Macro and Credit - The Rebound effect

"Credibility is a basic survival tool." Rebecca Solnit, American writer

While listening to the somewhat "dovish" comments of Fed in chief Janet Yellen as of late, we reminded ourselves for our title analogy of the "Rebound effect", being the emergence or re-emergence of symptoms that were either absent or controlled while taking a medication, but appear when that same medication is discontinued (QE taper), or reduced in dosage. In the case of re-emergence, the severity of the symptoms is often worse than pretreatment levels, such as valuations we would argue which are somewhat rich according to Janet Yellen. Obviously in "Rebound effect" one could argue that "rich" valuations get richer even with discontinuation of sedative substances. It seems that Janet Yellen's words have fallen on deaf ears given her latest "dovish" comments have had no effect to the partygoers who have gotten seriously intoxicated on the Fed's punch bowl in recent years as indicated by the ultra-low levels of volatility reached in various indices (VIX, MOVE, to name a few). Even implied credit volatility is steering towards historical lows while inflows into Investment Grade credit in 2017 have been spectacularly strong. 

In this week's conversation, we would like to look at low volatility in the credit space as yet another sign of complacency. While everyone is basking in the sun, we think that a return in volatility is lurking in the shadows yet Goldilocks in credit, one would have to admit has been saved again by a more Dovish tone from Janet Yellen. We wonder if the Fed's chair is not more interested in preserving her legacy while still at helm, hence the more recent rhetoric but we digress.

Synopsis:

• Macro and Credit - Oh My God! They Killed Volatility!
• Final chart - Get over it, the Phillips curve is dead.

• Macro and Credit - Oh My God! They Killed Volatility!

One could easily opine that the biggest effect from overmedication from our "Generous Gamblers" aka our central bankers, has been the disappearance of volatility thanks to financial repression. As our tongue in cheek bullet point reference to the old South Park catch phrase, one might wonder if this low volatility regime will end, now that the narrative has been more hawkish somewhat as per our recent conversation "The Trail of the Hawk".

In similar fashion to Le Chiffre, aka Mario Draghi from the ECB, Janet Yellen has as well steered towards "Credit mumbo jumbo", which has had a much vaunted "Rebound effect", at least for US equities. Yet Janet Yellen's "rich" valuation word has been totally ignored by the leveraged and carry crowd, particularly in European High Yield seeing as well not only record issuance numbers but also loose covenants and record tight credit spreads as reported by Bloomberg on the 17th of July in their article entitled "Europe's Junk-Bond Boom Triggers Alarm as Safety Nets Weakened":

"The whole European junk bond market is on track for the busiest July on record, whereas issuance in the U.S. is waning. So far this month, sales swelled by 400 percent from the same period last July, while equivalent U.S. offerings dropped about 75 percent, Bloomberg data show.

- source Bloomberg

While we recently mused that gamma hedges in credit were cheap, while credit remains an attractive carry trade in this long in the tooth credit Goldilocks scenario, as we indicated last week, it's not only in the VIX that there has been systematic selling of volatility for income. The game has also been played in the credit world. The warnings sent by our central bankers have continued to fall on deaf ears and the "beta" game is continued to be played although, recently High Yield fund flows have been weaker. What goes up often goes down to paraphrase Mark Yusko from Morgan Creek's previous quarterly gravity parabola. We would add that what goes too tight often goes too wide in relation to credit spreads. That was at least the story for the second part of 2016 when it comes to the Energy sector. But, as we indicated recently, it seems to us that in terms of risk-reward, High Yield has moved from expensive or "rich" to super expensive and in particular Euro High Yield. On that note we agree with Richard Barley's article in the Wall Street Journal entitled "The Vanishing Reward for Buying High-Yield Bonds":

"The risk premia on high-yield bonds in the U.S. and Europe were negative in June, PPMG calculates. The extra yield wasn’t enough to compensate investors for the risk of owning them over time.

