Macro and Credit - Eternal Sunshine of the Spotless Mind

"Right now I'm having amnesia and deja vu at the same time." - Steven Wright, American comedian

While watching with interest our home team France losing the Euro 2016 final against Portugal, being yet another case of "Optimism bias" coming from our fellow countrymen, and looking at the significant rally in various asset classes such as iShares iBoxx Investment-Grade Corporate Bond ETF, or LQD, taking in $1.1bn last Thursday, the largest ever recorded inflow as if "Brexit" had never happened, we reminded ourselves for our chosen title of the 2004 romantic comedy "Eternal Sunshine of the Spotless Mind". With various markets returning to dizzying heights such as the S&P500 or US High Yield markets, it seems to use that once again investors have found "romantic love" with risky asset classes and in many ways their bad memories have been erased, hence our title reference. As far as we are concerned, we haven't gone through the memory erasure procedure and we continue to feel that when it comes to credit in general and in in particular US High Yield, we are in the last inning of the game, particularly when we look at the most recent Fed Senior Loan Officers survey which clearly shows a slowly but surely deteriorating trend when it comes to financial conditions.

In this week's conversation we would like to focus on the on-going deteriorating trend in credit fundamentals and discuss why we think we are in the final inning and therefore one could indeed expect a final and important melt-up in risky asset prices which could last well into September. We will as well discuss Japan as there are indeed increasing "helicopter" noises in the background.

Synopsis:

• Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"
• Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening
• Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

• Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"

As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan". On the subject of this Japanese foreign allocation, we read with interest UBS Global Rates Strategy "What Japanese Investors Are Buying" from the 8th of July:

"Which government bond and credit markets benefit from Japanese demand?

We have previously described how Japanese investors have been significant net buyers of foreign assets – predominantly DM government bonds – in light of the BoJ’s negative interest rate policy. Net purchases have recently regained momentum, following a slowdown around the turn of the Japanese fiscal year. Today’s data of overseas purchases by destination for May highlights which markets are benefitting.

DM: US Treasuries on top; continued inflows into France, Canada, Italy

Japanese net buying of sovereign bonds recovered in May (¥1.8tn vs. ¥0.2tn in April), though still below the record level seen in March (¥5.5tn). US Treasuries made up for nearly 50% of all net purchases. France, Japan's historically preferred euro market, saw modest net buying of ¥159bn, roughly unchanged from April. Elsewhere, Canada and Italy saw continued net purchases, albeit at a slightly slower pace than in April.

EM: Reducing exposure to LatAm and High Yield

In May investors reduced positions in high yield EM markets. Mexico monthly outflows were the largest in five months; Brazil, Indonesia and South Africa were also net sold. China short-term bonds were net bought, other Asian markets were flat. Overall allocations into EM have been small relative to DM asset purchases, with the largest EM market (Mexico) accounting for less than 1% of all bond holdings.

- source UBS

What is as well of interest in UBS note is that since the implementation of NIRP by the Bank of Japan (BOJ), Japanese life insurance companies have gone into "overdrive":

"Japanese life Insurance companies’ net purchases of foreign long-term debt securities; subset of Figure 13 (¥bn). Lifers' hefty buying since Feb-16 continued in Jun-16 (¥1056bn, 3rd largest since the start of data in 2005), overall the 10th consecutive month of net purchases." - source UBS

No surprise therefore that "Bondzilla's size" has indeed been increasing at a rapid pace. This sudden acceleration in negative yielding bonds has been clearly "made in Japan" we think. The acceleration in "Lifers" bond purchases is as well confirmed by Nomura in their JPY Flow Monitor entitled "Foreign Investment continues amid increased uncertainty" from the 8th of July:

"Japanese foreign portfolio investment continued in June. Excluding banks, Japanese investors bought JPY2264bn ($22.6bn) of foreign securities in June, a slightly weaker pace than in May. Life insurance companies’ foreign bond investment accelerated again, while we judge most of them were on an FX-hedged basis. Pension funds and toshin companies remained net buyers of foreign securities too. Retail investors’ foreign investment is likely to stay weak for now, as risk sentiment among them deteriorates after the Brexit vote. Pension funds will probably remain dip buyers, even though the pace is likely slower than in 2015. May BoP data show that the current account surplus narrowed for the second month in a row, suggesting that the improved phase of the Japanese current account balance has likely ended for now, as oil prices recover and JPY appreciates." - source Nomura

If indeed "Bondzilla" is "made in Japan" this is clearly thanks to the acceleration of "Lifers" in the global reach for yield particularly since the implementation of NIRP by the Bank of Japan, but as pointed out by Nomura's note, this time around with a higher hedge ratio:

"Lifers continued strong foreign bond investment, likely with high hedge ratio
Life insurers bought a net JPY1056bn ($10.6bn) in foreign long-term bonds for the 10th month in a row. Although the pace of net buying has slowed over the past two months, this is the first time in three months that the pace of net buying has accelerated to above JPY1trn. Downward pressure on yields has strengthened globally in response to the decline in Fed rate hiking expectations after US NFP data early June and uncertainty over the Brexit referendum. 20yr JGB yields have fallen to almost 0%, forcing lifers to seek higher yields and shift to foreign bond investments. With JGB yields trending near 0% in all maturities, lifers are likely to continue to invest in foreign bonds at a high level
(Figure 2).

That said, we expect that most of their foreign bond investments will be FX hedged for the time being. After FX hedging, UST investment may not be so attractive owing to higher hedging costs. Nonetheless, Fed rate hiking expectations by year-end have almost completely disappeared. The Brexit vote has lowered USD/JPY, JGB and UST 10yr yields to the lower range of major lifers’ FY16 forecast, or even below, but on an unhedged based foreign bond investment may not accelerate anytime soon, amid increased political uncertainty (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016). With risk tolerance falling, we think there is little chance that lifers will shift to unhedged foreign bonds in the near future.

In the medium term, we still expect their interest in investing in hedged foreign bonds to wane gradually, as a result of the expected rise in hedging costs. Nonetheless, the timing of their shift from hedged to un-hedged foreign bond investment will likely be delayed after the Brexit vote and associated market volatility." - source Nomura

From the above we think that the implications are as follows in the short term, we have most likely seen the lows for now on Developed Markets' long term sovereign bonds and in terms of the Japanese Yen, further depreciation of the currency depends on the implications of the deployment of some form of "helicopter money" in Japan. We must confide we have re-initiated therefore a short Japanese yen position and thinking about adding going long Nikkei but in "Euros" via a quanto ETF (currency hedged).  Given we have not fallen to a memory erasure procedure, we reminded ourselves clearly of our April 2015 conversation "The Secondguesser":

"1. To criticize and offer advice, with the benefit of hindsight.

2. To foresee the actions of others, before they have come to a decision themselves.

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions"." - source Macronomics, April 2015

On a side note, in our April conversation, we showed that flows had lagged performance in Emerging Markets. We think now the time is ripe to add on some EM equity expsore which can be relatively easily done through the ETF EEM. EM equity funds saw $1.6 billion of inflows recently...


When it comes to the benefits of "helicopter money", we read with interest Bank of America Merrill Lynch's take from their Japan Watch note from the 15th of July entitled "Japan for “whatever it takes”; monetaryfiscal coordination not helicopter money":

"The monetary-fiscal hand-off

In recent months we have been writing more about the importance of and prospects for fiscal easing. In March we argued that “while monetary policy may be over-stretched in places, we think there is plenty of scope for fiscal policy to support global growth.” In particular, “low interest rates and sufficient fiscal space in many countries make now an opportune time for increased public-sector investment spending.” However, we worried arbitrary political constraints on policy would limit spending, delaying more decisive action until the inevitable recession arrives.

