Macro and Credit - Volition

"The true test of a leader is whether his followers will adhere to his cause from their own volition, enduring the most arduous hardships without being forced to do so, and remaining steadfast in the moments of greatest peril." - Xenophon

Looking at the dizzy heights being reached in equities with uninterrupted flows into US Investment Grade with yet another warning coming from the wise wizard from the BIS, namely Claudio Borio in the latest quarterly report, when it came to selecting our title analogy, we reminded ourselves of the term "Volition" from psychology given our fondness for behavioral economics. Volition or will is the cognitive process by which an individual decides on and commits to a particular course of action such as the normalization process undertaken by the Fed. It is defined as purposive striving and is one of the primary human psychological functions. Volition means the power to make your own choices or decisions. As an example of the classical concept of volition, comes from Eliezer Yudkowsky while discussing friendly AI development and "Coherent Extrapolated Volition" in 2004. The author came up with a simple thought experiment: imagine you’re facing two boxes, A and B. One of these boxes, and only one, has a diamond in it – box B. You are now asked to make a guess, whether to choose box A or B, and you chose to open box A. It was your decision to take box A, but your volition was to choose box B, since you wanted the diamond in the first place. Now imagine someone else – Fred – is faced with the same task and you want to help him in his decision by giving the box he chose, box A. Since you know where the diamond is, simply handling him the box isn’t helping. As such, you mentally extrapolate a volition for Fred, based on a version of him that knows where the diamond is, and imagine he actually wants box B. In developing friendly AI, one acting for our best interests, we would have to take care that it would have implemented, from the beginning. The question one might rightly ask is relating to the volition of the Fed, is it really for our best interests? One might wonder.

In this week's conversation, we would like to look at the volition of the Fed in its normalization process and the potential upcoming impacts in 2018 should the Fed, once again be behind the increasing flattish curve.

Synopsis:

• Macro and Credit - When the going gets tough
• Final chart -  The Fed can't escape Newtonian gravity

• Macro and Credit - When the going gets tough

Back in April 2017 in our conversation "Narrative paradigm" we argued that when it comes to credit market the only easy day was yesterday. Given the significant role of beta thanks to cheap credit and the "carry play" supported by low rates volatility, it becomes increasingly difficult for us to be supportive of at least the European beta play with the level touched by European High Yield. We also indicated recently that we were expecting a significant pick-up in M&A activity in 2018. This means that some investment grade issuers could experience some sucker punches in the form of blowing out credit spreads in 2018 hence the need of reaching out for your LBO screener à la 2007. A raft of M&A transactions in 2018 would clearly reinforce the view of the lateness in the credit cycle. In terms of change of narrative and in continuation of the "synchronicity" we mentioned in our previous post, the Fed's volition should not be taken lightly.

Also, regardless of the economic narrative put forward by many, including November payrolls rising by a seasonally adjusted 228K and beating expectations of 200K, leaving the unemployment rate in the US to 4.1%, rising wage pressure remains relatively absent. On top of that, surging consumer confidence and modest income growth should trigger much stronger loan demand in our "credit book". One could argue that the credit impulse in the US is tepid at best, no offense to the volition of the Fed. This is indicated by Wells Fargo in their Interest Weekly note from November 29th entitled "Mixed Credit Trends Among Businesses and Consumers":

"In the ninth year of the current economic expansion, credit standards point to a varied, but stable, outlook. Recent data suggest business lending demand has fallen, while consumer demand has seen modest gains.

Banks Optimistic (Yet Cautious) Approach to Lending

Banks continue to relax lending standards on business, commercial and industrial (C&I) loans and mortgages, as banks’ willingness to make loans has gained some stability. A slowdown in banks’ willingness to lend is customary with late cycle expansion. As seen in the below graph, banks’ willingness to extend credit follows a cycle-like trend.

At the start of an economic expansion, banks appear very willing to extend credit. But as the cycle matures, they become less willing to extend credit, and, in turn, tighten their standards in a cautionary nature.

Banks have reported increased competition from other bank and nonbank lenders, which in part, has led to the easing of standards. Continued loosening of lending standards of C&I and mortgage loans points to sustained confidence in the current state of the expansion. However, banks continue to tighten standards on credit card and auto loans, which may signal some caution in the consumer sector as the economic cycle ages.

Slowly Growing Consumer Demand for Loans

With an unemployment rate of just 4.1 percent, and in an environment of modest income growth and surging consumer confidence, theory would suggest robust loan demand. Loan demand, however, remains muted, pointing to a change in consumer sentiment towards debt. Credit card demand has remained unchanged, while we have seen a recent uptick in auto loan demand (below graph).

The rise in demand for auto loans is likely attributable to rebound effects in auto-sales due to damage from the recent hurricanes in Texas and Florida. Consumer demand for mortgage loans has slowed, which is expected to reverse as existing home sales edge higher off a recent slowdown.
Without an increase in income growth, loan demand should continue to increase modestly. Our forecast calls for an uptick in disposable personal income in Q2 2018, due to the effects of the proposed tax reform, followed by a slowdown in disposable personal income growth through the last year of our forecast (2019). Such slowing in income growth suggests consumers may increasingly turn to borrowing to fund their consumption habits in the future.
Demand for business loans remains weak, yet increased strength in business investment suggests that firms have turned to other sources of funding to fuel capital spending (below graph).

The loosening of lending standards, coupled with our positive outlook for business investment, should drive C&I loan demand higher in the near future. However, as the cycle continues to mature, we project equipment spending to slow, likely resulting in a reduction in business demand looking further ahead. The current credit climate insinuates stability within lending practices as growth continues in the ninth year of the current economic expansion."  - source Wells Fargo

While the Fed's volition is to continue with its hiking cycle, financial conditions remain loose and the lack of pressure on wages means that consumers are increasing their leverage through consumer loans in an environment where there is increased competition for business from other players. There are two ways we think the first part of 2018 could play out, "Goldilocks" or "Stagflation" with a sudden rise in inflation expectations that would provide support for a bond bear market narrative with rising interest rates volatility. This is of course without taking into account rising geopolitical risk aka the dreaded "exogenous" factors. We sidestepped various political "exogenous" risks in the first part of 2017 with various elections taking place in Europe in particular. It remains to be seen what will be the trigger of the return of volatility which has so badly wounded many large global macro funds in recent years thanks to its absence. As far as interest volatility is concerned it is at the lowest level in more than 20 years as displayed in the below Wells Fargo chart from their 2018 US Corporate Credit Outlook published on the first of December:

- source Wells Fargo

It won't last rest assured as it is getting late in the game we think and we are already seeing a "synchronized" change in the central banking narrative. Yet some "beta" players continue to be oblivious to the change in the central banking rhetoric. It doesn't mean that the "Goldilocks" environment won't last a little bit more in 2018 for credit, but, we think you should start thinking about playing "defense". This is why back in July we recommended to tactically going for duration again particularly in credit. This has been paying off nicely in 2017 (MDGA - Make Duration Great Again) as indicated by Bank of America Merrill Lynch Credit Market Strategist note from the 8th of December entitled "Year of Duration":

"Year of Duration

That 30-year corporate bonds, which we define in the following as 15+ years, have performed well in 2017 (+11.48% YtD) is no surprise. After all we expected “equity-like” 8-9% total returns in our 2017 outlook piece (see: 2017 US high grade outlook: Let’s do the twist 21 November 2016) on the back of a 27bps decline in 30-year corporate yields (actual: -48bps YtD, Figure 1).

