Macro and Credit - The Money Illusion

"The greatest obstacle to discovery is not ignorance - it is the illusion of knowledge." -  Daniel J. Boorstin, American historian

Looking at the most recent print in US nonfarm payrolls in conjunction with stronger than expected 2.9% wage growth (AHE) in August, with US Annual core-CPI declining to 2.2% in August vs 2.4% expected, leading to a tentative rebound in gold prices, when it came to selecting our title analogy we decided to steer towards a reference to the seminal work done by Irving Fisher in 1928 in his book "The Money Illusion". In economics, the money illusion is also referred as price illusion. It is the tendency for people to think of currency in nominal, rather than real terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value) at a previous point in the general price level (in the past). The term "Money Illusion" was coined by maverick economist Irving Fisher in his book "Stabilizing the Dollar" though it was popularized by John Maynard Keynes in the early twentieth century. Irving Fisher was the first economist to produce what is now called "The Fisher equation" in financial mathematics and economics which estimates the relationship between nominal and real interest rates under inflation. The existence of money illusion is disputed by monetary economists who contend that people act rationally (i.e. think in real prices) with regard to their wealth. Eldar Shafir, Peter A. Diamond, and Amos Tversky (1997) have provided empirical evidence for the existence of the effect and it has been shown to affect behaviour in a variety of experimental and real-world situations in three main ways:

• Price stickiness. Money illusion has been proposed as one reason why nominal prices are slow to change even where inflation has caused real prices or costs to rise.
• Contracts and laws are not indexed to inflation as frequently as one would rationally expect.
• Social discourse, in formal media and more generally, reflects some confusion about real and nominal value.

Apparently "The Money Illusion" influences people's perceptions of outcomes. Experiments were conducted and have shown that people generally perceive an approximate 2% cut in nominal income with no change in monetary value as being unfair, but do see a 2% rise in nominal income as fair where there is 4% inflation, despite them being almost rational equivalents. This result is consistent with the "Myopic Loss Aversion theory" but this will probably be an interesting title for another post. The "Money Illusion" is indeed a cognitive bias which can vary depending on the "inflationary/deflationary" context. Numerous studies have documented a negative correlation between nominal yields and inflation. Modigliani and Cohn (1979) assumes that the valuations of the assets differ from their fundamental values because of two inflation-induced errors in judgment: the tendency to capitalise equity earnings at the nominal rate instead of at the real rate, and the inability to understand that, over time, the debts will devalue in real terms. What does it means? Simply that stock prices are overvalued during periods of low inflation. If indeed inflation accelerates, this will lead to some "repricing" and some reversion to the mean. For a bear market to ensue as we have repeated on numerous occasions on this very blog, you need inflation to "accelerate". Past history has shown, what matters is the "velocity" of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. So, if QE could be seen as "deflationary" then QT could be seen as "inflationary". If the "money illusion" is "fading" and real wages starts accelerating, then the Fed will have no other choice but to pursue a more aggressive hiking pace. Of course if "inflation" is accelerating in conjunction with real wages, then again this will trigger "Bracket creep" being the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation for those who remember our post from January this year:

"Most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple." - source Macronomics, January 2018

Yet another illustration of the existence of the "Money illusion" we think but we ramble again...

In this week's conversation, we would like to look at rising inflation creating therefore a shift in the "Money illusion" and what it entails down the line from a liquidity perspective.

Synopsis:

• Macro and Credit - The Money illusion is fading
• Final charts - Always remember that liquidity is a coward

• Macro - The Money illusion is fading

As we indicated back in June 2015 in our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation. Also in our January conversation "Bracket creep" we indicated the following:

"As pointed out by Christopher Cole from Artemis Capital in his must read note "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. But flow wise, as we have pointed out in numerous conversations, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" so far." - source Macronomics, January 2018

While the latest inflation figure for August is considered as a miss, the Fed has most recently appeared much more hawkish it seems. The big question therefore should be about the strength of inflation. Subdued real wage growth could be one of the reasons put forward for the surprise election of Donald Trump in the United States. The election could be marking a return of Main Street versus Wall Street which has experienced tremendous asset inflations thanks to low volatility and low "perceived" inflation. Yet it seems to us from a "macro" perspective that, indeed the "Money Illusion" is now fading on the back of "QT". 

Is inflation returning? On that subject we read with interest Wells Fargo Economics note from the 12th of September entitled "Inflation not as benign as first indicated by drop in PPI":

"Producer prices came in softer than expected in August, falling 0.1%. The miss stemmed largely from the volatile trade-services sector, which measures margins. The underlying trend in inflation continues to inch higher.

At the Margin

• PPI inflation unexpectedly slipped 0.1% in August. Goods prices were flat, but the miss came in large part from services, specifically a 0.9% drop in the volatile trade-services sector, which measures margins, not selling prices. Declining margins at machinery and equipment firms accounted for 80% of the decline in services this month and suggest producers may be struggling to pass on rising input costs related to recent tariffs.

Core Inflation Continues to Gradually Climb

• Our preferred measure of core inflation, which excludes food, energy and trade services, also came in a bit softer than expected –up 0.1%— as transportation & warehousing prices fell. The trend remains upward, however, with the “core-core” measure climbing to 2.9% over the past 12 months versus 1.9% the 12 months prior.
• Input prices eased a bit in August, but are still running ahead of final prices. Pressure on margins therefore looks to continue.

- source Wells Fargo

Additional escalation in the trade war would as we pointed out in various conversations put additional pressure on inflationary trends and on the US consumer we think. The question on everyone's mind is how are we shifting into a new inflationary state meaning that the "Money illusion" is finally fading?

On this subject we read with interest Bank of America Merrill Lynch's take from their Inflation Strategist note from the 13th of September entitled "Signs of life":

"The old normal shows signs of life

• Globalisation delivers a fall in price level masquerading as deflation. Both secular and cyclical deflation forces are fading.
• We update our long list of determinants of the low real rate era. Bernanke's "global savings glut" obviously has a place.

The three big picture inflation supports

Cyclical, secular and survivorship

We can be critical of the different ways output gaps are calculated, the numbers themselves and their usefulness as a single measure for encapsulating spare capacity in economies. Nevertheless, the reduction/elimination of slack that they signal, apart from being encouraging in its own right, should help towards resolving the question over how much of the “lowflation” experienced has been cyclical and how much secular.

Even when it comes to secular, long term trends, these shouldn’t necessarily be misconstrued as meaning a permanent shift to a new inflationary state. Whether it be the deflationary influence of globalization or the internet, to the extent that this means greater competition (so reduced pricing power), then it does perhaps reduce inflationary potential “permanently”.

However, in a shift from closed economies to open economies (globalization) or from weaker price discovery to stronger price discovery (the internet), a large part of the impact on prices is a one-off adjustment in the level not a permanent reduction in the inflation rate. It just looks like the latter because it doesn’t happen all at once. Inflation should firm if the pace of globalization slows.

Chart 2 suggests globalization is at least experiencing a pause. It shows the extraordinary shift in the openness of the global economy since the 60s but a leveling off in the trade share of GDP in recent years. And, as Governor Carney of the BoE has warned, “deglobalization” (an ugly word for an ugly concept) would threaten a meaningful build-up of inflation pressures.

Perhaps the last line of defense for inflation, as measured, is “survivorship bias”. If economies open up to trade with each other, production gravitates to their respective comparative advantages and (in principle) output is boosted and prices fall. In advanced economies, we have become used to falling goods prices. But, as Chart 3 illustrates simply, if goods prices fall and services prices rise steadily over time, then the overall inflation rate will rise because the index weighting for goods will fall, unless the relative price change prompts a consumption shift from services to goods.

