Macro and Credit - The Ultimatum game

"Never accept ultimatums, conventional wisdom, or absolutes." -  Christopher Reeve, American actor

Looking at the United Kingdom under the guidance of Prime Minister Theresa May moving towards "hard BREXIT", we decided this time around, when it comes to selecting our title analogy to go for the "Ultimatum game", which is a game in economic experiments. In this game, the first player (the proposer) receives a sum of money and proposes how to divide the sum between the proposer and the other player. The second player (the responder) chooses to either accept or reject this proposal. If the second player accepts, the money is split according to the proposal. If the second player rejects, neither player receives any money. The game is typically played only once so that reciprocation is not an issue.  Given our fondness for behavioral economic and psychological accounts, our title analogy and the aforementioned experiment suggest that second players who reject offers less than 50% of the amount at stake do so for one of two reasons. An altruistic punishment account suggests that rejections occur out of altruism: people reject unfair offers to teach the first player a lesson and thereby reduce the likelihood that the player will make an unfair offer in the future. Thus, rejections are made to benefit the second player in the future, or other people in the future. By contrast, a self-control account suggests that rejections constitute a failure to inhibit a desire to punish the first player for making an unfair offer. The ultimatum game is important from a sociological perspective, because it illustrates the human unwillingness to accept injustice. The tendency to refuse small offers may also be seen as relevant to the concept of honour. The extent to which people are willing to tolerate different distributions of the reward from "cooperative" ventures results in inequality that is, measurably, exponential across the strata of management within large corporations. Some see the implications of the ultimatum game as profoundly relevant to the relationship between society and the free market, with Prof. P.J. Hill, (Wheaton College, Illinois) saying:

"I see the [ultimatum] game as simply providing counter evidence to the general presumption that participation in a market economy (capitalism) makes a person more selfish."

Given the rise in inequality in conjunction with populism, there is a rising drift between the have and the have not, which is leading for some politicians to somewhat embrace or envisage rebalancing Wall Street towards Main Street in order to avoid capitalism's own demise. As of late we find of interest that, as we posited in our previous musing, the cozy relationship between politicians and central bankers is waning as illustrated by rising criticism coming out from German leaders and directed towards the ECB. But, moving back to "Brexit" and the "Ultimatum game" currently being set in motion, as we posited in our conversation "Optimism bias" from June 2016 from a game theory perspective we indicated at the time:

"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016

While having correctly guessed in 2016 both Brexit and the US election (which earned us some nice bottles of wine from "optimistic" friends), given the English common law system is UK's best export (Singapore, Hong Kong, etc.) as well as its best business friendly feature, we do think that the United Kingdom benefit from first mover's advantage to that respect. Why so?

"Common law as a foundation for commercial economies

The reliance on judicial opinion is a strength of common law systems, and is a significant contributor to the robust commercial systems in the United Kingdom and United States. Because there is reasonably precise guidance on almost every issue, parties (especially commercial parties) can predict whether a proposed course of action is likely to be lawful or unlawful, and have some assurance of consistency. As Justice Brandeis famously expressed it, "in most matters it is more important that the applicable rule of law be settled than that it be settled right." This ability to predict gives more freedom to come close to the boundaries of the law. For example, many commercial contracts are more economically efficient, and create greater wealth, because the parties know ahead of time that the proposed arrangement, though perhaps close to the line, is almost certainly legal. Newspapers, taxpayer-funded entities with some religious affiliation, and political parties can obtain fairly clear guidance on the boundaries within which their freedom of expression rights apply." - source Wikipedia

 "Assurance of consistency" - try to have this in France. It is totally the opposite. As per our previous conversation: 

"The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them." - source Macronomics, January 2017

Hence our long term more favorable view for the United Kingdom and the Common Law premia that needs to be taken into account when it comes to assessing the prospect for the country and its currency we think. 

Furthermore, the Ultimatum game is clearly being played out by president elected Donald Trump with US corporations in his quest to "make America great again". Again, the ultimatum game is profoundly relevant to the relationship between society and the free market economy. As we posited in our conversation "The Great Wall of China hoax", global rise in populism, came hand in hand with lowering the living standards of the average American, and hearing the inaugural speech from president elected Trump on the 20 of January makes it clear to us, that this will have a significant impact on allocations as the Ultimatum game will be starting in earnest:

Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response": 

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

So you already might be asking yourself where we are going with all this, well, we have long argued the following as per our conversation "The Grapes of Wrath" back in October 2016:

"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.

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. Also 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.

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"." - source Macronomics, October 2016.

While the inaugural speech of the newly elected President Trump did focus on bringing jobs back to America and making America first, on that subject we read with great interest our former esteemed colleague David Goldman's take in his latest column published in Asia Times entitled "Donald Trump, American hero" and his take on "productivity":

"The problem is how to protect Americans. The global supply chain is so closely integrated that it is hard to discourage some imports without doing real damage to American industries. The border tax proposed by House Republicans would prevent corporations from deducting imported inputs as costs for tax purposes. For industries like oil refining, that would create enormous distortions, while providing windfalls elsewhere. My own preference would be to use selected tariffs for products that benefit from government subsidies overseas, which is entirely permissible under World Trade Organization rules.
Ultimately, no government can protect American workers unless productivity growth resumes. American productivity growth has fallen to zero for the first time since the stagflation of the 1970s. Without productivity growth, American living standards will fall, irrespective of whether the government pursues protection or free trade. I have argued elsewhere in this publication that reviving military and aerospace R&D is the key to productivity growth." - source David Goldman, Asia Times,  20th of January 2017

There lies the crux of the problem, to make "America great" again, you need CAPEX growth and more importantly, "productivity" growth.