It has taken a long time, with monetary ammunition running low, but finally fiscal easing seems to be starting to kick in. In May, we noted that fiscal expansion had started in a number of regions, including the US, Europe, and China, although much of that easing has been more by accident than design. At the time, we thought Japan would delay its second consumption tax, but could not be certain they would not make another policy mistake.

Japanese for “whatever it takes”

Recent news makes us increasingly confident Japan will join the fiscal expansion and both Europe and the US will increase their stimulus efforts. Policy decision making in Japan often seems like a ritual kabuki play. In the first act, facing whether to delay the consumption tax hike, Prime Minister Abe met with three advocates of easy policy—Paul Krugman, Joseph Stiglitz and Christina Romer. Then at the G-7 meeting in Japan in late May, he warned of risks of a Lehman-like economic crisis. Recall that earlier he had said that only a major event similar to the 2011 earthquake or a Lehman-like crisis could delay the tax hike. Weeks later, in the second act, there was no sign of Lehman II in sight, but sure enough the consumption tax hike was delayed.

In the third act, policy was put on hold awaiting the results of the upper-house election, which returned a solid victory for Abe. He then announced work on a “bold” stimulus package, which major Japanese media outlets suggest to be at least ¥10tn. Former Fed Chairman Bernanke was invited to offer policy advice in the fourth act this week. It is not hard to imagine what Bernanke told them.

The fifth and final act, in our view, will be a major stimulus package, of ¥15-20tn in total, financed by at least a ¥10tn supplementary budget, likely coupled with additional easing by the Bank of Japan at end-July. We look for the BoJ to double its ETF purchases to around ¥6tn annually and potentially lift its JGB purchase pace in line with the increased issuance from the fiscal stimulus plan. Inclusion of municipal and agency bonds is also possible, but given their small market and limited liquidity, we see this as a more symbolic gesture. We do not expect a further cut in interest rates at this time, but we would not completely rule it out either. The BoJ would need to find a way to minimize the adverse impact upon banks from a more negative policy rate.

Risk markets have responded well to this potential program: Japanese equity markets just about reversed their post-Brexit funk, having risen 9.5% since 24 June. The global spillover is palpable; US stocks are up 8% over the same period, while most European markets have rebounded as well. The USDJPY also weakened to above 105, having touched 100 after Brexit. This is a fairly small retrenchment: the yen has appreciated over 12% against the USD on net this year alone. A top advisor to Abe suggested this week that Japan cannot defeat deflation with the USDJPY around 100." - source Bank of America Merrill Lynch

Once again, you probably want to think about "front-running" the Bank of Japan hence our interest in going long the Nikkei index but currency hedged.

When it comes to the options Abe and Kuroda have to reverse the deflationary woes of Japan, Bank of America Merrill Lynch makes some interesting points:

"Can Abe-Kuroda beat high expectations?

Implicit fiscal-monetary coordination

Expectations of fiscal and monetary easing are building in the financial markets, but there seem to be different ideas about the degree of coordination.
1. Implicitly coordinated fiscal-monetary easing: The government unleashes huge economic measures with a supplementary budget of more than ¥10tn. The BoJ expands monetary easing, potentially including through increased purchases of JGBs. The two are “synchronized” with roughly concurrent announcements.

2. Explicit coordination between the government and BoJ: In addition to the above fiscal-monetary easing, the government and BoJ announce an accord of commitment to fiscal expansion financed (semi-)directly by the BoJ’s JGB purchases until the inflation target is met (from the 13 July Sankei Shimbun’s front page).

3. Debt monetization: The BoJ restructures its existing JGB holdings to zero coupon perpetual JGBs, and/or the government issues perpetual bonds to the BoJ directly. (leaving legal issues aside; where there is a will there is a way).

Options (2) and (3) could be called the soft and hard versions of helicopter money, and the likelihood of either being adopted in the near term is low, in our view. This is because (1) Japan's economy, with its 3.3% unemployment rate, can hardly be defined as in crisis; (2) such drastic policies could shake the JGB market and JGB investors; and (3) there have been no cases of developed economies resorting to dropping helicopter money in recent history, and considerable uncertainty surrounds the consequence of such a plan.

We, especially those based in Tokyo, find it hard to believe anyone or any groups in Japan, including the Abe Administration, the MoF, the BoJ, or the public, aspires for hard helicopter money at the moment. Even if they did, nobody seems to have the political capital to pull it off and conduct it for a prolonged period of time. As such, “implicitly coordinated fiscal-monetary easing” – or some other bold fiscal expansion, and expansion of the existing monetary easing – is the most likely possibility." - source Bank of America Merrill Lynch

While it is always hard to fathom the impossible, where we slightly disagree with Bank of America Merrill Lynch is that we could have yet another case of "Optimism bias" and that Japan decide to be even bolder. We touched on the "boldness" of Japan in our April conversation "The Coffin corner":

"There are old wise central bankers (Paul Volcker) and bold bankers (Ben Bernanke now joined by Haruhiko Kuroda ); we have no old central bankers, just bold central bankers". - Macronomics.

"Looking at the desperate attempts by the Bank of Japan to cancel out the deflationary forces at play by increasing the "angle of monetary attack" with the "bold" central pilot banker Kuroda pulling very strongly on the stick, we wonder if Japan will indeed endure structural failure in the end. Maybe Kuroda is a gifted pilot such as pilots from the famed Lockheed U-2 spy plane, but, maybe he isn't.
We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013

If central bankers are now joining force with Ben Bernanke advising directly the Bank of Japan there is indeed a strong possibility they will go for "bolder" policies such as "helicopter money". This policy is fraught with danger we think and agree with Nomuras's take on the subject from their Japan Trade Ideas note from the 15th of July entitled "The danger of helicopter money":

"The adoption of helicopter money by Japan is being discussed a lot more frequently these days. Until recently it was principally by international investors, but, with “Helicopter” Ben Bernanke meeting both BOJ Governor Kuroda and Prime Minister Abe this week, local media is giving it much more coverage. According to a Bloomberg article on Thursday, Mr Bernanke suggested during an April meeting with Abe adviser Etsuro Honda that “helicopter money – in which the government issues non-marketable perpetual bonds with no maturity date and the Bank of Japan directly buys them – could work as the strongest tool to overcome deflation.” Mr Honda said he relayed this message to Prime Minister Abe, although according to another key official, Koichi Hamada, the former Fed Chairman reportedly stuck to more orthodox policies in his meeting with Mr Abe on Tuesday (Bloomberg).

The two main sources of helicopter money views cited by international investors that I have met in recent months are Mr Bernanke’s blog and Adair Turner’s book “Between Debt and the Devil: Money, Credit, and Fixing Global Finance.” 

Mr Turner's suggestion for JGBs is as follows: “That debt could be written off and replaced on the asset side of the Bank of Japan’s balance sheet with an accounting entry – a perpetual non-interest-bearing debt owed from the government to the bank. The immediate impact of this on both the bank’s and the government’s income would be nil, since the interest which the bank currently receives from the government is subsequently returned as dividend to the government as the bank’s owner. So in one sense a write-off would simply bring public communication in line with the underlying economic reality. But clear communication of that reality would make it evident to the Japanese people, companies, and financial markets that the real public debt burden is significantly less than currently published figures suggest and could therefore have a positive effect on confidence and nominal demand.”

