Macro and Credit - Rescission

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

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

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

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

Synopsis:

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

• Macro - Low inflation mystery? The Fed is gone fishing.

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

While in various recent musings we have been pounding this Norwegian Blue Parrot, which is still resting for the Phillips Curve "cult members", we couldn't resist to bring back this subject following the support coming from Claudio Borio, Head of the BIS Monetary and Economic Department in his most recent discussion on the low inflation issues entitled "Through the looking glass" published on the 22nd of September 2017.  

"Central banks must feel like they have stepped through a mirror, and who can blame them? They used to struggle to bring inflation down or keep it under control; now they toil to push it up. They used to fear wage increases; now they urge them on. They used to dread fiscal expansion; now they sometimes invoke it. Fighting inflation defined a generation of postwar central bankers; encouraging it could define the current one.

What is going on in this topsy-turvy world? Could it be that inflation is like a compass with a broken needle? That would be a dreadful prospect – central bankers’ worst nightmare. And what would be the broader implications for central banking?

In my presentation today, I would like to address these troubling questions. I will do so recognising that “in order to make progress, one must leave the door to the unknown ajar”, as Richard Feynman once said. We should not take for granted even our strongest-held beliefs. That, of course, means that I will be intentionally provocative.

I will make three key points – putting forward two hypotheses and drawing one implication.

First, we may be underestimating the influence that real factors have on inflation, even over long horizons. Put differently, Friedman’s famous saying that “inflation is always and everywhere a monetary phenomenon” requires nuancing (Friedman (1970)). Looking back, I will focus mainly on the role of globalisation; but, looking forward, technology could have an even larger impact.

Second, we may be underestimating the influence that monetary policy has on real (inflation-adjusted) interest rates over long horizons. This, in fact, is the mirror image of the previous statement: at the limit, if inflation were entirely unresponsive to monetary policy, changes in nominal rates, over which central banks have a strong influence, would translate one-to-one into changes in real rates. And it raises questions about the idea that central banks passively follow some natural real interest rate determined exclusively by real factors, embodied in the familiar statement that interest rates are historically low because the natural rate has fallen a lot. Here, I will provide some new empirical evidence to support my hypothesis.

Finally, if these hypotheses are correct, we may need to adjust monetary policy frameworks accordingly. As I shall explain, that would mean putting less weight on inflation and more weight on the longer-term real effects of monetary policy through its impact on financial stability (financial cycles). Incidentally, the stronger focus on financial stability would bring central banking closer to its origins (Goodhart (1988), Borio (2014a))." - source Claudio Borio, BIS

Of course, we would argue that, if indeed, one is to make progress, one should be ready to reassess the validity of its framework such as the sacrosanct Phillips Curve. We were pleasantly surprised to read in the excellent speech from one of the BIS maverick economists, that globalization was put forward as one of the reasons for the lack of responsiveness of the Phillips Curve framework, which for some is simply resting like a "Norwegian Blue parrot":

"The one I find particularly attractive is that the globalisation of product, capital and labour markets has played a significant role. Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening-up of other emerging market economies? This added something like 1.6 billion people to the effective labour force, drastically shrinking the share of advanced economies, and cut that share by about half by 2015. Similarly, could it have remained immune to the technological advances that allowed the de-location of the production of goods and services across the world? Surely we should expect the behaviour of both labour and firms to have become much more sensitive to global conditions. We know that workers are not just competing with fellow workers in the same country but also with those abroad. We know that, for a given nominal exchange rate, the prices of two tradable goods that are close substitutes should track each other pretty closely. And we know that exchange rates have not been fully flexible, as the authorities have been far from indifferent to exchange rate movements. In other words, we should expect globalisation to have made markets much more contestable, eroding the “pricing” power of both labour and firms. If so, it is quite possible that all this has made the wage-price spirals of the past much less likely.
More specifically, one can think of two types of effect of globalisation on inflation. The first is symmetrical: assuming something akin to a global Phillips curve, one would expect domestic slack to be an insufficient measure of inflationary or disinflationary pressures; global slack would matter too. The second is asymmetrical: one would expect the entry of lower-cost producers and of cheaper labour into the global economy to have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge." - source Claudio Borio, BIS

As we pointed out earlier in September in our conversation "Ouroboros", these are the reasons why the Phillips Curve is broken we think:

"For us, there are three main reasons why the Phillips curve is a Norwegian Blue parrot, simply resting in a Monty Pythonesque way:

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

This is why we think the Phillips curve is obsolete, for structural reasons." - source Macronomics, September 2017

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

The pace of wage inflation is influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 - 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase, that simple. We already discussed the issue of US productivity in June 2016 in our conversation "Optimism bias":

"In our book, "secular stagnation" is not only due to the burden of high global debt levels but, as well by the evident slowdown in productivity labor growth, which is clearly impacted by the "rise of the robots". This does not bode well for the stability of the "social fabric" and with rising populism in many parts of the world." - source Macronomics, June 2016

As we pointed out to Kevin Muir author of the Macro Tourist in our conversation "The Dead Parrot sketch", a business owner is a "deflationista" at heart because he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. Also it is worth mentioning French economist Jean Fourastié's work relating to real wages, real prices and in particular around productivity. In our last conversation we indicated that when it comes to the Phillips curve, the deflationary bias of capitalism and the Experience Curve should not be neglected in addition to the globalization factor:

"As we move towards the end of an economic expansion in the US, productivity has been falling, and jobs have been mostly created for lower skills workers, hence the lower wages conundrum weighting on inflation expectations." - source Macronomics, September 2017

When it comes to productivity issues, it seems to us that the Fed is unaware of what's going on, namely, that they've "gone fishing". On the issue of low productivity, we read with interest Bank of America Merrill Lynch's Economic Weekly note from the 22nd of September entitled "Productivity growth is a procrastinator":

• "The US economy is currently in a low productivity regime, averaging just 0.6% growth since 2011.
• The near-term outlook appears dim due to headwinds from unfavorable demographic factors and weak capital investment.
• Broad adoption of new IT goods and services could generate better productivity growth. But a regime shift is likely a long-term story.

