Macro and Credit - Tantalizing takeoffs

"When everything seems to be going against you, remember that the airplane takes off against the wind, not with it." -  Henry Ford

Watching at the dizzying summits reached by US stock market indices with the Dow flirting with 20,000 on the back of the Trump rally, as we move towards the final days of 2016, with a continuation of US Treasuries getting pummeled, when it comes to selecting our title analogy, we decided to go for a vintage flying analogy this time around, "Tantalizing takeoffs" being the nickname for the 50th Beechcraft AT-11 Kansan AT-11 built in 1941 and being currently the oldest flying. The AT-11 was setup as a smaller version of the B-17 Flying Fortress or B-24 Liberator. This provided a simulated training environment similar to the full sized bombers. While in the past we have used as well a reference to aircrafts, particularly in our long 2013 post "The Coffin Corner", which is the altitude at or near which a fast fixed-wing aircraft's stall speed is equal to the critical Mach number, at a given gross weight and G-force loading. At this altitude the airplane becomes nearly impossible to keep in stable flight:

"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013.

On a side note the latest decisions from the ECB amounts to us as clear confirmation of that indeed Mario Draghi is clearly affected by "the spun-glass theory of the mind" given that he stated that “uncertainty prevails everywhere,”

The current melt-up dynamics reminds us what we indicated back in January 2012 in our conversation "Bayesian thoughts" when we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices." 

Are we entering the final melt-up for asset prices, or is really the much vaunted "reflationary story" playing out in earnest? Or is it simply a case of "Information cascades playing out again as they are often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...)? We wonder.

In this week's conversation we would like to look again at some Emerging Markets vulnerabilities given the recent hike by the FED and the continued pressure stemming from "Mack the Knife" aka King Dollar + positive real US interest rates. 

Synopsis:

• Macro and Credit -  Emerging Markets, from convexity to concavity?
• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

• Macro and Credit -  Emerging Markets, from convexity to concavity?

Back in 2013 we expressed our concern regarding the impact a dollar squeeze of epic proportion would have on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

Also back in December last year we indicated a macro convex trade to think about for 2016 relating to a potential devaluation of the HKD which won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016. We made our call for a break in the HKD currency peg as per our September conversation and made additional points made last year in our conversation "Cinderella's golden carriage". In February in our conversation "The disappearance of MS München", we also looked out the Yuan hedge fund attack through the lenses of the Nash Equilibrium Concept :

"When it comes to the risk of a currency crisis breaking and the Yuan devaluation happening, as posited by the Nash Equilibrium Concept, it all depends on the willingness of the speculators rather than the fundamentals as the Yuan attacks could indeed become a self-fulfilling prophecy in the making." - source Macronomics, February 2016

While obviously our prediction was too outrageous for 2016, we do think that the HKD peg will once again come under pressure in 2017. On that very subject we read with interest Bank of America Merrill Lynch Asia FI and FX Strategy Viewpoint note from the 15th of December entitled "HKD to be challenged in 2017":

"HKD under pressure again

The HKD is under depreciation pressure again. We believe investors’ recent positions were based more on speculative than on fundamental reasons. These positions may be supported by the increase in the US Federal Reserve’s rate hike expectations for 2017. There is a risk of a pullback in USD/HKD forward points and HKD rates if RMB depreciation expectations stabilise over the coming weeks and investors take profit.

Brace the outflows

We believe 2017 will be a year of outflows from Hong Kong. The current account surplus is expected to decrease while capital outflows accelerate. That would cause Hong Kong to draw down its foreign exchange reserves.

Weaker FX, higher rates

Outflows, a slowdown of CNH-HKD conversion, and a declining aggregate balance will shape the HKD market next year. We forecast USD/HKD to rise to 7.80 and 3M HIBOR to rise to 1.50% by end-2017. We are biased to pay USD/HKD forward points and biased to pay front-end HKD rates." - source Bank of America Merrill Lynch

As we pointed out back in November in our conversation "When Prophecy Fails", when it comes to currency attacks it is more about the resolve of the speculators than the fundamentals:

"It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think." - source Macronomics, November 2016

As pointed out by Bank of America Merrill Lynch in their note, we are seeing a repeat of last year brief attack on the HKD:

"The HKD is under depreciation pressure again. Investors have recently long USD, short HKD forward outright, which has pushed up USD/HKD forward points to its highest level since early 2016. HKD rates have consequently increased and the 3M Hong Kong Interbank Offered Rate (HIBOR) fixing jumped over 10bps (Chart 1).

Both speculative and fundamental reasons related to Mainland China supported the recent market movement (Exhibit 1):

Speculative

The correlation between the HKD and CNH broke down in 3Q: while the RMB continued to depreciate, the HKD was stable (Chart 2). 

But the strong economic links and the growing impact of China on Hong Kong’s interest rates suggest insufficient risk premium was priced into the HKD. So even if Hong Kong’s currency board is credible, which is our base case not least because it has withstood multiple tests in the past, interest in the market to hedge against tail risks persists.

