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 - White Tiger

"Earnings don't move the overall market; it's the Federal Reserve Board... focus on the central banks, and focus on the movement of liquidity... most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets." - Stanley Druckenmiller

Watching with interest the trade war between the United States and China ratcheting up with Beijing cancelling its plans to send two delegations to Washington, given the season of fall is upon us, when it came to selecting our title analogy, we decided to go for "White Tiger". The White Tiger is one of the four symbols of the Chines constellations. It is sometimes called the White Tiger of the West and represents the West in terms of direction as well as the autumn season.  It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, or if there was peace throughout the world. Obviously for those who remember our June conversation "Prometheus Unbound", we argued the following:

"It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by Graham Allison former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:
- source Macronomics June 2016 

"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War" -

In similar fashion, more recently maverick hedge fund manager Ray Dalio came to a similar prognosis in his recent musing entitled "A Path to War" on the 19th of September:

"The economic/geopolitical cycle of economic conflicts leading to military conflicts both within and between emerging powerful countries and established powerful countries is obvious to anyone who studies history.  It’s been well-described by historians, though those historians typically have more of a geopolitical perspective and less of an economic/market perspective than I do.  In either case, it is well-recognized as classic by historians.  The following sentence describes it as I see it in a nutshell:

When 1) within countries there are economic conflicts between the rich/capitalist/political right and the poor/proletariat/political left that lead to conflicts that result in populist, autocratic, nationalistic, and militaristic leaders coming to power, while at the same time, 2) between countries there are conflicts arising among comparably strong economic and military powers, the relationships between economics and politics become especially intertwined—and the probabilities of disruptive conflicts (e.g., wars) become much higher than normal.

In other words economic rivalries within and between countries often lead to fighting in order to establish which entities are most powerful.  In these periods, we have war economies, and after them, markets, economies, and geopolitics all experience the hang-over effects.  What happens during wars and as a result of wars have huge effects on which currencies, which debts, which equities, and which economies are worth what, and more profoundly, on the whole social-political fabric.  At the most big-picture level, the periods of war are followed by periods of peace in which the dominant power/powers get to set the rules because no one can fight them.  That continues until the cycle begins again (because of a rival power emerging).

Appreciating this big economic/geopolitical cycle that drives the ascendancies and declines of empires and their reserve currencies requires taking a much longer (250-year) time frame, which I will touch on briefly here and in more detail in a future report.
Typically, though not always, at times of economic rivalry, emotions run high, firebrand populist leaders who prefer antagonistic paths are elected or come to power, and wars occur.  However, that is not always the case.  History has shown that through time, there are two broad types of relationships, and that what occurs depends on which type of relationship exists.  The two types of relationships are:

a) Cooperative-competitive relationships in which the parties take into consideration what’s really important to the other and try to give it to them in exchange for what they most want.  In this type of win-win relationship, there are often tough negotiations that are done with respect and consideration, like two friendly merchants in a bazaar or two friendly teams on the field.

b) Mutually threatening relationships in which the parties think about how they can harm the other and exchange painful acts in the hope of forcing the other into a position of fear so that they will give in.  In this type of lose-lose relationship, they interact through “war” rather than through “negotiation.”

Either side can force the second path (threatening war, lose-lose) onto the other side, but it takes both sides to go down the cooperative, win-win path.  Both sides will inevitably follow the same approach.

In the back of the minds of all parties, regardless of which path they choose, should be their relative powers.  In the first case, each party should realize what the other could force on them and appreciate the quality of the exchange without getting too pushy, while in the second case, the parties should realize that power will be defined by the relative abilities of the parties to endure pain as much as their relative abilities to inflict it.  When it isn’t clear exactly how much power either side has to reward and punish the other side because there are many untested ways, the first path is the safer way.  On the other hand, the second way will certainly make clear—through the hell of war—which party is dominant and which one will have to be submissive.  That is why, after wars, there are typically extended periods of peace with the dominant country setting the rules and other countries following them for the time it takes for the cycle to happen all over again." - source Ray Dalio

Because the color white of the Wu Xing theory also represents the west, the white tiger became a mythological guardian of the West on the mythological compass. The White Tiger is as well considered in China as the ruler of the Autumn and the governor of the metallic elementals (hint for you gold bugs out there...) but we ramble again. Will the age of reason disappear with the White Tiger? We wonder.

In this week's conversation, we would like to look at the gradual path towards recession in the US and how does the credit cycle will end.

Synopsis:

• Macro and Credit - Credit cycles die of "old age". 
• Final chart - Hey Fed, NAIRU this!

• Macro and Credit - Credit cycles die of "old age". 

While many pundits have been focusing on the continuation of the flattening of the yield curve, as we pointed out in our most recent conversation again, credit cycles die because too much debt has been raised. What the most recent Fed quarterly survey Senior Loan Officers Opinion Survey (SLOOs) tells us is that financial conditions remain very benign still. Yet, no one can ignore the hiking path followed by the Fed and that already some part of the economy such as housing are already feeling the heat and the gradual tightening noose of financial conditions. 

From a "White Tiger" perspective, a full-blown trade war between China and the United States would push US companies to pass on prices increases onto the US consumer. Any acceleration in inflation would lead to the Fed to be more aggressive with its hiking stance. The rhetoric of Fed members in recent week has become decisively more “hawkish”.

First question we are asking ourselves is when does the US consumer gets "maxed out"? We are already seeing credit card usage surging as well as the return of housing equity extraction thanks to the return of HELOC. On this subject we read with interest Wells Fargo Economics Group note from the 18th of September entitled "Consumer outlook in a rising rate environment":

"Executive Summary

Conventional wisdom has it that rising interest rates are bad for consumer spending because swelling financing costs put a squeeze on a household’s capacity for other outlays. What if conventional wisdom is wrong? Our analysis finds that a rising interest rate environment does not immediately snuff out consumer spending growth.