Productivity growth down in the dumps

Labor productivity growth has been abysmal. Since 2011, it has averaged less than 1% and the trend is pointing down, as it came in flat in 2016. As we wrote last week, low productivity growth is likely one of the factors holding down wage gains and one of the catalysts that led some FOMC participants to revise down their longer-run dot in the latest SEP projections. In this note, we break down productivity growth into its three major components—labor quality, capital deepening and multifactor productivity—and ponder the near-term outlook.

Not all hours are created equal

Labor quality measures the effect of shifts in the age, education, and gender composition of the workforce. One can imagine that total output will vary given a workforce with a certain set of education, skills, and experience. Contribution of labor quality to productivity growth has varied over time as the composition of the workforce has shifted (Chart 1).

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

Today, the forces affecting labor quality are mixed (Chart 2).

On one hand, the share of the prime-age workers is declining as Baby-Boomers begin to retire and the Bureau of Labor Statistics projects that the trend will remain flat over the next decade. On the other hand, a greater share of workers are obtaining college degrees or higher and the trend looks broadly positive. In the long run, a more-educated labor force should pay dividends for productivity growth. However, in the near term the “Silver-Tsunami” effect will likely be a bigger countervailing force, keeping the contribution of labor quality to productivity growth below levels experienced in the 90s and 2000s.

You got to spend money to make money

Capital deepening or capital intensity is the amount of capital investment in relation to labor input. More machinery or equipment should make a worker more efficient, which should translate to more output per hour. Prior to the Great Recession, capital deepening contributed on average 0.9pp to labor productivity growth. Moreover, we experienced a big surge in capital investment at the turn of the century as businesses invested more in information and communication technology during the IT revolution. Since then, the pace of capital investment has slowed. The Great Recession played a role in holding down business investment, but during the current recovery, the pace of net stock of capital investment growth has remained well below prior trends (Chart 3).

Recently, businesses have placed investments on hold, as they wait to see if Congress passes corporate tax reform. Moreover, in the industrial sector, capacity utilization remains well below pre-recession levels and overall capital formation is only modestly outpacing depreciation, lessening the need to invest heavily in new equipment and machinery. All told, given our expectations for nonresidential fixed investment to grow at a tepid pace over the next several years, we see little prospects of a strong pickup in capital deepening.

Multifactor productivity: the magic elixir for growth?

Multifactor productivity (MFP) measures the output per unit of capital and labor input. In essence, it measures the overall production efficiency of the economy. The driving force of MFP is hard to pinpoint. In fact, empirically MFP is usually estimated as the residual of the production function. But the right combination of labor and capital can lead to significant productivity growth similar to what we experienced during the IT boom.

Although productivity growth at the aggregate remains weak, certain sectors have benefited from adoption of new technologies (Table 1).

For example, the oil and gas industry experienced a surge in MFP growth due to new drilling methods such as “pad” drilling, which allows rig operators to drill groups of wells simultaneously. Additionally drillers have found further efficiencies by developing fracking methods, which reduce the amount sand and water needed to drill wells. The IT-producing and service industries such as “computer and electronic products” and “computer systems design and related services” industries continue to see productivity gains from faster processors and algorithms and the adoption of cloud computing technology. In the retail world, ecommerce has led to a surge in the share of retail activity at non-store retailers, while job growth has remained limited, boosting productivity growth in the sector. In fact, according to the BLS, labor productivity growth for non-store retailers has averaged 5.6% over the last five years, well above the aggregate pace.

Innovation in robotics and artificial intelligence, adoption of big data and machine learning analytics raise the prospects for productivity gains. However, broad diffusion of these technologies will likely take years if not decades, implying that the hoped for rebound is likely a long-term story. We could see some incremental increase in the meantime, but a full regime shift seems unlikely.

A word on mismeasurement

It’s possible that there are some mismeasurement issues in the data. The skeptics of low productivity growth usually argue that prices for IT products used to deflate nominal expenditures are too high given the quality improvements, implying more real output and greater productivity. The jury is still out, but the preponderance of evidence suggests that mismeasurement issues were around prior to the slowdown in productivity growth and there’s little evidence to suggest it has exacerbated. One area where we see potential measurement issues is profit shifting of US corporations abroad, distorting the way corporate income is reported, which leads to wider trade deficits than the official measure. According to Guvenen et. al., adjusting for this mismeasurement would add 0.1pp annually to productivity growth for 1994-2004 and 0.25pp for 2004-2008, mitigating some of the productivity slowdown.

Adding it all up

The prospects of returning to a high-productivity regime and seeing better potential growth in the near term seem limited. In fact, the risks are likely skewed to the downside to our already low estimate for potential growth of 1.7%. Demographic trends are unfavorable and businesses appear to be in a “wait and see” mode on capital spending. Multifactor productivity remains an unknown factor: the trend doesn’t look too promising, but broad diffusion of new IT products could lead to some modest productivity gains in the short run before seeing greater gains once potential is fully realized. Until then, we remain comfortable with our call for productivity growth to stay subdued and for growth to hover around 2% over the next several years." - source Bank of America Merrill Lynch

As we pointed out, productivity has been falling, and jobs have been mostly created for lower skills workers. On top of that, business owners have been more creative in keeping costs under control and not only due to "globalization". Overall, low inflation should not be a mystery for the Fed:

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

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

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

• Credit - Beware of rapid credit expansion

As we pointed out in our previous conversation, the work of Claudio Borio from the BIS, has been very interesting when it comes to pointing out the risks for Financial Stability including rapid credit expansion. As a reminder, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:

"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS 

A common sign of brewing instability has always been rapid credit expansion. The "controlled demolition" analogy we used in the past when discussing the threat of the Shadow Banking sector in the Chinese economy was a clear illustration that the Chinese authorities were clearly aware of the risks. So far they have managed to dampen the issues at hand. It is always critical to assess rapid credit expansion to gauge rising instability in our current credit world. On this subject we reminded ourselves of September 2016 paper by Matthew Baron and Wei Xiong, Quarterly Journal of Economics, entitled "Credit Expansion and Neglected Crash Risk":

