Macro and Credit - The Canton System

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Watching the intensification of the trade war rhetoric, with additional dollar weakness, and a softening tone in US macro data, when it came to selection our title analogy, we reminded ourselves of the 1757-1842 Canton System which served as a mean for China to control trade with the West within its own country by focusing all trade on the Southern port of Canton (now called Guangzhou). This policy arose in 1757 as a response to a perceived political and commercial threat from abroad on the part of successive Chinese emperors. To some extent, one could argue that the Trump administration would like to reassert its control on trade like the Chinese emperors did back then, hence our chosen analogy this week. For the history buffs out there, the 1842 Treaty of Nanking put an end to the Canton System.

In this week's conversation, we would like to look at the relationship between interest rates and the price of credit, in conjunction with the relationship between credit and cycles as well as into the trade war narrative building up.

Synopsis:

• Macro and Credit - Credit relationships and cycles and trade wars should not be taken lightly.
• Final chart - Deglobalize me...

• Macro and Credit - Credit relationships and cycles and trade wars should not be taken lightly.

Back in October 2016 in our conversation "An Extraordinary Dislocation" we reminded ourselves of the Wicksellian Differential and the credit cycle (linked to the leverage cycle):

"When the natural rate of interest is lower than the money rate which is the case today (rising Libor), the demand for credit dries up (our CCC credit canary are being shut out of credit markets) leading to a negative disequilibrium and capital destruction eventually. In a credit based global macro world like ours, the Wicksellian Differential provides a better alternative estimation of disequilibrium than the more standard Taylor Rule approach of our central bankers." - source Macronomics, October 2016

Also we find interesting that Wicksell used the housing sector to illustrate his theory, particularly in the light of the start of some housing prices weakness seen such as in London for instance. We added at the time of our musing:

"Why is the Wicksellian Differential so important when it comes to asset allocation? Either profits increase due to an increase in the return of capital and/or a fall in the cost of capital (buybacks funded by a credit binge). This is clearly reminded by Credit Capital Advisors' note from July 2012 entitled "Navigating the business cycle: A new approach to asset allocation":
"The calculation of the Wicksellian Differential is however an ex-post measure, so is unhelpful for investors to use as an investment trigger, hence an ex-ante model needs to be constructed based on the underlying drivers of growth in the Wicksellian Differential, which is of course leverage. However, an ever-increasing amount of leverage is clearly unsustainable and will cause expectations to shift at some point, resulting in a period of deleveraging and falling profits. As a result, an investment trigger can be set up based on the dynamic relationship between leverage ratios and the rate of profit, which requires constant recalibration as new data is made available.

The relationship between each leverage ratio and the rate of profit is unique and dynamic through time. For example, the slowdown and fall in the consumer leverage ratio caused the Wicksellian Differential to reverse between 1990 and 1992. Furthermore, during the tech bubble between 1996 and 1999, corporate leverage fell followed by consumer leverage, causing the rate of profit to fall. This highlights that there was no real basis for rising equity returns during the tech bubble as the rate of profit growth was falling. Thus the dotcom bubble ought to be seen as akin to John Law’s South Sea bubble, which was purely based on a rather large misconception. The extent of the credit bubble leading up to the recent financial crisis is highlighted by the substantial rise in consumer leverage, the rate of which began falling at the end of 2006, highlighting the downturn in the rate of profit growth in 2007, and thus a shift to bonds. Finally consumer leverage rose again in 2009, signaling a recovery in profits, although the recovery was short-lived. In 2011 the trend fell again, and the 2012 signal highlights a continuing slowdown in the underlying trend of profit growth. 

There are of course other factors that impact profits, such as significant changes in the general price level and in output per worker, as well as other known variables such as the tax rate; however, the most important driver with respect to the turning points is the realisation that a period of credit expansion has become unsustainable, leading to changing expectations." - source Credit Capital Advisors, July 2012

And of course dear readers, we have long been warning that the credit cycle was slowly but surely turning thanks to credit "overmedication"."  - source Macronomics, October 2016 

We are starting to feel some keen interest in becoming contrarian again when it comes to a "long US duration" exposure (MDGA - Make Duration Great Again). Once more, it is fairly simple to explain particularly in the light of the most recent Atlanta Fed forecast for Q1 2018 coming at a paltry 1.9% (below consensus) and remember these guys have been right on cue on numerous occasions in the past Q1 weak US GDP prints:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."

With record net short duration exposure thanks to Treasury Futures Net Aggregate Speculative Position at around $3.8 trillion, one could argue that, when everyone is thinking the same, then maybe no one is really thinking. 

In the light of our reminder of the "Wicksellian Differential", bond maverick Jeff Gundlach recent webcast caught our attention as pointed out by Zero Hedge in one of their recent post:

"The highlight of Gundlach's webcast, was his remarkable indicator for the "fair value" of nominal 10Y yields, which he calculates simply as the average of Nominal US GDP and the yield on the German 10Y bund. As shown in the chart below, there is an uncanny correlation between the two series, which would suggest that all one needs to trade the 10Y is to know the latest GDP estimate and where the German Bund is trading.

- source DoubleLine - Zero Hedge

If the Atlanta Fed is right again on its call on a weak Q1 2018, (and we have seen this movie before given that since 1980 there have been 15 instances where growth came in below a 2% SAAR in Q1), then again, tactically playing a rally in the long end looks more and more enticing to us from an"asset allocation" perspective" given the huge consensus which has built up in being short duration and the most recent weaken tone in US macro data (retail sales dipping 0.1% sequentially in February for third month in a row). If it was not for the increased deficit spending by the US administration, we would be jumping in and buying US duration at this stage. 

