Macro and Credit - The Carrington Event

"Faith may be defined briefly as an illogical belief in the occurrence of the improbable." -  H. L. Mencken, American writer

Watching with interest US stocks markets reaching new record levels, while investors are pondering what are the risks coming up in the horizon such as a potential trade war initiated by the Trump administration, China credit bubble bursting, an end of the euphoria in US High Yield, upcoming European elections in Holland, France and potential elections in Italy, we reminded ourselves for our chosen title analogy of the 1859 Carrington Event, a perfect solar superstorm and arguably the most underpriced risk in the world. At 11:18 in the morning on September 1st 1859, English astronomer Richard Carrington in his observatory saw two patches of intensely bright and white light breaking out as he wrote in his report "Description of a Singular Appearance seen in the Sun". The massive solar flare had the energy of 10 billion atomic bombs and hit our planet a couple of hours later wreaking havoc to the nascent global telegraph system. Today such natural "Electromagnetic Pulse" (EMP) disaster would inflict considerable damages to critical infrastructures around the globe. Extreme solar storms pose an existential threat to all forms of high-technology and create widespread power blackouts, disabling everything that plugs into a wall socket. According to NASA from their 23rd of July 2014 article entitled "Near Miss: The Solar Superstorm of July 2012", a similar storm to the Carrington Event of 1859 would exceed $2 trillion or 20 times greater than the costs of a Hurricane Katrina according to a study by the National Academy of Sciences. We find it interesting that the more technology and connected we are the more fragile we have become, the thesis of Nassim Taleb's "antifragile" theory. Furthermore as per our long fascination with "Rogue Waves" and risk, depicted in our February 2016 conversation "The disappearance of MS München", what apparently seemed to be an oddity in terms of probabilities, isn't in terms of frequencies as discovered by scientists studying the phenomenon to their dismay. In similar fashion, a solar superstorm appears to many people to be an extremely rare type of event with a low probability. It isn't. As per NASA's article to paraphrase Taleb, we are fooling ourselves with randomness: 

"In February 2014, physicist Pete Riley of Predictive Science Inc. published a paper in Space Weather entitled "On the probability of occurrence of extreme space weather events." In it, he analyzed the records of solar storms going back to 50+ years. By extrapolating the frequency of ordinary storms to the extreme, he calculated the odds that a Carrington-class storm would hit Earth in the next ten years. The answer is 12%. "Initially, I was quite surprised that the odds were so high, but the statistics appear to be correct", says Riley. "It's a sobering figure"." - source NASA

To paraphrase Donald Rumsfeld, while in financial markets today they are known unknowns, when it comes to solar superstorms it represent an unknown known, yet simply ignored by so many.  Such an event, if it hits Earth would cost several trillions of dollars, with a potential lasting recovery time given we are much more reliant on technology these days. Therefore we are way more vulnerable to these types of "rare" event than in the past, same goes with financial markets. Central banks meddling with assets prices have rendered the system much more "interconnected" therefore much more fragile and unstable. Globalization as well, has rendered economies much more entangled than in the past.

You might be wondering where we are going with our analogy. It seems to us that 2016, the many pundits that made the case for catastrophic events for BREXIT and Trump election got not only the outcome wrong, but also got the results wrong when it came to predict the impact on financial markets. In the case of 2016 we had "bad news" (on the back of "fake news") leading to "good news" for financial markets, we are wondering if in 2017 will not be "good news" (on the back of "real news") leading to "bad news" for financial markets.

In this week's conversation we will look at if indeed the "Trumpflation" story is not losing some steam and also what it entails in terms of allocation.

Synopsis:

• Macro and Credit - 2017 - From optimism bias to realism bias 
• Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends

• Macro and Credit - 2017 - From optimism bias to realism bias 

2016 for "credit" performances was a story of "bad news" leading to "good news", with the first part of the year plagued by the widening in the energy sector thanks to oil woes and spilling over to equities. Clearly the second part of the year saw a dramatic reversal of fortunes with US High Yield and in particular the energy sector leading the way, while investors extended both their credit exposure and duration exposure. While 2017 continues to see a rally in both US equities reaching new height and credit continuing its strong pace thanks to very significant inflows. This is particular the case for fixed income which is clearly seeing no sign of the "Great Rotation" story playing out, from bonds to equities that is. In fact, what is of interest is that this "great rotation" is happening with significant inflows into High Yield, most likely out of Government bond funds. As we have commented before on numerous occasions, we believe we are moving into the last inning of the credit cycle and at this stage we do not think High Yield could easily repeat its 2016 feat.

When it comes to "reaching for yield", whereas 2016 saw an extension of both credit risk and duration risk, 2017 so far is seeing somewhat a more defensive play when it comes to duration, but in terms of credit risk, High Yield has been seeing some significant flows as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 10th of February 2017 entitled "Reach Higher (yield), go Shorter (duration):

"No losers; everyone benefitting so far

Rising rates are not deterring investors from allocating more into fixed income funds. In fact last week’s inflow into the asset class was the strongest in 28 weeks. Inflows were strong mainly in the higher yielding part of the market, i.e. HY and EM debt funds, but also into high grade ones; predominantly on the short-dated part looking for a “shield” against rising rates. In other words investors are seeking high-yielding instruments and shifting into low-duration IG to protect against rising rates. Rising uncertainty is also favouring flows into commodity (particularly gold) funds.

Over the past week…

High grade funds continued on a positive trend for the third week in a row. The weekly inflow was also the highest in six weeks. High yield funds saw inflows for the tenth consecutive week, and the latest inflow was the largest since March ‘15. Looking into the domicile breakdown, the inflow last week came largely from US domiciled and globally-focused funds. Nevertheless the European-focused funds inflows improved from the previous trend.

Government bond funds had their third week of outflows despite rising rates. Money market funds weekly flows were positive after three weeks of outflows. Overall, fixed income funds recorded an even stronger week of inflows than the previous one, the highest in 28 weeks and the seventh positive in a row. The asset class is rapidly approaching the $20bn mark of inflows YTD. European equity funds flows were positive for a third week but with marginal volumes.

Global EM debt fund flows continued on the positive trend for a second week; and the latest inflow was the highest in 28 weeks. Commodities funds flow remained positive for a fourth week in a row, with the inflow pace going up again.

On the duration front, inflows continued in short-term IG funds for the eighth week in a row. Note that last week’s inflow was the highest since July ‘14. Mid-term funds’ flows flipped back to negative territory after last week’s strong inflow. On the other hand, flows into long-term funds moved back to positive after two weeks of outflows." - source Bank of America Merrill Lynch

Given such powerful flows as of late, it is hard to see what could be the catalyst that will finally derail this long in the tooth credit cycle. We are wondering what could potentially be the Carrington Event for credit. In the meantime, the rally runs unabated thanks to solid macro data and reasonable earnings for the time being. As we indicated earlier one, we wonder if 2017 will not be the reverse of 2016, namely that we will have a solid first half and probably a more difficult second half of the year. It is very difficult to assess what lies ahead with so many political events lining up for the year. In this context, we have raised our cash levels, and continue to play the gold mining theme while we are waiting for more clues from the Japanese crowd before being enticed again towards US Treasury notes. On the subject of tail events, we read with interest Bank of America Merrill Lynch Relative Value Strategist note from the 9th of February entitled "Always looking on the bright side of life":

"The anti-climax of tail events

In our view, the biggest financial misjudgments in 2016 were not about underestimating the probability of certain political events. We believe the larger error, in hindsight, was overestimating the immediate severity of the market’s reaction should they come to pass. So while we had two unexpected outcomes in Brexit and the US election results, both of which were viewed negatively in their respective run-ups, the aftermath has been quite anti-climactic in our view. The market has chosen to focus on the bright side of things, building up policy proposals that it favors like lower taxes and fiscal stimulus, while casting aside those like border adjustment taxes and renegotiating trade deals that could be detrimental to asset prices. While this may eventually prove to be the right call, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way.

As it stands, there seems to be widespread optimism that tax reform, deregulation and fiscal expansion this year will spur strong growth and inflation in the US. While this may eventually prove to be true, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way. This speaks to some complacency in our view, with not enough weight being given to medium-term policy uncertainty. 

Uncertainty is high. Stay liquid. Be hedged.

In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and favor CDX HY over indices referring cash bonds, as the basis is unlikely to compress much further." - source Bank of America Merrill Lynch

As per our last conversation, we would side again with Bank of America Merrill Lynch in regards to favoring the liquidity of CDX HY over cash bonds particularly in the light of the compression seen so far in US High Yield since the beginning of the year (European High Yield as well has had a solid run):

But, nonetheless, a barbell strategy of quality investment grade including short duration High Yield, could still represent an attractive investment proposal, particularly in the light of continuing widening in European Government bonds and the convexity risk for long dated investment grade securities.

"Stay liquid: long CDX HY over HY cash

In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun – SPX is down 0.5% in the last two weeks, while IG is 2bp wider. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and prefer CDX HY over indices referring cash bonds.

The CDS-cash basis is unlikely to go much higher

The CDS-cash basis has reverted towards its pre-2015 levels. The BAML HY index, H0A0, now trades just about 50bp wider than CDX HY (Chart 1). (Note it was 38bp wider until IHRT was removed from HY27 post default.)

