Macro and Credit - The Butterfly effect

"The foolish are like ripples on water, For whatsoever they do is quickly effaced; But the righteous are like carvings upon stone, For their smallest act is durable." -  Horace

Watching with interest the retreat in government bond yields, thanks to overall dovishness from our "Generous gamblers" aka central bankers including recently ECB's Le Chiffre (Mario Draghi), leading to renewed inflows into High Yield and equities in the US making new records in the prospect, with a continuation of the bull market in complacency, we reminded ourselves for our title analogy of the much used "Butterfly effect" narrative. While the "Butterfly effect" is the concept that small causes can have large effects and was initially used in weather prediction, in chaos theory, the sensitive dependence on initial conditions in a nonlinear system such as financial markets can lead to large differences in a later state of a credit cycle. The name was coined by American mathematician, meteorologist and chaos theory pioneer Edward Lorenz.

Our chosen analogy is also a veiled reference to US Treasuries Butterfly, given we think it is showing us that the US economy to some extent is tracking Japan. The butterfly spreads formed by the gaps between short, medium and long term US Treasury yields has been narrowing with Japan as of late:

- source Bloomberg 

In this week's conversation, we would like to look at what continues to provide inflows and support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan". 

Synopsis:

• Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets
• Final charts - Financial conditions? The punch bowl is still plentiful.

• Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. 

While 2016 was a record year in terms of foreign bond purchases by Japanese Lifers, 2017 was more tepid thanks to European elections risk, but according to Nomura in their JPY Flow Monitor note from the 21st of July, Insurance companies bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row:

"Insurance companies: Insurance companies kept purchasing foreign bonds in June, but momentum remained relatively weak (Figure 1). They bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row. They tend to be net buyers of foreign bonds in June, and the amount of net purchases was not significant (see “JPY: Season of seasonality”, 2 March 2017). Their investment in JGBs slowed to JPY171bn ($1.5bn). We expect lifers to keep purchasing foreign bonds, as major lifers’ investment plans suggest JGB yields will remain unattractive (see “BOJ review: Waiting longer for tailwinds”, 21July 2017).

Banks: Banks were net buyers of domestic and foreign bonds in June for the second month in a row (Figure 2).

They were large net sellers of bonds in April, but as seasonality shows, they resumed purchasing bonds in May and June. Foreign bond investment has slowed from May, but the FX impact was limited, in our view.

Pension funds: Trust banks, which manage pension funds’ money, kept purchasing foreign securities in June for the third month in a row (Figure 3).

The pace of net purchases slowed to JPY132bn ($1.2bn) though. Pension funds were also net buyers of domestic equities for the first time in five months. They bought JPY236bn ($2.1bn) of domestic equities, the biggest amount since August 2016. They were net buyers of JGBs too (JPY411bn or $3.7bn). The GPIF’s latest portfolio data up to end-March showed the fund’s portfolio is closer to its target portfolio. However, it accumulated short-term assets at a high level, and the president of the fund said the accumulation of short-term assets is to enhance available capacity for the next investment. Diversification from short-term assets into portfolio assets should continue for the time being as European political uncertainty has diminished. We expect pension funds to be dip buyers of foreign bonds and equities." - source Nomura

Not only for Japanese Lifers, but also for retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years as per Barclays JPY Monthly Flows noted from the 20th of July:

• "Japanese institutional investors continued to buy foreign bonds, but net outflow slowed down from last month. By investor type, banks and trust banks remained net buyers of foreign bonds. Meanwhile, life insurers continued to purchase foreign bonds. Foreign equity investments also decreased slightly in June, led by banks and bank trust account. Weekly data indicates that a net purchase of foreign bonds by Japanese investors turned positive again in the first week of July amid yield curve steepening globally since the end of June. Regional breakdown of foreign bond flow shows that Japanese investors turned net buyers of US, German and French bonds in May (Figure 1).

• Among retail investors, toshin funds remained popular while net issuance of foreign-currency-denominated uridashi bonds decreased somewhat in June. In bonds, INR- and RUB-denominated uridashi bonds continued to attract solid demand from investors. As for toshin funds, BRL-denominated funds increased for the first time since January this year and TRY- and INR-denominated funds continued to tick higher. Margin FX investors reduced their net long positions in USDJPY and AUDJPY notably and increased their short EURJPY and GBPJPY positions.

- source Barclays

Clearly, for Japanese retail investors, it has all been in recent years about low bond volatility and "king dollar". We continue to believe that when it comes to global flows, Japan matters and matters a lot. Japanese yen is indeed the source of the carry trade on a global basis and this has very significant implications from a tactical perspective when it comes to foreign bonds overall. Since the implementation of NIRP in 2016, Japanese Lifers went into "overdrive" in their purchases of foreign bonds. No surprise therefore that, when it comes to the "Butterfly effect", Bondzilla's appetite has been increasing at a rapid pace. 

