Credit - The Vortex Ring

"When a system is in turbulence, the turbulence is not just out there in the environment, but is a part of the organization or organism that you are looking at." - Kevin Kelly

While looking at the burst of turbulences last week in the credit and government bond high beta space, in conjunction with the expected results coming out of the European elections and given our fondness for "flying" analogies which we abundantly used in our conversation "The Coffin Corner", in this "Tapering" environment we reminded ourselves of the Vortex Ring when it came to choosing our post title. The famous Vortex Ring also known as the "Helicopter Stall" can happen easily under certain specific conditions particularly when approaching landing, as illustrated more recently in the movie Bravo Two Zero when the Special Operations 160th SOAR helicopter came crashing down in Abbottabad during Operation Neptune Spear after experiencing the infamous vortex ring state.

You are probably already asking yourselves where we are going with this analogy already but, given Ben Bernanke's various QE programs have been compared to "helicopter money", we thought a reference to a "helicopter stall" given the Fed's tapering stance would be more than appropriate for this week's chosen title. 

Therefore in this week's conversation we will review various states of central banks at play, between the Fed, Japan and the much expected ECB move in June.

In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust). 

For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":

"To get into vortex ring, three factors must all be present:

• There must be little or no airspeed.
• There must be a rate of descent.
• There must be power applied.

Note that all three of these must be going on at the same time."

• There must be little or no airspeed.

In our conversation"The Coffin Corner" we indicated the following:

"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy."

With the latest reading from the US GDP coming at 0.1% for the 1st quarter indicates for us little or no "airspeed" for the US economy and the aforementioned "economic" stability we mused on last year.

For Europe the latest inflation readings indicates little or no "airspeed" on top of the very weak economic growth reading making it paramount for the ECB to act sooner rather than later in order to avoid the Vortex Ring state.

• There must be a rate of descent.

Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via "helicopter"easing will require interest rate hikes, and will also necessitate asset sales by central banks, according to April's IMF Stability Report. The tapering stance of the Fed does include indeed a rate of descent of $10 billion a month.

Of course another rate of descent which we have been following has indeed been US Velocity. What we have found most interesting is the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3% - Graph source Bloomberg:

It has been downhill from 1997 with velocity falling linked to factor number three of the "vortex ring" namely "There must be power applied" (ZIRP in conjunction with the various iterations of QE).

Yet, the recent fall in unemployment has been masking the Fed's progress in avoiding the dreaded Vortex Ring as seen in the lack of breakout in the employment population ratio. The Fed has not been able yet to reach "escape velocity" from this vortex ring as displayed in the Bloomberg graph below indicative of the conundrum:

The lack of "recovery" of the US economy has indeed been reflected in bond prices, which have had so far in 2014 in conjunction with gold posted the biggest returns and upset therefore most strategists' views of rising rates for 2014 (excluding us given we have been contrarian). Those who read between our lines have done well so far in 2014 given we hinted  a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

• There must be power applied.

When it comes to applying power, like many pundits, we have been baffled by the action in US Treasury bond buying from Belgium which increased its holdings in US debt by $201 billion in five months to $381 billion at the end of March this year, making it the third largest holder after China and Japan - graph source Bloomberg:

Helicopter pilot students, have a tendency to slow down, if they are afraid of overshooting their landing point, which can put the helicopter they are flying in a vortex ring state. In similar fashion, central bankers have a tendency to slow down if they are afraid of overshooting. 

It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets as displayed by the below graph plotting the performance of the Nikkei index, the USD/JPY currency pair and the inverse Itraxx Japan indicative of credit risk for corporate Japan:

If one looks at unemployment levels and inflation levels for a gauge of the respective situation of various central banks it seems that, while Japan has achieved full employment, it has failed for many years to spur inflation, while the US as well as the United Kingdom, have achieved to reduce their unemployment levels, Europe is still closer to the Vortex Ring State (deflationary bust) given it boasts very low inflation levels compared to the other G4 and record unemployment level, as displayed in this Barclays graph from their recent Market Strategy note entitled "Japan at the end of the post VAT hike tunnel" from the 26th of May:

"Monetary policy: Potential growth & expected inflation, quantity & quality

Opinion regarding deflation in Japan has long been divided between those who believe the problem cannot be solved by monetary policy alone, ie, potential growth is tied with inflation expectations, and those arguing conversely that inflation is a pure monetary phenomenon that can be controlled by monetary policy independently of potential growth. For some reason, the latter group appears to overlap almost completely with those claiming that the degree of monetary easing can be measured unambiguously via the monetary base (monetarists). We agree with the second group that deflation can be overcome by monetary policy without a change in potential growth, and believe that this is in fact occurring at present. However, we think that the driving force behind the BoJ’s present Quantitative and Qualitative Easing (QQE) is not the quantitative but the qualitative side.

