Macro and Credit - Klondike

"Having patience is one of the hardest things about being human. We want to do it now, and we don't want to wait. Sometimes we miss out on our blessing when we rush things and do it on our own time." -  Deontay Wilder

Looking at the latest FOMC decision, leading to further compression of US yields in conjunction with rising negative yielding bonds to the tune of $12.3 trillion, making credit and high beta risky assets TINA (There Is No Alternative) again, when it came to selecting our title analogy, we decided to continue with the theme of games and playing cards this time around. Klondike (North America) or Canfield (traditional) is a patience game (solitaire card game). In the U.S. and Canada, Klondike is the best-known solitaire card game, to the point that the term "solitaire", in the absence of additional qualifiers, typically refers to Klondike. Elsewhere the game is known as American Patience. 

The game rose to fame in the late 19th century, being named "Klondike" after the Canadian region where a gold rush happened. With the FOMC (Federal Open Market Committee) holding interest rates steady on Wednesday while opening the door to a cut by dropping its commitment to being "patient" in its policy statement, in similar fashion to the name of the card game of Klondike also known as "patience", the Fed conceded to more accommodation to come in July in the form of a rate cut. No wonder it led in similar fashion to a "Klondike" leading yet to another "gold rush" it seems as anticipated somewhat in our previous musing. What we find of interest in the game of "Klondike" played by the Fed is that from a probability perspective, about 79% of the games are theoretically winnable, but in practice, human players do not win 79% of games played, due to wrong moves that cause the game to become unwinnable. In addition to this probabilistic feature, some games are "unplayable" in which no cards can be moved to the foundations even at the start of the game; these occur in only 0.25% (1 in 400) of hands dealt. 

Also, there is a modified version of the game called "Thoughtful Solitaire", in which the identity of all 52 cards is known. Because the only difference between the two games (Klondike and Thoughtful) is the knowledge of card location, all "Thoughtful" games with solutions will also have solutions in "Klondike". Similarly, all dead-ends in "Thoughtful" will be dead ends in "Klondike". However, the theoretical odds of winning a standard game of "non-Thoughtful Klondike" are currently not known exactly. The inability of theoreticians to precisely calculate these odds has been referred to by mathematician Persi Diaconis as "one of the embarrassments of applied probability but we ramble again...

In this week's conversation, we would like to look at what the latest Fed decision entails as we think that we are on the cusp of a final melt-up which could be given an additional boost from some cease-fire agreement between China and the United States when it comes to the lingering trade war.

Synopsis:

• Macro and Credit - Is the Fed ready for "easing" after being "easy"?
• Final charts - Fed "easing" should undermine the US dollar.

• Macro and Credit - Is the Fed ready for "easing" after being "easy"?

Given the global "dovishness" now being actively espoused globally and with the Fed conceding to what the financial markets want, we view a continuation of the "Japanification" playing out, meaning that credit spreads will continue to perform and compress, and the corporate debt bubble to inflate in this Chinese year of the pig. The appetite for yield hungry investors will continue to push even more government bonds yields to absurd level and even more European corporate yields into negative territory. 

From an allocation perspective, as we pointed out before, where oil price goes, so does US High Yield, clearly since the beginning of the year US Investment Grade has outperformed US High Yield, respectively up 10% and 9%. Our defensive stance favoring quality (Investment Grade) over quantity (US High Yield has been vindicated. As well our preference for the long-end of the US yield curve is paying decently with long-term US Treasuries ($TLT) up by 11%. Year to date the ETF ZROZ we follow is up by a decent 14.4%. Gold is rising again in a very much "Klondike" way with gold miners racing ahead thanks to the return of the "D" word of "Deflation" and "D" for "Dovishness".

As we highlighted in our most recent musing, weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand as a reminder. The trajectory of real yields matter when it comes to gold:

"The ongoing trade war could turn into a currency war, further boosting investor appetite for gold hence our negative stance on the US dollar." - source Macronomics, June 2019

We also added:

"If big dollar cycles are dominated by flow as indicated by Deutsche Bank, then again, the dovish Fed has finally triggered a USD sell-off it seems with hedge funds selling from a long position. If flows are indeed turning against the USD, then a US dollar weakness could be sustained." - source Macronomics, June 2019

Given the latest tone down from the Fed with rate cut expectations in July, and a possible form of resolution between the United States and China with the upcoming G20, there is indeed a potential for an additional melt-up, and in this scenario, high beta would therefore start to outperform again strongly.

A weaker US dollar is as well highly beneficial to the Emerging Markets complex. Should you therefore "buy" the proverbial dip? Obviously credit continues to benefit from "Bondzilla" the NIRP monster close to $13 trillion. In that context yield hunt will resume its trajectory.

When it comes to the much discussed "leveraged loans" we continue to see the "great rotation" playing out from the feeble hands of retail, namely them leaving the asset class and investing into US High Yield. This is clearly indicated by LeveragedLoan.com part of S&P Global Market Intelligence:

"Outflows from mutual funds and ETFs that invest in U.S. leveraged loans totaled $686 million for the week ended June 12, according to Lipper weekly reporters. That's less severe than the $1.47 billion withdrawal a week ago, but marks the 30th straight net outflow from the investor segment, for a total of slightly more than $30 billion over that span.

Retail investors have beat a steady retreat from the floating rate asset class as prospects of a Fed rate hike have evaporated, and as expectations of rate hikes solidify.

The record for consecutive withdrawals from U.S. loan funds is 32 weeks, for a streak that ended March 2, 2016, though outflows during that time totaled only $17.6 billion, according to Lipper.

Mutual funds provided the bulk of the outflow over the past week, at $572 million, while loan ETFs saw a withdrawal of $114 million. The four-week average is now a net $781 million outflow. The change due to market conditions over the past week was positive $56 million.

Year to date, including the week ended Jan. 2, outflows from the segment now total $16.5 billion. Assets at U.S. loan funds stand at $78.6 billion, of which $8.2 billion are via ETFs, according to Lipper." - source S&P Market Intelligence

At the same time, the feeble retail investors crowd did put $602M into US High Yield funds, the second straight week of inflows. YTD: +$8.9B $HYG $JNK according to S&P Market Intelligence:

 - source S&P Market Intelligence

With the market now pricing in a 100% probability of a rate cut in July, from a "Klondike" perspective, we do think there is a potential for more melt-up in the high beta space.

So what's our current view on the US 10 year yield you might rightly ask?

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you." - Macronomics, December 2015, The Ghost of Christmas Past

So if indeed US GDP growth is decelerating, then, obviously the US 10 year yield is right where it should be given FOMC change in real GDP for 2019 is around 2.1%. Case closed.

Giving the global dovishness from our "generous gamblers" aka our dear central bankers, when it comes to this game of Klondike and asset implications we read with interest UBS take from their Global Macro Strategy note from the 20th of June entitled "Fed, ECB Promise Insurance: Asset Implications":

"Rates: Lower long end real; front end sits oddly with financial conditions

The market has celebrated the readiness from the Fed to provide insurance and bull steepened the curve. Compared with the beginning easing cycles over the last 30 years, inflation is marginally lower today, but financial conditions are significantly looser (Figure 1).

