Macro and Credit - Another Brick in the Wall

"Success is having to worry about every damn thing in the world, except money." -  Johnny Cash

Looking with interest at the elections of new French president maverick Macron, in effect putting another brick in the wall of worry, hence our title analogy, we reminded ourselves of Pink Floyd's 1979 rock opera with "Another Brick in the Wall being the title of three songs set to the variations of the same basic theme:  subtitled Part 1 (working title "Reminiscing"), Part 2 (working title "Education"), and Part 3 (working title "Drugs"). Part 2 was in fact a protest song which somewhat resonates clearly with the rise of populism in general leading to Brexit and Trump's election, whereas the results so far in 2017, seems to be the reverse of what has been playing out in Financial markets in 2016 where we had a dismal first part of the year and political surprises in the second part of 2016 in conjunction with a very significant rally in all things beta in the second part of 2016. 2017 so far has seen significant records being broken for equities indices, tighter credit spreads, and record low vix, which many pundits punting towards "complacency". In our previous conversations, we have indicated that while we did remain short-term "Keynesian" when it comes to our "risk-on" feeling, hence our reduction in both our gold miners exposure and duration exposure, we believe that the second part of 2017 could play as a reverse of the second part of 2016.

In this week's conversation we would like to look at a trade which has been put forward by many pundits including Jeffrey Gundlach of DoubleLine Capital, which is the case for EM equities versus the S&P 500 from an allocation and macro point of view.

Synopsis:

• Macro and Credit - Emerging Markets vs S&P 500, the old versus the new or the new versus the old?
• Final chart - Weak loan demand tends to be associated with high volatility

• Macro and Credit - Emerging Markets vs S&P 500, the old versus the new or the new versus the old?

While many pundits have been mesmerizing at the record low level touched recently by the "fear index" VIX, we reminded ourselves a previous conversation from 2013 entitled "Long dated volatilities: a regime change". As we posited back in 2013, it seems we are clearly back in the low regime of 2004-2007, and credit spreads as of late are also a reminder of the tightness in credit we experienced firsthand in our banking days at the time. Back in our old conversation we made some interesting comments relating to Emerging Markets and volatility which, we think, from a macro perspective are still extremely valid:

"Financial liberalization, for instance in Emerging Markets, has been a good way to attract foreign investments. It has often led to a rise in volatility given investors had been reaping in the process higher daily return rates. When equity market becomes more open, there are increases in stock return volatility (on the subject see the study realised by Vuong Thanh Long, Department of Economic Development and Policies at the Vietnam Development Forum - Tokyo Presentation - August 2007).

Regime switches also lead to potentially large consequences for investors' optimal portfolio choice hence the importance of the subject." - source Macronomics, January 2013.

We also mentioned at the time that different regimes corresponds to period of high and low volatility, and long and bull market periods in conjunction with the credit cycle. At the time of our previous post we also indicated that the importance of regime change was paramount to asset allocation given:

"The relation between the investor horizon of a buy-and-hold strategy and the optimal portfolio varies considerably from one regime to the other.

• For example, in a bear regime, stocks are less favored and short-term investors allocate a smaller part of their portfolio to stocks. 
• On the contrary, in the longer run, there is a high probability to switch to a better regime and long-term investors dedicate a larger part of their portfolio to stocks. 
• In a bear regime the share allocated to stocks increases with the investor’s horizon." 

- source The Princeton Club of New-York, 27th of April 2012, EDHEC-PRINCETON Institutional Money Management Conference.

Also we mentioned at the time that retail investors had been net sellers of stocks since 2007. Yet, in recent years, it seems many have returned using ETFs as an investment vehicle of choice, shunning active management to passive management in the process.

Returning to the very subject of our conversation, there is indeed a case being made which so far year-to-date has been validated performance wise to go long EM equities versus the S&P 500. As a reminder, since the inception of the MSCI EM index back in 1988, the MSCI EM / S&P 500 ratio has experienced two significant boom/bust cycles:

Arguably there has been a significant growing gap between both indices since 2014, while the S&P 500 has been no doubt racing ahead:

- source MacroCharts.pro

With the benefit of hindsight, we can summarize those two cycles in the following way:

Cycle 1 (1988-1999)

• Boom phase (EM outperforming between 1988 and 1996): With the disappearance of the Eastern Bloc, Second and Third World countries were bound to join the First World, and mankind would reach Fukuyama’s “End of history” (1992). Trade barriers fell, stable governments became the norm, and EMs became an investible asset class. The first EM boom culminated with the 1997 Asian crisis.
• Bust phase (S&P outperforming between 1996 and 1999): As EMs were still suffering from the aftermath of the crisis, US equities were led by the first tech bubble.

Cycle 2 (1999-Now)

• Boom phase (EM outperforming between 1999 and 2011): Following the tech crash 2000, investors turned away from the new economy. The term itself became used derisively, as the tangible economy came back with a vengeance, introducing new investment themes: the commodities super cycle, stagflation, the Hubbert peak, etc.
• Bust phase (S&P outperforming since 2011): In the early 2010s, the new economy finally started to become a reality, capitalizing on the huge infrastructure investments that were made during the first tech bubble. At the same time, new technologies (fracking, clean tech, electric cars…) made the developed world less dependent on energy and raw materials.

To sum up, EMs vs. S&P is not a merely a bet on global growth but put it simply a sectorial bet:

• MSCI EMs returns are dominated by old economy industries, commodity- and more generally stuff-producing companies. EM equities are a bet on scarcity and inflation.
• S&P 500 returns are dominated by the new economy: tech, platform companies, business services etc. The S&P is a bet on innovation, deflation and creative destruction.

One might argue that EMs are not pure old economy with the significant weight of Samsung and Tencent for example. But, one might also opine that Korea and Taiwan are not really truly Emerging Markets anymore. Though our simplified interpretation doesn't match the truly "old economy", you get our point when it comes to the sectorial bias.

After its nearly 60% correction since its 2011 heights, there are currently several factors at play indicating that we could be at the beginning of a third cycle in the MSCI EM / S&P ratio.

The CRB Industrial Metals Equity Index (CRBIX Index) has had a significant rally since January 2016:

Following the same trend until recently, there were some indications that there was somewhat a revival in the Chinese materials sector:

- source MacroCharts.pro

(Correlation 0.909, R2 = 0.826, 228 months in sample).

But given our premises that EM being a sectorial bet, still dominated by old economy industries, commodity and more generally stuff-producing companies, EM does indeed appear to be a bet on scarcity and inflation. With Chinese PPI slowing down, one might rightly ask, what's the overall picture if we take into account Chinese Iron Ore spot prices?