Japanese market participants tend to subscribe to the former view. This may reflect a general feeling based on experience rather than the result of academic study. The nation has failed to quash deflation despite 15 years of sundry monetary easing measures, which may have convinced many that inflation expectations are being affected by factors that cannot be controlled by monetary policy, such as a decline in potential growth (including demographic trends). For those holding to this argument, the opposing view sounds like a vacuous theory ignoring a decade and a half of actual events. In particular, since the majority of those supporting the second view are “reflationists”, who believe monetary policy should give greatest weight to quantity, the two sides basically find themselves talking at cross purposes.

Those taking the former view, which is the market consensus, feel that events in 2001-06 proved that the size itself of the BoJ’s balance sheet has no impact. They claim therefore that if the QQE focuses solely on increasing this volume, it cannot achieve a change in inflation expectations. However, we think instead that the important point is the quality of the bank’s balance sheet; ie, the volume of risk in the bank’s acquired assets. We believe the effectiveness of the monetary easing by the Fed and BOE after the Lehman shock and the rapid turnaround in the Japanese economy after the launch of the BoJ’s QQE stemmed from their purchases of long government bonds and risk assets, pushing supply/demand above levels (in other words, pushing yields below levels) that the economic fundamentals would indicate as fair. The general social principle that economic policy should not intervene in the free market, which prior to the Lehman shock also applied tacitly to monetary policy and financial markets, prevented the BoJ from turning to asset purchases in JGB markets even in deflation-racked Japan. The serious crisis brought about by the Lehman collapse led to market intervention by countries worldwide and a shared belief that the ideology itself needed to change. With the success of this monetary policy approach in the US and UK, the BoJ also shifted its focus from quantity to quality, carrying out a market intervention of unprecedented scale with the QQE.

That is, QQE is a new monetary easing stance that had not been tried in over 15 years of deflation. Still, the markets perceived this to be little more than an extension of previous policy and assumed from past experience that it would have no effect on inflation expectations. A good number of market participants still dismiss the claim by BoJ Governor Haruhiko Kuroda and other BoJ executives that the bank’s 2% price stability target is achievable. Some likely hold the view that the BoJ itself is simply maintaining the 2% target in the hope of raising inflation expectations in the market.

In contrast, we think the bank is conducting an easing policy with entirely different effects than its earlier efforts, and we do not believe its past inability to beat deflation means that it will be unsuccessful this time as well. Furthermore, we suspect that the BoJ itself likely shares this view. Its confidence in the price stability target may well have deepened in light of ongoing developments in the Japanese economy. The statement from last week’s Monetary Policy Meeting noted anew that “QQE has been exerting its intended effects”. As we have explained, we see this not as calculated optimism designed to perk up the Japanese public but as a straightforward reflection of the bank’s actual belief at this time. As long as the bank maintains this stance, we think it is unlikely to alter its monetary policy. At the same time, we believe it will be relatively flexible in adjusting its current policy in the event of any upward or downward risk to the economy." - source Barclays.

When it comes to the US and the United Kingdom, it is interesting to note the very strong correlation between 10 year bond yields throughout the years as displayed in the below graph from Bloomberg comparing yields for UK gilts and US treasuries since March 1994:

And on a shorter time frame since 2011, UK 10 year yields versus US 10 year yields - graph source Bloomberg:

The question on everyone lips is of course who will blink first (raise rates that is), the Bank of England or the US Fed? One thing we are certain of, not anytime soon.

So in relation to the veiled question from our title and from Barclays take, the big question is of course can the "Vortex Ring" (aka deflationary bust) can be avoided by monetary policy alone?

We are still sitting tightly in the deflationary camp and expect further yield compression on US Treasuries. As such, we agree with the Wall Street Rant Blog on that subject:

"Many Government Bonds Yielding Less Than United States

I can't listen to a talking head, bond manager, strategist or seemingly anyone without hearing about how "Rates can only go higher from here". When in reality THEY CAN go lower! In fact, when you look around the world, on a relative basis, THEY SHOULD!" - source Wall Street Rant Blog

Indeed they should. To add ammunition to this, one should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower, in particular its upcoming reforms and asset shift scenarios as reported by Nomura in their recent report from the 23rd of May:

"The yen bond market remains range-bound as market participants’ interest in Abenomics and expectations of additional BOJ action fall. The consensus view is that the USD/JPY outlook is dependent on the US economy and yields. However, it is increasingly likely that the government’s June growth strategy will exceed market expectations, which have dropped markedly. We are focused on the likely scenario that the GPIF and other public pensions will start shifting from a yen bond bias in the near future. In our upside scenario, these reforms would lead to approximately JPY20trn in foreign securities investment in the next 12-18 months, potentially weakening JPY by about 10%." - source Nomura

Here are the two potential "re-allocation" scenarios according to Nomura's paper:

"As of end-

December 2013, the GPIF had JPY128.6trn ($1.3trn) in managed assets. Of 

the three associations, KKR had JPY7.8trn ($78bn), Chikyoren had JPY17.5trn ($175bn) 

and Shigaku Kyosai had JPY3.6trn ($36bn, all as of end-March 2013). Total managed 

assets for the four pension funds amount to almost JPY160trn ($1.6trn). The GPIF has 

attracted the most attention because of the sheer scale of its assets, but the three 

associations manage about JPY30trn or $300bn in assets.