"By analyzing 20 developed economies over 1920–2012, we find the following evidence of overoptimism and neglect of crash risk by bank equity investors during credit expansions: (i) bank credit expansion predicts increased bank equity crash risk, but despite the elevated crash risk, also predicts lower mean bank equity returns in subsequent one to three years; (ii) conditional on bank credit expansion of a country exceeding a 95th percentile threshold, the predicted excess return for the bank equity index in subsequent three years is -37.3%; and (iii) bank credit expansion is distinct from equity market sentiment captured by dividend yield and yet dividend yield and credit expansion interact with each other to make credit expansion a particularly strong predictor of lower bank equity returns when dividend yield is low." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics

As pointed out by the BIS work, rapid credit expansion can have severe consequences on the real economy. The recent Great Financial Crisis (GFC) was an illustration of out of control credit expansion in the housing markets with global dire consequences:

"The recent financial crisis in 2007–2008 has renewed economists’ interest in the causes and consequences of credit expansions. There is now substantial evidence showing that credit expansions can have severe consequences on the real economy as reflected by subsequent banking crises, housing market crashes, and economic recessions, (e.g., Borio and Lowe 2002, Mian and Sufi 2009, Schularick and Taylor 2012, and L´opez-Salido, Stein, and Zakrajˇsek 2016). However, the causes of credit expansion remain elusive. An influential yet controversial view put forth by Minsky (1977) and Kindleberger (1978) emphasizes overoptimism as an important driver of credit expansion. According to this view, prolonged periods of economic booms tend to breed optimism, which in turn leads to credit expansions that can eventually destabilize the financial system and the economy. The recent literature has proposed various mechanisms that can lead to such optimism" - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.

As we have discussed recently, in credit booms such as the ongoing one, credit quality is deteriorating, which is the case when it comes to US Investment Grade. The deterioration of credit quality forecasts not only lower future corporate bond returns but, will also have an impact on the recovery value. In their very interesting paper, Matthew Baron and Wei Xiong look if credit expansion predicts a significantly higher likelihood of bank equity crashes:

"We find that one to three years after bank credit expansions, despite the increased crash risk, the mean excess return of the bank equity index is significantly lower rather than higher. Specifically, a one standard deviation increase in credit expansion predicts an 11.4 percentage point decrease in subsequent three-year-ahead excess returns." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.

Their analysis demonstrates the clear presence of overoptimism by bank shareholders during bank credit expansions, which of course not a surprise given this phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. You might already be wondering where we are going with this but, we think that right now, loose financial conditions are leading to rapid credit expansion which is probably a concern for the Fed relating to Financial Stability. On this subject we read with interest Société Générale Market Wrap-up note from the 19th of September entitled "What the macro number tell us about borrowing" which indicates that leverage is rising now in Europe as well:

"Market thoughts

In “Leverage is rising in Europe too,” we used two bottom-up data series of leverage, built from the companies in the iBoxx euro-denominated IG and high yield indices, to show how European companies were getting more risky. Do the macro figures back these conclusions up?

The Banque de France published its latest update on the financing of the corporate sector on 12 September. The year-on-year growth rate of loans to non-financials remains just under 5%, more or less unchanged from where it has been since mid-2015 (as Chart 1 shows).

The growth rate is broadly in line with the levels seen in mid-2011, ahead of the euro crisis, but less than half the peaks in 2001 (ahead of the 2002 bear market) or 2007/8 just before the US-led global financial crisis. The level of borrowing is not striking, but the composition is more noteworthy. While borrowing for short-term needs is now stable year-on-year, and borrowing to finance property investment has dipped, the borrowing for other forms of capital investment is running at 7% per annum, well above the 2011 peaks.

This suggests that companies are borrowing to invest, and explains some of the rise in balance sheet leverage noted in our earlier study.

Seen at a pan-European level, however, the trend looks far less significant. Chart 3 shows the growth in borrowing from the ECB for corporates and households (with the latter split into consumer credit and house purchases).

Corporate borrowing is not only growing less quickly than household borrowing, but the year-on-year growth rates have decelerated recently.

On balance, then, the macro data is rather less alarming than the bottom-up figures, which do show that leverage is rising. As we noted in our earlier study, however, this could be because of the increase in high yield borrowing and issuance in euro-denominated debt from issuers outside the eurozone. The bank lending figures themselves are more likely to be biased towards domestic borrowers." - source Sociéte Générale.

While on balance the macro data seems less alarming, there is no doubt that leverage is creeping up and that covenants are being loosened, even in Europe, which seems to indicate rapid credit expansion in some instances. No surprise some central banks including the Bank of England are wary about these developments. As shown in a recent article by the Wall Street Journal, leverage loans are coming back at a rapid pace, as indicated in their article from the 24th of September entitled "Leveraged Loans Are Back and on Pace to Top Pre-Financial Crisis Records":

"Lending to the most highly indebted companies in the U.S. and Europe is surging, a development that investors worry could pressure financial markets if the global economic expansion starts to fade.

Volume for these leveraged loans is up 53% this year in the U.S., putting it on pace to surpass the 2007 record of $534 billion, according to S&P Global Market Intelligence’s LCD unit.

In Europe, recent loans offer fewer investor safeguards than in the past. This year, 70% of the region’s new leveraged loans are known as covenant-lite, according to LCD, more than triple the number four years ago. Covenants are the terms in a loan’s contract that offer investor protections, such as provisions on borrowers’ ability to take on more debt or invest in projects.

