Macro and Credit - Eternal Sunshine of the Spotless Mind

"Right now I'm having amnesia and deja vu at the same time." - Steven Wright, American comedian

While watching with interest our home team France losing the Euro 2016 final against Portugal, being yet another case of "Optimism bias" coming from our fellow countrymen, and looking at the significant rally in various asset classes such as iShares iBoxx Investment-Grade Corporate Bond ETF, or LQD, taking in $1.1bn last Thursday, the largest ever recorded inflow as if "Brexit" had never happened, we reminded ourselves for our chosen title of the 2004 romantic comedy "Eternal Sunshine of the Spotless Mind". With various markets returning to dizzying heights such as the S&P500 or US High Yield markets, it seems to use that once again investors have found "romantic love" with risky asset classes and in many ways their bad memories have been erased, hence our title reference. As far as we are concerned, we haven't gone through the memory erasure procedure and we continue to feel that when it comes to credit in general and in in particular US High Yield, we are in the last inning of the game, particularly when we look at the most recent Fed Senior Loan Officers survey which clearly shows a slowly but surely deteriorating trend when it comes to financial conditions.

In this week's conversation we would like to focus on the on-going deteriorating trend in credit fundamentals and discuss why we think we are in the final inning and therefore one could indeed expect a final and important melt-up in risky asset prices which could last well into September. We will as well discuss Japan as there are indeed increasing "helicopter" noises in the background.

Synopsis:

• Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"
• Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening
• Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

• Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"

As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan". On the subject of this Japanese foreign allocation, we read with interest UBS Global Rates Strategy "What Japanese Investors Are Buying" from the 8th of July:

"Which government bond and credit markets benefit from Japanese demand?

We have previously described how Japanese investors have been significant net buyers of foreign assets – predominantly DM government bonds – in light of the BoJ’s negative interest rate policy. Net purchases have recently regained momentum, following a slowdown around the turn of the Japanese fiscal year. Today’s data of overseas purchases by destination for May highlights which markets are benefitting.

DM: US Treasuries on top; continued inflows into France, Canada, Italy

Japanese net buying of sovereign bonds recovered in May (¥1.8tn vs. ¥0.2tn in April), though still below the record level seen in March (¥5.5tn). US Treasuries made up for nearly 50% of all net purchases. France, Japan's historically preferred euro market, saw modest net buying of ¥159bn, roughly unchanged from April. Elsewhere, Canada and Italy saw continued net purchases, albeit at a slightly slower pace than in April.

EM: Reducing exposure to LatAm and High Yield

In May investors reduced positions in high yield EM markets. Mexico monthly outflows were the largest in five months; Brazil, Indonesia and South Africa were also net sold. China short-term bonds were net bought, other Asian markets were flat. Overall allocations into EM have been small relative to DM asset purchases, with the largest EM market (Mexico) accounting for less than 1% of all bond holdings.

- source UBS

What is as well of interest in UBS note is that since the implementation of NIRP by the Bank of Japan (BOJ), Japanese life insurance companies have gone into "overdrive":

"Japanese life Insurance companies’ net purchases of foreign long-term debt securities; subset of Figure 13 (¥bn). Lifers' hefty buying since Feb-16 continued in Jun-16 (¥1056bn, 3rd largest since the start of data in 2005), overall the 10th consecutive month of net purchases." - source UBS

No surprise therefore that "Bondzilla's size" has indeed been increasing at a rapid pace. This sudden acceleration in negative yielding bonds has been clearly "made in Japan" we think. The acceleration in "Lifers" bond purchases is as well confirmed by Nomura in their JPY Flow Monitor entitled "Foreign Investment continues amid increased uncertainty" from the 8th of July:

"Japanese foreign portfolio investment continued in June. Excluding banks, Japanese investors bought JPY2264bn ($22.6bn) of foreign securities in June, a slightly weaker pace than in May. Life insurance companies’ foreign bond investment accelerated again, while we judge most of them were on an FX-hedged basis. Pension funds and toshin companies remained net buyers of foreign securities too. Retail investors’ foreign investment is likely to stay weak for now, as risk sentiment among them deteriorates after the Brexit vote. Pension funds will probably remain dip buyers, even though the pace is likely slower than in 2015. May BoP data show that the current account surplus narrowed for the second month in a row, suggesting that the improved phase of the Japanese current account balance has likely ended for now, as oil prices recover and JPY appreciates." - source Nomura

If indeed "Bondzilla" is "made in Japan" this is clearly thanks to the acceleration of "Lifers" in the global reach for yield particularly since the implementation of NIRP by the Bank of Japan, but as pointed out by Nomura's note, this time around with a higher hedge ratio:

"Lifers continued strong foreign bond investment, likely with high hedge ratio
Life insurers bought a net JPY1056bn ($10.6bn) in foreign long-term bonds for the 10th month in a row. Although the pace of net buying has slowed over the past two months, this is the first time in three months that the pace of net buying has accelerated to above JPY1trn. Downward pressure on yields has strengthened globally in response to the decline in Fed rate hiking expectations after US NFP data early June and uncertainty over the Brexit referendum. 20yr JGB yields have fallen to almost 0%, forcing lifers to seek higher yields and shift to foreign bond investments. With JGB yields trending near 0% in all maturities, lifers are likely to continue to invest in foreign bonds at a high level
(Figure 2).

That said, we expect that most of their foreign bond investments will be FX hedged for the time being. After FX hedging, UST investment may not be so attractive owing to higher hedging costs. Nonetheless, Fed rate hiking expectations by year-end have almost completely disappeared. The Brexit vote has lowered USD/JPY, JGB and UST 10yr yields to the lower range of major lifers’ FY16 forecast, or even below, but on an unhedged based foreign bond investment may not accelerate anytime soon, amid increased political uncertainty (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016). With risk tolerance falling, we think there is little chance that lifers will shift to unhedged foreign bonds in the near future.

In the medium term, we still expect their interest in investing in hedged foreign bonds to wane gradually, as a result of the expected rise in hedging costs. Nonetheless, the timing of their shift from hedged to un-hedged foreign bond investment will likely be delayed after the Brexit vote and associated market volatility." - source Nomura

From the above we think that the implications are as follows in the short term, we have most likely seen the lows for now on Developed Markets' long term sovereign bonds and in terms of the Japanese Yen, further depreciation of the currency depends on the implications of the deployment of some form of "helicopter money" in Japan. We must confide we have re-initiated therefore a short Japanese yen position and thinking about adding going long Nikkei but in "Euros" via a quanto ETF (currency hedged).  Given we have not fallen to a memory erasure procedure, we reminded ourselves clearly of our April 2015 conversation "The Secondguesser":

"1. To criticize and offer advice, with the benefit of hindsight.

2. To foresee the actions of others, before they have come to a decision themselves.

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions"." - source Macronomics, April 2015

On a side note, in our April conversation, we showed that flows had lagged performance in Emerging Markets. We think now the time is ripe to add on some EM equity expsore which can be relatively easily done through the ETF EEM. EM equity funds saw $1.6 billion of inflows recently...


When it comes to the benefits of "helicopter money", we read with interest Bank of America Merrill Lynch's take from their Japan Watch note from the 15th of July entitled "Japan for “whatever it takes”; monetaryfiscal coordination not helicopter money":

"The monetary-fiscal hand-off

In recent months we have been writing more about the importance of and prospects for fiscal easing. In March we argued that “while monetary policy may be over-stretched in places, we think there is plenty of scope for fiscal policy to support global growth.” In particular, “low interest rates and sufficient fiscal space in many countries make now an opportune time for increased public-sector investment spending.” However, we worried arbitrary political constraints on policy would limit spending, delaying more decisive action until the inevitable recession arrives.

It has taken a long time, with monetary ammunition running low, but finally fiscal easing seems to be starting to kick in. In May, we noted that fiscal expansion had started in a number of regions, including the US, Europe, and China, although much of that easing has been more by accident than design. At the time, we thought Japan would delay its second consumption tax, but could not be certain they would not make another policy mistake.

Japanese for “whatever it takes”

Recent news makes us increasingly confident Japan will join the fiscal expansion and both Europe and the US will increase their stimulus efforts. Policy decision making in Japan often seems like a ritual kabuki play. In the first act, facing whether to delay the consumption tax hike, Prime Minister Abe met with three advocates of easy policy—Paul Krugman, Joseph Stiglitz and Christina Romer. Then at the G-7 meeting in Japan in late May, he warned of risks of a Lehman-like economic crisis. Recall that earlier he had said that only a major event similar to the 2011 earthquake or a Lehman-like crisis could delay the tax hike. Weeks later, in the second act, there was no sign of Lehman II in sight, but sure enough the consumption tax hike was delayed.

In the third act, policy was put on hold awaiting the results of the upper-house election, which returned a solid victory for Abe. He then announced work on a “bold” stimulus package, which major Japanese media outlets suggest to be at least ¥10tn. Former Fed Chairman Bernanke was invited to offer policy advice in the fourth act this week. It is not hard to imagine what Bernanke told them.