As Chart 2 shows, the IBOXHY cash index has consistently outperformed its CDX counterpart for a year now. We think there is limited upside to this now i.e. the basis is unlikely to compress all the way back to 2012 levels thanks to some amount of liquidity premium embedded in high yield cash bonds after the events of the last two years.

Liquidity, liquidity, liquidity

CDX HY offers a better value, liquid long here than HY cash in our view. In the event of a macro shock, the synthetic index might initially underperform cash, but if the weakness persists, bonds will eventually catch-up. More importantly, we think the level of uncertainty regarding policy and the prospect of a flare-up following this period of extremely low volatility demands a higher allocation to liquid products.

Hedge against rate risk

This switch to CDX or a positive basis trade (long CDX, short cash spread) will also perform well as a hedge against a sharp rate rise, should one materialize.

US equities outperformed European equities while volatility continued to decline in both
markets (Table 4). Equity vol in the US currently stands at 11 vol points, near the lows
seen over the past 10 years:

 (Click to enlarge)

- source Bank of America Merrill Lynch

What is of interest to us in the case of US High Yield is the very slow deteriorating trend as shown per the Q4 Fed Senior Loan Officer Survey which has been recently released. On this subject we read with UBS latest Global Credit Strategy note from the 7th of February entitled "Has US High Yield priced too much good news?":

"Has US high-yield priced too much good news?

One of the most critical questions that portfolio managers face when investing relates to what is priced into the market. We have tackled this question before. One year ago, we highlighted to investors that it was not attractive to short US high-yield, as spreads near 850bps implied a US recession was imminent, while underlying fundamental data suggested otherwise. Fast forward one year, and we are in a very different world. US high-yield spreads sit at 400bps, only 43bps above cycle tights in July 2014. US highyield has returned a superb 21.2% over the last 12 months, one of the strongest rallies ever outside of a post-recession recovery. The key question for investors: Is there still room for US high-yield to rally?

It’s certainly possible. In our recent client meetings, we have heard the strong current of institutional pressure dragging active managers into the market to stem client outflows and reduce what has been an exceptionally difficult period of active manager underperformance vs. the broader index (Figure 1). We think this theme is dwindling as cash balances are falling, but it cannot be discounted from extending further . In addition, if developed market central banks remain dovish (i.e. only 2 Fed hikes in 2017, ECB keeps Taper talk to a minimum, BOJ keeps 0% 10yr JGB yield target), we believe that would be a positive near-term for setting the marginal price of credit.

However, it is becoming impossible to ignore downside fundamental and political risks that are more elevated than when high-yield last traded at such levels. Bank and nonbank lending standards are not easing, credit card and auto loan delinquencies are rising, bank C&I loan growth has stalled, and more protectionist sentiment is being underprized in our view as a macro risk. We believe investors should protect gains at current levels, with both high-quality (BB) and low-quality (CCC) high-yield credit at expensive prices. We suggest investors own junk credit through CDX to protect against illiquidity risk in cash bonds. Investors can also bet on a widening Cash-CDX HY basis as a downside hedge with very attractive risk-reward characteristics. Lastly, we reiterate our 2017 preference for US investment-grade credit and leveraged bank loans over US high-yield.

We believe the main conclusion that investors should take away is the following: While US high-yield has rallied to near cycle peaks, fundamental data highly correlated to US high-yield has not followed suit. Today’s release of the Q4 Fed Senior Loan Officer Survey highlighted a net 0% of banks tightening standards on small firm C&I loans, marginally worse than the -1.5% of banks easing conditions in Q3 (Figure 2). While 0% is not terrible, we need to remember that in the sweet spot of the cycle, a net -5% to -10% of banks typically ease conditions. It should be rather disappointing to bullish investors that one of the strongest high-yield rallies in history has been unable to induce banks to ease standards on CI loans.

Even more important than the headline number, we found only a net 7.4% of banks tightened spreads on C&I loans (average across large and small firms). This reduction of spreads is very modest in light of the massive spread tightening seen in the high-yield bond market. In context, this reading is worse than that experienced in Q2’98 and Q2’07. Put simply, banks are not passing on the decrease in market funding costs to their customers, at least not to the same extent as in the high-yield bond market. Given that these two lending indicators empirically lead both high-yield spreads and default rates, we keep our year-end forecasts for HY credit spreads, default rates, and total returns unchanged (YE 2017 HY spread: 570bps, 2017 HY Default Rates: 3.6%, 2017 HY total returns: 0.1%). For more details on our overall credit forecasts, please see our 2017 outlook pieces. In addition, the rather mixed performance of the lending survey was not limited to C&I loans; a net 23.8% of respondents tightened standards on CRE loans, a net 8.3% tightened on credit cards (worst post-crisis) and 7.3% tightened on auto and other consumer loans (worst post crisis) (Figure 3).

The Q4 Senior Loan Officer Survey also asked two sets of special questions regarding the future outlook for 2017 lending standards and delinquencies. The results here again are mixed, but mixed is not good enough with prices so high. On the former, it is true that a net -16.4% of banks expected lending conditions to ease for C&I loans to small firms, assuming economic activity progresses in line with consensus forecasts. This is the most bullish reading in the SLOS survey for credit investors and if it came to fruition could indicate the credit cycle is restarting. However, at the same time, a net 10.5% of banks expected to widen spreads on small firm C&I loans over the next year. This expected level of spread widening is empirically inconsistent with the forecasted easing in lending conditions, given the strong correlation between the two (Figure 2). To put in context, 10.5% of banks widening spreads is consistent with late 1999 and 2007 levels.

Significant numbers of banks indicated continued tightening for CRE (23.6%) and consumer loans (0% credit cards, 5.1% auto loans next year) as well in 2017. The outlook for delinquencies was also rather mixed. C&I loans only saw a small improvement, with a significant fraction of banks expecting rising NPLs in credit cards and auto loans (Figure 4).

This weakness in the consumer area remains a key source of concern. Our recent Evidence Lab primary survey on the US consumer suggested that rising post-election optimism was balanced out by households stating they were more likely to default on a loan over the next 12 months. Bottom line, there is clear potential for winners and losers post-election, rather than all winners.

The divergence of spreads relative to fundamentals goes beyond bank lending. Non-bank liquidity continues to tighten, largely flying under the radar of most investors. This has continued to tighten since we wrote our initial warning piece on the credit cycle in 2015 (Figure 5).

Non-bank trade credit (i.e. the financing of working capital) in particular continues to struggle, as improvement in the CMI trade-credit index has been modest and highly focused on better-quality names. (The favorable component of this series is currently at 60.8, the highest since July 2015). More stressed firms are under pressure however, with the unfavourable component of the CMI index at 49.5 in January, in contraction territory. The divergence of high-yield spreads versus weaker trade credit is now gaping. Figure 6 highlights that high-yield spreads are tightening rapidly at a time when the usage of collection agencies to collect on unpaid debt continues to grow.

When high yield spreads were at similar levels in 2014, the prospect of collection agencies was not even a remote concern. The CMI Index highlighted that retail names in the service sector were facing the most pressure, consistent our preference for underweighting this sector in US HY.

Another hole in the rally is how high-yield spreads have decoupled from underlying bank C&I loan growth (Figure 7).

Despite the well-publicized increase in consumer confidence and business optimism post the US election, bank C&I loan growth has stalled. We think this is not normal for an economy that is expected to hit mid 2% to 3% growth rates in 2017. In fact, the current growth rate of bank C&I loans is more consistent with levels seen just before recessions. Historically, high-yield spreads lead loan growth, as banks take time to restructure old loans and new firms wait to see evidence of consumer spending before borrowing anew. But this is typically an argument made after a recession. It is difficult to reconcile why bank loan growth has slowed already, since it is now generally established that the prior increase in credit spreads and funding costs did not impact US real GDP broadly to a meaningful extent. Could non-bank financing be crowding out bank financing to skew these numbers lower? This may matter somewhat, but many small US businesses with no access to capital markets must rely on bank financing if they wish to expand their businesses. Bottom line, we need to see loan growth picking up again.

Lastly, we believe there is significantly more political risk than many investors are appropriately pricing. We see the prospect of future protectionist policies from the new administration has the potential to be a key headwind, and our conversations with clients suggest this is not being taken seriously enough. A September 2016 paper by now Commerce Secretary Wilbur Ross and National Head of Trade Council Peter Navarro indicates a desire to reduce the US trade deficit meaningfully. The authors wrote in this report that “Those who suggest that Trump trade policies will ignite a trade war ignore the fact that we are already engaged in a trade war.” On the concept of tariffs, Mr Ross and Navarro wrote that “tariffs will be used not as an end game… Trump will impose appropriate defensive tariffs to level the playing field.” The authors believe that deregulation, lower taxes, lower energy costs, and a strong US bargaining position would offset any price increases and retaliation from increased protectionism, leading to a boom in US growth. However, we view any aggressive move to reduce the US trade deficit near-term via perceived protectionist measures would likely create considerable volatility in financial markets." - source UBS

You probably understand by now why our bullet point is entitled "From optimism bias to realism bias". It is important at this stage of the credit cycle to keep a heavy dose of realism. As we mentioned as well in numerous conversations we are tracking closely US Commercial Real Estate (CRE) particularly in the light of significant tightening financial conditions as depicted in the most recent Senior Loan Officer Survey. In recent musings we pointed out that tightening financial conditions were already showing up in the US in Commercial Real Estate (CRE). This is a segment we will be particularly monitoring in conjunction with its synthetic CMBS proxy the CDS CMBX index and in particular series 6 which comprises the highest retail exposure with 37%. As a reminder in our February 2016 conversation "The disappearance of MS München", we discussed the significant headwinds for the retail sector and in particular series 6 for the CMBX index due to its larger retail exposure. We recently read with interest from an article from Matt Scully in Bloomberg from the 9th of February entitled "Deutsche Bank Says Next Big Short Is on CMBS as Malls Suffer":

"Analysts at Deutsche Bank AG, one of the biggest underwriters of bonds tied to U.S. commercial mortgages, say now it’s time to bet against the securities.