Our Economic team's view is now for a 50bps cut in July, (64% priced), which may take some deterioration in financial conditions to be fully priced. Based on the current information, and with 76 bps already priced till year end, we would not be receiving the very front end here, and would rather position through long 5-year breakevens and receiving long-end real rates. The Fed Chair cited concerns over fall in 5y5y breakevens several times as a reason for the material shift lower in dots." - source UBS

 What is indeed striking to use as we mused in our previous conversation is that financial conditions, while tightening already in some parts are not as tight as in previous cycles as highlighted by UBS table above. This is what we had to say in our previous conversation:

"Taking it easy is not taking it to easing and as per our above discussion we think investors are a little bit ahead of themselves when it comes to the number of cuts expected and the pace. One nonfarm payroll bad number doesn't yet make a trend though the most recent data highlights disappointment and worries from the ongoing trade war." - source Macronomics, June 2019

Though we were steering towards a more cautious side, given flash U.S. Composite Output Index just came out 50.6 (50.9 in May), a 40-month low, we would not dare to "fight" the Fed and we'd rather probably switch slightly to "offense" from "defense". Credit wise, European Investment Grade remains unattractive with European yield at 0.55% (Barclays EuroAgg Corporate ISMA Yield). So all in all, we'd rather stick with US Investment Grade than European Investment Grade. In Europe we prefer European High Yield in that context. As far as US High Yield is concerned, just follow oil prices.

For the "perma bear" out there, it's the velocity of oil prices that matter on the way up as well as on the way down when it comes to "high beta". We still think that eventually the spark of a "crash" will be ignited by a sudden spike in inflation à la 2008. We are not there yet, and on that front, it could come from a "geopolitical exogenous" factor.

Clearly as highlighted by Société Générale in their 20th of June report "On Our Minds" entitled "The Fed loses patience and ready to act", the game of Klondike comes to mind:

"Summary: The Fed lost patience in June. Dropping this key word and announcing they will closely monitor incoming information strongly suggests rate cuts. Timing and magnitude are the questions. We see two cuts in 2019 matching a heavy weighting of the dots offered in the June Summary of Economic Projections.

Median held in 2019—but large mass of dots imply two rate cuts

The Fed announced they are monitoring information closely. They dropped their reference to patience. The news implies they are at willing to make insurance cuts to keep the expansion intact. The first cut likely at the next FOMC meeting in July.

FOMC revises up GDP and lowers the unemployment projections

The US growth outlook alone does not immediately justify rate cuts, but with inflation low and risks and uncertainty increasing, Fed officials appear willing to make one to two cuts.

Insurance cuts that the Fed foresees pulling back eventually

The Fed median does not fully grasp the number of Fed officials willing to cut by 50bps. Cuts are likely sooner than the median implies Yet hikes into 2021 imply the Fed will pull back these insurance cuts. The Fed does not yet appear back a full rate cut cycle.

Fed insurance cuts vs full rate-cut cycle

The Fed dot plot assumes one to two cuts and then rates are held steady and eventually hiked again. This would follow a pattern more akin to insurance cuts that achieve a soft landing.

Markets are priced for more. Eventually we view the US economic situation as requiring more. We now foresee the Fed following up with insurance cuts in 2019 and highlight July and September for the moves that reduce the fed funds rate by 25 bps each. The magnitude and timing remain sensitive to the G20 meetings and trade talks between the US and China. Additionally, incoming US data with strong US consumers and still solid employment influence timing.

We still see a need for more aggressive rate cuts eventually as sigs of US economic weakness are more pronounced. US manufacturing is currently soft, but that may be needed to reduce inventory overhang. US consumption and employment remain solid for now. Our preliminary call for June non-farm payrolls is for a 175k increase. We still have 3.6% unemployment rate, but that rate can still drop further due to the pace of hiring.

The FOMC revised up its GDP estimate for 2020! Further, the FOMC reduced their unemployment rate projections. These projections do not reflect major risks. Rather it is the low inflation rate along with risks that allow the Fed to make insurance cuts.

Low inflation – the Fed lowered their headline and core inflation readings for 2020, is a major driver in the Fed’s willingness to cut rates. Fed officials foresee uncertainty, global sluggishness and a stronger dollar as over-riding domestic labor markets in shaping the outlook on inflation." - source Société Générale.

Given in the game of Klondike the issue is that a wrong move cannot be known in advance whenever more than one move is possible, we remain agnostic about how aggressive the Fed will be as it has clearly shown us to be "data dependent". Is the recent weakness transitory and mostly due to the trade war narrative being extended into overtime? We wonder.

For our final chart, the big known unknown remains the trajectory of the US dollar. We continue to think though there is more weakness ahead.

• Final charts - Fed "easing" should undermine the US dollar.

Our final chart below comes from Deutsche Bank FX Special Report from the 18th of June and entitled "A unique Beast". It displays the trajectory of the US dollar surrounding Fed easing cycles:

"The FX market. 

In the 3m after easing the dollar TWI tends to continue the pre-easing trend (up or down!) rather than automatically start weakening. In this cycle unique features include: i) low/negative rates elsewhere; and, ii) the unusual US rate-spread advantage across short and back-end yields. It will then take multiple Fed rate cuts to undermine the USD’s rate advantage, generating even more USD resilience than usual.

Fed easing will undermine the dollar's upside on a TWI basis, but the central bank will have to deliver more than the 50bps of cuts by Dec meeting to kick start EUR/ USD meaningfully higher.

Momentum trading has had a record of doing poorly in easing cycles.

Value currency investing does better especially a year after easing cycles begin.

This favors short base metals – long precious metals." - source Deutsche Bank

From a "Klondike" perspective and an additional "gold" rush, it remains to be seen how aggressive the Fed will be in July. While we do expect at least some short-term pull-back on gold prices, it really depends if the Fed decides to throw early in the kitchen sink and the trajectory of "real yields (Gibson's paradox) and obviously the G20 outcome surrounding the US-China tug of war. American patience is, it seems, the name of the game...

"Just be patient. Let the game come to you. Don't rush. Be quick, but don't hurry." - Earl Monroe

Stay tuned !

Macro and Credit - Inflationism

"For the merchant, even honesty is a financial speculation." - Charles Baudelaire

Watching with interest the Fed's additional dovishness with the continuation in the rally in high beta and in particular credit, marking the return of "goldilocks at least for this asset class, when it came to selecting our title analogy, given the potential stagflationary outcome thanks to the Fed being S&P500 dependent, we decided to go for "Inflationism". "Inflationism" is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy. The contemporary Post-Keynesian monetary economic school of Neo-Chartalism, advocates government deficit spending to yield full employment, is attacked as inflationist, with critics arguing that such deficit spending inevitably leads to hyperinflation. Neo-Chartalists reject this charge, such as in the title of the Neo-Chartalist organization the Center for Full Employment and Price Stability. Also, a related argument is by Chartalists, who argue that nations who issue debt denominated in their own fiat currency need never default, because they can print money to pay off the debt similar to what we are hearing these days from the MMT supporters. Chartalists note, however, that printing money without matching it with taxation (to recover money and prevent the money supply from growing) can result in inflation if pursued beyond the point of full employment, and Chartalists generally do not argue for inflation. It also worth noting that Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some." [...]
"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." 

Keynes explicitly pointed out the relationship between governments printing money and inflation:

"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance." 

The direct result of inflation is a transfer of wealth from creditors to debtors – the creditors receive less in real terms than they would have before, while the debtors pay less, assuming that the debts would in fact have been repaid, and not defaulted on. Formally, this is a de facto debt restructuring, with reduction of the real value of principle, and may benefit creditors if it results in the debts being serviced (paid in part), rather than defaulted on. In a context of "Japanification", the carry trade is back on and credit markets will definitely benefit from the global dovishness from central bankers. In  that context, we would tend to agree with our former esteemed colleague David Goldman's recent post in Asia Times from the 20th of March entitled "Fearing slower growth, Fed says no rate hikes this year":

"Markets expected forbearance from the Federal Reserve, but the US central bank Wednesday leaned further towards monetary ease than the optimists expected. The Fed envisions no change in interest rates until sometime in 2020, and not at all if the economy weakens further. It won’t reduce the $4 trillion securities portfolio it built up through so-called quantitative easing.

