Macro and Credit - The Grapes of Wrath

"When anger rises, think of the consequences." -  Confucius

Looking at the impervious performance of credit markets and in particular US High Yield since this year lows while noticing no doubt a rise in global discontent and populism, it seems to us appropriate this time around for our title analogy to steer towards John Steinbeck's 1939 masterpiece "The Grapes of Wrath". In recent musings we have been pretty vocal about our pre-revolutionary mindset, not because we are of the revolutionary breed but, as we noted in our conversation "Empire Days", there is in Europe growth in disillusion / social tensions which can be ascertained for instance in France with the daily demonstrations of the French police and growing discontent hence our title. The Grapes of Wrath was set during the Great Depression and focuses on a poor family of tenant farmers which when they reach their Californian destination finds out that the state is oversupplied with labor, wages are low and workers are exploited to the point of starvation while big corporate farmers are in collusion and smaller farmers suffer from collapsing prices. When preparing to write the novel, Steinbeck wrote: "I want to put a tag of shame on the greedy bastards who are responsible for this [the Great Depression and its effects]."

The intensity of the US presidential election is indeed resonating with Steinbeck's work as it is representative in similar fashion to the growing global discontent with "elites" and the rising disconnect given the rise in inequality thanks to soaring asset prices courtesy of central banks "wealth effect" policies. It might still be goldilocks period for asset prices and in particular credit with additional melt-up but, no doubt in our minds that political clouds are lining up, while the tide is slowly but surely turning for the credit cycle.

In this week's conversation, we would like to look at the relationship between inflation, wages and labor growth, which would entice us to "buy" the recovery mantra of some sell-side pundits. Furthermore, we believe that for the "stagflation" story to play out it is conditional on a continued rebound of oil prices and an overall surge in commodity prices.

Synopsis:

• Macro and Credit - Is inflation truly rearing its ugly head? A look at the United States, Japan and Europe
• Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk

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

With the intensification of the use of the dreaded "stagflation" word and in continuation to our most recent musing, we continue to believe that rising 10 year US breakevens have been mostly driven by the change in oil prices as illustrated by the below Bank of America Merrill Lynch chart from their CMBS Weekly note from the 28th of October entitled "Still neutral for now":

- source Bank of America Merrill Lynch

In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.

For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp we think.as reported in the Wall Street Journal on the 4th of October:

"Rents in San Francisco declined 3%, while they fell about 1% in New York and edged lower in Houston and San Jose, Calif., the first drops in those markets since 2010, according to apartment tracker MPF Research. Across the U.S., rent growth was 4.1% on average." - source WSJ

As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds as posited by Société Générale in their American Themes note of the 19th of October entitled "Equilibrium fed funds: how low and for how long? Demographics the answer!":

"Historic observation: Labor demographics key driver of real long-term fed funds rate

An equilibrium fed funds rate—or interest rate—can depend on many factors that vary over time. The biggest driver under consideration is the inflation rate. Inflation is a straight-forward driver, and more scrutiny is placed on movement in the real interest rate. Economic growth and demographics are key. The perception of equilibrium is an issue too. In the current environment, we believe 2.0% inflation is achieved in balance. In the post-war period, the US economy has operated mostly out of inflation equilibrium with an average inflation rate of 3.64% (CPI) since the 1950s. So far in the 2010s, inflation is averaging 1.53%, just about the closest the US economy has been to a sense of equilibrium, and we are generally worried about deflation risks. The 2.0% inflation-equilibrium may be a challenge for a fed funds equilibrium rate, but we use it.

Drivers and rules of thumb for the Fed Funds rate

Old rules of thumb for determining the fed funds rate have lost prominence over the past decade as the rules appear to have changed. The fed funds rate is substantially lower than these rules of thumb might have suggested. Yet an examination of why they may have worked in the past but fail today is insightful. There are two key rules of thumb:

1. Fed funds rate should equal nominal GDP. Traditionally, nominal GDP has exceeded fed funds, yet the components of GDP are all the same and influence long-term GDP, namely inflation and real growth. Real growth is determined by demographics, productivity and investment. These latter variables are all the key variables contributing to a dynamic real fed funds determination.
2. Fed Funds equal 2% plus inflation. This rule coincides with the Taylor rule (In appendix) which originally had 2.0% as a real component. If output gaps and inflation gaps zero out over time, then the fed funds rate rule would be 2% plus inflation. Since the original formulation, however, the 2.0% is now in question. The rule was dependent on the time period examined and later updates used a lower real rate as the time horizon expanded or shifted. We can select a different fixed rate. Yet it is the dynamism of the real rate that is now in question. A different time period could yield a different fixed rate and we could fit the data but gain no insight into an evolving real rate. Today, we assume the real rate component is lower than the past but don’t know how low. Also important, if the real rate turns higher again, will we observe or be aware of the upturn?

The real short-term rate can depend on a large set of factors. In fact, the number of variables that can influence the real rate, and the inability to observe these variables, renders many ambitious under-takings to model the real rate useless. The potential growth rate, or GDP, is likely a top choice as a variable determining the real interest rate. However, the real potential GDP can only be estimated. Further, changes in potential GDP growth are difficult to detect and often require a period of time before a consensus can build on what the potential GDP growth is and how it has changed.

Historically, the nominal GDP averaged a rate significantly higher than the fed funds rate. Nominal GDP is composed of two easy parts, inflation plus real GDP. Like the fed funds rate, it suggests that the real fed funds would over time be equal to real growth. Over the six decade period of examination, nominal GDP exceeded the fed funds rate by 1.55%, and the standard deviation of that spread was 4.45%. Historically, we conclude that nominal GDP has not offered an appropriate guide.

Using a simple benchmark as nominal GDP for the fed funds rate is clearly an oversimplified approach. Yet much of the modeling approaches to consider the long-term fed funds rate are decomposing GDP and weighting the components.

Inflation is the first component, and in the long term, we expect inflation and inflation expectations to converge. The inflation component is assumed one-for-one in the long-term GDP. The real components to GDP are demographics, productivity and technological change. We can model and weight these components, but the approach is fraught with limited transparency. Productivity and technological change are observed with certainty only in hindsight, and sometimes many years after revisions. Additionally, it takes several years to distinguish between a temporary or a more permanent change in these variables.

Labor force and demographics – a more observable component of real growth.

Examining the different components of real GDP over the long term such as labor demographics and productivity as well as the aggregate real GDP growth rate, the movement in the labor force commanded strong interest. What is most compelling about the labor force growth is that it has some predictability, at least far more so than productivity or real GDP growth. Labor force growth is determined by population growth and retirement. Many of these features we can predict long in advance. On a monthly basis, we find the labor force participation rate (percent of working age population that has employment or is looking for job), but large moves can be predicted by the aging of the population. Another interesting characteristic is that the labor force data is not subject to major quarterly revisions like productivity and GDP.

In the tables above, we created another fed funds benchmark, which is the simple addition of inflation and the labor force growth rate. The aim is to generate a function based upon more readily observable components of potential growth. The goal is also to keep it simple. The two components, labor force and inflation, together offer an easy, dynamic calculation for long-term GDP. Over six decades, such an easy measure posted the narrowest spread to the fed funds rate. Moreover, the standard deviation on the spread was only modestly higher than using a fixed real rate benchmark. Labor force movements appear to be capturing a key, dynamic portion of the real rate movement, and importantly, the labor force variation is more observable, less prone to revision, and easier to project going forward relative to other fundamental explanatory variables.

Labor force growth has slowed appreciably in the 21st century and particularly after the crisis. The slowdown is a chief factor explaining a slowdown in GDP. Since 2009, the labor force has grown at just a 0.5% pace. That was down from 0.8% in the 2000s and 1.3% in the 1990s. Adding to that an equilibrium inflation rate of 2.0% would generate an equilibrium fed funds rate of 2.5% in the 2010s, versus 2.8% in the 2000s and 3.3% in the 1990s. Inflation was higher or lower than 2.0% during the decades and our historical calculation uses the actual CPI inflation measure.