But moving back to the subject namely the relationship between interest rate and credit, and somewhat the Wicksellian Differential, we read with interest Wells Fargo note from the 28th of February entitled "The Evolution of Irrationality" and relates to the relationship between the complex economic relationships that drive the credit cycle:

"The credit cycle, much like the business cycle, is driven by complex economic relationships. Understanding the emotional component in these cycles can equip investors to better identify turning points in the cycle.

“Many liquid assets which are close substitutes for money… [are] only inferior when the actual moment for a payment arrives.” – Radcliffe Report (1959)

For the Radcliffe Commission, the growth of credit rises with euphoria. As animal spirits take hold, investors seek out opportunities, producing more credit in the system. We only have to look at the “dot.com” bubble and the subprime housing bubble to see the wisdom that credit risk grows with prosperity. What makes the current scene so challenging is to value new instruments against the administered interest rates of central banks. We know the central bank rates are not normalized, but what do we know of the anticipated market returns for new investment opportunities?
As illustrated in the below graph, when the moment of payment arrived in southern European debt in 2014, liquidity and credit quality came under a cloud. As a result, bond yield spreads tightened considerably within a very short period of time.

Interest Rates and Credit Allocation Over the Cycle

As illustrated in the below graph, credit benchmarks differ significantly over the business cycle—to emphasize the problem, these credit benchmarks are very procyclical.

Initially, both the creditor and the debtor start the allocation process with an apparently economically legitimate project, where risk/return has a sense of balance. However, as the first projects demonstrate success, more projects are financed. Moreover, as credit becomes more available, the expected rates of return diminish. It is no surprise to see an inverse relationship between demand for C&I loans among firms and the credit standards required by banks to offer loans. Credit agencies are certainly aware of the behavior of investors over the business cycle and try to mitigate credit risk by tightening standards as demand soars.

Credit For Income or Capital Gain

For J.P. Morgan, the success of the railroads depended on traffic flow—when he looked at the railroad industry, it was badly overbuilt. But for Jay Cooke, the key concept was the promotional sale of bonds to European investors with limited knowledge of American geography.
Upon what basis is credit advanced? The problem is that at the start of many innovations, credit is advanced in anticipation of an income flow to pay off that credit. The initial investors often get their return. However, as time moves on, credit is advanced in an effort to realize capital gains, but they are less available while the risk rises. This phenomenon is represented in the bottom chart, which depicts the run-up in home prices in the mid-2000s.

Many individuals were under the impression that home prices could not fall and treated the homes as an investment opportunity with little downside. Irrational exuberance coupled with inexperienced investors contributed to the subprime housing bubble, which devastated the global economy. Credit relationships and cycles should not be taken lightly." - source Wells Fargo

Wicksell using the housing sector to illustrate his theory was clearly a good indicator, particularly with US home prices now 6.3% higher than their peak in July 2006 and 46% above their trough in February 2012. In our last conversation we did also put a very interesting chart from Wells Fargo and concluded:

"On a more cautionary note, plans to buy a car or a house both rose much less during the month, although the proportion of consumers stating that now is a good time to sell a house jumped 7 points to 73 percent." - source Wells Fargo

"In this ongoing "intermezzo" period giving us that 2007 feeling, what is really striking to us is that the amount of leverage for the US consumer is not what it seems, and no matter how strong the willingness of the Fed to hike is, it appears to us that much sooner than in previous hiking cycle, the Fed is going to "break" something. As per the above chart, it seems to us that Main Street has a pretty good forecasting record in calling housing market tops it seems, much better than some sell-side pundits but we ramble again..." - source Macronomics

Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street. Maybe after all, they are spot on and now is a good time to sell in the US, just a thought. As we have stated before, the Fed will continue its hiking path, until something breaks, and we have already seen some small leveraged fish coming belly up when the house of straw build up by the short-vol pigs blew up. We keep pounding this but, Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount this year as the credit noose tightens. 

No doubts that years of QE, ZIRP and NIRP have turned the market upside down and played with asset prices and grew a large disconnect in some instances from fundamentals. The level of interest rates does indeed matter for the credit cycle and things are slowly but surely turning towards the end of an already very long cycle. On the relationship we read with interest another interesting piece from Wells Fargo from their Economics Group published on the 7th of March and entitled "Interest Rates as the Price of Credit: Altered Fundamentals":

"Interest rates are connecting fibers between the real economy and credit markets. In recent years, the price of credit has been manipulated to spur the real economy, but has altered capital allocation along the way.

Back to Normalization: Administered Rates to Market Rates

Credit allocation has been distorted in recent years in an attempt to spur the real economy. Alterations of market prices, whether in credit or product or exchange markets, creates a tension, an observable disequilibrium between markets that must be resolved over time. For the 1970s, wage-price controls created the disequilibrium. In the early 1990s, the tension in the Exchange Rate Mechanism led to a large, sharp adjustment in exchange rates.
In recent years, the era of administered rates has created a credit disequilibrium and thereby provides little guidance on what should be the proper level of interest rates to price financial capital and thereby judge the viability of real world activity. As illustrated in the top graph, we have moved to a new economic environment since the fall of 2017. We are searching for a new equilibrium in interest rates, exchange rates and real markets.

Altered Fundamentals: Altered Market Prices

Since November, there has been a distinct shift in the fundamentals underlying the search for equilibrium in credit markets. Expectations for economic growth, inflation and exchange rates have moved, so why not market interest rates?
Growth expectations have risen. Inflation expectations have risen. Expectations on the dollar’s value have declined. Net result? Interest rates have risen.