The GPIF‟s weighting of Japanese bonds had fallen to 55% as of end-December 2013. It was reported that after the Industrial Competitiveness Council‟s follow-up section meeting on 8 April, the GPIF‟s head office explained that this weighting had dropped to 53.4% on the withdrawal of pension benefits. Thus the weighting of Japanese bonds is already below 55% and could be nearing the 52% floor of the allowable deviation. At the same time, the weighting of Japanese equities stood at 17.2% at end-December 2013, close to the maximum allowable deviation of 18%. Foreign bonds. weighting was 10.6%, close to the standard median value of 11.0%. At 15.2%, foreign equity's weighting is still some way from the maximum deviation (17.0%). Trends in the weightings of Japanese bonds and Japanese equities suggest that, as described in the FY14 investment plan, the GPIF has already been investing flexibly within the permissible range of deviation, and it may be investing such that the respective weightings do not approach the median value. As the strong equities/weak JPY trend has continued since end-2012 and the fund has changed its basic portfolio in June 2013, the GPIF.s portfolio is already shifting gradually from domestic bonds to risk assets.

Asset shift scenarios based on the new basic portfolio

We look at simulations for fund shifts following changes in the basic portfolios of the GPIF and the three public pension funds, in line with two scenarios, based on their current portfolios as described above. In Scenario (1), the four funds lower the weighting of Japanese bonds to 40% and allocate 8% of the money thus freed up to Japanese equity (from 12% to 20%) and 6% each to foreign bonds (11% to 17%) and foreign equity (12% to 18%), as Panel Chairman Takatoshi Ito recommended. Scenario (2) assumes more moderate changes, with the Japanese bond weighting lowered 10% to 50%, the Japanese equity weighting raised 4% (12% to 16%) and the foreign bond and foreign equity weightings raised 3% each (from 11% to 14% and from 12% to 15%). As we expect a compromise between the stance of President Mitani, who is cautious about portfolio changes, and Mr. Ito, who is more aggressive, a reduction in the Japanese bond weighting to about 50% is close to our main scenario for now. If the aggressive scenario (1) advocated by Mr Ito is realized, the GPIF.s balance of Japanese bond holdings would drop by about JPY19.6trn ($196bn), from JPY71.0trn ($710bn) at end-2013 to JPY51.4trn ($514bn). This JPY19.6trn decrease would translate into a JPY3.6trn ($36bn) increase in Japanese equity, a JPY8.3trn ($83bn) rise in foreign bonds and a JPY3.6trn ($36bn) increase in foreign equity. This scenario assumes that the weighting of short-term assets would recover to 5% of the basic portfolio, with short-term assets rising by JPY4.1trn ($41bn). Assuming that the ratio of short-term assets is fixed at the 1.8% level of end-2013 and that money is allocated to risk assets, the increase in respective assets would expand accordingly. When including the three public pension funds, the decrease in the Japanese bond balance would balloon to JPY26.8trn ($268bn), and the funds could allocate JPY5.8trn ($58bn) to Japanese equity, JPY10.8trn ($108bn) to foreign bonds and JPY6.0trn ($60bn) to foreign equity.

In Scenario (2), the GPIF.s and three public pension funds. balance of Japanese bond holdings would decrease about JPY11.1trn ($111bn). The GPIF.s Japanese equity weighting has already increased to 17.2%, so if we assume that it returns to the median after the basic portfolio change (16%), the balance of Japanese equity would fall about JPY0.5trn ($5bn). At the same time, the balance of foreign bonds would rise by JPY6.1trn ($61bn) and the balance of foreign equity would increase about JPY1.2trn ($12bn).

The above figures are rough estimates that do not take valuation gains or losses into account. Amounts may also differ considerably depending on fluctuations in short-term assets and investments within the permissible range of deviation. As noted above, our main scenario at this point expects changes in the basic portfolio to be around the scale of Scenario (2) in the near term. However, in what we can Scenario (2)-2, we assume that Japanese bonds account for 50% of the basic portfolio, the permissible range of deviation expands to }10“, the ratio of risk assets is kept higher than the median value to avoid a sharp drop in Japanese bonds as a result of a sharp acceleration in the inflation rate, and the weighting of short-term assets is kept at about 2% (permissible range of deviation from median value set at -10% for Japanese bonds, +5% for Japanese equity, +4% for foreign bonds, 4% for foreign equity and -3% for short-term assets). In this case, similar to Scenario (1) the balance of Japanese bonds held by the GPIF and the three public pension funds would decrease by JPY26.8trn ($268bn), the balance of Japanese equity would increase JPY7.4trn ($74bn), the balance of foreign bonds would rise JPY12.4trn ($124bn) and the balance of foreign equity would increase JPY7.5trn ($75bn). At first glance, Scenario (2) looks like a conservative change, but depending on the actual stance on investments after the basic portfolio is changed, the asset mix could be significantly changed as envisioned by Mr. Ito." - source Nomura

No wonder peripheral bonds in Europe have been benefiting from Japan's appetite as displayed by Bloomberg's recent Chart of the Day entitled "Euro-Area Periphery Hooked on BOJ stimulus":

"The CHART OF THE DAY shows Europe’s peripheral bond rally stalled this month as the yen strengthened versus the euro. Last week the Bank of Japan refrained from adding to the 60 trillion yen ($589 billion) to 70 trillion yen poured into the monetary base each year that has encouraged Japanese investors to put money into higher-yielding European assets.