The HKD is also sometimes used as a proxy for the CNH. Proxies for the CNH are attractive when the associated carry costs on shorting the CNH are high (Chart 3).

But provided Hong Kong’s currency board does not change, we believe the potential gains from shorting the HKD as a proxy for the CNH are ultimately limited. In our view, trades based on this rationale are vulnerable to being unwound in the short term.

Fundamental

Hong Kong has started to experience outflows so far this year: in 1H 2016, Hong Kong recorded outflows equivalent to -0.9% of GDP. As such, there are already signs that the HKD will be under fundamental depreciation pressure. We believe the outflow theme in Hong Kong will be much more pronounced in 2017 than in 2016, especially since the US Federal Reserve raised its policy rate for the second time after the global financial crisis in December.

We believe recent positions were based more on speculative than on fundamental reasons, based on the timing of the move.

Speculative depreciation pressure on the HKD picked up after concerns over the RMB increased due to:

• China’s low FX reserve numbers in November
• Reports of curbs on capital outflows from China
• Growing uncertainty over the US-China trade relationship

These speculative pressures may persist in the near-term after the US Federal Reserve raised its Federal Funds rate projections from two hikes to three hikes in 2017. A broad USD rally could raise concerns over capital outflows from China and, ultimately, raise RMB depreciation expectations: we showed that broad USD strength and an increase in policy uncertainty raise capital outflows from China by Chinese investors.

But we also point out that Hong Kong’s 2Q balance of payments (BoP) data have been available since September 2016 and so we think the outflow theme was not the main driver behind the recent move.

As such, there is a risk of long USD, short HKD forward outright positions based on speculative reasons being unwound if the RMB depreciation expectations stabilise over the coming weeks and investors take profit." - source Bank of America Merrill Lynch

While clearly the current pressure on the HKD is based on rising speculations, obviously, the amount of currency reserves is a crucial parameter. The accumulation of reserves by the Hong Kong Monetary Authority (HKMA), make the current speculative move difficult to sustain.

One thing for certain, when it comes to Hong Kong and its vulnerability with their currency board matching the path of the Fed with rate hikes is clearly its real estate market. On that matter we read with interest Deutsche Bank's Hong Kong Property note from the 16th of December entitled "Risk of falling off the edge":

"Every 25bps rate hike would push up mortgage payments by about 2.4%

By looking at the sensitivity of residential affordability in Hong Kong to mortgage rate hikes, every 25bps increase in mortgage rates would translate into an approximate 2.4% increase in monthly mortgage payments or to push down residential affordability (i.e. increasing the debt-servicing ratio) by about two percentage points. Conversely, residential property prices would need to fall by about 2.4% in order to maintain the debt-servicing ratio at the current 68%. By assuming Hong Kong will follow the 75bps rate hike expectation in the US in 2017, residential prices would need to fall by 7.2%. Alongside our expectation of a 3% decline in median household income, we anticipate an 11% decline in Hong Kong residential prices in 2017. If mortgage rates are to normalize to the level of 2005/06 at about 5.75%, residential prices would need to fall by 28% from current levels.

Liquidity conditions look ample for now, although downside risks are rising

Liquidity conditions remain ample in Hong Kong so far, with a stable monetary base, currency lying in strong side convertibility and composite interest rates remaining low. However, the recent surge in interbank rates in HK has led to some concerns about the need to lift the Prime rate in HK. We believe that the near-term spike in interbank rates could be a reflection of expectations of higher rates, potential liquidity outflow and HIBOR finally catching up with USD LIBOR.

Although the large banks have signaled that the Prime rate will remain unchanged, we believe there is a risk that HK banks may need to move the Prime lending rate upward if: 1) HIBOR continues the upward shift that led to increasing the proportion of mortgage loans moving to capped rate Prime loans, 2) a strong liquidity outflow leads to higher deposit funding costs for large banks, and 3) there is much weaker/reversal of system deposit growth, with more signs of a tightening of loan-to-deposit ratios.

- source Deutsche Bank

So overall while our outrageous predictions seems difficult to materialize, the pressure on HKMA to intervene again in 2017 will rise again and if indeed there is vulnerability somewhere, then it might be smarter to "short" some Hong Kong real estate players rather than betting for now the demise of the currency peg.

When it comes to Asia and vulnerabilities, clearly China comes to mind particularly given its rapid credit expansion and the potential for a trade war to flare up with the new US administration. In relation to China being concerning, we read with interest Deutsche Bank take in their Asia Local Markets Weekly note from the 16th of December entitled "Jamais vu":

"Fed & AsiaFor all of the Draghi like nuances, Yellen (& the Fed) sounded and acted hawkish this week. And for once, it looks like the market has no choice but to chase the dots, which are moving away (and up).

