Macro and Credit - A shot across the bows

"History is a vast early warning system." - Norman Cousins, American author

Looking at the markets wobbles on Friday, with the ructions taking place in various asset classes with continued pressure on bonds, there were nowhere to hide except maybe cash in US dollar, so we reminded ourselves for our title analogy of the phrase "A shot across the bows" given our fondness for maritime analogies. Admiral William Smyth, the author of the 1865 book "The sailor's word-book: an alphabetical digest of nautical terms, defines the bows as follows:

"The fore-end of a ship or boat; being the rounding part of a vessel forward, beginning on both sides where the planks arch inwards, and terminating where they close, at the rabbet of the stem or prow, being larboard or starboard from that division". 

"A shot across the bows" derives from the naval practice of firing a cannon shot across the bows of an opponent's ship to show them that you are prepared to do battle. But, the more general figurative use of the expression, just to mean warning. During the 18th century, a warning shot (in nautical terms, called "a shot across the bow") could be fired towards any ship whose "colours" (nationality) had to be ascertained. According to the law of the sea, a ship thus hailed had to fly her flag and confirm it with a gunshot. The latest nonfarm payroll number with U.S. Average Hourly Earnings rising 2.9% Y/Y, the most since 2009 against expectations could be perceived as the shot across the market bows we think as the markets are starting to feel the threat of inflation expectations building up which would mean a more aggressive hiking stance from the Fed. After all the last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan. On this very blog we warned in numerous conversations about the risk for "balanced funds" getting "unbalanced" due to rising positive correlations thanks to central banks meddling with volatility and interest rates. At the end of August 2016, we were reminded how stocks and treasuries could move together. We had the same pattern following the surprise Chinese Yuan devaluation in August 2015 as well. The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield, that simple. In this repeated scenario we saw on Friday, the diversification benefits of a traditional 60/40 (stocks/bonds) portfolio disappears, yet another shot across the bows, as in 2015 and 2016. 

In this week's conversation, we would like to look at the recent sell-off thanks to rising positive correlations rendering once again balanced funds unbalanced. Instability thanks to rising positive correlations have been brewing in recent years. We have discussed this problem in numerous conversations (as pointed out in our short August 2016 conversation "Positive correlations and large Standard Deviation moves").

Synopsis:

• Macro and Credit - Is the luck of "balanced fund managers" about to run out?
• Final charts - The "Wealth" defect

• Macro and Credit - Is the luck of "balanced fund managers" about to run out?

Back in February 2016 in our conversation "The disappearance of MS München" in which at the time we said we were writing for posterity and tackling in depth various aspects of risk including the inadequacy of VaR (Value at Risk) as a risk measurement tool, we argued the following:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing. The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016

Once again, the correlation between macro variables in recent months have gone in concert significantly in recent months as highlighted by Deutsche Bank in their Asset Allocation note from the 31st of January entitled "Stretched Consensus Positioning":

"Has the fever broken?

Whatever the fundamental case for each of these trades, extended positioning argues at a minimum for a breather and more likely a pullback soon. Moreover, the tight correlation in the moves across the major asset classes (oil up, dollar down, equities and bond yields up) suggests a pullback in one for idiosyncratic reasons would likely spill over to the others. There are several potential fundamental catalysts for a positioning unwind although cases of extended positioning do not always require one:

■ Oil looks most vulnerable from the vantage point of positioning. While it has been supported by a series of positive factors, a turn in any, especially a lagged increase in supply as is typical after periods of rising oil prices, risks a sharp positioning unwind.

■ A rise in the dollar has potentially the widest fundamental impact across asset classes. Arguably its depreciation has been an important driver of the run up in oil prices to which breakeven inflation and bond yields have been well correlated. The decline in the dollar and higher oil prices have been a significant positive for equities but in our view not the most important as the drivers of the rebound in earnings have been very broad based (Very Strong Earnings Growth Before Tax Reform, Jan 2017).

■ Equities while vulnerable to a positioning unwind have seen very little in terms of inflows. Recent inflows look largely to be a catch up for prior outflows. In particular US equities have seen almost no inflows cumulatively since the start of the 15-month rally.

■ Short positioning in rates is at an extreme and vulnerable to a pullback but bond valuations remain in our view completely out of line with growth, reflecting weak inflation which we expect to turn up. If inflation fails to pick up, the large short positions are likely to be unwound and rates turn lower in turn, as happened last year. Our house view remains a gradual rise in inflation which supports the large short positions and would allow for a continued orderly rise in rates. This will have implications in our view mainly for the bond market which has enjoyed the bulk of inflows through the cycle and to which end investors remain massively over allocated. However the risk is that with all 4 fundamental drivers of inflation pointing up, a move in concert has the potential to create a sharp pickup in inflation which is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle, resulting in broad based risk aversion." - source Deutsche Bank

Positive cross-asset correlation  and balanced funds getting "unbalanced" is a subject we discussed in our May 2015 conversation "Cushing's syndrome". We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out. We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

Arguably rising positive correlations and repressed volatility are we think, recipe for large trouble ahead. In similar fashion to CPPI strategies, Vol Control funds (representing close to $200 billion) must decrease leverage to protect principal hence the dangerous feed-back loop for these strategies increasingly at risk from rising cross-asset correlations with reduced buffer from the bond allocations in some case such as the much vaunted stars of the last decade aka "balanced funds". Vol control products sell equities when volatility is rising and buy equities when volatility is falling, creating a market feedback loop.

In our "investing book", these strategies are indeed directly impacted by the rise of "positive correlations". On the subject of "Risk Parity Strategies" we would like to redirect you dear readers to the guest post from our Rcube friends which we published on the 14 August 2013 entitled "Is Risk Parity a Scam":

"Because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a big rotation that would bring 10-year yields back to a theoretical long-term equilibrium value.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…
From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself."