“Peripheral yield spreads appear vulnerable to a correction following the strong rally and the yen tends to often strengthen on credit risk,” said Anezka Christovova, a foreign- exchange strategist at Credit Suisse Group AG in London.

“Japanese portfolio flows usually have an impact. Those flows could now divert elsewhere. We don’t expect any substantial action from the Bank of Japan in coming months and that could also lead the yen to strengthen.”

Japanese investors bought a net 1.41 trillion yen of long-term foreign debt in the week ended May 16, the most since Aug. 9, data from the finance ministry in Tokyo showed on May 22.

Flows into Europe may be tempered as yields in Europe’s periphery climb. The average yield spread of 10-year Portuguese, Greek, Spanish and Italian bonds over German bunds has risen 20 basis points this month to 270 basis points, after touching 239 basis points on May 8, the lowest since May 2010, based on closing prices.

New York-based BlackRock Inc., the world’s biggest money manager, said on May 8 it had cut its holdings of Portuguese debt, while Bluebay Asset Management said on May 9 it had seen the majority of spread tightening it was looking for.

Trading euro-yen based on movements in the bond-yield spreads of the euro area’s peripheral nations would have been a successful strategy, Credit Suisse strategists, including Christovova, wrote in a May 21 note." - source Bloomberg.

It is worth noting Japanese have bought a record $86 billion of US treasuries in the last 12 months according to Bloomberg data. It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998,  as per monthly data compiled by Bloomberg showed recently. So if the GPIF starts deploying its "allocation firepower" in June, maybe you ought to cling to your US treasuries a little bit longer, and maybe after all the Belgian central bank is just a very "astute" investor after all...

One thing for sure our "Generous Gambler" aka Mario Draghi has shown he is truly a magician when it comes to driving market expectations and given all of the above, maybe just a few tricks such as a rate cut and negative deposit rates will do the trick nicely to provide continued support for European government bond markets. Eurozone-residents' demand for foreign assets could be further extended and exacerbated if the ECB were to try introducing negative rates on deposits rather than the proverbial QE bazooka unless of course he goes for the €1 trillion option. The current account excesses which so far have been supportive of a strong euro versus the dollar have been the result of Eurozone residents wish of increasing savings as security against an uncertain future. The willingness of Eurozone residents to accept net receipts of foreign-currency assets  has weighted on the value of the euro in recent years and has forced the current account into surplus. Given that surplus it seemed unlikely for us until recently that the euro would fall much against other currencies unless credible fears of currency break-up re-emerge. Of course the latest European elections results could has well re-ignite fears in the coming months and allow for Mario Draghi to enjoy a depreciation of the euro without having to resort to the proverbial QE bazooka in conjunction with the help from the Japanese pension funds allocation.

In recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have significantly diverged as displayed in the below Bloomberg chart:

Mario Draghi is definitely the greatest central bank magician and probably an astute student of Sun Tzu and the Art of War we think:

"The best victory is when the opponent surrenders of its own accord before there are any actual hostilities... It is best to win without fighting." - Sun Tzu

It is as well probably worth taking Sun Tzu's wise quote in anticipation of the next ECB meeting:

"All warfare is based on deception. Hence, when we are able to attack, we must seem unable; when using our forces, we must appear inactive; when we are near, we must make the enemy believe we are far away; when far away, we must make him believe we are near."

On a final note, when it comes to avoiding the dreaded helicopter stall aka the Vortex Ring,  as per Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'" it is supposed very easy. It wasn't for the ace helicopter pilots of the 160th SOAR during Operation Neptune Spear, There is "no easy day", same goes with QEs:

"It is actually very easy to get out of vortex ring… at least in the incipient stage when the juddering and yawing starts. Some say it is impossible to get out of the fully developed state, but when you start to perceive signs of vortex ring, all you need to do is remove one of the three factors noted above. So, you push the cyclic forward to increase airspeed, or lower the collective to reduce power.  It is not possible to reduce the rate of descent to stop vortex ring, as that would involve increasing power.  In practice, pilots usually increase the airspeed, as unless the helicopter is very high, you don’t want to lower the collective and risk hitting the ground!" - source Helen Krasner - Decoded Science - January 8, 2013.

Unfortunately, getting out of vortex QE ring won't be that easy rest assured, particularly given we have not been in the incipient stage given Japan, the Fed and the Bank of England have all been repeated "QE offenders", but we ramble again...