The fifth and final act, in our view, will be a major stimulus package, of ¥15-20tn in total, financed by at least a ¥10tn supplementary budget, likely coupled with additional easing by the Bank of Japan at end-July. We look for the BoJ to double its ETF purchases to around ¥6tn annually and potentially lift its JGB purchase pace in line with the increased issuance from the fiscal stimulus plan. Inclusion of municipal and agency bonds is also possible, but given their small market and limited liquidity, we see this as a more symbolic gesture. We do not expect a further cut in interest rates at this time, but we would not completely rule it out either. The BoJ would need to find a way to minimize the adverse impact upon banks from a more negative policy rate.

Risk markets have responded well to this potential program: Japanese equity markets just about reversed their post-Brexit funk, having risen 9.5% since 24 June. The global spillover is palpable; US stocks are up 8% over the same period, while most European markets have rebounded as well. The USDJPY also weakened to above 105, having touched 100 after Brexit. This is a fairly small retrenchment: the yen has appreciated over 12% against the USD on net this year alone. A top advisor to Abe suggested this week that Japan cannot defeat deflation with the USDJPY around 100." - source Bank of America Merrill Lynch

Once again, you probably want to think about "front-running" the Bank of Japan hence our interest in going long the Nikkei index but currency hedged.

When it comes to the options Abe and Kuroda have to reverse the deflationary woes of Japan, Bank of America Merrill Lynch makes some interesting points:

"Can Abe-Kuroda beat high expectations?

Implicit fiscal-monetary coordination

Expectations of fiscal and monetary easing are building in the financial markets, but there seem to be different ideas about the degree of coordination.
1. Implicitly coordinated fiscal-monetary easing: The government unleashes huge economic measures with a supplementary budget of more than ¥10tn. The BoJ expands monetary easing, potentially including through increased purchases of JGBs. The two are “synchronized” with roughly concurrent announcements.

2. Explicit coordination between the government and BoJ: In addition to the above fiscal-monetary easing, the government and BoJ announce an accord of commitment to fiscal expansion financed (semi-)directly by the BoJ’s JGB purchases until the inflation target is met (from the 13 July Sankei Shimbun’s front page).

3. Debt monetization: The BoJ restructures its existing JGB holdings to zero coupon perpetual JGBs, and/or the government issues perpetual bonds to the BoJ directly. (leaving legal issues aside; where there is a will there is a way).

Options (2) and (3) could be called the soft and hard versions of helicopter money, and the likelihood of either being adopted in the near term is low, in our view. This is because (1) Japan's economy, with its 3.3% unemployment rate, can hardly be defined as in crisis; (2) such drastic policies could shake the JGB market and JGB investors; and (3) there have been no cases of developed economies resorting to dropping helicopter money in recent history, and considerable uncertainty surrounds the consequence of such a plan.

We, especially those based in Tokyo, find it hard to believe anyone or any groups in Japan, including the Abe Administration, the MoF, the BoJ, or the public, aspires for hard helicopter money at the moment. Even if they did, nobody seems to have the political capital to pull it off and conduct it for a prolonged period of time. As such, “implicitly coordinated fiscal-monetary easing” – or some other bold fiscal expansion, and expansion of the existing monetary easing – is the most likely possibility." - source Bank of America Merrill Lynch

While it is always hard to fathom the impossible, where we slightly disagree with Bank of America Merrill Lynch is that we could have yet another case of "Optimism bias" and that Japan decide to be even bolder. We touched on the "boldness" of Japan in our April conversation "The Coffin corner":

"There are old wise central bankers (Paul Volcker) and bold bankers (Ben Bernanke now joined by Haruhiko Kuroda ); we have no old central bankers, just bold central bankers". - Macronomics.

"Looking at the desperate attempts by the Bank of Japan to cancel out the deflationary forces at play by increasing the "angle of monetary attack" with the "bold" central pilot banker Kuroda pulling very strongly on the stick, we wonder if Japan will indeed endure structural failure in the end. Maybe Kuroda is a gifted pilot such as pilots from the famed Lockheed U-2 spy plane, but, maybe he isn't.
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

If central bankers are now joining force with Ben Bernanke advising directly the Bank of Japan there is indeed a strong possibility they will go for "bolder" policies such as "helicopter money". This policy is fraught with danger we think and agree with Nomuras's take on the subject from their Japan Trade Ideas note from the 15th of July entitled "The danger of helicopter money":

"The adoption of helicopter money by Japan is being discussed a lot more frequently these days. Until recently it was principally by international investors, but, with “Helicopter” Ben Bernanke meeting both BOJ Governor Kuroda and Prime Minister Abe this week, local media is giving it much more coverage. According to a Bloomberg article on Thursday, Mr Bernanke suggested during an April meeting with Abe adviser Etsuro Honda that “helicopter money – in which the government issues non-marketable perpetual bonds with no maturity date and the Bank of Japan directly buys them – could work as the strongest tool to overcome deflation.” Mr Honda said he relayed this message to Prime Minister Abe, although according to another key official, Koichi Hamada, the former Fed Chairman reportedly stuck to more orthodox policies in his meeting with Mr Abe on Tuesday (Bloomberg).

The two main sources of helicopter money views cited by international investors that I have met in recent months are Mr Bernanke’s blog and Adair Turner’s book “Between Debt and the Devil: Money, Credit, and Fixing Global Finance.” 

Mr Turner's suggestion for JGBs is as follows: “That debt could be written off and replaced on the asset side of the Bank of Japan’s balance sheet with an accounting entry – a perpetual non-interest-bearing debt owed from the government to the bank. The immediate impact of this on both the bank’s and the government’s income would be nil, since the interest which the bank currently receives from the government is subsequently returned as dividend to the government as the bank’s owner. So in one sense a write-off would simply bring public communication in line with the underlying economic reality. But clear communication of that reality would make it evident to the Japanese people, companies, and financial markets that the real public debt burden is significantly less than currently published figures suggest and could therefore have a positive effect on confidence and nominal demand.”

The assertion that there would be no immediate difference from the current situation is not strictly correct. The average yield on the BOJ’s current JGB portfolio is about 0.42%. While some of the income from this will indeed be returned to the government, a large portion is used to 1) pay higher rates to banks on most of its deposits than the official minus 0.1% policy rate; 2) cover losses and build reserves against losses on its riskyasset purchases; and 3) subsidize its efforts to lower yields across the curve – the central bank is currently buying JGBs at an average yield of around -0.26%, well below its cost of funds.

While restructuring the asset side of the BOJ’s balance sheet may seem like a worthwhile idea, the picture is not nearly as rosy when we take into consideration its liabilities. Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis, has pointed out that, “The apparent attractiveness of the helicopter approach ignores something important: Money has a cost, too. When the Treasury spends the $100 billion, it will appear in bank accounts. Banks, in turn, will deposit the money at the Fed – a liability on which the central bank pays interest.”

Mr Bernanke acknowledges this problem in his April blog on helicopter money. “Moneyfinanced fiscal programs (MFFPs), known colloquially as helicopter drops, ….present a number of practical challenges of implementation, including integrating them into operational monetary frameworks and assuring appropriate governance and coordination between the legislature and the central bank. As my former Fed colleague Narayana Kocherlakota has pointed out, the fact that the Fed (and other central banks) routinely pay interest on reserves has implications for the implementation and potential effectiveness of helicopter money. A key presumption of MFFPs is that the financing of fiscal programs through money creation implies lower future tax burdens than financing through debt issuance. In the longer run and in more-normal circumstances, this is certainly true…..In the near term, however, money creation would not reduce the government’s financing costs appreciably, since the interest rate the Fed pays on bank reserves is close to the rate on Treasury bills. Here is a possible solution. Suppose that the Fed creates $100 billion in new money to finance the Congress’s fiscal programs. As the Treasury spends the money, it flows into the banking system, resulting in $100 billion in new bank reserves. On current arrangements, the Fed would have to pay interest on those new reserves; the increase in the Fed’s payments would be $100 billion times the interest rate on bank reserves paid by the Fed (IOR). As Kocherlakota pointed out, if IOR is close to the rate on Treasury bills, there would be little or no immediate cost saving associated with money creation, relative to debt issuance. However, let’s imagine that, when the MFFP is announced, the Fed also levies a new, permanent charge on banks – not based on reserves held, but on something else, like total liabilities – sufficient to reclaim the extra interest payments associated with the extra $100 billion in reserves. In other words, the increase in interest paid by the Fed, $100 billion * IOR, is just offset by the new levy, leaving net payments to banks unchanged. (The aggregate levy would remain at $100 billion * IOR in subsequent periods, adjusting with changes in IOR.)”

Adair Turner’s suggestion for getting round this IOER cost of money-financed deficits is as follows: “the rate would have to be zero on at least some reserves to ensure that money finance today does not result in an interest expense for the central bank in the future or in central bank losses that would need to be paid for by government subsidy and ultimately by taxpayers. Setting a zero interest rate for reserve remuneration might in turn seem to impair the central bank’s ability to use reserve remuneration as a tool to bring market interest rates in line with its policy objective. But central banks can overcome this problem, for instance, by paying zero interest rates on some reserves, while still paying the policy rate at the margin.“

So it turns out that for helicopter money to work as its advocates envisage, there needs to be a scheme in place to stop/offset IOER payments to banks. Without that, losses at the central bank will rise quickly when policy rates rise. In the current policy framework, the average yield in the BOJ’s portfolio has been gradually dropping, which is why I think it will be slow to raise rates in the future and I particularly like long-term conditional bear steepeners on the front part of the curve. However, the average yield will recover gradually as the central bank re-invests maturing JGBs at higher yields, allowing the BOJ eventually to raise rates without incurring too many losses. This would not be the case if the central bank has locked up its portfolio in perpetual bonds. With JGB yields the lowest on record, locking in 10yr borrowing costs of -0.24% and 40yr costs of 0.23% seems like a much more sensible policy.

