Macro and Credit - The Numbers Game

"Nobody trusts anyone in authority today. It is one of the main features of our age. Wherever you look, there are lying politicians, crooked bankers, corrupt police officers, cheating journalists and double-dealing media barons, sinister children's entertainers, rotten and greedy energy companies, and out-of-control security services." - Adam Curtis

Watching with interest the trade war escalation with Mexico, leading to de-escalation, triggering more volatility in already jittery markets, in conjunction with more dovishness expectations from Central Banks, and with the prospect of the introduction of the so-called “mini-BOT” scheme, named after Italy’s Treasury bills in Italy, when it came to selecting our title analogy in continuation to our previous Chinese game of "Banqi" reference, we decided to go for the Italian game of the "Numbers Game". The numbers game, also known as the numbers racket, the Italian lottery, or the daily number, is a form of illegal gambling or illegal lottery played mostly in poor and working class neighborhoods in the United States, wherein a bettor attempts to pick three digits to match those that will be randomly drawn the following day. For many years the "number" has been the last three digits of "the handle", the amount race track bettors placed on race day at a major racetrack, published in racing journals and major newspapers in New York. 

What we find of interest, before we enter our usual "Macro and Credit" musing is that closely related is a policy, known as the policy racket, or the policy game. 

There is more to our title that meet the eye given Peter Navarro wrote in 1984 (the famous "dystopian" year) a book entitled "The Policy Game: How Special Interests and Ideologues Are Stealing America". 

Peter Navarro being Trump's top trade adviser we find it interesting in the light of the current trade war developments to look more closely at his change of views as put forward by AXIOS in June 2018 in their article entitled "Peter Navarro's radical transformation":

"People think of Peter Navarro, the top White House trade adviser, as President Trump’s mind-meld on tariffs — the most hardline protectionist in the White House. But Navarro used to preach very different ideas in his early career as an economist.

The bottom line: In his 1984 book, "The Policy Game: How Special Interests and Ideologues are Stealing America," that's no longer in print — Axios got a copy from a university library — Navarro sounds a lot like the very administration officials he's sparred with on trade policy. And he argues that tariffs will inevitably send the global economy into crisis.

We asked Navarro what prompted the radical change in his views, and he explained how he went from a free trader to an economic nationalist. In response to "The Policy Game," specifically, Navarro told Axios:

It borders on the comical that Axios would spend so much time on a book written 34 years ago and completely ignore the insights of my later works like the 2006 Coming China Wars, the 2011 Death By China, and the 2015 Crouching Tiger.  Together, these books explain at length why the globalist Ricardian free trade model is broken and urgently needs fixing in the name of both the economic and national security of the United States.
— Peter Navarro

From the book...

"The clear danger of this trend [protectionism] is an all-out global trade war; for when one country excludes others from its markets, the other countries inevitably retaliate with their own trade barriers. And as history has painfully taught, once protectionist wars begin, the likely result is a deadly and well-nigh unstoppable downward spiral by the entire world economy.

If the world is, in fact, sucked into this spiral, enormous gains from trade will be sacrificed. While such a sacrifice might save some jobs in sheltered domestic industries, it will destroy as many or more in other home industries, particularly those that rely heavily on export trade. At the same time, consumers will pay tens of billions of dollars more in higher prices for a much more limited selection of goods. Sacrificed, too, on the altar of protectionism will be the very heart of an international world order that since World War II has successfully changed the aggressive struggle among nations for world resources and markets into a peaceful economic competition rather than a confrontational political or military one."— "The Policy Game," pg. 55

There are multiple passages in "Policy Game" that directly argue against Navarro's current positions. Navarro's go-to argument defending the White House's trade moves has been national security. In a June New York Times op-ed, he wrote:

"President Trump reserves the right to defend those industries critical to our own national security. To do this, the United States has imposed tariffs on aluminum and steel imports. While critics may question how these metal tariffs can be imposed in the name of national security on allies and neighbors like Canada, they miss the fundamental point: These tariffs are not aimed at any one country. They are a defensive measure to ensure the domestic viability of two of the most important industries necessary for United States military and civilian production at times of crisis so that the United States can defend itself as well as its allies."

But Navarro's own book topples that argument as well:

"On the benefit side, protectionism within certain basic industries like autos, steel, and electronics helps to create and sustain an industrial base that, in times of war or national peril, can be shifted to defense purposes, However, this national security argument — and the existence of any benefits resulting from protecting these industries — can be legitimately called into question for several reasons.

First, the existence of any sizable benefits rests on the assumption that import competition in our defense-related industries would not only reduce the size of these industries but also shrink them to the point where they would be too small to support our defense needs. The threshold of danger is a matter of some dispute. How big, after all, do our auto, steel, or electronics industries have to be to keep our borders safe? In spite of this uncertainty, few analysts would argue that import competition is likely to push a nation with as large and mature an industrial base as ours anywhere close to that threshold.

Second, it is highly possible that our defense capability might actually be enhanced — not damaged — by import competition. Without the umbrella of protectionism, our defense-related industries would be forced to operate at lowest cost, engage in more research and development, aggressively innovate to stay one step ahead of the competition, and modernize their plants at a faster pace. Thus, while import competition might shrink these industries, they would be leaner, tougher, more efficient, and more modern and in all likelihood outperform a bigger and inefficient (protected) version of those same industries.

On the national security cost side, the major effect of protectionism is to threaten the stability of the international economic order through a global trade war..."
— "The Policy Game," pg. 82

Navarro lauded the impact of tariffs on saving American jobs in a May op-ed in USA Today, writing:

"There can be no better way to make America — and American manufacturing — great again than to start to rebuild those communities of America most harmed by the forces of globalization. These new facilities will stand as shining testimony to the success of tough trade actions, smart tax policies and targeted worker-training programs."

But he warned against the harmful longer-run effects of tariffs on jobs in his 1984 book:

"American protectionism threatens employment and profits in the export-dependent nexus because it invites retaliation from our trading partners ...

From these direct and indirect effects, it is clear that over time, the major benefits of protectionism — more jobs and higher profits — are largely and perhaps completely offset by a reduction in jobs and profits in export and linkage industries and in those industries vulnerable to the 'end run.' Therefore, the argument that protectionism serves as a jobs and income assistance program must be discounted."
— "The Policy Game," pg. 79-80

And Navarro has emphasized that tariffs won't hurt American consumers, saying on CBS' "Face the Nation" in March that the Trump administration's moves' effect on the prices of consumer goods will be "negligible to nothing."

In 1984, Navarro held a very different view:

"The biggest losers in the protectionist policy game are consumers. Even here. however, 'consumers' do not constitute a monolith, for there are several different consumer categories.

