Macro and Credit - Circus Maximus

"I can calculate the motion of heavenly bodies, but not the madness of people." -  Isaac Newton

Watching with interest new records being broken in equities reaching new highs, with credit "carrying on" thanks to uninterrupted inflows into funds ($6.5bn of inflow into European IG credit funds and High grade funds recorded another week of inflows; their 21st in a row according to Bank of America Merrill Lynch), we reminded ourselves for our title analogy of the Circus Maximus, the ancient Roman chariot racing stadium and mass entertainment venue located in Rome, which was the first and largest stadium in ancient Rome and its later Empire. It measured 621 meters (2,037 feet) in length and 118 meters in width and could accommodate over 150,000 spectators. In its fully developed form, it became the model for circuses throughout the Roman Empire. While we have been quite comfortable riding the uninterrupted bullish tide from our short term "Keynesian" perspective as indicated in our earlier musings of 2017, as of late, we indicated that tactically we were reducing our beta exposure credit wise and that we would rather stick to quality given that not only we feel that the credit cycle is slowly but surely turning, but, it feels like when it comes to the abundant generosity from our "Generous Gamblers" aka central bankers, when it comes to the Fed and the latest FOMC, it feels like the tide is turning. We posited in the past the following quote, which was a derivation of Verbal Kint's quote in the Usual Suspects movie:

"The greatest trick central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

We have used in the past as a title for a post a reference to the great text from Charles Baudelaire called the "Generous Gambler". This poem appears to be the 29th poem of Charles Baudelaire masterpiece Spleen de Paris from 1869.

As one knows, the "Devil is in the details" and if indeed the Fed is serious with its hiking plan and balance sheet reduction, then it does indicates that, regardless of the slowly turning credit cycle and the flattening of the yield curve, there is an increasing possibility of the liquidity tide to turn, you have been warned. For now in all markets it's "Circus Maximus" as we move towards the euphoria stage, with additional melt-up in asset prices, in the final innings of this great credit cycle we think.

In this week's conversation, we would like to look at why credit is "carrying on" and why we prefer for the moment playing it safe via Investment Grade in case volatility heats up in the near future.

Synopsis:

• Macro and Credit - If you love low volatility, stick to investment grade credit
• Final charts - Italy? It's getting complicated

• Macro and Credit - If you love low volatility, stick to investment grade credit

Reminiscences of a flow credit operator comes to mind in true 2007 fashion these days given the continuous inflows into Investment Grade funds, in conjunction of continuous tightening in credit spreads. Discussing recently with another credit pundit on a macro chat platform, we reminded ourselves of the 2007 spread compression with the current situation:

Him - "I've had banks pretty much telling me I can name my price in itraxx tranches, off the back of structured stuff they've issued to retail."

Me - "Not surprising, this is playing out like 2007, structured products issuance leads to relentless selling in CDS which is compressing even more spreads and market makers can't recycle in the market because the only takers would be loan books buying protection. Lather, rinse, repeat..."

Of course both of us like many others, have seen this movie before. As we pointed out in our recent musing, when it comes to High Yield and in particular European High Yield, given the tightness of the spreads relative to Investment Grade, we have switched to being tactically negative, underweight that is. Sure, some would argue that, it's all about the carry and that given the ECB's supportive stance, it's all about "carrying on" through the summer lull. We have a hard time seeing the relative attractiveness in Europe of € High Yield versus € Investment Grade credit as pointed out by Deutsche Bank in their European Credit Update note from the 13th of June entitled "Carry is King...For Now":

"Credit Valuations and Spread Forecasts

Despite the change in view we still think it will be difficult to see much spread tightening. More specifically, we would argue that valuations appear to be more stretched for EUR HY relative to EUR IG credit. Looking at our often used analysis in Figure 2, showing where spreads currently trade relative to their own histories, we can see that EUR HY spreads are generally at the top of the list.

More specifically BB and B spreads are well into their tightest quartile, in fact for Bs current spread levels are now close to the tightest decile through history. In addition looking at Figure 3 we can see that the HY/IG spread ratio remains around the all time lows having seen HY outperform on a relative basis since September last year.

We should stress here that we think the outperformance would be on a risk-adjusted basis. Given that we think carry will be driving returns from here, the extra yield available (although low in absolute terms) could see absolute outperformance. One other thing to potentially consider is the stark difference in duration of EUR IG vs. HY. The duration to maturity on the IG index is 5.4 years while for the HY index it is 4.1 years. This also does not take into account the fact that many HY bonds are trading to their call date rather than to maturity and therefore the duration of the HY index is likely to be even lower in practice. This could create some further benefit for IG if we do see more spread compression.

