Macro and Credit - The recurrence theorem

"Some things never change - there will be another crisis, and its impact will be felt by the financial markets." - Jamie Dimon

Looking at the elevated volatility in Emerging Markets in conjunction with continued outflows and pressure on the asset class, on the back of rising US yields and a strengthening US dollar marking the return of "Mack the Knife", with losses not limited to the currencies but with Emerging Markets Yields continuing surging throughout, when it came to selecting our title analogy we reacquainted ourselves with French mathematician Henri Poincaré's 1890 recurrence theorem building on the previous work of fellow mathematician Simeon Poisson. In mechanics, Poincaré recurrence theorem states that an initial state or configuration of a mechanical system, subjected to conserved forces, will reoccur again in the course of the time evolution of the system. The commonly used example to explain the theorem is that if one inserts a partition in a box, pumps out all the air molecules on one side, then opens the partition, the recurrence theorem states that if one waits long enough that all of the molecules will eventually recongregate in their original half of the box. The theorem is often found mixed up with the second law of thermodynamics to the effect that some will loosely argue that there exists a very small probability that an isolated system will reconfigure to a more ordered state (thus effecting an entropy decrease).The theorem is commonly discussed in the context of dynamical systems and statistical mechanics. When it comes to pressure and outflows, as we mused in our last conversation, one would argue that continued capital outflows pressure is contained until it isn't. 

In this week's conversation, we would like to look at the return of "Mack the Knife" in conjunction with rising oil prices and what it entails. 

Synopsis:

• Macro and Credit - US yields - It's getting real!
• Final chart - US core CPI tends to rise in the two years leading up to a recession

• Macro and Credit - US yields - It's getting real!

While US 10yr Real Yields are a key macro driver, the US dollar so far in 2018 has dramatically diverge from yields. "Mack the Knife" aka the King Dollar also known as the Greenback in conjunction with US real interest rates swinging in positive territory has recently put some pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation:

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

With the start of an unwind in global carry trade,  "Mack the Knife" aka King Dollar is making a murderous ballad on the EM tourists and carry players alike. Back in July 2015 in our conversation "Mack the Knife" we indicated the following as well:

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - source Macronomics, July 2015

The question for continued pressure on Emerging Markets when it comes to "Mack the Knife" is are we beginning to see a reconnect between the US dollar and yields? The jury is still out there. Rising Breakevens tend to be negative for the US dollar. Also what matters for US equities given they have remained relatively spared so far would be a meaningful widening in credit spreads. This would be accompanied of course by higher volatility.

Right now, as we pointed out last week, dispersion is the name of the game in both credit and Emerging Markets with the usual suspects and weaker players getting the proverbial trouncing as of late such as Turkey and Argentina. We also indicated recently that the continuous rise of volatility in Emerging Markets would lead to additional outflows given the Hedge Funds were the first to reduce their beta exposure. Some investors might follow suit and follow a similar pattern of "derisking" it seems. On the subject of continuous volatility on EM assets we read with interest Barclays take from their Emerging Markets Weekly note from the 17th of May entitled "Shaken and stirred":

"Volatility in EM assets remains elevated. As 10y UST yields have moved further above 3% and the USD has resumed its strengthening trend, total returns in EM assets have taken a further hit – which in turn continues to weigh on flows: YTD returns in EM credit and EM local markets now stand at -3.7% and -2.4%, respectively (Bloomberg Barclays USD EM Agg and EM local-ccy government bond indices), while EM dedicated bond and equity funds had their worst week of outflows last week since the volatility spike in February (see EM flows: Outflows materialize, 11 May 2018). Economic data has hardly helped to improve sentiment, with weaker European and Chinese activity data feeding concerns about weakening global growth momentum.

The market’s focus remains firmly on those countries with external vulnerabilities and financing needs, especially Turkey and Argentina. Even though current account balances can only provide a partial reflection of external positions and vulnerabilities, there has been an interestingly clear correlation between current account dynamics (changes, rather than levels) and asset performance both in EM credit (Figure 1) and local markets (Figure 2).

Although we have argued in the past that aggregate vulnerabilities have improved in EMs since the 2013 ‘taper tantrum’, they have deteriorated over the past year (see the EM Quarterly Outlook: The going gets tougher, 27 March 2018). Furthermore, the confluence of Fed balance sheet reduction, increased UST issuance, effect of US tax law changes on the repatriation of offshore USDs alongside a wider US CA deficit has implied a potentially more challenging capital flow environment for EM.

As the flow environment for financing in international markets has become more difficult, countries’ plans (or necessity) to tap primary markets have also been in the spotlight. While EM sovereign Eurobond supply has run at a record pace in January to April, recent issuance volumes have fallen short of expectations (including the recent Ghana and South Africa bond issues). We would interpret the latter point as a market positive, however. Given the frontloading of issuance in Q1, there are few countries with sizeable issuance needs for the remainder of 2018. Based on our updated supply expectations for individual countries shown in Figure 4, we now expect an additional USD 41bn of supply in 2018.

Given that c.USD104bn has been issued YTD already, this would result in 2018 full-year supply of USD155bn. In this context, we think there is an interesting divergence between Turkey and Argentina: Argentinean authorities have indicated that they do not want to issue any more in international markets in 2018. Remaining financing needs for this year are c.USD5bn on our estimates, which could potentially be covered by an initial disbursement of the requested IMF programme, or by local currency issuance. In contrast, Turkey’s fiscal measures (including this week’s announcement to reduce the special consumption tax on fuel products) will likely keep incentives to raise financing in international markets in place, even in a less receptive market.

Supply-redemption dynamics in EM credit are not the only silver lining for markets. While recent China data has been weak, we see signs of a shift in priorities towards growth, with deleveraging de-emphasised (see China: Softer FAI and retail sales; signs of pro-growth priority and trade tension de-escalation, 15 May 2018). This should in turn support commodities and while well-supported oil and commodity prices have not been able to prevent the sell-off in EM assets, they should at least provide some fertile ground for differentiation.

With regard to oil prices, Venezuela’s election on Sunday 20 May may be of particular importance (see The ship is taking on water, 15 May 2018). Even if President Maduro is reelected, against a backdrop of the main opposition parties boycotting the process and the government’s control over the electoral system, the vote could still be a catalyst for fractures within the regime. Meanwhile, Venezuela oil exports have been disrupted, amid legal action against PDVSA and a broader decline of oil production – one of the likely drivers of the recent increase in oil prices, in addition to US sanctions on Iran.

EM oil exporters naturally benefit from the surge in oil prices. In Iraq, however, this is overshadowed by uncertainties following last week’s legislative elections (and we recommend switching out of Iraq and into Angola and Gabon in our top trade recommendations this week). Full results are yet to be announced but the partial count indicates a clear defeat of current PM al-Abadi favouring cleric Muqtada al-Sadr who has called for the end of corruption and opposed both the US and Iran. The emergence of the Saeroun and Fateh coalition as winners would complicate political negotiations to form a coalition government and it is still unclear whether PM Abadi will be able to secure a second mandate. Ultimately, we believe coalition talks may be protracted, adding uncertainty to the outlook, also with respect to the IMF talks to finalise the third review under the three-year Stand-By Arrangement. The 2018 budget and transfers to the semi-independent region have represented contentious issues which could be exacerbated by negotiations between Kurdish political parties and Baghdad over government formation." - source Barclays

When it comes to "dispersion" we continue to view favorably Russian local bonds in that context, thanks to the support of oil prices on the ruble and central bank easing that will continue.  On the subject of "dispersion" and weaker players in the EM space, we read with interest UBS take from their EM Equity Strategy note from the 18th of May 2018 entitled "This is not a 'Crisis': It is Rising Yields + a Strong $":

"The central story here, in our view, is that the recent 'less friendly' global market environment has allowed investors to 'pick away' at some of the weaker EM stories, especially via FX (Figure 5 below), as the dollar has continued to rebound. These are the EMs that typically do well when the dollar is weak, as the 'carry trade' holds sway. In the face of recent dollar strength, the result has been significant localized EM FX weakness (Figure 6).