- source MacroCharts.pro

(Correlation 0.907, R2 = 0.823, 72 months in sample).

Clearly Iron Ore spot prices are very volatile particularly given the recent clamp down on the famous Wealth Management Products (WMP) by the Chinese government but also reflects a tightening in Chinese financial conditions as well.

After all, weaker commodity prices was reflected in the latest data out of China given the  producer price index (PPI) slowed more than expected in April, falling to a year-on-year pace of 6.4% from 7.6% in March.

Regarding commodities themselves, Dr. Copper, (the PhD in economics) is something we would like to look at to get some cues on this sectorial premise of ours:

- source MacroCharts.pro

(Correlation 0.896, R2 = 0.802, 228 months in sample).

Australia’s terms of trade is also an interesting indicator of MSCI EM/ S&P ratio, due to Australia’s heavy reliance on commodities:

- source MacroCharts.pro

(Correlation 0.932, R2 = 0.869, 228 months in sample).

After all, we are seeing tighter liquidity from China in its moves to rein in leverage which could potentially weigh on economic growth as it is attempting a "controlled demolition" of the shadow banking bubble which was let loose.

Regarding inflation, the recent increase in inflation expectations hasn’t yet been factored in by the MSCI EM vs. S&P ratio:

- source MacroCharts.pro

(Correlation 0.859, R2 = 0.737, 132 months in sample).

Additionally, Chinese devaluation fears, which roiled world markets during the summer of 2015, have substantially receded since the beginning of the year:

- source MacroCharts.pro

(Correlation -0.869, R2 = 0.741, 36 months in sample).

Yet the pullback in TIPS inflation "breakeven" rates with US 5 year breakeven rates trending lower have shown that the "Trumpflation" trade has been cooling as of late. Though the recent weakness in precious metals with silver getting spanked daily can be attributed to a gradual rise in real rates we think, another manifestation of Gibson's paradox as a reminder:

"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 a 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." - source Macronomics

On a side note, there has never been an episode in history when Gibson's paradox failed to operate. The real interest rate is the most important macro factor for gold prices. Also the relationship between the gold price and TIPS (or “real”) yields is strong and consistent. Gold and TIPS both offer insurance against “unexpected” (big and discontinuous) jumps in inflation. The price of gold normally falls along with the price of TIPS (which means that TIPS yields rise). So to conclude our side note, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates. This is clearly illustrated in the below chart from Deutsche Bank European Equity Outlook note from the 11th of May:

- source Deutsche Bank

So far in 2017, the outperformance continues to play out in favor of EM as per the chart below displaying the S&P 500 performance relative to iShares MSCI EM:

- source Bloomberg

Flow wise commodities funds according to the latest Follow the Flow note from Bank of America Merrill Lynch have seen their eighth week of inflows, however showing signs of slowing down with gold and oil prices moving lower recently. We think most of the ongoing correction in the commodity complex is tied up to the "controlled demolition" of WMP led by China. Emerging market equities have historical strong correlation to commodities, yet, investors have continued pushing emerging market equites higher.

Given the pressure on Chinese A shares, should you want to play this trade via ETFs we would agree with Bloomberg's take from the video embedded in their article  "Gundlach Says Short the S&P 500 and Buy Emerging Market ETF" from the 9th of May, that you would be better off using IEMG ETF (South Korea and no China A shares) rather than EEM ETF given the ongoing tightening pressure in China. Yet, with KOSPI rallying as well 13.6% and breaking through the 2300 at an all-time high, the rally has been significant but mostly led by Samsung. We continue to believe that overall markets are trading on expectations of structural reforms in many instances (US, France, South Korea, etc.).

In relation to Emerging Markets, if in Macro, demography is destiny, we continue to like the asset class given as shown in the recent Bloomberg graph workforces are still expanding in India, Southeast Asia, Vietnam as well has a very young population and Southeast Asia overall is offering very compelling growth prospects:

- source Bloomberg (H/T Tiho Brkan

On top of that, China's Silk Road initiative with their willingness in expanding towards the West is clearly going to spur in its surroundings economic growth and renewed demand for commodities while China is transitioning its internal imbalances towards consumption rather than domestic fixed asset investments. The long term macroeconomic impact of such endeavor should not be underestimated.

While we still believe in some continuation of "risk-on", yet we could potentially get a pullback, we are closely watching oil, being at the moment the major brick within our wall of worry when it comes to potential credit spreads widening and spillover. We continue to follow closely the credit cycle and the global credit impulse which has shown recently by China and as well from the latest US Fed Senior Loan Officer survey, continues to point towards a slowdown thanks to weaker demand as per our final chart below.

• Final chart - Weak loan demand tends to be associated with high volatility

While markets have successfully climbed the wall of worry with the French elections angst, we continue to track the slowly but surely eroding credit cycle and credit impulse. The significant performance of risky asset classes and beta in particular since the second part of 2016 in the on-going low volatility regime thanks to central banks meddling, makes us feel a tad more nervous about the continuation of the rally in the second part of the year while we are acutely aware as we wrote recently that the final inning in a credit cycle always is often associated with a final large melt-up.

When it comes to the volatility quandary, we read with interest DataGrapple's take on the subject from their blog post from the 9th of May entitled "Is volatility a thing of the past?":

"Most of the political risk is behind us in Europe. Unless his party shows very poorly during the general election next month, Mr Macron should be in a position to at least form a coalition with the center right. In the UK, there seems to be little doubt that the Conservative will secure a strong majority in Parliament in a few weeks. In Germany, whoever comes on top in the September ballot will be a member of the current ruling coalition. So the main source of uncertainty is Italy where the 5-star movement and its anti-euro stance is leading the poll, but elections should not be held this year. We know that they will take place before May 2018, but their exact date has not been set. With talks around the restructuring of the Greek debt apparently making progress, the euro area should enjoy a period respite. That is the message sent to the market by investors who are selling options, betting on a very low realized volatility up to the September expiry. The implied volatility of options with a strike 10% out of the money are trading sub 40% on all indices for the next 5 expiries." - source DataGrapple.

Have reached peaked complacency? One might wonder. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 8th of May and displays C&I Loan demand versus the VIX index which clearly shows that often weak credit demand tends to be associated with high volatility which shouldn't be that surprising given we live in a credit based world:

"Senior loan officers vs. VIX

One of the key stories we have been tracking for most of the year is the lack of loan demand in the US across the board. That was apparent in the February Senior Loan Officer Survey as well as subsequently weekly bank asset data from the Fed. Hence not surprisingly today's fresh Sr. Loan Officer Survey showed continued very negative
growth in consumer loan demand as well as deterioration into negative territory for C&I lending. It thus appears that the key post-election story continues - i.e. while optimism is high everybody is in wait-and-see mode pending details on tax reform from the new administration. The longer this lasts the greater the risk of more weakness in hard data. It appears a great contradiction to these circumstances that the VIX closed today at 9.77 - the lowest since December 1993. Weak loan demand tends to be associated with high volatility, not low (Figure 1)."