This has happened before, most recently in 2014. That was followed by a selloff that gathered pace in 2015 as the falling oil price hit energy-company balance sheets, most notably in the U.S. There may not be an immediate catalyst for the market to fall now. But for investors buying high-yield bonds, the risk-reward balance doesn’t look encouraging."  - source Wall Street Journal

Although oil prices have been under pressure in 2017, credit has been widening at a much slower pace than what we saw in early 2016. It seems to some instance that overmedication have led to some sort of permanent anesthetization and significant complacency although central bankers have started reducing in earnest the prescription drugs recently. Many pundits have been impressed by how resilient credit has been in the latest bout of Sovereign yields volatility. Everyone and their dog has been focusing on the low levels touched on VIX as indicative of the current complacency, but, if there is one asset class that has shown low volatility for different reasons than the equities space, it is in credit. On that subject we read with interest Morgan Stanley's take from their Credit Derivatives Research note from the 14th of July entitled Vol AWOL.

"Over the past year, we have analyzed credit valuations through several frameworks and found US credit markets to be rich most ways we slice them. Spread per leverage is close to all-time tights, and spread per duration has rarely been lower, while the quality of the IG market has deteriorated over time (see Investment Grade Research: Not Your Parents’ Market). The one exception is that credit spreads adjusted for the level of volatility still look attractive relative to history. In other words, if this low-vol environment persists, then credit may remain an attractive carry trade.

In our view, the recent bout of low volatility (implied and realized) is yet another sign of complacency in credit markets. And while volatility has been low this year, it is worth remembering that we have seen considerably higher return volatility in this cycle than in prior bull markets, with IG and HY spreads hitting ‘recessionary’ levels twice (2011, 2016).
Therefore, focusing on just the last 3-4 months misses the bigger picture. In our view, central banks have been somewhat successful in this cycle at responding to periods of tighter financial conditions, muting volatility in the process. We believe recent hawkish rhetoric out of many global central banks, on top of the Fed pushing ahead with its plan to continue hiking rates while shrinking the balance sheet is a clear catalyst for vol to again rise (see US Fixed Income Strategy: Trading the Fed's Balance Sheet). And when that happens, buying credit as a carry trade at very tight spread levels will no longer look as appealing.

Just as investors have reached for yield in this cycle, low implied volatility levels have also been driven by a search for income, a trend that has accelerated at tight spreads. We think both fundamental (central bank policy) and technical (systematic selling of vol for income) factors have driven volatility to these low levels, and an unwind of these dynamics could impact volatility in the other direction on the way down. In this week’s report, we dig into credit volatility in more detail.

Volatility and Valuations

We start by looking at the current level of volatility in credit markets on an absolute basis and in the context of credit valuations. In Exhibit 3 below, we show the level of 3M implied volatility for CDX HY.

Quite simply, implied volatility is close to historical lows across many asset classes. In the context of credit vol specifically though, we would note a few additional points. First, the repricing in credit implied volatility has been more meaningful when compared to prior lows. For example, CDX HY 3M implied vol recently hit a level of 3.5% vs. 5.2% at the tights in spreads in 2014. In comparison, 3M SPX implied vol hit a recent low of 9.6%, marginally below the lows of 2014. Second, on a historical basis, implied credit volatility trades closer to realized than in many other markets (Exhibit 4).

The importance of low volatility for credit markets should not be understated. Credit is a low-beta asset class and is inherently short volatility and tail-risk. At low yields and tight spread levels, the case for credit rests in part on attractive risk-adjusted returns. Low levels of volatility boost ‘carry’ trades, make fund Sharpe ratios look better and of course, are a general barometer of risk appetite. In Exhibit 6 below, we show trailing CDX IG spreads normalized by the level of 3M price volatility. Volatility-adjusted spreads clearly do not look as extreme as other metrics, like spreads adjusted for balance sheet leverage (Exhibit 5).

The risk with looking at spread/vol is that volatility is backward looking and is much less stable than a fundamental measure like leverage. For example, 3M realized price volatility in CDX IG would need to rise by just 0.3% for vol-adjusted spreads to trade back to historical averages. In addition, an ‘extreme’ level of spread/ volatility has not been a great predictor of future market performance. In Exhibit 7 below, we break-out the spread to volatility ratio into different buckets and show the average 1M forward index return and hit rate of performance (percentage of times returns are positive). Across both these metrics, we find that when spread/vol is high, returns going forward tend to be low and positive returns are less frequent.