Whether it be this “survivorship bias” or the tendency of economies to consume proportionately more services as they advance (and as their populations age), Chart 4 shows the mild but meaningful shift from goods to services in CPI baskets. 

We suggest that perceptions of r*, the neutral real policy rate consistent with growth at trend and inflation at target, have been framed by the experience of a prolonged period of economic slack and an even longer period of globalization. The impacts of both on inflation are probably fading and the real policy rate required to keep inflation pressures in check will likely rise gradually to a considerably higher level than currently priced.

Real rate drivers - the usual suspects

It is worth periodically rounding up the “usual suspects” cited as causes of the low real rate world we have been in. Here we list suggestions from a variety of sources and throw in a few of our own. We do not claim that it is exhaustive and readers would no doubt add and subtract from what we have below.

Thinking in terms of potential longer-dated real rates drivers – those shifting the supply and demand for savings and investment – it is perhaps useful to split them into those drivers that might have shifted the savings curve and those that might have shifted the investments curve.

Most items we list are self-explanatory and we do not want to go over well-trodden ground in a lot of detail before getting to our main contentions. However, some of the drivers we identify should actually be broken-down into arrays of sub-drivers. In particular, we suggest that there are many facets to the apparent change in capital/labour preference that has subdued capital investment, so we carve out a sublist for that driver.

Causes of investment curve shift to the left?

• The long shadow of the crisis – reduced expected real returns, greater uncertainty over those expected returns or greater risk aversion to that uncertainty
• A decline in innovation, reducing opportunities
• The cost of equity capital has fallen, but nothing like as much as the risk free rate.
• Falling prices of investment goods (and inelastic demand).
• Capital/labour substitution – replacing the former with the latter.

Causes of savings curve shift to the right?

• The “Global Savings Glut” (GSG), especially imported savings from reserve accumulators.
• Demographics – a falling dependency ratio. Workers can save more because they are supporting fewer dependents.
• Precautionary savings accumulated because of crisis.
• Rising inequality raising the average propensity to save."  - source Bank of America Merrill Lynch

We would like to add a couple of comments to the above  relating to the GSG theory put forward by former Fed president Ben Bernanke relating the reasons for the Great Financial Crisis (GFC). Once again we would like to quote our February 2016 conversation "The disappearance of MS München" on this subject:

"The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "The financial cycle and macroeconomics: What have we learnt?": 
"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012

Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research.

Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before." - source Macronomics, February 2016

Indeed, conflating financing and savings is the main issue when it comes to the GSG theory. From a "Wicksellian" perspective, one would argue that low rates for too long leads to mis-allocation of capital. For instance if one looks at CAPEX expenditures in US High Yield since 1997, one can see in the chart below from Bank of America Merrill Lynch that prior to the onset of the GFC, capital raised through bond issuance went into more leverage thanks to a buying spree with Acquisitions/LBOs. Of course a feature of a late credit cycle does lead to seeing more LBOs and acquisitions:

- graphs source Bank of America Merrill Lynch

As we pointed out in our October 2017 long conversation relating  to inflation entitled "Who's Afraid of the Big Bad Wolf?", we had over-inflation of asset prices and too low inflation thanks to the "Money Illusion". The Fed, subdued inflation expectations and inflation with its various QE iterations. We indicated at the time:

"Credit cycles die because too much debt has been raised

When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are still fairly loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion" - source Macronomics, October 2017

Financial conditions remain very loose and with the fiscal boost coming from the Trump administration, no wonder the Fed is becoming more hawkish. You have been warned. 

But returning to real rate drivers, Bank of America Merrill Lynch in their note highlight what has mattered most for the "Money illusion" to take place:

"What has mattered most?

Over the past ten years, bond market participants would almost certainly cite risk-free bond buying by central bank reserve accumulators and the duration extinguished by quantitative easing, mitigating the impact of heavy government bond supply as the crisis lifted debt/GDP levels.

However, real rates were already in long-term decline well before the crisis. Taking a longer time frame, a Bank of England Working Paper by Lukasz Rachel and Thomas D. Smith (No. 571, “Secular drivers of the global real interest rate”, December 2015) claimed to be able to account for 400 of the 450 basis point fall in long term real interest rates over the preceding thirty years.

Exhibit 1, clipped from their paper, suggests that the global savings glut has only had a small walk-on part in the unfolding real rate drama.

In their analysis, the big four drivers were: lower growth, demographics, an increase in the spreads between risk-free real rates and the real rates experienced in the real economy (including, for instance, the real cost of equity finance), and the falling relative price of capital. For this last to be a driver of lower real rates one must assume that demand for capital goods is price-inelastic.

They concluded that: “most of these forces look set to persist and some may even build further. This suggests that the global neutral rate may remain low and perhaps settle at (or slightly below) 1% in the medium to long run.” In their forecasts, they see demographics delivering most of this increase, as the Exhibit shows. Chart 6 shows how this relates to an end to the downtrend in the world dependency ratio, with upswings well underway in advanced economies.

Later, we will discuss the interaction between risk-aversion, driving the “spreads” component in the Exhibit, and the global savings glut, in order to contend that this can be a force for a bigger upward adjustment in real rates in the future.

The replacement of capital with labour has many aspects

As before, we will list what we see as potential causes of this phenomenon, rather than discuss them in any detail. They should be self-explanatory. We would also stress that the ordering should not be regarded as signalling an attempt to rank them in order of importance.

Drivers of the trend shift from capital to labour

• Increasing labour market flexibility
• A global “labour supply glut”, resulting from:

o A falling dependency ratio
o Globalisation
o A post-crisis workforce that needed to re-skill and price itself back
into work

• A change in firms’ perceived capital-labour risk/cost efficient frontier since the crisis
• Capital intensive goods production has been driven out of advanced economies (their comparative advantage being in services)
• Production reflects consumption. Advanced economies consume fewer goods and more (labour intensive) services
• As a result of the above, the modern advanced economy business is capital-light

Ben Bernanke memorably used the term “global savings glut” to describe excess savings circling the world in pursuit of a return. Admittedly, the world saving rate was a little higher in 2005 (when he coined the term) than now but the overall increase in the world savings rate over time has not been great, while that for the OECD has seen a gentle decline.

The glut that is generally understood to have exerted downward pressure on nominal and real yields refers to the savings recycled from surplus countries to deficit countries as large current account imbalances emerged.

However, there are reasons to be a little uncomfortable with that seemingly axiomatic received wisdom without further elaboration. To the extent that current account surpluses represent the excess savings of countries, there are equal and opposite savings shortfalls in current account deficit countries (notably the US and UK).

Conventional wisdom used to have it that countries with persistent current account deficits needed to pay higher prospective returns to attract and retain foreign capital. Investors have a natural preference for domestic assets, so need to be paid a premium for accepting foreign market risk. Therefore, without any change in global saving, an increase in imbalances would be expected to depress real yields in surplus economies but raise them in economies with savings shortfalls.

Conventional wisdom upended

If the above framework is accepted, then a mild increase in the global saving rate accompanied by the development of large global imbalances would have exerted a downward “income effect” on real yields but an upward “substitution effect” on real yields in economies on the negative side of the global imbalances identity. The net impact on real yields in the US (with the greatest need for imported savings) would have been ambiguous. What has upended this logic has been the change in the risk preferences of the exporters of savings.

When an economy is “self-sufficient” in savings, domestic savers have diverse risk appetites; they invest across the risk spectrum. And when an economy does have a savings shortfall but is financed by foreign private capital, risk appetite also tends to be diverse (FDI, equity portfolio acquisition, etc). Up until the late 90s, this was the norm.

So our contention is that the rise of the reserve accumulators, in pursuit of risk-free government paper, crowded-out risk appetite. The substitution effect became one of increasing risk-free investment appetite surpluses and risk-taking appetite shortfalls. Therefore the nature and sign of the substitution changed.

