Macro and Credit - The Superposition principle

"The highest ecstasy is the attention at its fullest." - Simone Weil, French philosopher

Watching with interest the Wilson cycle playing in earnest on some various Emerging Markets, leading to additional significant fund outflows in the process, with effectively our previously discussed reverse osmosis theory playing out on some weaker EM players, when it came to selecting our title analogy, we reminded ourselves the "Superposition principle" from physics and systems theory. It states that, for all linear systems, the net response caused by two or more stimuli is the sum of the responses that would have been caused by each stimulus individually. So that if input A produces response X and input B produces response Y then input (A + B) produces response (X + Y). The homogeneity and additivity properties together are called the "Superposition principle". Also, wave interference is based on this principle.  When two or more waves traverse the same space, the net amplitude at each point is the sum of the amplitudes of the individual waves. In some cases, such as in noise-cancelling headphones, the summed variation has a smaller amplitude than the component variations; this is called destructive interference. In other cases, such as in Line Array, the summed variation will have a bigger amplitude than any of the components individually; this is called constructive interference, which one could imply it could be the situation for some specific Emerging Markets countries currently facing tremendous pressure from rising US interest rates and in conjunction with the recent surge of the US dollar but we ramble again...

In this week's conversation, we would like to continue to look at the outflows from some Emerging Markets and the consequences of the global tightening financial conditions we are seeing thanks to the Fed's rate hikes in conjunction with its Quantitative Tightening (QT) process.

Synopsis:

• Macro and Credit - Balance of Payments pressures in some EMs are building up
• Final charts - Flatter for longer 

• Macro and Credit - Balance of Payments pressures in some EMs are building up

In our previous conversation we touched on the fact that for some macro tourists which had extended their stay in the carry trade that, the tourist trap was closing. QT to some extent is leading to the weaker leveraged hands being blown apart it seems. After the explosion of the house of straw of the short-vol pigs, it seems to us that next on the line, given the intensity in fund outflows and pressure on some EM currencies will be some of the "usual suspects" such as Turkey, Argentina to name a few. The global tightening of financial conditions has indeed been induced by the Fed with its hiking process in conjunction with QT. In similar fashion to the "Superposition principle", this process seems to be homogeneous and additive. As the noose of financial conditions is slowly tightening, the pressure is showing up in earnest in the weaker part of the "global capital structure", namely some leveraged EM countries. For some indeed, there is some risk of balance of payments crisis à la 1998 it seems as pointed out by Nomura in their Emerging Market Insights note from the 11th of May entitled "Looming balance of payment risks in EM":

"The pressure is building for several central banks to hike rates sooner than we thought

On 9 May, Argentina requested financing from the IMF to avoid a crisis. This came after the central bank hiked policy rates to 40% in response to the Peso’s sharp depreciation. From Turkey to Indonesia, the one-two punch of rising US rates and USD appreciation is leading to a rising market risk premium in EM countries whose the balance of payments (BOP) is vulnerable. EM central banks are responding by allowing some exchange rate flexibility (i.e., depreciation) and some FX intervention, but if BOP pressures intensify, policy rate hikes may be needed. Our country economists have considered the likelihood of earlier and/or larger rate hikes this year relative to their base cases if BOP pressures continue to build, and the central banks that stand out are Romania (+25bp), India (+50bp), Indonesia (+50bp), Chile (+75bp) and most notably, Turkey (+300bp).

Balance of payments vulnerability

The trio of higher US bond yields, USD appreciation and rising oil prices has led to some market repricing of balance of payment (BOP) risk – e.g., large current account deficit, high short-term external debt, limited buffer of FX reserves – resulting in capital outflow pressure. A scatter plot of current accounts against local currency moves against USD since the start of the year highlights that, with the exception of Russia, EMs with large current account deficits have generally experienced large currency depreciations (Figure 1).

The amount of local government debt owned by foreign investors and the share of corporate debt denominated in foreign currencies are also under close scrutiny (Figure 2).

Our house view is that the weak economic data outside the US represents a temporary soft patch and that market concerns over global growth desynchronising (rising in the US, but falling elsewhere) will soon fade, which should help temper USD appreciation (see Asia Economic Monthly, One step at a time, 11 May 2018).

However, even if we are right that global growth is holding up, this is likely to be only a brief respite for EM. In our mind, Q3 2018 is the high-risk quarter for a painful EM snapback, as this is the quarter in which markets will likely focus not just on the US but a global QE unwind, which could lead to a larger repricing of EM risk premia and the evaporation of market liquidity. Moreover, George Goncalves, our US rate strategist, is warning that, as US inflation rises, UST debt supply balloons and the Fed keeps hiking, there is an upside risk of a bearish overshoot relative to his base case of UST 10s hitting 3.25% in Q3 (see Global macro trade ideas in summer 2018, 2 May 2018).

The US decision to exit the Iran nuclear deal and reinstate sanctions (see US to withdraw from Iran Nuclear Agreement, 8 May 2018) has increased the risks of instability in the Middle East and further oil prices increases (Figure 3).

This could further widen the twin current account and fiscal deficits of large net energy importers – Turkey, India and the Philippines (see Higher oil prices drive EM divergence, 25 April 2018). Q3 will also be around the time that President Trump is likely to double-down on America First policies, such as trade protectionism, ahead of November mid-term elections.

Overall, while there may be a brief, near-term respite, there is a risk that BOP pressures in EM continue to build and possibly intensify in coming quarters. We updated our BOP risks scorecard of 20 EM economies that we introduced in our anchor report (see In an EM snapback, where do the risks lie?, 23 March 2018). Of the 20 EMs, the most exposed to BOP risks are Hong Kong, Romania, Hungary, Turkey and Chile, and for varying reasons (Figures 4 and 5).

For example, Hong Kong’s exposure is due to its massive cumulative capital inflows since 2010 and low interest rate compensation for BOP risk; in Romania and Turkey, it is because of their large current account deficits and low FX reserves; in Hungary it is due to high external debt and relatively low FX reserves. The least-exposed countries to BOP risk are Singapore and Taiwan, according to our scorecard.

We acknowledge that there are a host of country-specific factors (beyond variables that we use for scorecard; current account, FX reserves, external debt, cumulative portfolio flows, real interest rates and interest rate differential) that can also impact EM, most notably geopolitics and domestic politics. For example, the Russian Ruble (RUB) and Brazilian Real (BRL) depreciated against USD by 8.8% ytd and 7.9%, respectively, despite showing lower BOP risks in the scorecard.

