Macro and Credit - Circus Maximus

"I can calculate the motion of heavenly bodies, but not the madness of people." -  Isaac Newton

Watching with interest new records being broken in equities reaching new highs, with credit "carrying on" thanks to uninterrupted inflows into funds ($6.5bn of inflow into European IG credit funds and High grade funds recorded another week of inflows; their 21st in a row according to Bank of America Merrill Lynch), we reminded ourselves for our title analogy of the Circus Maximus, the ancient Roman chariot racing stadium and mass entertainment venue located in Rome, which was the first and largest stadium in ancient Rome and its later Empire. It measured 621 meters (2,037 feet) in length and 118 meters in width and could accommodate over 150,000 spectators. In its fully developed form, it became the model for circuses throughout the Roman Empire. While we have been quite comfortable riding the uninterrupted bullish tide from our short term "Keynesian" perspective as indicated in our earlier musings of 2017, as of late, we indicated that tactically we were reducing our beta exposure credit wise and that we would rather stick to quality given that not only we feel that the credit cycle is slowly but surely turning, but, it feels like when it comes to the abundant generosity from our "Generous Gamblers" aka central bankers, when it comes to the Fed and the latest FOMC, it feels like the tide is turning. We posited in the past the following quote, which was a derivation of Verbal Kint's quote in the Usual Suspects movie:

"The greatest trick central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

We have used in the past as a title for a post a reference to the great text from Charles Baudelaire called the "Generous Gambler". This poem appears to be the 29th poem of Charles Baudelaire masterpiece Spleen de Paris from 1869.

As one knows, the "Devil is in the details" and if indeed the Fed is serious with its hiking plan and balance sheet reduction, then it does indicates that, regardless of the slowly turning credit cycle and the flattening of the yield curve, there is an increasing possibility of the liquidity tide to turn, you have been warned. For now in all markets it's "Circus Maximus" as we move towards the euphoria stage, with additional melt-up in asset prices, in the final innings of this great credit cycle we think.

In this week's conversation, we would like to look at why credit is "carrying on" and why we prefer for the moment playing it safe via Investment Grade in case volatility heats up in the near future.

Synopsis:

• Macro and Credit - If you love low volatility, stick to investment grade credit
• Final charts - Italy? It's getting complicated

• Macro and Credit - If you love low volatility, stick to investment grade credit

Reminiscences of a flow credit operator comes to mind in true 2007 fashion these days given the continuous inflows into Investment Grade funds, in conjunction of continuous tightening in credit spreads. Discussing recently with another credit pundit on a macro chat platform, we reminded ourselves of the 2007 spread compression with the current situation:

Him - "I've had banks pretty much telling me I can name my price in itraxx tranches, off the back of structured stuff they've issued to retail."

Me - "Not surprising, this is playing out like 2007, structured products issuance leads to relentless selling in CDS which is compressing even more spreads and market makers can't recycle in the market because the only takers would be loan books buying protection. Lather, rinse, repeat..."

Of course both of us like many others, have seen this movie before. As we pointed out in our recent musing, when it comes to High Yield and in particular European High Yield, given the tightness of the spreads relative to Investment Grade, we have switched to being tactically negative, underweight that is. Sure, some would argue that, it's all about the carry and that given the ECB's supportive stance, it's all about "carrying on" through the summer lull. We have a hard time seeing the relative attractiveness in Europe of € High Yield versus € Investment Grade credit as pointed out by Deutsche Bank in their European Credit Update note from the 13th of June entitled "Carry is King...For Now":

"Credit Valuations and Spread Forecasts

Despite the change in view we still think it will be difficult to see much spread tightening. More specifically, we would argue that valuations appear to be more stretched for EUR HY relative to EUR IG credit. Looking at our often used analysis in Figure 2, showing where spreads currently trade relative to their own histories, we can see that EUR HY spreads are generally at the top of the list.

More specifically BB and B spreads are well into their tightest quartile, in fact for Bs current spread levels are now close to the tightest decile through history. In addition looking at Figure 3 we can see that the HY/IG spread ratio remains around the all time lows having seen HY outperform on a relative basis since September last year.