Further, several of these so-called 'weaker' markets have also faced idiosyncratic domestic concerns:

• Turkey (-25% in USD, year-to-date): fears over central bank independence, concerns around monetary policy, widening current account deficit;
• Brazil (+1.7%): weaker than expected economic recovery, uncertainty ahead of the October elections;
• India (-6.8%): higher oil prices and higher inflation with residual concerns over whether Prime Minister Modi's BJP will be re-elected in 2019;
• Indonesia (-16.7%): current account worries and a slow policy response by the Bank of Indonesia;
• The Philippines (-12.6%): domestic overheating.

To this list, we could add South Africa (-6.3% year-to-date, on a minor hangover from the euphoria of Ramaphosa's elevation to the presidency as the market begins to understand the substantial policy challenges ahead) and Mexico (also - 6.3%, as the July 1st 'first-past-the-post' Presidential election approaches with a shift to the left seeming almost inevitable now).

Further, the dramatic weakness of financial markets in Argentina in recent weeks has added to the sense of 'crisis' in emerging markets, even though technically (from an equity perspective) the country is still, for now anyway, in the MSCI Frontier index. MSCI Argentina is down just over 25% so far this year, almost entirely due to the plunge in the peso (from ARS/USD18.35 to 24.40), which has forced a double-digit rise in interest rates to 40%.

However, the major theme of this report is that, in our view, this is far from being an EM 'crisis'. Several EM equity markets continue to do well such as China, by far the biggest EM with a weight of over 31% in the EM benchmark (+5.1% year-to-date, aided by a resilient CNY, even as other EM currencies have fallen sharply), Taiwan (+2.2%), Russia (+4.1%, which has become a relative 'safe haven' again recently as Brent oil prices hover close to $80/bbl) and parts of the ASEAN and Andean regions, notably Colombia (+10.8%) and Peru (+7.7%).

As with the equity markets, the dramatic differences in currency performance across EM so far this year are very clear from Figure 6.

By de-composing the drivers of 2018 total returns in individual markets in Figure 7 below, we partly combine the results from the two previous charts. The blue bars below show the contributions of currency movements to total returns; these are significantly negative for many markets, especially Turkey, Brazil, Russia, India, Poland and the Philippines.

It is also notable how, for most markets, there has been a negative contribution to returns from the P/E ratio, showing the breadth of the de-rating of EM equities so far this year; Peru (given very strong earnings expansion) is a small but truly remarkable example. In the other direction, sharply lower earnings in Greece and Egypt have translated into a significant re-rating in both this year. For EM as a whole, decent earnings growth (+6%) has been fully offset by currency weakness and a lower P/E ratio to leave the 2018 total return close to zero.

'Correction Counter' Update: The Dollar Rears its Head

With the recent minor break of the early-February post-correction low for MSCI GEMs, we update our 'correction counter' from earlier in the year (Figure 8).

The interpretation of this data is more important than the actual figures themselves. In our February report, we noted that the fall in the EM Currency Proxy accounted for a smaller share (14%) of the early 2018 correction in EM equities than its average share (22%) in previous bull market corrections back to 2003. Therefore, one reason, in our view, why the early 2018 correction (-10.2%) was less severe than the average of previous 'bull market corrections' (-17.2%) was the lack of a major USD rally or, alternatively, the resilient behaviour of EM currencies.

This is no longer true, given that the recent action involves more FX weakness in EM, compared to the initial correction. The updated table shows that this FX factor now accounts for much more (28%) of the newly-defined correction (-10.8% to May 5th). Even more tellingly, after EM rallied to an interim peak in mid-March, MSCI GEMs is down 5.6% since then and, with the EM Currency Proxy down by 2.8% over this period, FX weakness has accounted for exactly half of the EM pullback over the past two months. The US dollar has 'reared its ugly head' for EM equities in recent weeks." - source UBS

There goes the murderous propensity of "Mack the Knife" on EM equities. In similar fashion to the recurrence theorem, the US dollar has indeed "reared its ugly" head and reoccurred again in the course of the time evolution of the "financial system" or, to some effect our macro reverse osmosis theory once again playing out as discussed in our recent ramblings. Add to the mix rising oil prices, and if oil stays above $80/bbl (Brent) this will clearly hurt growth in all major net oil importing countries. That's a given.

Moving back to the subject of US yields and real rates, we think they matter a lot for the direction of the US dollar. On this subject Nomura published a very interesting Rates Weekly note on the 18th of May entitled "Did UST sell-off awaken bond vigilantes?":

"10yr Treasuries break 3% with conviction

The 3% level on 10s has been frustrating to break through of late, having failed once in late April and again last week. However, as with all things related to three, the third time is usually a charm as 10yr USTs are now clearly on the other side of 3%.

All along through this process to higher rates we have sensed a great level of investor skepticism about how high rates could go and how long they would stay at higher levels. This is one reason why we are not overly concerned that spec accounts have a historical short in place. For once, as far as we can recall, specs are being proven right; so why cover now unless the economy and/or financial conditions unravel? The bigger risk we think is that those under-hedged and exposed to convexity start paying rates now.

Overall the market seems too dismissive of how high rates could go in this cycle. We think the Fed has conviction and may continue with its quarterly hikes until “something breaks.” Even then, the Fed might have a hard time throttling back if the real economy is doing well but the financial economy suffers a blow that results in lower valuations. Meanwhile, the perfect storm of more UST debt and less foreign buyers may lie ahead.

We explore some drivers that may impact our overall US rates views. Overall we expect duration dynamics to matter more now than the curve; meanwhile spreads and vols will likely have stronger correlations to higher rates and real rates could hold the key ahead.

Even if this sell-off takes a pause, we continue to see 10s moving towards our 3.25% target and are positioned paid on 5y5y US-IRS and in similar conditional expressions.

US rates views update: Still bearish but now real rates hold the directional key

Duration: 3%, besides being a nice round number, has been a hard nut to crack as the last time we crossed this level was during 2013, a year made famous by taper tantrum. For us, a move beyond 3% was always the next logical step as the Fed is hiking rates and shrinking the B/S during a period of decent growth and more UST supply.

The 3% nominal level seems to be all the focus, but in actuality the next big step for US rates is what happens with real rates. Fig. 1 highlights a few regimes for the 10yr real rate vs the real Fed Funds rate (see note for calculation).

Real rates were in a tight range during the last cycle as well, it was only once the Fed was mid-way through its hiking campaign that market real rates began to rise. The past ten years of financial repression (driven by the Fed’s QE and then Global QE) has kept 10yr real rates in a tight range. Just like the 10yr UST was held captive by the taper-tantrum high of 3%, 10yr TIPS have been unable to break and stay above 0.90-1.00% levels. We believe the Fed is on track to deliver many multiple hikes (which could drive real rates higher in the process too).