The assertion that there would be no immediate difference from the current situation is not strictly correct. The average yield on the BOJ’s current JGB portfolio is about 0.42%. While some of the income from this will indeed be returned to the government, a large portion is used to 1) pay higher rates to banks on most of its deposits than the official minus 0.1% policy rate; 2) cover losses and build reserves against losses on its riskyasset purchases; and 3) subsidize its efforts to lower yields across the curve – the central bank is currently buying JGBs at an average yield of around -0.26%, well below its cost of funds.

While restructuring the asset side of the BOJ’s balance sheet may seem like a worthwhile idea, the picture is not nearly as rosy when we take into consideration its liabilities. Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis, has pointed out that, “The apparent attractiveness of the helicopter approach ignores something important: Money has a cost, too. When the Treasury spends the $100 billion, it will appear in bank accounts. Banks, in turn, will deposit the money at the Fed – a liability on which the central bank pays interest.”

Mr Bernanke acknowledges this problem in his April blog on helicopter money. “Moneyfinanced fiscal programs (MFFPs), known colloquially as helicopter drops, ….present a number of practical challenges of implementation, including integrating them into operational monetary frameworks and assuring appropriate governance and coordination between the legislature and the central bank. As my former Fed colleague Narayana Kocherlakota has pointed out, the fact that the Fed (and other central banks) routinely pay interest on reserves has implications for the implementation and potential effectiveness of helicopter money. A key presumption of MFFPs is that the financing of fiscal programs through money creation implies lower future tax burdens than financing through debt issuance. In the longer run and in more-normal circumstances, this is certainly true…..In the near term, however, money creation would not reduce the government’s financing costs appreciably, since the interest rate the Fed pays on bank reserves is close to the rate on Treasury bills. Here is a possible solution. Suppose that the Fed creates $100 billion in new money to finance the Congress’s fiscal programs. As the Treasury spends the money, it flows into the banking system, resulting in $100 billion in new bank reserves. On current arrangements, the Fed would have to pay interest on those new reserves; the increase in the Fed’s payments would be $100 billion times the interest rate on bank reserves paid by the Fed (IOR). As Kocherlakota pointed out, if IOR is close to the rate on Treasury bills, there would be little or no immediate cost saving associated with money creation, relative to debt issuance. However, let’s imagine that, when the MFFP is announced, the Fed also levies a new, permanent charge on banks – not based on reserves held, but on something else, like total liabilities – sufficient to reclaim the extra interest payments associated with the extra $100 billion in reserves. In other words, the increase in interest paid by the Fed, $100 billion * IOR, is just offset by the new levy, leaving net payments to banks unchanged. (The aggregate levy would remain at $100 billion * IOR in subsequent periods, adjusting with changes in IOR.)”

Adair Turner’s suggestion for getting round this IOER cost of money-financed deficits is as follows: “the rate would have to be zero on at least some reserves to ensure that money finance today does not result in an interest expense for the central bank in the future or in central bank losses that would need to be paid for by government subsidy and ultimately by taxpayers. Setting a zero interest rate for reserve remuneration might in turn seem to impair the central bank’s ability to use reserve remuneration as a tool to bring market interest rates in line with its policy objective. But central banks can overcome this problem, for instance, by paying zero interest rates on some reserves, while still paying the policy rate at the margin.“

So it turns out that for helicopter money to work as its advocates envisage, there needs to be a scheme in place to stop/offset IOER payments to banks. Without that, losses at the central bank will rise quickly when policy rates rise. In the current policy framework, the average yield in the BOJ’s portfolio has been gradually dropping, which is why I think it will be slow to raise rates in the future and I particularly like long-term conditional bear steepeners on the front part of the curve. However, the average yield will recover gradually as the central bank re-invests maturing JGBs at higher yields, allowing the BOJ eventually to raise rates without incurring too many losses. This would not be the case if the central bank has locked up its portfolio in perpetual bonds. With JGB yields the lowest on record, locking in 10yr borrowing costs of -0.24% and 40yr costs of 0.23% seems like a much more sensible policy.

From a strategy perspective, I would treat helicopter money as a very low-probability, high-risk event. It may start out with some seemingly good, risk-on results, but, given the points mentioned above, it is easy to imagine eventual panics among policymakers and/or investors. Rather than his prescription for Japan, I prefer Mr Turner's approach for the euro zone, “If the European Investment Bank funds infrastructure investment, raising money with long-term bonds that the ECB buys, we edge closer to money finance without quite crossing the line.” As outlined in last week’s report., I believe that Japan’s policy mix has reached a stage where it makes sense to begin transitioning from QQE quantity and rates to QQE quality (such as ETFs) and fiscal policy. Nomura expects the BOJ to focus on a combination of rate cuts and ETF purchases at its policy meeting at the end of this month. Although there is very little chance, in our view, of a helicopter-type policy being adopted in Japan any time soon, the current debate could prompt a greater willingness to stretch the boundaries of monetary policy. For example, the central bank has traditionally limited its risky-asset purchases such as ETFs to amounts where potential mark-to-market swings can be comfortably absorbed by its earnings/reserves. Perhaps running the risk of a little negative equity is the right amount of crazy for the BOJ." - source Nomura

And perhaps indeed that running the risk of negative equity is not the right amount of "crazy" for the bold pilots running the Bank of Japan. And if indeed money has a cost too, ultimately the cost will be beared by Japanese taxpayers and in the process the Japanese currency could depreciate rapidly in conjunction with horrendous liquidity problems for the foreign investors still holding to their Japanese Government Bonds (JGBs).

So overall its risk-on again and most likely in Japan but then again, if we are tactically short term bullish, our long term appreciation of the credit cycle is telling us we are in the last inning as shown by the continued deterioration in financial conditions which we develop in our next point.

• Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening

What is ultimately driving default rates you might rightly ask?

For us and our good friends at Rcube Global Macro Research, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey):

"Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans. We have used the net percentage of banks tightening standards for commercial and industrial loans to small firms as tightening credit standards should have a direct effect on the credit market." - source UBS.

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.

As we indicated in our "Bouncing bomb" October 2015 conversation, given the strong inflows in the asset class (US High Yield in particular), we remain Keynesian bullish short term when it comes to credit:

"While we have been "tactically" short-term "Keynesian" bullish, when it comes to our recent "credit" call, we remain long term "Austrian" bearish, particularly when it comes to our "credit" related "Bouncing bomb" analogy and the High Beta gamblers. We would recommend moving into a higher quality spectrum in terms of "credit ratings" and exposure." - source Macronomics

From a tactical and leverage perspective, we would continue to be overweight European High Yield versus US High Yield and remain more inclined towards US Investment Grade credit versus Europe.

We would not at the moment go against the "flow" given the latest inflows so far in US High Yield have been very significant, hence our tactical "Keynesian" bullishness, but then again the latest survey is validating our heigtened concerns as highlighted bu Deutsche Bank in their US Fixed Income Weekly note from the 8th of July:

"Bank lending standards continue to tighten for the business sector. The Fed’s Senior Loan Officer Survey (SLOS) measures lending standards of the largest commercial banks. Similar to tax receipts and motor vehicle sales, the SLOS data do not get revised. There are four broad categories of lending: commercial and industrial (C&I), commercial real estate, consumer, and residential mortgages. On balance, the SLOS data are flashing a cautious signal. In Q2, the net percentage of commercial banks tightening lending standards for C&I loans increased a little over three percentage points to 11.6%, which was the highest reading since Q4 2009. This was the third consecutive quarter in which banks tightened C&I lending standards, a troubling development. As the below chart from our Deutsche Bank colleague Jim Reid illustrates, tightening C&I lending standards are a leading indicator of high-yield default rates.