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong

Stay tuned!

QE - To infinity ... and beyond!

"The last proceeding of reason is to recognize that there is an infinity of things which are beyond it. There is nothing so conformable to reason as this disavowal of reason." - Blaise Pascal, French philosopher

Apologies dear readers for not having posted recently our credit ramblings, but, once in a while, bloggers such as ourselves are in the need for some R and R (Rest and Recuperation). This is exactly what we did. We rested our mind while enjoying some wine tasting in the United States. Of course, one would immediately turn their initial thoughts on California. Luckily the immensity of the United States means diversity, and we found ourselves enjoying Long Island and its many wineries as well as a particular Paumanok 2005 Cabernet Franc but then again, we fall prey to our usual rambling habits. 

Following up on our recent conversation entitled "Zemblanity", and "The inexorable discovery of what we don't want to know", we could not resist to refer to Buzz Lightyear's catchphrase from the Toy Story franchise in our title as another reference to the unlimited pledge in Quantitative Easings by the Fed and the continuous game of global "easiness" provided by most Central banks across the globe (Fed, BOE, BOJ, ECB). In this post we will revisit the consequences of unlimited QE.

Buzz Lightyear of Star Command (central bankers), space ranger protecting the universe from Evil Emperor Zurg (deflation):

While Buzz Lightyear was indeed the most popular toy in the first outing of Toy story, it looks to us that currently QE is the most popular toy being used by our central bankers over the world. But, in similar fashion to our Buzz Lightyear from the movie Toy Story, it looks to us that central bankers are indeed as deluded as Buzz Lightyear was. Buzz Lightyear in the first movie believed he was a space ranger before realizing he was just a toy. It appears to us that, courtesy of "Zemblanity", at some point, central bankers will have indeed to realize that QE is just a toy and a dangerous one to play with for too long in fighting Evil Emperor Zurg (deflation). This is clearly illustrated by Japan's plight in fighting off "Zurg" for the last 25 years as indicated by Bloomberg:

"The Bank of Japan’s failure to halt yen gains through domestic bond buying over the past decade is pushing policy makers to consider a new tack, purchasing foreign debt to produce the currency weakness exporters crave. The CHART OF THE DAY shows the yen’s effective exchange rate climbing to about 5 percent above its 10-year average, ignoring BOJ asset purchases that helped swell the money supply to 124.33 trillion yen ($1.6 trillion), the most ever in data going back to 1970. Policy makers’ efforts are faltering as bank lending dropped 3 percent from a six-year high reached in March 2009, preventing the cash injected into the financial system from filtering into the wider economy. Buying foreign bonds is a promising tool, Economy Minister Seiji Maehara said this week, echoing the two newest BOJ board members who’ve said new types of easing should be considered. BOJ Governor Masaaki Shirakawa said such purchases would be a type of currency intervention, which only the government can do. The BOJ starts a two-day policy meeting today. “Current policy tools are reaching their limits in ending deflation and yen appreciation, increasing political pressure on the BOJ,” said Koji Takeuchi, senior economist at Mizuho Research Institute. “Purchases of foreign bonds are being considered, which would require changes to the central bank charter.” The yen traded at 78.48 per dollar as of 8 a.m. in Tokyo from 78.49 yesterday. The currency reached a post World War II record of 75.35 per dollar on Oct. 31, 2011. The yen’s 14 percent climb over the past three years is reducing earnings at exporters." - source Bloomberg.

The approach of "infinity...and beyond" has been clearly demonstrated by our "Buzz" Central Bankers' willingness in committing to maintaining interest rates at zero for a long period. In Japan's case, the BOJ has promised to keep rates at or near zero until inflation reaches a certain level, and thus close to an "inflation target". "To infinity and beyond!"...One may posit, as Japan has been playing with its QE toy for the last 25 years.

In a recent note published by Nomura Securities entitled "Lessons from Japan" - Securities Investment in a Low-Yield, Low-growth Environment from the 2nd of October 2012, they indicate the following:
"Japanization trades in rates markets BOJ measures were in response to falling growth and inflation expectations The roots of Japanization lie in the substantial declines in growth and inflation expectations (graph below). This process took place over more than 10 years, starting with the financial bubble burst in the early 1990s – the BOJ’s policy duration and QE measures appear to have had a direct effect on JGB price action, but the BOJ only responded to the low growth and inflation environment." - source Nomura.

"Government bond markets mean revert under policy duration regime Policy rates are the starting point in shaping the yield curve. As these rates are likely to be kept close to zero for a prolonged period, government bond yields will likely be anchored as if to mean revert, with their volatility falling (see below graph). As such buying maturities with high carry and roll on dips (i.e., on yield upswings) and holdinh onto them may appear the best option as  long as the low-rate commitment remains in place." - source Nomura.

