Macro and Credit - Tantalizing takeoffs

"When everything seems to be going against you, remember that the airplane takes off against the wind, not with it." -  Henry Ford

Watching at the dizzying summits reached by US stock market indices with the Dow flirting with 20,000 on the back of the Trump rally, as we move towards the final days of 2016, with a continuation of US Treasuries getting pummeled, when it comes to selecting our title analogy, we decided to go for a vintage flying analogy this time around, "Tantalizing takeoffs" being the nickname for the 50th Beechcraft AT-11 Kansan AT-11 built in 1941 and being currently the oldest flying. The AT-11 was setup as a smaller version of the B-17 Flying Fortress or B-24 Liberator. This provided a simulated training environment similar to the full sized bombers. While in the past we have used as well a reference to aircrafts, particularly in our long 2013 post "The Coffin Corner", which is the altitude at or near which a fast fixed-wing aircraft's stall speed is equal to the critical Mach number, at a given gross weight and G-force loading. At this altitude the airplane becomes nearly impossible to keep in stable flight:

"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.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013.

On a side note the latest decisions from the ECB amounts to us as clear confirmation of that indeed Mario Draghi is clearly affected by "the spun-glass theory of the mind" given that he stated that “uncertainty prevails everywhere,”

The current melt-up dynamics reminds us what we indicated back in January 2012 in our conversation "Bayesian thoughts" when we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices." 

Are we entering the final melt-up for asset prices, or is really the much vaunted "reflationary story" playing out in earnest? Or is it simply a case of "Information cascades playing out again as they are often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...)? We wonder.

In this week's conversation we would like to look again at some Emerging Markets vulnerabilities given the recent hike by the FED and the continued pressure stemming from "Mack the Knife" aka King Dollar + positive real US interest rates. 

Synopsis:

• Macro and Credit -  Emerging Markets, from convexity to concavity?
• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

• Macro and Credit -  Emerging Markets, from convexity to concavity?

Back in 2013 we expressed our concern regarding the impact a dollar squeeze of epic proportion would have on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

Also back in December last year we indicated a macro convex trade to think about for 2016 relating to a potential devaluation of the HKD which won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016. We made our call for a break in the HKD currency peg as per our September conversation and made additional points made last year in our conversation "Cinderella's golden carriage". In February in our conversation "The disappearance of MS München", we also looked out the Yuan hedge fund attack through the lenses of the Nash Equilibrium Concept :

"When it comes to the risk of a currency crisis breaking and the Yuan devaluation happening, as posited by the Nash Equilibrium Concept, it all depends on the willingness of the speculators rather than the fundamentals as the Yuan attacks could indeed become a self-fulfilling prophecy in the making." - source Macronomics, February 2016

While obviously our prediction was too outrageous for 2016, we do think that the HKD peg will once again come under pressure in 2017. On that very subject we read with interest Bank of America Merrill Lynch Asia FI and FX Strategy Viewpoint note from the 15th of December entitled "HKD to be challenged in 2017":

"HKD under pressure again

The HKD is under depreciation pressure again. We believe investors’ recent positions were based more on speculative than on fundamental reasons. These positions may be supported by the increase in the US Federal Reserve’s rate hike expectations for 2017. There is a risk of a pullback in USD/HKD forward points and HKD rates if RMB depreciation expectations stabilise over the coming weeks and investors take profit.

Brace the outflows

We believe 2017 will be a year of outflows from Hong Kong. The current account surplus is expected to decrease while capital outflows accelerate. That would cause Hong Kong to draw down its foreign exchange reserves.

Weaker FX, higher rates

Outflows, a slowdown of CNH-HKD conversion, and a declining aggregate balance will shape the HKD market next year. We forecast USD/HKD to rise to 7.80 and 3M HIBOR to rise to 1.50% by end-2017. We are biased to pay USD/HKD forward points and biased to pay front-end HKD rates." - source Bank of America Merrill Lynch

As we pointed out back in November in our conversation "When Prophecy Fails", when it comes to currency attacks it is more about the resolve of the speculators than the fundamentals:

"It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think." - source Macronomics, November 2016

As pointed out by Bank of America Merrill Lynch in their note, we are seeing a repeat of last year brief attack on the HKD:

"The HKD is under depreciation pressure again. Investors have recently long USD, short HKD forward outright, which has pushed up USD/HKD forward points to its highest level since early 2016. HKD rates have consequently increased and the 3M Hong Kong Interbank Offered Rate (HIBOR) fixing jumped over 10bps (Chart 1).

Both speculative and fundamental reasons related to Mainland China supported the recent market movement (Exhibit 1):

Speculative

The correlation between the HKD and CNH broke down in 3Q: while the RMB continued to depreciate, the HKD was stable (Chart 2). 

