Macro and Credit - Unobtainium

"Progress is impossible without change, and those who cannot change their minds cannot change anything." - George Bernard Shaw

Watching with interest the significant compression in credit spreads thanks to "Le Chiffre" aka Mario Draghi going "all in", which to some extent, is putting pressure on Haruhiko Kuroda and the Bank of Japan, to raise the stakes once more in this global game of liar's poker, given their respective ability in reaching their inflation targets and both their repeated failures, we reminded ourselves for our chosen title analogy of "Unobtainium", being any fictional, extremely rare, very costly, or impossible material, or (less commonly) device needed to fulfill a given design (inflation) for a given application (QE+NIRP). The word "Unobtainium" derives humorously from unobtainable (inflation) followed by the suffix -ium, the conventional designation for a chemical element. 

What we also find of interest in our chosen title is that there is a cryptocurrency named Unobtainium, which uses Bitcoin's source code with some modifications to the monetary policy. UNO aka Unobtainium is a SHA256 Proof of Work cryptocurrency unique for low inflation, scarcity, a fair launch and distribution. Just 250,000 Uno will ever be mined over 300 years. Unobtanium is merged mined with Bitcoin, resulting in a secure high-difficulty blockchain that is 3x faster than Bitcoin. Uno is rare not only in the number coins issued, but also in it's fair launch and distribution. Uno was not pre-mined. There is no POS inflation. On that matter we find it very amusing to read about the proto-currency known as RSCoin in recent column by Ambrose Evans-Pritchard on the 13th of March in the Telegraph in his article entitled "Central banks beat Bitcoin at own game with rival supercurrency" as a better alternative to Bitcoin and it's smaller rival "Unobtainium":

"The RSCoin is deemed more likely to gain to mass acceptance than Bitcoin since the ledger would remain exclusively in the hands of the central bank, with the 'trust' factor of state authority. It would have the incumbency benefits of an established currency behind it....RSCoin may be irresistible for central banks. Dr Danezis said it is allows them to turn the money tap on and off with calibrated precision, and lets them track the sort of counterparty liabilities that nearly blew up the financial system during the Lehman crisis. "There would be instant visibility. They could react very quickly in an emergency, " he said.
Ultimately it could achieve some of the objectives of 'narrowing banking' proposed by Adam Smith, or the Chicago Plan put forward by US economists in the 1930s - but never enacted - to transfer control of money creation from private banks to the state. Arguably, this would make the financial system safer and less prone to boom-bust cycles." - source The Telegraph, Ambrose Evans Pritchard, 13th of March 2016

We find it particularly hilarious that RSCoin is deemed more likely to "mass acceptance" thanks to the 'trust factor of state authority'. To paraphrase Hayek's 1988 book, one could argue that RSCoin will not likely be more successful than Bitcoin because having the "trust factor" of the central bank would be a "fatal conceit", but we ramble again...

On a side note, before we move on our weekly musing, we find as well very entertaining that China and its Popular Bank of China (PBOC) are thinking about the implementation of a "Tobin tax" given one of our latest musing was the "reverse Tobin tax". This was reported by Bloomberg on the 15th of March in their article "China Tobin Tax Riles Analysts as Citi Warns of Foreign Exodus":

"China’s central bank has drafted rules for a tax on foreign-exchange transactions, a plan that still needs central government approval, people with knowledge of the matter said on Tuesday. The initial rate may be kept at zero to allow authorities time to refine the rules and to deter speculators by letting them know that there is a system in place, said the people, who asked not to be identified as the discussions are private. 

The People’s Bank of China has been fighting to drive out traders who take advantage of the difference in the yuan’s rates at home and abroad. The PBOC drove the currency’s offshore borrowing costs to records in January, increasing short-selling costs, and instructed banks on the mainland to restrict sending yuan overseas. 

Among the biggest Tobin tax concerns cited by analysts is that the levy would sap market liquidity. One gauge of the ease of trading the yuan -- the currency’s bid-ask spread against the dollar -- was about 0.05 percent on average in March, versus 0.01 percent for the dollar-yen rate, according to data compiled by Bloomberg Intelligence." - source Bloomberg

As a reminder from our conversation, the Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system which ended on August 15 of 1971. Also we would like to point out, that this additional precautionary measure from the PBOC, does seem to us overstretched as we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"It seems to us that speculators, so far has not been able to  gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals." - source Macronomics, 1st March 2016.

For us, this announcement from the PBOC is posturing and ambitions to deter further speculation and prevent speculators to gather together, ensuring in effect that renewed attacks will be postponed and inflict sufficient damage to the "short crowd". It seems to us that, shorting the yuan is indeed a very costly "Unobtainium" for now. End of our side note.

In this week's conversation, we would like to look at inflation expectations and what it means in terms of allocation and credit given the significant tightening move seen in recent weeks.

Synopsis:

• Macro and Credit - Is inflation really rearing its ugly head?
• Macro and Credit  - The bond yield curves are now fully inelastic
• Final chart: Demography is destiny

• Macro and Credit - Is inflation really rearing its ugly head?

Back in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:

"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", and of course it has worked again like a charm in 2016:

"If the policy compass is spinning and there’s no way to predict how central banks will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up."

Given it seems that US inflation expectations jumped after a renewed dovish Fed, one could argue that the compass in the US has somewhat stopped spinning hence the move in US breakevens and TIPS, in conjunction with the continuous support for Gold Miners (yes we are still long...). 

We continue to like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?

What we also find of interest is that some have argued that with inflation supposedly "rearing its ugly head", US Treasuries are vulnerable in this situation. No doubt the dovish stance of the Fed is going to wreak havoc on the short end of the curve, but we do think the very long dated part of the curve (30 years) still offer some good carry and roll-down in a growing NIRP world (yes we are still long, very long US duration as well, if you'd like to ask). 