 

Reasons to use such a simple labor force and CPI construct for considering long-term equilibrium:

1. Historical accuracy: If we consider a long-term analysis assuming that short-term rates find their needed equilibrium, the simple rate has been accurate. Moreover, the points of departure in the 1970s and 1980s are of interest. Fed funds were arguably held too low in the 1970s, giving rise to high inflation. Conversely, in the 1980s the fed funds was higher than it should have been due to abnormally high inflation expectations. Back testing this simple measure offers intriguing results. Over a six decade history, a simple benchmark of adding the labor force and the CPI inflation rate than GDP that implicitly moves with productivity and technological innovation.
2. Observable: A black-box model on the real rate can be constructed. Transparency and ease of observations are strong positives. Many important concepts behind a real rate—from demographics, real growth, productivity, potential growth—are not directly observable. Furthermore, the variables can be revised substantially over time. Variables used to fit a model could be materially altered at a later date. Labor force counts and the CPI are less subject to revisions.
3. Robustness of time varying real rate: Demographics pay a large role in potential GDP growth and additionally on the supply/demand for savings/investment. Having a simple demographic measure such as that has historically had a degree of accuracy, which offers a neat tool for gaining insight. The aging US population and the slowdown in immigration are captured indirectly in the labor force statistic.

There are weaknesses as well that are a narrowly focused driver of the real fed funds and the labor force overall. First, consider the chart on US labor force growth on the preceding page. Volatility argues against using this variable as any short-term guide for the fed funds rate. Second, the swings are numerous enough that deciphering a temporary versus a more permanent change is not straight forward. Yet variation could be minimized with more judgment, given that the aging labor force and the growing participation of women in the workforce were robust elements for change. Labor force gains accelerated into the late 1970s and have been decelerating since.

Conclusion

Estimates of the long-term fed funds rate remain well above current levels and therefore do not offer any short-term guidance for the fed funds rate. Demographics may be suggesting that we have reached a low point. At present, we expect labor force growth of 0.5-1.0%. With an inflation goal of 2.0%, the fed funds rate needs to converge to a 2.5-3.0% range. That range encompasses the Fed’s view and that of many other forecasters as well. It would also allow for further revisions downward. Yet, there is a growing risk that the next step in labor force growth will be faster. We see workers putting off retirement until later and /or the effects of the baby boomers entering retirement fading.

Has the drop in interest rates reached its bottom? 

That is a question regarding most bond maturities. Beyond the inflation question, a bottoming of labor force growth suggests that real rates have reached a bottom. This is an interesting outcome that we stress. The  models now used to explain the persistence of low rates may not yet be ready to determine whether an upturn is underway. Two contributions to slowing labor force growth since 2000  have been the retirement of the baby-boom generation and the slowdown of immigration. The oldest baby boomers are now 70, and the mid-point of the baby boom generation (those born in 1955) reach 62 in 2017.

Meanwhile, we know we have not considered productivity and technological change in this analysis. The question of productivity growth is immensely important, but even more difficult to answer relative to labor force growth as a driver of the economy. In terms of our six-decade view, productivity appears useful in explaining current low interest rates, but not much prior to the current period." - source Société Générale

While Société Générale has an interesting take in relation to demographics, the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality. On top of that we do not agree with Société Générale that real rates have reached a bottom. The effect of ZIRP has in effect pushed many baby boomers to postpone taking their retirement due to lack of returns and until we see a clear change in the Fed's monetary policy, we disagree with Société Générale and do not think workers putting off retirement until later and /or the effects of the baby boomers entering retirement  will be fading anytime soon.

When it comes to Japan and Europe (which is undergoing a clear "Japanification" process), both countries face different inflation expectations than the US mostly due to demographics headwinds as we have pointed out in numerous conversations. Interestingly enough, when it comes to demographics, Japan leading the timing of Europe, it does boast a key advantage compare to Europe which is indeed its much tighter labour market leading to some creeping wage inflation as highlighted by Société Générale Albert Edwards in his latest note from the 26th of October:

"After consolidating around ¥100 for about one year, the yen saw a second step decline in H2 2014 towards ¥125. This additional competitiveness caused Japanese corporate profits to boom. The downside was that household incomes were squeezed as higher import prices pushed up headline CPI inflation - this sounds much like the UK today! Although all this was exactly the intention of government policy, the trick is, like kick-starting a motorcycle, to get this one-off stimulus to profits to fire up the engine into a virtuous wage/price spiral and sustainable growth. And from long experience of kick-starting a BSA 1954 M21 600cc single cylinder, it often takes repeated attempts and bruised ankles to get it fired up - link.
Having driven the yen down towards the key 30-year support level of ¥126 at the start of 2015, the BoJ blew its big chance to drive it down through ¥126. If the yen had broken ¥126, I felt it would have quickly run down to ¥145. But having failed to break below this key support level, this year saw it rapidly head in the opposite direction to peak at ¥100 by June, hence squeezing profits (see chart above) and stalling growth. This led foreigners to take flight by selling a record ¥6tn of Japanese shares in the first nine months of the year. I felt the BoJ had blown their chance of reviving the economy via QE and that Abenomics was doomed.

But I might yet be premature in writing Japan off. One key advantage Japan has in trying to produce inflation is, perversely, its appalling demographics. Why? Because even quite moderate GDP growth has resulted in a very tight Japanese labour market (see chart above), and this has resulted in wage inflation crawling higher. In real terms, wage inflation is now rising above 1% (see charts below – indeed Japan’s real wages are rising faster than the US).

Much to my surprise, despite this year’s H1 yen strength hitting growth badly, the Japanese PMI has actually revived in H2 (see left-hand chart below). But this H2 Japanese PMI recovery may be coming at the cost of the US recovery as PMIs now seem to move inversely (see chart below) – especially with the dollar now surging on expectations of a Fed rate hike).

Leo Lewis of the FT wrote a very interesting Short View, essentially concurring with Andrew’s front page chart, that Japanese companies are heaving with surplus cash. He notes a record high 55 per cent of Japanese non-financial companies now hold more cash than debt, in contrast to less than 20% of the S&P 500. And with valuations where they are (see chart below), which equity market do you think QE has set up to collapse in the next recession?

- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June this year in our conversation "Road to Nowhere":

"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016

We concluded at the time:

"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street".

For Europe, the story is as well different, though from a credit perspective, the on-going Japanification means that Europe, in similar traits to Japan has been deleveraging overall (except Italy and Spain) whereas in the United States and as illustrated by Albert Edwards' note the US has been releveraging thanks to cheap credit and buybacks favoring in the process multiple expansion on a grand scale:

"In a low-growth world, debt is dangerous; in a deflationary world, debt is toxic. Japanese companies, through years of experience, probably understand this and have deleveraged as a result; US corporates, perhaps foolishly, have done the exact opposite.” No “perhaps” about it Andrew. This is nuts!

- source Société Générale

Exactly, in a low yield environment, defaults tend to spike as low yields tend to coincide with higher spreads and default rates. Often low yields are associated with slow growth which eventually should evolve towards wider credit spreads when the credit cycle eventually turns but, we are not there yet. If growth eventually picks up while yields stay low then spreads could indeed normalize but it is not our core scenario.

Why inflation matters therefore? Because in low inflation environment, like the one we are going through often tend to be associated with spiking defaults historically (deflation bust of the energy sector earlier this year).