Policy response to balance of payment pressures

Those EM central banks facing BOP pressures are mostly responding to in an eclectic manner (see First Insights - Turkey: Core problem, 3 May and Asia Insights - IDR: Challenging flow backdrop amid global risks, 9 May). They are allowing for some exchange rate flexibility (i.e., depreciation) and some FX intervention (drawing down FX reserves), but if BOP pressures intensify, these initial policy responses may become constrained. For example, the larger the currency depreciation the greater the risk of an inflation overshoot and a foreign currency debt mismatch problem or, if FX reserves are drawn down too far, the market may lose confidence in the ability of authorities to defend the exchange rate.

If BOP pressures mount, policymakers could shift to more draconian responses, such as interest rate hikes, tapping central bank FX swap lines, borrowing from the IMF (or in Asia, utilising the Chiang Mai pooled FX reserve initiative), tightening fiscal policy or, in the extreme case, imposing capital controls.

Our country economists have focused on the possible interest rate response. They have considered, on the assumption that BOP pressures continue to build (and oil prices stay at these levels or go higher), the likelihood of earlier and/or larger policy rate hikes over the rest of this year relative to their current base cases (Figure 6).

This “what if” exercise highlights that, if BOP pressures continue to build, there is a 50% or higher likelihood that we will need to build more rate hikes into our base case forecasts for  Romania (+25bp), India (+50bp), Indonesia (+50bp), Chile (+75bp) and most notably, Turkey (+300bp). The likelihood is lower, but if we added rate hikes in Brazil and Chile, it would be several, not one and done. Also, instead of our current base case forecasts of rate cuts by year-end, if BOP pressures continue to build, it could be that we have rates on hold (Colombia, Mexico and South Africa)." - source Nomura

We agree with Nomura that the trio of higher US bond yields, USD appreciation and rising oil prices has led to some market repricing of balance of payment resulting in capital outflow pressure (what we called in our last musing as a reminder "reverse osmosis"). "Reverse osmosis" as well as QT make more and more the front-end of the US risk curve appealing from a risk management perspective and ensures as well US dollar cash is back in the allocation tool box. Furthermore, as Renaissance Macro pointed out on their Twitter feed, when it comes to the 2013 Taper Tantrum comparison, this time it's different when it comes to current account deficits:

"A more hawkish Fed is a risk for emerging markets, but for most EM economies, current account positions have improved relative to the 2013 taper tantrum year, Argentina being a notable exception." - source Renaissance Macro

Argentina of course continues to be in the line of fire with FX reserves being burn rapidly to support currency woes. It is always the leverage players who blow up first when financial conditions are gradually tightening with Fed's hikes and QT. No surprise as well to see Turkey in the crosshair facing the Superposition principle. This is clearly highlighted by David Goldman again in Asia Times in his comment from the 11th of May entitled "Buy ruble, sell Turkish lira":

"After two sets of emergency conferences with economic leaders and Turkey’s ebullient president, the Turkish lira dropped from a peak of 4.38 to the dollar to 4.23 this morning, before weakening back to 4.25. Turkey’s economic problems remain insoluble: The Turkish economy is a credit-fueled bubble with a growing current account deficit and dangerous dependency on short-term capital inflows and interbank borrowings.

As Swaha Pattanik wrote this morning at Reuters, “Turkey’s president is pursuing contradictory goals. Tayyip Erdogan wants to support the sagging lira. That would require measures to curb inflation and the current account deficit. However, his efforts to pump prime growth, especially before June elections, will achieve the exact opposite.”

The ruble is a different story. The political threat of sanctions against Russia caused the currency to collapse from a low of 57 to the dollar on April 1 to a high of 64 to the dollar on May 2. Since then it has rallied a bit, trading at 61.7 at noon EST on May 10. The ruble is a pretty good proxy for the price of oil (the r-squared of regression of the ruble on the oil price since 2010 is around 93%).

As the chart above shows, regression analysis of the ruble vs oil puts the Russian currency three standard errors away from the regression line. The currency’s fair value vs oil is around 50. Sanctions against Russia are not likely to continue (Washington wants Russia’s cooperation in keeping the Iranian genie in the bottle). They will be flouted in any event by the Europeans, whose trade with Russia is a multiple of Russian-US trade. The market vastly overreacted to US sanctions, and the ruble’s cheapness continues to represent a buying opportunity." - source Asia Times - David Goldman

Not only is the Russian currency attractive, but we would contend that local currency bonds also are enticing from a yield perspective, so what's not to like about them? And if you believe in a commodity "rebound" thanks to rising inflation expectations why not buying what is cheap in terms of PE? Russian equities are relatively cheap and offer decent dividend yields as well we think.

What we think we are seeing in Emerging Markets is similar to what we are seeing in High Yield, namely a rise in "dispersion", which means in effect some investors are becoming more discerning when it comes to reassessing "credit risk" and issuer profiles on the back of a weaker "global market put" provided by central bankers. This rise in dispersion means that everything is not rising anymore in synchronized fashion thanks to massive liquidity injections given now it is being gradually withdrawn. As we pointed out recently in various musings, this could mean that some active players could potentially start outperforming again passive strategies. This also mark we think the return of the global macro game thanks to volatility being less repressed by the central bankers/planners as of late. 

From a fund outflows and risk perspective, for a continuation of pressure on the weaker links in the EM segment, the direction of yields and the US dollar matters for the pressure to continue or subside somewhat as far as the Superposition principle is concerned. On that subject we read with interest Deutsche Bank's take from their 9th of May note entitled "EM Flows and Risk Sentiment: Outflows, but size still contained":

"The EM Flow Indicator (chart below) shows that outflows are emerging – the last two weekly prints have been negative (indicating outflows from EM).

The last time there were two consecutive weekly outflow prints was in Dec 2016, thus this is a significant development. However, the size of outflows remains relatively contained, with the magnitude of the flow indicator nowhere near as stretched as in late 2016. Therefore, it is likely that the recent sharp EM FX depreciation has been driven more by FX hedging of EM assets held by foreign investors, rather than the outright selling of these assets (which would have triggered larger outflows). This remains the main risk for EM – the potential transition from FX hedging to outright outflows – but would require continued significant dollar strength and rising US yields. Over the coming weeks, the EM flow data will take on even greater importance, as it could provide a signal on whether we transition from phase 1 of the EM FX sell-off (FX hedging) to phase 2 (outright asset sales).

[Note that the indicator captures flows normalized by the standard deviation, with values greater than +0.5 indicating sizable inflows and values less than -0.5 indicating sizable outflows.]

The EM Risk Monitor – an EM-specific measure of risk sentiment – has entered risk negative territory, but is by no means stretched. This indicates that if external conditions remain unfavourable (e.g. continued broad dollar strength) there is potential for more negativity in EM sentiment.