Conclusion

Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance based arguments that are often put forward by the proponents of risk parity.
From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:
1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategy's performance under different scenarios.
2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.
3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.
4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.
5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.
For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).
There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's numerous flaws.

However, we have little doubt that when the next "black swan" terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage one's life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.-"Is Risk Parity a Scam", August 2013

We still could not agree more with our friends. This risk is still valid today and it got even more "crowded" in recent years.  One should always pay great attention to rising positive correlations as they portend some pull-back eventually with no one truly spared. 

When it comes to market jitters and flows, the High Yield ETF crowd, mostly made up of retail players continue to be feeble when it comes to exiting the party when the heat is on. Bank of America Merrill Lynch in their High Yield Flow report from the 1st of February 2018 entitled "HY outflows accelerate" continues to point towards the nervousness of the retail crowd:

"US HY sees large outflow, EM debt and high grade gain

Outflows from US HY funds totaled $1.39bn (-0.6%) last week, accelerating from $838mn and $938mn during the previous two sessions, respectively. Most of the outflows continue to be concentrated in ETFs which experienced a $1.02bn (-2.1%) redemption last week, whereas open-ended funds recognized a $375mn (-0.2%) withdrawal. These most recent outflows completely wiped out the $3bn in gains during the first two weeks of the year, sending the YTD total to -$188mn. HY funds domiciled outside the US continued to see moderate outflows as well with a $1.3bn (-0.4%) redemption last week. Because the majority of these funds still invest in USD debt, these outflows amplify the selling pressure in the secondary USD HY market. January’s 34bps spread tightening and +0.64% total return is even more impressive when viewed in this context.

 - source Bank of America Merrill Lynch

Could the current trend in continuous outflows start in earnest biting credit spreads in the High Yield space? This is an important question from an allocation perspective for the yield hungry crowd. On that subject we read with interest Barclays take in their US High Yield note from the 2nd of February entitled "Stumble and a Trip over Treasuries":

"High yield spreads have continued to rally through their 2014 tights even in the face of a pickup in supply and persistent outflows, with the 24 bp spread tightening year-to-date through Wednesday almost offsetting the 31 bp increase in 5y rates in January. As discussed in Fuller Cushions In Lower Quality, the ability of spreads to absorb rates is diminished when spreads have been at similar levels. And while markets have largely shrugged off weakening technicals, we take a more cautious near-term and tactical view considering tight valuations and the potential for further outflows driven by large adverse rate moves.

As noted in Temporary Relief from Rate Fears, outflows alone are typically not a catalyst for prolonged spread widening and particular pressure on returns. The recent experience has followed that playbook, and cumulative outflows of $23 bn over the past 12 months have done little to derail cumulative total return of 6.6% over the same period of generally stable or improving macro trends. But looking further back, episodes such as the "taper tantrum" suggest that the opposite can occur. Over the one-month period following the 34bp flare-up in 5y rates in May 2013, high yield mutual funds endured outflows of more than $8.5 bn and the High Yield Index widened by more than 50bp. We do not anticipate a similar response, but believe that this could be indicative of the direction of fund flows, if not the magnitude.

To examine the relationship between rate moves and flows in and out of high yield mutual funds more closely, we rank monthly moves in 5y rates by decile in rate rising environments and look at the average mutual fund flow as a percent of total AUM the following month. When considering all spread environments. Figure 1 shows that outflows tend not to materialize even when rates increase by more than 30bp, as they have recently.

But restricting our analysis to months when the high yield market has started tighter than 450bp (approximately the long-term average, excluding the financial crisis), shows a clearer relationship: the sharper the rate move, the larger the outflow (Figure 2).

The last two deciles, in particular, seem relevant today given a similar-sized increase in Treasury yields over the past several weeks.

The recent divergence between flows and returns, particularly stark in 2017 (Figure 3), warrants further analysis of whether rate moves and associated outflows can be a drag on total returns.

We thus tweak the analysis above to examine how High Yield Index returns vary with changes in rate movements in both normal and tight spreads environments. Two things stand out:

• When considering the full history of spread environments, increases in Treasury yields typically do not weigh on returns. Figure 4 shows no clear relationship between changes in 5y Treasury yields and one-month-forward total returns, largely in keeping with the results of Figure 1, which shows the ensuing fund flows.

• But in tight spread environments, adverse rate movements can affect the near-term performance of the High Yield Index. The inflection point beyond which returns are dragged down by rate movements appears to be around 23bp. Past that threshold, rate moves have, on average tended to produce negative returns for high yield credit in the next month (Figure 5).

The findings in Figure 5, particularly the negative high yield total returns after month of large moves in Treasury yields in tight spread environments, are logical and intuitive. Carry in tighter spread environments is not able to offset the drag on total returns produced by large increases in base yields. But we think this is amplified by our findings that escalation in Treasury yields similar to those seen year-to-date have historically preceded larger-than-average outflows from high yield mutual funds the following month. Finally last week, in Vol Hunting Heading into Earnings, we noted that there is historical evidence to support a pause or outright reversal in spreads during earnings seasons in similar tight spread environments. All of these data suggest near-term caution toward the high yield asset class" - source Barclays.

As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. Pretty simple. Therefore we are not surprised by Barclays take on the feedback loop we can have between higher rates and outflows for US High Yields in a very tight spread environment. Things can indeed turn "South" rapidly, regardless of how feeble the retail investment crowd is in the ETF sector.