Bearing the greatest burden of protectionism are American retail shoppers who pay over $70 billion annually in higher prices (and reduced consumption) for products ranging from autos, bicycles, and color TVs to shoes, shirts, and cutlery."
— "The Policy Game," pg. 65

We find it very interesting given we already discussed the trend of "de-globalization" in this blog on numerous occasions, particularly again in January 2018 in our post entitled "The Twain-Laird Duel":

"In numerous conversations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Furthermore, in our recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. Protectionism, in our view, is inherently inflationary in nature. To preserve corporate margins, output prices will need to rise, that simple, and it is already happening.

Productivity in the US has been eviscerated. We feel we are increasingly moving from cooperation to "non-cooperation", a sort of "deglobalization". " - source Macronomics, January 2018

It is a theme we approached in January 2015 in our conversation "The Pigou effect" when we quoted the books The Trap and The Response from Sir James Goldsmith published in 1993 and 1994. Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015:

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.

“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

Real wage growth has been the Fed's greatest headache and probably the absence of it has been of the main reasons behind President Trump's election.

For those wondering what comes next, as discussed in January 2018, weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand as a reminder.

We indicated in January 2017 in our conversation "The Woozle effect" the following:

"If indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar." - source Macronomics, January 2017

This we think has the potential to happen in the coming week/months provided there is no deal between China and the United States. The trajectory of real yields matter when it comes to gold.

In this week's conversation, we would like to look at a potential turn in the credit cycle, given the very weak tone coming from the latest US employment report and nonfarm payrolls coming at 75 K on a back of the blunt use of tariffs as economic policy which is already neutering gains from tax cuts.

Synopsis:

• Macro and Credit - Tariffs as a blunt instrument of economic policy? Handle with care.
• Final charts - Fed it taking it "easy" not "easing" yet.

• Macro and Credit - Tariffs as a blunt instrument of economic policy? Handle with care.

On the question of the "misuse" of tariffs as economic policy we read with interest the latest article on Asia Times from our esteemed former colleague David P. Goldman in his article from the 7th of June entitled "How I nailed the May payroll bust":

"Today’s data is a warning to the Trump Administration about the misuse of tariffs as a blunt instrument of economic policy.  The uncertainty generated by the threats to global supply chains from China to Mexico discourages capital investment. The tariffs already in place have taken back almost the whole of Trump’s $930 tax cut for the average American family, according to research by the New York Federal Reserve. That explains why retail sales are growing just 1% a year in real terms.

America’s growth spurt during the past two years has been Donald Trump’s great success. Tax cuts and deregulation (as well as the promise of more deregulation) revived the animal spirits of small business and produced an employment boom. But the president’s reliance on tariffs threatens to undo his good work, and prejudice his chances for re-election in 2020.

Paradoxically, the terrible, horrible, no-good, very bad payroll report is very good news for equities. It will strengthen the position of those among Trump’s counselors who have warned him that tariff wars are bad news for the economy. Sadly, the equity market depends more on how the president reacts to economic news than on the economic news itself." - source David P. Goldman, Asia Times

Already the trade war rhetoric is taking its toll on employment levels with US automakers coming under pressure recently. From China to the U.K., Germany, Canada and the U.S., companies have announced at least 38,000 job cuts in the past six months. Auto demand is increasingly becoming collateral damage when it comes to the ongoing tensions between the United States and China. As we pointed out in our last conversation, Germany is greatly exposed to the rising tensions. This can be ascertained by the latest industrial production print for April falling by 1.9%, the most since August 2014 and four times more than expected. 

As well, inflation expectations have been trending down, particularly in Europe with oil prices down 22% since its April high and as we stated before, where oil prices go, so does US High Yield and in particular the Energy sector as per the below chart from Bank of America Merrill Lynch for the month to date returns for May 2019, with CCCs being highly exposed to oil prices woes (Energy sector = 20.4% of face value, 15.1% of market value):

- source Bank of America Merrill Lynch

As the trade war intensifies, this doesn't bode well for both CAPEX and employment levels. Leaders from G20 countries will convene in Osaka on June 28 and 29 and markets are hoping for a deal between China and the United States.

In a context of weakening macro data on top of exogenous factors such as rising geopolitical tensions, no wonder the Fed has adopted a more dovish stance leading to market pundits expecting significant cuts to come during the summer hence the significant bounce we are currently seeing on the back as well of the end of the most recent true "Mexican standoff".

But what about the inverted yield curve and the potential for a recession ahead of us, one might rightly ask. On this subject we read with interest Nomura's take from their Japan Navigator note number 826 from the 3rd of June entitled "Inverted yield curve in UST market and monetary policy conduct":

"Many FOMC members have indicated that they would allow inflation rates in the 2.0-2.5% range during an economic recovery, but they are not willing to use average inflation rates from the past to constrain future policy conduct. They have also stated that monetary policy should not be used to pop asset bubbles. We believe that this question of whether the Fed should tolerate an inverted yield curve in the UST market will be a critical subtextual theme (discussed below). However, we believe that Fed Chair Jerome Powell and other mainstream Fed officials do not buy into this idea.

We expect the US-China trade dispute to reach the next stage between 4 June and the G20 meeting on 28 June, where Presidents Trump and Xi could meet. We sense that with every day that passes, markets become more convinced that an agreement between the two countries will prove difficult and a fourth round of US tariffs is on the way. Nevertheless, semiconductor stocks, which are more likely to be directly influenced, began to halt their fall this week, which suggests that the market has priced this scenario in to a considerable degree.

We do not think that a fourth round of tariffs alone would have an impact sufficient to trigger a global economic downturn. Moreover, judging from the actions of Chinese policymakers, they seem to have determined that weakening RMB would represent a risk for China as well (due to capital flight), and there are no signs that they will guide RMB to weaker levels. Unlike many economists, we believe that if negotiations essentially break down and the US goes ahead with more tariffs, China will beef up its subsidies to export companies rather than taking measures aimed at expanding domestic demand, and in this case the damage to China and the global economy would be lower than a simple estimate premised on a reduction in Chinese exports and other countries serving as substitutes. This is because Chinese companies would absorb most of the hit from tariffs and continue to export goods. No matter how much China bolsters domestic demand measures, it is difficult to paint a growth strategy for China’s economy that does not depend on US markets. Moreover, from a US perspective, it is easier to play up a “success” if tariff revenue increases and Chinese companies, rather than US consumers, are forced to bear the load. This kind of scenario suggests a high risk that US rates, which have priced in an economic downturn, will rise. This upturn could occur when the US government officially announces a fourth round. At this point, we expect EM currencies and equities as well as USD/JPY and Japanese equities to rebound, so investors should prepare for this scenario.

