Credit - The Dunning-Kruger effect

"The truest characters of ignorance are vanity and pride and arrogance." - Samuel Butler, British poet

Watching with interest the impressive volatility in the bond space which has yet to normalize, we thought this week we would use a reference to human psychology in our reference title, given so far our "Central Bankers" mind tricks (call them jedi skills if you want) seems to differ widely, between the Fed and Bank of Japan, between the Bank of England and the Reserve Bank of Australia, and the ECB of course.

For those who have been following us, you know that like any good cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. 

So why our chosen title you might rightly ask?

"The Dunning–Kruger effect is a cognitive bias in which unskilled individuals suffer from illusory superiority, mistakenly rating their ability much higher than average. This bias is attributed to a metacognitive inability of the unskilled to recognize their mistakes" - source Wikipedia

When one look at how central bankers have been previously apt in preventing formation of asset bubbles or identifying asset bubbles, one can easily be drawn to the Dunning-Kruger effect given that ignorance of standards of performance is behind a great deal of incompetence.

Of course we are not surprised to see the Dunning-Kruger effect at play, given it is a continuation of the "Omnipotence Paradox" of our central bankers or deities:

"In similar fashion, the financial crisis and the consequent burst of the housing bubble which had taken aback the beliefs of some forefront central bankers such as Alan Greenspan; have clearly shown that Central Banks are not omniscient either (omniscient being the capacity to know everything that there is to know).

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief." - Alan Greenspan -  October 2008." - Macronomics, 18th of November 2012.

In the Dunning-Kruger effect, for a given skill, incompetent people will:
"1.tend to overestimate their own level of skill;
2.fail to recognize genuine skill in others;
3.fail to recognize the extremity of their inadequacy;
4.recognize and acknowledge their own previous lack of skill, if they are exposed to training for that skill." - source Wikipedia

In continuation to our "Omnipotence Paradox" conversation,  we believe this time around that the Dunning-Kruger effect can explain the failures of some economic school of thoughts, namely the Keynesian school of thought and the Monetarist School of thought. We have argued in our conversation "Zemblanity", when looking at the evolution of M2 and the US labor participation rate that both were indicative of the failure of both theories:

"Both theories failed in essence because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows"."

"Credit growth is a stock variable and domestic demand is a flow variable" as indicated by Michael Biggs and Thomas Mayer in voxeu.org entitled - How central banks contributed to the financial crisis.

Obviously one can posit that not only do our central bankers suffer from the Dunning-Kruger effect but they are no doubt victim of the well documented "optimism bias" which we discussed in our "Bayesian Thoughts" conversation:

"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."

Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

We have on numerous occasions discussed shipping as being not only a leading credit indicator (with the collapse in European structured finance) but as well a leading economic growth indicator (on that subject please refer to "The link between consumer spending, housing, credit and shipping"), in our "Bear Case", excess capacity and a weak global economy with a China slowdown will drive rates down even with price increases, pressuring margins - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark rose 21.8% to $2,236 in the week ended July 3, as a $400 rate increase went into effect. Rates are 11.2% lower yoy, as slack capacity pressures pricing. With four increases in 2013, rates are up 1% ytd. Carriers are expected to implement a $400 peak season surcharge ahead of back-to-school and holiday shopping on containers from Asia to all U.S. destinations, effective Aug. 1." - source Bloomberg.

Not only slack capacity are pressurizing pricing in the shipping space but in general, we have long argued that overcapacity has been plaguing various economic segments such as the car industry with European car sales back at 1993 sales levels (on that subject see our 21st of April "European Clunker" conversation), but with the incoming threat of a China slowdown or even hard landing, metal prices such as Aluminum prices are indicative as well of the great deflationary forces at play and the overcapacity fuelled by "cheap credit" (the Baltic Dry reached 11,783 on May 20, 2008 and is now at 1103) - graph source Bloomberg:

"Aluminum prices, which have fallen for three straight quarters, may be poised for further declines as new production in China and the Middle East increases global output even as Alcoa Inc. trims capacity.
The CHART OF THE DAY shows production has gained 5.1 percent since the end of 2011, helping drive prices down 9.3 percent, according to data from the International Aluminium Institute. Output will reach a record near 50 million metric tons this year, up from 45 million in 2012, Harbor Intelligence forecasts.
“The market is still looking at over-capacity, over-production and an unprecedented overhang of metal,” said Jorge Vazquez, a managing director at Austin, Texas-based Harbor. “There’s a lack of credibility for the producers, and even if these cuts take place, investors expect nothing to change.” Alcoa, Aluminum Corp. of China Ltd. and United Co. Rusal, the world’s largest producer, are among companies trimming capacity amid ample supplies. The price outlook remains “depressed” as some investors are concerned that producers won’t follow through on planned cuts and amid the prospect of new and expanded plants and restarts at some older sites, Vazquez said.
Aluminum for delivery in three months on the London Metal Exchange dropped 12 percent this year to settle at $1,832.50 a ton yesterday. The metal may fall to $1,675 in the next few weeks said Vazquez, who expects supply to exceed demand by 350,000 tons in 2013 for a seventh straight year of surplus." - source Bloomberg.

