Macro and Credit - Iconic Memory

"There are things known and there are things unknown, and in between are the doors of perception." - Aldous Huxley

Looking at the significant acceleration in the melt-up in the equities space in early 2018 on the back of decent macro data and earnings, with credit spreads going towards the 11 level on the credit amplifier in true Spinal Tap fashion, when it comes to selecting our first title analogy for the new year we decided to go for "Iconic memory". The development of iconic memory begins at birth and continues as development of the primary and secondary visual system occurs.  A small decrease in visual persistence occurs with age. Iconic memory is the visual sensory memory (SM) register pertaining to the visual domain and a fast-decaying store of visual information. It is a component of visual memory and is described as a very brief:

1. The duration of visible persistence is inversely related to stimulus duration. This means that the longer the physical stimulus is presented for, (QE 1, 2 and 3) the faster the visual image decays in memory.
2. The duration of visible persistence is inversely related to stimulus luminance. When the luminance, or brightness of a stimulus is increased, the duration of visible persistence decreases. Due to the involvement of the neural system, visible persistence is highly dependent on the physiology of the photoreceptors and activation of different cell types in the visual cortex. This visible representation is subject to masking effects whereby the presentation of interfering stimulus during, or immediately after stimulus offset interferes with one's ability to remember the stimulus

Information persistence represents the information about a stimulus that persists after its physical offset (Tapering). It is visual in nature, but not visible. The brief representation in iconic memory is thought to play a key role in the ability to detect change in a visual scene such as the continuation of the Fed's reduction of its balance sheet and its impact which has yet to be fully assimilated by many investors due to their "Iconic memory" we think. In similar fashion the "Iconic memory" of the Great Financial Crisis (GFC) has led many retail investors including the US middle-class to continue to be scared out of the stock market and leading the top 10% of American households to now own 84% of all stocks. 

In this week's conversation, we would like to look at what allocations could benefit 2018 in the on-going "goldilocks" environment thanks to a very muted volatility overall but, the most important question, we think will be once again the direction of the US dollar. In terms of "allocation" we gave a small Christmas present in our last musing on the 17th of December when we hinted that we liked gold miners again because they had "cheapened" a lot. We continue to like the sector for 2018. 

Synopsis:

• Macro and Credit - The US Dollar New Year's hangover
• Final charts - Credit Conditions in early 2018? Take it "easy"

• Macro and Credit - The US Dollar New Year's hangover

While in early January last year we indicated our contrarian view to the long USD investing crowd and we also indicated that in the context of a weaker US Dollar one should rather be overweight Emerging Markets (EM) equities versus US equities. The US dollar index fell by around 10% in 2017 which does indeed validates our early contrarian stance of 2017 as per our conversation "The Woozle effect":

"It appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier." - source Macronomics, January 2017

And as indicated from the table below from the blog "The Capitalist Spectator", playing the outlier namely being overweight EM versus Equities has rewarded the "contrarian crowd" handsomely in 2017:

- source The Capitalist Spectator

Could 2018 play out differently than 2017 when it comes to the US Dollar? We do not think so, yet no doubt we could see in the early stage of 2018 a technical bounce of the US dollar. But, for us, from our "Iconic memory" perspective, we still see a weakening of the US dollar from a medium term perspective. On that note we agree with Barclays take from their note from their Thought for the Week Ahead note from the 7th of January entitled "The perils of following the consensus":

"USD: Holiday hangover

The USD has lost ground versus practically all major G10 and EM currencies (except for the JPY and MXN) since mid-December. Price action suggests that FX markets had largely anticipated the announced tax bill. Our economists have taken a closer look at the final details and recently updated their forecasts (see US Economics Research: 2018-19 US Outlook: Tax cut-induced bounce in activity, 4 January 2018). The tax plan is likely to boost near-term growth prospects by about 0.5pp and push out any slowing in the economy into 2019. Above-trend growth and a tightening labor market imply an increase in inflation toward the Fed’s target, and we now look for four Fed hikes in 2018 and three in 2019, taking the target fed funds rate to 3.00-3.25%.

That said, we do not see a lasting effect of the tax plan in pushing potential growth and, hence, long-term rates higher. The expected temporary boost to growth would be driven, largely, by a one-time improvement in disposable income. With many of the changes to personal taxation expected to be phased out of the bill, we do not expect it to have a permanent effect. In addition, it is likely to have heterogeneous effects for consumers based on household situations and the type of income earned. On the investment side, business spending has tended to have low elasticity with respect to changes in the required rate of return on capital, and as such, we are skeptical that it can deliver a substantial increase, particularly given the maturity of the business cycle. Finally, the discussion of restrictive immigration and trade policies that are also on the administration’s agenda may work against delivering lasting productivity improvements.

We remain USD bears over the medium term on account of an overvalued exchange rate (13% versus BEER), compression in risk premium in the US as symbolized by a bear-flattening yield curve, and a global backdrop that remains positive both in terms of cyclical prospects (the US cycle looking more mature) and from a valuation perspective. We believe the market’s focus will shift from tax policy to other policy priorities in Washington. These include approving the budget, immigration (DACA, the border wall, etc.), healthcare (renewal of CHIP, paying for Obamacare subsidies, etc.), and trade policy (NAFTA, alongside Korea and China). The 19 January government shutdown deadline and the seventh round of NAFTA negotiations on 23-28 January should be on investors’ radar." - source Barclays

As per our final conversation for 2017, either you think we are in a bull flattening case or in a bear flattening case:

"In a Bear Flattener case thanks to the Fed's Rician fading, it is still TINA playing out for the Japanese investor crowd" - source Macronomics December 2017.

We argued in our previous conversation that Japanese investors (and global credit and overall allocation wise these guys matter a lot) tends to be dip buyers ensuring in effect a bear flattening of the US yield curve. In 2018 we will watch again very closely what "Bondzilla" the NIRP monster "Made in Japan" will do in terms of "allocation". It is a major support to US credit markets as well. We think monitoring what the Bank of Japan (BOJ) does in 2018 will be paramount. On that note we agree with Deutsche Bank's take from their Japan Fixed Income Weekly note from the 5th of January entitled "BOJ normalization could pose a tail risk to domestic and overseas rates":

"Global investors focusing on the BOJ?

We expect the BOJ to be a major focus of attention among global investors in 2018. We say this because any change in the BOJ's monetary policy stance could have significant ramifications for how Japanese investors approach foreign bonds.

For example, the January 2016 launch of BOJ NIRP and September 2016 institution of YCC each had an important impact on international bond investment flows. Japanese banks were net sellers of foreign bonds to the tune of around JPY1 trillion and life insurers were big net buyers (+JPY4.8 trillion) over the 34- month period between the April 2013 launch of QQE and the January 2016 launch of NIRP, but the subsequent eight-month period up until the September 2016 launch of YCC saw net purchases of JPY5.2 trillion by banks and JPY9.3 trillion by lifers. The obvious conclusion is that the introduction of BOJ NIRP played a major role in the decline in the 10y UST yield from above 1.9% to below 1.4% that was observed between January and July 2016.