This is a market that rewards cowardice – holdings of stable income-earning assets like credit and real estate – more than it rewards bravery. I continue to believe that carry will be king in 2019 as the Fed keeps interest rates low." - source David Goldman, Asia Times

This is clearly a market favoring "coupon clipping" we think but we ramble again.

In this week's conversation, we would like to look at the growing "stagflation" risks, which have been on this very blog a scenario we highlighted could happen.

Synopsis:

• Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig
• Final charts - Oh my God they killed Macro volatility again!

• Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig

In our previous conversation we highlighted the fact that "Deleveraging" and Deflation were good for credit markets. As expected, the additional dovish tone from the Fed is leading towards a reach for yield across credit. We also indicated that as long as interest rates volatility was remaining muted, it would be hard to be negative on credit markets. Given last Tuesday, Merrill Lynch's Move index, which tracks implied volatility on one-month Treasury bill options fell to a reading of 43.68, the lowest since the index’s inception in 1988, no surprise to see a continuation of the rally in high beta credit.

Rentiers seek and prefer deflation and fixed income investors continue to benefit from central bankers accommodative stance in that context. This definitely doesn't put us into the perma bear camp but more into the "realistic" camp we think hence our "japanification" stance.

Looking at the latest data coming out of Europe in general and Germany in particular, with Eurozone Manufacturing PMI coming at 47.6 vs 49.5 expected and previously at 49.3, no wonder the 10 year German bund is going again negative. As well, France Services PMI fell to 48.7 from 50.2 and expectations of 50.6 and Manufacturing PMI declined to 49.8 from 51.5 clearly pointing towards recession for the Eurozone.

Global dovishness has indeed favored the return of the "yield" hogs as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 22nd of March entitled "Bond mania":

"Dovish central banks and uncertainty favour quality

The epic U-turn in central banks’ stance, the round of fresh stimulus from the ECB and most recently the announced end of quantitative tightening from the Fed, have spurred a global search for yields that mainly benefited fixed income securities.
As flows pour into fixed income funds in 2019, outflows from equity funds have gathered pace, spurred by a macro picture that keeps deteriorating in Europe as shown by the below-45 print in German manufacturing PMI.

Over the past week…

High grade funds recorded an inflow for the third week in a row, with the pace of inflows ticking up. High yield funds enjoyed their fourth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the flows, with the other half evenly shared between US- and European-focused funds.
Government bond funds saw inflows following two weeks of outflows.
Money Market funds recorded an outflow last week, reversing a two-week streak of inflows.
All in all, Fixed Income enjoyed strong weekly inflows, the second largest print since 2004 and the best 12-week streak since 2017.
European equity funds continued to record a weekly outflow for the sixth consecutive week, whilst the pace of outflows remains strong relative to historical standards.
Global EM debt funds recorded four straight weeks of inflows. Commodity funds saw an inflow last week, the tenth over the last twelve weeks.
On the duration front, long-term IG funds were the laggards as short- and mid-term IG funds recorded inflows." - source Bank of America Merrill Lynch

Back in March 2016 in our conversation "The Pollyanna principle" when it comes to "japanification" and the attractiveness of credit markets in a central banking dovishness context we wrote the following:

"The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!
Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going  exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:

"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016

This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".
One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure..." - source Macronomics, March 2016.

If "Japanification" is still the trade "du jour" then, obviously, credit markets will benefit from it as we posited in our previous conversation. The new TLTRO might not do wonders for the European economy given many banks are still "capital" constrained due to still large legacy assets sitting on their balance sheets in the form of nonperforming loans, but, from a credit investors point of view, they will continue to enjoy the "bond" party rest assured.

This is what we suggested in our previous conversation:

"An allocation to credit rather than equities for these weaker players would seem prone to less "repricing" risk should buybacks dwindle and some dividends start to be cut in some instances." - Macronomics, March 2019

Clearly global growth deceleration is favoring the "D" word for "Deflation", therefore the D trade is back on and US long bonds are enjoying the bond party as well, not only the German bund. Gold miners and gold as well are benefiting as well again from the growing negative yielding "Bondzilla" the NIRP monster.

We have also recently advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. We continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength.

On that note we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 15th of March entitled "Eliminate the Impossible":

"The last on our list of recent positive developments is some improvement in pricing of illiquid HY cap structures (Figure 1).

As a reminder, we noted in February that most of the rally to that point had been concentrated in large, liquid, higher-quality cap structures, i.e., relatively easy investments. Bonds in the opposite corner of the market remained largely bidless. This may have started to change in the last couple of weeks, as we are beginning to see some early signs of positive price momentum in that corner of the market. It remains modest so far, offsetting about one-third of the extent of the initial decline, but it nonetheless represents important progress.

Shifting gears to the other side of this equation, other factors that underpinned our recent defensive positioning remained largely unchanged or have even deteriorated further.

Key among them is the degree of dispersion in the overall HY market and in CCCs that refuses to show any signs of improvement. To the contrary, its current readings are below year-end as well as both month-ends since then. The dispersion index measures the proportion of all bonds that are trading close to the index level (+/-100bps for overall HY and +/-400bps for CCCs). The rationale behind this measure is that dispersion tends to be low at times of high investor confidence and risk appetite and drops significantly as credit conditions tighten as buyers remain cognizant of risks and differentiate strongly between relatively stronger and weaker names (Figure 2).

About one-third of all CCCs continue to trade at distressed levels, whereas for most of last year that proportion stood at 20% or below. This outcome suggest that investors remain cautious in reaching for credit risk among the names that otherwise would have the highest upside from here if a low-default scenario were to play out in coming months.
Note that reopening in the CCC new issue market has done little so far to alleviate concerns surrounding these two real-time indicators (dispersion and distress). Perhaps, the newly minted CCCs are yet again viewed as carrying relatively stronger credit profiles compared to the rest of that space, although any comps here are particularly challenging given the highly idiosyncratic nature of this segment. In addition, the B3/below segment in leveraged loans also experienced a sharp slowdown around yearend and has only recovered modestly since then. The latest-3mo pace of activity here is running at less than one-fifth of its peak levels reached in the middle of last year.
Lastly, Moody’s has reported 17 global HY defaults in the first two months of 2019, of which 12 were among US issuers. These counts are the highest over the past year and compare to an average of 2.7 default events per month in the second half of 2018." - source Bank of America Merrill Lynch

Obviously their defensive position has been vindicated by the most recent weakness we have seen in the high beta space, with equities as well in the first line of the volatility hence our more positive stance on credit relative to equities as per our previous conversation for those who follow us regularly.

When it comes to the support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan".

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. On this very subject we read another Bank of America Merrill Lynch's take in their Situation Room note from the 14th of March entitled "Japan 101":

"Japan 101

It is hard to imagine any country more transparent with investment flows than Japan. Hence, we know from the Japan Ministry of Finance’s weekly Data on securities investment abroad for medium and long term bonds as of March 8th that purchases are off to the strongest start to the year (¥5.76tr ) since 2012 (where the number was only slightly higher). This translates into $52bn of buying YtD, a dramatic change from sales of $6bn and $33bn during the same periods in 2018 and 2017 (Figure 1), respectively, and one of the key reasons the US corporate bond markets has been so strong this year, in our view.

Going forward, we can expect Japanese selling in a narrow window around fiscal year-end (March 31), where they tend to repatriate money (Figure 2).

