Macro and Credit - Klondike

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

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

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

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

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

Synopsis:

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

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

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

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

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

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

We also added:

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

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

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

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

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

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

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

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

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

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

 - source S&P Market Intelligence

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

FOMC revises up GDP and lowers the unemployment projections

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

Insurance cuts that the Fed foresees pulling back eventually

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

Fed insurance cuts vs full rate-cut cycle

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

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

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

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

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

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

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

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

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

"The FX market. 

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

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

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

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

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

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

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

Stay tuned !

Macro and Credit - Lethe

"Forgiveness is the fragrance that the violet sheds on the heel that has crushed it." - Mark Twain

Looking at the continuation of the rally seen in January, with markets being more oblivious to macro data given the return of the central banking support narrative, when it came to selecting our title analogy we decided to go for Greek mythology and the reference to the underground river of the underworld named "Lethe". The river of "Lethe" was one of the five rivers of the underworld of Hades. Also known as the Ameles potamos (river of unmindfulness), the Lethe flowed around the cave of Hypnos and through the Underworld, where all those who drank from it experienced complete forgetfulness. 

In similar fashion, every investors drinking again from the "river of liquidity" provided by central banks including the large infusion from China's PBOC are experiencing complete forgetfulness given the significant rise in anything high beta such as small caps in the US up 18%, Emerging Markets up 10% (EEM) and US high yield up by 6% (HYG) to name a few. In Classical Greek, the word lethe (λήθη) literally means "oblivion", "forgetfulness", or "concealment". It is related to the Greek word for "truth", aletheia (ἀλήθεια), which through the privative alpha literally means "un-forgetfulness" or "un-concealment". While the privative "alpha" might means "un-forgetfulness", the on-going rally is purely of one of "high beta" given the return of the "carry" trade thanks to low rate volatility and global central banking dovishness. 

In Greek mythology, the shades of the dead were required to drink the waters of the Lethe in order to forget their earthly life. In the Aeneid, Virgil (VI.703-751) writes that it is only when the dead have had their memories erased by the Lethe that they may be reincarnated. One might wonder given the global surge of zombie companies from China to Japan, including the United States and Europe, if indeed the central banking Lethe river will enable them to become reincarnated but we ramble again...

In this week's conversation, we would like to look at the state of the credit cycle through the lens of the much discussed auto loan sector in the US.

Synopsis:

• Macro and Credit - The road to oblivion?
• Final chart - It's not only central banks, buybacks got your back...

• Macro and Credit - The road to oblivion?

Given the definition of "oblivion" is a state in which you do not notice what is happening around you (very weak global macro data), usually because you are sleeping or very drunk (thanks to central banks being reluctant in removing the credit punch bowl), we wonder how long the return of "goldilocks" will last following the baby bear market we saw during the fourth quarter of 2018. 

Sure it’s  a great start  in 2019, yet, the slowdown we are seeing is real with US December retail sales down -1.2% against a consensus of +0.1%, or the fall in US manufacturing output with motor vehicles posting their biggest fall since 2009. As we pointed out in previous conversations, global growth has been slowing and Korea, being a good "proxy" for global trade, has seen recently unemployment surging to 4.4%.

No wonder given the on-going US versus China trade spat, and with global growth decelerating that China has decided to doubling down on leverage with its financial institutions making a record 3.3 trillion yuan of new loans, the most in any month back to at least 1992 when the data began. The slowdown in Chinese car sales as well has been significant. Passenger vehicle wholesales fell 17.7 percent year-on-year, the biggest drop since the market began to contract in the middle of last year, while retail sales had their eighth consecutive monthly decline, industry groups  reported this week.

No surprise the "D" for "Deflation" trade is back on. We are back to $11tln of bonds globally with a negative yield according to the WSJ. The rise has been significant according to David Rosenberg and is up 16% since October. So yes TINA (There Is No Alternative) is back on the menu and gold is as well rising in sympathy with everything else thanks to the "Lethe" river flowing again.

If retail sales are indeed weakening and delinquencies on US auto loans are rising and with existing home sales coming in well below expectations at a 4.94 million annual rate, then the Fed's latest FOMC dovish comments appears for some pundits warranted. The sustained rebound in oil prices has been supportive of US high yield in particular and high beta in general.

While investors took another bath into the central banking river of "Lethe", when it comes to credit in general and the US consumer in particular, we do see cracks forming up into the narrative as the credit cycle is gently but slowly turning as we argued last week looking at the next Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount. If some parts of Europe are stalling and in some instances falling into recession, when it comes to the US, we have a case of deceleration. After all "recessions" are "deflationary" in nature, and most central banks have been powerless in anchoring solidly inflation expectations. 

When it comes to the state of credit for US consumers given its important weight in US GDP, we read with interest the US PIRG report published on the 13th of February relating to auto loans and entitled "The Hidden Costs of Risky Auto Loans to Consumers and Our Communities":

"The loosening of auto credit after the Great Recession has contributed to rising indebtedness for cars, increased car ownership and reductions in transit use.

• Auto lending rebounded from the Great Recession in part because of low interest rates (fueled by the Federal Reserve Board’s policy of quantitative easing) and a perception by lenders that auto loans had held up better than mortgages during the financial crisis. As one hedge fund manager noted in a 2017 interview with The Financial Times, during the recession, “consumers tended to default on their house first, credit card second and car third.”
• A 2014 report by the Federal Reserve found that a consumer’s perception of interest rate trends had as strong an effect on the decision of when to buy a car as more expected factors like unemployment and income.
• Low-income borrowers are particularly sensitive to changes in loan maturity according to a 2007 study, suggesting that the longer loan terms of recent years may have been an important spur for the rapid rise in auto loans to low-income households.
• A 2018 study by researchers at the University of California, Los Angeles, tied the fall in transit ridership in Southern California to increased vehicle availability, possibly supported by cheap auto financing.

The rise in automobile debt since the Great Recession leaves millions of Americans financially vulnerable — especially in the event of an economic downturn.