In this week's conversation, we will look at jobs, wages and the difference between Japan and the United States, in relation to the "reflation" story or "Trumpflation".

Synopsis:

• Macro and Credit - The wage / productivity paradox
• Final chart - International trade and Nash equilibrium

• Macro and Credit - The wage / productivity paradox

While we recently used Japan as a base case when assessing the negative impact low rates have had on real estate assets, leading some becoming nonperforming in our recent conversation  "The Great Wall of China hoax", what has been plaguing Japan since they have reached effectively full employment is indeed the outlook for wages. Without wage rising, there is no way Japan can truly break its deflationary spiral and the Bank of Japan create sufficient inflation. This is clearly indicative of the malaise of the Japanese economy. On that subject we read with interest Nomura's take in their Japan Economic Weekly note from the 13th of January 2017 entitled "Outlook for wage rises remains bleak":

"Employers and employees deaf to government's calls for wage rises

No sign of a pickup in the rate of wage rises from New Year events

Prime Minister Shinzo Abe has taken the opportunity provided by New Year events such as those organized by Japan's economic associations to reiterate his calls for companies to raise wages. However, we see no sign from the response of either employers (and their associations) or employees (and their trade union representatives) of any pickup in the rate of wage rises at this year's spring wage negotiations. Any discussion of what is happening to the Japanese economy, inflation, or market factors such as interest rates will have to assume for the time being that there will be no marked increase in wage rises.

Deep-seated reluctance of employers to increase fixed costs

While Japanese business leaders share Abe's positive attitude towards wage rises in general terms, they appear to be slightly less enthusiastic when it comes to putting this into practice. A good example of this is the frequent inclusion by Sadayuki Sakakibara, Keidanren chairman, of the provisos "companies that enjoyed earnings growth last year" and "on an annual pay basis" when expressing his desire for wage rises. We see this as reflecting a deep-seated reluctance by business leaders to increase fixed costs. With companies facing increasing uncertainty, they may well be more reluctant to increase the base pay of their regular employees as this would amount to an increase in fixed costs.

The unions are also cautious about demanding wage rises

A certain reluctance of some trade unions to demand wage rises also appears to be an impediment to a pickup in the rate of wage rises. We think that the cautious attitude of the trade unions probably reflects the less optimistic view that companies now have of their growth prospects as well as the increasing uncertainty they face and that workers and their trade union representatives may tacitly prefer the stability of a job for life to a bigger increase in base pay (see our 21 October 2016 Global Research report Why is wage inflation so low despite a shortage of labor? - The ''base pay wall'' facing the Japanese economy).

Limits to how far working practices can be reformed without freeing up the market for regular employees

In view of the attitude of employers and employees, the only way to overcome obstacles to speeding up the rate of wage rises would be to free up the market for regular employees to make the cost of employing full-time employees a variable cost. Similarly, safety nets such as vocational training and greater provision of unemployment benefits would be needed to overcome the concerns of workers and trade unions about freeing up the labor market for full-time employees. It seems that, as freeing up the market for full-time employees touches on the system of lifetime employment that forms the cornerstone of Japanese employment and working practices, it is off limits for those seeking to reform working practices such as the present government." - source Nomura

Indeed, the cornerstone of the Japanese employment system has long been lifetime employment and a clear impediment in freeing up the market. There is no way the Bank of Japan on its own can fill its inflation mandate without the government stepping in and playing out the "Ultimatum game" with Japanese business leaders. When it comes to the "Ultimatum game" and reflationary policies in the United States, we think that the recent raft of corporations folding under the pressure exercised by Donald Trump is clearly a sign that the new US administration is clearly being serious on its willingness to focus on America and Americans. Obviously this will have significant implications in terms of allocations. Put it simply as displayed by our friend Cyril Castelli from Rcube, rising wage pressures imply lower profit margins:

- source Rcube

End of the day, earnings revisions matter, as they are according to our friend, the best leading indicator for expected cash flows momentum. Negative earnings revisions always imply weakening cash flows and inversely. Also, "Mack the Knife" aka King Dollar + positive real US interest rates is tightening financial conditions globally. Cheap dollar funding has been exported to many Corporate Emerging Markets as highlighted in recent studies completed by the Bank for International Settlements (BIS). 

When it comes to Japan, clearly as indicated by Nomura, the Japanese wage paradox is weighing heavily on inflation, when the country is getting close to full employment (which is not the case in the US regardless of the much vaunted 4.7% unemployment rate put forward by the Fed).  Japan has been a productivity laggard for many years. Japan's labor market is a two-tiered market. There is one group of Japanese workers, called "seishain" which has retained its privileged, old-style jobs comprising job security, benefits and regular raises while the other group is made up of low-security, low-pay, low-benefit, dead-end jobs. These individuals have very little chance of ever jumping up to the "seishain" track. In similar fashion, if someone digs deep into the BLS, one can argue that the US employment market has been facing similar issues since the Great Financial Crisis (GFC). 

