Macro and Credit - Common knowledge

"When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion." - Dale Carnegie, American writer

While playing the commenting "tourist" on a Macro-Man post relating to banking woes, we came across a very interesting comment from one of their readers relating to Central Banks, which we decided would make a good analogy for our post title:

"Eddie said...

 Wikipedia: Game of Common Knowledge

This might be a good way to think about CBs and their presumed or real abilities"

So we decided to investigate further given this fellow commentator piqued our curiosity and also because it has become quite a challenge for us to come up with relevant analogies, week after week in our musings (if you think of any of interest we could use in the near future, give us a shout). 

The concept of "Common knowledge" was first introduced in the philosophical literature by David Kellog Lewis in 1969 and was first given a mathematical formulation in a set-theoretical framework by Robert Aumann in 1976 according to the Wikipedia page. The idea and concept of the common knowledge is often introduced by some variant of the following puzzle:

"The idea of common knowledge is often introduced by some variant of the following puzzle:
On an island, there are k people who have blue eyes, and the rest of the people have green eyes. At the start of the puzzle, no one on the island ever knows their own eye color. By rule, if a person on the island ever discovers they have blue eyes, that person must leave the island at dawn; anyone not making such a discovery always sleeps until after dawn. On the island, each person knows every other person's eye color, there are no reflective surfaces, and there is no discussion of eye color.
At some point, an outsider comes to the island, calls together all the people on the island, and makes the following public announcement: "At least one of you has blue eyes". The outsider, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that he is truthful, and thus it becomes common knowledge that there is at least one islander who has blue eyes. The problem: assuming all persons on the island are completely logical and that this too is common knowledge, what is the eventual outcome?

The answer is that, on the kth midnight after the announcement, all the blue-eyed people will leave the island." - source  Wikipedia: Game of Common Knowledge

We would like to offer a variation of the above which we think ties up nicely with Eddie's comment quoted initially about Central Banks and the current state of affairs:

In the island of central bankers there are k central bankers who have a credit crisis on their hands, and the rest of the central bankers do not have a credit crisis on their hands. At the start of the puzzle, not one central banker realizes he has a credit crisis starting. By rule, if a central banker discovers he has a credit crisis, he must act swiftly at dawn to counteract the deflationary bust coming. In the central banking island, each central banker knows every other central banker's credit situation but there is never a real discussion around the evolution of the credit markets.

At some point an outsider, the Bank of International Settlements (BIS) comes to the island of the central bankers and makes the following public announcement: "At least one of you has a credit crisis"

"Emerging market economies may be facing tighter liquidity conditions as cross-border lending to emerging economies, especially China, shrank in the third quarter of 2015 and U.S. dollar borrowing by non-bank companies in those economies was flat for the first time since 2009, according to the Bank for International Settlements (BIS).
    BIS General Manager Jaime Caruana said global liquidity – a term that captures the ease of financing in global financial markets –  shows that the stock of U.S. dollar-denominated debt of non-bank borrowers outside the U.S. was unchanged at $9.8 trillion from June to September and dollar borrowing by non-banks in emerging economies also was steady at $3.3 trillion.
    An even clearer sign that global liquidity conditions for emerging markets may have peaked comes from a decline in cross-border lending to China, Brazil, India, Russia and South Africa. In the third quarter of last year lending shrank by $38 billion to $824 billion from the second quarter, Caruana said in a speech at the London School of Economics (LSE)." - source Reuters, Emerging markets may be facing tighter liquidity – BIS, 5th of February 2016"

The BIS, furthermore, is known by all to be truthful, and all know that all know this, and so on: it is common knowledge that it is truthful, and thus it becomes common knowledge that there is at least one "islander" who has a credit crisis on his hands.

So dear readers, the problem is as follows, assuming all the central bankers on the island are completely logical and that this too is common knowledge, what is the eventual outcome?

For us it is very simple, a liquidity crisis always leads to a financial crisis. 

And this, dear readers is unfortunately "Common knowledge" and will nonetheless be the outcome because knowing that everyone knows does make a difference. When the BIS public announcement (a fact already known to all) becomes common knowledge, the central bankers having a credit crisis on their hands on their island eventually deduce their status but we ramble again...

On a side note we touched on central bankers and their "deity" status "Omnipotence Paradox"  back in November 2012:

"A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie)."

Therefore the concept of "Common knowledge" is central in game theory.

If a deity status is only attained if it is not able to lie (SNB, BOJ, ECB, FED...) then central bankers are not omnipotent except the BIS...

Back in 2012 in our conversation we also argued:

"The "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives)."

 And in October 2014 in our conversation "Pascal's Wager" we argued:

"Pascal's wager was devised by 17th century French philosopher, mathematician and physicist Blaise Pascal (1623-1662). It posits that humans all bet with their lives either that God exists or not. In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not.

Pascal's Wager is of great importance and was groundbreaking at the time because it charted new territory in probability theory, making the first use of decision theory.
Pascal's Wager in the form of a decision matrix:

The only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods"." - source Macronomics, October 2014.

In this week's conversation, we will again look at the debilitation of the credit markets and what it entails according to the BIS "deity" and the central bankers islanders and the implications for "risk assets".

Synopsis:

• Instability risk and large standard deviation moves - Rising positive correlations are a cause for great concern and so is the denial on the state of US growth
• Credit - the liquidity canary, willingness to lend and the credit cycle
• Final chart - The Bank of Japan is a Black Hole for JGBs

• Instability risk and large standard deviation moves - Rising positive correlations are a cause for great concern and so is the denial on state of US growth

We would like to point out once more, like we did in our conversation "Positive correlations and large Standard Deviation moves" back in August 2015 the growing instability risk which creates large standard deviation moves thanks to rising positive correlations:

"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations.

Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:

- source IMF, April 2015

This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoil, bond prices and equities are all moving in concert.

Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market." - source Macronomics, August 2015.