Chart 9 shows the IMF’s presentation of these global imbalances.

In Chart 10, we regroup and simplify the picture. By unifying European creditors and debtors (which appear above and below the zero line in the IMF layout) we change the outline of the picture a bit.

However, the main thing highlighted by Chart 10 is the surplus share recorded by China and the oil exporters up until the last few years. It’s a major oversimplification, obviously, but these are perhaps the most conspicuous reserve accumulators pursuing risk-free external assets.

But that era appears to be over, insofar as we accept IMF forecasts for the development of imbalances. The present and near future of imbalances looks simpler than the past – Europe will be financing the US.

The flows will be private capital, not public reserves, so have the potential to restore the old regime where a US savings shortfall delivers higher not lower risk-free real rates. This also suggests that even though the spread between US and Euro real rates has widened significantly, there’s more to come.

Was the equity risk premium a casualty of this risk appetite shift?

The BoE working paper discussed earlier discussed widening “spreads” as an important driver of low real rates. No doubt the crisis was a major contributor to a gapping wider in the equity risk premium and a shifting preference towards government bonds will reflect other things, like the aging of the average saver. However, we would suggest that if global imbalances have extinguished risk appetite in the way we have described, then this also played a big part in the late-90s bond-equity “correlation flip” shown in Chart 11 and the widening gap between bond and equity earnings yields.

In this context, the post-millennium US experience of debt-financed equity buybacks (widely pilloried as “short-termism” and “financial alchemy” looks, more objectively, to be a rational response to a dramatic increase in the relative cost of equity finance. It’s been about giving investors what they want.

New normal looking more like old normal than we thought

In this note we have discussed very big picture influences that are likely evolving very slowly. However, the underlying messages seem clear. A closing of the global output gap appears to be coinciding with a waning in the deflationary influence of globalisation, resulting in firming global inflation, or at least a higher r* to keep inflation in check. This would be aggravated if globalisation is actually in retreat.

That a global savings glut depressed risk-free real rates is universally accepted but perhaps the bigger global real yield depressant from global imbalances was the extinguishing of risk appetite – “bad” savings driving out “good” savings. The global imbalances are still with us but the composition is changing in a way that should restore risk appetite and lift US real yields, both outright and (especially) relative to European." - source Bank of America Merrill Lynch

We disagree on the above a GSG was not the reason risk-free rates were depressed, no offense to Bank of America Merrill Lynch but we would rather side with the wise wizards at the BIS than with the reckless wizards such as Ben Bernanke at the Fed and others.

Before we move on to our final charts regarding the "liquidity illusion", we would like to quote the wise words of Irving Fisher from his 1928 book:

"We may now summarize our findings
1. The problem of what to do about our unstable money is one of prime importance
2. It has been all but overlooked because of the Money Illusion
3. This Illusion is the more serious because every man finds it harder to free his mind of this Illusion as to the money of his own country than of foreign money.
4. This Money Illusion so distorts our view that commodities may seem to be rising or falling when they are substantially stationary, wages may seem to be rising when they are really falling, profits may seem to exist when they are really losses, interest may be believed to be rewarding thrift when no real interest exists, income may seem to be steady when it is unsteady, bond investments may seem to be safe when they are merely a speculation in gold. It makes a unit of weight appear to be a unit of value; it hides a chief cause of the so-called business cycle; it has enabled political financiers to employ unsound finance with burdens heavier but with complaints less than if sound finance had been employed; it has led to unjust blame of "profiteers" and of the "money lenders"; and above all it has held back stabilization by concealing the need of it.
5. The present fixity of weight of our dollar is a very poor substitute for a fixity of value or buying power.
6. By actual index number measurement our dollar rose nearly four fold and fell back to the starting point again between 1865 and 1920.
7. Most of the dollar's fluctuations were while the dollar was a gold dollar (1879-1922).
8. They were largely peace time fluctuations; most of them occurred while America was at peace (1879-1898, 1899-1917, and 1918-1922), and much of them when there were no important wars elsewhere (1879-1914 and 1918-1922).
9. These fluctuations through serious shrink into insignificance in comparison with the thousand-fold, million fold, billion-fold, and trillion-fold fluctuations in Europe.
10. The cause of a falling or rising dollar is monetary inflation or deflation and that , in practice, it is seldom or never necessary to specify that the inflation or deflation is merely relative since it is also absolute as well.
11. To go back to the cause of inflation or deflation, the extreme variability of money is chiefly man-made, due to governmental finance, especially war finance, as well as to banking policies and legislation; but also due in part to discoveries or exhaustion in gold mines, and changes in metallurgical art.
12. The tremendous fluctuations of money produce tremendous harm analogous to what would result if our physical yardstick were constantly stretching and shrinking but far greater

• a. because the money yardstick is used so much more generally
• b. because it is so much more used in time contracts, because stretching and shrinking are unseen.

13. This harm includes a constant robbery of Peter to pay Paul - amounting to sixty billion dollars in six years in the United States alone - a net loss to all Peters and Pauls taken together, confusion and uncertainty in all financial, commercial and industrial relations, constituting much what is called the business cycle, producing depression, bankruptcy, unemployment, labor discontent, strikes, lockouts, class feeling, perverted legislation, Bolshevism and violence. In short the harm is threefold: social injustice, discontent and inefficiency." - source Irving Fisher, The Money Illusion.

He also added that credit control must always be an important part of any program for stabilization. This is leading us to our final charts relating to the "liquidity illusion" in credit markets.

• Final charts - Always remember that liquidity is a coward

As a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately. In our February 2016 conversation "The disappearance of MS München" on this subject we quoted Dr Jochen Felsenheimer and Philip Gisdakis from their 2008 book Credit Crises:

"Asset price inflation in general, is not a phenomenon which is limited to one specific market but rather has a global impact. However, there are some specific developments in certain segments of the market, as specific segments are more vulnerable against overshooting than others. Therefore, a strong decline in asset prices effects on all risky asset classes due to the reduction of liquidity.
This is a very important finding, as it explains the mechanism behind a global crisis. Spillover effects are liquidity-driven and liquidity is a global phenomenon. Against the background of the ongoing integration of the financial markets, spillover effects are inescapable, even in the case there is no fundamental link between specific market segments. How can we explain decoupling between asset classes during financial crises? During the subprime turmoil in 2007, equity markets held up pretty well, although credit markets go hit hard." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

Our final charts come from Bank of America Merrill Lynch's Credit Market Liquidity report from the 12th of September and highlights the "buy-side" versus the "sell-side" imbalance after the GFC and seems to be on every credit investors mind these days, rightly so:

"The ECB has been tapering its QE programme, and asset purchases will finish by the end of this year. Credit market liquidity is becoming more challenging with market participants seeing fewer bids when they need them. We think that when bond market liquidity becomes more challenging, the CDS market is the vehicle to manage risk. Bond trading frequencies have slowed down over the past years; trading volumes in the CDS market are rising rapidly, both in the index and the options market.
The “buy-side” vs. “sell-side” imbalance is the largest it has ever been. In a world of growing buy-side assets but lower street liquidity, sharp corrections are more common. Dealer inventories of corporate bonds are clearly way down on where they were in ’07, but banks also appear more nimble in managing their mark-to-market risks and overall exposures on their securities portfolios.

The CSPP has dominated the European credit market in recent years. The ECB has bought more than €167bn of euro-denominated corporate debt (and this is still growing, albeit slowly). The CSPP has been pivotal in improving the credit market’s strength and resilience. But we can see a shift in market liquidity for the worst in recent months amid rising markets volatility.