The additional charts below show that both debt and equity flows have dipped into negative territory; but the magnitude of outflows remains relatively contained. Meanwhile, the charts displaying the raw flow data by source show outflows on IIF (local source) data, but flat flows on EPFR (ETF + mutual funds) data.

- source Deutsche Bank

Of course as the Superposition principle goes, it is contained when it comes to outflows until it isn't . Continued capital outflows pressure could lead to more pronounced "derisking". We highlighted in our last musing how hedge funds had already cut on their beta exposure in EMs. It remains to be seen with continued pressure on yields and in particular the US front-end how long this stability will last. 

This is Barclays take on the recent bout of EM volatility from their The Emerging Markets Weekly note from the 10th of May entitled "After the volatility eruption":

"Pressures on EM assets have accelerated over the past week. And although improved market sentiment fueled a relief rally on Thursday, concerns of a negative performance - outflow loop, which we discussed in the EM weekly: No spring in EM’s step last week appear to remain very much alive. While the market has focused on countries with external vulnerabilities and financing needs, especially Argentina and Turkey, market volatility has significantly broadened in scope over the past few weeks. This has evoked memories of the 2013 taper tantrum, as investor concerns have been centred on higher UST yields and tighter USD funding conditions, coupled with a painful parallel strengthening of the USD.

More granularly, we see four issues as having driven the weaker risk appetite in EM asset markets: (1) signs of softening activity relative to expectations; (2) increased risks of supply side shocks (eg. oil/Iran and trade protectionism); (3) the cascading sharp selloffs in some heavily-owned EM asset markets likely causing some investors to breach their risk limits; and (4) the correlation between EM credit spreads and US rates having turned positive (ie. higher UST yields being aligned with wider spreads) – a pattern usually only observed in periods of sharp UST adjustments. The last point, especially, illustrates the resemblances of the current sell-off with the taper tantrum.

However, we also think that there are important differences to 2013. Although it is difficult to see where the upside surprises in activity or a reduction in supply side shock risks will come from in the near term, we think EM fundamentals provide some buffers against a period of flow retrenchment. EM growth is stronger now than in 2013 and current account deficits in most market-relevant EM countries are smaller than they were in 2013 – with some notable exceptions (Figure 1).

And while EM debt levels are generally higher (Figure 2), EM countries have used the favourable issuance environment over the past few years to lengthen maturity profiles.

For example, the share of newly issued EM sovereign and corporate eurobonds with a tenor of 15 years or longer has increased significantly over the past few years (Figure 3), while near-term maturities have in many cases been addressed pro-actively via early buybacks/tenders.

We think that these buffers make it possible that, eventually, the negative cycle can be broken. In EM credit, flows should be supported by a pick-up in redemptions in June/July and the self-regulatory effect of supply, which we would have expected to slow down in any case after the record pace in Q1 18. Moreover, the recent underperformance of EM versus rating-and-maturity matched DM credit (see the Global EM Credit Monitor, 8 May 2018) has reversed the relative richening of EM in the early weeks of 2018 (Figure 5).

While EM is still not cheap relative to DM based on historical ranges, this should provide an eventual anchor for crossover sponsorship.

More generally, cheapening in the EM asset class may help normalize spread-rates correlations, when portfolios have fully adjusted to the higher levels of market volatility. This would support a technical retracement of EMs, absent additional idiosyncratic risks developing in key markets. We note that alongside the modest cheapening in EM credit, local rates have cheapened as well (Figure 6) but spreads vs. UST (on an FX hedged basis) remain shy of the midpoint of historical averages.

This is because much of the selloff in EM local rates has been driven by a weaker FX (Figure 7), which is now approaching lows after  stripping out their relation with broader asset market variables (Figure 8).

Therefore, we see greater opportunities to express near-term constructive views on EM FX than local rates if position reduction and the USD rally take a breather. We hit our stop loss in our long HGB October 2027 and long SAGB February 2048 positions but FX-hedging in the case of the former was able to more than offset for the loss on the local bond position. We do think there is scope for a near-term EM FX retracement and see value in short USDZAR through options.

However, a more lasting recovery may require increased investor confidence in a pick-up in EM fundamentals, a dovish shift by core market central banks (or a shift in investor perceptions of the likely path of core rates) and/or a reduction in global risks. The decision of the US to withdraw from the Iran nuclear deal does not suggest that a reduction in global geopolitical risks is imminent. President Trump was widely expected to withdraw from the Iranian nuclear deal but his announcement was one of the most hawkish options we previously discussed (Iran Special Report: Trump and the Art of (Breaking the Iran) Deal, 8 May 2018). Leaving the JCPOA may not only ultimately increase transatlantic tensions as many European companies have signed contracts to increase investments in Iran, but geopolitical risks in the Middle East will equally be on the rise. The recent escalation between Israel and Iran in Syria is perhaps the most concerning near-term risk which may be exacerbated by tensions with Saudi Arabia and the Yemeni conflict.

At a country-specific level, the market’s focus has been on Argentina and Turkey, as well as elections in Asia and the ongoing NAFTA negotiations involving Mexico.

The dramatic change in sentiment in Argentina has exposed its vulnerabilities given its large financing needs and twin deficits. In an effort to prevent a sharper weakening of the exchange rate, the central bank hiked the policy rate in three out-of-cycle decisions by a total of 1275bp, taking it to 40%, alongside other measures including interventions in FX markets. A stabilization of the exchange rate remains vital to the macroeconomic outlook with a high level of pass through into inflation. The government has sought to reassure markets by also announcing a more ambitious primary fiscal target for 2018 of 2.7% of GDP (down from 3.2% of GDP), which we think can be met, and which will also make the 2019 target of 2.2% of GDP attainable. Finally, as the ARS continued to selloff this week, the government announced its intention to enter into negotiations with the IMF for a high-access stand-by agreement. The program is meant to be precautionary but is planned to secure Argentina’s 2019 financing needs. It remains to be seen how stringent the conditionalities imposed by the IMF program will be but it remains crucial to assess the impact on the short-term macroeconomic outlook, as well as its longer-term political costs for the Macri government. With regards to the latter, the government has sought to allay concerns by expecting fiscal targets to be similar to the current official ones.