- source Bank of America Merrill Lynch

If credit conditions are tightening in both China and the US, and we continue to see a weaker tone in the commodities space, it is hard not to start worrying about weaker aggregate demand overall and not only in oil prices. Yet another brick to keep an eye on in your personal wall of worry we think but we ramble again...

"Worry is interest paid on trouble before it comes due." - William Ralph Inge, English clergyman.

Stay tuned!

Credit - Magical thinking

"Once to every person and nation come the moment to decide. In the conflict of truth with falsehood, for the good or evil side." - James Russell Lowell, American poet

Watching with interest the rising tremors in the markets current fault lines with the fragility in credit markets now spilling into the equities space, we reminded ourselves of the definition of Magical thinking for our chosen title analogy. In clinical psychology, magical thinking can cause a patient to experience fear of performing certain acts or having certain thoughts because of an assumed correlation between doing so and threatening calamities. Of course, magical thinking is creating fear in our "omnipotent" central bankers, who have indeed gone a little bit too far in their sorcerer's apprentice experience with their buckets of liquidity and their beliefs in real economy recovery with their numerous QE "healing rituals", but, we ramble again...

Whereas "Magical thinking" is most dominantly present in children between age 2 to 7 years old, it is interesting to see that according to developmental psychologist Jean Piaget's theory of four developmental stages, children during the stage of his Preoperational Stage of development are not able to use logical thinking. And, according to Piaget, children within this age group are often "egocentric", believing that what they feel and experience is the same as everyone else's feelings and experiences. In similar fashion our central bankers believe that what they feel and experience when it comes to the much vaunted "economic recovery" is the same as everyone else's feelings and experiences. We beg to see it differently. To paraphrase Star Wars, Jedi mind trick only works on the weak minded, same goes with central bankers talk.
 

In this week's conversation we would like to point out again the worrying deterioration in the overall global demand picture with the continuation of EM FX onslaught, deterioration in credit metrics with rising leverage in the US as well as outflows in credit funds in conjunction with significant widening in credit spreads, which explains why in the recent conversations we have indicated why we did put our deflation hat back on, meaning an increase in our US long duration exposure (partly via ETF ZROZ).

Synopsis:

• In US credit, net debt continues to rise at an unsustainable rate
• End of the day when it comes to credit and default, what matters is "leverage"
• The deepening "commodity rout" is a cause for concern credit wise
• Final chart: LatAm FX weakening with commodity prices

• In US credit, net debt continues to rise at an unsustainable rate

In this conversation, once again we have decided to focus on the credit cycle and where we stand when it comes to the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

In early 2014 we indicated our long duration exposure, which we partly played via ETF ZROZ as an illustration of us playing and understanding the "macro" game. Given we think the US is moving firmly into the higher quadrant, we have increased our exposure once more to US long government bonds. 

Also in September 2014 we indicated the following in our conversation "Sympathy for the Devil":

"Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day." - Macronomics, 9th of September 2014

We have long argued that in the US the credit channel clock has been ticking at a faster pace, as indicated in our October 2014 conversation "Actus Tragicus":

"The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is likely coming to an end as we move in the US towards the upper quadrant of the "Global Credit Channel Clock".
Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...)." - source Macronomics, October 2014

What we are seeing recently is indeed we think a clear move towards in the upper quadrant with a flatter yield curves, a widening in credit spreads and a very weak tone in the carry players space, namely Emerging Markets (EM). When it comes to the previously discussed "releveraging" taking place in the US corporate credit space, we read with interest Société Générale Global Equity Market Arithmetic note from the 17th of August entitled "Above the results din, US corporates continue to pile on the debt": 

"Despite all the excitement surrounding the Chinese currency devaluation overall global developed equity markets finished the week only 0.2% down. The real volatility however was to be seen in Asia ex Japan and more broadly Emerging Market equities and currencies. The MSCI EM Index fell 2.4% during the week and is now down over 20% from last August’s high.
It would appear then that US investors in particular are reasonably sanguine about the risks associated with a slowing China and declining commodity prices. However as we have highlighted before, counter-cyclical positioning is not confined to EM and commodities. The Global Semiconductors index, for example, has fallen in lockstep with Global Energy sector over the last three months and tellingly high yield corporate bond spreads have been markedly wider over the last couple of months – see chart below.

With the US reporting season largely complete, we have taken a quick look at what has been going on under the hood. These numbers all exclude financials. Net Income growth has fallen by just over 10% YoY largely as a function of the weakness in the energy sector , it is only slightly down once energy is excluded. However ex-energy profit momentum is weakening when you compare 12 months trailing profits growth in Q2 versus Q1.
Revenue growth is up a robust 5% ex-energy, driven by strong sales growth in the likes of Apple and Amazon. However it is also heavily affected by M&A, primarily among healthcare stocks. Meanwhile dividend growth is up a robust 12% per annum (including or excluding energy) – and while net buybacks are slowing once you include energy, they continue to rise when you don’t. More worrying though is that net debt continued to rise at around 20% pa." - source Société Générale

 A 20% rising rate for net debt is clearly "unstainable" unless you are affected by "Magical thinking". We believe the on-going widening in credit spreads warrants close monitoring.

We note as well the arguments made by Bank of America Merrill Lynch in their Relative Value Strategist note from the 20th of August entitled "Stocks, HG, HY: Unhappy in their own way" where they make the point that credit does not always portend doom for stocks:

