shows the history of 30yr bond yields in Japan, Germany, and the United States over the past 15 years. Japan has led the way lower while Germany has followed suit and narrowed the gap to JGB yields. US yields have moved lower but not to the same degree.

The question arises: will the US inevitably follow and see 30yr bond yields head below 1%? So far, US yields have proven to be somewhat more resilient than in Japan and Germany, and the different demographic outlook (less aging) argues for less downward pressure on yields than in Europe and Asia. Nonetheless, we should note that one of our conference presenters, Scott Minerd of Guggenheim Partners, made the case for a 1% 10yr treasury yield at some point in the not too distant future; currently, we are simply at the middle of the downward trend channel in rates of the past 30 years (Chart 2).

At a minimum, the aging of the global population suggests it is not unreasonable to think this is at least reasonably likely outcome at some point in the future. " - source Bank of America Merrill Lynch.

No offense to Bank of America Merrill Lynch but the title they used has not been authored by Dr. Joseph Coughlin of the MIT AgeLab but by August Comte, a French sociologist (1798-1857).

You probably understand by now, our inclination towards long dated US Treasuries. End of the day, if central banks cannot generate "Unobtainium" in the form of "renewed" inflations, what is not to like in the "carry play" offered in the long part of the US Treasury curve? We wonder.

"Low interest rates are usually attributed to low inflation, weak economic growth and super easy monetary policy. But there's another deep-seated factor that doesn't get much attention: demographics." - Greg Ip, Canadian journalist

Stay tuned!