Conversely, the eight-month period following the launch of BOJ YCC (October 2016~) saw banks sell off foreign bonds to the tune of JPY9 trillion while lifers cut back their net purchases to just JPY1.3 trillion. We attribute this to bear-steepening of the JGB curve under YCC leaving domestic players with less of  an incentive to invest in foreign bonds, with life insurers in particular probably becoming more willing to wait for overseas interest rates to move higher once they perceived that the risk of the JGB curve bull-flattening had diminished.

Banks began FY2017 by selling off foreign bonds to the tune of JPY5.6 trillion in April (the biggest monthly selloff on record), rebuilt their holdings somewhat through July, and then shifted back into selling mode, meaning that they have now sold more than they have bought since April 2013. Lifers have also remained slow to add to their positions. We attribute this to a flattening of the UST curve —with the 10y yield having ranged between 2.00% and 2.60% even as the Fed has proceeded with multiple rate hikes—reducing the relative appeal of USTs. The flipside is that we see ample potential for Japanese investors to shift into dip-buying mode in the event of overseas yield curves starting to face bear-steepening pressure.

The key question among overseas investors is whether BOJ easing will continue to serve as an anchor for global interest rates. Under the current easing framework, demand from yield-starved Japanese investors should help to prevent overseas long-term interest rates from rising more than modestly. Conversely, if domestic long-term interest rates rise as a consequence of the BOJ commencing "normalization" efforts, then overseas interest rates could rise sharply due to Japanese players seeing less of an incentive to invest abroad. The trajectory of overseas interest rates in 2018 and beyond could therefore depend in significant part on what the BOJ decides and does.

It would not be at all surprising for short- to medium-term JGB yields to move significantly higher if BOJ normalization starts to be seen as a realistic possibility given that (1) foreigners have been by far the most active traders in negative yield short- to medium-term JGBs and (2) BOJ normalization is liable to reduce the FX "hedge premium" available to foreigners (and hence the attractiveness of short- to medium-term JGBs) by causing (negative) USD/JPY basis swap spreads to tighten.

Foreigners' cumulative net purchases have totaled JPY23 trillion for Japanese long-term debt securities and JPY14 trillion for short-term debt securities since the April 2013 launch of QQE, with medium-term JGBs likely to have accounted for much of the former if purchases were indeed funded mostly via the basis swap  market. Up until 2016 net purchases tended to increase when basis swap spreads widened, with this positive correlation reflecting the ability of foreign investors to earn positive spreads over USD LIBOR. However, we would expect foreigners to start reducing their Japanese bond holdings if and when the BOJ commences normalization, in which case short- to medium-term JGB yields might face some quite strong upward pressure until the YCC framework (which will presumably remain in place at least initially) begins to exert its influence once again.

Much will ultimately depend on inflation, but we are wary of bear-steepening risk under the YCC framework

Our US economics team expects US inflation to quicken in 2018, supporting a total of four further Fed rate hikes and a rise in the 10y UST yield to around 3%. The JGB yield curve is liable to face at least some bear-steepening pressure under such a scenario. However, we do not expect Japanese inflation to establish a firm foothold at or above +1% and thus see little prospect of the BOJ actually commencing normalization this year. As such, we will be looking for Japanese investors to step up their purchases of foreign bonds if interest rates move higher, thereby acting as a counterbalance. Irrespective of how many times the Fed hikes, upside for JPY rates is likely to be limited so long as Japanese inflation remains sluggish, leaving foreign bonds as the best means of generating carry. We expect the JGB curve to face a certain amount of bear-steepening pressure in 1H 2018 if overseas interest rates do indeed rise, but bull-flattening pressure may then start to dominate if the Japanese economy loses momentum, domestic CPI inflation peaks out, and the BOJ persists with its YCC framework.

The most obvious risk scenario is that of the BOJ shifting into normalization mode, in which case interest rates could rise quite sharply both at home and abroad. Attention in the first quarter of 2018 is thus likely to be focusing largely on (1) whether domestic and overseas inflation accelerates and (2) whether the Fed hikes once again in March." - source Deutsche Bank

As we pointed out it is still TINA (There Is No Alternative) for the Japanese investing crowd therefore we believe the bear-flattening of the US yield curve will continue its "Iconic memory" movement in 2018.

But moving back to the US dollar and the New Year's hangover, we read with interest Nomura's take in their FX Insights note from the 4th of January entitled "Two factors hurting the dollar":

"As is often the case, markets move when it is least convenient. The dollar has tumbled since mid-December until now – a period when investors were more likely to be embroiled in family dramas and over-eating than to be trading FX markets. Dollar weakness has come despite the passing of US tax cuts, an associated upgrade to US growth expectations and a hawkish Fed. There are many medium-term factors that we think are weighing on the dollar, but in terms of short-term factors, two stand out:

1. The dollar typically falls after a hike. Markets are all about expectations and it was likely the expectation of the December Fed hike that was helping the dollar. The actual hike, then, would naturally reset those expectations and would lead to a “buy the rumour, sell the fact” dynamic in the dollar. Indeed, the dollar has followed a pattern of trading relatively well into Fed hikes, but selling off after (Figure 1).

This time appears to be no different.

2. Rising US inflation expectations could be hurting the dollar. Wednesday’s ISM report showed the prices paid component bouncing back from an earlier dip. Oil prices are marching higher. Importantly, US inflation expectations as priced by US rates markets have consistently risen since early December. The 10yr breakeven from the TIPS market breached 2% in recent days – the first time since early 2017, and the 5y5y inflation swap inflation breakeven has gone above 2.35%. The dollar does not always move with inflation expectations (notably during the” Trumpflation” phase), but typically it does (Figure 2).

Some of this co-movement could be the dollar influencing inflation expectations, but some could be inflation affecting the dollar (through PPP, real yields or “credibility”). Either way, inflation could be returning as a market factor.

Of course, the start of the year is a period when market liquidity is poor. Therefore, we need to be cautious in extrapolating too much from price action, but these two factors do warrant some attention." - source Nomura

It isn't a surprised to see inflation returning as a market factor. A surge in inflation expectations would indeed mark a return of volatility and would be negative for bond yields. If inflation expectations are rising, then again it would continue to be headwind we think on the US dollar. Morgan Stanley in an interesting FX Pulse note from the 4th of January 2018 entitled "New USD Lows in Store" make as well the case for a lower US dollar:

"The case for USD weakness. The USD has come back under selling pressure and the DXY is set to break its early September low. This renewed weakness has occurred despite continued positive US economic surprises (Exhibit 2).

However, we note that the strength of US performance should be taken in the context of the global economy. Global synchronized growth, which should eat into global capacity reserves, will in turn clear the way for a pick-up in investment. Investment requires funding, which augurs poorly for funding currencies.

USD is the world's dominant reserve and funding currency. In order for a currency to be considered a funding currency, it should meet two important criteria: expected funding costs should stay below anticipated returns on investment; and the availability of capital must be ample.

In other words, there needs to be a substantial supply of the currency to be lent out and institutions or individuals willing to lend it. By definition, a dominant reserve currency meets this criterion.

