Macro and Credit - Through the Looking-Glass

"Always speak the truth, think before you speak, and write it down afterwards." - Lewis Carroll

While parsing through the FOMC's latest "hawkish" statement, which somewhat reversed "The return of the Gibson paradox" as per our 2013 rambling, making our gold miners exposure on the receiving end of a proverbial "sucker punch", we reflected on the semantics (the study of meaning) and pragmatics (the ways in which context contributes to meaning) of the Fed's latest musing in similar fashion the character Humpty Dumpty discussed with Alice in Lewis Carroll's Through the Looking-Glass (1872), hence our chosen title analogy:

    "I don't know what you mean by 'glory,' " Alice said.    Humpty Dumpty smiled contemptuously. "Of course you don't—till I tell you. I meant 'there's a nice knock-down argument for you!' "    "But 'glory' doesn't mean 'a nice knock-down argument'," Alice objected.    "When I use a word," Humpty Dumpty said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."    "The question is," said Alice, "whether you can make words mean so many different things."    "The question is," said Humpty Dumpty, "which is to be master—that's all." - source, Lewis Carroll's Through the Looking-Glass (1872)

One could have had a similar discussion with Fed chair Janet Yellen on the very subject of the supposed upcoming rate hike in June or July we think:

"I don't know what you mean by 'incoming data consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective' " Alice said.
Janet Yellen smiled contemptuously. "Of course you don't—till I tell you. I meant 'there's a nice knock-down argument for you!' "
"But 'incoming data consistent with economic growth picking up' doesn't mean 'a nice knock-down argument'," Alice objected.
"When I use a word," Janet Yellen said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."

Indeed, the question is whether the Fed can make its words mean so many different things. What we also find of interest with our analogy is that Humpty Dumpty has been used to demonstrate the second law of thermodynamics. This law describes a process known as "entropy", a measure of the number of specific ways in which a system may be arranged (the Global Financial system as a whole), often taken to be a measure of "disorder". The higher the "entropy", the higher the disorder (hence our take on rising "positive correlation" and "disorder" with more and more large standard deviation moves in recent musings). After Humpty Dumpty's tragic fall and subsequent shattering, the inability to put him together again is representative of this principle, as it would be highly unlikely (though not impossible) to return him to his earlier state of lower entropy, as the entropy of an isolated system never decreases in similar fashion it has been incredibly difficult to return the Global Financial system to some state of "normalcy/lower entropy" but we ramble again...

In this week's conversation, we will start by looking at why the ECB is failing regardless of its QE, ZIRP and now NIRP and other tricks in spurring credit growth in Europe through the lens of European banks lack of "profitability". We will as well look at lending growth and the credit cycle.

Synopsis:

• Macro and Credit - Regardless of QE, ZIRP and now NIRP, the ECB is failing in spurring credit growth
• Macro and Credit  - Lending growth and the credit cycle and why the Fed is in a bind
• Final chart: US bond market - The warning sign from the long end

• Macro and Credit - Regardless of QE, ZIRP and now NIRP, the ECB is failing in spurring credit growth

While many pundits are highlighting "Price to book valuations" for global banking stocks. and are asking themesleves if banks cheap enough to take a risk here, we reminded ourselves our conversation from February 2015 entitled "The Pigou effect" where we clearly indicated our discomfort with European banking stocks:

"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe." - source Macronomics, February 2015

We also quoted at the time Berenberg's take on the "Japanification" of Europe "Through the Looking-Glass" of its banking sector:

"In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans." - source Berenberg as per Macronomics note from February 2015

Given our recent April conversation "Shrugging Atlas", musing around "Atlante", the Italian structure set up to tackle the sizable issue of Nonperforming loans (NPLs) plaguing the Italian banking sector, the performance of Italian banking stocks in particular and European banking stocks in general does validate our preference for financial "credit" than for financial "stocks" in Europe:

"No matter how low interest rates on corporate loans have fallen and has been much vaunted by the ECB and many pundits as a "great success", lack of "Aggregate Demand" (AD) and loans flowing to SMEs thanks to insufficient demand, this will not, rest assured, resolve the on-going woes, which have been much increased by the recent implementation of Negative Interest Rate Policy (NIRP), of the Italian banking sector. Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercice of dubious intellectual utility, hence our chosen title. Also as per our analogy, we wonder if, at some point, in similar fashion to Ayn Rand's book, investors will not go on "strike" when it comes to helping out the Italian banking sector as a whole." - source Macronomics, April 2016

Through the looking glass of the European banking sector, one can ascertain the futility of the ECB's policy in terms of QE, ZIRP and now NIRP in not only stabilize the "equity value" of Italian banks, but as well in resuming "credit growth". In continuation to us "Shrugging Atlas", we read with interest Bank of America Merrill Lynch's Money in the Bank note from the 20th of May entitled "Europe’s riskiest bank bonds":

"From bel canto to bank analysis 

It would be fair, we think, to typify the first trimester of this year for the Italian banks as a torrid one. It’s been tough for all global financials but Italian banks have particularly suffered. YTD Unicredit’s stock has fallen -43%, Monte dei Paschi -53%, Banco Popolare -65% and Intesa -25%. There are a number of reasons for this underperformance but at the base we see the systemic asset quality, credibility and capital problems in Italy as the drivers of investor concerns.

From bel canto to bank bond analysis: we measure the empirical riskiness of bonds by looking at the standard deviation of daily excess returns. We are not surprised that the Top 5 riskiest bonds in Europe YTD are all Italian banks, specifically Monte dei Paschi Tier 2, Veneto Banca T2 and Unicredit USD AT1. Excluding DB, Italian bank bonds occupy all 9 places of the Top 10 most volatile bonds. Following the 1Q reporting season and the recent events in the Italian banking sector, perhaps it’s a good time to reassess whether the market’s assessment is really a robust one.