The bonds are vulnerable because they are supported in part by leases from retailers, a lagging part of the economy, wrote Ed Reardon and Simon Mui in a note this week. A combination of bankruptcies and closures could lead to faster-than-expected mortgage defaults for stores and malls, as long-term pressure from internet competitors wears many companies down, the analysts wrote.

Deutsche Bank recommends that investors bet against two series of indexes of commercial mortgage bonds: one from 2012, and another from 2013, a trade that amounts to shorting the underlying securities. Those indexes have larger exposure to malls than their more recent counterparts.

The lender famously recommended betting against real estate before. Before the financial crisis, traders led by Greg Lippmann shorted residential mortgage bonds, which helped the lender weather the global banking meltdown. His efforts were portrayed in the book and movie “The Big Short.”

Falling Index

In this week’s note, Deutsche Bank advised buying credit default protection on the parts of CMBX indexes that are a single step above junk, known as the BBB- tranches. Morgan Stanley recommended betting against portions of those indexes last week. The BBB- rated portion of the 2012 Markit CMBX price index, known as the series 6, has been falling since the end of January.

That index traded at 90 cents on the dollar on Wednesday, compared with 95.2 cents on the dollar on Jan. 27, according to data compiled by Bloomberg. The price has dropped as wagers on the index have climbed in recent weeks, reaching $2.3 billion at the end of last week, according to Depository Trust & Clearing Corp. data.

Deutsche Bank was the biggest underwriter of commercial mortgage bonds in 2012 and 2013, selling about a fifth of the deals, according to trade publication Commercial Mortgage Alert. Buying default protection on the CMBX indexes from those years amounts to betting against many of the bonds the bank sold during that period.

Commercial mortgage bonds that the bank underwrote have performed worse than those of many rivals, said Don McConnell, a senior portfolio manager at Bank of Montreal’s BMO Global Asset Management in Chicago, who helps manage $15 billion of taxable bonds. Of property securities that are delinquent, 40 percent were underwritten by Deutsche Bank, the highest of any lender, even though it is the second-biggest underwriter, he said. JPMorgan Chase & Co., the biggest underwriter, accounts for 10 percent of delinquencies.

Failing Malls

More losses may be coming. The Hudson Valley Mall went into foreclosure last year after Macy’s Inc. and J.C. Penney Co. left the mall. The mall liquidated last month at a $42 million loss to investors -- by far the largest realized loss since the CMBS market restarted in 2010, according to Morningstar Credit Ratings. Sears Holdings Corp.’s credit rating was recently cut further into junk territory after sales in stores open at least a year fell 12 to 13 percent during the holidays.

“Big mall loans have outsize losses for investors,” said Morningstar analyst Edward Dittmer. “We expect the stores like Sears, Macy’s and Penney to close more stores later this year and next year, and as they close, there will be knock-on effects that lead to other mall tenants leaving. This can start the cycle of blight.”- source Bloomberg

While CMBX Series 6 saw it prices recover somewhat following the volatile first semester of 2016, the recent price action in conjunction with the weaker Senior Loan Officer Survey does suggest that there is indeed more pain coming for the sector and it is already playing out in this particular CMBX series. This as well documented in Bank of America Merrill Lynch's latest Securitized Products Strategy Weekly note from the 10th of February;

"Recap & relative value

With benchmark conduit spreads unchanged, no private label deals pricing and only one conduit transaction in the marketing process, the majority of this week’s conversations remained focused on the retail sector. Over the past two weeks short-risk interest in lower-rated CMBX6 tranches surged (Chart 45), fueled by a consensus among some hedge funds that retail and regional mall problems will accelerate in the coming months.

As a result, lower-rated CMBX6 tranches, which are collateralized by about 37% retail exposure, have borne the brunt of the pain (Chart 46), falling by as much as 3.5 points since the beginning of the month.

Although retail sector problems will likely continue to unfold over the coming months and years, it is important to understand what sparked the recent selloff. Over the past two weeks there has been some negative retail-related news (Wet Seal, LLC, filed for bankruptcy on Feb 2, Hudson’s Bay Co. approached Macy’s about a takeover, etc.) and the recent broader-market risk-rally stagnated as evidenced by range bound equity markets and falling 10-year Treasury yields and breakevens (Chart 47).

Ultimately, however, we think the recent move lower in the CMBX wasn’t based on new, fundamental information. Despite the selloff among lower-rated CMBX6 tranches over the past few weeks the underlying cash reference obligations have held in extremely well: there has been little client selling and cash bond spreads have barely moved. As a result, the BBB-minus and double-B cash/synthetic spread differential gapped sharply negatively (synthetics underperformed the similarly rated cash bonds) and (Chart 48) and are now testing, or through, their tightest historical ranges.

This isn’t to say that problems don’t exist. The regional mall space is likely to consolidate over the coming years, which may put pressure on some of the loans collateralized by these assets. Aside from those investors that are using lower-rated CMBX6 tranches to hedge their long-risk books (as some distressed investors do), in order for the “short CMBX6.BBB- or CMBX6.BB” trade to work successfully for an investor that is selling risk outright, the retail sector would need to experience a significant, large shock that has systemic implications to serve as a catalyst. The most commonly mentioned catalyst by many investors would be a near-term bankruptcy of a large retailer. Among retailers, Sears tends to be one that many investors focus on, given the company’s broad-based regional exposure in regional malls and the difficulties that it has experienced over the past few years.

Over the past few weeks, however, no new negative announcements have been made by the company that could have sparked renewed downward pressure on the CMBX. In fact, the company today issued a press release in which it announced it initiated a restructuring program targeted to deliver at least $1 billion in annualized cost savings in 2017. This is not to say that all is fine: although 4th quarter earnings were better than expected, total comparable store sales for the fourth quarter declined 10.3%, comprised of a decrease of 8.0% at Kmart and a decrease of 12.3% at Sears Domestic.

Ultimately, there are several independent “variables” that need to play out simultaneously for an outright short-risk CMBX6 trade to work as well as many hedge fund investors hope it will. In all likelihood, we think this is unlikely to happen. Instead, we think lower-rated CMBX6 tranches will trade in a wide range over the upcoming months and be exposed to potentially significant price fluctuations – both higher and lower – as investors react to headlines. At this point, following the magnitude of the recent move, which began at the end of January (Chart 49), we think the lower-rated CMBX6 tranches are over-sold and could rally as investors get short squeezed.

Given the lack of material, significant fundamental news, this week’s move seems largely technically driven. Over the past few weeks we’ve analyzed the regional malls collateralizing the CMBX6 and last week looked at loss severities for mall loans that were liquidated last year (Regional mall rhetoric has become too negative). One additional data point that we didn’t discuss, but which we think is important, relates to the timing between when loans first show signs of stress and when they were ultimately liquidated. Although this may not matter for investors shorting CMBX6 as a trade, it is important to investors shorting the index outright, since losses would need to be crystalized in order to receive a payout. On average, for the loans liquidated in 2016 that were collateralized by regional malls, it took approximately 48 months between when loans first began to show signs of stress and when they were ultimately liquidated" - source Bank of America Merrill Lynch

So, while no doubt, when it comes to the retail sector there is blood in the water and sharks are starting to circle, it appears to us that in this particular case "someone" is effectively "talking his book". While some pundits might eagerly follow the "Optimism bias" course of action with that "short" trade idea, we would rather side with Bank of America Merrill Lynch and play the "Realism bias" given the potential for the enthusiastic punters to get "short-squeezed" in very short order on that move.

For our final chart and when it comes to being more a "realist" the recent significant widening in French yields have been explained by many pundits by the sudden rise in the political risk in French from seeing Marine Le Pen getting elected at the next presidential election in France. For us, as we have been explaining in numerous conversations, when it comes to European government yields, you seriously need to track the flows from Japan.

• Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends

In 2016, in numerous conversations we have indicated the importance of tracking Japanese flows from the Government Pension Investment Fund (GPIF), their Lifers friends and Mrs Watanabe playing it through the famous Uridashi retail funds. We believe that in 2017, following Japanese flows is paramount when it comes to assessing yield movements in European government bonds. While the political rational might be enticing for some, for us it is simply a question of flows, or lack thereof, from the voracious 2016 Japanese investors which have been on a diet as of late. Our final chart comes from Bank of America Merrill Lynch Japan Rates and FX Watch note from the 8th of February and displays the cumulative purchase of European sovereign bonds by Japanese since 2012 (JPY trn):

"FDI and portfolio outflow offset current account surplus

Today Japan's Ministry of Finance (MoF) released international balance of payment statistics for December and a preliminary portfolio investment report for January (based on reports from designated institutions). The seasonally adjusted current account surplus was ¥1,669bn, somewhat lower than in November (¥1,780bn), but still a high level. The current account surplus for CY2016 was ¥20.6trn, and direct investment deficit of ¥14.6trn cancelled out most of this. The ¥30.5trn deficit in portfolio investment is sizable, but a significant part of this portfolio investment should have been hedged. This pattern of investing surplus funds overseas and using the profits to fund the home country reflects Japan’s status as an aging developed country. Also, due to the rising number of foreign visitors to Japan, a surplus of ¥1,339.1bn was recorded in the travel account, the largest such surplus since 1996.