As the current expansion stretches further into its tenth year, the economy is on track to eclipse the expansion of the 1990s as the longest on record. In this report we consider the outlook for consumer spending against this backdrop of a record-setting expansion and consider how long the good times will last. Our base-case scenario, spelled out in this special report, anticipates a modest pick-up in consumer spending, at least in the near term. Eventually, like all good things, the longest economic expansion on record will come to an end and consumer spending will come back down with it. That will likely occur alongside financial conditions that warrant rate cuts by the Fed. The precise timing of these events is tough to get right, but by signaling this drop-off in activity in late 2020, we are essentially saying that while the end of the party is not imminent, no cycle lasts forever.

- Source Bloomberg LP, The Conference Board, University of Michigan and Wells Fargo Securities

As per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return:

- source Macrobond (click to enlarge).

Before we go into more details of Wells Fargo's note, there are a couple of points we would like to make. Despite decreasing significantly from its peak prior to the Great Recession, household debt still remains quite elevated, stabilizing around 77%. Also back in March in our long conversation "Intermezzo", when it comes to consumer credit, as pointed out by famous French economist Frédéric Bastiat, there is always what you see and what you don't see. We pointed out the following from Deutsche Bank's State of the US Consumer report from the 26th of February entitled "Robust Consumer with Pro-cyclical and Seasonal Tailwinds on the Horizon":

"Items to watch

Lower income consumers are more levered than they appear: The aggregate deleveraging post-crisis has largely benefited from mortgage leverage sitting at its lowest level since 2001. However, other consumer leverage (card, student, auto, and personal) continues to grind higher into 2018 and is now at all time highs (~26%). Excluding disposable income for the Top 5% income bracket of US consumers, consumer debt levels are closer to 43% of adjusted disposable income—almost double the reported measure of ~26%. The latest triennial Fed Survey of Consumer Finances highlights this dynamic, with the bottom 40% income households running at ~50% non-mortgage DTI, which is ~10% more than LT averages.

The subprime/low income consumer is stretched: Sluggish wage growth and rising healthcare and rent expenses as a percentage of income (non-debt obligations near 25 year highs) among lower income households have stretched subprime consumers as they look to augment rising expenses with debt. 

Banks have met this increased demand by providing deeper credit access to subprime (increased participation, especially for cards), leading to higher leverage and an increased severity risk of loss as delinquencies start to diverge for lower quality consumers. Like DTI, adjusting debt payment burdens to exclude the top 10% income brackets almost doubles the reported Fed figure (9.6% PTI vs. 5.8% reported PTI by the Fed).

Socio-economic divide driving credit cycle: While aggregate consumer fundamentals remain robust, subprime consumers are seeing rising delinquencies and losses starting to normalize much faster than other credit tiers: +90-day DQs within subprime cards have rose+300bps Y/Y in 3Q17 vs. only~30bps on average for near prime/prime borrowers. ~45% of Americans would have difficulty paying a surprise medical bill of ~$500 (Kaiser Foundation), while ~50% of US consumers live paycheck to paycheck (FITB). Taken all together, a disconnect between the lower credit tier borrowers and the economic cycle is starting to emerge." - source Deutsche Bank

The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles.

But let's return to Wells Fargo's take:

"A Consumer Spending Framework in the Context of Rates

As we would at any time in the business cycle, we consider the macro drivers of consumer behavior. Consumer sentiment and confidence, by about any measure, are at or near high levels last seen around 2001; which, not coincidentally, was in the late stages of that prior long-lasting expansion (Figures 1 & 2). We also look at the purchasing power in consumers’ wallets, be it in the form of personal income, which is at last picking up (albeit in only a modest way) or in access to capital through borrowing, where measures of revolving consumer credit growth indicate a levelling off more recently. Finally, we tally the actual spending numbers reflected in the personal income and spending report and the monthly retail sales numbers, both of which have been on a roll in recent months.

In an effort to better inform a consumer outlook, it is essential to have a framework for thinking about these fundamentals and how households will manage finances at this late stage of the cycle. The trouble with considering this period in the context of what has happened in prior cycles is that for a long stretch in the current cycle, from December 2008 until December 2015, the Federal Reserve maintained a near zero interest rate policy (ZIRP), and at various points during those years was engaged in a broad expansion of the balance sheet through quantitative easing (QE), (Figures 3 & 4).

- source Federal Reserve System and Wells Fargo Securities

The Fed has historically purchased Treasury securities to expand the monetary base, although the monetary policy “medicine” applied during that era, including the purchases of mortgage-backed securities and other assets, had not been tried before, at least not in the United States.

Central bank actions, no doubt, are a factor in the remarkable duration of the current cycle, and on that basis any informed outlook for consumer spending ought to not only consider these macro drivers (like confidence, access to capital and willingness to spend) but to consider them in the context of Fed policy.

To that end, we went back to just before the 1990s expansion began in 1989 and divided the years since into four broad categories based on what the Federal Reserve was doing with monetary policy at the time: (1) lowering the fed funds rate, (2) a “stable” rate environment, (3) raising the fed funds rate and (4) ZIRP with QE.

The date ranges for each of these periods is spelled out in Table 1 below.

Most of the time periods are straightforward, although the one period that might invite critique is that we have characterized the time period from March of 1995 through January 2001 as “stable” (revisit Figure 3).

One could reasonably observe that the fed funds rate actually moved up and down during that nearly six-year stretch. Our argument for calling it “stable” is that this period was essentially from the “mid-cycle” slowdown until the end of that expansion. Admittedly, there were adjustments up and down throughout the period, but from the start of the period to the end, the funds rate finished just 50 basis points higher. Reasonable minds could disagree, but in our view, the idea of thinking of that period as four unique rate cycles would unnecessarily complicate our analysis.

With our various Fed cycle dates established, we looked at our macro drivers for consumer spending through the lens of the Fed policy that was in place at the time. For each interest rate backdrop, we calculated the average levels for various measures of consumer confidence, the average annualized growth rate of personal income, the average net monthly expansion in consumer credit and finally the average annual growth rates of both real personal consumption expenditures and of nominal retail sales.

A key takeaway from our exercise, depicted in Table 2 below, is that measures of consumer fundamentals tend to do best in periods of stable interest rates. Interestingly though, a rising rate environment is almost as good for these same consumer fundamentals.