We’re mindful that Italian financials are a significant part of the HY Index. There is €27.5bn of Italian paper in the HY Fins Index which is 45% of the total. It’s one thing to be negatively positioned in these when they are in decline but what if there is a turnaround in the assessment of the fortunes of these banks?" - source Bank of America Merrill Lynch

We do not think there will be a turnaround through the looking glass of their "better earnings" thanks to "lower provisioning levels". On this subject we read with interest Bank of America Merrill Lynch's take from the same note:

In 2014, some banks briefly circulated the idea that they were more conservative in their classification of NPLs than other European peers as the reason for the high quantum – this got quashed when the AQR clearly demonstrated the opposite. There have also variously been tax reasons and legacy lending issues, amongst others. We think the reasons may encompass many of these, but at root the answer is probably simpler: Italian banks did not seem to be very good at underwriting, in our view. We think high levels of NPLs are, in some respects, a management choice. To be fair, up to 2016, no one seemed to care and we could get little traction with investors when we talked of asset risks in Italy. This indifference possibly explains the relatively high level of complacency on the part of the banks on the NPL front. Remember this is a jurisdiction where a bank with a 16% NPA ratio is considered best in class.
In contrast to what we might describe as the pusillanimity of the banks in face of this significant challenge, we think the Italian Government has moved relatively proactively to try and address systemic concerns. It orchestrated a fund to help recapitalize some of the banks and avoid failed IPOs which would likely have caused further systemic issues, we think. Importantly, there have also been a series of measures which have been designed to reform insolvency practice in Italy and address tax issues around provisioning. There has even been an attempt to create a kind of bad bank, or more precisely to kick start a more liquid market for NPLs, through the provision of a Government-guarantee to NPL securitisations. We consider the efficacy of these operations in turn. 

Atlante 

Initially, we assessed the Atlante fund as a positive development for the Italian banks as we saw it as an attempt to break the cycle of bad news around the banks. We were slightly disappointed that the fund raised only €4.25bn compared to the €5-6bn that was originally mooted. Originally designed to ensure the success of the BP Vicenza IPO, and in our view, also help rescue Unicredit from its ill-fated decision to be sole underwriter for said transaction, the IPO of BP Vicenza has now passed, with Atlante having to take up the entirety of the €1.5bn in stock that was offered, because outside investors did not take up any allocation in sufficient quantity. According to Borsa Italiana, 10 insitutions offered to buy 5.1% of the shares which was insufficient free float. Atlante now has €2.75bn in resources left. The IPO of Veneto Banca is upcoming (pre-marketing was to start at the end of this week) and has been widely considered e.g. in the Italian press to have a greater chance of success when compared with Vicenza, not least because the bank is trying to place a smaller amount (€1bn). Market conditions remains hazardous though, we think, as recent comments by CONSOB underline. We have seen some discussion in the Italian press that the fund could be scaled up but we haven’t seen anything concrete on this – Bloomberg reported on Wednesday that the Italian Finance Minister was suggesting in an interview that it could be enlarged. Atlante is in any case a closed fund now but 66% of holders could vote to expand it, so we can’t exclude that the fund will grow, especially if it needs to.

In spite of being ostensibly private to avoid the state aid rules in Europe, Atlante seems to us to be serving a specifically public policy role, on our reading of its presentation, ‘by eliminating excessive supply with respect to the demand for shares’ though it is supposed to have the ‘interest of investors as its sole objective’. It seems to be an unusual set-up even by European standards.
Atlante has already served one of its primary purposes, we think, in subscribing to the Vicenza increase and sub-underwriting the IPO thereby reducing the risk to Unicredit ofbeing left with a significant overhang of shares. 70% of the funds resources are designed to be available for the support of capital raises, with the balance, or just under €1.3bn currently, for the purchase of NPLs. On NPLs, the idea is not that Atlante replaces the NPL market, but that it promotes ‘the creation and development of an efficient market of distressed assets in Italy’. In other words, Atlante may facilitate the sales of NPLs e.g. by buying mezzanine or equity tranches of NPL securitisations – especially those that take advantage of the Government guarantee (the so-called GACS) for the senior/investment grade tranche of the structure. The first bad loan securitization, with a GACS guarantee, is already happening in Italy with a €500m 3 year transaction for BP Bari. However, as the chart shows, loan sales in Italy have been relatively few. The expectation is that Atlante, plus GACS (plus the legal reforms, below) might provide the conditions to accelerate the creation of a more active market for bank bad loans.

We keep an open mind on the Atlante structure and its benefits – the market has been skeptical hitherto. We recall Fitch’s warnings that Atlante potentially drags healthy banks down in their rescuing less healthy institutions. But we still believe perceptions can quickly change as e.g. NPL transactions materialize using GACS, whether or not Atlante participates. Currently, in our view market sentiment around the Italian banks is still overwhelmingly bearish, especially after the last reporting season which was, in summary, rather underwhelming, in our view. We think it’s rather soon to assess the potential benefit from Atlante. We will need to see successful transactions concluded, however. Positive conclusions for the upcoming IPOs of other Italian banks would also be helpful, we think." - source Bank of America Merrill Lynch

We do not think it is rather "too soon" to assess the potential benefit from "Atlante", as we reiterated earlier on, either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercice of dubious intellectual utility, and through the "looking glass" of Italian banking woes and credit growth, the ECB is failing we think because with its QE and NIRP, it has not enticed Italian banks to accelerate the clean up of their balance sheets on the contrary as indicated in Bank of America Merrill Lynch's note:

"Perhaps the banks are anticipating the benefits of the patto marciano and so believe there is less need to keep provisions high (we understand that many European banks are also eager to anticipate the -0.40% rate at which they may be able to borrow from the ECB, even though that rate strictly speaking can’t be calculated ex ante). Lower provisions was a driver of many of the beats to consensus expectations in Italy, though, it seems. " - source Bank of America Merrill Lynch

Exactly, why bother? On a side note, and in similar fashion, for some countries and in particular France, why bother launching structural reforms when the ECB enables you to borrow for close to nothing (0.5%) for 10 year?

But moving back to why the ECB is failing is once again its lack of basic understanding of "stocks" versus "flows". We have long argued that for Eurozone members, if credit growth does not return, economic recovery may prove to be difficult in the absence of sizable real exchange rate depreciation. Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth. 