But the strong economic links and the growing impact of China on Hong Kong’s interest rates suggest insufficient risk premium was priced into the HKD. So even if Hong Kong’s currency board is credible, which is our base case not least because it has withstood multiple tests in the past, interest in the market to hedge against tail risks persists.

The HKD is also sometimes used as a proxy for the CNH. Proxies for the CNH are attractive when the associated carry costs on shorting the CNH are high (Chart 3).

But provided Hong Kong’s currency board does not change, we believe the potential gains from shorting the HKD as a proxy for the CNH are ultimately limited. In our view, trades based on this rationale are vulnerable to being unwound in the short term.

Fundamental

Hong Kong has started to experience outflows so far this year: in 1H 2016, Hong Kong recorded outflows equivalent to -0.9% of GDP. As such, there are already signs that the HKD will be under fundamental depreciation pressure. We believe the outflow theme in Hong Kong will be much more pronounced in 2017 than in 2016, especially since the US Federal Reserve raised its policy rate for the second time after the global financial crisis in December.

We believe recent positions were based more on speculative than on fundamental reasons, based on the timing of the move.

Speculative depreciation pressure on the HKD picked up after concerns over the RMB increased due to:

• China’s low FX reserve numbers in November
• Reports of curbs on capital outflows from China
• Growing uncertainty over the US-China trade relationship

These speculative pressures may persist in the near-term after the US Federal Reserve raised its Federal Funds rate projections from two hikes to three hikes in 2017. A broad USD rally could raise concerns over capital outflows from China and, ultimately, raise RMB depreciation expectations: we showed that broad USD strength and an increase in policy uncertainty raise capital outflows from China by Chinese investors.

But we also point out that Hong Kong’s 2Q balance of payments (BoP) data have been available since September 2016 and so we think the outflow theme was not the main driver behind the recent move.

As such, there is a risk of long USD, short HKD forward outright positions based on speculative reasons being unwound if the RMB depreciation expectations stabilise over the coming weeks and investors take profit." - source Bank of America Merrill Lynch

While clearly the current pressure on the HKD is based on rising speculations, obviously, the amount of currency reserves is a crucial parameter. The accumulation of reserves by the Hong Kong Monetary Authority (HKMA), make the current speculative move difficult to sustain.

One thing for certain, when it comes to Hong Kong and its vulnerability with their currency board matching the path of the Fed with rate hikes is clearly its real estate market. On that matter we read with interest Deutsche Bank's Hong Kong Property note from the 16th of December entitled "Risk of falling off the edge":

"Every 25bps rate hike would push up mortgage payments by about 2.4%

By looking at the sensitivity of residential affordability in Hong Kong to mortgage rate hikes, every 25bps increase in mortgage rates would translate into an approximate 2.4% increase in monthly mortgage payments or to push down residential affordability (i.e. increasing the debt-servicing ratio) by about two percentage points. Conversely, residential property prices would need to fall by about 2.4% in order to maintain the debt-servicing ratio at the current 68%. By assuming Hong Kong will follow the 75bps rate hike expectation in the US in 2017, residential prices would need to fall by 7.2%. Alongside our expectation of a 3% decline in median household income, we anticipate an 11% decline in Hong Kong residential prices in 2017. If mortgage rates are to normalize to the level of 2005/06 at about 5.75%, residential prices would need to fall by 28% from current levels.

Liquidity conditions look ample for now, although downside risks are rising

Liquidity conditions remain ample in Hong Kong so far, with a stable monetary base, currency lying in strong side convertibility and composite interest rates remaining low. However, the recent surge in interbank rates in HK has led to some concerns about the need to lift the Prime rate in HK. We believe that the near-term spike in interbank rates could be a reflection of expectations of higher rates, potential liquidity outflow and HIBOR finally catching up with USD LIBOR.

Although the large banks have signaled that the Prime rate will remain unchanged, we believe there is a risk that HK banks may need to move the Prime lending rate upward if: 1) HIBOR continues the upward shift that led to increasing the proportion of mortgage loans moving to capped rate Prime loans, 2) a strong liquidity outflow leads to higher deposit funding costs for large banks, and 3) there is much weaker/reversal of system deposit growth, with more signs of a tightening of loan-to-deposit ratios.

- source Deutsche Bank

So overall while our outrageous predictions seems difficult to materialize, the pressure on HKMA to intervene again in 2017 will rise again and if indeed there is vulnerability somewhere, then it might be smarter to "short" some Hong Kong real estate players rather than betting for now the demise of the currency peg.

