Macro and Credit - The Cult of the Supreme Being

"The supreme quality for leadership is unquestionably integrity. Without it, no real success is possible, no matter whether it is on a section gang, a football field, in an army, or in an office." -  Dwight D. Eisenhower, American president

Looking at the continuation in the rally in risky assets and watching with interest our friend Michael Lebowitz getting blocked on Twitter by Narayana Kocherlakota, the former president of the Federal Reserve Bank of Minneapolis, we made the following sarcastic comment that if you are not a "cargo cult" follower you get blocked. While being a "cargo cult member" entails various ritualistic acts such as "wealth effect" via QE not manifesting itself in the appearance of material real economic recovery, we could have used this very reference for our title analogy but, given our previous reference to the French Revolution in our last conversation, it made us want to dig further into history when it comes to selecting an appropriate title. 

The Cult of the Supreme Being (French: Culte de l'Être suprême) was a form of deism established in France by Maximilien Robespierre during the French Revolution. It was intended to become the state religion of the new French Republic and a replacement for Catholicism and its rival, the Cult of Reason. It can be easily argued that the Cult of Reason, namely reasonable/rational central banking has indeed been replaced by the Cult of the Supreme Being, namely the "cult of the central banker". The Cult of Reason distilled a mixture of largely atheistic views into an anthropocentric philosophy. No gods at all were worshiped in the Cult—the guiding principle was devotion to the abstract conception of Reason which seems to have been totally ditched by our central bankers "deities" as of late. For Maximilien Robespierre, "The Cult of the Supreme Being" was said to have contributed to the Thermidorian Reaction and the ultimate downfall of Robespierre and his execution.

Furthermore, in our July conversation "Confusion" we made another reference to French economist Florin Aftalion 1987 seminal book entitled "The French Revolution - An Economic Interpretation" given the extension of Negative Interest Rate Policy now in German banks affecting retail deposits above the €100,000 threshold, the words of revolutionary figure Louis Antoine de Saint-Just, one of Robespierre's closest ally during the French revolution who ended up guillotined the very same day on the 28th of July 1794 are very interesting in relation to "monetary creation" and "assignats" we have discussed in our recent musings:

"There is no money-saving going on nowadays. We have no gold, and yet a state must have gold; otherwise it is basic commodities that are piled up or kept back, and the currency loses more and more value. This, and nothing else, lies behind the grain shortage. A labourer, having no wish whatsoever to put paper money in his nest-egg, is very reluctant to sell his grain. In any other trade, one must sell in order to live off one's profits. A labourer, however, does not have to buy anything, for his needs have nothing to do with trade. This class of persons was accustomed to hoarding every year, in kind, a part of the produce of the earth, and nowadays it prefers to keep its grain rather than to accumulate paper" - Louis Antoine de Saint-Just.

No offense to the Supreme Being Cult members out there, but, in our book, NIRP is insanity as there cannot be productivity and economic growth without accumulation of capital, because simply put, NIRP is killing capital (savings).

In this week's conversation we will look at the continuation of the rally thanks to inflows which validates our short-term "Keynesian" stance. We do remain though medium to long-term "Austrian" when it comes to assessing the credit cycle and the slowly but surely tightening noose of financial conditions as displayed evidently in the below chart from Bank of America Merrill Lynch CMBS weekly note from the 12th of August entitled "Bad news is once again good news; remain overweight":

"Through the rest of 2016, we expect several headwinds to CRE price growth will remain. For instance, underwriting standards look set to continue to tighten. Over 44% of respondents to the most recent Senior Loan Officers Survey, which was released last month, indicated they were tightening underwriting standards (Chart 24), although the OCC’s most recent semi-annual risk report says differently. Regardless, with the topic squarely on the regulators’ radar screens, we think it is only a matter of time before underwriting standards begin to tighten, particularly for smaller local and regional banks. " - source Bank of America Merrill Lynch.

