Macro and Credit - The Butterfly effect

"The foolish are like ripples on water, For whatsoever they do is quickly effaced; But the righteous are like carvings upon stone, For their smallest act is durable." -  Horace

Watching with interest the retreat in government bond yields, thanks to overall dovishness from our "Generous gamblers" aka central bankers including recently ECB's Le Chiffre (Mario Draghi), leading to renewed inflows into High Yield and equities in the US making new records in the prospect, with a continuation of the bull market in complacency, we reminded ourselves for our title analogy of the much used "Butterfly effect" narrative. While the "Butterfly effect" is the concept that small causes can have large effects and was initially used in weather prediction, in chaos theory, the sensitive dependence on initial conditions in a nonlinear system such as financial markets can lead to large differences in a later state of a credit cycle. The name was coined by American mathematician, meteorologist and chaos theory pioneer Edward Lorenz.

Our chosen analogy is also a veiled reference to US Treasuries Butterfly, given we think it is showing us that the US economy to some extent is tracking Japan. The butterfly spreads formed by the gaps between short, medium and long term US Treasury yields has been narrowing with Japan as of late:

- source Bloomberg 

In this week's conversation, we would like to look at what continues to provide inflows and support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan". 

Synopsis:

• Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets
• Final charts - Financial conditions? The punch bowl is still plentiful.

• Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. 

While 2016 was a record year in terms of foreign bond purchases by Japanese Lifers, 2017 was more tepid thanks to European elections risk, but according to Nomura in their JPY Flow Monitor note from the 21st of July, Insurance companies bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row:

"Insurance companies: Insurance companies kept purchasing foreign bonds in June, but momentum remained relatively weak (Figure 1). They bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row. They tend to be net buyers of foreign bonds in June, and the amount of net purchases was not significant (see “JPY: Season of seasonality”, 2 March 2017). Their investment in JGBs slowed to JPY171bn ($1.5bn). We expect lifers to keep purchasing foreign bonds, as major lifers’ investment plans suggest JGB yields will remain unattractive (see “BOJ review: Waiting longer for tailwinds”, 21July 2017).

Banks: Banks were net buyers of domestic and foreign bonds in June for the second month in a row (Figure 2).

They were large net sellers of bonds in April, but as seasonality shows, they resumed purchasing bonds in May and June. Foreign bond investment has slowed from May, but the FX impact was limited, in our view.

Pension funds: Trust banks, which manage pension funds’ money, kept purchasing foreign securities in June for the third month in a row (Figure 3).

The pace of net purchases slowed to JPY132bn ($1.2bn) though. Pension funds were also net buyers of domestic equities for the first time in five months. They bought JPY236bn ($2.1bn) of domestic equities, the biggest amount since August 2016. They were net buyers of JGBs too (JPY411bn or $3.7bn). The GPIF’s latest portfolio data up to end-March showed the fund’s portfolio is closer to its target portfolio. However, it accumulated short-term assets at a high level, and the president of the fund said the accumulation of short-term assets is to enhance available capacity for the next investment. Diversification from short-term assets into portfolio assets should continue for the time being as European political uncertainty has diminished. We expect pension funds to be dip buyers of foreign bonds and equities." - source Nomura

Not only for Japanese Lifers, but also for retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years as per Barclays JPY Monthly Flows noted from the 20th of July:

• "Japanese institutional investors continued to buy foreign bonds, but net outflow slowed down from last month. By investor type, banks and trust banks remained net buyers of foreign bonds. Meanwhile, life insurers continued to purchase foreign bonds. Foreign equity investments also decreased slightly in June, led by banks and bank trust account. Weekly data indicates that a net purchase of foreign bonds by Japanese investors turned positive again in the first week of July amid yield curve steepening globally since the end of June. Regional breakdown of foreign bond flow shows that Japanese investors turned net buyers of US, German and French bonds in May (Figure 1).

• Among retail investors, toshin funds remained popular while net issuance of foreign-currency-denominated uridashi bonds decreased somewhat in June. In bonds, INR- and RUB-denominated uridashi bonds continued to attract solid demand from investors. As for toshin funds, BRL-denominated funds increased for the first time since January this year and TRY- and INR-denominated funds continued to tick higher. Margin FX investors reduced their net long positions in USDJPY and AUDJPY notably and increased their short EURJPY and GBPJPY positions.