The recent trends in ECB QE could also benefit this view. The ECB appears to have trimmed corporate purchases less than government bond purchases as shown in Figure 4.

(For more details, see our report “CSPP Trimmed Less Than PSPP, with a Record Share of Primary Purchases” available at goo.gl/2pgpdM.) In addition, the latest ECB communication has implied that the overall withdrawal of QE could be even slower. Combined with the Italian election risk seemingly pushed back into Q1 2018, these latest developments are conducive to low volatility and tight spreads. In fact, as the market repriced QE for longer with a relatively increased emphasis on corporate purchases so far, CSPP-eligible bonds have again started to mildly outperform ineligible ones (Figure 5).

With the change in view we have also updated our year-end spread targets and what they translate to in terms of excess returns (Figure 6).

We have also trimmed our view on defaults given the combination of the positive macro data and continued low yield environment. The change in view is focused on the next few months and we will likely review this again as we move towards Q4. We have effectively pushed out our moderate widening view given the events of the last few days. And while we now expect the carry environment to last longer than we originally thought, the moderate widening stage might set in before the year end. Our end-2017 forecasts should therefore be seen with that caveat in mind.

Note that the forecast performance is risk-unadjusted. While higher-beta HY may outperform lower-beta IG in absolute terms, we expect the latter to outperform in risk-adjusted terms as mentioned earlier. On the margin, we expect the following relative performance adjusted for risk, which is in line with our previous published views:

• IG outperforms HY

• Financials to outperform non-financials

• Senior financials outperform subordinated financials

• EUR credit outperforms GBP credit

The UK elections have only reinforced our view that more macro uncertainty currently hangs over the UK economic outlook than over the eurozone, which makes us relatively more cautious on GBP credit.
The above cash bond excess returns are over government benchmarks. The total returns will additionally depend on the performance of government bonds." - source Deutsche Bank

This ties up nicely with our recent call in favoring style over substance, quality that is, over yield chasing from a tactical perspective. While the Italian elections probability has been postponed and has therefore moved from a "known unknown" towards a "known known", there is still a potential from a geopolitical exogenous factor to reignite in very short order some volatility, which would therefore put a spanner in the summer lull and "carry on" mantra. But as the Circus Maximus goes on, with very supportive inflows into the asset class, the carry trade continues to be the trade du jour for fixed income asset allocators. On this subject we read with interest Société Générale Credit Wrap-up from the 14th of June entitled "Why fixed income allocators are loving credit":

"Market thoughts

Risk-adjusted returns have become an important tool for fixed income allocation in recent years. Volatility and correlations tend to follow regimes, meaning that the past can be a decent approximation of the future under most conditions. Yields give a reasonable sense of what returns could be, unless the market moves sharply in one direction or another. Thus, dividing current yields by historical volatility is a useful tool for knowing which fixed income classes look most attractive at the moment.

Such calculations flatter the credit markets. Chart 1 uses the risk adjusted yield from our quant team (which they define as current yield divided by the standard deviation of yield over the past year) across a range of fixed income asset classes.

The horizontal axis shows the current level, and the vertical axis shows the change in the level since the end of 2016. Credit has suddenly jumped to the top of the pack, ahead of emerging markets, thanks largely to the very low level of volatility in returns since the start of the year.

But past performance is no guarantee of future returns, as every careful reader of financial boilerplates knows. Will corporate bond volatility remain low?

In the short term, yes, quite possibly, and this is one of the reasons we are bullish on the asset class into 4Q (as explained in Why credit markets could test the summer of 2014 tights). In the longer term, however, two factors worry us. First, the level of equity implied volatility is near 30-year trough levels. It could stay there for a while (as we explained in How this period of low volatility will end), but volatility always eventually gets driven higher by credit problems, and rising leverage – mostly notably in China – could be the trigger once again by early next year.

Second, the low level of credit volatility has been driven by a very high negative correlation between government bond yields and credit spreads. In Why government yield/credit spread correlations will likely reverse next year, we noted that there are fundamental reasons for thinking that this correlation could change in 2018. If it does, then the volatility of corporate bonds will necessarily rise because yields will not be a shock-absorber for spreads and vice versa.

Therefore, a word of warning. 2H may bring further inflows into credit from other parts of the fixed income world as asset allocators look at indicators like this one and draw optimistic conclusions. This may however spell the final phase of the credit market rally, for lower spreads and changing correlations could make the risk-adjusted yields look much less enticing come 2018." - source Société Générale.