• Americans are carrying car loans for longer periods of time. Of all auto loans issued in the first two quarters of 2017, 42 percent carried a term of six years or longer, compared to just 26 percent in 2009. Longer repayment terms increase the total cost of buying an automobile and extend the amount of time consumers spend “underwater” — owing more on their vehicles than they are worth.
• Many car buyers “roll over” the unpaid portion of a car loan into a loan on a new vehicle, increasing their financial vulnerability in the event of job loss or other crisis of household finances. At the end of 2017, almost a third of all traded-in vehicles carried negative equity, with these vehicles being underwater by an average of $5,100.
• The increase in higher-cost “subprime” loans has extended auto ownership to many households with low credit scores but has also left many of them deeply vulnerable to high interest rates and predatory practices. In 2016, lending to borrowers with subprime and deep subprime credit scores made up as much as 26 percent of all auto loans originated.
• Auto lenders — and especially subprime lenders — have engaged in a variety of predatory, abusive and discriminatory practices that enhance consumers’ vulnerability, including:

• Providing incomplete or confusing information about the terms of the loan, including interest rates.

• Making loans to people without the ability to repay.

• Discriminatory markups of loans that result in African-American and Hispanic borrowers paying more for auto loans.

• Pushing expensive “add-ons” such as insurance products, extended warranties and overpriced vehicle options, the cost of which is added to a consumer’s loan.

• Engaging in abusive collection and repossession tactics once a consumer’s loan has become past due.

- source US PIRG, February 2019

In similar fashion to the predatory practices leading to the Great Financial Crisis (GFC) and tied up to subprime loans we can find many similarities in auto lending. One could argue that the depreciation value of the collateral is even more rapid than for housing and probably less "senior" when it comes the recovery value potential. 

As we pointed out in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?", credit cycles die because too much debt has been raised:

"When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion." - Macronomics, October 2017 

This is why on this very blog we follow very closely financial conditions and the Fed's quarterly SLOOs as well a fund flows. 

Returning to US PIRG report we also think it is very important to look at what has been happening in the auto loans sector:

• "7% of auto loans are 3+ months delinquent . Auto loan delinquencies climbed to $9 billion in 2018. 
• Transportation is the second-leading expenditure for American households, behind only housing. Approximately one hour of the average American’s working day is spent earning the money needed to pay for the transportation that enables them to get to work in the first place.
• Americans owed $1.26 trillion on auto loans in the third quarter of 2018, an increase of 75 percent since the end of 2009.
• The amount of auto loans outstanding is equivalent to 5.5 percent of GDP — a higher level than at any time in history other than the period between the 2001 and 2007 recessions." - source US PIRG, February 2019

Given that the auto industry is notoriously cyclical,  and that the production of motor vehicles and parts dropped 8.8 percent in January, the steepest decline since May 2009 you might want to start paying attention, particularly when consumer spending is down 1.2% which is the biggest drop since 2009.

On the subject of the severity of rising delinquencies in the US auto loan sector, we read with interest Wells Fargo's Economics Group Weekly Economic and Financial Commentary from the 22nd of February:

"Canary in the Camry?

Seven million Americans are seriously delinquent on their auto loans, according to the New York Fed. The current number of borrowers 90 days behind on their auto loan payments vastly exceeds the maximum reached in the height of the last recession. With wage growth picking up and job growth still incredibly strong, is this a harbinger of widespread financial distress or something more benign?

Due to the centrality of cars to the economic and personal stability of so many, consumers typically prioritize auto loan payments over other liabilities—even mortgage or credit card debt. Thus, a growing number of consumers transitioning into delinquency on their auto loans can be an indicator of significant financial distress. Yet, this alarming number of delinquent borrowers is to a large extent simply a consequence of an increase in the magnitude of the auto loan market. Lenders originated a record $584 billion of auto loans in 2018, increasingly to prime borrowers, who still comprise a much larger share of outstanding debt than subprime borrowers. The portion of vehicle purchases financed by debt has remained stable, and the flow into serious delinquency in Q4 only reached 2.4%. Still, this marks a noticeable deterioration in performance—this is up from the 2012 cycle low of 1.5%, and is concentrated among the young and the subprime. While the headline of seven million may not indicate a systematic threat, it can offer clues into where financial hardship is the most acute." - source Wells Fargo

Could that be the reason for restaurant sales declining in four of the past five months and at a pace we haven't seen in the last 25 years? We wonder.

If credit quality in the US has been deteriorating particularly in Investment Grade credit with a large part of the market close to the high yield frontier in the BBB segment, in similar fashion when it comes with auto loans and as posited on numerous occasions on this very blog we do expect recovery rates to be much lower in the next downturn. On the subject of the trend for recovery rates for auto loans, we read with interest Bank of America Merrill Lynch ABS Weekly note from the 23rd of February entitled "Spreads stall heading into SFIG":

"Consumer Portfolio Services, Inc (CPSS or CPS) - sponsor of $2.3bn in subprime auto loan ABS; lender with an auto loan portfolio of $2.4bn

Management continues to believe competition is aggressive. CPSS implemented a new credit underwriting scorecard mid last year, which lead to better quality originations.

The company’s originations grew in 2018 relative to 2019, which led to 2% growth in the company’s managed portfolio. Management indicated that incremental originations in 4Q18 were driven by turndowns from banks and other lenders.

The thirty day delinquency rate for the company’s managed portfolio was 12.35% at the end of 4Q18, up 254bp YoY. The net charge off rate for the quarter was 7.19%, down 5bp YoY. Management attributed higher delinquencies to lower portfolio growth and denominator effect. Net losses for the full year were 7.74% compared to 7.68% in all of 2017. Recoveries declined 170bp YoY to 33%. Management said unemployment is the primary driver of performance, and the employment picture is strong today.

The company’s total blended cost for on-balance sheet ABS debt 4.25% in 4Q18 compared to 3.82% for the 4Q17. Management noted that EU risk retention impacted the company’s January ABS transaction." - source Bank of America Merrill Lynch

To repeat ourselves, credit cycles die because too much debt has been raised. Given the Fed has shown its weak hand as it is clearly "S&P500 dependent", the latest dovish tilt from the Fed will encourage more aggressive issuance as the competition is ratcheting up in the weakest segment of consumer lending. So all in all the "Lethe" liquidity river is flowing strong with many pundits oblivious to cracks forming into the credit narrative. We think that in the ongoing high beta rally, it is more and more important to play the capital preservation game, meaning one should start reducing in earnest the "illiquid stuff" such as the now "famous infamous" leveraged loans regardless of their recent "strong" performance.

