Macro and Credit - Who's Afraid of the Big Bad Wolf?

"If you live among wolves you have to act like a wolf." - Nikita Khrushchev

While still being mesmerized by the "goldilocks" environment for credit thanks to low interest rates volatility, in conjunction with new records being broken in the equities sphere, when thinking about what our title analogy should be, we reminded ourselves of the popular song "Who's Afraid of the Big Bad Wolf?" written by Frank Churchill originally featured in the 1933 Disney cartoon Three Little Pigs. It was sung by Fiddler Pig and Fifer Pig as they arrogantly believe their houses of straw and twigs would protect them from the Big Bad Wolf. With the continuation of the beta game played by the "yield hogs", obviously the Big Bad Wolf would be a sudden burst of inflation, which would no doubt take down their "credit" houses of straw and twigs. This would clearly change the central banking narrative and put an end to the "goldilocks" environment we are seeing. We do not think we are there yet, but as we pointed out in our recent musings, for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation". In the Disney cartoon, an angry Practical pig did warn his two brothers though:

"You can play and laugh and fiddle. Don't think you can make me sore. I'll be safe and you'll be sorry when the Wolf comes through your door!"

Overall, we'd rather be seen as "Practical yield pigs" than "perma bears". As such we do think that a surprised return of inflation could indeed be a catalyst for a "repricing" of the bond "bubble". 

In this week's conversation, we would like to look at if indeed it's not the Fed which is responsible for its lackluster record in reaching its 2% inflation target. In terms of asset prices "inflation", one could argue that the Fed's record is "untarnished". 

Synopsis:

• Macro - Low inflation? Blame the Fed 
• Credit - Credit cycles die because too much debt has been raised
• Final chart - Senior officer loan survey leads default rates

• Macro - Low inflation? Blame the Fed 

In our most recent musing, we mentioned that inflation in the US was suffering from an autocorrelation problem. What we have long posited is that while wanting to induce inflation, QE induces deflation and that's exactly what the Fed has been doing. This is what we discussed in March 2015 in our conversation "The China Syndrome". At the time, we quoted CITI's Matt King's 27th of February note entitled "Is QE Deflationary":

"It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?
Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”
Clearly this is not what’s supposed to happen. QE, and stimulus generally, is supposed to create new demand, improving capacity utilization, not reducing it. But as we pointed out in our liquidity wars conference call this week, it feels ever moreas though central bank easing is just shifting demand from one place to another, not augmenting it.
The same goes for the drop in oil prices. In principle, this ought to be hugely stimulative, at least for net oil consumers. And the argument that it stems solely from the surge in US supply, not from any dearth of global demand, seems persuasive as far as it goes.
But in practice, the wave of capex cuts and associated job losses in anything even vaguely energy-related feels much more immediate than the promise of future job gains following higher consumption. The drop in oil prices, while abrupt, in fact follows a three-year decline in commodity prices more broadly. It’s not just oil where we seem to have built up excess capacity: it’s the entire commodities complex." - source CITI

Also, stronger USD leads to higher deflationary risk leading to lower long-term bond yields. Even though exports are only 13% of the US economy, remember that 40% of S&P 500’s earnings now come from outside the US. But when it comes to "anchoring" inflation expectations and the threat of the Big Bad Wolf, it seems that the Fed has failed as pointed out by BNP Paribas in their note from the 12th of October entitled "US: Blame the Fed for low US inflation":

• Too hawkish rhetoric too early and too little attention to inflation expectations are the main reasons why core inflation is nearer to 1% than 2%. It’s the Fed’s fault.

• The taper tantrum lowered inflation expectations a lot, and the 2015 and 2016 rate hikes both came when data were signalling a rise was inappropriate.

• Inflation expectations are not at a level that is consistent with hitting 2% inflation – we reckon break-evens would need to be 2.5% to be consistent with that; we’re well short.

• The Fed is a poor inflation forecaster and its reaction function is foggy, hence the need to heavily flag its moves. Bond rallies after rate hikes question the wisdom of the hikes.

Over-inflation of asset prices but too low inflation

Fed policy has achieved full employment – in fact, it has gone a bit beyond it. But after more than eleven years since its first cut in 2007, core inflation is 1.3%; at the same time it has overinflated asset prices. The Fed has not managed this alone – the “everything bubble” owes much to fellow central bankers who have helped pump up the liquidity that inflated financial assets.

What flattened the Phillips curve? The Fed.

However, we believe it is the Fed’s fault that US inflation is too low. Despite only four hikes in just under two years the Fed has subdued inflation expectations and therefore inflation. The Fed’s rhetoric has constantly been about raising rates, from way too early in the cycle and its rate hikes have too often been path dependent rather than state dependent.

Not enough attention given to inflation

The FOMC has too often ignored inflation when hiking. When Bernanke started the taper tantrum, core PCE inflation had descended from 2% in early 2012 to 1.4% – no wonder the market took fright. In the six months preceding the first hike, core inflation averaged only 1.3%.

Too ready to talk about hikes too early

Before the taper tantrum, the Fed had often signalled a desire to raise rates. By December 2012, it was saying that it would not hike until the unemployment rate was below 6.5%, well before full employment was reached. The same statement suggested an asymmetric inflation target: “The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective”.

The Fed has hurt inflation expectations

Inflation expectations are central to the inflationary process. The rate of increase of both wages and prices has decelerated this year– at least before hurricane effects gave them a boost. The Fed puts the inflation deceleration down to “idiosyncratic factors”. But the shocks have been so widespread and long-lasting that something else seems to be at play, especially when the deceleration also affected wages. Inflation expectations have generally declined since 2013 and we believe this has played a role in 2017’s disappointments. The end of 2013 is when the Fed started its tapering process. We don’t see this as a coincidence.