It is also a straightforward assumption that Japanese purchases of foreign bonds accelerate in the new fiscal year starting April 1st, as seasonally about 75% of buying tends to take place in fiscal 1H, 25% in 2H.

EUR bonds and JGBs for life

Of course, this Ministry of Finance data covers all foreign bonds – not just US corporate ones. Luckily, Japanese lifers update on their investment plans twice a year – our most recent update is in the section “JGBs for life” in here: Situation Room 24 October 2018, which contained detailed plans for 2H of the Japanese Fiscal year (runs April 1-March 31). Clearly, heading into the first part of 4Q18 USD hedging costs had increased so much that they planned to shift hedged buying away from USD, into EUR – likely in a mix of European core corporate and sovereign bonds. Also, with rising rates and 30-Situation Room | 14 March 2019 3 year JGB yields already at 90bps+, they were getting ready to shift back into local government bonds as well. Of course, they planned to continue investing on a currency unhedged basis in the US.

Who let the doves out?

However, we suspect these plans had changed dramatically to favor much more US corporate bonds on a hedged basis by early this year as 1) market expectations for Fed rate hikes collapsed dovishly from about three over the following year heading into 4Q18 to none and 2) local 30-year JGB alternatives had plummeted as well to the 60bps range - far from the 100bps needed. Of course, they likely remained sizable buyers of EUR bonds, but probably less than originally planned.

While it is helpful that dollar hedging costs have come down somewhat over the past several months, as Libor-OIS tightened materially, that is not the main driver of increasing Japanese buying of US corporate bonds. We see this as US corporate yields have declined by roughly the same amount as dollar hedging costs (Figure 3), leaving yields after hedging relatively unchanged.

Instead, the main driver is the Fed’s dovish capitulation. The most common dollar hedging strategy for foreign investors involves a maturity mismatch with the underlying assets, as they roll short term – such as 3-month – forward fx rates. The cost of such strategy is driven by the difference between short term interbank rates, which in turn is driven mainly to relative monetary policy rates.
In early 4Q18 the Fed was the only major central bank hiking rates (3x priced in in 12months), as the BOJ and ECB were on hold. Foreign investors buying US corporate bonds rationally expected to be rolling into prohibitively expensive dollar hedges in 2019, leaving expected future yields after hedging costs on par with 90bps for 30-year JGBs (Figure 4).

Hence, US corporate bonds looked unattractive to Japanese investors. However, that all changed as markets priced out future rate hikes, and Japanese investors could thus have confidence dollar hedging costs would not increase. By the beginning of this year, Japanese investors could expect to keep, for example, 1.8% for dollar hedged 10-year BBB rated US corporate bonds, which compared very favorably to just 0.7% for 30-year JGBs.

Here to stay

We expect healthy Japanese and other foreign buying of US corporate bonds – which this year was always a key ingredient in our bullish call on spreads - to continue to help drive tightening for quite some time. Right now, the global corporate bond market – and USD is the biggest and most liquid chunk of that – is basically the only option for foreign investors. This changes when 1) valuations become unattractive – which will likely take a long time (Figure 4), 2) the market starts pricing in Fed rate hikes – which is not any time soon, or 3) US recession risk becomes too high – which should be years away, in our view." - source Bank of America Merrill Lynch

Not only Japanese Lifers have a strong appetite for US credit, but 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 so watch also that space.

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 to take on more credit risk.

This is confirmed by Nomura's Japan Navigator note number 815 from the 18th of March entitled "ECB and BOJ's policy impasse and risk of JPY appreciation":

"Lifers opt for credit rather than anticipating weak JPY

In an interview with Bloomberg last week, a major life insurer stated that it was offsetting the impact of currency hedging costs by selling FX call options (partly giving up the advantages of weak JPY), and by taking credit risk, generating returns of about 1% even after fully hedging. This former approach resembles that taken by two other major lifers interviewed recently (see page 7 of the 5 March Navigator), but this lifer seems to be more concerned about the minimal room JPY has to weaken than worried about the risk of stronger JPY. Regarding the latter, credit spreads are not only wider overall in the US than in Japan, but the yield curve is steepening (Figure 5), and as a result, lengthening  maturities have a greater effect in improving yields.

For this reason, if investors buy A rated US corporate bonds with maturities near 20yrs, they can bring in yields of about 1% even if they convert it to JPY using currency swaps with the same maturity. That said, we do not expect lifers to take risks on such long-term credit without a US economic downturn combined with a sense that the Fed will not turn hawkish again." - source Nomura

In relation to our "gold" outlook, 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.  Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. That simple.

Returning to credit, we have been advocating going higher the quality spectrum and use the recent rally to reduce highly illiquid high beta exposure such as leveraged loans. US Leveraged Loan Funds have seen 17 Weeks of outflows totaling $21.8 billion. Regardless of the performance, it is indicative, we think of risk reduction due to illiquidity factor coming into play. When it comes to US High Yield, though everyone has been talking about the BBB monster in Investment Grade sitting on the edge of the downgrade cliff, discussions surrounding High Yield has been more muted. On that specificity, we have read with great interest Morgan Stanley's take from their Corporate and Credit Derivative Research note from the 22nd of March entitled "A High Yield Hedge":

"Trends in the high yield market over the past few years, in particular, have been somewhat different from what we have seen elsewhere. For example, when thinking about the excesses in credit, many (us included) talk about BBBs in IG, which have seen enormous growth in this cycle, or the leverage loan market, where credit quality has arguably deteriorated for years (higher leverage levels, weaker covenants, weaker structures, etc.). But the high yield market is often left out of the discussion. After all, high yield went through a mini default cycle in 2016, centered on Energy, and since then, issuance has steadily declined, leading to no growth in par outstanding, very different from the trends noted above. Some investors assume that as a result, high yield is more insulated from the fundamental risks present in other pockets of credit markets. In fact, for much of 2018 (at least for the first three quarters), we regularly heard the view that the resilience of HY (relative to the weakness in IG, for example) was a testament to healthier fundamentals in the former.

Through the third quarter of last year, we published several notes (see: US Corporate Credit Strategy Brief: I Can't Believe It's Not Beta, 25 Apr 2018) on why we thought HY was so resilient at the time (i.e., low supply and very strong earnings growth, among other factors), but more importantly, why we also believed HY was very much not immune from the broader macro challenges to come. Fundamentally, we agree, it is hard to point to specific metrics that seem as glaring in HY as in other credit markets, especially since 2016. For example, post the Energy recovery, leverage now looks weaker in IG than in HY (beta-adjusted), while both the growth in and deterioration in ratings quality of the IG and loan markets has also been much more extreme than that of HY over the same time period. However, in our view, this certainly does not mean high yield is out of the woods.

First, speaking to the growth (or lack thereof) in HY par outstanding since 2016, and what that may imply, we think some often forget that this has been a very long ten-year cycle. The HY market, in fact, has grown substantially (+112% since the end of 2008, based on the index we track), just all that growth took place in the first six years.

Leveraged finance markets have been consistently growing the entire time (other than a small blip lower in 2016), and that is what matters most, in our view, as these markets will always be closely tied together, especially in a credit cycle.

Yes, the driver of the growth in leveraged finance markets has shifted over the course of this cycle, as we show in Exhibit 6, with HY the main contributor early on and loans over the past few years, but we don't see this change in trend as overly surprising or abnormal.

As we point out in Exhibit 7, the story was similar in 2006/07 when the growth in HY par outstanding was minimal in the last two years before the financial crisis, while loans were growing at an exponential rate.