As the world's primary reserve currency, then, it is no surprise that the USD makes up the majority of cross-border foreign-currency lending (Exhibit 5).

Other currencies may temporarily fall into the funding currency category, such as JPY, EUR, and CHF, which have seen periods of significant outflows.

Funding qualifications. The use of QE by global central banks has altered the funding environment, with central banks absorbing outstanding sovereign bonds in exchange for base money. In the case of QE programs from the ECB and Riksbank, EUR- and SEK denominated sovereign bonds held by foreigners declined as a proportion of total bonds outstanding (Exhibit 6).

In comparison, the proportion of foreign holdings of US Treasuries held relatively stable despite the Fed conducting its QE operations.

However, the relative stability of foreign Treasury holdings masks an important underlying shift. While foreign private accounts reduced their Treasury holdings, the ownership by foreign central banks increased. Two factors explain this. First, the Fed's QE operations took place in a period when global currency reserves were rising (2009- 2013), so demand for Treasuries from reserve managers rose in tandem. Second, debt issuance by the US government during this period also increased, so as demand for Treasuries grew with the Fed entering the market, supply also expanded simultaneously.

US assets for sale. Importantly, US agency debt and higher-yielding corporate bonds did experience a significant uptick in foreign holdings. Unlike in Europe and Japan, where private fixed income assets are in relatively limited supply, the US bond market offers a high yielding alternative to sovereigns. This in part explains the increase in the US' net foreign liability position (Exhibit 7).

Private foreign investors selling their Treasury holdings to the Fed reinvested those funds into higher-yielding USD-denominated bonds.

Our key point here is that foreign holdings of USD-denominated debt have increased, while foreign holdings of European debt instruments have declined. A similar dynamic has taken place for equities, where foreign ownership of US equities has more than doubled, which contrasts with trends in the foreign ownership of European equities. An important implication is that, should US assets lose their relative attractiveness (e.g., widening credit spreads, declining equities), then there could be a substantial amount of foreign-held USD-denominated assets for sale. In comparison, the relatively smaller share of foreign-owned assets in Europe renders it more immune to a pullback in foreign sentiment. This is why an environment of rising global bond yields may see the USD lose further ground.

The increase in the US's net foreign liability position comes at a time of relative stability in the US current account, with the deficit fluctuating around 2.5% of GDP since 2009 (Exhibit 8).

However, inward US net foreign direct investment (as provided by the World Bank) has turned negative for the first time since 2006. The composition of US inflows has become narrower, which renders the USD more vulnerable to selling once US equity and credit markets turn lower.

The case for JPY strength. One could argue that foreign ownership within the JGB market has increased, too. The BoJ's QE operations resulted in a significant absorption of JGBs held by the Japanese banking system, which reached the lowest level since 2007 and is now lower than that held by foreign investors (Exhibit 9). 

Importantly, many of these foreign JGBs have been currency hedged - with the FX hedge offering additional income, as opposed to a cost. Indeed, with the widening of the USDJPY basis, the returns offered for asset swaps into Japanese fixed income have increased. These foreign purchases have helped keep JGB yields low, particularly as the majority of the currency-hedged return comes not from the yield on the JGB itself, but from the currency hedge, which renders these foreign investors fairly price-insensitive.
The cross-currency basis represents the cost difference between domestic and offshore FX. A wider basis, all else equal, suggests tight offshore liquidity conditions, while a narrower basis indicates that offshore liquidity is relatively more ample. At this point, the 1 year USDJPY cross-currency basis is trading at its tightest since the summer of 2017, reducing the relative attractiveness of foreign accounts holding FX-hedged JGB exposures (Exhibit 10).

The reduction in this exposure may have no initial FX impact given the FX-hedged nature of the investments. The second order effects, though, are important, as reduced exposures could lead to a potential steepening of the JGB curve. A steeper JGB curve raises the incentive for Japan-based investors to keep funds at home, instead of investing in higher yielding foreign securities. For more detail on our JPY framework and why we no longer view the JPY as a funding currency, see: JPY: Impact of Bank Lending.

The neutral rate matters. Despite the Fed hiking rates 5 times since 2015, the USD will remain the globe's best funding currency. Buoyant financial conditions suggest that the Fed's gradual pace of rate hikes has not yet overtaken the market's perceived neutral rate of interest. The continued easing of financial conditions and the strong growth environment, it can be argued, suggest that the Fed may be behind the curve. Moreover, with soon-to-be Chair Powell taking the reins of the Fed in February, President Dudley planning to retire in mid-2018, and the three vacancies on the Board, markets may begin to question whether the FOMC's reaction function is set to change.

Forget the textbook. Textbook analysis would suggest that the estimated $1.5 trillion deficit expansion as part of the recently-passed tax reform bill, coupled with the limited degree of economic slack, should lead to higher US rates and a stronger USD. However, real yields remain at low levels by historical standards.

One way to explain this dynamic is that markets believe that there has been a structural shift in the mix between growth and inflation. However, another explanation could be a perceived shift in the Fed's reaction function, justifying real yields staying low.

Accommodative Fedspeak. FOMC participants have generally eschewed aggressive policy tightening, remaining instead in favor of a gradual normalization which keeps financial conditions from tightening prematurely. Indeed, despite the 5 rate hikes so far this cycle, financial conditions are at their loosest level since 2014 (Exhibit 13).

The most recent FOMC minutes support this thesis. However, some have also supported a looser regulation approach, most notably soon-to-be Chair Powell, whose comments during his testimony suggested an openness to regulatory reform.

Combining easy monetary policy with financial deregulation suggests that the velocity of money is poised to rise, which bodes well for USD liquidity conditions remaining ample. Other major central banks such as the ECB and the BoJ are also likely to gradually normalize their policy stances. This speaks in favor of the EUR and JPY against the USD as these areas remain investment destinations.

Explaining real yields. What drives real yields? Traditional academic research has suggested that factors such as demand deficiency, demography and aging societies, inequality, and poor total factor productivity are important, and these may explain the current low real yield environment within the DM world.

A recent BIS study has enriched this debate by claiming that the above factors may explain the evolution of DM real yields over the past 30 years, but they fail to explain real yield behaviors in eras preceding the 1980s. Instead, they argue, changes in central bank regimes may have had a bigger impact on the broader evolution of real yields. The current low real yield environment began in the early 1980s when DM central banks began adopting inflation-targeting regimes.

The effects of inflation targeting. Inflation targeting has been successful by maintaining price stability and providing stable funding conditions in the DM and EM alike, which has been an important foundation for EMs to develop income and wealth. Another implication, though, may have been an increase in liquidity preference (increased demand for cash and cash-like instruments) within DM economies which may also explain demand deficiency and, implicity, weak DM investment. This is because low and stable inflation reduces the costs of saving - compared to higher and less stable inflation, which may incentivize consumers to invest in other financial assets or consume.

Creating higher inflation expectations may reduce this liquidity preference, pushing these funds into circulation within the economy. The combination of Fed policy accommodation and financial deregulation may be sufficient to do so. A weaker USD in the FX market would be the side effect.