We should stress here that we think the outperformance would be on a risk-adjusted basis. Given that we think carry will be driving returns from here, the extra yield available (although low in absolute terms) could see absolute outperformance. One other thing to potentially consider is the stark difference in duration of EUR IG vs. HY. The duration to maturity on the IG index is 5.4 years while for the HY index it is 4.1 years. This also does not take into account the fact that many HY bonds are trading to their call date rather than to maturity and therefore the duration of the HY index is likely to be even lower in practice. This could create some further benefit for IG if we do see more spread compression.

The recent trends in ECB QE could also benefit this view. The ECB appears to have trimmed corporate purchases less than government bond purchases as shown in Figure 4.

(For more details, see our report “CSPP Trimmed Less Than PSPP, with a Record Share of Primary Purchases” available at goo.gl/2pgpdM.) In addition, the latest ECB communication has implied that the overall withdrawal of QE could be even slower. Combined with the Italian election risk seemingly pushed back into Q1 2018, these latest developments are conducive to low volatility and tight spreads. In fact, as the market repriced QE for longer with a relatively increased emphasis on corporate purchases so far, CSPP-eligible bonds have again started to mildly outperform ineligible ones (Figure 5).

With the change in view we have also updated our year-end spread targets and what they translate to in terms of excess returns (Figure 6).

We have also trimmed our view on defaults given the combination of the positive macro data and continued low yield environment. The change in view is focused on the next few months and we will likely review this again as we move towards Q4. We have effectively pushed out our moderate widening view given the events of the last few days. And while we now expect the carry environment to last longer than we originally thought, the moderate widening stage might set in before the year end. Our end-2017 forecasts should therefore be seen with that caveat in mind.

Note that the forecast performance is risk-unadjusted. While higher-beta HY may outperform lower-beta IG in absolute terms, we expect the latter to outperform in risk-adjusted terms as mentioned earlier. On the margin, we expect the following relative performance adjusted for risk, which is in line with our previous published views:

• IG outperforms HY

• Financials to outperform non-financials

• Senior financials outperform subordinated financials

• EUR credit outperforms GBP credit

The UK elections have only reinforced our view that more macro uncertainty currently hangs over the UK economic outlook than over the eurozone, which makes us relatively more cautious on GBP credit.
The above cash bond excess returns are over government benchmarks. The total returns will additionally depend on the performance of government bonds." - source Deutsche Bank

This ties up nicely with our recent call in favoring style over substance, quality that is, over yield chasing from a tactical perspective. While the Italian elections probability has been postponed and has therefore moved from a "known unknown" towards a "known known", there is still a potential from a geopolitical exogenous factor to reignite in very short order some volatility, which would therefore put a spanner in the summer lull and "carry on" mantra. But as the Circus Maximus goes on, with very supportive inflows into the asset class, the carry trade continues to be the trade du jour for fixed income asset allocators. On this subject we read with interest Société Générale Credit Wrap-up from the 14th of June entitled "Why fixed income allocators are loving credit":

"Market thoughts

Risk-adjusted returns have become an important tool for fixed income allocation in recent years. Volatility and correlations tend to follow regimes, meaning that the past can be a decent approximation of the future under most conditions. Yields give a reasonable sense of what returns could be, unless the market moves sharply in one direction or another. Thus, dividing current yields by historical volatility is a useful tool for knowing which fixed income classes look most attractive at the moment.

Such calculations flatter the credit markets. Chart 1 uses the risk adjusted yield from our quant team (which they define as current yield divided by the standard deviation of yield over the past year) across a range of fixed income asset classes.

The horizontal axis shows the current level, and the vertical axis shows the change in the level since the end of 2016. Credit has suddenly jumped to the top of the pack, ahead of emerging markets, thanks largely to the very low level of volatility in returns since the start of the year.

But past performance is no guarantee of future returns, as every careful reader of financial boilerplates knows. Will corporate bond volatility remain low?

In the short term, yes, quite possibly, and this is one of the reasons we are bullish on the asset class into 4Q (as explained in Why credit markets could test the summer of 2014 tights). In the longer term, however, two factors worry us. First, the level of equity implied volatility is near 30-year trough levels. It could stay there for a while (as we explained in How this period of low volatility will end), but volatility always eventually gets driven higher by credit problems, and rising leverage – mostly notably in China – could be the trigger once again by early next year.

Second, the low level of credit volatility has been driven by a very high negative correlation between government bond yields and credit spreads. In Why government yield/credit spread correlations will likely reverse next year, we noted that there are fundamental reasons for thinking that this correlation could change in 2018. If it does, then the volatility of corporate bonds will necessarily rise because yields will not be a shock-absorber for spreads and vice versa.

