Charts of the Day - Positive correlations and large Standard Deviation moves

"The least initial deviation from the truth is multiplied later a thousandfold." - Aristotle

The Charts of the Day we have chosen to display reflects our concerns relating to the relationship between rising positive correlations due to the "divine" intervention of our "generous gamblers" aka "omnipotent" central bankers and the significant rising "instability" à la Minsky it entails. This can be ascertained from the rise in +/-4 standard deviations moves or more in various asset classes. 

The significant rise in these large standard deviation moves can be seen in the chart below from Bank of America Merrill Lynch European Credit Strategist note from the 11th of August entitled "The liquidity paradox":

"Chart 1, above, refreshes our “correction counter” that we first published in May. It sums, over time, the number of instances that assets in our sample register +/- 4SD moves. The chart shows that asset classes more directly impacted by central bank policy (such as government debt and currencies) are indeed seeing a relative rise in the number of “corrections” over time. But assets where central bank policy is a less direct driver of performance (such as equities, where the growth outlook is arguably key) are seeing “corrections” increase in a more linear fashion.Why might the era of high central bank help be, perversely, resulting in more market corrections? We argued in May that the cumulative result of so much monetary policy support is that the market’s emotional gap between fear and greed has narrowed." - source Bank of America Merrill Lynch

This pattern was expected given following the Great Financial Crisis (GFC), positive correlations have been rising between different asset classes, a subject we discussed again in May this year in our conversation "Cushing's syndrome" and leads us to use once more to use the below IMF chart in the light of Bank of America Merrill Lynch standard deviations move chart above:

"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations.

Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:

- source IMF, April 2015

This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoils, bond prices and equities are all moving in concert.
"Positive Correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson
We could not agree more with the above. Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). When it comes to rising risk and the threat of "positive correlations" and Cushing's syndrome we read with interest Nomura European Strategy note from the 6th of May 2015 entitled "At the mercy of macro":

• "The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. This is the first time this has happened since 2006 and the difference between the two correlations is the largest than at any point in the post 2000 era.

• The average pairwise correlation between stocks in Europe is close to its post Lehman low. However, we do not think that this heralds the return to some kind of stock-picking nirvana (if such a thing exists).

• The rapid move up in bund yields and EUR-USD reversals of recent weeks has been felt in some sharp factor reversals, most notably an underperformance of Momentum both across the market and within sectors.

• We have moved away from a world where changes in macro variables cause short-term rallies and corrections in the overall index level, to a situation where the same macro variables are the driving force for groups of stocks within the market. So understanding the macro risks is no less important. This perhaps represents a market where the main focus is on the nature of the recovery and the timing and type of earnings growth rather than macro developments prompting a continuous existential crisis as we have seen in recent years. We take this as a positive development." - source Nomura

No offense to Nomura but, we do not take it at all as a "positive development". On the contrary, we think it is representative of the excess of "alkaloids" use leading to Cushing's syndrome and rising instability as posited by the great Hyman Minsky." - source Macronomics, May 2015.

As a reminder:

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

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

We would like to repeat what we indicated back in January 2012 in our conversation "Bayesian thoughts" when we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

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

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

"History has not dealt kindly with the aftermath of protracted periods of low risk premiums." - Alan Greenspan

Stay tuned! 

Credit - Ephedrine

"Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom." - Viktor E. Frankl, Austrian psychologist

Watching with curiosity our "secondguessing" playing out on our Chinese exposure supported by PBOC intervention in the process, it reminded us of course of our October 2014 note "Pascal's Wager" as the only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose the belief that our central bankers are indeed "Gods". 

When it comes to choosing this week's title analogy, we remembered the herb Ephedra sinica used in traditional Chinese medicine which contains ephedrine and pseudoephedrine as its principal active constituents. Ephedrine in its natural form was known as má huáng (麻黄) in traditional Chinese medicine and has been documented in China since the Han dynasty (206 BC – 220 AD) as an antiasthmatic and stimulant. In traditional Chinese medicine, má huáng has been used as an attempted treatment for asthma and bronchitis for centuries so no wonder when economies catch the proverbial cold, it can also be used as a powerful "stimulant". What we find of historical interest is that in 1885, the chemical synthesis of ephedrine was first accomplished by Japanese organic chemist Nagai Nagayoshi based on his research on traditional Japanese and Chinese herbal medicines. In similar fashion the Japanese chemist/central bankers at the Bank of Japan were the first to realise the chemical synthesis of ephedrine and its "stimulant" effect on "asset prices". Though Ephedrine is a potentially dangerous natural compound as it can sometimes lead to mania/hallucinations as well as delusions but we ramble again...

What we find of interest with this week's analogy is many pundits musing around the probability of China launching a QE of its own to offset the debilitating effects of its past credit binge. Therefore in this week's musing we would like to focus our attention on China's potential approach in offsetting the effects of past excesses given that as we pointed out previously, while Europe is attempting to avoid demolition, China as we pointed out in our February 2014 "Crosswind" conversation is attempting to deflate these past excesses:

"Chinese crosswind is of two folds, on one hand China's deflating exercise is akin to a "controlled demolition" and will need to allow at some points some defaults to take place, on the other hand, it has to maintain sufficient credit conditions to ensure a certain level of growth for its economy.
As we wrote back in September 2011 in our conversation "Controlled demolition", as far as Europe and China are concerned, nothing has really changed in terms of the treatment of the on-going crisis:
"While Europe is busy with the demolition, we have China attempting deconstruction. In both case we have an attempt of controlled demolition, it is just a question of style." - Macronomics, 19th of September 2011." - source Macronomics

Synopsis:

• China's debt pile and household debt
• Private debt matters but so does private consumption
• US and Europe = reducing "equity" versus China increasing "equity"
• China and QE and the myth of the Opium plague
• Final note: Dr Copper, the metal with the economics Ph.D is still in a bear market

• China's debt pile and household debt

China's Purchasing Managers' Index from HSBC/Markit slowed to 48.9 in April vs 49.6 last month, We saw a similar pattern in 2014. But, when it comes to assessing the meteoric rise in China's debt, one need to take into account household debt relative to GDP as indicated in Bank of America Merrill Lynch's Cause and Effect note from the 27th of April entitled "The great US-China convergence trade":

"Between 2011 and 2014, loans from financial institutions to Chinese households more than doubled; during the same period, the debt of US households was unchanged. As a result, Chinese household debt as a share of GDP has climbed to 36% while US household debt as a share of GDP has fallen to 77% (Chart 14). 