Fed driving expectations

Chart 1 shows the ASTIX measure of inflation expectations from the Philadelphia Fed.

Prior to the recession, real rate expectations and inflation expectations were positively correlated: as inflation expectations rose, so the Fed would tend to raise real rates. Since the crisis, spells of negative correlation have increased, suggesting that monetary policy is driving expectations, rather than being driven by them. We can see that QE1 and, especially, QE2 reduced real rate expectations and raised inflation expectations. Chart 2 shows this happened in markets too.

Taper tantrum drove down price expectations

The taper tantrum accompanied a big fall in inflation expectations and a rise in the expected real rate (Charts 1 and 2). We would be very critical of the Fed ignoring the much tighter monetary conditions caused by the taper tantrum when deciding to taper later that year. Not for the last time, once the Fed has been set on a course in this cycle, it has put its data blinkers on.

Fed failed to grasp import of taper tantrum

Since everyone knew that rate hikes could not start until tapering had finished, the act of tapering had a strong signalling effect. That was one of the reasons for the 2013 taper tantrum, sparked by two Ben Bernanke speeches in May and June, when unemployment was still 7½% or three points above full employment. The one-year one year (1y1y) forward rate rose almost immediately – from 0.25% to 0.50%. Bernanke had signalled that rate hikes were coming.

Fed paid too little heed to 2015 financial conditions

The reaction to Bernanke’s speeches suggests the market saw a move as premature. Before QE ended, the 1y1y had advanced, topping 1%. Rate policy had been tightened even though the policy rate was unchanged. Policy also tightened through other dimensions; the dollar appreciated and by December 2014 was up 9.2% y/y on the broad index. As rate hike expectations mounted and expectations of ECB QE built, by December 2015 there had been a further rise of 10.3%. This had a major effect on growth, inflation dynamics, including through growth, commodity prices and on expectations, we would argue. We don’t think the Fed paid enough attention to financial conditions, interpreting monetary policy too narrowly as the short rate, otherwise the December 2015 hike might not have happened.

First hike too date driven – hence no more for a year

The run-up to the first hike in December 2015 hardly suggested monetary conditions needed tightening. GDP growth in Q4 was only 0.5% aar; the ISM was sub-50 and core inflation was 1.3%. A data-dependent Fed probably would not have hiked in December, but the Fed appeared cornered by credibility concerns and delivered the first hike. Almost immediately, FOMC rhetoric switched and became much more data dependent, with the Fed backing off its hiking stance. By August, 2016 the 1y1y had declined by about 70bp from the December 2015 high. Bond yields rallied, with expected real rates falling and break-evens rising.

Fed had to press market to price in Dec 2016 hike

Things changed in mid-2016, with the ISM rallying. The Fed increasingly talked up the possibility of hikes, with Dudley saying in August that a September hike was possible. That didn’t happen, but when Dudley said on 19 October that he expected a 2016 hike, the market’s probability of a December hike rose to 75% on 26 October versus 47% on 26 September.

Hikes caused inflation expectations to fall further

The result was a sharp rise in bond yields, again largely driven by the expected real yield. The delivery of the December 2016 hike, as with the first hike, was a trigger for real rates to start to decline, after an abbreviated period. By spring, break-evens followed. The March and June 2017 rate hikes each saw bond yields and break-evens decline, along with ASTIX inflation expectations, which would suggest the market judged these hikes unnecessary.

 Difficult to see what can stop a December 2017 hike

The FOMC on 20 September gave a clear signal of a desire to hike in December. The September drop in the unemployment rate and the 0.5% m/m rise in average hourly earnings will probably have reinforced that. Despite core inflation at only 1.3% and inflation expectations seemingly too low to hit the 2% target for core PCE, it looks increasingly likely that the Fed will hike in December, short of another downward surprise to inflation.

Too late to avoid a policy mistake?

We doubt the wisdom of this and have sympathy for St. Louis Fed President James Bullard’s view that we are heading for a policy mistake. We also see support for Minneapolis Fed President Neel Kashkari’s point that the reason the Fed is undershooting its targets is the Fed itself. It has tightened too early and has dampened inflation expectations. This now leaves it in a quandary, we believe. To lift inflation to target, it will have to keep rates soft and risk even further asset overvaluation, while taking unemployment to too low levels risks a bust and a rise in unemployment that delivers recession and ends with the economy close to deflation. However, if the Fed were to raise rates with inflation so low, it would run the risk of further suppressing inflation expectations. This is a bind that has been caused by too many mistakes in the past and it appears difficult to thread a satisfactory way through." - source BNP Paribas

What the Fed has effectively been doing is playing the hand of aging populations by creating inflation in asset prices and in particular bond prices. Aging savers buy future goods (securities) rather than present goods. As we wrote previously, the issue we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year but also in terms of cumulative flows in bond mutual funds and ETFs as displayed in the below chart from Deutsche Bank from their Global Market Strategy note from the 20th of October untitled "Jumping equilibrium?":

- source Deutsche Bank

But is the game turning? Should we switch camp from the "deflationista" towards the "inflationista" camp? We wonder.

Back in our October 2012 conversation "QE - To infinity...and beyond" we quoted Richard Koo, chief economist at the Nomura Research Institute regarding the challenges of moving from QE to QT:

"Perceived limits on fiscal policy increase pressure on monetary policy

In spite of these experiences, the baseless view that fiscal policy has reached its limits has come to dominate the debate in many countries, including Japan. That, in turn, has placed a great deal of pressure on central banks and led them to inject a sea of liquidity into the market when there is no reason why more liquidity should have any effect. This liquidity will create no problems as long as there is no private demand for loans, since the funds essentially sit in the financial system. The problems come when private demand for loans returns to normal levels and those funds resume circulating. 