Perhaps that is not altogether surprising, considering that the Fed is apt to raise rates when the economy is at full employment and inflation is heating up beyond the Fed’s comfort zone. Those factors tend to exist when the economy is doing particularly well or even overheating.

The inverse of that dynamic may explain why the worst rate theme for consumer spending is during periods when the Fed is lowering rates. Personal income and spending as well as nominal retail sales all performed worst during periods when the Fed was cutting rates. Interestingly, the lowering of interest rates does not compel consumers to increase their appetite for credit, at least not immediately. The average net monthly increase in consumer credit came in a distant last during periods when the Fed was actively lowering rates.

2020 Vision

So what sort of Fed policy theme should we consider looking forward? To judge from the Fed’s dot plot, a visual rendering of policymakers’ own forecasts for the fed funds rate, the FOMC is closing in on its neutral rate for fed funds. With most dots clustered around 3.00 to 3.25% and the current fed funds rate at 2.00%, there are only four or five quarter-point rate hikes left to go in the current cycle, barring some change in forward guidance from the Fed (Figure 5).

Our forecast anticipates two more hikes this year and another three next year. After that it stands to reason we would be in a stable rate environment slightly above the neutral rate until the Fed’s understanding of r* changes (favoring another hike) or until conditions warrant a cut. In a separate special report1, we explained our use of an analytical framework we recently developed to inform our view of Fed policy going forward and why we look for the FOMC to raise rates another 125 bps before it cuts rates at the end of 2020.

In forming our outlook for the consumer, we take the findings of our rate-environment study and overlay them with our expectations for Fed policy over the next couple of years. If things play out the way we anticipate, monetary policy is entering an era of transition unlike anything the economy has seen in more than a decade. For a number of factors including the longevity of the cycle, growing fiscal budget imbalances and a potential fallout from the global economy, we indicated in our initial 2020 forecast that by the end of our forecast horizon the Fed would likely begin cutting the fed funds rate.2 A rate-tightening environment is expected to prevail at least through the first part of 2019, which will be followed by a stable rate for another year or so before the Fed begins to signal eventual rate cuts.

For the consumer, this Fed forecast implies a pick-up in the pace of consumer spending in the near term before an eventual slowing the further out we go in the forecast period. Full year PCE growth was 2.5% in 2017. By the time we close the books on the current year, we expect the comparable number for 2018 to pick up to 2.6%, prior to quickening to 2.7% in 2019 and slowing to just 2.2% in 2020 (Figure 6).

- Source: Bloomberg LP, Federal Reserve Board, U.S. Department of Commerce and Wells Fargo Securities

Outlook

Consumers may be better prepared to endure a slowdown than in the past. The saving rate, currently at 6.7%, is rather elevated given the late stage of expansion, while real median household income surpassed its pre-recession peak in 2017. With the unemployment rate currently matching low levels last seen in the late 1960s, there remains little slack in the economy. The labor market is expected to grow increasingly tight, with the unemployment rate trending to as low as 3.3% by 2020. Similarly, inflationary pressures that continue to gradually build over our forecast horizon will put downward pressure on real income gains.

The length of the current expansion is expected to surpass that of the 1990s, taking the title as the longest expansion on record. While monetary policy changes act as signals to markets about the health of the economy and/or concerns about inflation expectations, we must be sensitive to policy movements and their implication for consumer spending. Our initial 2020 forecast expects the Fed to surpass its neutral rate, prior to beginning to cut policy by the end of 2020. With this signal of a slowdown in activity, we are essentially saying that this expansion will eventually draw to a close. The rate cutting environment will act as a last call announcement – and for the consumer sector it serves as a valuable indication for longevity of this expansion." - source Wells Fargo

Whereas we agree with the timing, we disagree with the perceived health of the US consumer, as per the above points illustrated in a previous Deutsche Bank research note. There is more leverage than what can be seen, not only when it comes to the US consumer but as well when it comes to the distorted balance sheets of many US corporates after years of a buy-back binge and a fall in the quality of the overall rating for the Investment Grade category much closer to "junk" than in the previous cycle.

Overall the timing for the end of the credit cycle could indeed be in the region of 2020. This is as well Ray Dalio's most recent view and also Christopher R. Cole, CFA from Artemis Capital Management as per his July  2018 letter entitled “What is water?”:

“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents. The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets. Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.Despite this trend, U.S. equities will very likely escape 2018 without a crisis or volatility regime shift because of the one-time wave of corporate liquidity unleashed by tax reform. Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” – Source Christopher R. Cole, CFA from Artemis Capital Management

The whole note written by Christopher R. Cole is worth a read particularly on the subject of passive management and liquidity. His quote from above resonates as well with our opening quote from maverick investor Stanley Druckenmiller.

 As well in his note, Christopher R. Cole indicates when he thinks we will most likely have another crisis on our hands:

“When does this all end? If or when the collective consciousness stops believing growth can be created by money and debt expansion the entire medium will fall apart, otherwise it is totally real… and will continue to be real.

A crisis-level drought in liquidity is coming between 2019 to 2022 marked by a perfect dust storm of unprecedented debt supply, quantitative tightening, and demographic outflows.

Quantitative easing has caused the natural relationship between corporate debt expansion and default rates to break down. U.S. debt is at an all-time high of $14 trillion (45% of GDP) and high yield default rates are near all-time lows at 3.3% (MarketWatch, 13d). This is not sustainable. Years of cheap money has led scores of investors to buy debt at levels that do not reflect credit risk. The poster child is the 2017 issuance of 100-year Argentina bonds (USD denominated) that were oversubscribed 3.6x with a 7.9% yield. It is hard to find a decade where Argentina has not defaulted, much less a century. That medium of bond market demand has already begun to show signs of cracking.” – Source Christopher R. Cole, CFA from Artemis Capital Management

Fiduciary duty anyone? Credit cycles tend to die of old age and too much debt. We have entered the season of the White Tiger we think. Only a few innings left. 