By the way, the McKinsey Global Institute recently estimates that total debt to GDP ratio for China has reached 282%, versus 269% for the US." - source Bank of America Merrill Lynch

To quote Bastiat, when it comes to debt levels:

"That Which is Seen, and That Which is Not Seen" - Frédéric Bastiat

From our macro perspective, low household debt levels versus GDP is an essential positive factor when it comes to the "deleveraging" exercise undertaken by China. Therefore, given the lower leverage of Chinese households we think the bubble watchers will watch with interest the Chinese market continue to surge in the near future. In fact as indicated by Asia Times, and relating to our HSI exposure, April saw significant inflows into the Chinese stock market:

"April saw HK$20.5 billion ($2.6 billion) flow into the Hang Seng H-Share Index Fund (SEHK STOCK CODE 2828). It was the largest monthly inflow since 2010 and the third-most among equity ETFs globally, according to data compiled by Bloomberg.
The Hang Seng H-share ETF holds the stocks of 40 of China’s biggest state-owned companies. Financials make up 67% of the portfolio. The fund is valued at about 10 times forward earnings, compared with the 17 multiple on the Shanghai Composite Index, according to Bloomberg.
The ETF’s shares rose 17% last month to HK$145.20, its third consecutive month of gains. Over the past four months, the ETF has received a total of HK$29 billion, its longest stretch since 2013. Total assets grew to HK$57.1 billion.
The U.S.-listed iShares China Large-Cap ETF (FXI) received $385 million last month, the biggest inflow in eight months. It jumped 16% in April, for a 51% return over the past 12-months.
One big reason for the rally is that Chinese companies trading in Hong Kong are priced at a significant discount to their dual-listed counterparts on the mainland. UBS said even though the Hang Seng China Enterprises Index leapt 17% in April, its largest jump since October 2011, Chinese A shares still trade at a 31% premium to Hong Kong stocks." - source Asia Times

Given the discount and the lag in term of performance of the Hang Seng China Entreprises benchmark versus the Shanghai Composite Index's A shares (up 48% vs 119%), there is still some upside move to close the gap.

• Private debt matters but so does private consumption

While arguably China has experienced a slowdown and is playing a complicated "rebalancing" act from investment towards domestic consumption, we agree with Jeffrey Towson and Jonathan Woetzel from the adapted book excerpt from their follow-up to their "The One Hour China Book" as displayed by McKinsey in their article "Why China's consumers will continue to surprise the world":

"China has an awesome consumer story. Yet lately you can’t pick up a newspaper, go online, or watch television without hearing continual moaning about the country’s slowing economic growth and the need for “rebalancing.” The reality is that Chinese consumers are going to continue to increase in wealth and complexity. And if you’re worried the country’s economic importance is declining, you’re probably looking at its performance the wrong way.
Don’t worry about consumer spending as a percentage of GDP
As in most developing Asian economies, China’s early growth was based on savings, investment, and exports. You get your population to save, move to the cities, work in factories, and make stuff. This is sold, and cash is brought back home for investment. Plus, you get some foreign investment as well. This process enabled China to develop its infrastructure largely with its own cash. That, by the way, is not the norm. Developing economies typically borrow from foreigners and then default—for example, American states such as Mississippi and Florida were chronic defaulters on foreign debt as they initially developed.
One of the downsides of this investment-first approach is that it makes consumption look small and often like it’s shrinking. Chinese consumption decreased from approximately 51 percent of gross domestic product in 1985 to 43 percent in 1995, 38 percent in 2005, and 34 percent in 2013. By comparison, consumption is around 61 percent in Japan and about 68 percent in the United States. In fact, China’s small and decreasing consumption percentage is one reason why people keep talking about “rebalancing”—the need for the economy to become driven more by consumer spending than investment and exports.

Our position? Don’t worry about this stuff.

First, from 2000 to 2010, the size of the Chinese economy more than doubled
So consumption grew from around $650 billion to almost $1.4 trillion. Regardless of its relative percentage of GDP, China’s consumption has been growing faster than just about any other country’s in absolute terms. Second, just getting consumer spending back to 43 percent of GDP, the level in 1995, would have a huge impact on “rebalancing.” It would also create the largest consumer market in the world. Third, most of these numbers are wildly inaccurate. Consumer spending is nearly impossible to measure in such a big, complicated economy. Combining a vague number with two other big vague numbers (investment and net exports) is very fuzzy math. Until economists start putting uncertainty estimates on their China calculations, relative percentages aren’t worth paying much attention to.

Household income is what matters, and it’s great
The number you really want to keep in mind is household income. You can’t have consumption without income. And here’s where it gets really awesome. China’s household income is huge. It is now likely above $5 trillion a year. Plus, lots of income is unreported, so this is really the lower boundary for true household income. Developing economies—especially the BRIC nations of Brazil, Russia, India, and China—are frequently grouped together, but Chinese consumers dwarf all the others in terms of household income.

Rising discretionary spending is the exciting part
Discretionary spending is buying the stuff you like but don’t need. Or you only sort of need. And, fortunately, people seem to have an endless appetite for everything from entertainment to skiing to caffe lattes. Chinese citizens are now moving beyond being able to only afford the basics of life, and their discretionary spending is taking off. Growth in spending on annual discretionary categories in China is forecast to exceed 7 percent between 2010 and 2020, and growth of 6 to 7 percent annually is expected in a second category of “seminecessities.” Both of these categories are growing faster than spending on actual necessities, which are expected to grow around 5 percent a year, about the same as expected GDP growth
Finally, an important related issue is the Chinese tradition of saving. If we compare spending and saving rates across the emerging markets, we see a spike in savings in China. That spike is fairly understandable. First, it’s cultural. Second, they are precautionary savings—no social safety net means if you get sick, it’s all on you. Third, Chinese savings are not unique. Japan, Korea, and Taiwan all hit 30-percent-plus savings rates in their early development. And fourth, without much of a consumer-finance system, it’s tough to use debt to hit truly spectacular consumption levels. After all, a vacation home or car may cost the equivalent of a year’s income.

That’s our rant on China’s macro consumer situation. Basically, we believe it remains a great story. It may be volatile. It’s also somewhat unpredictable. But you just don’t get a consumer growth story this good anywhere else." - edited excerpt from The One Hour China Consumer Book: Five Short Stories That Explain the Brutal Fight for One Billion Chinese Consumers (Towson Group, 2015). 

Compared with other latecomer countries, China has its own advantages. 

First, with a total population of 1.3 billion people, China contends with a huge domestic market that is rapidly growing. 

Second, although China has faced shortage of rural labor force, the influx of 6 to 7 million college graduates into the job market every year will satisfy an increasing demand for high skilled workers to fuel further growth.

China's manufacturing advantages are conducive to the industrialization of scientific and technological achievements. Over the past three decades, China has achieved enormous economic growth, but its market economy system still has substantial room for improvement.

Manufacturing is going up the « added value » chain: high-speed rail, nuclear power, construction, biotechnology to name a few.