We agree with the above, namely that from a risk/reward perspective, we have moved at least in European High Yield space from expensive levels to very expensive. While we had some confidence in the rally so far in the first part of the year, no doubt we could see additional melt-up in asset prices, credit included but it remains to be seen how enticing the risk-adjusted yields will look in 2018 in the Circus Maximus. The pain from rising yields and the continuation of the flattening of the yield curve will probably come to bite at a later stage.

When it comes to Deutsche Bank's recommendation in playing Senior financials versus subordinated financials, it makes sense, given the latest Banco Popular bloodbath. On this subject we read with interest Euromoney's article from the 13th of June entitled "Spain’s bank rescue could make tier 2 less Popular":

"Both AT1 and tier-2 investors lost everything when Banco Santander rescued Banco Popular, while senior bondholders were untouched. The rescue has shown that when banks in Europe get into trouble it is liquidity, not capital, that matters and that the fate of subordinated bondholders is anything but predictable.

There is no doubt that the AT1 market took the surprise bail-in of Banco Popular’s subordinated debt and equity in its stride. Despite its tier-1 and tier-2 debt trading at around 50c and above 70c, respectively, the day before, both became worthless when Spain’s Fondo de Reestructuración Ordenada Bancaria placed the bank into resolution on Wednesday, imposing losses of around €3.3 billion on debt and equity investors. The market has been patting itself on the back ever since, calling the sale of Banco Popular to Banco Santander for €1 a textbook outcome. Peripheral bank AT1s barely stirred. According to CreditSights, these bonds traded down over the course of the following week, but many by less than a point. 

Overall, the AT1 market has been trading close to 12-month highs, the memory of the market disruption caused by questions over Deutsche Bank’s ability to meet coupon payments on its AT1 paper in the first quarter of last year seemingly a faint one. Even peripheral names only fell to around 85% to 90% of those 12-month highs after Popular’s wipeout. Sorely needed This was a sorely needed win for the EU’s Bank Recovery and Resolution Directive (BRRD) after its shaky start with Novo Banco at the beginning of 2016 and the protracted horse trading over state support to Italy’s troubled MPS ever since.

The overnight move by the Single Resolution Board (SRB) saw Popular’s AT1s pushed past their CET1 triggers by the extra provisioning that Santander has demanded to take on Popular’s €36.8 billion of non-performing assets – just 45% of which were covered by provisions. So far, so good. However, there are a few things about this bail-in that are not exactly text book as well. The whole point of contingent convertible tier-1 debt is that it has triggers: Popular’s were set at 5.125% and 7%. It has two AT1 deals outstanding – a €500 million 11.5% low trigger deal and a €750 million 8.25% high trigger deal.

In the bank’s Q1 2017 presentation, its CET1 was 10.02% ­– still a long way from both of those, although its fully loaded CET1 ratio was closer to 7.33%. However, Popular had never missed a coupon payment on any of these notes: if this situation had really been played by the book that is what should have happened first. This is what the hoo-ha over Deutsche Bank’s available distributable items was all about last year. Banco Popular's situation has shown that the fate of subordinated bondholders actually has very little to do with the precise structure of the instruments that they are holding. Neither of Popular’s tier-1 notes had breached their triggers before the SRB decided that the bank had become non-viable late on Wednesday. Indeed, European Central Bank (ECB) vice-president Vitor Constâncio has clearly stated that the bank’s solvency was not the issue.

“The reasons that triggered that decision [to deem the bank non-viable] were related to the liquidity problems,” he explains. “There was a bank run. It was not a matter of assessing the developments of solvency as such, but the liquidity issue.”

There certainly was a bank run. €20 billion left Banco Popular’s coffers between the end of March and June 5 – the same day that its chairman Emilio Saracho declared that he did not plan to request emergency assistance from ECB because it was not necessary. The sale to Santander is understood to have been put together in less than 24 hours.

It was thus depositor withdrawals that caused the SRB to deem the bank to be failing or likely to fail under Article 18 (1) of the Single Resolution Mechanism Regulation. This meant that it had hit the point of non-viability (PONV). 

Investors in AT1 instruments should, therefore, be paying much closer attention to the PONV language in their documentation than to trigger language. When a takeover deal that blows through the latter is hammered out overnight there is not a lot that you can do.
The market has long muttered about the death spiral effects in the CoCo market – whereby debt investors that are converted into equity on breach of a trigger are forced to immediately sell that equity and accelerate the demise of the institution. This is the first time that there has been any principal or coupon loss in the AT1 market and there was no sign of a death spiral. 