You might be wondering where we going with the reference to the Butterfly effect and the importance of Japan but for US credit markets, Japan matters as well and matters a lot. Back in March 2017 in our conversation "Outflow boundary", we indicated the following:

"The big question, as we await the allocation decision from our Japanese friends, if there will be enticed again by foreign bonds like they have in recent years. The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment." - source Macronomics, March 2017

For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments.  

One thing that appears clear to us is that USD corporate credit in recent years has been supported by a large contingent of foreign investors in particular Japan. Reading through UBS Credit Strategy note from the 21st of July entitled "Where are we in the credit cycle?" we were pleasantly surprised that indeed, Bondzilla the NIRP monster is "made in Japan" and it is as well a critical support of US credit markets:

"Our deep dive analysis isolates Japan as the critical support for US credit"

- source UBS

Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk. 

The latest dovish retreat from our "Generous gamblers" (Fed and ECB) has created a "Rebound effect" as posited last week in the sense that is has not only prolonged the goldilocks state in credit markets with spreads tightening further for a longer period in this credit cycle, but, equities wise, it has provided additional strong support as well. Summer 2017 has led to record stock indices and all time spread tights in many instances. For now it seems it is "carry on" and we are indeed in the final melt-up of this last inning of the credit cycle risky assets wise. For many it continues to be the most hated bull-market in history. So far it seems our gamblers are reluctant in removing too early and too fast the credit punch bowl. For the moment the credit love boat is still sailing strong during this summer lull and unless we see some exogenous factors coming into play, it is difficult to see what could be a catalyst for a reversal before September where the Fed and the ECB could decide to tighten the financial conditions spigot as per our final charts.

• Final charts - Financial conditions? The punch bowl is still plentiful.

As we have seen recently, the Butterfly effect from the hawkish comments from Le Chiffre aka Mario Draghi led to a mini-tantrum in the Euro government bond space. Obviously the recent tone down in the rhetoric from both the Fed and the ECB has led to a continuation of "goldilocks" for risky assets thanks to record low volatility. Given the current financial conditions on both side of the Atlantic, it remains to be seen if our "Generous gamblers" will maintain further their dovish rhetoric in September. Our charts below come from Nomura and displays the US and Euro area financial conditions and comes from their recent Japan Navigator notes:

"Euro area and US policymakers are likely concerned about riskier asset rally;

Japanese policymakers may welcome it

This week 40yr and 2yr JGB auctions will be held. Japanese CPI data will be released.

The FOMC meets.

This week’s ECB announcement and market reaction have strengthened our conviction that the global yield upcycle that started from the euro area in late June has faded. We believe bond markets will move substantially only in September, when the Fed and ECB are likely to tighten policy, but only if riskier asset markets remain bullish despite Fed and/or ECB action. During this period, yields are likely to trade in a fairly narrow range, with risks on the downside, in our view. Riskier asset markets may strengthen and prevent yields from rising, but they tend to destabilize in the summer, particularly because US growth expectations are unlikely to rise.

UST yields have begun to fall. Although the market had become bearish owing to momentum from the euro area government bond (EGB) market, it lacked bond-negative factors (Figure 1).

There have been fairly strong concerns over US growth and inflation, and August data will likely be interpreted with scepticism – at the very least, a single month’s worth of data are unlikely to dispel these concerns, in our view.

We believe the ECB and Fed will look to tighten policy further if the output gap continues to improve and the riskier asset rally continues, even as they express concern about slow inflation growth, in our view. However, the Fed and ECB are unlikely to have an opportunity to jawbone until the Jackson Hole symposium in late August. Although the BOJ has emphasized its dovish stance, we believe it has basically the same stance as the Fed and ECB, and is unlikely to adopt an easing stance again as long as the output gap continues to improve. However, if JPY strengthens on risk aversion this summer, the market’s easing expectations may rise again, if only temporarily.

Compared with the Fed and ECB, the BOJ appears more tolerant about an increase in JPY carry trades and a riskier asset rally, and appears to be concerned about how much it can increase its JGB purchases further, rather than ETF buying, in our view. That said, if the BOJ revises its policy framework in such a way as to (erroneously) cause risk aversion, the negative impact on the appointment of the next governor should be substantial. Therefore, we do not expect policymakers to change the upper end of the target 10yr JGB yield range (0.11%) in the near term." - source Nomura

There you go, for now the ECB and the Fed have been mindful of the "Butterfly effects" in risky asset markets, hence the tone down of the rhetoric and insisting on a gradual process in removing the proverbial punch bowl, while the Bank of Japan (BOJ) has so far been in a holding pattern, ensuring in effect that investors in Japan as well continue to play out the low volatility leveraged "carry" play into overtime. No wonder the "Butterfly effect" is made in Japan, maybe it's related to the famous Opera play Madame Butterfly by Giacomo Puccini where the hero was so excited to marry an American that she had earlier secretly converted to Christianity or like Bank of Japan to central bankers' current religion we wonder. It didn't end well for Madame Butterfly in the end but we ramble again...