On the current evolution of the credit cycle we read with interest Bank of America Merrill Lynch's take in their High Yield Strategy note from the 21st of September entitled "The Evolution of the Credit Cycle:

"The Evolution of the Credit Cycle

As we continue to study the state of the current credit cycle, the accumulated evidence sides with the argument that it has more room to develop, as long as few more years. Previous cycles have lasted anywhere between 6-8 years, on average, and this observation would make it an unusual development to see the current cycle extend for much longer. However, we also note that more broadly, this economic cycle has been an unusual one in many respects, including how long it took the US GDP to return to trend growth rates, the unemployment to decline, and the inflation to recover. And if those major macroeconomic variables took an unusually long time to return to normal levels, then why should we expect the credit cycle to be an average one?

Away from this argument, we also continue to believe that the commodity episode in 2015-2016 represented a partial cycle in and of itself. Among the most conclusive pieces of evidence in support of this view, we present the charts in Figure 3 for debt growth and Figure 4 for capex.

In both cases, we highlight cyclical turns, as defined by catalyst events as the starting points and subsequent observed peaks in trailing 12mo HY issuer default rates as ending points.

Both graphs suggest that previous cyclical turns have occurred at similar points on each respective line, had similar impact on each measure, and had left them at similar levels after defaults receded. Both graphs also suggest that a cyclical turn at current levels and given their recent trends would be inconsistent with historical experiences going into previous default cycles.

And yet, inconsistent does not imply impossible, particularly in light of trade tariffs that are being threatened and imposed by the Trump Administration. It remains our view that at the end, these policies are unlikely to survive the test of time, however it is difficult to say how much time it would take to prove them wrong and how much damage they could do in the meantime.

The exact timing of cyclical turns is an inherently uncertain exercise and we do not claim to possess superior skills to do so. Instead, our approach relies on using all available data and analytical tools to help us make a judgment on a relatively short next-12mo time horizon, and continue doing so as time progresses and new data becomes available. As such, we made a call that this cycle was unlikely to turn at this point last year. With all the evidence we accumulated since then, we believe this view still holds today.

Our default model continues to suggest low likelihood of a meaningful spike in defaults over the next year, based on its latest inputs. It currently projects a 3.25% issuer weighted rate during this time period, marginally lower than the actual realized 3.41% rate as calculated by Moody’s (Figure 5). A 3.25% issuer default rate would be consistent with 2.0% par-weighted rate. 

How it ends?

In our last year’s outlook on the prospects of this credit cycle, we listed three key risks to its longevity: (1) inflation spike; (2) trade contraction; and (3) sector distress. We think all three remain valid and potent sources of known risks going forward as well. In our judgment, the spike in inflation remains a lower probability risk, followed by trade contraction, somewhat higher on our scale of likely developments, and still inside of a tail risk zone.

A contraction in one of the key industry sectors is a higher probability outcome, in our opinion, albeit not an imminent one. Previously, we published our thoughts on capital allocation trends across various sectors, and identified healthcare as the most overextended sector in terms of the amount of capital raised in recent years.

A higher capital formation could lead to higher capex, higher production capacity, higher supply, lower prices, and an eventual need to remove excess capacity. The latter stage often goes hand in hand with a need to eliminate excess debt that was used to finance excess capex.

Other sectors that we found to be overextended on this scale include autos, utilities, and food producers, although these three are relatively small compared to healthcare.

And at the end of this conversation on risks, we think it is also important to remind ourselves that previous cycles have ended with a surprise event, a “black swan” of sorts, which, by definition, was unexpected by the consensus and meaningful in its impact. We do not see any particular reasons as to why the next one would break out of this mold." - source Bank of America Merrill Lynch

From our "White Tiger" perspective, an inflation spike is something very much on our radar, hence our close attention to market gyrations in oil prices and geopolitical risk, the famous known unknowns which have been building up recently in world which has decisively moved from cooperation to noncooperation.

As we have stated above, many pundits are focusing on the flattening of the yield curve, from an employment and non-accelerating inflation rate of unemployment (NAIRU), Monetary policy conducted typically involves allowing just enough unemployment in the economy to prevent inflation rising above a given target figure, we think the Fed will once again be behind the curve as per our final chart.

• Final chart - Hey Fed, NAIRU this!

In our previous conversation we discussed the great work of American economist Irving Fisher, in relation to NAIRU,  the concept arose in the wake of the popularity of the Phillips curve which summarized the observed negative correlation between the rate of unemployment and the rate of inflation (measured as annual nominal wage growth of employees) for number of industrialised countries with more or less mixed economies. This correlation (previously seen for the U.S. by Irving Fisher) persuaded some analysts that it was impossible for governments simultaneously to target both arbitrarily low unemployment and price stability, and that, therefore, it was government's role to seek a point on the trade-off between unemployment and inflation which matched a domestic social consensus, the famous dual mandate of the Fed. We won't go into more details about our fondness of the Phillips curve, it's a subject we have discussed on this very blog on many occasions. Our final chart comes from Deutsche Bank's US Economic Perspectives note from the 20th of September entitled "How the Powell Fed can make history" and shows that the Fed has never succeeded in returning unemployment to NAIRU from below without a recession ensuing:

"With unemployment now noticeably below standard measures of its natural level of full employment and likely to tighten further and with wage and price inflation returning to desired levels and likely to continue upward, the Fed has a delicate task on its hands. It needs to begin to close the gap between growth of aggregate demand and aggregate supply in the economy — in other words, to slow and eventually reverse the tightening of the labor market before it risks pushing up inflation and inflation expectations excessively. The question is whether it can do so without pushing the economy into recession and causing unemployment to surge upward, overshooting its natural rate.

Many in the market already see the storm clouds of recession gathering in the distance, a narrative that has found an ally in the flattening yield curve. Talk of a downturn by 2020 is increasingly in vogue and for good reason: a soft landing in unemployment from below NAIRU has never been achieved before. In the modern history of US national economic statistics since the late 1940s, every time the unemployment rate has overshot to the downside, policy firming by the Fed has helped drive the economy into recession (Figure 1).

