Macro and Credit - The Society of the Friends of Truth

"Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth." - Marcus Aurelius

Looking at the surging demand for insurance to protect cash aka "hoarding" taking place in Switzerland courtesy of NIRP, given this exactly what we discussed in our previous conversation "The Law of the Maximum", we decided again this week to pick yet another analogy in our chosen title towards the French Revolution given our "pre-revolutionary" mindset. The Society of the Friends of Truth (Amis de la Vérité) also known as the Social Club, was a French revolutionary organization founded in October 1790 and formulated political theories on democratic government, more equitable distribution of wealth and was the first revolutionary group to identify itself as cosmopolitan and made appeals to scholars worldwide. The Club's political orientation was liberal and promoted the ideal of a society composed of small and medium economic producers such as craftsmen, farmers, merchants and entrepreneurs. Given the rising critics relative to the "wealth effect", a strategy openly supported by the members of "The Cult of the Supreme Beings" aka central bankers, we wonder if we should not recreate through our musings "The Society of the Friends of Truth" hence our title. After all we have been hammering for a while the on-going "japanification" process of the European banking system and the unresolved issues of some banking system such as the Italian one in supporting economic growth through the "credit impulse" given their balance sheets "constraints". 

In this week's conversation we would like to revisit the threat of rising positive correlations thanks to the "The Cult of the Supreme Beings" and what it entails for diversification strategies, risk parity strategies as well as "hedging" for credit and more. After all, we do not think there is a better way to rekindle "The Society of the Friends of Truth" than discussing again the subject of "tail risks" and non-linearity events.

Synopsis:

• Macro and Credit - Watch out for rising positive correlations
• Macro and Credit  - Is inflation back into play?
• Final chart: The downward trend in bond yields has limited insurers' hedging budgets

• Macro and Credit - Watch out for rising positive correlations

While we mused on twitter at the end of August the following: 

"Piece of advice for Central Bankers, rising cross-asset positive correlations and risk parity strategies do not mix well..." - source Macronomics, twitter feed.

It is time we think for the members of the Society of the Friends of Truth to reacquaint themselves with our wise words from our February conversation "The disappearance of MS München" in which at the time we said we were writing for posterity and tackling in depth various aspects of risk including the inadequacy of VaR (Value at Risk) as a risk measurement tool. You might already be wondering where we are going from there but as a gentle reminder, in our book, rising correlations reduces the benefit from diversification, in the end hitting fund's equity directly. Whereas we have mostly disregarded "diversification" this year we opted to avoid the diversification risk in a NIRP world (putting in jeopardy "balanced funds" with reduced downside protection of the bond buffer component thanks to lower yields) for a much simpler "barbell strategy". Therefore we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that is there was a huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up and apart from the most recent "jittery" Fed induced hiking or not hiking moves, for us this strategy worked out fairly well in 2016.

This is what we wrote in our February long conversation:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing. The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016

In our Society of the Friends of Truth, rising positive correlations are a warning sign and also clearly indicative of central bankers meddling with asset prices. This can be clearly seen in the below CITI chart displaying rising cross-asset correlation and the VIX index:

- source CITI, H/T Steen Jakobsen

This also a subject we discussed in our May 2015 conversation "Cushing's syndrome". We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment.

Furthermore, there are some more indications of some other strategies being directly threatened by central banks intervention and rising positive correlations which could lead to some nasty non-linear price movements and VaR shocks we think.

This clearly the case for Volatility Control Products as indicated by Deutsche Bank in their Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions":

"One year later, vol control funds continue to draw focus in severe selloffs

One year ago today, on August 24, 2015, severe volatility drove S&P 500 futures to be halted in pre-market trading, listed SPX option markets to go black, and other equity market dislocations to arise. That moment was one of the most severe shifts in SPX volatility, switching from a relatively low volatility period to extremely high volatility (11% selloff in a week) almost instantaneously. Vol control funds, multi-asset investment portfolios with a dynamic asset allocation determined by market volatility, were important contributors to the severity of that selloff. In this piece, we provide background on vol control funds and guidance on how investors can monitor them going forward.

Vol up, sell stocks: a market feedback loop

Vol control products sell equities when volatility is rising and buy equities when volatility is falling, creating a market feedback loop. Product growth has slowed - but rebalancing impact has grown in illiquid, risk-averse markets. This has been, and continues to be a driver, of the repeated pattern of sharp selloffs followed by consistent rebounds seen in the last 2Y, and contributes to high skew and vol-of-vol in derivative markets. Several fund features - most importantly lags in trading following a volatility spike - keep the products from becoming a systemic risk. Vol control products are not the only large market feedback loop structure (risk parity, leveraged/inverse ETPs, and CPPI are other important ones) - but we believe they are the most important feedback loop given their size and responsiveness to market shifts.

 Sharp transitions from low vol to high vol are becoming increasingly common

The most important trading implication of a large vol control market is the funds' impact on sharp selloffs. We have had almost as many transitions from very low vol to much higher vol in the last 6Y as we have had in the prior two decades.

DB Vol Control Composite tracks current positioning

Through fund-by-fund research of $200bln of vol control funds, we have categorized the funds into four categories, and created a DB Vol Control Composite model based on systematic strategies that we believe captures the essence of these products' equity allocation patterns. We estimate that a sudden 4% global equity selloff today would drive $20bln of selling by vol control funds - less than earlier this year - as realized vol is now below many funds' thresholds.

Last August, around $50bln of equities were sold by vol control funds

We estimate that in the aftermath of the Aug-15 selloff, vol control funds sold around $50bln of global equities, and in the aftermath of the Brexit vote sold around $25bln. These numbers are large in absolute terms - and stand out when they're coming from an investment type that does minimal asset allocation rebalancing on a typical day-to-day basis.

Arguably rising positive correlations and repressed volatility are we think, recipe for large trouble ahead thanks to central banks meddling. A clear illustration of the impact of "Brexit" was discussed in our conversation "Optimism bias" back in June, which clearly caught "off-guard" many pundits. This "Brexit" sucker punch or Blue Monday" price action was clearly illustrated in Deutsche Bank 's very interesting report:

"Brexit: what matters is how big a surprise the vote was

In the aftermath of the UK's referendum to exit the EU, vol control funds likely sold around $25bln of global equities due to the sudden pickup in volatility. This would have been different had polls been more accurate: had market-implied Brexit likelihood drifted toward a Leave result over several days rather than shocking market participants in the middle of the night, markets may have ended at the same prices - but in a gradual path. Unlike what actually happened, this slow-motion drift toward Brexit would have left vol control products fully invested. It's not the outcome of the Brexit vote that drove selling by these investors - it's the path markets took to get there.

In the figure below, we compare the number of SPX shares held by a $10bln investment in a hypothetical fund linked to the S&P 500 Managed Risk Index - Moderate (a representative index of some vol control funds that we describe later in the note) under two scenarios: what actually happened, and a hypothetical slow-motion Brexit in which the market hypothetically realizes that Leave will win over the course of the vote week. The shock nature of the Brexit vote caused 900,000 shares of the SPX to be sold by this strategy than it would have had just four trading days' prices been replaced with a gradual descent toward the post- Brexit low.

Vol control products aim to achieve a fixed realized vol

Volatility control products are funds that promise their investors a specific realized volatility – either by aiming to achieve an exact number (e.g. 10% realized vol), a specific range (e.g 8-12% realized vol), or a limit (no more than 12% realized vol). The volatility objective is a constraint on the otherwise return-maximizing goal of the portfolio.