"See, the night doth enfold us! See, all the world lies sleeping!" - Giacomo Puccini

Stay tuned !

Macro and Credit - Eternal Sunshine of the Spotless Mind

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

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

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

Synopsis:

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

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

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

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

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

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

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

EM: Reducing exposure to LatAm and High Yield

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

- source UBS

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

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

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

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

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

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

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

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

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

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

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

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

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


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

"The monetary-fiscal hand-off

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

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

Japanese for “whatever it takes”

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

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

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

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

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

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

"Can Abe-Kuroda beat high expectations?

Implicit fiscal-monetary coordination

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is ultimately driving default rates you might rightly ask?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

- source Bank of America Merrill Lynch

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

Deflationary flows into gold, IG and govies

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

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

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

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

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

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

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

- source Bank of America Merrill Lynch

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

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

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

Stay tuned!

Credit - The Magnus Effect

"As long as the world is turning and spinning, we're gonna be dizzy and we're gonna make mistakes." - Mel Brooks

While looking at the disappointing US macro data (ISM and nonfarm payrolls), we reminded ourselves of the Magnus effect, which the commonly observed effect in which a spinning ball curves away from its principal flight path. Our analogy refers somewhat to golf given backspin generates lift by deforming the airflow around the ball, in a similar manner to an airplane wing. This is called the Magnus effect. A ball moving through air experiences two major aerodynamic forces, lift and drag. Modern golf balls called Dimpled balls fly farther than non-dimpled balls due to the combination of these two effects. In relation to our chosen title and the analogy with economy, looking at the performance of the US 10 year treasuries since the beginning of the year is directly countering the thesis that the American economy has truly achieved "escape velocity". When it comes to lift and drag, no doubt to us that the US economy recent economic data is more indicative of "stalling momentum" rather than "escape velocity momentum" when ones look at the recent ISM new orders index (-13.2 points to 51.2, the largest decline since December 1980) as well as pending home sales.

We argued in the past that the growth divergence between US and Europe were due to a difference in credit conditions. In this short post we will look at the reverse in the divergence between US growth and Europe in conjunction with the significant flows out of Emerging Markets Equities seen in recent weeks.

The divergence between US and European PMI indexes is all about credit conditions. This is why the US was ahead of the curve when it comes to economic growth compared to Europe since December 2011. We have discussed this before, the US PMI versus Europe - source Bloomberg:

The Fed’s January Senior Loan Officer Opinion Survey released this week indicated weaker demand in mortgages over the past quarter. A net 28.2% and 45.7% of banks reported weaker demand for prime and non-traditional residential mortgages, the worst data since April 2011 and January 2009 respectively.

Of course when it comes to "Magnus effect" and major aerodynamic forces, some Emerging Markets have suffered the full force of outflows as "tourist" investors have been leaving in drove. For instance EM retail outflows represented -18 billion $ year to date according to JP Morgan's recent EM Fixed Income Flows Weekly:

"EM equity retail outflows persisted with $6.5bn of outflows this week, comparable to last week's $6.4bn in redemptions as the MSCI EM extended YTD losses to -8.4%. Meanwhile, EM woes drive flight-to quality as US bond funds experienced a surge in demand as inflows reached $14.6bn, the largest single weekly inflow in EFPR's history." - source JP Morgan

What is of interest as well have been the outflows from the famous Japanese Double-Deckers which favorite "carry" currency has long been the Brazilian real as indicated as well in JP Morgan's note:

"Japanese funds experienced outflows of $254mn with dedicated local Brazil funds accounting for most of this (-$222mn)." - source JP Morgan

The reason behind the depreciation of the Brazilian Real in 2011 was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again. It looks to us that, in similar fashion to what happened in 2011, a similar exit by these Japanese retail funds is adding pressure on the Brazilian currency:

In blue the Brazilian real versus the US dollar, in red the Australian dollar versus the US dollar, as one can see the correlation between the Australian currency and the Brazilian real broke down spectacularly in 2011.

But when it comes to Brazil, not only the Japanese outflows have been putting additional pressure on the currency but the slack in industrial production is as well putting some pressure as indicated by Bloomberg's recent Chart of the Day:

"The biggest monthly plunge in Brazil’s industrial output since December 2008 shows policy makers’ confidence that a weaker real will stimulate manufacturing is proving misguided.