But, moving back to Europe and its inflation conundrum, when it comes to wage growth, it could put additional pressure on its inflation expectations due to decelerating wage growth as highlighted by Ban of America Merrill Lynch in their Euro Area Economic Watch note from the 28th of October entitled "Wage growth: potential for worse":

"Wage growth: potential for worse

This is a half-hearted labour market recovery

Employment growth in the Euro area is continuing its relatively steady recovery. The number of employees (excluding self-employed) rose 1.7% and 1.6% in 1Q and 2Q16, respectively, predominantly driven by the services sectors. The number of employees is back at 2008 levels now (Chart 1).

However, robust headline employment growth masks a much shallower recovery in hours worked, which continue to stand nearly 4% below their 2008 level in the economy as a whole (Chart 2). 

Meanwhile, Euro area wage measures, including compensation, wages and salaries, contractual wages, etc, continue a gentle downward trajectory. Wages and salaries per employee, for example, slowed to 1.4% yoy in 1H16 on average compared with 1.5% in 2015 and 2.1% on average since 2001.

Some blame sector composition for slower wage growth – we disagree

A predominantly services sector-driven labour market recovery is not surprising given the composition of the Euro area growth recovery: domestic demand components, public and private consumption in particular, are a lot more service-intense than capex or exports. Services, in turn, are more labour-intense.
Some hawkish ECB council members have cited the sector composition of the labour market recovery as the driver of slowing wage growth, as services wage growth typically underperforms that of industry.
We believe this line of argument is flawed and not supported by the data. On the contrary, our findings suggest that wage-setting behaviour may have changed also in the services sector post-crisis, which would be disconcerting. Even if we assume that wage structures did not change, wage growth prospects would still be rather gloomy and under pressure to decelerate further.

Sector drag on aggregate wage levels? Not if you look at hourly wages

Since 2002, the share of employment in industry excluding construction has fallen by more than 4pp to 17% in the Euro area, while that of the services sector has risen 6pp to 77%. We wanted to know if and how much drag this reshuffle of employment poses to average wage levels. To do this, we calculated a counterfactual wage level measure, assuming the composition of employment and the composition of working hours had remained at the 2002 level. Results are shown in Chart 3.

We find that wages per employee are currently some 1.5% lower than they would have been if the sector shares of employment had not changed. The trend has been very steady, however, lowering wage growth per headcount by 0.1pp every year – hardly enough to justify the wage growth deceleration we have seen post-crisis.

Wage growth per employed, however, does not reflect the rise in part-time employment. So we run the same exercise for hourly wages. We find that, if anything, wage levels today are marginally higher than they would have been (blue line in Chart 3). This would suggest that sector composition cannot really be held responsible for what we see in the recovery.

Wage growth has slowed across most sectorsIf sector composition were solely to blame, we would also expect wage growth to have remained intact across sectors, particularly in those where wage growth is typically lower but employment growth currently faster. Again, data suggests that things are not so simple.

Chart 4 shows hourly wage growth in the industry (excl. construction) and services sectors (including the public sector). In both aggregates, dynamics have slowed from pre-crisis standards (although industry wages have continued to decelerate more quickly recently).

We have equally checked standard deviations of wage growth across 10 different sectors at any point in time (grey area in Chart 4). During 2012-14, wage growth was more harmonious across sectors, but it has started to reflect typical dispersion again (as has the differential between the fastest and slowest sector wage growth). This could suggest the entire spectrum has shifted a gear lower.

Slowing wage growth in response to inflation – even in services

Generally, a lower wage level could be “normal” if it results from a) lower productivity growth and/or b) more economic slack now than before. But again we find that more may be at play here, both in the economy as a whole and in individual sectors.

We replicate an exercise we ran over the summer, when we were warning to be vigilant of second round effects of inflation on wages. As a reminder, we had found at the aggregate level that the deviation in compensation growth from its long-term average could be explained by slack (high unemployment), but also larger and more persistent than usual negative contributions of inflation. These, we argued, were tentative signs of second-round effects."  -source Bank of America Merrill Lynch

So, if wages are a backward looking indicator of inflationary pressures and labor markets continue to weaken in the US and in some parts of Europe such as France and oil prices finally recede, we have a hard time buying the stagflationary story for the time being. We also have a hard time buying the Q3 US GDP at 2.9% but that's another story.

What we are seeing we think, is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand. The illustration of buying essential items is clearly shown by Visual Capitalist.com Jeff Desjardins on the 28th of October:
"Prices Are Skyrocketing, But Only For Things You Actually Need

"The average price increase, as shown by the CPI (Consumer Price Index), is 55% over the last 20 years. Meanwhile, the prices of individual sub-categories have a much wider variance." - source Visual Capitalist, Jeff Desjardins.

Of course the consequences of central banks meddling with interest rates is in our mind seeding "The Grapes of Wrath" and is causing biflation to some extent. This is leading to not only rising cross asset correlations as of late between stocks and bonds, but, leading to wider variances and larger standard deviation moves. Instability is not only brewing in financial markets but is leading as well towards instability in various countries and risks of social unrest.

Whereas the United States, Japan and Europe face different situations when it comes to dealing with inflation expectations and wage pressure in conjunction with different demographics, back in October we recommended (a little bit early) to look at US TIPS  in our conversation "Sympathetic detonation" from a great diversification perspective:

"Given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed 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

In March again in our conversation "Unobtainium" we commented that we continued to like US TIPS:

"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?" - Macronomics, 19th of March 2016

So from a biflation allocation perspective, US TIPS still remain particularly attractive particularly given their embedded deflation floor. While "balanced funds" are getting "unbalanced" by recent correlated move downwards for both bond prices and stocks, what is not to like about the lower correlation offered between linkers and equities/sovereign bonds? Inflation-linked bonds still provides you with very interesting diversification benefits. For instance the Ishare TIPS bond ETF exposed to US TIPS has delivered you a total return of 6.53% so far. For the long duration braves out there Pimco's 15 years + ETF has LPTZ has rewarded them with handsome year to date total return after fees of 18.70%. Who said there wasn't sometimes some "embedded" actionable ideas in our musings? We rest our case.

In our final chart, while we have been monitoring the credit cycle as it is slowly turning in this "overmedicated" central bank meddling environment, we continue to look at the slow but evident deterioration in credit fundamentals particularly in the US which has been "releveraging" thanks to cheap credit.

• Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk

While the relentless liquidity provided to the credit markets thanks to Japanese NIRP and the ECB and now BOE being competing with investors in the credit investment world, when it comes to default in a low yield environment, leverage matters and so does credit fundamentals. Our final chart displays US debt growth relative to EBITDA and comes from JP Morgan's Credit and Market Outlook and Strategy note from the 20th of October:

"The ongoing deterioration of credit fundamentals remains the key market risk, however. Debt issuance continues to grow much faster than EBITDA, even if the expected uptick in revenue growth this quarter materializes. Investors are aware of this, but are focused on the strong technicals outweighing these risks. This has been the right view since 1Q of this year. However, our sense is that some investors are uncomfortable with market valuation given these technicals, and if there is a catalyst for a risk off market, this concern about fundamentals would reassert itself.
Fundamental credit metric deterioration is not itself likely to be a catalyst as it occurs slowly and it is difficult to define a red line for specific metrics that causes a problem. A renewed trend of rating downgrades, as occurred in 1Q in the Energy sector, could refocus markets on these risks, but if and when this will happen is difficult to predict." - source JP Morgan

While the party has been running strong "uphill", mostly to the bond market that it, courtesy of the "wealth effect", and not downhill to the real economy, if real assets are positively correlated with inflation and deflation fears are subsiding, we believe that some commodities could stage a comeback, US TIPS will be as well one of the beneficiaries rest assured. Meanwhile, our politicians and central bankers alike have indeed sowed "The Grapes of Wrath", putting financial assets at risk of heightened political backlash from the have not of the real economy namely "Main Street" versus "Wall Street". 

"You will not be punished for your anger, you will be punished by your anger." - Buddha

Stay tuned!