When it comes to Asia and vulnerabilities, clearly China comes to mind particularly given its rapid credit expansion and the potential for a trade war to flare up with the new US administration. In relation to China being concerning, we read with interest Deutsche Bank take in their Asia Local Markets Weekly note from the 16th of December entitled "Jamais vu":

"Fed & AsiaFor all of the Draghi like nuances, Yellen (& the Fed) sounded and acted hawkish this week. And for once, it looks like the market has no choice but to chase the dots, which are moving away (and up).

For Asia, that should mean,

• Policy divergence will get more acutely in focus in 2017. The market is pricing in slightly over 60bp of tightening by the Fed next year - and still below the dots - but at best one rate hike anywhere in Asia. Indeed, DB Economics, and most of consensus forecasts, do not think even this modest amount of tightening will be realized. FX is then the natural outlet for this divergence in policy outlooks. And like we have been arguing, not just in the high yielders which run the risk of capital reversal - or more likely, no fresh inflows - but also in the low yielders, and ones which also map to the trade/geopolitical policy narrative of the incoming US administration (think Korea, think Taiwan)
• China in particular has some tough policy choices to make here. The Fed tailwind to the dollar will only make these choices harder for the Chinese. Either allow a significant re-pricing of the RMB complex (and take the risk of an unstable cobweb pattern), or burn down reserves (and take the 'credit' hit on the sovereign), or shut the capital gates down even tighter. Likely that they will opt for a mix of the lot. Importantly, though, none of these options look supportive of the liquidity or rates complex - offshore and (increasingly) onshore. Overnight CNH rates are trading at 12%; trading in key bond futures has been halted for the first time; and local press (Caixin) is reporting of big banks suspending lending to non-financial institutions. The move up in inflation only makes the rates re-set story in China that much more compelling to own.
• The local stories will likely define the axis of differentiation in 2017. The dollar move will probably take most of the Asia currency and rates complex with it, to begin with. But the local stories will likely define where on the dollar smile each market ends up next year - be it the policy choices the central banks make (rates, FX, regulatory), or the headwind from political noise (Korea, Malaysia, India)." - source Deutsche Bank

Obviously until "Mack the Knife" aka King Dollar + positive real US interest rates ongoing rampage stops, there is more pain to come for some Emerging Markets players in 2017. Yet, we think that the movement has been too rapid on both the US dollar and interest rates and have yet to be meaningfully confirmed by US fundamentals. While the EM fund flows hemorrhage has stabilized, at least for equities, it remains to be seen how long the resiliency will remain with a continuation of rising yields and we agree with Deutsche Bank's comments from their note:

"US equity bullishness has likely helped arrest outflows from Asia

The buoyancy in US equities – despite the large repricing in US yields – and the softness in vol indicators like VIX has helped contribute to a general resilience in risk. After close to $10bn of outflows from Asian equities in November, the outflows have stopped, although money has not really returned. Again we remain skeptical on the durability of this calm. The correlation of Asian equities to US stocks has been falling since the election and indeed with the US less likely to share the spoils of growth with the world, a decorrelation in returns should widen. Moreover, January has been seasonally weak for US equities for the last three years, which suggests a correction could lie ahead. Chinese equities have also been under strain given the rates market developments, with Asia straddling the divergence.

The market has not been as focused on the potential negative Trump dynamics for Asia from trade, geopolitics, and widening policy divergence 

The market has primarily focused in this first-round on the fiscal implications of a Trump administration, and the re-pricing of growth and inflation expectations. The other side of the coin – of potential protectionist and geopolitical disruption – has been harder to price given large outstanding uncertainties about Trump’s approach off the campaign trail. Once Trump actually assumes office in January, this uncertainty should fade, with a need to take a formal stance on issues like labeling China a currency manipulator, imposition of tariffs and the bargaining chips in play from the One China Policy to North Korea. There has also been outsized focus on the divergence theme between US versus Europe and Japan, but this is equally pertinent for Asia where markets have been in a multi-year easing mindset driven by disinflation, poorer demographics, sensitive credit cycles, and little external lift. If, as DB Economics believes, there is little appetite and ability in Asia to follow the Fed, rate differentials are going to impose pressure on Asian FX. On the other hand, if markets begin to price rate hikes, then unwind of duration stories and debt outflows from the region could be equally painful.

The market has been fighting the “major” battles

With dramatic moves in major G10 currency pairs like USD/JPY, EUR/USD, and in US rates, it is quite likely that macro positioning has been concentrated on trading these bigger themes and breaks. Indeed, even as JPY shorts were being added last week (on the IMM), investors were believed to be squaring back on KRW shorts. However as price action in the majors gets more stretched, the market should begin to look for catch-up trades and mis-pricings elsewhere.