The CHART OF THE DAY tracks Brazil’s industrial production index, the real on a percentage-change basis and exports on a rolling six-month average. Output fell in December by the most in five years even as the exchange rate weakened 34 percent since the manufacturing index reached a record-high in May 2011.

The currency is the biggest decliner against the U.S. dollar in the last three years among 16 major currencies tracked by Bloomberg after the South African rand.

President Dilma Rousseff said on Feb. 3 that a weaker real would help drive exports this year, an affirmation of Finance Minister Guido Mantega’s comments in September that a currency drop would make Brazilian products more competitive and boost manufacturing. Goldman Sachs Group Inc.’s Alberto Ramos said the government’s optimism isn’t warranted, as companies are hampered by rising labor costs and lack of incentives to modernize.

“The bottom line is that we expect the industrial sector to underperform,” said Ramos, Goldman’s New York-based chief Latin American economist. “It is a sector that is still facing significant foreign competition and cost-competitiveness issues, which will handicap performance.”

The country’s main manufactured exports and destination by value last year included passenger cars to Argentina and Mexico and automobile parts to Argentina and the U.S., according to Trade Ministry data. Brazil, which is the world’s largest emerging market behind China, saw its economy contract in the third quarter by the most since 2009 as investments dropped.

Fiat SpA is one manufacturer that has seen financial results hindered by Brazil operations. The carmaker’s 2013 trading profit in Latin America dropped 41 percent largely from price increases in Brazil, Chief Financial Officer Richard Palmer said in a Jan. 29 earnings call." - source Bloomberg.

When it comes to outflows as well, it is worth noticing the significant outflows from equities, putting somewhat a dent to the "Great Rotation" story from bonds to equities as indicated by Bank of America Merrill Lynch's note from the 6th of February entitled "Stampeding Bears":

"The bottom-line: big capitulation out of stocks into US Treasuries…marks end of Jan/Feb correction

The big numbers: largest weekly equity fund outflow since Aug’11 ($28bn); largest equity ETF outflow since Feb’09 ($26bn); largest bond fund inflow since Apr’10 ($15bn)

The caveat: our trading rules not yet flashing “strong buy”… Bull & Bear index now down to 4.2 (hit 1.8 late-June – Chart 1); Global Breadth index now up to 44% (hit 96% late-June – Chart 3) and…

…EM Flow Trading Rule: another $7-8bn outflow next week triggers contrarian buy-signal (last buy-signal on 6/27/13 followed by 14% rally in EEM next 3 months)" 

- source Bank of America Merrill Lynch

As far as equity flows are concerned, the "reverse osmosis" namely the tapering impact on some Emerging Markets have led to the following as detailed in Bank of America Merrill Lynch's note:

"Equity Flows

$6.5bn outflows from EM equity funds (15 straight weeks of outflows = longest outflow streak on record – Table 3)

4-week outflows from EM equities = 2.1% of AUM; another $7-8bn outflows next week would trigger contrarian “buy” signal from our EM Flow Trading Rule (3.0% is threshold)

Huge $24bn outflows from US equity funds (almost all via ETF’s SPY, IVV, IJH – but see above for caveat on Good Harbor)

Business as usual for Europe (32 straight weeks of inflows) and Japan (7 straight weeks of inflows)" - source Bank of America Merrill Lynch

Whereas Fixed Income Flows,such as the ones seen in US Treasuries, shows the asset class hasn't lost its appeal:

"Monster $13.2bn inflows to Govt/Tsy funds (caveat: $10bn inflows likely due to Good Harbor rebalancing from SPY to SHY, IEI & UST)" - source Bank of America Merrill Lynch

When it comes to Emerging Markets woes, not all countries in the Emerging Markets suffer from acute imbalances and as far as the long term trend is concern in true "Angus Maddison" fashion, the future is brighter for many Emerging countries than it look in the near term. Just wait for the "tourists" to exit and value will come back, no doubt to the fore-front.

"There's no limit to how complicated things can get, on account of one thing always leading to another." - E. B. White, American writer

Stay tuned!

Credit - The tourist trap

"Employ your time in improving yourself by other men's writings, so that you shall gain easily what others have labored hard for." - Socrates

Looking at the continuous outflows from Emerging Markets funds and in continuation of our recent title analogies relating to the "reverse osmosis" thesis, we thought this time around we would use a simpler analogy in our title reference namely the colloquial "tourist trap". As per the definition of a "tourist trap", a tourist trap is an establishment, or group of establishments, that has been created or re-purposed with the aim of "attracting tourists" and their money.