"Unhappy in their own wayHappy families are all alike; every unhappy family is unhappy in its own way. The opening lines of Anna Karenina provide an apt metaphor for markets today. Credit has undoubtedly had a very difficult year. Within the asset though, high grade and high yield have each had to deal with their own unique issues. For the former it’s been about immense bond supply (our HG Strategists expect $1.1 trillion for 2015) meeting little demand and the upcoming rate hike cycle. For HY cash, it’s been about the sizable exposure to commodity related sectors and poor fundamentals including increasing leverage and stagnant earnings growth. Equities on the other hand have been frustratingly range-bound. Within the S&P 500, more than 80% of mega-caps delivered earnings beats for Q2, easily offsetting any bad news from smaller companies. On a related note, our Equity Derivatives team has shown how equity inter-sector correlations have been very low, thereby dampening the overall volatility of SPX.
As a matter of fact, it is this relatively low volatility in stocks that there has been much hand-wringing about, standing as it does in sharp contrast to the steady leak wider in credit spreads. And we’ve been fielding many questions on what that ultimately portends for stocks. Our contention so far has been that portfolio matters. We analyzed the seeming divergence between CDX IG and VIX, adjusted for the outliers in IG that aren’t part of SPX, and the gap didn’t look as wide as at first glance. The underperformance of HY relative to SPX seems to be largely Energy driven and HY returns appear to be in line when compared to Russell 2000.
Credit does not always portend doom for stocksThe anxiety among equity investors regarding signals from the credit market is understandable. The most recent memory of a meaningful divergence is from 2008 and that did not end well. But times are different now and we thought we’d look at relative moves between spreads and equity volatility over a longer period. Over the three months to 17-Aug-2015, our HG cash index is 31bp or about 23% wider, the HY index is 104bp wider, also 23%, while the VIX is 1pt higher. The shaded regions in Chart 1 show past periods with similar HG vs. VIX changes, specifically 3m windows over which HG spreads widened by 20% or more and VIX did not increase. 

For HY, we used a lower threshold of 15% in Chart 2 to account for recent Energy underperformance (exEnergy HY is 17% wider over 3m).

Over the last 25 years there have been a number of occasions where spreads have widened substantially without affecting equity volatility. More importantly though, these divergences did not always result in an equity sell-off; equities were up the following month more often than not (Chart 3 and Chart 4).

The S&P 500 return in the month following a HG-VIX divergence was positive 60% of the time and the median return for the index was 0.8%. In the month following a HY-VIX divergence, SPX return was positive 53% of the time and the median was 0.3%. So credit does not always portend doom for stocks. Other than 2007-08 sizable and sustained equity corrections are observed in the late-‘90s/early ‘2000s following a divergence.

It is well possible that the VIX goes up over the next 2-3 months or the S&P 500 sees a meaningful correction. We’d caution against expecting either of these as necessary simply because credit is weak. Credit has been mired in its own problems including dreadful bond liquidity, high supply volumes (HG), sizable exposure to commodities (HY) and uncertainty around what the upcoming hiking cycle means for yields and investor risk appetite. The Fed, China, USD and commodities all remain the inter-connected common catalysts affecting both assets. These factors are more likely to directly determine the fate of stocks in the near-term, than a transmission mechanism through credit." - source Bank of America Merrill Lynch.

We believe that, if indeed, the Fed is not able to use logical thinking and continues with its "Magical thinking" then indeed, regardless of the weaker tone in credit we have been indicating in recent conversations, equities will be in the receiving end and both assets will continue to reprice accordingly.

Of course, for a more severe equity sell-off to materialize you need three deteriorating factors :

1. Corporate balance sheet leverage, 
2. Credit availability, 
3. Earnings revisions.

From the same Bank of America Merrill Lynch note, one can indeed see that so far this year the widening in credit spreads in both Investment Grade credit and High Yield have been significant:

The opposite risk, that of a melt-up on no hike or a hike + very dovish Fed, seems more plausible now. This house is far from constructive on credit, but given valuations and underperformance versus equities there is some chance of a snapback in Q4. CDX option flows, which have had a somewhat bullish tilt even as the indices themselves sold-off, hint that this is the risk that hedges are being set against. Indeed, option implied volatility has been remarkably subdued despite wider spreads (Chart 7 and Chart 8).

 - source Bank of America Merrill Lynch.

Of course a more "dovish" fed could indeed spell some sort of rebound but, this is not the main scenario we are buying and we expect further weakness in the coming weeks when it comes to credit spreads.

We continue to believe that we are coming towards the end of the credit cycle and credit investors have indeed played well into overtime thanks to central bankers' generosity and overmedication. 

This brings us to our second point, namely that "instability" in credit is brewing thanks to the increase in leverage hence the move in the higher quadrant of the "Global Credit Channel Clock". 

• End of the day when it comes to credit and default, what matters is "leverage"

On this specific matter of rising leverage in the US credit markets, which has been one of recurring theme on this blog, we read with interest Bank of America Merrill Lynch's take on the subject in their Situation Room note from the 17th of August entitled "2Q HG Fundamentals":

"2Q HG fundamentals: Leverage peakingWith the 2Q earnings reporting season mostly over, our estimates show that credit fundamentals of public US high grade non-financial issuers continued to deteriorate during the quarter1. Leverage increased, including outside of the troubled Energy and Basics sectors. This was simply the result of a brisk pace of borrowing outpacing weak earnings growth. Hence net and gross leverage in 2Q increased to 2.15 and 2.62x, respectively, from 2.07 and 2.51x in 1Q-15 (Figure 1). 

After having risen since the end of 4Q-2013, we expect leverage in the high grade market to peak in 2Q or 3Q this year and then decline next year. This the result of more challenging conditions in the high grade market and strong US economic growth.

Cash balances (relative to assets) increased in 2Q while the pace of capex growth declined, suggesting that companies pulled forward borrowing to the second quarter, which likely continued during the summer given the record supply volumes. For issuers outside of Energy, Basics and Utilities YoY gross debt rose 4.0% in 2Q – the highest increase since 3Q-11 – while net debt was up just 1.6% YoY. For the same set of issuers median YoY revenue (0.0%) and EBITDA (0.2%) growth were close to flat, thus pushing leverage higher (Figure 2).

Coverage for the high grade market declined in 2Q to 9.18x from 9.34x in 1Q and 9.78x in 4Q-2014 (Figure 3). 

Liquidity metrics improved, with the cash rising to 4.05% of assets in 2Q from 3.80% in 1Q and the share of long-term debt increasing to 93.5% from 92.9% in 1Q. Revenues declined 2.4% YoY in 2Q while EBITDA rose 0.7% YoY. Gross and net debt increased 4.5 and 4.6%, respectively, over the same quarter last year.

Leverage

Both net and gross leverage increased in 2Q, rising to 2.15x and 2.62x from 2.07 and 2.51x in 1Q-15. This is notably above the peak 1.98x and 2.46x net and gross leverage during credit crisis in 2009 (Figure 1). Leverage also increased for our control group that excludes Energy, Materials and Utilities. There net and gross leverage were 1.26x and 2.06x in 2Q-15, up from 1.22x and 1.94x in 1Q." - source Bank of America Merrill Lynch

Where we beg to differ with Bank of America Merrill Lynch is that we believe that the strong US economic growth story is more akin to "Magical thinking" hence our current negative stance on US credit. We continue to believe that, in the near term, US rates will outperform US credit. After all flows from the asset class seem to validate our position as indicated in another Bank of America Merrill Lynch High Yield Wire note from the 17th of August entitled "Death by a thousand cuts":

"Flows: Outflows galore
Credit funds reported outflows last week: US HY at -$1.1bn driven by ETFs (-$960mn), Loan funds at -$350mn, while IG funds also came in negative at -$1.1bn. Other fixed income asset classes also experienced outflows with EM bond funds, non-US domiciled HY funds and Municipal funds, all posting outflows. Equities experienced a small rebound reporting +$890mn and commodities also breathed a sigh of relief coming in at +$450mn after a month of consecutive outflows." - source Bank of America Merrill Lynch.