The Trump shock’s aftereffects and Europe’s political risk

The rise of US yields following the US presidential election appeared to settle down around the beginning of 2017, but Japanese investors continued to sell a net ¥1.62trn of foreign bonds in January. Banks were the main sellers. They were net sellers of ¥1.97trn in one month. Life insurers, who had been net sellers along with banks in the previous month, switched to a net purchase of ¥159.8bn in January. Details of flow for January have not been released yet, but we do know from December figures that the net sale of US Treasuries was ¥2.39trn that month, the largest since May 2013." - source Bank of America Merrill Lynch

So if indeed in the Land of the Rising Sun, the sun is in fact setting on their appetite for European sovereign bonds, then no doubt you might get your equivalent of a Carrington Event and solar storm in European bond land we think. It might simply be that "Bondzilla" the NIRP monster might have a serious case of "bond" indigestion after his epic fest of 2016, but we ramble again...

"The world is divided into two classes, those who believe the incredible, and those who do the improbable." -  Oscar Wilde

Stay tuned !

Macro and Credit - The Woozle effect

"When everyone is thinking the same, no one is thinking." - John Wooden, American basketball player and coach

Watching with interest more fake news such as more stories surrounding evidence by citations of Russian involvement in US elections and fake prices, leading to some violent market gyrations as in Bitcoin, given our last musing around the thematic of hoaxes, we decided that for this week's title analogy, we would stick with the theme. The Woozle effect, also known as evidence by citation, or a woozle, occurs when frequent citation of previous publications that lack evidence misleads individuals, groups and the public into thinking or believing there is evidence, and nonfacts become urban myths and factoids. More importantly, "The Woozle effect" describes a pattern of bias seen within social sciences and which is identified as leading to multiple errors in individual and public perception, academia, policy making and government and markets as well (herd mentality). A woozle is also a claim made about research which is not supported by original findings. Given the creation of woozles is often linked to the changing of language from qualified ("it may", "it might", "it could") to absolute form ("it is"), we found interesting that the "Trumpflation story" has suddenly morphed from "it may" to "it is". To some extent, the Woozle effect is yet another example of confirmation bias we think. People tend to interpret ambiguous evidence as supporting their existing position. A series of experiments in the 1960s suggested that people are biased toward confirming their existing beliefs. Later work re-interpreted these results as a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. In certain situations, this tendency can bias people's conclusions. Explanations for the observed biases include wishful thinking and the limited human capacity to process information. Another explanation is that people show confirmation bias because they are weighing up the costs of being wrong, rather than investigating in a neutral, scientific way. Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor decisions due to these biases have been found in political and organizational contexts but, also in financial markets. As we have often indicated in our past musings, our contrarian stance comes from our behavioral psychologist approach given we would rather focus on the process of the woozles rather than their content. In our last musing, for instance we indicated we had turned slightly more positive on gold and gold miners alike. We must confess we have been adding in late December.

In this week's conversation we would like to discuss our contrarian stance surrounding "Mack the Knife" aka King Dollar + positive real US interest rates and why we think that eventually "Trumpflation" could morph into "DeflaTrump", meaning a lower dollar thanks to that 30s model we discussed as of late,  namely that populism and discontent means we are potentially facing a global trade war with the rise of protectionism.

Synopsis:

• Macro and Credit - All the promises we've been given...
• Final chart - The central bank "put" has been weakening

• Macro and Credit - All the promises we've been given...

From a Woozle effect perspective, we find it very interesting how easy weighing up the costs of being wrong leads to overconfidence.

We might sound a bit philosophical in these early days of 2017 but, we do share Jim Chanos and Steen Jakobsen, that we are going to see some tectonic shifts.

These shifts will have some significant consequences in terms of allocations rest assured. You might be wondering why we have entitled our bullet point this way? Well as goes the lyrics for an Electro House song we like "All the promises we've been given", government and central bankers have been very good at promising:

"All the promises we’ve been given
All the fires that we’ve feedin’
All the lies that we’ve been livin’ in
Wouldn’t it be nice if we
Could leave behind the mess we’re in
Could dig beneath these old troubles return
To find something amazing" - The Presets - Promises

This is somewhat the "Trumpflation" story playing out. Unfortunately, we cannot leave the mess we are in thanks to so many years of lax policies, lies and fires which our central bankers have been feeding. But, there is more to it. and at this juncture, we would like to remind ourselves with our November 2013 conversation entitled "Squaring the Circle" in which we tackled the paramount issue between "explicit guarantees" and "implicit guarantees":

"We quoted Dr Jochen Felsenheimer in our conversation "The Unbearable Lightness of Credit" in August 2012, let us do it again for the purpose of the demonstration:
"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"

We will not discuss the issue of implicit guarantees and explicit guarantees from a credit valuation point of view as we have already approached this subject in our conversation quoted above. The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them. Obviously our great poker player "Mario Draghi" at the helm of the ECB has played with his OMT a great hand but based only on "implicit guarantee". That's a big difference." - source Macronomics, November 2013

And this is the great swindle politicians have been pulling selling entitlements based on "implicit" guarantees rather than "explicit" ones. Let us explain, the developed world is awashed in unfunded liabilities, therefore "it may" has for so many people clinging to their pension benefits has become "it is". The woozle effect in that case is that many think that what is in reality clearly "unfunded" is "funded". It isn't. 

While everyone is focusing on the asset side of the "Trumpflation" story (lower corporate taxes, cash repatriation, etc.), no one has really been focusing on the liability side, which could have some important implications. What has been weighting so much on bond prices since the US election has been once again the Japanese investors crowd. Again what we indicated back in 2016 in our conversation "Eternal Sunshine of the Spotless Mind", still holds in 2017, namely that you want to track what these investors are doing flow wise:

"As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan"- source Macronomics July 2016

On this subject we read with interest Bank of America Merrill Lynch's Japan and FX Watch notes from the 12th of January entitled "Japanese investors sell foreign bonds after US election":

"Surplus structure keeps yen in check

Japan's Ministry of Finance today released the November international balance of payments and a preliminary portfolio investment report for December. Japan’s current account stood at a ¥1.8tn surplus in November to match the recent trend (Chart 3).

We are seeing a gradual recovery in Japan’s real exports, which seems in line with the positive cyclical trend in global manufacturing. Oil imports have stabilized, but remain low. Outward direct investments exhibit structural strength, but the yen’s significant depreciation since the summer suggests “tactical” large-scale purchases of foreign companies (eg, Softbank buying ARM) are probably behind us for the time being (Chart 4).

The BoJ’s yield curve control has widened the yield gap between foreign and yen rates, which should support Japan’s thick income surplus. Overall, the surplus structure marginally stabilizes the yen’s move especially as Japanese investors first reacted to the US election by selling foreign bonds (Chart 2).

Trump shock led to foreign bond sale

In December, Japanese banks and lifers sold ¥1.48tn of foreign bonds, the biggest sale since June 2015 amid the Bunds tantrum. This is in line with our view given the rise in volatility in the US and the likely loss from the move in rates after the election. Details are yet to be reported, but we would assume this is a continuation of November where most of the sales happened in the US rather than Europe (Table 1).

Given our core view in the US remains bearish duration while the BoJ’s monetary policy helps keep JGB yields relatively low, this likely leads to some repatriation of Japanese money to the JGB market, which explains the rise in JGB purchases at both banks and lifers in November.

Pensions rebalance into bonds, out of equity

In Oct-Dec, trust accounts–represented by pension accounts–sold domestic and foreign equities and bought JGB and foreign bonds (JGB data up to November) (Chart 6).

In our view, the GPIF portfolio is close enough to its target that large moves in financial markets would lead to rebalancing activities where appreciating assets are sold and depreciating assets are bought, reducing market volatility at margin.

Flows may keep USD/JPY basis from widening for now

Meanwhile, foreign investors net-sold ¥123bn of JGBs in December. This most likely resulted from quarterly redemption of JGBs as a data from the JSDA, which excludes redemptions, shows foreign investors were net purchasers for a 29th straight month in November. We argued that tightening in USD/JPY basis spread is unlikely to become a trend, but a combination of cautious Japanese investors in foreign bond investment (and some repatriation into JGBs) and demand from foreign investors for JGBs will keep the USDJPY basis off the high seen in November for a while." - source Bank of America Merrill Lynch

So, from a "flow" perspective, no matter what the latest woozle is, namely the "great rotation" from bonds to equities pushed forward by many pundits, when it comes to Japan, not only the voracious foreign bid from Japanese investors has tempered it's pace, but if indeed, Japanese are more cautious about their foreign allocations, then indeed this will put some additional upward pressure on sovereign bond yields we think.