Our favorite "magician central banker in chief", namely Ben Bernanke, has indeed engineered the "best" of tourist trap when it comes to Emerging Markets. 

In our case, Ben's "tourist trap" involved ZIRP, low volatility and high carry trades in Emerging Markets currencies which, for many years, had the favors of Japanese retail investors in the form of the "double-deckers" (the famous Uridashi funds which particularly favored the Brazilian real). 

Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:

"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:

 Wave number 1 - Financial crisis

 Wave number 2 - Sovereign crisis

 Wave number 3 - Currency crisis

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?"

"Wave number 3", namely a Currency crisis is still in its infancy and is highly dependent on the "tapering" stance of the US Fed although, as per its members, the fate of Emerging Markets, is not really their "primary" concern...
"An appropriate next step toward normalizing monetary policy could be to reduce the pace of purchases from $85 billion to something around $70 billion per month." - Kansas City Federal Reserve Bank President Esther George - 6th of September 2013.

So in this week's conversation, and in continuation to our "reverse osmosis" analysis from previous weeks, we will look at the evolution of the "tourist trap" as well as the "Great Rotation" story as far as flows are concerned and the potential evolution in the markets (our own "Forward Guidance" so to speak), which warrants caution we think in this "statistically" bearish month of September ("Over the long haul, September has been the weakest of the 12 calendar months" - Doug Short).

A good illustration of our chosen theme of "tourist trap" can be seen in the slide of India's rupee which saw its dollar denominated external debt swell in recent years courtesy of "hot money" thanks to the "generosity" of our "magician-in-chief" aka Ben Bernanke:

- graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics.

Also, when it comes to India's external debt and as illustrated recently by Bloomberg Chart of the Day, the rise of its external debt burden does complicate the situation for India in defending its currency. We could in fact call it the rupee "tourist trap" we think:

"India’s record foreign debt threatens to undermine the government’s plan to halt the rupee’s biggest slide in more than 20 years by reining in the budget and current-account deficits.
The CHART OF THE DAY shows the rupee weakened to an all-time low this year even as the combined deficits shrank. Previously the currency rose when the shortfalls narrowed and fell when they widened. The rupee dropped 8.1 percent last month to as weak as 68.845 per dollar. The lower panel tracks external debts owed by Indian governments and companies, which swelled to $390 billion as of March 31.
“Until the start of the current sell-off, the rupee had stuck pretty closely within the confines of its combined current-account and budget deficits,” said Philip Wee, a senior currency economist in Singapore at DBS Group Holdings Ltd. “By that measure, the rupee should be between 50 and 60 to the dollar, not 65 and 70.” 
India’s offshore liabilities rose to 21.2 percent of gross domestic product in the year ended March 31, according to official estimates, the highest since 2001. The rupee has plummeted 18 percent since then, the steepest drop among 24 emerging-market currencies tracked by Bloomberg. This has made refinancing the debt more expensive as global borrowing costs climb because investors expect the U.S. to pare stimulus thisyear, curtailing flows to emerging-market assets.
Finance Minister Palaniappan Chidambaram told the lower house of parliament on Aug. 27 that India’s twin deficits are responsible for the rupee’s fall, and that external debt was manageable.
He announced plans on Aug. 12 to reduce the current-account shortfall to within 3.7 percent of GDP this fiscal year from a record 4.8 percent in the prior period. The government us seeking to contain the budget shortfall to 4.8 percent of GDP from 4.9 percent." - source Bloomberg.

All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates.

And, when volatility is not repressed due to "tapering", this is what you get as illustrated by Merrill Lynch MOVE index rising back towards its record high of 118 bps:

We recently added JP Morgan Emerging Markets Currencies Volatility Index to our graph to display the on-going effect US Treasury volatility has on Emerging Market currencies.

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

With US real interest rates moving into positive territory, it is therefore not really a surprise to read that Asian dollar denominated bonds have dropped below par for the first time since 2011 as reported by David Yong in Bloomberg in his article from the 2nd of September 2013 entitled "Asian Bonds Tumble Below Par in Capital Flight":
"Asia dollar-denominated bonds have dropped below par for the first time since 2011 as investors pull money out of the region amid concerns that growth is slowing and as currencies from the rupee to rupiah plunge.
Average prices of company debentures in the region fell to 98.61 cents on the dollar on Aug. 22, the least since October 2011, Bank of America Merrill Lynch indexes show. Dollar bonds globally have held above 100 cents since September 2009. Both investment- and non-investment-grade debt in Asia were below par on Aug. 22. The last time that happened was in September 2008, when Lehman Brothers Holdings Inc. collapsed.
Investor sentiment toward Asia is shifting as economic growth in China slows and currencies in India and Indonesia -- the two countries with the biggest external funding needs in the region -- plunge. About $44 billion has been pulled from emerging-market stock and bond funds globally since the end of May, data provider EPFR Global said on Aug. 23." - source Bloomberg

