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!

Credit - The Pigou effect

"Nothing is perfect. Life is messy. Relationships are complex. Outcomes are uncertain. People are irrational." - Hugh Mackay, Australian scientist

While continuously following the evolution of the Euro convolution, with the temporary relief of the outcome for a Greece and the high probability of a Grexit in the end, as well as looking at the continuous fall in one of our favorite global demand indicator namely the Baltic Dry Index falling below its 1986 level towards 513 on the 22nd of February, we reminded ourselves for our title analogy of the Pigou effect, which is the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation. For Arthur Cecil Pigou, real wealth was simply defined as the sum of the money supply and government bonds divided by the price levels. He argued that when an economy was in a liquidity trap, monetary stimulus to increase output could not be used given there is little connection between personal income and money demand. Of course what we find of interest is that if the Pigou effect had been effective, then Japan should have exited deflation much sooner. Pigou, (just like our central bankers of the world today) hypothesized that falling prices would make consumers feel richer (and increase spending, that famous "wealth" effect) but Japanese consumers tended to report that they preferred to delay purchases, expecting that prices would fall further, which of course is exactly what has been happening.
It appears that "The Pigou effect" has been highly criticized as well by Michał Kalecki because: "The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a confidence crisis."

But, when it comes to our title analogy and the "Pigou effect", we find it quite amusing that Pigou had been John Maynard Keynes' professor. Pigou's theory is completely flawed as it is based on the hypothesis that there cannot be a prolonged period of overproduction (China) and the artificial life support of "zombie" companies (European banks, Chinese shipping companies, etc). Arguably, the trajectory of the Baltic Dry Index is indeed putting to the test that very assumption from the University of Cambridge professor. It is interesting to note that his student, John Maynard Keynes argued that a drop in aggregate demand could lower both employment and the price level in unison, an occurrence observed in the deflationary depression, which is what we are currently seeing in Europe and what is also coined by some economists the "Keynes effect":

"The effect that changes in the price level have upon goods market spending via changes in interest rates. As prices fall, a given nominal money supply will be associated with a larger real money supply, causing interest rates to fall and in turn causing investment spending on physical capital to increase." - source Wikipedia

Of course both the teacher and the student were wrong, as the former ignored the probability of extended oversupply and the latter implied that insufficient demand in the product market cannot exist forever. The Keynes effect does not occur in a "liquidity trap" according to "Keynesians", which is the result we are seeing in Europe with lack of aggregate demand due to lack of private credit as most European banks as they are constrained by their inherent "lack of capital". It is also particularly due to ZIRP and the Zero Lower Bound Problem. The result of this "liquidity trap" is, for us, self-inflicted. We discussed the issue of "crowding out" of the private sector in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector."Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments. It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

In this week's conversation we will take another look at the long term prospect for the European banking sector, as we strongly sit in the deflationary camp. We believe that rates will stay low for longer, particularly in Europe, which is caught in a vicious "japanification" process. We will also reassess some of our earlier views (long US treasuries, long Gold, short JPY), particularly in the light of the increased volatility and the impressive rise in US yields during the month of February which we highlighted in our most conversation.

Synopsis:

• The "crowding out" effect
• Banks stocks or credit?
• Banking crisis? Sweden lead the way
• Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!
• Reassessing some of our earlier views
• The battle against the deflationary bust looming will not be won by ZIRP and QEs
• Real wage growth is the Fed's greatest headache
• Volatility is a buy and will greatly impact negative convexity assets
• On the fallacy of "Balance accounting" as per Sir James Goldsmith

• The "crowding out" effect:

The "crowding out" effect we mentioned on numerous conversations pushes yields down further meaning bonds investors are having a field day. Weak demand and ZIRP entices speculations and buy-backs rather than investments and employment. Banks play heavily the carry trade and therefore increase their link to their respective sovereigns while the private sector (SMEs) hasn't been able to easily access credit, leading to a credit crunch in Europe in the last couple of years triggering weaker aggregate demand, surging unemployment, etc.

In similar fashion to Japan, government bonds have replaced private sector lending on European banks' balance sheet. The comparison between Japan and Europe in terms of "evergreening" bad loans (extend and pretend that is, such as "shipping loans" for instance) and impaired financial sector can be ascertained from German bank Berenberg's note entitled "Turning Japanese...we really think so" published on the 10th of February.

"Policy responses – lessons not learned: In terms of fixing the banking system (the need to recapitalise banks rapidly and early on) and monetary policy (the need for shock and awe), European policy makers appear to be aware of, but have not taken on board, the lessons from Japan or the US in the 1930s. Perhaps, like their Japanese peers before them, they believe the economy is facing cyclical not structural challenges, or maybe they are concerned about their reputations or wish to prevent panic. But to be clear: fixing the European banking system remains unresolved and will remain so until hidden loan losses are dealt with.
● Interest rates will be lower for longer than anyone is prepared for: Deflationary forces arising from the balance sheet recession will see loose monetary policy
persist for another 10-15 years. For European banks, the implications are clear.

o Balance sheet structures to transform: Private sector deleveraging, continuing fiscal deficits and tightening regulation will make balance sheets smaller, drive the loan-deposit ratio below 100%, see (sovereign) fixed income assets double their share of bank assets, and lead to ever increasing equity-to-assets ratios.
Non-performing loan (NPL) ratios may yet double as they did in Japan following the onset of deflation.
o Balance sheet profitability to decline: Flat yield curves close to the zero bound and a substitution of private sector loans with sovereign bonds will push the net interest margin lower for many years to come. Combined with elevated loan losses, returns on assets (RoAs) will remain at half the levels of the precrisis, golden age.