If the Fed cuts rates to correct inverted yield curve, it would essentially be trying to fix a problem it created itself

The Fed’s dovish members, centered on Vice Chair Clarida, view an inverted yield curve in the UST market as an important sign presaging an economic downturn, and advocate policy conduct that would avoid such an inversion. In fact, if we look at the three economic cycles since 1980, the yield curve inverted, with yields on 3m Treasury bills higher than 10yr UST yields, followed by an economic downturn (Figure 2).

We believe this inverted yield curve is not simply significant as a sign, but also indicates a situation in which a deterioration in financial institutions’ earnings environment is likely to set off a credit crunch. However, there are many problems with simplifying this issue and arguing that monetary policy should be conducted to avoid an inverted yield curve. 1) Inverted yield curves occur when the market begins to anticipate a future rate cut, but the market tends to almost automatically move in this direction when the Fed sends the message that it will end rate hikes. 2) In past cycles, there has been a lag of at least six months to two years before the economy enters a downturn after the end of rate hikes (Figure 3).

3) There have been cases, such as in 1998, when the yield curve has inverted, but the yield curve has returned to normal levels as the economy recovered. In other words, if the Fed itself decides to cut rates to correct the yield curve, which inverted in response to the Fed’s own message, it would essentially be fixing a problem of its own making. Of course, if the Fed can accurately predict the economy’s cycle (i.e., even if it stops raising rates, an economic downturn in the near future is inevitable), the Fed could probably use policy to minimize the damage of an economic downturn. However, if this is not the case, a premature rate cut could exacerbate the asset bubble and worsen the damage done by a future economic downturn. In fact, in the aforementioned 1998 example, the IT bubble worsened after the Fed cut rates.

Does the bond market have better foresight?

In addition, the theory that an inverted yield curve leads to an economic downturn tends to lead to the erroneous perception and belief that the bond market is better at predicting the economy than equities and other risk assets. However, this is simply due to differences in these financial instruments, and does not indicate any particular capacity for judgment. While bonds tend to perform better in economic downturns and periods in which inflation is falling, most risk assets are just the opposite. As a result, in economic recoveries, risk assets, not long-term yields, tend to identify the signs of a recovery and rise accordingly. Moreover, as noted above, the time lag from the inverted yield curve to an economic downturn differs considerably depending on the cycle. For example, in the cycle in the 2000s, after the yield curve inverted (from July 2006), the economy continued to expand for almost two years, and during this period long-term UST yields fell and then rose again, reaching their highest point in this cycle (June 2007). The subsequent subprime (Paribas) shock in August 2007 all but guaranteed an economic downturn (it officially began in December 2007), and we very much doubt that bond market participants predicted this shock and acted accordingly all the way back in 2006, when the yield curve began to invert.

We believe 10yr UST yields peaked at 3.23% in this cycle, but…

In this cycle, we believe that the Fed raised rates last in December 2018 and 10yr UST yields peaked just before this, in November 2018 (3.23%). As a result, in this cycle as well, observers will likely credit the bond market with having predicted an economic downturn before the risk asset market and acting accordingly (with an inverted yield curve a sign of an economic downturn). However, the bond market has not already accurately predicted the kind of event or shock that would ensure an economic downturn, which we expect to occur in the future. We suspect that, while bond investors continue to price in a rate cut and test out the market, they will coincidentally reach this kind of event. The period of time from now until the economic downturn is not predetermined, and before this event occurs, we expect to see a period (2019 H2) in which the market reverses its excessive rate cut expectations. For this reason, we believe it would make sense to wait for 10yr UST yields to rebound to about 2.60% rather than chasing yields down to 2.30% and buying." source Nomura Japan Navigator No. 826 June 2019

From a tactical perspective, we do believe that the long-end of the US yield curve has been "overbought" and we are already seeing signs of exhaustion, so no surprise to see somewhat a pullback in our favorite proxy being ETF ZROZ (strips of 25 years plus zero coupon). As well, gold is also marking a pause which can be ascertained by a bounce in real yields and the "risk-on" tone prevailing today.

When it comes to our title and the "policy game" being played, we think we are far from any meaningful "cease fire" between the United States and China. Volatility will continue to run high we think and in that context, we continue to view quality credit such as US Investment Grade as more protective than currently high beta, which in the case of US High Yield is tied up to the direction of oil prices. 

As we stated before, we would rather continue playing it on the defensive side given the many uncertainties surrounding a potential trade deal. With this ongoing "Numbers Game", while we might see unfolding a tactical bounce, fundamentals are rapidly deteriorating with this lingering confrontation. On the potential outcome we read with interest CITI's take from their Global Strategy and Macro Weekly note from the 10th of June entitled "Trade Wars: Game Theory Suggests Escalation Risk is Underestimated":

"The uncertainty around the negotiations makes for a challenging backdrop for investors. Recession risk is rising. As our Global Macro Strategy team points out; the 3m10y yield curve inverted on a closing basis for the first time this cycle at the end of May. This, they believe, could start the clock towards a recession mid- 2020. The tailwinds of fiscal policy are fading. Trade wars could be the additional shock that break the resilience of global, and US, economies (see: Global Macro Strategy Weekly: Trade War = Recession).

The GMS team offers three scenarios: (i) a trade deal at the G20; (ii) no trade deal and no Fed easing and (iii) no trade deal and aggressive Fed cuts (75bp quickly). Our current assessment is that we are in Scenario 2 but may be transitioning to Scenario 3.

Scenario One: Trade Deal at G20

• Equities sharply higher with EM significantly outperforming as so much more is priced here for slower global trade growth. SPX~2900
• Yields higher, probably parallel shift higher or bear flattening. 10y yields ~2.5%
• Gold lower, maybe $1300
• USD lower with risk on but not much as Fed easing would likely be priced out to some degree.

Scenario Two: No Trade Deal and No Fed Cuts

• Equities sharply lower, probable full scale bear market. SPX to 2350
• Yields sharply lower with curve twist/ bull flattening. 10yr UST to 1.50%, maybe
• lower
• Gold higher. $1600+
• USD higher bar JPY

Scenario Three: No Trade Deal, Fed Cuts (75bp or more)

• SPX higher; new highs. Other equities mixed.
• Yields lower with bull steepening 10yr UST 1.75-2.0%
• Gold higher on lower rates and lower USD. Target $1500
• USD lower as carry is eroded. EUR/$ 1.15

- source CITI

We think that, right now investors are displaying two cases of "overconfidence", one being the pace and number of rate cuts coming from the Fed, second being a clear resolution between China and the United States when it comes to this much discussed trade war. Fiscal policy results are starting to be obliterated by the blunt use as economic policy instrument of tariffs. They are being used way too much by the Trump administration and it is starting to bite, not only on the employment front but, as well on earnings.