This rising instability risk we discussed previously can be once more ascertained by the rise in correlations across asset classes such as Chinese equities and selected asset classes as well as with oil prices, which are all well above averages as shown in the below charts from IIF:

- source IIF

We told you at the end of 2015, that, 2016 would be a year of high "risk reversal" opportunities. The large move experienced as of late such as the one seen this week in the US dollar are clearly an indication of the brewing instability in financial markets (not that you haven't been warned on numerous occasions on this very blog). These "sucker punches" should not come as a surprise. The herd mentality has made various exposures crowded trades, with very poor risk reward after all, as pointed out by our Rcube friends in their November guest post "US Equity / Credit Divergence: A Warning":

"Everyone is expecting higher equities due to lower yields and depressed food and energy prices. But when everyone is thinking alike, no one is really thinking…."

As contrarian investors we don’t like sitting with the crowd. The fact that a long dollar was too consensual, was to us a serious "red flag". Also, our fears that the raging currency war would clearly escalate (thank you Bank of Japan) shows that it has had a bigger impact on the Fed’s reaction function than people were thinking.

Under the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity. This is what we pointed out in December 2014 in our conversation "The QE MacGuffin":

"What we find of interest is that under the ZLB, many pundits have expected a recovery. When one looks at the commodity complex breaking down in conjunction with a weakening global growth picture which can be ascertained by a weakening Baltic Dry Index. No wonder yields in the government bond space are making new lows and that our very long US duration exposure we have set up early January (in particular via ETF ZROZ) has paid us handsomely and will continue to do so we think." - source Macronomics, December 2014

While in early 2015, we tactically booked our profits on our long duration exposure, as we have told you end of 2015, following the December FOMC we not only re-entered our tactical long duration exposure, but, we also added started adding on our "Gold Miners" exposure.

Why so?

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is  again working nicely in 2016:

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

Easy as 1-2-3...

Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe. By the way if you are a "credit investor, you sure want to be "duration" hedged in Europe and probably less so in the US...

Also, what we find of "instability" as of late and in response to the "bullish recovery" crowd we would like to point out towards the evident fragility of the "Consumer Discretionary" complex. Because if you want to talk about the "quality" of jobs created in the US and their consumer discretionary potential here is a chart we have built our from the Bureau of Labor Statistics (BLS) that tells it all, depicting the Employment Status by educational attainment:

- source Macronomics / BLS

And if you think this doesn't represent a "headwind" for consumer discretionary, we could as well point out from a "Common knowledge" perspective, the situation relation Food Stamps:

- source Macronomics / Bloomberg.

The American economy is doing so well that it can subsidies for free 45 million of Americans (14.24% of the population)...

In this context, the price action aka "sucker punchers on two bellwether "Consumer Discretionary" stocks namely Royal Caribbean on the 4th of February and Ralph Lauren are clearly indicative of the global mood in the consumer discretionary sector we think (it is not only in dwindling Rolex sales in Hong Kong):

- graph source Bloomberg

Now if low oil prices are a "boon" for US consumption, then this "boon" is clearly hiding under the mattress...

We wonder when it is coming to become "Common knowledge". 

Conclusion:  maybe you should "Get shorty" Consumer Discretionary stocks that is...

When it comes to "Common knowledge" and growth outlook, it seems we always follow the same trajectory:

We start with an overall 3% consensus for US growth and US 10 year yield end of the year targets of between 2.50% to 3%, then after a couple of months, it gets revised down to 1.50% / 2% and US yields get revised accordingly towards the same objective.

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."

We hope, at some point, this will become "Common knowledge" and that some sell-side pundits will stop defying this simple yet compelling "Wicksellian" logic.

When it comes to the importance of liquidity, stability and credit, the latest Fed's latest Senior Officer Lending Survey is showing that US regional banks are starting to close the credit flows (it is not only happening in Emerging Markets!). You need to understand how important this is. The BIS seems to understand this but, clearly the "islanders" are in denial hence the title of our second bullet point in our long conversation.

• Credit - the liquidity canary, willingness to lend and the credit cycle

Whereas last week we pointed out again on the CCC credit canary's current state of affairs, being shut out entirely of the primary markets, whereas every pundits around are focusing on the correlation between oil and equities, earnings and additional sucker punches such as the one delivered to internet darling LinkIn corporation down by more than 40%, we would like to focus our attention on the real "elephant" in the China credit shop, namely liquidity.

When it comes to forecasting the default trajectory and in particular when one wants to assess the vulnerability of High Yield, we have pointed out that willingness to lend is paramount when it comes to the state of the credit cycle. On that particular subject we read with interest Bank of America Merrill Lynch's Securitization Weekly note from the 5th of February:

"Willingness to lend and the credit cycle

This week’s Senior Loan Officer Survey Report from the Fed for January (Chart 13) showed that lenders have gotten the message from capital markets: C&I and CRE credit is tightening on a net basis (8.2% and 5.6% of respondents, respectively).

It is noteworthy to us that the most closely related sectors, CLOs and CMBS, are those that are facing risk retention deadlines at the end of this year. As a reminder, the primary purpose of risk retention rules is to ensure that originators of loans are on the hook for the risk of the loans they originate. It may be too early to make the connection between the willingness to lend data and risk retention deadlines, but it seems fair to say that as the deadline draws closer, lenders are likely to further tighten lending standards, as they will own the risk. It is also noteworthy that the one sector exempt from risk retention rules, GSE mortgages, shows a fairly large number of respondents (-14.3%) that are loosening credit. We can see that this trend will be observed by investors in the risk transfer space and likely cause them to demand additional spread compensation for credit risk going forward. Credit card lending has not quite tightened yet (-1.9%), but it is getting close. GSE mortgages are the clear outlier on this chart.

We also layer on top of Chart 13 the high yield loan default cycle. Not surprisingly, tightening C&I and CRE credit has either coincided with (early 2000s) or led (2008-2009) a loan default cycle. The amount of tightening observed to date has been fairly minimal compared to the prior cycles. Nonetheless, if Liquidity Stress and credit market spreads continue in the direction they have been heading (higher), then more credit tightening and a more pronounced default cycle seem likely in the not too distant future.