But when it comes to "inflation" and "Unobtainium", we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine":

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

A very interesting 2015 paper by the Bank of Israel ( (Sussman, N and O Zohar 2015, “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015.) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area. Therefore, given the recent significant surge in oil prices towards the $40 mark, we do not think it is such a surprise to see a rise in inflation expectations in that context. This latest rise in inflation expectations could after all be transitory as well as the sudden rise in oil prices, particularly in the light of the tight relationship between the US dollar and oil prices. We think that the latest dovish stance of the Fed all has to do with their concerns relating to the "velocity" of the US dollar and the "unintended consequences" a too rapid rise of the "Greenback" could have on Emerging Markets (EM).

When it comes to the assessing the transitory nature of the rise in inflation expectations, we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 18th of March entitled "Yellen: The lady doth protest too much" where they disagree with the impact of the change in oil prices moves on inflation expectations we mentioned above:

"Key takeaways

• The Fed's dovish commentary on inflation is getting stale very fast.

• The evidence for a pick-up in wage and core price inflation is not just a couple data points, but is broad based.

• Markets are only beginning to come to terms with the reality of a steady upward move in inflation.

Our core disagreement with the Fed 

Once every year or two a significant gap develops between our thinking relative to the Fed. For example, early last year, we were struck by the Fed’s apparent complacency about the strong dollar. Fed officials seemed to dismiss the dollar, arguing that the US is a relatively closed economy and a strong dollar could be viewed as a vote of confidence in US growth rather than as a shock to US growth. That view seemed increasingly out of touch given both the size of the dollar move and the fact it continued to strengthen in the face of very weak US data. The Fed did not capitulate until March when they acknowledged the weaker outlook and moved out the expected timing of the first hike.
Today, a similar sized gap in thinking has emerged; this time around the outlook for core inflation. Despite stronger data, the FOMC continues to question whether core inflation is really picking up. “Inflation is expected to remain low in the near term …but to rise to 2% over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” Asked about the pick-up in core inflation during the press conference, Chair Yellen vaguely talked of volatile components. The forecasts were similarly dovish: even though year-over-year core has already jumped from 1.3 to 1.7% YoY, the median forecaster continued to look for 1.6% inflation this year and the median forecast for next year actually dropped from 1.9% to 1.8%.

Here we take a closer look at the gap between the FOMC and our own thinking. We think the Fed’s views are stale in several respects. We also argue that the FOMC is more willing to allow inflation to overshoot the 2% target than they are suggesting. Looking ahead, we think this meeting outcome will be the high point for Fed dovishness this year and we reiterate our long-standing call for hikes in June and December. 

It was a new day yesterday 

A key Fed concern is that weakness in oil prices will pass through to the core over time. However, most studies find very weak or nonexistent pass through. The worst of the oil price drop now appears behind us: prices seem to be finding a floor, with Brent up about 40% from its 20 January low. As base effects fall out of the data, headline inflation should continue to converge to the core (Chart of the day above).
The Fed is concerned that the strong dollar will continue to drive import prices lower as the lags play out. Presumably they are also concerned that if they are too hawkish the dollar could surge again. In our view, the period of rapid dollar appreciation is fading into history (Chart 1).

As a result, consumer import price deflation has already slowed sharply. For much of last year, consumer import prices were falling at 1.3% YoY, but the rate of decline has now dropped to just 0.2%. In our view, this is a major factor in the recent pickup in core goods price inflation. 

Yellen and company seem skeptical about any pick in wage growth: “in the aggregate data, one doesn't yet see any convincing evidence of a pickup in wage growth. It's mainly isolated to certain sectors and occupations.” She also pointed to the pickup in the participation rate as a hopeful sign. In our view, the evidence of a pickup in wages is compelling. The growth in average hourly earnings in the last 12 months is higher than the prior 12 months for seven out of 10 major industries. Overall compensation growth has accelerated relative to a year ago for all the major compensation gauges except the employment cost index. A lot of second-tier measures, such as surveys from the Fed, have also picked up modestly. 

At her press conference Chair Yellen was asked why she was skeptical about the recent inflation numbers. She said, “I see some of that as having to do with unusually high inflation readings in categories that tend to be quite volatile without very much significance for inflation over time.” We agree that there are a few special factors in the numbers, but not enough to cancel out the inflation signal. The Fed has developed “trimmed mean” measures of core inflation that strip out all volatile items rather than somewhat arbitrarily eliminating all food and energy items (Chart 2).

The trimmed CPI measure is still up at a solid 2.5% annual pace in the last two months and on a year-over-year basis has been accelerating since May 2015. A similar story applies for the trimmed PCE: it is rising at a 2% annual pace in the last two months and has been drifting higher since last January. In our view, these are trends, not noise. 

The one dovish aspect of the Fed view we agree with is the risk of inflation expectations unhinging to the downside. Measuring inflation expectations is difficult. Survey measures have an upward bias and market-based measures can be heavily distorted by technical factors. Nonetheless, after six years of weakness in wage and price inflation it would be surprising if inflation expectations for real people had not fallen. We believe confidence in the Fed’s inflation-creating ability surely is under pressure and is already impacting wage and price setting. Despite this headwind, however, wage and price inflation is already starting to pick-up. This suggests the economy is already at full capacity.