Toys ‘R’ Us offered a reminder of the risks of piling on debt when the company filed for bankruptcy protection on Monday. The toy seller’s chief executive said in court papers that Toys ‘R’ Us had been hampered by its “significant leverage.” Its $5.3 billion in debt included a large number of leveraged loans and high-yield bonds" - source Wall Street Journal

Given in the US a third of loans to private-equity backed companies this year are leveraged six times or more, according to LCD’s calculations of companies’ debt to earnings before interest, tax, depreciation and amortization and despite 2013 guidelines from U.S. regulators, including the Fed, on loan underwriting stating that leverage of more than six times "raises concerns for most industries", you probably understand why the Fed is envisaging "Rescission" from its generosity, and draining some of the alcohol out of the credit punch bowl. In similar fashion, credit expansion and loose covenants have become more aggressive in Europe as indicated in the Financial Times on the 20th of September in their article "Aggressive term in Stada bond sale causes outcry":

"Analysts and investors are crying foul at an aggressive term in the bond sale backing the €4.3bn buyout of Stada, which they say creates a new way for the drugmaker’s private equity owners to strip cash out of the business.

The €825m high-yield bond deal is being sold alongside a €1.95bn syndication of leveraged loans, in order to finance Bain Capital and Cinven’s acquisition of German generic drugmaker Stada. The acquisition is the largest leveraged buyout of a European-listed company in four years." - source Financial Times

European companies are indeed getting more risky. This another indication of the lateness of the credit cycle, even in Europe, although one could argue that US is ahead of Europe when it comes to its rapid credit expansion phase as pointed out by JP Morgan in their note from the 20th of September entitled "Age isn't everything -  Gauging the DM business cycle":

"The US looks modestly more vulnerable

On balance, most indicators suggest that the DM as a whole is not close to its next recession, despite having returned to full employment. While this case can be made for the DM as a whole, the picture is more mixed for the US—the economy farthest advanced in its cycle. Our US team’s recession risk tracker places the risks of a recession in the next twelve months at a relatively low at a 1-in-4 chance. However, the risk profile rises sharply to a 3-in-4 chance at the two to three year horizon.

Two factors appear to differentiate the US from other DM economies. First, falling productivity growth and weak pricing power has led to a significant decline in corporate profit margins from the highs. Some of this margin compression owed to the hit to the energy sector in recent years. With oil prices having bounced from the severely depressed levels in early 2016, and also with productivity growth having recovered, US corporate margins are staging a bit of a recovery. Still, with labor markets continuing to tighten, the pressure will be for some compression in US corporate margins.

Second, there has been a large increase in nonfinancial corporate credit with debt/asset leverage at the 85th percentile of its nearly four decade average. It is important to recognize that our US recession probability model does not account for the fact that rising corporate leverage and falling margins have usually been accompanied by other late cycle pressures that push interest rates up. With US interest rates low and the Fed unlikely to tighten policy significantly over the next year, forces magnifying problems due to tight labor markets and lower corporate margins do not look likely to intensify soon. Still, US shocks generate powerful reverberations through the rest of the world, and it is important to track the factors generating US vulnerabilities alongside our assessment of DM risks in the aggregate." - source JP Morgan

One thing for sure, the Fed might be in "Rescission" mood when it comes to its balance sheet and the credit punch bowl, the US Yield curve is still not buying their "Jedi tricks" as it is getting flatter even after the latest FOMC. So overall credit is becoming stretched and productivity is remaining low in the US. Meanwhile business investment remains very low as well in this unusual "recovery" cycle as per our final chart below.

• Final chart - "Broken" asset investment in Developed Markets

Although the Fed is lost in "inflation" translation, and with the ongoing low productivity seen so far in this cycle, there has been as well a notable imbalance such as the downward trend in business investment. Our final chart comes from JP Morgan report quoted above and displays the trend in Fixed asset investment in Developed Markets (DM):

"With regard to imbalances, there are few signs of an overstretched durables spending cycle. Even accounting for a downward trend, the level of outlays for business investment remains relatively low by historical standards (Figure 18).

Similarly, DM spending on housing and motor vehicles remains low relative to GDP or to population growth. At the same time, household balance sheets are quite healthy even if corporate balances are beginning to look somewhat stretched. 

It is difficult to be precise about the timing of recessions,which are inherently coordination failures among millions of economic actors. The historical record on slack underscores a wide range of outturns once full employment is reached, and there is sufficient evidence to suggest that the typical vulnerabilities associated with recessions are not currently present. However, as vulnerabilities rise, they can be amplified by unforeseen shocks, often coming from financial or commodity prices. It is worth noting that every US recession (except one) was preceded by a material increase in oil prices and every oil market disruption (except one) was followed by an economic recession (“Historical Oil Shocks,” J. Hamilton, 2011). The fact that oil prices have witnessed a spectacular supply-led collapse since 2014 and continue to struggle is encouraging in this regard. While the direction of causation is widely debated, it is arguably the interaction between the various vulnerabilities noted above, along with tightened economic conditions, with financial and commodity prices that becomes the catalyst for recession." - source JP Morgan

As we pointed out last week, for a bear market to materialize, you would need a buildup of inflationary pressure that would reignite the volatility in bonds via the MOVE index. We also pointed out in a previous conversation in similar fashion to JP Morgan that past history has shown that what matters is the velocity of the increase in the oil prices. A price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. No need to press the "panic" button yet, but it is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation. The Fed might be in "Rescission" mode when it comes to its bloated balance sheet, the US Yield curve remains oblivious to its Jedi tricks and continues to flatten. This does indicate that "Rescission" could eventually lead to "Recession" in 2018, but that's another story...

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

Stay tuned !

Macro and Credit - Common knowledge

"When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion." - Dale Carnegie, American writer

While playing the commenting "tourist" on a Macro-Man post relating to banking woes, we came across a very interesting comment from one of their readers relating to Central Banks, which we decided would make a good analogy for our post title:

"Eddie said...

 Wikipedia: Game of Common Knowledge

This might be a good way to think about CBs and their presumed or real abilities"

So we decided to investigate further given this fellow commentator piqued our curiosity and also because it has become quite a challenge for us to come up with relevant analogies, week after week in our musings (if you think of any of interest we could use in the near future, give us a shout). 