3%, well specifically the 3.05%, has been a technical level on which markets seem to have been obsessed with. The market cleared that level for the first time on Tuesday this past week and intra-week the 10yr hit an intra-day high of 3.12% before settling into the end of the week around 3.07%. We usually refrain from being super technical, with both what these levels mean and we do not like to be handicapped by chart formations; however markets often pay attention to these wrinkles. Fig. 2 shows that 10s once again broke out of the range and this time term premia is also rising with the move too.

Net net, we believe it will take a serious breakdown in all the trade talks, geopolitical tensions and/or economic data to weaken (where instead our economists are projecting stronger growth and higher inflation ahead) for 10s to start a massive rally now. It is also interesting to see that stocks, although down on the day 10s broke 3%, took it in stride. In Fig. 3 we list the top 3 two-day yield changes in 2018 vs the S&P500 reaction. If stocks do not correct meaningfully, the full UST yield curve should rise as Fed hikes.

Curve: Earlier in the year we opportunistically traded the curve before going neutral on curve spreads in late Q1 (after the last micro-steepening). Recently the sell-off has also coincided with some bear-steepening. We think this is a healthy development that serves as a reminder that the curve is not pre-destined to fully flatten in this cycle, at least not at these yield levels. The Fed is raising rates but also shrinking its bond holdings, at a time when US fiscal stimulus is resulting in a spike in govie issuance. The curve never fully flattened in Japan during its low rate experience (Fig 4).

We argue that we need a higher overall level of rates (and many more Fed hikes) before we go fully flat too.

Spreads: 10yr swap spreads have begun to see a stronger correlation with the level of 10yr USTs in the current cycle, especially since last September (Fig. 5).

In past hiking cycles, 10yr spreads tended to have a positive slope relative to 10yr UST yields. We expect this correlation to be maintained, similar to the dynamics at the end of the ’04-06 cycle. Also with higher yields, 10yr spreads are more likely to widen due to convexity hedging activities from mortgages portfolios. Less need for corporate issuance due to overseas dollar repatriation would also reduce the tightening pressure on belly spreads." - source Nomura

The continued pressure on EMs can only abate if the US dollar finally mark a pause in its recent surge. A toned down trade war rhetoric would obviously continue to be supportive of a rising dollar and support stronger US growth in the process. The trajectory of the US dollar when it comes to the recurrence theorem for EM is essential. Morgan Stanley in their EM Mid-Year Outlook published on the 18th of May reminded us in the below four graphs what to look for when assessing the US dollar in terms of being bearish (their take) or bullish:

"Why USD Is in a Long-Term Bear Market

 - source Haver Analytics, Bloomberg, Macrobond, Morgan Stanley Research

With mid-term elections coming soon in the US, it is clear to US that the administration would not like to rock the boat and therefore would favor "boosting" the US growth narrative. This would entail further gain on both US yields and the US dollar in the near term we think. 

Also of interest when it comes to growth outlook, UBS made an important point in their EM Economic Perspectives note of the 17th of May entitled "EM by the Numbers: Where is EM's growth premium over DM?":

"EM growth spread over DM has fallen close to its lowest decile since 2001

Strong Chinese growth and low US inflation strongly supported EM asset markets over the last two years. But the growth levers have slowly been shifting in the background. Having registered a cycle high in early 2017, EM growth has moderated sequentially since, while DM growth has picked up. The levels were strong enough in both to keep the market uninterested as to how far EM growth was above DM growth. Now, however, sequential EM growth has slowed to 20th percentile of its distribution since 2001, and, more importantly, the premium of EM growth over DM has shrunk to the bottom decile of its historical distribution.

The spread between EM and DM is an important input in the call of relative stock market returns in the two regions. In y/y terms, this spread is now at 15th percentile of its distribution since 2001. In q/q terms this spread has shrunk to the sixth percentile of its historical distribution." - source UBS

Whereas EM equities clearly outperformed DM in 2017, it might be that 2018 could make the reverse with DM outperforming. Reduced carry has obviously been a headwind for EM equities as discussed above. If the US dollar strength can persist then indeed, US equities will continue to outperform EM equities on a relative basis we think.

For our final chart, as we posited in numerous conversation, we have often repeated that for a bear market to materialize, you would need an "inflation" spike as a trigger. 

• Final chart - US core CPI tends to rise in the two years leading up to a recession

Positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, higher inflation will coincide with lower growth, therefore bonds will not be a good hedge for an equity portfolio. As we pointed out in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this the biggest near term concern of markets right now we think. Our final chart comes from CITI Emerging Markets Strategy Weekly note from the 17th of May entitled "Fragile 5 now down to Fragile 2" and shows that US core CPI tends to rise in the two years leading up to a recession:

"US rates with more upside. 

After US CPI release last week we had wondered whether or not the EUR was in a bottoming process. While it had been trading better for a few days, the move higher in US rates has led to renewed USD strength. To be clear, we have been expecting higher US rates based on our belief in late-cycle behavior. Figure 4 shows that core inflation typically rises by 50bp in the last two years of an expansion.

Over the same two-year period, 10-year US Treasury yields tend to go up in the first year before retreating as rate cuts get priced by the market. Higher yields are therefore not surprising to us." - source CITI

If indeed a rising US Core CPI is a leading US recession indicator then again, we would have another demonstration of the recurrence theorem one could argue...

"Any idiot can face a crisis - it's day to day living that wears you out." -  Anton Chekhov

Stay tuned!

Macro and Credit - When Prophecy Fails

"Experience is the only prophecy of wise men. Alphonse de Lamartine," - French poet

Looking at the dislocation and violent bond market gyrations that followed our second "prescient" call (following our correct Brexit call) on Trump being elected in the US as indicated in our conversation "Empire Days" which by the way earned us two nice bottle of wines thanks to our friends being plagued by "Optimism bias", we decided to steer towards "behavioral psychology" for our chosen title analogy this time around by referencing the classic 1964 book of social psychologists Leon Festinger, Henry Riecken and Stanley Schachter where they deal with the psychological consequences of disconfirmed expectations. While we have already used "Cognitive dissonance" as a previous title, this book was very importance in the sense that it published the first cases of dissonance. The chief reason for us selecting the above title reside in the fact that not only did the US election was a case of disconfirmed expectations and of course "Optimism bias" but, the resulting wakening of "Bondzilla" the NIRP monster led to the reversing of Gibson paradox given the sudden rise in real yields that lead to not only a bloodbath in the bond space but also a vicious sell-off in both gold and gold miners, with silver not spared either. As a reminder about Gibson paradox from previous conversations: When real interest rates are below 2%, then you get bull market in gold, the reverse also works. There has never been an episode in history when Gibson's paradox failed to operate. Real interest rate is the most important macro factor for gold prices. Also the relationship between the gold price and TIPS (or “real”) yields is strong and consistent. Gold and TIPS both offer insurance against “unexpected” (big and discontinuous) jumps in inflation. The price of gold normally falls along with the price of TIPS (which means that TIPS yields rise). So to conclude, gold and gold miners are not the best hedge at the moment given the negative correlation with real rates and the aforementioned "sucker punch" delivered in a very short order. So while many noses have been bloodied in recent days following Trump's victory, our contrarian and behavioral posture tells us we think the market might be trading way ahead of itself given the uncertainties relating to what the policies which will be implemented by the new US administration. When it comes to disconfirmed expectations and its inflationary bias as of late, we are still awaiting to see additional pressures coming from wages before we embrace the recovery mantra. Nonetheless we have been gradually de-risking our early 2016 barbell position significantly (long US long bonds / long gold miners) in favor of cash in US dollar terms waiting for the time being for the dust to settle and the fury to abate before dipping back our toes.