For Asia, that should mean,

• Policy divergence will get more acutely in focus in 2017. The market is pricing in slightly over 60bp of tightening by the Fed next year - and still below the dots - but at best one rate hike anywhere in Asia. Indeed, DB Economics, and most of consensus forecasts, do not think even this modest amount of tightening will be realized. FX is then the natural outlet for this divergence in policy outlooks. And like we have been arguing, not just in the high yielders which run the risk of capital reversal - or more likely, no fresh inflows - but also in the low yielders, and ones which also map to the trade/geopolitical policy narrative of the incoming US administration (think Korea, think Taiwan)
• China in particular has some tough policy choices to make here. The Fed tailwind to the dollar will only make these choices harder for the Chinese. Either allow a significant re-pricing of the RMB complex (and take the risk of an unstable cobweb pattern), or burn down reserves (and take the 'credit' hit on the sovereign), or shut the capital gates down even tighter. Likely that they will opt for a mix of the lot. Importantly, though, none of these options look supportive of the liquidity or rates complex - offshore and (increasingly) onshore. Overnight CNH rates are trading at 12%; trading in key bond futures has been halted for the first time; and local press (Caixin) is reporting of big banks suspending lending to non-financial institutions. The move up in inflation only makes the rates re-set story in China that much more compelling to own.
• The local stories will likely define the axis of differentiation in 2017. The dollar move will probably take most of the Asia currency and rates complex with it, to begin with. But the local stories will likely define where on the dollar smile each market ends up next year - be it the policy choices the central banks make (rates, FX, regulatory), or the headwind from political noise (Korea, Malaysia, India)." - source Deutsche Bank

Obviously until "Mack the Knife" aka King Dollar + positive real US interest rates ongoing rampage stops, there is more pain to come for some Emerging Markets players in 2017. Yet, we think that the movement has been too rapid on both the US dollar and interest rates and have yet to be meaningfully confirmed by US fundamentals. While the EM fund flows hemorrhage has stabilized, at least for equities, it remains to be seen how long the resiliency will remain with a continuation of rising yields and we agree with Deutsche Bank's comments from their note:

"US equity bullishness has likely helped arrest outflows from Asia

The buoyancy in US equities – despite the large repricing in US yields – and the softness in vol indicators like VIX has helped contribute to a general resilience in risk. After close to $10bn of outflows from Asian equities in November, the outflows have stopped, although money has not really returned. Again we remain skeptical on the durability of this calm. The correlation of Asian equities to US stocks has been falling since the election and indeed with the US less likely to share the spoils of growth with the world, a decorrelation in returns should widen. Moreover, January has been seasonally weak for US equities for the last three years, which suggests a correction could lie ahead. Chinese equities have also been under strain given the rates market developments, with Asia straddling the divergence.

The market has not been as focused on the potential negative Trump dynamics for Asia from trade, geopolitics, and widening policy divergence 

The market has primarily focused in this first-round on the fiscal implications of a Trump administration, and the re-pricing of growth and inflation expectations. The other side of the coin – of potential protectionist and geopolitical disruption – has been harder to price given large outstanding uncertainties about Trump’s approach off the campaign trail. Once Trump actually assumes office in January, this uncertainty should fade, with a need to take a formal stance on issues like labeling China a currency manipulator, imposition of tariffs and the bargaining chips in play from the One China Policy to North Korea. There has also been outsized focus on the divergence theme between US versus Europe and Japan, but this is equally pertinent for Asia where markets have been in a multi-year easing mindset driven by disinflation, poorer demographics, sensitive credit cycles, and little external lift. If, as DB Economics believes, there is little appetite and ability in Asia to follow the Fed, rate differentials are going to impose pressure on Asian FX. On the other hand, if markets begin to price rate hikes, then unwind of duration stories and debt outflows from the region could be equally painful.

The market has been fighting the “major” battles

With dramatic moves in major G10 currency pairs like USD/JPY, EUR/USD, and in US rates, it is quite likely that macro positioning has been concentrated on trading these bigger themes and breaks. Indeed, even as JPY shorts were being added last week (on the IMM), investors were believed to be squaring back on KRW shorts. However as price action in the majors gets more stretched, the market should begin to look for catch-up trades and mis-pricings elsewhere.

End of year and idiosyncratic effects may have helped slowed moves

While market illiquidity into year-end could have exaggerated negative price action, there are other yearend forces which could have helped. There has been little fresh supply of debt in local markets which should have helped with bond technicals. Similarly, on the debt side, major asset allocation decisions are likely to be taken only in the New Year. Issuance calendars will start up afresh in January, when demand-supply mismatches would be more acutely felt. Central banks  may have also been more active in supplying dollars to manage FX weakness, given greater sensitivity to year-end closing levels. In individual markets like  Indonesia, inflows related to tax amnesty repatriation are likely helping contain the moves. In Malaysia, the wind down of the NDF market, and the immediate provision of greater exporter supply may have helped, but we estimate that significant hedges from real money, equity, and banks could be transitioning onshore in the coming months as offshore hedges roll off. Current account surpluses in much of North Asia are seasonally stronger around year-end, but dip significantly in Q1, with Chinese New Year inactivity, and with holiday export orders behind them