Sure the Fed might be providing some much needed support to the strains already showing up in credit markets such as rising dispersion, but the continuation of the trade war could push the US economy and the rest of the world towards recession and led to a stagflationary outcome in conjunction with wider credit spreads and that would mean trouble ahead we think. We have not reached that point but, playing this trade war game into overtime is a recipe for disaster. In that context, gold prices look likely do well if the trade war escalates further. 

The ongoing trade war could turn into a currency war, further boosting investor appetite for gold hence our negative stance on the US dollar. On the subject of the US dollar's trajectory we read with interest Deutsche Bank's take from their FX Special  Report note from the 5th of June entitled "What happens to the dollar if the Fed cuts rates?":

"We have been worried about global growth and have positioned our FX Blueprint portfolio accordingly for nearly a month now. But what happens if the Fed cuts rates as soon as July or September? How would this impact our views and what does this mean for the dollar? In this special report, we show that Fed rate cuts are a necessary, but not a sufficient condition to drive the dollar weaker.

Near-term, the dollar almost always weakens in the run-up to Fed rate cuts. But dollar weakness usually does not follow through. We argue that the Fed would need to cut rates by at least 100bps for a sustained, large move lower in the dollar. In its absence, an “insurance cut” of 50-75bps will likely keep the dollar mixed with the JPY and CHF continuing to be the primary beneficiaries (they remain our favourite longs), Asia FX the primary casualty (we remain very bearish), and the EUR stuck, though vulnerable to a squeeze higher given market positioning.

If the Fed ends up cutting by a lot more, these conclusions would change however. In the event of a full Fed easing cycle, we would expect EUR/USD to head back beyond 1.20 and dollar weakness across the board, with the possible exception of Asia. Our portfolio at the moment is more closely aligned to the former, rather than the latter scenario.

Low growth tends to be good for the dollar

The dollar has been part of our defensive portfolio together with the Swiss franc and Japanese yen. Historically, the dollar tends to do well in global slowdowns. First, the US is one of the most closed economies in the world so that global slowdowns tend to be asymmetrically reflected in the rest of the world (chart 1).

Second, even though the dollar can’t claim the huge positive internal investment positions of the franc and yen (chart 2), it benefits from the shortage of dollar funding that has been well documented by the BIS, among others .

Fed rate cuts are not always bearish for the dollar

Does the dollar lose its safe-haven status when the Fed cuts rates? The short answer is, sometimes, but certainly not always. We start by looking at the last five instances of Fed easing. Two of these instances were Fed “insurance” cuts (1995 and 1998) while three were full-blown easing cycles (1989, 2001, 2007). The clear conclusion is that while the dollar nearly uniformly weakens into a Fed easing, the subsequent performance is far from consistent. Indeed, the dollar has ended up strengthening in 3 of the last 5 Fed easing cycles. The conclusion is valid for both EM and DM (charts 3 and 4).

What other central banks do matters

So, if Fed rate cuts are not a consistent driver of the dollar what else matters? The interest rate differential is a useful starting point. If the Fed is cutting but the rest of the world is cutting even more it may well be that interest rate differentials drive the dollar higher. This was indeed the case during the 1995 and 1998 insurance cuts which saw rates move sharply in favour of the USD even though the Fed cut (chart 5).

Is this a risk today? Highly unlikely. The US- rest of world differential is already sitting at record extremes and almost every other DM central bank is constrained by the zero lower bound. If the Fed is cutting rates, the rate differential should be worsening for the dollar.

The level of rates also matters

Is a narrowing interest rate differential enough to turn the dollar? It is a necessary, but not a sufficient condition. Take 2001 when the Fed started an easing cycle and rates collapsed against the USD. The dollar continued rallying for a year until it finally turned. What helped? First, the absolute level of US rates which made the dollar a high-yielder (chart 6).

Second, the continued strength in the US basic balance, with the dollar only peaking once the US current account deficit turned sharply wider and the dollar became a low yielder (chart 7 and 8).

Indeed, the broad dollar cycle tends to be more correlated to the absolute level of US yields that the relative changes.

Lessons for today

The dollar is in a remarkable global position today holding the developed world’s highest yields. Never before in the history of free-floating FX has the dollar held such a preeminent position. How much does the Fed need to cut for this to stop being the case? Assuming other central banks follow the forwards, the Fed would have to cut rates by 125-150 bps to a little below 1% for the dollar to lose its high-yielding preeminence. With the rates market pricing a terminal Fed funds of 1.3% we are still one or two rate cuts away from that level. This of course also assumes that central banks with high rates such as the RBA and RBNZ would not cut more than the forwards.

An alternative approach to answering this question is to look at when the dollar lost its sensitivity to changes in yields, i.e. when did the absolute level of rates start dominating over the changes in the rate differential? Looking at the beta of EUR/USD to the EU-US rate differential we note that the sensitivity of rates to FX peaked in 2017, just when the 5-yr rate differential crossed 2%. This differential is now back at 2.3%  so we are still about 30bps away from the relative changes in yields reasserting themselves in importance. Overall, we reach a similar conclusion to the previous analysis: we need to price 1 or 2 more cuts for the level of US yields to again become "low".

Two other important observations

Interest rates aside we would make two other observations. First, the developed market dollar is already at the upper end of its historical valuation bounds (chart 9).

Valuation is a powerful medium-term anchor and a natural constraint to further dollar appreciation. The conclusion is different for the dollar including EM, mostly due to the undervaluation of USD/CNY (chart 10).

This valuation discrepancy between EM and DM would support a conclusion that the dollar has far more room to strengthen against EM – especially Asia, given the nature of the global trade war – even if the Fed cuts rates. The second observation is that US flow dynamics are not sending a particularly strong signal. The dollar is strong but so is the underlying US basic balance, without any large movement either way. In other words, the market is already overweight dollar assets but there are no clear shifts either higher or lower for now.

Conclusion

Putting it all together, we conclude that Fed rate cuts are a necessary, but not a sufficient condition to drive the dollar weaker. We argue that the Fed would need to cut rates by more than 100bps for a broad-based and sustained move lower in the dollar. In its absence, an “insurance cut” of 50-75bps will likely keep the broad dollar mixed with the JPY and CHF continuing to be the primary beneficiaries of weaker growth, EM FX (especially Asia) the primary casualty, and the EUR stuck in the 1.10s.