We define vol control funds as products having these characteristics:

■ Dynamic asset allocation. The percentage of assets invested in equites varies, at least partially systematically, over time based on market conditions.

■ Asset allocation is a function of volatility levels. The product's allocation to equities is primarily a function of how high either equity volatility or cross-asset volatility is, whether measured through implied, realized, or subjective metrics. We do not include products whose asset allocation is a function of asset classes' relative volatility to each other.

Typical vol control funds are global, multi-asset portfolios

Even though vol control funds are largely a US-based investment option, most vol control funds are managed as global asset allocation portfolios, including equities and fixed income, from both US and international markets. They typically hold almost-static allocations to either security-level or fund-level investments, and then manage the overall expected volatility of the portfolio by trading futures
contracts on global equity indices in response to changes in market volatility. The charts below show the asset allocation of the long and short sides of a typical vol control fund. The fund holds a diversified, multi-asset long portfolio, and then reduces its equity exposure by 17% of AUM via several short futures positions:

In similar fashion to CPPI strategies, these funds must decrease leverage to protect principal hence the dangerous feed-back loop for these strategies increasingly at risk from rising cross-asset correlations with reduced buffer from the bond allocations in some case such as the much vaunted stars of the last decade aka "balanced funds".

As we have pointed out, positive cross-asset correlations are on the rise and should be monitored and of great concern. As we pointed out in our short August conversation "Positive correlations and large Standard Deviation moves", indicates growing systemic risk we think. As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger...That simple.

The below chart made on Bloomberg by Adnan Chian (through our twitter feed), represents an illustration of the risk for "balanced funds" getting "unbalanced" as mentioned above:

- source Bloomberg / H/T Adnan Chian - Twitter - 30th of August 2016

In addition to this, we read with interest Bloomberg's take on rising correlations from their article from the 31st of August entitled "Stocks and Treasuries haven't moved together like this since China's Yuan devaluation":

"The last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan, with strategists heralding the onset of "quantitative tightening."

In stark contrast to the recent experience, modern portfolio construction has typically been predicated on a negative correlation between stocks and bonds, lowering the overall volatility of the portfolio and producing better risk-adjusted returns.
"The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield but that shift from negatively correlated to positively correlated will play havoc for portfolio level risk management (and risk parity)," writes Peter Tchir, head of macro strategy at Brean Capital LLC.
The risk parity strategy, which, in very basic terms consists of a levered long position in Treasuries and a long position in stocks, has been on fire in 2016. Bank of America Merrill Lynch Head of Global Rates and Currencies Research David Woo has warned that tough times could be in store for this strategy if investors heading into the U.S. presidential election begin to price in the possibility of fiscal easing in the U.S., anticipating a clean sweep at the polls by either party." - source Bloomberg

While we have touched on "Vol Control Products", "balanced funds" and CPPI, no doubt to us that very successful "Risk Parity Strategies" could as well be impacted by the rising trend as put simply by Bloomberg in their article:

"The diversification benefits of a traditional 60/40 (stocks/bonds) portfolio would disappear in such an environment, causing portfolio managers to scramble and search for a new hedge." - source Bloomberg

In our Society of the Friends of Truth, which you hereby are a member by now, in our "investing book", these strategies are indeed directly threatened by the rise of "positive correlations". On the subject of "Risk Parity Strategies" we would like to redirect you dear member to the guest post from our Rcube friends  which we published on the 14 August 2013 entitled "Is Risk Parity a Scam":

"Because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a big rotation that would bring 10-year yields back to a theoretical long-term equilibrium value.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…
From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself."

Conclusion

Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance based arguments that are often put forward by the proponents of risk parity.
From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:
1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategy's performance under different scenarios.
2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.
3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.
4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.
5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.
For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).
There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's numerous flaws.

However, we have little doubt that when the next "black swan" terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage one's life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.-"Is Risk Parity a Scam", August 2013

We could not agree more with our friends.  In addition to this, dear member of "The Society of the Friends of Truth", is that when it comes to Risk Parity and "Risk" we reminded ourselves Bank of America Merrill Lynch US Equity Derivatives Research note from the 30th of August 2015 entitled "Risk parity is not the risk, vol control is, but how big is it really?":

"Risk parity is not the risk, vol control is
Much has been made recently of the threat of forced selling by risk parity funds during market shocks as volatility spikes. However, the risk in our view lies not in the basic construct of a risk parity fund, but rather in the risk-management mechanism often overlaid onto risk parity funds (as well as other funds) which aims to manage an investment such that it has constant volatility. This “target volatility” risk overlay is a dynamic portfolio rebalancing mechanism that can induce rapid shifts in a portfolio’s allocation, particularly when volatility spikes from a low base level, which is when these funds apply maximum leverage.

The perverse side effects of vol of vol tail events

Our core thesis for volatility in 2015 was that we would witness a greater number of “local tail events” or contained but violent shocks in markets including volatility due to bank deleveraging, waning liquidity and the growth in high frequency trading. The recent market events appear to be yet another example of these risks playing out. A byproduct of these violent shocks, which erupt from a calm, low vol market, is true tail events in the volatility of volatility – the VIX recorded its largest 2-day percentage rise in history last week. This is also a toxic mix for strategies that aim for constant volatility exposure as the amount of leverage they employ is directly linked to their volatility.

Vol control applied to risk parity can further exacerbate risks

Because risk parity funds are inherently low volatility strategies (the recent volatility of an unlevered fund is less than 5%), they are often levered to achieve higher volatility (and higher returns), and in many cases a volatility control is also overlaid to maintain a more constant risk exposure through time. Risk parity derives its low volatility from the diversification benefits of holding both stocks and bonds in equal risk weighting. However, if a spike in volatility occurs at the same time that bond/equity correlation breaks down, this will lead to even larger spikes in risk parity volatility and therefore greater de-leveraging. In theory if these funds were large enough, their rapid liquidation of both bonds and stocks could lead to heightened correlation thus further exacerbating their rise in volatility and demanding further deleveraging.

From theory to reality, near term risks are much reduced

Volatility control is a dynamic risk-management strategy that has been applied widely in
recent years, not only to risk parity funds. If we assume $400bn in risk parity funds, half of which use vol control, we estimate recent events could have generated $30-$80bn in selling pressure on equities and $50-150bn on bonds. Estimated selling pressure from risk-control funds applied to non-risk parity portfolios could equate to an additional $25bn- $50bn in equity selling, which together is less than 10% of the $1.7tn of S&P 500 e-mini futures traded last week. Interestingly, we also see almost no evidence of impact on the Treasury futures market despite estimated liquidity demands from risk parity rebalancing being even greater. This selling pressure also assumes funds all operate mechanically. Many funds can exercise discretion to smooth out their rebalancing. Importantly, for those funds that operate mechanically, they likely have already de-levered, and with volatility now elevated, further shocks will be much less impactful." - source Bank of America Merrill Lynch.

By now you probably understand our "nervousness" in these strategies given that if correlations break down, and they are by the way, then no doubt that there is a heightened risk of "fast and furious" deleveraging at play.

All these strategies suffer from not only "optimism bias" but from a "herd mentality", meaning everyone is playing the same way, this for us reinforce somewhat this "doom-loop" or negative feedback loop which would entail much steeper drawdowns for these strategies than anticipated. All in all, these strategies we discussed are very sensitive to a spike in volatility, and what matters therefore as shown by the "Brexit" episode is not the news outcome but the "velocity" of the news to have an impact on the forced deleveraging prospects for these investment strategies mentioned. After all asset allocation strategies allocate capital on the basis of volatility. When "The Cult of the Supreme Beings" aka central bankers mess with the signal (VIX index), we wonder how "Vol control" is going to operate if indeed we get very large volatility moves going forward as put it bluntly by Bank of America Merrill Lynch in their 2015 report:

"It is really the combination of a sudden, violent drawdown following an extended period of calm that is most toxic for target volatility funds and generates the largest potential rebalancing needs" - source Bank of America Merrill Lynch

So what to do in this kind of "environment", we think that "diversification" is being threatened by rising positive correlations, therefore, increasing cash levels, cash being a strategy is therefore paramount in the case of violent intraday drawdowns and sudden spike in volatility.