For now, investors have dipped again into "Lethe" hence the return of the "goldilocks" narrative following a short bear market during the final quarter of 2018. Bad news have been good news again thanks to the dovish tone embraced by central banks globally but, we remain very cautious when it comes to equities given the velocity in revised earnings. In that context, playing defense by favoring credit markets, including Investment Grade appear to us more favorable as the rally in equities has been very significant and potentially overstretched as many pundits are placing their hope on a trade deal being made between China and the United States. Sure "goldilocks is back but we are cautious given the late stage of the credit cycle. On that point we agree with Morgan Stanley from their CIO Brief from the 21st of February:

"The Trouble with ‘Goldilocks’The Goldilocks narrative has reappeared: inflationary pressures have receded, giving central banks cause to pause on policy tightening; global growth is slowing, but not enough to be truly concerning; and investors are increasingly optimistic about US-China trade. However, we think that investors should be skeptical of the Goldilocks narrative, as fundamental data is weak and earnings are challenged.

We are not looking to add exposure, and have reduced some emerging market beta into strength. We remain short the broad USD and overweight international over US equities." - source Morgan Stanley.

A dovish Fed in that context make selected Emerging Markets still enticing, yet from an allocation perspective, dispersion for both equities and credit markets have been rising. So, you need to be much more discerning in 2019 when it comes to your stock/credit picking skills.

Though we are getting concerned for the damage inflicted to earnings in recent months on the back of the trade war narrative and deceleration in global growth, there is no doubt that central banks are back into play and it should not be ignored. Bank of America Merrill Lynch made some interesting comments in their "The Inquirer" note from the 18th of February entitled "Is Global Monetary Reflation here?":

"In the last week, it seems like global central banks have started a possible process of monetary easing, in line with our views (The Inquirer: Planet Earth to Policymakers: Please Reflate 31 December 2018). If so, this would be very positive for Asia/EM stocks.
In the US, Fed governor Lael Brainard raised the possibility of ending balance sheet contraction by year-end 2019, ahead of schedule; in Europe, the possibility of a TLTRO came from Commissioner Benoit Coeure, and China printed a massive January Total Social Financing number, RMB4,640bn from RMB1,590bn in Dec 2018, above market expectations of RMB3,300bn and the BofAML forecast of RMB3,500bn. Global monetary reflation is possibly on the way. As of now, we remain bullish. We expect the world's central banks to reflate monetary policy, a view we have held since late last year.
Paraphrasing Mike Tyson, everyone's got an investment strategy, until they get punched in the face by a shrinking Central Bank Balance Sheet. Monetary and liquidity analysis (different from "fund flows") was popular in financial markets three decades ago. We remember having a standalone research product in the mid-1990s called "Liquidity Analysis" replete with central bank balance sheets, commercial bank entrails, and the net supply and demand for equity. These days, eyes glaze over when we bring up base money growth, money multipliers, and monetary velocity. However, as the last decade has taught us, we should pay attention to this stuff. Our global strategist, Michael Hartnett, has maintained a consistent focus on liquidity and central bank balance sheets
as part of his toolkit.
1) We think the biggest risk to equities in Asia and EMs is the potential mismanagement and premature contraction of central bank balance sheets. Conversely, it is also the most lucrative opportunity. The correlation of EM equities with the major central banks balance sheets is 0.94 in the past three years. World equities have a similar correlation of 0.94 since 2009. Central bank balance sheets are the most important driver of stock prices, in our view, by lowering risk premia, and cutting off deflation risk. The rest is detail, in our view.

2) We think the Fed is the most flexible in course correcting - they have the alacrity of market strategists and change their minds if the facts change. Just last week, Fed Governor Lael Brainard suggested that the Fed balance sheet contraction should end by 2019, rather than 2020-21. A host of Fed governors changed their minds about rate hikes from December last year to early January. While being bearish the USD was consensus at our CIO conference on Jan 18, 2019, we think US Fed flexibility is an under-appreciated asset for the USD, which refuses to fall.

3) However, we worry that in Europe, Japan, and most importantly, China - a total of USD40tn in GDP, or half the world's total - a misreading of the secular decline in monetary velocity, and the general drop of money multipliers, will lead to lower nominal earnings growth, a return to deflationary dynamics, and asset market dislocations. EM/Asian equities tend not to like this scenario.

The world monetary base is shrinking, only the sixth time since 1980 - each prior episode resulted in massive losses in Asian/EM equities (1982: -31%, 1990: -14%, 1998: -28%, 2000: -32%, 2008: -54% for EMs). In all five cases, Asia was in recession.

Why should this time be different? The US Fed's projected balance sheet contraction of about USD40bn a month will likely reduce the US monetary base 13.8% this year (after contracting 10.7% last year), and the global real monetary base by 1.6%. After spending seven years telling us that the Fed B/S expansion was equivalent to rate cuts, we are now told that the opposite - B/S contraction is like "watching paint dry". Ostensibly, this comes from heroic assumptions of a rise in the US money multiplier, even a potential doubling in three years. The Lael Brainard "end-QT earlier" is helpfully walking back some of this prior aggressive QT fervor. And that’s a good thing -that’s the main impetus to growth in old, indebted and unequal societies.
4) Apart from China, which has control over its money multiplier through the high reserve requirement ratio, most large economies have seen falling money multipliers for the last two decades. Stopping QE - or slowing the QE-induced growth of the monetary base - will likely lead to a sharp drop in M2 growth (M2 is simply the monetary base multiplied by the money multiplier). Couple that with the secular drop in monetary velocity from the declining incremental productivity of debt, and slower nominal global GDP (and EPS) growth is highly likely. Rising indebtedness globally, demands a stronger money supply growth rate to maintain a desired level of economic (and earnings
growth). This is an identity, not a theory. This is increasingly true for China, with its 253% debt to GDP ratio. A lack of Chinese monetary stimulation is likely to impose more severe costs on growth there. The world's central bankers seemed oblivious to this until last week, and even now it is not clear where they stand. Welcome back to the secular stagnation debate. And the potential threat of a "too tight policy mistake".