Liquidity has been challenging according to the findings of our analysis, and credit investors seem to think that it will deteriorate as the buyer of last resort withdraws and they will be the only buyers left in the market (chart 3).

With inflows drying up and possibly continuing to do so as the rates cycle between US and Europe pushes money out of the latter, liquidity will likely become more challenging (more here).

The trend of selling in secondary to participate on primary is the new norm as inflows have stopped. If macro deteriorates further and investors need to replenish their cash balances to cover weaker fund flows technicals, the bid for bonds would weaken more, we think. No wonder that the key concern for credit investors is that “market liquidity evaporates”; the August 2018 survey reading was the highest since H2 2015 heading into the February 2016 sell-off and amid HY market weakness (on the back of a flare-up in the Greek debt saga, EM risks and oil prices tanking).

Our liquidity indicator at the most distressed levels

Arguably it is difficult to quantify liquidity. So many metrics (bid/offer, turnover, volumes and trade counts), but none of these have the ability to measure “illiquidity aversion” and to what extent risk-aversion has dominated the market. We think the volatility market is providing unique and eye opening insight on the current state of the “illiquidity scare” for market participants.

In our Hold your breath for a bumpy ride note, we highlighted an interesting and rather unique phenomenon that recently emerged in the European credit index options market. Amid significant volatility during the Italian BTP sell-off, we have seen an increase in hedging demand. As a result implied vols have moved well above the levels justified by the underlying spread market. But not only that, as not only have vols underperformed (moved more than) the underlying market, but implied vol skews were heavily bid too, steepening to the highest levels we have seen historically (chart 4).

We think we could gain significant insight on risk aversion from examining the correlation between the forward moves of the implied vol skew (payer vs. receiver implied vol differential) vs. the preceded moves in the underlying implied vol market. In simple terms, the higher the correlation the stronger the need for tail hedging going forward post a vol shock in credit. Currently we find that the level of positive correlation (steepening of implied vol skew, post a rise in implied vols) is the highest we have ever seen, according to our data.

In our opinion this clearly reflects the high levels of risk aversion and illiquidity fear during the recent sell-off. It seems that investors hit the “panic” button harder than at any other time in history. A continuation of outflows, a weak macro and declining market liquidity could ultimately push too many investors to the exit." - source Bank of America Merrill Lynch

It seems that some credit investors are getting wary about the "liquidity illusion" in credit markets and some are already lining up for the exit as no one wants to really pick up the tab of the very large credit punch bowl offered by our "generous gamblers" aka our dear central bankers but we ramble again as we are not there yet and equities continue to surge oblivious to the on-going shift in the "Money Illusion". Oh well...

 “Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

Stay tuned ! 

Greece - Cognitive Restructuring

"Economic depression cannot be cured by legislative action or executive pronouncement. Economic wounds must be healed by the action of the cells of the economic body - the producers and consumers themselves." - Herbert Hoover

Like any good cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. We have been therefore watching with interest the Greek saga and it's "Schedule Chicken" redux:

"The practice of schedule chicken often results in contagious schedules slips due to the inner team dependencies and is difficult to identify and resolve, as it is in the best interest of each team not to be the first bearer of bad news. The psychological drivers underlining the "Schedule Chicken" behavior are related to the Hawk-Dove or Snowdrift model of conflict used by players in game theory." - source Wikipedia.

It is therefore not a surprise that, given our fondness for behavioral analogies, we decided this week to use as our title analogy "Cognitive Restructuring" with the on-going Greek debt odyssey taken by its new hero, Greek Finance Minister Yanis Varoufakis to alleviate Greece's €315bn Damocles sword. 

When it comes to our title, as a tongue in cheek to debt restructuring, it refers firstly to a psychotherapeutic process of learning to identify and dispute irrational or maladaptive thoughts known as cognitive distortions, such as "all-or-nothing" thinking (splitting), magical thinking, filtering, over-generalization, magnification, and emotional reasoning, which are commonly associated with many mental health disorders according to Wikipedia. Our title is even more appropriate when one realizes that  "Cognitive Restructuring" is used to help individuals experiencing a variety of psychiatric conditions, including "depression", substance abuse disorders (debt), anxiety disorders collectively, bulimia (more debt), social phobia, borderline personality disorder, attention deficit hyperactivity disorder (ADHD), and gambling, just to name a few.

In this week's conversation, we will visit Greece issues from an historical perspective and look at solutions as well for the long term.

Synopsis:

• Greece: a story of "unfinished business"
• Redistribution without efficient taxation cannot work on the long run
• How do you deal with a Mezzogiorno country like Greece?
• Will a GREXIT solve Greeks' woes?
• Keynesian solution to counter the fall in aggregate demand even with QE will fail

• Greece: a story of "unfinished business"

The on-going Greek Tragedy and its "Cognitive Restructuring is from an historical point of view a question of "unfinished business", in the creation of a modern state. On that subject we recommend reading "The Greek State: Its Past and Future" - An interview with Anastassios Anastassiadis from March 2012:

"Greece’s budget deficit and debt started growing rapidly in the eighties. At first, devaluations of the drachma and inflation softened the blow, but they were also bad for that Greek “frugality” that I mentioned a moment ago. In the second half of the 1990s, control of public finances was only ephemeral, and was quickly set aside by the euphoria elicited by the pharaoh-like projects that were planned for the 2004 Olympics. Furthermore, upon entering the euro, the Greek economy benefited from broad access to cheap credit. Within barely twenty years, frugality had given way to consumption, leading to a heavy dependence on credit. The Greeks borrowed from their banks, which borrowed from French and German banks. Why? To buy French and German goods." - Anastassios Anastassiadis.

On the subject of Greece, we read with interest the following comment from a reader of the Economist article "What emergency liquidity assistance means":

"Syriza seems determined to generate a payments crisis in Greece.
They have pledged (this weekend) extra spending:
- rehiring over 10,000 redundant civil servants
- increased pensions for lower income pensioners
- various schemes for providing free utilities & food to low income households
They have pledged (this weekend) to cut taxes:
- tax-free threshold for income increased to €12,000 (above median wage)
They have proposed no areas for spending cuts or raising tax revenue (beyond vague notions of tackling tax avoidance; some hopes that a higher minimum wage might boost tax revenue; alongside wishful consideration of fiscal multipliers and Laffer effects).
Against that background (a Greek payments crisis seems pretty certain, irrespective of whatever credit conditions Europe offers Greece), we should also recognize that a Greek begging bowl is offensive to the many poorer countries in the eurozone (Portugal, Slovakia, Slovenia, Estonia, Latvia, Lithuania).
Note:
- Greece has a basic state pension of €400/ month (which will be €5,200/ year when Syriza reintroduce the "13th month payment"), but most Greeks receive much more than this (state pension increases based on earnings). That is far more generous than, say, Lithuania's €236/ month (flat) state pension (only 12 months - they can count). Why should Lithuania pay for Greek profligacy? Compare public sector wage levels, government transparency, court performance, corruption, etc and there are many good reasons for most eurozone countries to grudge lending Greece a cent more than they already have.
If Syriza wants to rescue this, then they are going to have to come forward:
1) with sensible cashflow (revenue, expenditure) projections, and with proposed policy adjustments (moving forward) for accommodating any surprises. There must be a high degree of confidence that Greece can function without additional borrowing, without triggering a payments crisis in the near future.
2) with a credible programme of structural reforms, e.g. disempowering the oligarchs, taxing the church, forming a land registry and progressively taxing land, reforming courts, slashing military budgets, investing in education and R&D, making it *easy & quick* to register a business online and to begin doing business (without obtrusive or protracted licensing requirements), etc.
3) with a credible pledge to (by 2016) run a small primary fiscal surplus (perhaps a 1-2% of GDP target) and some domestic mechanism (auditing, legal review, etc) for generally pursuing this target (with some flex, but without bias towards deficit)

These three points are the absolute minimum - without these three points, there can be no further credit provisions for the Greek state. Syriza must somehow be brought to recognize this - based on their remarks over the past couple of days, they seem determined to default on pensions & wages, bankrupt the banks, wipe out business and broadly destroy the Greek economy entirely."