When it comes to assessing "banking revenues", it is actually pretty straightforward as presented by Société Générale in their European Banks note from the 20th of May entitled "The revenue crisis":

"Net interest income is nothing more complicated than the revenue spread on the balance sheet. It depends on three pretty straightforward variables: the size of the balance sheet, the yield on assets and the cost of liabilities. It is the first two of these variables that have been under consistent, sustained pressure across the sector. Liabilities have not got cheap enough, quickly enough to compensate.
Across the sector, NII contributes c. 60% of the revenue base, and so is the major part of the dynamic. Non-interest income is more volatile, and spread between a multitude of different business lines. Essentially, fee income is a flow on the franchise value of the bank: the branches, the product range, the staff, etc. The outlook is less clear, and the drivers can change quickly. Strong markets would tend to be the biggest single force." - source Société Générale

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of budget deficits and NPLs.

Furthermore, the ECB's NIRP policy has aggravated the "deflationary" spiral in the deleveraging process by limiting the possibilities for banks to offset their NPLs woes with more revenues as pointed out by Société Générale in their note:

"Revenue wipe-out European banks are suffering. Every bank we cover has reported a year-on-year drop in Q1 16 revenue. A heady mix of zero rates, tough markets, weak CIB and stagnant lending volumes is taking a heavy toll. This matters for the sector. While nearterm earnings have been underpinned by better credit quality, this is not a theme that can continue forever. Sector earnings are stuck in a downgrade cycle, and pressure on the revenue line is at the heart of this." - source Société Générale

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think. Although the ECB has been trumping the convergence in Europe in interest rates charged on new corporate loans, as we stated before, the "fun" is uphill, in the bond market, not downhill, in the "real economy". If there is one chart displaying the failure of the ECB we believe it is the below chart from the same Société Générale note that illustrates the ECB's failure in spurring credit growth:

- source Société Générale

With the ECB's NIRP, there is no revenue, and there is as well no loan growth, so some pundits might be highlighting "Price to book valuations" for global banking stocks, we haven't change our views and we would rather play the "credit" side than the "equity" side from an investment perspective particularly "Through the Looking-Glass" of "consensus" EPS trend as displayed by Société Générale in their note:

"The weak revenue environment helps to explain a major anomaly with the Q1 16 results season: the sector generally ‘beat’ consensus on earnings, but consensus EPS downgrades have continued unabated." - source Société Générale

Indeed thanks to the ECB and its NIRP policy, when it comes to European banks stocks, you can no doubt, expect lower, for longer, that's a given. Whereas, the leveraging in the US has run fast and furious in the US credit markets, courtesy of the Fed, as we pointed in our last conversation we expect the impact of the ECB's much anticipated "credit binge" to materially deteriorate the credit quality of European credit markets which had been in recent years much more defensive of their balance sheets, no doubt even in High Yield than in the US. This leads us to our second point namely that, "Through the Looking-Glass", the Fed appears to us to be in a bind, with its "hawkish" stance, highlighting more and more the law of diminishing returns when it comes to its "credibility".

• Macro and Credit  - Lending growth and the credit cycle and why the Fed is in a bind

As indicated in our conversation "The disappearance of MS München", we have been tracking the price action in the Credit Markets and particularly in the CMBS space. The reason behind us starting to track à la 2007 is that the CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. 

As a reminder from our February conversation, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so in the future.

For instance, the continued weakened price action noticed in some space of the CMBX market as per the below chart from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 20th of May illustrates why we are watching closely that space:

- source Bank of America Merrill Lynch

"Through the Looking-Glass" of "retail" CDS price action and the link between retail and CRE, given we told you about this relationship in February with Sears’s management announcing in February that the company would accelerate the pace of store closings, sell assets and cut costs, this is clearly a "headwind" for CMBX and CRE. This is ncreasingly a sign that all is not well in the much vaunted "economic recovery" picture painted by the Fed and Humpty Dumpty aka Janet Yellen and her 'incoming data consistent with economic growth picking up in the second quarter'. As an illustration of the tailwind facing the Fed, the CDS price action depicted by DataGrapple on the 13th of May is indicative of the risk facing CRE investors:

"The above grapple depicts the weekly change of the risk premia of the constituents of the US Corporate cluster identified by DataGrapple. Retailers are easy to spot. In an otherwise resilient market as shown by the greenish shades of most boxes, all of them are red (and some bright red). Most of them reported first quarter numbers, and all of them managed to disappoint. Today, JCP (J C Penney Company, Inc) posted revenues that trailed analysts’ estimates and joined fellow discount-oriented KSS (Kohl’s Corporation) which missed estimates yesterday. Higher end rivals did not fare any better. M (Macy’s, Inc) reported lacklustre results and lowered EPS guidance for the year by 57cts (to $3.15-$3.40 from $3.80-$3.90), while JWN (Nordstrom, Inc) also added to evidence that the department store industry is mired in a deep slump when it cut its annual earning forecast. Shoppers across the income spectrum appear to pull back on purchases of apparel and other discretionary goods." - source Datagrapple, 13th of May 2016

For those with a "short bias mentality", please note that CMBX.6 has the highest percentage of retail exposure. CMBX.6 has considerably more exposure to B/C quality malls...just saying. 

And when we say the Fed is in a bind because of this relationship between "retail" and CRE we are not the only one meaning it. For instance Bank of America Merrill Lynch make the following interesting points in their Weekly Securitization note:

"While limited issuance might otherwise provide a powerful tailwind for spreads, myriad uncertainties remain on the horizon lead us to adopt a more cautious near term view. 

First, as we mentioned above, is the increasing probability that the Fed may raise rates over the next two months. Although a rate hike in and of itself won’t be overwhelmingly negative, it is likely, if not probable, that any near-term hike will be negatively viewed by many investors and could possibly be interpreted to signify that the Fed will be overly zealous as they seek to normalize interest rates against what they believe is an improving economic environment. Second, to the extent higher rates exacerbate the recent credit tightening, it is reasonable to fear that CRE price growth, which is already showing signs of slowing, could be exacerbated to the downside. While the recent Federal Reserve Senior Loan Officers Survey showed that bank lending standards have tightened since the end of 2015, rising recent conduit debt yields (Chart 52) and stabilizing Moody’s stressed LTV (Chart 53) metrics indicate the same is true within CMBS. Risk retention, which dealers are actively planning for, is likely to tighten lending standards further.