However the surprise has been that credit spreads and Treasury yields were almost equally responsible for this decline in yields (25bps tightening in spreads and 30ps decline in 30-year Treasury yields as of yesterday, Figure 2).

This positive correlation between credit spreads and Treasury yields for such large moves is noteworthy and counterintuitive, but not unseen in the post-crisis years.

How did duration become king?

There are many reasons corporate yield curves are flattening so much including first and foremost that the Fed plans to hike rates actively in an environment of weak inflation data (Figure 3, Figure 4).

This was highlighted by today’s mixed jobs report for November where, although headline nonfarm payrolls were strong at +228k (vs. +195k consensus, Figure 5), average hourly earnings grew only 2.5% YoY (vs. 2.7% expected, Figure 5).

There are many other reasons for flattening yield curves including Treasury’s refunding announcement, where they committed to meet any increased issuance needs using shorter maturities (see: On funding and refunding), the ongoing shift in Europe out of cash and way out the curves (see: QE is dead, long live NIRP), macro risks, etc.

Re-iterate 10s/30s spread curve flatteners

Unusually - and a testament to extreme investor need for both yield and duration – we have seen the 10s/30s corporate spread curve (non-fin, commodities) flatten 8-9bps this year, despite the fact that the 10s/30s Treasury curve has flattened 22bps. More broadly this environment of both flattening Treasury and spread curves has been in place since spreads began tightening in early 2016 (Figure 7). However, the past six months has seen little flattening of the spread curve – but the lack of steepening is actually very impressive as the Treasury curve has flattened 27bps over the same period of time. Needless to say if the Treasury curve continues to bull flatten our recommended non-banks spread curve flattener will not work. We are probably even now reaching levels where further bull flattening actually leads to steeper spread curves. Our house view (see: Global Rates Year Ahead) remains that the Treasury curve is too flat and eventually will re-steepen, which should be very favorable for our spread curve flattener trade. The trade also works with higher interest rates as long as the curve does not flatten.

- source Bank of America Merrill Lynch

As we concluded back in early June in our conversation "Voltage spike", the MDGA trade (Make Duration Great Again) has made a very good come back as indicated by the ETF ZROZ we follow, which delivered a 10.53% return so far this year. For 2018, we continue to favor style over substance, quality that is, over yield chasing from a tactical perspective. As well in another conversation of ours in June this year entitled "Goldilocks principle" we indicated:

"The relentless flattening of the US yield curve shows that in the current inning of the credit cycle, and with a Fed determined in continuing with its hiking path, from a risk-reward perspective, we believe long duration Investment Grade still offers support to the asset class and not only from a fund flows perspective with retail joining late the credit party. On another note the "Trumpflation" narrative has now truly faded to the extent that the deflation trade du jour, long US Treasuries (the long end that is) is back with a vengeance, while inflation expectations has been dwindling on the back of weaker oil prices (after all they still remain "expectations" from our central bankers perspective). " - source Macronomics, June 2017

Our call has been vindicated as well as our contrarian stance against the "bullish" dollar crowd. We continue to believe we will see further weakness ahead for the US dollar in 2018. If we do see additional pressure on the leverage play thanks to the carry trade due to central banking's volition, then one should expect a rise in the Japanese yen we think. As well we continue to see value in the long end of the US curve. Also while gold prices have been weaker recently, the recent pullback as for goldminers looks to us enticing, particularly in the light of a growing risk in "exogenous" factors. If credit options are cheap, gold/gold miners options are "cheaper" as well from a convexity reward perspective in 2018. When it comes to the bull run in credit spreads it has not yet ended and probably will last longer than many might expect, until we hit 11 that is on the "credit amplifier" in true Spinal Tap fashion. We do not see any value left (apart from playing the "dispersion" game with active credit management) in European High Yield at these levels. What is left is "carry" and clearly not enticing enough for us from a risk reward perspective in 2018. We would rather continue playing the US Investment Grade long duration play when it comes to credit allocation. What about US equities being priced to perfection and US High Yield? Given the strong correlations of both asset classes (close to 1 regardless of what some pundits would like to tell us), it is all a matter of "earnings" and they have been so far holding fairly well.

The big risk out there is, as we pointed out the return of the "Big Bad Wolf" aka inflation. This would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant repricing on the way. Inflation is our concern numero uno and this would we think be the trigger for higher volatility. This is as well the view of Deutsche Bank from their Asset Allocation note from the 4th of December entitled "What to make of volatility at 50-years lows":

"In our view the leading candidate for a shock that would lead to a sustained increase in vol is a sharp increase in inflation

As noted above, exogenous shocks have historically played a significant role in increasing and sustaining vol at higher levels. Shocks in general of course tend to be inherently unpredictable. Our economists forecast is for a gradual rise in inflation. But in the current context a sharp increase in inflation sticks out as a leading candidate for a shock that raises volatility in a sustained manner in 2018 given the extent to which it is priced in and the likely reaction of monetary policy:

• Slow inflation priced in. The slowdown in US inflation beginning in March this year had large impacts across asset classes and looks to be priced in (The Growth-Inflation Split, Sep 2017).
• Few expect a sharp pickup in inflation. The market and FOMC narrative around low inflation with widespread buying into structural declines and a breakdown of traditional relationships looks to have gotten carried away (Six Myths About Inflation, Oct 2017). This suggests few are expecting a sharp pickup in inflation.
• Four fundamental reasons to expect inflation to move up. First, the lagged impacts of inflation to the growth slowdown during the dollar and oil shocks points to a pick up. Second, the labor market continues to tighten and in our reading there is no reason to believe the traditional Phillips curve has broken down, just swamped by other factors. Third, the direct drag from the past appreciation of the dollar should begin to pass through. Fourth, idiosyncratic factors together have had a strong negative run but tend to mean revert over time. Acting in concert, the four factors clearly have the potential to create a sharp move higher in inflation.
• A sharp pickup in inflation is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle. Fed hiking to keep inflation in check has been a—if not the —leading driver of recessions historically. Market expectations of Fed hikes are currently of course far below the Fed’s guidance and a sharp pickup in inflation is likely to entail a significant re-pricing. We don’t see Fed rate hikes from current low levels as ending the cycle any time soon (Is Unprecedented Monetary Policy Easing Creating Secular Stagnation? Jul 2016). But we do see faster rate hikes against the backdrop of a sharp pickup in inflation as having the potential of raising and sustaining vol at higher levels as concerns about the end of the cycle grow." - source Deutsche Bank