Of course the evolution of US Senior Loan Officers Survey is worth tracking as it will clearly impact going forward the default rate and the US High Yield asset class. For now, everyone is "dancing", but, we think, it's worth "dancing" closer towards the exit we think, hence our recommendation in favoring "Style" over "Substance", namely US Investment Grade over US High Yield or playing simply the "beta" game.

Synopsis:

• Macro and Credit - The melt-up is "Breaking bad" thanks to "cult members" inflows
• Macro and Credit  - While credit spreads are grinding tighter, quality is eroding faster
• Final chart: US Investment Grade credit - Growing duration mismatch between cash and synthetic

• Macro and Credit - The melt-up is "Breaking bad" thanks to "cult members" inflows

When looks at the continuing rally into risky assets and particularly "credit", one would indeed conclude that the cult of the Supreme Being is alive and well particularly in the light of some long dated corporate bonds trading in the region of $200 cash price. As indicated by the Financial Times in their article "Latest bond rally eye sore: one for the price of two", "Bondzilla" the NIRP monster is getting bigger every day thanks to the Supreme Being cult members:

"The Bank of England’s recent stimulus splurge, including a move to buy corporate paper, has driven the market prices for several sterling corporate bonds up to more than two times their initial face value, even for those unlikely to qualify for the central bank’s shopping list, writes Joel Lewin.
The price of US industrial conglomerate General Electric’s 2039 sterling bond, for example, has rocketed to a record high of 215.5 pence on the pound. That’s up from 165p at the start of the year and 100p when it was issued in 2009.
The yield has plunged from more than 10 per cent in 2009 to a low of 1.805 per cent.
Coupons aside, paying £215.50 today to be repaid £100 in 2039 amounts to a capital loss of 5 per cent every year for the next 23 years. Tasty.
“It’s another sign of how far central banks have pushed things,” says Luke Hickmore, a senior investment manager at Aberdeen Asset Management.
National Grid Gas’ 2044 bond has surged from 154p at the start of the year to 205p.
While those are the only two sterling corporate bonds* past the 200p mark at the moment, according to Bloomberg data, a number of others are on the brink." - source Financial Times

In conjunction to cult members being induced price wise by their Supreme Being, putting aside any reason or rational thinking, flow wise, the latest move by the Bank of England has also added fuel to the fire leading to some "overdrive" in spread tightening but inflows as well! This can be clearly seen in the United Kingdom credit markets as shown by Bank of America Merrill Lynch in their Follow the Flow note from the 12th of August entitled "Thank you Carney – Largest inflow ever":

"The state of play: IG > EM > HY >Equities
In a world dominated by central banks’ QE programs, BoE has been the latest to join – or re-join – the party. Last week’s inflows into sterling IG funds were the largest ever.
Since the ECB announced the CSPP, $30bn has flown into IG funds. And from February’s risk assets lows, equity funds have lost $82bn. During the same period, EM debt funds have been boosted by $28bn of inflows. 

High grade funds recorded their 22nd week of inflows. Despite getting into August, inflows to the asset class remained strong. High yield funds retraced back from negative territory with a marginal inflow. As shown in chart 13, inflows emanated mainly from global and European funds, while US-focused high yield funds recorded outflows.

Government bond funds recorded their second week of inflows. Money Market funds flows also remained positive for a second week.
Outflows from European equity funds continued for a 27th consecutive week. The intensity of the outflows – which peaked in mid-July – has been slowing down over the past four weeks.

EM global debt funds recorded a sixth week of inflows, but the summer season is taking its toll on the flow strength. Commodity funds recorded their 16th consecutive inflow, the 31st so far this year, and the highest in four weeks.
Looking at duration, all parts of the IG curve recorded strong inflows. Short-term funds recorded their third consecutive inflow, slightly lower than the previous week, but still high in AUM % terms. Mid-term IG funds had their seventh week of inflows, while longterm ones had a sixth positive week." - source Bank of America Merrill Lynch

We might be sounding like a broken record, at least for our "Cult of Reason" members, but, the "Supreme Beings" of various central banks are not only pushing investors outside their comfort zone into credit risk they should not be taking, they are also pushing them into increasing significantly duration risk rest assured. Some are indeed racing into the "beta" transformation game into "alpha", in a dwindling liquidity world, this will not end well, but, for the time being it's "rally monkey" time for the Cult of the Supreme Being Members.