Also, the note indicates that defaults are on the rise which will continue to impact the High Yield asset class as a whole:

"The best of times are behind the market
The basis for our relatively bearish outlook for 2015 stemmed from the realization that the best of times are now behind the market and, with rising defaults and a higher premium demanded for liquidity, that high yield would struggle to maintain any significant traction following a seasonally strong first quarter. 

Headed into the fall, we maintain our view that the best of times are in the market’s rearview mirror and continue to believe that the end of this credit cycle is now upon us. Although it sounds disastrous, we think the end is likely to play out over a long time, characterized by an increase in defaults, likely dominated by commodity names at first, and a slow unwind of crowded trades.

In many ways, this could be more painful than the alternative: a steep cathartic move that cleanses the market. We think the remainder of the year likely experiences further weakness as poor energy performance leaks into the rest of the market, and lackluster global growth and a strong dollar weighs on fundamentals." - source Bank of America Merrill Lynch

As it seems they are indeed different views within Bank of America Merrill Lynch, for choice, we would side with the above given we strongly believe that the ear of "selling" "beta" as "alpha" is coming to an end. When it comes to "Magical thinking" which causes a patient to experience fear of performing certain acts, investors in this case, should rethink their "collective mindset" as aptly described in Bank of America Merrill Lynch's High Yield note:

"The era of indiscriminate beta compression is over
We have had a long-standing view that accounts have shifted their collective mindset from one where they were scared to sell bonds for fear of not being able to buy them back to one where they want to sell positions they don’t view as core long-term holdings for fear of not being able to sell them later. As such, we wrote, the bond market would struggle in 2015 to surpass 2-3% total returns and that there would be more disparity between winners and losers.
Again, we continue to like this theme going into the end of the year as we expect continued bifurcation between credits and sectors. With underwhelming fundamentals serving as a backdrop for higher leverage and increasing scrutiny on earnings (see Telecom recently), we believe those companies that manage to avoid big earning misses or being swept up in the weak global growth and strong dollar environment will fare better than those which are exposed to non-domestic forces or have questionable balance sheets and future growth prospects." - source Bank of America Merrill Lynch

In our September 2014 conversation "Sympathy for the Devil"we argued:

"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters."

To repeat ourselves, leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). Now in EM, our "reverse macro osmosis" theory is clearly playing out. 

Forget your "Magical thinking", the credit cycle has reached "maturity" in the US. Meanwhile the continuation of the commodity carnage is a cause for concern credit wise.

• The deepening "commodity rout" is a cause for concern credit wise

The continuation of the EM FX massacre thanks to commodities tanking and rising US dollar is a cause for concerned for some EM corporates which are directly exposed to these serious headwinds. The recent devaluation of the Yuan has indeed added the proverbial fuel to the fire. The credit impact on over exposed countries will be significant, particularly credit wise with the significant risk of defaults for some. The impact of the Yuan devaluation was indicated in another Bank of America Merrill Lynch note from the 18th of August entitled "Adding Fuel to the Fire":

"CNY devaluation adds fuel to the fireThe extent to which the CNY devaluation last week negatively affects the EM credit market will depend largely on the impact it has on EM currencies and commodity prices. The devaluation will negatively impact countries that have large export exposure to China through their terms of trade, and will most negatively affect commodities that China holds a dominant consumer position in (platinum, iron ore & copper).
Our commodities team expects very different outcomes for commodity prices depending on the size of the CNY devaluation. A small CNY devaluation could actually be positive for commodities (negative impact on USD commodity prices outweighed by stronger domestic demand), while a large CNY devaluation (not the base case) that comes as a result of worsening domestic demand in China, would be much more disruptive to commodity prices. Our estimates are that a 10% depreciation of the CNY could translate to as much as 6% downside to commodity prices. Breaking it down by commodity, a 10% CNY depreciation could imply 5% downside to Brent crude oil prices but as much as 12% downside to copper prices.
From a macro perspective, our EEMEA team expects commodity exporters (Russia & South Africa) to be hit hardest as does our team in LatAm, which see’s Chile and Peru as most exposed given their high level of commodity exports specifically to China. In Asia, activity cycles are highly correlated to China, and Hong Kong, Indonesia, Malaysia and Korea specifically should be the most negatively affected as the CNY devalues.
Last week’s performance showcased that the broad impact the CNY devaluation will have on EM. Chart 3 below shows performance on a country level from 8/10 (deval announcement) through 8/14 for EM FX relative (1wk % spot change, vertical axis) to EM credit (1wk % spread change, horizontal axis). 

Chart 4 below shows commodity exposure of corporate credit markets by country. The most noteworthy take-aways from Chart 3 below are the markets that stand out as highly exposed to China/Commodities, but where credit markets did not react very negatively. South Korea and Chile specifically saw FX depreciation of roughly 1.5%, while credit spreads were nearly unchanged."

 - source Bank of America Merrill Lynch

What is of interest is that not only we have the usual suspects high beta countries in the above chart, but looking at the recent devaluation wave in EM FX land with Kazakhstan recently joining the party, you can expect an additional weaker tone in FX which will lead as well for some to a continuation in spreads widening.

You should monitor the sovereign CDS space as another indicator of more trouble ahead.

Activity in some sovereign names (South Korea, Malaysia, Indonesia and China) is picking up as displayed in the below table from S&P Capital IQ:

- source S&P Capital IQ

Even Saudi Arabia is not spared with its CDS now above 102 bps up on the 20th of August by 22 bps as reported by S&P Capital IQ.

The significant moves in the Sovereign CDS space can be ascertained from the following chart from Bank of America Merrill Lynch Asia Fixed Income and FX Strategy Watch from the 20th of August entitled "Fears Higher than Taper Tantrums":

"In CDS, ASEAN is clearly widened the most (see Chart 6). In the case of Indonesia, the widening of the CDS has been the result of Malaysia CDS widening as well as some spillover from Brazil CDS and outlook downgrade. On the other hand, SBI CDS (proxy to India) has moved little. This also means that if risk off moves were to amplify and correlations start approaching 1, SBI CDS has considerable distance to cover." - source Bank of America Merrill Lynch.