Central banks must tighten aggressively when loan demand picks up 

As soon as private loan demand recovers the central bank will have to mop up the excess liquidity, which is currently running at two to three times the normal level. Otherwise prices could double or triple. But to do so the central bank must sell the bonds it bought, putting upward pressure on interest rates just when the private sector is ready to borrow money again. The Fed, for example, will have to sell $1.4trn in bonds when conditions in the private sector return to normal, at a time when the economy is recovering and businesses and households are becoming sensitive to interest rates. And if the market decides that the central bank is not mopping up excess liquidity fast enough, that alone could lift private inflation expectations and send bond yields sharply higher. In short, the central bank finds itself in a difficult position whether it sells the securities or not. Either way a major ordeal awaits both the central bank and the bond market. Once this point is reached, the central bank will probably attempt to reduce the “real value” of liquidity in the market by sharply raising the statutory reserve ratio for commercial banks, a tactic frequently employed by the People’s Bank of China. But all these measures will have significant negative implications for the economic recovery. While QE will do little damage at a time when private loan demand is weak or nonexistent, like today, it requires the central bank to engage in aggressive tightening just when the private sector is beginning to recover." - source Nomura - Richard Koo.

Given China's most recent uptick in its PPI to 6.9%, we are indeed wondering if this is not a sign that we should change allegiance slightly towards the "inflationista" camp and start fearing somewhat the possibility of the return of the Big Bad Wolf aka inflation. We will be monitoring closely this latest China "inflation impulse". China's rising costs via exports could boosts inflation expectations in the US. These higher inflation expectations in the US would mean a steeper yield curve with a rise in long-duration yields ovcrall and it would lead to higher rates volatility down the line. A bear market needs a wolf and this wolf would materialize in a return of inflation we think.

Obviously the return of the Big Bad Wolf aka inflation would trigger a return of bond volatility. On this subject we read with great interest Christopher R. Cole, CFA from Artemis Capital Management latest note entitled "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987". It was very interesting in Christopher Cole's must read note to see his reference to the Ouroboros, the ancient symbol of a snake consuming its own body. We have used a similar reference as a title analogy recently in our September musings also called "Ouroboros". For us the Ouroboros represents the eternal return or cyclicality especially in the sense of something constantly re-creating itself like credit cycles. For Christopher Cole at Artemis the Ouroboros represents the dangerous feedback low between ultra-low interest rates, debt expansion, asset volatility, and financial engineering that allocates risk based on volatility. What is of interest to us, when it comes to the Big Bad Wolf and the Ouroboros mythical snake are the points made by Christopher Cole from Artemis relating to volatility always coming from debt markets:

"The death of the snake...

Volatility fires almost begin in the debt markets. Let's start with what volatility really is. Volatility is the brother of credit... and volatility regime shifts are driven by the credit cycle.

Volatility is derived from an option on the shareholder equity, but equity itself can be thought as a perpetual option on the future success of a company. When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions will lead to higher equity volatility. When credit is easily available and rates are low, volatility remains suppressed, but as credit contracts, volatility rises.

In the short term we do not see the credit stress required for a sustained expansion of volatility, but this can change very quickly. Storm clouds are gathering around 2018-2020, as rising interest rates, rich valuations, and corporate debt roll-overs all converge as potential triggers for higher stress and volatility. The IMF warned that 22% of US corporations are at risk of default if interest rates rise. Median net debt across the S&P500 firms is close to a historic high at over 1.5x earnings, and interest coverage ratios have fallen sharply. Between 2018-2019 an estimated $134 billion of high yield debt must be rolled-over, presenting a catalyst for higher volatility in the form of credit stress.

Reflexivity in the Shadow of Black Monday 1987

Thirty years ago, to the day, financial markets, around the world crashed with volatility never seen before or equaled again in history. On October 19th, 1987 the Dow Jones Industrial Average fell more than -22%, doubling the worst day from the 1929 crash. $500 billion in market share vaporized overnight.

Entire brokerage firms went bankrupt on margin calls as liquidity vanished. It was not a matter of prices falling, there were no prices. You couldn't exit a position. Trading desks refused to pick up the phone. Black Monday appeared to come out of nowhere as it occurred in the middle of a multi-year bull-market. There was no rational reason for the crash. In retrospect, financial historians blame portfolio insurance, ignoring the role of interest rates, inflation, and the Federal Reserve. The demon of that day still haunts markets, and 30 years later the crash is still not well understood. Black Monday 1987 was the first post-modern hyper crash driven by machine feedback loops, but it all started in a very traditional way.

Be careful what you wish for... Today every central bank in the world is trying to engineer inflation, but inflation was the hidden source of the 1987 financial crash. At the start of 1987 inflation was at 1.5%, which is lower than it is today! From 1985 and 1986 the Federal Reserve cut interest rates over 300 basis points to off-set a slowdown in growth. That didn't last for long. Between January and October 1987 inflation violently rose 300 basis points. Nominal rates jumped even higher, as the 10-year US treasury rose 325 basis points from 6.98% in January 1987 to 10.23% by October 1987.

The Fed tried to keep pace by raising rates throughout the year but it was not fast enough. The quick increase in inflation was blamed on the weak dollar, falling current account balance, and rising US debt-to-GDP levels. None of this hurt equity markets, as the stock market rose +37% through August 25th, 1987. Then the wheels fell off." - source Christopher R. Cole, CFA - Artemis Capital - "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987"

As pointed out by Christopher Cole in his must read note, the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. The only issue is once the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:

“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”

Also, in addition to Christopher Cole's points, credit investors have a very weak predictive power on future default rates. Credit investors are collectively subject to an extrapolation bias. When default rates are high, credit investors behave as if default rates were going to stay high for the next 5-10 years. They liquidate their portfolios in panic (or because they are forced to do so). This snowball effect leads to spread levels that have no economic rationale. Inversely, when default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to malinvestment, and sows the seeds of the next credit crisis.  Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns, that simple as pointed out by our good friend Paul Buigues:

"For us, credit is spread, not yield. A high-yield bond is a bet on the issuer’s creditworthiness combined with a bet on risk-free interest rates. Consequently, people who rely mostly on the low yield argument to justify their bearishness on high yield bonds should concentrate their hostility against Treasuries."