Much should be revealed on this front over the next 1-2 months. Will some policy “fix” to liquidity stress be delivered, or will there be a disorderly move higher in liquidity stress? We shall see." - source Bank of America Merrill Lynch

As we pointed out in our introduction, liquidity crisis always lead to financial crisis, and yes, dear readers, credit always lead equities. When it comes to assessing "liquidity" risk, which we highlighted in our previous conversation, we think the situation is clearly pointing out to some deterioration. This is as well highlighted again in Bank of America Merrill Lynch we quoted as well in our previous conversation. We are indeed on the same page and share "Common knowledge":

"Liquidity stress: the canary in the coalmine

Introduction

Last week (“Things are bad, at risk of getting worse”), we discussed the BofAML Global Financial Stress Index (GFSI, Chart 1), noting that it is currently near the elevated levels of 2007-2008, right before the Great Financial Crisis (GFC). 

The message was that the GFSI signals some fragility for the financial system, which puts the system at risk of destabilizing quickly, perhaps due to policy error or some other shock. For securitized products credit sectors such as CMBS and CLOs, we think this means downside risks are still too high to look to take advantage of the spread widening that has occurred in recent weeks and months.

This week, we take a look at a sub-index of the GFSI, the Liquidity Stress index (Chart 2, IRISILIQ on Bloomberg), and consider the trends in liquidity stress and securitized products credit spreads over the past two years. We highlight in Chart 2 some of the key events that have occurred around the time liquidity stress has been rising: beginning of the taper by the Fed in early 2014, the Swiss and Chinese currency revaluations and Fed rate hike in 2015, and Japanese NIRP in 2016.

Chart 3 shows that, compared to the broader GFSI, liquidity stress has somewhat methodically and steadily risen over the past two years: while the GFSI has moved higher in fits and starts, liquidity stress has more persistently risen, only pausing its rise at times, before moving higher.

This persistence suggests to us that deteriorating liquidity is at the heart of and may be the primary driver of broader rising financial stress. If so, then continuation of the rising trend in liquidity stress may eventually lead to another spike in broader financial stress in the months ahead." - source Bank of America Merrill Lynch

Credit flows matters, because if indeed, the "credit tap" is about to be turned off, recovery and growth will be difficult particularly for China, in the absence of course of a sizeable real exchange rate depreciation. This would trigger a significant deflationary wave impulse for the rest of the world rest assured.

Also credit spreads are a more useful indicator of credit supply disruptions than credit quantities. The increase in spreads during the Great Financial Crisis (GFC) is symptomatic of unusual financial distress, and not just the reflection of the increased default risk faced by borrowers.
(See 2012 papers from Adrian, Colla and Shin, Gertler, Gilchrist and Zakrajsek quoted in a Bruegel Policy Contribution of February 2013, by author Zsolt Darvas in his note entitled "Can Europe Recover Without Credit?").

So watching what credit spreads are doing, given they are gently drifting wider à la 2007 is paramount we think. Much more important than being obnubilated by "oil prices".

When comes to assessing the state of the credit markets, we have to agree with DataGrapple's note from the 3rd of February entitled "It is still a bear grind":

"Credit indices have been weak throughout the session, and they were no different from all other risky assets today in that respect. The most striking feature of the move wider so far - over the last few days, but that is true since the beginning of the year - is that we have not seen any panic. Credit investors have not had their “coyote moment” yet, when they suddenly realise that they have gone over the edge and that they are hanging in the air. Some sessions have been brutal - iTraxx Main (ITXEB) widened by almost 6bps today and closed above 100bps at 104bps for the first time since 2013 -, but bases – the difference between the traded value of an index and the therotical value computed with the risk premia of its individual constituents - remain large across the board and it is still worth in excess of 50cts at the close on ITXEB. The latest DTCC statistics show that investors are still long risk on most indices. They are slowly bleeding in this steady bear grind." - source DataGrapple

When one looks at the closing prices for European Itraxx 5 year CDS indices with Itraxx Europe Main S24 (Investment Grade proxy) closing 5bps wider on Friday at 110 bps and Itraxx Crossover S24 closing 20 bps wider on the day to around 423 bps you get the drift...

Moving back to our liquidity concerns, we would like to point out once more to Bank of America Merrill Lynch's take from their Securitization Weekly recent note:

 "Liquidity stress: possible causes and “solutions”

The natural question that arises from Chart 1 is: why has liquidity stress risen so persistently since the beginning of 2014? No doubt, this is a complex question with no simple answers. Nonetheless, we think there are at least two plausible key drivers:
1. The post-crisis regulatory (Volcker) and capital (Basel) regime that has substantially raised trading restrictions and capital requirements for banks/dealers and, in so doing, reduced liquidity dealers can provide to markets.
2. Emerging market and high yield credit problems related to the collapse in oil prices, and commodities more broadly. With balance sheet scarce due to higher capital requirements, and capital charges high for poor credits, liquidity in stressed sectors perhaps naturally is the first to go.

The combination of these two factors has led to a somewhat vicious cycle and feedback loop, where poor liquidity is spreading, and liquidity problems appear to be turning into fundamental problems. Moreover, tightening of monetary policy by the Fed, first through tapering and now through tightening, may have been necessary from an economic perspective, but the tightening appears to be adding fuel to the fire of liquidity deterioration.

The next question that arises is: what can be done to stabilize liquidity, or even reverse the trend of liquidity deterioration? This is an even harder question to answer than the first one posed above on causality. Arguably, poor liquidity was part and parcel of the post-crisis design for the financial system: in a world of significantly higher capital requirements for dealers, nobody should really be surprised that balance sheet is scarce and liquidity is lower. This suggests there is no “fix” coming for cause #1 above; what we have now was in fact “the plan.” The only response to poor liquidity would be related to cause #2, the credit problems. We see two possible alternatives to watch for:

 1. A coordinated global policy response. Here we are referring to what BofAML Chief Investment Strategist Michael Hartnett is calling the “Shanghai Accord,” a coordinated policy response from G20 Finance Ministers and Central Bankers at the February 26-27 Shanghai meeting.