Altered expectations of growth and inflation have moved investor expectations of monetary policy actions.

The probability of Fed action in March moved from 65 percent in January to 99 percent in February.

Modeling Interest Rates: Setting The “Normal” Benchmark

The Great Recession has “added fun” to interest rate modeling. The most widely utilized estimation method is OLS, and one major assumption of OLS is that the underlying data is stationary and has no structural breaks. However, if the data is non-stationary or/and have breaks, then OLS estimations are not reliable. As we have discussed in the past, almost all major macroeconomic variables, including interest rates, experienced structural breaks during the Great Recession. Furthermore, both the 10-year and two-year series have non-linear (declining) trends since the 1980s (bottom graph).

Thus interest rates and the growth rate of the economy, which is also a declining rate, are not constant overtime.
Another major hurdle for modeling interest rates is the fed funds rate’s behavior since 2008. The fed funds rate hit the 0-0.25 percent range on December 2008 and stayed there until December 2015. Unusual fed funds rate behavior, along with structural breaks in interest rates, pose great challenges for modeling. “Add factors” are the best friends of analysts since the Great Recession and it does not seem likely to change in the near future. One thing is very clear for us, and that is due to breaks/altered fundamentals finding a “normal” is similar to “waiting for Godot.” " - source Wells Fargo

The battle rages on between the two camps, namely the "deflationista" who thinks we have yet to see the lows in US yields versus the "inflationista" camp who thinks the secular downtrend in yields is broken and that the only way is up. 

As shown by the burst of the short-volatility bubble in February, there has been a change in the narrative leading to less financial repression which had been a clear sign of central banking intervention in recent years. Now obviously, everyone and their dog are talking about the end of financial repression and normalization of interest rates with the Fed leading the central banking pack. This is leading to renewed real "price discovery" in some segments of financial markets. On that note we read another interesting note from Wells Fargo in continuation of their previous one from the 14th of March and entitled "Ending the Financial Repression Era":

"Markets seek an equilibrium after years of financial repression but the path to equilibrium means backtracking through the minefields of mispriced real and financial assets based upon administered rates.

Back to Normalization: Part II

Economic fundamentals have been moving since 2016 in the direction of higher economic growth, higher inflation, a weaker dollar and larger Treasury fiscal deficits. In this difficult context, central bankers now wish to move away from an environment of administered prices (interest rates and bond prices). However, for investors the problem is policymakers. Financial markets are moving from one disequilibrium point with interest rates held below market values (and below inflation, see below graph) to generate growth, to another nexus of interest rates, growth and inflation that remains undefined given the uncertainty about the equilibrium of real interest rates, the potential growth rate of GDP and the Fed’s commitment to a two-percent inflation target.

Finally, as the year moves forward, we must ask ourselves if the central bank is committed to market-setting interest rates or are we simply moving from an era of close-to-zero interest rates to an era of slightly higher rates, while still being administered by the central bank?

“John Bull Can Stand Many Things, But He Can’t Stand 2 Percent”

For John Stuart Mill, the problem was that “a low rate of profit and interest… makes capitalists dissatisfied with the ordinary course of safe mercantile gains.” That is, capitalists push the envelope of risk to achieve higher returns commensurate with their perceived target or normal rates of return. For today, the pursuit of yield has taken investors to a very broad range of asset classes where the accurate measure of risk/return has been altered by the low administered interest rates set by central banks.
In recent years, the era of administered rates provided little guidance on what should be the proper level of interest rates to price financial capital and thereby judge the viability of real world activity. As illustrated in the below graph, sovereign yields in European debt appear remarkably low, and in some cases are below U.S. Treasury yields. Some observers see this as odd.

Our view is that these low yields reflect the policy of the ECB in buying both sovereign and corporate debt. But here is the rub. When the ECB normalizes interest rates, what then happens to business finance, real growth and the euro exchange rate? Again, we are moving from an era of administered rates to an era of market rates—or perhaps less administered rates. 

What About Real Interest Rates and Inflation Discounts?

In the bottom graph, we see the pattern of current market pricing for the nominal and real component of interest rates. There is one positive signal here. The rise in the real component is consistent with market expectations for an improved economy since early 2017.

In this case, higher real interest rates would be consistent with higher expectations for the real return on capital—a very positive sign indeed." - source Wells Fargo

Given current positioning, everyone is expecting an acceleration in US growth in conjunction with inflationary pressure from rising wages. What if indeed the growth is not as strong as one would expect? On top of a weaker US dollar, the recent surge in the trade war narrative will continue to weight not only on the US dollar but, can add to the inflationary pressure building up in the US. This indeed is a poor recipe for risky asset prices and for a continuation of the support from the US consumer given we noticed that consumer credit has been slowing in January, undershooting the consensus. Nonrevolving credit accounted for nearly all of the consumer credit growth to begin 2018 according to Wells Fargo. Non-revolving credit rose at a 5.6% annual rate, or $13.2 billion, compared to December's rate of $13.1 billion. Total non-revolving credit is now $2.83 trillion. If the US government is going for the "Canton System and we get an all-out trade war, this could spark more threatening inflation and impact the US consumer in full. This would put the Fed in bind as inflation would be rising above the Fed’s comfort zone while real GDP growth would likely be slowing, pushing some economists to already use the dreaded word "stagflation". The most recent US unemployment and wage numbers have provided additional support to the "Goldilocks environment" narrative yet recent softness in some economic data in conjunction with rising trade tensions could indeed put a spanner into this narrative in very short order. Global growth looks fine until it doesn't thanks to a change in sentiment, and that could come quickly through trade war escalation with the US and the rest of the world as indicated by Barclays in their Global Synthesis note from the 9ht of March entitled "Goldilocks is nervous":