Given the change in the narrative of the Fed and it's continuing hiking path and the fear of rising inflation expectations, one could rightly ask given recent market gyrations if the shot across the bows mark the end of financial repression and indicate trouble ahead for the Risk Parity investing crowd. On this subject we read with interest Deutsche Bank FX Special report from the 4th of February entitled "Risk Parity, FX and the end of financial repression:

"The charts below show that consecutive weeks of higher US bond yields and lower equity prices, have become progressively less common since the 1980s/1990s, and especially since the 2008 financial crisis. Three weeks, of equities down,10y yields up, has not happened for more than a decade. The bad news, is the markets may be contending with a shift in two big macro factors that point to a change in the post-2008 world: i) reduced financial repression, and, ii) some inflation creep

A look through history does show that in an environment where US 10y yields go up and equities go down, the USD tends to go up sharply versus the AUD and the JPY. The JPY loses out more from higher US yields than it gains protection from the retreat in risk appetite. In a higher 10y yield, lower equities environ, the USD has historically traded near flat versus the EUR, but in aggregate this still leaves the USD up moderately on a TWI basis. With bond and equity prices tumbling in the last week,the FX markets price action did conform remarkably closely to how the USD has traded in tough risk parity environments of the past, going back over the last 30 years.

Bond and equity prices falling sharply on the week may feel like an unusual environment, because in the last decade, it has become unusual. However, especially as we go back to the 1980s and 1990s it was a more frequent occurrence to see the following causal chain develop: Equities go up, supporting growth with a lag, pushing bond yields up, to the point where higher bond yields eventually pull equities down. In this way the equity - bond causality and correlation shifts, from a positive correlation where equities drive up yields, to a negative correlation as bond yields take the causal lead in pushing equities down.

From a macro perspective what is intriguing about this dynamic is two old school factors could be back in play: i) At least in the US there is a confluence of inflationary factors - lagged demand, tight labor markets, the tax reforms impact on wages/bonuses and growth, higher oil prices, latent protectionism, and the weak USD. All these factors are apt to have a cumulative effect, chipping away at global disinflation and inflation inertia. ii) the Fed and other Central Bank's balance sheet adjustments, may signal the end of financial repression, and this repression likely helped risk parity trades.  Risky assets are understandably worried because these are indeed important changes.

Now for the good news. Figure 1 below shows the number of weeks in each year where the S&P went up and the 10y yield went up. This was a common event in a high inflation era, but dwindled in the noughties, and especially after 2008 when the Central Banks went out of their way to support asset prices by supporting bonds. The good news that Figure 1 reveals, is it becomes very rare for the S&P and Bond yields to go up two and especially 3 or 4 consecutive weeks on the trot. Three weeks, of equities down 10y yields up has not happened for more than a decade.

Consecutive week after week of both bond and equity price declines is unusual. This is likely to prove true in current circumstances, where the US bond market is such a stand-out relative to other G10 bond markets. US 10y yields will likely not easily soar much above 3% without finding some real support, most obviously near the 3.03% January 2014 yield peak. In addition, were bond yields to keep on going higher, it would do enough damage to stocks to start hurting growth expectations, in turn supporting bonds. Bond bears would in this way create the source of their own demise, which is not an unusual self correcting mechanism.

In that sense we do not want to exaggerate the prospect of weeks like we have gone through that threaten risk parity trades consistently. At the same time, if inflation pressures and quantitative tightening are not about to change, then the weeks where both equities and bonds sell-off will become a good deal more frequent than we have seen since the Great Financial crisis.

So what does this all mean for currencies?

The Tables below shows how currencies have traded under different bond (10y yield) and equity (S&P) scenarios.

We first demarcate each week as falling into one of 4 scenarios: S&P up, 10y yield up; S&P up 10y yield down; S&P down and 10y yield down, and S&P down, 10y yields down. We then looked at how currencies traded, taking medians and averages of the weekly performances for ach scenario.

The table below shows the following:

i) The percent of time when S&P is down and 10y yields are up is roughly 1 in 6 trading weeks, so not all that unusual, but certainly less common than the other scenarios.

ii) In the environment where 10y yields go up and equities go down, the USD tends to go up sharply versus the AUD at least in the past decade. The USD also goes up substantially versus the JPY. The USD is mixed to near flat versus the EUR (or before the EUR the DEM). This leaves the USD up moderately on a Trade weighted basis. Since 1999, the USD also appreciates (somewhat less than we might expect) versus EM carry - using the Bloomberg EM-8 carry index of cumulative total returns. The USD's positive response versus EM looks much more substantial when using average weekly gains as distinct from median weekly gains. This suggests that every now and then there are some very large negative EM moves, when US bond prices and stock prices go down, which is not a huge surprise.

To summarize, past history does tend to support the thesis that when it feels like there is nowhere to hide between poor simultaneous trading conditions in the equity and fixed income markets, the USD and more recently the EUR have been the currencies to shelter in.

With bond and equity prices tumbling in the last week, the FX markets price action conformed remarkably closely to how the USD and other currencies have traded in tough risk parity environments of the past 30 years." - source Deutsche Bank

As a rule of thumb, positive correlation between growth assets is most notable when investors are most concerned about risk as we indicated in our May 2012 conversation "Risk-Off Correlations - When Opposites attract". Whereas opposite attracts during "Risk-Off" periods, it looks like the greenback is still working so far as a powerful magnet. As posited above rising positive correlation between macro variables in recent months should always be seen as instability brewing which increases the probability of a pull-back.

From a credit perspective, another shot across the bows is also coming from the Citi Economic Surprise Index (CESI) which could potentially indicate that economic fundamentals are trading ahead of themselves and could portend some credit spreads widening in the near future. On this subject we read Bank of America Merrill Lynch's take from their Securitization Products Strategy Weekly note from the 2nd of February:

"As nominal Treasury yields and breakeven inflation rates moved steadily higher over the past month (Chart 69), several market indicators we analyze suggest that the wind in the market’s sails may be fading.