While we are indeed tactically bullish for "religious" reasons, we do think that we are witnessing the final melt-up in risky assets given that many signs are starting to add up when it comes to gauging the state of the credit markets. 

When it comes to "Bondzilla" the NIRP monster now close up to $13.4 trillion, we expect the Japanese to come back into play in September thanks to additional "unconventional" measures from the Bank of Japan, and their "zealous devots". 

In a world turned upside down by rising "financial repression", Bondzilla's growth is evidently more and more "Made in Japan". This can be clearly seen in the below Nomura chart from their Flow Monitor note of the 8th of August entitled "Lifers’ foreign bond investment reached a record high":

"Japanese foreign portfolio investment accelerated in July. Excluding banks, Japanese investors bought JPY3287bn (USD32.2bn) of foreign securities in July, a much higher pace than in June. Life insurance companies’ foreign bond investment continued to accelerate, although we judge most was on an FX-hedged basis. Toshins also increased foreign investment in July. On the other hand, pension funds decreased their foreign investment. Although retail investors’ foreign investment is likely to stay weak for now, their risk appetite for foreign investment should improve thanks to the supplementary budget. Pension funds will probably remain dip-buyers, but their additional capacity to buy foreign securities also increased. 

Foreign portfolio investment stayed strong in July 

According to the International Transactions in Securities for July, released on 8 August by the MOF, Japanese investors bought a net JPY6,365.6bn (USD62.4bn) in foreign securities (equities and intermediate and long-term bonds). Since banks were major net buyers of foreign bonds at JPY2,685.7bn (USD26.3bn), this represents a sharp gain over the previous month (JPY2,453.0bn in net buying). If we eliminate the bank accounts that carry out FX-neutral short-term trades, net buying amounted to JPY3,286.5bn (USD32.2bn) in July. This is a major increase in net buying over the previous month (JPY2,311.7bn in net buying; Figure 1).

The breakdown by asset shows that Japanese investors were net buyers of JPY522.8bn (USD5.1bn) in foreign equity, flat over the JPY525.6bn in net buying the previous month. At the same time, they were net buyers of JPY2,763.7bn (USD27.0bn) of foreign bonds, up sharply over the previous month (JPY1,786.1bn in net buying).

Lifers bought foreign bonds at the highest pace
Life insurers bought a net JPY2,037.8bn (USD20.0bn) in foreign bonds, the highest net buying since these data began to be compiled (Figure 2).

This is also the eleventh straight month of net buying. With 20yr JGB yields near 0%, foreign bond investment has picked up sharply as lifers look for even slightly higher yields. Although JGB yields have risen to the 0.3% range again, we expect foreign bond investment to continue at a pace of more than JPY1trn per month if yields remain at current levels.
That said, we expect most of their foreign bond investment to be hedged. Although USD/JPY rose to the 107 range in mid-July in response to heightened expectations of BOJ easing, lifers took a cautious view of the July BOJ policy board meeting. They likely bought hedged foreign bonds and also increased currency hedges. Accordingly, despite a large amount of foreign government bond investment, upward pressure on USD/JPY should be minimal, in our view. Nevertheless, some lifers seem to be starting to buy unhedged foreign bonds at rates near JPY100.
With the US presidential election about to get under way in earnest, we see little chance of investments in unhedged foreign bonds picking up significantly. We expect lifers to continue investing primarily in hedged foreign bonds in the near term. " - source Nomura

While the ECB and now the Bank of England are in the corporate bond buying business making the "fun" going "uphill" thanks to the "wealth effect" and in no way flowing "downhill" to the "real economy" that is, the Japanese investor crowd is ratching up its bidding as the competition for financial assets rises.