Credit - The Vortex Ring

"When a system is in turbulence, the turbulence is not just out there in the environment, but is a part of the organization or organism that you are looking at." - Kevin Kelly

While looking at the burst of turbulences last week in the credit and government bond high beta space, in conjunction with the expected results coming out of the European elections and given our fondness for "flying" analogies which we abundantly used in our conversation "The Coffin Corner", in this "Tapering" environment we reminded ourselves of the Vortex Ring when it came to choosing our post title. The famous Vortex Ring also known as the "Helicopter Stall" can happen easily under certain specific conditions particularly when approaching landing, as illustrated more recently in the movie Bravo Two Zero when the Special Operations 160th SOAR helicopter came crashing down in Abbottabad during Operation Neptune Spear after experiencing the infamous vortex ring state.

You are probably already asking yourselves where we are going with this analogy already but, given Ben Bernanke's various QE programs have been compared to "helicopter money", we thought a reference to a "helicopter stall" given the Fed's tapering stance would be more than appropriate for this week's chosen title. 

Therefore in this week's conversation we will review various states of central banks at play, between the Fed, Japan and the much expected ECB move in June.

In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust). 

For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":

"To get into vortex ring, three factors must all be present:

• There must be little or no airspeed.
• There must be a rate of descent.
• There must be power applied.

Note that all three of these must be going on at the same time."

• There must be little or no airspeed.

In our conversation"The Coffin Corner" we indicated the following:

"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy."

With the latest reading from the US GDP coming at 0.1% for the 1st quarter indicates for us little or no "airspeed" for the US economy and the aforementioned "economic" stability we mused on last year.

For Europe the latest inflation readings indicates little or no "airspeed" on top of the very weak economic growth reading making it paramount for the ECB to act sooner rather than later in order to avoid the Vortex Ring state.

• There must be a rate of descent.

Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via "helicopter"easing will require interest rate hikes, and will also necessitate asset sales by central banks, according to April's IMF Stability Report. The tapering stance of the Fed does include indeed a rate of descent of $10 billion a month.

Of course another rate of descent which we have been following has indeed been US Velocity. What we have found most interesting is the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3% - Graph source Bloomberg:

It has been downhill from 1997 with velocity falling linked to factor number three of the "vortex ring" namely "There must be power applied" (ZIRP in conjunction with the various iterations of QE).

Yet, the recent fall in unemployment has been masking the Fed's progress in avoiding the dreaded Vortex Ring as seen in the lack of breakout in the employment population ratio. The Fed has not been able yet to reach "escape velocity" from this vortex ring as displayed in the Bloomberg graph below indicative of the conundrum:

The lack of "recovery" of the US economy has indeed been reflected in bond prices, which have had so far in 2014 in conjunction with gold posted the biggest returns and upset therefore most strategists' views of rising rates for 2014 (excluding us given we have been contrarian). Those who read between our lines have done well so far in 2014 given we hinted  a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":

"If the policy compass is spinning and there’s no way to predict how governments 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 governments, the option-value of both gold and bonds goes up."

• There must be power applied.

When it comes to applying power, like many pundits, we have been baffled by the action in US Treasury bond buying from Belgium which increased its holdings in US debt by $201 billion in five months to $381 billion at the end of March this year, making it the third largest holder after China and Japan - graph source Bloomberg:

Helicopter pilot students, have a tendency to slow down, if they are afraid of overshooting their landing point, which can put the helicopter they are flying in a vortex ring state. In similar fashion, central bankers have a tendency to slow down if they are afraid of overshooting. 

It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets as displayed by the below graph plotting the performance of the Nikkei index, the USD/JPY currency pair and the inverse Itraxx Japan indicative of credit risk for corporate Japan:

If one looks at unemployment levels and inflation levels for a gauge of the respective situation of various central banks it seems that, while Japan has achieved full employment, it has failed for many years to spur inflation, while the US as well as the United Kingdom, have achieved to reduce their unemployment levels, Europe is still closer to the Vortex Ring State (deflationary bust) given it boasts very low inflation levels compared to the other G4 and record unemployment level, as displayed in this Barclays graph from their recent Market Strategy note entitled "Japan at the end of the post VAT hike tunnel" from the 26th of May:

"Monetary policy: Potential growth & expected inflation, quantity & quality

Opinion regarding deflation in Japan has long been divided between those who believe the problem cannot be solved by monetary policy alone, ie, potential growth is tied with inflation expectations, and those arguing conversely that inflation is a pure monetary phenomenon that can be controlled by monetary policy independently of potential growth. For some reason, the latter group appears to overlap almost completely with those claiming that the degree of monetary easing can be measured unambiguously via the monetary base (monetarists). We agree with the second group that deflation can be overcome by monetary policy without a change in potential growth, and believe that this is in fact occurring at present. However, we think that the driving force behind the BoJ’s present Quantitative and Qualitative Easing (QQE) is not the quantitative but the qualitative side.

Japanese market participants tend to subscribe to the former view. This may reflect a general feeling based on experience rather than the result of academic study. The nation has failed to quash deflation despite 15 years of sundry monetary easing measures, which may have convinced many that inflation expectations are being affected by factors that cannot be controlled by monetary policy, such as a decline in potential growth (including demographic trends). For those holding to this argument, the opposing view sounds like a vacuous theory ignoring a decade and a half of actual events. In particular, since the majority of those supporting the second view are “reflationists”, who believe monetary policy should give greatest weight to quantity, the two sides basically find themselves talking at cross purposes.

Those taking the former view, which is the market consensus, feel that events in 2001-06 proved that the size itself of the BoJ’s balance sheet has no impact. They claim therefore that if the QQE focuses solely on increasing this volume, it cannot achieve a change in inflation expectations. However, we think instead that the important point is the quality of the bank’s balance sheet; ie, the volume of risk in the bank’s acquired assets. We believe the effectiveness of the monetary easing by the Fed and BOE after the Lehman shock and the rapid turnaround in the Japanese economy after the launch of the BoJ’s QQE stemmed from their purchases of long government bonds and risk assets, pushing supply/demand above levels (in other words, pushing yields below levels) that the economic fundamentals would indicate as fair. The general social principle that economic policy should not intervene in the free market, which prior to the Lehman shock also applied tacitly to monetary policy and financial markets, prevented the BoJ from turning to asset purchases in JGB markets even in deflation-racked Japan. The serious crisis brought about by the Lehman collapse led to market intervention by countries worldwide and a shared belief that the ideology itself needed to change. With the success of this monetary policy approach in the US and UK, the BoJ also shifted its focus from quantity to quality, carrying out a market intervention of unprecedented scale with the QQE.

That is, QQE is a new monetary easing stance that had not been tried in over 15 years of deflation. Still, the markets perceived this to be little more than an extension of previous policy and assumed from past experience that it would have no effect on inflation expectations. A good number of market participants still dismiss the claim by BoJ Governor Haruhiko Kuroda and other BoJ executives that the bank’s 2% price stability target is achievable. Some likely hold the view that the BoJ itself is simply maintaining the 2% target in the hope of raising inflation expectations in the market.

In contrast, we think the bank is conducting an easing policy with entirely different effects than its earlier efforts, and we do not believe its past inability to beat deflation means that it will be unsuccessful this time as well. Furthermore, we suspect that the BoJ itself likely shares this view. Its confidence in the price stability target may well have deepened in light of ongoing developments in the Japanese economy. The statement from last week’s Monetary Policy Meeting noted anew that “QQE has been exerting its intended effects”. As we have explained, we see this not as calculated optimism designed to perk up the Japanese public but as a straightforward reflection of the bank’s actual belief at this time. As long as the bank maintains this stance, we think it is unlikely to alter its monetary policy. At the same time, we believe it will be relatively flexible in adjusting its current policy in the event of any upward or downward risk to the economy." - source Barclays.