With respect to the other aforementioned categories, the net percentage of banks tightening lending standards for commercial real estate loans showed an even sharper increase in Q2 (+24.2% vs. +13.6% previously). This was the highest level since Q1 2010 (+27.3%). The only positives in the Q2 SLOS were consumer and residential mortgage lending standards, where, on balance, banks continued to ease in Q2. This should prove to be a mild tailwind for consumer spending and the housing market in the near term." - source Deutsche Bank

Since February we have highlighted the Commercial Real Estate Market (CRE) and particularly through CMBX series 6, the most exposed to retail, the latest survey does indeed confirm the debilitating trend of the underlying. In our recent conversation "Through the Looking-Glass" in May we indicated the following:

" When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2." - source Macronomics, May 2016

We do think you need to track both the CRE and its derivatives CMBX series, as well as the US Senior Loan Officer Survey in the near future.

In our final point we will revisit what represents to us yet again a manifestation of Gibson paradox.

• Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

While we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices. When it comes to the deflationary forces of our very potent "bondzilla monster", this can be assessed by the below chart from Bank of America Merrill Lynch displaying the relationship between negative yielding assets and gold fund flows from their Credit Derivatives Strategist note from the 14th of July entitled "Deflationary flows, the Central Banks' put and yield hunting":

- source Bank of America Merrill Lynch

This relationship was as well confirmed in another note from Bank of America Merrill Lynch in their Follow the Flow note entitled "Deflationary flows into gold, IG and govies":

Deflationary flows into gold, IG and govies

The size of negative yielding assets has reached new highs. Amid rising
deflationary pressure investors are moving into gold and “ECB-eligible” assets like
government and high-grade bonds. A clear theme so far this year has been assets
that are backed by CBs’ policies and “deflationary” plays like gold are in vogue. On
the other hand, assets like equities have been suffering record outflows amid
concerns that the global recovery is losing steam." - source Bank of America Merrill Lynch

 Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. What we are monitoring from a tactically more bearish approach is that very recently surprises, real rates and breakevens are on the rise as displayed in this final chart from Bank of America Merrill Lynch's latest Securitization note from the 15th of July:

"Since Brexit, economic numbers have increasingly surprised to the upside; last week’s June employment report was especially surprising. In “Navigating the summer doldrums (June 3),” we noted that in recent years, the Citigroup economic surprise index has tended to be weak in the first half of the year, bottom in June, and rise in the second half of the year. In Chart 1, we show the seasonal pattern of the average for 2011-2015, along with the 2016 performance. The rise in the index over the past two weeks suggests the “normal” H2 scenario of relatively good economic performance and fundamental data is off to a good start.

If so, it could mean the June plunge in interest rates that pushed the 10yr treasury yield to as low as 1.32% created a near term low for rates. Note that the official BofAML call is for the 10yr yield to end Q3 at 1.25%, and then rise to 1.50% by the end of 2016 (the nominal 10yr is at 1.58% as of writing). If rates and fundamentals have in fact bottomed, at least locally, it’s good news for securitized products, as prepayment risk for agency MBS and credit risk for the credit sectors are reduced. Given the possibility of the worst for rates and fundamentals being seen in June, we have moved to an overweight across most securitized products sectors. 

Chart 2 gives some sense of what rising economic surprises mean for the real 10yr rate, comparing it with the economic surprise index over the past two years. We observe common directionality from 2014 through early 2016, although the coincidence of the timing of the moves is loose at best. 2016 shows a somewhat sustained break in the pattern, however. The surprise index has been trending higher since the low in February. Meanwhile, the real rate has steadily moved lower since the Fed hiked rates last December, as the market has steadily faded the Fed’s ability to hike rates further; for example, the recent bottoming of the real rate on July 6 coincided with the peaking of the no hike probability by December 2016 at 93%.

The bottom line here is that if the economic numbers continue to surprise to the upside, which may have improved chances because real rates got so low, due in part to exogenous global factors, Fed hike probabilities will likely rise, as will the real 10yr rate. For now, though, we think the divergence seen in 2016 between economic surprises and the real rate is a big positive for risky assets: the real rate is probably far too low, and stimulative, relative to fundamentals.
The other side of the coin for nominal rates is breakeven inflation rates, which due to observed correlations over the past year, is the central component of our crosssector valuation framework for securitized products. Chart 3 shows the history of the 10yr breakeven rate in recent years; it remains in the downward trend channel that started around the time of taper talk in 2013.

Chart 4 shows the seasonal view of the breakeven rate in 2016 versus the 2011-2015 average."

- source Bank of America Merrill Lynch

So overall, tactically we think that indeed "risk-on" can further continue and that we could have seen the lows for now on Government bond yields which, would entice further short term weakness on both bond prices as well as gold in true "Gibson's paradox fashion.

Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact.

"Memories are the key not to the past, but to the future." Corrie Ten Boom, Dutch author

Stay tuned!

Credit - Simpson's paradox

"Politicians fascinate because they constitute such a paradox; they are an elite that accomplishes mediocrity for the public good." - George Will 

Looking at the growing deterioration in the European space, with Portugal coming back into the forefront, and France losing its final AAA courtesy of French rating agency Fitch, we thought this week we would move back towards "Bayesian" analogies in our chosen title given the practical significance of Simpson's paradox. In decision making situations, it poses the following dilemma, about which data should be consulted in choosing an action, which is, we think an appropriate analogy following all the recent conversation surrounding not only the tapering noises from the Fed but as well the recent "forward guidance" conversations initiated by the ECB. If for example we refer to the unemployment level being a target for the Fed, which we previously discussed as an application of "Goodhart's law", like any other paradoxes, it only appears to be a paradox because of incorrect assumptions, incomplete or misguided information, or most likely because of a lack of understanding of a particular concept, namely the "unintended consequences" of prolonged ZIRP (zero interest rate policy) has had on the real economy (increased productivity and margins preservation mean some jobs will never return) and the effect negative interest rates always had on triggering asset bubbles.

On the application of the Simpson's paradox, it can be seen in the recent "improving" European PMIs: a positive trend appears for separate countries, a negative trend appears when the data are combined. For instance applying similar treatments to different countries, has had similar effect to the real life example from a medical study for kidney stone treatments which shows that different treatments should have been applied to different patient populations. In similar fashion different treatments should have been applied to the different countries in Europe suffering from different issues of course, but we ramble again.

In this week conversation, we would like to look at few gathering storms ahead, given we have already started hurricane season early with Tropical Storm Chantal taking a rare early path, but first our market overview.

Our "Daisy Cutter" effect as displayed by the evolution of the Merrill Lynch MOVE  index, has been receding as of late. But, it is still displaying signs of high volatility in the fixed income space - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Of course, in that context of receding bond volatility, the rebound in Investment Grade Credit and High Yield as indicative by the price action of the most liquid and active ETFs in the credit space namely the LQD (Investment Grade) and HYG (High Yield) ETFs, graph source Bloomberg:

Investors who thought ETFs as a fast and easy way to trade corporate bonds, had the pleasant surprise in the recent sell-off to discover that accessibility doesn't equate liquidity given that as reported in Bloomberg by Lisa Abramowicz and Mary Childs on the 8th of July in their article entitled "Crowded ETF Exit Proving Costly as Bonds Trail", the early exit comes with a cost:

"Investors who sought exchange-traded funds as a faster way to trade corporate bonds are finding that they can be as expensive to trade as the underlying debt.

As trading in the three-biggest credit ETFs surged to unprecedented levels last month amid the market’s biggest losses since 2008, the funds’ shares dropped as much as 1.1 percentage points more than the net value of the less-traded securities they hold. The two largest high-yield bond ETFs have lost about 6 percent since reaching a five-year high May 8. That’s about 2 percentage points more than the loss for the Bank of America Merrill Lynch U.S. High Yield Index.