Therefore, a word of warning. 2H may bring further inflows into credit from other parts of the fixed income world as asset allocators look at indicators like this one and draw optimistic conclusions. This may however spell the final phase of the credit market rally, for lower spreads and changing correlations could make the risk-adjusted yields look much less enticing come 2018." - source Société Générale.

We agree with the above, namely that from a risk/reward perspective, we have moved at least in European High Yield space from expensive levels to very expensive. While we had some confidence in the rally so far in the first part of the year, no doubt we could see additional melt-up in asset prices, credit included but it remains to be seen how enticing the risk-adjusted yields will look in 2018 in the Circus Maximus. The pain from rising yields and the continuation of the flattening of the yield curve will probably come to bite at a later stage.

When it comes to Deutsche Bank's recommendation in playing Senior financials versus subordinated financials, it makes sense, given the latest Banco Popular bloodbath. On this subject we read with interest Euromoney's article from the 13th of June entitled "Spain’s bank rescue could make tier 2 less Popular":

"Both AT1 and tier-2 investors lost everything when Banco Santander rescued Banco Popular, while senior bondholders were untouched. The rescue has shown that when banks in Europe get into trouble it is liquidity, not capital, that matters and that the fate of subordinated bondholders is anything but predictable.

There is no doubt that the AT1 market took the surprise bail-in of Banco Popular’s subordinated debt and equity in its stride. Despite its tier-1 and tier-2 debt trading at around 50c and above 70c, respectively, the day before, both became worthless when Spain’s Fondo de Reestructuración Ordenada Bancaria placed the bank into resolution on Wednesday, imposing losses of around €3.3 billion on debt and equity investors. The market has been patting itself on the back ever since, calling the sale of Banco Popular to Banco Santander for €1 a textbook outcome. Peripheral bank AT1s barely stirred. According to CreditSights, these bonds traded down over the course of the following week, but many by less than a point. 

Overall, the AT1 market has been trading close to 12-month highs, the memory of the market disruption caused by questions over Deutsche Bank’s ability to meet coupon payments on its AT1 paper in the first quarter of last year seemingly a faint one. Even peripheral names only fell to around 85% to 90% of those 12-month highs after Popular’s wipeout. Sorely needed This was a sorely needed win for the EU’s Bank Recovery and Resolution Directive (BRRD) after its shaky start with Novo Banco at the beginning of 2016 and the protracted horse trading over state support to Italy’s troubled MPS ever since.

The overnight move by the Single Resolution Board (SRB) saw Popular’s AT1s pushed past their CET1 triggers by the extra provisioning that Santander has demanded to take on Popular’s €36.8 billion of non-performing assets – just 45% of which were covered by provisions. So far, so good. However, there are a few things about this bail-in that are not exactly text book as well. The whole point of contingent convertible tier-1 debt is that it has triggers: Popular’s were set at 5.125% and 7%. It has two AT1 deals outstanding – a €500 million 11.5% low trigger deal and a €750 million 8.25% high trigger deal.

In the bank’s Q1 2017 presentation, its CET1 was 10.02% ­– still a long way from both of those, although its fully loaded CET1 ratio was closer to 7.33%. However, Popular had never missed a coupon payment on any of these notes: if this situation had really been played by the book that is what should have happened first. This is what the hoo-ha over Deutsche Bank’s available distributable items was all about last year. Banco Popular's situation has shown that the fate of subordinated bondholders actually has very little to do with the precise structure of the instruments that they are holding. Neither of Popular’s tier-1 notes had breached their triggers before the SRB decided that the bank had become non-viable late on Wednesday. Indeed, European Central Bank (ECB) vice-president Vitor Constâncio has clearly stated that the bank’s solvency was not the issue.

“The reasons that triggered that decision [to deem the bank non-viable] were related to the liquidity problems,” he explains. “There was a bank run. It was not a matter of assessing the developments of solvency as such, but the liquidity issue.”

There certainly was a bank run. €20 billion left Banco Popular’s coffers between the end of March and June 5 – the same day that its chairman Emilio Saracho declared that he did not plan to request emergency assistance from ECB because it was not necessary. The sale to Santander is understood to have been put together in less than 24 hours.