When it comes to the US and the United Kingdom, it is interesting to note the very strong correlation between 10 year bond yields throughout the years as displayed in the below graph from Bloomberg comparing yields for UK gilts and US treasuries since March 1994:

And on a shorter time frame since 2011, UK 10 year yields versus US 10 year yields - graph source Bloomberg:

The question on everyone lips is of course who will blink first (raise rates that is), the Bank of England or the US Fed? One thing we are certain of, not anytime soon.

So in relation to the veiled question from our title and from Barclays take, the big question is of course can the "Vortex Ring" (aka deflationary bust) can be avoided by monetary policy alone?

We are still sitting tightly in the deflationary camp and expect further yield compression on US Treasuries. As such, we agree with the Wall Street Rant Blog on that subject:

"Many Government Bonds Yielding Less Than United States

I can't listen to a talking head, bond manager, strategist or seemingly anyone without hearing about how "Rates can only go higher from here". When in reality THEY CAN go lower! In fact, when you look around the world, on a relative basis, THEY SHOULD!" - source Wall Street Rant Blog

Indeed they should. To add ammunition to this, one should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower, in particular its upcoming reforms and asset shift scenarios as reported by Nomura in their recent report from the 23rd of May:

"The yen bond market remains range-bound as market participants’ interest in Abenomics and expectations of additional BOJ action fall. The consensus view is that the USD/JPY outlook is dependent on the US economy and yields. However, it is increasingly likely that the government’s June growth strategy will exceed market expectations, which have dropped markedly. We are focused on the likely scenario that the GPIF and other public pensions will start shifting from a yen bond bias in the near future. In our upside scenario, these reforms would lead to approximately JPY20trn in foreign securities investment in the next 12-18 months, potentially weakening JPY by about 10%." - source Nomura

Here are the two potential "re-allocation" scenarios according to Nomura's paper:

"As of end-

December 2013, the GPIF had JPY128.6trn ($1.3trn) in managed assets. Of 

the three associations, KKR had JPY7.8trn ($78bn), Chikyoren had JPY17.5trn ($175bn) 

and Shigaku Kyosai had JPY3.6trn ($36bn, all as of end-March 2013). Total managed 

assets for the four pension funds amount to almost JPY160trn ($1.6trn). The GPIF has 

attracted the most attention because of the sheer scale of its assets, but the three 

associations manage about JPY30trn or $300bn in assets.

The GPIF‟s weighting of Japanese bonds had fallen to 55% as of end-December 2013. It was reported that after the Industrial Competitiveness Council‟s follow-up section meeting on 8 April, the GPIF‟s head office explained that this weighting had dropped to 53.4% on the withdrawal of pension benefits. Thus the weighting of Japanese bonds is already below 55% and could be nearing the 52% floor of the allowable deviation. At the same time, the weighting of Japanese equities stood at 17.2% at end-December 2013, close to the maximum allowable deviation of 18%. Foreign bonds. weighting was 10.6%, close to the standard median value of 11.0%. At 15.2%, foreign equity's weighting is still some way from the maximum deviation (17.0%). Trends in the weightings of Japanese bonds and Japanese equities suggest that, as described in the FY14 investment plan, the GPIF has already been investing flexibly within the permissible range of deviation, and it may be investing such that the respective weightings do not approach the median value. As the strong equities/weak JPY trend has continued since end-2012 and the fund has changed its basic portfolio in June 2013, the GPIF.s portfolio is already shifting gradually from domestic bonds to risk assets.

Asset shift scenarios based on the new basic portfolio

We look at simulations for fund shifts following changes in the basic portfolios of the GPIF and the three public pension funds, in line with two scenarios, based on their current portfolios as described above. In Scenario (1), the four funds lower the weighting of Japanese bonds to 40% and allocate 8% of the money thus freed up to Japanese equity (from 12% to 20%) and 6% each to foreign bonds (11% to 17%) and foreign equity (12% to 18%), as Panel Chairman Takatoshi Ito recommended. Scenario (2) assumes more moderate changes, with the Japanese bond weighting lowered 10% to 50%, the Japanese equity weighting raised 4% (12% to 16%) and the foreign bond and foreign equity weightings raised 3% each (from 11% to 14% and from 12% to 15%). As we expect a compromise between the stance of President Mitani, who is cautious about portfolio changes, and Mr. Ito, who is more aggressive, a reduction in the Japanese bond weighting to about 50% is close to our main scenario for now. If the aggressive scenario (1) advocated by Mr Ito is realized, the GPIF.s balance of Japanese bond holdings would drop by about JPY19.6trn ($196bn), from JPY71.0trn ($710bn) at end-2013 to JPY51.4trn ($514bn). This JPY19.6trn decrease would translate into a JPY3.6trn ($36bn) increase in Japanese equity, a JPY8.3trn ($83bn) rise in foreign bonds and a JPY3.6trn ($36bn) increase in foreign equity. This scenario assumes that the weighting of short-term assets would recover to 5% of the basic portfolio, with short-term assets rising by JPY4.1trn ($41bn). Assuming that the ratio of short-term assets is fixed at the 1.8% level of end-2013 and that money is allocated to risk assets, the increase in respective assets would expand accordingly. When including the three public pension funds, the decrease in the Japanese bond balance would balloon to JPY26.8trn ($268bn), and the funds could allocate JPY5.8trn ($58bn) to Japanese equity, JPY10.8trn ($108bn) to foreign bonds and JPY6.0trn ($60bn) to foreign equity.

In Scenario (2), the GPIF.s and three public pension funds. balance of Japanese bond holdings would decrease about JPY11.1trn ($111bn). The GPIF.s Japanese equity weighting has already increased to 17.2%, so if we assume that it returns to the median after the basic portfolio change (16%), the balance of Japanese equity would fall about JPY0.5trn ($5bn). At the same time, the balance of foreign bonds would rise by JPY6.1trn ($61bn) and the balance of foreign equity would increase about JPY1.2trn ($12bn).

The above figures are rough estimates that do not take valuation gains or losses into account. Amounts may also differ considerably depending on fluctuations in short-term assets and investments within the permissible range of deviation. As noted above, our main scenario at this point expects changes in the basic portfolio to be around the scale of Scenario (2) in the near term. However, in what we can Scenario (2)-2, we assume that Japanese bonds account for 50% of the basic portfolio, the permissible range of deviation expands to }10“, the ratio of risk assets is kept higher than the median value to avoid a sharp drop in Japanese bonds as a result of a sharp acceleration in the inflation rate, and the weighting of short-term assets is kept at about 2% (permissible range of deviation from median value set at -10% for Japanese bonds, +5% for Japanese equity, +4% for foreign bonds, 4% for foreign equity and -3% for short-term assets). In this case, similar to Scenario (1) the balance of Japanese bonds held by the GPIF and the three public pension funds would decrease by JPY26.8trn ($268bn), the balance of Japanese equity would increase JPY7.4trn ($74bn), the balance of foreign bonds would rise JPY12.4trn ($124bn) and the balance of foreign equity would increase JPY7.5trn ($75bn). At first glance, Scenario (2) looks like a conservative change, but depending on the actual stance on investments after the basic portfolio is changed, the asset mix could be significantly changed as envisioned by Mr. Ito." - source Nomura

No wonder peripheral bonds in Europe have been benefiting from Japan's appetite as displayed by Bloomberg's recent Chart of the Day entitled "Euro-Area Periphery Hooked on BOJ stimulus":

"The CHART OF THE DAY shows Europe’s peripheral bond rally stalled this month as the yen strengthened versus the euro. Last week the Bank of Japan refrained from adding to the 60 trillion yen ($589 billion) to 70 trillion yen poured into the monetary base each year that has encouraged Japanese investors to put money into higher-yielding European assets.