As a result, the massive stock rally and price momentum experienced since the beginning of the year were thwarted this week as markets endured a spike in the VIX index and the worst weekly declines since 2016 (Chart 70).

Furthermore, the Citi Economic Surprise Index (CESI), which has previously been a decent indicator of the future direction credit spreads may take, continued to fall this week (Chart 71) while liquidity risk and financial stress, as measured by BofAML GFSI™ liquidity risk and financial stress indicators, rose (Chart 72).

Admittedly while the falling CESI could be somewhat seasonal in nature, the decline may also reflect the notion that expectations regarding economic fundamentals may have gotten ahead of actual fundamentals.

Historically, we’ve noticed a reasonably strong relationship between the inverse of Citigroup Economic Surprise Index and both the IG CDX (Chart 74) and HY CDX (Chart 75) indices: credit spreads tend to tighten as the CESI rises and vice versa.

With the CESI currently showing few, if any, indications that it may rebound over the near term, Treasury yields gapping higher and equity markets selling off, it is likely that credit spreads from other sectors will remain under pressure over the near term, which sets the stage for softer CMBS spreads as well." - source Bank of America Merrill Lynch

Is this time different when it comes to the relationship with rising yields, outflows and weakening CESI in recent weeks? We do not think so. 

At some point there is a potential strong risk reversal in US long bonds we think and that would put us back into the "deflationista" camp. For now the "inflationista" camp are having a field day but, as we pointed out be careful of what you wish for when it comes to inflation. Global rise in inflation expectations would indeed intensify the pressure on risky assets as we pointed out in our conversation "Who's Afraid of the Big Bad Wolf?". Remember what our friends say above according to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…You have been warned, again...

Back in December in our conversation "Rician fading" we  reminded ourselves about the Laffer Curve which used to mean the following: "Too Much Tax Kills the Tax". With the upcoming Tax deals mostly benefiting the 1%, we mused that "Too Much Wealth Effects Kills the Wealth". In our final chart below we tackle again the "Wealth" defect.

• Final charts - The "Wealth" defect

The wealth effect is the premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more. According to the Fed and other central bankers following the same policies, the wealth effect should have enabled a repair of the balance sheet of households deeply impacted by the Great Financial Crisis (GFC). On top of the Wealth Effect thanks to ZIRP, NIRP and various QE iterations, the US has just implemented at the late stage of the credit cycle some "Trickle-down economics", also referred to as trickle-down theory. This economic theory advocates reducing taxes on businesses and the wealthy in society as a means to stimulate business investment in the short term and benefit society at large in the long term. However has shown in our final charts below from Wells Fargo Economics Group note from the 2nd of February 2018 entitled "The Rich Get Richer - Ownership Drives Net Worth", only the wealthiest American families have fully recovered from the financial crisis:

"Diverging Trends in Median and Mean Net Worth

Key indicators associated with household wealth might give the impression that balance sheets should be in much better shape than they actually are. Home prices, for example, are at or near their pre-recession peak in many markets. Stock prices are more than 80 percent above their prerecession peak. Yet, in inflation-adjusted terms, median household net worth is still about 30 percent below where it was back in 2007 (Figure 1).

Only the wealthiest American families have fully recovered from the financial crisis (Figure 2).

 - source Federal Reserve Board and Wells Fargo Securities

The outsized wealth gains recorded in recent years by high-net-worth families are reflected in the disparity between median and mean net worth, which have de-coupled since 2007. This is because “mean” net worth is calculated by taking the average net worth of all families, and is pulled up by very high values at the top of the distribution. Meanwhile, “median” net worth is that of the middle family (50th percentile), and is therefore not lifted by extreme values at the top of the net worth distribution, or impacted by changes isolated at either end of the distribution.

What Figure 1 shows is that before the financial crisis, net worth for the median American family was growing on a similar trend as net worth across all families. However, after 2007, high-net-worth families experienced much larger gains (or smaller declines) in net worth than middle wealth families. As a result, the mean – pulled up by wealthy families - did not show the same precipitous decline as median net worth post-financial crisis so the data does not track net worth growth of individual families. Rather, data from the SCF reflects how the distribution debt and asset ownership changes across society over time.

Fewer and Smaller Mortgages Reduces Debt

Changes in net worth occur because of growth (or decline) in debt and asset values. In the years after the Great Recession, middle- and high-net-worth families have reduced the quantity of debt on their balance sheets, contributing positively to net worth (Figure 3).

  - source Federal Reserve Board and Wells Fargo Securities

The median family with debt owed $59,800 in 2016, which is $18,200 less than in 2007 in real dollars. Mean family debt has similarly declined, down $22,500 since 2007 to $123,400.

Residential debt is the most commonly-owned type of debt after credit card debt, and makes up the largest share of debt that families hold. Therefore, trends in mortgage debt have a large influence on trends in overall family debt. A main contributor to debt reduction since the Great Recession is fewer, smaller mortgages. For mortgage owners, median and mean mortgage debt have both declined by about $13,500 since 2007. In addition, fewer families have mortgages: 40 percent of families in 2016, compared to 46.3 percent in 2007.

Lower debt among families is not just as a result of paying down mortgage balances, but also because fewer families are participating in the real estate market. The homeownership rate has declined from 69 percent in 2007 to less than 64 percent today. Whether by choice (preference for renting) or circumstance (tighter regulatory standards), fewer Americans have a piece of the American Dream in this expansion.

It’s Not What You Owe, it’s What You Own

The source of the divergence in median and mean net worth is asset values more than quantity of debt. Whereas the median family which holds assets owned about $256,500 worth in 2007 (in 2016 dollars), this has since dropped to $189,900 (Figure 4).