It was thus depositor withdrawals that caused the SRB to deem the bank to be failing or likely to fail under Article 18 (1) of the Single Resolution Mechanism Regulation. This meant that it had hit the point of non-viability (PONV). 

Investors in AT1 instruments should, therefore, be paying much closer attention to the PONV language in their documentation than to trigger language. When a takeover deal that blows through the latter is hammered out overnight there is not a lot that you can do.
The market has long muttered about the death spiral effects in the CoCo market – whereby debt investors that are converted into equity on breach of a trigger are forced to immediately sell that equity and accelerate the demise of the institution. This is the first time that there has been any principal or coupon loss in the AT1 market and there was no sign of a death spiral. 

However, that was only because the bondholders didn’t have time to be converted into anything that could be sold: Popular’s AT1s and tier 2s were converted into shares that were immediately written down to zero. The market has spent too much time fretting over the impact of CET1 triggers that – if Popular is a textbook case – will never get to be hit.

The wipeout of Popular’s equity and AT1 investors is unquestionably the BRRD doing what it was designed to do and investors will not have been surprised by their treatment.

Pimco is understood to have been holding €279 million of the AT1s at the end of March – the giant US money manager also held more than €100 million of Novo Banco senior bonds that were bailed in under its disputed resolution.

However, the fallout from Popular’s demise might be more keenly felt by its tier-2 investors.

The deal with Santander means that Popular’s tier-2 investors were dealt with in exactly the same way as its AT1 investors – they were written down to zero – although the tier-2 investors got the €1. This in effect removes any distinction between the two asset classes in resolution.

The temptation to wipe out anything that you can in resolution is understandable as it makes the bank more attractive to a potential buyer, but if this will always happen then why buy tier 2? You are getting paid more for the same risk with AT1.

All eyes are now on the tier-2 bonds of two other Spanish lenders: Liberbank, whose 6.875% €300 million tier-2 bonds traded below 81c on Friday – while a short selling ban was placed on its shares on Monday.

Another lender, Cajamar, also has a €300 million 7.75% tier-2 bond outstanding that is now trading below 90c. Popular’s tier 2s were trading at between 70c and 80c immediately before they became worthless.

What is key here is that Popular had yet to issue any new style bail-inable senior debt. If banks want investors to buy their tier-2 debt then in future, a resolution such as this might need to involve – very different – haircuts for both tier 2 and senior debt rather than oblivion for one and protection for the other; Popular’s senior bonds were up from 90c to 104c after the deal.

Although this takeover is a neat and straightforward demonstration of what investors can expect under BRRD, there needs to be a closer examination of the loss-absorbing hierarchy of tier 1 and tier 2 in the process. If they are the same then you don’t have a repayment waterfall – you have a lake." - source Euromoney

Of course, we would argue that no matter how much liquidity via LTROs the ECB has injected, liquidity doesn't amount to solvency hence the importance lessons in dealing swiftly with nonperforming loans as done by the Fed, while the ECB has been following a path more akin to Japan (here comes our "japanification" analogy). But, from a technical perspective on the subject discussed in details by Euromoney, there is a technical aspect that needs to be discussed namely protection offered only to some subordinated bondholders via the CDS market:

"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."

A typical LT2 Structure is as follows:
10 years, non-callable for 5 years (10-NC5)
-Final maturity is hard, meaning no get out clauses.
-No coupon deferral. A coupon deferral would constitute a credit event and therefore trigger a credit event and the relating CDS.
-Ratings: 1 notch below senior debt (Moody's / S&P).
-More standardised structure than Tier 1 or UT2. Given regulatory capital treatment decreases as it moves towards maturity (as it gets closer to 5 years to maturity) so many deals structured have had callable features, meaning the issuer can decide to call the bond.

As a reminder the Dutch bank SNS resolution in 2013 meant that Tier 1 bonds and LT2 losses equated to 100%. At the time the SNS intervention clearly pushed the envelope on how national authorities and now the ECB being the European regulator are willing (and able) to go in the resolution of a failing financial institution. The downside recovery for LT2 (using Irish precedents) was generally assumed to be 20%. This should have been understood to be 0% back in 2013, but yet again investors have been blind. Why the change in recovery rate from 20% to 0% matters in the CDS space?