“Peripheral yield spreads appear vulnerable to a correction following the strong rally and the yen tends to often strengthen on credit risk,” said Anezka Christovova, a foreign- exchange strategist at Credit Suisse Group AG in London.

“Japanese portfolio flows usually have an impact. Those flows could now divert elsewhere. We don’t expect any substantial action from the Bank of Japan in coming months and that could also lead the yen to strengthen.”

Japanese investors bought a net 1.41 trillion yen of long-term foreign debt in the week ended May 16, the most since Aug. 9, data from the finance ministry in Tokyo showed on May 22.

Flows into Europe may be tempered as yields in Europe’s periphery climb. The average yield spread of 10-year Portuguese, Greek, Spanish and Italian bonds over German bunds has risen 20 basis points this month to 270 basis points, after touching 239 basis points on May 8, the lowest since May 2010, based on closing prices.

New York-based BlackRock Inc., the world’s biggest money manager, said on May 8 it had cut its holdings of Portuguese debt, while Bluebay Asset Management said on May 9 it had seen the majority of spread tightening it was looking for.

Trading euro-yen based on movements in the bond-yield spreads of the euro area’s peripheral nations would have been a successful strategy, Credit Suisse strategists, including Christovova, wrote in a May 21 note." - source Bloomberg.

It is worth noting Japanese have bought a record $86 billion of US treasuries in the last 12 months according to Bloomberg data. It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998,  as per monthly data compiled by Bloomberg showed recently. So if the GPIF starts deploying its "allocation firepower" in June, maybe you ought to cling to your US treasuries a little bit longer, and maybe after all the Belgian central bank is just a very "astute" investor after all...

One thing for sure our "Generous Gambler" aka Mario Draghi has shown he is truly a magician when it comes to driving market expectations and given all of the above, maybe just a few tricks such as a rate cut and negative deposit rates will do the trick nicely to provide continued support for European government bond markets. Eurozone-residents' demand for foreign assets could be further extended and exacerbated if the ECB were to try introducing negative rates on deposits rather than the proverbial QE bazooka unless of course he goes for the €1 trillion option. The current account excesses which so far have been supportive of a strong euro versus the dollar have been the result of Eurozone residents wish of increasing savings as security against an uncertain future. The willingness of Eurozone residents to accept net receipts of foreign-currency assets  has weighted on the value of the euro in recent years and has forced the current account into surplus. Given that surplus it seemed unlikely for us until recently that the euro would fall much against other currencies unless credible fears of currency break-up re-emerge. Of course the latest European elections results could has well re-ignite fears in the coming months and allow for Mario Draghi to enjoy a depreciation of the euro without having to resort to the proverbial QE bazooka in conjunction with the help from the Japanese pension funds allocation.

In recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have significantly diverged as displayed in the below Bloomberg chart:

Mario Draghi is definitely the greatest central bank magician and probably an astute student of Sun Tzu and the Art of War we think:

"The best victory is when the opponent surrenders of its own accord before there are any actual hostilities... It is best to win without fighting." - Sun Tzu

It is as well probably worth taking Sun Tzu's wise quote in anticipation of the next ECB meeting:

"All warfare is based on deception. Hence, when we are able to attack, we must seem unable; when using our forces, we must appear inactive; when we are near, we must make the enemy believe we are far away; when far away, we must make him believe we are near."

On a final note, when it comes to avoiding the dreaded helicopter stall aka the Vortex Ring,  as per Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'" it is supposed very easy. It wasn't for the ace helicopter pilots of the 160th SOAR during Operation Neptune Spear, There is "no easy day", same goes with QEs:

"It is actually very easy to get out of vortex ring… at least in the incipient stage when the juddering and yawing starts. Some say it is impossible to get out of the fully developed state, but when you start to perceive signs of vortex ring, all you need to do is remove one of the three factors noted above. So, you push the cyclic forward to increase airspeed, or lower the collective to reduce power.  It is not possible to reduce the rate of descent to stop vortex ring, as that would involve increasing power.  In practice, pilots usually increase the airspeed, as unless the helicopter is very high, you don’t want to lower the collective and risk hitting the ground!" - source Helen Krasner - Decoded Science - January 8, 2013.

Unfortunately, getting out of vortex QE ring won't be that easy rest assured, particularly given we have not been in the incipient stage given Japan, the Fed and the Bank of England have all been repeated "QE offenders", but we ramble again...

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong

Stay tuned!

Credit - The Dunning-Kruger effect

"The truest characters of ignorance are vanity and pride and arrogance." - Samuel Butler, British poet

Watching with interest the impressive volatility in the bond space which has yet to normalize, we thought this week we would use a reference to human psychology in our reference title, given so far our "Central Bankers" mind tricks (call them jedi skills if you want) seems to differ widely, between the Fed and Bank of Japan, between the Bank of England and the Reserve Bank of Australia, and the ECB of course.

For those who have been following us, you know that like any good cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. 

So why our chosen title you might rightly ask?

"The Dunning–Kruger effect is a cognitive bias in which unskilled individuals suffer from illusory superiority, mistakenly rating their ability much higher than average. This bias is attributed to a metacognitive inability of the unskilled to recognize their mistakes" - source Wikipedia

When one look at how central bankers have been previously apt in preventing formation of asset bubbles or identifying asset bubbles, one can easily be drawn to the Dunning-Kruger effect given that ignorance of standards of performance is behind a great deal of incompetence.

Of course we are not surprised to see the Dunning-Kruger effect at play, given it is a continuation of the "Omnipotence Paradox" of our central bankers or deities:

"In similar fashion, the financial crisis and the consequent burst of the housing bubble which had taken aback the beliefs of some forefront central bankers such as Alan Greenspan; have clearly shown that Central Banks are not omniscient either (omniscient being the capacity to know everything that there is to know).

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief." - Alan Greenspan -  October 2008." - Macronomics, 18th of November 2012.

In the Dunning-Kruger effect, for a given skill, incompetent people will:
"1.tend to overestimate their own level of skill;
2.fail to recognize genuine skill in others;
3.fail to recognize the extremity of their inadequacy;
4.recognize and acknowledge their own previous lack of skill, if they are exposed to training for that skill." - source Wikipedia

In continuation to our "Omnipotence Paradox" conversation,  we believe this time around that the Dunning-Kruger effect can explain the failures of some economic school of thoughts, namely the Keynesian school of thought and the Monetarist School of thought. We have argued in our conversation "Zemblanity", when looking at the evolution of M2 and the US labor participation rate that both were indicative of the failure of both theories:

"Both theories failed in essence because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows"."

"Credit growth is a stock variable and domestic demand is a flow variable" as indicated by Michael Biggs and Thomas Mayer in voxeu.org entitled - How central banks contributed to the financial crisis.

Obviously one can posit that not only do our central bankers suffer from the Dunning-Kruger effect but they are no doubt victim of the well documented "optimism bias" which we discussed in our "Bayesian Thoughts" conversation:

"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. 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."

Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

We have on numerous occasions discussed shipping as being not only a leading credit indicator (with the collapse in European structured finance) but as well a leading economic growth indicator (on that subject please refer to "The link between consumer spending, housing, credit and shipping"), in our "Bear Case", excess capacity and a weak global economy with a China slowdown will drive rates down even with price increases, pressuring margins - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark rose 21.8% to $2,236 in the week ended July 3, as a $400 rate increase went into effect. Rates are 11.2% lower yoy, as slack capacity pressures pricing. With four increases in 2013, rates are up 1% ytd. Carriers are expected to implement a $400 peak season surcharge ahead of back-to-school and holiday shopping on containers from Asia to all U.S. destinations, effective Aug. 1." - source Bloomberg.