• Redistribution without efficient taxation cannot work on the long run:

We agree with the above analysis from a reader from The Economist and we reminded ourselves what we wrote back in August 2011 in our conversation "Liquidity? The IV Greek Credit Therapy":

"One thing Greece must address is tax cheats who represents 30 billion euros, or 12 per cent of GDP, every year. Another American solution to European woes would be, for Greece, to tax its citizens on their worldwide income, similar to the US. It would be a very efficient way to stabilise its ailing banking system and deposit outflows given one third of its funds withdrawn have gone abroad for fear of a crackdown on tax evasion. By imposing Greek citizens on their worldwide income like US citizens, and with the help of Luxembourg authorities, Cyprus, Switzerland and the United Kingdom, the outflow could be stemmed and vital tax receipts could rapidly help close the gap on the very acute budget deficit, but that's another story..."

There is nothing new about the Greek situation and the errors that have been made by its creditors, French and German banks initially (before being bailed out by European taxpayers) as written by French great writer Edmond About in 1858 as reported in Vox Europe in their article of February 2012 "Greece 1858 – plus ça change":

"Loans are only granted to governments that are well established. Loans are only granted to governments that are believed to honest enough to honour their commitments, and loans are only granted to governments that lenders want to maintain in office. Nowhere in the world does the opposition lend to the government. Finally, lenders can only grant loans when they have the necessary funds themselves." - Edmond About

But the issue with Greece, when it comes to "Cognitive Restructuring" and focusing on the process rather than the content (as any good behavioral psychologist would do), is the "unfinished creation" of a proper Greek state we would argue. It was further debilitated by the introduction of the Euro .It led the government access cheap credit and mis-allocation of European subsidies, mixed with corruption of the government, who used European funds to boost public spending on a grand scale. This "mis-allocation" of "capital" (funded by European banks) led to prices rising to inappropriate levels due to the inappropriate level of salaries in the increasing cohorts of public servants hired:

"The Greek system nonetheless suffered from three serious shortcomings: finances that were generated primarily by indirect consumption taxes; haphazard enforcement, which gave some professional groups better salaries simply because of their superior negotiating powers; and, finally, the use of public-sector employment and of advantages granted on the basis of “social criteria” as a cheap way of providing social insurance." - Anastassios Anastassiadis

Of course a fiscal policy based mostly on consumption taxes and the lack of a proper land registry (even after Europe poured €100 million euros for this specific purpose) meant that as soon as "austerity" measures were put in place by the Troika, revenues collapsed and misery increased on a grand scale. 

• How do you deal with a Mezzogiorno country like Greece?

As clearly highlighted by Dr Dambisa Moyo, in her book "Dead Aid" relating to the $1 trillion in development-related aid transferred to Africa, we believe Greek Finance Minister Yanis Varoufakis is right in the need for a sort of New-Deal for Greece.

Without the mis-allocation of a large part of European subsidies, sunk into Greece, and the completion of a Greek state there would not be such a difficult debt problem in the first place. Direct investments in infrastructures which human capital benefits from as well as productive capital, is the strategy currently followed by China, for instance in Africa. This is as well a subject tackled by Dr Dambisa Moyo in her most recent book "Winner take all".

• Will a GREXIT solve Greeks' woes?

Without "Cognitive Restructuring" and dealing with the "unfinished business" of creating a proper state with efficient records and taxation, Greece's exit from the Euro with a devaluation and a return to the Drachma, will not bring an end to its misery. This is clearly shown by Dr Constantin Gurdgiev's post from the 30th of January 2012 entitled "Fake Doctors Treating Fake Disease in Greece":

"There are many 'expert' voices in the media saying Greece should exit the Euro zone in order to return to growth. This, as I commented earlier today, is a gross oversimplification of the reality.
There is simply no evidence whatsoever that Greece can grow on its own any faster or more sustainably than it did within the Euro. In fact, the evidence presented below shows that the only period during the last 30 years in which Greece was able to somewhat marginally close the gap in growth between itself and the Advanced Economies group is the period immediately following its accession to the Euro.
It is a fallacy of 'alternative expectations' to believe Greece will be enabled to grow its economy under post-euro devaluation beyond achieving a 1-2 years-long 'bounce'. Analysts who expect Greece to recover on the back of exiting the euro & devaluing are deluding themselves for two major reasons:
1.Greece has no fundamentals for growth & its debt overhang will remain, unless it defaults hard. Even with a default, removing debt overhang is not going to deliver growth to Greece beyond simple mechanical post-depression bounce, as Greece lacks all fundamentals for growth - institutional, cultural and historical.
2.However, with a hard default option, post-Euro, Greece will not be able to borrow & absent Government spending Greece has no capacity to grow. This is clearly shown in the charts below which highlight that in 23 out of the last 29 years, Greece has managed to achieve growth only with accompanying fiscal imbalances.
In summary, Greece never once had any fundamentals to grow on its own without massive subsidies either via loose monetary policy or overinflated expectations relating to the country accession to the European common structures. Greece is not about to get real growth-driving fundamentals within or outside the euro area.
 In short, all those talking about 'Greece must exit euro zone to achieve growth' are nothing more than fake doctors treating a patient who himself is faking a disease. Greece's problem is not the Euro. It's problem is Greece itself." - Dr Constantin Gurdgiev - True Economics blog

There is no good decision for Greece between Grexit or No Grexit. Regardless of the path it chooses, the lack of completion of its state is the only way to put an end to the misery of its people.

• Keynesian solution to counter the fall in aggregate demand even with QE will fail

We already touched on debt deflation in our August 2011 conversation "AAA ratings - 10 little indians...and debt deflation (why Irving Fisher is right)":

"For Keynesians, the fall in aggregate demand caused by falling private debt can be compensated by growth in public debt, a government credit bubble. It isn't working."

When it comes to Greece in particular and Europe in general we reminded ourselves of the wise words as well of our good credit friend in 2012:

"When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.
But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.
This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

We keep reminding ourselves that credit dynamic is based on Growth. No growth or weak growth can lead to defaults and deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels.

The only way to make the marginal-utility-of-debt go positive, is to decrease the debt load back to a level where the private sector can produce more than its interest payments.

In Europe without debt mutualisation and fiscal transfers on a grand scale, deflation will not be avoided, QE or not.