From a strategy perspective, I would treat helicopter money as a very low-probability, high-risk event. It may start out with some seemingly good, risk-on results, but, given the points mentioned above, it is easy to imagine eventual panics among policymakers and/or investors. Rather than his prescription for Japan, I prefer Mr Turner's approach for the euro zone, “If the European Investment Bank funds infrastructure investment, raising money with long-term bonds that the ECB buys, we edge closer to money finance without quite crossing the line.” As outlined in last week’s report., I believe that Japan’s policy mix has reached a stage where it makes sense to begin transitioning from QQE quantity and rates to QQE quality (such as ETFs) and fiscal policy. Nomura expects the BOJ to focus on a combination of rate cuts and ETF purchases at its policy meeting at the end of this month. Although there is very little chance, in our view, of a helicopter-type policy being adopted in Japan any time soon, the current debate could prompt a greater willingness to stretch the boundaries of monetary policy. For example, the central bank has traditionally limited its risky-asset purchases such as ETFs to amounts where potential mark-to-market swings can be comfortably absorbed by its earnings/reserves. Perhaps running the risk of a little negative equity is the right amount of crazy for the BOJ." - source Nomura

And perhaps indeed that running the risk of negative equity is not the right amount of "crazy" for the bold pilots running the Bank of Japan. And if indeed money has a cost too, ultimately the cost will be beared by Japanese taxpayers and in the process the Japanese currency could depreciate rapidly in conjunction with horrendous liquidity problems for the foreign investors still holding to their Japanese Government Bonds (JGBs).

So overall its risk-on again and most likely in Japan but then again, if we are tactically short term bullish, our long term appreciation of the credit cycle is telling us we are in the last inning as shown by the continued deterioration in financial conditions which we develop in our next point.

• Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening

What is ultimately driving default rates you might rightly ask?

For us and our good friends at Rcube Global Macro Research, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey):

"Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans. We have used the net percentage of banks tightening standards for commercial and industrial loans to small firms as tightening credit standards should have a direct effect on the credit market." - source UBS.

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.

As we indicated in our "Bouncing bomb" October 2015 conversation, given the strong inflows in the asset class (US High Yield in particular), we remain Keynesian bullish short term when it comes to credit:

"While we have been "tactically" short-term "Keynesian" bullish, when it comes to our recent "credit" call, we remain long term "Austrian" bearish, particularly when it comes to our "credit" related "Bouncing bomb" analogy and the High Beta gamblers. We would recommend moving into a higher quality spectrum in terms of "credit ratings" and exposure." - source Macronomics

From a tactical and leverage perspective, we would continue to be overweight European High Yield versus US High Yield and remain more inclined towards US Investment Grade credit versus Europe.

We would not at the moment go against the "flow" given the latest inflows so far in US High Yield have been very significant, hence our tactical "Keynesian" bullishness, but then again the latest survey is validating our heigtened concerns as highlighted bu Deutsche Bank in their US Fixed Income Weekly note from the 8th of July:

"Bank lending standards continue to tighten for the business sector. The Fed’s Senior Loan Officer Survey (SLOS) measures lending standards of the largest commercial banks. Similar to tax receipts and motor vehicle sales, the SLOS data do not get revised. There are four broad categories of lending: commercial and industrial (C&I), commercial real estate, consumer, and residential mortgages. On balance, the SLOS data are flashing a cautious signal. In Q2, the net percentage of commercial banks tightening lending standards for C&I loans increased a little over three percentage points to 11.6%, which was the highest reading since Q4 2009. This was the third consecutive quarter in which banks tightened C&I lending standards, a troubling development. As the below chart from our Deutsche Bank colleague Jim Reid illustrates, tightening C&I lending standards are a leading indicator of high-yield default rates.

With respect to the other aforementioned categories, the net percentage of banks tightening lending standards for commercial real estate loans showed an even sharper increase in Q2 (+24.2% vs. +13.6% previously). This was the highest level since Q1 2010 (+27.3%). The only positives in the Q2 SLOS were consumer and residential mortgage lending standards, where, on balance, banks continued to ease in Q2. This should prove to be a mild tailwind for consumer spending and the housing market in the near term." - source Deutsche Bank

Since February we have highlighted the Commercial Real Estate Market (CRE) and particularly through CMBX series 6, the most exposed to retail, the latest survey does indeed confirm the debilitating trend of the underlying. In our recent conversation "Through the Looking-Glass" in May we indicated the following:

" When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2." - source Macronomics, May 2016

We do think you need to track both the CRE and its derivatives CMBX series, as well as the US Senior Loan Officer Survey in the near future.

In our final point we will revisit what represents to us yet again a manifestation of Gibson paradox.

• Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

While we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices. When it comes to the deflationary forces of our very potent "bondzilla monster", this can be assessed by the below chart from Bank of America Merrill Lynch displaying the relationship between negative yielding assets and gold fund flows from their Credit Derivatives Strategist note from the 14th of July entitled "Deflationary flows, the Central Banks' put and yield hunting":

- source Bank of America Merrill Lynch

This relationship was as well confirmed in another note from Bank of America Merrill Lynch in their Follow the Flow note entitled "Deflationary flows into gold, IG and govies":

Deflationary flows into gold, IG and govies

The size of negative yielding assets has reached new highs. Amid rising
deflationary pressure investors are moving into gold and “ECB-eligible” assets like
government and high-grade bonds. A clear theme so far this year has been assets
that are backed by CBs’ policies and “deflationary” plays like gold are in vogue. On
the other hand, assets like equities have been suffering record outflows amid
concerns that the global recovery is losing steam." - source Bank of America Merrill Lynch

 Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. What we are monitoring from a tactically more bearish approach is that very recently surprises, real rates and breakevens are on the rise as displayed in this final chart from Bank of America Merrill Lynch's latest Securitization note from the 15th of July:

"Since Brexit, economic numbers have increasingly surprised to the upside; last week’s June employment report was especially surprising. In “Navigating the summer doldrums (June 3),” we noted that in recent years, the Citigroup economic surprise index has tended to be weak in the first half of the year, bottom in June, and rise in the second half of the year. In Chart 1, we show the seasonal pattern of the average for 2011-2015, along with the 2016 performance. The rise in the index over the past two weeks suggests the “normal” H2 scenario of relatively good economic performance and fundamental data is off to a good start.

If so, it could mean the June plunge in interest rates that pushed the 10yr treasury yield to as low as 1.32% created a near term low for rates. Note that the official BofAML call is for the 10yr yield to end Q3 at 1.25%, and then rise to 1.50% by the end of 2016 (the nominal 10yr is at 1.58% as of writing). If rates and fundamentals have in fact bottomed, at least locally, it’s good news for securitized products, as prepayment risk for agency MBS and credit risk for the credit sectors are reduced. Given the possibility of the worst for rates and fundamentals being seen in June, we have moved to an overweight across most securitized products sectors. 

Chart 2 gives some sense of what rising economic surprises mean for the real 10yr rate, comparing it with the economic surprise index over the past two years. We observe common directionality from 2014 through early 2016, although the coincidence of the timing of the moves is loose at best. 2016 shows a somewhat sustained break in the pattern, however. The surprise index has been trending higher since the low in February. Meanwhile, the real rate has steadily moved lower since the Fed hiked rates last December, as the market has steadily faded the Fed’s ability to hike rates further; for example, the recent bottoming of the real rate on July 6 coincided with the peaking of the no hike probability by December 2016 at 93%.

The bottom line here is that if the economic numbers continue to surprise to the upside, which may have improved chances because real rates got so low, due in part to exogenous global factors, Fed hike probabilities will likely rise, as will the real 10yr rate. For now, though, we think the divergence seen in 2016 between economic surprises and the real rate is a big positive for risky assets: the real rate is probably far too low, and stimulative, relative to fundamentals.
The other side of the coin for nominal rates is breakeven inflation rates, which due to observed correlations over the past year, is the central component of our crosssector valuation framework for securitized products. Chart 3 shows the history of the 10yr breakeven rate in recent years; it remains in the downward trend channel that started around the time of taper talk in 2013.

Chart 4 shows the seasonal view of the breakeven rate in 2016 versus the 2011-2015 average."

- source Bank of America Merrill Lynch

So overall, tactically we think that indeed "risk-on" can further continue and that we could have seen the lows for now on Government bond yields which, would entice further short term weakness on both bond prices as well as gold in true "Gibson's paradox fashion.

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 getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact.

"Memories are the key not to the past, but to the future." Corrie Ten Boom, Dutch author

Stay tuned!