Living in the past 

This brings us to our final point. Chair Yellen has been adamant that the Fed has not changed its inflation target: it is still 2% and it is still symmetric; they are just as concerned about above-target inflation as below-target inflation. We are skeptical. In our view, there is a very strong economic case for “really risking” overshooting the target. Recall that the reason the Fed’s target is 2% rather than zero is that the Fed wants to minimize the risk of deflation and avoid hitting the zero lower bound for the funds rate when fighting recessions. Recent experience argues strongly for a higher inflation target:
• the Fed and other central banks have been stuck at zero for many years,
• inflation has been chronically low
• inflation expectations have fallen below the Fed’s target
• and the equilibrium real rate has probably dropped.
With the benefit of 20-20 hindsight we think the Fed would have adopted a higher target: say 3%, instead of 2%. The problem is that resetting the goal would require a very complicated debate at the Fed, raise concerns about a slippery slope (if 3%, why not 4%?) and would likely subject the Fed to even bigger political attacks. In our view, the politically correct answer is to keep the target, but err on the side of overshooting and then wait for the inevitable recession to knock inflation back down to target.
The bottom-line of all of this, in our view, is ongoing upside risks to inflation breakevens as the markets recognize the Fed can create inflation after all." - source Bank of America Merrill Lynch

It seems to us that Bank of America Merrill Lynch is focusing on the content, like any good behavioral psychologist we prefer to focus on the process. If indeed, the Fed has recently preferred a slowdown in the "velocity" of the surge in the US dollar for obvious external EM concerns, hence its dovish tone, what has also been a concern has been the overall global tightening of financial conditions. What is also of interest is that the surging dollar in recent years and falling US treasury yields have happened in conjunction with falling commodity prices and particularly a sharp drop in energy prices. This has therefore reinforced the possibility of coordinate actions from central banks which could have happened given the US dollar has dropped as much as 3 percent since the G-20 meeting held in Shanghai which ended on February 27. Whereas the Fed's latest dovish tone aims at somewhat lessen the impact of a rapidly surging US dollar, clearly to us the ECB's ambition of purchasing corporate bonds, is a clear demonstration of its willingness in suppressing a surge in credit spreads and a flattening of the credit curves which would in effect trigger a rise in the cost of capital and funding for banks and other players, and trigger a renewed credit crunch in Europe in the process. Not only has the US dollar fallen relative to other currencies, but in Europe credit spreads have fallen very rapidly to much lower levels thanks to the ECB "credit put".

When it comes to wage inflation, which would entice us to validate the "recovery" mantra, we believe wage inflation remains "Unobtainium", an impossible material as posited by Zero Hedge in their article from the 18th of March entitled "Feeling Underpaid? This Is What Wage Inflation Around The World Looks Like" which is pointing to the similar Deutsche Bank report we read with interest "Inflation Sensation - a global inflation monitor" from the 16th of March. If US inflation is indeed rearing its ugly head, then the jury is still out there when it comes to monitoring wage inflation in the US:

"Wage developments are striking across the G10. While there are tentative signs of producer and consumer price disinflation bottoming in some countries, wage growth remains particularly weak. This may be because wages are a backward looking indicator of inflation pressure, but it may also be a sign of second-round effects influencing price-setting behaviour." - source Deutsche Bank

What seems so evident to us is that Central banks such as the ECB are pouring oil on the fire as they have trying to push long-term rates down after having succeeded in pushing short term rates to zero. 

In Europe, it is clear that the ECB's policy is having no lasting effect on prices and inflation. It is because the ECB can create all the money it wants, but it cannot command it to flow "uphill", in wages, hence the "Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hands:

 - graph source Deutsche Bank

As we pointed out in our recent conversation "The Monkey and banana problem":

"Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. 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" - source Macronomics, February 2016

The results of the "Unobtainium" process is that money flows into Wall Street and less so into Main Street as a result. The latest decision by the ECB is putting the demand for credit products into "overdrive" while in no way the most recent TLTRO is altering the credit profile of ailing Italian banks and their balance sheets bloated by Nonperforming loans (NPLs). "Liquidity" via funding at zero cost doesn't resolve "Solvency". But, yes, the rally in credit has legs for the time being.

The "Unobtainium" process followed by our generous gamblers have not only enticed even more speculation downhill, in the government bond markets but now in the credit markets where we still favor quality and in particular US Investment Grade (for carry purposes...). All of this brings us to our next point, namely that bond yield curves behavior have changed dramatically.

• Macro and Credit  - The bond yield curves are now fully inelastic

Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach for the long end of the curve particularly because, we agree with Louis Capital Markets latest points made in their most recent cross asset note from the 16th of March entitled "How does it end?":

"Last week there was also a huge move on long term Japanese rates. The 10 year Government bond yield appears now to be well anchored in negative territory. How is this possible? In what world do we live? 

Below, we show the average 10-year bond yield for developed countries and it stands at an all-time low, below 1%. We live in a world in which the public sector has never been so indebted. However, it can borrow money at a rate that has never been so low.

Economic textbooks are filled with details of the term structure of interest rates and the message of the bond yield curve. Below right we show that these academic books should be used now for lighting fires because the historical relationships have fully broken down. Since 2009, we have faced a long lasting capitulation towards the idea that one day long term bond yields will recover their pre-crisis levels. Thus, while the slope of the bond yield curve was negatively correlated to short term rates, it is now fully inelastic: short term rates have been stuck to 0% since 2009 and long term bond yields have moved from 3% to 1%.

The fact that long term bond yields confirm that even in the long term the situation will never normalise poses two questions. Firstly, do bond markets fundamentally misunderstand the economic situation or are they correct in their expectations? The problem is that central banks, who decide the level of short term rates, have remained unclear about what will be the next “normal situation”? The case of Sweden, one of the first countries having experienced deeply negative rates, is worth mentioning. We show below the dynamic of the core CPI, of wages, of Employment and we add the main refinancing rate into the mix as well. The  first chart below shows absolute data and the second one, it is a z-score (in standard deviations around the mean).