Or in Europe, given the levels reached on some European Sovereign bonds, they should concentrate their hostility against them, given the ECB is the most important buyer in town, for now...

As we have repeatedly pointed out, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy". As we pointed out in our conversation "Thermidor" in August 2016, this of course is leading to a "pre-revolutionary" mindset setting in, and the rise of "populism" with the deafening sound of "helicopter money" and fiscal profligacy as the "elites" and their central bankers are starting in earnest to "panic" somewhat. Could the rotation from "deflation" to "inflation" trigger indeed a surge in commodities? We wonder... After all the recent surge in the Chinese PPI could indeed be somewhat pointing towards some inflation surprises down the line.

If as indicated by Christopher Cole, volatility is the brother of credit, then obviously assessing the longevity of the credit cycle is paramount. We do agree with Christopher that, for the time being, we do not see the credit stress required for a sustained expansion of volatility. It's only when the Big Bad Wolf will rear its ugly face that we will change our "Practical yield pigs" stance. But if indeed the credit cycle matters from an Ouroboros perspective, then obviously one has to wonder how the death of the credit snake comes about as per our next point below.

• Credit - Credit cycles die because too much debt has been raised

When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion. 

On the issue of how the credit cycle could end, we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 13th of October entitled "The Evolution of the Credit Cycle":

"How it ends?

Our observations and model estimates so far have painted a relatively benign picture, suggesting that defaults could remain low for some time. Having adopted this as the base case, we now turn to discussion of factors that could potentially derail it and prove us wrong.

All cycles before this one have ended with a surprise event, a “black swan” of sorts, which, by definition, was unexpected by the consensus and meaningful in its impact. This one is probably not going to be unique in this respect. And while forecasting the exact event is a futile exercise, we can still think about the general set of circumstances that could potentially turn this credit cycle.

Broadly speaking we envision three kinds of developments that could play such a role:

1. Inflation returns. If low inflation and loose central bank policies have played a critical role in helping the markets get to this stage, it would be natural to expect them to play a certain role in reversing this move. At any given level of inflation, major central banks have proved time and again that they are more dovish than consensus expects them to be, and there are few signs to suggest that their behavior is about to change. With that it seems that only a genuine inflation surprise would wake them up and cause the kind of correlated policy tightening that few people currently expect to take place. So far, decent economic growth numbers in the US, Europe, and Asia have failed to spark any measurable inflation pressures. However, we are watching certain economic indicators closely, such as PMIs or Korean and Japanese exports (all at cyclical highs), which could prove to be early signs of an overheating. In the long run, we believe inflation will remain secularly squeezed by technology, but a temporary rise cannot be ruled out.

2. Distress in isolated sectors spreads. We have seen an example of this most recently in energy and commodities, where a 25% default wave nearly pushed the broad HY market into a full-blown default cycle. At the moment, there are few reasons to expect something like that to play out in the next year, with all known problematic segments, such as retail, wireline telecoms, and selected healthcare providers, representing tiny shares of the market (cumulative distress ratio is under 5% today). Again, we see few immediate reasons to believe that these known problems in narrow industries would spread elsewhere, but it’s usually helpful to think about broader vulnerabilities if things develop in some unexpected fashion. To that end, if we expanded the range of problematic sectors to broad retail, healthcare, wireline telecoms, and also brought energy/mining back into the fold, their combined size grows to 30% of the total HY market. An additional layer of risk is being created by extreme concentration of large IG issuers, where the top ten non-financial capital structures today represent 50% of the total size of the HY market, the second-highest on record except for 2002 (Figure 7).

A fallen angel of that magnitude would create a meaningful disruption on transition.

3. Geopolitics cause a trade contraction. The long list of unresolved global conflicts here is well known and does not require a recital here. Suffice to say that a flare up in any one of them could easily awaken the markets from their QE-induced hypnosis. And even outside the worst-case scenarios of an open military engagement, things could develop in a way such that the global economy suffers a shock. Consider the fact that S Korea is the single-largest source of Chinese imports, followed by the US and Japan. The same trio also appears on the other side of this trade superhighway, only as the largest destinations of Chinese exports. It is probably fair to say that some major global supply chains depend critically on these lanes staying wide open and unencumbered. One could draw a dotted line between where we are and a sharp contraction in this epicenter of global trade even if the world avoids the worst-case scenario on the Korean peninsula." - source Bank of America Merrill Lynch

Indeed, credit should be afraid of the Big Bad Wolf aka inflation. This would clearly generate renewed volatility in the rates space and obviously a reaction in the credit space. It seems for now the market doesn't seem much concerned by an inflation surprise, while the carry and beta game continue to be played significantly thanks to low volatility. We are part of the crowd that thinks that any small upside surprises in inflation could potentially affect markets materially. Such a surprise would trigger a surge in volatility. So who is afraid of the Big Bad Wolf? We are.

For our final chart, when it comes to predicting a move in the credit cycle and a surge in default rates as we pointed out in the past, you need to track the quarterly Fed's Senior Loan Officer Opinion Surveys (SLOOs).