Asia for us continues to be a good value play given they are much more positively impacted by the fall in oil prices but more importantly by the fall in food prices as displayed by Société Générale in a recent cross-asset note:

"Asia is the EM region where the share of food in the consumer price index is the highest on average." - Source Société Générale

With food prices falling for Chinese households, this is indeed an additional boost for discretionary spending as displayed in McKinsey's projection of per-household annual consumption in China by category in percentage terms:

- source McKinsey

China’s consumption strength is real and the economic rebalancing is happening with a growing role of the Services sector as indicated in CITI Asia Macro and Strategy Outlook 30th of March 2015:

“Services sector account for an average of 58% share of EM Asia’s GDP (vs. 22% share in manufacturing), accounted for 43% of real GDP growth in EM Asia over the last decade (vs. 32% contribution from manufacturing sector), and employed 2.3x more people than manufacturing sector to account for the jobs of 35% of EM Asia’s working population (manufacturing accounts for 16% of jobs).”- source CITI Asia Macro and Strategy Outlook 30th of March 201

Strong services demand is linked to rising per capita income leading to stronger consumption. This has generated real sales growth which have been trending up since July 2014

• US and Europe = reducing "equity" versus China increasing "equity"

The "controlled demolition" of their credit bubble has been sustained by the two recent interest rates cuts and the banks' reserve requirement ratios by the PBOC in conjunction with the high level of savings of the Chinese household than can be "redirected" from housing towards an additional "equitization" of the Chinese market as put it by Asia Times in their April 22nd article entitled "China's stealth deleveraging":

" Western analysts remain obsessed with the size of China’s debt problem.
China is gradually deleveraging, though, through the following mechanisms:
1) Equity is slowly replacing debt as the soaring stock market cheapens the cost of equity capital, including at the small-and-medium enterprise level through the Shenzhen and Qianhai stock exchange;
2) Debt is shifting out of the usurious shadow banking market (where loan rates for small businesses can reach 20%) to banks, and to securitized debt markets (Alibaba, China’s e-commerce giant, has listed an asset-backed security based on small business loans on the Shenzhen stock change;
3) The commercial banks are recapitalizing (including $110 billion of preferred debt issuance in 2014);
4) The government is starting to swap high-yield and sometimes dodgy Local Government Financing Vehicles (LGTV’s), the equivalent of US municipalities’ economic development bonds, for provincial bonds backed by tax revenues–at much lower interest rates;
5) The overall level of interest rates is coming down from the highest in world (4% real short-term yields vs. negative yields in most of the industrial world." - source Asia Times

We would also like to make the following point, on the contrary, in the US and now Europe, debt has indeed been replacing equity thanks to debt issuance to fuel a buy-back binge as of late, meaning that leverage once more is trending up, which can be viewed as "credit negative" from a "ratings" perspective. For illustrative purposes, this trend of "releveraging" in Europe can be ascertained in Bank of America Merrill Lynch's graph below from their European Credit Strategy note from the 1st of May entitled "Who has done the deleveraging or not?":

- source Bank of America Merrill Lynch

On a side note, given the particular weaker tone for France's PMI and rising unemployment, as per our conversation "A Deficit Target Too Far" from the 18th of April 2012, we continue to think the following: "We also believe France should be seen as the new barometer of Euro Risk

From a credit perspective not only French "corporates" have been releveraging but in terms of EBITDA, Germany's growth, once again, is making outsized gains thanks to its "mercantilism" approach with its low wages/strong export model helped even more by a weaker Euro as displayed as well in Bank of America Merrill Lynch's European Credit Strategist note:

- source Bank of America Merrill Lynch

And, when it comes to France's unemployment woes, we have yet to see a rise in CAPEX in France clearly showing that French president Hollande's economic's policy is based more on hope than reality as again indicated in the below Bank of America Merrill Lynch graph below from the same report:

- source Bank of America Merrill Lynch

But being French ourselves, we ramble again and get sidetracked in the process. Let's move back to our traditional Chinese medecine má huáng (麻黄).

• China and QE and the myth of the Opium plague

While musing around QE and it similarities with narcotics given our choosing title, we reflected on the history of drugs in China and the myth of the "Opium Plague" as there is indeed a case for the myth of the "QE" plague when it comes to perceiving China's PBOC actions.

Many pundits believe that, China will eventually resort to QE and face a similar demise due to imperialist Britain's most desirable trade commodity namely opium.

From a historical perspective we would like to point towards Frank Dikotter, Lars Lamann and Zhou Xun 2004 book entitled "A history of drugs in China" published by the University of Chicago:

"To this day, the perception persists that China was a civilization defeated by imperialist Britain's most desirable trade commodity, opium—a drug that turned the Chinese into cadaverous addicts in the iron grip of dependence. Britain, in an effort to reverse the damage caused by opium addiction, launched its own version of the "war on drugs," which lasted roughly sixty years, from 1880 to World War II and the beginning of Chinese communism. But, as Narcotic Culture brilliantly shows, the real scandal in Chinese history was not the expansion of the drug trade by Britain in the early nineteenth century, but rather the failure of the British to grasp the consequences of prohibition.
In a stunning historical reversal, Frank Dikötter, Lars Laamann, and Zhou Xun tell this different story of the relationship between opium and the Chinese. They reveal that opium actually had few harmful effects on either health or longevity; in fact, it was prepared and appreciated in highly complex rituals with inbuilt constraints preventing excessive use. Opium was even used as a medicinal panacea in China before the availability of aspirin and penicillin. But as a result of the British effort to eradicate opium, the Chinese turned from the relatively benign use of that drug to heroin, morphine, cocaine, and countless other psychoactive substances. Narcotic Culture provides abundant evidence that the transition from a tolerated opium culture to a system of prohibition produced a "cure" that was far worse than the disease.
Delving into a history of drugs and their abuses, Narcotic Culture is part revisionist history of imperial and twentieth-century Britain and part sobering portrait of the dangers of prohibition." - source The University of Chicago Press Books

In similar fashion we think that the "war on the savers" thanks to ZIRP and QE, that, in the future historians will paint a sobering portrait of the dangers of meddling with markets and interest rates, but we are ranting again.

When it comes to "easing" the POBC will be launching soon its own credit-easing but in no way a QE sort of program as interestingly described in Asia Times on the 28th of April in their article "PBOC goes back to drawing board on bond/loan swaps":

"After going back to the drawing board, the People’s Bank of China now plans to launch its own version of the credit-easing programs seen in the U.S. and Europe, reported the Wall Street Journal on Tuesday.
The central bank will allow Chinese banks to swap local-government bailout bonds for loans as a way to bolster liquidity and boost lending, said the Journal.
The big problem is that in an effort to stimulate the economy regional governments have borrowed huge amounts of cash to fund infrastructure projects, said the Financial Times. Now the Chinese economy is slowing down and many citizens are pulling huge amounts of capital out of the country and investing it overseas. But as the property and manufacturing industry suffer, policy makers want to cushion the economic slowdown into a soft landing with more infrastructure spending.
Amid all this many of these loans are coming due. So the central bank wants to help the local governments by converting short-term high interest loans into low-interest long-term bonds.
Strictly speaking it’s not quantitative easing. The central bank just wants more people to buy the debt of the cash-strapped local governments. And one way it hopes to accomplish this is by letting institutions use the debt as collateral for loans to commercial lenders. China’s Finance Ministry said it would do this by allowing heavily indebted local governments to sell new bonds with explicit government guarantees to replace their existing debt — mostly bank loans,” said the Journal" - source Asia Times

Hence our title, this PBOC monetary policy amounts to "Ephedrine" or "Opium", not the highly addictive "heroin" QE like embraced by central bankers of the BOE, FED, BOJ and ECB.

