Macro and Credit - Charles' law

"There is no such thing as talent. There is pressure." - Alfred Adler, Austrian psychologist

Watching with interest the demise of some Distressed/High Yield funds thanks to "price action" and "low liquidity", with continuous pressure as well on some other asset classes in true "Risk-Off" fashion, we reminded ourselves for this week's title analogy of Charles' law, or the law of volumes. Charles' law simply states that a gas tends to expand when heat is applied to it. This law was published in 1802 by French chemist Joseph Louis Gay-Lussac, who credited Jacques Charles for all his work on the subject. Jacques Charles was a French scientist and inventor whose most notable work came during the late 18th century. Charles was presumably the first to discover that hydrogen could be used as a lifting agent in balloons. More recently, central bankers discovered that liquidity injections could be used as a lifting agent in "asset prices" ("Cantillon Effects"). In similar fashion, in our "macro" world, credit spreads "expand" (widen) when heat is applied to it. In physics, when the combustion starts, it is difficult to stop, same happens in credit and macro, when the credit cycle is turning, leading as well to "capital outflows" and surge in yields. When it comes to lifting agent, balloons, and combustion, we remember what happened to the LD129 Zeppelin Hindenburg on the 6th of May 1937 but, that's another story...

In this week's conversation, we would like to look at the continuous effect of positive correlations and large standard deviations move we discussed in August. Given the rise in volatility, we will also look at why we think "volatility" is the asset class to own as we move towards 2016 and the gradual erosion of central banks' credibility in 2016.

Synopsis:

• The opportunities in unprecedented turbulences
• "Negative carry" - Central banks' credibility is effectively suffering from "time decay"
• Final chart - CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies

• The opportunities in unprecedented turbulences

As we posited back in August, rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky. We argued at the time:

"There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, August 2014

And we concluded:

"Expect more violent moves going forward as a consequence. For us, there is no "Great Rotation" there are only "Great Correlations"..." - source Macronomics, August 2014

The 3rd of December was a good illustration of the "instability" due to rising "positive correlations" which inflicted havoc on "balanced fund". Below are two charts illustrating the large standard deviations move in Europe following the ECB - graph source Bloomberg:
EUR/USD:

German 10 year Bund:

- Graph source Bloomberg

To illustrate further our prognosis of "rising instability" à la Charles' law, we read with interest Bank of America Merrill Lynch's take in their Global Equity Derivatives Outlook for 2016 published on the 9th of December:

"As we highlighted in our 2015 outlook, the most distinguishing feature of markets today is not the general trend in volatility, but the unprecedented turbulence.

Rising fragility; moving deeper into uncharted waters
In 2016 we expect volatility to maintain its gradual upward trend, however, to continue to be punctuated with violent but short-lived shocks owing to poor liquidity, extreme positioning and a market still heavily manipulated by (and dependent on) the central bank put. Despite below-normal levels of volatility across asset classes, we are in uncharted waters in terms of a lack of stability: 

• Markets are setting records in terms of jumping from calm to stressed & back
• Our indicator of cross-asset market fragility is near its highs (Chart 1)

• CB liquidity is tightening, making markets more accident prone (Chart 7)

Asset managers are struggling, with the poorest hedge fund performance relative to the risk they are taking since 2008, despite overall market volatility being only 1/4th of 2008 levels. Their poor performance is better explained by the extreme levels of market fragility, which by our metric is at 80% of its 2008 highs (Chart 1 above).

Unfortunately, we don’t see conditions improving and only becoming more acute as liquidity continues to deteriorate, asset valuations become increasingly stretched, and the Fed navigates the unwind of the greatest policy experiment in history. " - source Bank of America Merrill Lynch

We don't see conditions improving either in 2016 and last Monday was once again an illustration of "Blue Monday" in the works we think. With liquidity deteriorating and hydrogen having been used by our "generous gamblers" as a lifting agent in  "asset balloons", there is indeed no surprises in seeing a significant rise in idiosyncratic risk leading to significant price movements. 2015 saw an increase in the number of "sucker punches" inflicted to the "cross-asset" crowd. By no means 2016 is going to be different.

When it comes to High Yield's jitters, we have long seen it building up as we carefully studied the credit cycle, it doesn't come to us as a surprise. As a reminder, this is what we have repeated in numerous conversations:

"The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

But, from a short term tactical "contrarian" perspective, we are seeing in US High Yield and Equity / Credit volatility some early signs of "capitulation" (volumes, implied volatilities for ETFs) which, would make for the "adventurous" punter some interesting entry point, to play a short term rally in the making.

Following Friday's move, we have noticed a multiple of "alarmist articles/headlines" from various pundits which have been late to the "party" on the matter of US credit. We believe it is a short term contrarian sign from our behavioral psychologist mantra, given we prefer to focus on the process rather than the content. For instance, we are seeing real signs of capitulation, via flows and implied volatilities on listed options on both principal liquid ETFs.

Volumes for iShare HYG:

- graph source Bloomberg

Implied Volatility 3 months HYG US:

- graph source Bloomberg

Spread volatility Russel / volatility HYG : 

It represents some good entry points for a tactical short term long/short strategy. The implied volatility on credit is trading on comparable levels with "mid-cap" equity volatility.  We believe it is an interesting "capital structure trade" that warrants attention, either from a "directional" perspective (selling straight "Put" options on HYG / buying straight "Put" options on RTY/SPX) or through a "pure" volatility strategy. 

In fact as we were typing this very post, we noticed a rebound on the aforementioned HYG. To paraphrase our November 2015 conversation "Ship of Fools", this time around on HYG we remain tactically short-term "Keynesian" bullish but, remain long term "Austrian" bearish given the lateness in the US credit cycle.

More and more in 2016, we believe there will be many opportunities in unprecedented turbulences movements we have seen so far in 2015. 2016 will be a year in which "tactical" global macro "convexity" trades such as the one highlighted above will be plentiful. Volatility will therefore be one of the core asset class to own, in various "cross-assets" (FX, rates, commodities, credit, etc.). On that point we agree with Bank of America Merrill Lynch's take from their latest Global Equity Derivatives Outlook:

"Successfully trading a less stable worldWhile many are struggling with this new market dynamic, we believe there are smart ways to combat it – and even profit – by monitoring cross-asset risk, and taking advantage of the inflection point in asset correlations. For example:• Gaps in cross-asset volatility can aid in differentiating between “local” and global risks, to determine when to fade the market or add a hedge• Shocks create entry points for cross-asset RV between leader and laggard assets which has been successful in generating alpha• Risks implied by derivatives, including correlation, often are unlikely to realize as stress unfolds, allowing for cheap directional trades• Cheaper hedges can be constructed by harvesting underpriced volatility through proxy puts overlaid on standard put spreads• Strategies that collect the volatility risk premium, for example through call overwriting, while dynamically managing these risks can add alpha" - source Bank of America Merrill Lynch

Although "volatility" is a "negative carry" proposal, the events of the 3rd of December on the German Bund following the ECB, which were close to a 7 standard deviation move, have shown how quickly your "carry" can be wiped out. But, as liquidity is being drained by the Fed and given the increasing signs of global financing conditions tightening, if the "trend" is your "friend", then we are bound to see a surge in volatility in 2016. This trend is pointed in the same report from Bank of America Merrill Lynch:

"A trend of rising vol as liquidity drains
Our Economics of Volatility1 framework has been anticipating the 2015 starting point to a turn in volatility for the last two years2. From here on we expect to see a rising trend in equity volatility levels, a trend that could last 1-2 years, transporting us from the low volatility regime of the last 3 years towards a sustained high volatility regime.
Our expectation for a turn in the volatility cycle follows from a clear turn higher in 5Yr real rates in 2013, and allows for a 2-year lag (Chart 6).  