These relative moves are already broadly in line with our forecasts, but these would change in the event of a full-fledged easing cycle from the Fed back down to zero. In this instance, we would expect the EUR in particular to more broadly participate in a dollar down-cycle, a topic which we will investigate in a future publication." - source Deutsche Bank

If big dollar cycles are dominated by flow as indicated by Deutsche Bank, then again, the dovish Fed has finally triggered a USD sell-off it seems with hedge funds selling from a long position. If flows are indeed turning against the USD, then a US dollar weakness could be sustained.

When it comes to market expectations, and the Fed in this "Numbers game" as per our final charts below we think the Fed is "data" dependent and has noticed the slowdown but is not yet ready to go full on the brakes as the market is expecting in "overconfidence".

• Final charts - Fed it taking it "easy" not "easing" yet.

Taking it easy is not taking it to easing and as per our above discussion we think investors are a little bit ahead of themselves when it comes to the number of cuts expected and the pace. One nonfarm payroll bad number doesn't yet make a trend though the most recent data highlights disappointment and worries from the ongoing trade war. Our final charts below comes from Wells Fargo's Weekly Economic and Financial Commentary from the 7th of June and shows the growing hints of the slowdown in conjunction with the appropriate pace of policy firming:

"Growing Hints of a Slowdown

In the midst of rising prospects of a prolonged and more pronounced trade war, data this week seemed to lend some credence to the idea that the domestic economy is beginning to succumb more materially to all the uncertainty. Nonfarm employers added just 75,000 jobs in May, missing even the lowest forecast, while downward revisions shaved off a further 75,000 from prior months’ reported gains. Average hourly earnings also missed expectations, up 0.2% on the month and 3.1% over the year, the slowest rise since September. The bond market reaction was swift; yields on both the two-year and 10-year immediately fell more than six bps, likely out of a belief that the growing hint of labor market weakness may force the Fed’s hand and induce a rate cut.

Indeed, the market has come to view a cut this year as a foregone conclusion; futures markets have priced in around 75 bps of easing this year. A more defiant stance from the Trump administration towards China and the threat of a new volley of tariffs directed against Mexico are likely driving the pessimism and risk-off attitude. Despite high-level negotiations regarding the U.S.-Mexico border situation this week, 5% tariffs on all imports from Mexico are slated to go into effect Monday, and could rise as high as 25% by October. This latest escalation more than doubles the total value of goods subject to tariffs to around $700 billion and, perhaps more worryingly, brings into stark view the willingness of the administration to use tariffs as leverage for political or diplomatic concessions, dropping even the pretense of an economic rationale. See Topic of the Week for more detail.

The question for the Fed, then, is whether markets are overreacting to trade uncertainty by expecting three cuts in a 3.6% unemployment rate economy. Noted dove James Bullard kicked off the Fedspeak on Monday, stating that a cut “may be warranted soon”, and noted that even if growth does not succumb to trade tensions significantly, lower rates would help bring inflation up to target more quickly. Chair Jay Powell took the baton on Tuesday, saying, “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion”. Markets took these comments and ran with them, as the S&P 500 surged 2.1% on the day and remained buoyant the rest of the week. We would suggest a more leveled view, as his comments are not anything new, per se. Expectations of a ‘Powell put’ may be a bit premature, if we resist reading into his comments too deeply, and in light of Robert Kaplan’s call for patience amidst trade threats that could be reversed as quickly as the president can tweet. John Williams similarly suggested staying on the path of data dependence.

To that end, the ISM manufacturing survey fell 0.7 points to a 31-month low of 52.1, while the non-manufacturing survey rose 1.4 to 56.9, offering some evidence that the divergence between the manufacturing and the much larger service sector is persisting; in other words, the slowdown in the trade and global growth-exposed manufacturing sector has yet to spill over into the broader economy in a major way.

Still, the majority of economic data lags. The cyclical parts of the economy are already slowing, and the uncertainty over the entire economy is already here." - source Wells Fargo

To conclude we see two cases of "overconfidence", one is the pace and number of rate cuts coming from the Fed, the second is a clear resolution between China and the United States. We therefore think it is premature to bet in the "Numbers Game" run by the Fed and we would rather stick to defense and watch a little bit from the sideline rather than going again "all in" on a supposed return of the famous "infamous" Fed put. We don't think we are there yet and what matters for the Fed is financial stability overzealous markets racing ahead we think.

"The more people rationalize cheating, the more it becomes a culture of dishonesty. And that can become a vicious, downward cycle. Because suddenly, if everyone else is cheating, you feel a need to cheat, too." -  Stephen Covey

Stay tuned!

Macro and Credit - Ouroboros

"History is about loops and continuums." - Mike Bidlo, American artist

Reading with interest a summary of the paper co-authored by top-ranking Philadelphia Fed economist Michael Dotsey indicating "no evidence for relying on the Phillips curve", we felt indeed that our latest musing title had been more than appropriate We were amused to see a Monty Pythonesque title from Bank of America Merrill Lynch title when it comes to the Phillips curve: "The Phillips curve: it’s not dead, it’s sleeping" on this subject. Of course this relates perfectly to the Norwegian blue parrot we mentioned in our previous conversation:

- source Bloomberg

You might already ask yourselves why we choose "Ouroboros" as a title analogy. The Ouroboros is an ancient symbol depicting a serpent or dragon eating its own tail. Via medieval alchemical tradition, the symbol Orobouros entered Renaissance magic and modern symbolism, often taken to symbolize introspection, the eternal return or cyclicality especially in the sense of something constantly re-creating itself (like credit cycles). It also represents the infinite cycle of nature's endless creation and destruction, life and death (creative destruction à la Schumpeter comes to mind). The first known appearance of the ouroboros motif is in the Enigmatic Book of the Netherworld, an ancient Egyptian funerary text in KV62, the tomb of Tutankhamun, in the 14th century BC. Also, the alchemical textbook, Chrysopoeia (gold making) of Kleopatra contains a drawing of the ouroboros representing the serpent as half light and half dark, echoing symbols such as the Yin Yang, which illustrates the dual nature of all things, but more importantly, that these opposites are not in conflict. No matter how many tricks (ZIRP, QE, NIRP) used by our modern alchemists, aka central bankers, they cannot alter cyclicality of credit, that simple. Let's be very clear about that. When it comes to our assessment of the credit cycle, it's getting late in the game, and capital preservation is becoming essential. This means starting moving to higher grounds credit quality wise we think.

In this week's conversation, we would like to look at the importance of wages for signs of inflation as we discussed last week. In our previous conversation we indicated that we thought that real wage growth mattered for inflation expectations. Could we be wrong? We will also look at the unintended consequences in liquidity thanks to regulation and the Volcker rule.