In the coming weeks the Sovereign CDS market in the EM space will have to be watched more closely particularly if indeed there is a Fed hike coming due in September.

This brings us to our final chart showing the relationship between LatAm FX and commodity prices.

• Final chart: LatAm FX weakening with commodity prices

Whereas Asian countries from a sovereign external debt perspective not in the same situation as in 1998, the vulnerability of certain LatAm countries and default probability (think Venezuela) goes hand in hand with commodity prices as displayed in Bank of America Merrill Lynch Liquid Insight note from the 20th of August entitled "LatAm currency drivers":

"LatAm currency drivers
We estimate how currency drivers have changed in recent years. Commodity prices are important drivers for BRL, COP and CLP, but not MXN. The explanatory power of US interest rates has increased for BRL and MXN. We remain bearish BRL and COP as commodity prices are still plunging. We stay neutral CLP and MXN – we believe they are undervalued based on fundamentals, but exposed to lower copper prices and higher US rates.

Changing currency factors in Latin America
We estimate the main driving factors for Latin American currencies and how they have evolved from 2012 to 2015. The explanatory power of global factors (the US dollar, the VIX index. 10y US rates and commodity prices) has increased significantly for the Brazilian real and Colombian peso. It has reduced modestly for the Mexican and Chilean pesos.
In particular, commodity prices are more important drivers for BRL and COP now than they were two years ago. Their importance for CLP has remained high and stable, while they are not a significant driver for MXN. Our analysis also shows the explanatory power of US interest rates has increased for BRL and MXN, but decreased for COP and CLP." - source Bank of America Merrill Lynch

When it comes to "Magical thinking", we hope our omnipotent central bankers will to use logical thinking as the upcoming rate hike and with our "reverse macro osmosis" theory playing out, it sures look for EM as a US dollar margin call from hell...

"Petroleum is a more likely cause of international conflict than wheat." - Simone Weil, French philosopher.

Stay tuned!

Credit - Pareto Efficiency

"This is no time for ease and comfort. It is time to dare and endure." - Winston Churchill

While in last week conversation we mused around our "uneasiness" in the current "easiness", the latest round of Quantitative Easing iteration number 3 courtesy of Dr Ben Bernanke at the Fed, made us wander towards an important economic as well as engineering concept for our title, namely the Pareto Efficiency:

"In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off. Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made." - source Wikipedia

The impact QE2 has had on commodity prices has been clearly analyzed in a very interesting paper from the Bank of Japan - Recent Surge in Global Commodity Prices back in March 2011.

Given that in a Pareto efficient economic allocation, "no one can be made better off without at least one individual worse off", looking at the causality between the Arab Spring and the rise in commodity prices, one has to wonder what will be this time around the impact worldwide of this latest round of "easing" from the Fed, hence our title.

Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops. 

Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.

The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788), of course any similarities with this year's meteorological events are purely fortuitous given we are rambling again...Are we?

In similar fashion to QE2, QE3 has already triggered a significant rise in Inflation Expectations - source Bloomberg:

"The CHART OF THE DAY shows the gap between yields on 10- year Treasuries and same-maturity inflation-protected notes, a gauge of consumer-price expectations, jumped to the widest since May 2011 after Bernanke said the central bank will buy $40 billion of mortgage debt a month. It also charts five-year U.S. inflation swaps that let holders exchange fixed interest rates for returns equal to price gains. The figures suggest inflation will climb after dropping to the lowest since 2010. “We will see higher inflation pressure in the next few years,” said Hiroki Shimazu, an economist in Tokyo at SMBC Nikko Securities Inc., a unit of Japan’s third-largest publicly traded bank by assets. “It will be difficult to control.”

The breakeven rate -- the difference between yields on 10- year notes and Treasury Inflation Protected Securities -- widened to as much as 2.54 percentage points today, the most in 16 months. The swaps climbed 12 basis points to 2.50 percent yesterday, the biggest one-day jump since February 2011, data compiled by Bloomberg show. Annual inflation was 1.4 percent in July, about half the 3 percent pace at the end of 2011." - source Bloomberg

Those who follow us know that we have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 was announced - source Bloomberg:

QE2 saw a surge of the SPX (Standard and Poor's 500) as well as a surge in oil prices as well as significant surge in US Treasuries yield, which surge by 100 bps from 2.50% to 3.50%. 2011 saw a significant correlation with SPX, Oil and US treasury yields falling significantly during the "risk-off" period triggered by liquidity. This time around, one can expect during the on-going "risk-on" period to see as well rising US Treasury yields in conjunction with surging SPX and oil prices.

We discussed asset correlation back in May in our conversation "Risk-Off Correlations - When Opposites attract". Whereas in "Risk-Off" periods the dollar acts as a powerful magnet for investors seeking safe haven, whenever there is a Fed meeting week, it ultimately weighs on the Dollar index as indicated by Bloomberg:

"The CHART OF THE DAY shows the gauge, which measures the dollar against the currencies of six major trading partners, has fallen the week of FOMC meetings four out of five times this year. The Dollar Index fell 1.7 percent in the week of Jan. 25 when the central bank extended its pledge to keep interest rates near zero until 2014. The measure declined 0.3 percent in the week of the March 13 gathering even as the Fed raised its assessment of the economy." - source Bloomberg.

This time was not different. The Dollar Index fell to around 79 with Gold rising in the process as indicated in the below graph displaying the Dollar Index versus Gold since June 2011:

"Pareto efficiency is an important criterion for evaluating economic systems and public policies. If economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements can be made to at least one participant's well-being without reducing any other participant's well-being." - source Wikipedia.

Therefore in this week credit conversation we would like to delve into the diminishing returns QE has on the real economy following our usual credit overview.

The Itraxx CDS indices picture displaying yet another very significant rally in the credit derivatives space below the March lows for some indices - source Bloomberg:

The High Yield risk gauge indicated by the Itraxx Crossover index (50 European entities) is tighter this week by another 40 bps courtesy of the third round of QE triggered by the Fed. The move tighter for credit derivatives indices was significant on Friday with the Itraxx Crossover index tighter on the day by 35 bps and with the Itraxx Financial 5 year subordinated index closing below its March lowest point of 313 bps at around 300 bps. It wasn't only the Itraxx Financial Subordinated 5 year index falling to the lowest levels since the series 17 was launched in March, the Itraxx SOVx index (15 Western Europe sovereign CDS including Cyprus) declined by 10 bps towards 173 bps, retreating for a 10th straight week, the longest-ever streak.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

Clearly, the HY risk gauge indicated by the Itraxx Crossover is moving towards expensive territory close to 400 bps falling in synch with volatility. The gap between the Itraxx Crossover and Eurostoxx volatility has closed.
As well as the European High Yield market, the US High Yield market continues to perform and becoming a cause for concern as a market maker put it bluntly:

Why has the market rallied and stayed bid? Here's one reason.....Massive credit issuance continues. Monday was the LARGEST day of US corporate issuance ever (14 deals, $19bn) and the largest day for European corporate issuance this year (9 deals, E7.5bn). Yield! Yield! We know that companies are using this money for one thing more than any other: Buybacks. Non directional activity in US stocks (gamma hedging, liquidity providers, quant strategies) has become over 65% of activity...."