Drivers of Low Realized Volatility

There are clearly many drivers of the current low vol environment. While we won’t spend much time on the fundamental elements, central banks have clearly played a role. As Exhibit 8 shows, this cycle has been characterized by elevated uncertainty and multiple growth scares. 

These environments have led to big waves of spreads widening. However, each of these episodes have also been followed by unprecedented levels of stimulus from the Fed as well as other global central banks. This ‘Fed’ put has no doubt muted volatility, at least for extended periods of time in this cycle.

Beyond central banks, portfolio dispersion has also played a role in low volatility levels this year. In fact, we think the current low level of volatility is masking some underlying dynamics in the CDX market. For example, dispersion in US credit is actually higher today than it was at the tights of the cycle in 2014. We try to show this using two charts: First, comparing the widest 10 names in the CDX IG index vs. the rest of the portfolio (Exhibit 9).

Second, we look at the standard deviation of weekly cross-sectional spread changes for the CDX IG constituents and normalize it by the level of volatility (Exhibit 10).

Both these metrics show that credit dispersion is higher today than it was at the tights of the cycle back in 2014. Effectively, this has played some role in keeping the index levels more range-bound and less volatile than may be the case otherwise.

In the equity market, very low levels of single-stock correlations have helped drive low realized volatility. In that sense, this dispersion dynamic in credit markets is not that unique. However, we would highlight an important distinction. The low correlation level in equities seems more about sector rotation (Tech unwind, value vs. growth) and certain sector-specific factors (Financials). In credit, the drivers of dispersion are mostly negative stories related to certain sectors that either face structural or fundamental challenges (e.g. Retail, Energy, Autos). As we have noted in the past, issues in credit tend to show up first in the most fundamentally stressed sectors, and are initially treated as idiosyncratic. Eventually, the stress spreads to the broader market as credit conditions tighten. As a result, we would not use the dispersion argument in credit to justify low volatility levels over a long period of time.

Drivers of Low Implied Volatility

Having discussed some of the drivers of low realized volatility, we now shift to the drivers of implied credit volatility. The first point we note is the move lower in implied is not just a function of low realized volatility. For example, at the tights of the cycle in June 2014, CDX HY 3M vol traded 1.45x 3M realized vol and CDX IG traded 1.29x 3M realized vol. Today, CDX HY vol trades 1.17x, whereas IG trades 1.19x. We see a similar trend of implied compressing to realized when comparing the credit and equity markets. However, historically, credit implied vol has traded at a larger premium to realized than the implied premium to realized in the equity market. In recent months, this relationship has flipped (i.e., a lower implied/realized ratio in credit than equities).

More specifically, looking just over the past 12 months, we have noticed a large pick-up in systematic selling of credit volatility. Anecdotally, these investors have been most active in shorter-dated expiries. In Exhibit 12, we show 1M and 3M implied volatility levels in CDX IG to highlight the importance of these flows. While 3M implied spread vol in IG is just ~3.5% below the average levels around cycle-tights (June 2014), 1M implied volatility has repriced even more meaningfully, lower by 5%.

Broadly, this selling of volatility in the credit options market, motivated by the same global reach for yield driving flows into US credit, has helped compress implied volatility to new cycle lows. Arguably, as credit valuations richened, these flows if anything strengthened as the relative benefit of selling options (vs. long spreads) became more attractive.

To the extent the selling of volatility is driven by an income-generating alternative to long carry via spreads, we think these flows may be reaching a limit. Implied volatility, when adjusted by historical index spreads levels, is already very low. We show this in Exhibit 13 below.

For example implied CDX HY spread vol today is around 27%, relative to a regression implied level of 36% based on the last 7 years of data. Also, as we mentioned earlier, historically, implied credit volatility used to trade richer to realized than many other asset classes. This is not the case today and hence selling credit volatility may not look as attractive on a cross-asset basis.

At the other end of the spectrum, demand for credit option hedges has also slowed down quite meaningfully. Large non-economic buyers of credit vol, such as banks, have been much less active this year relative to prior years. Anecdotally, the lower demand for credit hedging has been driven by expectations for easier capital requirements around less onerous stress scenarios.