The gap reflects the extra charge investors paid for a speedier exit in a declining market by using ETFs that trade like stocks rather than buying and selling the less-liquid debt.

Investors yanked about $1.83 billion of shares from the two-biggest junk ETFs last month, forcing sales of their holdings a ta time when demand was evaporating. “Just buying ETFs doesn’t solve the liquidity problem,” said Andrew Feltus, a money manager who helps oversee about $37 billion in U.S. fixed-income assets at Pioneer Investment Management Inc. in Boston. “You’re almost outsourcing your liquidity, because now your creator is the guy who’s going to have to go out and source the bonds in order to get it to work.”" - source Bloomberg

It is evident that liquidity comes with a price, given the low level of inventories sitting on market makers balance sheet, so it doesn't come much as a surprise that price performance is deeply affected by the significant volatility and outflows witnessed as of late:

"Shares of BlackRock Inc.’s $13.7 billion iShares iBoxx $ High Yield Corporate Bond ETF, the biggest of its kind, plummeted 4.3 percent in the six days ended June 24, while the net value of its assets dropped 3 percent, data compiled by Bloomberg show. The fund’s share price fell to the lowest level in 12 months on June 24, to $89.04. The lowest value last month for the underlying assets was $89.66, the data show." -source Bloomberg.

More interestingly the latest "marketing campaign" coming out from a European Central bank near you aka "Forward guidance" have had so far the desired effect in limiting the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields falling below the 1.60% level and French yields now around 2.20% - source Bloomberg:

But looking at the gathering storms from Portugal, and with Italy's sovereign credit downgrade to BBB (negative outlook) from BBB+, the on-going "complacency" should not be taken for granted given the rising political tensions taking back center stage again. While Italy's downgrade, for bond indices is not an issue, Spain's downgrade would be problematic as it is currently sitting just above junk territory (BBB- / Baa3 / BBB).

In relation to the US dollar, this week saw the dollar index receding overall with gold bouncing back somewhat from the low point touched previously - graph source Bloomberg:

The volatility from the fixed income space has been spilling over the FX space, leading to some impressive proverbial "sucker punches" such as the one delivered to the Australian dollar this week, on the back of Chinese weaker growth prospects - AUD/USD intraday movements on the 12th of July - graph source Bloomberg:

An interesting graph we have been tracking with much interest displays the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

Moving on to the subject of gathering storms ahead, rising interest rates and oil prices could indeed derail the consequent surge in US equities we have seen so far. Monitoring the impact rising gasoline prices are essential given the weak tone the US recovery has had so far, which has been further impacted by rising mortgage rates.

As far as Europe is concerned, our "Simpson's paradox" clearly indicates that the trend is negative, regardless of the latest "improving" economic data. 

The clear and present danger no doubt, comes from the austerity fatigue which is leading to political risks and turmoil as witnessed in Portugal and the recent slush funds scandal coming from Spain which could bring the Spanish government down.

The key issue of course for Europe is indeed unemployment which continues to rise, creating tensions in the process. On that subject CITI, in their latest Global Economic View from the 11th of July entitled "The euro area isn't working" is fairly clear on the subject:

"The euro area (EA) isn’t working. Quite literally. Roughly seven million more people are unemployed in the EA currently than in 2007 and in recent quarters the number of unemployed persons has been rising by almost half a million per quarter. Since the crisis started, unemployment has risen by 50% in the EA, doubled in Italy, tripled in Greece and Spain, and quadrupled in Portugal. It is now at record highs in all GIIPSSC countries (Greece, Ireland, Italy, Portugal, Spain, Slovenia, and Cyprus) except Ireland, as well as in the EA as whole. This is despite the fact that employment and labour force participation were relatively low in some of these countries even before the crisis.

(Un)employment matters greatly. In addition to its high social costs, unemployment makes it harder to repair the public finances, leads to skill degradation and creates the risk of greater social dislocation and social unrest. In this piece we consider past and prospective labour market reforms and the outlook for unemployment in the EA.

We conclude that unemployment is likely to remain very high for a long time. In the euro area as a whole, unemployment may still be above 10% at the end of this decade and in Spain maybe twice that. This is despite quite extensive labour market reforms in the EA in recent years, particularly in Greece, Portugal and Spain. In all three countries and in Ireland unit labour costs have fallen significantly. Models and precedents for how labour markets and labour market reforms can work in Europe also exist, even though the initial conditions in the precedent countries were generally more favourable than they are in the EA today." - source CITI.

Of course the most illustrative picture of the European "lost generation" can be seen in the below CITI graph:

"Long-term unemployment and youth unemployment – probably the most economically and socially harmful forms of unemployment – are particularly high in many EA countries. Conventional measures of youth unemployment suggesting that more than half of under-25 year olds are unemployed are misleading. The ‘NEET’ (not in employment, education, or training) measure of youth unemployment is more appropriate and less dramatic, but still sobering: in 2012, around one fifth of young persons in Italy, Greece, Spain and Ireland were NEETs (Figure 2) and the NEET ratio has risen in all EU countries since 2008. Meanwhile, the number of people in the EA that have been unemployed for more than 12 months has almost doubled in the last 5 years to nearly 9m people." - source CITI

Of course European politicians have once again demonstrated the Simpson's paradox in terms of "allocation" given the mediocre amounts involved in the latest EU Council decision of putting youth unemployment as its first agenda item and the focus for EU structural funds spending as displayed in the below figure:

"The financial amounts involved are ‘de minimis’. Thus, the funds allocated to the YEI under the new EU budget for 2014-20 are a mere €8bn over seven years (funds are meant to be spent in 2014-5 already), less than 1% of the total 2014-20 EU budget and less than 0.1% of EA GDP in 2012. For comparison, the new EU budget envisages spending more than 30 times on each farmer what will be spent on each unemployed youth. And due to the recent attention that the topic of youth unemployment has received, there are proportionally more funds available to fight youth unemployment than unemployment more generally.

The €8bn figure understates the total amount of resources available to fight youth unemployment (or employment), as a number of other ‘pots’ of money are used at least in part to support employment (notably the European Social Fund and some of the funds left unspent in the EU budget) and the EIB is supposed to give preference to projects supporting employment prospects. But the conclusion remains that the scale of the external help available is very limited and unlikely to make a noticeable dent in the employment numbers. "- source CITI

And CITI to conclude their recent note:

"One risk is that reform efforts will run out of steam before EA economies have become competitive, so that even these forecasts would prove optimistic. An even more worrying risk is that continued high unemployment will raise the prospect of widespread social unrest. ILO (2012) noted that its ‘social unrest index’ had risen by more in the EU than in any other region since 2006/7. Even if the more extreme reflections of public dissatisfaction are avoided, these factors will likely have a significant impact on political decisions and outcomes, and on growth prospects.

‘Austerity fatigue’ is often closely related to ‘unemployment fatigue’ and before long could become ‘debt service fatigue’, a risk we have been highlighting repeatedly in recent years. These considerations all play a major role in our assessment that sovereign debt restructuring will be a material risk for a number of EA economies with high public debt." - source CITI

Another point we would like to make as well in terms of the credit cycle, as we indicated in our conversation "What-We Worry?", we think it is much shorter this time around. For instance creditworthiness in the US is deteriorating at the fastest pace since 2009 with earnings growth slowing as yields rise from record low as indicated by Matt Robinson in Bloomberg on the 26th of June in his article - Ratings Ratio Worst Since 2009 as Profits Slow:

"The ratio of upgrades to downgrades fell to 0.89 times in the first five months of the year after reaching a post-crisis high of 1.55 times in 2010, according to data from Moody’s Capital Markets Group. At Standard & Poor’s, the proportion has declined to 0.83 as of last week from 1 a year earlier.