We think that geopolitical risks expose Turkey’s external vulnerabilities against a backdrop of rising USD funding costs and increasing concerns about EM capital inflows’ outlook (25% of Turkish banks’ liabilities are foreign and gross external financing needs are c.20% GDP). This, accompanied by the market's perception of the CBT being behind the curve amid a deteriorating inflation narrative and de-anchored medium-term inflation expectations, has amplified the pressures on Turkish assets. Nevertheless, as discussed in Turkey MPC Preview: Early elections strengthen the case for a hike, 18 April 2018, the early elections also increased the desire of politicians for a stable TRY, as indicated in Wednesday’s economic coordination council (ECC) meeting chaired by President Erdogan and the statement that followed. The CBT could come under pressure again going into the 7 June MPC meeting and any decisive action could provide a temporary backstop for Turkey assets." - source Barclays

For now the markets is playing the dispersion game even in US high yield. The CCC energy bucket in US high yield is of course benefiting from rising oil prices leading to a significant recent rally in the high beta space. But, as the Superposition principle goes no offense to the "contained crowd", problems can be additive it seems given flows follow performance usually for some "usual suspects" in the EM world...

When it comes to investor becoming more discerning risk wise hence the rise in dispersion, this is most likely due to the gradual fading of the powerful anesthetic provided by central banks and more importantly the Fed during so many years. While we keep indicating that we are moving in the final innings of this long credit cycle, though we do see cracks showing up in the goldilocks narrative which has prevailed for so long, we still haven't reached the end of the game and still remain short term "Keynesian" for various technical reasons such as prolonged buybacks activity, US tax reform and record earnings and strong M&A activity to name a few. The perma bear crowd will eventually get their day, but we still haven't gotten to that point yet we think. In our final point below we touch on the pace of the flattening of the US yield curve, being an important topic in these days and ages.

• Final charts - Flatter for longer 

Given the gradual hiking pace followed by the Fed, on the back of still loose financial conditions has indicated by the most recent Fed quarterly Senior Loan Officer Opinion Survey, this is not playing out like the previous rapid hiking pace of the Fed of the 2004 period. Therefore, the flattening process will take a little bit longer to play out before we see the dreaded inversion so many financial pundits are talking about. Our final charts comes from Bank of America Merrill Lynch Securitized Products Strategy weekly note from the 11th of May and indicates that the inversion of the curve necessary to display a recession signal may take indeed a while to manifest itself:

"The ongoing flattening of the yield curve to post-crisis lows – the 2yr-10yr spread hit 43 bps this week – continues to elevate concerns among some that recession is on the verge of being signaled. For example, (dovish) St. Louis Fed President Bullard said “yield curve inversion is getting close to crunch time” and that “yield curve inversion would be a bearish signal for the US economy if that develops.” From our perspective, the key part of that quote is “if that develops:” 43bps may be closer to curve inversion than before, but it is still not inverted.

As Chart 1 shows, yield curve inversion has been relatively rare over the past 30 years, occurring briefly in 1989, 2000, and 2006, about 12-18 months in advance of the recessions of July 1990-March 1991, March 2001-November 2001, and December 2007-June 2009. We find the 1995-2000 timeframe in Chart 1 especially noteworthy.

The average 2yr-10yr spread over the 5-year period was 35 bps, flatter than today’s level of 43 bps, yet it was only when the curve finally inverted in early 2000 that the 2001 recession was ultimately signaled. The point here is that the curve may have flattened substantially, but, by the standards of the late 1990s, it’s nowhere near the level that it is signaling recession.

Another way of saying this is: “it may be late cycle, but it’s not end of cycle.” We think this distinction is important when it comes to recognizing that securitized products spreads may have at least a couple more years of tightening ahead of them, in a grind lower; in our view, meaningful spread widening is not expected until the cycle comes to an end. We don’t expect this to happen until at least 2020-2021. We are waiting for curve inversion as the first signal that the cycle will be ending. The lesson of the late 1990s is that inversion could take much longer to experience than some or many might expect.

Next, we consider interest rate volatility, as measured by the MOVE index in Chart 2.

Most of the spike in late January/early February has been retraced and volatility is back near the all-time lows seen in late 2017. Given the flattening move in the yield curve, we suspect that new lows in the MOVE index will be seen in the near term.

As seen in Chart 3, in the past two late cycle curve flattening environments (1990s, 2000s), interest rate volatility generally grinded lower as the yield curve flattened/inverted and only increased when the curve began to steepen. In the 2005- 2007 period, for example, as the curve flattened and then inverted, rate volatility moved steadily lower.

For example, the MOVE index went from 75 in May 2005 (about the time the 2yr-10yr spread was near today’s level of 43 bps) to a low of 59 bps in May 2007, when the yield curve had flattened to -3bps. (In the subsequent seven months, as the 2yr-10yr spread went from -3 bps to 120 bps, volatility more than doubled, with the MOVE index jumping to 145 by December 2007.)

We’re looking for similar late cycle behavior this time around. Following the yield curve flattening lead, the MOVE index appears poised to head to new post-crisis lows over the near term." - source Bank of America Merrill Lynch

One caveat is that the Superposition principle when it comes to Argentina has shown sentiment can indeed turn on a dime, or simply a rising US dollar. When it comes to credit markets and high beta, for "goldilocks" to return in the short term, lower rate volatility does indeed help out carry players and yield hogs alike. Yet, one would be wise to start using even at least partially the new tool in the tool box, namely cash in US dollar thanks to the front-end of the US yield curve. It has become more and more enticing relative to dividend yields as of late but we ramble again...

"Attachment is the great fabricator of illusions; reality can be attained only by someone who is detached." -  Simone Weil

Stay tuned!

Macro and Credit - Gullibility

"Mystical references to society and its programs to help may warm the hearts of the gullible but what it really means is putting more power in the hands of bureaucrats." -  Thomas Sowell

Watching with interest the 10th day of record highs for the Dow Jones and the on-going rally in other asset classes and in continuation to our previous theme of "Barnum statements" and "Woozle effects", we decided to pursue on the path of "tricks of the mind" in our title analogy by selecting "Gullibility".

"Gullibility" is a failure of social intelligence in the sense that a person or an investor gets tricked or manipulated (by central bankers) into ill-advised course of action (insatiable yield chasing). While it is closely related to credulity, many investors in the past have been vulnerable to this form of exploitation. If you would like to make a small experience on the subject you could try this popular test of "gullibility" by telling one of your friends that the word gullible isn't in "the" dictionary (earliest dictionaries did not by the way). If your friend is a gullible person he might respond "really?" and he will go and look it up. 

Some writers on gullibility have focused on the relationship between the negative trait of gullibility and positive trait of trust. The two are related, as gullibility involves an act of "trust", same goes with central banking (remember: "believe me it will be enough"). On this subject we find it amusing that a certain Stephen Greenspan (not Alan) in 2009, in his book "Annals of gullibility: why we get duped and how to avoid it" presented dozen of examples of gullibility in literature and history to name a few: The Adventures of Pinocchio, Little Red Riding Hood, The Emperor's New Clothes, The Adventures of Tom Sawyer, Romeo and Juliet, Macbeth, Othello and even in the classic The Art of War, The Prince or The Trojan Horse story. Greenspan argues that a related process of self-deception and groupthink factored into the planning of the Vietnam War and the Second Iraq War in his book. In science and academia, gullibility has been exposed in the Sokal Hoax which we referenced to in a previous post of ours "The Sokal affair" describing the acceptance of early claims of cold fusion by the media. 