High volatility regimes may resemble periods like 1998-2003 or 2008-2011, as two examples. Transition periods can also take various forms. Unlike the 1996-1998 transition period which was gradual and well behaved, the 2008-2009 transition was short and violent, as a suppressed and overdue re-pricing of risk finally manifested itself. It’s hard to predict the exact form the next transition will take. While our base case is for an orderly transition, we are wary of the possibility of unpleasant surprises resulting from an unwinding of the highly unusual monetary policy of the last 7 years.

Unwinding extreme easy monetary policy is a tightening
The monetary tightening cycle which started with the 2013 taper has continued its progress, reflected in rising 5yr real rates. This in turn has driven a significant tightening in global liquidity as capital flows from developed to emerging markets start to reverse, evidenced in a slowdown and reversal of FX reserve accumulation."

Tightening liquidity combined with fragility: equity markets are accident proneChart 7 (earlier in our post) shows a measure of global US$ liquidity derived from the momentum of the Fed’s balance sheet. Historically we see that tightening cycles have typically started at high liquidity levels. The current cycle in fact started in anticipation of the tapering of the open-ended QE3 program in 2013, with the impact evident in the sharp turn in the 5Yr TIPs rate (Chart 6), and the subsequent fall in US$ liquidity. Given how far liquidity has already dropped, it is going to be interesting to watch the impact of the more traditional part of the tightening cycle – actual rate hikes – which are expected to start imminently. Combined with our view of an increased likelihood of local shocks due to deteriorating trading liquidity, we may find the markets more accident prone in 2016 than they have been in some time. "- source Bank of America Merrill Lynch

This "reversal" of capital flows in Emerging Markets is exactly the manifestation of our "reverse osmosis" macro theory playing out we think. As a reminder from our August 2013 conversation "Osmotic pressure":

"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." - source Macronomics

Of course as the Fed is on the "normalization" path as anticipated by market participants, stemming capital flows will continue to be increasingly difficult, particularly for the hard hit commodity players and as well China, trying to "deflate" its "hydrogen fueled "credit" balloon.

Whereas volatility is a "negative carry" proposal, so is central banks' credibility which is effectively suffering from "time decay" we think. 2015 has already shown the weak hand for some of the central banks "punters" such as the SNB and the PBOC losing its cool during the summer. "Le Chiffre", aka Mario Draghi, as well, our "poker prodigy" has shown some weakness in his "bluffing" abilities as of late. We wonder if 2016 will not see further "erosion" in their "ability" to steer markets. This brings us to our second point.

• "Negative carry" - Central banks' credibility is effectively suffering from "time decay"

Whereas "volatility" is a "negative carry" proposal" as posited earlier one, as we move towards 2016, it remains clear to us that 2015 saw many players at the "poker" table fold earlier (such as the SNB). On the 3rd of December, our "Le Chiffre" bluffing abilities suffered as well at the "poker table." As we move towards 2016, we are wondering wether 2016 will see additional weaknesses from our powerful "omnipotent" central bankers. For sure, we think their abilities will be tested even further, given the high deflationary forces at play, particularly with the further weakening of the CNY/Yuan, which will represent yet an additional "headache" for our enduring "gamblers".

On that subject, once more, Bank of America Merrill Lynch's 2016 Global Equity Derivatives Outlook makes some very interesting remarks relating to the "weakening" of the global markets "Central banks Put":

"Power of CB put shows risk of its lossCentral banks have had a tremendous impact on financial markets in the last seven years, which is never more apparent than when looking at the world through the volatility lens. As shown in Chart 12, cross-asset volatility reached all-time lows in the summer of 2014, falling even below the 2007 pre-GFC bubble lows, crushed under the weight of unprecedented monetary policy (or in the ECB case, the promise of policy). This is remarkable considering the size of the risk “bubble” created pre-GFC.

The result is that risk is not fairly priced based on fundamentals but rather is better explained by investors not wanting to stand in front of central banks as they embark on QE. As Chart 13 shows, when decomposing the 41 factors of risk covering 5 asset classes from our GFSI index into regions, both Europe and Japan (the two regions still actively engaging in QE) are the two regions with the most depressed price of risk.

This is despite being the two developed regions with some of the greatest fundamental risk.

Unprecedented CB – market co-dependenceCentral banks have never been more sensitive to financial market conditions as they are today. This hyper-sensitive reaction function has placed huge downward pressure on volatility, and has accentuated local shock behavior as investors have become accustomed to CBs verbally supporting the market at very low levels of stress compared to the past.

In the last three instances when our GFSI critical stress signal has triggered, during the taper tantrum in June 2013, the Oct 2014 growth tantrum, and the Aug 2015 China tantrum, central banks have stepped in to verbally support the market (Chart 14). 

In each case central banks have reversed market stress, creating a string of three false signals, which is historically unusual. From 2000-2012, the GFSI’s critical stress signal triggered 15 times, 12 of which resulted in a further escalation of risk and a pull-back in global equities of at least 5%. This illustrates the extent to which central banks have essentially capped risk at levels where it historically was likely to spill over. 

This has self-reinforced a “buy-the-dip” mentality which, together with the fact that investors have generally been underweight US equities this year, has caused the S&P to record larger returns on days the market was rising than when it was falling. Combined with the fact the S&P fell more days than it rose YTD but the market overall was up makes this historically unusual, occurring only 5 other years since 1928.

Pulling the safety net away will be riskyArguably one of the reasons central banks have been so sensitive to market risk is that they are fearful of a negative wealth effect resulting from a financial market sell-off hurting the real-economy, given they have little monetary ammunition left. Keeping rates low to avoid the rising costs of record high debt burdens could also be a motive. 

The US Fed’s fear was made particularly clear by Yellen’s decision to not hike in September, citing the sell-off in equities and China weakness, at a time when the S&P
500 was only about 10% below all-time highs. 