The Federal Reserve has pumped more than $2.5 trillion into the financial system since markets froze in 2008, helping companies improve profitability by lowering their borrowing costs. Policy makers are considering curtailing $85 billion in monthly bond buying intended to prop up the economy as analysts surveyed by Bloomberg forecast earnings growth of 2.5 percent in the current quarter, the least in a year.

“The trend of improving credit quality has slowed as profits are slowing,” Ben Garber, an economist at Moody’s Analytics in New York, said in a telephone interview. “As the recovery matures, companies are liable to get more aggressive in taking on share buybacks and dividends.”

Rather than using cash to pay down debt, companies in the S&P 500 Index are attempting to boost their share prices by buying back almost $700 billion of stock this year, approaching the 2007 record of $731 billion, said Rob Leiphart, an analyst at equity researcher Birinyi Associates in Westport, Connecticut.

Borrowers controlled by buyout firms are on pace to raise more than $72.7 billion this year through dividends financed by bank loans, surpassing last year’s record of $48.8 billion, according to S&P Capital IQ Leveraged Commentary & Data.

After cutting expenses as much as they could to improve profitability, companies “will need to see further revenue growth to boost earnings from here,” Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., which oversees $350 billion, said in a telephone interview." - source Bloomberg.

So not only the rally seen so far has been boosted by a "Simpson's paradox", leading to a surge in the "wealth effect" courtesy of our "omnipotent" central bankers, but "steroids" have also been used in this liquidity "alkaloid" induced equity rally as indicated by the impressive surge in stocks buy backs. Graph source Bloomberg:

"Companies focused on buying back shares may provide U.S. investors with “an enduring recipe for success,” according to Jeffrey Kleintop, LPL Financial Holdings Inc.’s chief market strategist. As the CHART OF THE DAY shows, the Standard & Poor’s 500 Buyback Index beat the S&P 500 from its introduction on Nov. 29 through the end of June. The newer gauge rose 24 percent in the seven-month period and came out ahead by 10.5 percentage points. “We expect it to outperform in the second half as well,” Kleintop wrote two days ago in a report. Many companies will turn to buybacks to increase earnings per share at a time of slower revenue growth, he wrote.

Sales rose 1.3 percent for S&P 500 companies last quarter after increasing 0.6 percent in the first quarter, according to data compiled by Bloomberg from analyst estimates and earnings reports. Profit growth slowed to 1.8 percent from 2.7 percent.

The buyback index consists of about 100 companies in the S&P 500 that had the highest repurchase ratios in the previous four quarters. The ratios are calculated by dividing the total dollar amount spent on a company’s shares by its market value when the 12-month period began. Each stock has an equal weight. Investors who mirror the index stand to benefit from its composition, the Boston-based strategist wrote. Companies that cater to consumers and depend on discretionary income amount to 26 percent of the buyback gauge, according to data compiled by S&P Dow Jones Indices. Consumer-discretionary stocks are the top performers this year among the 10 main industry groups in the S&P 500, where they only have a 12 percent weight." - source Bloomberg.

We would not call "buy backs" an "enduring recipe for success", us being credit investors, given the debilitating effect they can have on a corporate balance sheet and long term ratings, taking into account as well the cash burn effect. But then again, everyone is entitled to their own opinion...

On a final note, our good credit friend made the following great comments relating to reasons of the Fed's tapering:

"There have been a lot of talks recently about the FED decision to possibly reduce its liquidity injection at the end of the summer. Some market participants still think the FED will not taper as the economy is not yet on a very strong footing, and because the various thresholds announced by B. Bernanke (unemployment level, inflation,…) are still far from being reached. These arguments are undeniably right and strong, but one must consider other information prior to declare the “tapper” off.

First of all, B. Bernanke has explicitly announced that the FED will not look at economic data over the next few months, but rather at the trend which has developed.

Second, and more importantly, the FED currently owns about 33% of the outstanding US Federal debt. As funding needs of the US Treasury are diminishing following the sequester, there is less issuance and the FED ownership of bonds in percentage is rising quicker. Should the Central Bank continue buying the same amounts of bonds, it will own 40% of the outstanding in 2014, then north of 50% in 2015. The subsequent volatility on the interest rate market will increase drastically as the liquidity of the bond market disappears, and the currency could debase very quickly, creating a new crisis.

Third, and also a cause of concern, the bond market repo activity is facing an increasing number of failures (fails to deliver are on the rise exponentially) due to the large FED holding, which has ripple effect on the overall bond market activity. 

Fourth, and finally, economic growth in a society based on consumption requires credit. In order for credit to grow, or in other words banks to lend, collateral must be available. Since the 2007-2008 financial crisis, high quality collateral has slowly but surely become less available. If Central Banks continue to buy various government bonds (and US Treasuries are among those bonds), the available collateral will trend lower and the economy will stall, or worst spiral down as a credit crunch will occur at some point. So the FED has no other choice than to slow and even stop its QE if it wants the game to go on.

To resume, the FED may have more incentive to tapper and even stop its QE over time than to continue it, even if the economy slows down and some asset prices move lower. Apparently, it is the price to pay if one wants to avoid bigger problems in the future. The only remaining question is the following : “Is it the right time to do the tapper, or did the CB already crossed an invisible dangerous line?”  The way asset prices will behave and re-price in the coming weeks/months will give us the answer (nice retreat or collapse)."

"The words of truth are always paradoxical." - Lao Tzu 

 

Stay tuned!

Credit - Singin' in the Rain

"You learn to know a pilot in a storm." - Lucius Annaeus Seneca 

Looking at the epic bloodbath this week which started with the mechanical resonance of bond volatility in the bond market which we cautioned about recently, with carry trades in FX and High Yield ETFs (HYG) taken to the cleaners, and with equity starting to feel the spillover heat, you might think our title this week is a little bit "over the top" as far as sarcasm is concerned and you might not at first glance see the irony in it.

The epic bloodbath caused by a surge in bond volatility. The MOVE and CVIX indices rising contagion spilling to the equities sphere. We have added the VIX index as well - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Let us explain our title choice. While "Singin' in the Rain" is a 1952 American musical comedy film directed by Gene Kelly, it does involve "Tap Dancing". In similar fashion to Gene Kelly's routine in the movie, credit investors have been "tap dancing" to the Fed's liquidity "rain" for the last couple of years until the music stops 'in true Citigroup - Chuck Prince fashion ("As long as the music is playing, you've got to get up and dance"). Well, it looks to us that the music has indeed stopped. After all, should be we surprised that "Tap dancing" follows "Operation Twist"?

On a side note, we would have used "Spinal Tap" as a title, in reference to this cult movie but it had already been used two days ago by the WSJ, and by Jeremy Warner in the Telegraph in December 2012 and in many other instances.

Therefore in this week's conversation, while we will review some of the market action driven by liquidity issues, we will ponder what the implications are for some risky assets and the underlying issue of "convexity".

As we posited in the conversation "The Unbearable Lightness of Credit":

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

The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year is broken. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

We got seriously wrong-footed by the market's reaction to the "tapering QE" scenario and we still think at some point the Fed will maybe redirect its buying towards MBS, given that rising rates could seriously dent any hope of a "housing recovery" should the move continue at a rapid pace like it has this week.

The name of the game, we have kept saying is as follows:

"It is all about capital preservation rather than a hunt for yield".