In society, tulip mania and other investment bubbles (Bitcoin comes to mind) involve gullibility driven by greed, while the spread of rumors involves a gullible eagerness to believe (and retell) the worst of other people. You might be wondering where we are going with this but hearing the other Greenspan recently, Alan that is, making yet another claim that there is a bond bubble in the making, although he has done so in recent years made, it interesting to say the least.  Two years ago, when the 10-year US yield was 2.44% the other Greenspan told Bloomberg TV that "we have a pending bond market bubble." In a Bloomberg TV interview in July 2016, he again expressed concerns about stagflation and said "we're seeing the very early signs of inflation beginning to tick up." He also told us at the time with 10-year Treasury yield at 1.50% thanks to Brexit concerns, that he was "nervous" bond prices were too high. In terms of "gullibility", this is the same Greenspan that told us that no one saw the previous crisis coming. Is third time a charm for the "Maestro"? We wonder. Stephen, the other Greenspan, in 2009 wrote that exploiters of the gullible "are people who understand the reluctance of others to appear untrusting and are willing to take advantage of that reluctance." In 1980, Julian Rotter wrote that the two are not equivalent: rather, gullibility is a foolish application of trust despite warning signs that another is untrustworthy. When we see European Junk Bond yields falling to another record low of 2.33% and closing on 10-Year US Treasury Yields at 2.26%, we think that "gullibility" applies for European high yield investors as a foolish application of trust despite warning signs that our central bankers are untrustworthy hence our chosen title. To check your investor gullibility factor you could simply ask yourselves if you would rather hold US Treasuries for the next 3 years or European High Yield but we ramble again...

In this week's conversation, we would like to look again at the potential risk for a convexity event we discussed previously in our conversation "Bond ruck" from a NAIRU ((non-accelerating inflation rate of unemployment) perspective. 

Synopsis:

• Macro and Credit - Convexity - A NAIRU headache?
• Final charts - The barrel in the credit revolver is getting empty

• Macro and Credit - Convexity - A NAIRU headache?

Traditional measures of monetary policy such as the Taylor Rule that are based on growth and inflation and a nonaccelerating inflation rate of unemployment, or NAIRU, of 5 percent. NAIRU is the lowest unemployment rate an economy can sustain without spurring inflation according to the definition. The name "NAIRU" arises because with actual unemployment below it, inflation is expected to accelerate, while with unemployment above it, inflation decelerates. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve, hence the concerns of the "Maestro" and his bond bubble fears. The "NAIRU" analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed. As we posited in our June 2013 conversation "Lucas critique":

"As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion." - source Macronomics, June 2013

Also as we pointed out in our July conversation "The Rebound effect" in our final chart relating to the death of the Phillips curve, the framework is still adhered to by the Fed, meaning that they should be very slow in removing the credit punchbowl. We also pointed out that subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. The Fed's models are built on past relationships. Yet, what seems of key importance to us is that many believe the NAIRU unemployment rate to be around 4.5%, while inflation and wage pressures remain muted because as we pointed out in recent conversation demographics mismatch in the labor market is affecting wage growth. 

You might already being asking yourselves what it has to do with convexity and bond bubble fears for the "Maestro"? It all has to do with "gullibility". On the subject of the non linearity of the Fed's hiking path and therefore convexity risk, we read with interest Bank of America Merrill Lynch's take in their Liquid Insight note from the 4th of August entitled "Who doesn't love 90s rerurns?":

"Key takeaways

• The Fed is facing a similar situation to the 1990s; the unemployment rate is uncomfortably low, but so is core inflation.
• In the '90s, there were data head-fakes and confusion in the Fed's reaction function, resulting in a "fits and starts" cycle.
• This sounds familiar. We think we should prepare for the possibility of further pauses in the hiking cycle, akin to the '90s.

A not-so-distant memory

Nostalgia for the 1990s is tangible: the economy was in a prolonged expansion, the budget deficit was turned into a surplus and, importantly, the quality of television improved with Seinfeld, The Simpsons and Friends. We are now facing a feeble recovery from the Great Recession, a swelling budget deficit and reality television. Don’t fret; there are some things in common. The Phillips Curve faced similar challenges in the late 1990s as it does today (Table 1). Today’s Fed should keep in mind the lessons of the 1990s:

1. Relying on the Phillips Curve relationship can prove dangerous
2. It is essential to maintain credibility as a defender of price stability
3. Hiking cycles can have fits and starts

We think the 1990s episode puts the spotlight on a risk to our forecast. Although we have been arguing that the risks are skewed toward a slower cycle, our baseline expectation is still for the Fed to follow their dots (a hike in December and three more hikes next year). Given the lessons learned from the experience of the 1990s, we should prepare for the potential of a pause in the tightening cycle early next year.

Measured pace is the exception, not the rule

Many investors tend to look back at the 2004-6 “measured pace” episode as the norm for Fed tightening cycles. In reality, the 1990s offers a much better comparison. In the 1990s, there were many head-fakes in the data and changes in the Fed's reaction function, which led to a “fits and starts” hiking cycle. As Chart 1 shows, the Fed delayed hiking rates until three years into the recovery; did a relatively normal tightening cycle, but then did two mini-cycles of cuts followed by another hiking cycle.

On paper, this seems like a Federal Reserve that was quite confused. Why start the hiking cycle in 1994 with inflation still low? Why the abrupt reversal and then the delayed resumption of hikes? It helps to think about Fed hikes back then as a complicated interactive process rather than a pre-ordained plan.

Stage 1 (1994-1995): preemptive tightening of monetary policy against the "inflation scare" in bond markets. The unemployment rate at the onset of the hiking cycle was only 6.5% while wage and price inflation was subdued. But the 30-year Treasury rate soared to 8.1% in November 1994 from 5.9% in October 1993. Fed officials became concerned about losing their inflation-fighting credibility. In the February 1994 minutes, Fed officials noted that “a relatively small move would readily accomplish the purposes of signaling the Committee’s anti-inflation resolve” and in the March 1994 minutes argued that “a stronger policy action …would serve to underscore the Committee’s commitment to its price stability.”