Synopsis:

• Macro - Real wages growth? The "deflationistas" have won the war.
• Credit - Credit Supply is cyclical, so is liquidity...
• Final chart - Japanese support for credit - The boys are back in town

• Macro - Real wages growth? The "deflationistas" have won the war.

As we pointed out in our previous conversation, we indicated that the most important point for a rise in inflation expectations had been real wages growth. We also posited in our conversation "Perpetual Motion" in October 2014 that real wage growth would indicate the US would be reaching "escape velocity":

"In fact the Fed's conundrum can be seen in the lag in wage growth given nominal wages are only up 2% yoy whereas real wage growth remains at zero. Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, October 2014

Obviously the latest disappointing Nonfarm payroll for August, still point towards weak real wage growth and it isn't the time for clamoring victory for the Fed. 

In our previous musing we pointed out the amazing work of Jean Fourastié on the subject of real wages, real prices and productivity (which in our humble opinion should have been worthy of a Nobel prize). True capitalism is inherently "deflationist" when it comes to prices. While any aspiring economist and/or central banker should get acquainted with the work of Jean Fourastié, same goes with the work of BCG's founder Bruce Henderson seminal work on the Experience Curve.

For us, there are three main reasons why the Phillips curve is a Norwegian Blue parrot, simply resting in a Monty Pythonesque way:

1. Demographics: as population ages, there are more pressure on aggregate demand and total consumption. 
2. Globalization: real wages have come under pressure thanks to offshoring of labor in different parts of the world, leading to good solid wages jobs in the industrial sector being replaced by low qualification low paying jobs in the service and hospitality sectors.
3. Technology: As per Henderson's work and recent progress in technology, pressure on prices as been appearing thanks to the Experience curve. The fight between Amazon and the retail sector comes to mind we think about it. Technology has been holding down costs overall and facilitated rapid price competition in some sector (internet on retail).

This is why we think the Phillips curve is obsolete, for structural reasons. On the subject of the relationship between inflation and wages we read with great interest Wells Fargo's take from their note from the 31st of August entitled "Do Wages Still Matter for Inflation?":

"Executive Summary

Wage growth has garnered increasing attention in the heavily watched monthly employment reports. The scrutiny reflects the emphasis many Fed officials have placed on the critical link between slack in the labor market and inflation. With wages accounting for a significant share of costs in most industries, it makes intuitive sense that rising labor costs would soon develop into higher inflation. The reality, however, is that wage growth tells us little about future inflation. If anything, the relationship runs the other way, with inflation leading wage growth.

The limited influence of wage growth on inflation reflects the changing structure of the U.S. economy. Technology is making it easier than ever for consumers to compare prices, intensifying price competition. At the same time, globalization has diminished the role of the domestic labor market with a larger share of goods consumed imported from overseas. Finally, the inability of many firms to adjust prices frequently generates the need to set prices in anticipation of future costs, making inflation expectations a more significant driver of inflation than wages.

Watching Wages for Signs of Inflation

The PCE deflator has only briefly brushed the Fed’s 2 percent target since the start of the

expansion (Figure 1).

Nevertheless, most FOMC members remain confident that inflation will move higher from here. In the Committee’s most recent economic projections published in June, the median estimate for where inflation would end the year was 1.6 percent and 1.7 percent for headline and core inflation, respectively, while both measures were projected to end 2018 at 2.0 percent (Figure 2).

Although those estimates will likely come down a tick or two following recent months’ softness, the path remains upward and is a key factor in the Committee’s baseline outlook to further raise interest rates over the next year.

The FOMC’s confidence that inflation will head higher over the next year and a half hinges critically on the assumption that as resource slack is absorbed, upward pressure on prices follows. While resources include both labor and capital, the link between slack in the labor market and inflation garners more widespread attention. As unemployment declines, firms need to pay higher wages to attract and retain workers, and those costs in turn generate the need to raise prices. Over the past couple of years, the unemployment rate has fallen to where it is now below many estimates of full employment, while inflation—headline or core—has remained stubbornly below 2 percent. The result has been to closely watch wage growth as a sign of future inflation.

Wage growth has remained frustratingly low for workers and policymakers alike. After increasing only about 2 percent a year in the early years of the expansion, average hourly earnings began to strengthen in 2015. The uptrend has fizzled by multiple wage measures this year, however, and wage growth remains weak by historic standards (Figure 3).

There are some signs that higher pay may be in the offing. Job openings are at an all-time high, underemployment is shrinking, and the share of small businesses raising compensation is hovering near cycle highs (Figure 4). But even if we see stronger wage growth, will it lead to more inflation?

Wages as a Driver of Inflation: Not What It Used to Be

The relationship between labor market slack and inflation, known as the Phillips Curve, has had its share of critics over the years as it appeared to break down completely (as in the 1970s) or at the very least weaken in recent decades. Nevertheless, Fed Chair Janet Yellen has made comments over the years indicating she is a subscriber of the Phillips Curve and that short-run fluctuations in labor market slack affect inflation. As indicated in the most recent FOMC meeting minutes, however, doubts seem to be emerging among more FOMC members about the link between labor market slack, wages and inflation. Research by Federal Reserve economists has found that the impact of labor costs on inflation has diminished in recent decades.

A simple regression of our own shows that an increase in wages is associated with a smaller rise in inflation than in previous decades. For this we look at the “nominal” component of wage growth, or average hourly earnings growth minus labor productivity since productivity drives real wages. While a one percentage point rise in the year-over-year rate of productivity-adjusted average hourly earnings was consistent with a 0.4 percentage point rise in CPI inflation from 1985 to 2000, that relationship has fallen by half since 2000. Moreover, when determining if in recent decades changes in wage growth cause changes in inflation and are not simply associated with these, we find no statistically significant support. If anything, inflation drives wage growth.

Domestic Labor Costs Only Part of the Story

For most businesses, labor represents a sizable share of costs. This is particularly true for service sector industries, where labor compensation accounts for at least 30 percent and often more than half of input costs. Why then do wages provide so little information about inflation if labor is such a big input cost? Labor conditions have increasingly taken a backseat in inflation dynamics in recent years as the U.S. economy has evolved. Technology has changed the way consumers shop and the way in which businesses offer goods and services. At the same time, globalization has opened up new sources of labor beyond the domestic workforce. And while workers may think about future inflation when negotiating wages, businesses are also thinking about future inflation when setting prices.