However, that was only because the bondholders didn’t have time to be converted into anything that could be sold: Popular’s AT1s and tier 2s were converted into shares that were immediately written down to zero. The market has spent too much time fretting over the impact of CET1 triggers that – if Popular is a textbook case – will never get to be hit.

The wipeout of Popular’s equity and AT1 investors is unquestionably the BRRD doing what it was designed to do and investors will not have been surprised by their treatment.

Pimco is understood to have been holding €279 million of the AT1s at the end of March – the giant US money manager also held more than €100 million of Novo Banco senior bonds that were bailed in under its disputed resolution.

However, the fallout from Popular’s demise might be more keenly felt by its tier-2 investors.

The deal with Santander means that Popular’s tier-2 investors were dealt with in exactly the same way as its AT1 investors – they were written down to zero – although the tier-2 investors got the €1. This in effect removes any distinction between the two asset classes in resolution.

The temptation to wipe out anything that you can in resolution is understandable as it makes the bank more attractive to a potential buyer, but if this will always happen then why buy tier 2? You are getting paid more for the same risk with AT1.

All eyes are now on the tier-2 bonds of two other Spanish lenders: Liberbank, whose 6.875% €300 million tier-2 bonds traded below 81c on Friday – while a short selling ban was placed on its shares on Monday.

Another lender, Cajamar, also has a €300 million 7.75% tier-2 bond outstanding that is now trading below 90c. Popular’s tier 2s were trading at between 70c and 80c immediately before they became worthless.

What is key here is that Popular had yet to issue any new style bail-inable senior debt. If banks want investors to buy their tier-2 debt then in future, a resolution such as this might need to involve – very different – haircuts for both tier 2 and senior debt rather than oblivion for one and protection for the other; Popular’s senior bonds were up from 90c to 104c after the deal.

Although this takeover is a neat and straightforward demonstration of what investors can expect under BRRD, there needs to be a closer examination of the loss-absorbing hierarchy of tier 1 and tier 2 in the process. If they are the same then you don’t have a repayment waterfall – you have a lake." - source Euromoney

Of course, we would argue that no matter how much liquidity via LTROs the ECB has injected, liquidity doesn't amount to solvency hence the importance lessons in dealing swiftly with nonperforming loans as done by the Fed, while the ECB has been following a path more akin to Japan (here comes our "japanification" analogy). But, from a technical perspective on the subject discussed in details by Euromoney, there is a technical aspect that needs to be discussed namely protection offered only to some subordinated bondholders via the CDS market:

"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."

A typical LT2 Structure is as follows:
10 years, non-callable for 5 years (10-NC5)
-Final maturity is hard, meaning no get out clauses.
-No coupon deferral. A coupon deferral would constitute a credit event and therefore trigger a credit event and the relating CDS.
-Ratings: 1 notch below senior debt (Moody's / S&P).
-More standardised structure than Tier 1 or UT2. Given regulatory capital treatment decreases as it moves towards maturity (as it gets closer to 5 years to maturity) so many deals structured have had callable features, meaning the issuer can decide to call the bond.

As a reminder the Dutch bank SNS resolution in 2013 meant that Tier 1 bonds and LT2 losses equated to 100%. At the time the SNS intervention clearly pushed the envelope on how national authorities and now the ECB being the European regulator are willing (and able) to go in the resolution of a failing financial institution. The downside recovery for LT2 (using Irish precedents) was generally assumed to be 20%. This should have been understood to be 0% back in 2013, but yet again investors have been blind. Why the change in recovery rate from 20% to 0% matters in the CDS space?

If the recovery rate for LT2 subordinated bonds is zero (again for Banco Popular and in similar fashion to the SNS case), the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. Subordinated debt should in essence trade much wider to Senior! Particularly if liquidity, not capital, matters and if the fate of subordinated bondholders is anything but predictable.

Here is your "known unknown". Yet in Banco Popular's case the short end of the CDS curve was already inverted before the takeover for €1 was announced so while in the above article we read that there was no sign of a death spiral, this is not entirely correct. If indeed AT1 are known unknowns, and are American options like short gamma trades, who really cares about the capital threshold trigger aka the strike price seriously? We don't and continue to dislike these bonds but hey, some might enjoy nonlinearity, we are not big fans.