In sum, we are unconvinced that regional FX resilience can last, and would be positioning for a catch-up move higher in USD/Asia into the New Year. We continue to concentrate our USD longs against North Asian pairs that would be most exposed to any worsening in Chinese stress, fallout from a US equity market correction, a negative shift in the regional trade/geopolitical order, and where currencies have relatively poorer seasonality at the start of the year." - source Deutsche Bank

As we posited in our recent musing, the biggest "known unknown" remains the political stance of the US administration relating to trade with China. From our perspective, 2017, will continue, as per 2016 to offer renewed volatility on the back of political uncertainties given the new year will have plenty of political events, ensuring therefore an increase in volatility and large standard deviation moves like we have been used so far this year. Overall "Mack the Knife" will continue to weight on global financial conditions, particularly in EM where there has been a significant amount of US dollar denominated debt issued in recent years. As pointed out as well by Deutsche Bank, the pressure of the US dollar and rising rates will put further pressure on Chinese financial conditions:

"Risk of further capital measures remains high.

In response to the ongoing RMB weakness, driven in part by the divergence in US-China monetary policy, China has again introduced a series of capital measures particularly on RMB cross-border flows (see Trying Times for RMB, 7 December 2016). However, with outflows not abating and as RMB depreciation pressure continues to build, the risk of more such controls remains high, which are likely to drive further tightening in offshore RMB liquidity.

Reversal of RMB internationalisation should tighten

RMB liquidity further. The latest regulations introduced are likely to have accelerated the decline in RMB deposits in the offshore market again, shrinking the overall RMB liquidity pool in the offshore market.

Possible maturing of USD/CNH forwards. 

China earlier this year accumulated a large chuck of short USD forward positions, which are likely to mature in the coming months. If a part of these are allowed to mature, like in August/September, it could well be sufficient to create CNH tightness." - source Deutsche Bank

Whereas for now, convexity rules, be aware that concavity could once again come back to the forefront in early 2017 with markets at the moment continuing the probe again the willingness of the HKMA to defend the peg with additional weakness coming from the RMB and a potential slowing growth outlook for China.

If indeed there is a potential in 2017 for an early "risk-reversal" à la 2016, then again, it looks to us that, from a contrarian perspective the level reach by long US treasuries is starting to become enticing.

• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

Whereas gold and gold miners in conjunction with bonds have been on the receiving end of "tantalizing takeoffs" for equities on the back of the US election, our final chart comes from Bank of America Merrill Lynch Securitized Products Strategy Weekly report from the 16th of December shows that in recent years, rising yields have been followed by declining breakevens, which have been therefore followed by declining real rates:

• The 60 basis point rise in the breakeven rate since late June 2016 is the largest rise of the past 4 years. The unusually large move would seem to have some room to give back some of the recent gains.
• The past month’s rise in the real rate is the second largest of the past 4 years. Over the 4-year period, sharply rising real rates have been followed by declines in the breakeven rate, which in turn have been followed by declines in the real rate.

"Given the persistence of the patterns in recent years, we think that over the next 4-8 weeks, the odds favor a decline first in the breakeven rate and then in the real rate. Overall, nominal yields are therefore likely to move lower. Given that the nominal rate has risen by 80 basis points over the past month, we would not be surprised to see a 50% retracement over the next 4-8 weeks, which would bring the 10yr yield back to the 2.20% area. Time will tell." - source Bank of America Merrill Lynch

If indeed, this scenario plays out, then we could see some reversal of Gibson's paradox given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. End of the day the most important factor for gold prices is real interest rates. One thing for sure 2017 will have sufficient political events to offer yet again plenty of risk-reversal opportunities rest assured.

"The political graveyards are full of people who don't respond."- John Glenn, Astronaut

Stay tuned!

Macro and Credit - When Prophecy Fails

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

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

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

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

Wave number 1 - Financial crisis 

Wave number 2 - Sovereign crisis 

Wave number 3 - Currency crisis

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

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

Synopsis:

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

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

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

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

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

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

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

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

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

"Asia: It’s complicated

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

Nota bene: Hypertonic

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

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

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

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

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

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

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

Global EM FX Pressure Index

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

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

Global EM Fixed Income Pressure Index

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

Pressure on EM bonds rose in October

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

- source Nomura

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

-source Société Générale

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

- source Nomura

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

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

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

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

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

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

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

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

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

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

"Does dollar strength dominate everything?

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

US tax cuts – this time is different for Asia

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

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

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

Trade policy risks

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

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

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

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

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

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

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

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

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

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

Stay tuned!

Macro and Credit - The reverse Tobin tax

"A question that sometimes drives me hazy: am I or are the others crazy?" - Albert Einstein

Watching with interest the stabilization and even tightening in the credit markets, in conjunction with People's Bank of China (PBOC) cutting by 50 bps its Reserve Requirement Ratio (RRR), adding to the "risk-on" environment witnessed recently and given the continuous conversations relating to NIRP, we decided, for our elected title analogy to refer to the Tobin tax. The Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system which ended on August 15 of 1971. 

Why, you might rightly ask dear readers, did we elect to talk about a reverse Tobin tax in our chosen title?