We think the Powell Fed can make history by achieving the unprecedented outcome of a soft landing from below sans recession." - source Deutsche Bank

Contrary to the elements put forward in this very interesting note, we think that once again this time isn't different. On a final note we thought we had run out of arguments against the cult of the Philipps curve as per our conversation "The Dead Parrot Sketch" back in August 2017, we did read additional arguments against the Phillips curve cult in Saad Filali's take on Seeking Alpha in his article "There Is No Inflation: Too Much Supply, Not Enough Unions", which we found of great interest.  It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, it could be said that the white tiger only appeared when the BIS ruled with absolute virtue as per their very interesting most recent quarterly survey, but we digress...

"Liquidity is oxygen for a financial system." -  Ruth Porat

Stay tuned!

Macro and Credit - Poker tilt

"If you're playing a poker game and you look around the table and can't tell who the sucker is, it's you." - Paul Newman

Looking at the tentative rebound in gold prices thanks to the fall of the US dollar in conjunction with some respite for some selected Emerging Markets (EM) as well as the escalating tensions between Italy and the European Commission on migrants with pressure building up on the ECB's "Le Chiffre" aka Mario Draghi, when it came to selecting our title analogy, we decided to go yet again for a poker reference. As we stated in our previous conversation, it remains to be seen who ultimately is going to be the ongoing buyer of Italian government bonds with plans for a reduction in QE in Europe. In the game of poker, tilt is a term used for the state of mental or emotional confusion or frustration in which a player adopts a less than optimal strategy usually resulting in the player becoming over-aggressive (such as Turkey's Erdogan calls on Turks to ignore forex developments and to sell their gold and dollars to support their crumbling lira). Placing an opponent on tilt or dealing with being on tilt oneself is an important aspect of poker. It is a relatively frequent occurrence due to frustration, animosity against other players, or simply bad luck. Experienced players recommend learning to recognize that one is experiencing tilt and avoid allowing it to influence one’s play. In our October 2015 conversation we praised both Le Chiffre and Mario Draghi. Both of them share the same trait, both are poker prodigies hence our title analogy at the time. We wonder if President Donald Trump could be one as well given the pressure he has applied in his various negotiations on numerous issues including trade tariffs. In this current game of high stake poker, particularly with China, one might wonder if Trump is not trying to upset the mental equilibrium of his adversaries which is essential for optimal poker judgment (NAFTA being the most recent example). Though many advanced players (after logging thousands of table-hours) claim to have outgrown poker "tilt" and frustration, many other poker professionals admit it is still a "leak" in their game but we ramble again.

In this week's conversation, we would like to look at the potential for tactical rebound for EM, as we move towards the important US midterm elections.

Synopsis:

• Macro and Credit - Could we see a tactical bounce in EM?
• Final chart - US credit growth still on cruise control

• Macro and Credit -  Could we see a tactical bounce in EM?

Whereas the heat was on during the summer for various Emerging Markets thanks to murderous rampage of "Mack the Knife" (King Dollar + positive real US interest rates), we recently touted MDGA aka Make Duration Great Again. Recently, not only have we seen some small yield compression in the long end of the US yield curve, but as well the dollar has slowed down and fallen a tad ensuring a small bounce in gold prices as well. Also, credit markets in particular US Investment Grade credit have had more favorable returns in recent months. One can therefore wonder, with the latest NAFTA discussions, if indeed some sort of tactical rally for EM is in the cards on the road to the important midterm US elections.

On this subject we read with interest Bank of America Merrill Lynch's take in their Global Liquid Markets Weekly note from the 27th of August entitled "EM climbs out of Jackson hole":

"US midterms a winner for EM

After Jackson Hole the focus this week shifts to EU and US inflation, but the real story for the months ahead will more likely be the US midterms. We think they are about to turn from a bearish to a bullish theme for EM through positive news on trade and a peak in the USD. So we expect a post-summer EM rally – though a tactical one before global risk assets, this time including the US, come under pressure in 2019.

Midterms trigger post-summer rally

Since our year ahead report (“Taxing EM”) we have been looking at EM through the lens of the midterms – now about to turn from a negative to a positive factor. The fiscal stimulus package and trade tensions have been closely linked to the approaching elections and have weighed on EM so far. Trade wars have become by far the most feared risk, according to our monthly investor survey. Now, however, David Woo expects an imminent NAFTA deal and some progress with China, as the polls suggest that the US administration has a strong incentive to present good news on trade. Importantly, we expect the next round of China tariffs scheduled for Sep 6 to lapse as they would be too painful for the US consumer and the agricultural heartland (via China retaliation).

A glass half full – just about

Predictably, EM sold off during our usual August break – as in 8 of the last 10 ones: the 10-year average EMFX return in August is the 2nd worst after November. However, the volatility occurred on low volumes, and neither external nor local debt saw fund outflows over the summer.

The current level of our EMFX carry sentiment indicator implied positive returns in EM carry in 56% of the subsequent 4-week periods since 2004: ie, a glass half full but hardly convincing enough for a big “Back to School” party. 

Softer USD = EM outperformance

Time and again a weaker USD dominates any other EM driver, whether global or local. Chart 2 shows this on the basis of monthly correlations of EM returns with the USD and other potential drivers.

This has also been the case during periods of Fed tightening – as long as other factors have managed to hold the USD down. In fact, monthly EM returns have surprisingly been negatively correlated with the G3 central bank balance sheet.

Indeed, our G10 team now sees the USD rally this year close to its peak. (1) Trade war fears seem to have become USD positive lately, so their easing should be USD negative. (2) The US-EU data surprise differential seems to have peaked too for now. (3) Positioning in US vs rest-of-the-world assets is back to historical highs. Short term, Italy budget fears could still weigh on EUR/USD, but for next year our team targets 1.20.

QT doesn’t matter … until US HY cracks

Quantitative tightening per se isn’t EM bearish: it still comes down to its impact on the USD. If the USD really weakens into 2019, a repeat of the experience of the last cycle is likely: US high yield peaked in mid-2007, then it moved sideways for one year while EM debt continued to perform. However, when US credit finally entered an outright bear market mid-2008, EM wasn’t spared either, and risk-off became USD bullish (Chart 2). A key difference to ‘07 is that EM is unlikely to benefit from rating upgrades (Chart 3).