We agree with Asia Times. This does not amount to QE.

Nomura also shared the same views on the 28th of April in their Asia Insights note entitled "China QE on the way? No!":

"Is the PBoC’s liquidity injection equivalent to a Chinese version of QE? No. QE, in essence, is a monetary policy regime change with an accelerated expansion of a central bank’s balance sheet while policy rates are close to zero. Given China’s monetary background, QE would mean a more aggressive expansion of the PBoC’s balance sheet, but this is not what is happening. As explained above, the recent liquidity injections have mainly been to offset shrinking FX purchases in the maintenance of the normal expansion of the central bank’s balance sheet. The bottom line is that there is no extra liquidity growth in terms of the monetary base or broad money (M2) from the PBoC’s liquidity injections.

Will the PBoC inject liquidity by buying local government bonds? Unlikely, and not in any QE way. First, the PBoC is forbidden by law to buy government bonds directly; second, the primary aim of injected liquidity is to provide the monetary base rather than bailing out local governments. The PBoC already has enough tools to create the monetary base, so has no need to buy government bonds in the secondary market. That said, we suspect that the PBoC may participate in local government bonds in some way in future. According to a recent Xinhua article, local governments have had difficulty in issuing bonds as banks are reluctant to buy them at such low yields.1 To encourage the banks to replace current high yield local government debt – mainly in form of loans and LGFV bonds – with low yield local government bonds, the PBoC may need to provide banks with some compensation via RRR cuts or low interest rate re-loans, or some other creative arrangement. In particular, as the policy banks – such as the China Development Bank (CDB) – hold lots of local government debt, there could be some special arrangement between the PBoC and CDB in future to deal with a debt swap.

To sum up, we believe the PBoC will continue to ease monetary policy through RRR cuts, rate cuts and liquidity injections. But QE is not the correct term to describe the PBoC’s framework of monetary easing – because its balance sheet has never stopped expanding and will not suddenly jump due to asset buying like that of the Fed, ECB and the BOJ." 

- source Nomura

Indeed, as depicted by Professor Frank Dikotter  in an inaugural lecture given in 2003 and entitled "Patient Zero": China and the Myth of the "Opium Plague", is the growing "demonisation" of central banks intervention when it comes to assessing the "QE" factor such as the PBOC:

"Another problem which needs to be addressed is the demonisation of 'opium' into a single and uniform substance. The paste varied immensely in strength and quality, while many consumers were connoisseurs who could distinguish between a large variety of products, ranging from expensive red Persian opium to qualitatively poor local produce. Opium is an extremely complex compound containing sugars, gums, acids and proteins as well as dozens of alkaloids which varied in proportion and content. General statements about the purported effects of 'opium' are thus as vague as blanket condemnations of 'alcohol': a world of difference existed between weak homebrewed beers in medieval Europe and strong spirits in Victorian England, and both were used in radically different social contexts. Most of the imported paste from India and the locally cultivated opium in China had a very low morphine content, on average 3 or 4 per cent. On the other hand, the opium imported every year into England from Turkey in tens of thousands of tonnes was very rich in morphine, ranging from 10 to 15 per cent. Moreover, smoking was generally acknowledged to be more wasteful than ingestion, although the morphine content reached the bloodstream more quickly and caused a rush: 80-90 per cent of the active compound was lost from fumes which either escaped from the pipe or were exhaled unabsorbed by the smoker." - source Professor Frank Dikotter.

In similar fashion, China's current's monetary easing stance has a very low morphine content whereas the BOE, the FED, the BOJ and the ECB's QE have become highly addictive and are more akin to heroin than opium we think. As pointed out by Professor Frank Dikotter's lecture, opium was a medical panacea for many working people before modern synthetic medications became available in similar fashion "Ephedrine" is used a stimulant for the "ailing" Chinese economy by the PBOC.

• Final note: Dr Copper,  the metal with the economics Ph.D is still in a bear market

While Dr Copper, the metal with the economics Ph.D has seen a recent rally, as a final note this was merely driven by short covering as indicated by Bank of America Merrill Lynch's Global Metals Weekly note from the 1st of May entitled "Do you believe in the copper rally":

"Near-term strength, followed by weakness
We believe the immense weakness of copper prices in the first quarter was driven partially by flows, so was not entirely justified. As such, we kept an average 2Q15 forecast of $6,150/t ($2.79/lb). Considering more policy support by Chinese authorities and keeping in mind that demand usually strengthens seasonally after winter, prices may rally further through 2Q, a point we made in various notes. Yet, that rebound does not change our view that copper fundamentals are structurally challenged, with prices likely coming under renewed pressure in 2H15 and 2016 at the latest" - source Bank of America Merrill Lynch

Of course we agree as we are not "believers" in the copper rally.

"Religion is the opium of the masses."- Karl Marx

Stay tuned! 

Credit - Zugzwang

"I have with me two gods, Persuasion and Compulsion." - Themistocles

Watching with interest the escalating tensions between Greece and Germany while a payment was made in favor of "special creditor" IMF, we reminded ourselves, for this week's analogy in our chosen title of a situation called Zugzwang (German for "compulsion to move") found in chess and other games given Greek Finance minister Yanis Varoufakis is an expert in game theory. We found it of special interest because in German chess literature, one player is put at a disadvantage because he must make a move when he would prefer to pass and not to move. The fact that the player is compelled to move means that his position will become significantly weaker. The term is also used in combinatorial game theory, where it means that it directly changes the outcome of the game from a win to a loss. Positions with "zugzwang" occur fairly often in chess endgames, a topic we have discussed in a previous chess analogy surrounding European woes in our conversation "The Game of The Century" where we discussed at the time the great chess master abilities of German Chancellor Angela Merkel :

"By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...). Question being for us now, can Europe survive in the current form (number of countries) without making material sacrifices in true Bobby Fischer fashion? One has to wonder." - Macronomics, July 2012

As we indicated in our conversation "Eastern promises" on the 9th of June 2012, we think we are clearly approaching the end of the great European "chess" game and ultimately the only possible Nash equilibrium for Germany will be to defect:

"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

The ability to play these endgames well is a major factor distinguishing "masters" from "amateurs". In what was labeled "The Game of the Century" and in reference to our previous 2012 chosen title, Bobby Fischer 13 years old at the time, won the game against Donald Byrne, one of the leading American chess masters, by making material sacrifices at the time. 

On a side note and in continuation to our previous chess reference, the same Bobby Fischer used "Zugzwang" twice against Mark Taimanov in 1971 in the World Championships Candidates match. Mark Taimonov was crushed and lost 6 to zero to Bobby Fischer. The Soviet government was deeply embarrassed, and found it "unthinkable" that he could have lost the match so badly to an American without a "political explanation". In response, Soviet officials took away Taimanov's salary and no longer allowed him to travel overseas. The Soviet government later "forgave" Taimanov, and lifted the sanctions against him following Fischer's 6–0 later win the same year against Danish Bent Larsen known for his "unorthodox" style of play,  which paved the way for Bobby Fischer's achievement in reaching the first World Chess Federation (FIDE) number-one-ranked player. Bobby Fischer held the number one slot for 54 months. Maybe Greek Finance minister Yanis Varoufakis will suffer the same "orthodox" measures than Mark Taimanov, in the short term but we ramble again...