Sweden: Key Economic Data  

We see that in Sweden, the employment situation has normalised, the core inflation rate has normalised, the wage dynamic is a bit weak but interest rates have never been so low in economic history. Why has the Swedish central bank decided on such a policy? Or to put it in another way, what is required to put rates back above 0%?

The Fed will meet in two days. We believe Fed Board members remain very uncomfortable with the current situation. We will not repeat what we have said for many months now, that slacks in the economy no longer exist and that inflation is back to trend. The problem is not the US economy, the problem is the US$ leverage in the emerging world and the declining EM currencies. The question for Fed members is clearly subjective. Should they grant more time to EM countries to make their adjustments or should they reload their monetary policy tool because the US economic cycle is reaching maturity? These are two different questions and up to now, Fed members have refused to choose, leaning however a little towards the first solution.

Our stance remains the same, because we are bullish on the US economy, we do not understand how 5y×5y forward USD rates can trade below 3%." - source Louis Capital Markets

Apparently, the Fed has chosen to throw a lifeline to EM countries and to give them more respite by tampering their "normalization" process, but as far as our "inflation expectations are concerned and in relation to "Unobtainium", when it comes to the US we remain "data dependent" and it remains to be seen if the US has indeed reached "escape velocity" when it comes to "wage inflation". We do not share the same optimism as LCM on that matter and believe the rise in "inflation expectations" to be for the time being a temporary phenomenon. Yet, if indeed the slope of the bond yield curve which was negatively correlated to short term rates, is now fully inelastic from a strategy perspective, we believe being long US TIPS (given their embedded deflation floor), long gold miners and long US long bonds still represent a relatively attractive "allocation". What is as well interesting is that the short-end of the US yield curve is prone to more volatility in similar fashion than long-dated Japanese and German government bonds have become as well significantly volatile thanks to NIRP. 

The volatility of of the US yield curve is clearly in the front-end of the curve as indicated by Bank of America Merrill Lynch in their Situation Room note from the 16th of March entitled "Marking the Fed toward the market":

"Marking the Fed toward the market 

The main story at the conclusion to the March FOMC meeting was that, by lowering the dot plot to two rate hikes this year, the Fed chose to mark their view on the near term path for the Fed funds toward market expectations. In other words, the Fed acknowledged, what the market has suspected for a long time, that it will be difficult for the Fed to hike rates in an environment of global weakness and deflationary pressures. Hence the big bull steepening move in the Treasury curve with 2-year yields 10.9bps lower while 30-year yields were comparatively little changed (-2.0bps). 

As a result the likelihood of a hawkish monetary policy mistake derailing the US economy declined significantly and VIX dropped 11.0% as stocks rose 0.6%. Less economic uncertainty in turn is positive for credit spreads, while the decline in interest rates is negative. However, with longer term interest rates holding up well the net effect is positive and supportive of our bullish outlook for HG credit as well as the Treasury curve steepening move supports our view that the 5s/10s spread curve flattens. Sector wise today's Fed moves are more positive for industrials than banks, although relative valuations and last weeks's ECB moves mitigate that." - source Bank of America Merrill Lynch

Whereas the rally in the US Investment Grade has been significant, the ECB's latest "generosity" package has lead to a rush towards credit spread products, enticing investors to renew the "beta" game in the process, namely reaching for yield and credit risk in the process. If indeed the short end of the European government bond market has become irresponsive thanks to NIRP and has plunged most of European short term bonds into negative territory, the consequences of yield curves becoming "inelastic" is pushing punters towards the only "less perceived risky"decent game in town namely investment grade credit. This is validated by the flows seen in Europe as shown in Bank of America Merrill Lynch chart below from their Follow the Flow note from the 18th of March entitled "Front-running” the ECB…":

"…as investors rush to buy corporate bonds 

We have seen it in the past. When the ECB announced the government bond buying program, inflows accelerated into the asset class. With the help of the ECB, credit flows broke free from a long period of outflows. Last week’s positive inflow into high-grade and high-yield funds was the third consecutive and the biggest in 53 weeks.

This considerable shift in momentum was mainly thanks to a decisive shift in high grade. The asset class recorded its first inflow in ten weeks and the biggest for more than a year. High yield funds enjoyed another - the fourth in a row - week of inflows.

Elsewhere in fixed income, government bond funds recorded another outflow during the previous week.

Money market fund flows were also in the negative territory, recording a fourth consecutive outflow – the longest streak since March ‘15.

To the contrary outflows continued from equity funds. The asset class has suffered outflows for the last six weeks, which now sum up to $15bn. This is the longest period of outflows seen in equities since October ’14." - source Bank of America Merrill Lynch

The outflows from equity funds do not surprise us. This what we pointed out in our recent conversation "The Monkey and banana problem":

"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." - source Macronomics, February 2016

No doubt that the "European investor monkey community" is fearful of another "electric shock", so for now they'd rather play the "reach for bonds", ditching equities in the process. The beauty of the Skinner box...or from "Unobtainium" (Main Street) to "Obtainium" (Wall Street), but, we are ranting again...

This leads to our final point and final chart, that no matter how hard central bankers try to generate "Unobtainium", demography matters, end of the day, no matter how big your "printing press" is.

• Final chart: Demography is destiny

As we have pointed out, like many others before us, when it comes to the trajectory of bond yields and inflation expectations, demography matters. This is the point we made in our February 2015 conversation "The Pigou effect" relating to our long term deflationary stance. 

You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:

Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price!

"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."