For the time being, the dollar woozle is still working its way, being the largest consensus trade around for many pundits, also for the likes of Deutsche Bank from their FX Blueprint note entitled "King Kong Dollar" from the 12th of January:

"King Kong Dollar

The most prominent theme in our 2017 FX blueprint is that a Trump presidency changes everything. The US economy is the 800-pound gorilla in the room – policy shifts are too important to not matter for global FX. Our overall assessment is that Trump will be highly supportive of the dollar. Whether this mostly happens against the low-yielding EUR and JPY or EM FX will depend on the policy mix that is delivered: greater emphasis on growth and the euro and yen will suffer most; greater trade protectionism and EM, particularly Asia, will bear the burden. Either way, the broad trade-weighted dollar should strengthen, with a Trump administration coming at a convenient time for our medium-term bullish view. First, the greenback has finally entered the ranks of a G10 FX top-3 high-yielder, an important driver of dollar appreciation in the past. Second, a rally that is front-loaded to the beginning of a Trump presidency fits in nicely with the mature stage of a typical 7-10 year dollar up-cycle.
It is tempting to only talk about President-elect Trump, but currency drivers run beyond the US. From Brexit to European elections and China’s ongoing battle with outflows, politics and de-globalization stand out as the broader FX drivers of 2017. In most instances, particularly in Europe, idiosyncratic stories provide further support to a bullish dollar view. In other cases, local drivers allow for useful diversification against dollar longs, with ZAR, RUB and IDR standing out in particular. 2017 promises to be another exciting year for FX.

Looking for the dollar catalysts

We see Trump’s Fed appointments and corporate tax reform as the most important drivers of the dollar in 2017. Four out of seven board nominations are due this year, including Yellen’s replacement. These are likely to lean hawkish and entirely reshape the Fed. Corporate tax reform may well mean lower rates, but far more important would be an imposition of a “border tax” –potentially the biggest shift in global trade since Bretton Woods and leading to a big US competitiveness gain. Beyond America’s shores, idiosyncratic drivers point to a stronger dollar against both the JPY and EUR. In the Eurozone, negative surprises in either the French or potential Italian election open up existential risks. Even if all goes well, the beginning of ECB taper could accelerate record portfolio outflows: wider spreads (and redenomination risk) and more volatility in bunds should further lower demand for European assets. Japan stands out for the opposite reasons: political stability will allow the BoJ to continue targeting JGB yields unhindered, further increasing policy divergence with the US. We expect EUR/USD to break parity and USD/JPY to approach its all time-highs this year.

It’s all about Trump’s tax policy

While most attention is focused on US fiscal stimulus, we think corporate tax reform stands out as the biggest positive driver of the dollar in 2017. Lower tax rates, border adjustments and a tax holiday on unrepatriated earnings all matter. Border adjustments would impose a 15-20% tax on all US imports while exempting export income from taxation. The policy would amount to a 15% backdoor competitiveness gain for the US economy. A mechanical application of trade elasticities would imply that the US basic balance would go back to the highs seen at the start of the
century (chart 1).

A tax holiday and shift to a territorial system of taxation would allow more than $1 trillion of dollar liquidity and $200bn of annual future earnings to be brought back to the US. Most of this cash is already in USD: but the withdrawal of offshore liquidity will maintain widening pressure on cross-currency basis pushing offshore dollar yields higher. Corporates are likely to use the liquidity for buybacks and dividend hikes which together with corporate tax cuts would encourage equity inflows and further support the dollar. With foreigners not having invested in US equities for the last five years, there is plenty of potential for foreign buying of the S&P (chart 2).

- source Deutsche Bank

Like any woozle, while the above narrative is enticing, we are not buying it. 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. In this previous conversation we showed in our final chart that gold could indeed shine after the Fed and guess what it has:

"Whereas investors have been anticipating a lot in terms of US fiscal stimulus from the new Trump administration hence the rise in inflationary expectations and the relapse in financial "Dystopia", which led to the recent "Euphoria" in equities, the biggest unknown remains trade and the posture the new US administration will take. If indeed it raises uncertainty on an already fragile global growth, it could end up being supportive of gold prices again." - source Macronomics, November 2016

So 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. This is a point put forward by Nomura in their FX Insight note from the 5th of January entitled "The weak dollar revolution could be tweeted":

"Weak dollar policy is a natural extension of protectionist policies

Clearly, the one area of trade policy that has been so far little discussed is FX policy. In a detailed interview on 30 November 2016, soon-to-be Treasury Secretary Steve Mnuchin evaded a pointed question on whether he supports a strong dollar. Instead, he responded:

“I think we’re really going to be focused on economic growth and creating jobs and that’s really going to be the priority.” (CNBC, 30 November 2016).

FX policy cannot be ignored in trade policy. A weak currency can be effective in giving domestic industries an advantage over foreign industries. Indeed, this has generally been the policy of emerging Asia economies from China to Thailand. Their substantial growth in FX reserves since the Asia crisis in 1997 is testament to a concerted policy to curb strength in their currencies. For Donald Trump, at a fundamental level, any appreciation of the dollar would offset some if not all of any import tariffs introduced.

As for the practicalities of introducing a weak dollar policy, the Plaza Accord of 1985 under a Republican administration is the last such example. However, it was coordinated with key trade partners and monetary policy was moving in a supportive direction. Replicating such an Accord would be a gargantuan task. The other precedent of sorts is the Nixon shock – again under a Republican administration. This was a unilateral move and involved both a currency devaluation and the imposition of import tariffs.

However, the better reference points may actually be emerging markets. They have pursued weak currency policies without coordination and often at odds with domestic monetary policy. Admittedly, the presence of capital controls makes it easier to separate FX and monetary policy (thereby overcoming the so-called Triffin dilemma).

The success of their policies has often hinged on the scale of their interventions whether through direct currency intervention or sovereign wealth fund purchases of foreign assets. One study featuring 133 countries over the past 30 years found that such state-directed outflows were a significant positive driver of the current account (i.e. pushed it into surplus)9. An IMF study featuring 52 countries (13 advanced and 39 emerging) from 1996 to 2013 found that currency intervention had a larger and more significant impact on exchange rates than interest rate differentials10.

It should be noted that Japan, which has been the most active G7 intervener in currency markets, has typically engaged in sterilised intervention. That is, intervention that would not affect domestic money supply (and so not impact monetary policy). Studies have shown that Japanese intervention has at times been successful even though it was sterilised. Moreover, one study by former Deputy Vice Minister of Finance for International Affairs, Taktatoshi Ito, showed that FX intervention over the 1990s, which was predominantly uncoordinated with other countries, resulted in a profit of JPY9 trillion ($75 billion). This showed that the MoF was buying USD/JPY at the lows and selling at the highs11. Therefore, there could be nothing to stop the US engaging in FX intervention to weaken the dollar. " - source Nomura

It appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier.

What appears to be clear to us is that the Woozle effect from a central banking perspective has been fading as shown below in our final chart.

• Final chart - The central bank "put" has been weakening

What has clear in recent months has been rising signs of the Woozle effect fading when it comes to central banks credibility. With rising populism, which in recent ways has been driven by central banking interventionism, there are growing indications that the cosy relationship between politicians and central bankers is getting tested. Our final chart comes from Bank of America Merrill Lynch European Credit Strategist note from the 9th of January entitled "Yielding to populism" and displays how the central bank "put" has been weakening:

"Yielding to populism

We expect to return frequently to the theme of “populism” as 2017’s big narrative. For credit investors, populism doesn’t have to be all bad news. As our US credit strategy colleagues have highlighted, potential Republican tax reform could be very beneficial for some parts of the US market. In Europe, though, we worry that populism will manifest itself in two bearish ways this year: a weaker ECB “put” (read: weaker credit technicals), and rising political risk, which we believe is not reflected in European spreads.
Thus, while Euro corporate bonds have nudged tighter in the first week of 2017, with reach for yield behaviour still evident, we think Euro spreads stand to end the year wider. We look for the Euro high-grade market to finish the year 15bp-20bp wider than today’s levels, and for high-yield spreads to end 50bp wider (applying some tweaking to our Nov ’16 forecasts given the big high-yield tightening in December).

Draghi’s populist moment

In our view, Dec 8th 2016 should be seen as a game changing moment for Euro credit markets. We think the ECB yielded to another form of “populism” – namely pressure from a hawkish governing council to step away from the negative yield era, given undesirable side effects. So from April this year, ECB monthly QE buying will decline from €80bn to €60bn.

But we think that Draghi’s actions highlight a bigger story: namely that the central bank “put” (or influence on the market) is already showing signs of weakening. Chart 1 shows cumulative central bank asset purchases including EM FX reserves (which we think should be viewed as another form of QE buying). Note the peak in September last year, due to declining EM FX reserves (such as China). 

But in 2017, we know that the ECB is set to tone down its asset buying, and we also expect the BoE to stop buying gilts and corporate bonds once their respective targets have been reached (which we estimate to be in February ’17 and April ‘17, respectively). A weakening influence of central banks therefore means a weakening of the very strong technicals that have been asserting themselves on European fixed-income markets."

- source Bank of America Merrill Lynch

From a credit tightening perspective, we think you ought to monitor US Commercial Real Estate (CRE) because as reported by UBS in their latest US Credit Strategy Outlook for 2017, CRE nonperforming loans are likely to rise for the first time since 2010 and monthly CMBS deliquency rates were up 6 bp to 5.23% Y/Y in December. Bank loan officers have started to tighten lending standards since the first quarter 2016. US CRE is therefore something you want to keep a close eye on 2017. If the equity crowd are indeed the eternal optimist and suckers for the Woozle effect, the credit crowd is often the eternal pessimist, but then again, regardless of the narrative, as indicated above, in a world stifled by very high debt level, both duration risk and credit risk have been clearly extended meaning that price movements like we have seen in the Energy sector in 2016 are larger. When things will turn nasty at some point, recoveries this time around are going to be much lower, so forget the assumed recovery rate of 40% when you price your senior CDS but, that's a story for another day...or year...