Bigger picture, in our view, the conditions for volatility to remain low seem to be fading. For example, central bank rhetoric globally has turned hawkish at the margin, with the Fed seemingly more focused on financial conditions as well as risk-asset valuations. And when volatility does start picking up, some of the technicals noted above that have pushed it to such low levels, could exacerbate volatility on the way down. Just as strong and consistent flows have pushed spreads to very tight levels in this cycle multiple times, but when these flows turn the other way, weak liquidity has driven sharp moves in the other direction." - source Morgan Stanley

As we have reiterated recently, the credit mousetrap is coiled and has been set by our "Generous Gamblers". Of course flow wise the credit mouse trap continue to be coiled on a weekly basis, particularly in Investment Grade Credit according to Bank of America Merrill Lynch Follow The Flow note from the 14th of July entitled "Not giving into your (rates) tantrum":

"IG inflows are strong and stable

The high volatility in the rates markets has done little to deter the inflow stream into high grade funds. The resilience of the credit bull story (thanks for the backdrop of CSPP) is proving strong. This is evident in the divergence seen in fixed income flows, as IG credit fund flows remain high and positive, while government bond flows have moved into negative territory.

Over the past week…

High grade funds recorded another week of inflows; their 25th in a row and the third consecutive one above the $2bn mark. High yield fund flows remained negative for a third week and we note that the volume of the outflow has remained strong for a second week. Looking into the domicile breakdown, the aggregate number has been pulled down predominantly by European-focused funds, just as US focused funds flows were negative for the sixth consecutive week.

Government bond fund flows turned negative for the first time in six weeks. Overall, Fixed Income funds recorded their 17th consecutive inflow, again predominately driven by strong flows into IG credit funds." - source Bank of America Merrill Lynch

The Rebound effect is still going strong credit wise. Investors continue chasing yields, having both extended their duration and credit risk in recent years thanks to central banks meddling and selling volatility as well. No wonder volatility has been neutered. As we pointed out last week, there is a growing disconnect between fundamentals from the real economy and asset prices. We have used this analogy before of Disney's Fantasia movie and the sorcerer's apprentice. At some point having poured so much water (liquidity) our little apprentice finally loses control and eventually the old and wise wizard has to step in (BIS?). We are slowly but surely getting there. Are central bankers ready to take the proverbial credit punch bowl away? We wonder. 

Right now there are still a lot of buyers in credit with still so much liquidity sloshing around but clouds are gathering such as the US debt limit falling in the first half of October. To repeat ourselves, in the current Goldilocks scenario for credit, there is still room for further credit spreads tightening. With such strong inflows, unless we see some exogenous geopolitical factors coming into play, even with the most recent toned down rhetoric from Janet Yellen, it is hard to see just yet a change in markets volatility dynamics. As this long rally continues to be hated by so many, eventually Goldilocks will finally catch up with the three bears but it isn't the time yet. For now it is still yield chasing time but you would be well advise to start building up some "duration" and "credit" defenses while it is still cheap, just a thought. 

In our conversation "The Trail of the Hawk" we indicated that cheap gamma could be found in credit options and that in Investment Grade there were relatively cheap to own. You might already been wondering if there is a trade here. On that subject we read with interest Bank of America Merrill Lynch take in their Relative Value Strategist note from the 13th of July entitled "Volatility is low. In credit, especially so":

"Within credit, IG vol appears cheaper than HY

As we wrote recently, the plunge in oil prices and weakness in retail names have made HY quite vulnerable to macros risks. The implied vol premium in HY reflects that risk. However, the realised volatility of HY hasn’t really increased relative to IG. As a matter of fact, the beta is near its lows

Is there a trade here?

The divergence between credit volatility and comparable equity metrics has persisted for a while now. It is a symptom, we think, of the low volatility-high fragility regime that has characterized markets over the last couple of years.

We are reluctant to recommend a credit-equity relative value trade here for two (related) reasons. One, cross-asset beta has been very unstable and it is difficult to pick the ‘right’ value with any degree of confidence. Two, we suspect that unless the economic cycle turns, stocks are likely to respond more aggressively to shocks than credit i.e. the risk premium in equity vol is probably justified. All that said, for those looking for a low cost hedge, IG volatility appears to be the cheapest here, relative to equities and HY.