When it comes to Fixed Income, what would really drive a sell-off in the asset class, would be a return of inflationary pressures. When it comes to our views, us being members of the Society of the Friends of Truth, we are in the "lower for longer" camp and until we see a clear manifestation of wages pressure in the US we will sit tightly in the deflationary camp. This brings us to our second point about "inflation" and "flows".

• Macro and Credit  - Is inflation back into play?

While back in March 2016 in our conversation "Unobtainium" we discussed the possibility of a rise in inflation hence the current perceived heightened risk of a rate hike in September by the Fed. Back 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

Obviously has indicated by Markit, our case for UK linkers in August clearly blew away our preference given the performance of UK linkers over US linkers with a very significant performance overall:

- source Markit, H/T Simon Colvin

But, given our "deflationary" incline and the embedded deflation floor of US linkers, from a diversification perspective we continue to like the asset class, particularly given as of late of the significant inflows through ETF as indicated by Société Générale in their ETF Market Signals note from the 5th of September entitled "Record creations on inflation-linked bonds":

"Inflation-linked bonds came back to net creations after net outflows in July and posted all-time-high $600m monthly inflows, mainly thanks to USD denominated benchmarks (see chart 6).

- source Société Générale

 
 Now, as per our October 2015 conversation, inflation-linkers, even in a rising cross-asset correlation world bring diversification benefits, although they have not been immune to the rising trend in cross-asset correlations. However their embedded deflationary floors at least for US linkers make them, we think particularly attractive. What is of interest is that unlike US TIPS, Gilt linkers do not benefit from this "deflation" floor. In a growing NIRP world with now some European Investment Grade companies (Henkel, Sanofi), US linkers have the advantage that both the principal face value and the coupon payment can never decline below the value at issuance. How that for a financially repressed world we dare to ask dear members of the Society of the Friends of Truth?

If we are indeed, in a prolonged period of deflation, such as the one we think we are currently experiencing, the embedded "deflation floor" both applied to the stated coupon as well as to the face value of the bonds. These are indeed very interesting features that should not be neglected when selecting an exposure to the index-linked sovereign bond markets. This is particularly true for believers like us that, the US economy is weaker than what every pundits think and that, going forward, US growth is likely to disappoint (see recent PMI for services for example...).

As we asked ourselves back in October 2015, could the  the Fed really hike when US breakevens are falling , which could be clearly indicative of deflationary forces at play? This also another reason why the embedded "deflation floor" in US TIPS is so enticing:

- graph source Thomson Reuters Datastream - H/T Warburg on Twitter

But, there is a caveat, with the on-going discussions surrounding "fiscal stimulus", especially in the US as both presidential candidates are pushing for it. As well at play, we think there is, in similar fashion to "Brexit", markets it seems are falling once more for an easy victory for Hillary Clinton it seems. 

We know how that played out for "risky assets" once the news hit the screens. On that subject we read with interest Bank of America Merrill Lynch's Cause and Effect note from the 26th of August entitled "Pricing a perfect gridlock":

"Gridlock = Goldilocks

Our analysis suggests the market is pricing an easy victory for Hillary Clinton but a split Congress in the November elections. In other words, the market is pricing a high probability of continued gridlock in Washington. We believe this is the reason why the market is long risk parity trades and short volatility right now.

Risk-off ahead of November 8

Risk parity portfolios have not done well when uncertainty and volatility go up. History tells us to expect Clinton’s lead to narrow and volatility to rise in the final stretch of the elections. We recommend buying a 3-month AUD/USD digital put to position for a possible unwinding of risk parity trades that can become self-fulfilling once it starts.

Clean sweep = higher USD and higher US rates

We cannot remember the last time the FX and the rates markets have so much at stake in a US election. While gridlock probably means lower rates and a weaker USD, a clean sweep would likely lead to both higher USD and higher rates over the medium-term, in our view. We believe the volatility market is underpricing the bi-modal nature of the outcome of the election for US fiscal policy outlook." source Bank of America Merrill Lynch

From our perspective, as members of The Society of the Friends of Truth and given our long lasting contrarian stance, we would tend to fade the "easy victory" for Hillary Clinton and as, we posited in our first bullet point, we would rather go short risk parity trades and long volatility right now, no offense to Bank of America Merrill Lynch. We do not want to suffer from "Optimism bias" but we are not yet falling for the "pessimism bias", we tend to sit nicely in the "realistic bias" camp. Overall, the big issue for risk parity trades comes when both volatility and correlation of the underlying components rise together. This we think is going forward a very important factor to keep in mind. Furthermore, we think that option markets are too complacent and pricing too little of a potential move. With risk parity still remaining levered at elevated levels, this we think could turn out to be a "bad recipe" for asset prices and significantly "boost" the "velocity" in the surge of "volatility".

When it comes to our inflation expectations, we continue to believe that wages acceleration hold the key to the "recovery story", so far, we are not buying it, and we will continue to fade it hence our attraction for the embedded deflation floor of US linkers.

For our final chart, we would like to point out to our fellow members of the Society of the Friends of Truth, that the unintended consequences of the "The Cult of the Supreme Beings" aka central bankers has had an impact on hedging budgets (particularly because both duration risk and credit risk have risen).

• Final chart: The downward trend in bond yields has limited insurers' hedging budgets

Our final chart comes from Deutsche Bank' s Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions". It shows that the unintended consequences of the trend in low bond yields has limited insurance companies' hedging budgets:

"Low interest rates, high vol-of-vol, and volatility aversion have driven growth

Three financial market trends have been catalysts for growth of vol control
products:

■ High vol-of-vol. Volatility itself has been volatile for the past few years, and as a result insurers' hedging costs have been changing quickly. In this environment, vol control funds' more stable volatility profile is particularly valuable to issuers.
■ Low interest rates. Interest on invested funds can be another source of hedging funds for insurers. With US interest rates repeatedly hitting new lows, insurance companies have little margin for error. Stabilizing hedging costs is one way to reduce the need for this cushion.
■ Post-financial crisis worries. Investors continue to be haunted by the ghost of 2008: recency bias has driven heightened worry about another 2008-like event. This volatility aversion has made volatility control attractive to investors (as a peace-of-mind feature) - even in products that do not have the technical hedging needs that drive much of the growth." - source Deutsche Bank

Furthermore, there is a well a clear warning in Deutsche Bank's note for the pundits such as pension funds that keeps picking up pennies in front of a steamroller namely selling volatility:

"Tail protection for short vol strategies increasingly timely at low vol levels

The growth of vol control products has, at least at the margins, the potential to re-frame how volatility sellers manage their positions. Conventional wisdom has typically been that selling vol is more dangerous at very high vol levels than it is at low levels despite the seemingly more attractive entry points. However, the potential for market feedback loops like vol control funds to intensify selloffs that start at low vol levels makes short vol strategies riskier at low starting vol levels - increasing the need for tail protection as an overlay." - source Deutsche Bank

 As a member of the Society of the Friends of Truth, we could not agree more. Any good trader will tell you that being short gamma is a very poor risk/return proposal....particularly pension funds with fiduciary duties we think...