Chair Ben Bernanke during his testimony about the Federal Reserve Board’s semiannual report on monetary policy said that he equated $150-200 billion of QE as being equivalent to a 25bps reduction in short term rates. So 600billion in QE2 was equivalent to a 75bps reduction.
https://www.c-span.org/video/?298238-1/monetary-policy-report (at 32 minute)

Fed Balance sheet contraction is NOT watching paint dry. Math question: If USD100bn of expansion was equivalent to a 14bp fall in the fed funds rate, a USD400bn contraction is equivalent to? (answer: a 56bp rise)" - source Bank of America Merrill Lynch

It seems to us that Jerome Powell has finally done the math hence the "u-turn" as seen in the increasing use of "patience" in the most recent FOMC notes. This explains why investors have returned to becoming oblivious to the deteriorating macro picture given once again they have taken a dip into the "Lethe" river thanks to the rescue of central banks.

Another strong support as well to the "high beta" rally narrative and "risk-on" environment as per our final chart has been the return of stocks buybacks which have received some strong critics as of late from the US political "left" side.

• Final chart - It's not only central banks, buybacks got your back...

Since 2012, multiple expansion through share buybacks have provided a strong support to US equities. Not only Jerome Powell has made au-turn but he has also told markets that balance sheet contraction aka QT is ending sooner rather than later, in 2019 that is. Our final chart comes from Bank of America Merrill Lynch Equity Flow Trends note from the 19th of February entitled "Buybacks on pace for another record year" and shows that in similar fashion to 2018, the return of buybacks on top of the central banking "Lethe" river provides additional support to the "oblivious" crowd of investors jumping with both feet on the high-beta wagon:

"Buybacks remain strong in Tech and Financials, but have broadened out across other sectors YTD: notably, Staples and Materials buybacks are on track to handily exceed 2018 levels (Chart 1).

The current pace of buybacks would suggest a record year in these two sectors plus Financials and Utilities; Industrials and Discretionary buybacks, while below post -2009 records, are also set to eclipse last year’s levels." - source Bank of America Merrill Lynch

If "R" is for Recession and "L" is for Leveraged then "G" is for Gold. With the recent return of the river of unmindfulness, no wonder, the strong "bull" market has been "reincarnated" and the zombie companies can continue to "live" another day but we are ranting again...

"To err is human; to forgive, divine." - Alexander Pope, English poet

Stay tuned !

Macro and Credit - The Clemency of Titus

"Clemency is the noblest trait which can reveal a true monarch to the world." - Pierre Corneille

Watching with interest France getting a onetime exemption for its swelling budget deficit for 2019 with France now expecting a budget deficit of 3.2% of GDP (it will be higher rest assured...), whereas Italy in recent days has offered to target a budget deficit of 2%, when it came to selecting our title analogy for our first post for 2019, we decided to go for a musical one, Mozart's 1791 opera entitled "The Clemency of Titus". 

In 1791, the last year of his life, Mozart was already well advanced in writing Die Zauberflöte by July when he was asked to compose an opera seria. The commission came from the impresario Domenico Guardasoni, who lived in Prague and who had been charged by the Estates of Bohemia with providing a new work to celebrate the coronation of Leopold II, Holy Roman Emperor, as King of Bohemia. The coronation had been planned by the Estates in order to ratify a political agreement between Leopold and the nobility of Bohemia (it had rescinded efforts of Leopold's brother Joseph II to initiate a program to free the serfs of Bohemia and increase the tax burden of aristocratic landholders). Leopold desired to pacify the Bohemian nobility in order to forestall revolt and strengthen his empire in the face of political challenges engendered by the French Revolution. No opera of Mozart was more clearly pressed into the service of a political agenda than "La clemenza di Tito" (The Clemency of Titus), in this case to promote the reactionary political and social policies of an aristocratic elite. No evidence exists to evaluate Mozart's attitude toward this, or even whether he was aware of the internal political conflicts raging in the kingdom of Bohemia in 1791. 

In similar fashion, we think that the European Commission's one off "clemency" in relation to France's budget deficit trajectory comes from a desire to "pacify" and "forestall" revolt and maintain the European "empire" in the face of upcoming European elections and political challenges. These challenges have been increasing at a rapid pace in 2018 with the rise of their nemesis aka "populism" but, we ramble again...

In this first post of the year, we would like to look at the continuation of "risk-off" and what it entails. We have been pretty clear about the need to reduce your high beta exposure credit wise in the light of additional weakness in oil prices affecting dearly the US High Yield CCC bucket. Also, we did advise you to raise your cash levels to start playing defense and we were lucky enough to spot the peak in US equities in our first October conversation "The Armstrong limit". The rest, as we say, is history...But, as 2019 is already showing, volatility is very strong. 

Synopsis:

• Macro and Credit - Looking for "safe havens"
• Final chart  -   Confidence has taken a knock

• Macro and Credit - Looking for "safe havens"

As we pointed out in our November conversation "Zollverein", when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock". The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index managed to lose 2.54% over the month of December, still managing to post a positive return of 0.44% whereas US High Yield was down 2.26% for the year, close to US Investment Grade losses at 2.25%. Flow wise, U.S. High Yield funds ended up a bloody 2018 with a $3.94 billion withdrawal for the week ending on December 26. The full-year outflow amounts to a cool $35.3 billion, according to Lipper weekly reporters.

Back in September in our conversation "The Korsakoff syndrome", we pointed out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).

This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. In their paper they pointed out that investor portfolio choice towards high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms.

Why do we look at fund flows? There is as well another reason to our focus.

We like to look at fund flows from a total return perspective. This is a subject we also discussed in our January 2018 conversation "The Lindemann criterion":

"Fund flows have a tendency to follow total returns

Fund flows have a tendency to follow total returns, both on the way up and on the way down. When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash. As the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off." - source Macronomics, January 2018

Of course, retail investors, being more feebler when it comes to their holding, no wonder they have been recently fleeing leveraged loans ETFs given the "liquidity" focus and attention it has been given by many pundits including former central bankers. As indicated by LeveragedLoan.com on the 1st of January, outflows in leveraged loans have been significant in recent weeks:

U.S loan funds saw yet another record outflow during the week ended Dec. 26, as retail investors withdrew $3.53 billion, according to Lipper weekly reporters. 