Technology: Holding Down Costs and Facilitating Price Competition

Technology seems to have infiltrated every corner of life so it is not a leap to believe it has affected inflation. Technological improvements have always held down inflation by improving the production processes or lowering the input costs of existing goods and services. By making it cheaper to produce products, firms can raise margins without increasing prices. It’s tough to argue, however, that technology in this way is playing a bigger role today in holding down inflation given the weak rate of productivity growth in the last decade. Instead, competitive forces unleashed by new technology have been pointed to as a recent factor holding down prices. The internet has made it easier than ever for consumers to compare prices of goods and services. Nowhere though has competition been more intense than in the retail sector as e-commerce has grown to nearly 10 percent of sales. Yet while increased competition should pressure margins, margins for retailers have held up over the past decade as the shift to online sales has limited the need for costly brick and mortar stores (Figure 5).

The upshot is prices for core consumer goods have been falling for the better part of the past 15 years (Figure 6).

The service sector has not been immune to competitive pressures either. The recent drop in the cost of cell phone services offers a relevant example. However, part of the decline since the start of the year is traceable to quality adjustments made by the Bureau of Labor Statistics (BLS). When the quality of a product improves, the BLS imputes the value of the improvement and downwardly adjusts the product “price” to account for the fact that while the listed price may be unchanged or higher, consumers are getting a better product.

Globalization: Not Just a U.S. Labor Market

Of course, the decline in core consumer goods prices has coincided with increasing global trade. The start of the North American Free Trade Agreement (NAFTA) in 1994 and China’s entrance to the World Trade Organization in 2001 both opened up significant sources of global labor. In 1992, only about one-third of U.S. consumer goods were imported from overseas, but that share has grown to about 55 percent today (Figure 7).

Although goods only account for one quarter of the core CPI, global price dynamics have had a significant, albeit small, impact on U.S. inflation. With foreign-made goods accounting for a larger share of consumption, the cyclical state of the U.S. labor market has lost importance in price setting.

Expectations: Firms Get Ahead of Cost Pressures

Inflation expectations play a more crucial role for inflation than wages. Expectations of future inflation affect firms’ decisions in price setting. As price changes can be costly in their own right, many businesses change prices infrequently. The stickiness of prices generates the need for businesses to make assumptions about future costs, including labor.7 As a result, price changes can precede wage growth, rather than wage growth leading to inflation. While a Granger- Causality test as previously noted shows wages do not drive inflation, the same test shows that inflation expectations are a significant driver of realized inflation.

Conclusion: Don’t Look to Wages for Early Signs of Inflation

The payroll figures and unemployment rate have typically been the focus of the closely-watched Employment Situation report each month, but increasingly those figures have taken a backseat to average hourly earnings. Market participants have been closely watching wage growth for signs of inflation in order to anticipate future policy decisions by the FOMC. Despite the emphasis placed on labor market conditions as a as a driver of inflation, average hourly earnings contain little information about inflation. Changes in wage costs are often already anticipated by businesses, meaning there is not much new information contained in them from an inflation perspective. Moreover, the ability and need to raise prices has been altered by technology and globalization, making the state of the domestic labor market less important.

We continue to watch wage growth as a source of household income and, therefore, spending power. In conjunction with aggregate hours worked, average hourly earnings remain a useful guide of near-term income for consumers (Figure 8).

As a signal of future inflation, however, the emphasis on wage growth appears misplaced."  -source Wells Fargo

Why wage growth has remained frustratingly low for workers and policymakers alike? You have the answer, there are structural changes at play. Therefore using a Norwegian Blue parrot aka the Phillips curve in the expectation of changes in the inflation outlook is at best misplaced by the FOMC, at worse plainly wrong because of the inherently "deflationist" bias of capitalism with innovation, technology and globalization. The model might have been working in a less open world but in today's globalized world, it's just not working anymore, it's not "resting" put it simply, it's broken.

If the PhDs at the Fed had closely studied both Fourastié and Henderson, they would have stopped making wrong assumptions and discarded their obsolete models as pointed out by our friend "Polemic" recently who runs the excellent blog "Polemic pains" in relation to the Phillips curve:

"Real problem is it is used for local policy using local employment/inflation when really, with globalisation, its inputs are global not local. Take UK, falling unemployment doesn't mean labour supply diminishes.. just suck in more from Europe/RoW. So wage inflation stays low but number of employed rises. Then screw it all up again with FX rates flying around altering actual wages for migrant labour relative to their spending location and it gets really confusing. I guess it will only work if free migration of labour is stopped so we no longer have a 'spare tank' of labour that sits outside the Phillips curve measure of unemployment" - source Polemic, 24th of August 2017

Exactly. It might be fun using it locally but in a globalized world, it is just isn't working anymore dear FOMC. That's the main issue with your Norwegian Blue parrot. If indeed everyone is focusing on real wages for a change in inflation expectations, then obviously we are wrong like so many others and the US will not reach that easily escape velocity. Also, the FOMC should look more closely to the Experience curve as it refers to the ability to produce existing products more cheaply and deliver them to an ever-wider audience. Could we call this the Amazon factor? We wonder.

• Credit - Credit Supply is cyclical, so is liquidity...

When it comes to "Orobouros", as we pointed out at the beginning of our conversation, no matter how many tricks (ZIRP, QE, NIRP) used by our modern alchemists, aka central bankers, they cannot alter cyclicality of credit, that simple. If they do not believe us in similar fashion to the many points we have made when it comes to the state of their Norwegian Blue parrot, they could indeed look at the work of Bo Becker and Victoria Ivashina (link above) and their working paper from 2011 published at Harvard Business School:

"Theory predicts that there is a close link between bank credit supply and the evolution of the business cycle. Yet fluctuations in bank-loan supply have been hard to quantify in the time series. While loan issuance falls in recessions, it is not clear if this is due to demand or supply. We address this question by studying firms’ substitution between bank debt and non-bank debt (public bonds) using firm-level data. Any firm that raises new debt must have a positive demand for external funds. Conditional on issuance of new debt, we interpret firm’s switching from loans to bonds as a contraction in bank credit supply. We find strong evidence of substitution from loans to bonds at times characterized by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. The bank-to-bond substitution can only be measured for firms with access to bond markets. However, we show that this substitution behavior has strong predictive power for bank borrowing and investments by small, out-of-sample firms." - source HBS, Bo Becker and Victoria Ivashina, 2011

The provision of credit is highly pro-cyclical in the sense that not much new credit is issued during recessions. As shown in Europe with the "credit crunch" in 2012 thanks to the collapsing of loan books leading to disintermediation, from loans into new bonds issues, to paraphrase Bastiat, there is what you see, and what you don't see. In their paper Bo Becker and Victoria are showing that credit is pro-cyclical because banks have not been willing to lend (supply shift = Economics 101). In very simple terms, the contraction in bank credit supply has been offset by bond issuance on a grand scale. They conclude their paper by adding that a strong predictor of overall contraction in credit is when firms cannot tap into the bond market, hence the importance of monitoring the weaker part of the bond market namely the CCC bucket.