Well, if you remember correctly from our previous conversation "The Monkey and banana problem", we argued that NIRP doesn't reduce the cost of capital. NIRP is simply a currency play.

And if indeed NIRP is a currency play, given James Tobin's objective was to mitigate currency volatility, no doubt to us that the latest bout of volatility witnessed on the Japanese yen is indeed some form of a "reverse Tobin tax". What we find amusing is that James Tobin was influenced by the earlier of John Maynard Keynes on general financial transaction taxes and the famous chapter XII of the General Theory on Employment Interest and Money. Keynes was an avid speculator and the recent NIRP put in place by various generous gamblers aka central bankers, is leading to a renewed frenzy of speculation in the bond market where all the fun is with more and more bonds yielding on the negative side and their prices reaching new record high levels:

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation." - John Maynard Keynes, page 104.

Indeed the situation is becoming serious when the bond market has become a whirlpool of speculation. On a side note, we find the PBOC move amusing given, as we posited with the ECB LTROs, liquidity injections doesn't resolve solvency issues, particularly when it comes to Nonperforming loans (NPLs).

John Maynard Keynes would be proud of NIRP given it will definitely lead to the "euthanasia rentier" but unfortunately also to the disappearance of "capital" as he wrote:

"I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.

Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward..." - John Maynard Keynes

We do not think in the end, capital will be "free and "abundant" with NIRP. Keynes added at the time in relation to tax on transactions the following:

"The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States." - John Maynard Keynes, page 105.

For us, NIRP is a "reverse Tobin tax" leading in the end to the "euthanasia of the rentier" as more and more government bonds fall into negative yield territory, hence our chosen title. If indeed James Tobin tax was supposed to lead to lower volatility in the FX markets, the reverse Tobin tax aka NIRP is leading to the reverse, that's a given but we are rambling again...

In this week's conversation, we will look again at the credit cycle and the issue with correlations with diversification we recently discussed. We will as well look at how NIRP will be playing out credit wise and trouble brewing in Asia. 

Synopsis:

• Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months
• Macro and Credit  - The US late stage will have nasty credit consequences on Asia
• Final chart: US Rates skew may reflect policy mistake / recession risks

• Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months

In our last conversation "The Monkey and banana problem" we indicated that NIRP would exacerbate the demand for yield as the saving rate goes up, which no doubt is leading the negative feedback-loop to push the frenzy for bonds into "overdrive" hence for the first time we have seen the demand for the Japanese 10 year government bond (JGB) pushing for the first time the yield into negative territory. This of course a clear manifestation of the "reverse Tobin tax" and the "euthanasia of the rentier".  The operant conditioning chamber we discussed last week, aka the Skinner box has indeed led to a "Pavlovian" response leading to even further greater compression. As we posited last week, what matters more and more to us is tracking "correlations" given the implications for "diversification" are not neutral:

"The consequence for this means that classical theories based on allocation become more and more challenged in a NIRP world because correlation patterns change in a crisis period particularly when correlations are becoming more and more positive (hence large standard deviations move)." - Macronomics, February 2016

When it comes to "correlations" we read with interest Société Générale's take from their Multi Asset Snapshot note from the 26th of February entitled "A balanced portfolio for an imperfect world":

"While we may have been too aggressive with a balanced allocation before the market downturn, we're not keen to take the revolving door and go risk averse now. We are recommending a balanced allocation. The average correlation between assets has recently pulled back, making us more convinced to keep the current allocation of 50% equities/50% bonds and others.

- source Société Générale

What effectively Société Générale is showing is confirming somewhat we have posited as of late in our conversation "The disappearance of MS München". Namely that in a world of growing "positive correlations" diversification reduces the benefit of diversification:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by this sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world." - source Macronomics, February 2016

This also a subject we discussed in our May 2015 conversation "Cushing's syndrome":

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

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

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

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

What we are currently seeing is a repricing of bond volatility which had been "anesthetized" by central bankers leading to Cushing's syndrome. Central bankers meddling with interest rates levels have led investors to get out of their comfort zone and extend both their risk exposure and duration, taking the repressed volatility regime as an empirical factor in their VaR related allocation risk process. Now they are rediscovering in the ongoing turmoil that, yes indeed long duration exposure is more volatile than shorter ones. They are also rediscovering "convexity" with artificially repressed yields. They are being significantly punished the more exposed to "credit" duration they are." - Macronomics, May 2015

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment. Where is the value left in your bond holding when the German 10 year government bond (Bund) yield is about to turn negative? Yes, it will go negative and so will probably be the rest of the Japanese curve to mimic what has been happening on the Swiss yield curve. The most dangerous negative side effect of the "reverse Tobin tax" is already pushing the Swiss real estate bubbly market into overdrive as indicated by Bloomberg on the 29th of February in their article "Mom-Pop Investors Rush Into Swiss Property at Riskiest Time":

"Mom-and-pop investors are rushing into Swiss properties just as the market faces its greatest threat of a bubble in a quarter century.
“I see two protracting trends,” Patrik Gisel, chief executive officer of Swiss Raffeisen, the country’s third-largest bank, said in an interview in Zurich. One involves big money -- institutional investors such as pension funds and insurance companies who have invaded the market, driven by negative yields on Swiss government bonds. More recently, a new group of investors has entered the fray, buying properties to rent or develop rather than for a primary residence.
“What’s really new is that private investors are piling in to buy real-estate assets for yield due to limited options,” he said. These aren’t ultra-rich speculators, rather well-to-do people looking to build nest eggs at a time of record-low interest rates and market turmoil. Although they are still just a small part of the market, “this is reducing the professionalism,” he said.