A good illustration of the success of the Cult of the Supreme Being, when it comes to "capital destruction" can be seen in Japanese's net household savings rate thanks to "financial repression" as well as major demographic headwinds as illustrated in the below chart from Deutsche Bank's Japan Economics Weekly note from the 5th of August entitled "Inconsistency of policy to promote 'savings into investment'":

"Japanese households have been said to be persistently highly risk-averse, with a strong preference for financial assets with principal guarantees. This tendency has been structural, both in the bubble era and now. Financial flows from households since the end of the 1990s show continued inflows into principal-guaranteed financial assets, including cash, deposits, government debt, insurance, pensions and corporate bonds, with the exception of 2006-08. In the most recent years, fiduciary trusts have become popular, mainly for inheritance reasons, although inflows to these assets remain small.
The Japanese government plans to expand the eligibility for the personal defined contribution pension system (personal DC) to house wives, employees in the government sector, and those in the private sector whose employers are equipped with corporate pensions. The eligibility is said to expand by 26m people. The personal DC account has tax benefits of 1) fully deductible contributions from income, 2) no tax on investment returns and 3) taxdeductible benefits after retirement. These are much more generous than NISA (Nippon Individual Savings Account), which was introduced in January 2014, with active accounts of 2.9m. NISA’s sole tax advantage is #2 above. We believe that financial inflows from households into the expanded personal DC will likely be JPY3.1tr a year, twice the size of the inflows via NISA. However, a large part of these new inflows should go into principal-guaranteed assets.
We are curious about the effect of the introduction of these investment schemes with tax benefits on the household saving rate, which has been stuck near zero over the past ten years. Considering various strong headwinds against target savers, such as lack of income growth and inability to save, strong preference for principal-guaranteed assets, persistent low interest rates, QQE for more than three years and the introduction of negative rates in January, we believe that the households could view this expanded personal DC as a tailwind to mitigate those headwinds. This could lead to a continued rise in the household saving rate that began in 2015 well into 2017 and beyond, and might pose a downside risk in the near-term economic outlook. 

The proposition of ‘savings into investment’ contains misleading elements. Investing (in flow terms) in financial assets is nothing more than giving up current-period consumption out of disposable income for saving (in flow terms), regardless of its destination (say, bank deposits or equities). The proposition of mobilizing households’ financial assets (in stock terms) worth JPY1,700tr into investments does forget that these financial assets have already been deployed to the final borrowers, regardless of its channels (i.e., directly through capital markets or indirectly via financial intermediaries). There is no guarantee that the use of these funds by the current borrowers is inefficient and that by alternate borrowers is efficient." - source Deutsche Bank

We will not go back into the false "rethoric" from "The Cult of the Supreme Being" related to the "Savings glut" as we have already touched on this very subject in February in our conversation "The disappearance of MS München". Put it simply, no offense to the "zealous devots" of the "Supreme Beings" but in our book (and also in Claudi Borio's book from the Bank for International Settlements), "financing" doesn't equate "savings", at least in our cult, "The Cult of Reason" that is. If NIRP is killing "savings", there cannot be "proper" financing" to the "real economy" as stipulated earlier on in our conversation.

Furthermore, we keep hammering this, but, our "core" macro approach lies in distinguishing "stocks" from "flows". When it comes to dealing swiftly with "stocks" of Nonperforming loans (NPLs) such as in Italy via "flows" of liquidity, it looks to us that the "Supreme Beings" do not understand that "liquidity" doesn't equate solvency.

Moving one to our second point, while the rally is "technically" driven thanks to "financial repression" thanks to the mischiefs of the "religious cult", we continue to believe we are in the last inning of this credit cycle, making us continue to believe in quality and capital preservation rather than chasing yield for the sake of it.