Of course our "omnipotent" central bankers "fail to recognize the extremity of their inadequacy" in true Dunning-Kruger effect as far as "cheap credit" and "bubbles" implications are concerned. They have even come up with a new marketing campaign as of late "forward guidance" in Europe.

Forward Guidance:
"Forward guidance arms central banks with fresh ammunition even when they have lowered short-term interest rates close to zero. It allows them to influence not just current rates but those stretching into the future through pledges to keep them low. The forward guidance can be for a period of time or it can be linked to specific indicators, such as an unemployment-rate threshold (which is not, however, a trigger) in the case of the Fed." - source The Economist

Fresh ammunition? Yet another demonstration of the Dunning-Kruger effect at play we think. Thank god, our "central bankers" are not in the guide dog training business to lead blind and visually impaired people around obstacles...
"Forward Guidance" might be as effective as using a "Yorkshire Terrier" as a guide dog, instead of the usual Labrador retriever. The "Yorkshire Terrier" could be trained to do the job, but would they really be effective? We wonder and ramble again.

Unemployment-rate threshold? As we have argued in "Goodhart's law":
"Conducing monetary policy based on an unemployment target is, no doubt, an application of the aforementioned Goodhart law. Therefore, when unemployment becomes a target for the Fed, we could argue that it ceases to be a good measure." - Macronomics, 2nd of June 2011

In this week's conversation, we would like to focus our attention to the "Bail-in" effect and the recent clarifications made surrounding financial subordinated debt instruments which have long been a pet subject of ours ("Subordinated debt-Love me tender?") given the "Bail-in" conversations which took place on the 26th of June (BRRD) which we touched last week, will have as well  "ripple" effects in the subordinated credit space but first our market overview.

The US dollar still rising against one of the most impacted asset commodity classes since the beginning of the year namely gold - graph source Bloomberg:

The greenback is still benefiting from the surge in bond volatility which has yet to recede.

The "Daisy Cutter" effect as displayed by the evolution of the Merrill Lynch MOVE  index, which is still showing sign of high volatility in the fixed income space as witness this week and CVIX indices closely followed by the recent rise in the VIX index - graph source Bloomberg:

No wonder interest rate sensitive asset classes such as Investment Grade Credit and High Yield are as well suffering from the increased turbulences as displayed by the price evolution of the most liquid and active ETFs in the credit space namely the LQD (Investment Grade) and HYG (High Yield) ETFs, graph source Bloomberg:

In the HY Fixed Income space HYG (iShares $ High Yield Corporate Bond, Expense Ratio 0.50%) has lost $1.78 billion year to date in terms of net redemption flow.

In terms of weekly allocation trends, bond market outflows have jumped in the week of the 27th of June until the 3rd of July as reported recently by Nomura's Fundflow insight published on the 5th of July:

"Asset allocation trends: Bond market outflows jumped/money market turned to inflows
- Bond market: -USD28.1bn vs -USD8.0bn in the previous week
- Money market: +USD7.7bn vs -USD25.1bn in the previous week
For the week ending 26 June, the bond market reported outflows for the 4th week in a row — the longest streak since August 2011. Despite bond market outflows easing slightly in the week before, the latest outflows jumped more than 3x to USD28.1bn from USD8.0bn in the previous week. In contrast, the money market turned to mild"- source Nomura, Fundflow insight, 5th of July 2013.

With the recent surge in both US Treasury yields courtesy of a better than expected Nonfarm payroll number coming at 195 K and in oil prices thanks to increased tensions in Middle-East, we wonder how long equities  in general and the S&P in particular will stay immune from the growing nervousness - graph source Bloomberg:

The latest "Forward guidance" European marketing stunt is no doubt meant to prevent a dramatic repricing in the European government space and avoid the trigger of the much "hyped" OMT. The volatility jitters in the bond space, have led to a surge in European Government Bonds yields in the process as indicated in the below graph with German 10 year yields rising towards the 1.70% level and French yields now around 2.30% - source Bloomberg: - graph source Bloomberg:

Of course our "omnipotent" central bankers in Europe had to come up with another playing trick up their sleeves, given as we indicated in last week's conversation, contagion risk is now bigger than ever and the customer/investor security system is now weaker than ever because the LTROs have encouraged banks to increase even more their holdings of government debt to fund fiscal deficit, making them in the process even more "Too-Big To Fail". Yet another demonstration of the Dunning-Kruger effect.