Macro and Credit - Road to Nowhere

"The person attempting to travel two roads at once will get nowhere." -  Xun Zi, Chinese Philosopher

Looking at the Japanese PMI coming at 47.7, and Japan recording its seventh straight month of falling exports in April down 10.1% on-year with Haruhiko Kuroda, Bank of Japan's governor declaring at a two-day Group of Seven (G-7) meeting in Sendai:

"I think, yes, we have enough ammunition," Kuroda said, when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the target. "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." - Haruhiko Kuroda, Bank of Japan's governor

We had Japan in mind when we selected our title analogy for this week's musing "Road to Nowhere", the 1985 rock song written by David Byrne from the Talking Heads album "Little Creatures". What is of "humoristic" interest is that David Byrne indicated the following about his song:

"I wanted to write a song that presented a resigned, even joyful look at doom," - David Byrne

Clearly when one looks at the recent raft of dismal data from the Japanese behemoth, one can relates to our chosen title and analogy we think. Haruhiko Kuroda, also added when asked about what remained in Bank of Japan's "tool box" the following:

"I think, yes, we have enough ammunition," (when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the 2% inflation target). "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." Haruhiko Kuroda, Bank of Japan's governor

As far as we are concerned, we think Japan is indeed on a "Road to Nowhere". In this week's conversation we will look at Japan's "achievements" after 3 years of "Quantitative and Qualitative Easing (QQE), and what the lackluster Nonfarm payroll number means to us as well as the growing complacency in the on-going risk-on rally which we thinks warrants not only caution, but probably "hedging" as well.

Synopsis:

• Macro and Credit - Looking back a the "Three arrows"
• Macro and Credit  - Is the Fed on a "Road to Nowhere"?
• Final chart: Now is the right time to "hedge"

• Macro and Credit - Looking back at "The Three arrows"

As a reminder, the massive experience that started on the 4th of April 2013 by the Bank of Japan ambitioned to achieve a 2% inflation rate within 2 years by expanding drastically the monetary base.
In our April conversation "Shrugging Atlas" we already touched on the impact of three years of QQE and the impact of the deflationary mindset that has taken hold in Japan. We argued at the time:

"It seems more and more evident that, the experiment overtaken by the BOJ in the last three years has failed to move upwards inflation thanks to any significant wage increases. The Japanese government cannot afford to allow rates to rise, and yet by keeping rates so low it increases distortions in the economy through the "mispricing" of risk. This is clearly evident by the inversion in correlation between bond prices and the Nikkei index!
Furthermore, the size of the BOJ's buying spree in the Japanese market has led to the market becoming not only unstable but as well as totally broken and volatile. Basically what was supposed to be riskless in the Japanese Government Bond (JGB) has become the most risky and volatile investment of all thanks to the BOJ" - source Macronomics, April 2016

We also argued that the headwinds facing Japan and as well Europe in our April conversation stem from "demography", rendering the problems more "structurally" acute. When it comes to Japan and its central bank and credit transmission we have a case of "broken arrow". Europe seems to be as well facing very similar difficulties we think.

When it comes to assessing the effectiveness of the "Three arrows", we read with interest Nomura's take on the subject in their Japan Economic Weekly note from the 20th of May entitled "Taking a fresh look at the three arrows":

"Summary: 1) Reconstructing the "three arrows"

When the second Abe administration was formed in December 2012, it announced what it called "the three arrows." Since last year, the government has been talking about "three new arrows," policies aimed at achieving its goal of the "dynamic engagement of all citizens." While the label may have changed, the government is presumably still committed to what it has called "growth strategies," structural reforms aimed at supporting economic growth.

Summary: 2) Shortcomings of existing economic policies

While the government has in the past claimed that deflation would soon be overcome, it cannot be said to have achieved this or to have boosted economic growth. We see two shortcomings in its policies. First, it has failed to sufficiently counter dwindling expectations of economic growth, with the result that the first and second arrows of traditional monetary and fiscal policy have not had the expected impact. Such policies seek to bring forward demand at the expense of the future. With demographics depressing growth expectations, policies that seek to bring forward future demand can make households and companies even more reluctant to spend. Second, in terms of the third arrow of growth strategies, the government may not have properly considered whether to bias its policies in favor of either labor or capital or, how in what order to do so.

Summary: 3) Some distinctive features of the Japanese economy now

The government's focus, which during the early stages of its strategies for growth was on capital (specifically on increasing corporate earnings power by means of structural reforms such as corporate governance), has since gradually shifted to trying to boost the labor participation rate (eg, by means of the government's Plan to Realize the Dynamic Engagement of All Citizens) and improving the share of labor. As a result of implementing policies biased towards capital and, especially, improving shareholders' rights, Japanese companies have probably become more focused on efficiency, productivity, and profitability than ever. The result is a state of affairs where wage growth and the labor share have failed to increase and a virtuous cycle of rising employment, incomes, and consumption has failed to develop.

Summary: 4) Challenges

It would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. What the government needs to do next is to increase the number of companies that succeed in improving their earnings power, thereby increasing both employment and the labor share, rather than encourage such companies to use those earnings to increase the labor share." - source Nomura

When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited. This is clearly explained in Nomura's interesting note:

"To put it rather bluntly, traditional fiscal and monetary policies seek to boost the real economy and stir inflation by bringing forward demand at the expense of the future. Monetary policy basically works by artificially reducing the future value of a currency, whether by means of positive or negative policy interest rates or by means of interest rates or the quantity of money, in order to encourage companies and households to spend more. Fiscal policy, on the other hand, does not exactly bring forward future demand but achieves a similar effect by using (increased) future government revenue as collateral to fund current spending.
The Nikkei and other news media reported on 14 May that Mr Abe is probably going to announce that the planned increase in the consumption tax is going to be postponed for a second time. Bolstering current demand by postponing a tax increase is also a kind of fiscal policy as it tries to encourage current spending by using future government revenue as collateral.
However, policies that try by one means or another to bring forward future spending in order to boost current economic growth assume that people will expect the economy to grow. However, if people are convinced that the economy is going to shrink, traditional economic policies may have the unintended consequence of making people even more reluctant to spend. We cannot rule out the possibility that the demographic headwinds facing the Japanese economy in the form of a declining and aging population may have led many Japanese households and companies to assume that the Japanese economy will inevitably shrink. This may explain why traditional fiscal and monetary policies have not had the expected impact." - source Nomura

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) as displayed in Nomura's note:

"ROIC, far from declining, has been rising despite a substantial decline in interest rates in general suggests to us that companies have increasingly been focusing their capex on projects with better returns than in the past. In other words, that companies have been increasing their capex and stepping up depreciation of their existing plant and equipment without raising more capital suggests to us that they have managed to both increase their capex and improve their margins without expanding their balance sheets.
At the same time, we note a marked tendency for the profits generated by this efficient capex to accumulate as retained earnings and to be paid out as shareholder returns in the form of dividends, etc without impairing ROE." - source Nomura

If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere". The challenges facing Japan in revisiting its "three arrows" are clearly underlined in Nomura's note:

"Challenges

Assuming the above analysis is correct, it would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. The main challenge is how to raise growth expectations, and the solution probably lies in the existing policy mix.
Two of the existing growth strategies that have proved relatively successful are probably (1) the corporate governance reforms aimed at increasing corporate earnings power and (2) the resulting increase in capex. If that is indeed the case, the next step that needs to be taken is presumably to implement a strategy for increasing the number of companies that succeed in increasing their earnings power.
The labor and employment policies the government has begun to push strongly should focus on those aimed at further improving corporate earnings power as well as on increasing employment and the labor share by increasing the number of Japanese and foreign companies that develop their earnings power, rather than focus on policies aimed at increasing labor participation or the labor share that target existing Japanese companies.
With a widening income gap becoming a social problem on a global scale and politics heading in a direction that reflects that trend, coming up with such policies will be no easy matter. However, in view of Japan's position as the most disadvantaged country in terms of the impact of its demographics on growth expectations, the need for such policies is all the greater." - source Nomura

We could not agree more, unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable".

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street".

When it comes to the effect NIRP has had on Japanese Life insurers, we have discussed on numerous conversations the impact it has had on their foreign allocations and in particular bonds. This was as well clearly displayed in Nomura FX Insights note from the 26th of May entitled "JPY: Lifers' hedge ratio inched up":

"As monthly flow data have been showing, the nine major lifers accumulated foreign exposures aggressively during H2 FY2015 (Figure 2). 

Total foreign exposures held by the nine lifers increased to JPY42.9trn ($391bn) from JPY40.2trn six months ago. After considering the FX valuation impact, we estimate they have increased foreign exposures by JPY4.9trn ($44bn) during H2 FY2015, the highest pace at least since FY2002, which is consistent with the historically biggest foreign bond investment by lifers in February and March, after the introduction of negative rates by the BOJ (see “Temporary pause in portfolio outflows”, 12 May 2016).

Unhedged foreign exposures stood at JPY18.8trn ($171bn), largely unchanged from JPY18.7trn in September 2015. As we expected, most of the recent foreign bond investment by lifers has been on an FX-hedged basis. At the same time, they kept unhedged exposures almost constant despite JPY appreciation in Q1, which suggests lifers were likely small dip buyers of USD/JPY, to keep FX exposures.