End of year and idiosyncratic effects may have helped slowed moves

While market illiquidity into year-end could have exaggerated negative price action, there are other yearend forces which could have helped. There has been little fresh supply of debt in local markets which should have helped with bond technicals. Similarly, on the debt side, major asset allocation decisions are likely to be taken only in the New Year. Issuance calendars will start up afresh in January, when demand-supply mismatches would be more acutely felt. Central banks  may have also been more active in supplying dollars to manage FX weakness, given greater sensitivity to year-end closing levels. In individual markets like  Indonesia, inflows related to tax amnesty repatriation are likely helping contain the moves. In Malaysia, the wind down of the NDF market, and the immediate provision of greater exporter supply may have helped, but we estimate that significant hedges from real money, equity, and banks could be transitioning onshore in the coming months as offshore hedges roll off. Current account surpluses in much of North Asia are seasonally stronger around year-end, but dip significantly in Q1, with Chinese New Year inactivity, and with holiday export orders behind them

In sum, we are unconvinced that regional FX resilience can last, and would be positioning for a catch-up move higher in USD/Asia into the New Year. We continue to concentrate our USD longs against North Asian pairs that would be most exposed to any worsening in Chinese stress, fallout from a US equity market correction, a negative shift in the regional trade/geopolitical order, and where currencies have relatively poorer seasonality at the start of the year." - source Deutsche Bank

As we posited in our recent musing, the biggest "known unknown" remains the political stance of the US administration relating to trade with China. From our perspective, 2017, will continue, as per 2016 to offer renewed volatility on the back of political uncertainties given the new year will have plenty of political events, ensuring therefore an increase in volatility and large standard deviation moves like we have been used so far this year. Overall "Mack the Knife" will continue to weight on global financial conditions, particularly in EM where there has been a significant amount of US dollar denominated debt issued in recent years. As pointed out as well by Deutsche Bank, the pressure of the US dollar and rising rates will put further pressure on Chinese financial conditions:

"Risk of further capital measures remains high.

In response to the ongoing RMB weakness, driven in part by the divergence in US-China monetary policy, China has again introduced a series of capital measures particularly on RMB cross-border flows (see Trying Times for RMB, 7 December 2016). However, with outflows not abating and as RMB depreciation pressure continues to build, the risk of more such controls remains high, which are likely to drive further tightening in offshore RMB liquidity.

Reversal of RMB internationalisation should tighten

RMB liquidity further. The latest regulations introduced are likely to have accelerated the decline in RMB deposits in the offshore market again, shrinking the overall RMB liquidity pool in the offshore market.

Possible maturing of USD/CNH forwards. 

China earlier this year accumulated a large chuck of short USD forward positions, which are likely to mature in the coming months. If a part of these are allowed to mature, like in August/September, it could well be sufficient to create CNH tightness." - source Deutsche Bank

Whereas for now, convexity rules, be aware that concavity could once again come back to the forefront in early 2017 with markets at the moment continuing the probe again the willingness of the HKMA to defend the peg with additional weakness coming from the RMB and a potential slowing growth outlook for China.

If indeed there is a potential in 2017 for an early "risk-reversal" à la 2016, then again, it looks to us that, from a contrarian perspective the level reach by long US treasuries is starting to become enticing.

• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

Whereas gold and gold miners in conjunction with bonds have been on the receiving end of "tantalizing takeoffs" for equities on the back of the US election, our final chart comes from Bank of America Merrill Lynch Securitized Products Strategy Weekly report from the 16th of December shows that in recent years, rising yields have been followed by declining breakevens, which have been therefore followed by declining real rates:

• The 60 basis point rise in the breakeven rate since late June 2016 is the largest rise of the past 4 years. The unusually large move would seem to have some room to give back some of the recent gains.
• The past month’s rise in the real rate is the second largest of the past 4 years. Over the 4-year period, sharply rising real rates have been followed by declines in the breakeven rate, which in turn have been followed by declines in the real rate.

"Given the persistence of the patterns in recent years, we think that over the next 4-8 weeks, the odds favor a decline first in the breakeven rate and then in the real rate. Overall, nominal yields are therefore likely to move lower. Given that the nominal rate has risen by 80 basis points over the past month, we would not be surprised to see a 50% retracement over the next 4-8 weeks, which would bring the 10yr yield back to the 2.20% area. Time will tell." - source Bank of America Merrill Lynch

If indeed, this scenario plays out, then we could see some reversal of Gibson's paradox given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. End of the day the most important factor for gold prices is real interest rates. One thing for sure 2017 will have sufficient political events to offer yet again plenty of risk-reversal opportunities rest assured.

"The political graveyards are full of people who don't respond."- John Glenn, Astronaut

Stay tuned!