• Final chart - Senior officer loan survey leads default rates

The most predictive variable for default rates remains credit availability. The SLOOS report is that it does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. Our final chart comes from Bank of America Merrill Lynch Collateral Thinking note from the 20th of October and entitled "Deconstructing the default rate". It displays that SLOOs leads default rate in general:

"Being in one of the longest running credit cycles in history, the question we get asked most frequently is: when will we get the next default cycle? While we believe we are in the ninth inning, there is also evidence suggesting that the cycle has some more room to run in terms of accumulation of debt and generation of profits. As such we don’t think that default rates have quite bottomed out yet and believe next year to be characterized by even fewer default losses than this year. Our belief rests on both the macro and micro indicators that we use to predict the direction of default rates in Loans as well as HY.

Specifically for the loan universe, which we define as the loans in the LCD index, we gauge the state of the macro environment through the senior loan officer survey. This survey determines the ease with which medium to large sized companies (annual revenue&$50mn) are able get bilateral loans from banks, and thus is a good broad level indicator of on-ground credit conditions. On a micro level, we capture the change in the credit risk of the Loan universe through migration rates. A combination of these two factors is able to explain almost all of the variation in default rates since 2009 with about a 12 month lag. Today, both those factors are largely supportive of loans- the survey shows financial conditions have been easing for two quarters in a row (Chart 3), while credit migration rates have not materially deteriorated to flash warning signs. We think this firmly sets the stage for a lower default rate in 2018." - source Bank of America Merrill Lynch

Of course, should the Big Bad Wolf rear its ugly face again, then obviously, all credit bets for high yield would be off with the return of heightened volatility, the dear brother of credit as pointed at by Christopher Cole from Artemis Capital. For now Fiddler Pig and Fifer Pig continue to arrogantly sing while the volume is pumping up towards 11 in true Spinal Tap fashion but we ramble again it seems...

"It never troubles the wolf how many the sheep may be." -  Virgil

Stay tuned!

Macro and Credit - Two Generals' Problem

"It is impossible to suffer without making someone pay for it; every complaint already contains revenge." -  Friedrich Nietzsche

Watching with interest, the trade war narrative escalating thanks to the new US administration and reciprocal tweets between president elect Donald Trump and former Mexican president Vicente Fox relating to the Mexican wall to be erected, in true MMMA fashion (Macro Mixed Martial Arts) reminded us for our title analogy of the Two General's problem. The Two Generals Problem is a thought experiment meant to illustrate the pitfalls and design challenges of attempting to coordinate an action by communicating over an unreliable link. It applies to any type of two party communication where failures of communication are possible. The problem we chose as a title analogy highlights the importance of "Common knowledge", which we have used in the past as an analogy about potential outcomes for credit crisis. 

The Two General's problem is also known as the Two Generals Paradox, the Two Armies Problem or the Coordinated Attack Problem. We find of interest that it was the first computer communication problem to be proved to be unsolvable in the face of arbitrary communication failures, thus providing a base of realistic expectations for any distributed consistency protocols. In regards to realistic expectations, with the latest US GDP in Q4 rising only 1.9% and below the expected 2.2%, one could argue that given the heavier debt load which has been accumulated in recent years, some would be wise to review their growth expectations in the light of US growth being lower for longer but we ramble again. 

But, moving back to our analogy, the problem is as follows: Two armies, each led by a general, are preparing to attack a fortified city. The armies are encamped near the city, each in its own valley. A third valley separates the two hills, and the only way for the two generals to communicate is by sending messengers through the valley. Unfortunately, the valley is occupied by the city's defenders and there's a chance that any given messenger sent through the valley will be captured. While the two generals have agreed that they will attack, they haven't agreed upon a time for attack. It is required that the two generals have their armies attack the city at the same time in order to succeed, else the lone attacker army will die trying. They must thus communicate with each other to decide on a time to attack and to agree to attack at that time, and each general must know that the other general knows that they have agreed to the attack plan. Because acknowledgement of message receipt can be lost as easily as the original message, a potentially infinite series of messages are required to come to consensus. The thought experiment involves considering how they might go about coming to consensus. In its simplest form one general is known to be the leader, decides on the time of attack, and must communicate this time to the other general. The problem is to come up with algorithms that the generals can use, including sending messages and processing received messages, that can allow them to correctly conclude:

"Yes, we will both attack at the agreed-upon time."

Allowing that it is quite simple for the generals to come to an agreement on the time to attack (i.e. one successful message with a successful acknowledgement), the subtlety of the Two Generals' Problem is in the impossibility of designing algorithms for the generals to use to safely agree to the above statement. The first general may start by sending a message "Attack at 0900 on August 4." However, once dispatched, the first general has no idea whether or not the messenger got through. This uncertainty may lead the first general to hesitate to attack due to the risk of being the sole attacker. To be sure, the second general may send a confirmation back to the first:

"I received your message and will attack at 0900 on August 4." 

However, the messenger carrying the confirmation could face capture and the second general may hesitate, knowing that the first might hold back without the confirmation. Further confirmations may seem like a solution - let the first general send a second confirmation: 

"I received your confirmation of the planned attack at 0900 on August 4." 

However, this new messenger from the first general is liable to be captured too. Thus it quickly becomes evident that no matter how many rounds of confirmation are made, there is no way to guarantee the second requirement that each general be sure the other has agreed to the attack plan. Both generals will always be left wondering whether their last messenger got through. Since the protocol is deterministic, the general sending that last message will still decide to attack. We've now created a situation where the suggested protocol leads one general to attack and the other not to attack - contradicting the assumption that the protocol was a solution to the problem.

You are probably already asking yourself, where we are going with this analogy, but, it appears to us that the tweeting protocol of the new US president of the United States is not the solution to the trade problem of his country. On another note, while in our analogy and example a protocol is deterministic, regardless of the generals at the Fed, so is the credit cycle.