Why is credit volatility so low?

There are several explanations for this persistently low implied volatility. For one, there are simply more sellers than buyers. CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. Among those who do employ derivatives, the bias has been towards selling volatility as a means to generate premium. This leaves banks as the sole structural buyers of index options. Secondly, implied volatility is low because realised volatility has remained persistently low. CDX IG has been realising less than 30% (annualised daily spread) volatility for a little over 6m now, longer than similar stretches in 2014 and 2015. Finally, economic data volatility has been subdued. While there have been some signs of weakness, the economic narrative hasn’t shifted dramatically. If economic volatility returns, either through the Fed committing a policy mistake or by falling behind the curve, we think credit volatility will follow suit." - source Bank of America Merrill Lynch

Whereas High Yield has remained more sensitive to macro risks such as the variation in oil prices, Investment Grade credit volatility has remained subdued hence its relative cheapness. Even in credit, when it comes to volatility, there is a simple rational behind the low level reached, there are simply more sellers than buyers as pointed out in Bank of America Merrill Lynch's note:

"Why is credit volatility so low?

The evident reason: more sellers than buyers CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. While some may choose to hedge using the underlying index, the practice isn’t prevalent among a majority of money managers. Among those who do employ derivatives, the bias has been towards selling protection or selling volatility as a means to park incoming funds while ramping up the portfolio or simply to generate carry/premium. This is particularly true in CDX IG, where for several years now there has been a large non-dealer long base in the index.

The reluctance to hedge with derivatives can be attributed to a few factors. For many, it

may just stem from unfamiliarity with the product and never having used derivatives

before.

There is also the issue of mismatch between cash credit portfolios and CDX. CDX IG

doesn’t include any Banking names, which is the largest sector within High Grade.

Similarly, until recently CDX HY had very few Energy names even though the sector is

one of the largest in High Yield.

Corporate bond benchmarks and the portfolios that follow them are weighted by market capitalization, making them highly sensitive to the largest debt issuers. In contrast the CDX portfolio is equally weighted.

Beyond differences in portfolio construction, there is also the fundamental question of risk i.e. what is the exposure that needs to be hedged? CDX is a spread product, a vehicle to gain exposure to pure credit risk. However, most high yield accounts and more than half on the high grade side are ‘total return’ investors i.e. they are sensitive to both spreads and rates.

There is very little default risk in high grade portfolios and at the portfolio level there is perhaps more concern with hedging duration risk than credit risk. Also, since rates and spreads are negatively correlated, spread widening is often accompanied by lower rates, which softens the PnL impact.

In high yield, we also think there is some ‘hedge fatigue’. Because the CDX HY index did a poor job of representing the cash market in the past, it has not always held up as a good hedge for high yield bond portfolios. This issue has been corrected to some extent with changes in the index composition, but past experience perhaps continues to sting.

All this leaves banks as the sole structural buyers of credit options. They tend to buy low delta payers to hedge their loan books or origination activity or receive regulatory capital relief, among other things. What’s more, this technical is largely isolated to IG." - source Bank of America Merrill Lynch

So all in all, there much more concerns for investors with hedging duration risk rather than credit risk when it comes to Investment Grade credit. The risk of a "convexity event" with the perilous exercise of the reduction of the Fed balance sheet means that the focus should rather be on bond volatility and its indicator the MOVE index in the coming months. Obviously the recent dovish tone from Janet Yellen is we think representative of our "Generous gamblers" concerns with bond volatility given leveraged players and carry speculators, only love one thing and that's low rate volatility. Our central bankers are walking on a tight rope. After having coiled the volatility spring with their financial repression, they are trying to unwind it at a slow pace and avoid rocking the boat. It remains to be seen in the coming months how they are going to pull it off. 

While volatility seems to be at the moment "flatlining", so is the Phillips curve dear to the economists at the Fed, in true "Japanese" fashion as per our final chart. On a side note we have become more positive on gold and gold miners as of late thanks to Janet Yellen, therefore playing the "Rebound effect".

• Final chart - Get over it, the Phillips curve is dead.