"In a time of universal deceit - telling the truth is a revolutionary act." -  George Orwell

Stay tuned!

Macro and Credit - The Law of the Maximum

"Capitalism believes that its remit is exclusively to make maximum short-term profits." -  Jeremy Grantham

While watching "market's gyrations" in anticipation of the gathering of "The Cult of the Supreme Beings" aka central bankers at Jackson Hole and the much anticipated speech of Janet Yellen in conjunction with French dairy farmers protesting against low prices and their fight with industry giant Lactalis, we decided we would make yet again a reference to the French Revolution as per our latest musings when it came to choosing this week's title analogy. The Law of the Maximum was a law created during the course of the French Revolution as an extension of the Law of Suspects on 29 September 1793. It succeeded the 4 May 1793 "loi du maximum" which had the same purpose: setting price limits, deterring price gouging, and allowing for the continued flow of food supply to the people of France. Numerous food crisis during the French Revolution which led to speculation on a grand scale were linked to the "inflationary" bias of the much dreaded heavy issuance of "assignats" which lost rapidly their value, a subject we discussed in our previous conversations. According to Andrew Dickson White, Professor of History at Cornell, the ever greater and ultimately uncontrolled issuance of paper money authorized by the National Assembly was at the root of France's economic failure and most certainly the cause of its increasingly rampant inflation. This is as well confirmed by French economist Florin Aftalion 1987 in his seminal book entitled "The French Revolution - An Economic Interpretation" we have been quoting as of late.  What we find of interest with our title, from a historical perspective is that with the repeal of "The Law of The Maximum" in December of 1794 came inflation, mass economic strife and riots that ultimately lead to the rise of the Directory and the end of the Thermidorian period. As per our last conversation, not only did "The Cult of the Supreme Being" contributed to the Thermidorian Reaction and the ultimate demise of Maximilien Robespierre, its instigator, but, "The Law of the Maximum" was as well an important factor. By now, you probably understand our "pre-revolutionary" mindset when it comes to the selection of our recent title analogies. We would posit that NIRP, to some extent is akin to "The Law of the Maximum" and creating as such a very strong "hoarding" mentality leading to the unintended consequence for some consumers to increase their savings and company to delay "investing". In our last conversation we argued, while as well the Law of the Maximum encourages even more the search for short-term profits as highlighted above in our introductory Jeremy Grantham quote:

"No offense to the Supreme Being Cult members out there, but, in our book, NIRP is insanity as there cannot be productivity and economic growth without accumulation of capital, because simply put, NIRP is killing capital (savings)." - source Macronomics, August 2016.

In this week's conversation we will revisit again the lack of "credit impulse" and "credit growth" in Southern Europe in conjunction with our "japanification" theme given that the "capitalization weakness of some European banks have yet to be addressed.

Synopsis:

• Macro and Credit - Thanks to NIRP, for European banks, "japanification" is at play
• Macro and Credit  - ECB and NPLs? Either put up or shut up
• Final chart: US Investment Grade credit, great returns for less risk, we told you so...

• Macro and Credit - Thanks to NIRP, for European banks, "japanification" is at play

While like many pundits we have repeatedly pointed out that the credit transmission mechanism was broken in Southern Europe because these specific European banks were capital constrained. Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

Back in September 2015, we pointed out the following in our long conversation "Availability heuristic":

Before we delve more into the nitty-gritty of our second point, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 

"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 

We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org

We have always wondered in relation to the global rounds of quantitative easings the following:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think." - source Macronomics, September 2015

What is very clear to us is that the Fed and the ECB have been following different path, which obviously have led to different "growth" outcomes in recent years. The lack of "credit impulse" in Italy for instance, leading to lack of economic growth is entirely due to the capital constraints put on already stretched balance sheets of Southern European banks which had no choice but to collapse their loan books, in effect, the credit crunch in Europe was a self-inflicting wound. The "japanification" outcome of the European banking sector is well described by Deutsche Bank in their European Banks Strategy note from the 25th of August entitled "More Japan than US playbook":

"Our core investment thesis for European banks remains unchanged: the net interest income outlook remains at the forefront; litigation and regulation are more idiosyncratic while politics remains an unknown. In this context, we continue to favour Nordic, Benelux and French banks, remain Underweight Italian banks and avoid UK and Spanish banks, as well as Wealth Managers.

More Japanese, than US Playbook

The lower-for-even-longer rate environment remains a critical headwind with the sector. Margin compression over the past year should be seen in the context of a multi-year trend similar to Japan and the US through extended QE. Indeed, our economists anticipate a 9-12 month extension of QE in September and complementary moves to ensure a sufficient supply of bonds.

Indeed, a 5% change in NII has a 10% impact on PBT ie amplified by a factor of c2x, all else being equal. Our Margin Monitor continues to demonstrate a steady grind of back-book (ie stock) spreads (4bps pq) implying NIM erosion of c7% pa. Moreover, front-book (ie flow) spread compression accelerated to 8bps pq.

Recent credit impulse metrics do not suggest a meaningful pick-up in credit growth (see Figures 32 and 33).

With euro area credit growth of ‘only’ c1%, further NII pressure seems inevitable. In other words, the euro area experience appears much more like the Japanese than the US playbook where loan growth compensated for NIM pressure.

More Value Trap, Than Value

Year-to-date, the sector is down c25% vs earnings downgrades of c23%. In other words, the sector performance predominantly reflects earnings trends rather than a valuation de-rating. Furthermore, relative sector performance continues to demonstrate a strong correlation with 10yr Bund yields, or the rate environment more broadly. The decline in swap rates will also continue to have implications for pension deficits and capital ratios.

Following c6% decline in 2016E, consensus expectations are for c1-2% pa NII growth over 2017-18E. Thus, further reductions in consensus earnings expectations seem inevitable. Hence, we continue to believe that the sector – despite trading at an optically cheap PTBV multiple of 0.8x – is more value trap, than value.

Risks Rising for the UK; Nordic and Benelux Offer US Playbook

Much of European banking reflects the Japanese playbook namely ongoing margin compression only partly offset by credit growth. If anything, we believe that the recent combo of 25bps rate cut and launch of Term Funding Scheme by the Bank of England could imply that the UK may follow the euro area experience of TLTRO. Beyond the near-term positive of deposit and funding costs decline, asset spread compression and lack of meaningful credit pick-up has weighed. Hence, we continue to avoid the UK with earnings risks rising." - source Deutsche Bank

We could not agree more, in our "playbook" European Bank stocks are more a trap than a value play hence our continue distaste for the sector. We would stick to "credit" when it comes to banks, rather than side with the many sell-side pundits that keep trying to sell us the "optically cheap" fallacious argument.

Furthermore, the growth outlook for Southern Europe is much more linked to the ability for their banks to provide credit to corporates and in particular Small to Medium Enterprises (SMEs). This is as well clearly illustrated in the below Deutsche Bank chart from their report:

- source Deutsche Bank

This leads us to our second point about the need to deal swiftly with Nonperforming loans and "capital constrained" banks (the politically correct of describing them...).