● Share price and valuation parallels offer no support: The parallels with Japan have also held at a share price and valuation level, and suggest that there remains considerable relative downside to come (30-40%?) for European banks." - source Berenberg

Japan and the "crowding out" effect as illustrated by Berenberg in their lengthy note:

- source Berenberg

• Banks stocks or credit?

As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe. This can also be ascertained by the comparison in terms of returns for banks between Japan and Europe as highlighted by Berenberg in their great note:

"Given the continuing poor disclosure of loan quality by the European banks, we cannot say for certain what the capital deficit really is. However, history consistently shows that at the end of a 60-70 year debt cycle when an extended balance sheet recession takes hold, there are substantial hidden loan losses. But at some point, in the face of continuing weak nominal economic growth, banks must move from forbearance to foreclosure within their loan books and thus crystallise the loan losses." - source Berenberg

This support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

The extend and pretend game of hidden losses has been of course been supported by both LTROs and by now the much anticipated ECB QE.  So, forget about "dead cat bounces" in European banks share prices, as Japanese history has shown, pain is here to stay for shareholders as illustrated as well clearly by Berenberg:

"In Figure 29 we compare the relative performance of banks against the market in Europe and the US with that of Japan (with the Europe/US data rebased by 11 years to map the timescale of Japan). The good news is that the material relative underperformance of Eurozone, UK and US banks matches that of Japan both in terms of scale and duration. The bad news, however, is that the worst is not over. Japanese banks staged a three-year rally on the back of the restructuring of the banking system driven by the 2002 Takenaka plan (which forced the recognition of NPLs and the recapitalisation of banks). However, the underperformance resumed over the last eight years and Japanese banks are now at close to their 40-year+ relative lows. With Europe yet to achieve closure on balance sheet uncertainty (ie achieve a successful restructuring of the banking system) and with flat yield curves at the zero bound squeezing net interest margins, European banks are likely to continue to grind lower relative to the market. Further, as we show in Figure 30, banks do not like QE. In Japan and the US, banks underperformed during episodes of QE (QE flattens yield curves thus squeezing net interest margins and also signals an environment of low nominal growth which is negative for asset quality)."

- source Berenberg

• Banking crisis? Sweden lead the way

When it comes to the outperformance of "Nordics" share prices versus Japanese banks as displayed above it can be very simply explained. Sweden decided to tackle head on the issues of its ailing banking sector on numerous occasions. Sweden has a good firsthand experience of financial crisis unlike Europeans. 

Sweden suffered through a banking crisis in the early 1990s and then again in 2008 and 2009. It chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.

The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office. 

As far as European banks are concerned, regardless of the European Banking Union, AQR and other shenanigans, we agree with Berenberg's take on the triviality of the AQR adjustments:

"The triviality of the AQR adjustments was the most damning in our view. It is simply not credible that at the end of a 60-70 year debt cycle and after seven years of near nonexistent economic growth that the adjustment to Non-Performing Exposures equalled just 62bp of total assets. Charitably, this could be blamed on IFRS and its requirement to only identify losses on an “incurred” basis rather than expected one (indeed, rephrasing the critique given IFRS only allows provisioning on an incurred basis and given the adjustments were so trivial, it must imply that the ECB acquiesced in covering up the scale of hidden losses in banks’ balance sheets). Indeed, as Hoshi and Kashyap wrote presciently in October 2013, the European authorities “appear to be hesitant to admit to the size of the problems facing the banks” perhaps out of fear of triggering a panic.

In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans. As shown in Figure 36, NPLs were over-valued for in excess of a decade.

Such forced disposals should help achieve price discovery around the true value of bank assets. And in turn, this should pave the way to achieving confidence around the capital bases of the European banks." - source Berenberg

• Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!

In relation to our title the "Pigou effect" and central banks' intervention leading to a "liquidity trap therefore neutralizing the "Keynes effect" , Japan is clear illustration of the failure of the "wealth effect" of Pigou's proposal as pointed out by Berenberg:

"In Japan, where the burden was shifted early on from monetary to fiscal policy, a Catch-22 is emerging. The Japanese government cannot afford to allow rates to rise, yet keeping rates low risks increasing distortions in the economy through the mispricing of risk. It has been estimated that a 2ppt increase in average bond yields would require almost all tax revenues to be used to service the government’s debt. Thus QE and the monetisation of the national debt must continue in size (apparently the Bank of Japan purchases the majority of all new debt traded) until the Bank of Japan owns most of the government’s debt. But if the quantity of something is increased and demand is constant then the price must fall, ie the yen must weaken further (and Japan exports deflation).