The problems facing Europe and Japan are driven by a demographic cycle not a financial cycle. This once again illustrated in our final chart and table from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 18th of March:

"Demography is destiny 

The big picture
We borrow this week’s title from Dr. Joseph Coughlin of the MIT AgeLab, who was a featured speaker at this week’s BofAML Residential Mortgage and Housing Finance Conference. For financial markets, the key demographic reality is that populations across the globe are aging, some more rapidly than others. BofAML Chief Investment Strategist Michael Hartnett noted this in the recent piece, BofAML’s Transforming World Atlas: Investment themes illustrated by maps.Table 1 shows, by country, the percentage of populations that are 65 years old or over, as of 2015 and projected for 2050.

Japan is seen as the world’s leader in age, both now (26%) and in 2050 (37%). Europe (Germany, Italy, Spain) is not too far behind. The US, currently at 15%, is next, although countries such as China and Brazil will age more rapidly over the next 35 years and overtake the US in terms of the percentage of people above 65 years old. Not surprisingly, as populations age, productivity and consumption patterns change, with deflation conceivably an associated phenomenon. The bond market experiences of Japan and Germany relative to the younger US are perhaps illustrative. Chart 1 shows the history of 30yr bond yields in Japan, Germany, and the United States over the past 15 years. Japan has led the way lower while Germany has followed suit and narrowed the gap to JGB yields. US yields have moved lower but not to the same degree.

The question arises: will the US inevitably follow and see 30yr bond yields head below 1%? So far, US yields have proven to be somewhat more resilient than in Japan and Germany, and the different demographic outlook (less aging) argues for less downward pressure on yields than in Europe and Asia. Nonetheless, we should note that one of our conference presenters, Scott Minerd of Guggenheim Partners, made the case for a 1% 10yr treasury yield at some point in the not too distant future; currently, we are simply at the middle of the downward trend channel in rates of the past 30 years (Chart 2).

At a minimum, the aging of the global population suggests it is not unreasonable to think this is at least reasonably likely outcome at some point in the future. " - source Bank of America Merrill Lynch.

No offense to Bank of America Merrill Lynch but the title they used has not been authored by Dr. Joseph Coughlin of the MIT AgeLab but by August Comte, a French sociologist (1798-1857).

You probably understand by now, our inclination towards long dated US Treasuries. End of the day, if central banks cannot generate "Unobtainium" in the form of "renewed" inflations, what is not to like in the "carry play" offered in the long part of the US Treasury curve? We wonder.

"Low interest rates are usually attributed to low inflation, weak economic growth and super easy monetary policy. But there's another deep-seated factor that doesn't get much attention: demographics." - Greg Ip, Canadian journalist

Stay tuned!

Macro and Credit - The reverse Tobin tax

"A question that sometimes drives me hazy: am I or are the others crazy?" - Albert Einstein

Watching with interest the stabilization and even tightening in the credit markets, in conjunction with People's Bank of China (PBOC) cutting by 50 bps its Reserve Requirement Ratio (RRR), adding to the "risk-on" environment witnessed recently and given the continuous conversations relating to NIRP, we decided, for our elected title analogy to refer to the Tobin tax. The Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system which ended on August 15 of 1971. 

Why, you might rightly ask dear readers, did we elect to talk about a reverse Tobin tax in our chosen title?

Well, if you remember correctly from our previous conversation "The Monkey and banana problem", we argued that NIRP doesn't reduce the cost of capital. NIRP is simply a currency play.

And if indeed NIRP is a currency play, given James Tobin's objective was to mitigate currency volatility, no doubt to us that the latest bout of volatility witnessed on the Japanese yen is indeed some form of a "reverse Tobin tax". What we find amusing is that James Tobin was influenced by the earlier of John Maynard Keynes on general financial transaction taxes and the famous chapter XII of the General Theory on Employment Interest and Money. Keynes was an avid speculator and the recent NIRP put in place by various generous gamblers aka central bankers, is leading to a renewed frenzy of speculation in the bond market where all the fun is with more and more bonds yielding on the negative side and their prices reaching new record high levels:

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation." - John Maynard Keynes, page 104.

Indeed the situation is becoming serious when the bond market has become a whirlpool of speculation. On a side note, we find the PBOC move amusing given, as we posited with the ECB LTROs, liquidity injections doesn't resolve solvency issues, particularly when it comes to Nonperforming loans (NPLs).

John Maynard Keynes would be proud of NIRP given it will definitely lead to the "euthanasia rentier" but unfortunately also to the disappearance of "capital" as he wrote:

"I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.

Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward..." - John Maynard Keynes

We do not think in the end, capital will be "free and "abundant" with NIRP. Keynes added at the time in relation to tax on transactions the following:

"The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States." - John Maynard Keynes, page 105.

For us, NIRP is a "reverse Tobin tax" leading in the end to the "euthanasia of the rentier" as more and more government bonds fall into negative yield territory, hence our chosen title. If indeed James Tobin tax was supposed to lead to lower volatility in the FX markets, the reverse Tobin tax aka NIRP is leading to the reverse, that's a given but we are rambling again...

In this week's conversation, we will look again at the credit cycle and the issue with correlations with diversification we recently discussed. We will as well look at how NIRP will be playing out credit wise and trouble brewing in Asia. 

Synopsis:

• Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months
• Macro and Credit  - The US late stage will have nasty credit consequences on Asia
• Final chart: US Rates skew may reflect policy mistake / recession risks

• Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months

In our last conversation "The Monkey and banana problem" we indicated that NIRP would exacerbate the demand for yield as the saving rate goes up, which no doubt is leading the negative feedback-loop to push the frenzy for bonds into "overdrive" hence for the first time we have seen the demand for the Japanese 10 year government bond (JGB) pushing for the first time the yield into negative territory. This of course a clear manifestation of the "reverse Tobin tax" and the "euthanasia of the rentier".  The operant conditioning chamber we discussed last week, aka the Skinner box has indeed led to a "Pavlovian" response leading to even further greater compression. As we posited last week, what matters more and more to us is tracking "correlations" given the implications for "diversification" are not neutral:

"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)." - Macronomics, February 2016

When it comes to "correlations" we read with interest Société Générale's take from their Multi Asset Snapshot note from the 26th of February entitled "A balanced portfolio for an imperfect world":

"While we may have been too aggressive with a balanced allocation before the market downturn, we're not keen to take the revolving door and go risk averse now. We are recommending a balanced allocation. The average correlation between assets has recently pulled back, making us more convinced to keep the current allocation of 50% equities/50% bonds and others.