In this week's conversation we would like to revisit our July 2015 theme of "Mack the Knife", also known as the Greenback in conjunction with US real interest rates swinging in positive territory hence the pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation. Of course what is happening in the Emerging Markets space is of no surprise to us given we mused on Emerging Markets risks in our conversation "The Tourist trap" back in September 2013:

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

Wave number 1 - Financial crisis 

Wave number 2 - Sovereign crisis 

Wave number 3 - Currency crisis

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

Real interest rate and US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple.

Synopsis:

• Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife
• Final chart - People are trading on hope: Higher growth or higher inflation?

• Macro and Credit - Gold and Emerging Markets : The return of Mack the Knife

For us, Mack the Knife = King Dollar + positive real US interest rates. 

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2016 after the US elections in very short order) started once again the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been China with the acceleration in capital outflows put forward by many pundits and displayed in the below chart from Bank of America Merrill Lynch from their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go":

"Asia: It’s complicated

We expect weaker Asian currencies vs USD. In addition to the higher US rates channel, Asia is very exposed to US trade protectionism and will rely on rate cuts, weaker currencies and domestic fiscal policies to offset those risks. We like short KRW and SGD vs USD, and we remain short CNH against a narrow CFET basket as outflows are expected to continue (Chart 2). A complicating feature will be the greater scrutiny on USDCNH and whether President elect Trump will come true on his election threat to charge 45% punitive tariffs on Chinese exports to the US." -source Bank of America Merrill Lynch

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

As a reminder and what is playing out again is what we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs China). So, all in all, the likely Fed hike in December in conjunction with USD strength will once again result in additional capital outflows which are leading not surprisingly to textbook bigger CNY depreciation from China.

When CNY / USD depreciation expectations continue to rise or USD strengthens, you can expect once again more pressure on capital outflows if other macro factors remain relatively stable. Emerging Markets including China are in a hypertonic situation; therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield (ETF JNK and outflows) and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates) hence our propensity in this kind of situation to raise significantly cash levels in US dollar terms.

Our reverse osmosis process theory from a macro perspective can be ascertained by monitoring capital flows. On the subject of monitoring for the purpose of the exercise, we read with interest Nomura's latest Capital Flow Monitor from the 14th of November entitled "EM Pressure Index Update":

• EM central banks (excluding China and the OPEC countries) continued to buy reserves in foreign currencies to the tune of $37.7bn in October vs. $12.0bn the prior month, led primarily by strong purchases from Hong Kong (around $25.3bn). This is the eighth consecutive month of net buying by these EM central banks. Of these 20 EM central banks, two sold reserves, nine bought, and nine did not intervene.

• After adjusting for FX valuation and coupon payment effects, we estimate that China sold FX to the tune of $11.2bn in October, after having sold around $29.8bn in September.

• EMFX pressure rose moderately: Our Global EM FX Pressure Index (excluding China and the OPEC countries) continues to deteriorate. The main contributors to the pick-up in pressure are the South Korea, Indonesia, Israel and Russia, in that order of significance. This was partly offset by lower FX pressure in the Philippines, Mexico (MXN appreciated significantly in October), and Brazil.

Global EM FX Pressure Index

The Global EM FX Pressure Index combines information on EM central bank reserve dynamics and EM FX price action.
EM FX price action is measured by the monthly percentage change in EM currencies against the USD. Reserve dynamics are measured by EM central bank intervention (in USDbn) scaled by the money base. EM central bank intervention is estimated to be based on changes in the level of FX reserves, adjusted for valuation effects. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
The methodology above is developed by the IMF

• EMFI pressure rose in October: Our Global EM Fixed Income Pressure Index, which combines information on cross-border flows into EM local bonds and price action, indicates a significant increase in pressure. The absolute pressure level was high in October relative to history.

Global EM Fixed Income Pressure Index

The Global EM Fixed Income Pressure Index follows a similar methodology and combines information on cross-border flows into EM local currency bonds and EM local currency bond price action.
EM local currency bond price action is measured by the change in bond prices, computed based on the monthly change in 10yr sovereign yields and a 7yr duration assumption. Cross-border flows are acquired from various local sources; most of them are estimated based on changes in foreign holdings of local currency bonds. The two indicators are then summed up on a vol-adjusted basis to arrive at the final index value.
Estimates for the current month are made based on flow data from Mexico, India, Indonesia, Hungary, South Africa, and Turkey. A revision will be made (in the following month) once data from Colombia, Brazil, Malaysia, Korea, Russia, Poland, Israel, Thailand, and the Czech Republic are released.

Pressure on EM bonds rose in October

• EMFI pressure rose: The index fell to -1.2% (a significant rise in pressure). As indicated in Figure 2, this level of pressure is low compared to historically.
• Bond flow: EM local bond markets saw an estimated outflow of $4.3bn, compared with an inflow of $9.1bn of inflows in September and $2.0bn of inflows in August (based on a consistent sample of six countries that have reported for May: Mexico, India, Indonesia, Hungary, South Africa, and Turkey).
• Price action: Of the 19 EM countries we track, two countries saw their sovereign yields fall, while 17 rose (Figure 9). Russia (+54bp) and Turkey (+33bp) saw their sovereign yields rise the most, while Brazil (-19bp) and India (-2bp) saw their yields fall the most. Yields in the advanced economies rose, with US 10yr yields up around 23bp, Japanese only up 4bp, and eurozone up an average of 35bp, led by Italian bonds.

- source Nomura

From our monitoring perspective and our interest in dwindling currency pegs with Egypt being the latest one to throw in the towel, given that we won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September 2015 conversation and with the additional points made in our conversation "Cinderella's golden carriage", we might have had once again our timing wrong in 2016 as far as the HKD is concerned. But, when it comes to dwindling currency pegs and with our own prophecy failing so far to materialize in 2016 we would like to remind you the trend for currency pegs so far. When it comes to our 2016 "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop if Mack the Knife continues his run unabated:

-source Société Générale

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been". We also note from Nomura's research piece that when it comes to intervention by country and capital flows, once again Hong Kong Monetary Authority (HKMA) had to step in significantly in October:

- source Nomura

What has been happening of course for Emerging Markets and yield hunters alike is that central bank's meddling with interest rates (ZIRP, QE, NIRP) drove traditional investors seeking mid-to-high single digit yields out of investment grade/ crossover credit into high yield, leveraged loans and emerging market debt to satisfy their yield appetite. The problem, however, is some of these "macro tourists" underappreciating exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle will eventually turn in earnest (not yet the case according to the latest US Senior Loan Officer Survey showing some easing as of late) annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range as we have seen earlier on in 2016 for the energy sector. Yet, it seems given the significant returns delivered in the second part of the year to the High Yield sector, that some of these "macro dimwits" have not learned their lesson, given that not only they have increased their credit exposure, but, they have also extended their duration exposure at the same time! Hence the on-going bloodbath. As a reminder, in the current low yield environment, both duration and convexity are higher; therefore price movements lower for bonds are larger.