Not only slack capacity are pressurizing pricing in the shipping space but in general, we have long argued that overcapacity has been plaguing various economic segments such as the car industry with European car sales back at 1993 sales levels (on that subject see our 21st of April "European Clunker" conversation), but with the incoming threat of a China slowdown or even hard landing, metal prices such as Aluminum prices are indicative as well of the great deflationary forces at play and the overcapacity fuelled by "cheap credit" (the Baltic Dry reached 11,783 on May 20, 2008 and is now at 1103) - graph source Bloomberg:

"Aluminum prices, which have fallen for three straight quarters, may be poised for further declines as new production in China and the Middle East increases global output even as Alcoa Inc. trims capacity.
The CHART OF THE DAY shows production has gained 5.1 percent since the end of 2011, helping drive prices down 9.3 percent, according to data from the International Aluminium Institute. Output will reach a record near 50 million metric tons this year, up from 45 million in 2012, Harbor Intelligence forecasts.
“The market is still looking at over-capacity, over-production and an unprecedented overhang of metal,” said Jorge Vazquez, a managing director at Austin, Texas-based Harbor. “There’s a lack of credibility for the producers, and even if these cuts take place, investors expect nothing to change.” Alcoa, Aluminum Corp. of China Ltd. and United Co. Rusal, the world’s largest producer, are among companies trimming capacity amid ample supplies. The price outlook remains “depressed” as some investors are concerned that producers won’t follow through on planned cuts and amid the prospect of new and expanded plants and restarts at some older sites, Vazquez said.
Aluminum for delivery in three months on the London Metal Exchange dropped 12 percent this year to settle at $1,832.50 a ton yesterday. The metal may fall to $1,675 in the next few weeks said Vazquez, who expects supply to exceed demand by 350,000 tons in 2013 for a seventh straight year of surplus." - source Bloomberg.

Of course our "omnipotent" central bankers "fail to recognize the extremity of their inadequacy" in true Dunning-Kruger effect as far as "cheap credit" and "bubbles" implications are concerned. They have even come up with a new marketing campaign as of late "forward guidance" in Europe.

Forward Guidance:
"Forward guidance arms central banks with fresh ammunition even when they have lowered short-term interest rates close to zero. It allows them to influence not just current rates but those stretching into the future through pledges to keep them low. The forward guidance can be for a period of time or it can be linked to specific indicators, such as an unemployment-rate threshold (which is not, however, a trigger) in the case of the Fed." - source The Economist

Fresh ammunition? Yet another demonstration of the Dunning-Kruger effect at play we think. Thank god, our "central bankers" are not in the guide dog training business to lead blind and visually impaired people around obstacles...
"Forward Guidance" might be as effective as using a "Yorkshire Terrier" as a guide dog, instead of the usual Labrador retriever. The "Yorkshire Terrier" could be trained to do the job, but would they really be effective? We wonder and ramble again.

Unemployment-rate threshold? As we have argued in "Goodhart's law":
"Conducing monetary policy based on an unemployment target is, no doubt, an application of the aforementioned Goodhart law. Therefore, when unemployment becomes a target for the Fed, we could argue that it ceases to be a good measure." - Macronomics, 2nd of June 2011

In this week's conversation, we would like to focus our attention to the "Bail-in" effect and the recent clarifications made surrounding financial subordinated debt instruments which have long been a pet subject of ours ("Subordinated debt-Love me tender?") given the "Bail-in" conversations which took place on the 26th of June (BRRD) which we touched last week, will have as well  "ripple" effects in the subordinated credit space but first our market overview.

The US dollar still rising against one of the most impacted asset commodity classes since the beginning of the year namely gold - graph source Bloomberg:

The greenback is still benefiting from the surge in bond volatility which has yet to recede.

The "Daisy Cutter" effect as displayed by the evolution of the Merrill Lynch MOVE  index, which is still showing sign of high volatility in the fixed income space as witness this week and CVIX indices closely followed by the recent rise in the VIX index - graph source Bloomberg:

No wonder interest rate sensitive asset classes such as Investment Grade Credit and High Yield are as well suffering from the increased turbulences as displayed by the price evolution of the most liquid and active ETFs in the credit space namely the LQD (Investment Grade) and HYG (High Yield) ETFs, graph source Bloomberg:

In the HY Fixed Income space HYG (iShares $ High Yield Corporate Bond, Expense Ratio 0.50%) has lost $1.78 billion year to date in terms of net redemption flow.

In terms of weekly allocation trends, bond market outflows have jumped in the week of the 27th of June until the 3rd of July as reported recently by Nomura's Fundflow insight published on the 5th of July:

"Asset allocation trends: Bond market outflows jumped/money market turned to inflows
- Bond market: -USD28.1bn vs -USD8.0bn in the previous week
- Money market: +USD7.7bn vs -USD25.1bn in the previous week
For the week ending 26 June, the bond market reported outflows for the 4th week in a row — the longest streak since August 2011. Despite bond market outflows easing slightly in the week before, the latest outflows jumped more than 3x to USD28.1bn from USD8.0bn in the previous week. In contrast, the money market turned to mild"- source Nomura, Fundflow insight, 5th of July 2013.

With the recent surge in both US Treasury yields courtesy of a better than expected Nonfarm payroll number coming at 195 K and in oil prices thanks to increased tensions in Middle-East, we wonder how long equities  in general and the S&P in particular will stay immune from the growing nervousness - graph source Bloomberg:

The latest "Forward guidance" European marketing stunt is no doubt meant to prevent a dramatic repricing in the European government space and avoid the trigger of the much "hyped" OMT. The volatility jitters in the bond space, have led to a surge in European Government Bonds yields in the process as indicated in the below graph with German 10 year yields rising towards the 1.70% level and French yields now around 2.30% - source Bloomberg: - graph source Bloomberg:

Of course our "omnipotent" central bankers in Europe had to come up with another playing trick up their sleeves, given as we indicated in last week's conversation, contagion risk is now bigger than ever and the customer/investor security system is now weaker than ever because the LTROs have encouraged banks to increase even more their holdings of government debt to fund fiscal deficit, making them in the process even more "Too-Big To Fail". Yet another demonstration of the Dunning-Kruger effect.

The issue of course is "convexity", given the debt levels for both the private sector and the public sector are high in most developed countries meaning their economies are now even more sensitive to interest rate risk courtesy of global ZIRP! The more sensitive their economies get, the more solvency risk you have, the greater the risk of a sudden spike of defaults you get in a low yield environment with surging yields.

Back in November 2011, we posited the following in our conversation "Complacency":
"In a low yield environment, defaults tend to spike. Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation."

"Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - Morgan Stanley - "Understanding Credit in a Low Yield World.


Moving on to the subject of the "Bail-in" factor and the financial subordinated credit space, given it has gathered much attention in the bank credit analysts sector as of late with very diverging views on the future for legacy subordinated Tier 1 securities, a subject which warrants some attention.