- source Barclays

Clearly, for Japanese retail investors, it has all been in recent years about low bond volatility and "king dollar". We continue to believe that when it comes to global flows, Japan matters and matters a lot. Japanese yen is indeed the source of the carry trade on a global basis and this has very significant implications from a tactical perspective when it comes to foreign bonds overall. Since the implementation of NIRP in 2016, Japanese Lifers went into "overdrive" in their purchases of foreign bonds. No surprise therefore that, when it comes to the "Butterfly effect", Bondzilla's appetite has been increasing at a rapid pace. 

You might be wondering where we going with the reference to the Butterfly effect and the importance of Japan but for US credit markets, Japan matters as well and matters a lot. Back in March 2017 in our conversation "Outflow boundary", we indicated the following:

"The big question, as we await the allocation decision from our Japanese friends, if there will be enticed again by foreign bonds like they have in recent years. The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment." - source Macronomics, March 2017

For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments.  

One thing that appears clear to us is that USD corporate credit in recent years has been supported by a large contingent of foreign investors in particular Japan. Reading through UBS Credit Strategy note from the 21st of July entitled "Where are we in the credit cycle?" we were pleasantly surprised that indeed, Bondzilla the NIRP monster is "made in Japan" and it is as well a critical support of US credit markets:

"Our deep dive analysis isolates Japan as the critical support for US credit"

- source UBS

Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk. 

The latest dovish retreat from our "Generous gamblers" (Fed and ECB) has created a "Rebound effect" as posited last week in the sense that is has not only prolonged the goldilocks state in credit markets with spreads tightening further for a longer period in this credit cycle, but, equities wise, it has provided additional strong support as well. Summer 2017 has led to record stock indices and all time spread tights in many instances. For now it seems it is "carry on" and we are indeed in the final melt-up of this last inning of the credit cycle risky assets wise. For many it continues to be the most hated bull-market in history. So far it seems our gamblers are reluctant in removing too early and too fast the credit punch bowl. For the moment the credit love boat is still sailing strong during this summer lull and unless we see some exogenous factors coming into play, it is difficult to see what could be a catalyst for a reversal before September where the Fed and the ECB could decide to tighten the financial conditions spigot as per our final charts.

• Final charts - Financial conditions? The punch bowl is still plentiful.

As we have seen recently, the Butterfly effect from the hawkish comments from Le Chiffre aka Mario Draghi led to a mini-tantrum in the Euro government bond space. Obviously the recent tone down in the rhetoric from both the Fed and the ECB has led to a continuation of "goldilocks" for risky assets thanks to record low volatility. Given the current financial conditions on both side of the Atlantic, it remains to be seen if our "Generous gamblers" will maintain further their dovish rhetoric in September. Our charts below come from Nomura and displays the US and Euro area financial conditions and comes from their recent Japan Navigator notes:

"Euro area and US policymakers are likely concerned about riskier asset rally;

Japanese policymakers may welcome it

This week 40yr and 2yr JGB auctions will be held. Japanese CPI data will be released.

The FOMC meets.

This week’s ECB announcement and market reaction have strengthened our conviction that the global yield upcycle that started from the euro area in late June has faded. We believe bond markets will move substantially only in September, when the Fed and ECB are likely to tighten policy, but only if riskier asset markets remain bullish despite Fed and/or ECB action. During this period, yields are likely to trade in a fairly narrow range, with risks on the downside, in our view. Riskier asset markets may strengthen and prevent yields from rising, but they tend to destabilize in the summer, particularly because US growth expectations are unlikely to rise.

UST yields have begun to fall. Although the market had become bearish owing to momentum from the euro area government bond (EGB) market, it lacked bond-negative factors (Figure 1).

There have been fairly strong concerns over US growth and inflation, and August data will likely be interpreted with scepticism – at the very least, a single month’s worth of data are unlikely to dispel these concerns, in our view.