In August 2013 in our conversation "Alive and Kicking" we argued the following:

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":

"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

It seems to us the central bank "deities" are in fact realizing the dangers of using too much "overmedication" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space and Emerging Markets bond funds alike. Even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in bond funds given that the Fed's role is supposedly one of "financial stability". We will not delve again into our views relating to positive correlations and large standard deviation moves as we have already tackled the subject in February in our conversation "The disappearance of MS München" conversation. We commented at the time that the fate of the attack of the Yuan and in effect the attack of the HKD peg could be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think.

When it comes to the much feared Mack the Knife and Asia, Bank of America Merrill Lynch in their Global Emerging Markets Weekly note from the 10th of November entitled "Should I stay or should I go" looks further into the dominating risk from a rising US dollar:

"Does dollar strength dominate everything?

The sharp reversal higher in risk assets following the Republican clean sweep has raised the question of whether reflation optimism (driven by the end of gridlock and expectations of US fiscal stimulus) could support Asia FX over the coming months. We are skeptical, at least vs the USD. As we have argued, the biggest implication of a Republican clean sweep is a stronger USD and higher US rates– this should lead to higher USD/Asia, even if trade-weighted FX performance remains more sensitive to risk.

US tax cuts – this time is different for Asia

Historically, large US tax cuts have been followed by a widening of the US current account deficit driven by higher imports (Chart 9).

This supported Asia export growth and exchange rates, especially during the Bush tax cuts of 2004 (Chart 10).

However, this time could be different, partly because the US household spending has been shifting towards non-tradable services. More importantly though, Trump’s policy platform itself is geared towards reducing dependence upon foreign goods and services.

Trade policy risks

While the prospect of draconian trade restrictions is still uncertain under a Trump Presidency, some risk premium is likely to be factored into Asia FX. There will be particular focus on the trade policy stance towards China. China is currently far from meeting the existing US Treasury criteria for currency manipulation, primarily because it has not engaged in RMB weakening intervention. It will be important to watch if the US Treasury amends these criteria under the new Administration. Another issue would be China’s expectations to be granted market economy status on 11 December 2016, fifteen years after its WTO accession, and the negotiations around this. A key risk is if China chooses to weaken its currency more quickly ahead of these events and the new Administration taking office." - source Bank of America Merrill Lynch

In the current context, from an allocation perspective, we are neutral on gold and silver until we see more stabilization in the move in real rates. While many have been jumping on the "equity" bandwagon, if indeed there is further weakening of the yen relative to the USD then again, the Japanese Nikkei should benefit so what is not to like in going long Nikkei hedged in either USD or Euro? Also, the strengthening of the HKD, should benefit Chinese shoppers and Japan from a "retail" perspective. This is already a subject we discussed in our conversation"Cinderella's golden carriage" in December 2015 as  tourists amounts to more than 12% of  Hong-Kong to GDP:

"So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again." -source Macronomics, December 2015

As we stated before, if Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think. While our "prophecy" failed in 2016, if the trend continues, who knows how long Hong Kong can hold the line.

When it comes to failing prophecies and high expectations, particularly of the inflationary type and the market trading ahead of itself our final chart below is highlighting once again the gap between equity investors (the eternal optimists) and fixed income investors (the eternal pessimists). 

• Final chart - People are trading on hope: Higher growth or higher inflation?

While the Fixed Income crowd continues to be trounced by rising real rates and surging inflation expectations we do believe that the market is trading way ahead of itself and speculating already on what the new Trump administration will be able to deliver. The significant rise in interest rate volatility in conjunction with real rates means that not only fixed income in general and emerging markets in particular are getting slammed, but, it means once more that Gibson's paradox is at play at the moment hence our neutral stance for the time being and cautiousness. Our final chart from Deutsche Bank's Torsten Slok Chief International Economist and illustrates the different trajectories of volatility between rates markets and equities:

"Fixed income markets and equity markets are following completely different narratives after the election. Rates markets are focusing on higher inflation and what it means for rates across the curve, including the risk of the Fed falling behind the curve. Equity markets, on the other hand, are focusing on higher GDP growth, and equity markets don’t seem to worry about the risks of an overshoot of inflation and the Fed falling behind the curve. These different ways of looking at the election outcome have opened up a huge gap between rates volatility and equity volatility." - source Deutsche Bank

Indeed, mind the gap, because if volatility continues to surge in rates markets, we have a hard time believing it will not eventually spill-over to equities. We shall see if the inflationary prophecy materializes itself in the coming months. For the time being, like any good behavioral therapist, we'd rather focus on the process of a rising US dollar rather than on the prophetic content of the policies which will be followed by the new US administration.

"In the computer field, the moment of truth is a running program; all else is prophecy." -  Herbert Simon, American scientist

Stay tuned!

Macro and Credit - Broken Arrow

"The seed of revolution is repression." - Woodrow Wilson, American president

While watching with interest unfolding our cross-asset correlation fears with equities, bonds, gold, oil and the lot getting the proverbial "sucker punches" thanks to VaR (Value at Risk) shocks and given Japan's on-going economic predicaments, we reminded ourselves the military code meaning of "Broken Arrow" when selecting this week's title analogy. "Broken Arrow" is a US military code phrase used at the last resort when a ground unit is facing imminent destruction from enemy attack and therefore needs all available air forces assets within range are to provide air support immediately. During the Battle of Ia Drang in Vietnam that took place on November 14–15 1965, as the battle along the southern line intensified, Lieutenant Charlie W. Hastings (USAF liaison forward air controller) was instructed by Lieutenant Colonel Hal Moore of the 7th Cavalry, (based on criteria established by the USAF) to transmit the code phrase "Broken Arrow", which relayed that an American combat unit was in danger of being overrun. When we look at the vicious rise in volatility, which is at the core of any allocation process, which we discussed in our previous conversation and what it entails for Risk Parity Strategies, Vol Control products and balanced funds getting "unbalanced", we do share the same concerns from various pundits such as Mark Spitznagel that, if indeed the Fed decides to "surprise" the market with a rate hike, things could indeed turn "south" very rapidly given that as our quote goes the seed of revolution is in our case "volatility" repression thanks for the actions of "The Cult of the Supreme Beings" aka central bankers. As we re-iterated in our previous rambling, "cash" is a "strategy" and given the potential risks that lies ahead (think Italy and more...), we think that rather than calling for a "Broken Arrow" to defend your positions from being "overrun" due to "herd mentality" and rapid deleveraging, you would be very wise to increase your cash levels accordingly in the current environment. While you might be at the mercy from yet another dovish Fed which would indeed be a catalyst for maybe yet another melt-up in assets, we do think that from our "credit perspective", we are indeed in the last innings of this credit cycle and we would stick with "Smart Alpha" (High Quality Investment Grade) rather than going for "Dumb Beta" (High Yield and High Dividends stocks) at this stage.

In this week's conversation we would like to look again at the dangerous paradigm of "repressed volatility" with "lower liquidity" and what it entails from a risk perspective for supposedly "diversified" strategies. We will also look again at "impaired" banking systems in Europe and why we continue to avoid like the plague "European banking stocks" such as Deutsche Bank due to their Investment Banking franchise being "broken" as well as it isn't only NIRP that is damaging their Net Interest Margins (NIM) on the "retail" side.