The issue of course is "convexity", given the debt levels for both the private sector and the public sector are high in most developed countries meaning their economies are now even more sensitive to interest rate risk courtesy of global ZIRP! The more sensitive their economies get, the more solvency risk you have, the greater the risk of a sudden spike of defaults you get in a low yield environment with surging yields.

Back in November 2011, we posited the following in our conversation "Complacency":
"In a low yield environment, defaults tend to spike. Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation."

"Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - Morgan Stanley - "Understanding Credit in a Low Yield World.


Moving on to the subject of the "Bail-in" factor and the financial subordinated credit space, given it has gathered much attention in the bank credit analysts sector as of late with very diverging views on the future for legacy subordinated Tier 1 securities, a subject which warrants some attention.

For instance Morgan Stanley on the 25th of June, in their European Banks note entitled "Get Ready: Regulatory Rating Par Calls Soon" argued the following:
"We have long been cautious on high cash price regulatory and rating par calls (see Reg Par Calls:
Closer, October 12, 2012, and The End of RAC Tier 2, April 2, 2013). The finalisation of CRD IV and S&P’s decision on RAC methodology mean possible calls are weeks away.
About 60 Tier 1 bonds have reg par call language (RPC) in our space, which means that if regulations change and bonds lose their Tier 1 regulatory status, they can be called at par. More than half of these RPC bonds are currently trading above par, leaving scope for significant downside from here.
Deutsche could be the first RPC next month… As we believe it will be able to trigger the reg par call of its €9.5% and €8% retail prefs as soon as CRD IV/CRR is published in the Official Journal of the EU, on June 27, which marks the end of the legislative decision-making process. At current levels, the yield to call in, say, a month is -26% for the €9.5% and -37% for the €8%. Bondholders risk losing up to 8 points in a day if the RPC is exercised.
… affecting all RPC bond pricing negatively, in our view. The language of nearly all other RPC bonds is far less clear than Deutsche’s, and such ambiguity could bring legal challenges many of these issuers (if not all) would not want to risk. However, particularly in today’s kind of market, we believe that many holders will simply take fright and it’s hard to say how much above par any bid might be, following a potential par call by Deutsche." - source Morgan Stanley

We were quite baffled by Morgan Stanley's note given we have been watching liability management exercise for a while in the European banking space and we completely disagree with their take on Tier 1 securities trading way above par that could be rapidly called by their issuers. For us, it doesn't make sense as we indicated in our conversation "The Doubt in the Shadow" on the 23rd of March 2013:
"Banks may have an incentive to buy back non-compliant Basel 2.5 hybrids that do not qualify as regulatory capital under Basel 3. To the extent that such "liability management exercises" can result in debt being repurchased at a discount to par (well below a cash price of 100), banks are able to generate common equity Tier 1 (CET1) gains. On that subject see our October 2011 conversation "Subordinated debt-love me tender?"."

Our views have been comforted by Bank of America Merrill Lynch note entitled "Bail-in: the ripples" from the 1st of July:
"Reg par calls – still a no-no?
The new need to have a bail-in buffer if anything supports the idea that the banks need to hold onto their existing subordinated debt and would be ill-advised to rush to redeem it, even if it optically appears to be expensive. The work we have presented on the need for bail-in buffers only underlines that European banks need to retain and rebuild capital, not redeem it, in our view. Why would a regulator permit the calling of an old Tier 1 bond just because it was ‘expensive’ to the bank? We think the emphasis on retaining capital until the banks are more comfortably positioned will remain for the foreseeable future so our base case remains: No reg par calls." - source Bank of America Merrill Lynch.

Morgan Stanley is putting the cart before the horse and we also agree with the below extract from Bank of America Merrill Lynch note:
"European banks’ need to retain and rebuild capital not redeem it. Why would a regulator permit the calling of an old Tier 1 bond just because it was ‘expensive’ to the bank? They would wish to see such a bond being replaced. If we were regulating the banks, we’d also like to see the banks issued the replacement capital prior to our allowing them to call the old." - source Bank of America Merrill Lynch

On top of that it seems to us Morgan Stanley's is not taking into account earnings boosting technique of FAS 159 which allows banks to book profits when the value of their bonds falls from par, meaning for us, that banks will be encouraged to issue more loss absorbing subordinated debt rather than reduce their buffer to avoid having senior unsecured bondholders or unsecured depositors paying the piper like it happened in the Dutch SNS case in the first instance due to lack of deliverables for the CDS trigger, and in the second case like it happened in Cyprus due to lack of sufficient subordinated and senior unsecured bonds buffers.