Soft Landing

Raiffeisen, a cooperative encompassing about 300 regional banks, is one of Switzerland’s five systemically relevant banks, along with UBS Group AG and Credit Suisse Group AG. It holds about 17 percent of the Swiss mortgage market, with home loans representing about 95 percent of the total volume of 166 billion francs ($166 billion) at the end of the 2015.
The Swiss property market is facing the greatest threat of a real estate bubble since 1991, UBS said in a report this month on the subject. Loan applications for properties not occupied by owners dipped in the fourth quarter, yet remain historically elevated at about 18 percent of the overall demand. House prices rose 0.5 percent from the third quarter and around 2 percent yearly.
While the risk of default on mortgages remains low in Switzerland, vacancy rates are rising, with prices “driven by investments, not by the need for living space,” Gisel said. Unlike in countries including the U.K. and U.S., Swiss buyers traditionally are looking to make a lifetime investment as capital gains taxes make it costly to speculate.
Gisel, formerly the deputy CEO who succeeded Pierin Vincenz at the head of Raiffeisen last year, said he sees a “soft landing” in the property market. The bank said during its earnings report Friday that prices are stabilizing at a high level or declining slightly.

Swiss apartment prices and mortgage lending climbed by about a third between 2007 and 2014. A price increase of 2 percent would have been unappealing just four years ago, Gisel said.
The Swiss National Bank introduced charges on bank deposits in an effort to weaken the franc, which soared after it lifted its three-year-old cap on the currency in January 2015. Some big banks such as UBS and Credit Suisse have passed on the pain of negative interest rates to their larger institutional clients. Retail clients have been spared, for now.
“Equities are too risky for many private investors, bonds don’t yield anything,
so people go for real estate but often have a poor understanding of this market,” says Fredy Hasenmaile, head of real estate research at Credit Suisse. Inexperienced investors tend to underestimate the costs associated to maintain a property." - source Bloomberg

We have argued in a 2011 conversation that the policy of achieving a high home ownership rate is the biggest threat to an economy:

"The issue with enticing a high home ownership rate is the level of household debt it generates. It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.

For us, a housing bubble is a Weapon of Economic Destruction (WED) and pushing real estate prices into overdrive is certainly akin to a "reverse Tobin tax" and the most efficient way in destroying "mis-allocation" of capital on a grand scale and "euthanizing the rentier" for good.

But moving back to the subject of the credit cycle, we still believe we are in 2007, although subprime is not the "prime" suspect this time around as the Energy sector woes have clearly spilled over into over sectors as well. The rising of distress securities is creeping up and it is not only in the Energy sector as displayed in the below S&P Global Market Intelligence chart:

"A host of U.S. energy companies joined LCD’s distressed debt Restructuring Watchlist last week, adding to an already hefty group of issuers from that still-struggling market segment.
The Watchlist tracks companies with recent credit defaults or downgrades into junk territory, issuers with debt trading at deeply distressed levels, as well as those that have recently hired restructuring advisors or entered into credit negotiations.

- source S&P Capital IQ LCD

This is entirely due to ZIRP and now NIRP as shown in the below Société Générale from their Credit Weekly note from the 26th of February 2016 entitled "Will the G20 disappoint credit investors":

"In a low real interest rate environment, however, such as the 1970s or the present, the four year period of stability disappears and the credit cycle becomes much shorter. Chart 3 illustrates this:

Table 2 above implies that the global credit cycle is, as always, relatively synchronous, with the US leading EM by around six months. Assuming two-year widening and two-year tightening cycles, with a peak of the cycle in early 2016 and a trough in late 2017 or early 2018, this implies the following:

- source Société Générale.

The United States are leading once more the credit cycle and the rapid pace at which spreads have widened since the cost of capital has been moving up since the summer of 2014 is indicative of how late the cycle is and the potential spillover to Emerging Markets thanks to Global Financial Conditions tightening in conjunction with the relentless rise of the US dollar.

When it comes to credit and the "Japanification" process, the hunt for yield is still running strongly although some might have already moved higher the quality spectrum in the light of the deterioration seen recently in credit spreads. European investors in a "reverse Tobin tax" environment will be eager to go for even more duration and credit risk as posited in Société Générale's note:

"European investors will still be hungry for yield. European ten-year yields have fallen almost 50 basis points this year, with the Bund yielding just over 10bp. It’s hardly surprising that European insurance companies are steering their clients away from guaranteed life products, as our insurance analyst Rotger Franz has noted, but they are still left with legacy products that need to be funded. Our SG shortfall model estimates the current gap between what insurers need and what the government markets are offering at almost 140bp.