Make no mistake, inflation is the "Boogeyman" for financial markets. From the long interesting report from Deutsche Banks, three graph stand out when it comes to heightened risk for large "sigma" events in 2018 given how coiled the volatility spring is:

- source Deutsche Bank

No matter how high your "interval of confidence" is, your VaR model is looking/asking for trouble, particularly your "liquidity" hypothesis. It is time to build some cheap "convexity" defenses as we posited above, not to mention the need for your LBO screener with rising M&A risk and the sucker punches they can deliver to your Investment Grade portfolio à la 2007. Just some thoughts for 2018.

When it comes to the relentless flattening of the US Yield curve as a harbinger for rising recession risk in a classical macro way, we read with interest Deutsche Bank's take from their Global Market Strategy note from the 1st of December entitled "The Fed, the Curve and Risk Assets in the Great Rate Normalization about the recession risk transmission:

"Recession risk transmission

The sharp curve flattening has given renewed life to worries that recession risks are on the rise. Given the flattening, our recession probability metrics – one using the outright slope of the 1s10s yield curve, and one that adjusts the 1s10s curve for the level of 1s – both suggest that November’s flattening was worth a ~6pp increase of the probability that a recession will begin in the next 12 months.

Holding all other inputs equal (the u-rate vs nairu, aggregate hours worked growth, core CPI ex-shelter, and the change in oil prices) puts the probability of a recession beginning in the next 12 months at 16.4% on the unadjusted model, and 26.4% when we adjust the curve for the level of front-end rates. This is still low.

The parallels between the current environment and the Greenspan conundrum are inevitable given the apparent insensitivity of long-end rates to the Fed’s hiking cycle – particularly in the context of a balance sheet unwind that many expected to put sustained steepening pressure on the curve. There is no “conundrum” in our mind – the Fed is simply hiking into a very low neutral rate, with no evidence that inflation is set to materialize to allow them to move faster. This cycle is following a somewhat similar path, however, to the mid 2000’s cycle from the perspective of recession probability.

Now 2 years into the current cycle, the recession probability is at a similar spot to mid-2006 (which was just months away from being within the 12 month window to the start of the great recession).

The risks presented by a flattening yield curve have a clear transmission mechanism to broader conditions as the Fed’s balance sheet shrinks. Before the Fed began to pare its balance sheet we discussed why a steep curve is important to a successful QE unwind – if the curve flattens too much, banks will have no incentive to hold securities over cash earning IOER, meaning non-banks will likely be the marginal buyers of securities no longer owned by the Fed, and deposits will leave the system. This in turn carries meaningful risks to loan growth, which had caught a fair amount of attention given the slowing earlier in the year. Our financial conditions index suggests that C&I growth should be accelerating, though that has not really materialized yet.

The lagged relationship between C&I loans and the Senior Loan Officer survey points to a pick-up in loan growth, but only into the ~5% y/y range, not the double digit range of years past. This has failed to materialize, however, and is a going risk amid the Fed’s balance sheet wind down.

It is still sufficiently early into the Fed’s balance sheet unwind that banks’ reaction function is hard to gauge – securities holdings have risen since the end of September, while cash holdings have been more or less stable and deposits have shown some recent volatility but might still be on an upward trend. So the limited evidence does not yet suggest that this is posing an imminent risk to the economy, but the flatter the curve gets, the more likely banks are to eschew securities for cash, increasing the risk that deposits leave the system, and banks have to pull back on lending."  - source Deutsche Bank

There you have it, no matter how strong the "volition" of the Fed is, the exercise is difficult to execute. While there is no imminent threat to the positive narrative from a fundamentals perspective, the relentless flattening of the Us yield curve is difficult to ignore on top of rising geopolitical exogenous factors. We could easily entertain a blow out of oil prices on the back of exogenous factor in an already tensed Middle East, which would no doubt spill into the inflation expectations surprises on the upside and lead to some repricing and heightened volatility. As we pointed out in our bullet point, when the going gets tough...volition or not.

In our last conversation, we pointed out that "volatility" conundrum was not a paranormal phenomenon, and no matter our strong the Fed's volition and "Forward Guidance" (or imprudence), what the US yield curve is telling us is that no matter how strong the Fed's volition is, they cannot escape Newtonian gravity:

"When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward." - source Macronomics, November 2017 

Our final chart below points towards the gravitational pull the Fed is facing.

• Final chart -  The Fed can't escape Newtonian gravity

No matter how strong the spells of the "wizards" at the Fed have been in recent years as pointed out by the wise wizard of the BIS aka Claudio Borio, the Fed's volition is one thing, Newtonian gravity is another. Our final chart comes from Bank of America Merrill Lynch's Weekly Securitization Overview from the 8th of December entitled "The gravity of the yield curve" and displays the 2Y10Y versus the US unemployment rate:

"Given the magnitude of recent yield curve flattening, we revisit our framework where we look at the 2y-10y spreads relative to the unemployment rate back to 1989 (Chart 1).

The flattener has moved more slowly than we anticipated back in 2014, dropping by about 50 bps per year over the last 4 years. Given where unemployment already is, and expectations that it will move lower in the year ahead, we see a strong gravitational pull lower on the curve. Moreover, given that the Fed likely has 4-5 rate hikes in store over the next year (including December 2017), while inflation readings remain low, dropping an additional 50 bps on the curve over the next year seems very achievable, particularly after the 30 bps drop in the 2y-10y spread in the past six weeks.

We note that flattening is not the house call: BofAML rates strategists believe the curve will steepen due to easier fiscal policy, higher deficits, and a higher inflation expectation and the Fed will require higher 5y-10y yields as a precondition to flattening or inverting the curve. We recognize that the flattening process has already taken longer than we expected a few years back, due to multiple “dovish” Fed hikes or pauses, and we acknowledge the potential for what we think would be steepening detours along the way.