On the Japanese conundrum, we read with interest Bank of America Merrill Lynch's take from their Japanese Economics Viewpoint note from the 19th of January entitled "Jobs, wages and the BoJ":

"The biggest medium-term macro surprise?

We believe that the re-acceleration of wage growth could provide one of the biggest macro surprises for Japan in 2017. Investors appear to be increasingly coming around to our view that the Japanese economy is due for a solid, 1.5% pick-up in 2017, up from 1.0% in 2016. However, skepticism around the potential for higher wage growth—the key to Japan’s reflation efforts—runs deep.

Tackling Japan’s wage paradox

The doubts may be warranted, given that wage growth has remained stagnant over the past few years despite the unemployment rate plunging post-bubble lows and business surveys pointing to record tightness in the labor markets. We think the relative weakness of the wage indicators reflects both cyclical and structural factors. On the demand side, the slowdown in the economic recovery after the 2014 tax hike reduced wage pressures. On the supply side, the reserve of lower-paid, part-time and “non-regular” workers meant that there was still some “invisible” slack in the labor sector.

Approaching full employment

However, 2017 could mark an important inflection point as both demand-side and supply-side factors drive the economy towards full employment. We forecast the unemployment rate to drop to 2.9% by the end of 2017, and 2.7% by the end of 2018, from 3.1% today. There is already evidence that remaining labor market slack is quickly diminishing. Moreover, demographic headwinds will begin blowing much harder in the coming years, resulting in tighter labor supply.

Wages growth to double in FY17, reach 2% in FY18 

The FY2017 Shunto spring wage negotiations are unlikely to result in significant base pay increases. But we still see the combination of tight labor supply and stronger demand lifting nominal per worker wages to around 1.4% in FY2017, and close to 2% in FY2018, up from the 0-0.5% pace of the past three years. Adjusting for job growth, we see nominal employee compensation holding steady between 2-2.5% and real employee compensation of around 1.2% over the next two years. This should support consumption.

But patient BoJ to keep rates on hold

Our optimism on the outlook for labor markets and wage growth underpins our above consensus inflation forecasts. We see Japan-style core inflation rising 1.2% in FY17 (0.9% on a CY basis), and 1.5% in FY18 (1.4% on a CY basis). If our forecasts are correct, the risks of early BoJ policy normalization, including rate hikes, may become an important theme in the markets in the second half of this year.

However, we remain of the view that the timing of BoJ “lift-off” remains far away and that the central bank will keep its rates targets under its Yield Curve Control (YCC) framework unchanged through FY2018. Running a “high pressure” economy is the best shot the BoJ has at re-anchoring inflation expectations and reducing future deflation risks." - source Bank of America Merrill Lynch

Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years.

As put forward by Bank of America Merrill Lynch's note, there is a disconnect between job growth and wages in Japan:

"Disconnect between job growth and wages

Investors are often perplexed by the disconnect between Japan’s headline wage data and the relative strength of its labor market indicators. As of November 2016, Japan’s unemployment rate stood at 3.1%, down from 4.1% at the beginning of the Abenomics recovery phase (November 2012). Meanwhile, the job-offers-to applicant ratio has been climbing steadily, reaching the highest level since 1991 (Chart 2). 

Various business surveys also point to record labor market tightness. The employment conditions indices in the Bank of Japan Tankan reflect deep labor shortages, especially among non-manufacturing SMEs (Chart 3).

Despite robust job growth, total cash earnings data in the Ministry of Health, Labour and Welfare’s Monthly Labour Statistics (MLS) have been disappointingly weak. This measure, which tracks nominal wages on a per worker basis—picked up in the initial phase of the Abenomics recovery but has recently weakened and is stuck at around 0.4%, while hourly wage growth is tracking around 1% (Chart 4).

Digging into wage growth by component, the slowdown in 2015-16 was in part due to a collapse in bonuses (which is linked closely with corporate profits) (Chart 5).

But more importantly, the combination of aggressive fiscal tightening, coupled with a downturn in the global export cycle caused Japan’s economic recovery to stall, reducing cyclical wage pressures.

That being said, structural factors may be in play as well. Over the years, wage growth— in both per worker and per hour terms--has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

Part of this reflects a trend rise in lower paid, “non-regular” workers, which include various forms of part-time and temporary employment (Chart 8).

The main split in Japan’s dual labor market is defined by job status. “Regular” workers generally work full time, are directly hired by the employer, and receive bonuses along with a wide range of employee benefits.1 While regular workers enjoy an upward sloping wage curve, reflecting regular, seniority-based pay promotions, the wage curve for non-regular workers is virtually flat, resulting in a huge pay gap—average lifetime income for non-regular workers is about 60% of “regular” workers’ levels (Chart 9).

Please note that due to differences in classification of workers between the MHLW Monthly Labor Statistics and the Ministry of Internal Affairs’ (MIA) monthly Labor Force Survey (which does not cover wage data), from here on out we focus on employment and wage developments of part-time workers, which are a decent proxy for the broader “non-regular” category.

Based on MLS data, the part-time employment doubled from around 15% in March 1990 to about 30% today (Chart 8). The good news is that the pace of increase in the part-timers’ employment share has been slowing, with the rise limited to a relatively modest 1.6ppt between Q3 CY2012 and Q3 CY2016. But even such a small drag represents a powerful drag on headline per worker wages since part-timers receive lower pay and work fewer hours by definition (Chart 10).