"Every swindle is driven by a desire for easy money; it's the one thing the swindler and the swindled have in common." - Mitchell Zuckoff, American journalist

Stay tuned!

Macro and Credit - Eternal Sunshine of the Spotless Mind

"Right now I'm having amnesia and deja vu at the same time." - Steven Wright, American comedian

While watching with interest our home team France losing the Euro 2016 final against Portugal, being yet another case of "Optimism bias" coming from our fellow countrymen, and looking at the significant rally in various asset classes such as iShares iBoxx Investment-Grade Corporate Bond ETF, or LQD, taking in $1.1bn last Thursday, the largest ever recorded inflow as if "Brexit" had never happened, we reminded ourselves for our chosen title of the 2004 romantic comedy "Eternal Sunshine of the Spotless Mind". With various markets returning to dizzying heights such as the S&P500 or US High Yield markets, it seems to use that once again investors have found "romantic love" with risky asset classes and in many ways their bad memories have been erased, hence our title reference. As far as we are concerned, we haven't gone through the memory erasure procedure and we continue to feel that when it comes to credit in general and in in particular US High Yield, we are in the last inning of the game, particularly when we look at the most recent Fed Senior Loan Officers survey which clearly shows a slowly but surely deteriorating trend when it comes to financial conditions.

In this week's conversation we would like to focus on the on-going deteriorating trend in credit fundamentals and discuss why we think we are in the final inning and therefore one could indeed expect a final and important melt-up in risky asset prices which could last well into September. We will as well discuss Japan as there are indeed increasing "helicopter" noises in the background.

Synopsis:

• Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"
• Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening
• Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

• Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"

As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan". On the subject of this Japanese foreign allocation, we read with interest UBS Global Rates Strategy "What Japanese Investors Are Buying" from the 8th of July:

"Which government bond and credit markets benefit from Japanese demand?

We have previously described how Japanese investors have been significant net buyers of foreign assets – predominantly DM government bonds – in light of the BoJ’s negative interest rate policy. Net purchases have recently regained momentum, following a slowdown around the turn of the Japanese fiscal year. Today’s data of overseas purchases by destination for May highlights which markets are benefitting.

DM: US Treasuries on top; continued inflows into France, Canada, Italy

Japanese net buying of sovereign bonds recovered in May (¥1.8tn vs. ¥0.2tn in April), though still below the record level seen in March (¥5.5tn). US Treasuries made up for nearly 50% of all net purchases. France, Japan's historically preferred euro market, saw modest net buying of ¥159bn, roughly unchanged from April. Elsewhere, Canada and Italy saw continued net purchases, albeit at a slightly slower pace than in April.

EM: Reducing exposure to LatAm and High Yield

In May investors reduced positions in high yield EM markets. Mexico monthly outflows were the largest in five months; Brazil, Indonesia and South Africa were also net sold. China short-term bonds were net bought, other Asian markets were flat. Overall allocations into EM have been small relative to DM asset purchases, with the largest EM market (Mexico) accounting for less than 1% of all bond holdings.

- source UBS

What is as well of interest in UBS note is that since the implementation of NIRP by the Bank of Japan (BOJ), Japanese life insurance companies have gone into "overdrive":

"Japanese life Insurance companies’ net purchases of foreign long-term debt securities; subset of Figure 13 (¥bn). Lifers' hefty buying since Feb-16 continued in Jun-16 (¥1056bn, 3rd largest since the start of data in 2005), overall the 10th consecutive month of net purchases." - source UBS

No surprise therefore that "Bondzilla's size" has indeed been increasing at a rapid pace. This sudden acceleration in negative yielding bonds has been clearly "made in Japan" we think. The acceleration in "Lifers" bond purchases is as well confirmed by Nomura in their JPY Flow Monitor entitled "Foreign Investment continues amid increased uncertainty" from the 8th of July:

"Japanese foreign portfolio investment continued in June. Excluding banks, Japanese investors bought JPY2264bn ($22.6bn) of foreign securities in June, a slightly weaker pace than in May. Life insurance companies’ foreign bond investment accelerated again, while we judge most of them were on an FX-hedged basis. Pension funds and toshin companies remained net buyers of foreign securities too. Retail investors’ foreign investment is likely to stay weak for now, as risk sentiment among them deteriorates after the Brexit vote. Pension funds will probably remain dip buyers, even though the pace is likely slower than in 2015. May BoP data show that the current account surplus narrowed for the second month in a row, suggesting that the improved phase of the Japanese current account balance has likely ended for now, as oil prices recover and JPY appreciates." - source Nomura

If indeed "Bondzilla" is "made in Japan" this is clearly thanks to the acceleration of "Lifers" in the global reach for yield particularly since the implementation of NIRP by the Bank of Japan, but as pointed out by Nomura's note, this time around with a higher hedge ratio:

"Lifers continued strong foreign bond investment, likely with high hedge ratio
Life insurers bought a net JPY1056bn ($10.6bn) in foreign long-term bonds for the 10th month in a row. Although the pace of net buying has slowed over the past two months, this is the first time in three months that the pace of net buying has accelerated to above JPY1trn. Downward pressure on yields has strengthened globally in response to the decline in Fed rate hiking expectations after US NFP data early June and uncertainty over the Brexit referendum. 20yr JGB yields have fallen to almost 0%, forcing lifers to seek higher yields and shift to foreign bond investments. With JGB yields trending near 0% in all maturities, lifers are likely to continue to invest in foreign bonds at a high level
(Figure 2).

That said, we expect that most of their foreign bond investments will be FX hedged for the time being. After FX hedging, UST investment may not be so attractive owing to higher hedging costs. Nonetheless, Fed rate hiking expectations by year-end have almost completely disappeared. The Brexit vote has lowered USD/JPY, JGB and UST 10yr yields to the lower range of major lifers’ FY16 forecast, or even below, but on an unhedged based foreign bond investment may not accelerate anytime soon, amid increased political uncertainty (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016). With risk tolerance falling, we think there is little chance that lifers will shift to unhedged foreign bonds in the near future.

In the medium term, we still expect their interest in investing in hedged foreign bonds to wane gradually, as a result of the expected rise in hedging costs. Nonetheless, the timing of their shift from hedged to un-hedged foreign bond investment will likely be delayed after the Brexit vote and associated market volatility." - source Nomura

From the above we think that the implications are as follows in the short term, we have most likely seen the lows for now on Developed Markets' long term sovereign bonds and in terms of the Japanese Yen, further depreciation of the currency depends on the implications of the deployment of some form of "helicopter money" in Japan. We must confide we have re-initiated therefore a short Japanese yen position and thinking about adding going long Nikkei but in "Euros" via a quanto ETF (currency hedged).  Given we have not fallen to a memory erasure procedure, we reminded ourselves clearly of our April 2015 conversation "The Secondguesser":

"1. To criticize and offer advice, with the benefit of hindsight.

2. To foresee the actions of others, before they have come to a decision themselves.

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions"." - source Macronomics, April 2015

On a side note, in our April conversation, we showed that flows had lagged performance in Emerging Markets. We think now the time is ripe to add on some EM equity expsore which can be relatively easily done through the ETF EEM. EM equity funds saw $1.6 billion of inflows recently...


When it comes to the benefits of "helicopter money", we read with interest Bank of America Merrill Lynch's take from their Japan Watch note from the 15th of July entitled "Japan for “whatever it takes”; monetaryfiscal coordination not helicopter money":

"The monetary-fiscal hand-off

In recent months we have been writing more about the importance of and prospects for fiscal easing. In March we argued that “while monetary policy may be over-stretched in places, we think there is plenty of scope for fiscal policy to support global growth.” In particular, “low interest rates and sufficient fiscal space in many countries make now an opportune time for increased public-sector investment spending.” However, we worried arbitrary political constraints on policy would limit spending, delaying more decisive action until the inevitable recession arrives.

It has taken a long time, with monetary ammunition running low, but finally fiscal easing seems to be starting to kick in. In May, we noted that fiscal expansion had started in a number of regions, including the US, Europe, and China, although much of that easing has been more by accident than design. At the time, we thought Japan would delay its second consumption tax, but could not be certain they would not make another policy mistake.

Japanese for “whatever it takes”

Recent news makes us increasingly confident Japan will join the fiscal expansion and both Europe and the US will increase their stimulus efforts. Policy decision making in Japan often seems like a ritual kabuki play. In the first act, facing whether to delay the consumption tax hike, Prime Minister Abe met with three advocates of easy policy—Paul Krugman, Joseph Stiglitz and Christina Romer. Then at the G-7 meeting in Japan in late May, he warned of risks of a Lehman-like economic crisis. Recall that earlier he had said that only a major event similar to the 2011 earthquake or a Lehman-like crisis could delay the tax hike. Weeks later, in the second act, there was no sign of Lehman II in sight, but sure enough the consumption tax hike was delayed.