From a credit point of view, we believe buybacks are credit negative.

Yes, the last two weeks have seen an "avalanche" of new issues coming to the market given the prevailing tone in markets leading to 19.3 billion euros worth of new issues coming to the markets with 12 billion alone last Monday. While core non-financial issues are getting more and more unattractive, there was a flurry of new issues coming from peripheral countries, such as Energias de Portugal on Friday which came to the market with 750 million euros worth of bonds which drew 7.5 billion in orders from 475 investors at a yield of 5.875% from an initial 6.25%. It was the first issue for Energias de Portugal (EDP) in the last 18 months. Effectively EDP had been shut out of the markets since February 2011.

This directly a translation of the pressure easing on Portugal sovereign CDS 5 year spread, as indicated in the below graph displaying Portugal 5 year sovereign CDS versus Ireland sovereign 5 year CDS:

Both Ireland and Portugal's respective CDS continue to Converge from -891 bps apart early 2012 towards -170 bps apart.

But, the severing of the link between Sovereign risk / Financial risk has yet to happen. The main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index has been trying to break that close relationship, expecting that the European Banking Union will finally break this relationship. We doubt it will - source Bloomberg:

The ECB is to be given new powers in the framework of the single supervisory mechanism for Eurozone banks. The EBA and national supervisory authorities will continue to carry out day-to-day tasks. While this change in profile is akin to an additional step towards a banking union, it is as well a precondition of the ESM's ability in lending directly to banks and part of the move towards fiscal, economic and political union. Given our "bipolar disorder" markets are in a positive "mania" phase, this ECB expanded role has been so far well received leading to further tightening in Itraxx Financial Spreads, sovereign CDS spreads and rising European financial stocks. The "unelected" President of the European Commission José Manuel Barroso set out this week his "vision" for Europe, namely a "federation of nation states". CreditSights recent report entitled - ECB Bank Supervision - The Road to Banking Union, indicated the following important points: "According to the commission between October 2008 and October 2011, European countries "mobilised Euro 4.5 trillion in public support and guarantees to their banks". It wants to break "the vicious circle between banks and sovereigns". However, whether this is achievable through a banking union is doubtful. The majority of most banks' assets are located in their home country and therefore intertwined with their local economy, and banks tend to hold large (and increasing) portfolios of home country government securities, which itself makes the link between the sovereigns and banks difficult to break. However the Commission is more concerned with removing the burden on national governments of bailing out their banks. It would probably be more logical to reduce sovereign risk first, but that is more difficult, practically and politically, than trying to fix the banks".

In relation to the European bond picture, the move was less dramatic for peripheral bonds this week with Spanish 10 year yields around 5.80%, slightly below 6% whereas Italian 10 year yields still well below 6% around 5.00% whereas German government yields continued rising, this time around towards 1.70% levels with other core European bonds yields rising as well in the process - source Bloomberg:

As far as "Flight to quality" picture is concerned, it is clearly pointing towards "Risk-On" with Germany's 10 year Government bond yields rising towards 1.70% and the 5 year CDS spread at 52 bps converging - source Bloomberg:

Both the Eurostoxx and German 10 year Government yields are still moving in synch in "Risk-On" mode in with rising German Bund yields towards 1.70% yield level and a stronger Eurostoxx 50 at the end of the week converging with the Itraxx Financial Senior 5 year index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

It's definitely called capitulation in the credit (bear?) space. The flattening of CDS curves is indeed happening with forward prices collapsing especially on 2/5 CDS curves, 3/5 and 1/5. On top of that the Itraxx Crossover 5 year CDS index versus the Itraxx Main Europe 5 year index is compressing, meaning the bull is back for now.

As a market maker rightfully commented: "Pure capitulation from Macro Funds is round the corner".

Back in our previous conversation "The Uneasiness in Easines" we argued:

"The lag in European stocks given the very recent negative tone in Europe has made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead to an outperformance of European stocks versus US stocks."

We stick to our call.

We have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:

In fact Spain's falling CDS may indicates additional extension of the on-going rally as displayed by Bloomberg:

"As the CHART OF THE DAY shows, Spain’s benchmark IBEX 35 Index has moved inversely to credit-default swaps on the country’s five-year bonds since 2010. The CDS contracts have tumbled since Sept. 6, when European Central Bank policy makers agreed to implement an unlimited bond-buying plan to boost confidence in the euro. The IBEX 35 has jumped 34 percent from this year’s low on July 24 as ECB President Mario Draghi pledged to do whatever it takes to preserve the single European currency and Federal Reserve Chairman Ben S. Bernanke said he would provide further

Moving on to the subject of the diminishing returns QE has on the real economy, we recently commented in the blogosphere our discontent with Dr Bernanke's latest round of QE and for obvious reasons we think. Namely that QE3 will only prove that monetary policy alone cannot prop up the labor market because in normal times triggering inflation expectations should trigger a credit boom, but given this is not your normal recession but a Balance Sheet Recession (BSR), it will eventually fail again.

We could not agree more with Cheuvreux's latest Microscope publication by Nicolas Doisy namely that:
"So far, only QE-2 is actually a quantitative easing as it has elicited banks into pure cash hoarding, while QE-1 (an emergency action) was credit easing. But QE-2's ability at capping nominal yields is stumbling against the law of diminishing returns: the impact of QE-2 is just around half that of QE-1.
While unmistakably signaling a real credit crunch, the QE-2 cash-hoarding also elicited an actual but temporary pent-up in inflation expectations.
If it has thus managed to reduce real interest rates, QE-2 has proved unable to prop up wage inflation, the effective driver of trend price inflation. Likewise, a QE-3 would just prove that monetary policy alone cannot prop up the labor market, as banks would keep hoarding cash and not lend it."