Consensus says EM fundamentals are still decent: we don't disagree on this specifically, but we do think that the rate of change of these fundamentals is negative, risks are to the downside and spreads are fair rather than cheap even after the latest sell-off.

Best local value: Indo, Mex, SoAf, Thai

Summing up, we see a post-summer rally in EM that benefits local more than external debt as its main trigger would be a weaker USD and less trade fears: it may last for a while, but by 2019 we expect EM debt to crack when US high yield does. To position for a tactical rally in September in Asia we like long THB FX and Indonesia local 10yr bonds. We have turned from bearish to neutral CNY, and local front-end bonds are starting to look attractive after the rebound higher in yields in the past two weeks.

In LatAm we like short EUR/MXN on a better global backdrop and NAFTA. In EEMEA South Africa has the best risk/reward in FX and rates given its high beta to China and EUR/USD. Valuations are good based on the real yield; three hikes priced in; and ZAR near our fair value estimate. EUR/CZK has downside if EUR/USD goes higher.

In contrast we don’t find risk/reward compelling in Russia and Turkey. In Russia we have argued for a while that sovereign sanctions risks were underestimated. We just closed our shorts but want to wait for a sell-off on an actual passing of the sanctions bill pre-midterms before buying ahead of the likely oil-bullish Iran sanctions in November. In Turkey real yields are finally in line with the peers, even accounting for the imminent CPI spike, but they are not high enough to compensate for the political noise (Chart 4).

Long term, sovereign external debt looks cheap with an implied CCC rating, but short-term investors have to brace for further volatility spikes driven by the exchange rate." - source Bank of America Merrill Lynch

Flow wise, this summer has been a bloodbath for many asset classes with no one being spared. These funds outflows have continued recently according to Bank of America Merrill Lynch which is somewhat revealing as well the magnet appeal of the US dollar as per their Follow The Flow Report from the 24th of August entitled "IG, HY, Equities and EM debt all down for the year":

"Outflows continue from IG, HY, govies, EM and equities

It seems that investors have nowhere to hide. Almost all the risk assets we follow recorded outflows last week. We saw outflows from IG, HY, Govies and EM debt; same in equities. Higher risk assets’ volatility, EM FX sell offs, trade wars and Italian political risks have instigated a risk off trend in flows across risk assets.

Rate differentials across the globe are shifting flows away from low yielding and risky markets. Note the significant shift of assets out of euro credit to dollar credit over the past months on the back of dollar strength.

Over the past week…

High grade funds recorded another outflow last week; but arguably more moderate to that of last week’s. High yield funds were hit again by outflows. Looking into the domicile breakdown, European-focused funds recorded the lion’s share of outflows, while outflows from global and US-focused funds were more moderate.

Government bond funds recorded another outflow last week, albeit more moderate to the outflow suffered a week ago. All in all, Fixed Income funds recorded another sizable outflow last week.

European equity funds continued to record outflows for the 24th consecutive week. $56bn has left the asset class over that period.

Chart 1: IG, HY, Equities and EM debt all down YTD (cumulative flows, $mn)

Global EM debt funds recorded another outflow last week, while the magnitude of the outflow more than tripled w-o-w. Commodity funds recorded an outflow.

On the duration front, reach for “safety” prevailed. Small inflows into IG short-term funds, were more than offset by outflows in the belly and the back-end of the curve. Mid-term funds suffered the most last week, with outflows increasing steadily over the course of the past three weeks." - source Bank of America Merrill Lynch

 The US have attracted inflows particularly given cash is becoming more and more attractive on a relative basis and for investors seeking some sort of safe haven in the context of EM gyrations. What is interesting to note as of late is the clear deceleration in some macro outputs in the US such as Existing home sales declining 0.7% to 5.34 million unit pace in July, new home sales falling as well thanks to the issue of "affordability" in conjunction with the softness in Durable goods orders slipping 1.7% in July. This is in contrast to the latest FOMC minutes showing Fed members clearly in the strong economic outlook camp. This is of course ensuring another hike in September.

Yet, some positioning in US bonds remains elevated we think, and if indeed some pundits get poker tilted, then there is a probability of seeing some sizable strong short covering in very short order. Same apply to some shorts in the gold mining space, which have been relentlessly hit by the fall in gold prices but it seems we are not there yet. Returning on the "contentious" issue argued by many on the stretched positioning on US Treasury notes, we read with interest Bank of America Merrill Lynch's take in their Global Liquid Markets Weekly note from the 27th of August entitled "EM climbs out of Jackson hole":

"Extreme positioning elevates risk of bond rally

While we continue to target 10y rates at 3.25% for the end of the year, the ongoing buildup in non-commercial short positioning in the Treasury futures complex does not bode well for our outlook. We studied the connection between positioning – as defined by the Commitments of Traders report published by the Commodity Futures Trading Commission – and subsequent changes in 10y rates and found a relatively high occurrence of 10y rallies after non-commercial positioning hit extreme short levels.

While positioning is just one piece of the duration puzzle, the ongoing trade negotiations and increased political headline risk moving into the midterm elections are also not favorable to our bearish rates outlook. On the flip side, however, we still view the minimal Fed pricing – just 70bp of hikes priced between now and the end of 2019 – as perhaps the most compelling reason to remain in the bearish camp for rates and in the flattening camp for the curve.

Chart 5 shows the net position of traders classified as non-commercial, or speculative, across the curve.

This classification is the residual of the commercial designation, which the CFTC defines as traders who use futures to hedge business risks. We also looked at the newer CFTC designations: leveraged, asset managers, dealers, and other, but found the strongest results within the original data set.

The net spec positions shown in Chart 5 are defined as spec longs minus spec shorts, where the units are 1000s of contracts. This is a measure of positioning within the spec category, and by definition will be offset by positioning in the commercial category (Chart 6).

As a result, a study of non-commercial positioning should show mirror image results in the commercial data, which is what we found.