Second, while easily-tracked fundamental metrics like leverage don’t look as extreme in high yield, we think other harder-to-track, more qualitative measures are more problematic. For example, when digging into the quality of the companies in various markets, we would argue high yield is more exposed to sectors with longer-term operational challenges (as we originally discussed in Cross-Asset Dispatches: Why We Prefer Equities Over Credit, 3 Nov 2017). In investment grade credit, 30% of the index is made up of Financials, a sector where balance sheets are very strong, thanks in part to a decade of financial regulation. The large cap equity indices are skewed towards fast growing technology companies. High yield, in our view, is more heavily exposed towards “old economy” business and Energy. Many of these companies also have high leverage, but they have survived because of such cheap money for so many years. We are guessing some of them will have trouble through another recession, especially if credit conditions tighten for a prolonged period of time.

Third, because some of the fundamental challenges are more widely discussed in other markets, they are likely also a bit more "in the price." A good example is that the BB/BBB spread basis is at cycle tights, in part because, on the surface, long-term problems seem more material in low-quality IG than in HY. However, while we have been very vocal around the issues with BBBs, we would actually buy BBBs over BBs, simply because we think the potential challenges in high yield in a credit cycle are less appreciated than the risks elsewhere (like in BBBs).

Finally, for those who still believe HY will be relatively resilient through a credit cycle due to better fundamental trends, let’s look at recent evidence. For example, we have had two growth scares in this cycle, in 2011 and in 2016, and in both cases HY traded to ~850bp, very close to prior recession wides (i.e., the levels where HY peaked in 1990 and in 2002).

Some still argue while that may be true, 2016 in particular, was unique due to the collapse in oil prices, which is a much lower risk in the future. In our view, any hope that HY would be more resilient in the next growth scare (or outright recession) should have been thrown out the window after witnessing the price action in 4Q18. After all, once the weakness in 2018 became about growth/earnings growth rolling over, the resilience of HY ended. At that point, spreads widened by almost 250bp, and HY underperformed the leveraged loan market, despite seemingly weaker fundamental metrics in the latter.

We think it is clear that high yield is and will remain highly sensitive to changing growth expectations as well as to changes in credit conditions.

Going forward, our view has been clear – we think the weakness in 4Q was not just a temporary valuation adjustment in a broader bull market, or about one-off headwinds like trade. We believe credit is in a bear market and the credit cycle is slowly turning. Defaults should remain low in 2019, but we think default expectations may rise this year, and actual defaults could start trending higher the year after. We believe this is a good time to position for this view, especially in places where it is clearly not priced, like short-dated HY CDX." - source Morgan Stanley

Now if indeed High Yield is highly sensitive to changing growth expectations and if as we posited last week CFOs in the Investment Grade space decide to reduce CAPEX, buybacks and dividends to address leverage concerns from investors, then it will be more "credit" friendly and less so for "high beta" related equities from these issuers. In a "japanification" context, we therefore think that playing quality and duration is less prone to burst of volatility and will be more rewarding for "yield hogs" cowards than the high beta punters out there.

With a return of ultra dovishness from our generous gamblers aka our dear central bankers, given the new record low in rates volatility as per the Move Index cited earlier on in our long conversation, as per our final charts below it seems to us that macro volatility has been somewhat "killed" again...

• Final charts - Oh my God they killed Macro volatility again!

Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed", we argued that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. Our final charts come from HSBC Asia Chart of the Week from the 22nd of March entitled "The demise of macro vol" and highlights the fall in the volatility of activity data to record lows:

"Glued to your trading screens these last few years, you may well believe the world economy was roiled by one shock after another. Well, not quite. Financial markets have spiked and plunged, but underlying economic activity, at least across Asia, has been remarkably steady. In fact, it’s been ‘flat as a pancake’ to borrow a phrase from HSBC’s chief fixed income strategist Steven Major (see Fixed Income Asset Allocation, 12 March). Ah, ‘China’, you might say: the economy’s growth numbers have indeed been extraordinarily stable in recent years. But that’s actually been the case in virtually all Asian economies. The volatility of activity data has fallen across the board to record lows, well below the mid-2000s, when, if you recall, economists were celebrating the demise of macro volatility amid the ‘Great Moderation’. It’s hard to pinpoint the exact reasons for this – highly supportive, and swiftly reactive, monetary policy is probably one, as are structural factors like the growing share of services in output and much shallower inventory cycles in manufacturing. The fall in growth volatility, unsurprisingly, has been accompanied by a drop in inflation volatility. All this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for.

"I may as well tell you that if you are going about the place thinking things pretty, you will never make a modern poet. Be poignant, man, be poignant." P.G. Wodehouse

Our fist chart is simple enough: it compares the standard deviation of GDP growth in the 2000s (2002 to 2007, to be exact) and 2010s (2012 to 2018).

Note that in virtually all cases, growth volatility has declined markedly. The exceptions are Sri Lanka, Thailand, Taiwan, and Vietnam. In the first two, this is easily explained by local political uncertainty and environmental disruptions. In the latter two, the increase in volatility has been slight or from a comparatively low level. Note also that China is often singled out as having rather stable GDP growth numbers, but the drop in volatility has been nearly uniform.

The decline in growth volatility, unsurprisingly, has been accompanied by a fall in the volatility of inflation. Our second chart replicates the first, this time showing the standard deviation of headline inflation for different economies. Again, the picture is broadly similar: in most markets, volatility has fallen. This time, the exceptions are Australia, India, Japan, New Zealand, and Singapore, with most increases being marginal (India is a stand-out, but may reflect computational issues). ‘Wait’, you might object, the decline in headline inflation volatility may simply reflect more stable global energy and food prices…perhaps, but core inflation is showing pretty much the same trend.

This fall in macroeconomic volatility is generally something that policymakers and investors alike desire. From this perspective, the past few years were quite positive, even if GDP growth itself fell short of expectations in many parts of the world, including in Asia. Financial markets, of course, have at times been highly volatile, but, overall, risk assets have performed quite well, which may in part be attributable to the ‘demise in macro vol’.

The trouble is, the longer a period of low volatility endures, the more desensitized everyone becomes to risk: if things are fundamentally stable, and memories of deep recessions are starting to fade, the appetite to leverage up grows and investors are increasingly tempted to buy ‘on the dip’.

But take a look at our last chart. This shows the volatility of GDP growth in emerging Asia over time. Note that this has been extraordinarily low in recent years (blue circle).

However, periods of low volatility often precede a spike: for example, vol plunged in the mid-1990s before the Asian Financial Crisis and also trended lower in the mid-2000s before the Global Financial Crisis (red circles).

Better stay nimble…" - source HSBC

 So while some central banks have decided that in order to acquire the resources they required, have printed notes for the balance to paraphrase Keynes, their inflationism policies, all of this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for indeed...

"Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services." -  Henry Ford

Stay tuned !

Macro and Credit - Bracket creep

"Declining productivity and quality means your unit production costs stay high but you don't have as much to sell. Your workers don't want to be paid less, so to maintain profits, you increase your prices. That's inflation." - W. Edwards Deming

Watching with interest the latest US CPI posting its biggest gain in 11 months to 1.8% in a US economy plagued by "fixed income" (lack of wage growth) and "floating expenses" (healthcare and rents), when it came to selecting our title analogy we reminded ourselves of the term Bracket creep, particular following the landmark tax reform passed on Christmas Eve to replace the 30-year-old, complex U.S. tax system. Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation. Given most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple.

In this week's conversation, we would like to look at rising inflation expectations and what it entails from a US TIPs and other linkers perspective as well as what are Japanese friends are up to from an overall flow allocation.