Even within this apparent steady tightening cycle there were plenty of head-fakes. Three times the Fed signaled that it might be done and skipped a meeting. Each time they came back with a “catch up” hike of 50bp, 50bp and 75bp, respectively. This stopand- start occurred for two reasons. First, they expected hikes to slow the economy, but the labor market continued to motor ahead. Second, most Fed officials came into the period thinking NAIRU was around 6.5% but as inflation failed to respond, they revised their estimates lower.

Stage 2: Recalibrating an overshoot: By July 1995, the Fed seemed to regret those hikes, noting in the minutes that “some modest easing was desirable now that the growth of the economy had slowed considerably more than anticipated and potential inflationary pressures seemed to be in the process of receding.” This led to 75bp of cuts over the next several months.

Stage 3: Watchful waiting: The Fed went on hold for roughly two years. While dissents were minimal (because of Greenspan’s domination of the Committee at that time), there was growing pressure from the Committee to resume hiking. Skimming through the transcripts, we find that Janet Yellen was one of the voices advocating for the Fed to hike rates. Her arguments echo those that she is making today.

In the September 1996 transcripts Yellen gave two arguments for hiking:
"First, an unemployment rate of 5.1% lies near the lower end of almost anyone's estimated NAIRU range. Second, whatever the NAIRU, the unemployment rate does have predictive power for changes in the inflation rate...for that reason, I would conclude that the risk of inflation has definitely risen, and I would characterize the economy as operating in an inflationary danger zone."

"My concern is that a failure to shift policy just modestly in response to shifting inflationary risks could undermine the assumptions on which markets' own stabilizing responses are based."

Stage 4: Crisis mode: The FOMC did eventually hike by 25bp in March 1997, but it proved to be a one-off as the economy faced a variety of exogenous shocks thereafter, including the Asian currency crisis in 1997, the Russian default and failure of LTCM. Through it all, the unemployment rate continued to glide lower, but yet the "inflationary danger zone" proved benign. As such, if the Fed actually engaged in a hiking cycle, the economy might have suffered, as would have the Fed's credibility. It turned out that Greenspan was right to hold off as he correctly saw that stronger economic growth was generated by strong productivity gains, which were disinflationary.

Stage 5: The real deal: Heading into 1999, the Fed was facing a tight labor market with the unemployment rate hovering just above 4%, wage growth of about 3%, but core PCE growth of only 1.4%. Asset prices were elevated with signs of "irrational exuberance" in the markets: by the time the Fed hiked, the cyclically adjusted P/E had climbed to historical highs. This sounds quite familiar to the situation we are in today with a tight labor market, but muted price pressures with the exception of assets.

A big theme then and now: shifting views of the Phillips curve

Janet Yellen was not the only one who believed that inflation would accelerate as the unemployment rate fell further. In fact, it was very much the consensus view. According to the Blue Chip consensus survey, economists in 1996 were looking for CPI inflation of 3.0% for 1998 while it ended up coming in at 1.6%. Core CPI similarly came in below 3%, averaging 2.3% for the year. Economists reacted to the data and within a year were bringing forecasts lower, coming in close for 1999 (Chart 2).

The challenge is that models are imperfect. If you were sitting in September 1996 with an unemployment rate just above 5%, a standard Phillips Curve would estimate 3.5% for core CPI over the next 12 months, which was about 1.3pp too high relative to the actual data. At the time, the weakness in inflation was explained by external factors such as globalization and technological improvements that could not be captured properly by the Phillips Curve. There was quite a lot of awareness at the time that the Phillips Curve was failing. In September 1999, John Williams and others at the Board authored a piece called “What’s Happened to the Phillips Curve,” which looks at various specifications of the Phillips Curve to attempt to improve the fit in the 1990s.

Finding the right re-runs

It is important to focus on the experience of the 1990s, rather than the 2000s, when considering risks to monetary policy. Fed officials struggled with the same questions two decades ago as they are today. How tight is policy? Does the Phillips Curve work? Have we maintained credibility as defenders of price stability? How should we handicap market risks?

The result in the 1990s was a hiking cycle that was not linear. It may end up being the same story today. The Fed had a 12-month pause between the first and second hikes before slowly delivering another 75bp of hikes. We could be reaching a crossroads once again as wage and price inflation remain subdued. After another hike, the Fed will be a hair away from neutral (Chart 3), which means the next hike would no longer be considered a removal of accommodation, but rather a true tightening of policy. 

We think a considerable risk to our forecast is that the Fed pauses the hiking cycle early next year, slowing the pace of rate hikes." - source Bank of America Merrill Lynch

The consensus view it seems is that inflation will accelerate as the unemployment rate falls further, in similar fashion to the 90s. We discussed convexity in our conversation "Bond ruck" recently, given that as well, some have been arguing that in a rising rates environment you would be better off with RMBS thanks to negative convexity features. We indicated there was a catch because of the significant need in "delta hedging". Maybe the Maestro's fear comes from the potential for a "Convexity event" fueled by MBS hedging, particularly in the light of the balance sheet exercise soon to be taken by the Fed. As we pointed out in the final point of this particular conversation, the unemployment rate is currently far below NAIRU. The risk again, is therefore a policy mistake in similar fashion to what was avoided by the Maestro in 1997, but, eventually burst the bubble in stage 5 as pointed in Bank of America Merrill Lynch above. If indeed Janet Yellen still believes in an acceleration of inflation as per the September 1996 transcripts, there is indeed a cause for concern from a "convexity perspective". Yet, when it comes to central banks' "Barnum statements" we are not rest assured that "gullible" and like any good behavioral psychologist we tend to focus on the process rather than on the content of their narrative.

What we think is very similar to the 90s so far is indeed the non linear hiking path chosen by the Fed. On that note we agree with HSBC's Steven Major take on disinflation sinking further Treasury Yields as reported by Bloomberg in their article from the 7th of August entitled "HSBC's Steven Major Sounds a Bearish Alarm on European Credit":

"Major, HSBC Holdings Plc’s head of fixed-income research, is a key proponent of the view that global interest rates can stay low for longer, he says investors aren’t being paid for the risks they are taking in corporate debt markets in the euro area, with yields a whisker away from post-crisis lows.

"Low volatility across asset classes may give a false sense of security and bond markets may be caught napping," HSBC strategists led by Major wrote in a note published Monday. "The risk is that with increasingly interconnected capital markets, driven by years of international spillover from quantitative easing, local triggers can have a more global impact than before.

Major’s bearish case: The European Central Bank’s asset-purchase program won’t be as large over the next year as the 12 months prior, while there’s a natural cap on credit demand as yields sit "materially below" typical expense ratios for retail funds, and to a lesser-extent insurance funds. "Gross yields leave very little left for income-seeking savers," he adds. "Spreads could widen with a volatility shock."