- source Société Générale

What effectively Société Générale is showing is confirming somewhat we have posited as of late in our conversation "The disappearance of MS München". Namely that in a world of growing "positive correlations" diversification reduces the benefit of diversification:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by this sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world." - source Macronomics, February 2016

This also a subject we discussed in our May 2015 conversation "Cushing's syndrome":

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

What we are currently seeing is a repricing of bond volatility which had been "anesthetized" by central bankers leading to Cushing's syndrome. Central bankers meddling with interest rates levels have led investors to get out of their comfort zone and extend both their risk exposure and duration, taking the repressed volatility regime as an empirical factor in their VaR related allocation risk process. Now they are rediscovering in the ongoing turmoil that, yes indeed long duration exposure is more volatile than shorter ones. They are also rediscovering "convexity" with artificially repressed yields. They are being significantly punished the more exposed to "credit" duration they are." - Macronomics, May 2015

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment. Where is the value left in your bond holding when the German 10 year government bond (Bund) yield is about to turn negative? Yes, it will go negative and so will probably be the rest of the Japanese curve to mimic what has been happening on the Swiss yield curve. The most dangerous negative side effect of the "reverse Tobin tax" is already pushing the Swiss real estate bubbly market into overdrive as indicated by Bloomberg on the 29th of February in their article "Mom-Pop Investors Rush Into Swiss Property at Riskiest Time":

"Mom-and-pop investors are rushing into Swiss properties just as the market faces its greatest threat of a bubble in a quarter century.
“I see two protracting trends,” Patrik Gisel, chief executive officer of Swiss Raffeisen, the country’s third-largest bank, said in an interview in Zurich. One involves big money -- institutional investors such as pension funds and insurance companies who have invaded the market, driven by negative yields on Swiss government bonds. More recently, a new group of investors has entered the fray, buying properties to rent or develop rather than for a primary residence.
“What’s really new is that private investors are piling in to buy real-estate assets for yield due to limited options,” he said. These aren’t ultra-rich speculators, rather well-to-do people looking to build nest eggs at a time of record-low interest rates and market turmoil. Although they are still just a small part of the market, “this is reducing the professionalism,” he said.

Soft Landing

Raiffeisen, a cooperative encompassing about 300 regional banks, is one of Switzerland’s five systemically relevant banks, along with UBS Group AG and Credit Suisse Group AG. It holds about 17 percent of the Swiss mortgage market, with home loans representing about 95 percent of the total volume of 166 billion francs ($166 billion) at the end of the 2015.
The Swiss property market is facing the greatest threat of a real estate bubble since 1991, UBS said in a report this month on the subject. Loan applications for properties not occupied by owners dipped in the fourth quarter, yet remain historically elevated at about 18 percent of the overall demand. House prices rose 0.5 percent from the third quarter and around 2 percent yearly.
While the risk of default on mortgages remains low in Switzerland, vacancy rates are rising, with prices “driven by investments, not by the need for living space,” Gisel said. Unlike in countries including the U.K. and U.S., Swiss buyers traditionally are looking to make a lifetime investment as capital gains taxes make it costly to speculate.
Gisel, formerly the deputy CEO who succeeded Pierin Vincenz at the head of Raiffeisen last year, said he sees a “soft landing” in the property market. The bank said during its earnings report Friday that prices are stabilizing at a high level or declining slightly.

Swiss apartment prices and mortgage lending climbed by about a third between 2007 and 2014. A price increase of 2 percent would have been unappealing just four years ago, Gisel said.
The Swiss National Bank introduced charges on bank deposits in an effort to weaken the franc, which soared after it lifted its three-year-old cap on the currency in January 2015. Some big banks such as UBS and Credit Suisse have passed on the pain of negative interest rates to their larger institutional clients. Retail clients have been spared, for now.
“Equities are too risky for many private investors, bonds don’t yield anything,
so people go for real estate but often have a poor understanding of this market,” says Fredy Hasenmaile, head of real estate research at Credit Suisse. Inexperienced investors tend to underestimate the costs associated to maintain a property." - source Bloomberg

We have argued in a 2011 conversation that the policy of achieving a high home ownership rate is the biggest threat to an economy:

"The issue with enticing a high home ownership rate is the level of household debt it generates. It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.

For us, a housing bubble is a Weapon of Economic Destruction (WED) and pushing real estate prices into overdrive is certainly akin to a "reverse Tobin tax" and the most efficient way in destroying "mis-allocation" of capital on a grand scale and "euthanizing the rentier" for good.

But moving back to the subject of the credit cycle, we still believe we are in 2007, although subprime is not the "prime" suspect this time around as the Energy sector woes have clearly spilled over into over sectors as well. The rising of distress securities is creeping up and it is not only in the Energy sector as displayed in the below S&P Global Market Intelligence chart:

"A host of U.S. energy companies joined LCD’s distressed debt Restructuring Watchlist last week, adding to an already hefty group of issuers from that still-struggling market segment.
The Watchlist tracks companies with recent credit defaults or downgrades into junk territory, issuers with debt trading at deeply distressed levels, as well as those that have recently hired restructuring advisors or entered into credit negotiations.