In this week's conversation we will look at France, as from our point of view, it continues to be for us as the new barometer for Euro Risk. We will also continue look at the US earnings picture, which appears to us more and more vulnerable to setbacks thanks to a rapid rising US dollar.

Synopsis:

• France appears to us as the weakest link in Europe at the moment
• Being "short" Euro is one of the most crowded trade
• Europe continues to be a "flow" driven market
• King Dollar even rules the Fed
• Final note "There is an anomaly in US share prices and UST yields"

• France appears to us as the weakest link in Europe at the moment

French politicians are benefiting from low rates on French debt issuance courtesy of on-going "japanification", but, on the economic and political front, France is showing increasing signs of growing stress as pointed out in our last conversation "China syndrome":

"Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term."

When it comes to complete credibility failure we have to agree with Louis Capital Market's Cross Asset Strategy note from the 9th of March entitled "Will China Resist America Pressure?" in relation to France's incapacity to reform:

"Last week In France we were amused to hear Pierre Moscovici of the European commission explaining to France that the economic policies implemented up to now were not of a satisfactory or adequate quality. The irony is not lost on us. Moscovici was still France’s Minister of Finance four months ago and a man in charge of deciding and implementing the country’s economic and budget policies. To see four months on telling his ex-boss that policies he most probably was involved in are inadequate is simply farcical.
Finance was promoted to head the world economic decision centre and to explain to countries what kind of reforms they should implement or what kind of macroeconomic policies they should run. In France, the nomination of Christine Lagarde as head of the IMF was seen as another farce.
It is striking to see these days the incapacity of France to adjust its economic policy, and in particular its fiscal policy. The charts below are impressive because they show that in Spain public expenditures have adjusted to the new economic reality of the country whilst in France, the public spending trajectory has not adjusted at all.

The chart below is crystal-clear: the pace of growth of public spending is intact! France and Germany are insistent upon the Greek government to maintain its previously defined fiscal consolidation objective. Yet, France has shown its incapacity to enter any fiscal consolidation. It is a shame to see the lack of effort on the expenditure side in France. However, this subject is of little importance, because confidence is so high in financial markets and because the ECB is financing states for free. The reality is that the ECB refuse to consider that they finance governments – however their actions give them away. With its government bond purchases, the ECB has ensured a low financing cost to investment grade countries, no matter what decision is taken on the budgetary front. The Germans were against QE, because they considered it to be an act similar to lending money for free without counterparties to secure risk. To put it simply their reasoning is true.

France will be the only important country in Europe to see a deterioration of its budget deficit in 2015 compared to 2013. It seems that the French government is betting on the economic recovery to get a cyclical rebound of its revenue that will prevent it from making the painful adjustment on the spending side. The opportunity for France clearly lies in its access to a very low financing cost for its public debt that – mechanically – will lower also its debt service in the budget.
Francois Hollande can send his thanks to Mr Draghi as the current context offers significant opportunities for France. French civil servants would have never accepted a decline in their remuneration as was seen in Southern Europe. These painful decisions have been avoided in France and the government is now ready to boast about the cyclical upswing France is enjoying. Such events leave us speechless." - source Louis Capital Markets

Of course the reason why French civil servants would have never accepted a decline in their remuneration is fairly simple to assess. It is the only support left to French president François Hollande! With only 25% of approval rate, there is indeed a large contingent of public servants still supporting the French president as they represent 22% of the working population versus 11% only in Germany. Please also note that 44% of the French National Assembly is made of public servants which explains the lack of "willingness" in implementing "structural reforms and only 3% of businessmen. In the UK you only find 9% of public servants in the House of Commons and 25% are businessmen. The big difference between the United Kingdom and France is that, in the United Kingdom, the particular problem of public servant eligibility was dealt with an absolute ban by the House of Commons Disqualification Act of 1975 and it was justified on the basis that civil servants should keep their political views a private matter. To do otherwise was deemed to impugn the neutrality of the British public service and its ability to serve government of whatever political persuasion. Civil servants therefore are required in the United Kingdom to resign before announcing their candidature. In France, put it simply, with their "bulletproof" status, they never lose, but, that's another matter...

On that particular point around the impossibility of major reforms, we read with interest Bank of America Merrill Lynch's note on France written by their European Economist Gilles Moec published on the 16th of March and entitled "France: doing more than it seems, but less than is needed":

"Tough fiscal and political equation
For this to be neutral for the fiscal balance, we think such a move should be offset by a reduction in public spending. Actually, Paris needs to do more than a mere offset, since the European institutions are still demanding a net fiscal tightening, in our view. This is where the political rigidities of the French centre-left kick in. Although the current administration has clearly embraced a reformist course, and is ready to confront its increasingly restive left wing minority in parliament, this imposes limits to the government’s room for manoeuvre. The administration needs to carefully choose its battles. The government can - and will - slow down spending, but changing the very structures of the public is out of reach in our view.
Cycle to help
Fortunately, a series of external factors are making the government’s job easier. The drop in oil prices will support consumer spending – which has already showed sign of recovery in the last few months. The decline in the exchange rate of the euro will be a major boost for growth, since the particular sensitivity of French exports to currency gyrations offset the low share of foreign trade in GDP. Still, while this should help keeping Paris on the right side of the European rules, we expect only peripheral progress on structural issues." source Bank of America Merrill Lynch

For the reasons stated above, we have to agree, changing the very structure in public spending is clearly out of reach. The game is not only locked but, it is rigged and the burden of taking France out of the proverbial doldrums has been put on the corporate sector. The issue of course is that the French corporate sector boasts a low and declining profitability thanks to important labor cost as indicated in Bank of America Merrill Lynch's note:

"Faced with low and declining profitability, firms have to choose between three solutions. First, run down headcounts and/or pay until the share of profits in value added is restored. Second, cut down on capital expenditure. Third, maintain headcounts/pay, and capex at the cost of higher debt. In the short run, the third solution is from a collective point of view the best one, since it is the only one which is consistent with some protection of aggregate demand (unless fiscal policy can offset the lack of private demand, at the cost of higher public debt), but obviously this is feasible only if interest rates are sufficiently low and banks have enough appetite to lend. Such option was not open in Spain for instance, where the initial level of corporate debt was high, interest rates were very high on account of the sovereign crisis and banks were not in position to lend. A “crash adjustment” of profitability was the only option (Chart 1)

Among the four largest economies of the Euro area, France is the only country where the investment rate of the non-financial corporate sector in 2008-2014 has exceeded the level of 1999-2007 (Table 2). 

Moreover, the investment effort exceeded gross saving, which is a broader measure of profitability, taking into account the impact of net interest and tax. In 2014, investment exceeded saving by 30% (from 11% in 1999-2007), while in Germany and Spain investment was lower than gross saving (in other words the corporate sector there is in a net lending position) and in Italy recourse to external funding fell (Table 3).