In the third act, policy was put on hold awaiting the results of the upper-house election, which returned a solid victory for Abe. He then announced work on a “bold” stimulus package, which major Japanese media outlets suggest to be at least ¥10tn. Former Fed Chairman Bernanke was invited to offer policy advice in the fourth act this week. It is not hard to imagine what Bernanke told them.

The fifth and final act, in our view, will be a major stimulus package, of ¥15-20tn in total, financed by at least a ¥10tn supplementary budget, likely coupled with additional easing by the Bank of Japan at end-July. We look for the BoJ to double its ETF purchases to around ¥6tn annually and potentially lift its JGB purchase pace in line with the increased issuance from the fiscal stimulus plan. Inclusion of municipal and agency bonds is also possible, but given their small market and limited liquidity, we see this as a more symbolic gesture. We do not expect a further cut in interest rates at this time, but we would not completely rule it out either. The BoJ would need to find a way to minimize the adverse impact upon banks from a more negative policy rate.

Risk markets have responded well to this potential program: Japanese equity markets just about reversed their post-Brexit funk, having risen 9.5% since 24 June. The global spillover is palpable; US stocks are up 8% over the same period, while most European markets have rebounded as well. The USDJPY also weakened to above 105, having touched 100 after Brexit. This is a fairly small retrenchment: the yen has appreciated over 12% against the USD on net this year alone. A top advisor to Abe suggested this week that Japan cannot defeat deflation with the USDJPY around 100." - source Bank of America Merrill Lynch

Once again, you probably want to think about "front-running" the Bank of Japan hence our interest in going long the Nikkei index but currency hedged.

When it comes to the options Abe and Kuroda have to reverse the deflationary woes of Japan, Bank of America Merrill Lynch makes some interesting points:

"Can Abe-Kuroda beat high expectations?

Implicit fiscal-monetary coordination

Expectations of fiscal and monetary easing are building in the financial markets, but there seem to be different ideas about the degree of coordination.
1. Implicitly coordinated fiscal-monetary easing: The government unleashes huge economic measures with a supplementary budget of more than ¥10tn. The BoJ expands monetary easing, potentially including through increased purchases of JGBs. The two are “synchronized” with roughly concurrent announcements.

2. Explicit coordination between the government and BoJ: In addition to the above fiscal-monetary easing, the government and BoJ announce an accord of commitment to fiscal expansion financed (semi-)directly by the BoJ’s JGB purchases until the inflation target is met (from the 13 July Sankei Shimbun’s front page).

3. Debt monetization: The BoJ restructures its existing JGB holdings to zero coupon perpetual JGBs, and/or the government issues perpetual bonds to the BoJ directly. (leaving legal issues aside; where there is a will there is a way).

Options (2) and (3) could be called the soft and hard versions of helicopter money, and the likelihood of either being adopted in the near term is low, in our view. This is because (1) Japan's economy, with its 3.3% unemployment rate, can hardly be defined as in crisis; (2) such drastic policies could shake the JGB market and JGB investors; and (3) there have been no cases of developed economies resorting to dropping helicopter money in recent history, and considerable uncertainty surrounds the consequence of such a plan.

We, especially those based in Tokyo, find it hard to believe anyone or any groups in Japan, including the Abe Administration, the MoF, the BoJ, or the public, aspires for hard helicopter money at the moment. Even if they did, nobody seems to have the political capital to pull it off and conduct it for a prolonged period of time. As such, “implicitly coordinated fiscal-monetary easing” – or some other bold fiscal expansion, and expansion of the existing monetary easing – is the most likely possibility." - source Bank of America Merrill Lynch

While it is always hard to fathom the impossible, where we slightly disagree with Bank of America Merrill Lynch is that we could have yet another case of "Optimism bias" and that Japan decide to be even bolder. We touched on the "boldness" of Japan in our April conversation "The Coffin corner":

"There are old wise central bankers (Paul Volcker) and bold bankers (Ben Bernanke now joined by Haruhiko Kuroda ); we have no old central bankers, just bold central bankers". - Macronomics.

"Looking at the desperate attempts by the Bank of Japan to cancel out the deflationary forces at play by increasing the "angle of monetary attack" with the "bold" central pilot banker Kuroda pulling very strongly on the stick, we wonder if Japan will indeed endure structural failure in the end. Maybe Kuroda is a gifted pilot such as pilots from the famed Lockheed U-2 spy plane, but, maybe he isn't.
We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013

If central bankers are now joining force with Ben Bernanke advising directly the Bank of Japan there is indeed a strong possibility they will go for "bolder" policies such as "helicopter money". This policy is fraught with danger we think and agree with Nomuras's take on the subject from their Japan Trade Ideas note from the 15th of July entitled "The danger of helicopter money":

"The adoption of helicopter money by Japan is being discussed a lot more frequently these days. Until recently it was principally by international investors, but, with “Helicopter” Ben Bernanke meeting both BOJ Governor Kuroda and Prime Minister Abe this week, local media is giving it much more coverage. According to a Bloomberg article on Thursday, Mr Bernanke suggested during an April meeting with Abe adviser Etsuro Honda that “helicopter money – in which the government issues non-marketable perpetual bonds with no maturity date and the Bank of Japan directly buys them – could work as the strongest tool to overcome deflation.” Mr Honda said he relayed this message to Prime Minister Abe, although according to another key official, Koichi Hamada, the former Fed Chairman reportedly stuck to more orthodox policies in his meeting with Mr Abe on Tuesday (Bloomberg).

The two main sources of helicopter money views cited by international investors that I have met in recent months are Mr Bernanke’s blog and Adair Turner’s book “Between Debt and the Devil: Money, Credit, and Fixing Global Finance.” 

Mr Turner's suggestion for JGBs is as follows: “That debt could be written off and replaced on the asset side of the Bank of Japan’s balance sheet with an accounting entry – a perpetual non-interest-bearing debt owed from the government to the bank. The immediate impact of this on both the bank’s and the government’s income would be nil, since the interest which the bank currently receives from the government is subsequently returned as dividend to the government as the bank’s owner. So in one sense a write-off would simply bring public communication in line with the underlying economic reality. But clear communication of that reality would make it evident to the Japanese people, companies, and financial markets that the real public debt burden is significantly less than currently published figures suggest and could therefore have a positive effect on confidence and nominal demand.”

The assertion that there would be no immediate difference from the current situation is not strictly correct. The average yield on the BOJ’s current JGB portfolio is about 0.42%. While some of the income from this will indeed be returned to the government, a large portion is used to 1) pay higher rates to banks on most of its deposits than the official minus 0.1% policy rate; 2) cover losses and build reserves against losses on its riskyasset purchases; and 3) subsidize its efforts to lower yields across the curve – the central bank is currently buying JGBs at an average yield of around -0.26%, well below its cost of funds.

While restructuring the asset side of the BOJ’s balance sheet may seem like a worthwhile idea, the picture is not nearly as rosy when we take into consideration its liabilities. Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis, has pointed out that, “The apparent attractiveness of the helicopter approach ignores something important: Money has a cost, too. When the Treasury spends the $100 billion, it will appear in bank accounts. Banks, in turn, will deposit the money at the Fed – a liability on which the central bank pays interest.”

Mr Bernanke acknowledges this problem in his April blog on helicopter money. “Moneyfinanced fiscal programs (MFFPs), known colloquially as helicopter drops, ….present a number of practical challenges of implementation, including integrating them into operational monetary frameworks and assuring appropriate governance and coordination between the legislature and the central bank. As my former Fed colleague Narayana Kocherlakota has pointed out, the fact that the Fed (and other central banks) routinely pay interest on reserves has implications for the implementation and potential effectiveness of helicopter money. A key presumption of MFFPs is that the financing of fiscal programs through money creation implies lower future tax burdens than financing through debt issuance. In the longer run and in more-normal circumstances, this is certainly true…..In the near term, however, money creation would not reduce the government’s financing costs appreciably, since the interest rate the Fed pays on bank reserves is close to the rate on Treasury bills. Here is a possible solution. Suppose that the Fed creates $100 billion in new money to finance the Congress’s fiscal programs. As the Treasury spends the money, it flows into the banking system, resulting in $100 billion in new bank reserves. On current arrangements, the Fed would have to pay interest on those new reserves; the increase in the Fed’s payments would be $100 billion times the interest rate on bank reserves paid by the Fed (IOR). As Kocherlakota pointed out, if IOR is close to the rate on Treasury bills, there would be little or no immediate cost saving associated with money creation, relative to debt issuance. However, let’s imagine that, when the MFFP is announced, the Fed also levies a new, permanent charge on banks – not based on reserves held, but on something else, like total liabilities – sufficient to reclaim the extra interest payments associated with the extra $100 billion in reserves. In other words, the increase in interest paid by the Fed, $100 billion * IOR, is just offset by the new levy, leaving net payments to banks unchanged. (The aggregate levy would remain at $100 billion * IOR in subsequent periods, adjusting with changes in IOR.)”