The concept of "Common knowledge" was first introduced in the philosophical literature by David Kellog Lewis in 1969 and was first given a mathematical formulation in a set-theoretical framework by Robert Aumann in 1976 according to the Wikipedia page. The idea and concept of the common knowledge is often introduced by some variant of the following puzzle:

"The idea of common knowledge is often introduced by some variant of the following puzzle:
On an island, there are k people who have blue eyes, and the rest of the people have green eyes. At the start of the puzzle, no one on the island ever knows their own eye color. By rule, if a person on the island ever discovers they have blue eyes, that person must leave the island at dawn; anyone not making such a discovery always sleeps until after dawn. On the island, each person knows every other person's eye color, there are no reflective surfaces, and there is no discussion of eye color.
At some point, an outsider comes to the island, calls together all the people on the island, and makes the following public announcement: "At least one of you has blue eyes". The outsider, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that he is truthful, and thus it becomes common knowledge that there is at least one islander who has blue eyes. The problem: assuming all persons on the island are completely logical and that this too is common knowledge, what is the eventual outcome?

The answer is that, on the kth midnight after the announcement, all the blue-eyed people will leave the island." - source  Wikipedia: Game of Common Knowledge

We would like to offer a variation of the above which we think ties up nicely with Eddie's comment quoted initially about Central Banks and the current state of affairs:

In the island of central bankers there are k central bankers who have a credit crisis on their hands, and the rest of the central bankers do not have a credit crisis on their hands. At the start of the puzzle, not one central banker realizes he has a credit crisis starting. By rule, if a central banker discovers he has a credit crisis, he must act swiftly at dawn to counteract the deflationary bust coming. In the central banking island, each central banker knows every other central banker's credit situation but there is never a real discussion around the evolution of the credit markets.

At some point an outsider, the Bank of International Settlements (BIS) comes to the island of the central bankers and makes the following public announcement: "At least one of you has a credit crisis"

"Emerging market economies may be facing tighter liquidity conditions as cross-border lending to emerging economies, especially China, shrank in the third quarter of 2015 and U.S. dollar borrowing by non-bank companies in those economies was flat for the first time since 2009, according to the Bank for International Settlements (BIS).
    BIS General Manager Jaime Caruana said global liquidity – a term that captures the ease of financing in global financial markets –  shows that the stock of U.S. dollar-denominated debt of non-bank borrowers outside the U.S. was unchanged at $9.8 trillion from June to September and dollar borrowing by non-banks in emerging economies also was steady at $3.3 trillion.
    An even clearer sign that global liquidity conditions for emerging markets may have peaked comes from a decline in cross-border lending to China, Brazil, India, Russia and South Africa. In the third quarter of last year lending shrank by $38 billion to $824 billion from the second quarter, Caruana said in a speech at the London School of Economics (LSE)." - source Reuters, Emerging markets may be facing tighter liquidity – BIS, 5th of February 2016"

The BIS, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that it is truthful, and thus it becomes common knowledge that there is at least one "islander" who has a credit crisis on his hands.

So dear readers, the problem is as follows, assuming all the central bankers on the island are completely logical and that this too is common knowledge, what is the eventual outcome?

For us it is very simple, a liquidity crisis always leads to a financial crisis. 

And this, dear readers is unfortunately "Common knowledge" and will nonetheless be the outcome because knowing that everyone knows does make a difference. When the BIS public announcement (a fact already known to all) becomes common knowledge, the central bankers having a credit crisis on their hands on their island eventually deduce their status but we ramble again...

On a side note we touched on central bankers and their "deity" status "Omnipotence Paradox"  back in November 2012:

"A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie)."

Therefore the concept of "Common knowledge" is central in game theory.

If a deity status is only attained if it is not able to lie (SNB, BOJ, ECB, FED...) then central bankers are not omnipotent except the BIS...

Back in 2012 in our conversation we also argued:

"The "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives)."

 And in October 2014 in our conversation "Pascal's Wager" we argued:

"Pascal's wager was devised by 17th century French philosopher, mathematician and physicist Blaise Pascal (1623-1662). It posits that humans all bet with their lives either that God exists or not. In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not.

Pascal's Wager is of great importance and was groundbreaking at the time because it charted new territory in probability theory, making the first use of decision theory.
Pascal's Wager in the form of a decision matrix:

The only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods"." - source Macronomics, October 2014.

In this week's conversation, we will again look at the debilitation of the credit markets and what it entails according to the BIS "deity" and the central bankers islanders and the implications for "risk assets".

Synopsis:

• Instability risk and large standard deviation moves - Rising positive correlations are a cause for great concern and so is the denial on the state of US growth
• Credit - the liquidity canary, willingness to lend and the credit cycle
• Final chart - The Bank of Japan is a Black Hole for JGBs

• Instability risk and large standard deviation moves - Rising positive correlations are a cause for great concern and so is the denial on state of US growth

We would like to point out once more, like we did in our conversation "Positive correlations and large Standard Deviation moves" back in August 2015 the growing instability risk which creates large standard deviation moves thanks to rising positive correlations:

"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations.

Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:

- source IMF, April 2015

This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoil, bond prices and equities are all moving in concert.

Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market." - source Macronomics, August 2015.

This rising instability risk we discussed previously can be once more ascertained by the rise in correlations across asset classes such as Chinese equities and selected asset classes as well as with oil prices, which are all well above averages as shown in the below charts from IIF:

- source IIF

We told you at the end of 2015, that, 2016 would be a year of high "risk reversal" opportunities. The large move experienced as of late such as the one seen this week in the US dollar are clearly an indication of the brewing instability in financial markets (not that you haven't been warned on numerous occasions on this very blog). These "sucker punches" should not come as a surprise. The herd mentality has made various exposures crowded trades, with very poor risk reward after all, as pointed out by our Rcube friends in their November guest post "US Equity / Credit Divergence: A Warning":

"Everyone is expecting higher equities due to lower yields and depressed food and energy prices. But when everyone is thinking alike, no one is really thinking…."