Newton's law of gravitation resembles Coulomb's law of electrical forces, which is used to calculate the magnitude of the electrical force arising between two charged bodies. Both are inverse-square laws, where force is inversely proportional to the square of the distance between the bodies. In similar fashion, the relationship between the US 2Y10Y and the US unemployment rate could be seen as inverse-square laws when it comes to the ongoing flattening stance of the US yield curve but we ramble again...

"A man of genius makes no mistakes; his errors are volitional and are the portals of discovery." -  James Joyce

Stay tuned!

Credit - Sympathy for the Devil

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

Looking with interest Spain issuing a 50 year bond with a 4% coupon, in conjunction with the latest raft of the decisions taken by our "Generous Gambler" aka Mario Draghi being a very crafty poker player no doubt in the steps of his July 2012 OMT bluff triggering a continuation in the weakness of the Euro versus the US dollar, we decided this week to venture towards a musical analogy in picking up our chosen title. Sympathy for the Devil is a song by The Rolling Stones which first appeared in 1968. 

In a 1995 interview with Rolling Stone, Jagger said: "I think that was taken from an old idea of Baudelaire's, I think, but I could be wrong. Sometimes when I look at my Baudelaire books, I can't see it in there. But it was an idea I got from French writing. And I just took a couple of lines and expanded on it. I wrote it as sort of like a Bob Dylan song." 

Mick Jagger wasn't wrong. As one knows, the "Devil is in the details" and if Mick Jagger had taken a closer look to his Baudelaire books he would have noticed that his inspiration indeed came from this great text from Charles Baudelaire called the "Generous Gambler" we have used in the past as a title for a post. This poem appears to be the 29th poem of Charles Baudelaire masterpiece Spleen de Paris from 1869 (an interesting anagram with 1968 we think):

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!" - Charles Baudelaire - The Generous Gambler

We previously pointed out in our conversation "Complacency" back in November 2011 that this seminal work from Baudelaire also inspired the scenarists of the great 1995 movie Usual Suspects:
"The greatest trick the devil ever pulled was to convince the world he didn't exist" - Roger "Verbal" Kint- The Usual Suspects

Of course as our earlier quote goes, we could not resist using Baudelaire's work as an inspiration as well but we ramble again.

In this week's conversation we will look at why European banks deleveraging has much further to go (hence the much commented latest round of ECB decisions taken to support the banks in Europe in the process) as well as the credit clock and the on-going fast releveraging in the US corporate sector which we touch briefly in our previously published Chart of the Day and our fear in a US dollar rising too fast for some Emerging Markets (EM).

Whereas investors have indeed been mesmerized by Mario Draghi with his "Whatever it takes" and "Believe me it will be enough" moments, it is no surprise to us to see an acceleration in the continuation in yield compression, going negative for some, in the European government space. 

Investors have indeed Sympathy for the Devil we think, as they continue to pile up with much abandon and more and more getting "carried away" in their insatiable hunt for yield. In that sense Baudelaire's 1869 poem rings eerily familiar with the current investment situation in the sense that investors have been giving our "Generous Gambler" the benefit of the doubt (OMT - and now full blown QE) and shown their sympathy and their blind beliefs in "implicit" guarantees, rather than "explicit" (such as the German Constitution as we argued in various conversations):

"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!" 

But as years have gone by in the European tragedy, we have become somewhat immunised from our great magician's spells. Many investors have indeed shown the greatest sympathy in respect to piling up on European Government Debt in the process, while banks have been shedding assets leading to outright credit contractions leading in the past two years European banks to cut their lending to businesses by about 8.5 per cent as reported by Matthew C Klein in FT Alphaville in his article "How to spend it: ECB bond-buying edition"  adding the following comment: "a remarkable development considering what has happened to credit spreads since Mario Draghi pledged to do “whatever it takes” to save the currency union"

For us, it isn't remarkable, as we have always stipulated in this blog that LTRO 1 and 2 in conjunction with the fateful EBA decision pushing banks to reach a Core Tier 1 ratio of 9% precipitated the recession and the credit crunch in peripheral countries more significantly. For us it amounted to "Money for Nothing" we argued at the time given the lack of transmission to the real economy. It looks to us the 8.5% credit contraction validates our take and the crowding out of the private sector we discussed in prior conversation "Tokyo Drift" being the latest:

Indeed, declining peripheral yields have not transferred to peripheral private sector funding due to "crowding out" which we discussed a year ago in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.

"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

We also commented at the time:

"Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 

As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.

"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

The issue of course is that the deleveraging in the European banking space has a very long way to go as indicated by this Loan-to-deposit ratios chart coming from McKinsey's Working Paper on +Risk number 56 entitled "Risk in emerging markets" published in June 2014:

-source McKinsey

The scale in the deleveraging can be ascertained from the chart above with a reduction of 58% in the US and 31% in the United Kingdom. 

In regards to the capital structure, in comparison to Europe, the United States have increased much rapidly their capital levels than their European counterparts as displayed in the below chart from the same McKinsey report:

-source McKinsey

US banks have increased their capital basis by 57% since 2007 until 2012 while Western European banks by only 37% on the same period.

While investors boast sympathy for our "Generous Gambler", some German economists do not seem to show much sympathy given that at the end of July the German Constitutional court received yet another challenge, this time around the European Banking Union. It has not been reported as much by financial pundits but, a group of professors in Germany has filed a complaint claiming the European Banking Union has no legal basis in the EU treaties as reported by EurActiv on the 29th of July:

 "European banking union constitutes a violation of fundamental rights, said professor of finance and economic policy at the Technische Universität Berlin Markus C. Kerber, in a statement for the German newspaper "Welt am Sonntag".

The rules for the new single supervisory mechanism "represent the first step towards unprecedented German taxpayer liability for banks outside national banking supervision", Kerber said. According to the economic law expert, European banking supervision can only be introduced if changes are made to the EU treaties.

Kerber is not alone. He stands alongside numerous critics from the Europolis Group who are convinced that the German government and Bundestag have disregarded the responsibility for integration while dealing with Brussels' plans for a banking union.

The group has decided to lodge a complaint before Germany's constitutional court against the underlying legal regulation as well as the law ratifying the transfer of bank supervision to the European Central Bank (ECB).

Announcing the group's decision on Sunday (27 July) in Berlin, Kerber also accused German Finance Minister Wolfgang Schäuble of deceiving the public regarding the risks of banking union.

The complainants announced their intention to extend the constitutional complaint as soon as the regulation on the Single Resolution Mechanism (SRM) and its corresponding bank resolution fund take effect.

Starting in November, the new single supervisory mechanism will fall within the remit of the European Central Bank (ECB). It is a central component of banking union.

“We consider the banking union constitutional,” the German Finance Ministry explained, adding its legal basis was thoroughly assessed with the constitutional department.