"Global growth still fine, but potential ‘trade war’ poses risk

"Recent data suggest there has been some modest deceleration in global manufacturing. Yet, this comes off elevated levels, following many months of increases. Notably, services PMIs picked up in both EM and DM economies, offsetting the manufacturing weakness. This week's robust US labour market report seems to confirm the Goldilocks scenario of a robust expansion with little underlying price pressure. Next week, February IP prints in the US and Europe, machine orders in Japan and investment numbers in China should provide further signals about the health of the global economy. However, with fiscal stimulus still ahead and financial conditions still supportive, the risks to global growth seems limited. That said, a serious deterioration in global trade relations could change that"

- source Barclays

When it comes to the US dollar, we think it can continue to weaken if US tariffs trigger a broader trade war and global crisis risks. It might be seen as being Goldilocks for the US economy but when it comes to credit markets, it has been "Goldilocks" for a while, but, since early 2018, the price actions and fund flows for both Investment Grade and US High Yield (17th consecutive week) have shown a weaker tone.

It seems some pundits have decided to quietly exit the credit dance floor. This is indicated by Société Générale in their Mutual Fund and ETF Watch note from the 15th of March entitled "Outflows from credit funds - Another sign that the good times may be over":

"We monitor the flow of funds into and out of mutual funds and ETFs in all asset classes.

• Exceptional outflows from credit funds. The latest outflows from high yield and investment grade credit funds mark a clear break from previous trends. For US high yield credit (HY), cumulative net outflows started in 2016 (chart below left) but have accelerated over the last month, with HY ETFs also seeing outflows. In the case of investment grade (IG) credit funds in the US and Europe, the turnaround comes after a prolonged period of strong cumulative net inflows. The series therefore appears to be peaking at very high levels (chart below right). So far, these outflows have had little impact on performance.

• Credit – an indispensable asset... Since 2010, the hunt for yield has turned credit into an indispensable asset, resulting in a fourfold increase in credit funds’ assets under management in the US and Europe (to $1,075bn, EPFR coverage). As a result, most investor portfolios are now heavily overweight on credit versus other asset classes compared to history. Within credit funds, the strongest implied overweight position is for European investment grade. But, increasingly this is a point of weakness. When the wind turns, these OW positions point to potential selling pressure.

• ... soon to be an undesirable asset? The latest outflows from credit may be a further sign that the golden years are increasingly behind us. In the editorial, we highlight several other reasons to be worried. Risk premiums indicate that credit is expensive compared to almost all asset classes. Rising rates are bringing closer the point at which credit is no longer indispensable for covering contractual obligations. No marginal buyers seem to exist to replace the ECB when it stops purchasing credit (CSPP) in September 2018. Meanwhile, worries about a pick-up in credit defaults seem premature, even if corporate leverage has risen and economic and earnings momentum seem to have peaked. That said, the credit market certainly looks stretched and it may take very little to puncture current complacency. And when credit gets hurt, equity is typically not far behind."

- source Société Générale

All in all it might feel like "Goldilocks" on the macro side for Main Street with expectations of higher wages, for Wall Street it seems, the only "easy day" seems more and more to be yesterday with the "Credit Goldilocks" narrative truly fading as of late...

While on numerous occasions we voiced our concerns for that 1930s with the rise of populism, which has once again been vindicated by the recent Italian elections, it seems that with the US Canton System we are moving from cooperation to noncooperation and lower cross-border capital flows. This could be a troubling development as per our final chart below.

• Final chart - Deglobalize me...

Back in January this year, in our conversation "The Twain-Laird Duel" we looked at the recent rise in the trade war rhetoric and we argued the following:

"Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing..." - source Macronomics, January 2018

Our final charts comes from Bank of America Merrill Lynch "The European Credit Strategist note from the 15th of March entitled "NIRP manias - the part 2" and ask the question if globalization is dead, displaying Global cross-border capital flows and the rise of "populist" votes since 2000: 

"Is “globalization” dead?

Draghi’s dovishness comes at an opportune time, as populism has been an all too familiar theme lately. But populism is now becoming synonymous with protectionism. Does this mean that the story of globalization is reversing? Cross-border capital flows are undoubtedly lower than in 2007, but much of this reflects the prudent retrenching by banks from global lending. Other signs are more encouraging, though. World trade is still low, but is forecast to improve relative to world GDP. Foreign direct investment has recovered much of the post-Lehman bankruptcy drop, and global migration rates have noticeably jumped over the last decade. Thus, it may be too early to hail “deglobalization”, we think. Instead, a lesser, but steadier and more fruitful form of globalization is emerging.

“Marginalized” workers around the world want a fresh political agenda that is more inclusive, and prosperous, for them. Understandably, ideas around “Frexit” and “Italexit” play no part in this given their wealth destructive consequences (see here for how Eurozone breakup fears have receded). Instead, the current brand of populist politics is more inward looking and seeks to play on voters’ fears about globalization and migration. Populism, therefore, has become more about protectionism: putting up barriers to entry and reworking free trade."- source Bank of America Merrill Lynch

As a reminder, the Canton System arose as a response to a perceived political and commercial threat from abroad, it seems to us that the US Government under Trump is keen on imposing further restrictions on foreign trade with China particularly in their sight, is Germany next? We wonder and ramble again...