From our August 2011, we indicated at the time that Irving Fisher's Forward Year Tax Receipts was indeed an interesting solution for the debt deflation situation plaguing the world (with the US in mind given the efficiency of the IRS and the fact that US citizens are taxed on their worldwide income):

"Recognizing that the federal government issues liabilities (debt) in its own currency and thus can never go bankrupt, another solution is for the federal government to become more like the corporate capital markets with debt issuance at high real interest rates and equity like issuance at even higher real rates of appreciation. The likely candidate for equity like issuance by the federal government is forward year tax receipts. A forward year tax receipt is a receipt for taxes paid in advance that are due some time in the future. Like government debt issuance, forward year tax receipts have a rate of appreciation and a duration. Unlike, government debt, the rate of return is not guaranteed. The realized rate of return is totally dependent on the owner's future income and subsequent tax liability. And so savers are rewarded with a positive real rate of return and debtors can realize an after tax cost of credit that is significantly less. For instance if the federal government sells 30 year debt with a 3% real rate of return and sells forward year tax receipts with a potential 7% real rate of return, then a debtor can realize a -4% cost of credit. At that point inflation is not required nor should it be desired." - source Debt deflation

Unfortunately, with most of the world implementing ZIRP, there will be no happy ending this time around rest assured:

"If you want to raise real GDP, you raise the real interest rate on government debt (which the federal reserve controls) and / or you lower the tax rate. This works well enough until you run a huge trade imbalance (like with China) that suppresses real interest rates or if you have a great depression type scenario where the inflation rate is severely negative (massive deflation). In the massive deflation scenario real GDP may show growth while nominal GDP would show contraction.
The way to get around both scenarios is to sell forward year tax receipts. A forward year tax receipt lowers the after tax cost of credit in the private sector while not depriving the bondholder of income (Friedman's permanent income hypothesis). This is the problem with monetary policy as it stands now. In a true great depression massive deflation type scenario even tax cuts don't have any traction because if nominal interest rates are 0, lowering the tax rate would have no effect on either money velocity or GDP." - source Debt deflation

On a final note we give you a revised Schedule Chicken" redux:

• "Wednesday February 11th – Likely t-bill auction to cover EUR 1.4bn maturity on 13th 
• Wednesday February 11th - potential emergency Eurogroup 
• Thursday February 12th – European Council of EU Leaders, Tsipras likely to meet Merkel on sidelines 
• Friday February 13th – Voting for new Greek President begins, EC Commissioner Avramopoulos most likely candidate, originating from New Democracy. Likely completed by second round on the following day requiring 151 MP majority
• Monday February 16th – Eurogroup where Greece likely to be top of agenda, conditions for extension of program to be made explicit by now 
• Wednesday February 18th-19th- - Bi-weekly ELA review Saturday February 28th – Current EFSF program expires" - source Deutsche Bank

As well as Greece debt profile as displayed in a recent CITI report:

- source CITI

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

Stay tuned! 

Credit - 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.

While watching with bemusement, or disbelief the "Yield famine" central banks induced rally turning to a credit feeding frenzy, and looking at a dealer's bond run on our Bloomberg on Ford company with no offer, but bid only, we could not resist but use again an aeronautical analogy in our title in similar fashion to our previous post "Bold Banking" where we stated:

"When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate. When one looks at the fragile state of the "House of cards" and the "boldness" of credit investors dipping their toes, once again in very risky credit structures such as CLOs made up more and more with Cov-lite loans, we think our title, and our analogy to the crash of "Czar 52" is this time around very appropriate, but once again our thoughts keep wandering."

As we indicated at the time, the demise of "Czar 52" on the 24th of June 1994 also called the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick" like our bold bankers.

This week's analogy refer to what is called by pilots the "Coffin corner" also called the "Q Corner", which was responsible for the accident of Air France Flight 447 in 2009 over the Atlantic Ocean when the three experienced Airbus A330 pilots were unable to recognize they were operating at a too high angle of attack to sustain flight:

"The coffin corner (or Q corner) is the altitude at or near which a fast fixed-wing aircraft's stall speed is equal to the critical Mach number, at a given gross weight and G-force loading. At this altitude the airplane becomes nearly impossible to keep in stable flight. Since the stall speed is the minimum speed required to maintain level flight, any reduction in speed will cause the airplane to stall and lose altitude." - source Wikipedia

Consequences:

"When an aircraft slows to below its stall speed, it is unable to generate enough lift in order to cancel out the forces that act on the aircraft (such as weight and centripetal force). This will cause the aircraft to drop in altitude. The drop in altitude may cause the pilot to increase the angle of attack (the pilot pulls on the stick), because normally increasing the angle of attack (pulling up) puts the aircraft in a climb. When the wing however exceeds its critical angle of attack, an increase in angle of attack (pulling up) will lead to a loss of lift and a further loss of airspeed (the wing "stalls"). The reason why the wing "stalls" when it exceeds its critical angle of attack is that the airflow over the top of the wing separates.

When the airplane exceeds its critical Mach number (such as during stall prevention or recovery), then drag increases or Mach tuck occurs, which can cause the aircraft to upset, lose control, and lose altitude. In either case, as the airplane falls, it could gain speed and then structural failure could occur, typically due to excessive g forces during the pullout phase of the recovery.

As an airplane approaches its coffin corner, the margin between stall speed and critical Mach number becomes smaller and smaller. Small changes could put one wing or the other above or below the limits. For instance, a turn causes the inner wing to have a lower airspeed, and the outer wing, a higher airspeed. The aircraft could exceed both limits at once. Or, turbulence could cause the airspeed to change suddenly, to beyond the limits. Some aircraft, such as the Lockheed U-2, routinely operate in the "coffin corner", which demands great skill from their pilots."  - source Wikipedia

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. On another note, movie buffs like us will remember the 1983 epic movie "The Right Stuff" depicting at one point Colonel Chuck Yeager crashing his NF-104 Lockheed Starfighter on the 4th of December 1963 (also known as the Widow maker, interestingly the same nickname as the  famous short Japanese JGB trade).

So how did Chuck Yeager encountered the "Coffin Corner" in his "Widow maker"? Why did this legendary test pilot crash?

"The flight data from Chuck’s last two flights, including the accident proved there was not a single system failure on either his first flight that day or during the entire accident flight.  The data was undamaged in the accident, due to the low impact falling in a flat spin, with virtually no fuel on board and no resulting fire in the airplane.  The aircraft had performed flawlessly!

The facts are clear.  Chuck Yeager proved incapable of doing the job.  He was totally outside his element.  He was a natural pilot who had learned by experience and feel, but never really understood stability, just ‘sensed’ how airplanes would act, but aerodynamics and space dynamics are night and day.  If he was to fail, I expected it to be outside the aerodynamics region.

But not even that can excuse his accident, which was his fault, alone and was an error of bad pilot technique during normal, aerodynamic flight.  His shortcoming was inability to gain and maintain the 70 degree climb angle.  That required strict and delicate airplane control.  No more and no less.

 His failure to do that made the space flight moot.  He made the mistake, not once but on each of his four zooms, exaggerated on each until his accident was inevitable long before he departed his familiar flying region. His failing started at the moment he began a 3½ g pull up to the required 70 degree climb.  He never once made his immediate angle close to 70 degrees thus losing so much energy that he could not fly high enough to stay out of trouble.  Worse yet, he repeatedly started climb at a lower angle, then pulled the nose up later losing energy even faster and making the situation far more critical.  He needed time outside the atmosphere to use the reaction controls to nose over and he denied himself that time with poor piloting in his element of expertise, aerial flight.

In effect, what he did was climb far too shallow and then pulled up very steep in aerodynamic flight to a hammerhead stall, which in any F-104 meant an irrecoverable pitch-up and likely spin." - source NF104.com

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...

In relation to Quantitative Easing program, our "bold" pilots/central bankers should really check the "structural" soundness of their "confident" policies given that in similar fashion to QEs the F-104 "Widow maker" series all had a very high wing loading (made even higher when carrying external stores), which demanded that sufficient airspeed be maintained at all times...Even Erich Hartmann, the world's top-scoring fighter ace, who commanded one of Germany's first jet fighter-equipped squadrons deemed the F-104 to be an unsafe aircraft with poor handling characteristics for aerial combat. To the dismay of his superiors, Hartmann judged the fighter unfit for Luftwaffe use even before its introduction. 

Maybe it is the reason why the German ace bankers from the Bundesbank are reluctant to retaliate with more QE in Europe, to the dismay of Mario Draghi at the ECB. 