The ministry said Germany did not feel the EU Treaty's internal market article [Article 127(6) TFEU], on its own, was sufficient for the union, as the Commission proposed. As a result, an additional agreement was made among the member states.

Kerber has been a strict opponent of EU bailout policy from the start. "The worst is yet to come", he warned in May 2012, predicting an imminent collapse of the eurozone. At the time, he called for the introduction of second currency in parallel to the euro called the "Guldenmark".

In March 2014, the German constitutional court finally gave the green light to the euro area bailout package, rejecting numerous complaints against the European Stability Mechanism (ESM). Kerber was among the official complainants at the time." - source EurActiv Germany

As we indicated in our conversation "Eastern promises" on the 9th of June 2012 we continue to think Germany could be the prime suspect in triggering a breakup:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

Keep in mind that Angela Merkel while only appearing to be making material sacrifices has managed to keep Germany's liabilities unchanged so far.

Moving back to credit and the lack of private credit to the real economy which has been plaguing the much vaunted "recovery", disintermediation in Europe has accelerated in Europe where asset managers and private investors are picking up the direct lending baton from banks which in many instances have been in retreat due to lack of capital therefore balance sheet constrained. 

In last week Chart of the Day focusing on the difference between US High Yield and US we indicated the following:

"In Europe, the situation is different, where the explosion in growth in the High Yield market comes from substitution from corporate loans to bond issuance due to the disintermediation on the back of bank deleveraging (which by the way is way behind the US). Existing loans in Europe are getting refinanced therefore via new High Yield issuance in the bond market, which implies that there is no significant releveraging as seen in the US so far."

An illustration of the direct lending trend business in Europe can be ascertained by the increase in loans origination to mid-cap corporates and the hiring taking place in that space, with Paris based asset manager Tikehau hiring for its direct lending business veteran banker Nathalie Bleuven former deputy head of the mid-cap LBO and corporate acquisition from Societe Generale, While large corporates in Europe do not have issues with loan syndication or directly taping the market through the bond market, there has been a rise in the European markets of new entrants in terms of issuance to the bond market. European corporates depended to around 85% to the loan market in 2011, with bond issuance only representing 15%.  Europe has a very large banking sector relative to GDP. The aggregate balance sheet of euro area banks is around 270% of GDP, whereas in the US, where capital markets are deeper, it is only around 70% of GDP. A deleveraging banking sector implies lower credit supply, which is problematic and explains therefore the lack of recovery in the European economy. Of course the ECB is aware of the size of the problem as indicated by the speech given by  Yves Mersch, Member of the Executive Board of the ECB, in a keynote speech entitled "Finance in an environment of downsizing banks" given at the Shanghai Forum in May 2014:

"In terms of location, the cost of and access to finance in the euro area remains strongly based on national conditions. For example, the average cost of borrowing for non-financial firms in Portugal is more than 5% per year, whereas the equivalent for French firms is around 2% per year.

One would imagine in this situation that a Portuguese firm would seek out a French bank, but the euro area banking market does not facilitate such arbitrage. Direct cross-border loans to firms account for just 7.5% of total loans to firms. And local affiliates of foreign banks represent on average only around 20% of national markets, and much less in larger countries. Thus, firms depend heavily on the health of their domestic banks.

Moreover, while corporate bond issuance has partially substituted for bank lending, it is strongly concentrated in non-distressed countries where there has been no decrease in the net flow of bank loans. The net issuance of debt securities, quoted shares and bank loans in non-distressed countries was plus €66 billion in 2013, whereas it was minus €93 billion in distressed countries.

Of course, in principle firms from distressed countries can issue securities in non-distressed countries. In practice, however, it is legally complicated due to issues of different governing law, especially when securities are traded along a chain of financial intermediaries.

This analysis points to two missing pieces in the euro area financial market: lack of retail banking integration and lack of capital market integration.

The low level of retail banking integration reflects several factors, but diverging approaches to supervision and resolution are certainly among them. For one, the persistence of national borders in a European financial market has in the past created compliance costs and reduced the synergies of banking integration. A European Commission survey in 2005 found that opaque supervisory approval procedures were a major deterrent to cross-border banking M&As. [4]

Moreover, national considerations may have reinforced the fragmentation of retail markets during the crisis. For example, some commentators have argued that supervisors erected de facto “internal capital controls” within the euro area, which restricted the flow of funds between banks and within cross-border banks.

A similar pattern can be observed in how national authorities in the euro area have dealt with failing banks. In general, non-viable banks were merged with other national banks, rather than being wound down or broken up and sold off. Thus, what could have been an opportunity to increase foreign competition in domestic markets, and indeed to work through the crisis more quickly, in some cases ended up increasing national concentration. To give a comparison with the US, the FDIC has resolved around 500 banks since 2008, mainly by selling parts of banks to other banks, whereas the equivalent figure for the euro area is around 50.

All this suggests that the move towards a genuine Banking Union in the euro area could help create the conditions for deeper retail banking integration. A Single Supervisory Mechanism (SSM) should lead to harmonisation of rules and standards, and also remove distortions created by national borders. And a Single Resolution Mechanism (SRM) should ensure that banks are resolved from a European perspective and according to least-cost principles, which should in principle open the door for cross-border resolution strategies.

In this way, even though the banking sector on aggregate is downsizing, credit allocation across the euro area may become more efficient. Banking Union is key part in ensuring that location becomes a diminishing factor in access to bank finance.

While Europe is and will remain a bank-based economy, adding the second missing piece of the euro area financial market – deeper capital market integration – is key to ensure that firms in all jurisdictions can use capital markets as a “spare tyre” when banks are not lending – and not only those in larger countries with more developed bond markets. Within a single currency area, there is no reason in principle why firms should not be able to tap a European pool of savings. What prevents this in practice, however, is regulatory heterogeneity across the euro area." - source ECB

A recent example of a firm tapping a large European pool of savings has been the recent set up of Banque PSA Finance (the banking arm of French automobile constructor) in Belgium attracted by the very large pool of short term deposits of around €250 billion euros.

There is indeed in Europe a growing shadow-banking on the back of bank deleveraging as illustrated by asset managers like Tikehau and Banque PSA Finance growing implantations. This is also illustrated in Mr Mersch speech given in May 2014:

"The size of this “shadow banking” system – which in my view is a misleading term – has increased considerably in the euro area since the crisis, rising by almost 20% since 2008. It has also taken on a greater role in financing the real economy. At end-2013, outstanding amounts of loans from euro area non-bank financial intermediaries to euro area non-financial firms amounted to €1.2 trillion. But the key challenge from a policy perspective is to ensure that these funds make their way to the most credit-starved SMEs." - source ECB

Most credit-starved SMEs are relying more and more on non-traditional players such as asset managers in providing much needed financing.