As we have argued in our March 2012 conversation "Modicum of relief":

"In relation to systemic risk, credit risk conditions can significantly and persistently be decoupled from macro-financial fundamentals as indicated by Bernd Schwaab, Siem Jan Koopman and André Lucas in their December 2011 paper "Systemic risk diagnostics: coincident indicators and early warning signals":

"We demonstrate that a decoupling of credit risk conditions from macro financial fundamentals has preceded financial and macroeconomic distress in the past with non-negligible lead time (about four quarters)."

Looking at the market reaction with liquidity withdrawal, makes us indeed feeling rather nervous as we have long posited that liquidity crisis always lead to financial crisis:

"So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door" - Macronomics - Pain & Gain

Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:

"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:

 Wave number 1 - Financial crisis

 Wave number 2 - Sovereign crisis

 Wave number 3 - Currency crisis

 In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011

Why are we feeling rather nervous?

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?

It is a possibility we fathom. 

Here is why:

As indicated by Andrea Wong in Bloomberg on the 21st of June, Asian countries have been on the receiving end of the Fed's latest "Tap dancing" - Asian Currencies Tumble Most in 21 months on Fed Exit Outlook: 

“The prospect of less quantitative easing has caused outflows and selloffs in Asian assets,” said Tobby Lin, a fixed-income trader at Yuanta Securities Co. in Taipei. “The countries that had experienced the most inflows, like South Korea and Southeast Asian nations, are being hit the most.” More than $19 billion has been withdrawn from funds investing in developing-nation assets in the three weeks to June 12, the most since 2011, according to data from EPFR Global. The Dollar Index, which tracks the greenback against six major counterparts, was up 1.3 percent for the week, while the MSCI Asia Pacific Index of shares slumped 3.4 percent." - source Bloomberg

As we indicated back in May 2012 in our conversation "Risk-Off Correlations - When Opposites attract":

"When investors are most concerned about risk, “positive correlation between growth assets is most notable. Everyone is looking at the same threats to growth, and so they are all selling together.” - Shane Oliver, head of investment strategy at AMP Capital Investors

"In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar" .

Dollar index versus Gold - graph source Bloomberg:

Looking at the ongoing predicament in the markets, in similar fashion to our May 2012, the Greenback remains the only place to hide as confirmed by Lu Wang, Inyoung Hwang and John Detrixhe in Bloomberg in their 21st of June article - Nowhere to Hide as Dollar Posts Only Gains Amid Stock, Bond Drops:

"The dollar is proving to be investors’ only haven as stocks, commodities, bonds and other currencies fall in unison for the first time since 2011.

Concern governments will curtail aid to economies pushed the MSCI All-Country World Index down 3 percent, spurred declines of 2.5 percent or more in gold, copper and crude oil, and sent bonds of all types to losses of 0.4 percent this week, according to Bank of America Merrill Lynch’s Global Broad Market Index. Currencies from Australia to Mexico slipped against the dollar.

Rallies that have lifted everything from Japanese banks to Italian government debt during a four-year global expansion are being revalued amid signs central bank stimulus through quantitative easing, or QE, is poised to slow. Global equities posted the biggest two-day retreat in 19 months after Federal Reserve Chairman Ben S. Bernanke said he may phase out stimulus and China’s cash crunch worsened.

“The old risk on/risk off trade is broken,” said Walter “Bucky” Hellwig, who helps manage $17 billion at BB&T Wealth Management in Birmingham, Alabama. “The stress in the markets as the result of the pullback in QE and concurrent higher rates is causing the unwind of many kinds of trades. The liquidation and the deleveraging forces more unwinding as asset prices decline and the dollar strengthens.” The world’s 10 biggest equity markets slumped yesterday, according to data compiled by Bloomberg. They have fallen in sync three times in the past two months, accounting for half of the occurrences over five years." - source Bloomberg.

Indeed the old risk on / risk off trade is broken, we have to agree and we had no choice but to shelve our beloved indicator which we had been monitoring, namely the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:

In "Risk Off" periods we noticed that the 120 days correlation was close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level.  The correlation between both the German Bund and US 10 year note is not telling us anything anymore. 

Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund). 

Bye bye indicator...

According to John Detrixhe from Bloomberg on the 29th of May 2012:

"The dollar is proving scarce, even after the Federal Reserve flooded the financial system with an extra $2.3 trillion, as the amount of the highest-quality assets available worldwide shrinks."

Could the reason behind the "Tap Dancing"stance from the Fed be coming from the increasing shrinkage of the highest-quality assets available worldwide and in particular US Treasuries because the Fed's vacuum cleaner had been running on full steam with its QE program has posited by Zero Hedge in their recent note "Is This The Chart That Scared Bernanke Straight"?

And if the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder...

We have to agree with Barclays recent note on FX trends entitled "Let the tapering begin". The genie is out of the bottle as far as the dollar is concerned:

"• A robust recovery in the US is leading to repricing of market expectations of future Fed asset

purchases.

• Higher risk premia typically lead to lower prices for risky assets and higher volatility.

• In FX, this implies weakness in high-carry and EM currencies versus the USD.

• A broader USD rally, which would include low-yielding currencies, however, will have to wait for expectations of rate hikes to be priced.

• The broad resurgence in the USD is likely to gain strength as H2 progresses.

• It is likely that the Fed will attempt to smooth market expectations of a premature exit. However, it

is unlikely that it will be able to put the genie of an eventual exit from unconventional monetary policy back in the bottle.

• Recommendations:

• We favor being long USD versus JPY, CHF and EUR.

• Additionally, we remain out of USD funded carry trades despite the recent selloff." - source Barclays

We do agree with Barclays that we are in an early stage of dollar strengthening as well:

"• Markets have been given a little taste of how tricky the Fed’s exit from extraordinarily loose

monetary policy will be in the months and years ahead.

• Even at its near-term peak, the USD saw muted gains of about 2% on a broad basis; however,

the average rise in the USD against risky currencies has been much larger, at more than 8%."

- source Barclays

As per Lu Wang, Inyoung Hwang and John Detrixhe Bloomberg's article published on the 21st of June entitled "Nowhere to Hide as Dollar Posts Only Gains Amid Stock, Bond Drops", outflows in funds have been significant in recent weeks:

"More than $19 billion left funds investing in developing-nation assets in the three weeks to June 12, the most since 2011, according to EPFR Global. Foreign investors dumped an unprecedented $5.6 billion of Brazilian stocks and $3.4 billion of Indian bonds this month, exchange data show. The MSCI Emerging Markets Index slid 4 percent yesterday while the rupee and Turkish lira hit record lows." - source Bloomberg

Basically "carry monkeys investors" as described by Macro-Man in his recent post "Beatings will continue until morale improves"  have been hammered. All the investors that piled in high beta trade, namely High Yield, Emerging Debt Bonds and Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play. 

Well, we did ponder about the potential end of the goldilocks period of "low rates volatility / stable carry trade environment this week: 

"As pointed out by Bank of America Merrill Lynch's note stable carry thrives in low rates volatility environment, the recent spike in US bonds volatility has had some devastating effect in high yielding assets:

"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past three years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels."

Why the move could potentially accelerate?

Because of real yields...graph source Bloomberg:

"U.S. government debt is the cheapest in more than two years with inflation not a threat as the Federal Reserve provides a timetable for the eventual end of its bond-buying program.

The CHART OF THE DAY shows the difference in U.S. Treasury 10-year note yields and the annual inflation rate, known as the real yield, rose past 1 percent for the first time since March 2011 this week after Fed Chairman Ben S. Bernanke said the central bank may start reducing bond purchases later this year and end them by mid-2014. Consumer inflation climbed 1.4 percent in the 12 months to May, less than the Fed’s 2 percent goal. Benchmark yields touched 2.47 percent yesterday, the highest level since October 2011.