"The United States can't keep a completely open system if the rest of the world is less open. The United States may have to take a leaf out of the book of Japan, China, and Germany, and have protectionism inside the system." -  Robert Mundell

Stay tuned!

Credit - Sprezzatura

"When you can't make them see the light, make them feel the heat." - Ronald Reagan

Listening with interest to the latest comments from our "Generous Gambler" aka Mario Draghi and the disappointment that followed his ECB conference with a significant wobble in European equities by more than 2% (given he didn't specify the size of the potential ABS program), we reminded ourselves for our chosen title and analogy of the Italian word originating from Baldassare Castiglione's "The Book of the Courtier" published in 1528. Sprezzatura is defined as the ability of the courtier to display "an easy facility in accomplishing difficult actions which hides the conscious effort that went into them" according to Wikipedia. In plain English, the word has entered the Oxford English Dictionary defined as "studied carelessness".

What we find of interest in our chosen analogy is that Castiglione wrote his book as the portrayal of an idealized courtier - one who could successfully keep the support of his ruler, in our European case, the support of Germany. 

It seems our "Generous Gambler" is losing his "Sprezzatura" we think when we hear about the rising German dissent for degrading further the quality of the ECB's balance sheet as indicated by the comment of Jurgen Stark, the former chief economist of the ECB:

“The ECB’s decision to double down on stimulus is an act of desperation. Its willingness to buy ABSs is especially risky and creates joint liability, with European taxpayers on the hook. The ECB lacks the democratic legitimacy to take such far-reaching decisions,” - Jurgen Stark

Of course it is of no surprise to us to see growing German dissent as we have long argued Germany holds the key to the unravelling of the European game. The essence of "sprezzatura" is making difficult tasks seem effortless: "whatever it takes", "believe me it will be enough", etc. 

Those who possess sprezzatura need to be able to deceive people convincingly. As of late our "Generous Gambler" hasn't. Also as per Wikipedia, Sprezzatura's negative attribute is "the art of acting deviously":

"This "art" created a "self-fulfilling culture of suspicion" because courtiers had to be diligent in maintaining their façades. "The by-product of the courtier's performance is that the achievement of sprezzatura may require him to deny or disparage his nature". Consequently, sprezzatura also had its downsides, since courtiers who excelled at sprezzatura risked losing themselves to the façade they put on for their peers."  - source Wikipedia

The "Sprezzatura" performance of our "Generous Gambler" Mario Draghi made us remind ourselves our quote from our conversation "Sympathy for the Devil"given that, in order to achieve "sprezzatura", it required Mario Draghi to deny or disparage his nature:

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

While the euro has indeed fallen by more than 9% against the US dollar since May, it won't be enough to sustain economic expansion we think, which unsurprisingly is falling, a subject we will discuss in this conversation as well as our continuous nervousness with the continuation in the rally in the US dollar, meaning tightening and dollar scarcity and the confirmation that CCCs credit being indeed the canaries in the risky asset coal mine.

As we posited in our previous conversation, as years have gone by in the European tragedy, we have become somewhat immunized from our great magician's spells and "sprezzatura" tricks.

It appears though that, we are not the only ones being less "receptive" to the "sprezzatura" skills of our "Generous Gambler" given that at the latest 2014 Global Macro Conference in London from Bank of America Merrill Lynch, some clients revealed their strong convictions through a survey, one being that bank lending will not step up post EU stress tests (83%) and that EUR will be the worst performing (32.7%) over the next three months:

"1. Will stress tests prove to be a turning point for market confidence in the balance sheets of European banks?

a.  Yes  37%

b.  No  63%

2.   Will bank lending step up meaningfully after the stress tests?

a.  Yes  17%

b.  No  83%" 

Which currency do you expect to be the worst performing over the next 3 months?

1. JPY  16.3%

2. EUR 32.7%

3. RUB  20.4%   

4. BRL  18.4%

5. SEK 9.2%

6. Other (specify) 3.1% "

- source Bank of America Merrill Lynch

Taking on the first subject of our conversation, the continuous fall of the Euro won't be enough to sustain economic expansion, we read with interest Natixis take on the subject from their note from the 18th of September entitled "What is the correlation between the euro's exchange rate and growth in the euro zone?":

"A 10% depreciation of the euro:

• Increases euro-zone exports by 4.2% (given the increase in their relative price);

• Increases euro-zone imports by 3.1% (given their relative price);

• Therefore increases the euro zone’s level of GDP by only 0.2 percentage point.

Historical relationship between the relative growth of the euro zone and the euro’s exchange rate

We look at the link between growth in the euro zone relative to the United States and to the world (Chart 9A) and the euro’s exchange rate. 

Chart 9B shows that growth in the euro zone relative to the United States was high in 2001 (with a weak euro) but also in 2006-2007 (with a strong euro), and then declined while the euro depreciated. 

Chart 9C shows that growth in the euro zone relative to the world fell from 2001 to 2003 (with a weak euro) and has since been stable. We see no link between the relative growth of the euro zone and the euro’s exchange rate.