US assets remained preferred

A large part of the foreign investment during H2 FY2015 was in USD-denominated assets as expected. The nine major lifers’ exposures in USD assets increased to JPY26.9trn ($245bn) from JPY24.6trn. The USD share in total foreign assets increased to 62.7% in March from 61.3% in September 2015, recording the highest share since September 2002. The FX hedge ratio for USD assets increased to 55.7% from 51.6% during the same period (Figure 3).

As a result, unhedged exposures in USD assets stayed at JPY11.9trn ($108bn), largely unchanged from September last year (Figure 4).

Lifers’ preference for US assets remained strong, but they still prefer FX hedged investment for now.

Fed policy and political risk to be important for lifers’ hedging stance

Major lifers’ FY2015 financial results confirmed their strong appetite for foreign bond investment, without increasing FX risks for now. The results also showed stronger preference for US assets over other foreign assets. As JGB yields remain low, UST investment could give lifers slightly higher yields than JGB investment even after FX hedging (see “Lifers’ shift into foreign bonds continues”, 20 May 2016). The major lifers’ investment plans for FY2016 showed a strong appetite for foreign bond investment this fiscal year, but their investment should be largely FX hedged for the time being (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016).
At the same time, the likelihood of a Fed rate hike by July is clearly rising now, which will increase hedging costs further. Lifers’ risk appetite could also improve after the UK referendum on Brexit. Thus, lifers may consider taking more FX risks in H2 this year." - source Nomura

Of course the latest "sucker punch" delivered to the US dollar versus the Japanese yen thanks to the clearly weak Nonfarm payroll data could somewhat tamper the hedging appetite of the Lifers and trigger some additional volatility on the currency pair.

Whereas Japan has stronger demographic headwinds, the latest miss in the United States coming from the labor market pushes us to ask ourselves on our second point if indeed the Fed is not as well on a "Road to Nowhere" when it comes to its willingness in hiking further during this summer.

• Macro and Credit  - Is the Fed on a "Road to Nowhere"?

Looking at the miserable May employment report published on Friday, one might rightly ask itself if indeed the Fed is not on the "Road to Nowhere". With only 38,000 jobs created in nonfarm payroll growth and a -59,000 of net revisions, given employment is a lagging indicator on the state of the economy and that we have long argued that the US economy was weaker than expected, it seems to us particularly clear that our long US duration stance will continue to be rewarding. 

While our stance relating gold miners had been vindicated in recent weeks, another surge in gold was clearly expected with this type of miserable NFP. We agreed with Martin Sibileau's view when he posted in his blog A View from the Trenches, on April 4th, 2011 "Gold, the Fed, Ron Paul and Napoléon Bonaparte" at the time he made the following comment:

"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."

In our previous conversation "Through the Looking-Glass", we argued that the Fed was in a bind given the late state of the credit cycle and tightening lending standards. What is of course of interest as well from the previous comments of our friend Martin Sibileau quoted above is that contrary to the key assumption, because the US fiscal deficit has fallen, the Fed had to start "tapering as displayed in the below chart from TradingEconomics:

- source TradingEconomics.com

What is of interest today is that with this kind of employment report, the job of Janet Yellen at the Fed has become even more complicated. On that note we read with interest Bank of America Merrill Lynch's take from their US Economic Watch note from the 3rd of June entitled "Payroll pain for the Fed":

"As expected, average hourly earnings grew 0.2% mom and 2.5% yoy, the latter pace holding steady from April. The modest acceleration in wage growth from last year reflects the tightening in the labor market, although there is still a debate as to whether we have reached full employment. Indeed, the broader measure of the unemployment rate, the U6 figure, held at 9.7%.

What does this mean for the Fed?

There was no saving grace in this disappointing report, and the recent sluggishness in the labor market warrants increased Fed cautiousness. We think a June hike is off the table (and the markets agree, pricing in less than a 5% chance of hike after the number this morning). While a hike in July is still a possibility, we are increasingly comfortable with our September call. There is simply not enough time leading up to those summer FOMC meetings to see the growth and labor data rebound convincingly, and inflation continue to accelerate—all necessary conditions for another increase in rates. After today’s report, Fed Chair Yellen’s speech on Monday will be even more important." - source Bank of America Merrill Lynch

As a reminder if a lower unemployment rate implies higher wages, sooner rather than later, then indeed Janet Yellen's hiking job is difficult. So far wage acceleration doesn't seem to be that material from the latest readings. A real tightening scare from the Fed would only happen if there is concrete evidence of an acceleration in wage pressure. On the other hand, deteriorating market conditions, meaning falling share prices and rising credit spreads à la Q1, would most likely lead the Fed to some renewed easing we think.

What is more and more apparently clear is that too much conflicting communication snippets from Fed members are leaving market pundits puzzled and are indeed eroding more and more the Fed's credibility. This was bound to happen and was clearly illustrated by Nomura's economist Richard Koo, quoted in our November 2014 conversation "Chekhov's gun":

"Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members."- source Richard Koo, Nomura Research Institute

This outcome of "eroding credibility" has been highlighted in our musings and has also been put forward by Bank of America Merrill Lynch in their Ethanomics note from the 3rd of June 2016 entitled  "The Fed's risk management":

"Dazed and confused

It is fair to say that many clients are a bit confused and frustrated with Fed communication. The Fed seems to be constantly changing its focus from one meeting to the next. They seem to regularly promise hikes, only to back off at the last second. Fed statements often seem stale, reflecting where the economy and markets were a couple months ago, rather than current conditions. They say their 2% inflation target is not a ceiling, and yet they only plan to bring inflation back to 2%. They argue that the risks to the outlook are very asymmetric—with rates near zero they have limited anti-recession ammunition—and yet their inflation target is symmetric. This is policy transparency?

Here we pierce the cacophony and offer a simple guidebook to understanding the Fed. The core lesson here is simple: until the Fed is able to achieve significant separation from the zero lower bound for interest rates they will remain highly risk averse. This means they will:
• focus on the latest risk factor rather than their baseline,
• pause at relatively small signs of trouble,
• be very slow to “turn off” risk warnings,
• take a very high risk of overshooting their inflation target,
• and take very little risk of an economically meaningful hawkish “policy mistake.” 

Attention deficit disorder

A common complaint from clients is that the Fed seems to be constantly shifting its focus. One day it is the labor market, and then it is GDP, then inflation, then global developments and then financial conditions. No wonder markets are confused about just what “data” the Fed are “dependent” on.
Contrary to popular belief, the Fed is not constantly changing its mind. Instead, their shifting focus is a sign of very high risk aversion. With the Fed and many other central banks facing chronically low inflation, a weak recovery and near-zero rates they are much more sensitive to downside risks to growth than to upside risks to inflation. As a result, their focus tends to shift to whatever is causing downside risks at the moment.
The labor market has been out of the Fed spotlight for a long time because it is the healthiest part of the economy. By contrast, there have been a number of troubling dead spots for GDP growth and there have been repeated periods of elevated global economic and financial risks.
We expect the Fed to remain highly risk aversion until they have created significant separation from the zero lower bound. Get used to it: as risks rotate, so will the Fed’s focus.

Markets are fast, the Fed is slow

Despite a rebound in the markets in late February and March, Fed officials remained super dovish until after the April 26-27 FOMC meeting. Some investors wondered “what more are they looking for to become more optimistic” and “if this improvement is not enough, will they ever hike?” Recall that even in normal times, there is a good deal of inertia in Fed decision making as they have a very strong aversion to flip flopping. This is one reason why the lagged funds rate is often included in econometric models of the Fed reaction function. Moreover, in our view, each shock is making the Fed a bit more risk averse, making them a bit slower to give the “all clear sign.”. Yellen’s next major speech is on June 6th and we expect her to offer a much less stale view, given months of better markets and no sign that the risk-off trade damaged the economy. There are two lessons here: (1) what the Fed is looking for is more time to decide, and (2) their caution means slow hikes, not no hikes.

The inflation target: do the right thing

Another confusing part of the Fed’s message is the way they describe their inflation target. On the one hand, they swear 2% is “not a ceiling” and they want to average 2% over time. On the other hand, they only want to raise inflation to 2% in the next few nyears, taking an equal risk of overshooting and undershooting. As we noted here, inflation tends to be low early in business cycles and then rise late in the cycle. Hence achieving average inflation of 2% requires overshooting in the second half of economic recoveries. As we also note, this has nothing to do with making up for past low inflation, but is a requirement if the Fed is going to avoid repeatedly undershooting its target in the future.

They also have an inconsistent message on the risks around policy. On the one hand, they underscore that their targets are “symmetric”; on the other hand, they argue that with interest rates near zero the risks to the economy are asymmetric to the downside.
If the risks are asymmetric, why would they have a symmetric target? Moreover, the zero lower bound constraint is one of many things arguing for asymmetry:
• Inflation expectations have clearly slipped below their 2% target, restoring
expectations requires proving that they can achieve average inflation of 2%.
• The increased volatility of the business cycle means the Fed needs to have a higher
nominal funds rate at the end of an expansion to have sufficient ammunition to
fight the next recession.
• The drop in the equilibrium real funds rate lowers the equilibrium nominal funds
rate, giving the Fed less anti-recession ammunition, not more.
• The risks of deflation have risen relative to when the Fed first set its target.
• With other central banks stuck at zero, the Fed may be alone to fight the next
recession.