As noted in the previous section, abundant liquidity and low interest rates squeezed net interest income for Japanese banks (two-thirds of the revenues for a typical bank). This arose through two effects. Ample liquidity and a lack of private sector demand for credit meant that the Japanese banks materially increased their holdings of government bonds (with typically lower yields than private sector loans). Secondly, low interest rates and QE flattened the yield curve, reducing the benefit of the maturity transformation.

Markets are rejoicing that the ECB is finally following the Bank of Japan and other central banks in embracing QE. But what if, as Kiyohiko Nishimura observed (the former deputy governor of the Bank of Japan), the problems facing Europe and Japan are driven by a demographic not financial cycle. He has noted that in Europe and Japan, as well as the UK and US, crises have almost always coincided with a decrease in the ratio of the working-age population to the non-working age population":

- source Berenberg

 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:

"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."

Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price! Exorbitant bond prices? How about Portuguese 10 year bonds at 2.13% trading briefly below US 10 year bonds?

• Reassessing some of our earlier views

Duration - party on Wayne! party on Garth!

While we endured the proverbial battering on our long duration exposure during February (offset somewhat by our short JPY stance), as discussed in our last conversation, the latest raft of weaker than expected US data such as US home resales falling to their lowest level in nine months last month at an annualized rate of 4.82-million units, as well as Industrial companies indicating they would only raise capacity by 1.8 percent in 2015, which is  the smallest increase since 2011, after boosting it 3.1 percent in 2014 according to  the Fed said in its Feb. 18 release on production, reinforce our view that we have probably seen the top of widening move in US yields for the time being. The current levels make it interesting to think about increasing slightly more our own long duration exposure.

Gold - everything that glitters...

In terms of flows, it seems precious metals saw their first outflows of $0.3bn in 5 weeks according to Bank of America Merrill Lynch "The Flow Show" from the 19th of February entitled "Out with the Safe, In with the Risk":

"YTD asset returns: stocks +3.1%, bonds -1.0%, commodities +1.4%, US dollar +4.4%; vol, gold & long duration bonds were the clear Jan “winners”; but risk assets have rallied big in Feb and quietly Treasury yields have jumped sharply (30-year up 50bps in Feb)" - source Bank of America Merrill Lynch

Our gold and duration calls from our conversation of the 6th of January entitled the "Fright of the Bumblebee" performed well in January and got punished in February:

"In terms of "allocation", we think we are looking more towards the upper left part of the Credit Channel Clock which means:
-a continuation of flattening yield curves,
-being long volatility as we enter a higher volatility regime
-a continued exposure to US long government bonds. Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe.
-adding again some gold exposure in early 2015. We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is going to be working again nicely in the first part of 2015"

The latest US raft of economic data has given some support of the $1200 level. We still remain positive for gold prices, given the lack of clear resolution of the Greek situation in conjunction with geostrategic tensions flaring with interventions looming in the Middle-East and with Ukraine 's economy in complete meltdown.

• The battle against the deflationary bust looming will not be won by ZIRP and QEs:

Looking at the global economy as a whole, we think the globalization of ZIRP is not reducing the deflationary forces at play but in fact reinforcing them, pushing us towards additional currency war which is reminiscent of the build up towards the crash of 1929 and the Great Depression that ensued. On that specific matter we share Dr Lacy Hunt's views and concerns. He is the Executive Vice President of Hoisington Investment Management and gave a month ago a long interview with Gordon T Long on the current economic situation. While gathering our thoughts since our previous conversation, we also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February:

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.
“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

• Real wage growth is the Fed's greatest headache

In similar fashion the slack in US real wage growth is the real problem to clearly validate the much vaunted US recovery  according to a University of Wharton article entitled "The Economy Is Coming Back — Why Wages Are Stuck in a Rut" and published on the 23rd of February:

"Despite that one bright moment in the late 1990s, U.S. real average hourly wages haven’t budged much for decades. The U.S. average hourly wage of $20.80 in January 2015 is about the same as that in January 1973, adjusted for inflation, according to the Bureau of Labor Statistics." - source Wharton University

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"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, 22nd of July 2014

Real wage growth, we think is the most important indicator to follow we think from a Fed tightening perspective.

We also indicated at the time:

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

• Volatility is a buy and will greatly impact negative convexity assets

From a market perspective, we recommended in our first conversation of 2015 that investors needed being long volatility as we enter a higher volatility regime, this is confirmed by the rise in the CVIX index (CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs) as displayed by Bank of America Merrill Lynch in their Liquid Insight note from the 23rd of February entitled "Letting the data speak again on G10 FX":