Currency war - The China Syndrome

"Battle is an orgy of disorder." - General George S. Patton

Looking at the first effects of the QE launch of our "Generous Gambler" aka Mario Draghi and following up on our "Information cascade" prognosis where we stated that central bankers around the world have done the same "marketing" exercise, namely inducing other central bankers to adopt QE, we reminded ourselves in the current "Currency war" of 1979 American Thriller "The China Syndrome" for our title analogy:

"China Syndrome" is a fanciful term—not intended to be taken literally—that describes a fictional worst-case result of a nuclear meltdown, where reactor components melt through their containment structures and into the underlying earth, "all the way to China." - source Wikipedia

Of course our dual reference is linked to our deflationary bias and the rising tail risk of a Chinese currency devaluation which has been impacted as of late not only by the rising US dollar but as well by the global slowdown in demand. China has been trying to offset its credit bubble in a "controlled fashion" and avoiding a "credit meltdown". 

Back in November 2011 we discussed a particular type of rogue wave called the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:

"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011

Wave number 3 - Currency crisis:

We voiced again our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

At the time we stated that we were in an early stage of a dollar surge.

Back in December 2014 in our conversation "The QE MacGuffin" we added:

"The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil."

Our friends at Rcube Global Asset Management  also voiced their concerns in a guest post entitled "A Chinese Déjà-vu?" published on the 17th of December:

"The Chinese capacity of utilization rate has dropped to 70%. The investment bubble, just like for the Tigers, has been financed with cheap - and until recently plentiful - credit. China now has the largest corporate debt pile in the world, having surpassed the US last year ($14.5 Trillion vs $13.1 for the US)." - source Rcube

As pointed out by our friends in their long contribution, the current situation in China is eerily familiar with the Asian economies in 1997 particularly when you look at domestic demand which is at its weakest since 1997!

In this conversation, we would like to discuss further this clear 2015 global deflationary "tail risk" as it seems it is becoming more and more a "topic du jour" in the financial blogosphere which we are part of. After all, China might as well embrace "QE" at some point in true "Information cascade" fashion which would trigger a global deflationary "wave" of significant proportion...

Synopsis

• Headwinds of deleveraging and the property markets are too powerful to offset by conventional rate cut measures
• Lower EUR = higher deflation risk, be careful what you wish for!
• Central bankers are falling for "Information cascade"!
• Time to put your contrarian hat on again and go long US Treasuries
• Final note « Optimism bias » or  how to underestimate Homeownership rates in the US

• Headwinds of deleveraging and the property markets are too powerful to offset by conventional rate cut measures

China just had its second rate cut in three months to offset the effects of disinflationary pressures sent by its economic powerhouse neighbor Japan and now increasing with the ECB's QE. China is trying to work a balancing act of avoiding an explosion of the credit bubble while maintaining sufficient steam in their economic growth.

Unfortunately, we do not think that a "conventional" approach will be sufficient to offset the "Shrinking pie mentality" we discussed in April last year:

"When it comes to the benefits of "Quantitative Easing" program which went on in various countries (Japan, United States and the United Kingdom), the possible gains of this uphill battle against strong deflationary trends for a small share of a shrinking pie rarely justify the risks in the long run we think.

In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:
"Revaluation of Japanese Yen, a historical lesson to draw: analysis" - Macronomics, April 2014

We also commented at the time:

"In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB. As we pointed out, the Chinese have learned their "Japanese lesson" unfortunately for the US Treasury and there are no US military bases in China (like the United States have in Japan...). Given the raging "Shrinking pie mentality" in the world today, the US economy won't benefit like it did in the 90s from Chinese committing "economic seppuku" as the Japanese did, as they have learned their "Japanese economic lesson" but we ramble again..." - source Macronomics, April 2014

Of course the start of Europe's own QE program is accentuating the difficulties for China to complete its balancing act and avoid a credit meltdown. To that effect, we agree with Nomura's take from their Asia Special Report note from the 28th of January entitled "Quantifying China's monetary policy" that conventional measures will not be enough to counteract disinflationary pressures now coming from Europe as well:

"• The ECB’s QE program is adding further appreciation pressure on the CNY nominal effective exchange rate (NEER), which by constraining exports and adding to disinflationary pressures, further adds to the likelihood of policy loosening in China.
• The types of monetary policy instruments used will depend on economic and financial conditions. Should net capital inflows surge again, we would expect the probability of four RRR cuts in 2015 (our base view) to fall, but the probability of more benchmark rate cuts to rise (we currently expect one 25bp rate cut in Q2).
The risk, however, is that the monetary policy framework may have changed. Given concerns of reigniting the property and credit market booms, authorities may be reluctant to send strong signals of policy easing through interest rate or RRR cuts, leaving piecemeal, targeted instruments as the PBoC’s new, preferred tools. The authorities have expressed their intention to continue targeted piecemeal measures this year. For example, at the 2015 World Economic Forum, Premier Li stressed that China will pay more attention to policy fine-tuning and better utilising targeted policies to ensure the economy within a reasonable band.
The problem is, however, that the headwinds of deleveraging and the property market correction are so powerful – domestic demand is at its weakest since 1997 – that the economy is unlikely to be stabilised on piecemeal easing measures. Moreover, the potency of stealth-like, piecemeal targeted easing on the real economy has weakened significantly, in our view, even for the sectors (e.g. small enterprises) that the targeted measures are supposed to support.
Should this time window for more traditional wholesale monetary policy loosening be missed, the authorities may eventually be forced to ease more aggressively when the economy is slowing more sharply and edging closer to deflation, adding volatilities to the economy." - source Nomura

Further pressure on CNY nominal effective exchange rate (NEER)? this can be ascertained from Société Générale's Cross Asset note from the 9th of March entitled "Is China the major tail risk for global equity markets?":

"RMB weakness

• The yuan appreciated strongly over the past ten years. Its recent depreciation has fuelled concerns that China could be about to join the currency war.
• But in fact, the PBoC has been consistently selling dollars to offset capital outflows and maintain the trading band. A continuation of dollar-selling intervention, rather than persistently raising the daily fixing, widening the band, or outright devaluation, remains our base case scenario
• Our EM strategists highlight that devaluing the RMB has little economic justification given a robust trade balance, medium-term objectives of rebalancing away from exports to the domestic economy, and could work against internationalisation efforts." - source Société Générale

The issue we have with Société Générale's EM strategists case that devaluating the RMB would have little economic justification in the current "rebalancing" act, is that increasing disinflationary pressures from outside China might indeed lead it to succumb to "Information cascade" as a cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts.

When it comes to China and "Deleveraging", the country is facing yet another "Long March" as indicated by Morgan Stanley in their March 10 China strategy note entitled "China Deleveraging - the long, bumpy ride continues":

"Total leverage to official GDP has risen to 247% at Sept 2014, still rising but at a slower pace than in the 2008-2011 time frame. Our score of progress on 10 dimensions of successful deleveraging drops back to 48 from 51 out of 100, erasing the improvement made in our last review. China’s deleveraging looks set to stay a long and bumpy ride.Scores have fallen most notably in
1) Guiding down real exchange rate; 2) Generating negative real borrowing rates; and 3) Fiscal transfers to low end households and SMEs. We raised scores for 1) better recognition of bank NPLs and, 2) accelerated capital markets development."

The absolute leverage scale has continued growing but its pace has slowed down. Total system leverage amount in RMB has only been growing at 12% YoY in 20143, ~1/3 of its growth during the peak year of 2009 at 30% (Exhibit 4).However, this is in the context of nominal GDP growth slowing.

Among different segments, mid/large enterprises are the only category that has consistently been growing its leverage amount faster than the entire economy since 2011. As a comparison, small business’s total leverage growth has been consistently lagging the overall economy during the same period. We have always argued that de-levering of large enterprises while further levering up the small enterprises is essential for China to achieve a successful deleveraging. Unfortunately this is not really happening. Exhibit 5 shows how mid/large enterprises’ share in total system leverage balance grows while that of the small enterprises shrinks.

On the plus side, the consumer segment has reported meaningful positive development. Total leverage by consumer has been growing faster than total system leverage in 2013 and 2014 (Exhibit 4), and its absolute share in total social leverage has grown from 8.6% in 2012 to 9.6% by Sep 2014 (Exhibit 5).
Local government also shows a minor slowdown in leverage growth in 2014. However the pace is slower than we would have preferred. This is consistent with our view that thorough auditing/quantifying and designation of LGFV obligations would be much more time-consuming than expected." - source Morgan Stanley

The on-going anti-corruption campaign in China has been gathering momentum, yet, the clean-up in the local authority credit binge as pointed out by Morgan Stanley in their report has been slower. We have long been advocating swift and fast restructuring when dealing with bloated balance sheets, a road Europe has not decided to follow hence the "japanification" process, but that is another matter.

In the devaluation case, Morgan Stanley doesn't believe in their recent note would be the right course of action:

"We have long argued that a lower real exchange rate should be part of an overall policy setting (along with fiscal and monetary adjustment) to help China achieve a successful deleveraging. This is because the net export sectors could play a cushioning role during the adjustment process for the broader corporate sector given its leverage problems and entrenched PPI deflation (see the next section). However, a sudden nominal devaluation of the CNY is not necessarily the right course of action or indeed likely to happen. Our baseline scenario sees only a modest and gradual weakening in the fixed parity of the CNY near term, before gradually appreciating back to 6.09 at the end of the year." - source Morgan Stanley

We agree to disagree with Morgan Stanley and side with Nomura and others on the devaluation risk given the weakness in global demand but we give them for now the benefit of the doubt in the light of exports data showing recently a 15% rise in the first two months of 2015, while the value of imports fell 20 by 20%. 