The divergent prospects for growth and interest rates between the United States and the euro zone explain the euro’s depreciation despite the euro zone’s external surplus. Is the euro’s depreciation good news if we take into account the weight of the euro zone’s necessary imports? First we looked at the elasticities of euro-zone export and import volumes and prices to the exchange rate. We saw a slightly positive effect of the euro’s depreciation on real GDP in the euro zone. Next we looked at the link between euro-zone growth relative to the United States and the world and the euro’s exchange rate. It appears no such link exists." - source Natixis

What is of course of interest is that the euro zone's massive external surplus has never been so large and creating indeed a very large imbalance. This of course, reminded us of Nobel Prize Robert A. Mundell 2000 book "The Euro as a Stabilizer in the International Economic System":

"The EU should also change its attitude towards the balance of international payments. Being a key currency issuer, it has the responsibility to provide the rest of the world with sufficient amount of euros. If it always keeps a surplus status, the euro cannot be an important international key currency. Other countries can obtain euro assets either directly through a trade deficit or a capital account deficit. But such a deficit is not a bad thing for the EU. It will bring seigniorage to the euro zone. The Asian countries traditionally belong to the dollar area. This is mainly because we have a trade surplus with the US or we have net capital inflows from the US. If the euro is going to be widely used in Asia, it should invest or lend more money to Asia. It should also expand its trade relations with Asian countries." - Robert A. Mundell, "The Euro as a Stabilizer in the International Economic System

In addition to the above, Deutsche Bank published today a very interesting report entitled "Euroglut: a new phase of global imbalances":

"This report argues that both “secular stagnation” and “normalization” are incomplete frameworks for understanding the post-crisis world. Instead, “Euroglut” – the global imbalance created by Europe’s massive current account surplus will be the defining variable for the rest of this decade. Euroglut implies three things: a significantly weaker euro (we forecast 0.95 in EUR/USD by end-2017), low long-end yields and exceptionally flat global yield curves, and ongoing inflows into “good” EM assets. In other words, we expect Europe’s huge excess savings combined with aggressive ECB easing to lead to some of the largest capital outflows in the history of financial markets." - source Deutsche Bank

Of course a symptom of this phase of global imbalance has been the very weak aggregate demand in Europe caused by the European crisis and the credit crunch triggered by the EBA in 2012 which accelerated the deleveraging of European banks and the lack of credit transmission to the real economy. 

"What is Euroglut? Euroglut is a global imbalances problem. It refers to the lack of European domestic demand caused by the Eurozone crisis. The clearest evidence of Euroglut is Europe's high unemployment rate combined with a record current account surplus. Both are a reflection of the same problem: an excess of savings over investment opportunities. Euroglut is special for one and only reason: it is very, very big. At around 400bn USD each year, Europe's current account surplus is bigger than China's in the 2000s. If sustained, it would be the largest surplus ever generated in the history of global financial markets. This matters." - source Deutsche Bank

Global Imbalances are indeed larger than before the Great Financial Crisis:

- graph source Deutsche Bank

The Euroglut according to Deutsche Bank:

"Europe has been running a current account surplus over the last two years but also benefited from

portfolio inflows as Eurozone risk premia normalized. This surplus was plugged by outflows in the “other investment” component of the balance of payments. This was mostly related to falling bank liabilities to foreigners. Even though banks reduced their foreign assets (deleveraging), their foreign liabilities dropped by more as foreigners reduced their euro loans and deposits." - source Deutsche Bank

Another issue we mentioned was the crowding-out effect which meant that the incestual relationship between European banks and their governments have led to investments being directed to "carry-trade", with credit not directed where it matters most, namely European SMEs.

On the matter of FX depreciation, in conjunction with Natixis take, Deutsche Bank argues that it will not be an effective tool:

"Domestic policy implications

A domestic implication of euroglut is that FX weakening will not be an effective policy response. Does the euro-area need an even bigger trade surplus? Europe faces a problem of domestic, not external demand. The global environment is hardly conducive to export-led growth either. Japan has engineered a close to 50% appreciation in USD/JPY yet exports have failed to recover. This lack of FX responsiveness does not mean that the ECB doesn't care. Absent fiscal policy or other "animal spirit"-boosting initiatives, there is very little left for the central bank than to push yields and the currency lower. QE in Europe will be ineffective, but it will happen anyway - it is the only tool the ECB has to protect its mandate.

From a "Macronomics" perspective the impact should indeed be substantial as posited by Deutsche Bank:

"Global impact

Euroglut means that as the world's biggest savers, Europeans will drive international capital flow trends for the rest of this decade. Europe will become the 21st century's largest capital exporter. This statement is close to an accounting identity - a surplus on the current account implies capital outflows elsewhere. Our premise is that the next few years will mark the beginning of very large European purchases of foreign assets. The ECB plays a fundamental role here: by pushing down real yields and creating a domestic "asset shortage", it is incentivizing European reach for yield abroad. Think about policy over the next few years: at least 500bn-1trio of excess cash will be sitting in European bank accounts "earning" a negative rate of 20bps. In the meantime, asset-purchases will drive yields down across the board – there will be nothing with yield left to buy. The asset implications are huge:

1. Currency weakness. As equity, fixed income and FDI outflows pick up, the euro should face broad-based weakening pressure. Our end-2017 forecast for EUR/USD is 95cents.

2. Very flat fixed income curves. What will Europeans buy? With the US Treasury - bund yield spread at record highs, US fixed income should be a primary beneficiary of European demand. "Secular stagnation" implies a low terminal Fed rate resulting in low long-end yields. "Euroglut" suggests that the level of neutral Fed funds doesn't matter. If there is sufficient demand for long-dated instruments, the US 10-yr yield could easily trade below terminal Fed funds. It happened during the 2000s "bond conundrum", it is even more likely now - global imbalances are bigger.