To each week of reported data we attach a simple z-score of the net position by looking at the current value versus the average over the past 2.5 years. We looked at both raw net positioning and net positioning relative to total open interest for the contract. The results were very similar. The data is reported on Fridays and corresponds to the Tuesday of that week. We tracked the 3-month change in 10y rates starting on the Tuesday of each week.

Go commercial

To summarize: when positioning becomes highly unbalanced between commercial and non-commercial traders, ie when a large net spec positon or equivalently a large net commercial position develops, the market tends to move in favor of the commercial positions and against the non-commercials over the following 3 months. Table 1 summarizes our results for TY contracts. The results for US contracts were similar.

There are 3 key takeaways:

1. When positioning becomes unbalanced, there is a higher occurrence of the 10y rate moving unfavorably for the spec positions. This is based on a comparison of how frequently 10y rates rise or fall over a 3-month horizon in the entire sample versus how frequently rates rise or fall when accounting for positioning. As an example, when the z-score of net positioning is lower than -1 (positioning is below its average by at least one standard deviation), we found the 10y rates rallied 63% of the time versus a full-sample rally frequency of 52%. Similarly, when looking at the net commercial position, we found that a net long position beyond 1 standard deviation resulted in a rally frequency of 60%.
2. The magnitude of 10y rate moves following position buildups increases as the position size becomes more extreme. For example, when short spec positioning is below average (z < 0), the 3-month rate rally averaged 6bp. When z < -1, the average rally was 11bp, and when z < -1.5, the average rally was 14bp. A similar type of tiering was seen for bond market selloffs following buildups of long spec positions.
3. Positioning typically gets partially covered in the 3 months following an extreme buildup. When non-commercial positions get short and commercials get long, the data show that on average, these positions partially unwind over the next 3 months. This position squaring shows a greater magnitude as position imbalances increase. For example, when net specs measure z < 0, the following 3-month cover is on average 28k contracts. But when spec shorts are z < -1, the 3-month average covering move is closer to +50k contracts. This provides evidence that the rate moves are exacerbated by position squaring, both on the spec side and the commercial side.

The latest data point was observed on 17 August for positioning as of 14 August and we will get an update this afternoon for positioning as of 21 August. The latest z-score for TY specs was -2.2, which occurred in only 4% of the days we looked at back to early 2003. The one bright side for bond bears, however, is that 10y rates have already rallied about 8bp since 14 August. But if the z-score remains high, it would not increase confidence in our 3.25% target for year-end.

- source Bank of America Merrill Lynch

One would therefore wonder if it's time to put back on your MDGA (Make Duration Great Again) hat on given their is a higher probability that the speculators at the table might at some point in the near future get poker tilted and start short covering massively should the macro picture deteriorates sensibly over the course of the coming months due to internal or geopolitical factors coming into play (the known unknowns). The key to putting on your MDGA will be the direction of the US dollar in the coming weeks/months. Right now it's still "risk-on" and we continue to favor a US overweight over the rest of the world, yet there could be some relief rally continuing for some oversold EM countries in the mix.

Returning to our poker analogy, us being fond of game theory, we read with interest Bank of America Merrill Lynch's Global Economic Weekly note from the 24th of August entitled "What good is a poker face if you aren't playing poker?":

"What good is a poker face if you aren’t playing poker?Last week we discussed the wide array of risks that the markets will have to navigate in the coming months. This week we focus on a common theme in what we view as the three headline risks on the horizon: the US-China trade war, the Iran oil sanctions and the risks emanating from Europe (Brexit and Italexit). These are all conflicts that live at the intersection of economics and politics. Political economists and other commentators have sometimes depicted such conflicts as games of poker or “chicken,” in which both sides use confrontational rhetoric to signal a position of strength, in the hope that the other side will capitulate. Here we argue:

• The “game of chicken” view of political conflict assumes a zero-sum outcome: serious accidents are avoided.
• But aggressive rhetoric increases the political cost of backing down. Mutual escalation might be the only feasible outcome.
• In other words there is a risk of stumbling into a “prisoner’s dilemma,” in which both sides incur serious economic costs.

The devil is in the details

The “game of chicken” and the “prisoner’s dilemma” are two popular game-theoretic frameworks that are often used to describe real-world situations. They are similar in many ways. Using terminology from our previous work, in both settings, two countries (or any two sides in a conflict) must choose whether to escalate or de-escalate a potential conflict. Mutual de-escalation preserves the status quo but mutual escalation results in a “lose-lose” scenario that leaves both sides worse off than they were under the status quo. And in both settings, a country “wins” when it escalates the conflict but the other country de-escalates.

There is only one real difference between a game of chicken and a prisoner’s dilemma, but it has important consequences. The framework represented in Chart 1 becomes a game of chicken when the unknown variable c, which is the cost of capitulation (losing when the other side wins), is not very large (c inferiror to 10). In this case, if one country is certain to escalate the conflict, the other prefers to de-escalate. That is, countries would rather “hand the other side a win” than pay the price of mutual escalation. As a result the
game of chicken typically has a relatively benign outcome or “Nash equilibrium.” One
country wins and the other loses, but barring some miscalculation, the mutually-painful scenario is avoided.

By contrast, Chart 1 represents a prisoner’s dilemma if the cost of “letting” the other side win is so high (c superior to 10) that both sides prefer the lose-lose outcome instead. Since they both have incentive to escalate the conflict regardless of whether the other side escalates or de-escalates, the only possible result is mutual escalation.