Synopsis:

• Macro and Credit - The credit cycle is deterministic
• Final chart -  High Yield priced to perfection is not a good sign

• Macro and Credit - The credit cycle is deterministic

While central bankers and in particular the Fed has been attempting in recent years to avoid pitfalls and failures to communicate appropriately their actions through a deterministic communication protocol, regardless of their numerous communication attempts, something still remains and it is the credit cycle. On numerous occasions we have looked back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube which we introduced in our conversation "The Night of the Yield Hunter":

- source Rcube

Although arguably, long government bonds appear to be a poor proposal at this very moment, particularly in Europe since the election of US president Donald Trump. There will come a point where US long bonds will get enticing again, particularly with such a consensus short base on the US 10 year Treasury Notes. What appears to us clearly "mis-priced" from our perspective is volatility. Risks are more and more asymmetric in 2017, therefore one should seek asymmetric payoffs in this context.

As shown by the latest US GDP in Q4 rising only 1.9%, if growth disappoints in Q1, as it did in 2016, the Fed has little ability to use a deterministic protocol, in a year where pundits are focusing more and more on inflation expectations. As we pointed out in our November conversation  "From Utopia to Dystopia and back":

"The second half rally saw credit investors piling on more duration and more credit risks, meaning more instability in credit markets at the time where "Dystopia" has been fading in financial markets. As we pointed out in our previous conversation, we think the market is trading ahead of itself when it comes to its expectations and utopian beliefs. Like any good behavioral therapist we tend to focus on the process rather than the content and look at credit fundamentals to assess the lateness of the credit cycle." - source Macronomics, November 2016

In a market where both US High Yield and European High Yield are "priced to perfection", we will be very wary about what credit spreads will be doing in the coming weeks. To repeat ourselves, there is no doubt to us that we are moving towards the last inning of the credit cycle. On that subject we read with interest Nomura's take from their Japan Navigator note number 702 from the 23rd of December:

"Sharp JGB market sell-off is the first sign of a credit crisis

From the perspective of a 10-year credit cycle,  financial markets have entered a third-year period that represents the last stage of expansion, and thus are approaching a credit crisis (Figure 3).

We would view a sharp JGB sell-off as the first sign of the credit crisis, and believe that the JGB market entered the bearish cycle in mid-2016.
In the current 10-year cycle, we believe a credit crisis will stem either from China’s property market or the US corporates market. Both of these markets have inflated to alarming levels. The Fed became aware of the risk of an asset inflation bubble in the corporates market in 2013, exiting QE3 and implementing two hikes. Despite these efforts, the market continues to inflate on investor flows from the Euro area, Japan and China, where central banks remain ultra-easy (Figure 4).

That said, government bond markets began to sell off in summer 2016, which we view as their pricing-in of the ECB’s and BoJ’s hawkish shift, suggesting the excess liquidity-driven rally has entered its final stage.

What will follow the US’ protectionism and isolationism

In our opinion, the Trump administration’s potential failure in its protectionist strategy is the biggest downside risk for bond yields in 2017. We believe the new administration is unlikely to seek a diminished equilibrium via a weaker USD and higher tariffs, as included in President-elect Trump’s campaign pledge, but instead use these measures as bargaining chips to win concessions from others in expanding domestic demand and opening markets – in short, it will likely seek an expanded equilibrium.

However, if the Trump government fails in its attempt, it could actually implement these bargaining chip measures, thus exporting deflation to other economies, in our view. We would also be concerned about a scenario of another Brexit as a result of isolationism gradually taking hold in the Euro area. If this materializes, we would expect substantial risk aversion, but we see little risk of any such scenario at this point.

We view China’s higher inflation as not only a downside risk in the bond market, but also a factor that could lead to a global credit crisis. If China’s CPI inflation rise above 3% (which we consider an optimal level) in 2017, we would expect fairly aggressive PBoC tightening, which could lead to the bursting of China’s property market bubble. In this materializes, we believe the last stage of the global credit cycle would be brought forward.

Medium-term scenario

• We believe the bearish cycle that started from the US presidential election (Trump risk-on rally) will end its first stage in December-February. In March-May, markets will likely test room for flattening as: 1) concerns over an increase in US fiscal spending under the Trump administration subside; 2) the US criticizes other countries’ weak currency policies; 3) the likelihood of three Fed hikes by end-2017 is questioned; and 4) investors begin their FY17 investments. We believe yields marked just before the 20-21 September BoJ meeting (20yr yields of 0.45%) will serve as a resistance point.

• We expect the Trump risk-on rally to enter its second stage before summer 2017 due to concerns over: 1) the US prompting other countries to increase fiscal spending; and 2) global higher inflation stemming from China. The BoJ could adopt an even more flexible approach to its quantitative target, or could abolish it in April-July 2017. As concerns over BoJ tightening increase, we believe 5yr, 10yr and 20yr yields could rise to positive levels, exceed 0.10% and rise to 0.80%." - source Nomura

In recent musings we pointed out that tightening financial conditions were already showing up in the US in Commercial Real Estate (CRE). This is a segment we will be particularly monitoring in conjunction with its synthetic CMBS proxy the CDS CMBX index and in particular series 6 which comprises the highest retail exposure with 37%.

Furthermore, if indeed we are moving towards somewhat a repeat of 2016, namely "risk-off" and a US Q1 GDP print at 1%, then obviously, it makes sense to put our contrarian boots on again we think. From a USD/JPY perspective, what has been driving the currency pair as of late has been the beloved "Mack the Knife" aka King Dollar + positive real US interest rates. On the subject of USD volatilities, we read with interest Bank of America Merrill Lynch's note from the 19th of January from their FX Vol Trader series entitled "USD vols are relatively overvalued":

"Enamoured by Trump

Since Trump was elected, markets have focused almost exclusively on the US. As an example, USDJPY has recently been driven almost entirely by US rates rather than the Japan story of easing and reform (Chart 1).