The strategist also takes exception with the argument that the euro-area economy is ensnared by Japanese-style stagnation, which would keep spreads in check for decades to come, amid low interest rates and a lifeless corporate sector." - source Bloomberg

We also agree with his forecast for 10 year UST yield of 1.9%, that still make us part of the bond bulls after all. As we pointed out at the beginning of the conversation, at this stage we would rather hold US Treasury notes than European High Yield no offense to the gullible investing crowd busy picking the remaining basis points in front of the credit steam roller. We also agree that the US treasury market and the US dollar are reflecting a weaker economy. If there is a market which is less gullible to the "Barnum statements" from the Fed, it is the US bond market.

The big "Gullibility" question is one of returning duration risk through a sudden rise in bond volatility and we are not even taking into account exogenous geopolitical risk at this stage (which would be bond and gold bullish and oil bullish). On this subject we read with interest Nomura's take in their Inflation Insights note from the 7th of August entitled "Returning real duration risk to the market":

"A central banker’s headache

There are still many scenarios in which the gradual normalisation in the real monetary stance pursued by central banks might not have a gradual impact on financial markets. Uncertainty still looms large on key variables conditioning a balanced path to “normal.” Separately and/or collectively, the lack of term premium in inflation valuations, the level of the natural real rate of interest, the anchoring of inflation expectations, and flow dynamics from the unwinding of large-scale asset purchases can often have outsized impacts on global bond markets. Of course, central banks might find a perfectly balanced path, yet risks remain that real rates could overshoot. We suggest short real rate trades as a hedge against an environment of fast-rising nominal rates and slow-rising inflation.

“Taper tantrum” vs. “gradualism”

In Inflation Insights - Mini “taper tantrum” vs. “dear Prudence”, we argued that risk of a large, unexpected upswing in real yields remained. Despite normalisation in the real stance of policies being widely expected and advertised by central bankers, some mechanisms might facilitate unusually large yield changes.

Several factors potentially generating unexpectedly large yield moves

These mechanisms originate in both cyclical and structural features of economies. At a conceptual level, they stem from the possibility of a sharp rebuilding in term premia accompanying higher interest rates. The inflation premium – the price of a risk of inflation overshooting – remains low on most metrics. The term premium on the inflation component of yield remains also very subdued, as we have shown in Inflation Insights - A short trip to the long end . Therefore it is from the real component of yields that the risk of fast-rising rates comes from.

At a practical level, factors potentially resulting in an unexpected and uncontrolled rise in real yields are:

• The non-linear dynamics between the level of real rates and the real term premium, as short-term nominal rates retrieve some margin away from the effective lower bound.
• The re-pricing of the natural real rate of interest (NRRI) until recently, financial markets have rather followed central banks in their downside revision of the natural real rate and accepted the consequences on fixed income valuations. Even though there is an active debate among Fed members about NRRI, most still believe it will be heading higher as they continue with their normalization. A repricing could happen if surprises on activity remain to the upside, e.g., as they have been in the euro area.
• The complex interplay between segmentation across market participants and largescale asset purchase programmes conducted by central banks. For example, the transfer back to private investors of MBS paper would probably be accompanied by reintroduction of interest rate hedges. Another example is the behaviour of insurance companies and pension funds in the euro area increasing their purchases of fixed income assets with the ECB purchase programme – against the intuition of the balance portfolio channel pushing such investors to invest more in riskier securities.
• The discontinuity of asset purchases and the “signalling channel” – an abrupt stop to bond buying or re-investment would result in the pricing in of a much denser sequence of “taper” and then rate hikes. In our opinion, the long lead time of preparing markets for the Fed’s eventual balance-sheet unwind could mean that it is rather unlikely in the US (that said, there is a risk to some US rate vol if the Fed gets new leadership). However, it is made possible in the euro area by the perception of technical constraints on the PSPP.

Low inflation duration risk, high real duration risk

All these factors would allow for potentially large and sudden nominal yield changes, translating into large and sudden real yield changes through the elasticity (“beta”) of real yields to nominal yields. However, we think there are reasons to expect real yield changes to be larger than nominal yield changes.

One feature of the environment of low inflation has been that inflation valuations are unusually highly sensitive to current realized inflation trends (both markets and consumer prices). It is not only the expectation component of inflation valuations that has remained subdued, it is also the inflation premium embedded in valuations that has only marginally corrected from its negative levels. The lack of any increase in inflation premia and also inflation term premia would push real yields upwards, even faster than nominal yields.

As Figure 1 shows, it was the case in the early stages of the “taper tantrum” in 2013. The 5y5y real rate increased by about 150bp initially - the 5y5y inflation rate lost about 40bp over the same period. With markets remaining sceptical about the sustainability of higher inflation, it is very possible that the next big bond market sell-off will be a real-rate story.

 Away from the Effective Lower Bound (ELB): a distributional change

The risk of non-linear dynamics on rates stems above all from the proximity of the ELB. The effectiveness of monetary policy is conditional on the ability of the central bank to change the real rate – in other words, to increase the nominal rate faster or slower than the expected change in inflation. At the ELB, the short-term real rate is fully determined by the (negative of the) level of expected inflation. Central banks must resort to other instruments to lower real yields further on the curve – a methodology much advertised in Japan for instance for QQE.

Credible alternatives to the use of the nominal short-term rate might lower real rates further along the yield curve. Their credibility rests to a large extent on the notion that long-term inflation expectations do not fall too much – otherwise the objective of lower long-dated real yields is difficult to achieve. This is why the focus on inflation valuations by central bankers increases – and not only the focus on realised inflation and inflation scenarios.

Figure 2 shows that 5y5y inflation rates remain above half a standard deviation below their 2014-17 average. 

The 1-year inflation rate in 9 years is 30bp below the 2% target in the euro area. In the US, it is 2.60% - which is only just consistent with the Fed’s long-term PCE target and the CPI/PCE basis. In the UK, the 1y in 9 years is 3.45% - the only inflation rate above the central bank’s target of about 3% in RPI-equivalent terms ( the target is set in terms of CPI inflation, UK markets quote RPI inflation). Yet the spread to the target has been contracting since the beginning of the year. In our view, inflation markets have not priced in risk of inflation overshoots that these numbers suggest, consequently as a result the right-side of the inflation distribution remains thin.

A particular risk arises in case of a “spurious” surge in inflation expectations – for example acceleration in prices stemming from rising energy prices. In this case, central banks could increase the pace of nominal rate normalisation on the back of a temporary increase in inflation and despite a low probability of protracted and self-sustained inflation backdrop. Although central banks in general try to “look through” temporary factors, the distinction between “temporary” and “persistent” is not always easy to make in the heat of the moment. In addition, one consequence of the effective lower bound is to skew the distribution of inflation expectations – the normalisation of the distribution to the right can easily be triggered by a temporary factor such as large oil price increases.