The combination of better underwriting, subdued new issuance activity and shrinking dealer balance sheets (Chart 54), which make it difficult for investors to add bonds in size away from the new issue market, have likely contributed to the cash bond spread rally. 

Recent CMBX spread/price movements, however, tell a different story and may provide insight into the macro-related nervousness investors are feeling.

On the week, CMBX prices, especially for tranches at or near the bottom of the capital structure, fell by as much as three points (Chart 55) and have fallen by as much as five points since the beginning of the month (Chart 56).

Again, to the extent that oil prices remain rangebound or increase and no major economic disruptions occur over the next month, we anticipate that CMBX spreads will trade directionally with broader markets." - source Bank of America Merrill Lynch

And of course, "Through the Looking-Glass" of the price action of CDS in the "retail" sector and CMBX, this is indeed a cause for concern regardless of "Humpty Dumpty" aka Janet Yellen's rethoric.

This brings us further "Through the Looking)Glass" of the relationship between lending growth and the credit cycle thanks to UBS's recent take on the subject from their Global Credit Comment note from the 17th of May 2015 entitled "Bank vs nonbank lending signals: the plot thickens...":

"In corporate (non-household) lending markets we believe the proverbial plot has thickened considerably. The two key lending segments are commercial and industrial (C&I) and commercial real estate loans (CRE). For C&I lending, banks comprise less than 20% of total lending; the bond markets are the new marginal provider of liquidity (Figure 2). 

Our non-bank proxy, incorporating bond and trade finance measures of credit conditions, has been indicating more tightening than bank proxies (i.e., the Fed's SLOOS survey) for several quarters. And our proxy is still suggesting further tightening ahead, primarily given that new issuance in US high yield and leveraged loan markets remains sluggish despite recent outperformance (US HY and institutional LL issuance are down 47% and 33%, respectively, in 2016; CLO issuance is off 68% YTD). That said, the rate of tightening has slowed, as HY issuance and trade-credit standards improved in April (Figure 3). 

In short, the trend in lending conditions is still tighter – but there has been some easing in funding conditions.
Conversely, lending conditions in commercial real estate have deteriorated. Banks comprise about 55% of total lending, so the Fed's SLOS survey is more telling. And, in the last quarter, banks tightened lending conditions in CRE, specifically in multifamily and construction/land development vs nonfarm non-residential (36% and 24% net tightening versus 12%, respectively, Figure 4; CMBS issuance is also down 38% through April). 

Why are banks tightening?

The most important factor cited was not CRE fundamentals, cap rates, competition nor funding, but 'other' factors – and by a large margin. What is our interpretation? Increased regulation was the underlying cause. We have previously flagged concerns around the pervasive easing of underwriting standards for corporate lending broadly 5 . Since 2007 FDIC-insured banks have increased nonfarm, nonresidential loans (ex-owner occupied) approximately 82% to $730bn; multifamily loans rose by roughly 142% to $344bn6 . In December, the OCC released its Statement on Prudent Risk Management for CRE Lending in response to "significant growth in CRE lending, increased competitive pressures, historically low cap rates and rising property values". This guidance was originally issued back in 2006, requiring banks with higher CRE concentrations to tighten risk and managerial controls.
We estimate approximately 8% and 16% of FDIC-insured banks by count and CRE debt outstanding, respectively, were above at least one of the concentration levels at YE 2015 (i.e., >100% CLD vs total capital, or >300% CRE vs total capital and >50% growth prior 3 years). For comparison, in 2006 about 31% and 40% of banks, respectively, exceeded one of the thresholds. Last month an American Bankers Association survey suggested similar, but modestly higher, figures in terms of bank concentration levels among respondents. Further, 40% indicated they expected a measurable reduction in credit availability to certain CRE sectors, while another 25% suggested a measurable reduction in credit availability across all sectors from the guidance. 

Why is this important? First, regulation can have a significant impact on the supply of credit, with US leveraged loans a recent case in point8. Back in 2006, the CRE guidance for banks also coincided with a significant tightening in CRE lending conditions. Second, changes in lending conditions for C&I and CRE loans have been quite highly correlated in the past (see Figure 4 above ).

One study finds banks that were above CRE guidance concentrations not only slowed CRE loan growth, but also tended to reduce C&I loan growth. Simply put, macroprudential regulation can have a more broad-based and severe effect on commercial bank lending. One could argue that constraints on lending as the credit cycle matures may guard against excess losses; conversely, an exogenous shock to the supply of credit at a time of lacklustre global growth and upcoming risk events could exacerbate
funding pressures.
And the linkages between CRE and C&I lending are multi-faceted. The lenders – in particular regional and community banks – tend to have higher concentrations of commercial and C&I loans, and some smaller business loans are collateralized by commercial property. Second, borrowers can also be concentrated in certain sectors across C&I and CRE. According to the Fed's Shared National Credit Review the largest industries in the leveraged C&I portfolio included Healthcare (14%), Media/Telecom (13%), Finance/Insurance (12%), Materials/Commodities (6%) and  Retail (5%)10. In CRE portfolios, larger concentrations lie in multifamily (28%), office (18%), retail (16%), industrial (12%), hospitality (8%) and healthcare (7%) according to the ABA. Much of the CRE growth has occurred in coastal cities. This implies, while not directly comparable, C&I and CRE depend more heavily on similar industries – media/telecom, finance (non-bank), retail and healthcare.

The conclusion is that the plot is thickening with respect to the signals of corporate lending conditions, and we believe clients should increasingly view them in a holistic framework. While there are signs of moderation in the rate of tightening for C&I loans, we are already seeing rising delinquencies and defaults weigh on corporate profits and growth (stages 3 and 4 of our rudimentary credit cycle model outlined earlier). But for CRE loans we think there is greater cause for concern as potential harbingers of greater credit constriction emerge.

Importantly, we have yet to see much rise in delinquency and default rates – although examiners noted rising concerns over CRE credit risk for 75% of banks and expected credit risk to rise in 50% of all commercial loans at year-end. The ESRB provides a simple but useful framework for the CRE cycle (Figure 5); while the CRE cycle appears less advanced than the C&I cycle, we believe investors should closely watch for evidence of potential negative effects on credit availability in CRE and potential broader spillover to C&I lending.