However, the challenge will be to remove this safety net given how dependent the market has become. And once the Fed begins its hiking cycle, it may be implicitly less able to provide the support for fear of being seen as making a policy mistake. This reduced power of the CB put will only help increase market fragility.

Central bank’s risk manipulation well explains local tails
A good way to explain why we have seen local tail risks arise so frequently since central banks began to heavily manipulate asset prices is with the following analogy, illustrated in Exhibit 1.

Essentially central banks, by unfairly inflating asset prices have compressed risk like a spring to unfairly tight levels. Unfortunately, the market is aware the price of risk is not correct, but they can’t fight it, and everyone is forced to crowd into the same trade. By manipulating markets they have also reduced investors’ inherent conviction by rendering fundamentals less relevant.
This then creates a highly unstable (fragile) situation that breaks violently when a sufficient catalyst causes risk to rise – overly crowded positioning meets a market with little conviction.

Catalysts can range from a “valuation scare” similar to Oct-14 or Aug-15 to a prominent investor stating that assets (e.g. bunds) are not fairly priced and are the “short of the century”. 

The unwinds from these crowded positions are violent, but almost equally violent in some cases are the reversals, which are driven from investors crowding back in when they realize central banks are still there providing protection. 

From this vantage point, it becomes clear that the biggest visible risk to financial markets is a loss of confidence in this omnipotent CB put." - source Bank of America Merrill Lynch

Exactly, 2016, will be all about "risk-reversal" trades. Given the extreme positioning and crowded positions in some asset classes, we expect to see much more "risk-reversal" pain trades aka "sucker punches" being delivered in 2016. From a global "macro" convex positioning, there are already many cheap "convex" overcrowded consensus trades, such as "short gold", "short oil", to name a few. From an "opportunistic approach, there is potentially tremendous "upside" in taking the opposite view via the option markets on various asset classes we think. 

Indeed, the "omnipotent CB put", that's why "Theta" is always "negative". Same goes with central banks' credibility. Whereas up until now, to be fair, thanks to the "omnipotent CB put", options sellers experienced lots of small wins, while getting lulled into a false sense of success and "security", in 2016 they might eventually suddenly find their profits (and possibly worse) obliterated in one ugly move against them as we pointed out in our previous conversation when using our "Cinderella's golden carriage" analogy. 

What would most likely dent even further "central banks' credibility" in general and the Fed in particular is indeed the biggest "deflationary" threat coming from China with a continuous "stealth devaluation" of its currency. This would indeed send a very strong "deflationary" impulse to Developed Markets (DM) and represents a major headwind for our "generous gamblers" as per our final chart.

• Final chart - CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies

We believe that a steady grind lower in Yuan/CNY will occur in 2016, this will put additional pressure on the rest of the world and won't be enough to counter "capital outflows" in China. This we think is a "big risk" for 2016 and amounts in effect to Charles' law playing out. On this subject, we would like to point out Société Générale's take from their Fixed Income Weekly note from the 10th of December entitled "EM deleveraging":

"CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies, creating a disinflationary shock in developed economies – bullish for bonds. ADXY is threatening to break YTD lows (Graph 3).  

Our Asian strategists warn that a currency war induced by CNY depreciation may take either a direct form, with policymakers trying to match CNY weakness, or an indirect one, with investors shorting Asian currencies as a proxy trade. If the depreciation in the CNY accelerates or volatility increases significantly, the risk is a destabilisation of the entire EM currency complex: an example of the butterfly effect we refer to in our 2016 FI Outlook.
When the PBoC fights excessive weakness to discourage capital outflows, it is a seller of bonds, especially Treasuries. However, the recent bout of CNY weakness has not seen any particular pressure on Treasury yields or USD swap spreads. If anything, the latter have recently recovered. That suggests lighter PBoC intervention, which might support the idea that it will be less proactive now that the IMF has given the green light on CNY inclusion to SDR." - source Société Générale

Finally, when it comes to Charles' law and our "reverse osmosis" macro theory and capital outflows from China, we would like to point out towards JP Morgan's chart below from their "China: Devaluation in 2016 - the why, the how and when it will occur" note from the 9th of December:

"Capital outflows will persist and will become an increasingly important driver of currency weakness. Capital outflows will persist for two reasons: firstly, growth headwinds are unlikely to dissipate, which, as chart 3 below highlights, should correlate well with further capital outflows.

The second factor will be continued corporate unwinding of dollar liabilities (we estimate another $400bn dollar liability needs to be deleveraged after recent rise of corporate hedging)" - source JP Morgan.

One thing for sure and as far as Charles' law is concern, in our "macro" driven world, trouble "expand" (widen) when heat is applied to it. Trouble will indeed expand to Asia, should the pressure on ADXY continues, rest assured.

"There are plenty of recommendations on how to get out of trouble cheaply and fast. Most of them come down to this: Deny your responsibility."- Lyndon B. Johnson, US President

Stay tuned!

Credit - Tokyo Drift

"As the blessings of health and fortune have a beginning, so they must also find an end. Everything rises but to fall, and increases but to decay." - Sallust, Roman historian

Watching with interest the continuation of the deflationary trend of peripheral yields in conjunction with the brewing turmoil in France given the recent dissolution of the latest government, we decided this week to use a relatively simple analogy, using the 2006 third opus of the "Fast and Furious" movie saga entitled "Tokyo Drift" as our title given the on-going "Japanification" process of Europe.

In fact, this "Japanification" process aka "Tokyo Drift" reminded us of our conversation from March 2012 entitled "St Elmo's fire" where we indicated the following:

"If Europe is moving towards a Japanese decade, there might be at least some solace for Spanish Golf players given that according to Bloomberg there has been a high correlation between Golf Membership fees and Tokyo land prices - source Bloomberg:"

The continuation of the European "adjustment" in similar fashion bodes well for European golfers but we ramble again...

Peripheral yields have been subdued even without the OMT being triggered. In similar fashion, the Euro has weakened without even QE being launched.

In this week's conversation, we will review the acceleration of the deflationary trend we are seeing and what to expect: QE or no QE?

Another sign of the "Tokyo Drift" in the European financial world can be seen in the Eonia which, as indicated by Morgan Stanley in their ECB Tender Tracker note from the 20th of August has been drifting towards Depo:

"Eonia fixing at new lows: Eonia has been fixing at record lows for the past two weeks, with spot Eonia currently being at 0.005% and 1y forward 1y Eonia at 0.042%."

"The next event the market will be watching out for is the first TLTRO take-up on September 18. At the press conference of the August ECB meeting, President Draghi quoted a lower range of the total take-up at the TLTRO from banks’ survey, i.e., €450-850 billion, compared to the ceiling of €1 trillion announced in June. While Draghi may have lowered the ECB’s expectation of the overall take-up at the TLTRO, our bank analysts’ estimates are at the lower end of the range – a total take-up of just €350-650 billion." - source Morgan Stanley

In fact 1 year 1 year Eonia has been trading down to -1.5 bps as of late.