Bringing China into the equation. Prices tend to fall when supply exceeds demand. DM investment-to-GDP ratios have come down within the post-Lehman environment. However, what investors often miss is that the global investment-to-GDP ratio has been rising since the early 1990s, driven in large part by China (which currently has a 40% investment-to-GDP ratio). Exhibit 17 shows the relationship between the US 10-year yield with the global investment-to-GDP ratio. Yields declined as investment rose relative to GDP.

The fact that much of the investment took place in China, which has closed and regulated capital and financial accounts, may have helped global bond yields to stay low via two key channels. First, China's investment boom had largely been funded by local savings, meaning that little foreign capital was needed (which would have drawn capital away from DM bond markets). High household savings and an accommodative PBoC provided the sufficient liquidity. Second, the emphasis on investment provided a source of latent deflationary pressure, pushing inflation risk premia lower. This, in turn, bolstered the demand for liquidity, as inflation risks were low and stable, and in turn supported subsequent demand weakness.

In general, it is fairly unusual within a historical context to see a domestic investment boom without foreign funding contributing to it. Typically, investment booms and current account deficits (where investment exceeds domestic savings) should go hand in hand. When this is not the case, then funding costs tend to decline. Another example has been Japan's investment boom in the 1980s, which turned Japan into a country of low inflation even before the 1990s and beyond.

The concentration of investment in China, where local liquidity was sufficient to finance it, meant that global demand for capital did not rise, which allowed yields to stay low. Should China's investment boom be replaced by investment in other jurisdictions with open capital accounts, prices may still face disinflationary headwinds, but funding pressures would rise. The Fed, then, has an incentive to counter these disinflationary headwinds by keeping policy accommodative.

Still bullish on EM: The bearish USD story has been seen across the emerging market spectrum too. As risk appetite remains strong, investors will likely focus on vol-adjusted carry again to capture excess return. As seen in Exhibit 18, most of the high-yielding EMFX offers such value and we are bullish on most of these currencies.

We believe that rising global growth momentum, improving EM fundamentals and reasonable valuation in EMFX will prompt new inflows into EM in 2018." - source Morgan Stanley

Whereas Morgan Stanley believes a steeper JGB curve raises the incentive for Japan-based investors to keep funds at home, instead of investing in higher yielding foreign securities, we do not think Japanese investors have much alternative at the moment so the TINA trade will still make them buyers of the dip as mentioned above in our conversation. While we do expect some short term pull-back and US dollar strength in the near term, we do think that from our Iconic memory perspective more weakness lies ahead for the US dollar and given the positive macro momentum, equities wise, we would continue chasing EM over US equities from an allocation perspective. When it comes to credit, it is still "carry on" as we move again towards that famous 11 on the credit amplifier in true Spinal Tap fashion, basically more of the same, though as we pointed out we expect debt-fueled M&A to be a big theme in 2018 which will no doubt deliver some "sucker punches" along the way to the Investment Grade investing crowd, so, as we repeated in various conversations, dust up your LBO screener in 2018.

Yes 2018 has started with a bang with relentless tightening and equities indices racing even higher, the goldilocks environment is still alive and kicking, even if there are some genuine geopolitical concerns on the background. It is still pretty much "carry on". In our final chart below, for those still rooting for US High Yield, financial conditions in early 2018 still remain plentiful. Apart from a surge in inflation expectations that would warrant a faster tightening by the Fed in 2018, we do not see at the moment the catalyst for a sell-off unless of course our Iconic memory is playing with our thought process but we ramble again...

• Final charts - Credit Conditions in early 2018? Take it "easy"

As we pointed out, the goldilocks environment continues to be supportive thanks to low volatility in various asset classes. Credit conditions remain a key support for sensitive credit such as US High Yield, yet we do think after the significant rally of low beta in 2017 including the CCC bucket, one should start switching from quantity (yield) towards quality (up the rating spectrum). After all the US yield curve continues to bear flatten thanks as well to its Japanese support. Our final charts come from CITI Monday Morning Musings from the 5th of January entitled "Five Charts to Start 2018" and display comforting credit conditions:

"Comforting Credit Conditions

Commercial & Industrial (C&I) lending standards are the key reasons for being comfortable with the upcoming trend in business activity. Figure 9, which is key, illustrates the long-term relationship between the two and Figure 10 provides additional underlying detail. Essentially, easy money lowers the cost of capital and allows corporations to fund hiring plans, capex and working capital needs with C&I credit conditions providing a nine-month lead getting us well into 4Q18. As we have shown in the past, industrial production is very closely correlated with changes in net income.

- source CITI

While the US dollar has started 2018 with a hangover, we do expect a short term rebound in the near future though we remain bearish in the medium term. Meanwhile, no doubt to us, the central banking narrative is changing and it isn't only the Fed which has been retreating from QE, the ECB and even the BOJ are paring as well. Though your Iconic memory might be still playing tricks, you have been warned, the level of the strike on the central banking put is fading we think.

"There is no truth. There is only perception." -  Gustave Flaubert

Stay tuned !

Macro and Credit - The Monkey and banana problem

"There are three growth industries in Japan: funerals, insolvency and securitization." - Dominic Jones, Asset Finance International Nov., 1998

Looking at the evolution of markets and convolution in which central bankers have fallen, we reminded ourselves for our chosen title analogy of the "Monkey and banana problem", which is a famous toy problem in artificial intelligence, particularly in logic programming and planning. The problem goes as follows:

"A monkey is in a room. Suspended from the ceiling is a bunch of bananas, beyond the monkey's reach. However, in the room there are also a chair and a stick. The ceiling is just the right height so that a monkey standing on a chair could knock the bananas down with the stick. The monkey knows how to move around, carry other things around, reach for the bananas, and wave a stick in the air. What is the best sequence of actions for the monkey?" - source Wikipedia

While there are many applications to this problem. One is as a toy problem for computer science, the other, we think is a "credit impulse" problem" for central bankers. The issue at hand is given financial conditions are globally tightening, as shown as well in the US in the latest publications of the Fed Senior Loan Officer Survey and the bloodbath in European bank shares, the problem is how on earth our central bankers or "monkeys" (yes it's after all the Chinese year of the fire monkey...) are going to avoid the contraction in loan growth? As put it bluntly by our friend Cyril Castelli from Rcube, the European credit channel is at risk as banks' share of credit transmission is much higher in EU than US, which of course is bound to create a negative feedback loop and could therefore stall much needed growth:

- source Rcube - @CyrilRcube

Another possible tongue in cheek purpose of our analogy and problem is to raise the question: Are central bankers intelligent? Of course they are, and most of them have to deal with complete lack of political support (or leadership). It seems we have reached the limits of what monetary policies can do in many instances.