In particular, investors should closely watch the media/telecom, finance (non-bank), retail and healthcare industries given the linkages across both markets. In terms of investments, our view of recent trends in corporate lending conditions does not support 'reach for yield' or down-in-quality trades. In corporate credit, we continue to prefer longer duration US high grade bonds versus high yield." - source UBS

We agree with UBS's preference for US longer duration US high grade bonds exposure versus High Yield. When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2.

This leads us to our final chart, indicating as well that "Humpty Dumpty" aka Janet Yellen should pay attention to what the long end of the US bond market is telling her no matter what she thinks whether or not she can make words mean so many different things in the FOMC...

• Final chart: US bond market - The warning sign from the long end

What "Humpty Dumpty" aka Janet Yellen doesn't seem to realize is that the credibility of the Fed, is "decaying" in similar fashion as the "theta" (time value) of the "put" option of the Fed. Given the recent "hawkish" tone to somewhat "dampen" the "credibility risk", we tend to agree with Bank of America Merrill Lynch's take on the warning sign being sent by the long end of the US yield curve as per their recent US Rates Watch note from the 18th of May entitled " Fed vs. bond market: The warning sign from the long end". The final chart taken from their note plots long term real rates in five major countries vs. the miss to the respective central bank’s inflation target:

"Bond market vs. Fed speak: look at the long end, not EDs 

Recent Fed speak and a slew of important speakers lined up to talk before the June meeting (Dudley, Yellen, Fischer) has shifted attention back to the front end of the rates curve. Eurodollar bears that were forced into hibernation since March have woken up, revisiting similar arguments of dots vs. the Fed, rates vs. US data surprises etc. To us, there is one worrying sign in the reaction of the bond market to the better data and hawkish Fed speak unlike 2013: instead of the optimistic signal the yield curve sent during the taper tantrum, long end rates now suggests a re-ignition of the policy mistake trade. Raising June/July probabilities is a small victory that is coming at the cost of dealing with higher probability of inverted yield curves 2-years forward, in our view. 

This is not 2013: reigniting the policy mistake trade 

A critical difference between 2013 and today is the inability of Fed optimism to filter through into higher long end yields. Chart 1 plots OIS forwards in mid and end 2013 (pre and post taper tantrum).

The combination of better data and shift in messaging from the Fed in 2013 was viewed to be a sign of an optimistic longer term growth picture – the resulting rise in yields was a healthy combination of 1) higher terminal rates 2) higher term premiums 3) and thereby a license for the Fed to hike sooner and faster than was originally thought. Recent communication however struggled in this regard: hawkish Fed talk and better US data has only helped 1) strengthen the dollar and weaken inflation expectations 2) lower terminal rates priced in 3) increase hike probabilities for the near meetings without shifting medium term expectations. 

Lack of credibility constrains effectiveness 

The policy mistake angle assigned to the Fed is visible in more areas than the yield curve. Chart 3 plots long term real rates in five major countries vs. the miss to the respective central bank’s inflation target. The market continues to believe that the Fed will deliver real rates that are far too high and miss on its long term inflation target by at least 50bp. To us, this inability of the Fed to improve longer term expectations priced in to the market tows the line of igniting a bigger concern: getting dangerously close to the market pricing in inverted yield curves, 2 to 3 years forward." - source Bank of America Merrill Lynch

So go ahead "Humpty Dumpty", hike, because looking through the "Looking-Glass" of retail earnings, their respective CDS price action, the state of CRE versus lending standards continuing to tighten and the state of the "long end" of the US yield curve, we do think that you will not be able to return the US economy to its earlier state of lower entropy...

"If you stop being scared, that's when entropy sets in, and you may as well go home." -  Tamsin Greig, English actress

Stay tuned!

Macro and Credit - The reverse Tobin tax

"A question that sometimes drives me hazy: am I or are the others crazy?" - Albert Einstein

Watching with interest the stabilization and even tightening in the credit markets, in conjunction with People's Bank of China (PBOC) cutting by 50 bps its Reserve Requirement Ratio (RRR), adding to the "risk-on" environment witnessed recently and given the continuous conversations relating to NIRP, we decided, for our elected title analogy to refer to the Tobin tax. The Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system which ended on August 15 of 1971. 

Why, you might rightly ask dear readers, did we elect to talk about a reverse Tobin tax in our chosen title?

Well, if you remember correctly from our previous conversation "The Monkey and banana problem", we argued that NIRP doesn't reduce the cost of capital. NIRP is simply a currency play.

And if indeed NIRP is a currency play, given James Tobin's objective was to mitigate currency volatility, no doubt to us that the latest bout of volatility witnessed on the Japanese yen is indeed some form of a "reverse Tobin tax". What we find amusing is that James Tobin was influenced by the earlier of John Maynard Keynes on general financial transaction taxes and the famous chapter XII of the General Theory on Employment Interest and Money. Keynes was an avid speculator and the recent NIRP put in place by various generous gamblers aka central bankers, is leading to a renewed frenzy of speculation in the bond market where all the fun is with more and more bonds yielding on the negative side and their prices reaching new record high levels:

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation." - John Maynard Keynes, page 104.

Indeed the situation is becoming serious when the bond market has become a whirlpool of speculation. On a side note, we find the PBOC move amusing given, as we posited with the ECB LTROs, liquidity injections doesn't resolve solvency issues, particularly when it comes to Nonperforming loans (NPLs).

John Maynard Keynes would be proud of NIRP given it will definitely lead to the "euthanasia rentier" but unfortunately also to the disappearance of "capital" as he wrote:

"I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.

Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward..." - John Maynard Keynes

We do not think in the end, capital will be "free and "abundant" with NIRP. Keynes added at the time in relation to tax on transactions the following:

"The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States." - John Maynard Keynes, page 105.