As contrarian investors we don’t like sitting with the crowd. The fact that a long dollar was too consensual, was to us a serious "red flag". Also, our fears that the raging currency war would clearly escalate (thank you Bank of Japan) shows that it has had a bigger impact on the Fed’s reaction function than people were thinking.

Under the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity. This is what we pointed out in December 2014 in our conversation "The QE MacGuffin":

"What we find of interest is that under the ZLB, many pundits have expected a recovery. When one looks at the commodity complex breaking down in conjunction with a weakening global growth picture which can be ascertained by a weakening Baltic Dry Index. No wonder yields in the government bond space are making new lows and that our very long US duration exposure we have set up early January (in particular via ETF ZROZ) has paid us handsomely and will continue to do so we think." - source Macronomics, December 2014

While in early 2015, we tactically booked our profits on our long duration exposure, as we have told you end of 2015, following the December FOMC we not only re-entered our tactical long duration exposure, but, we also added started adding on our "Gold Miners" exposure.

Why so?

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is  again working nicely 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."

Easy as 1-2-3...

Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe. By the way if you are a "credit investor, you sure want to be "duration" hedged in Europe and probably less so in the US...

Also, what we find of "instability" as of late and in response to the "bullish recovery" crowd we would like to point out towards the evident fragility of the "Consumer Discretionary" complex. Because if you want to talk about the "quality" of jobs created in the US and their consumer discretionary potential here is a chart we have built our from the Bureau of Labor Statistics (BLS) that tells it all, depicting the Employment Status by educational attainment:

- source Macronomics / BLS

And if you think this doesn't represent a "headwind" for consumer discretionary, we could as well point out from a "Common knowledge" perspective, the situation relation Food Stamps:

- source Macronomics / Bloomberg.

The American economy is doing so well that it can subsidies for free 45 million of Americans (14.24% of the population)...

In this context, the price action aka "sucker punchers on two bellwether "Consumer Discretionary" stocks namely Royal Caribbean on the 4th of February and Ralph Lauren are clearly indicative of the global mood in the consumer discretionary sector we think (it is not only in dwindling Rolex sales in Hong Kong):

- graph source Bloomberg

Now if low oil prices are a "boon" for US consumption, then this "boon" is clearly hiding under the mattress...

We wonder when it is coming to become "Common knowledge". 

Conclusion:  maybe you should "Get shorty" Consumer Discretionary stocks that is...

When it comes to "Common knowledge" and growth outlook, it seems we always follow the same trajectory:

We start with an overall 3% consensus for US growth and US 10 year yield end of the year targets of between 2.50% to 3%, then after a couple of months, it gets revised down to 1.50% / 2% and US yields get revised accordingly towards the same objective.

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."

We hope, at some point, this will become "Common knowledge" and that some sell-side pundits will stop defying this simple yet compelling "Wicksellian" logic.

When it comes to the importance of liquidity, stability and credit, the latest Fed's latest Senior Officer Lending Survey is showing that US regional banks are starting to close the credit flows (it is not only happening in Emerging Markets!). You need to understand how important this is. The BIS seems to understand this but, clearly the "islanders" are in denial hence the title of our second bullet point in our long conversation.

• Credit - the liquidity canary, willingness to lend and the credit cycle

Whereas last week we pointed out again on the CCC credit canary's current state of affairs, being shut out entirely of the primary markets, whereas every pundits around are focusing on the correlation between oil and equities, earnings and additional sucker punches such as the one delivered to internet darling LinkIn corporation down by more than 40%, we would like to focus our attention on the real "elephant" in the China credit shop, namely liquidity.

When it comes to forecasting the default trajectory and in particular when one wants to assess the vulnerability of High Yield, we have pointed out that willingness to lend is paramount when it comes to the state of the credit cycle. On that particular subject we read with interest Bank of America Merrill Lynch's Securitization Weekly note from the 5th of February:

"Willingness to lend and the credit cycle

This week’s Senior Loan Officer Survey Report from the Fed for January (Chart 13) showed that lenders have gotten the message from capital markets: C&I and CRE credit is tightening on a net basis (8.2% and 5.6% of respondents, respectively).

It is noteworthy to us that the most closely related sectors, CLOs and CMBS, are those that are facing risk retention deadlines at the end of this year. As a reminder, the primary purpose of risk retention rules is to ensure that originators of loans are on the hook for the risk of the loans they originate. It may be too early to make the connection between the willingness to lend data and risk retention deadlines, but it seems fair to say that as the deadline draws closer, lenders are likely to further tighten lending standards, as they will own the risk. It is also noteworthy that the one sector exempt from risk retention rules, GSE mortgages, shows a fairly large number of respondents (-14.3%) that are loosening credit. We can see that this trend will be observed by investors in the risk transfer space and likely cause them to demand additional spread compensation for credit risk going forward. Credit card lending has not quite tightened yet (-1.9%), but it is getting close. GSE mortgages are the clear outlier on this chart.

We also layer on top of Chart 13 the high yield loan default cycle. Not surprisingly, tightening C&I and CRE credit has either coincided with (early 2000s) or led (2008-2009) a loan default cycle. The amount of tightening observed to date has been fairly minimal compared to the prior cycles. Nonetheless, if Liquidity Stress and credit market spreads continue in the direction they have been heading (higher), then more credit tightening and a more pronounced default cycle seem likely in the not too distant future.

Much should be revealed on this front over the next 1-2 months. Will some policy “fix” to liquidity stress be delivered, or will there be a disorderly move higher in liquidity stress? We shall see." - source Bank of America Merrill Lynch

As we pointed out in our introduction, liquidity crisis always lead to financial crisis, and yes, dear readers, credit always lead equities. When it comes to assessing "liquidity" risk, which we highlighted in our previous conversation, we think the situation is clearly pointing out to some deterioration. This is as well highlighted again in Bank of America Merrill Lynch we quoted as well in our previous conversation. We are indeed on the same page and share "Common knowledge":

"Liquidity stress: the canary in the coalmine

Introduction

Last week (“Things are bad, at risk of getting worse”), we discussed the BofAML Global Financial Stress Index (GFSI, Chart 1), noting that it is currently near the elevated levels of 2007-2008, right before the Great Financial Crisis (GFC). 