Obviously there have been other impacts than loan contraction in Europe when it comes to dis-intermediation and bonds issuance. At least in the US the impact of financial regulation and Volcker Rule has had an impact on liquidity. This is particularly important we think with the rise of passive investing and the growing use of ETFs in the fixed income space. This of course will have serious implications when the markets turn, particularly when one takes into account the "liquidity" factor. On this subject we read with interest Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 25th of August entitled "When the tide goes out":

"When the tide goes out… the unintended consequences of financial regulation are revealed. High grade corporate bond trading has doubled over the post-crisis years (Figure 1).

However, because the size of the market tripled that means the overall market has become less liquid - due to a number of post-crisis changes - including financial regulation and most prominently the Volcker Rule, but also less leverage in the system. For example, while annual trading volumes in the HG corporate bond market were 135% of the size of the market back in 2006, we estimate that statistic is tracking only 86% for 2017 (Figure 2).

However, counterintuitively in this environment, market-based measures of liquidity – such as off-the-run/on-the-run spread premiums are back to pre-crisis levels. This is true for bid/ask spreads as well, although we are no fan of them as measures of liquidity as we have no information on the true cost to trade more than just a small block of bonds. Moreover quality data on bids and asks naturally is concentrated in what is liquid and trades. In contrast liquidity almost by definition has to be measured where there is liquidity risk, which in many market environments is not quoted actively by traders.

Market based measures are back to pre-crisis levels because of the unique post-crisis environment of extremely low global yields that has led to an unprecedented reach for yield in US HG corporate bonds. In recent years, yields have dropped so much that investors have been forced to enhance yields by reaching into normally illiquid off-the-run names and maturities, which naturally compresses the off-the-run/on-the-run liquidity measures. That means liquidity is OK because dealers are happy to use their  lean balance sheets to not only buy liquid on-the-runs that turn over quickly, but also normally illiquid off-the-runs because there is an army of investors waiting to buy them in short order.

In other words, in the post-crisis years the unprecedented reach for yield engineered by global central banks has likely mitigated the unintended consequence of financial regulation, which is diminished liquidity in the corporate bond market. This means everything is OK until it is not. Only when interest rates go up significantly, and we get large outflows, will we see just how illiquid the corporate bond market can be in the new regulatory regime. Initially liquid names and maturities would likely underperform as investors have to sell what they can. Then later when investors find they can no longer sell the vast majority of bonds they own – the off-the-runs – at meaningful prices we get a big widening in liquidity measures. This could get ugly, we think.

Rates vs. liquidity

To illustrate, Figure 3 shows our preferred measure of market liquidity - the percentage difference between credit spreads on 9-year and 10-year bonds (adjusted for the on-the- run curve).

The idea is that on-the-run 10-year bonds are issued and traded actively and are liquid. Then liquidity declines over time and they become off-the-runs. We use the 9-year maturity point for that, as the bonds have not become too illiquid for pricing to be somewhat accurate.

We plot this liquidity premium over time against interest rates to show the normal environment, which we saw for example around the US downgrade and European sovereign crisis in 2011, where there was an inverse relation. In such risk-off environment, Treasuries rally and liquidity dries up. But fast forward and starting in 2015, there has been a strong positive correlation between interest rates and the liquidity premium. The reason for this shift is very simple – as we described above – that interest rates had declined so much that further declines force investors to reach for yield in off-the-runs, while with increasing rates they are able to return to on-the-runs. Hence, the big decline in interest rates has compressed the liquidity premium to pre-crisis levels.

Why, you may ask, did investors not compress the liquidity premium back in 2H12/1H13 when interest rates were also low? Well remember that the dominant investor reaching for yield in US HG corporate bonds nowadays is the foreign investor. Back then, there was still some yield to be had in foreign fixed income (Figure 4) and foreign investors did not have to reach for yield in US corporate bonds (Figure 5).

Of course, with the collapse in foreign interest rates that has changed, and over the past few years foreign investors have had no choice but to buy US corporate bonds. To make things worse, the cost of dollar hedging has risen sharply for foreign investors, due in part to all the foreign buying of US fixed income (Figure 5).

Combined with the decline in US yields that means foreign investors are that much more pressed to reach for yield in off-the-runs." - source Bank of America Merrill Lynch

Obviously when it comes to "liquidity" and credit, when it comes to the supportive "bid", you need to pray the ECB but more importantly the Bank of Japan have your back with their NIRP and QE policies when it comes to "liquid" US credit markets that's a given as per our final chart.

• Final chart - Japanese support for credit - The boys are back in town

As we pointed out in many musings, the bid in US credit has been "Made in Japan". Back in July in our conversation "The Butterfly effect" we indicated that Japan had been heavily supporting US dollar flows but US credit as well. At the time we indicated:

"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." - source Macronomics, July 2017.

And even with prolonged US dollar weakness they have been wrong, no offense to their credit team. When it comes to Fixed Income flows, we keep saying this but, matters Japan and matters a lot. For instance we read with interest Bank of America Merrill Lynch Liquid Insight note from the 23rd of August 2017 entitled "Japan's outward portfolio investment resurging; diverging implications":

"Key takeaways

• Japan's outward portfolio investment is resurging led by banks' buying of US and French bonds.
• The rapid increase partly reflects a reversal of earlier unwinding, adding to structural demand for non-yen assets.
• Expect Japan investors to dip buy USD, continue buying AUD & NZD. EUR/JPY demand to remain subdued unless, until a deeper dip

Japan’s outward portfolio investment resurging

Although it may have gone unnoticed as the market has much to focus on elsewhere, the return of Japan’s outward portfolio investment since May has been notable. The purchase of foreign securities by Japanese investors hit a seven-year high on a 13-week base at ¥13.4tn in July (Chart of the day). This came after a period of net selling in the spring when we thought Japanese investors were resorting to a “wait-and-see” stance due to heightened external risks. We explore diverging implications across relevant markets." - source Bank of America Merrill Lynch

When it comes to the support provided by the Japanese investment crowd, which where there in force in 2016, particularly with Lifers, it remains to be seen how long these guys are going to stay in town. Just ensure you have a good view of the credit saloon's revolving doors, because when it comes to "liquidity", as Mark Yusko, Morgan Creek's CIO put it, it's a feeble creature:

"Liquidity is a coward, it only exists when you don't need it..." - Mark Yusko

In the current "Ouroboros" credit game, liquidity seems indeed to be plentiful particularly in the passive investment game, it remains to be seen, if it will be present when the tides goes out...

"The only relevant test of the validity of a hypothesis is comparison of prediction with experience. " -Milton Friedman

Stay tuned!