On average, the continued shift towards part-time employment has subtracted about 0.5ppt from growth in total cash earnings per worker (Chart 11).

Had the part-time share stayed neutral, per worker wages would be tracking closer to 0.8%YoY—about double the headline figure.

Reasons for optimism

The popular view in Japan seems to be that the Phillips curve is dead and that the weakness in wage growth will remain entrenched. There is also a strong belief that the secular shift in non-regular/part-time employment is unlikely to be reversed any time soon, keeping wage pressures contained. We disagree, and believe that growth in total cash earnings per worker will pick-up from around 0.5% in FY16, to around 1.4% in FY17, before rising to around 2% in FY18." - source Bank of America Merrill Lynch

The reason we have to disagree with Bank of America Merrill Lynch and their reason for optimism comes from our discussion from June 2013 in our post "Lucas critique":

"Robert Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:

"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.

For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia

So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  

In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:

"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia

In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.

The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia 

As we posited at the time, when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it on Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion.

On this occasion, we think's Bank of America Merrill Lynch's optimism is indeed leaning towards naivety because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property. As per our conversation "The Great Wall of China hoax" like in Japan, at some point low-yield assets such as real estate become nonperforming.

Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":

"He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.

“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

So if the "old" like in Japan still predominates the economy, we have a hard time believing the Bank of Japan will be able to control economic outcomes and it appears clear to us that their monetary policies have truly become ineffective.

In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that mattes in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again.

Finally for our final point and given our chosen title, we would like to look at a simplistic international game.

• Final chart - International trade and Nash equilibrium

Given we started our conversation mentioning a game relating mostly to BREXIT, we thought we would end this conversation by looking at the known unknown of what the new US Trump administration stance will be when it comes to international trade. To that effect, our final chart or diagram, comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 20th of January and entitled "The times they are changin' "and looks at international trade from a game theory perspective:

"International Trade game

Consider the following simplistic game of International Trade. Suppose there are two countries that can each choose between the two policies “Free Trade” and “Protectionism”. Because international trade in most circumstances boosts global growth it follows that protectionism is growth negative. Put differently, while in isolation a country can boost economic growth by playing the “Protectionism” card, the associated costs to the other country outweigh these gains. There are four possible outcomes (Figure 2). 

One equilibrium is that both countries agree to play “Free trade” (NW corner of figure), where we say that both have GDP of 10 (arbitrary units). Suppose now that Country 1 unilaterally plays “Protectionism”, in which case the outcome in the short term is the SW corner of the chart where this country boosts GDP by 2 to 12 at the expense of Country 2 that sees a 3 decline in GDP to 7. Note that world GDP declined by 1 as protectionism is distortive and thus creates inefficiencies.

However, the SW corner is not a sustainable equilibrium as Country 2 stands to benefit from playing the “Protection” card as well – i.e., retaliate – as they can increase GDP by 2 at the expense of country 1. That moves us to the SE corner – the “Trade Warfare” outcome - where each country has GDP of 9, a loss of 1 from the “Free Trade” equilibrium. Hence there are only two sustainable equilibria in this international trade game – “Free trade” in the NW corner, if both countries agree and commit, or trade warfare in the SE corner if they do not.

What this means is that the new administration’s intentions to restrict international trade are almost certainly negative for US economic growth in the longer run. Of course what prompted the coming US pushback against imports is that, even though trade boosts the economy, there are winners and losers. Thus we are unable to say unambiguously that the country is better off in utility terms just because that is the case in dollar terms." - source Bank of America Merrill Lynch

If the second country rejects protectionism, like in our case of the Ultimatum game, then neither countries receives any money, and this dear friends means to us lower global trade which is indeed bullish gold, in the end (hence our  recent positive stance), but we ramble again...

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Stay tuned!

Macro and Credit - Empire Days

"No one is free who has not obtained the empire of himself." - Pythagoras

Looking at the misery inflicted to battered German banking giant Deutsche Banks, emerging art getting trounced and the collectible car markets getting frothy (as we predicted back in July in our conversation "Who's Afraid of the Noise of Art?") , with luxury watches sales continuing to be under pressure in Asia, in conjunction with sabers rattling in the unresolved Syria situation and a tense election period in the United States with nationalist pressure on the rise globally, we reminded ourselves of this week title analogy of cold wave French-British group The Opposition's 1985 best album Empire Days. More and more we are convinced than the "statu quo" is failing and as we pointed out in our November 2014 "Chekhov's gun" the 30's model could be the outcome:

"Our take on QE in Europe can be summarized as follows: 

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014

It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "statu quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us.