Given this gap, we think the demand for credit will remain strong. It’s worth noting, however, that this demand will be much stronger in the BBB area than in the AA and A area, since spreads have compressed too much in those areas to offer the returns that investors need." - source Société Générale.

Insurers have are indeed struggling with NIRP and are slowly getting "euthanized". While we have long been highlighting the dangers with Emerging Market corporate debt denominated in US dollars, it is worth highlighting Société Générale's comment before we move on to our next point:

• "Emerging market sovereigns will not be able to bail out their corporates: The ratio between EM sovereign spreads and corporate spreads has narrowed this year, when the mismatches in the indices are accounted for. Yet EM corporate debt – either domestic debt as a percentage of GDP, or external debt as a percentage of reserves – is often much bigger than government debt, as we noted in "Can EM sovereigns really bail out their corporates?" We think this year, investors will realise that many EM corporates will not be bailed out by their sovereigns.
• EM defaults will be higher and recovery rates lower than the market expects. Given the weakness of commodity prices and the weakness of EM currencies, we are more bearish about these issuers than we are about US high yield issuers." - source Société Générale

The latest sign of the strain facing EM corporate issuers is clearly illustrated by Mexican giant PEMEX losing $32 billion in 2015. Mexico's largest company and big contributor to the government's budget has more than $87 billion in debt and hasn't recorded a profit since 2012 according to Bloomberg. The government of Mexico has pledged financial support for its ailing giant. 

This leads us to our second point and once again the unintended consequences of our Macro theory of reverse osmosis playing out as we have argued in our conversation "Osmotic pressure" back in August 2013:

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

Now the "flows" are turning into "outflows" leading to the following points we discussed at the time:

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

We also added at the time:

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

Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates)." - source Macronomics August 2013

While the PBOC might have indeed bought some time in adding more liquidity, the worrying trend of capital outflows have yet to meaningfully slow down, meaning for us that, indeed Asia should as well be the focus of more attention, but not only China...

  

• Macro and Credit  - The US late stage will have nasty credit consequences on Asia

Back in July 2015 in our conversation "Mack the Knife" we indicated that EM credit spreads and oil prices were highly correlated. 

The correlation of oil and credit spreads mean that indeed the unintended consequences of the surge of the US dollar and the fall in oil prices have not translated much as before into Asia's energy-importing economies as illustrated by Nomura in their Asia in Charts note from February 2016 entitled "Asia's coming credit crunch":

"• Cheap oil has not benefited Asia’s energy-importing economies as much as it had in the past. In early 2008, if you responded “sub-6%” to the question of how fast Asia ex-Japan’s economies would grow if oil prices halved and most Asian central banks slashed rates to new, or near, record lows, you would have been scoffed at. More of the oil windfall appears to have been saved or offset by the China slowdown, weak EM demand, high domestic leverage and low productivity growth.

• That said, the commodity price drop has been a big differentiator in favour of Asia, as fundamentals and growth have fared better in Asia vis-à-vis LatAm and EEMEA. Asia is the least ugly in EM, at least for now. If risk sentiment turns, Asia may experience a short-run relief rally, buoyed by: 1) still ample global liquidity; 2) any signs of China growth stabilising, albeit it would be temporarily, in our view; and 3) more discriminating investors in global emerging markets in Asia’s favour.

• However, more fundamentally the seeds are being sown for a credit crunch and financial stress in Asia:
1) high and still-rising private debt, combined with still elevated property prices; 2) slowing potential growth rates; 3) increasing foreign-currency debt exposure; 4) large herding-like investments by global asset management companies in Asia (‘original sin II’); 5) the Fed surprising with more/faster rate hikes; and 6) China’s economy facing a secular slowdown in growth in 2016 and 2017." - source Nomura

As our reverse "macro" osmosis has been playing out and given the credit binge witnessed in some parts of Asia, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring.

There is a heightened possibility of a credit crunch looming in Asia as posited by Nomura in their very interesting report:

"Asia is setting itself up for a credit crunch 

• The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can cause financial decelerator effects.

• Cheap credit has weakened productivity by misallocating capital (eg. property speculation), dis-incentivising supply-side reforms and keeping zombie companies alive. Potential growth is slowing across most of Asia.

• Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.
• Triggers of a credit crunch could be the market caught off-guard by Fed rate hikes, USD sharp appreciation, a China setback, or a high profile Asian corporate default prompting global asset managers to pull out from the region en masse and causing market liquidity to evaporate.

 Asia’s credit and property price gaps are sending warning signals

• Pioneering work at the BIS by Claudio Borio and Philip Lowe in the early 2000s found that over a 4-year horizon a credit gap of >4% predicted 88% of crises in industrial countries with a noise to signal ratio (NSR) of 0.21, while an equity gap >60% predicted 67% of crises with an NSR of 0.15. Jointly they predicted 73% of crises with an NSR of 0.02 (i.e., issued wrong signals only 2% of the time).
• Since then more studies, including of EM crises, have reaffirmed that credit is the single best predictor of crises and, with better data, property prices are generally found to be more important than equity prices.
• In a more recent 2011 BIS study (working paper No. 355) of 36 advanced and EM countries it was found that over a 3-year horizon, a credit gap >10% predicted 67% of crises with an NSR of 0.16, and a property gap >10% predicted 77% of crises with an NSR of 0.33. This is an ominous sign for Asia, as highlighted in the table below.