Unintended consequences of playing too long with a QE toy:
"Inflows of short-term capital create bond bubble 
In addition to long-horizon trades for carry and roll, government bond markets attract large amount of flows seeking short-term gains, which have resulted in yield curve shapes that are significantly flatter than the ones justified by the expected growth and inflation rates. When central banks buy government bonds as part of QE measures and thus tighten supply and demand in the market, government bonds are likely to outperform other assets due to capital gains, attracting further inflows of short-term capital. Moreover, this kind of rally is likely to be bolstered by optimistic views on market fundamentals that justify the low-rates regime (for example, the central bank will keep policy rates low further into the future, and the economy will become increasingly deflationary)." - source Nomura.

We agree with the above.

Nomura also made an important point in their note from the 2nd of October 2012 relating to the Taylor rule. A Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle):
"Undue reliance on policy duration may be risky
Considering that monetary policy measures are devised in response to changes in the macro backdrop, we should not ignore the impact that a low growth and inflation regime has had in shaping the government bond market and monetary policy, i.e., the concept of the Taylor rule. For that matter, we note that the Fed’s current forward guidance indicates that it will keep fed funds rates at ultra-low levels through “mid-2015,” but this is quite a bit later than the timing that would be deemed appropriate according to the Taylor rule*. Although the BOJ has set achieving 1.0% CPI inflation as its policy objective and thus has not specified the time until which it will keep the current policy in place, the market’s expected policy duration has been extended close to historical levels, after which sharp JGB sell-offs have followed – we doubt that such high expectations can be sustained as the economy begins to pick up." - source Nomura.

*Based on the current output gap and the Fed’s economic projections, the Taylor Rule would suggest that the Fed’s ZIRP should continue only until early 2014.

Some may put too much hopes that our "Buzz Lightyear" central bankers have designed an escape capsule from their "infinity...and beyond" policies.

We also agree with Nomura's chief economist Richard Koo in his most recent publication "Reconsidering quantitative easing" published on the 2nd of October, namely that one should not put too much hopes on the escape capsule:
"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.

Provided our "Buzz Lightyear" central bankers decide to use the escape capsule from their stricken spaceship, Richard Koo's commented:
"The magnitude of the increase would depend on how much liquidity had to be absorbed, but a major increase is possible given that both the economy and private loan demand will be recovering. 

The liquidity supplied to the market should be manageable if the rebound in private loan demand is weak, as it has been in Japan since 2006. But there could be negative implications for the economic recovery—including a sharp rise in long-term rates—if the central bank is forced to mop up these funds by selling long-term bonds." - source Nomura.

But then again a future rebound in private loan demand is questionable.

A sharp rise in long-term bonds would have indeed devastating effect on a country such as the United Kingdom and it reminded us what we wrote back in our June 2011 conversation "The UK conundrum - Stagflation redux and other housing/banking issues": "Bank of England will have to stay accommodative for longer than expected, given two thirds of UK mortgages depend on short term rates. This means that the UK households will continue to be battered by a declining real income, meaning an absolute decline in the standard of living. At the same time UK banks are piling on Gilts like US banks are piling on US Treasuries, not lending, shrinking their balance sheet but earning a nice spread in the process by borrowing close to zero and locking the spread on Government bonds."

So billionaires seeking safe haven for their wealth by investing in a luxury London home should be well advised to reconsider given gold has indeed presented higher returns from fixtures and fittings in the last decade than the property itself according to Knight Frank, as reported by Bloomberg:

"A typical so-called super-prime property in London’s Kensington neighborhood would have cost 24,000 ounces of gold a decade ago, compared with about 9,800 ounces now, Knight Frank said today in a report. “To visualize this, 9,800 ounces would be a cube about the size of a small footstool, admittedly a heavy one,” the London-based real estate broker said. The CHART OF THE DAY shows how the value of super-prime homes doubled in the past 10 years and climbed 14 percent since their previous peak in March 2008. In comparison, gold prices have surged more than fivefold in the last decade. Knight Frank defines super-prime as homes valued at 10 million pounds ($16 million) or more in central London neighborhoods such as Knightsbridge, Kensington, Mayfair and Belgravia." 
- source Bloomberg

Yes, every asset class has a cycle, and until the escape capsule is triggered, we are unlikely to see an end to the trend in surging gold prices, although the scarcity of prime real estate for sale have enabled prices to held their value better. You have a similar scarcity case in Paris, for prime real estate.

Some additional important points made by Richard Koo in his recent are the following:
"More liquidity = greater economic instability once QE ends
Those making a case for inflation targeting or GDP targeting never say how much liquidity will be needed. All they say is that the supply of liquidity should be increased until the targets are reached. 
But the actual outcome would be very different depending on whether achieving the targets required a 20% increase in liquidity or a 200% increase. 
If only a 20% increase were needed, it might be possible to drain excess liquidity in the course of normal market operations once the targets were reached. But absorbing a 200% increase in liquidity would require massive bond-selling operations that could have a major negative impact on interest rates and the economy. 
That the BOE was unable to turn the UK economy around with a 300% increase in the supply of liquidity suggests at the very least that 300% would not be enough. 
Moreover, economic activity supported by such a reckless increase in liquidity is likely to be unstable and to become even more so once the central bank began mopping up excess liquidity. 