We see only two offsetting arguments. First, overshooting could trigger political backlash. The Fed can deal with this by quietly overshooting and assuring that the overshoot will be limited. Second, a slow exit adds to bubble risks. However, even with its slow exit the Fed has already taken some of the froth out of high yield bonds and commercial real estate lending.1 Ultimately, we expect the Fed to do the right thing and acquiesce to a moderate overshooting of their inflation target. Hence we expect them to act like they have a de facto target of 2.5% over the next several years.

It is hard to fall down when you are crawling

For much of the economic recovery, the bond market consistently priced in rate hikes that never materialized, but the last two years the roles have reversed with the market pricing in less hikes than the Fed is forecasting. Thus a common refrain is that the Fed is “making a policy mistake.” They are going to hike too quickly, damaging the recovery and may be forced to reverse course.
We are skeptical. A corollary of this high risk aversion is that the Fed is unlikely to make a “hawkish” policy mistake. The Fed is moving at a snail’s pace and pauses at every sign of downside risks. Indeed, they have delayed every planned tightening. Moreover, the economy has done fine despite the “taper tantrum,” the “surging dollar” and repeated stock market corrections. The Fed may be making small tactical mistakes, but their goslow-and-hesitate strategy makes an economically meaningful tightening error very unlikely.

Damned if you do; damned if you don’t

The bond market sees a relatively low probability of a rate hike in the second half of the year (Chart 2).

Presumably this is partly because of the looming Presidential election. Clearly the Fed is under political pressure: some candidates have been quite critical of the Fed, there are several bills in Congress designed to reduce Fed independence and a move near the election is likely to attract a good deal of criticism. In our view, political pressure on the Fed is the highest since Paul Volcker broke the back of inflation in the early 1980s. A risk-averse central bank may decide to go into hibernation around the election." - source Bank of America Merrill Lynch

In relation to Bank of America Merrill Lynch's point about inflation tending to be low early in business cycles and then rising late in the cycle, we reminded ourselves that equity bear market tend to coincide with high global core inflation as we wrote about in June 2014:

"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:

 - source TradingEconomics.com

When it comes to "inflation" being the "Unobtainium" element we wrote about in March this year, we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "most important" piece of the puzzle the Fed has so far been struggling to "generate":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014

And if historically, a true peak in the equity market always happens between 2 and 14 months before recessions, a sudden burst of inflation on conjunction with heightened velocity in the rise in oil prices could indeed have severe consequences on equities we think. Given the on-going complacency and significant rally seen since the bottom of the first quarter, and the low level attained by the Vix, it seems to us that the time is right to start thinking about "hedging" your US equity risk as per our final chart.

• Final chart: Now is the right time to "hedge"

As clearly we are moving towards the final inning of this credit cycle and given the signs we pointed out recently coming from the Commercial Real Estate market (CRE) indicative of tightening financial conditions, we have to agree with Société Générale's Cross asset Quant Research note from the 26th of May entitled "The Right Hedge for You", now is the right time to hedge as per their table below:

"We’ve been here before

We also looked at buying options opportunistically, using various tactical indicators. We find that it is relatively easy to identify economic crises of a more cyclical nature by monitoring such indicators as the valuation of the stock market, high-yield spreads and the cost of hedging. Forecasting financial and geopolitical crises is a much more daunting task.
Using risk indicators can help reduce the cost of hedging in good times, and possibly buy more options in times of stress. But in the long run, such tactical choices matter less than such seemingly mundane issues as selecting the right expiry, leverage, and strike.
It is interesting to note that most of the indicators we have selected show that now is the right time to hedge equity risk. Volatility is cheap, especially for the S&P and Eurostoxx. As Andrew Lapthorne argues in ‘High aggregate PE valuations and weak profits and not wholly down to Energy’ [GS5], price/earnings valuations are high and profits weak. US high-yield spreads are wide, as they were in the late 1990’s and before the subprime crisis.

Nobody can predict exactly what will happen next, but we think it is a good time to take a serious look at hedging strategies." - source Société Générale

While nobody can predict exactly what will happen next, from our point of view, we know from the early signs of the growing stress in some segments of the credit markets, that it will happen, how it will happen, namely what will be the trigger remains a big unknown. Revisiting hedging strategies, we agree with Société Générale is essential particularly if one believes the US economy is indeed, like Japan on  a "Road to Nowhere".

"Fun without sell gets nowhere but sell without fun tends to become obnoxious." -  Leo Burnett, American businessman

Stay tuned!

Macro and Credit - When Doves Cry

"Bad logicians have committed more crimes involuntarily than bad men have by design" - Pierre Samuel du Pont de Nemours, French writer, economist, publisher and government official. 

During the French Revolution his two sons and their families immigrated to the United States. His son Éleuthère Irénée du Pont was the founder of E.I. du Pont de Nemours and Company. He was the patriarch and progenitor of one of the United States' most successful and wealthiest business dynasties of the 19th and 20th centuries.

While taking some much needed R&R (Rest and Recovery) far away basking in the sun, and in the process, we attended a few "board meetings" (windsurfing that is...) which explains our recent lack of weekly musings dear readers, not only did we manage to follow the news and Bank of Japan's predicament, which created yet some additional "sucker punches" and VaR nightmares for the short yen crowd and Nikkei holders, but, we also learned about the sudden disappearance of the maverick musician Prince, being for us the ultimate guitar hero hence yet another reference to the "artist" in our title analogy. Our "Prince" song analogy and central bankers reference follows previous analogies: "All that glitters ain't gold" in 2013 as our 2015 post "While My Guitar Gently Weeps". 

On a side note, about Prince being the "ultimate guitar hero" we would like to point towards the year 2004, when George Harrison was inducted posthumously into the Rock and Roll Hall of Fame as a solo artist. "While My Guitar Gently Weeps" was played in tribute by Tom Petty, Jeff Lynne, Steve Winwood, Steve Ferrone, Marc Mann, and Dhani Harrison, and concluding with arguably one of the most  memorable guitar solo by fellow inductee Prince. 

"When Doves Cry" was the lead single from Prince's 1984 album Purple Rain. While listening to this seminal title, we also managed the read a fascinating account on the "assignat" which was a type of a monetary instrument used during the time of the French Revolution (money printing on a grand scale with dire consequences...), in a book written by French economist Florin Aftalion in 1987 entitled "The French Revolution - An Economic Interpretation" hence our opening du Pont de Nemours quote. In similar fashion to our quote and chosen title, and our reference to the dreaded "assignat", we think our "generous gamblers" aka central bankers are indeed "bad logicians". At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point".

The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital. With QE becoming a global phenomenon with South Korea's president indicating that the country needs to look at possible 'selective' QE and Negative Interest Rate Policy becoming rapidly the "norm", one might wonder how on earth "capital" is going to continue to be "accumulated", particularly when one looks at negative yielding assets as illustrated by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 29th of April entitled "Show me the yield":

"Reaching for yield in a negative-yielding world 

Negative yielding assets now represent 23% of the global fixed income market, growing substantially from 13% at the beginning of the year. As commodity prices have stabilised and macro risks have receded - at least for now - risk sentiment has improved. Amid scarcity of yield investors are moving to higher yielding pockets of the FI world. This will be further aggravated in the months to come as credit investors will find less and less paper to buy as the ECB becomes essentially a competitor to them.

The ECB corporate bond QE is a clear win for cash bonds. However, synthetics have been lagging over the past month. This has been the case in parts of the market – highgrade non-banks - that the ECB will start buying in June, but also in places the ECB will not touch – like high-yield. While the high-yield non-fins index is almost 70bp tighter, since the day post the ECB corporate-QE announcement, the Crossover index is less than 10bp tighter." - source Bank of America Merrill Lynch

To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB. And when it comes to the "ultimate value" of the "assignat" (and the end result with NIRP...), a simple picture clearly display the trajectory of their final value:

Source: Le marché des changes de Paris à la fin du XVIIIe siècle (1778-1800) -1937 

As far as we are concerned, we continue to enjoy our exposure to gold miners "When Doves Cry". We did warn you well advance of the direction markets would be taking at the end of 2015 and why we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that if there was huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up. Of course, both did in Q1 and will continue to do so in Q2.

In this week's conversation, we would like to point out that thanks to "Doves Crying", given the continuation of NIRP, Investment grade credit in particular appears to us more favorable as an asset class versus equities thanks to the on-going support from Japanese investors.