This reflects the resilience of the French banking sector throughout the crisis which was able to meet the demand for credit from the firms. Since Q1 2013, corporate debt as a percentage of corporate output has been is higher in France than in Spain (Chart 2). 

In Q3 2014, the ratio stands at 249% in France, very close to the peak level it had reached in Spain (251% in 2009).

This level of corporate debt is however much more sustainable in France than it ever was in Spain. While in the periphery market rates, and bank interest rates margins shot up during the crisis, imposing a major burden on firms when refinancing their debt, in France the banking sector consented to a major drop in lending rates, while the sovereign bond market was likely never seriously under attack (Chart 3). 

This means that, in spite of the significant increase in the stock of debt, net interest payments have been falling. In Q3 2014, net interests stood at only 4.2% of gross operating surplus, significantly below Spain (Chart 4).

Is there a "zombification risk"?
Still, this can’t be a sustainable growth model, for three reasons. First, even if with QE is ECB has become very credible on the “low for long” interest rates policy stance, interest rates cannot remain below equilibrium in France forever.

Second, companies cannot likely maintain a decent level of capex if their expected profitability does not recover at some point. Third, cheap credit can trigger a process of “zombification” of the corporate sector by keeping fundamentally unsound businesses alive, which down the road would damage growth potential by keeping resources skewed towards the least productive sectors.

In France the number of corporate bankruptcies never exceeded the 1993 peak. This contrasts with the explosion in corporate failures seen in Spain (Chart 5 and Chart 6). 

One could find comfort in the fact that the pace of business failure is in line with the position in the cycle, but this could be a case of reverse causality: the reason why the French output gap is not deeper could simply come from the fact that businesses are allowed to survive by an overly complacent banking sector.
However, since the French productivity performance has been decent lately - when compared with Germany - we think that the high survival rate of French companies has not yet impacted overall economic performance, but it's a risk for the future."  - source Bank of America Merrill Lynch

While the corporate sector has been clearly preserved compared to Spain from lower leverage and a lesser credit crunch, the corporate sector, in our views cannot continue to do the "heavy lifting" when public expenses continue to represent around 58% of GDP. Furthermore as it can be seen in Chart 2 from Bank of America Merrill Lynch, the French Corporate debt over corporate output has been steadily increasing and is now above Spain which has been rapidly deleveraging during the last few years.

The political issue of course is that in the incoming elections, the French socialist party is facing serious bashing and as we mentioned before, it's only support comes from the public sector employees as also underlined by Bank of America Merrill Lynch's note:

"This gradualist approach – which generates a pervasive sense in the foreign commentariat that “France is not doing anything” – reflects in our view the fact that i) the current administration campaigned in 2012 on a rejection of Sarkozy’s stance, seen as “too brutal” and ii) an increasingly restive traditionalist left wing of the socialist party imposes limits to the reforms.
Indeed, a peculiarity of the socialist party is that the core of its support does not come from the working class employed in the private sector (which has been increasingly deserting the left for the National Front) but public sector employees.

This puts a limit to how far the government can go in any structural overhaul of how the state operates, while the reformist turnaround of Hollande has created a wedge in the socialist party's parliamentary group.

The fairly limited deregulation offered by the “loi Macron” was forced through parliament thanks to the 49.3 procedure, which explicitly links the passing of a bill to the survival of the government. The left wing of the socialist party had no choice but to support the government on this, to avoid early elections in which they would probably have been wiped out.

The 49.3 procedure can be used only once in each parliamentary session (although the budget bill is excluded from this limit, which means that the government can almost certainly get a budget through). This means that the government must now choose its battles carefully" - source Bank of America Merrill Lynch

While the international scene is watching with caution the rise of the French National Front, the political story, we think is the slow dislocation of the unity of the left. Statistically speaking, what has been rising is more the number of non-voters (around 60%), rather than the "absolute" number of people voting for the National Front.

But, let's move back to France and its "micro-economic" picture. In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 13th of March points to a deterioration in the Terms of Payments, which indicates that the improving trend since mid 2012 has turned decisively negative:

The monthly question asked to French Corporate Treasurers is as follows:

Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their March survey have reported an increase by corporate treasurers. Overall +17.9% of corporate treasurers reported an increase compared to the previous month (+13.9%), bringing it back to the level reached in October 2014 (17.9%). The record in 2008 was 40%.

Overall, according to the same monthly survey from the AFTE, large French corporate treasurers indicated that they are still facing an increase in delays in getting paid by their clients. It is therefore not a surprise to see that the overall cash position of French Corporate Treasurers which had been on an improving trend since 2011 has now turned more negative overall according to the survey:

The monthly question asked to French Corporate Treasurers is as follows:

"Is your overall cash position compared to last month falling, remains stable or rising?"

Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's provisional figure came at -8.5%. 

This warrants significant monitoring in the coming months we think from a "corporate monitoring health" perspective.

• Being "short" Euro is one of the most crowded trade

According to Nomura's FX Positioning Index from the 13th of March, short Euro positioning is still close to record high of November but, looks like it close to stabilising: 

"EUR positioning was little changed the week ended Tuesday, falling just $0.1bn. Since then, specs have sold a further $1.7bn. Positioning is estimated currently at -$25.9bn which is still shy of the lows from November (-$28.1bn) and February (-$28.2bn)."

 - source Nomura

The very significant rapid depreciation of the Euro in conjunction with record low yields are for us clearly signs of the on-going "japanification" process at play in Europe and validates our deflationary bias. But, in terms of risk reversal for the Euro, there could be a pause depending on the FOMC outcome we think.   

In terms of bond yields as well we are getting closer to some floor in Europe (except for Greece...). On that specific "bond" matter we agree with Louis Capital Markets take:

"We have been OW bonds for a while, but would be back to a neutral position because the upside/downside likelihood appears more balanced now. As Mr Weidmann from the ECB said, if the implementation of QE by the ECB is a success, nominal bond yields will increase in the end. This is indeed our conviction and the charts below explain the reasons why.

The green line above should creep higher as inflation expectations normalise. Indeed, the above chart on the right shows that current real yields (extracted from long term inflation linked bonds) are extremely low in Europe (well below the level reached by US inflation linked bonds during QE3). There should, therefore, be a limit to the downside of real rates in Europe which in the end implies a limit to the downside of nominal bond yields in Europe.

We would also like to add to what Mr Weidmann said that if QE is successful, bonds yields should rise AND the euro should stabilise or rise.
This is the contradiction that is emerging these days among investors: if investors continue to be short on the euro, they cannot continue buying European equities, because if the euro continues to decline it will reflect the failure of QE and will validate a deflationary scenario for Europe.
Therefore, the next phase is to see the stabilisation of the euro to validate the recovery of the growth expectations in Europe." - source Louis Capital Markets

When it comes to the success of QE in Europe, as we have stated before, QE without additional policies is bound to fail. 

While from a flow perspective we believe in short term stabilization of the Euro, we agree that the continuation of the decline of the Euro will indeed ultimately reflect the failure of QE and the deflationary scenario playing out in Europe à la Japan.