QE may have net negative economic impact when viewed across life of program 
It has been argued that during a balance sheet recession, when the private sector is rushing to minimize debt, liquidity supplied by the central bank does not stimulate the economy. Once the private sector completes its balance sheet adjustments and is ready to borrow again, draining liquidity will serve to lift interest rates and depress the economy. 
This means if we examine the impact of QE across the life of the program, the negative impact of mopping-up operations may actually outweigh the positive impact of the initial easing. 
During a balance sheet recession, after all, the absence of private loan demand dulls the economy’s sensitivity to interest rates, which means its response is likely to be muted regardless of whether the central bank engages in QE. 
When the economy starts to recover, however, private loan demand would have also picked up by then, increasing the economy’s interest rate sensitivity. A rise in rates then would have a major negative impact. 
Viewed overall, it may be better under some circumstances not to supply excess liquidity at all during a balance sheet recession. This is because without it, there is no need to drain liquidity once the economy pulls out of the recession. 
The debate up to now has ignored the fact that rates will rise when liquidity is drained from the system, with potentially adverse consequences for the economy. Proponents of further accommodation continue to urge the central banks to leave QE in place until deflation has been vanquished. But they might come to a very different conclusion if they also considered the impact of the exit from QE. 

Time to reconsider quantitative easing 
So far, no QE program has been successful, even if we consider only the initial impact and ignore the exit process. The Japanese, US, and UK economies all remain in the doldrums. It is hard not to question the overall effectiveness of QE when we consider the fact that aggressive tightening (i.e., a draining of excess liquidity) awaits once the private sector finally starts looking forward again. 
Recently QE has been welcomed in some quarters for its ability to boost share prices or devalue the local currency. But there are pitfalls here as well. 
Share prices, for example, must ultimately be justified by earnings. But while equity prices have been rising in the US, the economy remains sluggish and the outlook for corporate profits is not particularly bright." - source Nomura.

Yes, share prices must ultimately be justified by earnings, but also by "inflation expectations" so "mind the gap" between consumer discretionary stocks and consumer staples stocks:

"As the CHART OF THE DAY illustrates, the S&P 500’s consumer-related industry groups increasingly mirrored each other after the index peaked at a record five years ago today. They were the period’s best performers among the 10 broadest industry gauges in the S&P 500. Makers of food, beverages, household products and other consumer staples set the pace by rising 29 percent. Companies most dependent on consumers’ discretionary income -- retailers, media companies, homebuilders, automakers -- ranked second with a 25 percent gain. The chart also shows financial stocks, whose 55 percent decline was the steepest among the 10 groups. Consumer-discretionary stocks may falter as a falling dollar spurs inflation, Leger wrote in an Oct. 5 report. The Dollar Index, a gauge of the U.S. currency’s value against the currencies of six major trading partners, has dropped as much as 6.1 percent from this year’s high on July 24." - source Bloomberg

Following what we commented in our previous conversation "Zemblanity" on what our Buzz Lightyear central bankers might find out in targeting the unemployment level (given the relationship between M2-velocity and the US labor participation rate over the years) is that the jobless rate can be a misleading gauge of labor market health as indicated by Bloomberg:

"One reason the Federal Reserve may be unable to reach consensus on an unemployment target: the jobless rate can be a misleading gauge of labor market health. While unemployment has fallen to 8.1 percent from 10 percent in 2009, the CHART OF THE DAY shows the percentage of people working, known as the employment-population ratio, has remained near its lows of the recession, suggesting limited progress toward a recovery in jobs. “In a better economy we would see an improvement in this data,” said Adolfo Laurenti, deputy chief economist at Mesirow Financial Inc. in Chicago. While the ratio has fallen as the baby boomer generation retires and because more students are returning to school “the tougher nut to crack is those people who are truly discouraged workers, who could be in the job market but are leaving.” The employment-population ratio climbed to a record high 64.7 percent in April of 2000 before falling as low as 58.2 percent in December 2009, the lowest level since 1983. A lack of labor-market improvement, even with the drop in the unemployment rate, prompted the Fed to begin a third round of asset purchases, or QE3, in which it’s buying $40 billion a month of mortgage-backed securities. While Fed policy makers have proposed continuing the Fed’s accommodative policies until the unemployment rate hits a certain level, as long as inflation remains contained, they haven’t been able to reach consensus on a jobless target. “We want to see the unemployment rate come down, but that’s not the only indicator, obviously, of labor market conditions,” Fed Chairman Ben S. Bernanke said in a Sept. 13 press conference. “The unemployment rate came down last month because participation fell; that’s not necessarily a sign of improvement.”" - source Bloomberg.

Once again, there is what you see and what you don't see in true Bastiat fashion.

To infinity...and beyond...we think.