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

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.

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 and as shown in CITI Research Credit Strategy report entitled "Wider or Tighter recently published, the evolution of the median leverage ratio in the US warrants close monitoring we think:

"We calculated leverage for two baskets of names — the overall IG universe updated quarterly since ’06, and for a basket comprised of credits that held an IG rating at any time since ‘06 (to capture falling angels). Either way, it doesn’t look good."

Who is Levering Up?

Pretty much everybody. We calculate leverage for the IG universe today and three years ago (leverage ratio on the Y axis, names on the X axis and ordered from most to least levered). In gross and net terms there has basically been a parallel shift upward.

In theory and all else equal, a company that buys its own shares will boost its EPS, but unfortunately its default risk is likely to rise as well. This may not be good for share price. But in practice this is not necessarily true, since factors such as QE can drive default risk as much as company-specific actions." - source CITI Research

What of course is still supportive in the US fixed income space is the total net supply which hasn't quenched the fierce appetite for yield as displayed by CITI in their note:

"Net supply in the overall bond market has been well below the longer-term average in recent years ($1.4 tn vs. $1.8 tn), a trend we expect to remain in place in the near-term." - source CITI Research

More interestingly CITI Research highlighted an important point when it comes to traditional investors reaching for yield outside their comfort zone:

"In credit we have seen two way capital flows in the wake of QE; for example, corporate treasuries have increased HG exposure at the expense of Treasuries, but HG has lost capital to HY as traditional HG investors added HY risk. In essence, non-traditional capital entered, traditional capital left. Perhaps market segments that haven’t experienced two-way flows may be most vulnerable."

- source CITI Research

In continuation to us voicing our concerns of a potential currency crisis thanks to dollar scarcity in our conversation "The European Catharsis" we remind ourselves the following:

"We expect a "regime change" in FX volatility as well. In fact we voiced our concern with the impact the end of tapering would have in terms of dollar liquidity in June 2013 in our conversation "Singin' in the Rain":

"If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?

It is a possibility we fathom." - Macronomics, June 2013 

At risk in the LATAM region in the near term is Venezuela which saw its foreign currency reserves fall to an 11-year low of about $20 billion last month. Venezuela and its state-owned oil PDVSA has to make a $5.3 billion in bond payments in October. The country may find itself running out of cash to service debt as soon as next year as foreign reserves continue their downward trajectory to an 11-year low and oil prices continue to fall. When Chavez took over Venezuela oil giant PDVSA employed 51,000 people and produced 63 barrels per employee per day. 15 years later, PDVSA employs 140,000 people and the production per employee has fallen to 20 barrels per day per employee, meaning the country is envisaging importing oil from Algeria according to Reuters.

According to Bloomberg, the country earns about $70 billion a year from oil exports, with total debt service equal to about 25 percent of that amount.

Another candidate prime for "default risk monitoring" is in the High Yield corporate space in Brazil. Back in February 2013 in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds" we indicated the following:

Brazilian companies have sold the most junk bond on record since May 2011 last Month according to Boris Korby from Bloomberg in his article - Junk Bond Frenzy Poised to Spill Into February: Brazil Credit from the 1st of February:

"Brazilian companies led by Banco do Brasil SA sold the most junk debt since May 2011 last month as unprecedented global demand for high-risk securities enabled the neediest borrowers to chop their financing costs. State-owned Banco do Brasil sold $2 billion of junior subordinated perpetual bonds rated BB by Standard &Poor’s in the nation’s second-largest high-yield sale on record, pacing $4.25 billion of speculative-grade offerings in January. Junk- bond issuance accounted for 81 percent of Brazil’s corporate debt sales, versus 34 percent globally and 18 percent in the country last year, data compiled by Bloomberg show." -source Bloomberg

The reason Brazil High Yield is at risk and US High Yield by contagion is as follows, as indicated by Fitch in their August 2013 note entitled "U.S. High Yield Sensitive to Emerging Market Defaults":

"EM dollar denominated issues total $116.5 billion, or close to 10% of U.S. high yield market volume. The EM total is up from just $65 billion at the end of 2010 with $43.3 billion issued since January 2012. 

The $116.5 billion includes some large issuers that are in distress, including Brazilian oil company OGX (Issuer Default Rating CCC, Negative Outlook, $3.6 billion in bonds).

The largest country concentration in this group is Brazil ($30 billion), followed by Mexico ($16.3 billion) and China ($14.4 billion). The industry makeup of these issues befits their EM source with infrastructure-related and financial bonds representing most outstanding volume. The top sectors include energy ($27.7 billion), banking and finance ($18.0 billion), telecommunication ($11.2 billion), real estate ($11.1 billion) and building and materials ($8.5 billion). The cyclical nature of the industry mix adds to their vulnerability if growth stalls.

The par weighted average recovery rate on the EM issues has been 36.9% of par to date. With the exception of one bond, the affected issues were all unsecured. Of the $116.5 billion in EM bonds currently outstanding, an estimated $95.2 billion is unsecured." - source FITCH

Given Brazilian growth is clearly stalling with Brazil's GDP shranking 0.6% in the second quarter from the previous three months, and first-quarter data was revised to a 0.2% contraction, according to the Brazilian Institute of Geography and Statistics with a growth forecast of 0.48% this year and 1.10% next year, we would indeed watch closely the LATAM space in the coming months.

On a final note given our concerns in relation to a rising US dollar for local EM "players" who have attracted the yield "tourists", we leave you with some Morgan Stanley graphs and comments from their recent FX pulse note entitled "Don't fight the ECB" showing that Low US bond yields have indeed been driven by capital inflows:

"As the Fed has reduced its monthly security purchases, falling US bond yields in an environment of rising local economic activity are the result of US capital inflows. Once US capital demand increases at a faster pace than the increase of global savings into the US, US bond yields should increase. This is when the USD rally should broaden out.

There are direct and indirect effects to observe. Rising USD funding costs will increase the cost of existing USD debt and via the higher USD push the valuation of USD debt higher in local currency terms. Where currencies are still pegged against the USD, the translation into local currency debt funding costs is one to one. But, even where currency pegs have weakened over recent years; USD rates are providing reference indications for local rates. Within pegged or quasi-pegged environments the cost-increasing effect on local debt from rising USD funding costs is most significant. Most Asian and other EM economies fall into this category.

This is simply a function of the external funding requirements of EM economies, which remain heavily skewed to USD denominated funding. 