When it comes to the "inflationary" trends in Europe, the deceleration of inflation has been intensified by the volatility in energy/food prices as indicated by Bank of America Merrill Lynch in their note from the 22nd of August entitled "Tracking deflation: more worries":

"HICP fell to 0.4% yoy in July, while it had been expected to be unchanged at 0.5% yoy. Looking at its components, the changes were driven by energy dropping aggressively from 0.1% yoy to -1% yoy. Alcohol and tobacco receded from -0.2% to -0.3% yoy, non-energy industrial goods were stable, while services grew 1.3% yoy, unchanged from June (Chart 6)." - source Bank of America Merrill Lynch

Another significant indicator of the deterioration of inflation expectations in Europe can be seen in spot inflation break-evens in the same report, showing the various maturities falling in concert:

"Spot inflation break-evens have resumed their fall and are now at levels close to 0.5% on a one- and two-year horizon. Five-year break-evens are also falling and stand at around 0.99%.

Forward inflation break-evens computed from swaps also started to fall again and, for the first time, the 5Y5Y forward has crossed the 2% line. - source Bank of America Merrill Lynch

Looking as well at the recent weakness of Euro versus the US dollar, it is for us the continuation of our "Generous Gambler" aka Mario Draghi being very apt in applying some of General Sun-Tzu's greatest concepts following his July 2012 OMT bluff:

“The supreme art of war is to subdue the enemy without fighting.” ― Sun Tzu, The Art of War

To that effect, Mario Draghi has once more played a very smart hand in lowering the Euro without even firing his QE bazooka. We agree with Morgan Stanley's comment from their latest FX Pulse note from the 21st of August that lowering the value of the euro was indeed an obvious monetary policy goal:

"No EUR Value

Meanwhile, the ECB’s policy tools to revive the ailing economy have become a constraint. Lowering the value of the EUR has become an obvious monetary policy goal, explaining why a declining EUR is now taken as a bullish sign by European asset markets. The weakening exchange rate is now an indicator of the success of the ECB’s easing approach. This interpretation makes sense as declining sovereign spreads failed to reduce peripheral private sector funding costs, as shown in Exhibit 3, and implicitly failed to raise private sector credit supply. 

Nowadays, low sovereign bond yields will help reduce the foreign value of the EUR. This is best illustrated by Exhibit 4 showing volatility-adjusted yield differentials no longer support peripheral bond markets."

- source Morgan Stanley

Indeed, declining peripheral yields have not transferred to peripheral private sector funding due to "crowding out" which we discussed a year ago in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.

"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

We also commented at the time:

"Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 

As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.

"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

So QE or no QE?

Not yet.

We have to agree with Bank of America Merrill Lynch's take from the 19th of August entitled "Rates market still not priced for ECB QE as displayed in their Chart of the Day - 5y5y Euro inflation swap rate - breaking below the 2% level last Friday:

"Inflation swaps point to rising risk of no QE

Last but not least, the past two weeks saw a clear break in the relationship between forward nominal rates and breakevens, with a sharp fall in inflation forwards. While the rally in nominal forwards over the past few months used to be reflected in lower real rates, the last two weeks saw it translate into a drop in inflation forwards. The 5y5y inflation swap rate, closely monitored by the ECB as an indicator of long-term inflation expectations, has crossed the 2% on Friday, for the first time since October 2011 (Chart of the day). The drop in inflation forwards is even more noteworthy given that the end of July/start of August often sees firmness in breakevens because of July index events and the absence of supply." - source Bank of America Merrill Lynch

We also agree with Bank of America Merrill Lynch's comment on the heightened risk of "disappointment":

"Weak GDP but tighter spreads may seem consistent with QE…

Last week, the release of weaker-than-expected 2Q GDP for the Eurozone was still accompanied by a tightening in peripheral spreads. Many interpreted this as the market pricing in increased likelihood of QE. We would disagree with that view. While the weak data places more pressure on the ECB to act, we find the moves in peripheral spreads and other rates products inconsistent with the rates market discounting greater chance of QE. Unfortunately, there is no straight way to measure the probability that the market assigns to ECB QE, and even surveys have indicated a very large range of expectations, depending on investor class (Chart 5).

- source Bank of America Merrill Lynch

From a contrarian stance and from a risk reversal point of view, there is indeed a potential for a correction of the consensus long US dollar trade we think. Particularly when everyone is long gamma on EUR/USD as indicated by Bank of America Merrill Lynch in their note "Trading a new USD vol regime" from the 25th of August:

"There was significant demand for EUR/USD gamma over the last week as the pair weakened below 1.32. In the short term there is a strong likelihood of a rebound in the pair following the completion of a triangle breakout (Closing our tactical €/$ short). With short EUR/USD positioning at stretched levels, this rebound is likely to be volatile." - source Bank of America Merrill Lynch

But, then again, one of the real reasons behind the weakness in the Euro as of late has indeed been equity outflows as pointed out by Bank of America Merrill Lynch in their Liquid Cross Border Flows entitled "USD marching higher" from the 25th of August:

"Equity outflows drive EUR lower

Real money selling has been the main driver of EUR weakness in recent weeks, also reflected by outflows from Eurozone equities (Chart 5). 

The CFTC data shows EUR shorts near a two-year high and our quant and technical analysis warn of a short-term pause in EUR weakness. However, as long as the ECB avoids more aggressive easing, equity outflows could weaken the Euro in the medium term." - source Bank of America Merrill Lynch

Should the rebound in European equities accelerate, this could as well play for a rebound in the euro in the near term we think.

In similar fashion, the strong move of the US dollar versus the Japanese Yen appears to us slightly overdone and we might see as well some pull-back from a "contrarian" point of view but technicals, indeed appear less favorable for now when it comes to the yen trade.

From a credit perspective, we continue to believe in the safety of Investment Grade versus the risk of renewed volatility in the High Yield space. Our stance is as well confirmed by recent flows as described by Bank of America Merrill Lynch in their HY flows note entitled "Back to positive" from the 22nd of August:

"Safety over yield

European investors have poured more funds into high-grade and government bond focused funds over the last couple of months. On the other hand, investors have cut risk on more high-beta and growth related asset classes, like equities and high-yield credit. We present this dichotomy of trends in chart 2, by using the cumulative 4 week average flows per pair."