Investors are indeed trying to escape the "tourist trap" while some others are seeing their "tourist clients" finding their debt "less appealing" as witnessed in the recent auction failures for Russia, India and Taiwan, as discussed by Alex Nicholson and Lyubov Pronina in Bloomberg on the 4th of September in their article entitled "Russia joins India to Taiwan as Emerging Debt Sales Miss Targets":
"Russia failed to raise as much money as planned at a government bond auction, joining nations from India to Taiwan in missing borrowing targets as investors keep away from emerging-market assets.
The Finance Ministry in Moscow sold 6.07 billion rubles ($182 million) of its so-called OFZ notes due May 2016 after offering 13.6 billion rubles, according to a statement on its website. Russia canceled an auction last week as only one bidder took part. The ministry issued today’s bonds at a 6.5 percent average yield, the top of its proposed range.
Developing nations are trimming auctions as the prospect of the U.S. paring financial stimulus measures and tensions over Syria curb investor appetite for riskier assets. India’s central bank said it cut the size a debt auction this week to 100 billion rupees ($1.5 billion) from 150 billion rupees. Indonesia scaled back an Islamic debt offering for the first time since July, while Taiwan’s note sale yesterday fell short of the government’s goal for the first time since 2011." - source Bloomberg.

When it comes to the famous "Great Rotation" story from bonds to equities put forward since the beginning of the year, the only "Great Rotation" story as far as equities are concerned appears to be from Emerging Markets to Developed Markets as displayed by the cumulated weekly flows into Developed Markets and Emerging Markets from Nomura's recent Global Equity Fund Flow report from the 6th of September:

- source Nomura.

Of course some would argue that this "Great Rotation" story from bonds to equities, as far as flows are concerned, has been playing out in earnest in 2013 as displayed in Nomura's recent report:

- source Nomura.

So far, so right...but, if one looks at the inflows into bonds versus equities since 2010, then the "Great Rotation" story does seem much ado about nothing as displayed once more in Nomura's recent chart:

- source Nomura.

In fact, what seems to be happening, when it comes to "Great Rotation" for equities is a rotation out of equities except for European equities according to Nomura:
"Equity and bond funds both suffered outflows last week with USD 11bn redemptions from equity funds and a small net outflow of USD 0.8bn from bond funds according to EPFR. Money market funds also saw net sales totalling USD 7.5bn last week. Both developed market and emerging market equity funds suffered net selling and European funds once again outperformed, being the only region that we track to have received net inflows last week. Our global composite flows based equity sentiment indicator has oscillated fairly tightly around 1 standard deviation over the most recent eight weeks and last week dropped marginally to 0.97 standard deviations, a reading that we would consider as bullish but just below extended levels.
-US fund investors sold USD 5bn from equity funds last week. Over the past three weeks they have withdrawn a total net USD 15bn from equity funds, reversing only a fraction of the net USD 141bn invested into equity funds in the 33 weeks of the year to 14 August, according to the Lipper weekly reported dataset. Our US flows based indicator continued to moderate last week and now reads 0.7 standard deviations, signalling moderately bullish sentiment in our view.
-European equity funds bucked the global selling trend as they attracted an additional USD 0.8bn of net inflows last week. This is the 10th consecutive week of net inflows into European equity funds, a major reversal from the persistent selling seen in recent years. However, last week's inflow showed a moderation in the magnitude of money flowing recently into European equity funds. Consequently, our European flows based equity sentiment indicator was unchanged over the week at 2.24 standard deviations but remains close to the historical bullish extremes of sentiment measured over the past nine years.
-Emerging market equity investors continued selling equity funds last week with an additional net USD 2.8bn outflow from GEM equity funds. Although last week's outflow was the most significant since the end of June, our GEM sentiment indicator rose to -1.4 standard deviation but still reflects very depressed sentiment towards EM equities. Furthermore, investors continued to exit from the dedicated regional EM equity funds with net outflows of USD 1.1bn from Asia ex Japan funds, USD 0.1bn from LatAm funds and the highest weekly outflow (USD 0.5bn) from emerging EMEA funds in almost two years." - source Nomura.

"Great Rotation" or "Great Escape" you decide, given Bank of America Merrill Lynch also indicated on a note from the 5th of September entitled "EM Pain trade is up" the following:
Big weekly equity redemptions of $11.4bn. Past 3 weeks equity outflow of $29bn largest in 2 years (Chart 1). 