If the recovery rate for LT2 subordinated bonds is zero (again for Banco Popular and in similar fashion to the SNS case), the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. Subordinated debt should in essence trade much wider to Senior! Particularly if liquidity, not capital, matters and if the fate of subordinated bondholders is anything but predictable.

Here is your "known unknown". Yet in Banco Popular's case the short end of the CDS curve was already inverted before the takeover for €1 was announced so while in the above article we read that there was no sign of a death spiral, this is not entirely correct. If indeed AT1 are known unknowns, and are American options like short gamma trades, who really cares about the capital threshold trigger aka the strike price seriously? We don't and continue to dislike these bonds but hey, some might enjoy nonlinearity, we are not big fans.

For those who have been following us, we have been pretty vocal on the evident lack of resolution of the nonperforming loan issues (NPLs) plaguing the Italian banking sector. On a side note we did at the end of last month a podcast on the Futures Radio Show in which we discussed Italy, being for us the biggest risk in Europe.
The on-going issues plaguing the oldest bank in the world namely BMPS aka Banca Monte dei Paschi di Siena can be seen in the CDS market and the NPLs have yet to be meaningfully tackled as indicated in the recent blog post from DataGrapple from the 19th of June entitled "A Tricky Task Just Got More Difficult":

"On Friday, it emerged that Fortress Investment Group and Elliott Capital Management had dropped out of talks to buy bad loans from MONTE ( Banca Monte dei Paschi ) complicating the rescue plan for the lender backed by the Italian government. They were the only international bidders for the riskier tranches of MONTE’s bad loan securitization. That leaves Atlante, the fund set up to help the struggling Italian banking sector, as the only potential buyer and jeopardizes the asset sale, which is a key part of the plan to restructure the bank with a capital injection from the state, after MONTE failed to shore up capital privately. Ultimately, it could also make similar rescue plans for two other northern Italian lenders, Veneto Banca Spa and Popolare Vicenza Spa, much more difficult to pull off. Surprisingly, if MONTE’s 5-year risk premium was marked aggressively wider - insuring senior debt now costs 330bps per year, while insuring subordinated costs 73.5% upfront -, it did not feed through the whole Italian banking sector and most names were actually unchanged to a tad tighter." -source DataGrapple

And guess what 73.5% upfront Subordinated CDS still seems pretty cheap if you ascertain the fact that your recovery value on the subordinated bonds will probably be a big fat zero...Just a thought. So while you might want to continue playing the Circus Maximus credit show, when it comes to favoring Senior Financials over Subordinated bonds, use your credit skills wisely.

If you indeed love low volatility, stick to investment grade credit because as the party continues flow wise in that space, the feeble crowd aka retail is now joining the party with both hands according to Bank of America Merrill Lynch Credit Market Strategist note from the 16th of June entitled "ECB+BOJ&Fed, redux":

"Retail taking over from foreigners

US high grade corporate bonds have returned 4.2% this year driven by 7.3% in the backend. With the timing of the decline in interest rates, not surprisingly about two-thirds of this performance has accrued in 2Q. These stellar returns are now attracting retail money to HG bond funds and ETFs in the usual way (chasing performance). As we have often highlighted, in the first part of the year we had record inflows without supporting preceding performance necessary to attract retail inflows – in fact HG lost almost 3% in 4Q 2016 (Figure 2).

Our view remains that foreign investors were responsible for the big acceleration in HG bond fund/ETF inflows to begin the year, as the timing coincided with a big decline in the cost of dollar hedging (Figure 3).

Furthermore these inflows accelerated more at the end of the Chinese New Year." - source Bank of America Merrill Lynch

It looks to us that indeed Circus Maximus is getting crowded, but for now everyone in the credit "karaoke" is singing "carry on" so you probably got to keep dancing...

In our final charts below and given our take in the podcast, we continue to view Italy as the biggest European risk even though elections have so far been postponed. Growth is not meaningful enough, we think to alleviate the slowing but still growing very large nonperforming loans problem on Italian banks' balance sheets.