  - source Federal Reserve Board and Wells Fargo Securities

In contrast, the mean family with assets now values these at about $792,000, up from $775,900 just before the financial crisis.

This story has to do with the mix of assets that families of different wealth levels own, and trends in ownership rates. When looking at homeownership by net worth percentile, we see that the decline in homeownership is concentrated at lower percentiles of wealth. From 2007-2016, the share of families in the second quartile of net worth (25th-49th percentile) owning homes declined 14.1 percentage points to 58.1 percent, compared to a 2.2 percentage point decline in homeownership to 94.6 percent for families in the top decile of wealth (Figure 5).

  - source Federal Reserve Board and Wells Fargo Securities

The share of middle-wealth families owning other types of assets has also fallen at a faster rate versus high-net-worth families. Fewer families in the second quartile of the net worth distribution are owning vehicles (-1.5 points), retirement accounts (-5.5 points) and stocks (-4.3 points). Meanwhile, families in the top decile of net worth own stocks at a slightly lower rate (-1.8 points), but more own retirement accounts (+3.8 points) and about the same percentage own vehicles.

Lower asset ownership subtracts from net worth, since the value of asset holdings declines. Even for middle-net-worth families who own assets, they have not added as much to their holdings since 2007. Families in the second quartile saw retirement account and stock median values decline 13.8 percent and 5.7 percent, respectively. For families in the top decile, retirement accounts gained 71.3 percent and stocks 38.1 percent over the same period. This has exaggerated the pre-existing disparity in the value of asset holdings between middle and high-net-worth families (Figure 6).

 - source Federal Reserve Board and Wells Fargo Securities

The CoreLogic home price index has gained about 45 percent since its trough in February 2012. Meanwhile, the S&P 500 is up about 250 percent since its 2009 recession-low. The combination of lower asset ownership rates and smaller holdings for middle-wealth families, therefore, is a major reason that explains why mean family net worth has recovered since the Great Recession while median family net worth has languished." - source Wells Fargo

Some would argue that "Capitalism" has been seeding the seeds of its own destruction. As we posited in the past, bear markets for US equities generally coincide with a significant tick up in core inflation as we indicated again in our recent conversation "Bracket creep" until recently the US economy  has been plagued by "fixed income" (lack of wage growth) and "floating expenses" (healthcare and rents):

"Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation. Given most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple" - Macronomics, January 2018

After all it seems that the "Wealth defect" could be leading in the end to trickle-down "inflation" but the wrong one, but, we digress again... 

"The best way to destroy the capitalist system is to debauch the currency." - Vladimir Lenin

Stay tuned ! 

Macro and Credit - The Twain-Laird Duel

"All you need in this life is ignorance and confidence, and then success is sure." - Mark Twain

Watching the mesmerizing new heights reached by US equities in conjunction with US rumblings and looming threats of trade wars being felt, with ECB supremo Mario Draghi vainly trying to offset the weak dollar rhetoric coming from Treasury Secretary Steven Mnuchin's weak dollar recent stance, when it came to selecting our post title analogy, we reminded ourselves of the famous duel that opposed American writer Mark Twain with fellow country man James Laird. This was one of the most prominent duels in American History:

"While living in Virginia City, Nevada, sharp-witted satirist Mark Twain was up to his usual pot stirring, writing such outrageous editorials for The Territorial Enterprise that locals dubbed him “The Incorrigible.” When Twain wrote a piece erroneously accusing a rival paper, The Virginia City Union, of reneging on a promised pledge to charity, the publisher of the paper, James Laird, made such a stink over the false accusation that Twain challenged him to a duel. Twain’s second, Steve Gillis, took Twain to practice his shooting, only to find that the man’s pen was truly mightier than his pistol; Twain couldn’t hit the side of a barn. Filled with fear, Twain collapsed. As Laird and his men were making their way over, Gillis grabbed a bird, shot his head off, and stood admiring the corpse. Laird’s second asked, “Who did that?” and Gillis responded that Twain had shot the bird’s head off from a good distance and was capable of doing it with every shot. Then he gravely intoned, “You don’t want to fight that man. It’s just like suicide. You better settle this thing, now.” The creative ploy worked, and the men reconciled. Tom Sawyer would have been proud." - source The Art of Manliness

One could opine that in similar fashion to Mark Twain, when it comes to its inflation target, Mario Draghi cannot hit the side of a barn as well. Then again, as history as shown us, many times, sometimes you don't want to fight central bankers, because often their creative ploys work, whatever it takes, until they don't but for now that's another story.

In this week's conversation, we would like to look at the recent rise in the trade war rhetoric, the weakness in the US dollar and what it entails from an allocation perspective.

Synopsis:

• Macro and Credit - Trade and currencies, gloves are coming off
• Final chart - Pension rebalancing? Re-hedge this...

• Macro and Credit - Trade and currencies, gloves are coming off

We won't continue to blow our own trumpet, but as a reminder, in January 2017 in our conversation "The Woozle effect" we indicated our contrarian stance, namely that we were willing to stand against the US long dollar crowd and that we would rather be overweight Emerging Markets (EM) equities over US equities. Obviously with the continuation of the same trend in early 2018 with a weaker US dollar, we continue to advocate being overweight Emerging Market Equities over US equities from an allocation perspective. 

The recent "war" of words between US Treasury Secretary and Mario Draghi, tempered somewhat by the US president as of late has already revealed clearly that when it comes to being in a tight spot, the ECB is in a much more difficult position than the Fed when it comes to winding down its QE program. 

Also in our January conversation "The Woozle effect" we indicated the following:

"Equities pundits like to focus on the asset side, such as the impact of corporate tax rate mentioned above, we credit pundits tend to focus on the liability side which means that rather than focusing on the corporate tax relief effect we would rather side with our friend Michael Lebowitz from 720 Global from his latest note "Hoover's folly" from the 11th of January and focus on Global Trade risk, Hoover's style:

"Ramifications and Investment Advice

Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.