2. Coordinated oil supply cuts from OPEC and Russia, which would help alleviate the downward pressure on oil, and the associated credit stress. 

Barring developments on these fronts, further liquidity deterioration seems inevitable. If so, as the following discussion suggests, then securitized products credit spreads are likely to widen further. Moreover, the 10yr inflation breakeven rate is likely to head lower, creating downside risks for interest rates and upside risk for agency MBS prepayments.

 Liquidity stress, credit spreads and inflation breakevens

Next, we take a look at the relationship between liquidity stress and credit spreads, as well as the 10yr inflation breakeven. Given that credit spreads feed into the construction of the Liquidity Stress index, correlation between the index and credit spreads should be expected. Nonetheless, it is useful to take a look at how spreads in various credit sectors have trended in the past two years, as liquidity has inexorably deteriorated.

 We make the following observations:

• The HY CDX spread (Chart 5) seems to have tracked the deterioration in liquidity
over the past two years the most, starting in early 2014. The  modest narrowing of the spread in early 2015 appears to have been the anomaly.

• CLO BBB spread (Chart 6) tightening in the first half of 2015 appears especially anomalous.

In retrospect, deteriorating liquidity was a good signal that CLO spreads were at risk of significant spread widening. We missed the signal. At this point, CLOs currently appear to be “very cheap” on a fundamental basis, but if liquidity broadly continues to deteriorate, through correlation, CLO spreads are likely to continue to widen.

 • Like CLOs, BBB- CMBS (Chart 7) have played catch up on spread widening this year.

• Prime AAA auto ABS, often thought of as a highly liquid cash substitute, experienced disproportionate spread widening in 2015 (Chart 10), but has stabilized and even tightened over the past few months. 

We think the sector should be relatively strong from a defensive perspective going forward, but will not be immune from further spread widening if liquidity stress escalates further. Similarly, BBB subprime auto ABS (Chart 11) seems likely to widen further.

 • The correlation between liquidity stress and the 10yr breakeven inflation rate (Chart 12) is especially noteworthy, raising two important question: 1) is the collapsing breakeven rate just a reflection of deteriorating liquidity and, as the Fed suggests, not a particularly relevant indicator of future inflation (or more correctly, disinflation)? or 2) has the new regulatory/capital regime impaired liquidity so severely that it is heightening
disinflationary pressures, which the collapsing breakeven rate is correctly signaling? 

We’ll see whether the Fed is right on this one. But for now, the market is largely saying that deteriorating liquidity is disinflationary and further liquidity deterioration would bias interest rates lower. This means higher convexity cost for agency MBS, which leads us to recommend adding prepayment protection in the sector." - source Bank of America Merrill Lynch

And what does higher convexity means?
As a reminder: In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!

The negative convexity of High Yield callable bonds for instance enhance the downside during a sell-off. Furthermore, over the last 3.5 years, when spreads were at or below the current level (442bp), HY has widened 56% of the time over the next three months.

As we posited in our May 2015 conversation "Cushing's syndrome" expect as well lower liquidity:

"One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. " - source Macronomics, Cushing's syndrome, May 2015.

This we think is the current state of affairs in the credit space, which is akin to a 2007 environment. We've seen it before and we think it is playing out again, hence our heightened attention to the Securitized markets.

As well we keep an eye also in what is happening in the land of the "setting sun" aka Japan as per our final chart and bullet point.

• Final chart - The Bank of Japan is a Black Hole for JGBs

Finally when it comes to "liquidity", central bank meddling and common knowledge, what find of interest given Bank of Japan's latest jump in the NIRP bandwagon, is that when it comes to Japanese Government bonds aka JGBs, the Bank of Japan has become a Black Hole in JGBs, in effect Bank of Japan has vacuumed so many bonds that in effect it has become the market as displayed in our final graph we find in Bank of America Merrill Lynch Japan Rates Viewpoint note from the 2nd of February entitled "In BOJ-led JGB market, will target shift from quantity to real interest rates?":

"Chart 6 shows JGB transactions by major banks in the secondary market. Since the expansion of QQE, transactions have been running at a low level, now about ¥8.5trn monthly. Considering that monthly transactions were about ¥25trn before the expansion of QQE and before its introduction, transactions have declined sharply. This suggests that newly issued JGBs are absorbed by the BOJ without entering the secondary market.

Safe assets are usually considered to be those with high liquidity and low volatility, but a better description of the recent JGB market might be that it has simply lost activity. In the past, volatility has risen during low-liquidity phases in the JGB market, and we believe the current market needs monitoring because a slight move by investors could prompt a volatility increase. The introduction of negative interest rates has raised volatility, but for the time being yields will probably continue downward, albeit accompanied by higher volatility.

Sustainability of quantitative and qualitative easing with negative interest rates

The BOJ’s balance sheet has continued expanding, to the point where it reached about 76% of GDP at the end of 2015. This is a substantial figure compared to the about 25% accumulated by the FRB and ECB. In January 2015, when the Swiss National Bank (SNB) eliminated its ceiling on the Swiss franc’s exchange rate vs. the euro, its balance sheet was about 80% of GDP (it has expanded again recently, reaching about 90%). The meaning of a central bank’s balance sheet relative to GDP can be debated, and the assets held by the BOJ and SNB differ in kind, so a simple comparison is not possible. Nevertheless, the approach of the BOJ’s balance sheet to 80% of GDP is noteworthy. At the time, the SNB’s president described the situation as unsustainable. Even a central bank cannot go on expanding its balance sheet without limit.
Given that JGB supply-demand is tight and a shortage of sellers will gradually emerge, doubts are being raised about the BOJ’s ability to keep expanding its balance sheet at the current rate. The introduction of negative interest rates might shorten the viable period of the expansion. Also, the longer that balance sheet expansion continues, the more difficult that monetary policy normalization will become. As the BOJ’s purchasing operations go on, JGB yields are being lowered at ever-longer maturities. In other words, the longer that monetary easing continues, the more likely the JGB curve is to factor in monetary normalization as a very distant event. Therefore, when normalization comes, the probability of a strong reaction is rising." - source Bank of America Merrill Lynch

Yes indeed. Even a central bank cannot go on expanding  its balance sheet forever, and that's "Common knowledge". The problem is one need to assume that all our central bankers "islanders" are completely logical and not totally insane...