• Europe continues to be a "flow" driven market

As far as European equities are concerned, it is indeed a flow driven market which has seen strong foreign investments, particularly by Japanese investors as indicated by Nomura in their JPY Intraday Comment from the 12th of March entitled "Strong foreign equity buying continues":

"Strong foreign equity buying continues
Japanese investors continued to purchase foreign assets at a high pace last week.
They bought JPY356bn ($3.0bn) of foreign equities, for the sixteenth week in a row, while purchasing JPY270bn ($2.3bn) of foreign bonds, for the seventh consecutive week (Figure 1).

Foreign equity investment flows remain strong, with net purchases of over
JPY1trn per month (Figure 2). 

Japanese investors purchased JPY1384bn ($11.5bn) of foreign equities in February, more than JPY1trn for the third consecutive month . The record pace of Japanese investment in foreign equities continues so far in March. Pension funds and retail investors were two major net buyers of foreign equities recently, and we expect them to remain strong net buyers of foreign equities as public pension funds shift their portfolios from JGBs and better economic conditions support risk sentiment among retail investors. Strong foreign equity investment by Japanese investors should support USD/JPY this year.

Foreign bond investment has also been relatively strong, while February’s MOFdata showed that banks were major buyers of foreign bonds. Their foreign bond investment likely involved smaller FX transactions than other investor types. Pension funds and toshin companies were also likely small net buyers of foreign bonds, while life insurance companies may still be quiet ahead of fiscal year-end. Life insurance companies sold foreign bonds in February for the first time in two months, albeit a small amount." - source Nomura

The Ides of March...or when Japanese investors are "Zugzwang" (compelled to invest) before the end of the fiscal year (31st of March).

According to Nomura's report,  there was net buying of JPY31bn (USD255mn) in foreign currency denominated toshins on 10 March, according to NRI, the 56th consecutive business day of net purchases. We continue to closely look at Japanese flows when it comes to their European appetite.

• King Dollar even rules the Fed

Meanwhile the USD crowd remains near record high according to Nomura's FX Positioning Index from the 13th of March:

"According to the IMM data for the week ended March 10, non-commercial accounts increased their USD longs by $3.9bn. Our real time indicator suggests net longs increased by a further $1.2bn since. Net longs stood at $52.8bn by Tuesday and had increased to $54.0bn by Friday’s close, just shy of the all-time high of $55.6bn set the second week of January." 

- source Nomura

We do not believe in a June hike by the Fed and are adamant the Fed will remain rather dovish in the light of recent data disappointments regardless of the strong NFP data recently released. We are therefore content with our current long duration exposure which we added on recently.

On that point we agree with Nomura's latest take from their 13th of March note entitled "Fed - behind the curve or just right?":

"Cross Rates View
The start of the ECB bond-buying spree this week resulted in a further push to historical low yields in Germany, with Bunds breaking through the 20 bps barrier. Almost like clockwork, the UST auctions went over well as the overall EU curve flattening helped reverse the NFP-led selloff. Heading into FOMC next week, it will be another meeting in which they guide the market’s expectations that hiking will happen only when all factors give them enough confidence to do so later this year. The market has had a tendency recently to go into FOMC/Minutes expecting a hawkish event only to be let down. We think the recent reaction to such Fed events will be repeated next week, with the market adding to hedges ahead of time and unwinding them during the presser." - source Nomura

King Dollar: One currency to rule them all, even the Fed!

"Pace: Faster hikes should be self-restrained by an increasingly stronger USD

So far the pricing for a June hike has been a lot more uncertain compared with the 2004 cycle (Fig. 5),  and the Fed’s hiking pace is even more difficult to pinpoint—it should be anything but the well-telegraphed 25bp per meeting schedule we saw back in 2004. 

One key driver this time around is the total dichotomy of global monetary policy, wherein the Fed is about to embark on a hiking path, while the second-largest economic bloc, i.e., the Eurozone, has just started its easing program, while the BoJ is still in QQE. As a result, the FX adjustment is going to have a much more pronounced impact (Fig. 6) on both the financial markets and the U.S. economy. 

We are already seeing equity markets under a bit of pressure as the stronger dollar eats into corporate profits, especially given the heavy weighting of multinationals in the broader indices. As the effects of a stronger dollar trickle down to worsening trade and softer inflation prints, we expect the Fed to be very gentle, as a faster hike pace will have a compounded effect via FX tightening."

Terminal Rate – Higher debt loads call for a terminal rate much lower than before

The business cycle/equity rally is long in the tooth; and with other central banks easing while taper and the dollar act as tightening forces, the terminal rate will end up lower than in the past. The Fed has been ratcheting down terminal expectations (from 4.25% to 3.75%), but we believe that in the upcoming meetings it will avoid lowering this as much as the other dots. Instead we see it focusing more on lowering the dots in 2015 and 2016, because it doesn’t want to admit defeat just yet. Meanwhile, our Economics Team believes the terminal level will be closer to 3% when the Fed finishes tightening in this cycle, largely due to the dollar, as noted above (see link). We stated that the Fed will be lucky to get to 2-2.5% when all is said and done, largely because ratcheting up aggregate demand while performing debt deleveraging requires years of low real rates." - source Nomura

Exactly!
The large global debt overhang requires much smoother maneuvering from the Fed thanks to King Dollar although the Fed feels it needs "Zugzwang" due to latest employment data.

On the dichotomy between Economists' perception and consumers' reality we completely agree with Reorient Group David Goldman's take in their note from the 15th of March entitled "It's all about the dollar...even for the Fed":

"The fact is that consumer behavior with respect to gasoline purchases is not much different than with respect to other items in the consumption basket. The chart below shows year-on-year change in nominal purchases of all goods (excluding food services) and gasoline. The two lines have the identical shape; the only difference is that the absolute change in gasoline sales is much greater, reflecting the volatility of the gasoline price. Evidently American consumers do not feel as confident about the employment outlook as the economists. We observed last week that most of the new jobs created during the employment bounce of the past three months were in low-wage, labor-intensive industries (health care, hospitality, and retail), which explains why wage growth has been absent.

We have never been enthusiastic about quantitative easing: the drag on the US economy is regulatory and fiscal rather than monetary, and the Federal Reserve has had the unenviable task of promoting growth against these headwinds. But the prevailing view at the Fed that an economic rebound justifies higher rates—seemingly among the whole Board of Governors except for Chair Janet Yellen—is inconsistent with the data. The bond market has remained skeptical. The present 10-year Treasury yield of just over 2% reflects lower inflation expectations, consistent with falling commodities prices, and a modestly higher “real” rate (the yield on inflation-indexed securities)." - source Reorient Group, David Goldman

While the Board of Governors of the Fed might feel the "Zugzwang" urge, we remind ourselves that the fact that these players feel compelled to move means that their position will ultimately become significantly weaker. If their head prevails, at the FOMC, they will remain on hold and delay hiking interest rates in June until further data validates the "Zugzwang" we think.

• Final note "There is an anomaly in US share prices and UST yields"

Like many pundits, we believe the velocity of the rise in King Dollar represents a significant headwind for US corporate earnings and yet another important factor for the eager to trigger "Zugzwang" Fed. In that instance we read with interest Nomura's Japan Navigator comments from the 16th of March. US corporate earnings in April will be essential to watch!