Exhibit 11 shows current borrowing via tradable bonds issued by EM governments broken down by currency denomination; and shows that with exception of the CEE region, USD-denominated debt dominates. Borrowing by individuals and corporates broken down by FX denomination is also important in assessing FX sensitivity to rate market volatility – however, such data is not available for all currencies under our coverage. That said, we think government borrowing provides a good enough proxy.

- source Morgan Stanley

While we indeed have "Sympathy for the Devil" given the extent of European woes, when it comes to EM dollar sensitivity and a rising US dollar risk, we do indeed find the "Usual Suspects".

"You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time." - Abraham Lincoln

Stay tuned!

Credit - The Molotov Cocktail

"Incendiary capitalism is carrying its out evil works more dangerously than ever, and is doing so in the increasingly dangerous neighborhood of the powder kegs that are the great European military powers." - Karl Liebknecht, German politician, 1871-1919.

Looking at the dismal US GDP print for the 1st quarter at -2.9%r while enjoying the latest yield compression in US yields, thanks to our contrarian take since January 2014, and seeing the increasing trouble brewing in the Middle-East, with German businesses unsupportive of the sanctions against Russia according to Michael Harms, chairman of the Russian-German Trade Chamber, in conjunction with the complacency and lack of liquidity in the credit space, we reminded ourselves of the Molotov-Ribbentrop pact prior to the Second World War and the aforementioned explosive "Molotov Cocktail" created by the Finns during the Winter War which was highly effective against Russian tanks. 

When it comes to Germany's relationship with Russia, this relationship is very important for German companies as we highlighted in in our July 2012 conversation "The Game of The Century":

The European Union’s seven former communist members outside the common currency will have an average budget shortfall of 2.6 percent of gross domestic product and an average debt load of 44.7 percent of GDP this year, the European Commission estimates. That compares with 3.2 percent and 91.8 percent for the euro region according to Bloomberg. No wonder Germany, frustrated in the West, is increasingly looking more and more to the East:

"Russia is important for German companies. In 2011, there was a 30 per cent increase in trade between Germany and Russia, with a total volume of 75 billion euros. German economic representatives have been talking about the huge potential of the Russian economy for many years, and it is seen as advantageous that Russia is nearly as important for trade as Poland. In 2011, Russia ranked 12th in German exports behind Poland (10th) and before the Czech Republic (13th)."
"Russia is Germany’s biggest supplier of gas and oil, providing around 40 per cent of its gas and 34 per cent of its oil supply in 2011. With the government’s decision to stop producing nuclear energy by 2022, German demand for gas will increase in the short and medium term." - Source An Alienated Partnership - Vestnik Kazkaza - 7th of July 2012.
As we indicated in our conversation "Eastern promises" on the 9th of June:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

In relation to the German and Russian relationship, credit wise, it will be interesting to look at the outcome for the planned €5.1 billion sale of RWE Dea, the Oil and Gas business unit of Germany's utility giant RWE to a Russian group. Again, the "devil" is indeed in the "details" and like any good behavioral psychologist would tell you (and what we have kept doing) are as follows:

Try to watch the process, rather than focusing on the content given RWE (BBB+) is burdened by €31.5 billion of debt and posted a net loss of €2.8 billion in 2013. We would be very surprise to see Merkel blocking such a transaction given the deleveraging needs of its giant utility company RWE. It is just posturing, we think.

One of the reasons behind our chosen title is due to the increasing risks posed by the growing tensions in the Middle-East which could lead to another spike in oil prices, which would be of course highly damageable for growth in general and consumption in particular. The other being Financial Contingent Capital notes also called CoCos which we will discuss in this week's conversation as we think that as the quote above goes, they are akin to incendiary capitalism or most likely a "Credit Molotov Cocktail", but we ramble again.

When it comes to Middle-Eastern trouble brewing, oil prices are indeed the "Molotov Cocktail" for triggering recessions. As past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. As displayed in the below chart, no need to press the "panic" button yet, but it is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation:

These spot crude oil and oil product inflation-adjusted values are derived using Bloomberg's proprietary data. Each index is calculated by dividing a spot  ticker by the U.S. Urban consumer price index.

What has been as well of interest has been the growing relationship between oil and gold in conjunction with inflation expectations with the continuation of the Fed's grand monetary experience as displayed below in this Bloomberg graph:

"Prior to 2000, Brent had little observed relationship to gold, a financial asset traditionally viewed as a hedge against inflation. While Brent prices have been heavily influenced by geopolitics and security challenges, the relationship between Brent and gold has become more pronounced in recent years, with Brent possibly emerging as the liquid complement to the hard asset. This may also have provided an inflation hedge as monetary accommodation has driven commodity prices." - source Bloomberg

The famous "great accommodation" play can indeed be seen in the close relationship between brent prices and money supply as displayed by Bloomberg:

"Accommodative monetary policy has helped support crude oil pices in recent years. A likely tapering of that policy and other stimulus measures may have a humbling effect on broader commodity markets. Stagnating money supply growth provides a challenge for higher oil prices without an improving global economy and demand. The BI study examines the relationship between the price of Brent and money supply. Lower gasoline prices are a likely result of lower Brent." - source Bloomberg

In our conversation "St Elmo's fire" (yet another incendiary reference), we pointed out we had 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 had been announced - source Bloomberg:

Of course Oil has a stronger relationship with currencies markets rather than with 10 year US Treasuries as displayed in the below Bloomberg graph:

"Currencies, equity markets and other commodities may suggest stronger predictive relationships to crude, yet measuring a broader universe of factors may uncover other variables with less clear correlations. Disqualifying certain variables may be as important to investors as identifying those with greater predictive qualities, given that it allows for closer observation of those data that influence the direction of the subject being scrutinized." - source Bloomberg

Moving on to the subject of the Credit Molotov Cocktail and its incendiary capacity of the capitalist system, we reminded ourselves of the wise words of Dr Jochen Felsenheimer from asset management XAIA which we quoted back in September 2011 in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!":

"in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. efficient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth." - Dr Jochen Felsenheimer

Of course this is exactly what has happened and which can be ascertained by the meteoric rise in risky asset prices overall which can be illustrated by the significant correlation between the US, High Yield and equities (S&P 500). US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

Another illustration of the effect of our "Deus Deceptors" central bankers can be seen in the compression in yields of European 10 year bonds which have, for some made new record lows - graph source Bloomberg:

From our September 2011 conversation we also reminded ourselves this quote from Dr Jochen Felsenheimer's letter:

"In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer

Of course this "Credit Molotov Cocktail" induced by central bank easy money has indeed not made its way to the "Real Economy", rest assured the TLTRO will not either given than no sanctions have been debated surrounding the unappropriated use of the latest round of the ECB's generosity for banks not providing cheap funding to the "Real Economy", end of the day the message is clear, keep on deleveraging with our support and "carry on" (in both sense) supporting European government bond yields. End of the day the new TLTRO amounts once more to "Money for Nothing", given all that easiness can be assessed in the lack of transmission to Businesses as effectively real rates have risen as illustrated by Bloomberg:

"Mario Draghi’s newest stimulus package aims to do something previous measures haven’t achieved-- push ultra-low interest rates through to the economy.
The CHART OF THE DAY shows the real cost of borrowing for companies, or bank interest rates adjusted for inflation, rose in most euro-area nations in the 12 months through April, the most recent period for which data is available. While the European Central Bank president cut the benchmark rate by half a percentage point over that period, the effect was largely wiped out by stagnant or falling prices and lenders’ reluctance to pass on the reductions.
Draghi announced policies on June 5 including a negative deposit rate and conditional loans to banks to bolster credit and steer the currency bloc away from deflation. Consumer prices rose 0.5 percent last month, down from 1.2 percent in April 2013 and below the ECB’s goal of just under 2 percent.
“Real rates need to ease further, or the ECB might be forced to do more,” said Frederik Ducrozet, an economist at Credit Agricole CIB in Paris. “While a short period of low inflation might be supportive of households’ purchasing power, higher real rates for longer would impair the recovery.”
Higher financing costs hurt companies’ willingness to invest, curbing output and employment and in turn weighing on consumer prices. Spanish companies paid an average of 1.2 percentage points more in real terms to borrow money in April compared with a year earlier as the cost of bank loans held steady and inflation slowed. A drop in nominal rates in Italy was overwhelmed by a slump in inflation.
Estonia, the Netherlands and Slovakia were the worst hit. Only Portugal, with the biggest decrease in nominal bank rates, and Germany recorded a decline in real borrowing costs. Data wasn’t available for Greece, Malta and Luxembourg. Latvia wasn’t included as it wasn’t part of the euro area in 2013." - source Bloomberg

Euro Consumer Credit? Still trending down falling 3.9% to fresh lows in May - graph source Bloomberg:

Euro Corporate Loans? Same story, an extended decline in May - graph source Bloomberg:

We reminded ourselves of the wise words as well of our good credit friend in 2012:

When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.

But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.

This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels.

In relation to the subject of Contingent Capital notes also called CoCos, banks have issued more than €30 billion worth of these additional tier-1 instruments in order to build buffers to meet the new Basel rule for total-capital ratios. As indicated by Bloomberg recently CoCos, like European government bonds, are indeed underestimating risk to coupons and par value:

"In many cases these bonds are trading significantly above par. Instruments issued in 2010 to 2012 paid coupons of 6% to 8% and currently offer yields to maturity of 4% (at Credit Suisse) to 6%. The Bank of England suggests investors may be underestimating the likelihood of additional tier 1 instruments, known as CoCos (contingent convertibles), being converted into equity or written down in the event that a bank's capital ratio falls below a pre-defined level. A Bank of England report notes two risks which may not be adequately reflected in current CoCo prices: a lack of disclosure linked to certain elements of capital requirements, and guidelines dictating when a coupon may be cancelled."- source Bloomberg.

Again we reminded ourselves the wise words of Dr Jochen Felsenheimer we quoted in a previous conversation relating to banks, government and mis-pricing of risk:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."

A good illustration of the "japonification" process and the "Credit Molotov Cocktail" and its incendiary capacity in inflicting ultimately significant losses to investors (who are more than ever dipping their toes in untested markets and reaching for yield outside their comfort/risk zone) can be seen in the significant outperformance of the CoCos asset class as related by John Glover in Bloomberg on the 23rd of June in his article "CoCos in Best Debt Returns Win Regulators Plaudits":

"The riskiest debt from European banks is outperforming a gauge of 964 securities from Spain’s Abengoa SA to U.K.’s William Hill Plc, according to Bank of America Merrill Lynch indexes. The new-style contingent capital notes, or CoCos, issued to meet stiffer capital rules, returned 9.12 percent, compared with average gains of 5.86 percent for the broader high-yield bond index of companies in the region." - source Bloomberg.

From the same article, it is clear to us that banks and government are playing the same game when it comes to debt issuance and the duplicity of regulators for banks in issuing more debt rather than true sound capital in the form of more equity

"As long as governments agree to treat AT1s as debt rather than equity, interest payments out of pretax earnings make them cheaper to issue than stock." - source Bloomberg.

We discussed that very subject of equity buffers in our conversation "Dumb buffers" back in March 2013:

"The beauty for the issuer is that the CoCo automatically boosts its Core Tier 1 capital ratio in times of stress rather than being forced into a dilutive right issue during difficult market conditions. Owning a CoCo, according to a recent BNP Paribas note is very similar to selling a Down-and-In put option on the issuing bank’s shares with a knock-in barrier linked to a balance sheet capital ratio as opposed to stock price level.

The issuing bank is effectively buying skew and convexity (crash protection) from the investor, who is exposing himself to losses in stress scenarios. 

It is not a free lunch although a coupon in the region of 7% to 8% is outright appealing in this low rate / low yield environment." - source Macronomics

We were therefore not surprised to see an outperformance of this "Credit Molotov Cocktails". The compression in spreads for some of these issues since issuance as illustrated by Bloomberg:

"Benchmark spreads on Barclays and UBS CoCo bonds have narrowed since issuance, with some more than 300 bps tighter, implying few concerns among investors about credit risk. CoCo's pose risks to bondholders through write-downs if a certain trigger event occurs, often a minimum capital level defined by the regulator. Regulatory discretion to impose losses before a trigger level is reached has been cited as an additional risk, prompting Standard & Poor's to consider cutting credit ratings on the bonds." - source Bloomberg

By issuing more and more CoCos with the complacency and support from regulators given that under European Union rules, banks can count additional Tier 1 debt equivalent to 1.5 percent of assets weighted by risk when calculating certain ratios, banks are indeed issuing more "Molotov Cocktails" rather than building true equity buffers we think.

On a final note we would like to point out that without a significant depreciation of the euro which is not going to happen unless the nuclear QE option is triggered to the tune of at least €1 trillion, there is no such thing as a credit-less recovery in Europe as discussed in our conversation "In the doldrums":

"If credit growth does not return, economic recovery may prove to be difficult in the absence of sizeable real exchange rate depreciation." - Zsolt Darvas - Bruegel Policy Contribution.

"So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:

"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."

"Incendiary capitalism is carrying its out evil works more dangerously than ever, and is doing so in the increasingly dangerous neighborhood of the powder kegs that are the great European banks." - Macronomics.

Stay tuned!