"Logic is like the sword - those who appeal to it, shall perish by it." -  Samuel Butler, British writer

Stay tuned!

Macro - Availability heuristic - Part 1

"I go with the flow. Whatever music you play for me, I'll dance." - Gael Garcia Bernal, Mexican actor

Looking at the continuous dizzy gyrations in FX markets, equities and commodities and other asset classes alike, we decided to use this week as our title analogy yet another reference to psychology, this time more closely linked to behavioral psychology namely "Availability heuristic". Our reference was suggested by Polemic, author of the blog "Polemic's pain" and former member of the "Macro Man" team. As the China "devaluation" created somewhat a "panic" during the month of August and in conjunction with the weaker tone in equities and Emerging Markets, under the "Availability heuristic" people tend to heavily weigh their judgments towards more recent information, making their new opinions on the markets biased towards that latest news, hence our chosen title and the increasing volatility we think.  In other words, the easier it is to recall the consequences of the Chinese FX movement, the greater those consequences are often perceived to be:

"Under the availability heuristic, humans are not reliable because they assess probabilities by giving more weight to current or easily recalled information instead of processing all relevant information. Since information regarding the current state of the economy is readily available, researchers attempted to expose the properties of business cycles to predict the availability bias in analysts' growth forecasts. They showed the availability heuristic to play a role in analysis of forecasts and influence investments because of this.
In effect, investors are using availability heuristic to make decisions and subsequently, may be obstructing their own investment success. An investor's lingering perceptions of a dire market environment may be causing them to view investment opportunities through an overly negative lens, making it less appealing to consider taking on investment risk, no matter how small the returns on perceived "safe" investments. To illustrate, Franklin Templeton's annual Global Investor Sentiment Survey 1 asked individuals how they believed the S&P 500 Index performed in 2009, 2010 and 2011. 66 percent of respondents stated that they believed the market was either flat or down in 2009, 48 percent said the same about 2010 and 53 percent also said the same about 2011. In reality, the S&P 500 saw 26.5 percent annual returns in 2009, 15.1 percent annual returns in 2010 and 2.1 percent annual returns in 2011, meaning lingering perceptions based on dramatic, painful events are impacting decision-making even when those events are over." - source Wikipedia

Looking at the market's movements and outflows coming close (at least in credit) to what happened during the "Taper Tantrum", we would like, in this week's conversation discuss the on-going macro environment not from "availability heuristic" context but, as always from a slightly "contrarian" approach. This is part 1 of yet another long conversation.

Synopsis:

• Global growth is changing and FX is the "real issue" for financial markets
• "Availability heuristic" is driving outflows in EM funds and credit

• Global growth is changing and FX is the "real issue" for financial markets

As we argued again end of July 2015 in our conversation "Mack the Knife", the mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2015) started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

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

More liquidity = greater economic instability once QE ends for Emerging Markets, and its reverse as posited by Deutsche Bank QT for Quantitative Tightening in their special report from the 1st of September entitled "The Great Accumulation is over". 

If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike. 

Deutsche Bank's QT is in fact an interesting comparison to our "reverse osmosis" theory playing out:

"This piece argues that 2015 will mark the peak in global FX reserve accumulation. Following two decades of unremitting growth, we expect global central bank reserves to at best stabilize but more likely to continue to decline in coming years.

• Three cyclical drivers point to further reserve draw-downs in the short term: China’s economic slowdown, impending US monetary tightening, and the collapse in the oil price.
• Structural changes have permanently reduced the need for reserves as well. China’s new FX regime would lead to less intervention in the medium-term. EM external positions are stronger than two decades ago reducing the need to recover reserves beyond prior peaks. Oil prices are unlikely to return to previous highs reducing petrodollar recycling. And both the SNB and BoJ have moved away from currency intervention as their primary monetary policy tools.
• The implications of our conclusions are profound. Central banks have accumulated 10 trillion USD of assets since the start of the century, heavily concentrated in global fixed income. Less reserve accumulation should put secular upward pressure on both global fixed income yields and the USD. Many studies have found that reserve buying has reduced both bund and US treasury yields by more than 100bps. For every $100bn (exogenous) reduction in global reserves, we estimate EUR/USD will weaken by ~3 big figures.
• Against this new secular trend, there are forces that point in the opposite direction. The Euro-area with its huge current account surplus has become the world’s largest saver implying persistent capital outflows and European demand for foreign assets, a term we have previously called “Euroglut”. The BoJ and ECB quantitative easing programs remain in full swing, generating downward pressure on global yields.
• Placed against global QE, the secular shift in global reserve manager behavior represents the equivalent to Quantitative Tightening, or QT. This powerful, but countervailing force is likely to present additional headwinds towards developed market central banks’ exit from unconventional policy in coming years." - source Deutsche Bank

The US Dollar being the currency reserve of the world and thanks to interest rates in the US moving into positive territory, this has reversed the movement of investors from EM to DM, which was initially driven by the pressure coming from real negative interest rates hence massive inflows pouring into EM.

This is causing a manifestation of an EM "currency crisis" hence the fast and furious devastation in EM FX witnessed so far with Brazil being in the first line of the culprits in the receiving end.

Contrary to investors "availability heuristic" decision process and current fears, this was bound to happen and this has been on our bloggers' mind since late 2011 and repeated again following the "taper tantrum" in our conversation "The Tourist trap" back in September 2013:

"Of course if Bernanke is serious about initiating his "tap dancing" following "twist", this might spell out the "last tango" for Emerging Markets, and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 

Wave number 1 - Financial crisis 

Wave number 2 - Sovereign crisis 

Wave number 3 - Currency crisis 

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?" - source Macronomics, September 2013

Both the Fed's willingness to tighten and EM's necessary tightening bias have been causing a continuous deterioration in economic conditions in some EM, led by a weaker China which is now spilling into "global growth" in true "availability heuristic" fashion. 