We believe the ECB and Fed will look to tighten policy further if the output gap continues to improve and the riskier asset rally continues, even as they express concern about slow inflation growth, in our view. However, the Fed and ECB are unlikely to have an opportunity to jawbone until the Jackson Hole symposium in late August. Although the BOJ has emphasized its dovish stance, we believe it has basically the same stance as the Fed and ECB, and is unlikely to adopt an easing stance again as long as the output gap continues to improve. However, if JPY strengthens on risk aversion this summer, the market’s easing expectations may rise again, if only temporarily.

Compared with the Fed and ECB, the BOJ appears more tolerant about an increase in JPY carry trades and a riskier asset rally, and appears to be concerned about how much it can increase its JGB purchases further, rather than ETF buying, in our view. That said, if the BOJ revises its policy framework in such a way as to (erroneously) cause risk aversion, the negative impact on the appointment of the next governor should be substantial. Therefore, we do not expect policymakers to change the upper end of the target 10yr JGB yield range (0.11%) in the near term." - source Nomura

There you go, for now the ECB and the Fed have been mindful of the "Butterfly effects" in risky asset markets, hence the tone down of the rhetoric and insisting on a gradual process in removing the proverbial punch bowl, while the Bank of Japan (BOJ) has so far been in a holding pattern, ensuring in effect that investors in Japan as well continue to play out the low volatility leveraged "carry" play into overtime. No wonder the "Butterfly effect" is made in Japan, maybe it's related to the famous Opera play Madame Butterfly by Giacomo Puccini where the hero was so excited to marry an American that she had earlier secretly converted to Christianity or like Bank of Japan to central bankers' current religion we wonder. It didn't end well for Madame Butterfly in the end but we ramble again...

"See, the night doth enfold us! See, all the world lies sleeping!" - Giacomo Puccini

Stay tuned !

Macro and Credit - Narrative paradigm

"The first step towards philosophy is incredulity." - Denis Diderot, French philosopher

Watching with interest hard data becoming softer with the latest weak US CPI (-0.3%) and disappointing retail sales falling by 0.2% (0.1% fall expected), when it came to choosing our title analogy we reminded ourselves of the Narrative paradigm, a theory proposed by 20th century scholar Walter Fisher. It stipulates that all meaningful communication is a form of storytelling or reporting of events. It promotes the belief that humans are story tellers and listeners and are more persuaded by a good story than by good argument. Because of this, human beings experience and comprehend life and financial markets as a series of ongoing narratives, each with its own conflicts, characters, beginning, middle, and end. In his theory Walter Fisher believed that all forms of communication that appears to our reason are best viewed as stories shaped by history, culture, and character. The ways in which financial pundits and the Fed have been selling us the "Trumpflation" and "recovery" story justifying the hikes in interest rates have more to do with telling a credible story than it does in producing evidence or constructing a logical argument we would argue, hence our chosen title. These pundits, like the Fed are essentially storytellers and each individual chooses the ones that match his or her values and beliefs. Obviously, the test of the narrative rationality is based on the probability, coherence, and fidelity of the stories that underpin the immediate investment decisions to be made. Unfortunately, these "Jedi tricks" do not function well with us. We must confess that we never bought the strong dollar narrative story that everyone piled into. As of late, the latest raft of hard US macro data has pushed us to revisit a US long duration exposure. It seems to us that US GDP for Q1 2017 is going to be most likely more disappointing than Q1 2016, therefore we have gone with the narrative rationality of MDGA (Make Duration Great Again) from a tactical perspective but we ramble again...

In this week's conversation we would like to look at 

Synopsis:

• Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?
• Final charts - Credit, the only easy day was yesterday...

• Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?

At the end of March in our conversation "Outflow boundary", we argued that it was important to focus on what our Japanese friends such as GPIF, Lifers and Mrs Watanabe were doing in terms of foreign bonds allocations.  At the time we also added:

"The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment" - source Macronomics, March 2017

We also note that our tactical bullish US long bonds allocation since our recent post was validated:

"Now, if US long bonds yields such as 30 years continue receding, then indeed our contrarian stance of once again dipping our toes in long duration exposure (ETF ZROZ - TLT) and adding to Investment Grade credit with higher duration as well could be tactically enticing. We are watching closely the 3% level on the 30 year." - source Macronomics, March 2017

With the 30 year US bonds now at a yield of 2.89% supported mostly by geopolitical woes in conjunction with recent weaknesses in hard data such as CPI and retail sales. As we pointed out in our recent musings including our most recent one, we were eagerly anticipating a return of the Japanese investment crowd in US Treasuries and US credit thanks to an improving cross-currency basis. We also highlighted last week that European domiciled accounts had been front-running the Japanese investment crowd, which has now entered its new fiscal year. The big question one might ask in the current "Narrative paradigm" is as follows: are the Japanese back in town when it comes to their foreign bonds purchases?