For us, NIRP is a "reverse Tobin tax" leading in the end to the "euthanasia of the rentier" as more and more government bonds fall into negative yield territory, hence our chosen title. If indeed James Tobin tax was supposed to lead to lower volatility in the FX markets, the reverse Tobin tax aka NIRP is leading to the reverse, that's a given but we are rambling again...

In this week's conversation, we will look again at the credit cycle and the issue with correlations with diversification we recently discussed. We will as well look at how NIRP will be playing out credit wise and trouble brewing in Asia. 

Synopsis:

• Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months
• Macro and Credit  - The US late stage will have nasty credit consequences on Asia
• Final chart: US Rates skew may reflect policy mistake / recession risks

• Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months

In our last conversation "The Monkey and banana problem" we indicated that NIRP would exacerbate the demand for yield as the saving rate goes up, which no doubt is leading the negative feedback-loop to push the frenzy for bonds into "overdrive" hence for the first time we have seen the demand for the Japanese 10 year government bond (JGB) pushing for the first time the yield into negative territory. This of course a clear manifestation of the "reverse Tobin tax" and the "euthanasia of the rentier".  The operant conditioning chamber we discussed last week, aka the Skinner box has indeed led to a "Pavlovian" response leading to even further greater compression. As we posited last week, what matters more and more to us is tracking "correlations" given the implications for "diversification" are not neutral:

"The consequence for this means that classical theories based on allocation become more and more challenged in a NIRP world because correlation patterns change in a crisis period particularly when correlations are becoming more and more positive (hence large standard deviations move)." - Macronomics, February 2016

When it comes to "correlations" we read with interest Société Générale's take from their Multi Asset Snapshot note from the 26th of February entitled "A balanced portfolio for an imperfect world":

"While we may have been too aggressive with a balanced allocation before the market downturn, we're not keen to take the revolving door and go risk averse now. We are recommending a balanced allocation. The average correlation between assets has recently pulled back, making us more convinced to keep the current allocation of 50% equities/50% bonds and others.

- source Société Générale

What effectively Société Générale is showing is confirming somewhat we have posited as of late in our conversation "The disappearance of MS München". Namely that in a world of growing "positive correlations" diversification reduces the benefit of diversification:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by this sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world." - source Macronomics, February 2016

This also a subject we discussed in our May 2015 conversation "Cushing's syndrome":

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

What we are currently seeing is a repricing of bond volatility which had been "anesthetized" by central bankers leading to Cushing's syndrome. Central bankers meddling with interest rates levels have led investors to get out of their comfort zone and extend both their risk exposure and duration, taking the repressed volatility regime as an empirical factor in their VaR related allocation risk process. Now they are rediscovering in the ongoing turmoil that, yes indeed long duration exposure is more volatile than shorter ones. They are also rediscovering "convexity" with artificially repressed yields. They are being significantly punished the more exposed to "credit" duration they are." - Macronomics, May 2015

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment. Where is the value left in your bond holding when the German 10 year government bond (Bund) yield is about to turn negative? Yes, it will go negative and so will probably be the rest of the Japanese curve to mimic what has been happening on the Swiss yield curve. The most dangerous negative side effect of the "reverse Tobin tax" is already pushing the Swiss real estate bubbly market into overdrive as indicated by Bloomberg on the 29th of February in their article "Mom-Pop Investors Rush Into Swiss Property at Riskiest Time":

"Mom-and-pop investors are rushing into Swiss properties just as the market faces its greatest threat of a bubble in a quarter century.
“I see two protracting trends,” Patrik Gisel, chief executive officer of Swiss Raffeisen, the country’s third-largest bank, said in an interview in Zurich. One involves big money -- institutional investors such as pension funds and insurance companies who have invaded the market, driven by negative yields on Swiss government bonds. More recently, a new group of investors has entered the fray, buying properties to rent or develop rather than for a primary residence.
“What’s really new is that private investors are piling in to buy real-estate assets for yield due to limited options,” he said. These aren’t ultra-rich speculators, rather well-to-do people looking to build nest eggs at a time of record-low interest rates and market turmoil. Although they are still just a small part of the market, “this is reducing the professionalism,” he said.

Soft Landing

Raiffeisen, a cooperative encompassing about 300 regional banks, is one of Switzerland’s five systemically relevant banks, along with UBS Group AG and Credit Suisse Group AG. It holds about 17 percent of the Swiss mortgage market, with home loans representing about 95 percent of the total volume of 166 billion francs ($166 billion) at the end of the 2015.
The Swiss property market is facing the greatest threat of a real estate bubble since 1991, UBS said in a report this month on the subject. Loan applications for properties not occupied by owners dipped in the fourth quarter, yet remain historically elevated at about 18 percent of the overall demand. House prices rose 0.5 percent from the third quarter and around 2 percent yearly.
While the risk of default on mortgages remains low in Switzerland, vacancy rates are rising, with prices “driven by investments, not by the need for living space,” Gisel said. Unlike in countries including the U.K. and U.S., Swiss buyers traditionally are looking to make a lifetime investment as capital gains taxes make it costly to speculate.
Gisel, formerly the deputy CEO who succeeded Pierin Vincenz at the head of Raiffeisen last year, said he sees a “soft landing” in the property market. The bank said during its earnings report Friday that prices are stabilizing at a high level or declining slightly.

Swiss apartment prices and mortgage lending climbed by about a third between 2007 and 2014. A price increase of 2 percent would have been unappealing just four years ago, Gisel said.
The Swiss National Bank introduced charges on bank deposits in an effort to weaken the franc, which soared after it lifted its three-year-old cap on the currency in January 2015. Some big banks such as UBS and Credit Suisse have passed on the pain of negative interest rates to their larger institutional clients. Retail clients have been spared, for now.
“Equities are too risky for many private investors, bonds don’t yield anything,
so people go for real estate but often have a poor understanding of this market,” says Fredy Hasenmaile, head of real estate research at Credit Suisse. Inexperienced investors tend to underestimate the costs associated to maintain a property." - source Bloomberg

We have argued in a 2011 conversation that the policy of achieving a high home ownership rate is the biggest threat to an economy:

"The issue with enticing a high home ownership rate is the level of household debt it generates. It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.