For those who have been following us, we have been pretty vocal on the evident lack of resolution of the nonperforming loan issues (NPLs) plaguing the Italian banking sector. On a side note we did at the end of last month a podcast on the Futures Radio Show in which we discussed Italy, being for us the biggest risk in Europe.
The on-going issues plaguing the oldest bank in the world namely BMPS aka Banca Monte dei Paschi di Siena can be seen in the CDS market and the NPLs have yet to be meaningfully tackled as indicated in the recent blog post from DataGrapple from the 19th of June entitled "A Tricky Task Just Got More Difficult":

"On Friday, it emerged that Fortress Investment Group and Elliott Capital Management had dropped out of talks to buy bad loans from MONTE ( Banca Monte dei Paschi ) complicating the rescue plan for the lender backed by the Italian government. They were the only international bidders for the riskier tranches of MONTE’s bad loan securitization. That leaves Atlante, the fund set up to help the struggling Italian banking sector, as the only potential buyer and jeopardizes the asset sale, which is a key part of the plan to restructure the bank with a capital injection from the state, after MONTE failed to shore up capital privately. Ultimately, it could also make similar rescue plans for two other northern Italian lenders, Veneto Banca Spa and Popolare Vicenza Spa, much more difficult to pull off. Surprisingly, if MONTE’s 5-year risk premium was marked aggressively wider - insuring senior debt now costs 330bps per year, while insuring subordinated costs 73.5% upfront -, it did not feed through the whole Italian banking sector and most names were actually unchanged to a tad tighter." -source DataGrapple

And guess what 73.5% upfront Subordinated CDS still seems pretty cheap if you ascertain the fact that your recovery value on the subordinated bonds will probably be a big fat zero...Just a thought. So while you might want to continue playing the Circus Maximus credit show, when it comes to favoring Senior Financials over Subordinated bonds, use your credit skills wisely.

If you indeed love low volatility, stick to investment grade credit because as the party continues flow wise in that space, the feeble crowd aka retail is now joining the party with both hands according to Bank of America Merrill Lynch Credit Market Strategist note from the 16th of June entitled "ECB+BOJ&Fed, redux":

"Retail taking over from foreigners

US high grade corporate bonds have returned 4.2% this year driven by 7.3% in the backend. With the timing of the decline in interest rates, not surprisingly about two-thirds of this performance has accrued in 2Q. These stellar returns are now attracting retail money to HG bond funds and ETFs in the usual way (chasing performance). As we have often highlighted, in the first part of the year we had record inflows without supporting preceding performance necessary to attract retail inflows – in fact HG lost almost 3% in 4Q 2016 (Figure 2).

Our view remains that foreign investors were responsible for the big acceleration in HG bond fund/ETF inflows to begin the year, as the timing coincided with a big decline in the cost of dollar hedging (Figure 3).

Furthermore these inflows accelerated more at the end of the Chinese New Year." - source Bank of America Merrill Lynch

It looks to us that indeed Circus Maximus is getting crowded, but for now everyone in the credit "karaoke" is singing "carry on" so you probably got to keep dancing...

In our final charts below and given our take in the podcast, we continue to view Italy as the biggest European risk even though elections have so far been postponed. Growth is not meaningful enough, we think to alleviate the slowing but still growing very large nonperforming loans problem on Italian banks' balance sheets.

• Final charts - Italy? It's getting complicated

While we won't go through the debt trajectory of Italy and the dismal growth experienced in recent years, for our final charts we would like to point to charts from a recent presentation done by French broker Exane on the 12th of June. They point out to IMF work showing that the NPL ratio drops significantly when GDP growth reaches 1.2% (and particularly when this trend is sustained for a few years). Their charts below also display the relationship with the 2-10 Italian yield curve. This indicates that Italian banks are very sensitive to a surge in yields in the short-end which makes very interesting in the light of the willingness in tapering as of late from the ECB:

Italy: GDP Growth versus NPL ratio

Italy: NPL ratio versus 2-10 yield curve

- source Exane

According to them, YoY growth for Italy is likely to enable a significant decline in NPLs. Yet they indicate that while there is hope for a relaunch of the European project, the situation of the banking sector remains a concern and is still plaguing credit conditions for the corporate sector. They conclude their slide in their French presentation by saying that for the sustainability of the Italian debt, it's getting complicated. We could not agree more: "Troppo complicato!"

"Too much sanity may be madness and the maddest of all, to see life as it is and not as it should be." - Miguel de Cervantes

Stay tuned!

Macro and Credit - The Cult of the Supreme Being

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

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

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

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

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

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

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

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

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

Synopsis:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Foreign portfolio investment stayed strong in July 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

- source Wells Fargo Securities

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

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

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

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

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

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

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

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

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

Implications for Investors 

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

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

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

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

Stay tuned!