Adair Turner’s suggestion for getting round this IOER cost of money-financed deficits is as follows: “the rate would have to be zero on at least some reserves to ensure that money finance today does not result in an interest expense for the central bank in the future or in central bank losses that would need to be paid for by government subsidy and ultimately by taxpayers. Setting a zero interest rate for reserve remuneration might in turn seem to impair the central bank’s ability to use reserve remuneration as a tool to bring market interest rates in line with its policy objective. But central banks can overcome this problem, for instance, by paying zero interest rates on some reserves, while still paying the policy rate at the margin.“

So it turns out that for helicopter money to work as its advocates envisage, there needs to be a scheme in place to stop/offset IOER payments to banks. Without that, losses at the central bank will rise quickly when policy rates rise. In the current policy framework, the average yield in the BOJ’s portfolio has been gradually dropping, which is why I think it will be slow to raise rates in the future and I particularly like long-term conditional bear steepeners on the front part of the curve. However, the average yield will recover gradually as the central bank re-invests maturing JGBs at higher yields, allowing the BOJ eventually to raise rates without incurring too many losses. This would not be the case if the central bank has locked up its portfolio in perpetual bonds. With JGB yields the lowest on record, locking in 10yr borrowing costs of -0.24% and 40yr costs of 0.23% seems like a much more sensible policy.

From a strategy perspective, I would treat helicopter money as a very low-probability, high-risk event. It may start out with some seemingly good, risk-on results, but, given the points mentioned above, it is easy to imagine eventual panics among policymakers and/or investors. Rather than his prescription for Japan, I prefer Mr Turner's approach for the euro zone, “If the European Investment Bank funds infrastructure investment, raising money with long-term bonds that the ECB buys, we edge closer to money finance without quite crossing the line.” As outlined in last week’s report., I believe that Japan’s policy mix has reached a stage where it makes sense to begin transitioning from QQE quantity and rates to QQE quality (such as ETFs) and fiscal policy. Nomura expects the BOJ to focus on a combination of rate cuts and ETF purchases at its policy meeting at the end of this month. Although there is very little chance, in our view, of a helicopter-type policy being adopted in Japan any time soon, the current debate could prompt a greater willingness to stretch the boundaries of monetary policy. For example, the central bank has traditionally limited its risky-asset purchases such as ETFs to amounts where potential mark-to-market swings can be comfortably absorbed by its earnings/reserves. Perhaps running the risk of a little negative equity is the right amount of crazy for the BOJ." - source Nomura

And perhaps indeed that running the risk of negative equity is not the right amount of "crazy" for the bold pilots running the Bank of Japan. And if indeed money has a cost too, ultimately the cost will be beared by Japanese taxpayers and in the process the Japanese currency could depreciate rapidly in conjunction with horrendous liquidity problems for the foreign investors still holding to their Japanese Government Bonds (JGBs).

So overall its risk-on again and most likely in Japan but then again, if we are tactically short term bullish, our long term appreciation of the credit cycle is telling us we are in the last inning as shown by the continued deterioration in financial conditions which we develop in our next point.

• Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening

What is ultimately driving default rates you might rightly ask?

For us and our good friends at Rcube Global Macro Research, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey):

"Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans. We have used the net percentage of banks tightening standards for commercial and industrial loans to small firms as tightening credit standards should have a direct effect on the credit market." - source UBS.

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.

As we indicated in our "Bouncing bomb" October 2015 conversation, given the strong inflows in the asset class (US High Yield in particular), we remain Keynesian bullish short term when it comes to credit:

"While we have been "tactically" short-term "Keynesian" bullish, when it comes to our recent "credit" call, we remain long term "Austrian" bearish, particularly when it comes to our "credit" related "Bouncing bomb" analogy and the High Beta gamblers. We would recommend moving into a higher quality spectrum in terms of "credit ratings" and exposure." - source Macronomics

From a tactical and leverage perspective, we would continue to be overweight European High Yield versus US High Yield and remain more inclined towards US Investment Grade credit versus Europe.

We would not at the moment go against the "flow" given the latest inflows so far in US High Yield have been very significant, hence our tactical "Keynesian" bullishness, but then again the latest survey is validating our heigtened concerns as highlighted bu Deutsche Bank in their US Fixed Income Weekly note from the 8th of July:

"Bank lending standards continue to tighten for the business sector. The Fed’s Senior Loan Officer Survey (SLOS) measures lending standards of the largest commercial banks. Similar to tax receipts and motor vehicle sales, the SLOS data do not get revised. There are four broad categories of lending: commercial and industrial (C&I), commercial real estate, consumer, and residential mortgages. On balance, the SLOS data are flashing a cautious signal. In Q2, the net percentage of commercial banks tightening lending standards for C&I loans increased a little over three percentage points to 11.6%, which was the highest reading since Q4 2009. This was the third consecutive quarter in which banks tightened C&I lending standards, a troubling development. As the below chart from our Deutsche Bank colleague Jim Reid illustrates, tightening C&I lending standards are a leading indicator of high-yield default rates.

With respect to the other aforementioned categories, the net percentage of banks tightening lending standards for commercial real estate loans showed an even sharper increase in Q2 (+24.2% vs. +13.6% previously). This was the highest level since Q1 2010 (+27.3%). The only positives in the Q2 SLOS were consumer and residential mortgage lending standards, where, on balance, banks continued to ease in Q2. This should prove to be a mild tailwind for consumer spending and the housing market in the near term." - source Deutsche Bank

Since February we have highlighted the Commercial Real Estate Market (CRE) and particularly through CMBX series 6, the most exposed to retail, the latest survey does indeed confirm the debilitating trend of the underlying. In our recent conversation "Through the Looking-Glass" in May we indicated the following:

" When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2." - source Macronomics, May 2016

We do think you need to track both the CRE and its derivatives CMBX series, as well as the US Senior Loan Officer Survey in the near future.

In our final point we will revisit what represents to us yet again a manifestation of Gibson paradox.

• Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

While we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices. When it comes to the deflationary forces of our very potent "bondzilla monster", this can be assessed by the below chart from Bank of America Merrill Lynch displaying the relationship between negative yielding assets and gold fund flows from their Credit Derivatives Strategist note from the 14th of July entitled "Deflationary flows, the Central Banks' put and yield hunting":

- source Bank of America Merrill Lynch

This relationship was as well confirmed in another note from Bank of America Merrill Lynch in their Follow the Flow note entitled "Deflationary flows into gold, IG and govies":

Deflationary flows into gold, IG and govies

The size of negative yielding assets has reached new highs. Amid rising
deflationary pressure investors are moving into gold and “ECB-eligible” assets like
government and high-grade bonds. A clear theme so far this year has been assets
that are backed by CBs’ policies and “deflationary” plays like gold are in vogue. On
the other hand, assets like equities have been suffering record outflows amid
concerns that the global recovery is losing steam." - source Bank of America Merrill Lynch

 Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. What we are monitoring from a tactically more bearish approach is that very recently surprises, real rates and breakevens are on the rise as displayed in this final chart from Bank of America Merrill Lynch's latest Securitization note from the 15th of July:

"Since Brexit, economic numbers have increasingly surprised to the upside; last week’s June employment report was especially surprising. In “Navigating the summer doldrums (June 3),” we noted that in recent years, the Citigroup economic surprise index has tended to be weak in the first half of the year, bottom in June, and rise in the second half of the year. In Chart 1, we show the seasonal pattern of the average for 2011-2015, along with the 2016 performance. The rise in the index over the past two weeks suggests the “normal” H2 scenario of relatively good economic performance and fundamental data is off to a good start.

If so, it could mean the June plunge in interest rates that pushed the 10yr treasury yield to as low as 1.32% created a near term low for rates. Note that the official BofAML call is for the 10yr yield to end Q3 at 1.25%, and then rise to 1.50% by the end of 2016 (the nominal 10yr is at 1.58% as of writing). If rates and fundamentals have in fact bottomed, at least locally, it’s good news for securitized products, as prepayment risk for agency MBS and credit risk for the credit sectors are reduced. Given the possibility of the worst for rates and fundamentals being seen in June, we have moved to an overweight across most securitized products sectors. 

Chart 2 gives some sense of what rising economic surprises mean for the real 10yr rate, comparing it with the economic surprise index over the past two years. We observe common directionality from 2014 through early 2016, although the coincidence of the timing of the moves is loose at best. 2016 shows a somewhat sustained break in the pattern, however. The surprise index has been trending higher since the low in February. Meanwhile, the real rate has steadily moved lower since the Fed hiked rates last December, as the market has steadily faded the Fed’s ability to hike rates further; for example, the recent bottoming of the real rate on July 6 coincided with the peaking of the no hike probability by December 2016 at 93%.

The bottom line here is that if the economic numbers continue to surprise to the upside, which may have improved chances because real rates got so low, due in part to exogenous global factors, Fed hike probabilities will likely rise, as will the real 10yr rate. For now, though, we think the divergence seen in 2016 between economic surprises and the real rate is a big positive for risky assets: the real rate is probably far too low, and stimulative, relative to fundamentals.
The other side of the coin for nominal rates is breakeven inflation rates, which due to observed correlations over the past year, is the central component of our crosssector valuation framework for securitized products. Chart 3 shows the history of the 10yr breakeven rate in recent years; it remains in the downward trend channel that started around the time of taper talk in 2013.

Chart 4 shows the seasonal view of the breakeven rate in 2016 versus the 2011-2015 average."

- source Bank of America Merrill Lynch

So overall, tactically we think that indeed "risk-on" can further continue and that we could have seen the lows for now on Government bond yields which, would entice further short term weakness on both bond prices as well as gold in true "Gibson's paradox fashion.

Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact.

"Memories are the key not to the past, but to the future." Corrie Ten Boom, Dutch author

Stay tuned!