"This is just the beginning
We expect that the year so far is a preview of what will follow. Our year-ahead had argued FX volatility would increase as data dependence replaces forward guidance in monetary policy, ECB and BoJ QE would not be enough to replace Fed QE as boosters of global risk appetite, and oil prices would be lower and more volatile. In the global monetary union with the US we pointed out that loose Fed policy and forward guidance in G10 central banks had killed market volatility and FX correlations with data and fundamentals, and argued volatility and such correlations would come back as Fed QE ends, G10 monetary policies diverge and USD strengthens.
We believe these forces remain valid. We recently argued FX volatility has become the prime driver of global volatility, as central banks react differently to the common oil price shock and some are behaving as if they are in a currency war. The latest FOMC minutes also suggest the Fed is unlikely to continue ignoring the drop in inflation expectations, suggesting the upward USD." - source Bank of America Merrill Lynch

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

•  On the fallacy of Balance accounting as per Sir James Goldsmith

"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.
But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.
Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent.
When the Asian countries, as mentioned by the European Commission, invest their 'excess cash' abroad, normally they do so by buying into businesses or by lending money. The latter normally takes the form either of buying government debt or of deposits, say in sterling or dollars, in the banking system. Now consider the position of the nations which, unlike the Asian countries, import more than they export and which, as a result, have a deficit as opposed to an excess of cash.
To finance their deficit, businesses or other assets are sold and debt is issued. This puts them in exactly the same position as an individual who sells his house or borrows money to cover his debts. Such a haemorrhage can last only a limited time before ending in bankruptcy." - Sir Jimmy Goldsmith

Hence the need for central banks to issue more debt to sustain the global financial system...until it doesn't work but that's another story...

Thanks to Global ZIRP and our central bankers we are indeed living on the Planet of the Apes...oh well.

"If you pay peanuts, you get monkeys."- Sir James Goldsmith

Stay tuned!

Credit - Stimulant psychosis

"Every form of addiction is bad, no matter whether the narcotic be alcohol or morphine or idealism." - Carl Jung

Watching with interest our "Generous Gambler" aka Mario Draghi finally firing his "Chekhov's gun" and unleashing QE in Europe, pushing in effect more government bonds towards negative yields, we reminded ourselves, when choosing this week's analogy for our title of a specific kind of psychotic disorder called "Stimulant psychosis" that occurs in some people who use stimulant drugs:

"Stimulant psychosis commonly occurs in people who abuse stimulants, but it also occurs in some patients taking therapeutic doses of stimulant drugs under medical supervision." - source Wikipedia

While the symptoms of stimulant psychosis may vary slightly depending on the drug ingested, it generally include the symptoms of organic psychosis including hallucinations, delusions, thought disorder, and, in extreme cases, catatonia. We can already see in the MSM (Mainstream media) and in most of the comments from the European political "elite" symptoms of hallucinations, delusions and of course thought disorder of the highest order but we ramble again...

As a reminder of our conversation "Pascal's Wager" from October 2014, we pointed out the strength of the deflationary forces at play:

"In terms of the implication for Europe (as discussed in the "Coffin Corner"), the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe, unless the ECB of course decides to engage as well in a QE of its own:
"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013."

Of course in this week's conversation, we would like to review the supposed impact of what QE will bring to Europe, and we would like to point out the implications of the unleashing of the "Chekhov's gun by our "Generous Gambler" and the major difference between QE in Europe versus QE in the US, because once again the Devil is indeed in the details. 

Synopsis:

• The ECB has become the world's fastest QE gunslinger!
•  Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors.
• The on-going "Stimulant psychosis" experience led by our central banks deities is leading to more pronounced "Cantillon Effects" aka asset price inflation on a grand scale.
• In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets"
• The result of course is that the unquenchable hunt for yield is not only pushing investors towards the higher quality spectrum but also extending duration exposure
• When it comes to the "euthanasia of the rentier", what our central bankers deities are not realizing is that capital with ZIRP is not being deployed but merely destroyed
• We would like to re-iterate, investors shorting US Treasuries will continue to be punished!
•  European QE, the Devil is the detail and the future of the Euro lies in Germany's liability exposure

Talking about the Devil, it reminds us as well of the quote we used back in September 2014 in our conversation "Sympathy for the Devil":

"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

In fact in our previous conversation we indicated the following:

"Investors have indeed Sympathy for the Devil we think, as they continue to pile up with much abandon and more and more getting "carried away" in their insatiable hunt for yield. In that sense Baudelaire's 1869 poem rings eerily familiar with the current investment situation in the sense that investors have been giving our "Generous Gambler" the benefit of the doubt (OMT - and now full blown QE) and shown their sympathy and their blind beliefs in "implicit" guarantees, rather than "explicit" (such as the German Constitution as we argued in various conversations):
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
But as years have gone by in the European tragedy, we have become somewhat immunized from our great magician's spells. Many investors have indeed shown the greatest sympathy in respect to piling up on European Government Debt in the process, while banks have been shedding assets leading to outright credit contractions leading in the past two years European banks to cut their lending to businesses by about 8.5 per cent." - source Macronomics, 9th of September 2014

• The ECB has become the world's fastest QE gunslinger!