On a side note, while discussing the US elections outcome with some friends and there "Optimism bias" we reminded them our take on the subject around the time of the Brexit results and our contrarian stance which was indeed prescient:

"While assisting in Paris to the "Brexit conference" set up by our friends at Saxo Bank, one of the members of the audience during the Q&A session pointed out the "accuracy" of the bookmakers for the remain to "prevail". We could not resist but intervene to rebuke that statement by using as an illustration how bookmakers got it so wrong when offering 5000/1 odds at the beginning of the season for FC Leicester to clinch the British football Premier League and still having the odds at 500/1 around October. The biggest liabilities for the bookmakers were accrued at around 100-1 to 500-1. To quote Mike Tyson: "Everyone has a plan 'till they get punched in the mouth". Since that "FC Leicester punch" the longest odds that can now be placed on any event will be 1,000-1 to ensure that the betting company Ladbrokes is less exposed in future to 'black swan' events. We reminded also the Saxo crowd the Nash equilibrium concept, us playing on this occasion the "Devil's advocate". In fact not a single time did the bookmakers anticipated a victory for "Brexit" yet another display of the "Optimism bias"" - source Macronomics, June 2016

To that effect we argued with our friends about how irrelevant the results of the first television confrontation between Hilary Clinton and Donald Trump were and how low were their predictive nature when it comes to finding out about the potential "outcome" of the upcoming US elections. Therefore, given we like to put our money where our mouth is and our  long standing contrarian stance, we decided this time around to place a "friendly" bet with our friends as we argued that Donald Trump has a much higher probability of getting elected (in similar fashion to the "Brexit" base case) as the Mainstream Media (MSM) would like to "spin it". To that effect we bet on a nice bottle of wine for the winner, two friends deciding to take us on so that it's a nice 2 versus 1 situation for the time being.

But, when it comes to our analogy and this week's conversation, whereas everyone and their dog are focusing on Deutsche Bank, we would like to steer our attention to what lies beneath, namely, a dollar squeeze of epic proportion as we mused in our conversation "Singin' in the Rain" back in 2013:

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

It might be that indeed "Deutsche Bank is one of these "big whales" turning belly up, there are indeed increasing signs in Asia and Europe that point to caution given Euro/dollar 3-month FX basis swap widest in 4 years on Deutsche Bank's troubles (-62 basis points). There is something nasty lurking we think. In similar fashion to 2011, regardless of the liquidity provided by the ECB, a widening of Euro/dollar basis swap should always be taken seriously.

Synopsis:

• Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity
• Macro and Credit  - Loan growth under NIRP - The case of Japan
• Final chart: Market’s growing dependence on central bank stimulus means more 
  prone to “corrections”

• Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity

Back in 2011, increasing bank stress during the summer led not only to a widening of credit spreads but as well to a significant widening of Euro/dollar FX basis swap. To that effect, dollar illiquidity was manifesting itself in the FX basis swap market as well as in the CDS space with the European financial sector credit spreads significantly widening until the launched at the end of 2011 of LTROs by the ECB which was followed by the establishment of swap lines between the Fed and the ECB. Many pundits are pointing towards the upcoming reform for Money Market funds in the US as the prime culprit for this impressive spike in the Euro/dollar FX basis swap market. We think there is more to it as per our 2013 worries. As shown by the BIS in its latest quarterly report released this month, "ultra-loose monetary policies" have increased global dollar shortage. The "crowding out" effect from lower yielding Euro denominated assets is pushing investors towards the US dollar in drove such as Japanese Life Insurers as we have shown in various musings. Also we argued in our July conversation "Eternal Sunshine of the Spotless Mind" that Bondzilla, the NIRP monster is more and more "made in Japan" as for Japanese Lifers, US assets remain preferred. Therefore there is a potential "crowding-out" effect we are seeing with rising yields in Europe with an acceleration of their allocation towards the US meaning effectively additional demand for US denominated assets and rising costs for hedging FX exposure. Remember you need to follow "Japanese flows" as they matter a lot.

So when it comes to Deutsche Banks woes and the attention it is garnering, to paraphrase our Rcube friends, when everyone is thinking alike, no one is really thinking. As a reminder, under the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity. When it comes to quantity, the surge of the significant Euro/dollar FX basis swap market is displaying in earnest, a dollar shortage. 

"When a wise man points at the moon the imbecile examines the finger." - Confucius

To that effect, rather to continue musing on European banking woes, deleveraging and "Japanification" this week given we have long been touching on these issues in numerous conversations, to paraphrase Confucius, we would rather steer you towards the moon, namely issues brewing in Asia in general and China in particular. As of late was as caught our interest is the acceleration of ebt-equity-swaps (DES) and defaults in China as reported by Nomura in their note from the 20th of September entitled "Both DES and defaults likely accelerated":

"According to local media today (Caixin, 20 September), the first debt-equity swap (DES) in this round (vs the c.RMB400bn DES in 99s) has been approved, in which half of Sino Steel’s RMB60bn debt could be converted into a six-year convertible bond (ie, c.RMB30bn), while the other half remains debt at a relatively low interest rate, likely at a discount vs the one-year benchmark loan rate of 4.35% pa. For the c.RMB30bn CB, according to the same news article, the first three years would see no conversion, and the conversion would come in the fourth year at the pace of 30/30/40% until the sixth year. 

Meanwhile, Guangxi Non-Ferrous Metals announced its bankruptcy per court release on 19 September, being the first on China’s interbank bond market. On the same day, Dongbei Special Steel also announced a potential default due 24 September, the latest warning after a series of bond defaults. 

The DES ratio reportedly is up to the cash flow coverage of relevant debt, thus it varies for different banks 

Sino Steel has faced default risks since 2014 and the regulators called a meeting to resolve the company’s debt issue, which was chaired by BOC as per the news article above. The debt restructuring plan was finalised early this year, and now reportedly the DES has been approved for implementation. 