On that note we read with interest Bank of America Merrill Lynch's Global Watch note from the 3rd of September entitled "GLOBALcycle follows EM down" in which they show a marked slowdown of their proprietary "Economic Conditions Indexes" (ECIs):

"GLOBALcycle eases in August

Our GLOBALcycle coincident indicator weakened in August. Economic conditions deteriorated in EM, led by softer conditions in China and Poland. Business conditions in the developed world were largely unchanged, however. The activity pace seems to have held up in the US, euro area and the UK, but appears to have slowed notably in Japan. All in all, our indicator suggests that global growth has slipped below 3%.

Strengthened headwinds

The worsened EM outlook casts a shadow on the global economy. Emerging markets are facing tighter global financial conditions, lower commodity prices and wobbling business confidence. Concerns about the extent of the Chinese slowdown, in particular, are likely to linger. This poses downside risks to DM, but we still expect solid expansions in the US and the euro area. All told, we have trimmed our EM growth forecasts and now look for 4.1% (-10bp) in 2015 and 4.7% (-20bp) in 2016. In the developed world, we expect GDP growth to edged higher to 2.0% this year and 2.5% in 2016.

What is the GLOBALcycle?

The GLOBALcycle is a real-time indicator of economic activity covering 80% of the world economy. The indicator extracts a common factor from weekly, monthly and quarterly data. The GLOBALcycle is a GDP-weighted average of Economic Conditions Indices for (i) the US, euro area, Japan, the UK, Canada and Australia in the developed world, and (ii) Brazil, Russia, India, China, Indonesia, Korea, Poland, Turkey, Mexico and S. Africa in EM. The GLOBALcycle is based on the ADS index developed at the Federal Reserve Bank of Philadelphia." - source Bank of America Merrill Lynch

Of course, should one would like to compare Bank of America Merrill Lynch's proprietary indicator versus the OECD leading indicator this would graphically be the result:

"Comparing the GLOBALcycle to the OECD leading indicator

The OECD leading indicator has a two-month lag, while our GLOBALcycle is calculated in real time, providing a timely assessment of current economic conditions in each country. Chart 7 emphasizes the leading aspects and forecasting ability of our indicators."

 - source Bank of America Merrill Lynch

This of course indicative of "availability heuristic" being applied and somewhat a spillover effect to global growth as a whole thanks to EM and Chinese woes.

The issue at hand when it comes to "availability heuristic" being applied and the short term memory span of investors, can be ascertained by the overall "muted" picture of global growth as a whole on an "aggregate" level. On that specific point we read with interest Louis Capital Markets Cross Asset Weekly Report from the 31st of August entitled "The Growth Redistribution":

"Desynchronisation
If we take a large perspective, looking at the economic growth in the World, we would conclude that the situation is unchanged, almost boring as the expected growth for 2015 and 2016 should equal that of the past three years, at around the 3% level (see the below left chart). 

This benign situation on the surface could question the recent behaviour of financial markets: why anxiety would be back given the absence of any changes at the global growth level??? The answer lies therefore elsewhere and we think it lies in the content of this growth. Global growth has not changed but the contribution to this growth has well evolved, affected in our opinion, by the levelling off of the global trade (right chart below).

These two charts are a good summary of the current economic situation in the world: decent global growth but subdued growth of exports as the super cycle of the global trade is over. This super cycle started in 2001 with the entry of China in the WTO (World Trade Organisation) and seems to have ended in 2012 with the European double-dip. The collapse of commodity prices since the summer 2014 has accentuated the negative trend but it would be dishonest to limit the explanation of the decline of the global trade to the decline of commodity prices. The volume of goods traded as a share of GDP is finding a plateau at the aggregate level and there is no surprise here. The outsourcing process of the domestic industrial production is reaching its limit and automatic stabilisers (through the currency) have also played a role. It means today that countries should lean less and less on their foreign trading partners to revive their domestic economic growth. This is not a new diagnosis but it is the lesson to draw from the past years: the domestic demand becomes more than ever the main driver of the economic cycle for many countries like Europe, the US, Japan or China.

The US economy is very strong because its domestic demand is strong, supported by jobs’ creation, a buoyant housing market and a strong dynamism of the services sector. The Chinese economy is weak because its domestic demand is weak, pressurized by a declining construction sector and a weak private consumption.

The below left chart illustrates how the contributors to the global growth are changing: EM countries are in a significant deceleration mood while developed countries are in an acceleration mood.

Thus, the problem is not about a weakening world economy but about the end-cycle that is gaining momentum in the EM world.

This divergence is sustainable and we would not embrace the scenarios of a spill over of the EM meltdown to the transatlantic world. As we have just said, the strong US economy and the European recovery have nothing to do with the EM world because they are domestic driven. This is slightly different for Japan which could suffer a little more from the Chinese economy’s deceleration.
Anyway, the decoupling thesis is more than ever accurate to describe the world economy. Last time it happened was in 2007-2008 when the slowdown of the housing sector in the US was dragging down the economy whilst the commodity price boom was supporting the strong growth cycle in the EM world. At that time, the equity markets in the developed world were not too much affected. It is only when the banking system started to feel the pain with the rise of non-performing loans that equity indices entered a downward trend. The crisis was global because the roots of the crisis were the developed world whose economic weight was huge.
This time is a bit different because the problem is the EM world and its economic influence on the developed world remains weak. That’s for the economic diagnosis: if the client is healthy, the illness of the supplier will not affect him. This is therefore well different from the 2007-2008 situation when it was the client who was ill.
The market perspective is however less different because during the past years, the equity market has adapted to the new world’s order. The “domestic players” have been under pressure whilst the “global players” have grown up. The structure of the equity market today is therefore tilted towards the “global players”. This could explain why the equity market seems to have reacted earlier this time. Although the impact on the profits of listed companies cannot be felt significantly (with the exception of the commodity-related sector) the volatility of equity indices is increasing." - source Louis Capital Markets Cross Asset Research

Where we disagree with the author of the above is that, the US economy is not very strong given the Atlanta Fed GDPNow is pointing towards 1.5% of growth in the US whereas most sell-side pundits are still pointing towards around 2.8% of US GDP growth (2.8% for Bank of America Merrill Lynch). The US economy is not growing strongly but very much muddling through. When it comes to Europe, the story is different with Italy and France clearly being the laggards with Germany reaping all the benefits so far. 