The message was that the GFSI signals some fragility for the financial system, which puts the system at risk of destabilizing quickly, perhaps due to policy error or some other shock. For securitized products credit sectors such as CMBS and CLOs, we think this means downside risks are still too high to look to take advantage of the spread widening that has occurred in recent weeks and months.

This week, we take a look at a sub-index of the GFSI, the Liquidity Stress index (Chart 2, IRISILIQ on Bloomberg), and consider the trends in liquidity stress and securitized products credit spreads over the past two years. We highlight in Chart 2 some of the key events that have occurred around the time liquidity stress has been rising: beginning of the taper by the Fed in early 2014, the Swiss and Chinese currency revaluations and Fed rate hike in 2015, and Japanese NIRP in 2016.

Chart 3 shows that, compared to the broader GFSI, liquidity stress has somewhat methodically and steadily risen over the past two years: while the GFSI has moved higher in fits and starts, liquidity stress has more persistently risen, only pausing its rise at times, before moving higher.

This persistence suggests to us that deteriorating liquidity is at the heart of and may be the primary driver of broader rising financial stress. If so, then continuation of the rising trend in liquidity stress may eventually lead to another spike in broader financial stress in the months ahead." - source Bank of America Merrill Lynch

Credit flows matters, because if indeed, the "credit tap" is about to be turned off, recovery and growth will be difficult particularly for China, in the absence of course of a sizeable real exchange rate depreciation. This would trigger a significant deflationary wave impulse for the rest of the world rest assured.

Also credit spreads are a more useful indicator of credit supply disruptions than credit quantities. The increase in spreads during the Great Financial Crisis (GFC) is symptomatic of unusual financial distress, and not just the reflection of the increased default risk faced by borrowers.
(See 2012 papers from Adrian, Colla and Shin, Gertler, Gilchrist and Zakrajsek quoted in a Bruegel Policy Contribution of February 2013, by author Zsolt Darvas in his note entitled "Can Europe Recover Without Credit?").

So watching what credit spreads are doing, given they are gently drifting wider à la 2007 is paramount we think. Much more important than being obnubilated by "oil prices".

When comes to assessing the state of the credit markets, we have to agree with DataGrapple's note from the 3rd of February entitled "It is still a bear grind":

"Credit indices have been weak throughout the session, and they were no different from all other risky assets today in that respect. The most striking feature of the move wider so far - over the last few days, but that is true since the beginning of the year - is that we have not seen any panic. Credit investors have not had their “coyote moment” yet, when they suddenly realise that they have gone over the edge and that they are hanging in the air. Some sessions have been brutal - iTraxx Main (ITXEB) widened by almost 6bps today and closed above 100bps at 104bps for the first time since 2013 -, but bases – the difference between the traded value of an index and the therotical value computed with the risk premia of its individual constituents - remain large across the board and it is still worth in excess of 50cts at the close on ITXEB. The latest DTCC statistics show that investors are still long risk on most indices. They are slowly bleeding in this steady bear grind." - source DataGrapple

When one looks at the closing prices for European Itraxx 5 year CDS indices with Itraxx Europe Main S24 (Investment Grade proxy) closing 5bps wider on Friday at 110 bps and Itraxx Crossover S24 closing 20 bps wider on the day to around 423 bps you get the drift...

Moving back to our liquidity concerns, we would like to point out once more to Bank of America Merrill Lynch's take from their Securitization Weekly recent note:

 "Liquidity stress: possible causes and “solutions”

The natural question that arises from Chart 1 is: why has liquidity stress risen so persistently since the beginning of 2014? No doubt, this is a complex question with no simple answers. Nonetheless, we think there are at least two plausible key drivers:
1. The post-crisis regulatory (Volcker) and capital (Basel) regime that has substantially raised trading restrictions and capital requirements for banks/dealers and, in so doing, reduced liquidity dealers can provide to markets.
2. Emerging market and high yield credit problems related to the collapse in oil prices, and commodities more broadly. With balance sheet scarce due to higher capital requirements, and capital charges high for poor credits, liquidity in stressed sectors perhaps naturally is the first to go.

The combination of these two factors has led to a somewhat vicious cycle and feedback loop, where poor liquidity is spreading, and liquidity problems appear to be turning into fundamental problems. Moreover, tightening of monetary policy by the Fed, first through tapering and now through tightening, may have been necessary from an economic perspective, but the tightening appears to be adding fuel to the fire of liquidity deterioration.

The next question that arises is: what can be done to stabilize liquidity, or even reverse the trend of liquidity deterioration? This is an even harder question to answer than the first one posed above on causality. Arguably, poor liquidity was part and parcel of the post-crisis design for the financial system: in a world of significantly higher capital requirements for dealers, nobody should really be surprised that balance sheet is scarce and liquidity is lower. This suggests there is no “fix” coming for cause #1 above; what we have now was in fact “the plan.” The only response to poor liquidity would be related to cause #2, the credit problems. We see two possible alternatives to watch for:

 1. A coordinated global policy response. Here we are referring to what BofAML Chief Investment Strategist Michael Hartnett is calling the “Shanghai Accord,” a coordinated policy response from G20 Finance Ministers and Central Bankers at the February 26-27 Shanghai meeting.

2. Coordinated oil supply cuts from OPEC and Russia, which would help alleviate the downward pressure on oil, and the associated credit stress. 

Barring developments on these fronts, further liquidity deterioration seems inevitable. If so, as the following discussion suggests, then securitized products credit spreads are likely to widen further. Moreover, the 10yr inflation breakeven rate is likely to head lower, creating downside risks for interest rates and upside risk for agency MBS prepayments.