• Macro and Credit  - ECB and NPLs? Either put up or shut up

In our previous conversation and in relation to the aforementioned different growth outcome and trajectories between Europe and the United States, we indicated the following:

"We keep hammering this, but, our "core" macro approach lies in distinguishing "stocks" from "flows". When it comes to dealing swiftly with "stocks" of Nonperforming loans (NPLs) such as in Italy via "flows" of liquidity, it looks to us that the "Supreme Beings" do not understand that "liquidity" doesn't equate solvency.", source Macronomics, August 2016

Yet, the Nonperforming loans issues (NPLs) which are particularly acute in Italy have yet to be addressed, making it difficult for the "credit impulse" to be restored and therefore hindering any significant positive growth outcome for the likes of Italy and even Portugal. This is clearly indicated as well by Société Générale from their "On Our Minds" note from the 26th of August entitled "Bank loan take-up shows weak transmission of monetary policy":

"There have been encouraging signs in the growth in euro area lending to the private sector – with acceleration to 1.4% yoy in July from 0.6% the previous year. Interest rate spreads have narrowed materially, but signs of financial fragmentation remain in the volume of new bank loans. The bulk of the flow of loans to households and firms comes from the two largest countries, Germany and France. The transmission of monetary policy is thus not yet sufficiently uniform. Unsurprisingly, the countries where banks are struggling to increase their net lending also have the highest NPL ratios. Hence, fixing these weaknesses should be a key priority for euro area policymakers (SSM, EC and national authorities) in the coming years. All this could help rebuild some confidence in the euro area banking sector, although we still believe that credit demand will continue to be dampened by high political uncertainty (e.g. referendum in Italy this autumn, political gridlock in Spain, elections in France and Germany), low growth prospects and necessary deleveraging in some countries. Moreover, the process of disintermediation is accelerating: this weighs on bank profitability, while SMEs have little access to credit. To our minds, the need for government actions remains decisive: reforms capable of boosting potential growth and communication aimed at reducing policy uncertainty.

Over the past few months, there have been two noteworthy trends. First, loan take-up is highly fragmented. The bulk of the flow of loans to households and firms comes from the two largest countries, Germany and France. In some smaller countries (Portugal, Austria) loan take-up by SMEs has actually fallen, despite lower interest rates.

Second, the ECB CSPP has triggered a strong recovery in corporate bond issuance and this is weighing on the flow of bank credit to large firms.

Fragmentation still there in loan take-up

Since 2012, ECB policy has eased bank funding conditions (e.g. low money market rates, QE,TLTRO I and II). Between 2012 and 2014, the pass-through to end-customers was disappointing. Since 2014, however, the improvement in peripheral country bank lending costs has been very impressive (chart 1).

Interest rates paid by end-consumers and corporates have fallen markedly, including for peripheral banks. Discrepancies in lending rates between core and peripheral countries have narrowed significantly. There is no doubt that the transmission of monetary policy through the euro banking channel has improved.

In terms of loan take-up, the outcome is less clear. While growth in lending to the private sector recovered gradually in 2015-16 and stood at 1.7% yoy in July, this recovery has been more heterogeneous and has come mainly from core banks, German and French institutions in particular (chart 4).

For instance, small loan volumes to non-financial corporations (NFCs, <€1m) have decreased in Portugal, Italy and Austria, despite large drops in interest rates in Portugal and Austria (chart 2). In contrast, this flow of credit to SMEs has experienced double-digit growth in France, Germany and Ireland, and this despite unchanged interest rates.

High NPLs still a hurdle for supply of loans

Part of this fragmentation reflects various credit risks, and these are unlikely to decline in the near term. The heterogeneity in bank strength is illustrated by comparing NPLs. For a number of member states, a still-large stock of NPLs and weak profitability remain headwinds to credit supply in an operating environment of low interest rates and low nominal economic growth. NPL figures support the view that the banking systems in Greece, Italy and Portugal are still unsound, whereas recent developments have been encouraging in Spain and Ireland. Italian banks represent 31.7% of the euro area total stock of NPLs, twice the size of Italy in euro area GDP. Greece (1.7% of euro area GDP) also represents 8.9% of euro area NPLs. Austrian banks (4.2% of euro area NPLs vs 3.0% of euro area GDP) and Portugal (3.9% of NPLs vs 1.7% of GDP) are also overrepresented.

During the latest ECB press conference, President Mario Draghi spent some time discussing his views on a better framework for dealing with NPLs. Firstly, there needs to be a strong supervisory approach; secondly, a fully functional NPL market; and thirdly, more government action (legislation that promotes securitisation, review of bankruptcy laws and, interestingly, a public backstop). However, the time horizon for these changes is several years. Hence, the SSM and national regulators will have to implement a comprehensive approach to deal with the banking fragilities in the coming months." - source Société Générale

Back in July we re-iterated our stance in relation to what the ECB should do in order to restore the credit transmission mechanism to Southern Europe in our conversation "Confusion":

"The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":

"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016

 As highlighted above by Société Générale, time is running out and we do not think the ECB has several years when looking at the situation in Italy or the recent cash injection by Portugal in its ailing CGD bank of €2.7 billion. While the Italian situation has been well commented and documented including by ourselves in April this year, Banco Novo situation has yet to be resolved. This is clearly indicated by credit markets in both cash prices and synthetic (CDS) prices as described by Datagrapple in their 26th of August post:

"After Portugal’s state-owned bank Caixa Geral de Depositos’ recapitalization plan early in the week, we had a brief respite on the Portuguese banks. However, the situation at Banco Novo is unclear. Banco Novo is the good bank created in August 2014 out of Banco Espirito Santo (BES) - transferring BES’s good assets. Two years later, Banco Novo’s short dated senior debt is now trading at distressed levels - around 70cts on the dollar. The CDS is trading at 30% upfront plus 5% for a one year protection. This CDS is one of the most technical and, let’s say, controversial special situations of the CDS market, with contracts outstanding under 2 different rules (2003 and 2014) already offering different definitions of what constitutes a credit event not to mention the further complication even if under 2014 rules of what is determined to be a Government intervention or not (ref Banco Novo transfer of bonds announced end-15). According to the attached Grapple, the probability of a credit event within a year has moved from 25% to 50% over the last month. The situation is turning sour. For an outsider, buying a pool of assets from a distressed bank is an investment decision whilst buying a distressed bank’s stress resilience could be more like an act of faith." - source Datagrapple

So either "Le Chiffre" aka Mario Draghi put up, meaning monetizing the lot, or he should shut up because in our book, no matter how charming the bluff he has pulled in the past with his July 2012 "whatever it takes" moment and his OMT, when it comes to ailing Southern Europe banks, it is decision time. The members of "The Cult of the Supreme Beings" might be numerous, but, saving Southern Europe banks requires more than an act of faith we think and haven't even mentioned German banks with some of their struggle with shipping loans such as HSH Nordbank, do not get us started....

As we posited in our conversation "Le Chiffre" aka Mario Draghi and given the market's anticipation for the ECB's next moves:

"QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.

Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations". - source Macronomics, October 2015

So all in all, from an allocation perspective we continue to favor style over substance, namely Investment Grade credit and particularly US over High Yield, this has bee, our call since late 2015. As well when it comes to Investment Grade, we favor nonfinancials and it isn't a question of volatility but, more and more a question of recovery value in the end. When it comes to sleeping well at night we prefer the comfort of "smart alpha" rather than "dumb beta" as per our final chart.

• Final chart: US Investment Grade credit, great returns for less risk, we told you so...

When it comes to the Law of the Maximum, in our investment book we prefer sticking with the most favorable risk/return asset class when it comes to credit. We were not surprised to see in Société Générale's Credit Strategy Weekly note from the 26th of August entitled "The five things that credit investors need to do this autumn" that indeed, when it comes to risk and returns US Investment Grade continues to be enticing in a lower for longer world (no matter how charming the Fed's bluff is these days...):

"Risk/return performance is impressive: Chart 11 plots the returns (horizontal axis) against the risk (vertical axis) of IG and HY credit, equities and sovereigns in the US, Europe and EM. The best performers have been sterling IG and US high yield this year. EM stocks have generated as much return, but with four times as much risk. IG returns in either US domestic bonds or EM corporates in USD have been close to the performance of the US stock market, but again with less risk. European returns have been the lowest, and close to sovereigns, but much better than European stocks, which are still posting losses for the year.