Although both humans and monkeys have the ability to use mental maps to remember things like where to go to find shelter, or how to avoid danger, it seems to us that in recent years central bankers have lost the ability to avoid danger. While monkeys can also remember where to go to gather food and water, as well as how to communicate with each other, it seems to us as of late, that central bankers are losing their ability to communicate, not only with each other but, as well with markets, hence our chosen title. Could it be that monkeys have indeed superior abilities than central bankers given their ability not only to remember how to hunt and gather but to learn new things, as is the case with the monkey and the bananas? Despite the facts that the monkey may never have been in an identical situation, with the same artifacts at hand (printing press), a monkey is capable of concluding that it needs to make a ladder, position it below the bananas, and climb up to reach for them. It seems to us that despite the glaring evidence that the "wealth effect" is not translating into strong positive effects into the "real economy", yet it seems central bankers have decided to all embrace the Negative Interest Rate Policy aka NIRP as the new "banana". One would argue that, to some extent, central bankers have gone "bananas" but we ramble again...

In this week's conversation we will voice our concern relating to the heightened probability of a credit crunch in Europe thanks to banking woes and the unresolved Italian Nonperforming loans issue (NPLs). We will as well look at the credit markets from a historical bear market perspective and muse around the relief rally experienced so far.

Synopsis:

• Macro and Credit - The risk of another credit crunch in Europe is real
• Why NIRP matters on the asset side of a bank balance sheet
• Credit spreads and FX movements - Why we are watching the Japanese yen
• Final chart: US corporate sector leverage approaching crisis peak

• Credit - The risk of another credit crunch in Europe is real

The fast deterioration in European bank stocks in conjunction with the rising and justified concerns relating to Italian NPLs, constitute a direct threat to the "credit impulse" needed to sustain growth in Europe we think. As we pointed out on numerous occasions, the ECB and the FED have taken different approaches in tackling their banking woes following the Great Financial Crisis (GFC). In various conversations we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):

"We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation -The LTRO Alkaloid - 12th of February 2012."

Exactly. The issue with Italian NPLs is that the tepid Italian growth of the last few years is in no way alleviating the bloated balance sheets of Italian banks which would help sustain credit growth for consumption purposes in Italy as evidently illustrated in a recent Société Générale chart we have used in our conversation the "Vasa ship": 

"As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs" - source Macronomics, February 2016

- source Société Générale.

So, all in all, the ECB is going to have to find a way to shift these impaired assets onto its balance sheet, if it wants to swiftly and clearly deal with the worsening Italian situation. While some pundits would point out that the new "bail-in" resolutions in place since the 1st of January are sufficient to deal with such an issue, we do not share their optimism. This is a potential "political" problem of the first order, should the ECB decides to deal with this sizable problem à la Cyprus. Caveat emptor.

You could expect once more politicians and the ECB to somewhat twist the rule book in order to facilitate through this "securitization" process and an ECB take up of part of the capital structure (Senior tranches probably) of these new NPLs CDOs. A new LTRO at this point might once again alleviate funding issues for some but in no way alter the debilitating course of the credit profile of the Italian banks. On a side note we joked in our last conversation around these new NPLs CDOs being the new "Big Short":

"If you want to make it big, here is what we suggest à la "Big Short," given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honor the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs." - source Macronomics, February 2016

But, when it comes to the "credit impulse" and its potential "impairment" in Europe thanks to bloated banks balance sheets, and equities bleeding, we read with interest Deutsche Bank's take in their note Focus Europe note from the 19th of February entitled "Moving down a gear":

"The balance between the growth drivers and detractors is being tipped towards the negative as the questioning of confidence in European banks threatens to result in a less beneficial credit impulse. In last week’s Focus Europe we presented a scenario analysis to demonstrate the sensitivity of euro area GDP growth to the provision of bank credit. We did this via the credit impulse relationship. Our earlier assumption of 1.6% real GDP growth in 2016 was consistent with 2% credit growth. If, on the other hand, banks issue no net new credit this year, domestic demand would fall, confidence deteriorate and financial markets tighten. With no reaction from the ECB, 2016 GDP growth would fall to about 0.5%

The recent fall in bank equities and rise in bank debt costs combined with increasing economic risks, the balance of probabilities suggests that lending standards will tighten relative to what we expected previously. Therefore, to some degree the provision of bank credit, and hence economic growth, will suffer. The revision we are announcing is an attempt to capture this effect. There are considerable uncertainties as to the scale of the problem, but we feel a modestly weaker lending impulse is now a more appropriate baseline.

Credit (-0.2pp). Our previous baseline forecast of 1.6% GDP growth was consistent with an acceleration in bank credit growth from broadly zero in 2015 to about 2% this year. The improvement in credit conditions in the last Bank Lending Survey implied a modest upside risk relative to forecasts. The last Bank Lending Survey was conducted in December and published in January. There were no indications at that point of concern about capital, liquidity or risk. However, as we said above, the balance of probabilities implies that lending standards will now tighten. We are conservatively allowing for a scenario in which the contribution to GDP from bank credit is now 0.2pp weaker than our previous baseline.

The ECB can help minimize the damage… 

The onus is on the ECB to achieve two things at the next meeting on 10 March. First, to set an appropriately accommodative policy stance given the worsen outlook for both growth and inflation. Note, since December, our headline and core HICP inflation forecasts for 2016 have fallen from 0.9% and 1.3% to 0.2% and 1.1% respectively (see page 2 for updated country inflation forecasts).
Second, to set a policy stance that does not compound the pressures on a banking system that may be perceived as being more vulnerable.
We presented a detailed discussion of the ECB’s options in last week’s Focus Europe (pages 8-10)2. Suffice to say, the choice of policies will be affected by conditions in the banking system. Our expectation prior to this episode of banking stress in recent weeks was a 10bp deposit rate cut and a temporary acceleration in the pace of purchases. The bank stress implies that a further deposit rate cut may be unwise without a system of exemptions. A refi cut, for example targeted at TLTROs, would be more effective.

The bank stress also implies the ECB should offer some kind of supplementary liquidity tender. Excess liquidity is running at about EUR700bn, but if there was any sense of fragmentation re-emerging between strong and weak banks, it would be in the ECB’s interest to remove all doubt about bank access to liquidity. Finally, the justification for more QE has increased given the widening of credit and sovereign spreads. More QE would reduce the risk of a negative feedback loop between banks and sovereigns.

The ECB is conducting a technical review of the asset purchase programme (APP). This might result in some changes. In terms of broadening the eligible asset base, we suspect the ECB will remain in the sovereign/quasi-sovereign space for now. Corporate bonds are possible but not very impactful.

Purchasing unsecured bank debt might not be inconsistent with the Treaty but would be complex and politically controversial. Stresses would have to increase markedly to bring this option onto the table. 

There is no relaxation of regulation, however. Both Mario Draghi, President of the ECB, and Daniele Nouy, head of the ECB Single Supervisory Mechanism (SSM), were consistent in their messages this week that (a) the new regulatory regime is resulting is a more stable and sustainable banking system - there is no sense that regulation is a net cost - and (b) “all else unchanged” there will be no significant additional capital requirements imposed on banks.
Benoit Coeure, ECB Executive Board Member, said that if bank profits are under pressure the onus would be on governments to implement structural reforms and growth-friendly fiscal policies. In short, no change in ECB message.