• Macro and Credit  - While credit spreads are grinding tighter, quality is eroding faster

As we pointed out at the beginning of our conversation, we will continue to monitor closely US Senior Loan Officers Surveys in the coming quarters as it has always been driving the default rate in the past. Of course "flows" are driving the relentless search for yield while "credit tourists" are punting for "beta" but, nevertheless, we do believe that no matter our "zealous" the members of the "Cult of the Supreme Beings" are, the credit cycle is slowly but surely turning. On that note we read with interest Wells Fargo Securities latest Credit Connections note from the 12th of August entitled "The Linchpin":

"Credit spreads remain in a sideways pattern with a bias to grind tighter. We expect this trend to persist as we work through the dog days of summer. With Q2 earnings largely complete, coming in modestly better than expected, and most central banks on holiday, the market has little to focus on other than the regular flow of economic data and the technical underpinnings of demand and supply. On balance, the technical backdrop remains the dominant thread and remains supportive of a firm market tone as inflows to credit more than outpace bond issuance. Conversely, credit quality continues to slowly, but persistently erode as companies borrow money at a much faster pace than they earn it. To be fair, the steady drop in the cost of borrowing has helped alleviate some of the pressure. But with most of the proceeds going toward share buy backs and dividends, the funding gap within the corporate sector continues to expand and leverage is on the rise. Finally, corporate credit valuations look stretched by most traditional measures. Indeed, according to our proprietary fair value model, the current high yield (HY) yield-to-worst (YTW) of approximately 6.37% is about two standard deviations rich. However, when you consider that HY YTW is approximately 600% above the risk free rate, it is easy to understand why the "reach-for-yield" trade continues in an otherwise expensive market. As such, we continue to advocate a Neutral/Market Weight allocation to IG and HY credit to capture current yield, and emphasize sectors that offer "defensive carry." These include IG and HY Communications, IG Utilities, IG Consumer Staples and HY Consumer Discretionary.

Corporate bond prices have been on a steady march higher this year as interest rates have plunged, yield curves have flattened and credit spreads have narrowed following the ramp-up and expansion of quantitative easing (QE) outside the U.S. Although the U.S. Fed has not participated directly in these types of programs, its lack of action and continued dovish stance has effectively endorsed a dramatic loosening of credit conditions around the world (Exhibit 1). As such, the linchpin holding the bullish trade in corporate bonds together is on-going dovish central bank policy. To the extent it continues, credit investors should expect “more of the same,” namely, higher prices, lower yields, flatter curves and tighter credit spreads.
However, should central banks start to dial back, or simply slow, their stimulative policies, then bond prices and credit spreads could be in for a sharp reversal. To be clear, we expect "more of the same," albeit at a slower pace, as sluggish growth and tame inflation should keep dovish policies in place for the time being.

- source Wells Fargo Securities

There could no better illustration of all the "fun" playing "uphill" in the bond market that is, than the above chart. You can indeed put aside the "Great Rotation" marketing ploy by some pundits given, as we stated before, the only "riskless" game for now, worth playing thanks to the "Supreme Beings" is the bond market.

While "The Cult of the Supreme Being" is still thriving, credit investors should be well advised to read the wise words of one of the members of the "Cult of Reason, namely Nassim Taleb from his recently published note entitled "The Most Intolerant Wins: The Dictatorship of the Small Minority":

"The market is like a large movie theatre with a small door. 

And the best way to detect a sucker (say the usual finance journalist) is to see if his focus is on the size of the door or on that of the theater. Stampedes happen in cinemas, say when someone shouts “fire”, because those who want to be out do not want to stay in, exactly the same unconditionality we saw with Kosher observance." - Nassim Taleb

Whereas credit risk is increasing, giving the lower for longer mantra thanks to the macro fundamentals backdrop playing out and financial repression, not only as we have highlighted credit investors have been extending credit risk, they also have extended their duration risk, increasing in effect the duration mismatch between US cash investment grade and its synthetic credit hedge tool the CDX IG series 26 5 credit index as per our final point and final chart below.