"Credit flows (week ending 20th August)

HG: +$2.0bn (+0.3%) over the last week, ETF: +$183mn w-o-w

HY: +$734mn (+0.3%) over the last week, ETF: -$94mn w-o-w

Loans: -$96mn (-1.1%) over the last week

High-yield flows are back in positive territory after 5 weeks and a total of $13.4bn of non-stop outflows. High-grade inflows remained upbeat, with another $2bn (almost) inflow for another week. High-grade fund flows have been a strong 7.1% of AUM, the strongest since 2010. On the ETFs side, flows continued to decouple, as high grade ETF funds continued to see inflows, while high-yield suffered another outflow over the last week."

- source Bank of America Merrill Lynch

Flows continue to validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets" which we mentioned again in our last conversation. We like being long duration in European investment grade credit.

On a final note, as far as the Tokyo Drift is concerned and Japan in particular, the continuation of the increase in bank lending in Japan warrants close monitoring we think when it comes to assess Japan's never ending fight against the "deflation beast" - graph source Bloomberg:

"Harmony makes small things grow, lack of it makes great things decay." - Sallust, Roman historian

Stay tuned!

Credit - Cognitive dissonance

"The difference between stupidity and genius is that genius has its limits." - Albert Einstein

Watching with interest the significant compression of German bund towards the 1% level as deflationary forces à la Japan gather strengths in the European space with disappointing ZEW index pointing to lower growth in conjunction with Russian sanctions hitting hard some European economies, we decided to venture once more towards psychology when it came to choosing this week's analogy for our title (We already touched on the subject of cognitive bias in our "Dunning-Kruger effect" conversation. Cognitive dissonance in psychology which is when people are confronted with information that is inconsistent with their beliefs. For instance, in the case of Europe, the much vaunted "recovery" is no doubt going to be tested by the next GDP prints in the European space with France, no doubt straying towards recession in similar fashion to its Italian neighbor we think (-0.2%). Of course the prophecy of the "recovery" will fail in similar fashion to what was illustrated in Leon Festinger's 1956 book "When Prophecy Fails", which was an early version of cognitive dissonance. A good illustration of "Cognitive dissonance" is in the belief that having a single European banking supervisor will be supportive of lending in peripheral countries as indicated by the ECB and reported in Bloomberg by Maxime Sbaihi in Bloomberg:

"The transfer of power to a single European bank supervisor should be a game changer. The ECB is hoping to do more than simply strengthen financial stability. It also envisions unified authority as a tool to repair the broken channels of monetary policy transmission, prompting banks to make their comeback at the periphery and improve credit conditions there. The central bank timidly expressed this wish in its latest financial integration report, stating that “the banking union is expected to contribute indirectly to the return of crossborder credit flows.” - source Bloomberg

We beg to ask where the demand is going to come from? Yet another illustration of "Cognitive dissonance" from the ECB, or more akin to "wishful thinking" we think, but as always we ramble and rant.

In this week's conversation we will look at "Cognitive dissonance" informations which we think are inconsistent with many pundits' beliefs in the much vaunted "recovery" and cautious signs coming from various indicators for risky assets in the coming months we think.

Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. Not only as human beings we suffer, from optimism bias, but we suffer as well from "deception" and we also all play "deceit" to some extent. We are all "great pretenders", some way or another.

After all, one only need to look at the German 2 year yield  turning negative again to realize that credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 0.4% inflation rate is telling you. It is still the "D" world (Deflation - Deleveraging).

As we indicated in our conversation of November 2013 entitled "Squaring the Circle", when it comes to optimism bias and "Cognitive dissonance" we reminded ourselves of the "wise" words from Olli Rehn:

“I’m sure that we will be able to find a satisfactory solution as regards to how to ensure the fiscal gaps will be filled and the fiscal targets will be met.” - Olli Rehn

We also pointed out at the time:

"As far the "optimism bias is concerned, a majority of analysts believe the German Constitutional court will allow the OMT to stand on the basis that EU treaty allows for purchases in the secondary bond market. We beg to differ. 

Once a debt is a contingent liability, for instance "super senior" there is no turning back, but the ESM being capped and the OMT yet to be firmly backed by Germany, the nuclear option is still an option rather than a reality."

In this previous conversation we also argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months. Looking at the fall in Sotheby's stock price on the 8th of August following a second-quarter profit fall of 15% with the share plunging 11% after its earnings miss, we wonder if indeed the S&P 500 is indeed not vulnerable down the line using the aforementioned relationship we discussed - graph source Bloomberg:

Mind the gap...Also note that Sotheby's private sales fall by 50% in first half of 2014 as reported by Philip Boroff in Artnet on the 12th of August in his article entitled "What Sotheby’s Doesn’t Want You To Know About Its Private Sales":

"Sotheby’s private sales have plunged following the auctioneer’s public feud with activist investor Daniel Loeb.

Long a focus of company executives, private sales tumbled 48 percent in the first half of the year, according to an August 8 Securities and Exchange Commission filing. The value of private transactions, in which Sotheby’s discretely brokers art and other collectibles to one prospective purchaser at a time, dived to $294 million in the first half of 2014 from $561 million a year earlier. It was the lowest private sales total since 2010. The drop contributed to a 15 percent decline in quarterly earnings and an 8 percent drop in Sotheby’s stock on Friday. The shares are off 15 percent in the past year, as the benchmark Standard & Poor’s 500 Index rallied 15 percent." - source Artnet.

The role of Sotheby's stock price  as an indicator was as well confirmed by our good friends at Rcube Global Asset Management  back in our November conversation but them using MSCI World as a reference - graph source Bloomberg:

"The Art market has always been an interesting indicator. The only major public auction house is Sotheby's since its floatation in the mid-1980s. It has proved a timely indicator of potential global stock markets reversal.

Whenever its price reached 50 or so with sky high valuations, a reversal was not far away. We can also take notice of the extremely weak jewelry and contemporary art auctions recently."

Another "Cognitive dissonance" sign which has been put forward by our friends at Rcube Global Asset Management  in their latest monthly review is another warning coming from the MSCI World:

"According to various measures, bullishness in the US was back to January's levels and at historical extremes. Leverage also seemed to have increased in June to new highs, while the MSCI World had just reached its 2007 top." - source Rcube Global Asset Management 

While in our last conversation "Nimrod" we discussed the outflows in the High Yield space through the ETFs markets in general and ETF HYG in particular, while recently there was some price recovery, we have to agree with our friends from Rcube Global Macro Asset Management namely that the massive increase in shares repurchase indicates that High Yield spread should be considered too tight.

Massive outflows recently as pointed out by Bank of America Merrill Lynch in their recent Flow Show note from the 7th of August entitled "Credit Capitulation":

"Biggest week of outflows ($11.4bn) from HY bond funds EVER in dollar terms; 4thlargest week of HY outflows as % AUM ever (Chart 1)"

- source Bank of America Merrill Lynch

But recent price "recovery" of ETF HYG and another illustration of "Cognitive Dissonance" - graph source Bloomberg:

HYG and JNK are the two largest High Yield ETFs accounting for 80% of assets.