If actions are taken to impose tariffs, VATs, border adjustments or renege on trade deals, the consequences to various asset classes could be severe. Of further importance, the U.S. dollar is the world’s reserve currency and accounts for the majority of global trade. If global trade is hampered, marginal demand for dollars would likely decrease as would the value of the dollar versus other currencies.

From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

Investors should anticipate that, whatever actions are taken by the new administration, America’s trade partners will likely take similar actions in order to protect their own interests. If this is the case, the prices of goods and materials will likely rise along with tensions in global trade markets. Retaliation raises the specter of heightened inflationary pressures, which could force the Federal Reserve to raise interest rates at a faster pace than expected. The possibility of inflation coupled with higher interest rates and weak economic growth would lead to an economic state called stagflation. 

Other than precious metals and possibly some companies operating largely within the United States, it is hard to envision many other domestic or global assets that benefit from a trade war." - source 720 Global, Michael Lebowitz, Hoover's folly, 11th of January 2016

This makes perfect sense and as we indicated earlier on, we have become more positive on gold / gold miners in late December for that very reason. As we pointed out in our November conversation "From Utopia to Dystopia and back" the trade attitude of the next US administration is the biggest unknown, and the biggest risk we think." - source Macronomics, January 2017

Weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand. 

We also added at the time:

"If indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar." - source Macronomics, January 2017

In numerous conversations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Furthermore, in our recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. Protectionism, in our view, is inherently inflationary in nature. To preserve corporate margins, output prices will need to rise, that simple, and it is already happening. 

Productivity in the US has been eviscerated. We feel we are increasingly moving from cooperation to "non-cooperation", a sort of "deglobalization". 

It is a theme we approached in January 2015 in our conversation "The Pigou effect" when we quoted the books The Trap and The Response from Sir James Goldsmith published in 1993 and 1994. Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015:

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.

“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"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

Real wage growth has been the Fed's greatest headache and probably the absence of it has been of the main reasons behind President Trump's election. This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, 22nd of July 2014

The recent "Twain-Laird Duel" between US Treasury Secretary and the ECB clearly shows that there is a heightened risk for global trade thanks to a domestic agenda given low productivity and the consequences the "off-shoring" of labor has had on local communities as warned by Sir James Goldsmith in his great books. On the subject of global trade we read with interest Barclays Economics Research note from the 26th of January entitled "Trouble with trade?":

"Global trade at risk?

Protectionism and its adverse effect on the global trade system has been one of the key concerns in a 'Goldilocks' environment of favourable economic developments and rallying financial markets. The aggressive rhetoric on trade of the US started to turn into action this week, as President Trump's approved 'safeguard' tariffs on imported solar panels and washing machines. Later Secretary Mnuchin and Commerce Secretary Ross indicated at the World Economic Forum in Davos that further such trade measures could be forthcoming, while also criticising the WTO in principle. President Trump's speech at Davos struck a generally conciliatory tone on trade, but also lacked any specificity to meaningfully alleviate concerns. In parallel, the NAFTA re-negotiations entered their sixth round this week, with growing risk of collapse, as the US will present its response to Mexico and Canada's suggestions this Monday

Could this be a turn for the worse in global trade? Pessimists can point to the fact that an already quite 'globalised' world in the early 20th century experienced a collapse of trade openness as a consequence of war and protectionism in 1914-1945; it took many decades to regain such openness, and only since the early 2000s have global trade levels reached new highs.

However, several reasons (beyond the absence of a world war) speak against such gloom: first, leaders from Europe, Canada, China and elsewhere in EM continue to underline their commitment to openness and multilateral cooperations; the UK's apparent growing desire for a 'soft' Brexit could also be seen in this light. Second, undoing global trade has become ever more difficult: as it has transformed from an exchange of final goods between nations into a complex trading network of intermediate goods that cross borders as part of corporations' global value chains. Protectionism would, thus quite immediately backfire on an economy with as many global corporations as the US, likely affecting equity market valuations, etc.

We continue to believe the US administration will want to avoid deterioration into a trade war. However, the coming months will show whether this view could be too sanguine; markets will watch for the next steps in: NAFTA negotiations, additional trade actions by the US (eg, on steel and aluminium) and potential retaliation measures by China, as well as a possible turn of the US towards challenging its KORUS deal with Korea and a looming fight over the refusal of the US to grant China 'market economy' status in the WTO. 

Central banks: managing great expectations

Central banks this week acted broadly according to expectations. Facing market expectations for a more rapid policy normalisation and related appreciation pressures on their currencies, both the BoJ's Kuroda and the ECB's Mario Draghi tried to downplay expectations for policy change. However, both did so with limited success, as they did not deny the robust growth and data-dependence of their future actions. Thus, as long as the favourable economic trends persist, the BoJ and the ECB may struggle to reverse the market's growing anticipation of policy normalisation. We continue to expect the BoJ to shift its yield target in Q3 and the ECB to end QE in September, followed by a first depo rate hike in December.

Next week's meeting of the Fed - whose new chairman Jerome Powell was confirmed this week by Congress - should be relatively uneventful as well. The FOMC statement should remain largely unchanged, with the next hike expected only for March. The FOMC members' assessment will take note of recent developments: Q4 GDP growth at 2.6% was below consensus, but accompanied by strong durable goods orders, broadly confirmed the economy's robust expansion; the sharp USD depreciation contrasts with rising yields and ever highly equity market records; and the more aggressive trade policy moves and continued domestic political tensions (even if the government shut down has been ended this week at least temporarily) mean higher uncertainty.