…but negative feedback loops cannot be ruled out either 

Last week we showed how sensitive the economic cycle can be to the bank credit cycle. This negative dynamic can become self-reinforcing. One direction is via the private sector and another is through the public sector. A tightening of lending standards weakens demand, undermining growth and asset quality, triggering a second-order tightening in credit. At the same time, weaker demand undermines sovereign sustainability which can tightening bank funding cost and additionally contribute to second-order tightening. 

Fiscal dynamics have deteriorated. The primary balance gap is the difference between the debt-stabilising primary balance and the primary balance. It captures the underlying dynamic of the public debt-to-GDP ratio. A negative gap means the public debt ratio is falling. Our previous forecast was for a primary balance gap of -0.6% of GDP in 2016, the first genuine decline in the public debt ratio since the start of the crisis. Following the growth and inflation revisions, the primary balance gap is expected to be positive again. In other words, the benefits of lower funding rates thanks to ECB QE are not enough to compensate for the loss of economic momentum. Moreover, if the scenario of zero net new bank credit were to materialize, 2016 could see the primary balance gap rise back to levels not seen since 2012. That would imply a euro area public debt-to-GDP ratio of about 98%." - source Deutsche Bank

Whereas indeed we are waiting to Le Chiffre aka Mario Draghi to come up with new tricks in March to alleviate the renewed pressure on European banks, where we disagree with Deutsche Bank is that providing a new TLROs would provide much needed support for funding in a situation where some banking players are seeing their cost of capital rise thanks to a flattening of their credit curve (in particular Deutsche Bank as per our previous conversation), this intervention would in no way remove the troubled growing impaired assets from the likes of Italian banks. It is one thing to deal with the flow (funding) and another entirely to deal with the stocks (impaired assets). Whereas securitization of the lot seems to be latest avenue taken, you need to find a buyer for the various tranches of these new NPLs CDOs. Also more QE. will not deal with the stocks of impaired assets unless these assets are purchased directly by the ECB. 

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. In their latest survey, while it is difficult to assess for now a clear trend in the deterioration of financial conditions for French corporate treasurers, it appears to us that NIRP has already been impacting the margin paid on credit facilities given a small minority of French corporate treasurers are indicating that, since December, there is an increasing trend in margin paid on the aforementioned credit facilities:

"Does the margin paid on your credit facilities has a tendency, to rise, fall or remains stable?"

- source AFTE

Going forward we will closely be monitoring these additional signals coming from French corporate treasurers to measure up the impact on the overall financial conditions as well as the impact NIRP has on the margins they are getting charged on their credit facilities. For now conditions for French corporate treasurers do not warrant caution on the microeconomic level.

While we have recently indicated our medium to long term discomfort with the current state of affaires akin to 2007 in terms of credit markets, the recent "relief rally" witnessed so far is for us a manifestation of the "overshoot" we discussed last week. Some welcome stabilization was warranted, yet we do feel that the credit cycle has turned and that you should be selling into strength and move towards more defensive position, higher into the rating quality spectrum that is and rise your cash levels.

When it comes to enticing banks to "lend" more, as far as our analogy is concerned we wonder how the "monkey" bankers are going to react if indeed additional NIRP is going to remove more "bananas".

This brings us to our second point, namely that the flatter the yield curve, the less effective NIRP is.

• Why NIRP matters on the asset side of a bank balance sheet

Whereas, Europe overall has been moving more into the NIRP phenomenon, with over $7 trillion worth of global government bonds now yielding “less” than zero percent, the FED in the US is weighting joining the NIRP club in 2016 apparently, NIRP being vaunted as the new "banana" tool in the box to stimulate the "monkeys".

The issue of course at hand is that NIRP does matter and particularly when it comes to the asset side of a bank balance sheet as put forward by Deutsche Bank in their note from the 22nd of February entitled "Three things the market taught me this year":

"Negative rates – much more complicated

Negative rates look powerful at face value. Bank profits can be protected by exempting excess liquidity while market rates are pushed down. The turmoil in Japan points to three considerations that mute this view.
First, the impact of negative rates on the asset side of banks’ balance sheet can matter much more than the charge on excess liquidity. Banks that own large amounts of fixed income assets relative to the size of their total balance sheet (and their excess liquidity) are hit the hardest as returns on these assets drop. Japan and the US stand out as economies where the cost to the banks is biggest, Switzerland and Sweden the least, while Europe is somewhere in between:

Second, super-flat yield curves reduce the impact of negative rates. When bonds don’t offer risk premia, a perfect Keynesian liquidity trap exists: fixed income is the same as cash, and negative rates instantaneously transmit to the entire yield curve. The portfolio rebalancing into riskier assets declines as the marginal holders of zero-yielding bonds are naturally risk-averse. Japan’s yield curve, the flattest in the world, failed to steepen when the BoJ cut rates earlier this month – all yields just shifted down. Sweden, the UK and Europe stand out as yield curves where there’s still more risk premium to be squeezed, Japan, Canada and Norway the least:

Third, sub-zero rates can send a negative forward-looking signal. Until the technological and institutional framework is designed to pass negative rates to depositors without triggering banknote withdrawal, there will eventually be a (negative) lower bound. As this is approached the signaling cost of easing being exhausted may be bigger than the benefit of lower rates. At the extreme  cash and bonds turn into “Giffen goods”: the substitution effect of lower return is more than offset by expected lower future income. Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. The limitations of additional BoJ easing in addition to changing Japanese hedging behaviour, are some of the factors, that have led us to revise our USD/JPY forecasts for this year. We now think 2015 marked the peak in USD/JPY for this cycle and forecast a move down to as low as 105 this year." - source Deutsche Bank

Exactly, this negative feedback-loop, doesn't stop the frenzy for bonds and the "over-allocation process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP. This push yields lower and bond prices even higher. This is exactly what we discussed in our conversation "Le Chiffre" in October 2015:

"The big benefactors of the Fed and Le Chiffre's gaming style, particularly since is brilliant 2012 bluff in the European Government bond poker game have been bonds. We came across this very interesting chart from Deutsche Bank (h/t Tracy Alloway from Bloomberg on Twitter) which clearly illustrates "overconfidence" and "over-allocation" to the bonds relative to the trend which are $755bn above the normal trend. This is entirely attributable to the distortions created by QEs:

 - source Deutsche Bank (h/t Tracy Alloway).

Furthermore the significant repricing in European equities (where many pundits had been "overweight" at the beginning of the year) has led to a significant switch from equities to bonds as indicated by Bloomberg in their article from the 22nd of February entitled "They'd Rather Get Nothing in Bonds Than Buy Europe Stocks":

• "Estimates for Euro Stoxx 50 dividend yield at 4.3 percent
• The region's government debt is yielding 0.6 percent

The cash reward for owning European stocks is about seven times larger than for bonds. Investors are ditching the equities anyway.
Even with the Euro Stoxx 50 Index posting its biggest weekly rally since October, managers pulled $4.2 billion from European stock funds in the period ended Feb. 17, the most in more than a year, according to a Bank of America Corp. note citing EPFR Global. The withdrawals are coming even as corporate dividends exceed yields on fixed-income assets by the most ever:

Investors who leaped into stocks during a similar bond-stock valuation gap just four months ago aren’t eager to do it again: an autumn equity rally quickly evaporated come December. A Bank of America fund-manager survey this month showed cash allocations rose to a 14-year high and expectations for global growth are the worst since 2011.
If anything, the valuation discrepancy between stocks and bonds is likely to get wider, said Simon Wiersma of ING Groep NV.