For us, a housing bubble is a Weapon of Economic Destruction (WED) and pushing real estate prices into overdrive is certainly akin to a "reverse Tobin tax" and the most efficient way in destroying "mis-allocation" of capital on a grand scale and "euthanizing the rentier" for good.

But moving back to the subject of the credit cycle, we still believe we are in 2007, although subprime is not the "prime" suspect this time around as the Energy sector woes have clearly spilled over into over sectors as well. The rising of distress securities is creeping up and it is not only in the Energy sector as displayed in the below S&P Global Market Intelligence chart:

"A host of U.S. energy companies joined LCD’s distressed debt Restructuring Watchlist last week, adding to an already hefty group of issuers from that still-struggling market segment.
The Watchlist tracks companies with recent credit defaults or downgrades into junk territory, issuers with debt trading at deeply distressed levels, as well as those that have recently hired restructuring advisors or entered into credit negotiations.

- source S&P Capital IQ LCD

This is entirely due to ZIRP and now NIRP as shown in the below Société Générale from their Credit Weekly note from the 26th of February 2016 entitled "Will the G20 disappoint credit investors":

"In a low real interest rate environment, however, such as the 1970s or the present, the four year period of stability disappears and the credit cycle becomes much shorter. Chart 3 illustrates this:

Table 2 above implies that the global credit cycle is, as always, relatively synchronous, with the US leading EM by around six months. Assuming two-year widening and two-year tightening cycles, with a peak of the cycle in early 2016 and a trough in late 2017 or early 2018, this implies the following:

- source Société Générale.

The United States are leading once more the credit cycle and the rapid pace at which spreads have widened since the cost of capital has been moving up since the summer of 2014 is indicative of how late the cycle is and the potential spillover to Emerging Markets thanks to Global Financial Conditions tightening in conjunction with the relentless rise of the US dollar.

When it comes to credit and the "Japanification" process, the hunt for yield is still running strongly although some might have already moved higher the quality spectrum in the light of the deterioration seen recently in credit spreads. European investors in a "reverse Tobin tax" environment will be eager to go for even more duration and credit risk as posited in Société Générale's note:

"European investors will still be hungry for yield. European ten-year yields have fallen almost 50 basis points this year, with the Bund yielding just over 10bp. It’s hardly surprising that European insurance companies are steering their clients away from guaranteed life products, as our insurance analyst Rotger Franz has noted, but they are still left with legacy products that need to be funded. Our SG shortfall model estimates the current gap between what insurers need and what the government markets are offering at almost 140bp.

Given this gap, we think the demand for credit will remain strong. It’s worth noting, however, that this demand will be much stronger in the BBB area than in the AA and A area, since spreads have compressed too much in those areas to offer the returns that investors need." - source Société Générale.

Insurers have are indeed struggling with NIRP and are slowly getting "euthanized". While we have long been highlighting the dangers with Emerging Market corporate debt denominated in US dollars, it is worth highlighting Société Générale's comment before we move on to our next point:

• "Emerging market sovereigns will not be able to bail out their corporates: The ratio between EM sovereign spreads and corporate spreads has narrowed this year, when the mismatches in the indices are accounted for. Yet EM corporate debt – either domestic debt as a percentage of GDP, or external debt as a percentage of reserves – is often much bigger than government debt, as we noted in "Can EM sovereigns really bail out their corporates?" We think this year, investors will realise that many EM corporates will not be bailed out by their sovereigns.
• EM defaults will be higher and recovery rates lower than the market expects. Given the weakness of commodity prices and the weakness of EM currencies, we are more bearish about these issuers than we are about US high yield issuers." - source Société Générale

The latest sign of the strain facing EM corporate issuers is clearly illustrated by Mexican giant PEMEX losing $32 billion in 2015. Mexico's largest company and big contributor to the government's budget has more than $87 billion in debt and hasn't recorded a profit since 2012 according to Bloomberg. The government of Mexico has pledged financial support for its ailing giant. 

This leads us to our second point and once again the unintended consequences of our Macro theory of reverse osmosis playing out as we have argued in our conversation "Osmotic pressure" back in August 2013:

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

Now the "flows" are turning into "outflows" leading to the following points we discussed at the time:

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

We also added at the time:

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates)." - source Macronomics August 2013

While the PBOC might have indeed bought some time in adding more liquidity, the worrying trend of capital outflows have yet to meaningfully slow down, meaning for us that, indeed Asia should as well be the focus of more attention, but not only China...

  

• Macro and Credit  - The US late stage will have nasty credit consequences on Asia

Back in July 2015 in our conversation "Mack the Knife" we indicated that EM credit spreads and oil prices were highly correlated. 

The correlation of oil and credit spreads mean that indeed the unintended consequences of the surge of the US dollar and the fall in oil prices have not translated much as before into Asia's energy-importing economies as illustrated by Nomura in their Asia in Charts note from February 2016 entitled "Asia's coming credit crunch":

"• Cheap oil has not benefited Asia’s energy-importing economies as much as it had in the past. In early 2008, if you responded “sub-6%” to the question of how fast Asia ex-Japan’s economies would grow if oil prices halved and most Asian central banks slashed rates to new, or near, record lows, you would have been scoffed at. More of the oil windfall appears to have been saved or offset by the China slowdown, weak EM demand, high domestic leverage and low productivity growth.

• That said, the commodity price drop has been a big differentiator in favour of Asia, as fundamentals and growth have fared better in Asia vis-à-vis LatAm and EEMEA. Asia is the least ugly in EM, at least for now. If risk sentiment turns, Asia may experience a short-run relief rally, buoyed by: 1) still ample global liquidity; 2) any signs of China growth stabilising, albeit it would be temporarily, in our view; and 3) more discriminating investors in global emerging markets in Asia’s favour.

• However, more fundamentally the seeds are being sown for a credit crunch and financial stress in Asia:
1) high and still-rising private debt, combined with still elevated property prices; 2) slowing potential growth rates; 3) increasing foreign-currency debt exposure; 4) large herding-like investments by global asset management companies in Asia (‘original sin II’); 5) the Fed surprising with more/faster rate hikes; and 6) China’s economy facing a secular slowdown in growth in 2016 and 2017." - source Nomura

As our reverse "macro" osmosis has been playing out and given the credit binge witnessed in some parts of Asia, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring.