Synopsis:

• Macro and Credit - The seed of "repricing" is "volatility repression"
• Macro and Credit  - Broken Investment Banking franchises in Europe, time for some players to call it a day.
• Final charts: The business cycle is turning and storm season is coming

• Macro and Credit - The seed of "repricing" is "volatility repression"

While last week we touched on the rising costs in hedging strategies for insurers in conjunction with the "fast deleveraging" risks for some "leveraged" strategies that doesn't mix well with "herd mentality" when everyone is investing the same way in a poor liquidity environment, we think, that when it comes to the risk of being "overrun" and a case for calling for a "Broken Arrow", no matter how repressed volatility has been, it is bound to go higher which, in the current environment will have a significant impact on supposedly "diversification" strategies. When it comes to raising your cash levels, anything worth doing is worth "overdoing" in this central bank manipulated environment we think. When it comes to the new paradigm of low volatility and poor liquidity, we read with interest Bank of America Merrill Lynch's take in their Securitization Weekly Overview from the 9th of September entitled "The poor liquidity-low volatility paradigm":

"The poor liquidity-low volatility paradigm 

Arguably, the post-Brexit collapse in market volatility is the dominant story in financial markets these days. Many market participants, including the BofAML Quantitative Strategy team, think a pickup in volatility in the fall is likely. The Fed, US presidential election, seasonality, and the principal of mean reversion are some of the factors cited by various market participants as reasons for an increase. Stated somewhat simply, the view on historically low volatility seems to be: “this cannot last; it always goes higher.”
While the arguments for higher volatility are compelling, we explore the possibility that low volatility may simply be the central banker offset to the new, post-crisis regulatory regime that has substantially reduced market liquidity, which we measure using the BofAML Liquidity Stress Index. We note that while volatility has declined recently, liquidity stress remains stubbornly high, which should constrain central bank policy tightening.
This has been a consistent theme of ours for years. For example, published almost three years ago, our 2014 Securitized Products Outlook was titled “Regulatory tightening sustains monetary easing.” The argument has been a simple one: the highly restrictive post-crisis regulatory regime is a primary factor contributing to low global growth (we think ageing demographics is the other big factor), which has forced global monetary policy to remain exceptionally accommodative. In turn, this historic accommodation has reduced market volatility to historic lows.
One always has to be extra careful about positing new paradigms, since oftentimes the mere act of offering the characterization usually marks the end of the conditions that define the so-called new paradigm; but we posit it anyway. In our view, what could end the poor liquidity-low volatility paradigm is a sustained shift to less accommodative policies, such as the Fed tried with its December 2015 rate hike; but such a shift could well be catastrophic.
As we now know, the spike in liquidity and financial stress in early 2016 forced the Fed into a multi-month retreat from further tightening talk, while other central banks eased further. Recent statements make it clear the Fed wants to tighten again, even as the market remains dubious: current probabilities of hikes by September or December are 30% and 60%, respectively. We share the market doubts about September, which tells us volatility can remain low. But the Fed’s surprisingly hawkish Jackson Hole rhetoric makes us cautious about our view.
After strong post-Brexit performance across most securitized products, and the risk of a September Fed hike (the BofAML house view is December), we turn neutral on securitized products credit and agency MBS. Given liquidity considerations on the credit side, we don’t like to shift allocations too often. But, in the wake of Jackson Hole, the risk for the near term is too high for our liking, and remaining overweight seems imprudent." - source Bank of America Merrill Lynch

Indeed, being "overweight", for the time being is, we think fraught with danger in the near term and looking at the recent macro data as of late, if indeed, the markets does suffer again from "optimism bias" and the Fed decides to pull the proverbial rugh under investors' feet by hiking, then markets would indeed face a much more nasty reaction than during Brexit.

The "rate hike" risk remains elevated as posited by Bank of America Merrill Lynch's report while their Financial Stress index remain elevated:

"While the arguments in favor of higher volatility are compelling, and an increase over the near term seems likely, as we discuss below, we think the case for low volatility remains in place. We still believe that the combination of ageing demographics and a restrictive post-crisis regulatory regime (which has substantially reduced market liquidity) forces central banks to remain exceptionally accommodative and that it is this reality that keeps volatility at historically low levels. Periods of heightened volatility are indeed possible, as central banks attempt tightening or cease easing, but the past few years have shown them to be relatively short-lived.
If the Fed hikes in September, at least a modest replay of early 2016 market volatility is possible. This may sound like a change from our recent assertion that the probability of a market-disruptive Fed hike is low. It’s not. It would simply be that the low probability scenario is realized. In other words, the assumption of exceptionally accommodative monetary policy would no longer be valid. The shift to neutral on securitized products is an attempt to balance near term uncertainty on the Fed and the longer term constructiveness on securitized products that we have articulated in recent months. 

The poor liquidity – low volatility paradigm: liquidity stress remains elevated 

One possible reason for a September Fed hike is that financial stress has declined substantially in the post-Brexit period. Chart 2 shows the BofAML Global Financial Stress Index (GFSI) dropping over the past two months, through the 30, 40, and 50- week trend lines, to the lowest level in over a year.

The upward trend that started in mid-2014 appears to have reversed, and seemingly gives the Fed room to hike.

But if we consider a sub-index of the GFSI, the Liquidity Stress Index (Chart 3), the picture is less benign. Liquidity stress has declined in the post-Brexit period, but it is still elevated by historical standards.  

For context, the current level of 0.53 was observed in November 2007. As Chart 4 shows, by that time, the Fed had already begun to cut the Fed Funds rate, and was on its way to zero over the next year.

In other words, the current level of liquidity stress triggered massive easing in 2007, not tightening, as the Fed is now discussing.

The Chart 5 comparison of the Liquidity Stress Index (LSI) with the broader GFSI over the past year and a half shows two things:
• First, the current gap between the broad GFSI and the LSI is very high; in other words, although broad financial stress has declined substantially in the post-Brexit period, the decline in liquidity stress is far more modest.
• Second, the gap between liquidity stress and broader financial stress has tended to be closed by a sharp rise in financial stress (GFSI). Consider October 2015, when the GFSI of 0.06 was near the current level of 0.08. Over the next 3+ months, the GFSI rose to a peak of 0.85 and closed the gap to the Liquidity Stress Index. 

The takeaway is straightforward. A September Fed hike could quickly reverse the post-Brexit decline in financial stress and cause a surge to the upside, which in turn could create at least a modest repeat of the market sell-off of late 2015-early 2016. The BofAML Economics team, which is calling for a December hike, has repeatedly stressed that the Fed is risk averse and will be very cautious as it goes about raising rates (see “The Fed’s cacophony of sound”). Based on this characterization, it seems unlikely to us the Fed would risk a replay of another market meltdown. The more prudent path would seem to be to allow liquidity stress to decline further over the next few months and hike in December. Nonetheless, this is the chart that gives us greatest cause for concern, and pushed us to turn to neutral on securitized products. Post-Jackson Hole, a Fed-induced replay of October 2015-February 2016, where the GFSI rises sharply, seems quite possible.

The volatility-liquidity stress connection 

Chart 6 and Chart 7 provide long term views of liquidity stress relative to rate and equity volatility.