In similar fashion to Europe, could the decrease in imports in China and lower GDP means consumer have indeed less money to spend as well? We wonder.

Another point which is of great interest from the same Morgan Stanley note is the evolution of China's PPI which has fallen to level not seen since the Great Financial Crisis (GFC):

"The rise in the real interest rate has been mostly caused by the recent deflationary trend itself reflecting China’s excess capacity in over-leverage sectors. PPI in China has dropped to its lowest levels since the Financial Crisis. Feb 2015 PPI declined at accelerated rate of -4.8% yoy (versus -4.3% yoy in Jan 2015) whilst CPI inflation modestly edged up to 1.4% yoy (from 0.8% yoy in Jan 2015). Among all Asia EM countries, China has been in PPI deflation for the longest time – 36 months (Exhibit 14). This PPI deflation has been further exacerbated by the recent stagnated commodity prices at a global level.

China’s actual system wide credit costs are higher than official lending rates. Moreover, China’s system wide credit costs are significantly higher than the official lending rate. Our MS China Banks team estimates the overall system wide credit costs of 7.69% at year-end 2014 has fallen to 7.45% at the time of writing after the most recent official interest rate reduction to 5.35%. On this basis we calculate the real interest rate expressed in relation to PPI inflation is approaching 12% significantly above overall real GDP growth with the real interest rate expressed in relation to CPI quite close to current overall economic growth."

 - source Morgan Stanley

The actual system wide credit costs indicated by Morgan Stanley do validate additional rate cuts in the coming months to facilitate the deleveraging and the economic slowdown.

What could arguably put a spanner in the difficult Chinese "rebalancing" act is in our mind the deflationary impulse of the latest QE player being the ECB hence our next bullet point.

• Lower EUR = higher deflation risk, be careful what you wish for!

In terms of China Syndrome and currency war, we have also read with interest Bank of America Merrill Lynch from the 9th of March entitled "Currency war, ECB QE and deflation risk:

"Lower EUR = deflation risk?
The decline of EUR/USD below 1.10 may be less benign than it may appear at first.
We believe it is likely to exacerbate an exit from EM, increase the risk of an RMB devaluation, place renewed downward pressure on oil prices, and heighten concerns about deflation risks.
In our view, the decline of EUR/USD this week below 1.10 may be less benign than it looks at first glance:

• Lower EUR/USD is exacerbating the exit from emerging markets (Chart 10). 

USD/TRY hit an all-time high last week (a risky cut, and USD/MXN is within striking distance of its all-time high reached briefly after the Lehman bankruptcy. Even USD/BRL has moved above 3 for the first time since 2004.

• Lower EUR/USD will likely put more pressure on China to devalue the CNY (Chart 11). 

As we have argued, a CNY devaluation, which would signal which would signal to us that China is joining the currency war, is the biggest tail-risk of 2015.

• Lower EUR/USD will likely place downward pressure on commodity prices, particularly oil prices (Chart 12). 

Our commodity team continues to think that the balance of risks for oil prices points to further downside given the elevated level of inventory globally (Chart 13).

 - source Bank of America Merrill Lynch

On the deflationary impact of QE which we have discussed in numerous conversations, we read with interest CITI 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

 What we have long posited is that while wanting to induce inflation, QE induces deflation.

In our conversation "Supervaluationism" back in May 2014 we indicated we were in complete agreement with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":

"Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete

Capital gains in the form of exorbitant bond price? You bet!

Here is a good illustration we think in the meteoric rise of a long Portuguese Government Bond 4.1% maturing on the 15th of February 2045 issued on the 13th of January at par! - graph source Bloomberg:

A nice price increase to say the least...now trading around 134 in cash price meaning risk-free profits on a continuing basis, unconditionally offered to bond speculators thanks to Central banks and their QEs! "Irrational exuberance" à la Alan Greenspan? As we posited in our conversation "Pascal's Wager" bond investors are indeed making a "rational" decision based on the premises that central bankers are "deities".
  

• Central bankers are falling for "Information cascade"!

As we posited in our last conversation, central bankers around the world have done the same "marketing" exercise. They have induced other central bankers to adopt QE. The China Syndrome is leading to another form of mimic, this time around currency war as described by Bank of America Merrill Lynch in their 3rd of February note entitled "Currency war and its consequences:

"The unspoken war
There is a growing consensus in the market that an unspoken currency war has broken out. For many countries facing zero interest rates and binding fiscal constraints, the only policy tool left at their disposal to stimulate growth is a weaker exchange rate. The reason why this is a war is that it is ultimately a zerosum game – someone gains only because someone else will lose.