For instance Morgan Stanley on the 25th of June, in their European Banks note entitled "Get Ready: Regulatory Rating Par Calls Soon" argued the following:
"We have long been cautious on high cash price regulatory and rating par calls (see Reg Par Calls:
Closer, October 12, 2012, and The End of RAC Tier 2, April 2, 2013). The finalisation of CRD IV and S&P’s decision on RAC methodology mean possible calls are weeks away.
About 60 Tier 1 bonds have reg par call language (RPC) in our space, which means that if regulations change and bonds lose their Tier 1 regulatory status, they can be called at par. More than half of these RPC bonds are currently trading above par, leaving scope for significant downside from here.
Deutsche could be the first RPC next month… As we believe it will be able to trigger the reg par call of its €9.5% and €8% retail prefs as soon as CRD IV/CRR is published in the Official Journal of the EU, on June 27, which marks the end of the legislative decision-making process. At current levels, the yield to call in, say, a month is -26% for the €9.5% and -37% for the €8%. Bondholders risk losing up to 8 points in a day if the RPC is exercised.
… affecting all RPC bond pricing negatively, in our view. The language of nearly all other RPC bonds is far less clear than Deutsche’s, and such ambiguity could bring legal challenges many of these issuers (if not all) would not want to risk. However, particularly in today’s kind of market, we believe that many holders will simply take fright and it’s hard to say how much above par any bid might be, following a potential par call by Deutsche." - source Morgan Stanley

We were quite baffled by Morgan Stanley's note given we have been watching liability management exercise for a while in the European banking space and we completely disagree with their take on Tier 1 securities trading way above par that could be rapidly called by their issuers. For us, it doesn't make sense as we indicated in our conversation "The Doubt in the Shadow" on the 23rd of March 2013:
"Banks may have an incentive to buy back non-compliant Basel 2.5 hybrids that do not qualify as regulatory capital under Basel 3. To the extent that such "liability management exercises" can result in debt being repurchased at a discount to par (well below a cash price of 100), banks are able to generate common equity Tier 1 (CET1) gains. On that subject see our October 2011 conversation "Subordinated debt-love me tender?"."

Our views have been comforted by Bank of America Merrill Lynch note entitled "Bail-in: the ripples" from the 1st of July:
"Reg par calls – still a no-no?
The new need to have a bail-in buffer if anything supports the idea that the banks need to hold onto their existing subordinated debt and would be ill-advised to rush to redeem it, even if it optically appears to be expensive. The work we have presented on the need for bail-in buffers only underlines that European banks need to retain and rebuild capital, not redeem it, in our view. Why would a regulator permit the calling of an old Tier 1 bond just because it was ‘expensive’ to the bank? We think the emphasis on retaining capital until the banks are more comfortably positioned will remain for the foreseeable future so our base case remains: No reg par calls." - source Bank of America Merrill Lynch.

Morgan Stanley is putting the cart before the horse and we also agree with the below extract from Bank of America Merrill Lynch note:
"European banks’ need to retain and rebuild capital not redeem it. Why would a regulator permit the calling of an old Tier 1 bond just because it was ‘expensive’ to the bank? They would wish to see such a bond being replaced. If we were regulating the banks, we’d also like to see the banks issued the replacement capital prior to our allowing them to call the old." - source Bank of America Merrill Lynch

On top of that it seems to us Morgan Stanley's is not taking into account earnings boosting technique of FAS 159 which allows banks to book profits when the value of their bonds falls from par, meaning for us, that banks will be encouraged to issue more loss absorbing subordinated debt rather than reduce their buffer to avoid having senior unsecured bondholders or unsecured depositors paying the piper like it happened in the Dutch SNS case in the first instance due to lack of deliverables for the CDS trigger, and in the second case like it happened in Cyprus due to lack of sufficient subordinated and senior unsecured bonds buffers.

So what is the "ripple" effect of the latest "Bail-in" discussions for senior debt and legacy subordinated debt?
"But this brings us to the ripple effect: if banks need to focus on building this buffer, we believe it will prima facie entail potentially some new sub or bail-in bond issuance.
What about retaining the existing subordinated stock though where it is evidently cheaper than issuing new stuff? We are thinking particularly of low-back end Tier 1 bonds but there are also fixed-to-float UT2s and arguably even the dated LT2s too. It makes sense to keep these outstanding forever, arguably, or at least until such a time that the spreads on e.g. bail-in bonds are comparable to those low back-ends (which may, equally, be never of course). 
This is a totally separate discussion to whether the bonds in question are included in regulatory capital. Eventually, very little of the old stock of Tier 1s, Upper Tier 2s and Lower Tier 2s should there be any long-dated enough will ‘count’ as regulatory capital. But there is a role now for all these instruments in the liability buffer above own funds that perhaps they didn’t have before last Thursday. What sense for Credit Agricole to call the €4.13% Tier 1 bond with a back-end of +165bp? Or for BNP to call the US$5.186% bond with a back-end of +168bp? How to justify retiring these bonds which are subordinated and – indeed – loss absorbing – to expose senior bondholders to potential losses? A call of these bonds would look like negligence to us, if it increased the risk that senior bondholders would be bailed-in." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch's take on the subject. From a regulatory perspective and in relation to increasing capital buffers, previous bond tenders have shown that there is a greater call risk with low back-end bonds (convexity issue) and those trading below par:
"In most cases, that CRD 4 is now European Law. It must be domestic law too. It will take several countries some time to put CRD 4 into their own law. So in most cases, there is no immediate threat of a reg par call because there isn’t even the legal basis yet for one." - source Bank of America Merrill Lynch

What is the risk for senior unsecured bondholders and the implication of having low subordinated bond levels buffers for some European banks?
Here is Bank of America Merrill Lynch take on the subject:
"If banks don’t build up their buffers and appear to have no intention to either, then their senior will widen towards their sub and the sub-senior curve (in cash) will flatten at wider levels, mutatis mutandis, we think. Current CDS contracts may not be a reliable indicator of this of course, since they are locked in their own technical until the new contracts come into being in September" - source Bank of America Merrill Lynch

We could not agree more. Of course current CDS contracts are not yet reliable indicators of this risk until the much anticipated need to revamp CDS contracts in September. For more on the importance of this issue please refer to our conversation "The Week That Changed The CDS World" from the 26th of May.

So all in all, Morgan Stanley as put the horse before the cart, and in the case of financial subordinated bonds has even jumped the gun as indicated by a JP Morgan's note from the 5th of July entitled "Tier 1: Upgrade to Overweight":
"The clarification that legacy Tier I instruments will not be eligible as Tier II capital under transitional arrangements will be an undoubted positive for valuations as this will increase the certainty of call being exercised. Whereas previously our assumption was that the Tier I instruments would be eligible as Tier II capital, making the decision to call such instruments dependent on the relative cost of issuing Tier II capital instruments, the fact that the legacy Tier I instruments will not have any regulatory capital value will imply that it will merely be a question of comparing the post-call spread on the instrument versus the cost of senior funding. Under these circumstances, we assume that the issuers will have much lower incentives to maintain these instruments outstanding and as such, the certainty with regard to call has to increase. This would also be applicable for issuers such as DB which in the past have used economic rationale to justify the calling or not of Tier I instruments." - source JP Morgan

On a final note, we have always lacked conviction in the great rotation story from bonds to equities which has been put forward since the beginning of the year. As displayed in the below graph from Bloomberg, the rotation to stocks from bonds has been indeed less than great, so has been QE to the "real economy" courtesy of the Dunning-Kruger effect:

"Anyone who expects U.S. individual investors to push stocks higher by moving away from bonds may end up disappointed, according to Vadim Zlotnikov, Sanford C. Bernstein & Co.’s chief market strategist.
The CHART OF THE DAY illustrates how Zlotnikov drew his conclusion, presented in a report yesterday. He tracked the value of equities, owned directly or through funds, as a percentage of household financial assets. Stocks were 39 percent of assets at the end of March, according to data that the Federal Reserve compiles quarterly. The figure was the highest since 2007 and surpassed an average of 29.2 percent since 1950, as shown in the chart. “U.S. households’ exposure to equities is already above historical levels,” the New York-based strategist wrote. “With rates likely to rise over the next 12 months, the case for a rotation from bonds into equities may become less compelling.” Average inflation-adjusted returns on U.S. stocks are negative 2.3 percent a year when bond yields increase at an annual rate of more than 1.3 percentage points, he wrote. The calculation is based on performance from 1871 through April of this year.
Betting against stocks with relatively high dividend yields may pay off as rates increase, Zlotnikov wrote. These shares are 20 percent more expensive than their industry peers on average when judged by ratios of price to book value, or the value of assets after subtracting liabilities, the report said." - source Bloomberg

"Real knowledge is to know the extent of one's ignorance." - Confucius

Stay tuned!