Despite an overall c.50% DES ratio for the entire debt of RMB60bn for the Sino Steel group and its subsidiaries, this swap ratio varies according to individual banks, given that cash flow coverage over individual banks’ debt exposure differs, per the media coverage. It seems that loans well covered by collateral and/or cash flow of projects would remain as debt, and it is those loans primarily on credit or guarantee and not covered by cash flow that might be swapped into CB. Capital injections from SASAC were also expected in future, according to the media coverage. 

If the reports are accurate, DES through CB puts less pressure on banks’ capital and they could avoid material write-downs upfront; though debt burden remains in short-to-medium term 

DES triggers concerns over banks’ capital pressure, given that equity investments carry 400-1,250% risk weight vs 100% of loans (see DES: Trade-off between capital and provision, 6 April), and the swap through CB could likely alleviate banks’ capital pressure in the short to medium term, although in the long term capital pressure remains if such investments cannot be disposed of in a timely manner. 

Meanwhile, direct DES of potential bad debt requires either a bailout (like the DES in 1999-2003, Fig. 1) or material write-downs upfront.

Since a bailout for DES has been ruled out this time (Re-rating may start as defaults accelerate, 21 July), banks conducting DES may face material write-downs upfront if the loans convert into equity directly. DES through CB could have given banks more time vs direct swap into equity, and thus could facilitate progress.
For a company involved in DES, however, debt burden likely remains before equity conversion, and when conversion starts, it seems to be selective (eg, just the credit/guaranteed loans, with no underlying cash flow for Sino Steel). 

Reiterate our estimate of limited-scale DES this round 

With a full government bailout, the last round of DES digested c.RMB400bn in NPLs (non-performing loans) from banks, equivalent to c.30% of RMB1.4trn NPLs sold to AMCs (asset management companies) at par value. This time around, we see no government bailout, which makes DES a less attractive option both for banks and for companies, in our view. DES through CB may increase the feasibility of the swap, but long-term capital pressure remains for banks and debt burden remains for companies in the short to medium-term, as analysed above. We reiterate our view that DES is one of the options for NPL digestion in this credit cycle, but it is unlikely to be a primary tool for banks, compared with measures of cash collection, write-offs and sales to AMCs. 

Bond defaults expected to accelerate 

Compared to bank loans, the bond market is seeing a normalisation of risks, with this first bankruptcy case coming through on the interbank bond market today. We still see c.RMB50bn bonds on the watch list, all of which are bonds that have announced defaults but are still trying to work out repayment plans to avoid ultimate defaults, including Dongbei Special Steel as mentioned above. We believe that defaults are positive for the risk normalisation in the bond market, which we hope could lead to better risk pricing and higher liquidity efficiency. 

We see a change in the landscape, though we are cautious, with volatilities likely coming through as well 

As banks turn risk-off in 2Q16, DES were launched to start addressing the SOE debt issue (and may be a prelude to other more marketised deleveraging measures in future), as well as risk normalising on the bond market, we see the landscape change discussed in our 2016 outlook (see Changing the playbook in 2016, 2 November 2015) happening. However, fundamental volatilities may come together in this structural change, and we recommend booking profits on vulnerable banks, like mid-caps. In comparison, ICBC (1398 HK, Buy) remains our top pick, given its tighter risk control and stronger loss-absorbing capacity with decent capital ratios (12.5% CET1 by 1H16). CCB (939 HK, Buy) is the other fundamental pick, for similar reasons (13.0% CET1 by 1H16)." - source Nomura

Whereas prompt restructuring is a welcome feature when dealing with nonperforming loans (NPLs), as posited by Nomura, long term capital pressures will remain. Furthermore, the significant surge in Chinese property prices leading to many pundits talking about a large bubble, means that China needs no doubt to rein in credit growth at the time where credit continues to outpace nominal GDP growth!

Yet in another important report published as well by Nomura, it shows that all isn't that quiet on the Eastern front for some countries. in their September special report entitled "The party is getting crazier – stay close to the door":

"China is borrowing growth from the future 

1. China needs to adjust to the new normal of a persistent slowing in potential growth, as the working population shrinks and the low-hanging productivity gains diminish.
2. China has reached the point where the rubber hits the road: The problems of overcapacity, over-leverage and keeping zombie companies afloat have become so large that they are bearing down on growth via falling returns on capital and rising debt-servicing costs. Leaving it so late, rebalancing away from investment is being forced upon China, and is fraught with risks.

1. Rebalancing and restructuring is likely to hurt growth in the short run, including negative spillover effects on consumption and services. Unsurprisingly, the hardest supply-side reforms – restructuring SOEs, deleveraging and banks properly pricing credit risk – have been left to last. Monetary and fiscal stimulus can buy some time, but they are losing efficacy and can fuel bubbles.

1. For new engines of growth, the economy must be opened up to market forces, but as China is discovering, this is hard at the best of times, let alone when economic fundamentals are weak. History in EM shows that financial liberalisation often precedes credit crunches, banking crises and capital flight.

• We find it striking that the distribution of the latest 2017 growth forecasts display no fattening tail risk of hard landing (i.e., exactly 50% of forecasts are below the median).

• The downside risks to our growth forecasts of 6.5% in 2016 6.1% in 2017 and 5.5% in 2018 include a mass exodus of capital by Chinese residents and snowballing corporate defaults. Upside risks are mega policy stimulus (but this risks creating bigger bubbles) or window-dressing reported GDP (ultimately undermining policy credibility and the chance of policy mistakes).