• Final charts - Italy? It's getting complicated

While we won't go through the debt trajectory of Italy and the dismal growth experienced in recent years, for our final charts we would like to point to charts from a recent presentation done by French broker Exane on the 12th of June. They point out to IMF work showing that the NPL ratio drops significantly when GDP growth reaches 1.2% (and particularly when this trend is sustained for a few years). Their charts below also display the relationship with the 2-10 Italian yield curve. This indicates that Italian banks are very sensitive to a surge in yields in the short-end which makes very interesting in the light of the willingness in tapering as of late from the ECB:

Italy: GDP Growth versus NPL ratio

Italy: NPL ratio versus 2-10 yield curve

- source Exane

According to them, YoY growth for Italy is likely to enable a significant decline in NPLs. Yet they indicate that while there is hope for a relaunch of the European project, the situation of the banking sector remains a concern and is still plaguing credit conditions for the corporate sector. They conclude their slide in their French presentation by saying that for the sustainability of the Italian debt, it's getting complicated. We could not agree more: "Troppo complicato!"

"Too much sanity may be madness and the maddest of all, to see life as it is and not as it should be." - Miguel de Cervantes

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!

Play it again Sam ! - European problems not going away in 2011...

Portugal came back to the market today and auctioned 500 millions euros worth of bills repayable in July. The yield stood at 3.686% from 2.045% back in September 2010 for similar maturity bills.

A year ago Portugal was only paying 0.592 % to borrow for six months.
Portugal need to raise 20 Billions Euros this year and it is not going to be cheap for them to do so.

On the 23rd of December, Portugal was downgraded by Fitch Ratings from AA- to A+. S&P might downgrade further Portugal to A- in April, which will automatically increase its cost of funding.

Moody’s said on Dec. 15 it may cut Spain’s Aa1 credit rating and on Dec. 16 placed Greece’s Ba1 bond ratings on review for a possible downgrade. Ireland’s credit rating was cut by five levels by Moody’s on Dec. 17.

Below table displays the European Government spreads versus Germany in early 2010 and the situation at year end:

Early 2010:

By year end:

2011 is the raising money race year. Competition between Sovereigns and Banks to raise money fast will be furious. It is already happening. Deutsche Bank and Rabobank kicked of the race on the 4th of January by selling US bonds. Deutsche bank issued 1 billion USD of 5 years notes paying 3.25% (130 bps more than comparable Treasuries), while Rabobank sold 2.75 USD billion of securities, according to data compiled by Bloomberg. On the 5th of January, it was the turn of Societe Generale and Intesa to tap the market and issue bonds.

Europe Banks Race Sovereigns to Bond Investors:
http://www.bloomberg.com/news/2011-01-05/europe-crisis-drives-banks-to-sell-bonds-before-sovereigns-credit-markets.html

“There are several European government bonds paying more than banks for debt so it’s hard for lenders to raise cash in this situation,” said Serafi Rodriguez, a fixed-income trader at Banc Internacional d’Andorra.

Both funding costs for banks as well as for sovereigns is going up as reflected in the widening of CDS spreads we saw last year.
Evolution of CDS spreads between the 21st of September until the 21st of December:

European Sovereigns CDS spreads widened:

Asian Sovereigns CDS spreads were stable:

The risk of "Crowding Out" is alive and real. I previously posted on this very subject in February 2010: Crowding Out.

Banks need to raise 1.1 trillion USD this year.
From January 2010 until December 2012 the amount needed to be raised by banks amounted to 2.2 trillions Euros.

The important issue of rising global yields is a very important one. Debt markets are going to be more and more discriminating. This has serious implications in the development of the government finance bubble. Some cracks appeared with Greece in 2010 and you can expect similar cracks to show in 2011. After Greece and Ireland, Portugal seems to be the most obvious next weakest link to unfold.

In this race to funding, and with the markets becoming more and more selective, the competition will be fierce in 2011. The implications for public finances will be great. The era of cheap funding is definitely over.

Western countries are still trapped in a secular bear market. Particularly the US. Unemployment is still hovering around 9.8% after 4 trillion USD increase in government liabilities in just 9 quarters in conjunction with an extended near zero interest rate policy. Dear Ben, there is nothing to be proud of and QE2 is not going to be the remedy for the structural issues and housing mess which are still plaguing the US economy.

In this environment, Gold can continue to rise in 2011 as illustrated by the current term structure for Gold futures:

In relation to the evolution of yield on 10 year European Government debt, Ireland and Greece have reached new highs:

Evolution of Greek 10 year yield in the last 6 months until the 5th of January 2011:

Evolution of Ireland 10 year yield in the last 6 months until the 5th of January 2011:

Play it again Sam...