One clear trend seen in recent years has been Bank of Japan's QE programme between December 2012 and June 2016 which has enticed large inflows into the US bond markets as displayed in Nomura FX Insights note from the 10th of April entitled "Where has the ECB QE Money gone":

- source Nomura

Is this time going to be different? We wonder. There is currently a clear avoidance in terms of allocation by the Japanese investment crowd for French Government bonds given the looming French elections. There is as well prevailing uncertainties from the new US administration when it comes to fiscal policies. What appears to be the case is that the current level of uncertainties is clearly slowing the return of the Japanese crowd this time around.

Also, the recent bout or "risk-off" with USD/JPY trading through the significant 110 level is somewhat probably dampening the velocity in the return of this specific investment crowd. On this subject we read with interest Bank of America Merrill Lynch Liquid Insight note from the 13th of April entitled "New fiscal year, new flow":

"New fiscal year, new flow

Japan entered the new fiscal year this month. Last week, we argued JPY strength may be overdone and that the USD/JPY’s medium-term uptrend has not ended despite a near-term possibility of further technical sell off through 110 where we stop out (Is JPY strength justified? 105 first or 117? 07 April 2017). In our view, global risk events may not fully explain the extent of JPY strength, and flow dynamics could have been behind the JPY strength. With new data from the balance of payment statistics, we argue the demand/supply balance of USD/JPY should be improving especially after an eventful April.

Japanese money in the new fiscal year

We have seen a notable slowdown in foreign securities purchases by Japanese investors since the US election in November (Chart of the day).

The slowdown probably reflects position unwinding among bank accounts and a wait-and-see stance among the Japanese real money community amid a volatile Treasury market in the final months of the Japanese fiscal year (Chart 1-Chart 2).

Banks could continue to unwind Treasuries, but it would involve little FX impact as they usually fund these investments in the USD, unlike real money accounts we discuss below.

Lifers – more USD buying

There is a seasonality of increased foreign bond purchases by insurance accounts during the early part of Japanese fiscal year. This year, we observe (1) rising yields in the JGB’s super long sector, but still at a relatively low level; (2) lower FX hedge cost; and (3) higher US yields, and (4) a lower USD/JPY (Chart 4).

True, it is unlikely they would be very aggressive in unhedged foreign bond investments as investors would balance across JGBs, hedged foreign bonds, and unhedged foreign bonds. For now, the USD/JPY at 110 may not attract strong demand, but we believe the USD demand will increase in the next few months once we go through April full of risk events or if we get renewed optimism for the US tax reform.

Trust accounts – market stabilizer

Trust accounts continued to sell rising assets and buy falling assets last quarter as the GPIF portfolio has presumably been close to its target for some time (Chart 5).

Going forward, a traditional risk-off market, as we currently observe, would likely be met by selling of domestic bonds (and potentially foreign bonds) and buying of domestic and foreign equities by pension funds. Reflation trade would be met by selling of foreign and domestic equities and buying of foreign bonds (and potentially domestic bonds) by pension funds.

Exporters’ hedging

Another source of the earlier USD/JPY weakness may have to do with Japanese exporters’ hedging activity into the fiscal year-end. Japan’s trade balance has been rising in light of stable oil prices and rising real exports (Chart 7).

There is a possibility the final months of the fiscal year generated additional USD selling.

As FY17 starts, we think corporate hedging should be more orderly, unlike last year. According to the BoJ’s tankan survey, large manufacturers had assumed an average USD/JPY rate of 117.5 heading into FY16, while the year actually opened at 112s, which led to a severe USD selling pressure last April, in our view (Revisiting the dollar’s 100 yen scenario 07 April 2016). This year, corporates assume an average USD/JPY rate of 108.4 (Chart 8).