Synopsis:

• Macro and Credit - Investment Grade Credit or when Haruhiko Kuroda got your back
• Macro and Credit  - The consequences from a flow perspective for credit
• Final chart: When "doves" get a break from the "breakeven"

• Macro and Credit - Investment Grade Credit or when Haruhiko Kuroda got your back

As indicated in early April in our conversation "Paradise Lost", Investment Grade Credit, at least in the US appears to us more appealing from a flow perspective thanks to "flows" and on-going support from Japan's large institutional basis:

"As we move into the second Quarter, not only does Investment Grade appear enticing, but, from an allocation perspective US TIPS still remain particularly attractive. But, moving back to Investment Grade, we do believe that "Paradise" is not "Lost" and if indeed as we pointed out, Mrs Watanabe, Japan's GPIF and its pension friends are looking for yield abroad in a more aggressive fashion then indeed adding duration with less credit risk than High Yield makes sense" - source Macronomics, 5th of April 2016

In fact it seems to us that from a "flow" perspective, the rotation from equities to credit is no doubt a validation of our stance as pointed out by Bank of America Merrill Lynch from their Follow the Flow note from the 29th of April entitled "Outflows accelerate from equity funds":

"More inflows into credit…more outflows from equities 

The ECB corporate QE has been the catalyst for a U-turn on credit flows. The sudden course of action the ECB ignited for credit might have also caused another consequence for flows: with inflation expectations still anchored, equities have seen more outflows.
Flows in credit continued for another week. High grade fund flows, even though they slowed down, remained positive for a seventh week. However, inflows into high yield almost doubled w-o-w.

On the contrary European equity funds have suffered another week of outflows. The asset class recorded its biggest outflow in 80 weeks, losing close to $4.8bn of assets. This was also the 12th consecutive outflow week for the asset class, bringing the YTD cumulative outflows from equity funds to more than $24bn.

Government bond funds recorded a third week of outflows in a row, while money market funds recorded their largest outflow in four weeks. 

Commodity fund flows went back to positive territory after taking a breather last week, supported again by inflows into gold funds. The asset class is currently the best performer, with year to date % of AUM inflow at 15%, far ahead of all other asset classes.

Global EM debt flows reflected the bullish turn of the market on EMs, recording the tenth consecutive week of positive flows.
On the duration front, short-term funds recorded a marginal inflow, keeping a positive sign for the last four weeks. The mid-term IG funds continue to record strong inflows for a ninth week. But it looks like investors have started to embrace duration to reach for yield, as inflows into longer-term funds have recorded a cumulative 0.8% inflow in the past two weeks. " - source Bank of America Merrill Lynch

Whereas 1999, which was as well a Prince's 5th album from Prince, saw record inflows into equity before the 2000 internet bubble burst, it seems to us that this time around, our "crying doves" are instigating an "epic bond bubble". The recent decision by the ECB will no doubt boost the rally into credit in Europe into "overdrive" and as expecting we are already seeing more and more large corporate issuers issuing de facto "zero coupon" thanks to our "Generous Gambler" aka Mario Draghi. 
As we pointed out in our previous missive before going for our R&R, it seems to us that the ECB is failing because it is enticing the money "uphill" namely into "bond speculation" where all "the fun is",  not downhill, to the real economy. Flow wise this exactly what is happening. The "fun" is in the bond market and particularly in the European investment grade market as explained in Bank of America Merrill Lynch previous Follow the Flow note from the 24th of April entitled "Global QE - here we go":

"CSPP: clearer, bigger, broader 

The ECB was bolder than expected. With an eligible pool of assets that seems to be broader than initially thought, the ECB is now in the driving seat. Investors are “front running” the ECB, by buying more credit at the expense of equities. With inflation expectations still pointing to the downside, investors were directed to high-grade paper, while government, money market and equity funds saw outflows.Over the past eight weeks high-grade and high-yield funds have seen combined inflows of $10.6bn vs. more than $17bn of outflows from equity funds. Credit has still has room to go, as the YTD flow number remains in the negative territory as $11bn have left on aggregate from the asset class. The main target of the CSPP – namely investment grade credit – recorded its sixth week of positive flows with a significant volume compared to the previous week.High yield on the other hand saw only modest inflows, the second in a row. We also note that latest EPFR monthly data reveal that investment grade funds had their first monthly inflow in 10 months, and high yield funds their first in 4 months. 

Elsewhere in fixed income, government bond funds recorded another weekly outflow, the second in a row, while monthly flow numbers were also pointing to the downside for March. Money market funds had their first outflow in three weeks.
Equities fund flows were yet again negative, and have been so for the last 11 weeks. The asset class now approaches $20bn of outflows since the start of the year, the biggest among all asset classes we track with EPFR. On a monthly basis, in March equities had their biggest outflow in 17 months and the second in a row. 

 - source Bank of America Merrill Lynch

Whereas the issue with the assignats was that in no way it was capable of facilitating the sale of public lands (us thinking about Greek "privatisation" and the original goal of getting 50 billion euros, now reduced to 15 billion euros) in no way the ECB's recent policy will facilitate the "accumulation of capital", on the contrary, capital will eventually be destroyed. In similar fashion Pierre Samuel du Pont de Nemours explained on the 25th of September 1790 in front of the French National Assembly the mechanisms which enabled shrewd speculators to use devalued assignats to buy "biens nationaux" (collateral being the church's real estate) for next to nothing as written by Florin Aftalion in his book:

"Events were to prove him right, as huge fortunes were amassed by these same means. He also announced that, in the last analysis, the Assembly would be asked for much more than the issue of 1,900 billions that was necessary for the settlement of the exigible debt. In this case too, Dupont was to be proved right" - source Florin Aftalion, "The French Revolution - An Economic Interpretation" 

With NIRP and cheap credit, bond speculation, buybacks and takeovers can operate on a grand scale and generate outsized returns for the "shrewd speculators" on Spanish Real Estate and now on Italian Real Estate. Easy as 1, 2, 3...

Thanks to the ECB's latest and with Bank of Japan sticking with NIRP, Japanese investors are now facing an even bigger competition from the ECB to get hold of foreign bonds. In relation to having Kuroda's backing when it comes to investing in global investment grade, we read with interest Bank of America Merrill Lynch's Credit Market Strategist note from the 29th of April entitled "2bps per month":

"What can Kuroda do for you?

From the perspective of US HG corporate bond investors - probably not much more than presently. Easy BOJ monetary policy benefits the US corporate bond market in two main ways. First, and most importantly by far, through negative interest rates and QE the BOJ has more or less purged the Japanese fixed income market for yield. As result Japanese fixed investors - such as insurance companies and banks - are in a very challenging position where they are forced to buy foreign fixed income instead (Figure 10). 

For example Nikkei in an article on Thursday titled: "Japan insurers flock to foreign bonds as BOJ kills golden geese" estimated that the top-10 Japanese Life Insurance companies alone plan to buy $46.6bn of foreign bonds in the current fiscal year (that began April 1st). This is a big and long lived positive development for US corporate bonds. Second as we saw this week the BOJ affects global risk sentiment, but this effect should be relatively small and short lived. With JGBs trading at negative yields out to 10-years in maturity (Figure 12), and 30-year JGBs at just 33bps (Figure 13), there is very little the BOJ can do to drive even more Japanese investors into the US HG corporate bond market.

Even if the BOJ stepped up their buying of Japanese corporate bonds the impact would be limited, as the size of that market is just 3% of the size of the USD HG corporate bond market - an order of magnitude smaller than the EUR denominated HG market (Figure 11).

Hence, given the limited ability in the first place of the BOJ to provide further tailwind to the US corporate bond market, we expect that the surprising non-action by the BOJ at this week’s meeting will only work through the second channel - market sentiment - a likely small short term negative.Japanese investors being forced out the curve
The more interesting question is what foreign bonds Japanese investors buy. While clearly the US HG corporate bond market is the main game in town, the big rally in US credit spreads over the past two-and-a-half months works to push Japanese investors to take more risk in order to preserve yields. That means either moving out the curve in credit, or dialing down their currency hedges. Within HG this means chiefly longer maturities and also, but likely to a lesser extent given ratings mandates, down in quality.
However, beyond our own asset class we think many large Japanese investors will increasingly be looking at higher yielding asset classes - chiefly structured products for investment grade ratings, but in the case of less ratings constrained money also higher quality HY.
To understand corporate bond math for Japanese investors consider that in order to buy US corporate bonds they need USD funding. One way to get that on a fully currency hedged basis is through a JPY/USD cross-currency basis swap for the life of the bond. However, because funding in USD is relatively scarce that comes at a steep cost. But as that annual premium tends to increase relatively little, or even decrease, with maturity of the contract, and  However, beyond our own asset class we think many large Japanese investors will increasingly be looking at higher yielding asset classes - chiefly structured products for investment grade ratings, but in the case of less ratings constrained money also higher quality HY. To understand corporate bond math for Japanese investors consider that in order to buy US corporate bonds they need USD funding. One way to get that on a fully currency hedged basis is through a JPY/USD cross-currency basis swap for the life of the bond. However, because funding in USD is relatively scarce that comes at a steep cost. But as that annual premium tends to increase relatively little, or even decrease, with maturity of the contract, and because the US corporate spread curve is relatively steep, currency hedging costs as percentage of US corporate spreads declines with maturity (Figure 14). 

On adding the negative basis swap to the US corporate spread curve in Figure 14 we translate USD spreads into currency hedged JPY spreads on a 3-month Libor basis (Figure 15, Figure 16).