Four reasons not to overburden monetary policy

1.  Easing monetary policy risks inciting even stronger capital outflows.
2. Aggressive monetary easing risks creating even bigger financial imbalances, since debt and asset prices are interest-rate sensitive. The inflation-adjusted bank deposit rate is near zero.
3. Monetary policy is a blunt instrument affecting the overall economy; it can be less useful when the economy’s performance is more uneven. In 2014, only one of China’s 31 provinces had sub-3% nominal GDP growth; in 2015, eight did, with a total population of 304mn. Also, China’s large manufacturers had a PMI reading of 51.8 in August 2016, compared with 47.4 for small manufacturers.
4. It may be wise to save some interest rate ammo to ease the pain of eventual deleveraging." - source Nomura

One might wonder if indeed it is a case of "Big Trouble in Little China" or "Small Trouble in Big China" but we ramble again. Of course while everyone is focusing on Deutsche Bank, we would like to point out to Nomura's very valid points regarding a potential credit crunch unfolding in Asia at some point from their very interesting special report:

"There is a high risk of a credit crunch in Asia

• The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can activate financial decelerator effects.

• Cheap credit has weakened productivity by misallocating capital (e.g., property speculation), reducing pressure for supply-side reforms and kept zombie companies alive. Potential growth is slowing across most of Asia. 

• Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.

• Potential triggers: faster than expected Fed rate hikes; sharp USD appreciation; large RMB devaluation; a major EM corporate default prompting global asset managers to pull out from the region en masse, causing market liquidity to evaporate; inflation shock in Asia; politics.

- source Nomura

Of course, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring. As a follow up on our HKD take from our  December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. While we won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg back in December last year,we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. maybe it will be for 2017 after all. As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far have not been able to gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals. For a short strategy to succeed, it is much better to hunt as a pack than to be a lone wolf or at least to cry wolf on a specific situation. When it comes to the fate of the HKD peg, Nomura has been solacing again our concerns in their note:

"HK stuck between a rock (Fed hikes) and a hard place (ebbing China)

• Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 109% (the recent correction is reversing), and the ratio of private non-financial credit to GDP has surged to 278%.

• The real effective exchange rate has risen 21% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015, and is no longer a larger buffer to net capital outflows.

• Foreign assets and liabilities have surged since 2008. This leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.

• Economic hardship could ignite further political and social unrest, or vice versa, ahead of the selection of a new chief executive in March 2017. We would not rule out rising pressures on the HKD peg regime.

HKD re-pegged to the RMB? The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed were to accelerate hiking and China’s growth keep slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura.

Back in September 2015 in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.

It remains to be seen, if the recent spike in Hibor rates will not once more put yet again some end of the year additional pressure on the currency peg. We might have been early but, after all, we might not be wrong eventually. We will of course continue to monitor this interesting trend rest assured. End of the day currency pegs like "empires" are not eternal as a reminder:

- source Société Générale

When it comes to Asia, while Japan has been at the forefront of Quantitative Easing for many years, they recently joined the NIRP club in early 2016 on the footsteps of the ECB, in our next point we will look at the impact the policy has had on loan growth and what it entails.

• Macro and Credit  - Loan growth under NIRP - The case of Japan

While we have long been indicating that QEs and NIRP in no way on their own were sufficient enough to trigger a material change in "credit impulse" which would therefore entail a significant change in real economic growth, we find that Japan's recent experiment with NIRP in the footsteps of the ECB is as well a confirmation of the broken credit transmission which has plagued Southern Europe in recent years thanks to bloated banks balanced sheets and the insufficient rapidity with which these NPLs were addressed in both instance but has as well impacted the Japanese economy.

On this particular subject of loan growth under NIRP, we have read with interest yet another note from Nomura from the 17th of September entitled "Loan growth has not changed materially in

real terms":

"The BOJ expects its negative rates policy to boost borrowing by companies and households as loan rates fall, spurring capital investment and housing investment. In this report, we examine changes in loan balances since the negative rates policy was introduced, trends in loan rates, changes in loan demand by companies and households, and changes in financial institutions’ lending stance.We found that growth in bank lending seems to be falling. However, this was largely due to changes in currency exchange rates (stronger JPY reduces the amount of foreign currency lending in nominal terms), while actual lending growth is almost unchanged. Financial institutions appear to have become more aggressive in lending, but corporate loan demand has not changed much, and the increase in loan demand from households was largely attributable to refinancing, with few signs of accelerated loan growth.

Implications and points to watch for in comprehensive assessment 

As noted above, loan rates have fallen since the BOJ adopted negative policy rates, but loan growth has not picked up, which suggests that BOJ policy has only a limited impact on the real economy.
The BOJ cites an increase in the issuance of super-long corporate bonds and subordinated loans as a result of its adoption of negative policy rates, but we believe this has had only a limited impact on the economy overall. The BOJ should also look at the impact that a stronger stock market and weaker JPY could have on the economy.
The BOJ’s main concern has been a deterioration of the financial intermediary function, which could occur if banks tighten their lending (i.e., extending fewer loans, raising loan rates) as loan margins narrow. This has not yet been the case.
The BOJ should quantitatively assess the negative impact of its policy on financial institution earnings and their net capital, and determine how much policy rates can fall before destabilizing the financial system." - source Nomura

As loan margins will continue to narrow, there is a heightened risk that banks could decide to extend fewer loan due to lack of demand or poor profitability, in effect triggering a credit crunch in a context where there is subdued demand for credit overall. This is as well highlighted in Nomura's report:

"According to a survey on major loan trends, loan demand was unchanged for companies (5 in June from 7 in December) and rose sharply for households (9 in June from 0 in December). However, lending to households may have included substantial refinancing demand.
In fact, the key factor cited by financial institutions in explaining the increase in individuals’ demand for capital is the drop in loan rates, not growing housing investment and higher personal spending. Moreover, we believe slow growth in corporate lending likely reflects weak loan demand in the corporate sector, and not so much financial institutions’ stance on lending. " - source Nomura

Weak loan demand means that at the Zero Lower Bound (ZLB) and now NIRP, there is very little monetary policies can do. Now that we have a case of broken monetary transmission to the real economy, there is very little in that context for additional unconventional policies from the Bank of Japan to work their magic on the real economy.

We have already touched on this subject in April in our long conversation "Shrugging Atlas" where we discussed Japan and the kite string theory:

"That is the very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016

We keep hammering this but it seems to us that central banks do not understand clearly the difference between stock and flows. Aggregate Demand (AD) as well as "credit growth" are flow variables, NPLs are stock issues. That simple. Despite aggressive monetary policy easing, the ability of central banks to boost bank lending and hence economic growth is been limited at the ZLB or NIRP level. The basic problem, both with monetary expansion and NIRP, is that the primary transmission channel is via the commercial banks, and that channel has, for a variety of reasons, is broken as we have pointed out in numerous conversations.

Maybe "The Cult of the Supreme Beings" aka central bankers should Bank of America Merrill Lynch's recent primer entitled "How European Banks work" from the 26th of September to fully grasp the stupidity of NIRP in a difficult deleveraging environment akin to adding fuel to the fire they have set up:

"Bank profits leveraged to economic cycle 

Bank profits are naturally leveraged to the economic cycle. Net interest income accounts for c.50% of bank revenues. Increasing this revenue generally involves growing the loan book, which relies on a combination of economic growth and product penetration. Fee revenue also depends on economic activity. On the other hand, economic downturns cause banks to increase provisions for credit losses.

Summary

• Credit risk has a pro-cyclical effect on profits. Credit losses are higher ineconomic downturns
• Credit provisions cumulate on the balance sheet as a negative asset and reduceboth shareholders’ equity and regulatory capital

Banks lend money on the expectation that the full amount is paid back. However, borrowers cannot always pay back all of the money they have borrowed, nor can they always meet their monthly loan costs.
Payment difficulties typically increase during times of economic stress: Individuals may lose their jobs, see a sharp fall in incomes and not be able to cover their repayments. Companies may find reduced demand for their products, affecting revenues and their debt obligations.
Banks are exposed to potential losses, as they may not get back the full amount they initially lent. Once a borrower misses a payment they are said to be “in arrears”. Once they are 90 days behind, the outstanding portion becomes a non-performing loan, (NPL).
Banks must set aside provisions for such losses. These provisions can be large and reduce profits, equity and regulatory capital. While critical to a bank’s health, such provisions are a non-cash item. This undermines the usefulness of cash flow statements for banks.
Loan growth and revenues are linked to the economic cycle. Credit losses are also linked to the cycle. Bank profits can therefore be highly cyclical. 

• Credit risk has a pro-cyclical effect on profits. Credit losses are higher in economic downturns
• Credit provisions cumulate on the balance sheet as a negative asset and reduce both shareholders’ equity and regulatory capital

- source Bank of America Merrill Lynch

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings. And, to say the least, one thing for sure, NIRP marks the end of Banking Empire Days rest assured. Also like we posited before, the problems facing Europe and Japan are more acute than in the United States because they are driven by a demographic not financial cycle. So, when it comes to low loan growth under NIRP, in the case of Japan, thanks to unfavorable demography, it marks we think the end of the "Empire Days" and the sun is setting, not rising.

Finally, as we have been commenting as well on various occasion, central banks meddling with asset prices is not only pushing cross-asset correlations higher but it is as well brewing instability and triggering more significant large standard deviation movements overall.

• Final chart: Market’s growing dependence on central bank stimulus means more prone to “corrections”

While we have shown in various conversations the instability created by "The Cult of the Supreme Beings" aka central bankers thanks to rising correlations, the impact can be seen in our final chart coming from Bank of America Merrill Lynch's The European Credit Strategist note from the 20th of September entitled "QE’s merry-go-round" from the 20th of September which displays the number of 4 plus SD (Standard Deviations) movements across markets over time:

“Corrections” par for the course 

"More broadly, because of the market’s growing dependence on central bank stimulus, we think assets are generally becoming more prone to “corrections”. Chart 1 highlights our Correction Counter: the number of 4 SD moves registered across markets over time. Brexit (June ’16) and China (August ’15) were clearly powerful events that drove market reversals. Yet, we think chart 1 also shows a general rise in the number of “corrections” since mid-2014 – interestingly, a time when the ECB first embraced negative rates." - source Bank of America Merrill Lynch

So there you go, what is indeed NIRP accelerating is the end of the statu quo and end of the low volatility regime which will of course end many "Empires" including banking Empires we think but, that's a story for another day...

"All enterprises that are entered into with indiscreet zeal may be pursued with great vigor at first, but are sure to collapse in the end." - Tacitus

Stay tuned!