Synopsis:

• Macro and Credit - The return of the inflationistas
• Final chart - The "Bid 'Em Up Bruce" stage is now

• Macro and Credit - The return of the inflationistas

While inflation has been the elusive piece of the puzzle for many of our dear central bankers around the world, the latest print of core US CPI is marking the return of the "inflationista". This obviously should be welcomed good news for the members of the FOMC, but be careful what they wish for. As we indicated back in June 2015 in our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation. Also remember that in the headline CPI, rental prices represent 25% in the calculations and overall housing 42%. We will eagerly watch rental prices in the coming weeks and months. Back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008 as a reminder.

Yet as posited by Wells Fargo in their Economics Group from the 12th of January in their note entitled "CPI: Beyond the Headline, Inflation is Strengthening", consumer prices are it seems indeed edging up:

"Consumer price inflation edged up 0.1 percent in December despite a fall in gasoline prices. Reversing last month’s weakness, core inflation rose 0.3 percent and is up at a 2.5 percent pace over the past three months.

Gasoline Savings Going Elsewhere

Inflation cooled in December with the Consumer Price Index (CPI) increasing 0.1 percent. That followed a 0.4 percent gain in November.

The tamer increase stemmed from a pullback in energy costs as gasoline prices fell 2.7 percent over the month. That overshadowed a modest rise in energy services (electricity and utility gas). It was not until late in the month that unusually low temperatures led to a jump in natural gas prices. Although not quite halfway through the month, spot prices for natural gas are up about 6 percent from their December average. Therefore, we suspect energy services could provide an even larger lift to headline inflation next month.

For December, food prices rose 0.2 percent. That marks the largest increase since July and suggests that more stable prices for food commodities and rising labor costs for food services workers may be reasserting some modest upward pressure on the sector.

Core Inflation Rebounds

Core inflation bounced back after a weaker-than-expected reading in November. Excluding food and energy, prices were up 0.3 percent. Core goods prices posted a rare increase and moved 0.2 percent higher.

Leaner auto inventories after last year’s natural disasters spurred demand to replace vehicles and slower production growth more generally has given some support to prices. After falling from February to September, new and used vehicle prices have risen the past three months, including the largest monthly gain in December in more than six years. A 1.0 percent jump in prescription drug prices also pushed core goods inflation higher. Stronger core inflation was also driven by services. Shelter costs advanced an above-trend 0.4 percent in December. Rent of primary residences and owned residence both rose more than in November, while lodging costs partially reversed last month’s drop. Costs for medical care services also rebounded after a sharp decline in physician services in November.

Getting Back to the Fed’s Target

Inflation has been the darkest cloud hanging over the Fed’s efforts to normalize policy. Over the past year, inflation has risen 2.1 percent, a touch lower than November’s 12-month change and noticeably below the pace set earlier in the year. Yet the recent trend looks stronger. Over the past three months headline inflation is up at a 2.6 percent annualized pace. Similarly, core inflation, which is up 1.8 percent on a year-ago basis, has risen at a 2.5 percent pace over the past three months. This should help to allay some FOMC members’ fears that inflation is stuck at undesirably low levels. We expect to see a noticeable pick up in the year-over-year change by this spring. Although that will stem in large part from base effects following weakness last year, the trend remains upward." - source Wells Fargo.

Back in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves if indeed the game was turning and if we should switch camp from the "deflationista" towards the "inflationista" camp:

"Given China's most recent uptick in its PPI to 6.9%, we are indeed wondering if this is not a sign that we should change allegiance slightly towards the "inflationista" camp and start fearing somewhat the possibility of the return of the Big Bad Wolf aka inflation. We will be monitoring closely this latest China "inflation impulse". China's rising costs via exports could boosts inflation expectations in the US. These higher inflation expectations in the US would mean a steeper yield curve with a rise in long-duration yields overall and it would lead to higher rates volatility down the line. A bear market needs a wolf and this wolf would materialize in a return of inflation we think." - source Macronomics, October 2017 

As pointed out by Christopher Cole from Artemis Capital in his must read note "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. But flow wise, as we have pointed out in numerous conversations, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" so far. It seems the bond kings such Bill Gross and Jeff Gundlach as of late have picked up their side and are steering towards the "inflationista" camp whereas Dr Lacy Hunt, from is latest  quarterly note for Hoisington continues to sit tightly in the "deflationista" camp it seems. One might therefore wonder where we stand.

Also, in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:

"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", but that was because of the following:

"If the policy compass is spinning and there’s no way to predict how central banks will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up."

Given it seems that US inflation expectations are moving upwards it seems, one could argue that the compass in the US has somewhat stopped spinning hence the move in US breakevens and TIPS, in conjunction with the continuous support for Gold Miners (yes we are still long and we have been adding...). 

We like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment? 

At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument. We highly recommend our friend Kevin Muir aka The Macro Tourist post on a refresher on how breakeven works: "BREAKEVEN REFRESHER LESSON" for those not familiar with the concept. 

We would also like to add that if indeed the rise of inflation expectations is a global phenomenon, then our UK friends have an advantage with Gilt Linkers given they do not have an embedded deflation floor so, they should outperform US TIPS on a relative basis. 

Also, as all eyes are looking at the significant surge in oil prices in recent months as per our March 2016 conversation "Unobtainium":

"A very interesting 2015 paper by the Bank of Israel (Sussman, N and O Zohar 2015, “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015.) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area. Therefore, given the recent significant surge in oil prices, we do not think it is such a surprise to see a rise in inflation expectations in that context." - source Macronomics, March 2016

Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach of the "inflationistas" for the long end of the curve. We live in a world in which the public sector has never been so indebted (The world's global debt just reached $233 trillion in 3Q 2017). Demography is as well playing its part in rendering the US Yield curve "inelastic" therefore the volatility of the US yield curve is clearly in the front-end of the curve. We continue to witness a bear-flattening of the US Yield curve with the Japanese investment crowd and in particular Lifers continuing to be dip buyers. This is confirmed by Nomura from their JPY Flow Monitor report from the 12th of January entitled "Net buying continued but at a slower pace":

"Lifers sold foreign bonds, but seemed to maintain its recovery trend

Investment by life insurers, which are prominent medium- and long-term investors, remained lackluster. They were net sellers in November at JPY234bn and in December at JPY124bn ($1.1bn). Higher FX hedging costs for US bond investment may slow their foreign bond investment, but we do not believe that the recovery trend has ended, (see “US curve flattening and Japanese lifers”, 7 December 2017). Barring another resurgence of geopolitical risks, we believe there is a good possibility that lifers will resume their net buying at a high level due to pent-up demand. The recent rises in US and European yields should encourage them to consider foreign bond buying. Lifers’ FY17 investment plans show that the structural shift away from yen bonds and toward foreign bonds continues (see “JPY: Lifers upgrade EUR/JPY forecast”, 25 October 2017). Despite this, at JPY1834bn, lifers’ cumulative foreign bond investment from April through December 2017 is below the average since FY05 (JPY1959bn; Figure 3).