Nevertheless, it would seem that policymakers are becoming more open and ready to avail themselves of this last resort. This includes even those of some large and closed economies that are generally thought not to benefit as much from weaker exchange rates as small and open ones. This is not totally surprising given currency devaluation, unlike structural reforms that can also increase competitiveness, is relatively painless and easier to do politically.

How time has changed. Central bankers who are normally reticent when it comes to talking about exchange rates in public are now openly expressing their desire for a weaker currency. Last September, the BOJ Governor Haruhiko Kuroda suggested that “it is nothing strange at all for the dollar to strengthen” and said that he did not believe that “a weakening yen is undesirable for the Japanese economy.” A month before, ECB President Mario Draghi made the case as to why “the fundamentals for a weaker exchange rate [euro] are today much better than they were two or three months ago.”

All this is helping to reduce the stigma associated with currency devaluation in the international policy circles. Of course, respectable central bankers would still insist that currency depreciation is a consequence of their monetary easing rather than a goal in itself. However, evidence suggests otherwise. The ECB’s new asset purchase program is having a much bigger impact on the euro than on Eurozone interest rates (Chart 1) 

and the clearest impact that BOJ QQE has had so far is a boost to the profit margins of Japanese exporters (Chart 2)."

 -source Bank of America Merrill Lynch

• Time to put your contrarian hat on again and go long US Treasuries!

While it is no secret that we are sitting tightly in the deflationary camp and that our biggest 2014 has been to go long US duration (partially via ETF ZROZ), we have to confide that, as of late, we have been increasing our exposure following the decent pull-back seen during February. As we also indicated previously, our losses on our exposure have been mitigated by our long standing short exposure on JPY (via ETF YCS). With the EUR/USD touching 1.06 levels, we believe it represents an additional deflationary impulse that both China and the US cannot ignore. On that sense we fully agree with the additional comments made by Bank of America Merrill Lynch in their recent note:

"If the recent negative correlation between S&P 500 and USD/EUR (Chart 3) were to hold, a lower EUR/USD could trigger a more generalized risk-off that would benefit deflationary assets including lower long-term Treasuries. Note that the recent back up in nominal yields has been driven by increased inflation breakevens.

The obvious implication is that investors are becoming concerned about the ability of the US economy to cope with the strengthening USD. Even though on a trade-weighted basis the USD is still far from its highs in the mid-1980s or early 2000s, the pace of the USD appreciation over the past half year has been the second fastest in forty years (Chart 4).

Furthermore, even though exports are only 13% of the US economy, 40% of S&P 500’s earnings now come from outside the US. 

The fact that the weakness in manufacturing export orders appears to be spilling over to general manufacturing orders (Chart 5) and the lack of evidence that consumers are spending what they are saving on gasoline are also likely starting to concern investors.

  What is the trade?

Generally, strong US data lead to higher US bond yields and stronger USD, like on Friday after the February NFP came in stronger than expected. However, we are making the case that we are close to the point that the positive correlation between US rates and the USD begins to turn negative – stronger USD leading to higher deflationary risk leading to lower long-term bond yields." - source Bank of America Merrill Lynch

Indeed, we agree with the above. The economy in the US is much weaker than it seems as we posited in our February conversation "While My Guitar Gently Weeps":

"The recent widening in US Treasuries make a good entry point for those who missed out, we indeed, expect, the data in the US, from a contrarian perspective to be weaker than previously expected, regardless of the most recent NFP."

We will be continuing to add on our long US Treasuries exposure rest assured in true Lacy Hunt fashion.

• Final note « Optimism bias » or  how to underestimate Homeownership rates in the US:

On a final note we leave you with Bank of America Merrill Lynch's Home Ownership rate simulations from their Morning Market Tidbits note from the 9th of March entitled "The world against deflation" showing that the decline in the US has been more dramatic than the published data:

"Homeownership rate simulations: We derive a homeownership rate assuming household weights by age group as of 1994. In other words, we only allow for the change in the homeownership rates over time to matter, holding the household age weights constant. Under this methodology, the homeownership rate would have declined to 62.1% last year. Hence, the aging of households added 2.3pp to the homeownership rate since 1994. This suggests that the decline in the homeownership rate thus far has been even more dramatic than the published data suggest." - source Bank of America Merrill Lynch

So go ahead Dr Janet Yellen, normalize this...

"Thus it is that in war the victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterwards looks for victory." - Sun Tzu

Stay tuned!