That’s the sixth straight substantial outflow, totaling a massive $13.5 billion, punctuating a staggering turnaround for the asset class. Before that withdrawal streak, U.S. loan funds and ETFs had seen some $10.3 billion of net inflows. For 2018, then, the final figure will be a net outflow of $3.1 billion, according to Lipper. 

The most recent activity brings the four-week trailing average to a $2.6 billion outflow. 

Loan funds accounted for $2.9 billion of this week’s outflow, while ETFs accounted for a $626 million outflow. The change due to market value was negative $746 million. 

With the withdrawal, loan fund assets have dropped to $90.7 billion, including $9.8 billion from ETFs, says Lipper. — Tim Cross" - source LeveragedLoans.com

When the trend is not your friend...The pressure on funds has been relentless and outflows significant in various asset classes as indicated by Bank of America Merrill Lynch in there Follow The Flow report from the 28th of December entitled "The worst year since the ’08 crisis":

"Closing the worst year since ’08 

Only a few days to go before the end of the year, and 2018 will be remembered as the worst year since 2008. Outflows dominated this year across high-yield, high-grade, equities and EM debt funds. The lack of yield across European fixed income assets and the lack of catalysts to reverse the outflows we have seen this year are painting a dim picture for 2019. With macro indicators continuing to point to more downside, we expect further widening in credit land. We also expect further beta underperformance amid challenging liquidity backdrop and rising idiosyncratic risks as the ECB QE is now over. 

Over the past week… 

High grade funds suffered another outflow, making this one the 20th week of outflows over the past 21 weeks. High yield funds recorded another outflow, the 13th in a row. Looking into the domicile breakdown, US-focused funds led the outflow trend, while Euro and Global-focused funds were slightly less impacted. 

Government bond funds recorded an inflow this week, the fourth in a row. Meanwhile,

Money Market funds recorded another large outflow. 

All in all, Fixed Income funds recorded another outflow, bringing this year’s outflow to

$102bn, a negative record for the asset class. 

European equity funds also continued to record outflows, making this week the 16th

consecutive week of outflows. During the past 42 weeks, European equity funds

experienced 41 weeks of outflows.

Global EM debt recorded another large outflow this week, the 12th in a row.
Commodity funds recorded another inflow. 

On the duration front, short-term and mid-term IG funds led the negative trend by far, while the long-end of the curve recorded another small inflow." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch, cracks in credit markets have been significant and unless there is some stabilization, there will be additional pain inflicted to the high beta crowd hence the need to reach for quality.

As well throughout 2018, we mentioned rising dispersion in credit markets with investors becoming more discerning when it comes to selecting issuer profiles. We also touched on the increasing trend in large standard deviation moves in various asset classes typical in the late stage of an extended credit cycle which has been plagued by years of repressed volatility thanks to central banks meddling.

For instance, the latest Japanese yen's flash crash/rally highlighted how Mrs Watanabe aka Japanese retail investors, through Uridashi funds are still heavily invested in carry trades for extra yield such as the Turkish Lira, though in recent years they have drastically increased their allocation to the US dollar it seems as indicated by Bloomberg on the 3rd of January in their articled entitled "Flash-Crash’ Moves Hit Currency Markets":

"With Japan on a four-day holiday this week, traders said they struggled to handle a flood of sell orders with pricing erratic. Once the yen strengthened past 105.50 against the dollar, others were forced to cover their short yen positions, said traders who asked not to be identified as they aren’t permitted to speak publicly.

“It looks more like a liquidity event with the move happening in the gap between the New York handover to Asia,” said Damien Loh, chief investment officer of hedge fund Ensemble Capital Pte., in Singapore. “It was exacerbated by a Japan holiday and retail stops getting filled on the way down especially in yen crosses.”

As a result, the yen surged against every currency tracked by Bloomberg, and was up 1 percent against the dollar at 107.78 by 9:30 a.m. in London.

The haven asset has strengthened against all its major counterparts over the past 12 months as concerns over global economic growth mounted and stocks tumbled. It rose 2.7 percent against the dollar last year, the only G-10 currency to gain versus the greenback." - source Bloomberg

Given the intensity of the selling in December, with credit spread widening and gold surging as well in conjunction with the Japanese yen, no wonder investors are trigger happy when it comes to seeking refuge from the indiscriminate selling we have seen over the last quarter and in particular during the last month of the year.

The search for safe havens is well described also in Bloomberg's article from the 3rd of January entitled "In This Mess of a Market, Safe Havens Are Making a Comeback":

"The remarkable thing about recent yen performance may not be its almost 4 percent surge against the dollar on Thursday, but the fact the currency just clocked its best month in about two years.

That exact statistic also applies to gold, which in December notched the largest jump since January 2017. Both assets have continued to climb this year. Meanwhile, bonds of G-7 governments had their best December in a decade, according to a Bank of America Merrill Lynch index.

Put simply, traditional havens are back.

The same myriad of drivers bedeviling equity investors in 2019 is also sending them to safety. While the trade war is showing up in real-world data, it’s cropping up in company earnings too, as evidenced by Apple Inc.’s guidance cut on Wednesday. At the same time, Federal Reserve tightening is sapping liquidity and in the process reigniting volatility in markets. Idiosyncratic risks from the likes of Brexit and Italy’s budget squabble with the European Union are merely compounding the risk-off mood -- and adding fuel to the haven trade." - source Bloomberg

With earnings disappointment leading to more large standard deviations move in equities as indicated by Apple but by also Delta Airlines, with no real clear resolution as of yet in the trade war narrative between China and the United States, 2019 has started with even more volatility to say the least.

No wonder as indicated by Bloomberg's article above that the shiny little metal aka "gold" has been seen as well as a "safe haven" in times of acute turmoil:

"Going for Gold

Sentiment toward gold also brightened in mid-October, when money managers abandoned their record net-short position against the metal as the outlook for the dollar deteriorated.