The Class A mishap rate (write off) of the F-104 in USAF service was 26.7 accidents per 100,000 flight hours as of June 1977, (30.63 through the end of 2007), the highest accident rate of any USAF Century Series fighter. Some international operators lost a large proportion of their aircraft through accidents, although the accident rate varied widely depending on the user and operating conditions; the German Air Force lost about 30% of aircraft in accidents over its operating career, and Canada lost over 50% of its F-104s.

Overconfident pilots? Or poor structural design? You decide, but we ramble again.

So this week we will look again at the "unintended consequences of our "bold pilots".

The recent meteoric rise in the Japanese Yen, the Nikkei index and the receding pressure on Itraxx Japan credit spreads courtesy of Abenomics is validating we think, this week's aeronautical analogy - graph source Bloomberg:

Looking at Japan's consumer price index falling 0.9% in March from a year earlier, we do think Japan is indeed pushing towards the "Coffin corner":"The relationship of stall speed to critical Mach narrows at high altitudes, to a point where any sudden increases in angle of attack or roll rate and disturbances, such as clear-air turbulence, can lead to a stall." - source AINonline - Understanding High-altitude Aerodynamics Is Critical

Moving back to our Lockheed Starfighter reference, at extremely high angles of attack the F-104 was known to "pitch-up" and enter a spin, which in most cases was impossible to recover from. We think QEs  like the F-104 are very sensitive to control input, and extremely unforgiving of pilot error. No wonder another nickname for the plane was the Flying Coffin.

When it comes to Japan, the decade-high volatility in Japanese government bond debt induced by Bank of Japan Governor Haruhiko Kuroda, similar to Chuck Yeager's flying antics in the NF-104 Starfighter may have the unwelcomed effect of weakening bond prices and therefore undermine economic-growth goals, that  famous Q, in MV=PQ. Excess volatility, or "pull-up" for a Japanese plane can be seen, we think in the rise in JGBs volatility - source Bloomberg:

"The CHART OF THE DAY shows that the pace of swings in 10- year Japanese government bonds, known as JGBs, surged to levels not seen in more than 10 years, according to a gauge known as historic volatility. The measure, which represents the annualized standard deviation of price changes for a specific time period, surged amid swings in yields that came after the central bank increased monthly bond buying to 7.5 trillion yen ($76 billion) to reach a 2 percent inflation goal." - source Bloomberg.

In the case of Japan in general and JGBs in particular, another indicator we have been closely following has been the 30 year Swiss bond yields versus the Japan 30 year bond yields throughout 2012 until the recent "Big in Japan" bang moment following the Bank of Japan "all in" move - source Bloomberg:

As one can see for the above chart, it hasn't been really "plain flying" to say the least recently with the absolute spread widening from near zero to -54 bps again.

As far as the Nikkei is concerned versus Emerging Markets (MSCI EM), our Japanese Chuck Yeagers have really been pushing the envelope - source Bloomberg:

Push the envelope meaning:
"To attempt to extend the current limits of performance. To innovate, or go beyond commonly accepted boundaries."
This phrase came into general use following the publication Tom Wolfe's book about the space programme - The Right Stuff, 1979:
"One of the phrases that kept running through the conversation was ‘pushing the outside of the envelope’... [That] seemed to be the great challenge and satisfaction of flight test."
In aviation and aeronautics the term 'flight envelope' had been in use since WWII, as here from the Journal of the Royal Aeronautical Society, 1944:
"The best known of the envelope cases is the 'flight envelope', which is in general use in this country and in the United States... The ‘flight envelope’ covers all probable conditions of symmetrical maneuvering flight."

So good luck to our Japanese pilot Kuroda. We wonder if this latest surge in QE wars does not amount to a "Kamikaze" approach in dealing with deflation.

Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think.

As we posited on a number of conversation, the difference in the United States PMI and Europe's PMI and the growth outlook is purely a question of credit conditions - PMI US vs Europe (top graph) and US Leverage Loans versus European Leverage Loans (bottom graph) - source Bloomberg:

Any similarities are purely fortuitous? We think not...The S&P/LSTA U.S. Leveraged Loan 100 Index was little changed at 98.49 cents on the dollar. The measure, which tracks the 100 largest dollar-denominated first-lien leveraged loans, has gained 2.6% this year. What's the latest US GDP growth figure? 2.5%.

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (our case for Europe...). 

And, when we look at credit growth for non financial corporates in Europe, the picture cannot be clearer than this:

The absolute level of core European government yields has been falling even more with the anticipation of a 25 bps rate cut next week in conjunction with the expectations of unconventional measures which should be taken by the ECB to restore, somewhat the credit transmission mechanism to the real economy, which has been so absent as of late - source Bloomberg:

Both Italian and Spanish government yields are closed to the level they had back in 2010.

But, the new record set up by the Spanish unemployment rate moving at 27.2% in conjunction with Spanish minister Mariano Rajoy seeking a two year extension to tackle its soaring budget deficit to cut its current 10.6% shortfall towards the European limit of 3% by 2016 instead of 2014 is interesting for us for a very simple reason which ties up nicely with this week analogy, namely the non-linearity of public deficits when growth is either absent or very weak. A violent reaction of budget deficits to a loss of economic growth, in similar fashion to a high altitude stall can be very simply explained by a sudden and continuous rise in unemployment levels.

"Past-due loans in Spain have fallen to 161 billion euros ($210 billion) from a high of more than 191 billion euros in November 2012, according to the Bank of Spain, helped by transfers to a `bad bank,' reforms, increased provisions and write-offs. March's estimate-busting surge in unemployment will likely endanger this trend by further pressuring asset quality at both a corporate and retail level." - source Bloomberg

The case for Spain is interesting, but looking at the alarming rise in unemployment levels in France, at 3.2 million, the highest level since 1997 and an 11.5% annual increase , France looks increasingly close to the "coffin corner" we can argue. In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk".

As indicated by a recent note from Natixis on France and the non-linearity of deficits, when growth falls strongly (like in 1975, 1993 and 2009), the budget deficit is important, in particular when growth has stalled for two consecutive years. They indicated that if GDP growth falls by 2 points, the budget deficit, due to its non-linearity feature, rises not by 0.88 points of GDP in the case of France but by 1.32 points of GDP. So when the French Minister of Economy and Finance Mr. Moscovici targets 3.7% of budget deficit for 2013 with 0.1% of positive growth, we think he is seriously deluded given we think GDP growth for France will be between -0.5% to -1% in 2013.

France unemployment level versus Germany - source Bloomberg:

Meanwhile in the credit space the ""spring-loaded bar mousetrap" continues to be coiled. For instance on the 23rd of April in the US credit space the market has witnessed the lowest yield ever recorded (2.21%) out of more than 3000 observations spanning 12 years of iBoxx history.

We could not agree more with Societe General recent credit comment:

"Not quite speechless, but we're out of superlatives. The iBoxx junk index yield is at a record low of 6.19%, IG at a record low of 2.21%; returns YTD at 3.38% and 1.51% respectively - and it doesn't feel overheated. 

Annoyed at the poor liquidity? Frustrated at the level of the market and the low levels of supply? Well, we're going to have to get used to it. We're resigned to going tighter, all-in yields will likely go lower while secondary market accommodation of a trade will remain the exception rather than the rule. An exaggeration perhaps, but the point is made. It's not all about throwing in the towel - well, maybe it is - but performance will come from embracing risk. We think it is also about recognising that policy is forcing us to take higher risk on further massive (potential) manipulation of yields, while new marginal buyers emerge to take assets out of the market. If it has yield attached to it, there's pretty much a bid. The more nervous February and March months seem very far away now. Into the weakening eurozone economy, risks of corporate bond downgrades will be ignored for the foreseeable future; while the addition of risk assets outside of our comfort zone will be a necessity, but hopefully a measured investment in most cases. The recent data (PMIs, for example) paint a bleak picture with downside risks to the eurozone's Q2 GDP growth story. Much more of the same (as is likely) and the ECB might cut soon enough; and while the lower interest rate might have little direct impact on valuations, the sentiment behind it will matter more. Additionally, the use of non-conventional tools could lead to a new marginal buyer of credit risk - and this would heighten investor frustrations substantially. After all, we're waiting for the Japanese to put their buying boots on as well. If these buying cares eventually materialise - well, scary. And the way equities and fixed income assets are moving - higher in tandem into the bleak economic outlook - suggests that the market is expecting its next fix from further central bank policy response. There is some room for immediate disappointment, but it will come, and not too far down the road. There's no point in fighting it; instead embrace it, make yieldier assets your friend - single name event risk permitting. There will be a pull-back at some stage, but the feared structural unwind of credit positions isn't likely to be coming any time soon." - source Societe Generale.