- source Société Générale

Credit wise, we do indeed continue to like US Investment Grade, at least US Investors do not have to compete with the likes of the ECB and the Bank of England for now...This for us is the Law of the Maximum until the Fed jumps in that is...

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

Stay tuned!

Macro and Credit - The Cult of the Supreme Being

"The supreme quality for leadership is unquestionably integrity. Without it, no real success is possible, no matter whether it is on a section gang, a football field, in an army, or in an office." -  Dwight D. Eisenhower, American president

Looking at the continuation in the rally in risky assets and watching with interest our friend Michael Lebowitz getting blocked on Twitter by Narayana Kocherlakota, the former president of the Federal Reserve Bank of Minneapolis, we made the following sarcastic comment that if you are not a "cargo cult" follower you get blocked. While being a "cargo cult member" entails various ritualistic acts such as "wealth effect" via QE not manifesting itself in the appearance of material real economic recovery, we could have used this very reference for our title analogy but, given our previous reference to the French Revolution in our last conversation, it made us want to dig further into history when it comes to selecting an appropriate title. 

The Cult of the Supreme Being (French: Culte de l'Être suprême) was a form of deism established in France by Maximilien Robespierre during the French Revolution. It was intended to become the state religion of the new French Republic and a replacement for Catholicism and its rival, the Cult of Reason. It can be easily argued that the Cult of Reason, namely reasonable/rational central banking has indeed been replaced by the Cult of the Supreme Being, namely the "cult of the central banker". The Cult of Reason distilled a mixture of largely atheistic views into an anthropocentric philosophy. No gods at all were worshiped in the Cult—the guiding principle was devotion to the abstract conception of Reason which seems to have been totally ditched by our central bankers "deities" as of late. For Maximilien Robespierre, "The Cult of the Supreme Being" was said to have contributed to the Thermidorian Reaction and the ultimate downfall of Robespierre and his execution.

Furthermore, in our July conversation "Confusion" we made another reference to French economist Florin Aftalion 1987 seminal book entitled "The French Revolution - An Economic Interpretation" given the extension of Negative Interest Rate Policy now in German banks affecting retail deposits above the €100,000 threshold, the words of revolutionary figure Louis Antoine de Saint-Just, one of Robespierre's closest ally during the French revolution who ended up guillotined the very same day on the 28th of July 1794 are very interesting in relation to "monetary creation" and "assignats" we have discussed in our recent musings:

"There is no money-saving going on nowadays. We have no gold, and yet a state must have gold; otherwise it is basic commodities that are piled up or kept back, and the currency loses more and more value. This, and nothing else, lies behind the grain shortage. A labourer, having no wish whatsoever to put paper money in his nest-egg, is very reluctant to sell his grain. In any other trade, one must sell in order to live off one's profits. A labourer, however, does not have to buy anything, for his needs have nothing to do with trade. This class of persons was accustomed to hoarding every year, in kind, a part of the produce of the earth, and nowadays it prefers to keep its grain rather than to accumulate paper" - Louis Antoine de Saint-Just.

No offense to the Supreme Being Cult members out there, but, in our book, NIRP is insanity as there cannot be productivity and economic growth without accumulation of capital, because simply put, NIRP is killing capital (savings).

In this week's conversation we will look at the continuation of the rally thanks to inflows which validates our short-term "Keynesian" stance. We do remain though medium to long-term "Austrian" when it comes to assessing the credit cycle and the slowly but surely tightening noose of financial conditions as displayed evidently in the below chart from Bank of America Merrill Lynch CMBS weekly note from the 12th of August entitled "Bad news is once again good news; remain overweight":

"Through the rest of 2016, we expect several headwinds to CRE price growth will remain. For instance, underwriting standards look set to continue to tighten. Over 44% of respondents to the most recent Senior Loan Officers Survey, which was released last month, indicated they were tightening underwriting standards (Chart 24), although the OCC’s most recent semi-annual risk report says differently. Regardless, with the topic squarely on the regulators’ radar screens, we think it is only a matter of time before underwriting standards begin to tighten, particularly for smaller local and regional banks. " - source Bank of America Merrill Lynch.

Of course the evolution of US Senior Loan Officers Survey is worth tracking as it will clearly impact going forward the default rate and the US High Yield asset class. For now, everyone is "dancing", but, we think, it's worth "dancing" closer towards the exit we think, hence our recommendation in favoring "Style" over "Substance", namely US Investment Grade over US High Yield or playing simply the "beta" game.

Synopsis:

• Macro and Credit - The melt-up is "Breaking bad" thanks to "cult members" inflows
• Macro and Credit  - While credit spreads are grinding tighter, quality is eroding faster
• Final chart: US Investment Grade credit - Growing duration mismatch between cash and synthetic

• Macro and Credit - The melt-up is "Breaking bad" thanks to "cult members" inflows

When looks at the continuing rally into risky assets and particularly "credit", one would indeed conclude that the cult of the Supreme Being is alive and well particularly in the light of some long dated corporate bonds trading in the region of $200 cash price. As indicated by the Financial Times in their article "Latest bond rally eye sore: one for the price of two", "Bondzilla" the NIRP monster is getting bigger every day thanks to the Supreme Being cult members:

"The Bank of England’s recent stimulus splurge, including a move to buy corporate paper, has driven the market prices for several sterling corporate bonds up to more than two times their initial face value, even for those unlikely to qualify for the central bank’s shopping list, writes Joel Lewin.
The price of US industrial conglomerate General Electric’s 2039 sterling bond, for example, has rocketed to a record high of 215.5 pence on the pound. That’s up from 165p at the start of the year and 100p when it was issued in 2009.
The yield has plunged from more than 10 per cent in 2009 to a low of 1.805 per cent.
Coupons aside, paying £215.50 today to be repaid £100 in 2039 amounts to a capital loss of 5 per cent every year for the next 23 years. Tasty.
“It’s another sign of how far central banks have pushed things,” says Luke Hickmore, a senior investment manager at Aberdeen Asset Management.
National Grid Gas’ 2044 bond has surged from 154p at the start of the year to 205p.
While those are the only two sterling corporate bonds* past the 200p mark at the moment, according to Bloomberg data, a number of others are on the brink." - source Financial Times

In conjunction to cult members being induced price wise by their Supreme Being, putting aside any reason or rational thinking, flow wise, the latest move by the Bank of England has also added fuel to the fire leading to some "overdrive" in spread tightening but inflows as well! This can be clearly seen in the United Kingdom credit markets as shown by Bank of America Merrill Lynch in their Follow the Flow note from the 12th of August entitled "Thank you Carney – Largest inflow ever":

"The state of play: IG > EM > HY >Equities
In a world dominated by central banks’ QE programs, BoE has been the latest to join – or re-join – the party. Last week’s inflows into sterling IG funds were the largest ever.
Since the ECB announced the CSPP, $30bn has flown into IG funds. And from February’s risk assets lows, equity funds have lost $82bn. During the same period, EM debt funds have been boosted by $28bn of inflows. 

High grade funds recorded their 22nd week of inflows. Despite getting into August, inflows to the asset class remained strong. High yield funds retraced back from negative territory with a marginal inflow. As shown in chart 13, inflows emanated mainly from global and European funds, while US-focused high yield funds recorded outflows.