Indeed QE2 was arguably a period of credit crunch due to banks hoarding cash and QE2 did trigger inflation expectations upwards (via resumption of credit) but insufficiently to sustain credit expansion according to Nicolas Doisy's recent note:

We already touched on the impact credit conditions have had to the US growth versus Europe back in our conversation with the help of our friends from Rcube Global Macro Research in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...":

But avoiding a non-deflationary growth would entail fiscal stimulus in order to avoid a Japanese style deflation.

"The CHART OF THE DAY shows the yield on the benchmark Treasury 10-year note since 2005 has closely tracked the first seven years of Japan’s slow-growth period that started in 1990. That is a correlation central bankers should keep in mind when formulating policy, said Porter, deputy chief economist at BMO Capital Markets in Toronto. “It’s a tad unnerving,” Porter said in an interview. U.S. rates have followed Japan’s even as the Federal Reserve has been more successful than the Bank of Japan in fighting deflation, or a protracted drop in prices. “This could be a long-grinding episode where yields bounce around at low levels for an extended period of time,” he said. While there are plenty of differences between the two countries -- such as their rates of inflation, the aging of the population in Japan and the relative strength of U.S. financial institutions -- there are also similarities, said Porter. These include severe financial crises and protracted periods of weak growth that are difficult to shake off, he said. If U.S. Treasuries were to continue following the trajectory of securities for the world’s third-largest economy, the yield on the 10-year note over the next 15 years would decline to about 0.75 percent -- in line with the current level of Japan’s 10-year bond." - source Bloomberg.

Because, a decline in wage inflation is indeed a clear deflationary sign (paradox of thrift). Wage inflation has kept trending down since November 2008 with the exception of a short-lived plateau in November 2010 to August 2011 according to Nicolas Doisy' s recent report. QE2 has been running out of steam since with wages driving price inflation down again:

"The continued decline in wage inflation is a sign of deflation taking root as it is translating into rising household saving rate and decelerating consumption. Both reflect the impact of paradox of thrift / paradox of toil.

-aggregate demand is insufficient to kick-start growth (paradox of thrift).

-labor productivity gains are not accurately compensated (paradox of toil).

The final lesson is that any QE3 is pretty unlikely to ever be able to turn wage inflation around with no other pro-active policy aimed at the labor market. This is yet another sign of the paradox of thrift / paradox of toil: even unconventional, monetary policy is pushing on a string as long as fiscal policy does not come to the rescue to prop up the labor market. This one of Bernanke's recurrent messages."

"The central reason behind the QE's inability at durably triggering upward inflation expectations is that the Fed's cash does not leave the banking system. In simpler terms, the Fed's cash sits idly on the commercial banks current account at the Fed. It thus never sees the light of the real economy, just as if banks were anticipating an indefinitely continued decline in wage inflation and, thus aggregate demand." - Nicolas Doisy, Cheuvreux.

Fed's new easing will do little to lift bank lending:

"As the CHART OF THE DAY illustrates, banks reduced the amount of reserves held at the Fed’s regional banks and made more money available to businesses in the past 12 months. The shifts took place even though the central bank’s total assets were little changed, as Michael Shaoul, CEO of Oscar Gruss and Son Inc's wrote on the 11th of July in a report.

“This point is sadly missed by those looking for a new round of quantitative easing,” the report said. Between 2008 and last year, the Fed bought $2.3 trillion of debt securities in two rounds of easing to support economic expansion. Bolstering reserves through a third round of purchases “will not increase the supply of or demand for credit,” the New York-based analyst wrote. Reserves for the week ended July 4 were $179.2 billion lower than their peak last July, according to data compiled by the Fed. The decline coincided with a $171.2 billion increase in commercial and industrial loans, based on central-bank data. “This is precisely how monetary policy can affect domestic activity,” wrote Shaoul, who also helps oversee more than $2 billion as Marketfield Asset Management LLC’s chairman. “What it cannot do is magically increase employment.” - source Bloomberg

In addition to cash sitting idling on the commercial banks current account at the Fed, the business bank-balances boom is as well hurting the US economy (yet another sign of the paradox of thrift at play):

"Companies may have to tap into their bank balances in order for U.S. economic growth to accelerate, according to Pierre Lapointe, Brockhouse and Cooper Inc.’s global macro strategist.

As the CHART OF THE DAY depicts, U.S. non-financial companies held a record $931 billion of checking and savings deposits as of March 31, according to figures compiled by the Federal Reserve for quarterly flow-of-funds reports. Deposits more than doubled from June 2009, when the latest recession ended, as the economy grew 6.3 percent. “Corporations are still cash rich and could provide a much-needed boost to the economy,” Lapointe wrote on the 12th of September in a report that presented a similar chart. “We need companies to come in and start spending.” Cash is rising as companies guard against the risk of another slump, the Montreal-based strategist wrote. Data on capital spending, dividends, stock repurchases and takeovers

point toward the same conclusion, according to Lapointe, who prepared the report with two colleagues. “Even though they have cash in the bank, companies do not feel as rich as they used to,” he wrote. The ratio of cash to assets for the Standard & Poor’s 500 Index has declined about half a percentage point in the current economic expansion and now stands at 8 percent, according to the report. Checking accounts held 40 percent of non-financial companies’ deposits at the end of the first quarter, and the

other 60 percent was in savings. Deposit figures at the end of the second quarter will be included in the Fed’s next flow-of-funds report, due Sept. 20." - source Bloomberg.

Nicolas Doisy concluded is recent note with the following important point which we agree with:

“All in all, the US strategy to exit the current deflation(ary) trap misses the point by focusing only on monetary policy, while a fiscal stimulus is also needed. In other words, labor is insufficiently compensated for the sole reduction in real interest rates to kick start growth. So, either labor is given a larger bargaining power or it must receive massive money transfers to start spending again.”

Given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, investors are facing indeed an increasingly strong dilemma, due to the growing number of US retirees and a falling yield environment:

"The Baby Boomers Generation is that huge post-war cohort born between 1946 and 1964. The first wave of baby boomers turned 65 in 2011. It is estimated that during the next 20 years, roughly 74 million "boomers" will retire in the United States. That is an average of more than 10,000 new retirees a day!
The rest of the world also had their own "baby booms". The United Kingdom, France, Denmark, The Netherlands, and Australia are just some of the other countries considered to have had Baby booms starting around 1946." - source Keenan Overseas Investors.

As far as consumers and The Wealth effect is concerned courtesy of yet another round of QE, as indicated by Keenan Overseas Investors:
"- Many US and European property markets have significant unsold inventories.
- New generation of young adults in the US weighed down by student debt.
- Consumer demand reduced when people consider themselves poorer.
If interest rates increase, all of these problems get worse!"

The fight against deflation goes on...

"Trouble springs from idleness, and grievous toil from needless ease." - Benjamin Franklin

Stay tuned!