While we pointed out in our conversation "Chekhov's gun" that the BOJ and the FED had been QE fast drawers with the SNB front running aggressively the ECB as of late, as pointed out by Bank of America Merrill Lynch European Credit Strategist note from the 23rd of January entitled "QE Sera, Sera", the ECB has become the fastest gunslinger around:

"And so it begins…
The dawn of QE in Europe. Yesterday’s ECB meeting lived up to expectations, plus more. The central bank unveiled asset purchases of €60bn a month across Eurozone sovereign, agency, covered and asset-backed bonds. Banks were boosted by the TLTRO being made cheaper and thus more tempting. But the biggest victory for Draghi, in our view, was the open-ended feel that he was able to convey towards the programme.
Risk assets gave the ECB a vote of confidence by the end of the day, and understandably so – the ECB will likely now have the fastest growing balance sheet across the globe (chart 1). 

Stocks finished up yesterday, sub banks rallied and high-yield tightened. CCCs in particular were very strong, up 2-3pts, the first time in a number of months that the asset class has seen a big move.

But what of credit?

For credit investors, there was no pledge to buy corporate bonds. We had wondered whether the ECB might “tag on” corporate purchases just to make their asset gathering process easier. The dream could still live on if the ECB struggle to buy €60bn a month (note our rates team’s net Eurozone government bond issuance forecast of only €275bn this year). But for now, credit will not be bought.

Yet, there were few signs of weakness, or knee-jerk moves wider in corporate bonds yesterday. If anything, the need for income remains as intense as ever in Europe, with the backdrop of huge amounts of negative yielding government debt (chart 3), and note that the Danish Central bank lowered its deposit rate yesterday (the second cut in a week!). 

The race below zero by central banks is in full force, and so is the movement of money “up the value chain” in search of positive returns. Credit should benefit tremendously from this over time, we think.

The ECB is also becoming a prolific asset gatherer just at a time when financing needs, generally, are in decline. Sovereign funding needs have shrunk as budget deficits have reduced, bank funding needs have also dwindled amid deleveraging and the ECB’s focus on rejuvenating the loan market will mean less corporate supply over time, especially in high-yield (note SME lending rates are falling quickly now, chart 2).

 Chart 4 shows the net supply of fixed-income instruments in Europe on a yearly basis (we use sovereign debt, covered, senior banks and quasi-sovereigns), versus the net growth in the ECB’s balance sheet.

The bottom line is that the ECB is expanding its balance sheet just at a time when assets are being produced at a slower rate. As central banks exacerbate the demand/supply imbalance in asset markets, we see this as a backdrop for prices generally to rise, and by extension – credit spreads to rally." - source Bank of America Merrill Lynch

Of course we agree with the above when it comes to the value proposition of credit in Europe thanks to the on-going "japanification" process, with the slow "euthanasia of the rentier" to paraphrase Keynes from his 1936 "General Theory" book. On that subject we read with interest Andrew McKillop's January 2013 article entitled "Keynes Said: Euthanize The Rentiers, Instead We Euthanized The Economy":

"The bases of the French Revolution of 1789 had been set because even at that time, rentiers were struggling to defend the purchasing power of their interest income and at least preserve the capital value of their wealth. This put them in open conflict with the "traditional rentiers" of the monarchy, nobility, religious orders, and a few other players, who for political survival engaged in creating new and allied rentiers, giving them what French call "une rente de situation" for their personal political benefit, as well as personal financial or economic benefit. This was nothing to do with the national interest, it almost goes without saying.
Inflation is the first enemy of the rentier, but was also the friend of the state - basically the monarchy - in France throughout the 18th century. The very first "asset bubble" organized for and on behalf of the French monarchy by Scotsman John Law, before 1720, the Mississippi Company bubble, was aimed at destroying the real cost of debt owed by the monarchy and its associated nobility, to "the rentiers". Law's action, a Ponzi-type scam, had overkill effects. Some historians argue this first modern asset bubble, aimed at firstly inflating paper asset values, exchanging them against debt owed by the monarchy to rentiers, and then collapsing the bubble helped sow the seeds of the 1789 revolution through decades-long unwillingness of "the rentiers" to lend, after this asset implosion.
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. As early as 1820, this was a major theme of David Ricardo. Today, especially in Japan, it is intense daily action by the state and its central bank, seeking by all means to create inflation because "when there is inflation, the economy is still alive", and of course the cost of debt in real terms will fall.
This underlines the fatal flaw in Keynesian-type economics: high inflation, and-or extremely low or zero interest rates, "for prime borrowers", firstly needs rentiers to supply the capital to borrow. Before that, the capital has to be formed or accumulated. If both processes are unsure, uncertain, or inoperative the result can only be economic decline.
The problem today is starkly simple. Without massive money printing and issue, the dearth of capital would be so striking that the New Poverty of the world would be impossible to ignore. The global banking system, at latest since 2008, has vastly overvalued collateral or "assets", and a long-term basic trend, intensifying since 2008 of deflating balance sheets. Governments of all major OECD countries with a combined GDP of about one-half of the world's total output, through their central banks, are each day back-stopping the banks, which are insolvent institutions, flooding them with sovereign debt and fiat money, and manipulating credit markets to maintain apparent valuations.
THE NEW POVERTY OF NATIONS
Without this "window dressing", the reality is that the private sector economy is still contracting four years after the credit bubble burst. It is only concealed by the expansion of government spending and fiat money issue. Governments possibly do not understand they are in the midst of an economic collapse and will be the last to admit it, but as in previous epic struggles between the vested interests in play in a society and its economy, for example in the run-up to the French Revolution, the manipulation of credit, values, money and prices has made it impossible to accurately monitor the economy." - source  Andrew McKillop