The differences between the pre-crisis and post-crisis data struck as noteworthy. Pre-crisis, liquidity stress was generally quite low, while volatility, especially rate volatility, was generally elevated. Post-crisis, liquidity stress is relatively elevated, while both rate and equity volatility have been relatively low. 

We believe elevated liquidity stress is a direct result of the highly restrictive regulatory regime implemented in the wake of the financial crisis (higher capital charges, liquidity ratio tests, proprietary trading restrictions, etc.). We also believe this elevated liquidity stress, or poor market liquidity, constrains the ability of central banks to tighten monetary policy (see our 2014 Securitized Products Outlook, “Regulatory tightening sustains monetary easing” for an earlier discussion).
The reaction to the Fed’s December 2015 rate hike, when liquidity stress was already high (about the exact same level as today) and the GFSI and volatility surged in the subsequent weeks, was a recent example of what happens when the constraint is not recognized by central banks – market meltdown. The Fed’s eventual reaction to that volatility surge – shelving additional tightening plans – highlighted the market feedback loop at work: the liquidity constraint will eventually be acknowledged and volatility will have to be forced lower before tightening talk starts again. The coincident surges in both liquidity stress and volatility in 2008 provides insight into what happens when they simultaneously move higher – crisis. We make the assumption that crisis is an unacceptable outcome.
This is our poor liquidity-low volatility paradigm succinctly explained. Due to the post-crisis regulatory regime, elevated liquidity stress is likely here to stay; the system cannot tolerate simultaneous elevation in liquidity stress and volatility; if tighter monetary policy leads to higher volatility, and high liquidity stress is permanent, then tighter monetary policy is not possible. The paradigm hypothesis may soon be tested. " - source Bank of America Merrill Lynch

Unfortunately, for the Fed and other central banks, the higher are cross-asset correlations, the larger will be standard deviation moves, the more unstable financial markets will become due to "Mechanical Resonance" thanks to poor liquidity and heightened volatility. As a reminder, "Mechanical Resonance" is the tendency of a mechanical system to respond at greater amplitude when the frequency of its oscillations matches the system's natural frequency of vibration (its resonance frequency or resonant frequency) than it does at other frequencies. It may cause violent swaying motions and even catastrophic failure in improperly constructed structures including bridges, buildings and airplanes—a phenomenon known as resonance disaster. In similar fashion, thanks to central banks meddling with "risk signals" such as interest rates and "volatility" (which is at the core of any allocation process again), playing with "cross-asset" correlations by messing with the signals will eventually lead to "Mechanical Resonance" at some point and trigger a "Broken Arrow" call from supposedly "diversified" players all having the same allocations and positions on. The trouble is that many pundits do not realize yet how depleted are central banks' ammunition depot. This will lead to more "unconventional" responses from "The Cult of the Supreme Beings" aka central bankers rest assured.

Of course as we posited last week, we are already seeing trouble brewing in "Risk Parity strategies" thanks to "Mechanical Resonance" triggered by a surge in "interest rates" volatility. This is as well clearly indicated in Bank of America Merrill Lynch Liquid Insight note from the 15th of September entitled "Getting unreal":

"Risk parity unwind 

One of the most talked about themes recently has been the impending unwind of levered risk parity portfolios (see here and here). Our equity analysts estimate that the recent moves (bond and equity sell-off) could trigger as much as $50bn in bond selling from risk-parity type investors. While data on holdings is minimal, the influence of risk parity deleveraging on real rates is clear from Chart 1 and Chart 2. 

As the correlation between equities and nominal bond yields turn negative, the risk parity community delevers, resulting in a sustained underperformance of real yields. While it is easy to think this is because risk parity performance mirrors nominal bond yields, our Chart of the day makes the compelling case that this is purely a real rate phenomenon.

If anything, risk parity underperformance has historically meant higher real rates and lower breakevens, with the breakeven beta being about half the real rate beta. This relationship is the primary reason why we would rather be short real rates as opposed to nominal rates for an unwind of the risk parity theme. Further, anecdotal evidence in both the taper tantrum and the China reserve sales episodes also support this view: real rates increased, breakevens declined as average risk parity performance fell more than 5%.

To us, the focus on risk parity unwinds is here to stay even beyond the next couple of weeks. As the polls for the US elections narrow further, higher volatility and increasing likelihood of fiscal stimulus will keep this theme alive." - source Bank of America Merrill Lynch

Now of course, if indeed "real rates" shoot up thanks to "Risk Parity Strategies" forced deleveraging, what is of interest to us has been in 2016 the return of Gibson's paradox. Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which could potentially be the case with a possible rally in the 10 year US government bond if we get a surprise rate hike that is, then of course, gold prices will go down as a consequence of the interest rate impact and gold miners will go down as well. This would lead to further "cross-asset correlations" playing out on the downside that is.

When it comes to additional banking woes in conjunction with the recent surge in volatility in the bond space, the recent large fine imposed on German Deutsche Bank continues to validate our long standing distate for European banks stocks and our much vaunted, yet more stable preference for credit when it comes to having some "banking" exposure. In our next point we will look at that not only NIRP has been a headwind for NIM (Net Interest Margins) as of late, but, European banks versus their American peers are as well facing a risk of "Broken Arrow" when it comes to their Investment Banking franchise.

• Macro and Credit  - Broken Investment Banking franchises in Europe, time for some players to call it a day.

Many European banks when on to a hiring spree in 2010 following the significant bounce in 2009 as they were saved by central banks and by the suspension of the "mark-to-market accounting rule" as they believed that the "good days" were coming back. On our side we always believed that the changes facing banks were more structural in nature and kept thinking in terms of analogy that the banking industry would be facing a wave of restructuring not to dissimilar to what the Steel Industry went through in Developed Markets (DM) at the beginning of the 80s. As per our conversation "Thermidor" in August, we continue to disregard the "value" argument put forward by some pundits about the "cheapness" of the sector given, for us, a bank is the second derivative play on the economy and as a pure "beta" play, it is tied to changes in "credit impulse" leading to an acceleration of economic growth. As far as we are concerned, the "japanification" process in Europe runs unabated and the restructuring of the banking sector in Europe has only just started:

"We will not re-iterate why we dislike banks stocks and in particular European banks stocks given the "japanification" process and the significant on-going deleveraging. If there is indeed some clear culprits when it comes to "capital destruction" thanks to Zero Interest Rate Policies (ZIRP) and now with Negative Interest Rate Policies (NIRP), the blame is entirely on the shoulders of our "generous gamblers" aka central bankers and their experiments." - source Macronomics, 5th of August 2016

Not only are European banks facing earnings headwinds thanks to NIRP, but, when it comes to their Investment Banking franchises, some players are clearly facing too many hurdles to continue to make a case to maintain highly regulatory capital intensive activities such as Investment Banking. On this particularly subject we read with interest Société Générale's take in their Global Investment Banking note from the 15th of September entitled "Making sense of broken business models":

• "I-bank sector’s ROE looks set to be only 6.2% in 2016, much lower than the COE (which we deem to be a simple 10%).
• Most I-bank products achieve lower than 10% COE.
• The bulk of capital continues to be allocated to the lowest return FICC products. Less capital-intensive equities products have higher profitability. Primary IBD products (especially DCM and M&A) are the most profitable of all.
• US I-Banks have greater market share and more leadership positions compared with European peers.
• European I-Banks are deleveraging in order to become smaller but more profitable niche players.
• JPM continues to strengthen its position as the dominant “flow monster”, pulling away from GS, C, BoA and DBK.