 “The gap between bond and dividend yields will continue expanding,” said Wiersma, an investment manager in Amsterdam. “Investors fear economic growth figures. We’re still looking for some confirmations for the economic growth outlook.”
Dividend estimates for sectors like energy and utilities may still be too high for 2016, Wiersma says. Electricite de France SA and Centrica Plc lowered their payouts last week, and Germany’s RWE AG suspended its for the first time in at least half a century. Traders are betting on cuts at oil producer Repsol SA, which offers Spain’s highest dividend yield.
With President Mario Draghi signaling in January that more European Central Bank stimulus may be on its way, traders have been flocking to the debt market. The average yield for securities on the Bloomberg Eurozone Sovereign Bond Index fell to about 0.6 percent, and more than $2.2 trillion -- or one-third of the bonds -- offer negative yields. Shorter-maturity debt for nations including Germany, France, Spain and Belgium have touched record, sub-zero levels this month." - source Bloomberg

In that instance, while the equity "banana" appears more enticing from a "yield" perspective, it seems that the "electric shock" inflicted to our investor "monkey" community has no doubt change their "psyche".

The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box): When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock" hence the reach for bonds.

When it comes to our outlook and stance relating to the credit cycle we would like to point out again towards chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis where they highlight the work of Hyman Minsky's work on the equity-debt cycle and particularly in the light of the Energy sector upcoming bust:

"His cyclical theory of financial crises describes the fragility of financial markets as a function of the business cycle. In the aftermath of a recession, firms finance themselves in a very safe way. As the economy grows and expected profits rise, firms take on more speculative financing, anticipating profits and that loans can be repaid easily. Increased financing translates into rising investment triggering further growth of the economy, making lenders confident that they will receive a decent return on their investments. In such a boom period, lenders tend to abstain from guarantees of success, i.e; reflected in less covenants or in rising investments in low-quality companies. Even if lenders knowsthat the firms are not able to repay their debt, they believe these firms will refinance elsewhere as their expected profits rise. While this is still a positive scenario for equity markets, the economy has definitely taken on too much credit risk. Consequently the next stage of the cycle is characterized by rising defaults. This translates into tighter lending standards of banks. Here, the similarities to the subprime turmoil become obvious. Refinancing becomes impossible especially for lower-rated companies and more firms default. This is the beginning of a crisis in the real economy, while during the recession, firms start to turn to more conservative financing and the cycle closes again" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

The issue with NIRP and the relationship between credit spreads and safe-haven yields is that while the traditional pattern being lower government bond yields and a flatter yield curve is accompanied by wider spreads in "risk-off" scenarios, given more and more pundits (such as Hedge Funds)  have been playing the total return game, they have become less and less dependent on traditional risk-return optimized approach as they are less dependent on movements on the interest rate side. The consequence for this means that classical theories based on allocation become more and more challenged in a NIRP world because correlation patterns change in a crisis period particularly when correlations are becoming more and more positive (hence large standard deviations move).

But if indeed, the behavior of credit is affected in relation to safe-haven yields by changes in correlations, then you might rightly ask yourself about the relationship of credit spreads and FX movements given the focus as of late has been around the surge in the US dollar and the fall in oil prices in conjunction of the rise of the cost in capital since mid 2014.

In our next point we think that, from a credit perspective, once more you should focus your attention on the Japanese yen.

• Credit spreads and FX movements - Why we are watching the Japanese yen

Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings and in similar fashion in Europe previously the focused had been on the strength of the Euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward. Once again we take our cue from chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis:

"Many credit hedge funds not only implement leveraged investment strategies but also leveraged funding strategies, primarily using the JPY as a cheap funding source. A weaker JPY accompanied by tighter spreads is the best of all worlds for a yen funded credit hedge fund. However, these funds should be more linked to the JPY than the USD. One impact is obviously that the favorable growth outlook in Euroland triggers a strong EUR and tighter spreads of European companies (which benefit the most from the improving economic environment). However, the diverging fit between EUR spreads, the USD and the JPY, respectively, underpins the argument that technical factors as well as structural developments dominate fundamental trends at least in certain periods of the cycle. "  - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

However, NIRP doesn't reduce the cost of capital. NIRP is a currency play. This is clearly the case in Japan and has been well described in Deutsche Bank's note from the 22nd of February entitled "Yen hedging cycle risks rapid reverse":

"A lot of negative things have been said about negative rates, not least in Japan. Negative rates do not work by reducing financing costs materially, providing a ‘price of money’ stimulus. If negative rates do support activity, they primarily work through the exchange rate, adding to the portfolio substitution into risky asset.
For Japan the biggest problem is that macro policies have been directing capital toward risky assets for the last 4+ years. There are inevitably diminishing returns to this strategy, not least because ‘value’ matters. Value matters when it comes to the underlying domestic and foreign ‘risky’ asset, and the value of the exchange rate. Specifically on the latter, the yen even after the recent appreciation is still close to 20% cheap in PPP terms.

It is also cheap on a FEER and BEER basis, helped by a terms of trade shock that is seen lifting the Current Account surplus to near 5% of GDP in 2016. Figure 2 shows that in the last year, Japan has had the most favorable terms of trade shock of any major economy.

While FDI can recycle up to half of the C/A surplus, the question is whether other BoP components, notably net portfolio flows, will do the rest of the recycling, and at what exchange rate. For much of 2013 – H1 2015, vehicles like the GPIF were used to recycle (a much smaller) C/A surplus, that even briefly went into deficit in 2014. By June 2015, the GPIF’s portfolio of riskier assets inclusive of domestic stocks (22.3%), international bonds (13.1%), and international stocks (22.3%) was well within the desired base/benchmark ranges (see Figure 3).

For the latest data available for Q3 2015, GPIF domestic and international equity holdings declined led by weaker equity prices and a stronger yen – price action that underscores the risky nature of these investments.

As the C/A surplus grows and the above ‘structural’ pension shift toward capital flows abroad diminishes, there is a danger that we have already entered the realm where yen strength becomes self-fulfilling, as many of the hedging activities that were associated with a weak yen in the first four years of Abeconomics go into reverse.

Prior to Abeconomics, hedging on Japan equity flows was limited. Since 2011 when BOJ policy encouraged yen weakness, foreign inflows into Japan equities typically included much higher currency hedge ratios, while fully hedged instruments became popular. Precise numbers are not available, but it is estimated that as much as a quarter of the stock of foreign holdings of Japan equities of Y183tr has a currency hedge – a hedge that quickly becomes much less attractive with a stronger yen.