Furthermore, as we have pointed out in our "Charts of the Day - Positive correlations and large Standard Deviation moves" appears to us as critical in understanding today's global linkage and growing risks, given rising positive correlations creates distortions and large increases in volatility. Therefore we cannot agree with the author's take in saying that, this time it is different, just because "the economic influence of the EM world on the developed world remains weak". The rise in positive correlations is indicative of an intensification of the globalization and that the world's economies are becoming ever more intertwined. We are only just starting to understand the ripple effects through the on-going "contagion".

As we posited recently:

"There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis."

But when it comes to FX being the "culprit" in financial markets woes and hence the third wave we discussed at length since 2011, we do agree with the author of the LCM note:

"We will not repeat what we have just said for many months now but the end of the depreciation of the US dollar and of the EUR is a serious headwind for the global companies. In fact, the currency is the real issue for financial markets. On the previous right chart we show a basket of EM currencies against the US dollar and the speed of their depreciation is alarming. The intensification of the globalisation over the past two decades has increased the sensitivity of developed companies to the behaviour of currencies. The financial instability in the EM world is therefore affecting the equity markets in the developed world through the currency’s channel. To sum-up, we get the following scheme:

We do not expect the collapse of EM currencies to stabilise by themselves. We said it before in 2013 and we got wrong as they managed to stabilise by themselves in 2014. We think they benefited from the softness of the US economy that allowed 10y US bond yield to decline from 3% to 1.7% during that year. This unexpected support should not repeat in the coming months so this is why we expect the downward trend of EM currencies to continue.

No More Slack in the US Economy
An aggravating factor of the EM meltdown could be the necessary normalisation of the extremely accommodative US$ financial conditions. We have discussed it before: the last intention of the Fed is to create a global financial shock but at the same time, the Fed has to take into account the decline of the output gap of the US economy.

We belong now to the (small) group of economists who think that the Fed is not there to support the foreign economic agents who have abused of the eased US$ financial conditions during the past decade. In other words, if financial imbalances have emerged in the US$ semi-pegged world (China, Honk-Kong, Middle East) or in countries that have benefited from the low funding cost in US dollar, this is not the problem of the Fed. The potential moral hazard induced from this favourable financial context should not affect the Fed’s decisions.
The above chart is a reminder of how strong is the US economy. If the Fed misses the opportunity in the next FOMC meetings to “reload its ammunition in terms of interest rates” new questions will rise:
1) What is the needed economic context for the Fed to raise rates?? Does it exist?
2) Are short term rates still the relevant monetary policy or can we envisage that short term rates remain anchored to 0% and that long term rates become the new main monetary policy tool (through Q.E)?
The only relevant reason to justify another postponement of the first rate hike in the US is the behaviour of prices in our opinion. With the collapse of commodity prices and the tendency of economic agents to extrapolate short term trends, we can see that inflation expectations in the US are back at a level very close to their all-time lows.

- source Louis Capital Markets Cross Asset Research

When it comes to the LCM scheme above and given our long-standing "deflationary" bias, we would tend to steer towards the bottom left of the scheme, and expect continued negative impact on equities and DM corporates exposed to EM, particularly in the Energy sector but as well on peripheral financial players such as Spanish banking giant Santander over-exposed to Brazil (which is yet to find some solace or stability in its falling BRL currency).

To paraphrase the words of Nixon-era US treasury secretary John Connally, the US dollar is their currency but is now a big EM problem, particularly when it comes to stemming capital outflows and the risk for disorderly exits from EM dollar denominated corporate bond funds (which we will discuss at length in our second part).

This is leading us to our second point of this conversation, namely portfolio flows and reversals. 

• "Availability heuristic" is driving outflows in EM funds and credit

This is what we posited in our last conversation "Mack the Knife" and our "reverse osmosis theory explaining our difficult it is for EM countries to currently stem capital outflows:

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

When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing out as we have argued in our conversation "Osmotic pressure" back in August 2013:

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

When it comes to "availability heuristic" and "flows", investors do tend to react on recent news and particularly continuous outflows. When it comes to "outflows in both the EM related world and credit, these outflows have been nearly as significant as during the "taper tantrum" as indicated by Bank of America Merrill Lynch's High Yield Flow Report from the 3rd of September entitled "Ex-US funds post outflows":

"EM funds record another large outflow
Ex-US flows dominated the picture this week with Emerging Markets again taking center stage with their third consecutive billion+ outflow. Retail investors pulled out $3bn from EM funds this week, which has put the last four week total to -$10bn, rivaled only by the -$12bn during taper tantrum. The relatively weak economic data coming out of China is weighing on Emerging Markets because not only do EM countries export to China, but they also compete with it for US market share. Weak Chinese domestic demand along with the recent Yuan devaluation is spelling trouble for these countries on both accounts. Also registering outflows were non-US HY funds which put up a -$1.1bn outflow, a decline from last week’s -$2.5bn.
US HY funds posted a small inflow as ETF inflows balanced outflows from open-ended mutual funds. Also returning to inflows was US IG which attracted $1.2bn. Equities saw +$5bn flowing in. Commodity funds gave back some of the inflows of the month registering -$430mn in outflows. Loans, the worst performing asset class this year in terms of % of AUM added, saw another -$440mn leave the asset class. Loan funds have underperformed this year on the back of the diminishing potential of rate increases. It also doesn’t help that most of these securities won’t truly float in the near term due to their embedded LIBOR floors.