When it comes to our contrarian take on US yields since early January 2014 we argued the following in our conversation "Supervaluationism" back in May 2014 it comes from us agreeing with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":

"The behavior of the bond market has been consistent with Keynesianism. By his compassionate phrase “euthanasia of the rentier” Keynes meant the reduction of the rate of interest, to zero if need be, as part of the official monetary policy to deprive the coupon-clipping class of its “unearned” income. Perhaps it is not a waste of time to repeat my argument why, in following Keynes’ recipe, the Fed is acting contrary to purpose. While wanting to induce inflation, it induces deflation.The main tenet of Keynesianism is that the government has the power to manipulate interest rates as it pleases, in order to keep unemployment in check. Keynes argued that the free market economy was unstable as it was open to the swings of irrational investor optimism or pessimism that would result in unpredictable and wild fluctuation of output, employment and prices. Wise politicians guided by brilliant economists − such as, first and foremost, himself  −  had to have the power “to prime the pump” (read: to pump up the money supply) as well as the power to “fine-tune” (read: to suppress) the rate of interest. They had to have these powers to induce the right amount of spending needed to put people to work, to entice entrepreneurs with ‘teaser interest rates’ to go ahead with projects they would otherwise hesitate to undertake. Above all, politicians had to have the power to unbalance the budget in order to be able to help themselves to unlimited funds to spend on public works, in case private enterprise still failed to come through with the money.However, Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete

•  Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors.

In our October conversation "Actus Tragicus" we disagreed with Bank of America Merrill Lynch' s credit team in their Credit Market Strategist note from the 10th of October entitled "Breaking up is so easy to do":

"We find it unlikely that the existence of big global yield differentials will accelerate inflows to US fixed income for two reasons. First, while we would indeed expect inflows in a high return environment of both high and declining US yields, with rising US interest rates – which our interest rate strategists expect – returns are much less attractive, despite the higher yields. Second, there appears to be little mean-reversion in interest rate differentials – at least between US and German interest rates." - source Bank of America Merrill Lynch

We correctly argued at the time:

"We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...)."

"When the facts change, I change my mind. What do you do, sir? - Sir John Maynard Keynes

 What is of interest is that, when the facts change, Bank of America Merrill Lynch do change their mind given that in their latest Credit Market Strategist note from the 23rd of January 2015 entitled "All but corporate bonds" they argued the following:

"US IG credit benefits from the ECB action as investors are sent our way. First, the greater than expected expansion of the ECB’s balance sheet implies that for non-official European fixed income investors the investment opportunity set shrinks. The effect is that more European investors will be forced into US IG. Second, while the absence corporate bond purchases removes the potential for a big move tighter in spreads, in the short term certain sectors in US credit could benefit as investors unwind their expressed views that the ECB would buy corporate bonds. For example an investor that wanted exposure to a certain name that had both EUR and USD bonds outstanding might have been willing to give up spread by buying the EUR bond, in order to profit more from an ECB corporate bond buying announcement. Now with that upside potential eliminated the investor may rationally swap to the generally more attractive credit spreads offered in USD tranches."

- source Bank of America Merrill Lynch

• The on-going "Stimulant psychosis" experience led by our central banks deities is leading to more pronounced "Cantillon Effects" aka asset price inflation on a grand scale.

As we posited in our conversation "Pascal's Wager":

"The only "rational" explanation coming from the impressive surge in asset prices (stocks, art, classic cars, etc.) courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods"."

To further illustrate the "inflationary" bias of current monetary policies on asset price bubbles coinciding with "exogenous" (central banks) monetary policy, apart from the Art market, one could simply look at the price evolution of "classic cars" clearly indicative of "pure" Cantillon Effects (detached from the capital structure). To that effect and courtesy of United Kingdom Classic Cars magazine  please find enclosed a good illustration of this "effect" on the price evolution of a Citroën DS classic car:

- source Classic Cars Magazine

• In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets":

"Financial credit may be the next big opportunity

The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit." - source Nomura

This is what we wrote in June 2014 in our conversation "Deus Deceptor" when it comes to the value proposition of investment grade credit we discussed as well in "Quality Street":

"The "japanification" process in the government bond space continues to support the bid for credit, with the caveat that for the investment grade class, there is no more interest rate buffer meaning investors are "obliged" to take risks outside their comfort zone (in untested areas such as CoCos - contingent convertibles financials bonds)."