When it comes to unhedged investments, If USD/JPY trades below 112, this would trigger demand to buy USD on dips (sell JPY), in our view. Major lifers forecast USD/JPY in a core range of 109-115. According to major lifers’ H1 FY17 financial statements, their hedged ratio was 58.0% at end-September 2017, down slightly from end-March (60.2%), but this level was still high (see “JPY: Modest decline in lifers’ hedge ratio”, 24 November 2017). With the Fed raising rates, higher hedging costs should push lifers into reducing their hedged ratio (thus creating pressures pushing up USD/JPY). Lifers still have substantial room to unwind FX hedges, which should keep USD/JPY steady." - source Nomura

With government bond yields ratcheting up, this means more buying at some point FX unhedged from the Japanese investment crowd and still a strong demand for US credit given it is still a TINA trade (There Is No Alternative). When it comes to the on-going "bear-flattening" of the US yield curve, yes,  one could see a rebound with some tactical steepening in the 2s10s part of the curve as pointed out by Nomura in their FX and Rates Trade Ideas note from the 11th of January:

"In the US strategy outlook for 2018 (see link), we listed several reasons why we do not expect a full flattening of the US curve, or an inversion any time soon. It is inconsistent, in our view, for curves to pancake at this time given outright levels of rates are low (versus prior periods), global QE is fading, debt issuance is rising and the economy is growing. We expect these and other factors driving the US curve to result in sharp countertrend moves at times in 2018. We envision some bull and/or bear steepening factors ahead.

1. Bullish front-end factors: The front-end has quickly discounted the 2018 hiking path. US momentum looks solid but any sort of miss in US data could prompt a front-end rally. The front-end has also built up a sizable short base as seen in Figure 1.

2. Curve correlation factor: The curve versus the level of rates (Figure 2) is shifting quickly from the prior bull flattening/bear steepening regime.

Thus, those expecting the long end to outperform on any sort of risk-off (which is a common rationale we hear from investors long 10s plus) is misplaced, as 2s would now rally more in a risk-off.

3. Bearish long-end factors: As seen in Figure 3, one reason why the curve flattened in 2017 was 10-year rates were stuck in a range, while the Fed was hiking short-end rates.

This year will be unlike last year because Fed QT in ongoing, US tax reform passed (and deficits/debt loads are likely to expand) and global QE buying is slowing.

4. Curve momentum factor: We take the 3-month moving average of the curve as an indicator of momentum and take the rolling 1-week change to gauge its speed. As seen in Figure 4, the US curve momentum has hit its limit and is due for a rebound.

We recommend investors go short 10s on the curve (2s10s) and the broader butterfly in Q1 2018. For the 2s10s UST trade, our first steepening target would be half the flattening seen since November 2017 (roughly 15bp above current levels) before we re-assess." - source Nomura

While we might see indeed some rebound in the 2s10s part of the US yield curve, the continuation of the velocity in the "bear-flattening" of the US Yield curve which has started a while back is depending on renewed appetite from "Bondzilla" the NIRP monster "Made in Japan" we think.

But moving back to the attractiveness of US TIPS, we do think that, from an allocation perspective, they are of renewed interest. On that subject we read with interest another Nomura note, their Inflation Insights from the 11th of January entitled "Tip(s)-toeing into the US BEI pool":

"Avoid jumping but gradually wade into BEI waters

The macro case for adding long US inflation positions has strengthened with higher price pressure from the recovery in world trade, which has been a driver of higher commodity prices, especially for oil. These higher input costs coupled with what still remains a relatively accommodative global monetary stance (keeping real rates contained for now) is leading to wider TIPS breakevens inflation (BEI). Yet, this has been an orderly move and there are few relative value disruptions to take advantage of (i.e., cash/swap basis and curve disruption). A long US BEI position is therefore mostly a directional macro trade. 

We recommend investors stick with the macro trade, with limited risk and an oil hedge. We get long 5y breakeven rates at 1.95%, targeting 2.20% at the end of February (20bp net of negative carry) and pay for some oil price protection. We expect core inflation to strengthen in December. However, we would not hesitate to take losses if the December print meaningfully surprises to the downside. Globally we still prefer long euro BEIs.

US TIPS breakevens showed a strong performance into and out of year-end

The US 5-year breakeven inflation rate performed remarkably well into and out of yearend, increasing by about 15bp since mid-December 2017 (about 12bp net of the negative inflation carry). This is a solid performance that contrasts with the lack of movement between October and December. Inflation carry should remain negative in February, pushing forward breakeven rates higher at an increasing pace given the magnitude of the negative carry and the low number of days in the month (Figure 1).

The inflation carry profile therefore accentuates the skew to long breakeven positions into the CPI number on 12 January: a substantial positive surprise is needed for long positions to perform, while a small negative surprise would be enough to postpone long positions by a month. Note that our US economists’ forecasts for the December headline CPI are in line with both consensus and short-term inflation markets, although their forecast on core is higher (see US CPI Preview: A Potential Jump in Core).

Timing aside, the medium-term outlook for US TIPS BEIs appears favorable

As we highlighted in the TIPS section of Fixed Income Insights: 2018 Themes - US Strategy Outlook, “while valuation did not argue for a massive TIPS BEI long, the US may be the first place to benefit if the ‘reflation’ trade 2.0 is driven by Trump administration’s tax plans and fiscal stimulus”. Beyond the hurdle of short-term carry implications, various factors are forming a positive framework for US inflation valuations.

Global inflation is picking up and that should be supportive BEI wideners

The first positive technical stems from the behaviour of our Global Inflation Factor (GIF, a factor extracted from internationally-set prices such as commodity prices and manufacturing prices obtained from manufacturing surveys, which remain a large fraction of world trade). As the right chart in Figure 2 shows, global inflation picked up at the end of last year.

Furthermore the strong momentum on the price of manufacturing goods is further supported by the recent strength in energy and food commodity prices. Goods price momentum is particularly visible in Europe and is reflected in the right chart in Figure 2. The chart scaling shows this is why our favored long so far has been in euro inflation wideners. Yet, stronger momentum on commodity prices favors US TIPS breakevens, despite some discrepancy between wholesale and retail gasoline prices, probably due to margin changes after the weather-related disruptions of last year.

Valuations are balanced and not only driven by the hope of reflationary policy

The second factor supporting a long US inflation breakeven trade is a more balanced valuation framework/background. The left chart in Figure 2 shows this dynamic. In a reestimated version of a statistical model developed by Fed researchers (see IFDP notes, Dec.2016, "drivers of inflation compensation: evidence from inflation swaps in advanced economies", M.Rodriguez and E.Yoldas), the model is estimated over the 2008-2016 period, then projections are simulated since September 2016.

We find the large discrepancy that occurred between their model and actual inflation valuations that built up after the US Presidential election very informative. It validates our view at that time of some re-building of the specific inflation premium. Note that the risk premium captured by the model is generic and pertains to risk aversion, not inflation specific forces. Inflation valuations after October 2016 seem to have priced in too promptly the impact of expected reflationary policies, particularly on the fiscal side.

One year later, the US tax reform package has finally been voted on and passed. Yet, the fact that the discrepancy between the trajectory of breakevens and the fundamental factors (as implied by the model) is now small suggests there is room for upside that is motivated by expectations beyond just fiscal policy. We think the backdrop for US inflation is therefore much more balanced than was the case at end-2016 after the election.

The issue of timing and carry limits our exposure and enthusiasm

Investors should still scale into BEI wideners, as there are a few issues associated with an unconditional bullish stance on US inflation. We have already described the first issue in terms of seasonal carry not being ideal. There is also the issue of the near-term inflation profile which, according to both economists and markets, will not be very supportive.

As Figure 3 shows, year-on-year inflation is expected to fall between now and the end of Q1 2018, reaching a low of 1.8% in February 2018.

This year-on-year inflation downtrend should occur despite the robust core inflation rate forecast by our economics team at of 0.20% /month between December 2017 and December 2018, which is higher than average core inflation over the past two years. Some negative surprises on inflation are definitely not out of the question, although our economists see upside risks to the next core inflation print (see Economics Insights - US: December CPI Preview).