There is a heightened possibility of a credit crunch looming in Asia as posited by Nomura in their very interesting report:

"Asia is setting itself up for a credit crunch 

• The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can cause financial decelerator effects.

• Cheap credit has weakened productivity by misallocating capital (eg. property speculation), dis-incentivising supply-side reforms and keeping zombie companies alive. Potential growth is slowing across most of Asia.

• Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.
• Triggers of a credit crunch could be the market caught off-guard by Fed rate hikes, USD sharp appreciation, a China setback, or a high profile Asian corporate default prompting global asset managers to pull out from the region en masse and causing market liquidity to evaporate.

 Asia’s credit and property price gaps are sending warning signals

• Pioneering work at the BIS by Claudio Borio and Philip Lowe in the early 2000s found that over a 4-year horizon a credit gap of >4% predicted 88% of crises in industrial countries with a noise to signal ratio (NSR) of 0.21, while an equity gap >60% predicted 67% of crises with an NSR of 0.15. Jointly they predicted 73% of crises with an NSR of 0.02 (i.e., issued wrong signals only 2% of the time).
• Since then more studies, including of EM crises, have reaffirmed that credit is the single best predictor of crises and, with better data, property prices are generally found to be more important than equity prices.
• In a more recent 2011 BIS study (working paper No. 355) of 36 advanced and EM countries it was found that over a 3-year horizon, a credit gap >10% predicted 67% of crises with an NSR of 0.16, and a property gap >10% predicted 77% of crises with an NSR of 0.33. This is an ominous sign for Asia, as highlighted in the table below.

The best indicator of financial crises is the credit gap; the property price gap is also a strong indicator, and jointly they send a strong signal

 (click to enlarge picture)

- source Nomura

From the table above, and as a follow up on our HKD take from our  December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. On this specific case, Nomura's report has added more on our justified concerns in their note:

"Hong Kong could be Asia's flashpoint

 HK stuck between a rock (Fed hikes) and a hard place (ebbing China)

• Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 112% (they have corrected 11%), and the ratio of private non-financial credit to GDP has surged to 293%.

• The real effective exchange rate has risen 26% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015.

 • Foreign assets and liabilities have surged since 2008. this leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.

• Economic hardship could ignite further political and social unrest, or vice versa, ahead of the 2016 Legco elections (around Sep) and 2017 chief exec elections. We would not rule out a change to the HKD peg regime." - source Nomura

And, as per us winning the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our December "Cinderella's golden carriage", we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. Maybe it will be for 2017 after all...For now the Hong Kong dollar has recorded the biggest monthly gain since 2011 in February on optimism that the city will be able to maintain its peg to the US dollar as reported by Bloomberg in their article from the 29th of February entitled "Hong Kong Dollar in Biggest Monthly Gain Since 2011 as Peg Holds":

"The Hong Kong dollar advanced 0.18 percent this month to HK$7.7724 against its U.S. counterpart, the biggest increase since October 2011, data compiled by Bloomberg show. The currency rose 0.06 percent on Monday to trade near the strong end of its HK$7.75-HK$7.85 trading range.
“The Hong Kong dollar was one of the biggest speculative targets in January, especially amid fears of the yuan being devalued,” said Irene Cheung, a foreign-exchange strategist at Australia & New Zealand Banking Group Ltd. in Singapore. “We need to watch the yuan, given how it’s affecting sentiment across markets. If the dollar-yuan rate continues to remain broadly stable, there’s no reason to focus on the Hong Kong-dollar peg for now.”

Yuan Deposits

The Hong Kong dollar was linked to the greenback in 1983, when negotiations between the U.K. and Beijing over the city’s return to Chinese rule spurred an exodus of capital, and policy makers in 2005 committed to limiting declines to the current range.
Hong Kong’s yuan deposits rose by 0.1 percent to 852 billion yuan in January, the Hong Kong Monetary Authority said on Monday. The pool posted its first annual decline last year, while issuance of Dim Sum bonds fell for the first time since the market’s inception in 2007." - source Bloomberg

As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far has not been able to  gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals.

When it comes to the fate of the HKD peg, Nomura has been solacing our concerns in their note:

"HKD re-pegged to the RMB? 

The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported
US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed accelerates hiking and China’s growth keeps slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura

Given our keen interest on this eventuality, we will be not only monitoring that space but also tracking financial conditions in Asia rest assured.

Finally for our final point and chart, we would like to point out that it's not only Hong Kong which is stuck between a rock (Fed hikes) and a hard place (ebbing China). The Fed is as well in a bind.

• Final chart: US Rates skew may reflect policy mistake / recession risks

Our final chart comes from Bank of America Merrill Lynch's Liquid Insight note from the 1st of March entitled "Rates skew may be pricing a policy mistake":

"• US rates skew is now inverted in both short- and long-dated expiries, despite more dovish Fed expectations
• We believe this, at least in part, reflects higher perceived odds of a policy mistake and/or growth shock ahead
• From a historical standpoint, inverted long-dated skew is consistent with late stages of the hiking cycle

Inverted skew: Not a good sign for the Fed

A notable recent development in the US rates vol market is the inversion of the skew surface, with low strikes trading at a premium to high strikes. Short-dated skews were first to invert earlier this year. Today skews are inverted across the board, including very long expiries (Chart above). Importantly, the skew inversion occurred against expectations of a more dovish Fed. The market now sees the next Fed hike only by 4Q17, a much less hawkish outlook than FOMC projections. Lower rates coupled with expectations of a more accommodative Fed normally imply upward risks to rates. Yet, the volatility market sees risks to rates skewed on the downside even at very long horizons.
We believe this is a worrisome signal to policy makers. The inversion of the skew all the way into longer horizons suggests perceived risks go beyond the recent financial stress and may reflect greater perceived odds of a policy mistake/recession risks. Inverted long-dated skew is consistent with late stages of hiking cycles." - source Bank of America Merrill Lynch

To hike in March, or not to hike, that is the question...

"Insanity - a perfectly rational adjustment to an insane world." - R. D. Laing, Scottish psychologist

Stay tuned!