This has resulted in USD vols trading at a significant premium to non-USD pairs. In the case of EURJPY vs USDJPY vols, the former is now trading at the cheapest levels relative to the latter in the past decade (Chart 2).

While we see the possibility of the USD continuing to rally, we do see this dislocation in vols as an opportunity to fade the spread.

Vols mostly underperforming

Despite the recent USD correction, vols in general are underperforming on both a high and low frequency basis. Curve flatteners seem the optimal way to position for vol consolidation, given steep curves, while being hedged against event and headline risk of short-term volatility spikes." - source Bank of America Merrill Lynch

While the Japanese story has not been in the driving seat of the recent price action for the USD/JPY currency pair, we think it is important, not only to track as we have indicated the foreign investments from Japan's GPIF, Lifers and Mrs Watanabe to determine the outcome for government bond yields in the coming months, but, there are as well some implications from Japan's Current Account surplus as highlighted by Deutsche Bank in their recent Japan FX Insights note from the 13th of January entitled "Implications of Japan's C/A surplus":

"No need to regard Japan's C/A surplus as yen-bullish when US economy is expanding

Japan's current account (C/A) surplus has held at around an annualized ¥20trn. With recent yen weakness, there is a possibility of the trade balance and international tourism balance, compounded by a further rise in UST yields, contributing to an increase in the primary income surplus. However, we do not necessarily agree with the view that this will soon result in yen appreciation. C/A-related flows are a relatively small part of overall FX flow, so we do not expect this to be a dominant factor for the medium term JPY movements.
In the past, the USD/JPY has often tended to strengthen in phases when imbalance between the US-Japan C/A balances has expanded.

The US trade deficit has been prone to expand due to higher imports when US domestic demand outperforms major trading partners on the back of a booming economy. However, the robust US economy supported a rise in rates and asset prices, which energized fund inflows to the US and pushed up the USD.
Cyclically, it has been observed C/A cycle leading the USD/JPY by 1.5 years. Rather than supply-demand causal relationship, however, this can be explained by the cyclical phenomenon that the C/A balance changes with reflecting the economic cycle while the USD/JPY moves in line with the economic cycle with 1.5 years lag. So, we think the key focus should be the economic cycle.

We have maintained that the most important factor in the direction of the USD/JPY in this phase has been the strength of the US economy. The USD/JPY fell from above 120 toward 100 when the US economy slowed early in 2016, despite the BoJ using a negative rate policy to encourage the yen lower. In this process, no small number of market participants attributed the stronger yen to an expansion of Japan's C/A surplus.
However, the yen's weakening under the Trump market was not the result of the Japanese C/A balance falling into deficit. No critical turning point for USD/JPY can readily be grasped if the theory that "yen appreciation is due to a C/A surplus" (which may appear correct at first glance) is taken at face value. It is clear that the Trump market is the result of cyclical expectations of higher rates and a reacceleration of the US economy driven by aggressive fiscal measures.
Comprehensive forex supply/demand analysis incorporating factors such as trade balance, C/A balance, and investors' foreign securities investment trends is also often seen as a means of determining the yen exchange rate, but this is likely virtually useless in grasping market dynamism. This only reveals the degree of pressure that can gradually emerge when the market is in a lull. As seen in developments after Trump won the presidential election, market moves dramatically alter the composition of supply/demand." - source Deutsche Bank

So if indeed, the consensus for stronger growth is wrong again when it comes to the US 1st quarter GDP and we do get a repeat somewhat of 2016, then obviously, it seems to us that we could see a spike in FX volatility and somewhat renewed pressure on the USD/JPY currency pair and a potential strengthening of the Japanese yen versus the US dollar in short order. 

Although the consensus trade is still being long the US dollar, when looking at the credit cycle, we think we do sit an important fault line when it comes to real yields and inflation expectations. This could also have implications for the long USD crowd and our recent positive stance on gold miners. On that specific point we read Nomura's most recent Japan Navigator note number 705 from the 23rd of January:

"Inflation expectations continue to rise even without large stimulus spending

Next week, a 40yr JGB auction will be held, and trade and CPI data will be released. Expectations for the US substantially increasing fiscal spending under the Trump administration have apparently faded, and concerns over Fed hikes have fallen. Despite this, risk-on momentum remains in place and inflation expectations continue to rise
(Figure 1).

We attribute this to the strength of macro data in the US and China, and Treasury Secretary designate Steven Mnuchin’s comments aimed at easing concerns over a weak-USD policy under the Trump administration. Chair Yellen does not seem to be laying the foundation for a March hike but has been suggesting that the decision will be data dependent.
The UST market rallied on short covering, but stopped rising after regaining only one third of the ground lost since the US presidential election, which suggests investors expect the bearish cycle to continue. We believe risks in the UST market are skewed towards the downside until the January jobs data are released (early February) and Chair Yellen testifies before congress (mid-February).

In the yen rates market, while JGBis are slow to rise due to concerns over the 7 February supply, nominal JGB yields are likely to rise and the curve is likely to steepen on improved growth expectations and higher inflation expectations (Figure 1), in our view.

Super-long JGB rates are approaching levels just before the BOJ intervened with an increase in its purchases of super-long JGBs on 13 December (20yr rates of 0.65%). However, we believe investors may well not buy by assuming a support at this level, as the bank reduced its purchases of these bonds to previous levels only 10 business days after. We believe the BOJ is unlikely to target super-long JGBs at these levels, but intervened just because the curve steepened too sharply.

Assuming the short and intermediate tenors of the JGB market stabilizes and yields rise in a consistent manner, we believe the BOJ would intervene at yields higher than the market assumes (20yr rates of 0.8% or higher and 40yr rates of 1.0% or higher, seen before the excessive flattening in March 2016). 

Reasons why USD should strengthen under Trumponomics

Weak USD in the first stage of the credit cycle, strong USD in the last stage half
In this section, we look at the relationship between the credit cycle and US government policies.