"Concerns over US corporate earnings reports in April
Since last summer, we have been pointing out the anomaly in US share prices and UST yields that appeared at the start of the quarter, which remains in place (Figure 3). 

 This anomaly is: 1) overvalued stock prices correct before earnings season starts, which has been typical in recent quarters; and, 2) The Fed conducts policy based on its communications with the market, and adjusts its hawkishness depending on stock market conditions, which also drives movements in rates markets. Currently, the impact from strong USD on corporate earnings is a key theme, which should increase investor concerns over earnings announcements.

We believe the Fed will remove the “patient” wording in its next statement, but this alone is unlikely to change rate hike expectations. However, as this would means the Fed is maintaining its hawkish stance, investor risk sentiment should then deteriorate into next month’s corporate earnings reports.
Given this, it is worth considering a risk scenario in which the Fed sends an unexpectedly dovish message at its next meeting. While this would likely prompt bond yields to fall, risk sentiment could improve, laying the groundwork for higher share prices and bond yields in April-June.
In either case, this would not trigger the next upturn in yields, unless US economic indicators surprise on the upside." - source Nomura

So "bad news" (rate hike) could end up being good news for US Long bond holders like ourselves (holding pattern). After all that's exactly what we pointed out in the first bullet point of our conversation "Information cascade":

"Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently." - source Macronomics, 8th of March 2015

"What makes zugzwang such a painful death is that the deceased is executed not by a threat but by his own suicide" - Andrew Eden Soltis, American chess grandmaster.

Stay tuned!

Guest post - Consequences of a US Budget Balance Improvement

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley 

Please find below a great guest post from our good friends at Rcube Global Macro Asset Management. In this post our friends go through the consequences of a US Budget Balance Improvement.

The US budget deficit which has already shrunk at a pace never seen over the last 50 years is likely to shrink even more going forward given the ongoing republican fight for more spending cuts. This trend is likely to have some consequences on financial markets. We have selected 4 investment themes that we think, should materialize as a consequence.

• Rising volatility
• Consumer discretionary stocks underperformance
• EM assets underperformance
• Widening US long end swap spreads

The dollar is the reserve currency of the world, hence when the US runs a budget deficit it increases the amount of dollars in circulation, and provides the world with liquidity. When its financing needs shrink like it has been the case since 2010, global liquidity is reduced. This has ALWAYS created or exacerbated some kind of crisis around the world when it happened (Lat Am in the mid 80s, Asia in the late 90s followed by the tech bubble in 2000, the great recession in 2007).

Will it be different this time? QE has provided a necessary buffer to the liquidity shock that the sharp budget balance improvement has created. When QE ends, and if in the meantime spending cuts have intensified (budget ceiling debate) the pain will start being felt.

• Equity volatility has probably bottomed.

The pace of the deficit reduction is historical. it has shrunk by more than 6% of GDP over the last 3 years. In the past, this has pushed equity volatility upward systematically. Less liquidity means higher volatility, it is as simple as that as the chart below shows.

In previous cycles the trigger for the volatility to spike was bank lending behavior. So far no signs of the cycle being less supportive but there are hints that banks could become less accommodative going forward. Nevertheless this time, the trigger should be around the time investors will price the end of QE.

Another way to look at it is through the strong historical link between the fiscal cycle and corporate profit margins. As the chart below shows, corporate profits have followed the budget deficit momentum closely (with a lag) over the last 40 years. Fiscal gifts have in a way subsidized non]financial corporate profits. It is thus illusory and naive to believe that the ongoing war in Washington over spending cuts wonft have any impact on profits over time.

Earnings growth has also logically been correlated to the budget balance cycle.

The IMF just released global financial stability report highlights the recent rise in corporate leverage which on many counts now exceeds 2007 extremes.

As a result, the IMF baseline scenario for US HY default is to rise to about 10% by 2015. Clearly not priced in by investors at the moment...

Thus it will be particularly interesting to watch the Senior Loan Officer Survey Q3 results early November for clues about bank lending behavior. Both the rise in the financing gap and corporate leverage hint that banks could become slightly less accommodative going forward.

Our US Lending Standard model based on both the financing gap and non-financial corporate leverage suggests so.

• Consumer discretionary stocks should underperform.

The sector has been the main beneficiary of the fiscal cycle. Now that it has clearly turn, and that republicans will fight for more fiscal austerity, headwinds for the sector are clearly rising. Fiscal largeness or austerity impacts logically ones propensity to spend on discretionary items. As a consequence the relative performance of the sector can be explained by the fiscal cycle.

The urgency of its implementation came from another explanatory driver: interest rates. The spike in

mortgages and short term forward rates, creates further headwinds to an over loved, over owned, and overpriced sector.

Interestingly the same story holds in Europe. The luxury sector has underperformed its benchmark recently by more than 12%. LVMH earnings miss is we think another clear signal that developed markets consumer discretionary equities are set to underperform going forward. Fiscal tightening in developed countries combined with lower growth in Emerging markets are strong headwinds.

• Emerging market assets will underperform.

Emerging market assets have shown a remarkable negative correlation with the US financing needs. Since proper data began for EM equities, their relative performance versus developed markets has been strongly explained by the US budget balance.

The US budget went from 0 in early 1980 down to a deficit of 5% of GDP in the early 1990s, EM equities enjoyed simultaneously a powerful relative bull market. During the Clinton years, and the US boom, the deficit turned into a surplus of 2.6% in 2000, EM stocks crashed on a relative basis. From 2000 until early 2010 the budget balance nose-dived, and turned into a deficit of 10% of GDP. EM equities which were in the early 2000s extremely cheap on top, outperformed DM equities by close to 300%. Since then, the 6% shrinkage of the deficit has left EM equities underperforming by 35%. During that phase the underperformance was realized with a flat equity market. The MSCI EM is at the same level it was trading at in late 2009. We fear the next phase will see EM equities underperforming in a bear market.

Additionally, as we have mentioned more recently, we believe that China’s massive investment and property bubble is also at risk of rolling over. Private sector credit can’t rise at 40% of GDP every year for ever.

So, emerging markets could be hit from both sides. First by the liquidity withdrawal that the budget deficit reduction and the end of QE imply, second by the coming weakening investment cycle in China. Countries running a budget and current account deficit, together with a large export (to China) GDP ratio are at a particular risk here.

IBM results were we think very interesting; their sales in China were down 20% yoy. 20% is a big number. LVMH painted a similar message the day before. Caterpillar earnings next week will be another interesting read.

• US Long end swap spreads will widen

Long end swap spreads are a function of relative financing needs between the private and the public 

sector. At this time, the private sector is re-leveraging through increased shares buybacks, dividend 

payments and Capex spendings, while the public sector deleverages. This classic inverse relationship 

implies just like it did in the late 1990s that long end US swap spreads will widen from current levels.

"The consequences of an act affect the probability of its occurring again." -

B. F. Skinner 

Stay tuned!