• Substantial capital can be released back to shareholders from winding down investment banking business, especially FICC.
• CS has a CHF2.8bn capital deficit, DBK has €12.5bn deficit. Significant deleveraging could more than solve these capital deficits and put the banks in an excess capital position. Realistically, we think CS management is the one most likely to consider further deleveraging at its forthcoming strategy day (which should be on 7 December).

- source Société Générale

It should not come as a surprise that with the on-going "deleveraging" exercise taking place for many players, ROE has come down in conjunction with leverage and rising cost of regulations and new capital rules set up.

But, given recent woes for Germany's banking champion Deutsche Bank, it is interesting to note that, when it comes to its Investment Banking franchise, it is at risk of having a case of "Broken Arrow" as displayed in Société Générale's very interesting report:

• Very weak capital strength has forced significant deleveraging. Cuts to the bonus pool have also caused significant revenue attrition. Core I-bank ROE is set to be only 2.6% for FY16e. Most products across the board have very weak ROEs.

• DBK commits the bulk of its capital to FICC. Rates trading should have put DBK in a good position for decent revenue growth in 1H16 (similar to JPM), but it ended up being the third-worst FICC performer over the period. Franchise weakness is a key issue we think.

• We believe DBK’s I-bank is a broken franchise and needs to be wound up almost entirely, leaving just a minimal platform to service its commercial clients. Doing so would release up to €35bn in equity, which would more than plug its €12.5bn equity deficit." - Source Société Générale

Not only is Deutsche Bank's struggling with legal issues, but, when it comes to the ROE of its FICC franchise at a very low 2.6%, one might wonder how long this will go on, until the music stops.

Furthermore, for pundits still believing in the "relative value" proposal of investing in bank stocks rather than having a less volatile credit exposure, we could add that as displayed by Société Générale, if the trend is your friend, when it comes to investment banking activities, revenues have gone down since 2009:

Total capital markets revenues have been declining since 2009 due to:

• Tougher regulation (higher CET1 and leverage ratio requirements, Basel 2.5 mRWA inflation) 
• Central bank QE measures – asset purchase schemes drain liquidity from trading 
• Deteriorating macro conditions, as over-leveraged countries reach the limit of supply-led GDP growth

We expect modest growth from 2016e due to slightly stronger GDP growth and inflation. There are downside risks, however, from i) further deleveraging of I-banks; and ii) global asset deleveraging causing a recession." - source Société Générale

We do share Société Générale's concerns when it comes to the downside risks and when it comes to our profound dislike for European banks stocks in general, it will continue, rest assured as we continue to prefer the stability of Senior Financial bonds which benefits from the current "implicit" backstop from the ECB.

Still, should you want to have "stocks" exposure to the banking sector, from a cost/income ratios approach, you would be better off with having American exposure than European exposure as posited by Société Générale:

The most efficient banks have:

• An intense focus on keeping structural costs low
• A keen eye on integrating technology
• Revenues with low volatility and steady growth
• Strong capital adequacy

US banks are more efficient than European banks for most of the above reasons. Looking more specifically to I-bank operations, the US banks also are better than their European peers. A big caveat is that that the CIB operations of the US banks tend to include much more significant corporate banking, transaction banking, securities services and similar (i.e. non-capital markets) activities compared with their European peers, which makes the overall CIB ratios appear lower. We still believe that US I-banks have lower cost/income ratios in pure capital markets activities than their European counterparts." - source Société Générale

But, if you believe, like ourselves, that the US economy is weaker than expected and is slowing down as per the latest raft of macro data points, given the performances of the US banking sector as a whole in 2016, it might make sense from a "risk" perspective, to start trimming your exposure, unless of course, you are a firm believer in the Fed's normalization process (we are not...). As far as Europe is concerned, we already made our case that Southern Europe's credit impulse process is a case of broken credit transmission mechanism thanks to weaker banking players in Europe being capital constrained due to "bloated" balance sheets by unresolved Nonperforming loans (NPLs) as in Italy and Portugal.

There you have it, "japanification" in Europe is still up and running and when it comes to "banking woes", we do have the case of "broken franchises" which could lead to some "Broken Arrow" calls. While we have long been vocal about the lateness of the credit cycle, we do think that regardless of the recent complacency coming from "repressed" volatility, there is indeed a large storm brewing as we will show in our final charts for this week's conversation.

• Final charts: The business cycle is turning and storm season is coming

 In January 2016 in our conversation the "Ninth Wave" we indicated:

"Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should "risk" decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy." - source Macronomics, January 2016

It is time, we think to remember that indeed, cash is part of a "defensive" strategy, given many signs are now clearly pointing, such as CCC issuance being shut down, that there is a storm brewing. On this subject we read with great interest another Société Générale report from the 15th of September from their Global Volatility Outlook series entitled "Make hay while the sun shines (and prepare for the storm)" for our final charts of our conversation:

"US focus 

Business cycle update (the storm is coming) 

The data-based Fed policy has the appearance of a self-correcting system. Poor economic data allows for delaying further rate hikes, which reassures investors in the short term, while positive economic data, theoretically makes it possible for the Fed to gradually normalise policy. But the US central bank has remained so cautious for so long that it is now running late. While the labour market is close to full employment, corporate profits have already embraced the downturn, even without the burden of strong wage pressure. When put into historical context and despite a decent bounce in the last quarter (with the Energy sector recovering on more stable Oil prices), US corporate profit margins still are not growing. They are only decreasing less rapidly. This is exactly what you would expect at this time of the cycle (assuming a recession in mid-2019), making this cycle the longest (10 years) in history, alongside the 1991-2001 cycle.
The joint analysis of profit margins and equity volatility, which we have used widely in the past, tell us that equity volatility should be on the rise at this point of the cycle and not close to lows. While end-2015 and early-2016 led us to believe that the trend was underway, Q2 and Q3 look abnormal with the VIX sub 12%. In our view, central bank policy and the low yield environment are the culprits once again.
By delaying the cyclical forces for so long and keeping rates artificially low, the Fed has created an environment which distorts classic analysis frameworks. US equities, despite trading at very high valuations, look more and more like bonds, posting limited but steady returns with low volatility, while bonds are taking on the role of the risky asset.

On a medium- to long-term perspective, the situation looks too imbalanced and the reversal could prove painful. Also worries are mounting over the fact that central banks in general could be vulnerable to external shocks, leaving them with very limited options. In this environment, the hedging theme cannot be ignored and should be handled with care by investors.
Still, the trigger for a full-blown bear market is difficult to pin down. From a tactical standpoint it is fair to say that this regime has proved robust so far and that staying outside US equities is difficult in this low-yield environment Our equity strategists highlight that a very soft Fed (we forecast an exceptionally slow pace of tightening with the next rate hike likely in December this year, two in 2017 and a peak Fed funds rate of 1.5% in this cycle), more fiscal easing, higher oil prices and accelerating M&A all will be catalysts to push the S&P 500 still higher." - Source Société Générale

While some might enjoy continue "playing" another "melt-up", it is time, we think to start thinking seriously about "hedging" as we risk moving into a new higher "volatility" regime following years of "volatility repression" if one wants to avoid having to make that fateful "Broken Arrow" call we think.

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." -  Henry Ford

Stay tuned!