Since then, investors have piled into exchange-traded funds backed by bullion, which have amassed 126 tons of metal worth $5.2 billion in 60 sessions -- the biggest increase over a comparable period in more than 18 months.

A paring of expectations for rate hikes has also contributed to demand, as gold typically falls during periods of monetary tightening because it’s a non-interest bearing asset.

“Gold is bid due to multiple headwinds” for the world economy, said Ole Hansen, the head of commodity strategy at Saxo Bank A/S by email. “Stocks, the dollar and bond yields are all down while the risk of further U.S. rate hikes has almost been removed.” - source Bloomberg

This is as all to do with investors looking at the flattening of the yield curve, weaker macro data and deceleration in global trade in conjunction with weaker earnings than expected and trying to figure out if the Fed will show some "Clemency" in similar fashion as Titus did in Mozart's opera.

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it has been working again nicely in December:

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

Of course given the uncertainty surrounding the number of hikes and additional tightening from the Fed with the acute weakness in US equities, no wonder some pundits have been resorting to this "put-call parity" strategy.

Obviously, the sudden rise in US wages to 3.2% YoY in December, the fastest pace since April 2009 and with Nonfarm payrolls coming at 312K versus 177K expected, with a more dovish Fed on the wire as we type this very post, it seems that Fed chairman Jerome Powell has been listening to Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the Wall Street Journal, hence the strong rebound seen in equities markets today. Not only have we seen the return of a Fed put, hence our "clemency" title analogy, but China has well has come to the rescue of decelerating growth with its cut of the required reserve ratio by 1% to release cash into the economy and support rapidly stalling growth. The RRR for banks will drop by 0.5% on January 15 and a further 0.5% on January 25, the PBOC said. Here comes the central banking "cavalry".

For credit markets, at least on the US side damages have already been done as seen in large outflows seen in recent weeks. What would clearly stabilize the situation we think, at least for US High Yield, would be a bounce in oil prices which would probably lessen the velocity in credit spread widening particularly in the high beta space of the CCCs bucket highly exposed to the energy sector.

Can the Fed restore "goldilocks"? A not too hot and not too cold economy? We wonder again, how much damage has been inflicted to US earnings due to the long lasting trade war narrative. Was the Apple large standard deviation move a wake-up call for the Fed?

One thing for sure is that the Huawei fight with the US administration is not about trade war, but mostly about "tech" war (and 5G). On that subject, we recently used the following chart in relation to the quantity of jobs created versus the quality as per the data from the BLS, this doesn't comprise the latest data release:

- graph source BLS - Macronomics

Back in January 2017 in our conversation "The Ultimatum game" we argued:

"The United States needs to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017 

Once again it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits. The lackluster most recent Purchasing Managers Index showed a fall in the reading from new orders in the US from 61 to 51, and China as well has been decelerating with its export orders falling below the 47 mark. This clearly shows that there is no clear winner from a trade war. 

Sure talks are about to start again between China and the United States but at this stage, as we stated above, it is all about damage assessment on earnings. 

Given the Fed has been on a hiking path in conjunction with its QT, as we stated in our conversation "Ballyhoo" in October 2018,  using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions, a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions. On the subject of financial conditions we read with interest Nomura Special Report from the 28th of December entitled "Financial conditions turned restrictive for growth":

"Key Developments

• Our revised US financial conditions index (FCI) suggests financial conditions are now restrictive for growth (Figure 1).

•  Since the end of September our FCI has declined almost a full percentage point – from +0.7% to roughly -0.3% currently. The units of our FCI are the contribution of financial factors to growth over the next six months (see Refreshing US Financial Conditions Index for a complete explanation).

• After heightened volatility in October and November, US equity markets sold off sharply in December. So far this month the S&P 500 index is down 10.8% (through 27-Dec). Implied equity volatility remains high. The VIX index jumped sharply in December and remains elevated.
• Corporate spreads have widened notably since end-September. Investment grade options-adjusted spreads are now roughly at their long-term median, but they remain well below levels reached in late 2015 and early 2016.
• Business surveys suggest that credit is only modestly harder to get, at least for smaller businesses.
• The recent tightening of financial conditions is notable, in both equity and credit markets, and will probably affect how the FOMC sees the risks around its forecast.
• Potential external risks, such as Brexit, US-China trade negotiations and US fiscal policy debates in Congress, raise economic uncertainty and have a potential to tighten financial conditions further.
• At the margin, the recent tightening of financial conditions reduces the probability that FOMC will raise short-term interest rates again soon." - graph source Nomura.

This explains probably the "reflexivity" issue seen in the markets given the flattening of the yield curve with weaker macro data and decelerating global growth which created anxiety relating to the double impact of both rate hikes and QT on financial conditions.

As pointed out by Andreas Steno Larsen from Nordea on his twitter feed there is a direct relationship between US Financial Conditions and ISM Manufacturing PMI:

"We have been pretty explicit recently that ISM would drop FAST! ISM dropped from 59.3 to 54.1 in Dec.
Unfortunately more of the same is in store over the coming 3-4 months. Below 50 readings could be on the cards." - source Nordea, twitter

Obviously the recent dovish tone taken by Fed chairman Jerome Powell seems to have had the desired effect of tampering the velocity in the tightening.  

As pointed by Bloomberg in their article from the 3rd of January entitled "Jerome Powell Pledged Allegiance to Data and Some of It Looks Grim", the Fed is clearly in damage assessment mode when it comes to the data, regardless of the strong Nonfarm payroll print:

"Factory PainIf there’s one place where the data are souring decisively, it’s manufacturing. The Institute for Supply Management’s factory index dropped by the most since 2008 last month and touched a two-year low. While the ISM gauge remains in expansionary territory at 54.1, just 11 of 18 industries reported growth in December. That’s the fewest in two years.

Production problems are far-reaching. JPMorgan Chase &Co. and IHS Markit’s global manufacturing index fell in December to the lowest level since September 2016 as measures of orders and hiring weakened, data showed this week.

Trade uncertainty and concerns about global growth seem to be an important factor in the recent U.S. weakness: tariff worries have surfaced repeatedly in Fed surveys. Apple Inc. cut its revenue outlook this week for the first time in nearly two decades thanks to weaker demand in China.