So what is the "ripple" effect of the latest "Bail-in" discussions for senior debt and legacy subordinated debt?
"But this brings us to the ripple effect: if banks need to focus on building this buffer, we believe it will prima facie entail potentially some new sub or bail-in bond issuance.
What about retaining the existing subordinated stock though where it is evidently cheaper than issuing new stuff? We are thinking particularly of low-back end Tier 1 bonds but there are also fixed-to-float UT2s and arguably even the dated LT2s too. It makes sense to keep these outstanding forever, arguably, or at least until such a time that the spreads on e.g. bail-in bonds are comparable to those low back-ends (which may, equally, be never of course). 
This is a totally separate discussion to whether the bonds in question are included in regulatory capital. Eventually, very little of the old stock of Tier 1s, Upper Tier 2s and Lower Tier 2s should there be any long-dated enough will ‘count’ as regulatory capital. But there is a role now for all these instruments in the liability buffer above own funds that perhaps they didn’t have before last Thursday. What sense for Credit Agricole to call the €4.13% Tier 1 bond with a back-end of +165bp? Or for BNP to call the US$5.186% bond with a back-end of +168bp? How to justify retiring these bonds which are subordinated and – indeed – loss absorbing – to expose senior bondholders to potential losses? A call of these bonds would look like negligence to us, if it increased the risk that senior bondholders would be bailed-in." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch's take on the subject. From a regulatory perspective and in relation to increasing capital buffers, previous bond tenders have shown that there is a greater call risk with low back-end bonds (convexity issue) and those trading below par:
"In most cases, that CRD 4 is now European Law. It must be domestic law too. It will take several countries some time to put CRD 4 into their own law. So in most cases, there is no immediate threat of a reg par call because there isn’t even the legal basis yet for one." - source Bank of America Merrill Lynch

What is the risk for senior unsecured bondholders and the implication of having low subordinated bond levels buffers for some European banks?
Here is Bank of America Merrill Lynch take on the subject:
"If banks don’t build up their buffers and appear to have no intention to either, then their senior will widen towards their sub and the sub-senior curve (in cash) will flatten at wider levels, mutatis mutandis, we think. Current CDS contracts may not be a reliable indicator of this of course, since they are locked in their own technical until the new contracts come into being in September" - source Bank of America Merrill Lynch

We could not agree more. Of course current CDS contracts are not yet reliable indicators of this risk until the much anticipated need to revamp CDS contracts in September. For more on the importance of this issue please refer to our conversation "The Week That Changed The CDS World" from the 26th of May.

So all in all, Morgan Stanley as put the horse before the cart, and in the case of financial subordinated bonds has even jumped the gun as indicated by a JP Morgan's note from the 5th of July entitled "Tier 1: Upgrade to Overweight":
"The clarification that legacy Tier I instruments will not be eligible as Tier II capital under transitional arrangements will be an undoubted positive for valuations as this will increase the certainty of call being exercised. Whereas previously our assumption was that the Tier I instruments would be eligible as Tier II capital, making the decision to call such instruments dependent on the relative cost of issuing Tier II capital instruments, the fact that the legacy Tier I instruments will not have any regulatory capital value will imply that it will merely be a question of comparing the post-call spread on the instrument versus the cost of senior funding. Under these circumstances, we assume that the issuers will have much lower incentives to maintain these instruments outstanding and as such, the certainty with regard to call has to increase. This would also be applicable for issuers such as DB which in the past have used economic rationale to justify the calling or not of Tier I instruments." - source JP Morgan

On a final note, we have always lacked conviction in the great rotation story from bonds to equities which has been put forward since the beginning of the year. As displayed in the below graph from Bloomberg, the rotation to stocks from bonds has been indeed less than great, so has been QE to the "real economy" courtesy of the Dunning-Kruger effect:

"Anyone who expects U.S. individual investors to push stocks higher by moving away from bonds may end up disappointed, according to Vadim Zlotnikov, Sanford C. Bernstein & Co.’s chief market strategist.
The CHART OF THE DAY illustrates how Zlotnikov drew his conclusion, presented in a report yesterday. He tracked the value of equities, owned directly or through funds, as a percentage of household financial assets. Stocks were 39 percent of assets at the end of March, according to data that the Federal Reserve compiles quarterly. The figure was the highest since 2007 and surpassed an average of 29.2 percent since 1950, as shown in the chart. “U.S. households’ exposure to equities is already above historical levels,” the New York-based strategist wrote. “With rates likely to rise over the next 12 months, the case for a rotation from bonds into equities may become less compelling.” Average inflation-adjusted returns on U.S. stocks are negative 2.3 percent a year when bond yields increase at an annual rate of more than 1.3 percentage points, he wrote. The calculation is based on performance from 1871 through April of this year.
Betting against stocks with relatively high dividend yields may pay off as rates increase, Zlotnikov wrote. These shares are 20 percent more expensive than their industry peers on average when judged by ratios of price to book value, or the value of assets after subtracting liabilities, the report said." - source Bloomberg

"Real knowledge is to know the extent of one's ignorance." - Confucius

Stay tuned!

QE - To infinity ... and beyond!

"The last proceeding of reason is to recognize that there is an infinity of things which are beyond it. There is nothing so conformable to reason as this disavowal of reason." - Blaise Pascal, French philosopher

Apologies dear readers for not having posted recently our credit ramblings, but, once in a while, bloggers such as ourselves are in the need for some R and R (Rest and Recuperation). This is exactly what we did. We rested our mind while enjoying some wine tasting in the United States. Of course, one would immediately turn their initial thoughts on California. Luckily the immensity of the United States means diversity, and we found ourselves enjoying Long Island and its many wineries as well as a particular Paumanok 2005 Cabernet Franc but then again, we fall prey to our usual rambling habits. 

Following up on our recent conversation entitled "Zemblanity", and "The inexorable discovery of what we don't want to know", we could not resist to refer to Buzz Lightyear's catchphrase from the Toy Story franchise in our title as another reference to the unlimited pledge in Quantitative Easings by the Fed and the continuous game of global "easiness" provided by most Central banks across the globe (Fed, BOE, BOJ, ECB). In this post we will revisit the consequences of unlimited QE.

Buzz Lightyear of Star Command (central bankers), space ranger protecting the universe from Evil Emperor Zurg (deflation):

While Buzz Lightyear was indeed the most popular toy in the first outing of Toy story, it looks to us that currently QE is the most popular toy being used by our central bankers over the world. But, in similar fashion to our Buzz Lightyear from the movie Toy Story, it looks to us that central bankers are indeed as deluded as Buzz Lightyear was. Buzz Lightyear in the first movie believed he was a space ranger before realizing he was just a toy. It appears to us that, courtesy of "Zemblanity", at some point, central bankers will have indeed to realize that QE is just a toy and a dangerous one to play with for too long in fighting Evil Emperor Zurg (deflation). This is clearly illustrated by Japan's plight in fighting off "Zurg" for the last 25 years as indicated by Bloomberg:

"The Bank of Japan’s failure to halt yen gains through domestic bond buying over the past decade is pushing policy makers to consider a new tack, purchasing foreign debt to produce the currency weakness exporters crave. The CHART OF THE DAY shows the yen’s effective exchange rate climbing to about 5 percent above its 10-year average, ignoring BOJ asset purchases that helped swell the money supply to 124.33 trillion yen ($1.6 trillion), the most ever in data going back to 1970. Policy makers’ efforts are faltering as bank lending dropped 3 percent from a six-year high reached in March 2009, preventing the cash injected into the financial system from filtering into the wider economy. Buying foreign bonds is a promising tool, Economy Minister Seiji Maehara said this week, echoing the two newest BOJ board members who’ve said new types of easing should be considered. BOJ Governor Masaaki Shirakawa said such purchases would be a type of currency intervention, which only the government can do. The BOJ starts a two-day policy meeting today. “Current policy tools are reaching their limits in ending deflation and yen appreciation, increasing political pressure on the BOJ,” said Koji Takeuchi, senior economist at Mizuho Research Institute. “Purchases of foreign bonds are being considered, which would require changes to the central bank charter.” The yen traded at 78.48 per dollar as of 8 a.m. in Tokyo from 78.49 yesterday. The currency reached a post World War II record of 75.35 per dollar on Oct. 31, 2011. The yen’s 14 percent climb over the past three years is reducing earnings at exporters." - source Bloomberg.

The approach of "infinity...and beyond" has been clearly demonstrated by our "Buzz" Central Bankers' willingness in committing to maintaining interest rates at zero for a long period. In Japan's case, the BOJ has promised to keep rates at or near zero until inflation reaches a certain level, and thus close to an "inflation target". "To infinity and beyond!"...One may posit, as Japan has been playing with its QE toy for the last 25 years.