Meanwhile Employment opportunities remain elusive for some Americans meaning that the poverty rate could remain high particularly with the looming risk of the fiscal cliff:

"The CHART OF THE DAY shows that the percentage of Americans living below the poverty line was little changed last year at 15 percent, or 46.2 million people. The poverty line is defined by the U.S. Census Bureau as those living on less than $11,702 per year, or $23,021 for a family of four. Food-stamp use climbed to a record 46.7 million people in June, according to the Department of Agriculture." - source Bloomberg

Unless the housing rebound in the US is genuine, and the private wealth effect translates to the real economy, we cannot see the long term benefits but mostly greater risks in maintaining for too long the QE toy in place.

 "I cannot help it - in spite of myself, infinity torments me." - Alfred de Musset

 Stay tuned!

Sub-par recovery - Macro Update and outlook - Risk off...

Complacency could not last that long.

Sooner or later the markets had to take a close look at the weaker than expected data released recently and the implications.

ADP came yesterday at a very weak 38K, meaning that all economists forecasters had to revised agressively their estimates for Friday's NFP.
Everyone was expecting 175K and we got 38K. This is a major slowdown from the December-April average of above 200K, according to the ADP private employment report.

Everyone expecting a short term sell-off of UST 10 year due to discussions around the debt ceiling and budget debates, earlier this year have been hugely mistaken including myself. Mea culpa.
I posted earlier this year that I was expecting a continued surge in the TBT ETF in my post
"Dumb and Dumber - QE2 and the risks linked to global rising Yields in 2011". I got it badly wrong. When facts change, I have to change my facts (ProShares UltraShort 20+ Year Treasury ETF, NYSE:TBT).
Global bond market returned 0.93% in April and another 1.1% in May. US Treasuries returned 1.46%.
Given the weaker than expected US economy, the FED is in no position to raise rates. That's what you have in a balance sheet recession when you are facing still very strong deflationary forces.

Given Mr Market latest sell-off and risk-off mood, I would expect further tightening in UST. The economic recovery is just too weak.

Last week I indicated the issues still surrounding the US housing market and the implications for bank stocks. I advised last weak to stay clear. US Banks stocks have in fact so far reached their lowest point in 2011.
Bank of America down 4.3% to USD 11.24.
Wells Fargo down 5% to USD 26.84.
JP Morgan fell 3.4% to USD 41.76.
Citgroup down 3.7% to USD 39.65

In addition to the housing drag on the economy in general and for bank stocks in particular, rising US Treasuries isn't going to help them as well. It could further reduce bank profitability, by reducing the income banks receive on loans they make.

S&P/Case-Shiller nationwide home price index for the U.S. fell 4.1% y/y in Q1...a new cycle low:

Falling house prices will affect banks, translating in higher loan losses as collateral values fall and subdued mortgage loan growth. As I said before watch out for rise in loan provisions in future bank earnings report.

So what do we end up with according to the latest data?

We have weaker growth than expected, weaker job creation than expected, weaker housing market than expected and very weak loans to the private sector, private equity and venture capital activity. And consumer confidence is in the dumpster...

David Goldman in his Inner Workings blog is painting the situation it bluntly in his latest post:

"Here’s the String, As in “Pushing on a String”

ISM index for U.S. manufacturing activity fell as well sharply in May from a strong 60.4 to 53.5. Lowest since September 2009. Costs pressure from the rise in commodities? Most likely. Given surge in inflation in China caused by a surge in wages, how long is it going to take to have inflation
exported back to the US and starting to bite corporate margins?

A PMI reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent that it is generally declining.
If PMI falls next month below 50, we will come closer to a double dip. Simple as that:

Time for QE3?

Interesting comments in zerohedge about David Rosenberg's views:
In Preparation Of The Fed's Last Doubling Down: David Rosenberg Believes QE3 Will Be Nothing Short Of "Operation Twist 2"

This week winners:

• Poland's GDP Grows 4.4% in Q1 2011.

• Canada's economy accelerated to an annualized growth rate of 3.9% q/q in Q1 2011.

• Russia's gross domestic product (GDP) has grown 4.1% year-on-year in the first quarter of 2011.

This week losers:

• Australian Economy Contracts 1.2% in Q1. Biggest contraction in 20 years...

• India GDP Growth Slows to 7.8%. Slowest pace in five quarters.

• Japan's Economy Contracts 0.9% in Q4.

• UK's mortgage approvals, fell to 45K (peak was November 2006 at 129K approvals).

Same story for some of the peripherals.

• Greece downgraded by Moody's from B1 to Caa1, outlook negative.

According to Markit, Greek 5 year Sovereign CDS is now around 1470 bps and Portugal at 700 bps.

Europe issues are yet to be resolved and the game still being played by European politicians is kicking the issues down the road. Time is running out fast.

Given's very recent price action in the market, it doesn't look like we are going to have a nice and quiet summer. Brace for more trouble ahead. Core solvency issues for Greece have yet to be adressed and politicians are desesperately trying to keep kicking the restructuring can down the road.The macro picture is weaker than expected. Risk-off...