Government bond funds recorded their second week of inflows. Money Market funds flows also remained positive for a second week.
Outflows from European equity funds continued for a 27th consecutive week. The intensity of the outflows – which peaked in mid-July – has been slowing down over the past four weeks.

EM global debt funds recorded a sixth week of inflows, but the summer season is taking its toll on the flow strength. Commodity funds recorded their 16th consecutive inflow, the 31st so far this year, and the highest in four weeks.
Looking at duration, all parts of the IG curve recorded strong inflows. Short-term funds recorded their third consecutive inflow, slightly lower than the previous week, but still high in AUM % terms. Mid-term IG funds had their seventh week of inflows, while longterm ones had a sixth positive week." - source Bank of America Merrill Lynch

We might be sounding like a broken record, at least for our "Cult of Reason" members, but, the "Supreme Beings" of various central banks are not only pushing investors outside their comfort zone into credit risk they should not be taking, they are also pushing them into increasing significantly duration risk rest assured. Some are indeed racing into the "beta" transformation game into "alpha", in a dwindling liquidity world, this will not end well, but, for the time being it's "rally monkey" time for the Cult of the Supreme Being Members.

While we are indeed tactically bullish for "religious" reasons, we do think that we are witnessing the final melt-up in risky assets given that many signs are starting to add up when it comes to gauging the state of the credit markets. 

When it comes to "Bondzilla" the NIRP monster now close up to $13.4 trillion, we expect the Japanese to come back into play in September thanks to additional "unconventional" measures from the Bank of Japan, and their "zealous devots". 

In a world turned upside down by rising "financial repression", Bondzilla's growth is evidently more and more "Made in Japan". This can be clearly seen in the below Nomura chart from their Flow Monitor note of the 8th of August entitled "Lifers’ foreign bond investment reached a record high":

"Japanese foreign portfolio investment accelerated in July. Excluding banks, Japanese investors bought JPY3287bn (USD32.2bn) of foreign securities in July, a much higher pace than in June. Life insurance companies’ foreign bond investment continued to accelerate, although we judge most was on an FX-hedged basis. Toshins also increased foreign investment in July. On the other hand, pension funds decreased their foreign investment. Although retail investors’ foreign investment is likely to stay weak for now, their risk appetite for foreign investment should improve thanks to the supplementary budget. Pension funds will probably remain dip-buyers, but their additional capacity to buy foreign securities also increased. 

Foreign portfolio investment stayed strong in July 

According to the International Transactions in Securities for July, released on 8 August by the MOF, Japanese investors bought a net JPY6,365.6bn (USD62.4bn) in foreign securities (equities and intermediate and long-term bonds). Since banks were major net buyers of foreign bonds at JPY2,685.7bn (USD26.3bn), this represents a sharp gain over the previous month (JPY2,453.0bn in net buying). If we eliminate the bank accounts that carry out FX-neutral short-term trades, net buying amounted to JPY3,286.5bn (USD32.2bn) in July. This is a major increase in net buying over the previous month (JPY2,311.7bn in net buying; Figure 1).

The breakdown by asset shows that Japanese investors were net buyers of JPY522.8bn (USD5.1bn) in foreign equity, flat over the JPY525.6bn in net buying the previous month. At the same time, they were net buyers of JPY2,763.7bn (USD27.0bn) of foreign bonds, up sharply over the previous month (JPY1,786.1bn in net buying).

Lifers bought foreign bonds at the highest pace
Life insurers bought a net JPY2,037.8bn (USD20.0bn) in foreign bonds, the highest net buying since these data began to be compiled (Figure 2).

This is also the eleventh straight month of net buying. With 20yr JGB yields near 0%, foreign bond investment has picked up sharply as lifers look for even slightly higher yields. Although JGB yields have risen to the 0.3% range again, we expect foreign bond investment to continue at a pace of more than JPY1trn per month if yields remain at current levels.
That said, we expect most of their foreign bond investment to be hedged. Although USD/JPY rose to the 107 range in mid-July in response to heightened expectations of BOJ easing, lifers took a cautious view of the July BOJ policy board meeting. They likely bought hedged foreign bonds and also increased currency hedges. Accordingly, despite a large amount of foreign government bond investment, upward pressure on USD/JPY should be minimal, in our view. Nevertheless, some lifers seem to be starting to buy unhedged foreign bonds at rates near JPY100.
With the US presidential election about to get under way in earnest, we see little chance of investments in unhedged foreign bonds picking up significantly. We expect lifers to continue investing primarily in hedged foreign bonds in the near term. " - source Nomura

While the ECB and now the Bank of England are in the corporate bond buying business making the "fun" going "uphill" thanks to the "wealth effect" and in no way flowing "downhill" to the "real economy" that is, the Japanese investor crowd is ratching up its bidding as the competition for financial assets rises.

A good illustration of the success of the Cult of the Supreme Being, when it comes to "capital destruction" can be seen in Japanese's net household savings rate thanks to "financial repression" as well as major demographic headwinds as illustrated in the below chart from Deutsche Bank's Japan Economics Weekly note from the 5th of August entitled "Inconsistency of policy to promote 'savings into investment'":

"Japanese households have been said to be persistently highly risk-averse, with a strong preference for financial assets with principal guarantees. This tendency has been structural, both in the bubble era and now. Financial flows from households since the end of the 1990s show continued inflows into principal-guaranteed financial assets, including cash, deposits, government debt, insurance, pensions and corporate bonds, with the exception of 2006-08. In the most recent years, fiduciary trusts have become popular, mainly for inheritance reasons, although inflows to these assets remain small.
The Japanese government plans to expand the eligibility for the personal defined contribution pension system (personal DC) to house wives, employees in the government sector, and those in the private sector whose employers are equipped with corporate pensions. The eligibility is said to expand by 26m people. The personal DC account has tax benefits of 1) fully deductible contributions from income, 2) no tax on investment returns and 3) taxdeductible benefits after retirement. These are much more generous than NISA (Nippon Individual Savings Account), which was introduced in January 2014, with active accounts of 2.9m. NISA’s sole tax advantage is #2 above. We believe that financial inflows from households into the expanded personal DC will likely be JPY3.1tr a year, twice the size of the inflows via NISA. However, a large part of these new inflows should go into principal-guaranteed assets.
We are curious about the effect of the introduction of these investment schemes with tax benefits on the household saving rate, which has been stuck near zero over the past ten years. Considering various strong headwinds against target savers, such as lack of income growth and inability to save, strong preference for principal-guaranteed assets, persistent low interest rates, QQE for more than three years and the introduction of negative rates in January, we believe that the households could view this expanded personal DC as a tailwind to mitigate those headwinds. This could lead to a continued rise in the household saving rate that began in 2015 well into 2017 and beyond, and might pose a downside risk in the near-term economic outlook. 

The proposition of ‘savings into investment’ contains misleading elements. Investing (in flow terms) in financial assets is nothing more than giving up current-period consumption out of disposable income for saving (in flow terms), regardless of its destination (say, bank deposits or equities). The proposition of mobilizing households’ financial assets (in stock terms) worth JPY1,700tr into investments does forget that these financial assets have already been deployed to the final borrowers, regardless of its channels (i.e., directly through capital markets or indirectly via financial intermediaries). There is no guarantee that the use of these funds by the current borrowers is inefficient and that by alternate borrowers is efficient." - source Deutsche Bank

We will not go back into the false "rethoric" from "The Cult of the Supreme Being" related to the "Savings glut" as we have already touched on this very subject in February in our conversation "The disappearance of MS München". Put it simply, no offense to the "zealous devots" of the "Supreme Beings" but in our book (and also in Claudi Borio's book from the Bank for International Settlements), "financing" doesn't equate "savings", at least in our cult, "The Cult of Reason" that is. If NIRP is killing "savings", there cannot be "proper" financing" to the "real economy" as stipulated earlier on in our conversation.