- source S&P Capital IQ LCD

This is entirely due to ZIRP and now NIRP as shown in the below Société Générale from their Credit Weekly note from the 26th of February 2016 entitled "Will the G20 disappoint credit investors":

"In a low real interest rate environment, however, such as the 1970s or the present, the four year period of stability disappears and the credit cycle becomes much shorter. Chart 3 illustrates this:

Table 2 above implies that the global credit cycle is, as always, relatively synchronous, with the US leading EM by around six months. Assuming two-year widening and two-year tightening cycles, with a peak of the cycle in early 2016 and a trough in late 2017 or early 2018, this implies the following:

- source Société Générale.

The United States are leading once more the credit cycle and the rapid pace at which spreads have widened since the cost of capital has been moving up since the summer of 2014 is indicative of how late the cycle is and the potential spillover to Emerging Markets thanks to Global Financial Conditions tightening in conjunction with the relentless rise of the US dollar.

When it comes to credit and the "Japanification" process, the hunt for yield is still running strongly although some might have already moved higher the quality spectrum in the light of the deterioration seen recently in credit spreads. European investors in a "reverse Tobin tax" environment will be eager to go for even more duration and credit risk as posited in Société Générale's note:

"European investors will still be hungry for yield. European ten-year yields have fallen almost 50 basis points this year, with the Bund yielding just over 10bp. It’s hardly surprising that European insurance companies are steering their clients away from guaranteed life products, as our insurance analyst Rotger Franz has noted, but they are still left with legacy products that need to be funded. Our SG shortfall model estimates the current gap between what insurers need and what the government markets are offering at almost 140bp.

Given this gap, we think the demand for credit will remain strong. It’s worth noting, however, that this demand will be much stronger in the BBB area than in the AA and A area, since spreads have compressed too much in those areas to offer the returns that investors need." - source Société Générale.

Insurers have are indeed struggling with NIRP and are slowly getting "euthanized". While we have long been highlighting the dangers with Emerging Market corporate debt denominated in US dollars, it is worth highlighting Société Générale's comment before we move on to our next point:

• "Emerging market sovereigns will not be able to bail out their corporates: The ratio between EM sovereign spreads and corporate spreads has narrowed this year, when the mismatches in the indices are accounted for. Yet EM corporate debt – either domestic debt as a percentage of GDP, or external debt as a percentage of reserves – is often much bigger than government debt, as we noted in "Can EM sovereigns really bail out their corporates?" We think this year, investors will realise that many EM corporates will not be bailed out by their sovereigns.
• EM defaults will be higher and recovery rates lower than the market expects. Given the weakness of commodity prices and the weakness of EM currencies, we are more bearish about these issuers than we are about US high yield issuers." - source Société Générale

The latest sign of the strain facing EM corporate issuers is clearly illustrated by Mexican giant PEMEX losing $32 billion in 2015. Mexico's largest company and big contributor to the government's budget has more than $87 billion in debt and hasn't recorded a profit since 2012 according to Bloomberg. The government of Mexico has pledged financial support for its ailing giant. 

This leads us to our second point and once again the unintended consequences of our Macro theory of reverse osmosis playing out as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

Now the "flows" are turning into "outflows" leading to the following points we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

We also added at the time:

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates)." - source Macronomics August 2013

While the PBOC might have indeed bought some time in adding more liquidity, the worrying trend of capital outflows have yet to meaningfully slow down, meaning for us that, indeed Asia should as well be the focus of more attention, but not only China...

  

• Macro and Credit  - The US late stage will have nasty credit consequences on Asia

Back in July 2015 in our conversation "Mack the Knife" we indicated that EM credit spreads and oil prices were highly correlated. 

The correlation of oil and credit spreads mean that indeed the unintended consequences of the surge of the US dollar and the fall in oil prices have not translated much as before into Asia's energy-importing economies as illustrated by Nomura in their Asia in Charts note from February 2016 entitled "Asia's coming credit crunch":

"• Cheap oil has not benefited Asia’s energy-importing economies as much as it had in the past. In early 2008, if you responded “sub-6%” to the question of how fast Asia ex-Japan’s economies would grow if oil prices halved and most Asian central banks slashed rates to new, or near, record lows, you would have been scoffed at. More of the oil windfall appears to have been saved or offset by the China slowdown, weak EM demand, high domestic leverage and low productivity growth.

• That said, the commodity price drop has been a big differentiator in favour of Asia, as fundamentals and growth have fared better in Asia vis-à-vis LatAm and EEMEA. Asia is the least ugly in EM, at least for now. If risk sentiment turns, Asia may experience a short-run relief rally, buoyed by: 1) still ample global liquidity; 2) any signs of China growth stabilising, albeit it would be temporarily, in our view; and 3) more discriminating investors in global emerging markets in Asia’s favour.

• However, more fundamentally the seeds are being sown for a credit crunch and financial stress in Asia:
1) high and still-rising private debt, combined with still elevated property prices; 2) slowing potential growth rates; 3) increasing foreign-currency debt exposure; 4) large herding-like investments by global asset management companies in Asia (‘original sin II’); 5) the Fed surprising with more/faster rate hikes; and 6) China’s economy facing a secular slowdown in growth in 2016 and 2017." - source Nomura

As our reverse "macro" osmosis has been playing out and given the credit binge witnessed in some parts of Asia, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring.

There is a heightened possibility of a credit crunch looming in Asia as posited by Nomura in their very interesting report:

"Asia is setting itself up for a credit crunch 

• The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can cause financial decelerator effects.

• Cheap credit has weakened productivity by misallocating capital (eg. property speculation), dis-incentivising supply-side reforms and keeping zombie companies alive. Potential growth is slowing across most of Asia.

• Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.
• Triggers of a credit crunch could be the market caught off-guard by Fed rate hikes, USD sharp appreciation, a China setback, or a high profile Asian corporate default prompting global asset managers to pull out from the region en masse and causing market liquidity to evaporate.

 Asia’s credit and property price gaps are sending warning signals

• Pioneering work at the BIS by Claudio Borio and Philip Lowe in the early 2000s found that over a 4-year horizon a credit gap of >4% predicted 88% of crises in industrial countries with a noise to signal ratio (NSR) of 0.21, while an equity gap >60% predicted 67% of crises with an NSR of 0.15. Jointly they predicted 73% of crises with an NSR of 0.02 (i.e., issued wrong signals only 2% of the time).
• Since then more studies, including of EM crises, have reaffirmed that credit is the single best predictor of crises and, with better data, property prices are generally found to be more important than equity prices.
• In a more recent 2011 BIS study (working paper No. 355) of 36 advanced and EM countries it was found that over a 3-year horizon, a credit gap >10% predicted 67% of crises with an NSR of 0.16, and a property gap >10% predicted 77% of crises with an NSR of 0.33. This is an ominous sign for Asia, as highlighted in the table below.

The best indicator of financial crises is the credit gap; the property price gap is also a strong indicator, and jointly they send a strong signal

 (click to enlarge picture)

- source Nomura

From the table above, and as a follow up on our HKD take from our  December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. On this specific case, Nomura's report has added more on our justified concerns in their note:

"Hong Kong could be Asia's flashpoint

 HK stuck between a rock (Fed hikes) and a hard place (ebbing China)

• Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 112% (they have corrected 11%), and the ratio of private non-financial credit to GDP has surged to 293%.

• The real effective exchange rate has risen 26% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015.

 • Foreign assets and liabilities have surged since 2008. this leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.

• Economic hardship could ignite further political and social unrest, or vice versa, ahead of the 2016 Legco elections (around Sep) and 2017 chief exec elections. We would not rule out a change to the HKD peg regime." - source Nomura

And, as per us winning the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our December "Cinderella's golden carriage", we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. Maybe it will be for 2017 after all...For now the Hong Kong dollar has recorded the biggest monthly gain since 2011 in February on optimism that the city will be able to maintain its peg to the US dollar as reported by Bloomberg in their article from the 29th of February entitled "Hong Kong Dollar in Biggest Monthly Gain Since 2011 as Peg Holds":

"The Hong Kong dollar advanced 0.18 percent this month to HK$7.7724 against its U.S. counterpart, the biggest increase since October 2011, data compiled by Bloomberg show. The currency rose 0.06 percent on Monday to trade near the strong end of its HK$7.75-HK$7.85 trading range.
“The Hong Kong dollar was one of the biggest speculative targets in January, especially amid fears of the yuan being devalued,” said Irene Cheung, a foreign-exchange strategist at Australia & New Zealand Banking Group Ltd. in Singapore. “We need to watch the yuan, given how it’s affecting sentiment across markets. If the dollar-yuan rate continues to remain broadly stable, there’s no reason to focus on the Hong Kong-dollar peg for now.”

Yuan Deposits

The Hong Kong dollar was linked to the greenback in 1983, when negotiations between the U.K. and Beijing over the city’s return to Chinese rule spurred an exodus of capital, and policy makers in 2005 committed to limiting declines to the current range.
Hong Kong’s yuan deposits rose by 0.1 percent to 852 billion yuan in January, the Hong Kong Monetary Authority said on Monday. The pool posted its first annual decline last year, while issuance of Dim Sum bonds fell for the first time since the market’s inception in 2007." - source Bloomberg

As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far has not been able to  gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals.

When it comes to the fate of the HKD peg, Nomura has been solacing our concerns in their note:

"HKD re-pegged to the RMB? 

The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported
US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed accelerates hiking and China’s growth keeps slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura

Given our keen interest on this eventuality, we will be not only monitoring that space but also tracking financial conditions in Asia rest assured.

Finally for our final point and chart, we would like to point out that it's not only Hong Kong which is stuck between a rock (Fed hikes) and a hard place (ebbing China). The Fed is as well in a bind.

• Final chart: US Rates skew may reflect policy mistake / recession risks

Our final chart comes from Bank of America Merrill Lynch's Liquid Insight note from the 1st of March entitled "Rates skew may be pricing a policy mistake":

"• US rates skew is now inverted in both short- and long-dated expiries, despite more dovish Fed expectations
• We believe this, at least in part, reflects higher perceived odds of a policy mistake and/or growth shock ahead
• From a historical standpoint, inverted long-dated skew is consistent with late stages of the hiking cycle

Inverted skew: Not a good sign for the Fed

A notable recent development in the US rates vol market is the inversion of the skew surface, with low strikes trading at a premium to high strikes. Short-dated skews were first to invert earlier this year. Today skews are inverted across the board, including very long expiries (Chart above). Importantly, the skew inversion occurred against expectations of a more dovish Fed. The market now sees the next Fed hike only by 4Q17, a much less hawkish outlook than FOMC projections. Lower rates coupled with expectations of a more accommodative Fed normally imply upward risks to rates. Yet, the volatility market sees risks to rates skewed on the downside even at very long horizons.
We believe this is a worrisome signal to policy makers. The inversion of the skew all the way into longer horizons suggests perceived risks go beyond the recent financial stress and may reflect greater perceived odds of a policy mistake/recession risks. Inverted long-dated skew is consistent with late stages of hiking cycles." - source Bank of America Merrill Lynch

To hike in March, or not to hike, that is the question...

"Insanity - a perfectly rational adjustment to an insane world." - R. D. Laing, Scottish psychologist

Stay tuned!