The best indicator of financial crises is the credit gap; the property price gap is also a strong indicator, and jointly they send a strong signal

 (click to enlarge picture)

- source Nomura

From the table above, and as a follow up on our HKD take from our  December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. On this specific case, Nomura's report has added more on our justified concerns in their note:

"Hong Kong could be Asia's flashpoint

 HK stuck between a rock (Fed hikes) and a hard place (ebbing China)

• Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 112% (they have corrected 11%), and the ratio of private non-financial credit to GDP has surged to 293%.

• The real effective exchange rate has risen 26% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015.

 • Foreign assets and liabilities have surged since 2008. this leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.

• Economic hardship could ignite further political and social unrest, or vice versa, ahead of the 2016 Legco elections (around Sep) and 2017 chief exec elections. We would not rule out a change to the HKD peg regime." - source Nomura

And, as per us winning the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our December "Cinderella's golden carriage", we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. Maybe it will be for 2017 after all...For now the Hong Kong dollar has recorded the biggest monthly gain since 2011 in February on optimism that the city will be able to maintain its peg to the US dollar as reported by Bloomberg in their article from the 29th of February entitled "Hong Kong Dollar in Biggest Monthly Gain Since 2011 as Peg Holds":

"The Hong Kong dollar advanced 0.18 percent this month to HK$7.7724 against its U.S. counterpart, the biggest increase since October 2011, data compiled by Bloomberg show. The currency rose 0.06 percent on Monday to trade near the strong end of its HK$7.75-HK$7.85 trading range.
“The Hong Kong dollar was one of the biggest speculative targets in January, especially amid fears of the yuan being devalued,” said Irene Cheung, a foreign-exchange strategist at Australia & New Zealand Banking Group Ltd. in Singapore. “We need to watch the yuan, given how it’s affecting sentiment across markets. If the dollar-yuan rate continues to remain broadly stable, there’s no reason to focus on the Hong Kong-dollar peg for now.”

Yuan Deposits

The Hong Kong dollar was linked to the greenback in 1983, when negotiations between the U.K. and Beijing over the city’s return to Chinese rule spurred an exodus of capital, and policy makers in 2005 committed to limiting declines to the current range.
Hong Kong’s yuan deposits rose by 0.1 percent to 852 billion yuan in January, the Hong Kong Monetary Authority said on Monday. The pool posted its first annual decline last year, while issuance of Dim Sum bonds fell for the first time since the market’s inception in 2007." - source Bloomberg

As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

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

It seems to us that speculators, so far has not been able to  gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals.

When it comes to the fate of the HKD peg, Nomura has been solacing our concerns in their note:

"HKD re-pegged to the RMB? 

The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported
US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed accelerates hiking and China’s growth keeps slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura

Given our keen interest on this eventuality, we will be not only monitoring that space but also tracking financial conditions in Asia rest assured.

Finally for our final point and chart, we would like to point out that it's not only Hong Kong which is stuck between a rock (Fed hikes) and a hard place (ebbing China). The Fed is as well in a bind.

• Final chart: US Rates skew may reflect policy mistake / recession risks

Our final chart comes from Bank of America Merrill Lynch's Liquid Insight note from the 1st of March entitled "Rates skew may be pricing a policy mistake":

"• US rates skew is now inverted in both short- and long-dated expiries, despite more dovish Fed expectations
• We believe this, at least in part, reflects higher perceived odds of a policy mistake and/or growth shock ahead
• From a historical standpoint, inverted long-dated skew is consistent with late stages of the hiking cycle

Inverted skew: Not a good sign for the Fed

A notable recent development in the US rates vol market is the inversion of the skew surface, with low strikes trading at a premium to high strikes. Short-dated skews were first to invert earlier this year. Today skews are inverted across the board, including very long expiries (Chart above). Importantly, the skew inversion occurred against expectations of a more dovish Fed. The market now sees the next Fed hike only by 4Q17, a much less hawkish outlook than FOMC projections. Lower rates coupled with expectations of a more accommodative Fed normally imply upward risks to rates. Yet, the volatility market sees risks to rates skewed on the downside even at very long horizons.
We believe this is a worrisome signal to policy makers. The inversion of the skew all the way into longer horizons suggests perceived risks go beyond the recent financial stress and may reflect greater perceived odds of a policy mistake/recession risks. Inverted long-dated skew is consistent with late stages of hiking cycles." - source Bank of America Merrill Lynch

To hike in March, or not to hike, that is the question...

"Insanity - a perfectly rational adjustment to an insane world." - R. D. Laing, Scottish psychologist

Stay tuned!