Re-pricing the natural real rate of interest

The consequences of a lower natural real rate of interest for monetary policy are very far-reaching, in our opinion, and the uncertainty around the potential evolution of these rates would suggest in and of itself, an increased cautionary outlook for central banks in the pursuit of “normalisation”. An important aspect of this issue is that financial markets have priced in much lower levels of the “equilibrium” real rate. We focus on a simple statistical result – the mean-reversion level of the 5-year real rate, 5 years forward.

Figure 3 shows the contraction in this market’s estimate of the natural real rate. The magnitude is 150bp between our two samples across markets – the common magnitude of the contraction suggests a global issue rather than a country-specific problem.

The 5y5y real rate using swaps is currently about 0.40% in the US, 0% in the euro area and -1.40% in the UK. These levels are very close to the “mean-reverting” level that has prevailed since 2012 – but still very far from the levels before 2008. They are also not too far in the US and the euro area from estimates of the natural real rate provided by Laubach and Williams – respectively 0.45% for the US, -0.30% for the euro area and 1.50% for the UK. A very large discrepancy remains for the UK. In addition, these numbers suggest that “real normalisation” towards the natural real rate has already occurred for some version of the natural real rate – especially in the US.

When looking at the real rate curve in the US, given where 30-year TIPS have been trading, it seems as if the markets have taken to heart the idea that the long-run real rate is somewhere around 1% (2% inflation minus 3% median long-run dots). Down the curve is where the debate over how high the natural real rate could go, in our view. Further increase in real yields would therefore potentially put policy at or above the neutral level – a result that currency markets have not missed in the case of the euro area, with the consequence of a sharp euro appreciation. A sudden and sharp revision in the neutral level advertised by central banks could result in much higher real rates, with the risk to push policy into restrictive levels, which in turn would add to the negative pressure on inflation and activity. This would happen at a time when short-term rates are only some basis points away from the ELB, with limited restored potential for accommodation.

Rushing to the exit: the segmentation of investors

Another factor creating potential non-linear dynamics in real rates stems at a technical level from the segmentation of investors – a feature that accounted for the unusually large changes in US real yields in 2013 referred to as “taper tantrum.” We have explained this consequence of segmentation in Inflation Insights - Mini “taper tantrum” vs. “dear Prudence”.

In the US, a structural and potential destabilising feature for rates market dynamics is the process of MBS holdings of the Federal Reserve System slowly returning to private investors. For years, the Fed has basically warehoused US rate vol (see link) by holding so many MBS securities out of the private sector. MBS hedging in the past was an issue for global markets during quick rises in US rates (where MBS hedgers can push nominal US rates up even faster – known as “convexity hedging”). However, rates/spreads can also rise over time as private investors begin to hedge their MBS for interest rate risk.

In the euro area, the ECB provided evidence that the implementation of the PSPP resulted mostly in the selling of euro fixed income assets by non-residents to the eurosystem, while insurance companies and pension funds did not change their investment pattern. Such investors given their high fixed-income exposure would typically react to a change in the direction of monetary policy towards faster normalisation and create “rush-to-the exit” dynamics." - source Nomura

As we pointed out, a "Convexity event" would be possible depending solely on the "velocity" in the rise in US rates. Given the Fed's recent "Barnum statements" and dovish tone, we think that the Fed's first priority will be to go ahead with the initiation of its balance sheet reduction in September, before following up on additional rate hikes we think. There is a possibility though that, given the current NAIRU discrepancy, Janet Yellen travels "back to the future" so to speak, to the 90s and this, would of course generate significant instability and the aforementioned "bond" volatility which is so feared by the beta crowd and carry players alike. "Velocity" will induce "volatility" and therefore weigh on fund bond flows. Obviously, the risk is a significant rise in real rates, which would be simultaneously bond and gold bearish. We might have been gullible in some instances, but it isn't our core scenario for the time being. Not until we see the facts change, namely less muted wages growth, that we will change our mind to paraphrase Keynes.

For our final charts, back in our conversation "Orchidelirium" we asked ourselves if the US consumer was "maxed out". We noticed at the time that consumer loan demand, a finding consistent with the weaker spending in Q1 had been cooling. We mentioned it was a significant indicator to monitor in the coming months.

• Final charts - The barrel in the credit revolver is getting empty

In our book, consumer credit year-over-year change needs to be monitored very closely. Our final charts comes from Wells Fargo Economics Group note from the 7th of August and shows that Consumer Credit Growth has been slowing to end Q2. We are getting worried as well that total consumer credit momentum is decelerating:

"Consumer Credit Growth Slows to End Q2

Consumer credit rose $12.4 billion in June. Nonrevolving credit growth has been slowing for the past couple years, and with the recent halt in revolving credit’s momentum, total consumer credit is decelerating.

 Nonrevolving, Revolving Credit Both Slowing

• Steady growth in nonrevolving credit earlier in the economic expansion helped spur total consumer credit higher despite anemic growth in the revolving space.
• More recently, however, revolving credit growth has stalled. Net-charge offs have risen and delinquencies are up slightly, although both of these series have risen from historically low levels.

- source Wells Fargo

In June this year we mentioned our concern relating to the US consumer getting close to being maxed out in our conversation "Potemkin village":

"While it might be premature to pull the curtain on the Potemkin village, if indeed we break the 5% level for nonrevolving credit and continue to see a deteriorating trend in the coming months, then it will be a cause for concern. For credit markets at the moment, it's pretty much "carry on", though we are clearly tactically more cautious with High Yield and high beta in general." - source Macronomics, June 2017

If "Gullibility" is a failure of social intelligence in the sense that an investor gets tricked or manipulated by central bankers in buying European High Yield for example, then again, the US yield curve has been immune to the old tricks played by the Jedis at the Fed. As the economic cycle matures, so do credit standards and credit demand that simple. Most recent evidence indicates us that both consumer credit and business lending demand is slowing regardless of low unemployment and NAIRU readings. On top of that nonfinancial domestic corporate profit margins peaked in early 2014 and have declined in the last two years. This means, dear credit friends, that you need to have a more cautious stance going forward. Some investors might still be gullible enough to believe in "Barnum statements" and "Woozle effect", to paraphrase Jabba the Hutt in the Return of the Jedi, dear central banker your old Jedi mind tricks don't work on us.

"Most people are sceptical about the wrong things and gullible about the wrong things." - Nassim Nicholas Taleb

Stay tuned!