Though this may suggest some near-term pressure, the assumption itself seems conservative, in our view. While the improving trade balance may support the JPY over the medium-term at margin, we believe corporate USD selling will be spread out and less intense this year." - source Bank of America Merrill Lynch

Whereas the Narrative paradigm has been so far seen in renewed optimism for US tax reform, the latest raft of hard data makes us wonder how many weeks before we seen again "Bondzilla" the Japanese NIRP monster's appetite return. Our current stance, given the weaker tone in both geopolitical rising tensions in conjunction with a much softer tone in hard data, has pushed us, was we indicated earlier on in our conversation to play the duration game again, in effect front-running the Japanese investment crowd before they are back in town, yet this time around in 2017 with a delay we think. On that point we agree with Bank of America Merrill Lynch's conclusions:

"Flow in the new fiscal year will likely put widening pressure on JPYUSD basis but the magnitude will be less this time

As highlighted above (and here), lifers are expected to start investing in foreign bond markets after the French election, but in the early part of the Japanese fiscal year. Lifers’ outward flow usually pushes JPYUSD basis wider as they try to hedge FX risk. This will likely be no different this time, but we expect the widening pressure will be less and it would be difficult to see JPYUSD basis go wider to last year’s level. At the current level of USDJPY, lifers will be more open to keep their foreign bonds unhedged and some of the contributing factors to the tightening of USDJPY basis since the start of the year are structural." - source Bank of America Merrill Lynch

No doubt the Lifers will come into play in terms of their foreign bonds allocations, and this will also have some impact in the already volatile USDJPY currency pair. What is of interest of course, when it comes to the "Narrative paradigm" is that there are already early signs of the Japanese investment crowd dipping their toes back into foreign bonds as indicated by UBS in the Global Rates Strategy note from the 10th of April entitled "What Japanese Investors Are Buying":

"French bonds overtake US Treasuries as main force behind Japanese selling Japanese investors' post-US presidential election trend of considerable net selling of overseas bonds continues. Weekly flow data underscores how Japanese investors sold ~¥5.4 trillion of foreign bonds from the time of the election to the end of Mar-17.
Today's more granular data release of which individual sovereign bond markets were bought and sold in Feb-17 highlights that French bonds have overtaken US Treasuries as the main force behind the overall selling pressure. This suggests that political risks as of February overshadowed the increasingly attractive currency-hedged pick-up over JGBs offered by French bonds. Separately, we note that the last week of Mar-17 saw the largest net purchases of overseas bonds in six months. However, as this follows the typical pattern around Japan fiscal year-end (.Figure 4), we would caution interpreting this as a sign of a sustainable rebound in Japanese demand for overseas bonds.

 - source UBS

While, yes it might be seen as too early to embrace yet the "Narrative paradigm", in the light of the recent weakness in both the US dollar and hard macro data, we would rather be a little bit early and start tactically adding at least on the long end of US Treasuries, rather than wait for additional signs from the Japanese investor crowd. Some says fortune favors the brave, we would posit that in most occasions it favors the bold contrarian but we ramble again here.

Finally, for our final charts below, as we posited in previous conversations, when it comes to the situation in credit and in particular in 2017, we would rather go for US credit, given it seems to us that Euro High Yield is "priced to perfection" and when it comes to US High Yield we closely follow what oil prices are doing and much less sanguine than we were back at the end of 2015. Yes, the credit cycle seems to be turning, but, it is slowly turning.

• Final charts - Credit, the only easy day was yesterday...

Whereas the second part of 2016 saw a very significant rally in general for US High Yield and in particular for the US energy sector, the rally so far this year has been significant as well, making us wonder if there is any "juice" left given the performance so far. Yet something we would agree with Barclays from their Global Strategy Chart book from the 10th of April is that when it comes to credit we would favor US Investment Grade over Euro Investment Grade. On top of that agreement we also think that, when it comes to credit overall, the only easy day was yesterday:

"Credit was strong in 2016n but easy gains likely behind us" - source Barclays

As we pointed out, foreign demand remains key to not only US credit but as well for US Treasuries, so overall, let's see if indeed the Japanese Investment crowd and Bondzilla the NIRP monster find again their appetite while the "Narrative paradigm" surrounding the "Trumpflation" story fades away.

"Skepticism is a virtue in history as well as in philosophy." -  Napoleon Bonaparte

Stay tuned!