3. Good EM could survive. The Global Financial Crisis has seen a rotation of current account surpluses away from EM to Europe. At face value, this makes EM more vulnerable. But the sum of countries' current account surpluses is larger now than before 2008, so there is more spare capital around. European current account recycling should mean that the marginal demand for EM assets is likely to go up, not down." - source Deutsche Bank

We agree with the above, US investment grade has already seen large inflows and the flattening of the yield curve will continue to be supportive of credit. What we also found of great interest on the subject of the euro, current account surplus and global monetary policies was in a recent note from Exane BNP Paribas from the 2nd of October entitled "A Frankfurt Accord for a lower euro?":

Imagine the unimaginable: Europe and the US agree on a lower euro

The markets' focus is on the ECB taking more credit risk by purchasing Eurozone assets. But what

if the ECB buys US treasuries, instead of buying Eurozone government bonds, as is widely expected to happen sooner or later? This would help the ECB in its endeavour to bring its balance sheet back to 2012 levels (+EUR1trn needed). In other words, the ECB intervenes in FX markets, with the blessing of US authorities. We have coined this hypothetical scheme the ‘Frankfurt Accord’.

This ‘out-of-the-box’ idea is worth considering based on the following reasons:

1) The ECB avoids the legal and political uncertainty of buying Eurozone sovereign debt

2) FX intervention and US treasury buying is within the ECB’s mandate

3) A lower euro would quickly feed into the economy with a positive effect on prices and exports.

4) The main challenge is that the Fed and the US government would have to agree. The benefits for the US would be that it would delay Fed tightening and keep 10-year yields low, thereby supporting the US mortgage and residential real estate markets.

Is it likely to happen?

The ECB buying US sovereign debt is not our main scenario. However, we think that markets currently underestimate the political risk attached to large-scale purchases of EMU sovereign debt and the consequent possibility that the ECB may yet again have to become more creative in its conduct of monetary policy. The appropriate framework for such a political agreement is a G7 FinMin meeting (10 October in Washington, Germany takes over the presidency next year)." - source Exane BNP Paribas

On that interesting scenario unravelling, obviously our "Generous Gambler" Mario Draghi would have to regain his "sprezzatura" and the support of his masters as indicated by Exane BNP Paribas in their interesting note:

"Who has to agree? US treasury, Fed and European politicians

In the G7 context, the implicit political rule is that large-scale FX intervention should first be blessed by the major parties involved. Therefore, the US treasury and Fed would have to agree to the ECB buying US sovereign debt. And of course Eurozone politicians should be on board as well. This was the political procedure followed in 1985 for a lower USD (Plaza accord), and in 1987 to stabilise the USD (Louvre accord). It was also the case in 2000, when the ECB intervened in EURUSD to stabilise the euro, initially on a co-ordinated basis between the ECB, the Fed and BoJ.

Ideally, the Japanese authorities would also agree

The ECB would only be active in US and not Japanese markets. However, in our view, this should not be too much of an obstacle as a weaker USD is in Japan’s interest as well. The more sensitive issue would be EUR-JPY. We believe the currency pair may fall a bit, but given that we expect the BoJ to opt for another round of QE in 2015, we do not see a “brutal” decline. Hence, the ECB buying US treasuries may not be that much of a problem for Japan.

The most delicate country to deal with is China

A higher USD leads automatically to a Chinese currency appreciation vis-a-vis the Eurozone. This is not necessarily China’s preferred policy mix. Authorities would most likely prefer a supportive export environment through a low currency, which allows them to tighten monetary conditions domestically to counter developments in shadow banking and the property sector. So in a way, a significantly higher USD increases the risks for a Chinese devaluation of the RMB against the USD."  - source Exane BNP Paribas

As we wrote back in our conversation "The Shrinking pie mentality" in April this year, China is more likely to seek a weaker RMB against the USD to avoid bursting its credit bubble à la Japan and  its Nikkei 39,000 of 1989:  

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" 

"Under US pressure, the Japanese government and banks "honestly" carried out the "Plaza Agreement", starting to interfere the yen exchange market on a large scale together with the US. As a result the exchange rate of yen against US dollars skyrocketed, exceeding 200:1 by the end of 1985, going beyond 150:1 at the beginning of 1987 and nearing 120:1 in early 1988. This means that the Japanese yen had doubled its value against US dollars in less than two years and a half!" - People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

In order to fulfill its balance sheet expansion the ECB could possibly apply similar intervention levels as did the Bank of Japan and the SNB in order to lower their currency as indicated by Exane BNP Paribas:

Applying similar intervention amounts to the euro (as a % of daily FX turnover) points to annual ECB purchases of between EUR400bn (SNB) and EUR800bn (BoJ). In the current context, with the EUR-USD already having turned, we believe intervention sizes suggested by the BoJ’s precedent overstate what is needed to manage down EURUSD.

As the ECB committed itself to expanding its balance sheet by EUR1tr, the ECB’s FX intervention would have to be unsterilized. Hence, US treasury purchases would lead directly to a balance sheet expansion.

In terms of ECB balance sheet composition, the ratio of FX assets / euro denominated assets has been declining since the start of the Eurozone. Expanding them by EUR500bn would lead to a ratio of 38%, all else being equal.

- source Exane BNP Paribas

And Exane BNP Paribas to conclude their interesting intellectual exercise with the following comments:

"ECB easing has to start now

Given current inflation and growth readings, it is quite clear that ECB easing has to start now, and not vaguely at some point next year. This is of course already happening, as ABS and covered bond purchases are set to start in October. As we are not too sure whether the US would subscribe to rapid monetary tightening as of now, it could be that a broad based agreement cannot be reached this side of Christmas.