Furthermore, we keep hammering this, but, our "core" macro approach lies in distinguishing "stocks" from "flows". When it comes to dealing swiftly with "stocks" of Nonperforming loans (NPLs) such as in Italy via "flows" of liquidity, it looks to us that the "Supreme Beings" do not understand that "liquidity" doesn't equate solvency.

Moving one to our second point, while the rally is "technically" driven thanks to "financial repression" thanks to the mischiefs of the "religious cult", we continue to believe we are in the last inning of this credit cycle, making us continue to believe in quality and capital preservation rather than chasing yield for the sake of it.

• Macro and Credit  - While credit spreads are grinding tighter, quality is eroding faster

As we pointed out at the beginning of our conversation, we will continue to monitor closely US Senior Loan Officers Surveys in the coming quarters as it has always been driving the default rate in the past. Of course "flows" are driving the relentless search for yield while "credit tourists" are punting for "beta" but, nevertheless, we do believe that no matter our "zealous" the members of the "Cult of the Supreme Beings" are, the credit cycle is slowly but surely turning. On that note we read with interest Wells Fargo Securities latest Credit Connections note from the 12th of August entitled "The Linchpin":

"Credit spreads remain in a sideways pattern with a bias to grind tighter. We expect this trend to persist as we work through the dog days of summer. With Q2 earnings largely complete, coming in modestly better than expected, and most central banks on holiday, the market has little to focus on other than the regular flow of economic data and the technical underpinnings of demand and supply. On balance, the technical backdrop remains the dominant thread and remains supportive of a firm market tone as inflows to credit more than outpace bond issuance. Conversely, credit quality continues to slowly, but persistently erode as companies borrow money at a much faster pace than they earn it. To be fair, the steady drop in the cost of borrowing has helped alleviate some of the pressure. But with most of the proceeds going toward share buy backs and dividends, the funding gap within the corporate sector continues to expand and leverage is on the rise. Finally, corporate credit valuations look stretched by most traditional measures. Indeed, according to our proprietary fair value model, the current high yield (HY) yield-to-worst (YTW) of approximately 6.37% is about two standard deviations rich. However, when you consider that HY YTW is approximately 600% above the risk free rate, it is easy to understand why the "reach-for-yield" trade continues in an otherwise expensive market. As such, we continue to advocate a Neutral/Market Weight allocation to IG and HY credit to capture current yield, and emphasize sectors that offer "defensive carry." These include IG and HY Communications, IG Utilities, IG Consumer Staples and HY Consumer Discretionary.

Corporate bond prices have been on a steady march higher this year as interest rates have plunged, yield curves have flattened and credit spreads have narrowed following the ramp-up and expansion of quantitative easing (QE) outside the U.S. Although the U.S. Fed has not participated directly in these types of programs, its lack of action and continued dovish stance has effectively endorsed a dramatic loosening of credit conditions around the world (Exhibit 1). As such, the linchpin holding the bullish trade in corporate bonds together is on-going dovish central bank policy. To the extent it continues, credit investors should expect “more of the same,” namely, higher prices, lower yields, flatter curves and tighter credit spreads.
However, should central banks start to dial back, or simply slow, their stimulative policies, then bond prices and credit spreads could be in for a sharp reversal. To be clear, we expect "more of the same," albeit at a slower pace, as sluggish growth and tame inflation should keep dovish policies in place for the time being.

- source Wells Fargo Securities

There could no better illustration of all the "fun" playing "uphill" in the bond market that is, than the above chart. You can indeed put aside the "Great Rotation" marketing ploy by some pundits given, as we stated before, the only "riskless" game for now, worth playing thanks to the "Supreme Beings" is the bond market.

While "The Cult of the Supreme Being" is still thriving, credit investors should be well advised to read the wise words of one of the members of the "Cult of Reason, namely Nassim Taleb from his recently published note entitled "The Most Intolerant Wins: The Dictatorship of the Small Minority":

"The market is like a large movie theatre with a small door. 

And the best way to detect a sucker (say the usual finance journalist) is to see if his focus is on the size of the door or on that of the theater. Stampedes happen in cinemas, say when someone shouts “fire”, because those who want to be out do not want to stay in, exactly the same unconditionality we saw with Kosher observance." - Nassim Taleb

Whereas credit risk is increasing, giving the lower for longer mantra thanks to the macro fundamentals backdrop playing out and financial repression, not only as we have highlighted credit investors have been extending credit risk, they also have extended their duration risk, increasing in effect the duration mismatch between US cash investment grade and its synthetic credit hedge tool the CDX IG series 26 5 credit index as per our final point and final chart below.

• Final chart: US Investment Grade credit - Growing duration mismatch between cash and synthetic

While we have been recommending since the beginning of the year to favor quality over quantity (High Yield and size of the coupon that is...) through US Investment Grade credit and extended duration us, being in the camp of "lower for longer", credit investors have had no choice bit to take on both more credit risk as well as duration risk thanks to "The Cult of the Supreme Being". Our final chart comes as well from Wells Fargo Securities latest Credit Connections note from the 12th of August entitled "The Linchpin" and illustrate the growing duration mismatch between "cash" and "synthetic":

"While IG26 is a reasonable, liquid hedge for IG cash bonds, it does have some limitations. 

First, there is a meaningful duration differential. IG26 has a current duration of about 4.7 years, compared to the cash bond index of 7.5. Not only is there a difference in aggregate duration, there is a meaningful difference is where that duration comes from. Increasingly, the spread duration in the cash index is being driven by the long end of the curve, where durations continue to extend due to lower coupons.

Implications for Investors 

First, to fully hedge out a market-based cash portfolio with 7.5 years of duration, would require an extra 60% of protection to result in a CR01 neutral portfolio. The extra hedging costs would still leave the trade positive carry as even an additional 60% would only cost 114 bps based on today’s current index levels. For IG investors hedging CR01 is, in many ways, just as valuable as hedging the default risk, as the risk of spread widening is more clear and present for IG companies than actual defaults.
A second consideration is the contribution to duration within the IG market. With the long end being so key to IG investors, movements in the shape of the credit curve are also important. As a result, CDX, while a reasonable proxy for the overall IG market, can be less effective in periods of significant under- or outperformance from the long end of the market. For example, the overall market widened 32 bps in 2015, as front-end spreads widened 19 while long-end spreads widened a full 43 bps. By contrast, IG CDX widened only 22 bps." - Wells Fargo Securities

This means that as hedging tool, one would need to compensate for the extended duration rise in the cash market and needs to buy more "protection" to hedge a cash investment grade credit portfolio if ones wants to be "duration neutral" that is.

Finally for our parting quote, when it comes to "The Cult of the Supreme Being" we would like to end up our conversation with yet another extract from Florin Aftalion's 1987 seminal book entitled "The French Revolution - An Economic Interpretation", over the issues and discussions surrounding the "assignats" and what the abbé Maury, a deputy on the Right had to say about them at the French National Assembly during the French Revolution:

"What is one doing when ones creates a paper currency? One is stealing at sword point. Every man in France who owes nothing, and to whom everything is owed, is a man ruined by the paper currency. Have we the right to bring about the ruin of even a single one of our fellow citizens?" - Abbé Maury, extract from "The French Revolution - An Economic Interpretation" by Florin Aftalion, 1987

Stay tuned!