Investors reduced exposure in run-up to payroll. Big $6.1bn redemptions from EM stock & bond funds. Massive $60bn outflows from EM equity & bond funds over past 3 months = capitulation. Note EM equities outperformed after similar redemptions Jul'04, Aug'06 and Sep'08 (Chart 2).

Tactical bounce in EM equities continues unless a big payroll print (>250K) causes gap higher in treasury yields (>3%).
Inflows to Treasury funds this week despite historic sell-off. Follows 8 weeks of redemptions. Suggests onset of smart short-covering in recent days. Blowout payroll required for clean immediate break of 2%, 3%, 4% levels by 5, 10, 30-year Treasury respectively. No jobs blowout...look for reversals in recent sell-offs in bonds and EM." - source Bank of America Merrill Lynch.

Yes, the bounce in Emerging Markets has indeed occurred in the past after similar redemptions, but we disagree with Bank of America Merrill Lynch. We have not seen the bottom yet, and that the rebound could probably materialize at a later stage, maybe in 2014.

Why so?

Because of tightening financial conditions, particular in China following a massive credit growth, which will impact bank lending behavior in a negative way. China is increasing the clampdown on credit and on industrial overcapacity. Given banks are always a leverage play on economic growth, despite record profits at China's largest banks, stock valuations are not benefiting from this surge given the significant rise in nonperforming loans as displayed in the below Bloomberg graph:

"The CHART OF THE DAY shows that while combined net income of Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd. for the three months to June 30 was 72 percent higher than three years ago, their price-to-estimated earnings ratios have fallen since then. The lower panel shows total nonperforming loans in the nation started increasing in September 2011.
Default risk is rising in the world’s second-largest economy, which economists forecast will grow this year at the slowest pace in 23 years. The government has been clamping down on excess capacity in industries including steel and cement as it tries to transition to a more sustainable economic growth model based on consumption rather than export-driven production." - source Bloomberg.

The delicate rebalancing act for the Chinese economy is in fact being put at risk by the aggressive "tapering" stance at the Fed as indicated by Chinese Vice Finance Minister Zhu Guangyao comments at the G20 as reported by Bloomberg:
"The U.S. should be mindful of a possible “very significant spillover effect,” said Zhu, who called for greater coordination between nations and added that there’s no need for a rescue plan for developing countries."

He also added:
“Some emerging-market economies are facing difficulties,” Zhu said. “Capital is flowing out of these countries and their currencies are under pressure of depreciation, and the major direct cause of such a phenomenon is the Fed’s announcement that it may exit its unconventional monetary policy. However, on the other hand, there are some structural problems with these emerging market economies as well.” - source Bloomberg, "China Asks U.S. to Cap QE Exit Risk as Indonesia Warns of Impact"

Therefore the impact of a tightening credit channel in China means more pain for the current account of countries exporting to China (including Germany), given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.

The tightening credit channel in China and the clampdown on overcapacity will of course hurt Germany.

These were our concluding remarks in our recent conversation "Fears for Tears":
"The CHART OF THE DAY shows that Germany’s factory output as gauged by a manufacturing purchasing-managers’ index has mirrored Chinese bank-lending growth since a credit boom that began in 2008"

No surprise therefore to see German industrial production falling more than expected in July after surging in June, adding to signs that growth in Europe’s biggest economy is moderating:
-Output, adjusted for seasonal swings, fell 1.7 percent from June, when it jumped a revised 2 percent, the Economy Ministry in Berlin said on the 6th of September when economists were only expecting a decline of 0.5%.
-German exports, adjusted for working days and seasonal changes, fell 1.1 percent in July from the prior month, the Federal Statistics Office in Wiesbaden. Economists predicted an increase of 0.7 percent in a Bloomberg News survey.

On the impact of current account for countries exporting to China, we agree with our friends at Rcube Global Macro Asset Management:
"Current account of countries exporting to China are turning negative (and will remain so as long as China tighten its flow of credit). FX reserves’ pace of accumulation reverse and with them a host of asset prices that have been tightly correlated with it over the last decade: domestic real estate and equity prices, private consumption, commodity prices etc…"

- source Rcube Global Macro Asset Management

So, due to our Pareto efficient economic allocation, the weakness in Emerging Market equities, which have been simply the victims of currency wars and "Abenomics" mostly, (see our post "Have Emerging Equities been the victims of currency wars?"), will continue further, because the "reverse osmosis" occurring in Emerging Markets as displayed by "funds allocation" is positively correlated to US real rates moving into positive territory, or put it simply, when the risk doesn't match the reward anymore. 