In February 2017, the 1-year inflation swap rate was about 2.35% and effective inflation over the period consistent with the swap rate was 2.13%, a 20bp shortfall mostly due to the unexpected fall in inflation (mostly from transitory factors but real drivers of inflation nonetheless) between February 2017 and June 2017. A quick glance back at forecasts back in February 2017 shows an underestimation of inflation by up to 60bp for some months. The reason for the underestimation is not yet fully apparent (see Special Report - Why Does the Fed Appear Insensitive to Soft Inflation Data?), and we have pointed to evidence of less-anchored inflation expectations in Inflation Insights - Reality check. The persistence of uncertainty on the inflation mechanism in the US, acknowledged by the Federal Reserve, suggests some caution is warranted on outright long US inflation stances.

Sharing between real and inflation components of yields

Keeping inflation anchored is a key condition for smooth monetary policy normalization. 

Any sort of increase in nominal interest rates that would be accompanied by falling inflation compensation would in fact entail a much tighter real stance via higher real rates pushing up overall yields. This would risk putting the economy on a very volatile path.

A key part of our analysis has been to favour inflation markets where the fostering of expectations was supported by low real yields, and this is why we have favored the euro market, where 2-year real rates are now close to their historical lows (Figure 4).

Short-term real rates in the US have increased much more rapidly which, by contrast, makes the increase in inflation valuations very dependent on economic optimism, not on policy accommodation. The stabilization in real yields suggests this element of vulnerability of the long US inflation trade is less acute now than a few weeks ago.

Still, it remains the case that the increase in inflation compensation is highly dependent upon a modest path in the recovery of real yields (see Inflation Insights - A tale of two modes).

Trade Idea: Scaling into long US 5-year TIPS breakevens

Oil prices are rising, valuations are balanced, the next CPI print is likely to surprise markets to the upside: there are many reasons to go long US inflation despite the negative seasonals.

The focus in the rally has been on cash instruments rather than derivatives, which is consistent with EPFR data showing strong inflows into TIPS ETF based funds. Also, in the latest BEI rally, the 5-year point has outperformed the 10-year point probably due to higher oil prices. Yet as during previous rallies, the 5-year breakeven rate relative to 3- year and 7-year has not outperformed, see Figure 5.

As a result, the case for relative value on the US inflation curve is limited, in our view.

The case for long US breakeven inflation exposure is therefore mostly a macro trade, with few elements of relative value selection that could “enhance” the trade. Longs need to fight less than ideal carry profiles, prospects of volatile oil prices and the Fed’s hiking path ahead. We cautiously go with the macro arguments by scaling into a long 5y TIPS breakeven trade with limited risk exposure (limited notional and some oil price hedges)." - source Nomura

Indeed it is a "macro" trade. We like these. We would also like to repeat what we have pointed out in our conversation "Hypomania" in February 2017 relative to rising oil prices given the relationship with recessionary pressure in the US. 

"As we pointed out as well in 2014, in our conversation "The Molotov Cocktail", 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." - source Macronomics, February 2017.

As well there is a very important relationship between "gold" and "Tips" when it comes to their reaction to the velocity in rising inflation expectations as we indicated in last year's conversation:

"There is of course an explanation around this which was very clearly put forward by David Goldman in Asia Times on the 17th of February in his article "A mistery solved: Why real yields are falling despite higher growth":

"Economists often think of real yields as the “real interest rate,” or baseline rate of return, in a macroeconomic model. From this standpoint the low level of TIPS yields is a mystery: when economic growth is rising, the real interest rate should rise. The expected short-term interest rate has been rising as the Fed sets about normalizing rates, and the rising short-term rates affect real yields. The fall in TIPS yields in the face of Fed tightening and stronger growth presents a double challenge to the conventional wisdom.

The conventional way of looking at real yields ignores the way markets treat risk. Government debt (and particularly the government debt of the United States) is not just a gauge of economic activity, but a kind of insurance. If the world comes crashing down, you want to own safe assets. Investors hold Treasuries in their portfolios not just for the income, but as an insurance against disaster. And TIPS offer a double form of insurance: If economic crisis takes the form of a big rise in the inflation rate, TIPS investors will be paid a correspondingly higher amount of principal when their bond matures. That explains why TIPS yields sometimes are negative: investors will accept a negative rate of return at the present expected inflation rate in return for a hedge against an unexpected rise in the inflation rate.

The yield on TIPS has tracked the price of gold with a remarkable degree of precision during the past 10 years, as shown in the chart below. Gold tracks the 5-year TIPS yield with 85% accuracy. That’s because both gold and TIPS function as a hedge against unexpected inflation.

During the past year, for example, we observe that the relationship between gold and the 5-year TIPS yield has remained consistent, while the relationship between the expected short-term rate (as reflected in the price of federal funds futures for delivery a year ahead) has jumped around. There are lots of local relationships between federal funds futures and the TIPS yield, but the overall relationship is highly unstable." - source Asia Times - David Goldman

The rest of his article, is a must read we think. but if indeed there are rising inflation expectations, then it makes sense for real yields to continue to fall, which can be assimilated to the cost of the insurance for "unexpected outcomes" is rising. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations is going up." - source Macronomics, February 2017

The recent surge in both US Tips, gold and gold miners are a consequence of the rapid surge in "inflation expectations" hence the interesting case for going both long gold/gold miners and US TIPS in that particular context we think, while there might also be a seasonal factor too it given we witnessed a similar situation in December 2016. There is a well continued weakness in the US dollar which is positive for Emerging Markets equities relative to US equities from an overweight allocation perspective. Right now risk assets continue to push higher, this in conjunction with rising inflation expectations should trigger a more hawkish change of narrative from central banks. As we pointed out in our final post of 2017, "Rician fading", once the tax deal was a done deal, US corporates with more clarity ahead could resume/start some M&A typical in the late stage of the credit cycle game in the first part of 2018.

• Final chart - The "Bid 'Em Up Bruce" stage is now

 As a tongue in cheek reference to the mighty Bruce Wasserstein aka "Bid 'Em Up Bruce",  the M&A legend, our final point of this conversation highlights another sign of late cycle behavior, namely corporate M&A. This final chart displays M&A in the corporate sector since 1999 relative to the credit cycle seen since 1999. It comes from Nomura Japan Navigator note from the 9th of January entitled "Equities move on factors other than yields and exchange rates":

Unlike the pattern over the past three years, 2018 began with substantial risk-on momentum. China’s short-term money rates stopped climbing, allaying market concerns, and commodities and EM equities gained upward momentum. The closing of positions out of concern that the year would start with the anomaly of a risk-off flow and the winding down of selling for a loss ahead of the implementation of US tax cuts also played a role, in our view. In addition, the passage of the US tax cut legislation provided an opportunity for investors and companies to resume investments once uncertainty had been dispelled. We view corporate mergers and acquisitions as a key engine of growth during the latter part of an economic recovery, and had been concerned about their lackluster pace despite the strong credit market in 2017 (Figure 2). This should pick up now.

At the start of the year, many economists and analysts set out the major themes for the year, regardless of their probability, and we expect corporate M&As to become a market theme, at least temporarily. This year, in our view, while the stock market will place more weight on the corporate sector’s capital investment and M&As, we think the rates and FX markets will focus on policy changes by central banks, with the start of monetary tightening by the BOJ and ECB clashing with the end of Fed rate hikes. We think this explains the disjointed movements across markets." - source Nomura

Is this cycle different when it comes to late cycle behavior such as heightened M&A activity? We do not think so, and it is a consequence as well of the "Bracket creep". Get your LBO screener ready folks...

"The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation." -  Vladimir Lenin

Stay tuned!