In contrast, for Japan investments abroad, FX hedge ratios declined. This particularly relates to USD investments, where expectations of USD gains increased rapidly in the Abeconomics years, and FX hedges on USD investments dropped. At the end of Q3 2015, Japan had a total of Y770trillion non-Central Banks assets abroad, inclusive of Y418tr portfolio assets, of which Y153tr are equity and investment fund shares, and Y266tr are debt securities. Even if much of the investment abroad has only limited hedges, one observation is that a very small adjustment in hedge ratios can have a huge flow impact. A shift in the hedge ratio on foreign fixed income assets by 10% is roughly equivalent to a year’s C/A surplus. Secondly, to the extent that hedge ratios are very low, as is the case for, say, the GPIF, there are sizable potential losses for funds recently adding to foreign exposure, and an emerging disincentive to invest in the most risky assets abroad.

Of the large players that actively hedge FX exposure, the life insurance companies’ activities can most closely be tracked through quarterly statements, and the time series can provide a useful standard to benchmark recent activity. Life insurance companies as of Q3 2015 had some Y65tr in foreign securities. As per Figure 4, their currency hedge ratios on dollar-based investments are estimated to have dropped to ~46% by the end of Q3 2015, the lowest levels recorded since the Great Financial Crisis in 2008. The hedge ratio is down from a peak of 79% in September 2009.

Life insurance company hedge ratios have likely reached a cycle nadir at the end of 2015, as concerns about JPY appreciation start to rise.

Among the other largest participants that have foreign portfolios of comparable size to the Lifers, both Toshins (foreign securities of ~77tr) and particularly public pension funds ( ~ Y57tr foreign securities) have very low currency hedge ratios and are heavily exposed to currency risk. Japan investments abroad, so actively encouraged by policymakers, are slowly being shown to have a familiar ‘catch’ – interest parity! Nominal yields may be more attractive abroad, but the long-term currency risks are enormous, at least when placed in the context of a yen that is still significantly undervalued.

A crucial element of hedging activity is the expected exchange rate. Here three bigger macro forces are at play for the remainder of 2016: i) Japan/BOJ policy; ii) the Fed; and iii) China FX policy. Firstly on BOJ intervention, the market should not expect any official BOJ intervention barring extreme FX volatility. It would run counter to G20 rules and risk a serious rift with the US. On rates policy, adding significantly to NIRP looks increasingly unpalatable, with our Tokyo Economics team expecting only one more 10bp cut in Q3. The next set of actions will likely need to revolve around ‘qualitative QE’ and the buying of more risky assets, notably securitized products.

On the Fed, we expect USD/JPY to remain sensitive to Fed expectations, but not to the point where more Fed tightening is likely to lead to new USD/JPY highs. The yen has a history of doing well in 5 of the last 7 Fed tightening cycles, although it did weaken in the two big USD upswings." - source Deutsche Bank

As we posited in our conversation "Information cascade" back in March 2015, you should very carefully look at what the GPIF, and their friends are doing:

"Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets." - source Macronomics, March 2015

We also added more recently in our conversation "The Ninth Wave" the following:

"So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor.
When it comes to Mrs Watanabe, Toshin funds are significant players and you want to track what they are doing, particularly in regards to the so-called "Uridashi" funds. The Japanese levered "Uridashi" funds (also called "Double-Deckers") used to have the Brazilian Real as their preferred speculative currency. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted previously for 46 percent of double-decker funds in 2009 with close to a record 80% in 2010 and now down to only 22.8%.
As our global macro "reverse osmosis" theory has been playing out, so has been the allocation to the US dollar in selection-type Toshin
Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP." - source Macronomics, January 2016

So from a "flow" perspective and like any trained "monkey" looking to reach out for "bananas", at least the slippery type, whereas other "monkeys" are focusing on the US dollar and Oil related woes, we'd rather for now focus our attention onto the Japanese yen, and the allocation implications of a stronger yen. For us, like others, a PBOC devaluation move on the Yuan would send a deflationary impulse worldwide but, in terms of risk assets, it would have serious consequences on Japanese asset allocations and would lead to an acceleration in capital repatriation (this would mean liquidation of some existing positions rest assured) as indicated in Deutsche Bank's note:

"Even modest JPY gains against the USD should translate to a strong yen against all the other G10 currencies and EMG Asia FX, not least because of global macro risks elsewhere. Nothing is capable of lifting the yen trade weighted index more than a speed up in the Rmb’s depreciation rate, leading to knock-on devaluations in EM Asia. This risk alone should encourage higher Japan hedge ratios for investment abroad, inclusive of the stock of Japan FDI assets abroad. A risk-off China shock would tend to concentrate JPY gains against currencies of other G4, but initially would likely include additional yen strength against all currencies. It should also drive the Nikkei sharply lower.

The Nikkei and yen have a long and sometimes tortured history of moving in lock-step. A stronger yen has hurt the Nikkei for obvious reasons, but a weaker Nikkei also tends to lead to a repatriation of capital and a stronger yen. Interestingly, the current Nikkei levels are already consistent with a USD/JPY below Y105."  - source Deutsche Bank

When it comes to the year of the Fire Monkey, the slippery banana type, no doubt could come from Japanese investors hurt by the violent appreciation of the Japanese yen, which has indeed been a significant "sucker punch" when it comes to the large standard deviation move experienced by the Japanese yen versus the US dollar. If Mrs Watanabe goes into "liquidation" mode, things could indeed become interesting to say the least.

When it comes to Minsky and the equity-credit cycle, whereas central banks can affect the amplitude and the duration of the cycle, in no way can they alter the character of the cycle. In our final chart, we once again indicate our 2007 feeling thanks to the rise in leverage, tightening financial conditions with the issuance markets closing down on the weaker players, which bode poorly from a risk-reward perspective.

• Final chart: US corporate sector leverage approaching crisis peak

Like many pundits, we have voiced our concerns on the increasing leverage thanks to buybacks financed by debt issuance and the lack of the use of proceeds for investment purposes. Our final chart comes from the same Deutsche Bank note from the 22nd of February entitled "Three things the market taught me this year" quoted previously and displays the US corporate sector leverage which is approaching crisis peak:

"US deleveraging – not that great

US consumer deleveraging stands out as one of the major achievements of the Yellen Fed. Yet the corporate picture looks much less impressive. Total amount
of US corporate debt has approached the highs seen in the financial crisis (chart 3). 

Not only that but the bulk of the leverage has been directed towards corporate stock buybacks (chart 4), explaining how low investment but high borrowing have existed at the same time. Persistent volatility in the US credit market has highlighted vulnerabilities that weren’t a concern last year.

- source Deutsche Bank

While a respite is always welcome, when it comes to the rally seen recently, as far as the Monkey and banana problem is concerned as everyone is hoping from additional tricks from our "Generous gamblers" aka our central bankers, this rally might have some more room ahead but then again, it doesn't change our belief in the stage of the credit cycle and our focus on what's the Japanese yen will be doing.

"Life is full of banana skins. You slip, you carry on." - Daphne Guinness, British artist

Stay tuned!