The velocity in the "allocation" is entirely due of course to the speed of rising yields in developed countries as displayed in the chart below from Thomson Reuters Datastream / Fathom Consulting displaying by how many basis points 10 year yields have risen since the 30th of April:

- graph source Thomson Reuters Datastream / Fathom Consulting:

On a side note, those who piled into Apple 30 years, part of their $17 billion bond auctioned on the 30th of April are probably still licking their wounds given these bonds are currently trading around 83 in cash price...But, don't despair, you might get a "second chance" with Verizon which plans a record $25 billion debt offering as it gathers financing to buy Vodafone’s stake in their Verizon Wireless joint venture...

Moving on to our own "Forward Guidance", as we enter the statistically dangerous month of September, some additional signs in the markets, apart from "tapering" noise, Syrian issues, European political jitters in Italy and Emerging Markets tantrums, can be seen in the currency market according to our Rcube friends, in particular in the AUDCHF currency pair:

"The world’s economic momentum is slowing not accelerating, as evidenced by the AUDCHF:

The AUDCHF is a much better leading indicator of global growth than PMIs:

The Australian dollar is a commodity currency, with a high sensitivity to cyclical commodities, and hence to world growth. On the contrary, the CHF is a defensive, safe haven currency; it tends to appreciate when investors become risk averse.

As a result, the AUDCHF usually weakens when global growth economic momentum slows down and/or when financial stress kicks in. When the two happen at the same time (1998, 2001, 2008, 2011) the move is all the more violent. 

Today, the AUD is weakening because of the EM slowdown, but more recently the CHF has strengthened on its own, probably on the back of rising risk aversion due to the FED tapering anxieties (EURCHF peaked on May 22nd)." - source Rcube Global Macro Asset Management

And if you think that the "reverse osmosis" plaguing Emerging Markets has touched a bottom, think again because as our Rcube friends put it, regardless of the incoming chatter surrounding the "debt ceiling" debate, budget balances do matter, but the US budget balance, when it comes to Emerging Markets, it matters A LOT:
"Additionally, the US budget balance is improving faster than at any time in history. In the past this has been associated with a tighter liquidity environment (fewer dollars in circulation) which was particularly negative for emerging markets. As shown in the chart below, when the budget balance improves (deviation from 2yr trend goes up), emerging markets underperform DM equities, and inversely. Given the current expectation for the budget deficit to shrink further (‐2% of GDP in 2015 vs. ‐4.6% today), the relationship will remain negative for EM equities in the foreseeable future."

Another evidence that deflation might be a bigger threat than inflation is the fall of breakeven rates. In that sense, the negative correlation between equities and inflation expectations could be a complacency sign. Japan has won the currency war, it is now exporting deflation through lower export prices, and it is forcing others to do so as well. But because Europe is in a current account surplus and the US is moving towards the neutral zone, the currency war will be much less effective. This is also why inflation expectations are currently falling fast.

This would be worrying enough on its own. The problem is that Europe is deleveraging at the same time. Its credit channel remains weak. As a result, unemployment keeps rising." 
- source Rcube Global Macro Asset Management

On a final note, we would like to provide you with another "out of the box" interesting indicator we follow namely Sotheby's stock price versus World PMIs since 2007 - graph source Bloomberg:

The performance of Sotheby’s, the world’s biggest publicly traded auction house is indeed a good leading indicator and has led many global market crises by three-to-six months.

The recent stellar performance of the art market in general and Sotheby's in particular can also be partly explained by the flood of global liquidity provided by our "omnipotent" central banker at the Fed. Art markets and economic growth tend to be positively correlated we think.

And, when it comes to providing "liquidity" and market backstop, rest assured that Sotheby's has been as involved as any central bank, given it has started again into auction guarantees totaling $166.4 million in a move aimed at winning more consignments. But, more recently the New York-based auction house said last night it’s reducing its exposure by “irrevocable bids” of $23.5 million, which are from undisclosed third-party guarantors. It may further reduce risk by additional “irrevocable bids” before auctions in the fourth quarter, it said in the filing with the U.S. Securities and Exchange Commission as reported by Bloomberg.

Looks like even auction houses are preparing for "tapering"...
Oh well...

So move along, no risk of financial crisis:
“The probability of it happening again in our lifetime is as close to zero as I could imagine"

“The way these firms are managed, the amount of capital that they have, the amount of liquidity that they have, the changes in their business mix -- it’s dramatic.”

“The largest financial institutions in the U.S. are as healthy now as they have ever been,”

“There’s a difference between incompetence or mismanagement or poor judgment or excessive risk taking from actually breaking the law,”

“There’s nothing I’ve seen that would suggest that any of the major participants in the financial crisis should be in jail for their actions.”
- Morgan Stanley Chief Executive Officer James Gorman, on the Charlie Rose show.

Stay tuned!