“The 2.40 percent 10-year is a very good buying opportunity,” Guy LeBas, chief fixed-income strategist in Philadelphia at Janney Montgomery Scott LLC, said in the telephone interview. “For the first time in a couple years, there’s good value in the current level of interest rates.” Higher real yields tend to attract foreign investors to a country’s bonds. Rising yields, along with unprecedented easing by major and emerging-market countries, have contributed to the dollar outpacing all but two of the 31 currencies tracked by Bloomberg over the last five days. Easing refers to a country’s central bank purchasing assets from commercial banks to increase the monetary base." - source Bloomberg.

This is what happens when you take the proverbial punch bowl away. Volatility which has been repressed by Central Banks meddling with setting up the price of risk by artificially suppressing up interest rates movements via the increase in M (Money Supply). MV = PQ as per the great Irving Fisher's equation. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.)

Let's move on to the underlying issue of "convexity":

Like a spring severely coiled, when volatility is released, the destructive energy is massive because of convexity as indicated by our friend Martin Sibileau on his Popular Macro blog:

"Technical aspects that may matter tomorrow: While the Bank of Japan seems to have failed to control market forces, the Fed appears to have won the repression battle. However, there is an aspect that may be out of their reach: Convexity. The reach for yield (i.e. greed) has been such a powerful force that the rumor is that approx. only 15% in High Yield and 50% in Investment Grade portfolios are rate hedged.

Remember: When an investor wants to be long credit risk only, as the yield is driven by: US Treasury yield + swap rate + credit spread or Libor+ credit spread, said investor will buy the credit (i.e. bond, loan) and sell the rate, to keep only the credit spread. 

But if only 15% and 50% of positions in HY and IG are rate hedged, if Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau, Popular Macro blog

So all in all this is the perfect storm because market makers are running inventories at 2002 levels and they are always interest rates neutral...You buy a bond from a mutual fund, you sell treasuries, feeding even more the rising pressure on treasuries yield to rise further.

There is no place to hide except cash at the moment and in dollars...(or shorting treasuries for the  short term tactical braves out there...we like the ETF TBT out there as of late...)

To answer our friends Martin Sibileau's questions commodities have further to fall including gold.

Why? 

Gold is not an inflation hedge; it is a hedge against the end of the dollar’s status as a reserve currency, a deep out-of-the-money put against the US currency as a whole, ("The Night of the Yield Hunter" - Macronomics).

The S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play,  graph source Bloomberg (21st of June 2013):

As indicated above, we got seriously wrong-footed (long US bonds) by the market's reaction to the "tapering QE" scenario, because as per "The Night of the Yield Hunter" and David Goldman article about Gold and Treasuries and bonds in general he wrote in August 2011 (the former global head of fixed income research for Bank of America):

"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?

 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.

 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

So not only our Risk-On / Risk-Off indicator is broken, but our thermos bottle is lately behaving strangely (could it be caused by global warming we wonder) because central bankers have been busy trying to ignite inflationary expectations with various QE programs, but the YTD movements in 5year forward breakeven rates is still  falling are indicative of the strength of the deflationary forces at play - source Bloomberg:

So we will patiently monitor 5 year breakeven given last time the Fed put on its dancing shoes and started "Twisting" again, it was when we hit the 2% level.

When it comes to credit, at the moment, we are happy to sit on the sidelines and enjoy the show given poor liquidity, convexity issues, and rising yields do not mix very well with "total return" or preservation of capital that is. After all Shares of BlackRock Inc.’s $21 billion investment-grade bond ETF have plunged 3.7 percent this month as of 11:58 a.m. in New York, the biggest decline for a month since February 2009, according to data compiled by Bloomberg. Shares have dropped the furthest below corporate-bond prices since August 2011, signaling that the fund may reduce holdings to lower its net asset value, the data show according to Bloomberg.

As Friday came to a closure after an eventful week where market participants age in dog years, clearly there was a weaker tone by the end of the day as indicated by a market maker in the cash market:

"While holding stable for the most part of the day we saw a proper collapse into the close in corp cash bonds. Market depth is basically non existent with no place to hide at the moment it seems. The pain is coming from everywhere being it wider swap spreads, wider indices or weaker stocks. With swap spreads moving wider so will new issue spreads vs bunds if and when. It feels a bit overdone at current levels and I would advise to hold things near the ground since there is also the possibility of a strong squeeze back in but going into the weekend it feels very weak out there. Low beta bonds close between 2-6 bps wider again with the bid side the tough one to trade. Not all is panicky in the market though with still the strong low beta names holding well compared. Have a nice weekend." - source undisclosed market maker.

And when you come under pressure, with outflows due to heavy redemptions and with poor liquidity you sell the good liquid stuff first, and the illiquid stays at the bottom. 

So all in all the quality of the leftovers such as in a leveraged loans mutual fund for instance is not optimal to say the least as indicated by Sridhar Natarajan in Bloomberg in his article - Loans Penalized as Funds Attempt to Stem Losses:

"Leveraged loan prices are dropping from a six-year high on speculation managers of high-yield funds are discarding the floating-rate debt to contain steeper losses from junk bonds amid record redemptions.

The average price for the 100 largest, most liquid loans declined 1.22 cents to 97.66 through yesterday from 98.88 cents on the dollar on May 22, the highest level since July 2007, according to the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index. Bonds sold by speculative-grade companies fell 4.53 cents to 102.06 cents from 106.6 cents, Bank of America Merrill Lynch index data show.

Investors pulled $9.4 billion from high-yield funds since May 22, including two weeks of record outflows, according to a June 13 report from Bank of America Corp., as Federal Reserve officials signaled they may pare back their extraordinary stimulus measures this year. Loans have held up better because they have rates that fluctuate, offering some defense against higher borrowing costs.

“High-yield fund managers who sought the rate protection of senior loans to reduce their duration risk earlier this year and last year were now forced to sell those very instruments to meet the deluge of investors running for the exit,” said Bill Housey, a Wheaton, Illinois-based money manager at First Trust Advisors LP. “It really comes down to prices as loans are holding up better” than bonds, he said." source Bloomberg.

From the same article:

"“It is counterintuitive that they’d be selling off the loans, but yet they are because it’s the best place for them to fund the redemptions without having to realize much of a loss,” said Alex Jackson, the head of the bank loan group in Armonk, New York at Cutwater Asset Management, which manages about $30 billion in fixed-income assets. “It is better to sell off a loan with a one point loss rather than take a bigger hit on a similar quality bond.” "- source Bloomberg

On a final note, we discussed "convexity" with a very wise credit friend former head of credit research and this is what he had to say on the subject:

"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR"

US 5 year Swap spreads - graph source Bloomberg:

All in all, as we indicated last week in our conversation "Lucas critique", while it did cost us not to believe in  the "Tap Dancing" skills of Ben Bernanke and given Mr. Jeff Gundlach's opinion is that the Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming. 

As recently commented by Marc Faber: "I am tempted to buy a 10 year treasury at a yield of 2.5%. I think we will rebound in the treasury market. Yields will go down first, and if they go up further, it will kill the economy including the housing market." 

There is indeed a risk for the Fed, and like our wise credit friend said, the Fed might do a ECB in the end. Should we call that new dance "B-boying"? We wonder...and keep "Singin' in the Rain".

"If you are caught on a golf course during a storm and are afraid of lightning, hold up a 1-iron. Not even God can hit a 1-iron." - Lee Trevino 

Stay tuned!