And, like our credit friends, we keep dancing, but close to the door, knowing well enough, at some point the music will stop, and given the poor liquidity in the secondary space, the feeding frenzy on any new issues coming to the market, even with a miserable yield (Nestlé 7 year bond at mid-swaps +25 bps), when it will, it will no doubt be messy, like a NF104 Lockheed Starfighter falling from the sky.

But until then enjoy the liquidity party as indicated by Bank of America Merrill Lynch in their recent note from the 25th of April entitled "Great Divergences and Yogi Berra:

"The liquidity party continues: best performing asset in the past week = Italian equities; past month = Greek government bonds; YTD = Japanese equities.

“When you come to a fork in the road, take it.”

The financial markets are currently riddled with divergences and contradictions. High debt, low growth; record high stocks, record low bond yields; a bull market in US and Japanese real estate stocks; a bear market in Chinese real estate stocks. The Great Divergences are best explained by the war between deflationary debt fundamentals and aggressive reflationary policies. Real estate and banks remain the best barometer of policy success." - source Bank of America Merrill Lynch.

Could the below picture be the picture of the "Coffin Corner? Low growth and high debt:

- Source Bank of America Merrill Lynch.

Or could that be the one when one looks at the discrepancy between record low bond yields and record high equities?

- Source Bank of America Merrill Lynch.

Or maybe this one, when one looks at the discrepancy between low commodity prices and higher stock prices?

- Source Bank of America Merrill Lynch.

Just a fact in relation to the defensive nature of the S&P rally, year to date, 2013 buyback authorizations are at around $275 billion, +102% from a year ago and +8% vs 2007.

So what's the risk for our bold pilots / central bankers you might rightly ask? Well, on that very point we agree with Citi's recent note from the 25th of April entitled "Too much money, not enough assets to buy", which for us is reminiscent of the crazy days of 2007:

"What's the risk?

While the unconventional policies and the artificial inflation of asset prices has had few discernible negative side effects to date, the exit risk is clearly extremely large.
Part and parcel of the argument that we have made above is the fact that enormous volumes of non-dedicated money has been encouraged into risk assets, not least across fixed income markets.

Sharp adjustments like the one we have recently seen in gold are likely to become more commonplace in our view. More broadly, the reaction to the mini-backups in US yields early this year also illustrates how prone markets are to withdrawal symptoms.
Credit, in particular, has benefited from being a half-way house, offering less sensitivity to the global downturn than equities and retaining the upside benefit from falling yields. Our US credit strategists calculate that two-thirds of the inflows into US IG credit since 2009 has been through mutual funds and ETFs. A large portion of that will be retail money, more sensitive to total return prospects." - source Citi

Mutual funds and ETFs have seen significant inflows and at the same time inventories in the dealer space are nowhere near the 2007 levels, hence us still "credit dancing" but close to the exit door or ready to pull the handle on the ejection seat. As Matt King from Citi recently put it in his note from April 2013 - Mind the Gap:

- source Citi

And if you think liquidity in the credit space has improved, the unintended consequences of ZIRP from our "Top Guns" means that the turnover in IG corporate bonds is still falling, in similar fashion as velocity is as we move towards the "Coffin corner":

- source Citi

As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

Flying a "Central Bank" or a NF-104 Starfighter requires strict and delicate airplane/monetary control:
"Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via quantitative easing will require interest rate hikes, and may also necessitate asset sales by central banks, according to April's IMF Stability Report. Increased credit and securities losses would be the major negative impacts for banks as rates rise. Bank funding may also be disrupted if asset sales do take place." - source Bloomberg.

So buckle up, because our Central bankers Yeagers are indeed pushing on a string we think as indicated by the "altitude records", or spread tightening levels which are being broken as indicated by the level reached by corporate bonds worldwide as described by John Glover in his Bloomberg article entitled - Record Risk Discounted as Bonds Pass 110 Cents from the 25th of April:
"Corporate bond prices worldwide are poised to set a record as easy money policies by central banks
push investors into riskier investments even with the potential for losses at about an all-time high. Bondholders are paying an average of 110.22 cents on the dollar for the right to receive 100 cents back at maturity plus the interest from coupon payments, according to Bank of America Merrill Lynch’s Global Corporate & High Yield Index. At the same time, the so-called effective duration that measures how sensitive bond prices are to changes in yield has jumped, making the securities about the riskiest to hold ever.
Central bank purchases of government bonds to contain borrowing costs and stimulate economic growth have led investors to pour money into the $10 trillion global market for corporate bonds as they search for yield. Besides betting that interest rates won’t rise anytime soon, investors also face increased risk from restructurings." - source Bloomberg

And as indicated by the same article:
"For every 50-basis-point jump in yields, prices would drop an average 2.85 percent, compared with a low of 2.36 percent in September 2008, according to the average effective duration of the Bank of America Merrill Lynch index. Bond prices rose to a record 110.28 cents on the dollar in November. In 2009, the securities were trading below par." - source Bloomberg.

On a final note, we leave you with a Bloomberg chart indicative of the limited room which stock investors could benefit from a falling US savings rate:

"As the CHART OF THE DAY shows, household savings equaled 2.2 percent of disposable income in January and 2.6 percent in February, according to data compiled by the Commerce Department. The rate for March will be released on April 29. This year’s readings are the lowest since 2007, when the rate dropped as low as 2 percent. The chart shows the trend in savings since a peak of 8.3 percent was recorded in May 2008, when the economy was in a recession. “The potential for a further drop in the savings rate is obviously more limited,” Lapointe and two colleagues wrote in a report yesterday. “The best-case scenario” for stocks would be for savings to stabilize at less than 2 percent of disposable income or to rise gradually, they wrote. Quarterly increases of more than 1 percentage point since 1950 preceded declines in the Dow Jones Industrial Average for the next three, six and 12 months, according to data cited in the report. The Dow industrials moved higher on average when rates rose less than 1 point or declined. “The risk is that the savings rate rapidly bounces back to a more ‘normal’ level of 5 percent,” the report by the Montreal-based strategist and his colleagues said. “This would put additional pressure on equities.” The rate was 6.5 percent in December, when President Barack Obama and Congress were struggling to avert automatic tax increases and spending cuts." - source Bloomberg.

We still think deflation is the name of the game, the rest is poetry, and maybe the 1600 level for the S&P is the "Coffin corner" altitude for stalling where oxygen is rare and lift is low - triple top? - source Bloomberg:

Chuck Yeager made the mistake, not once but on each of his four zooms in the NF-104 Starfighter, and exaggerated on each until his accident was inevitable long before he departed his familiar flying region....just a thought...

"A kamikaze is a surprise attack, according to our ancient war tactics. Surprise attacks will be successful the first time, maybe two or three times. But what fool would continue the same attacks for ten months? Emperor Hirohito must have realized it. He should have said 'Stop.'" 

- Saburo Sakai, IJN flying ace