In a recent note published by Nomura Securities entitled "Lessons from Japan" - Securities Investment in a Low-Yield, Low-growth Environment from the 2nd of October 2012, they indicate the following:
"Japanization trades in rates markets BOJ measures were in response to falling growth and inflation expectations The roots of Japanization lie in the substantial declines in growth and inflation expectations (graph below). This process took place over more than 10 years, starting with the financial bubble burst in the early 1990s – the BOJ’s policy duration and QE measures appear to have had a direct effect on JGB price action, but the BOJ only responded to the low growth and inflation environment." - source Nomura.

"Government bond markets mean revert under policy duration regime Policy rates are the starting point in shaping the yield curve. As these rates are likely to be kept close to zero for a prolonged period, government bond yields will likely be anchored as if to mean revert, with their volatility falling (see below graph). As such buying maturities with high carry and roll on dips (i.e., on yield upswings) and holdinh onto them may appear the best option as  long as the low-rate commitment remains in place." - source Nomura.

Unintended consequences of playing too long with a QE toy:
"Inflows of short-term capital create bond bubble 
In addition to long-horizon trades for carry and roll, government bond markets attract large amount of flows seeking short-term gains, which have resulted in yield curve shapes that are significantly flatter than the ones justified by the expected growth and inflation rates. When central banks buy government bonds as part of QE measures and thus tighten supply and demand in the market, government bonds are likely to outperform other assets due to capital gains, attracting further inflows of short-term capital. Moreover, this kind of rally is likely to be bolstered by optimistic views on market fundamentals that justify the low-rates regime (for example, the central bank will keep policy rates low further into the future, and the economy will become increasingly deflationary)." - source Nomura.

We agree with the above.

Nomura also made an important point in their note from the 2nd of October 2012 relating to the Taylor rule. A Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle):
"Undue reliance on policy duration may be risky
Considering that monetary policy measures are devised in response to changes in the macro backdrop, we should not ignore the impact that a low growth and inflation regime has had in shaping the government bond market and monetary policy, i.e., the concept of the Taylor rule. For that matter, we note that the Fed’s current forward guidance indicates that it will keep fed funds rates at ultra-low levels through “mid-2015,” but this is quite a bit later than the timing that would be deemed appropriate according to the Taylor rule*. Although the BOJ has set achieving 1.0% CPI inflation as its policy objective and thus has not specified the time until which it will keep the current policy in place, the market’s expected policy duration has been extended close to historical levels, after which sharp JGB sell-offs have followed – we doubt that such high expectations can be sustained as the economy begins to pick up." - source Nomura.

*Based on the current output gap and the Fed’s economic projections, the Taylor Rule would suggest that the Fed’s ZIRP should continue only until early 2014.

Some may put too much hopes that our "Buzz Lightyear" central bankers have designed an escape capsule from their "infinity...and beyond" policies.

We also agree with Nomura's chief economist Richard Koo in his most recent publication "Reconsidering quantitative easing" published on the 2nd of October, namely that one should not put too much hopes on the escape capsule:
"Perceived limits on fiscal policy increase pressure on monetary policy
In spite of these experiences, the baseless view that fiscal policy has reached its limits has come to dominate the debate in many countries, including Japan. That, in turn, has placed a great deal of pressure on central banks and led them to inject a sea of liquidity into the market when there is no reason why more liquidity should have any effect. 
This liquidity will create no problems as long as there is no private demand for loans, since the funds essentially sit in the financial system. 
The problems come when private demand for loans returns to normal levels and those funds resume circulating. 
Central banks must tighten aggressively when loan demand picks up 
As soon as private loan demand recovers the central bank will have to mop up the excess liquidity, which is currently running at two to three times the normal level. Otherwise prices could double or triple. 
But to do so the central bank must sell the bonds it bought, putting upward pressure on interest rates just when the private sector is ready to borrow money again. 
The Fed, for example, will have to sell $1.4trn in bonds when conditions in the private sector return to normal, at a time when the economy is recovering and businesses and households are becoming sensitive to interest rates. 
And if the market decides that the central bank is not mopping up excess liquidity fast enough, that alone could lift private inflation expectations and send bond yields sharply higher. In short, the central bank finds itself in a difficult position whether it sells the securities or not. Either way a major ordeal awaits both the central bank and the bond market. 
Once this point is reached, the central bank will probably attempt to reduce the “real value” of liquidity in the market by sharply raising the statutory reserve ratio for commercial banks, a tactic frequently employed by the People’s Bank of China. 
But all these measures will have significant negative implications for the economic recovery. While QE will do little damage at a time when private loan demand is weak or nonexistent, like today, it requires the central bank to engage in aggressive tightening just when the private sector is beginning to recover." - source Nomura - Richard Koo.