Nasdaq Buyback achievers vs Standard & Poor's 500 index - graph source Bloomberg:

The Nasdaq gauge consists of companies that repurchased at least 5 percent of their shares in the previous 12 months. The US equities market has been increasingly being boosted by buybacks, yet another artificial jab in the on-going liquidity induced rally. Repurchases are largely designed “to boost earnings per share as revenue growth slows.

For our friends at Rcube Global Asset Management, corporate credit spreads are far too tight on US HY bonds, when we consider the massive increase in shares repurchase activity:

A measure of balance sheet leverage, which compares net equity issuance to corporate cash flows, also shows that HY spreads are too tight.

While spreads have narrowed massively over the last 2.5 years, liquidity has clearly not followed. The liquidity spread shown in the chart below measures changes in the short‐term differences in the bid and ask prices on 3‐Month US Treasuries, which reflects liquidity in financial markets. A widening spread signals illiquidity in the market, which is associated with growing stress.

What is interesting in the current episode is that despite much better fundamentals since the 2008 meltdown, strong inflows and tightening spreads, liquidity clearly has not improved.

- source Rcube Global Asset Management

Another illustration of the "liquidity risk" can be seen in the levels of inventory sitting on US primary Dealers as an illustration as displayed by Bank of America Merrill Lynch in their European Credit Stategist report from the 11th of August entitled "When it turns...":

“When it turns…”

“…it’s gonna be nasty” is the punchline in credit, used to describe today’s world of growing buyside assets and lower street liquidity. Admittedly, street bids have been somewhat of a rarity over the last few trading session, and the move wider – especially in Crossover – has been eye-catching.

But it’s easy to spin the party line on liquidity during a big risk-off moment. Dealer holdings of corporate bonds are clearly way down on where they were in the ’06 and ’07 era (chart 12), but banks are also more nimble in managing their mark-to-market risks, and overall exposures on their securities portfolios." - source Bank of America Merrill Lynch.

Another "Cognitive dissonance" indicator is also coming from the same Bank of America Merrill Lynch, pointing towards a change in the Business cycle in Europe turning South:

“It’s not me, it’s you!”

In our view, the risks for credit over the next few months stem more from continued equity weakness, than from any big changes in credit fundamentals. For spreads to tighten materially again, we think European equities need to stabilize. But as our equity team has been pointing out, stocks are currently undergoing a rotation from high-beta into defensives, due to the business cycle having moved from the Boom to Slowdown phase.

What does a rotation in equities look like? Bring up a chart of European Auto stocks (SXAP) against the Food and Beverage index (SX3P). Autos have underperformed by almost 8% this year, after having outperformed the Food and Beverage sector by 17% last year.

The bad news is that business cycle phases tend to last for some time, with the European cycle having only just rolled over earlier this year (and more recently for the periphery, as chart 3 shows).

While geopolitical risks and sanctions will only serve to dull the growth outlook in Europe further, the good news is that China is strongly surprising to the upside.

We think this has the potential to help lift growth expectations in Europe sooner.

But weak equities aren’t enough for us to suddenly become big bears on credit, though, although we admit the longer equities struggle the tougher it will be to get near to our big spread tightening targets for year-end, especially for high-yield credit." - source Bank of America Merrill Lynch.

On the potential rebound from China which would help lift growth expectations in Europe sooner, we disagree with Bank of America's take. Also, from the latest US Trace information is showing from the High Yield market, investors are selling CCC exposure to move up the rating chain towards single Bs which also can be seen in the resilient flows seen in the investment grade space as investors are playing "defense" in similar fashion to some players in the equities space. In the on-going European "Japonification" process as we pointed out in numerous conversations, credit can indeed outperform equities (see our conversation "Deleveraging - Bad for equities but good for credit assets") when of course management stays conservative and protects its balance sheet rather than "releverage".

On a final note, given Japan’s 10-year government bond yields around 0.51% today after reaching an all-time low of  0.315% in April 2013 and given it hasn’t been above 2 percent since May 2006, and that Switzerland is the only other country whose 10-year yields are below 1 percent, according to data of 25 developed nations tracked by Bloomberg, you can indeed expect Germany to join shortly the below 1% club. Another indicator we have tracking on our side has been the 30 year Swiss yield relative to Japan which is now as well getting close to the 1% level - graph source Bloomberg:

Since the beginning of the year, and in similar fashion to other Core long bonds, Swiss long yields have fallen significantly. For instance Swiss 30 year bonds have fallen by 63 bps relative to Japan 30 year bonds. We expect this divergence to increase.

"A man should look for what is, and not for what he thinks should be." - Albert Einstein

Stay tuned!

Credit - Nimrod

"I made Nimrod great; but he built a tower in order that he might rebel against Me" (Ḥul. 89b). 

While looking at Spanish 10 year government bonds "Bonos" breaking the 2.50% level, a level not seen since 1789 and French OAT 10 year at 1.51%, a level as well not seen since 1746 in conjunction with the German bund 10 year making new record low at around  1.119%, it seemed to us a clear validation of the "japanification" process we have long been depicting in our numerous credit conversations namely of a deflationary process taking place particularly in the light of the recent print of the European CPI estimate YoY coming at 0.4% in conjunction with very weak CPI pointing towards outright deflation for both Spain and Italy.

The European bond picture and the "japonification" process - graph source Bloomberg:

While we have already used a reference to central bankers' deception tricks in our conversation "Deus Deceptor" (being an omnipotent "deceptive god" as posited by French philosopher René Descartes), we decided this week to venture towards a religious analogy in our chosen title. We already touched on the "Omnipotence Paradox" back in November 2012 when it comes to central bankers and the market's perception of their "omnipotence" in sustaining asset price levels. In fact, last week we mused around  the notion of "perpetual motion" and its physical impossibility. As far as deities and omnipotence go:

"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

In continuation to the past reference of "omnipotence" in regards to central bankers actions, we decided to venture towards the biblical character Nimrod when choosing this week's title as he is generally considered to have been the one who suggested building the Tower of Babel and who directed its construction to challenge the "almighty".

By birth, Nimrod had no right to be a king or ruler (such as central bankers). But he was a mighty strong man, and sly and tricky (such as Mario Draghi, Janet Yellen and her predecessor Ben Bernanke), and a great hunter and trapper of men and animals (in their relentless hunt for yield). His followers grew in number, and soon Nimrod became the mighty king of Babylon, and his empire extended over other great cities, but that's another story and we ramble again.