Watching Wages

More quietly but no less importantly will be the monitoring of inflation and wage growth developments in core economies. This week’s December core CPI print failed to strengthen, suggesting the need for wage growth and higher service prices for more sustained inflation. Next week’s annual wage outlook survey should be a decent predictor for the actual Shunto wage negotiation outcomes in March. Amid a growing labour shortage, the outlook for Japanese wages should finally improve in Germany where unemployment is also at record low levels, the powerful 'IG metal’ trade union has threatened nationwide strikes, as the fourth round of wage negotiations has not satisfied their demand for a 6% wage increase. Again this could possibly signal the beginning of some upward pressure on wages.

For the same reason, attention will be on US core PCE (December) on Monday (we expect 1.5% y/y), as well as on next Friday’s labor market report. Besides some expected improvements in the monthly NFPRs from last month (to 175,000), we expect the pace of m/m wage growth to be unchanged at only 0.3%.

It will show whether some US companies' recent verbal commitment to increase investments, hire more worker and increase wages will be reflected in these aggregates" - source Barclays

Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing...

Could the word "stagflation" makes a return? We wonder given corporations which have spread their supply chains across the world in the last ten years could be impacted seriously via a rising cost bases due to protectionism. After all, "globalization" means the world is more connected than before, so are stock markets around the world, and we are not even talking about the ETF "interconnection" risk here (another subject yet an important one).

But moving back to the US dollar, we still think, when it comes to its relationship with oil, that it was the primary driver of the collapse in oil prices in 2014. The sudden vicious surge in the US dollar was an exogenous shock which impacted the oil market. The US dollar has been in the past as well problematic for oil prices when recessionary forces caused a safe haven surge in the US dollar in 2008, leading to oil prices collapsing as per the below FRED chart:

- source FRED

While some pundits would argue that correlation doesn't mean causation, the weakness in the US dollar in 2017 has translated in a surge in oil prices with a continuation of the theme in early 2018 it seems. The risk is that if the Fed reads the US dollar weakness as a sign of the global economy’s heating up too fast with a higher risk of inflation in the future (particularly in the US), then it could shift in a hawkish direction because the dollar weakness goes hand in hand with even looser financial conditions and financial stability matters a lot for these guys. This would mean that the Fed might feel it is once again behind the curve. Yet it seems many investors have not factored in a possibility of more rate hikes coming compared to what is being discounted. This is indicated by Deutsche Bank in their Global Fixed Income Weekly note from the 26th of January entitled "Exogenous currency shock and monetary policy":

"A weaker USD supports easier financial conditions in the US. In turn, easier financial conditions will support growth and inflation. Therefore, one can back the implied “rate cuts” from the currently extremely very loose financial conditions. The work done by our US economics team suggests that the improvement in financial conditions observed since December is equivalent to 15-20bp of Fed fund easing. In other words, to compensate for easier financial conditions, the Fed would need to add close to one additional hike.

- source Deutsche Bank

Also, many pundits have put into the forefront a risk of a repeat of a 1987 event in the making. On this subject we read with interest Nomura's Matsuzawa Morning Report from the 25th of January entitled "Similarities between the strong commodities/weak USD trend and Black Monday":

"Yesterday, USTs and Bunds softened (bear steepened), USD and equities weakened, commodities strengthened and inflation expectations increased. This combination provides a relatively clear message, namely that the Fed is beginning to fall behind the curve. If the US administration takes FX measures favoring US trade, the Fed would lose its freedom with monetary policy and faith in the USD could begin to crumble. This would be a relatively dramatic denouement. We can look back to Black Monday in 1987 and the Tequila Crisis in 1995 for examples. Ultimately, USD did not stop weakening until the G7 issued a joint statement and carried out coordinated interventions. At the same time, the implications for US rates and global rates could be the exact opposite, depending on economic sentiment at that point. In 1987, rates surged globally, but in 1995 they plummeted. Stronger-than-expected economic growth in 1987 led to calls for rate hikes but, in 1995, substantial Fed rate hikes over the previous year sparked fears of an economic slowdown. Opinions will differ on which of these scenarios mostly closely approximates our current situation, but we believe the 1987 scenario is a closer fit. EM equities continued to rise yesterday, demonstrating resilience in the face of higher US yields and weaker USD. Moreover, despite stronger EUR, Europe’s PMI has reached the highest level during the current phase.

We cannot be sure whether the current phase will play out as dramatically as it did in 1987 and 1995, but investors holding USTs will face a trial in the near term, in our view. If the US administration and Fed fail to address weak USD and higher inflation expectations, the support line of 2.75% for 10yr UST yields would lose its significance, and the bear steepening could accelerate (due to higher risk premiums). The outcome with the least damage would be for the Fed to turn hawkish at an early stage, curb inflation expectations, and encourage USTs to bear flatten. We will be watching the end-January FOMC statement and incoming Fed Chair Jerome Powell’s testimony before Congress in mid-February for any hints as to the approach the Fed will take. However, if the US administration continues to take action to weaken USD, the Fed’s efforts alone would not be enough to alter this course. This would create a difficult position for Japan and the EU, which face strong currencies, and for their central banks, for the opposite reasons. They must consider a QE exit given robust economies, strong commodities and higher inflation expectations, but they must also take into account the deflationary pressures arising from strong currencies (Note 1). As a result, the ECB and BOJ would find themselves unable to take action, which could encourage investors to pull their money out of the US and seek refuge in Japanese and euro area bonds instead. However, this flow would reverse as soon as the weak USD begins to wind down, accelerating upward momentum for global yields.