• The result of course is that the unquenchable hunt for yield is not only pushing investors towards the higher quality spectrum but, also extending duration exposure:

The result of course is that the unquenchable hunt for yield is not only pushing investors towards the higher quality spectrum which is in great demand as indicated by the additional +$1.2 billion in Investment Grade inflows in the week ending on the 21st of January versus -$445 million of outflows in High Yield, but, it is also leading to duration extension as indicated by Bank of America Merrill Lynch's chart from their recent Follow the Flow note from the 23rd of January entitled "It's Europe time":

"Quality yield and some growth down the line?
Pre-ECB, the big flows were into European equities, with the expectation that monetary policy will lead to stronger growth down the line. Equity funds saw a $2.3bn inflow, the largest since June last year while the inflow into equity ETFs was the strongest since May’12.
Income remained a dominant theme: investment-grade registered its 57th straight week of inflows. Money market funds have also seen 4 straight weeks of inflows – the best streak since mid-2013 – as negative deposit rates force money “up the value chain”.
High-yield has yet to get a boost from the income theme though: the asset class saw small outflows of $445m over the last week, and has seen $2.4bn outflows YTD.
European commodity funds recorded their biggest inflow ever, with oil stabilizing and with the bid for gold in the wake of the SNB rate cut. EM debt suffered another weekly outflow, the seventh in a row."

- source Bank of America Merrill Lynch

• When it comes to the "euthanasia of the rentier", what our central bankers deities are not realizing is that capital with ZIRP is not being deployed but merely destroyed as we have argued in our conversation of November 2012, "The Omnipotence Paradox":

"Fixed Income, Floating Expenses...We are more concerned about the "Profits Cliff" or "Peak margins" effect given that companies can't figure how to make use of their cash hence the flurry of buy-backs which we greatly dislike. Indeed, the "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives)"

 As illustration of the destruction of capital and the supposed recovery in the US, we would like to point to a small conversation our Macronomics fellow blogger and good cross-asset friend "Sormiou" had with a US derivatives sell-side practitioner on the micro news on the employment front:

"Sormiou": “In less than a week in the US:   SLB (-7k jobs/ 7% workforce)  / BHI (-9k, 12%) / EBAY (-4k / 7%) / AmEXpress (-4k, -8%) Oil sector of course, but not only.   We are  hearing the "wage growth / employment pick-up" consensus argument from many sell-side strategists, but on the micro front, things do not look as rosy to us, even though a few announcements do not make a trend yet... thoughts?”

Him: “First is on the macro level = Yellen (and other doves) have flagged, under-employment is still much too high.  the U6 number (USUDMAER in Bloomberg) is still 11.2% vs 8% pre-crisis.  The U6 is a measure of the unemployed and the "under" employed-those folks who want full time, but can only get part time...as well as people who have been unemployed for so long they have fallen off the headline U3 number of 5.6%.  In fact, underemployment has been a major argument for postponing rate rise by the doves.  Point here is I think you are exactly correct in digging -the U3 headline number of 5.6% is absolutely not telling the entire story! More worrying maybe is the unemployment rate dissected across demographics. Unemployment among US youth is shockingly high.

Second is on a company level as you have flagged. Much of the earnings growth over the past few years can be attributed to cost cutting rather than organic growth to operating income.  Once costs were more "in control" for some companies, they turned to M&A to help generate returns - again to increase / boost slack organic operating income growth.  This earning period I think will certainly be more interesting than the last few because there is only so long you can mask sluggish organic growth...and we are seeing it in a few names that have reported.  In general, earnings are coming in 50bps below estimates (according to FactSet numbers).  Granted, we are still early in the earning cycle so too early to call...but if M&A doesn't get you what you need via a bolt on...and organic growth is still lackluster then the only thing to do is turn to is costs again - which is what I think we are seeing (and what you have flagged).”

Could companies focusing on costs again be the reason on why US Weekly jobless claims in the US are remaining above 300K for the third straight week? This is indeed a point to closely monitor we think, going forward.

• We would like to re-iterate, investors shorting US Treasuries will continue to be punished!

We would like to re-iterate why investors shorting US Treasuries will continue to be punished because they do not understand the game being played, On that specific matter we will simply quote again Antal Fekete from our July 2014 conversation entitled "Perpetual Motion":

"Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing to far the "Perpetual Motion" experience":
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete

•  European QE, the Devil is the detail and the future of the Euro lies in Germany's liability exposure

In relation to the European QE and the details of the "plan", we would like to quote our good friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR from his last post entitled  "On the ECB and mutualisation of risk":