In this week's conversation we will look at the increasing risk in the much "crowded" credit market, namely investment grade and high yield which could be impacted by the rise in interest rate volatility as well as a rise in default rates. We will also look at the Banco Espirito Santo (BES) story which is a continuation of what we discussed recently in our conversation "The European Polyneuropathy":

(see our conversations, "Peripheral Banks, Kneecap Recap", "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

When one looks at the "new credit Tower of Babel", which construction has no doubt been directed by our "omnipotent" central bankers reaching dizzying height (or spread compression that is), we wonder how long this mighty tower will continue to hold given the recent outflows in the High Yield ETF HYG and the disconnect with stocks as depicted in the below Bloomberg graph warrants caution we think for our "equities friend":

HYG and JNK are the two largest High Yield ETFs accounting for 80% of assets.

Given Investment Grade is a more interest rate volatility sensitive asset, whereas High Yield is a more default sensitive asset what warrants caution for both we think is, the risk of rising interest rates for the former and the risk of rising default rates for the latter. And, as we indicated in November 2012 in our conversation "The Omnipotence Paradox", zero growth should normally led to a rise in default rates, in that context, a widening in credit spreads should be a leading indicator given credit investors were anticipatory in nature, in 2008-2009, and credit spreads started to rise well in advance (9 months) of the eventual risk of defaults. What credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield, not inflation.
(For a more in depth analysis on credit returns and valuation, please refer to our friend Rcube's guest post "Long-Term Corporate Credit Returns").

In relation to the outflows seen in the aforementioned High Yield segment of the market as illustrated by the above Bloomberg Graph, the recent note from Bank of America Merrill Lynch entitled "Greed Retreat" from the 24th of July indicates the largest weekly outflows from HY bonds since June 2013:

-source Bank of America Merrill Lynch

When it comes to our "new credit Tower of Babel" analogy, bonds ETFs in Europe have swollen as reported by Bloomberg by Alastair March on the 25th of July in his article entitled "Bond ETFs Swell in Europe as Debt Trading Slows":
"Bond buyers are pouring record amounts of money into exchange-traded funds in Europe that buy debt as central bank largess boosts demand and makes investors less willing to part with their fixed-income assets.
 Investors deposited more than $16 billion into ETFs that purchase debt from high-yielding corporate notes to sovereign bonds, almost quadruple the amount in the same period last year, according to data compiled by Bloomberg. BlackRock Inc., the world’s biggest provider of ETFs, estimates bond-fund inflows will climb to about $20 billion by year-end.
The unprecedented era of near-zero benchmark interest rates that’s fueling demand for debt shows no signs of abating in Europe, with European Central Bank President Mario Draghi pledging to keep borrowing costs at record lows for an extended period. Deposits into bond ETFs across the region are growing twice as fast as flows in the U.S. as Federal Reserve Chair Janet Yellen said rates in the world’s largest economy may rise sooner than it currently envisions if the labor market improves." - source Bloomberg

But, with volatility making a come back in the US Treasury space with US 10 year touching 2.59% following the better than expected US macro data as well as four-week average of jobless claims, considered a less
falling to 297,250, the lowest since April 2006, from 300,750 the prior week, given the spread compression seen in the Investment Grade space, there is no real buffer left to support a sudden rise in interest rate volatility, putting the YTD bond flows in Investment Grade at risk. As Bank of America put it in their flow report "quality" is a crowded trade:
"Quality-crowded: YTD bond flows show IG bonds (31 straight weeks of inflows) most at risk from crowding (Chart 2)

31 straight weeks of inflows to IG bond funds ($4.2bn)" - Source Bank of America Merrill Lynch

In true Japanese fashion, credit in a deflationary environment does indeed tend to outperform as we have previously discussed in our conversation from April 2012 entitled "Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"

As per our conversation "Deus Deceptor:
"The "japonification" process in the government bond space continues to support the bid for credit, with the caveat that for the investment grade class, there is no more interest rate buffer meaning investors are "obliged" to take risks outside their comfort zone (in untested areas such as CoCos - contingent convertibles financials bonds)."

When it comes to US default, the trend is up as indicated by Fitch's recent report on the matter in their note entitled "Another Jump in US HY Default Rate Looms"
"A potential bankruptcy filing from another struggling giant, Caesars Entertainment Operating Co., would propel the trailing 12-month US high yield default rate to 3.4% from its June perch of 2.7%, according to Fitch Ratings. With its $12.9 billion in bonds in Fitch's default index, the gaming company's impact on the default rate is pronounced - similar to Energy Future Holdings' (EFH) April bankruptcy. Caesars also adds to notable trends of busted LBOs and the exclusive camp of serial defaulters.

There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. The failed LBOs affected $21.8 billion in bonds this year and 26% of all bond defaults since 2008. Caesars would bring the latter tally to 29%. In addition, a Caesars filing would follow two prior restructurings via distressed debt exchanges (DDEs). Since 2008, 24% of issuers engaged in DDEs have subsequently filed for bankruptcy.

June defaults included Affinion Group, Allen Systems Group, MIG LLC, and Altegrity Inc., bringing the year-to-date high yield default tally to 20 issuers of $23.7 billion in bonds versus an issuer count of 19 and dollar value of $8.4 billion in first-half 2013. July defaults have so far included Essar Steel Algoma and Windsor Petroleum Transport.

Notwithstanding the likes of EFH and Caesars, the otherwise low default rate environment has some significant near-term support. Banks continue to ease standards on commercial and industrial loans, according to the Federal Reserve's Senior Loan Officer Survey, and they report stronger demand for such loans. The latter trend is an especially important gauge of economic activity and is consistent with the widely held view that GDP will improve in the second half of 2014.

At midmonth, approximately $33 billion in high yield bonds were trading at 90% of par or less - a relatively modest 2.9% of the $1.1 trillion in bonds with price data." - source Fitch Ratings-New York-29 July 201 - "Another Jump in US HY Default Rate Looms"

Given High Yield is a default sensitive asset class, no wonder the rising level of the default rate has triggered some outflows in the High Yield ETFs space as discussed above.