 Liquidity stress, credit spreads and inflation breakevens

Next, we take a look at the relationship between liquidity stress and credit spreads, as well as the 10yr inflation breakeven. Given that credit spreads feed into the construction of the Liquidity Stress index, correlation between the index and credit spreads should be expected. Nonetheless, it is useful to take a look at how spreads in various credit sectors have trended in the past two years, as liquidity has inexorably deteriorated.

 We make the following observations:

• The HY CDX spread (Chart 5) seems to have tracked the deterioration in liquidity
over the past two years the most, starting in early 2014. The  modest narrowing of the spread in early 2015 appears to have been the anomaly.

• CLO BBB spread (Chart 6) tightening in the first half of 2015 appears especially anomalous.

In retrospect, deteriorating liquidity was a good signal that CLO spreads were at risk of significant spread widening. We missed the signal. At this point, CLOs currently appear to be “very cheap” on a fundamental basis, but if liquidity broadly continues to deteriorate, through correlation, CLO spreads are likely to continue to widen.

 • Like CLOs, BBB- CMBS (Chart 7) have played catch up on spread widening this year.

• Prime AAA auto ABS, often thought of as a highly liquid cash substitute, experienced disproportionate spread widening in 2015 (Chart 10), but has stabilized and even tightened over the past few months. 

We think the sector should be relatively strong from a defensive perspective going forward, but will not be immune from further spread widening if liquidity stress escalates further. Similarly, BBB subprime auto ABS (Chart 11) seems likely to widen further.

 • The correlation between liquidity stress and the 10yr breakeven inflation rate (Chart 12) is especially noteworthy, raising two important question: 1) is the collapsing breakeven rate just a reflection of deteriorating liquidity and, as the Fed suggests, not a particularly relevant indicator of future inflation (or more correctly, disinflation)? or 2) has the new regulatory/capital regime impaired liquidity so severely that it is heightening
disinflationary pressures, which the collapsing breakeven rate is correctly signaling? 

We’ll see whether the Fed is right on this one. But for now, the market is largely saying that deteriorating liquidity is disinflationary and further liquidity deterioration would bias interest rates lower. This means higher convexity cost for agency MBS, which leads us to recommend adding prepayment protection in the sector." - source Bank of America Merrill Lynch

And what does higher convexity means?
As a reminder: In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!

The negative convexity of High Yield callable bonds for instance enhance the downside during a sell-off. Furthermore, over the last 3.5 years, when spreads were at or below the current level (442bp), HY has widened 56% of the time over the next three months.

As we posited in our May 2015 conversation "Cushing's syndrome" expect as well lower liquidity:

"One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. " - source Macronomics, Cushing's syndrome, May 2015.

This we think is the current state of affairs in the credit space, which is akin to a 2007 environment. We've seen it before and we think it is playing out again, hence our heightened attention to the Securitized markets.

As well we keep an eye also in what is happening in the land of the "setting sun" aka Japan as per our final chart and bullet point.

• Final chart - The Bank of Japan is a Black Hole for JGBs

Finally when it comes to "liquidity", central bank meddling and common knowledge, what find of interest given Bank of Japan's latest jump in the NIRP bandwagon, is that when it comes to Japanese Government bonds aka JGBs, the Bank of Japan has become a Black Hole in JGBs, in effect Bank of Japan has vacuumed so many bonds that in effect it has become the market as displayed in our final graph we find in Bank of America Merrill Lynch Japan Rates Viewpoint note from the 2nd of February entitled "In BOJ-led JGB market, will target shift from quantity to real interest rates?":

"Chart 6 shows JGB transactions by major banks in the secondary market. Since the expansion of QQE, transactions have been running at a low level, now about ¥8.5trn monthly. Considering that monthly transactions were about ¥25trn before the expansion of QQE and before its introduction, transactions have declined sharply. This suggests that newly issued JGBs are absorbed by the BOJ without entering the secondary market.

Safe assets are usually considered to be those with high liquidity and low volatility, but a better description of the recent JGB market might be that it has simply lost activity. In the past, volatility has risen during low-liquidity phases in the JGB market, and we believe the current market needs monitoring because a slight move by investors could prompt a volatility increase. The introduction of negative interest rates has raised volatility, but for the time being yields will probably continue downward, albeit accompanied by higher volatility.

Sustainability of quantitative and qualitative easing with negative interest rates

The BOJ’s balance sheet has continued expanding, to the point where it reached about 76% of GDP at the end of 2015. This is a substantial figure compared to the about 25% accumulated by the FRB and ECB. In January 2015, when the Swiss National Bank (SNB) eliminated its ceiling on the Swiss franc’s exchange rate vs. the euro, its balance sheet was about 80% of GDP (it has expanded again recently, reaching about 90%). The meaning of a central bank’s balance sheet relative to GDP can be debated, and the assets held by the BOJ and SNB differ in kind, so a simple comparison is not possible. Nevertheless, the approach of the BOJ’s balance sheet to 80% of GDP is noteworthy. At the time, the SNB’s president described the situation as unsustainable. Even a central bank cannot go on expanding its balance sheet without limit.
Given that JGB supply-demand is tight and a shortage of sellers will gradually emerge, doubts are being raised about the BOJ’s ability to keep expanding its balance sheet at the current rate. The introduction of negative interest rates might shorten the viable period of the expansion. Also, the longer that balance sheet expansion continues, the more difficult that monetary policy normalization will become. As the BOJ’s purchasing operations go on, JGB yields are being lowered at ever-longer maturities. In other words, the longer that monetary easing continues, the more likely the JGB curve is to factor in monetary normalization as a very distant event. Therefore, when normalization comes, the probability of a strong reaction is rising." - source Bank of America Merrill Lynch

Yes indeed. Even a central bank cannot go on expanding  its balance sheet forever, and that's "Common knowledge". The problem is one need to assume that all our central bankers "islanders" are completely logical and not totally insane...

"Logic is like the sword - those who appeal to it, shall perish by it." -  Samuel Butler, British writer

Stay tuned!