Provided our "Buzz Lightyear" central bankers decide to use the escape capsule from their stricken spaceship, Richard Koo's commented:
"The magnitude of the increase would depend on how much liquidity had to be absorbed, but a major increase is possible given that both the economy and private loan demand will be recovering. 

The liquidity supplied to the market should be manageable if the rebound in private loan demand is weak, as it has been in Japan since 2006. But there could be negative implications for the economic recovery—including a sharp rise in long-term rates—if the central bank is forced to mop up these funds by selling long-term bonds." - source Nomura.

But then again a future rebound in private loan demand is questionable.

A sharp rise in long-term bonds would have indeed devastating effect on a country such as the United Kingdom and it reminded us what we wrote back in our June 2011 conversation "The UK conundrum - Stagflation redux and other housing/banking issues": "Bank of England will have to stay accommodative for longer than expected, given two thirds of UK mortgages depend on short term rates. This means that the UK households will continue to be battered by a declining real income, meaning an absolute decline in the standard of living. At the same time UK banks are piling on Gilts like US banks are piling on US Treasuries, not lending, shrinking their balance sheet but earning a nice spread in the process by borrowing close to zero and locking the spread on Government bonds."

So billionaires seeking safe haven for their wealth by investing in a luxury London home should be well advised to reconsider given gold has indeed presented higher returns from fixtures and fittings in the last decade than the property itself according to Knight Frank, as reported by Bloomberg:

"A typical so-called super-prime property in London’s Kensington neighborhood would have cost 24,000 ounces of gold a decade ago, compared with about 9,800 ounces now, Knight Frank said today in a report. “To visualize this, 9,800 ounces would be a cube about the size of a small footstool, admittedly a heavy one,” the London-based real estate broker said. The CHART OF THE DAY shows how the value of super-prime homes doubled in the past 10 years and climbed 14 percent since their previous peak in March 2008. In comparison, gold prices have surged more than fivefold in the last decade. Knight Frank defines super-prime as homes valued at 10 million pounds ($16 million) or more in central London neighborhoods such as Knightsbridge, Kensington, Mayfair and Belgravia." 
- source Bloomberg

Yes, every asset class has a cycle, and until the escape capsule is triggered, we are unlikely to see an end to the trend in surging gold prices, although the scarcity of prime real estate for sale have enabled prices to held their value better. You have a similar scarcity case in Paris, for prime real estate.

Some additional important points made by Richard Koo in his recent are the following:
"More liquidity = greater economic instability once QE ends
Those making a case for inflation targeting or GDP targeting never say how much liquidity will be needed. All they say is that the supply of liquidity should be increased until the targets are reached. 
But the actual outcome would be very different depending on whether achieving the targets required a 20% increase in liquidity or a 200% increase. 
If only a 20% increase were needed, it might be possible to drain excess liquidity in the course of normal market operations once the targets were reached. But absorbing a 200% increase in liquidity would require massive bond-selling operations that could have a major negative impact on interest rates and the economy. 
That the BOE was unable to turn the UK economy around with a 300% increase in the supply of liquidity suggests at the very least that 300% would not be enough. 
Moreover, economic activity supported by such a reckless increase in liquidity is likely to be unstable and to become even more so once the central bank began mopping up excess liquidity. 

QE may have net negative economic impact when viewed across life of program 
It has been argued that during a balance sheet recession, when the private sector is rushing to minimize debt, liquidity supplied by the central bank does not stimulate the economy. Once the private sector completes its balance sheet adjustments and is ready to borrow again, draining liquidity will serve to lift interest rates and depress the economy. 
This means if we examine the impact of QE across the life of the program, the negative impact of mopping-up operations may actually outweigh the positive impact of the initial easing. 
During a balance sheet recession, after all, the absence of private loan demand dulls the economy’s sensitivity to interest rates, which means its response is likely to be muted regardless of whether the central bank engages in QE. 
When the economy starts to recover, however, private loan demand would have also picked up by then, increasing the economy’s interest rate sensitivity. A rise in rates then would have a major negative impact. 
Viewed overall, it may be better under some circumstances not to supply excess liquidity at all during a balance sheet recession. This is because without it, there is no need to drain liquidity once the economy pulls out of the recession. 
The debate up to now has ignored the fact that rates will rise when liquidity is drained from the system, with potentially adverse consequences for the economy. Proponents of further accommodation continue to urge the central banks to leave QE in place until deflation has been vanquished. But they might come to a very different conclusion if they also considered the impact of the exit from QE. 