In the early stage of the credit cycle, monetary policy tends to be accommodative and USD to weaken (Figure 2).

This is because inflation tends to head lower in that period due to a carry-over from the recession. In contrast, in the last stage of the credit cycle, Fed policy tends to be tightened and USD tends to strengthen.

However, we see little relationship between US fiscal policy and the credit cycle. A new administration’s stance on fiscal policy tends to be a reversal of its predecessor’s. In addition to political reasons (i.e., refuting the previous administration’s policy), the new government tends to face constraints in terms of the fiscal and current account balances.

The US may seek to increase fiscal spending, tighten monetary policy and strengthen USD under Trumponomics

Assessing Trumponomics in terms of the credit cycle, we note: 1) the new administration takes office in the last stage of the credit cycle; and 2) Former President Obama took fiscal austerity measures. The first point suggests USD would strengthen and the second point makes an increase in fiscal spending likely under the Trump administration.
However, the unemployment rate and other indicators show that the US economy is beginning to face supply-side constraints, and Fed policymakers and others say larger stimulus spending is unnecessary. Despite this, we believe the new administration will substantially increase fiscal spending as President Trump intends, at least in the first one to two years, because; 1) he won the election by calling for the need to stimulate growth, primarily via increased fiscal spending; 2) Republicans control the presidency and both houses; and 3) the fiscal and current account deficit look fairly small, leaving room for a further deterioration (Figure 3).

Reasons why USD remains supported even though the current account deficit increases

As the US currently faces supply-side constraints, an increase in demand brought about by tax cuts and infrastructure investments would likely translate into increased imports, and – contrary to President Trump’s intention – an increase in trade and current account deficits, which may weaken USD. 

However, USD historically begins to weaken several years after the current account balance begins to deteriorate (Figure 3).

This is because the current account balance tends to deteriorate in the last stage of the credit cycle, when tighter monetary policy, higher UST rates (i.e., relative to other government bond yields) and higher US domestic growth (relative to other economies) prompt higher investments into the US.
There is also a lag of about one year between the reversals in the movement of the UST-JGB yield differential and USD/JPY (Figure 4).

As the UST-JGB yield differential is still widening, we believe USD/JPY is unlikely to begin falling in the near term.

Judging by their comments, we believe President Trump and Treasury Secretary nominee Mnuchin will not look to improve US exporters’ competitiveness via macroeconomic policies (e.g., by guiding USD weaker, as seen in President Reagan’s second term and President Clinton’s first term). We believe the Trump administration is likely to use a weaker USD and higher tariffs merely as bargaining chips to win concessions from others. Instead, the new US administration will look to prompt its trading partners (governments, corporates) to increase investment into the US.
Higher investment into the US may lead to higher production in the US and an increase in US exports to others, but USD would likely remain supported while capital continues to flow into the US." - source Nomura

Interestingly, we agree with Nomura that, in the last stage of the credit cycle, Fed policy tends to be tightened and USD tends to strengthen. This overall has clearly had an impact on global financial conditions. But, if indeed the current account balance in the US deteriorates, then the US dollar should weaken as it generally happens in the late stage of a 10 year credit cycle, hence our contrarian stance versus the bullish US dollar crowd. The credit cycle is therefore deterministic we think.

So, overall, you might garner from the above our defensive stance and our "risk-off" feeling but, one thing that do makes us feel nervous is indeed the overall complacency in high yield where it seems as per our final chart, that the market is nearly priced to perfection.

• Final chart -  High Yield priced to perfection is not a good sign

Since the beginning of the year credit has continued to perform and in particular High Yield. As we indicated earlier on in our conversation, the second half rally of 2016 saw credit investors piling on more duration and more credit risks, meaning more instability in credit markets at the time where "Dystopia" has been fading in financial markets. Right now, we think that "Dystopia" has been replaced by "Euphoria" and the current levels reached by high yield, make us think that indeed, the risk/reward for the asset class appears to us particularly poor following a very good 2016. Our final chart comes from Société Générale's Credit Strategy Weekly note from the 20th of January and entitled "It's starting to get trickier". It displays how pricey High Yield relative to Investment Grade (IG):

"We're even more worried about High Yield

In the editorial of last week’s Credit Weekly, we argued that European high yield markets were too ebullient. Clearly, market participants disagree. This week in Europe, government bond yields rose to within a whisker of their December peaks (at 40bp on the Bund), equity markets corrected (slightly) lower, but European high yield spreads continued to tighten. While IG spreads in Europe were broadly unchanged, high yield spreads tightened another 5bp.

Note that the recent moves have brought the relationship between IG and HY markets in Europe to very rare levels. Chart 1 shows the spread ratio (HY/IG) and the spread differential (HY-IG) since the financial crisis. We have smoothed the data to reduce the impact of monthly rebalancing. Note that the spread ratio is closing in on the lowest levels since 2012, while the spread differential is at the lowest levels since the mid-2008 widening. High yield is very expensive indeed.

Beta, not supply, has driven the markets tighter this year. The risk here is that the mood may well sour. Indeed, we think it will, given the shakier tone in other markets and the political risks in evidence this week with Theresa May’s Brexit speech and ahead of the French leftwing primaries. We still recommend reducing risk in portfolios despite the rally seen in the year to date." - source Société Générale

While in recent years the "printing protocol" and "wealth effect" of various central banks has been seen as a solution to a global debt problem, it appears to us, in contradiction to their assumption, when it comes to GDP growth, the protocol they have used was clearly not the solution to the problem but we ramble again with our unsolvable Two Generals' Problem.

"An ignorance of means may minister to greatness, but an ignorance of aims make it impossible to be great at all." - Elizabeth Barrett Browning, English poet

Stay tuned !