No one wants to be chicken

We think this simple framework provides broad lessons for many of the political risks facing the global economy. The first is about rhetoric. In a game of chicken, strong rhetoric is helpful in signaling commitment to a confrontational stance. Examples include:

• The Trump administration’s threat to put tariffs on another $200bn in imports from China and raise the tariff rate to 25% (from 10%), even though the prices of consumer goods such as electronics will likely increase.
• China’s unwillingness to compromise thus far, even though economic activity appears to have slowed slightly because of the trade war, and the Shanghai Composite Index is down almost 20% year-to-date. China has responded to the latest US threats by promising to retaliate with tariffs on $60bn of US goods.
• The strong statements that have been made in the US-Iran conflict. For example, President Rouhani recently said that “war with Iran is the mother of all wars,” even though military conflict is not a realistic possibility.
• The UK government’s claims soon after the Brexit vote that it had a strong negotiating hand. More recently, Brexiters’ insistence on a clean break from the EU, even though a ‘hard’ Brexit would be economically very damaging for the UK.
• The euroskeptic Italian government’s proposals for aggressive fiscal expansion, even though it would run counter to EU rules, which call for a reduction in the structural deficit. Chiara Angeloni and Gilles Moec expect the 2019 Italian budget to target a deficit of less than 2% of GDP. This would be modest relative to campaign promises but would still be about double the previous government’s 2019 target.

In each case we think the goal is to make the other side blink in the face of aggression. However, the risk is that these conflicts will morph into prisoner’s dilemmas. How so?

First, very strong rhetoric increases both sides’ political cost from backing down. In our view, China would be willing to make some compromises to the US, including increasing its purchases of US agricultural and energy products, and taking stronger measures to protect the intellectual property of US firms operating in China. And in a game of chicken, given China’s exposure to US demand, such compromises would be in China’s economic interests.

But it is difficult for China to make concessions when the US is dialing up the rhetoric. The Trump Administration’s chief economic adviser Larry Kudlow recently stated on TV that China is a “lousy investment” and is “in a weak economic position,” which is “not a good place for them to be vis-à-vis the trade negotiations.” This sort of language makes compromise tantamount to an admission of weakness. Little wonder then that President Xi’s confrontational stance against the US remains popular in China.

Similarly, it is probably not in the US’ economic interests to enforce its sanctions on Iranian oil to the strictest degree possible. As we argued last week, driving supply out of Iran to zero would likely push oil prices above $100/barrel, which would be a headwind to growth. But the threats out of Iran raise the political costs of reconciliation and make the US-Iran conflict more like a prisoner’s dilemma. A mutually—and in this case globally—painful outcome could be in the offing.

The second, related concern is that strong rhetoric increases one’s own costs from backing down. Over the course of the Brexit negotiations, it has become increasingly clear that the EU will drive a hard bargain because conserving the single market is more valuable than undermining it to keep the UK in the EU. Moreover, the EU committed itself to a tough stance by publishing the EU Council’s negotiation mandate before the start of the negotiations. The mandate is all but impossible to change because all 27 countries and the European Parliament would have to unanimously agree to do so.

Some UK leaders, including Prime Minister May, seem to have realized that the UK is in a position where it must compromise, not least because of the looming March 29, 2019 deadline. This may be why they presented a Brexit deal last month that was economically negative for the UK—free trade in goods, the EU’s comparative advantage, but not in services, the UK’s comparative advantage—but was still economically better than no deal.

However, the proposal sparked rebellion among the Brexiters in her party, with threats to bring down the government. May’s “Chequers deal” proposal now appears to be in serious trouble. Brexiters have made the overly-ambitious promise to leave the EU but somehow continue to trade frictionlessly with the region. Now their political credibility concerns may be raising the risk of a no-deal Brexit.

Is talk cheap?

It might be possible to win a game of chicken by “bluffing,” i.e., convincing the other side that you are likely to escalate the conflict even if that is not the case. This is not an ideal outcome for the other side but at least there is room for compromise while avoiding an accident. In a prisoner’s dilemma, however, there is no value in bluffing or posturing because the other side will always call your bluff.

The conflict between the Italian government and the EU is in its early stages. It is possible that Italy will be able to elicit some compromise out of Brussels on budget targets and immigration by essentially bluffing on its willingness to leave the Eurozone. But to achieve this outcome, Italian leaders will have to reduce the political costs to the EU from making concessions. There should be room to sell any deal as a compromise rather than a repudiation of the EU.

Similar lessons can be applied to the trade war, Iran and Brexit. In each case there is room for compromise and the question is how much each side will give up. To a degree, strong statements can help because they might push the other side to make more concessions. But if the rhetoric becomes too strong, the only deal available is no deal at all." - source Bank of America Merrill Lynch

The questions remain whether the Trump administration will need to tilting or not with their current skills. The jury is still out there when it comes to trade negotiations taking place. Overall markets remain highly supportive, particularly in the US even if some weaknesses have shown up as of late in some macro data, although the Fed is tightening, lending surveys still point out towards economic expansion, even if we are late in this credit cycle.

• Final chart - US credit growth still on cruise control

The most predictive variable for default rates remains credit availability. The latest Senior Loan Officer Opinion Surveys (SLOOs) point that credit remains plentiful still. SLOOS report does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Our final chart comes from Deutsche Bank Strategy Update note from the 28th of August entitled "The bearish bias returns" and shows that the latest Fed SLOOs remain supportive of domestic demand (yes US consumer are using their credit cards...):

"Data supportive of higher rates, political risk remains a headwind

Since early August, the data has remained supportive of higher rates. In the US, the bank lending survey has improved and is consistent with domestic demand remaining comfortably above potential (left graph below). GDP trackers for Q3 are consistent with ~3% growth (right graph below), which is broadly in line with our economists' forecast.

It is worth noting that capex has upside relative to a series of indicators (graph below).

This could compensate a negative impact from trade wars on investment. On the inflation front, the latest data was generally encouraging. Our economists continue to expect core PCE and core CPI at 2.3% and 2.5% at the end of next year, which is broadly consistent with leading indicators such as the ISM or the NY Fed Inflation Gauge (graph below).

The recent USD strength could be a concern for the medium term inflation outlook. However, (a) it has been relatively modest so far and (b) given the lead/lags it should become a headwind in H2-19 at the earliest." - source Deutsche Bank

If indeed over the coming months inflation does indeed accelerates thanks to transfer of rising costs from the producers to the consumers, then, we think Jerome Powell the other poker player at the Fed will not be bluffing when it comes to hiking more aggressively and this might still catch quite a few pundits off guard.

"When people use the word 'science,' it's often a tell, like in poker, that you're bluffing." -  Peter Thiel

Stay tuned !