We also show in these figures credit spreads in the Japanese corporate bond market on a 3-month JPY Libor basis - because the quoting convention in Japan is on a 6-month Libor basis we add the 3-6 month LIBOR swap for the average four year maturity of the Japanese corporate bond market. Note that, because of the small size of the Japanese corporate bond market - and the lack of long paper - we assume a flat spread curve for simplicity.

Other ways for Japanese investors to reach for yield

Instead of extending out the maturity curve Japanese investors that have ratings flexibility can reach down the credit curve and even into higher quality high yield (Figure 17). In particular BB-rated HY bonds are one of the most effective sectors that offer significant yield-pick-up.

Alternatively, since a significant proportion of Japanese money is ratings constrained we suspect that a lot of investors will instead reach for yield in investment grade rated securitized products.Finally it is increasingly obvious that a lot of Japanese investors are dialing down their currency hedges in order to increase yields. That of course leaves them exposed to some extent to this year’s big appreciation of the yen Japanese, and we would expect that some investors are forced to pull out of US corporate bonds for that reason even as other investors put more money to work.
As our rates strategists discussed (see: Liquid Insight: The Japan flow playbook 04 April 2016), an alternative hedging strategy is to roll three month forward exchange rate contracts - a strategy that does not eliminate all currency risk and thus pays more a fully hedged strategy. The idea is to exchange JPY to USD in the spot foreign exchange market, buy US corporate bonds and at the same time enter a 3-month forward contract to sell USDs back to JPY in three months at a fixed price. While this currency hedges the first three months of the trade, if the Japanese investor wants to keep holding the US corporate bond after that he/she must at the time roll into a new 3-month forward contract – hence there is currency risk. The cost of this strategy is around 130bps annually, and thus a yield of around 3.4% on a 10-year US corporate bond becomes a roughly a 2.1% yield in JPYs using this approach. Figure 18 shows the significant yield advantage offered by such partially currency hedged spread curves over their fully hedged counterparts. 

- source Bank of America Merrill Lynch

Of course as well as in Japan, doves have been crying given that they much vaunted currency depreciation scheme has been put in reverse as of late. But given the mounting evidence of a global slowdown, one would expect the Bank of Japan to return to the QQE game during the second part of this year. Now that the ECB is directly in competition of the likes of Mrs Watanabe, Japanese insurance companies, the GPIF and their pension funds, one would expect that the "fun" uphill, namely bond speculation, continues to run unabated, for the real economy, we are not too sure...

When it comes to credit, we expect some more tightening in the second quarter thanks to "Doves crying", ECB's buying spree and Japan's foreign appetite for risky assets.

•  Macro and Credit  - The consequences from a flow perspective for credit

The consequences are that from a "flow" perspective, we are going to see a continuation of the "Great Rotation", namely from "equities" to "fixed income" until we get another merry go round of QEs. but that's another story. For the time being thanks to the ECB and its global corporate bond buying binge, it is forcing at sword point investors and particularly Japanese investors to switch to overdrive, leading a clear widening gap between equities and bonds as pointed out by Bank of America Merrill Lynch's Credit Market Strategist note entitled "2bps per month" from the 29th of April 2016:

"Mind the gap, redux 

One of the more striking decouplings last year occurred mid-August between spiking credit spreads and declining equity vols, before the equity market finally caught up (see: Situation Room: Mind the gap 13 August 2015). We are now seeing the opposite, as credit spreads are tightening hard in April while equity vol has been relatively constant (Figure 22).  

This time it appears that one of the key reasons for the decoupling is very favorable excess demand conditions in the high grade corporate bond market, as an influx of foreign investors meet less than expected supply. The foreign demand part of the equation is becoming particularly obvious as some of the biggest Japanese investors – including life insurance companies – have recently publicly announced expanded investments in foreign bonds for the new fiscal year that began April 1st." - source Bank of America Merrill Lynch.

Excess demand + weak supply+ Foreign buying from Japan = continuation of credit spreads tightening. A very simple equation, making credit more enticing versus equities for the time being we think from an asset allocation perspective.

When it comes to Japan's life insurance companies, they intend to increase their credit risk exposure compared to 2015 according to Nomura's note entitled "Major Life Insurers FY16 Bond investment" from the 4th of May:

"Comments suggest lifers are looking to credit risk to improve returns 

n comments on bonds other than domestic bonds, Insurer B said, “In addition to ramping up JPY-denominated investments such as infrastructure projects, we will consider buying major banks’ subordinated debt compliant with Basel III.” Insurer C said, “We will slow our purchases of super-long JGBs and buy more credit instruments as we expect yen bond yields to remain low,” and Insurer E said, “We plan to invest in AT1 bonds issued by major banks. These instruments do not have a long history, but have adequate market liquidity. We bought these bonds in FY15. Falling domestic rates mean that the only way we can secure investment returns is to take duration risk or credit risk.” Insurer F noted, “We will not buy JGBs, and will only buy corporate bonds,” while Insurer G said “We plan to limit reinvestment in domestic bonds to a low amount, focusing on domestic bonds with relatively high yields, primarily corporate bonds.” These comments suggest many lifers plan to take credit risk to improve return. 

Lifers are investing in a wider range of options 

Lifers commented on regions (markets) and the types of bonds that they target for investment. According to Insurer A, “We significantly increased balances of both hedged and unhedged bonds in FY15, particularly US bonds, and have not changed our stance in FY16. However, we plan to reduce the weighting of UST investments owing to higher hedging costs, and diversity into euro area bonds. We will invest flexibly based on yields and hedging costs.” Insurer B said, “For currency-hedged foreign bond investments, we plan to buy not only government bonds, but also corporate bonds, diversifying our investments in terms of bond type and maturity.” Insurer C stated, “We plan to invest in a wider range of regions, including peripheral countries in addition to core countries, and will also lengthen the duration of our investments. We will also look to corporate bonds. We aim to improve return by increasing investments in foreign credit assets.”

Insurer E commented, “We will focus on US bonds rather than EU bonds, whose yields are declining, and invest in credit instruments such as USD-denominated notes issued by domestic mega-banks and others.” Insurer F said, “We expect the Fed to raise rates twice in FY16 and currency hedging costs to rise accordingly, so we will invest in corporate and other higher-yielding US bonds. In the euro area, we will invest in peripherals.”
Insurer G noted, “We have primarily invested in USTs and EUR bonds, but we have diversified to include Australian and Mexican bonds, among others. Government bonds made up a high percentage of our foreign bond investments, but we will increase the weighting of credit instruments.” Insurer H stated, “We will continue to buy certain amounts of investment-grade US corporates, in addition to USTs. European bonds, including corporates, will also remain an option.”
Insurer G noted, “We have primarily invested in USTs and EUR bonds, but we have diversified to include Australian and Mexican bonds, among others. Government bonds made up a high percentage of our foreign bond investments, but we will increase the weighting of credit instruments.” Insurer H stated, “We will continue to buy certain amounts of investment-grade US corporates, in addition to USTs. European bonds, including corporates, will also remain an option.”

As bond yields continue to fall globally, lifers will likely look to add investments in a wider range of markets, in our opinion." - source Nomura

Because, Mrs Watanabe, Japanese Life insurers, GPIF and pension funds will continue to shift their portfolio allocation from JGBs into foreign assets and in particular credit, we believe the acceleration of the move will be Japanese yen negative and the current level of USD-JPY below 107, looks enticing we think to re-initiate a short on the Japanese currency. Maybe at some point the Japanese Yen will end up like the dreaded French Revolution "assignat"...

For our final chart below, while we have discussed on numerous occasions the attractiveness of US Tips in the current environment, when it comes to US breakeven levels, it seems to us that the Fed and its "doves crying" have been shedding "crocodile tears" and are indeed getting a welcome respite from US breakevens.

• Final chart: When "doves" get a break from the "breakeven"

As we discussed back in March in our conversation "Unobtainium", we argued that the FOMC was more willing to allow inflation to overshoot, hence our preference at the time for US TIPS and Gold Miners:

" If indeed the slope of the bond yield curve which was negatively correlated to short term rates, is now fully inelastic from a strategy perspective, we believe being long US TIPS (given their embedded deflation floor), long gold miners and long US long bonds still represent a relatively attractive "allocation". - source Macronomics, March 2016

When it comes to our final chart and inflation expectations, we would like to point out towards Bank of America Merrill Lynch's chart from their Securitization Weekly note from the 29th of April 2016 indicating that the 10 year breakeven inflation rate is somewhat validating the "inflation accommodative" stance of the Fed 

"The 10-year breakeven inflation rate seemed to break out to the upside of the downward channel that started with taper talk in mid-2013 (Chart 1).  

We view this as big news, as it seems to be saying that the Fed will tolerate or even wants further gains in inflation expectations. Data dependency says that is subject to change, but for now, we assume that we have transitioned to a new accommodative phase for the Fed. This should be good news for securitized products credit and create upside risk for the near term." - source Bank of America Merrill Lynch

If indeed "breakeven" are "breaking out", this is indeed showing than "when doves cry", it seems their are shedding "crocodile tears" given they'd rather tolerate inflation than deflation.

"There seems to be no limit to which some men will go to avoid the labor of thinking. Thinking is hard work." - Thomas Edison  

Stay tuned!