"Yes, I did take time off the desk yesterday afternoon to listen to St Mario's press conference. I heard everything he said and but I didn't understand quite a lot of it. Going into it, I had had a long talk with Ian McBride of Mirexa Capital, a fledgling agency brokerage in the rates space and one of the most experienced people I know in London when it comes to the whys, the  hows and the wherefores of the government bond market.
He made a very strong point that, as far as he was concerned, size didn't matter. To him there was only one critical issue of concern and that was the subject of mutualisation of risk. With it, so he reckons, the Eurozone is headed for stability. Without it, it is doomed in as much as it effectively ceases to be a harmonious, homogenous area. The dream of making a United States of Europe in the image of the United States of America is dead in the water and any claim the euro might have had to be like the dollar has just gone up in a puff of smoke.
As recently as Wednesday night, the Dutch parliament had voted against mutualisation and thus, with the Germans, the Finns and the Austrians also averse, unanimity was never going to be achieved. A split vote was not an option and so there had to be a fudge. The question was, how heavily was the fudge going to be tainted with the flavour of sauerkraut? When I heard Draghi begin to explain the split in loss-sharing, I knew all was not right. Ian titled his analysis of the outcome with "Mario Swings a Big Bat, But Misses the Mutual Ball?" Please permit me to share some of his thoughts:
"Call me a cynic, but you're trying to hide the fact that you failed to force through the most important component of the QE program... namely loss sharing, liability sharing, mutualisation, or whatever you want to call it and you end up with at best 20% loss sharing only, of which only 8% is on government bonds. You hide this shortcoming in the fetching headlines that you will be buying up to €60bil/month combined Public & Private securities. And on top of that you make the program longer than some expected taking it up to at least Sept/2016, having started in Mar/2015. That is in theory €1.14trn of securities you will accumulate. Sounds big right? Then the cherry on the Smoke and Mirror Cake is that you tell everyone you will make the program conditional on achievement of your mandate for price stability. Saying that the program will go on as long as needed. Or open ended if you like."
He continues "To illustrate how big the party is in Berlin tonight... Based on what is clearly a big win on the compromise (I'd say outright victory) that Germany and its allies wrung out of Draghi. Look at some rough numbers for new German joint loss sharing exposure by the end of the Program when and if the ECB and National CBs manage to buy the total of €1.14trn by Sept/2016. Based on the Capital Key, Germany is responsible for 18% of that total or €205.2bn and of that only 8% is held by the ECB with loss sharing. So that means that the total non-Bund exposure for the BUBA is only an additional €16.4bn out of the grand total of €1.14trn bought. It'll be lots of beer and sausages all around!!"
"That tiny 8% is symbolic, but not in any way significant enough to prevent, over time, the segregation/tiering/fragmentation of the credits within the Eurozone borrowers. The Haves vs. the Have Nots. I will expect, when the dust settles and purchases begin, that the credit spreads between the strong and the weak will widen. This is not a program that is designed to float all boats equally."
"It is a divisive piece of policy that Draghi, in my mind, has lost a lot of credibility over. He and other members clearly caved in to the demands of the big bully(s) on the block. And for me, despite the big size headlines and open ended-ness of the program, it comes up short of what is needed to maintain the structural integrity of European Monetary Policy and Fiscal Unity."
So, while they were dancing on the floors of the stock exchanges and while all the high fiving was going on that St Mario and his merry men had finally come to the rescue, wrapped in open-ended QE, it could quite well be that the seeds of the final destruction of that strangest and most incongruous of constructs, the European Single Currency, were yesterday sown.
It might, of course, be that the euro softens a little bit, that inflation is imported to the tune of roughly 2%, that exports pick up enough in order to push Eurozone unemployment down from the current 11½% to 5½-6%, that construction and consumption accelerate, that fiscal revenues rise to the level at which deficits are wiped out and surpluses are achieved without legislative intervention or trimming of benefits and that pigs learn to fly. Or it might be that the whole system falters when driving down the road by hitting a whole pile of cans which had been kicked there over time." - source Anthony Peters - "On the ECB and mutualisation of risk":

This is exactly what has happened with the QE plan put forward by our"Generous Gambler" aka Mario Draghi. Back in July 2012 in our conversation "Europe - The Game of the Century" we argued the following:

"The only possible Nash equilibrium for Germany will be to defect"

While only appearing to be making material sacrifices, German Chancellor Angela Merkel has managed to keep Germany's liabilities unchanged, this is again the case with the present QE, as it was the case with the capped ESM and EFSF.

As we indicated in our conversation "Eastern promises" on the 9th of June 2012, we still believe that eventually Germany will defect in the end:

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

We would like to point out there is no such thing as a credit-less recovery in Europe as discussed in our conversation "In the doldrums":

"If credit growth does not return, economic recovery may prove to be difficult in the absence of sizeable real exchange rate depreciation." - Zsolt Darvas - Bruegel Policy Contribution.

"So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in Germany's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."

What do we do sir? 

When the facts haven't changed, we do not change our mind.  In the European QE, there has indeed been no move towards "explicit guarantees" as it would have indeed entailed a significant increase in Germany' s contingent liabilities hence our continued negative stance on the future of the European Union.

On a final note we leave you with Bank of America Merrill Lynch's graph displaying Labor force growth vs US CPI from their Thundering Word note from the 18th of January 2015:

"Technology and demographics (Chart 3) continue to act as secular deflationary forces across the developed world. The end of QE in the US means the Fed is no longer inflating asset values. And investors are increasingly concluding that QE has ended up creating excess supply rather than excess demand. The relentless “lust for yield” continues. In Q1 it is the turn of REITs to be the asset class attracting large speculative inflows in search of Yield & Growth." - source Bank of America Merrill Lynch

"We need to ask whether, in the long term, some individuals with a history of psychosis may do better off medication." - Thomas R. Insel, American scientist

Stay tuned!