• Final chart: US Investment Grade credit - Growing duration mismatch between cash and synthetic

While we have been recommending since the beginning of the year to favor quality over quantity (High Yield and size of the coupon that is...) through US Investment Grade credit and extended duration us, being in the camp of "lower for longer", credit investors have had no choice bit to take on both more credit risk as well as duration risk thanks to "The Cult of the Supreme Being". Our final chart comes as well from Wells Fargo Securities latest Credit Connections note from the 12th of August entitled "The Linchpin" and illustrate the growing duration mismatch between "cash" and "synthetic":

"While IG26 is a reasonable, liquid hedge for IG cash bonds, it does have some limitations. 

First, there is a meaningful duration differential. IG26 has a current duration of about 4.7 years, compared to the cash bond index of 7.5. Not only is there a difference in aggregate duration, there is a meaningful difference is where that duration comes from. Increasingly, the spread duration in the cash index is being driven by the long end of the curve, where durations continue to extend due to lower coupons.

Implications for Investors 

First, to fully hedge out a market-based cash portfolio with 7.5 years of duration, would require an extra 60% of protection to result in a CR01 neutral portfolio. The extra hedging costs would still leave the trade positive carry as even an additional 60% would only cost 114 bps based on today’s current index levels. For IG investors hedging CR01 is, in many ways, just as valuable as hedging the default risk, as the risk of spread widening is more clear and present for IG companies than actual defaults.
A second consideration is the contribution to duration within the IG market. With the long end being so key to IG investors, movements in the shape of the credit curve are also important. As a result, CDX, while a reasonable proxy for the overall IG market, can be less effective in periods of significant under- or outperformance from the long end of the market. For example, the overall market widened 32 bps in 2015, as front-end spreads widened 19 while long-end spreads widened a full 43 bps. By contrast, IG CDX widened only 22 bps." - Wells Fargo Securities

This means that as hedging tool, one would need to compensate for the extended duration rise in the cash market and needs to buy more "protection" to hedge a cash investment grade credit portfolio if ones wants to be "duration neutral" that is.

Finally for our parting quote, when it comes to "The Cult of the Supreme Being" we would like to end up our conversation with yet another extract from Florin Aftalion's 1987 seminal book entitled "The French Revolution - An Economic Interpretation", over the issues and discussions surrounding the "assignats" and what the abbé Maury, a deputy on the Right had to say about them at the French National Assembly during the French Revolution:

"What is one doing when ones creates a paper currency? One is stealing at sword point. Every man in France who owes nothing, and to whom everything is owed, is a man ruined by the paper currency. Have we the right to bring about the ruin of even a single one of our fellow citizens?" - Abbé Maury, extract from "The French Revolution - An Economic Interpretation" by Florin Aftalion, 1987

Stay tuned!

Low rates environment and the risk of evergreening à la Japanese

In this new environment, corporate balance sheets appears to be in outstanding shape whereas banks balance sheets still appears to be bloated with toxic assets (non-performing loans).

This is can be reflected in the massive divergence between the Itraxx 5 year CDS Main index in Europe (125 CDS names) versus the Itraxx Financial Senior 5 year index:

As you can see the spread is now at around 62 bps between both indices.

UK Banks sub debt is as well following the trend for wider SUB CDS 5 year spreads, as of the 12th of December as indicated below:

As illustrated below, some corporate CDS 5 year spreads are tighter than both sovereign as well as banks senior CDS spreads, in this example, large European Chemicals versus Banks Senior 5 year CDS spreads:

It is interesting to see that Rabobank being one of the only AAA rated bank in the world, is trading wider than single A rated BASF as well as Dow Chemical currently rated BBB- by S&P, the lowest investment-grade rating.

Reason being is the following, corporate leverage has continued to decline in the third quarter of 2010, approaching its lowest level in two decades. In addition to this, large corporations are sitting on very high level of cash. They have been hoarding cash.

U.S. companies are hoarding almost 1 trillion USD in cash!

As per Reuters:
Cisco Systems (CSCO.O) has the largest cash balance, at 39.86 billion USD, Microsoft (MSFT.O) is second with 36.79 billion USD according to Moody's. Google (GOOG.O) has the third-largest balance with 30.06 billion USD, followed by Oracle (ORCL.O) with 23.64 billion USD and Ford Motor Co (F.N) at 21.89 billion USD.