Time to reconsider quantitative easing 
So far, no QE program has been successful, even if we consider only the initial impact and ignore the exit process. The Japanese, US, and UK economies all remain in the doldrums. It is hard not to question the overall effectiveness of QE when we consider the fact that aggressive tightening (i.e., a draining of excess liquidity) awaits once the private sector finally starts looking forward again. 
Recently QE has been welcomed in some quarters for its ability to boost share prices or devalue the local currency. But there are pitfalls here as well. 
Share prices, for example, must ultimately be justified by earnings. But while equity prices have been rising in the US, the economy remains sluggish and the outlook for corporate profits is not particularly bright." - source Nomura.

Yes, share prices must ultimately be justified by earnings, but also by "inflation expectations" so "mind the gap" between consumer discretionary stocks and consumer staples stocks:

"As the CHART OF THE DAY illustrates, the S&P 500’s consumer-related industry groups increasingly mirrored each other after the index peaked at a record five years ago today. They were the period’s best performers among the 10 broadest industry gauges in the S&P 500. Makers of food, beverages, household products and other consumer staples set the pace by rising 29 percent. Companies most dependent on consumers’ discretionary income -- retailers, media companies, homebuilders, automakers -- ranked second with a 25 percent gain. The chart also shows financial stocks, whose 55 percent decline was the steepest among the 10 groups. Consumer-discretionary stocks may falter as a falling dollar spurs inflation, Leger wrote in an Oct. 5 report. The Dollar Index, a gauge of the U.S. currency’s value against the currencies of six major trading partners, has dropped as much as 6.1 percent from this year’s high on July 24." - source Bloomberg

Following what we commented in our previous conversation "Zemblanity" on what our Buzz Lightyear central bankers might find out in targeting the unemployment level (given the relationship between M2-velocity and the US labor participation rate over the years) is that the jobless rate can be a misleading gauge of labor market health as indicated by Bloomberg:

"One reason the Federal Reserve may be unable to reach consensus on an unemployment target: the jobless rate can be a misleading gauge of labor market health. While unemployment has fallen to 8.1 percent from 10 percent in 2009, the CHART OF THE DAY shows the percentage of people working, known as the employment-population ratio, has remained near its lows of the recession, suggesting limited progress toward a recovery in jobs. “In a better economy we would see an improvement in this data,” said Adolfo Laurenti, deputy chief economist at Mesirow Financial Inc. in Chicago. While the ratio has fallen as the baby boomer generation retires and because more students are returning to school “the tougher nut to crack is those people who are truly discouraged workers, who could be in the job market but are leaving.” The employment-population ratio climbed to a record high 64.7 percent in April of 2000 before falling as low as 58.2 percent in December 2009, the lowest level since 1983. A lack of labor-market improvement, even with the drop in the unemployment rate, prompted the Fed to begin a third round of asset purchases, or QE3, in which it’s buying $40 billion a month of mortgage-backed securities. While Fed policy makers have proposed continuing the Fed’s accommodative policies until the unemployment rate hits a certain level, as long as inflation remains contained, they haven’t been able to reach consensus on a jobless target. “We want to see the unemployment rate come down, but that’s not the only indicator, obviously, of labor market conditions,” Fed Chairman Ben S. Bernanke said in a Sept. 13 press conference. “The unemployment rate came down last month because participation fell; that’s not necessarily a sign of improvement.”" - source Bloomberg.

Once again, there is what you see and what you don't see in true Bastiat fashion.

To infinity...and beyond...we think.

Meanwhile Employment opportunities remain elusive for some Americans meaning that the poverty rate could remain high particularly with the looming risk of the fiscal cliff:

"The CHART OF THE DAY shows that the percentage of Americans living below the poverty line was little changed last year at 15 percent, or 46.2 million people. The poverty line is defined by the U.S. Census Bureau as those living on less than $11,702 per year, or $23,021 for a family of four. Food-stamp use climbed to a record 46.7 million people in June, according to the Department of Agriculture." - source Bloomberg

Unless the housing rebound in the US is genuine, and the private wealth effect translates to the real economy, we cannot see the long term benefits but mostly greater risks in maintaining for too long the QE toy in place.

 "I cannot help it - in spite of myself, infinity torments me." - Alfred de Musset

 Stay tuned!