Our new Nimrod of the central banking world has no doubt pushed further down the line the day of reckoning as the "new credit Tower of Babel" continues to rise. For instance the recent CLO weekly report from Bank of America Merrill Lynch from the 18th of July entitled "Credit Outlook Benign Despite Loosening Lending Standards" indicates the following:
Credit Outlook Benign Despite Loosening Lending Standards
"Leveraged loan markets posted total returns of 2.6% and 2.9% in H1 in the US and Europe respectively, as compared to 5.4% for the HY markets. Up to the end of H1, institutional new-issue volumes totaled $242bn and €39bn in the US and in Europe. Repayment rates were subdued in the US in H1 with many deals having already refinancing in 2013, but hit a record high in Europe as many borrowers took advantage of favorable lending conditions to refinance their debt. If we look at the average leverage statistics for deals issued both in the US and Europe as well as the percentage of issuance that are cov-lite and second-lien, we clearly see that lending standards have loosened since the credit crunch. Despite this, the credit outlook for the loan markets remain benign largely due to a maturity wall that has been pushed out following all the refinancings that have taken place over the last two years and continued improvements in the economy." - source Bank of America Merrill Lynch

When it comes to illustrating our "new credit Tower of Babel" analogy we think that the below graphs from Morgan Stanley's Leverage Finance Chartbook from the 28th of July clearly shows our point:

- source Morgan Stanley

Moving on to the subject of Banco Espirito's woes, it is indeed the continuation of our 2011 prognosis, namely that weaker peripheral banks shareholders and bondholders would face further pain and losses down the line as reminded in our recent conversation "The European Polyneuropathy". The continuous widening in the CDS spread of Banco Espirito Santo illustrates the difficulties of the 2nd largest Portuguese lender:

- graph source S&P Capital IQ

The bank posted a €3.6 billion first-half net loss seeing its market capitalization falling to €1.2 billion. BES stock price - graph source Bloomberg:

Of course the junior subordinated bondholders were not spared either as it looks even more likely that a debt-to equity swap (in similar to what already happened to BES a couple of years ago) is in the pipeline - graph source Bloomberg:

Given the Bank of Portugal requires the lender to raise the money after it set aside 4.25 billion euros for bad loans in the first half, cutting its common equity Tier 1 ratio to 5 percent, below the 7 percent regulatory minimum, you can expect subordinated bondholders to face the Dutch SNS treatment, namely being wiped-out during the recapitalization process needed.

When it comes to the capital needed for the troubled BES, Bank of America Merrill Lynch in their note from the 28th of July entitled "Muddle, toil and trouble" put the capital needs at €6.5 billion but that was when the market cap was at €2.5 billion. Today it is 50% lower:

"Quantum of capital = substantial compared to market cap
BES’s capital needs are potentially substantial, we believe. First, there is the direct exposure to the Espirito Santo Group (GES) of up to €2bn. We think it would be best to adopt a ‘provide now, recover later’ strategy with this to be credible. Second, there is the Angola unit. This subsidiary is clearly in difficulty. Some relief came today with press reports that Angola would basically nationalise BESA but also repay the €3.2bn credit line BES had granted to its subsidiary ‘over time’ which we didn’t find that convincing. We think there is a world of difference between lending €3bn to a controlled subsidiary versus a Government-entity in Angola and would expect that to be reflected in the marks on the equity and debt exposures – perhaps at least another €1bn here at risk? Third, we are mindful of the large book of restructured loans for BES’s conventional lending and the low provisioning rate here which we think also is a risk ahead of the upcoming AQR. This is before we consider other third party risks, undeclared exposures or more contingent risk from investors who could claim that BES mis-sold them GES paper. We estimate a starting point of €4bn of potential capital needs, without the benefit of any tax effects. These compare with a €2.5bn market value today. In any case, a large recap number is required, in our view, for the market to turn the page on this affair."  - source Bank of America Merrill Lynch

What is of course of interest is that Junior Subordinated debt only represents €1.2 billion. When it comes to confidence, which is the name of the game in this credit story, a lot of investors believe that BES senior debt will be spared this time again as indicated in the Bank of America Merrill Lynch note:
"Senior
Lots of people are telling us that in BES, senior is ‘the trade’. Many of our investor interlocutors also appear to have done well out of buying BES senior – even if it is based on the simple equation that ‘senior won’t be touched’ in any scenario. This facile assertion may or may not prove to be correct. In any case, the trade has worked – for those who bought at the lows. At current levels, senior is less compelling in any case, we think – there are cheap AT1 securities that offer the yield and the cash price appreciation but potentially with less headline risk, for example.
If the market really believed the ‘senior won’t get touched’ theme, we would not have, we think, the sharply inverted credit curve that prevails for cash senior bonds – if senior isn’t touched, the inverted curve doesn’t make sense. 
Our base case is that there will not be a rush to bail-in senior under most scenarios but that the capital needs of BES are potentially high which could test this proposition. We are not rushing to load up on ‘less risky’ senior as we still lack sufficient data to be confident about outcomes, even the ‘senior won’t get burned’ scenario. We are also concerned about senior in the context of what might be a less than convincing quantum of capital raised by the bank and what the bank will look like in the future. But clearly, the shorter-dated seniors would be the first port of call if we get clarity on the bank’s future." - source Bank of America Merrill Lynch

We think the only reason senior could be spared would be in a "Dexia scenario" with the government taking in effect control of the bank. If the solution has to remain "private", then we do agree with Bank of America Merrill Lynch's take that an inverted credit curve and a spiking senior CDS spread indicates trouble ahead in particular in the light of the capital needed to restore confidence in the ailing Portuguese lender. As a reminder, BES debt distribution as shown in our conversation "The European Polyneuropathy":

Subordinated bonds cushion is not material enough in the light of the capital needed. "Bail-in" for senior bondholders likely? Possible and probable outcome unless the state gets involved. So either the state gets involved or the senior bondholder gets it....we think.

On a final note, and as we stated recently, the much vaunted US "recovery" depends on an acceleration in wage growth. We have yet to see this trend coming to fruition as displayed by Bloomberg's recent Chart of the Day:

"Miserly pay increases for working Americans back Federal Reserve Chair Janet Yellen’s view that
inflation isn’t about to accelerate, making the case for continued central bank stimulus.
The CHART OF THE DAY shows wage growth remains stuck around 2 percent a year, where it’s been since the recession ended five years ago, even as the Fed’s preferred measure of inflation has recently picked up. Slack in the labor market, including people in part-time positions because they can’t find full-time jobs and those who have stopped searching for work because they are discouraged over prospects, probably means it will be difficult for earnings to accelerate.
“Inflation doesn’t happen with lots of slack and when wage growth falls behind,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore who worked at the Fed’s division of monetary affairs from 2004 until 2008.
Yellen told Congress today that the Fed needed to press on with monetary stimulus because “significant slack remains in labor markets,” while inflation is projected to be between 1.5 percent and 1.75 percent this year. The difference between the underemployment rate, which takes into account discouraged workers and part-timers who want to work a full day, and the unemployment rate was 6 percent in June, compared with a 3.8 percent average from 1994 through 2007.
Critics of central bank policy, such as Harvard University’s Martin Feldstein, have argued the Fed is already behind in fighting a coming surge in price gains. Feldstein, a former chairman of the White House Council of Economic Advisers, said in June “we are facing a problem of rising inflation” and the Fed is “probably going to respond too weakly, too slowly.”
“Martin Feldstein and others have been warning since 2008 that accommodative monetary policy would lead to a repeat of the 1970s,” said Wright. “This prediction has clearly been false.” - source Bloomberg.

"Do you wish to rise? Begin by descending. You plan a tower that will pierce the clouds? Lay first the foundation of humility." - Saint Augustine

Stay tuned!