Housing Wobbles 

Fed officials watch the housing market because it’s an interest-rate sensitive sector, and it’s been showing signs of cooling for months. That hasn’t abated since the Fed last met: the pending home sales index dropped 0.7 percent on a monthly basis in November, compared to an analyst expectation for a 1 percent gain. Home prices are still rising, but the latest S&P CoreLogic Case-Shiller index showed that gains continue to moderate.

Market Souring

While it’s not a real-economy measure, the Fed closely watches market volatility because it can feed through to consumer and business sentiment and the real economy. Stocks saw the worst December rout since the Great Depression and a few near-term Treasury security yields have crept above their longer-term counterparts since Powell’s December press conference, a sign that investors were pessimistic about the outlook for growth.

That’s enough to make Powell’s colleague in Texas, Dallas Fed President Robert Kaplan, argue for putting rate increases on hold for the first couple of quarters of 2019.

“This is a very critical time. We need to be very vigilant. We need to be on our toes. And I think patience is a critical tool we should be using during this period. We can get this right,’’ Kaplan told Bloomberg Television in an interview on Thursday." - source Bloomberg

The big question is, will this be enough to initiate a strong rebound in equities and a rally in all things "high beta" such as leveraged loans? 

When it comes to leveraged loans, as pointed out by Lisa Abramowicz from Bloomberg on her twitter feed, there has been already some "short covering" happening:

"BKLN, the biggest leveraged-loan ETF, is posting its best one-day rally in its eight-year history. Loans are suddenly benefiting from both a more positive outlook on the U.S. economy paired with benchmark rates that are rising again." - source Lisa Abramowicz - Bloomberg - twitter

Again what could cause a sustained rally? Clearly the "Clemency" of both the Fed and the PBOC can trigger some significant "short covering" also a positive agreement between the United States and China would alleviate some concerns, yet when it comes to the forward EPS optimism we criticized back in 2018 as not being warranted, it is all about how much "reflexivity" has been triggered and how much "confidence" has been shattered by the recent violent gyrations in various asset classes we think.

"The Clemency of Titus" aka Fed Chairman Jerome Powell is linked to the transmission mechanism between FOMC policy and the real economy. On this very subject we read with interest Wells Fargo's take from their note from the 3rd of January entitled "Time to Press Pause? Financial Conditions & the FOMC":

"Financial Conditions Have Tightened

Financial markets deteriorated sharply at the end of 2018. The S&P 500 fell more than 10% in the fourth quarter, while the yield on the 10-year Treasury security slid about 30 bps as investors flocked to safer assets. Given the forward-looking nature of markets, the tumult raised concerns about growth in the new year and was even seen as a reason the FOMC might hold off on its widely telegraphed rate hike in December. Chairman Powell stated numerous times in his post-meeting press conference that the Committee was not looking solely at financial markets, but broad financial conditions. So how have financial conditions—not just markets—evolved recently, and what does it mean for economic growth and the future path of FOMC policy?

For a wide-ranging view of financial conditions, we turn to the Chicago Fed’s National Financial Conditions Index (NFCI). The index includes 105 variables, capturing leverage, risk and credit conditions. Since the index is constructed to average zero over time (with a standard deviation of one), negative readings indicate historically loose financial conditions, while positive readings indicate historically tight conditions. Therefore, higher values of the index are indicative of tighter financial conditions.

The NFCI rose 14 bps over the fourth quarter of 2018 (Figure 1).

 - Source: Bloomberg LP, Federal Reserve Bank of Chicago and Wells Fargo Securities

The move was the largest quarterly increase since the start of 2016—a point at which the FOMC hit pause on rate hikes. Specifically, risk-related measures, like the VIX index and TED spread, have risen over the past few months. At the same time, indications of leverage, like weakening corporate debt issuance, have pointed to more restrictive financial conditions (Figure 2).

- Source: Bloomberg LP, Federal Reserve Bank of Chicago and Wells Fargo Securities

Credit conditions, which reflect the willingness to borrow and lend at prevailing prices, have been little changed. But the overall NFCI generally remains at a low level, indicating that general financial conditions are not overly restrictive at present.

Financial Conditions: The Transmission Channel between FOMC Policy and the Real Economy

Financial conditions per se are not an objective for the FOMC, but they are taken into account due to their indirect effects on the Fed’s two policy goals: “price stability” and “maximum employment.” The committee’s aim in tightening policy is to prevent the economy from overheating to the point that it risks significantly overshooting its inflation target, which it defines as PCE inflation of 2%. However, the FOMC’s primary policy tools, the fed funds rate and the balance sheet, have little direct effect on the Fed’s two policy objectives.

Instead, the FOMC’s tools affect the economy by influencing other interest rates and risk taking. In that way, financial conditions capture the transmission of FOMC policy to the real economy. Businesses and households will modify investment and saving plans depending on the relative ease or tightness of financial conditions. Tighter conditions, reflecting the availability and cost of credit, may reduce the ability and/or willingness to take on debt, which, all else equal, could weigh on growth in investment and consumption and thereby on the overall rate of real GDP growth. In contrast, easier conditions could stoke up growth in consumption and investment.

Behind the Starting Line after Three Years of FOMC Tightening

Given that financial conditions are influenced by FOMC policy, it is not unexpected to see broader financial conditions tighten as the Fed normalizes policy. In other words, tighter financial conditions are an anticipated byproduct of FOMC rate hikes. But monetary policy decisions and broad financial conditions do not always move in tandem. Despite the FOMC raising its target range for the fed funds rate 225 bps since late 2015, financial conditions as measured by the NFCI have eased on net over the period (Figure 3).

 - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

The easing has primarily come in terms of credit, with, for example, corporate bond spreads narrower and bank lending standards looser. The overall easing in financial conditions since late 2015 stands in contrast to the previous two tightening cycles in which the FOMC raised rates by the same amount. As noted previously, general financial conditions do not appear to be overly restrictive at present.

With financial conditions still easy relative to when the Fed first began to normalize policy, does that mean there is more tightening in store? In each of the previous six rate-hiking cycles, the FOMC did not stop until financial conditions had tightened on net (Figure 4).

  - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

This historical record suggests that the FOMC may very well have a few more rate hikes to go in this cycle, at least at first glance.

Does the FOMC Need to See Financial Conditions Tighten Further?

The traditional NFCI does not take into account underlying economic conditions. All else equal, it makes sense for investors to take on more risk, for households to take on more debt and for lenders to ease standards in an improving economic environment. As a result, financial conditions and economic conditions are often closely correlated. Therefore, it is not unusual to see financial conditions ease, at least for a time being, at the same time the FOMC is raising rates—both are responding to a stronger economy.

To isolate financial conditions only, the Chicago Fed also calculates an Adjusted National Financial Conditions Index (ANFCI). The ANFCI controls for the macroeconomic environment, and thus it is more telling in regard to how underlying financial conditions have evolved. By this measure, financial conditions have tightened more in recent months than implied by the NFCI alone (Figure 5).

  - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

Specifically, the ANFCI has increased about 20 bps since late September, which is about twice as much as the increase in the NCFI. Although the ANFCI remains low in a historic context, the rise in the index implies that financial conditions are a bit tighter in total than when the Fed first began raising rates in late 2015 (Figure 6).

 - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

The degree to which financial conditions have tightened over a rate-hike cycle helps quantify how far—or short—the FOMC has come. Yet there is no set amount by which financial conditions need  to tighten, or a threshold to cross, before the FOMC stops raising rates. If the economy is showing few signs of overheating, looser financial conditions relative to the start of a tightening cycle are not necessarily a problem. The same can be said for an economy where growth is slowing back toward its longer-run trend, as is the case today.

How financial conditions impact the stability of the overall financial system may, however, be of concern. If a prolonged period of loose financial conditions stokes instability via greater risk taking, more leverage and questionable credit, then those factors may affect policymaking. That said, the primary means of addressing financial instability are likely to be targeted regulatory (macro-prudential) policies by the Federal Reserve and other federal banking agencies rather than the blunter tool of changes in interest rates by the FOMC. At present, the Fed generally does not seem to be unduly concerned with financial stability. The Federal Reserve Board’s inaugural Financial Stability Report released in November found that while valuations are elevated, private sector credit risks are moderate and leverage and funding risks are low.

Moreover, the cumulative amount of tightening in financial conditions may not be as much of an issue as the speed. Over the past month, the financial conditions indices rose faster than at any time since the start of 2016 (Figure 7).

Given that it takes time for financial conditions to effect the real economy, the FOMC could perceivably hold off on subsequent rate hikes in the near term as it waits to see how financial conditions have affected growth prospects.

Conclusion: The FOMC Might Revisit the Pause Button

The last time financial conditions tightened as sharply as this past December was at the start of 2016. Back then, the FOMC had just raised the fed funds target rate for the first time since the crisis. However, signs of slower growth in China caused volatility in financial markets to spike and overall financial conditions tightened. Following its initial rate hike in December 2015, the FOMC subsequently remained on hold until December 2016.

Our most recent forecast, which was compiled in early December, looks for two 25 bps rate hikes in 2019, first in March and again in September. But we readily acknowledge that the risks are skewed to a longer pause in the first half of the year than we thought just a month ago. Overall financial conditions do not appear to be overly restrictive at present, but they clearly have tightened in recent weeks. Consequently, the FOMC may decide that a period of wait-and-see is again appropriate, especially with the fed funds target rate already close to many committee members’ estimates of “neutral” and with inflation showing few signs of significantly exceeding the Fed’s target of 2%. We will be watching incoming data and making changes to our Fed call, as appropriate." - source Wells Fargo

Sure "Titus" might have shown some "late" clemency and maybe just re-initiated the infamous/famous "put" given the recent rout in various asset classes, but it remain to be seen if it too late to re-ignite the "animal spirits" and trigger a sustained rally given that a lot of damages have already been inflicted on the back as well of more surprises to be seen on more "earnings surprises à la Apple or Delta Airlines. We continue to advocate playing defense and use the rally to reduce your beta exposure in search of quality. It doesn't matter how long the Fed's clemency is going to last, we think we are clearly in the final innings of this extended credit cycle and you probably should focus more your attention on capital preservation than capital appreciation. 

If indeed the Fed is data dependent (or more likely S&P dependent...), then obviously, the "Clemency of Titus" is somewhat warranted as per our final chart below showing that for global CFOs, they have been less optimistic thanks to trade war fatigue obviously. 

• Final chart  -   Confidence has taken a knock

If success is a mind game, so is confidence and in the case of CFOs as per our final chart from Bank of America Merrill Lynch's The Inquirer note from the 31st of December entitled "Planet Earth to Policymakers - Please Reflate", then there is more downside to come when it comes to Global PMIs:

The view of asset markets and global CFOs is in sync – global growth is now in a broad, deep and persistent slowdown. The IMF, however, sees global real GDP growth going from 3.73% in 2018 to 3.65% in 2019, a second decimal slowdown. Policymakers are in the same stable boat, which is vulnerable to capsizing. The breadth of OECD leading indicators, which was near historical highs at the start of the year, has weakened considerably. In October 2018, only 10% of countries saw YoY rises in the OECD leading indicator vs. 71% in January 2018. In January 2018, 46 of 47 global equity markets were above their 200-day moving averages, now only 7 of 47 are. The world monetary base is contracting 0.5% YoY, and likely to shrink 4.6% by December 2019, unprecedented in 37 years.

The bottom line: Financial markets and CFOs think the world economy is in real trouble. Policymakers are oblivious to this scenario. One of them is going to be wrong. Past history suggests, the policymakers. The science experiment of Quantitative Tightening might be halted, the Chinese credit impulse is still in free-fall and might need to be revived a lot more dramatically, and global fiscal easing could be a lot more muscular. Those are 2019’s likely surprises. If this happens, Asia and EM equities could be in for massive gains. Stay tuned." - source Bank of America Merrill Lynch

Could the central bank cavalry come to the rescue of global equities? Or is too little too late? We wonder....

"If there is something to pardon in everything, there is also something to condemn." -  Friedrich Nietzsche

Stay tuned!