Note 1: In 1987, the Bundesbank gave a greater weighting to strong commodities and higher inflation expectations than to a strong currency and ramped up its rate hikes accordingly. This was one of the triggers for Black Monday. In contrast, the BOJ left its policy rates at a historical low (for that time), creating the most massive stock and real estate bubble since WWII." - source Nomura

In this new Twain-Laird Duel, it could be argued that both the ECB and the Bank of Japan have been effectively cornered. If some feels there is a 1987 risk to the current trend, some others think the period is more akin to the 1994-1995 period which showed significant pressure on bond prices with rising yields. This is what Deutsche Bank has argued in their FX Special Report note from the 25th o January entitled "Yes, it all makes sense":

"The lead market commentator of the Financial Times this morning writes that the dollar sell-off has “stopped making sense”. Viewed with the post-crisis lens of activist central banks and exceptionally tight correlations between FX and rates the dollar is entirely out of line with fundamentals. Take a step back to the 1990s and 2000s however and things look a lot less unusual. Back then, the correlation between US yields and the dollar was very weak. FX market drivers were influenced by the complex interaction of macro variables, politics and valuations. The deviation between rates and FX was the norm, rather than the exception (figure 1).

Currency moves over the medium-term ultimately boil down to one thing: flows. If inflows into an economy pick up the currency strengthens and vice versa. Looked at from a flow perspective, the dollar bear market makes complete sense. The US basic balance – the sum of the current account, portfolio balance and foreign direct investment flows - peaked last year and is on a steadily declining trend (chart 2).

The European basic balance, in contrast, is shooting up (chart 3).

Can this continue? In our FX outlook for the start of the year we argued that the answer is yes: US asset valuations are at record highs so it will be difficult to find the marginal buyer of dollar assets in 2018. US twin deficits are widening driven by fiscal stimulus at the wrong point in the macroeconomic cycle pushing the US current account deficit even wider. And the US is reengaging with a weak dollar policy similarly to the 1994-95 period. “Words” in the world of FX do matter – the big turn in the dollar cycle in 1985 was driven by the Plaza accord, and in 1995 by Treasury secretary Rubin’s initiation of a strong dollar policy. The US tax reform does not make a difference because corporates already hold the bulk of their offshore earnings in dollars and there was nothing preventing them from converting into dollars in previous years anyway.

What about Europe? Europeans have spent trillions of euros recycling their current account surplus abroad over the last few years, a phenomenon which we have previously termed “Euroglut”. This flow drove EUR/USD all the way down from 1.40 to parity. As a result, Europeans are exceptionally overweight foreign assets. In the meantime, Europe’s current account surplus has swelled to 400bn EUR a year. As these European outflows begin to normalize, even a small change makes the Eurozone basic balance look a lot more positive. Add the shifting political dynamics in Europe and we have the perfect cocktail for continued euro strength.

Turning points in the medium-term dollar cycle are often marked by material geopolitical events (chart 4).

We would argue the medium-term bear market in the dollar started with the inauguration of President Trump and President Macron in the US and France, respectively, last year. It has coincided with a structural shift in the relative flow dynamics between the US and the rest of the world. We continue to target 1.30 in EUR/USD for this year." - source Deutsche Bank

From cooperation and globalization to un-cooperation and "deglobalization" through "trade war"? One might wonder if indeed there is a definite change of narrative that could lead to a new "Twain-Laird" Duel. So far the "inflationista" camp is racing ahead, but given lackluster productivity growth in the US, automation, robotization and globalization and demographic headwinds, do all this mean that the "deflationista" camp has lost the battle and the reflation trade remains the "trade du jour"? We wonder, but so far, the trend in yield is up and is your friend. We'd rather be neutral on the duration front for now and wait for more clarity from the upcoming FOMC, making us more Laird than Twain on this occasion and not willing to fight these men for now.

• Final chart - Pension rebalancing? Re-hedge this...

Last week saw for the first time outflows in 5 weeks for Investment Grade funds as reported recently by Bank of America Merrill Lynch Follow The Flow note from the 26th of January entitled "Blame the tail" with a sizable outflow but, according to them there were only a handful of funds to blame for this event taking place. Higher outflows would be tied to renewed bond volatility than current rates levels according to them. Also, we would argue that as we are moving into the end of an extended credit cycle it would be wise for some investors to become more defensive credit wise and we would continue to expect some sort of rotation from US High Yield towards US Investment Grade. In fact their report indicated that High Yield fund flows remained into negative territory, recording 11th consecutive week of outflows. Yet, our final chart from Deutsche Bank US Fixed Income Weekly note from the 26th of January entitled "Easier financial conditions warrant higher short rates" indicates that we could see significant rebalancing or re-hedging needs from the pension community:

"Dramatic equity outperformance relative to fixed income such as that experienced thus far in 2018 can produce very large re-hedging needs. For example, at the time of writing the SPXT had outperformed the Bloomberg Barclays US Aggregate index by just over 7%, which produces an implied “static weight flow” of $87 billion out of equity and into the bond market. This demand is likely to remain a short term impediment to term premium recovery, and should continue to flatten the long end of the Treasury curve and steepening of the swap spread curve. This acute demand has been the third of our four key themes.

Note, however, that punitive hedge costs for yen based investors have the opposite effect, as the yield of hedged Treasuries over JGBs is at or near historically low levels. With these investors likely to look elsewhere for yield, it is pension demand at the moment which is the “swing factor” slowing term premium recovery. What reduces pension demand? Equity stabilization, or more generally tighter financial conditions. Ironically, the Fed will likely have to continue to hike rates to stabilize equities and provide an ultimate release for the long end." - source Deutsche Bank

With US 2 Year treasury now yielding 2.13% it remains to be seen at what level investors will start parking cash again and start paring back on their equity exposure and other risky credit such as high yield. For the time being in similar fashion to Twain and Laird, the duel seems to have been postponed but we ramble again...

"Prophesy is a good line of business, but it is full of risks." -  Mark Twain

Stay tuned !