 - source Bank of America Merrill Lynch

But, when it comes to outflows in EM land, all regions have not fared the same when it comes to "outflows" and "availability heuristic" investors' bias.

For instance, when it comes to capital flows into EM Asia, there has been some stability as of late as reported by Bank of America Merrill Lynch in their "Asia in Focus" note from the 4th of September 2015 entitled "Portfolio flows and reversal":

"Portfolio flows and reversals
Capital flows into Emerging Asia have come to a stop and turned negative in recent weeks. The magnitude of recent EM Asia portfolio outflows is comparable to the 2013 “taper tantrum” episode. Most of the recent portfolio outflows however are equity, not bond outflows. Size of the foreign equity outflows is comparable to the 2013 “taper tantrum” episode and the sharp withdrawals seen during the early phase of the global financial crisis. Foreign bond outflows however remain muted and significantly less than the “taper tantrum” episode.
The divergent behavior of bonds versus equity suggests that recent sell-off may be due more to China fears than the impending Fed rate hikes. Bond outflows could intensify when the Fed eventually hikes sometime this year, which our US economics team thinks will likely be this month (Sep). Recent pressure on Asian currencies and central bank FX reserves are therefore coming more from the Asian equity (than bond) sell-off. Currency hedging on foreign bond holdings may have nevertheless contributed to the Asian currency weakness, even though foreign positions have not been pared so far.
We capture the recent movements of non-resident portfolio flows to Emerging Asia, by using the high-frequency Institute of International Finance (IIF) data on equity and bond flows. Data available for Asia include India, Indonesia, Korea and Thailand. We think the sum of these countries should capture the broader foreign portfolio flow behavior. The IIF data are sourced from national central banks or exchanges, and are defined as nonresident purchases of stocks and bonds. Balance of payments data on capital flows are available only on a quarterly basis and comes with a long lag.
EM Asia foreign portfolio flows – inclusive of both equity and bonds – have turned consistently negative since 10 August, a day before the People's Bank of China (PBoC) devalued its CNY daily fix by 1.9% (Chart 1).

During August (up to the 28th), total foreign portfolio outflows reached $8.7bn. In the last week of August, foreign portfolio outflows averaged a staggering $1bn daily, compared to the average of +$156mn inflows daily during the first seven months of the year. The 7-day moving average of portfolio flows is already at 1 standard deviation below the 28-day mean.
Flow reversals have been driven largely by foreign equity, not bond outflows (Chart 2).

This is quite different from the 2013 “taper tantrum” episode, when both foreign equity and bond flows saw sharp reversals. Some cumulative foreign outflows of $9.4bn in equities have occurred over the roughly one month period since the “cut off” date of 20 July when the reversals started (Chart 3). 

This is comparable to the $9.8bn over the same period during the 2013 “taper tantrum” episode and $10.8bn during the global financial crisis.
Foreign bond holdings have been remarkably stable so far. The IIF data shows only some cumulative foreign outflows of $1.4bn in bonds since the “cut off” date of 20 July.
During the same period of the 2013 taper tantrums, the cumulative bond outflows had
already reached some $10.2bn over a month (Chart 4).

The dynamics so far looks not too different from the global financial crisis, when the Fed’s QE and zero interest rates pushed capital flows into Asia for yields and protection from a falling US dollar.
Foreign ownership of Indonesia government bonds remains at a high 37.8% of outstanding, slightly lower compared to the 40.3% at peak in January this year, but far higher than the 16% pre-Fed QE (Chart 5). Foreign ownership of Malaysia government bonds (MGS) has fallen only slightly from over 50% at the peak in May 2013 to 47.8% as at end-July. In Korea and Thailand, foreign ownership has also declined only marginally to 12.6% and 17.1% of the total respectively.
Divergent behavior of foreign equity versus bond flows suggests that the recent sell-off is driven more by China’s slowdown and devaluation fears than the looming Fed hike rate cycle. Foreign positioning in Asian local currency bonds remain high and the risk is that Fed rate hikes will likely tighten global monetary conditions, raise global interest rates and increase foreign selling of Asian bonds. We argued that Indonesia and Malaysia are probably the most vulnerable to large capital outflows on steeper-than expected Fed rate increases. Both countries have seen a surge in the foreign ownership of local currency bonds following the Fed’s QE programs from the lows during the global financial crisis. Indonesia is vulnerable given its current account deficit, faltering growth and the government’s slow progress in reviving investment. Malaysia is vulnerable given its high external debt, low FX reserves cover to short-term external debt, high household debt, and the ongoing political crisis. We are also worried about the return of “original sin” – the higher proportion of foreign currency debt – as funding costs in local currency rises and foreign appetite wanes.
Asian central banks and governments will try to support growth and defend their currencies, but several central banks, including Malaysia and Indonesia, are increasingly constrained in their policy options. Year-to-date, Malaysia’s foreign reserves have plunged $21.4bn to $94.5bn at mid-August, down from the peak of $141bn in May 2013 (Chart 6).

We don’t think capital controls is likely but cannot longer rule out the risk. Reserves have declined $4.3bn so far in Indonesia, falling to $107.6bn at end-July. Declining reserves and weaker currencies are limiting Bank Negara Malaysia and Bank Indonesia’s room to ease monetary policy and cut policy rates." - source Bank of America Merrill Lynch.

Hence our concerns for Wave number 3, currency crisis emerging and a big US dollar "margin call "on some vulnerable EM issuers.

In our conversation "Magical thinking" we have argued:

"To repeat ourselves, leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). Now in EM, our "reverse macro osmosis" theory is clearly playing out."

While the rout has not yet "accelerated", there is a clear potential for further deterioration in true "availability heuristic" fashion we think.

This will bring us to the second part of our conversation, namely that the "elephant" in the room could indeed be Dollar denominated EM corporate debt which could potentially be a victim of "availability heuristic" should defaults start materializing. We will also look at the importance of "Balance of Payments" and once again the difference between "stocks" and "flows".

To be continued...

"Men often act knowingly against their interest." - David Hume, Scottish philosopher

Stay tuned!