Technology companies held the most cash as a sector, at $207 billion, followed by pharmaceuticals with $124 billion, energy at $105 billion, and consumer products with $101 billion, Moody's said.

They are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty.
Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet.

These are effects you can see in a balance sheet recession as I posted earlier in "Honey I shrunk the balance sheet"

The deleveraging process will take years.

In relation to the title of the post, in the latest speech of the Governor of the Bank of Canada (thanks TPC for posting the link on your site pragcap.com), Mark Carney clearly highlights the risk of a prolonged low rates environment and the risk of creating asset prices inflation (a must read):
http://www.bankofcanada.ca/en/speeches/2010/sp131210.html

"Past experience has shown that low policy rates allow “evergreening,” or the rolling-over of non-viable loans. The classic example was Japan in the 1990s when banks permitted debtors to roll over loans on which they could afford the near zero interest payments but not principal repayments. By evergreening loans instead of writing them off, banks preserved their capital, but this delayed necessary restructuring of industry. Moreover, the presence of non-viable (or “zombie”) firms limited competition, reduced investment and prevented the entry of new enterprises."

Spot on Mark Carney! What crucified Japan in its lost decade were its zombie banks evergreening their toxic assets. It is better to restructure and fast. As I blogged about Ireland in September (Zombieland 2...The sequel...), Ireland is impaired by its zombie financial system.
In relation to the current predicament of US banks, I have argued as well the need for a new Resolution Trust Corporation (RTC II), similar to the one established following the Savings and Loans Crisis in the nineties.

What is as well outstanding from the speech from the Governor of the Bank of Canada is how well Canada has managed its financial sectors using strong regulations and using "selected use of macro-prudential measures" as a third line of defense. I hope the FED and Bank of England are taking notes. Outstanding work. Canada is indeed Canada, a great exemple of successful structural reforms and efficient banking regulation.

"In broader asset markets, counter-cyclical capital buffers can be deployed to lean against excess credit creation. Importantly, following the agreement of G-20 leaders in Seoul, the Basel Committee endorsed the Canadian-led proposal for this framework."

The role of Central banks as so clearly illustrated by Canada should be extended to prevent the creation of credit bubbles. Alan Greenspan, Ben Bernanke please read carefully, you might learn something...

"In the housing market, the Canadian government has already taken important measures to address household leverage. These include a more stringent qualifying test that requires all borrowers to meet the standards for a 5-year fixed-rate mortgage as well as a reduction in the maximum loan-to-value ratio of refinanced mortgages and a higher minimum down payment on properties not occupied by the owner."

As a reminder about the Austrian Business Cycle Theory:

http://en.wikipedia.org/wiki/Austrian_business_cycle_theory


"Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory."

Quod erat demonstrandum

In the post "The inflation debate or why you can have inflation in a deflationary environment", I reviewed the Austrian Business Cycle Theory in conjunction with Fisher's formulation of debt deflation and the following chain of consequences.

Those who cannot remember the past are condemned to repeat it."
George Santayana (16 December 1863 – 26 September 1952)

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867
I used this quote in "Creative destruction and the Minsky moment" in May 2010, at the start of the Greek sovereign crisis.

Financial fragility levels move together with the business cycle.

In relation to banks current conundrum with their impaired balance sheets bloated with toxic assets, Mark Carney stated in his speech: "For example, over the past year and a half, banks have used low short-term funding rates to rebuild capital by investing in long-term government bonds. This strategy is effective to a point, provided complacency does not set in over the duration of low policy rates. Making consistent positive carry may diminish the sense of urgency with which banks reduce leverage or write down bad assets. Financial institutions may also take this game too far, underestimating the risks."

It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery.

I will conclude this post quoting again the Governor of the Bank of Canada, "a massive deleveraging has barely begun across the industrialised world."

"Cheap money is not a long-term growth strategy. Monetary policy will continue to be set to achieve the inflation target. Our institutions should not be lulled into a false sense of security by current low rates."