Nevertheless, keep an eye on the G7 meeting on October 10. Next year, Germany takes over the G7 presidency, so perhaps our imaginative agreement would have a German name. Is it all likely to happen? Our spontaneous reaction was that ‘this is a banana republic approach’. However, the more we think about it, the more we like it…" - source Exane BNP Paribas

Taking on the second subject of our conversation, being our continuous nervousness with the continuation in the rally in the US dollar, meaning tightening and dollar scarcity, Bank of America Merrill Lynch came with interesting comments on the 3rd of October in their US Economic Weekly note entitled "Greenback grief":

"What kind of reaction?

Recent work finds that a 10% appreciation of the trade-weighted dollar leads to about a 0.3pp decline in GDP growth over four quarters, and a 0.25pp drop in inflation. 

As other currencies weaken, those economies should benefit, all else equal. But that effect happens only with a lag, and recent data have softened in several large economies, with the global outlook now looking less favorable. This creates a one-two punch for US exports, as both price and income channels work against them. Also, with a much larger share of corporate profits than GDP exposed globally, a strong dollar could have a bigger drag on stock prices, which might feed back adversely into confidence and spending.

On the inflation side, the Fed has undershot its target for much of the post-crisis period. Inflation accelerated somewhat earlier this year, but now seems stuck at 1.5%. If a dollar appreciation started to push down inflation —particularly core, and not just cheap imported energy and food — it would almost certainly stop Fed discussion of normalizing rates dead in its tracks. In our view, the Fed will not hike until inflation is expected to be on a sustainable path toward the 2% target. Indeed, pushing inflation down toward 1.2% or lower in the past has led to more easing not tightening. Markets may be expecting a further appreciation, but do not appear to be pricing in a shift from modest jawboning to a meaningful shift in Fed communications away from rate hikes next year." - source Bank of America Merrill Lynch

The 5y5y breakevens are now approaching levels at which the Fed has typically engaged in easing via asset purchases. Please keep that in mind. So, with the Fed scheduled to end QE3 by the end of the month, the bar to engage into additional purchases is indeed high making the October 10 central banks meeting a very important event indeed. What is indeed extremely evident to us is that the US yield curve will continue to flatten as it has been all year, in particular in the popular 5-30s part of the curve.

From the same Bank of America Merrill Lynch note, we agree that the velocity of the appreciation of the US dollar matters, particularly on the inflation front, which could postpone the normalization dead in its track:

On the inflation side, the Fed has undershot its target for much of the post-crisis period. Inflation accelerated somewhat earlier this year, but now seems stuck at 1.5%. If a dollar appreciation started to push down inflation —particularly core, and not just cheap imported energy and food — it would almost certainly stop Fed discussion of normalizing rates dead in its tracks. In our view, the Fed will not hike until inflation is expected to be on a sustainable path toward the 2% target. Indeed, pushing inflation down toward 1.2% or lower in the past has led to more easing not tightening. Markets may be expecting a further appreciation, but do not appear to be pricing in a shift from modest jawboning to a meaningful shift in Fed communications away from rate hikes next year." - source Bank of America Merrill Lynch

What is also of interest is that the surging dollar and falling US treasury yields have happened in conjunction with falling commodity prices and particularly a sharp drop in energy prices. This is therefore reinforcing the possibility of coordinate actions from central banks as it seems to us that the deflationary forces are once again taking the upper hand in the eternal struggle (see our post "The Night of the Yield Hunter").

Taking on the third  and last subject of our conversation, namely the confirmation that CCCs in credit  are being indeed the canaries in the risky asset coal mine in continuation of our take from our conversation "Wall of Voodoo", our earlier call was indeed confirmed for this segment of the market when we looked at the price action in the Euro CCC space in September as displayed in Bank of America Merrill Lynch's note from the 2nd of October entitled "The canary in the credit mine":

"In September, the pain was firmly felt in the lower reaches of the credit market. European CCC-rated bonds widened 240bp last month, a 3 standard deviation move, and the worst month of performance for CCCs (-5%) since November 2011 (-8%).

Why the reappraisal of low-quality risk in credit? A lot, we think, has to do with the recent negative credit events of Phones 4U and Banco Espirito Santo. These bonds dropped precipitously, with the effect filtering through to the rest of the market. 

But the ECB’s recent policy salvo (TLTROs, ABS purchases) have also been a subtle admission that Eurozone growth is faltering. None of this is conducive to the performance of low-quality bonds.

Inadvertently, the ECB may have called time on some of the euphoria that had crept into the credit market in 2014. Note that the Euro Stoxx index has been 90% correlated to CCC bond spreads since the start of 2012. But over the last month the two have hugely decoupled, with equities barely correcting." - source Bank of America Merrill Lynch

As a reminder low inflationary environment tend to be the ones where defaults can spike.

On a final note, when it comes to the "credit clock" and leverage in the High Yield space, since mid-2013 the net leverage has increased at a faster space as displayed by the following Goldman Sachs graph from their recent Global Macro Research note entitled "The Credit Trader: Not all dips are buys, but this one is" from the 30th of October:

- source Goldman Sachs

Obviously recent flows in High Yield with -$2.1bn (-0.9%) over the last week and ETF with -$138mn w-o-w counters somewhat the positive take from Goldman Sachs given the star of the again has indeed been investment grade saw $48 billion of inflows in high grade-credit fund in the last week of September with flows being tilted towards mid to long-term funds. EU domiciled funds have continued to see outflows for a fifth week in a row according to the latest Follow the Flow report from Bank of America Merrill Lynch from the 3rd of October.

This is confirming the gradual move of institutional investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit but that is another story...

“Practise in everything a certain nonchalance that shall conceal design and show that what is done and said is done without effort and almost without thought.” -  Baldassare Castiglione, The Book of the Courtier

Stay tuned!