Back in our May conversation "Wirth's law" we confided that we were part of the crowd claiming the death of the Phillips curve. As well, back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate in true "japanification" fashion. Our final chart comes from Deutsche Bank FX Daily note from the 14th of July entitled "When the Fed's punch bowl lacks punch" and displays the Phillips curve being flat on its back:

"From this we can conclude:

i) There is extreme inertia built in to inflation’s response to changes in economic activity, even if it is possible that the Phillips curve steepens in extreme circumstances of over and under capacity.

ii) The corollary is it is extremely difficult for the Fed to impact inflation through activity/growth measures. The Fed (and the Fed is not alone among Central Banks) has lost control over a half of its mandate.

iii) While doctrinaire goods and services inflation targeting persists, price cyclicality will be concentrated in larger asset price cycles. One difference between asset inflation compared with traditional goods & services inflation is that asset inflation also leads growth measures. The cycle then tends to show up as follows: asset inflation driving up capacity utilization, which does not show up meaningfully in traditional CPI measures, that leaves policy overly accommodative, that pumps up the asset cycle, until asset prices reach such extremes they turn on themselves.

iv) At least while the Phillips curve framework is being adhered to, the Fed will be very slow to ‘take away the punch bowl’.

v) The outstanding question for the Fed watchers is how will Fed deal with the status quo over the next year? IF inflation remains slightly below target, bonds handle the Fed balance sheet adjustment reasonably, risky assets remain strong, and growth remains at or above trend, will the Fed tighten in 2018? At least while the market cannot firmly answer in the affirmative, the USD is going to find limited support, especially against higher yielding currencies.

vi) The market assessment that there is more punch to be drunk, is probably correct. It still looks too early to bail-out of the positive risk story. In part because we have seen this narrative before in the late 1990s, asset froth in this cycle is prone to build more slowly and to lesser extremes. The Fed may have lost control, but the market will exert greater self-control. 

The optimistic risk conclusion is: drinking slowly from the punch bowl, extends the party – and should help with the hangover." - source Deutsche Bank

It looks to us that "The Rebound effect" is pushing towards a final melt-up regardless of the narrative of our "Generous Gamblers". For now, everyone keeps dancing, particularly in Investment Grade credit and in similar fashion to 2007, market makers keep getting hit on the bid, whether on CDS or Credit Options and continue to feel the pain of not being able to recycle effectively the relentless tightening seen in credit. As the sorcerer's apprentice in 1940 Disney's Fantasia movie, we would have to agree with Deutsche Bank, that the Fed has lost control and has tried too hard to exploit the Phillips curve as per Robert Lucas' critique. When unemployment becomes a target for the Fed, it ceases to be a good measure because like in Japan, over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. The Fed's models are built on past relationships. What these PhDs at the Fed need to understand is that these relationships change over time, making these models less reliable. At least you know that they will be slow in removing the punch bowl for the time being, that's a given. For more on the subject of the Phillips curve, we encourage you to read Hoisington Quarterly Review and Outlook for the Second Quarter 2017, a must read in our humble opinion. For now one could conclude from our conversation that "rich" valuations will get richer even with discontinuation of sedative substances. Sic transit gloria mundi...

"All things are only transitory." -  Johann Wolfgang von Goethe

Stay tuned!

Macro and Credit - Wirth's law

"People don't buy for logical reasons. They buy for emotional reasons." -  Zig Ziglar, American author

Watching with interest the unabated compression in credit spreads since the election of "Machiavellian" Macron in France, leading to a significant outperformance in beta (the carry game) as shown by the tighter levels reached for Itraxx CDS 5 year subordinated index (-55 bps since his election), we reacquainted ourselves with Wirth's law. Wirth's law, also known as Page's law, Gates' law and May's law, is a computing adage which states that software is getting slower more rapidly than hardware becomes faster. The law is named after Niklaus Wirth, who discussed it in his 1995 paper, "A Plea for Lean Software". The Swiss computer scientist is best known for designing several programming languages, including Pascal, and for pioneering several classic topics in software engineering. In 1984 he won the Turing Award, generally recognized as the highest distinction in computer science, for developing a sequence of innovative computer languages. In similar fashion, while High Frequency Trading has become faster, one could argue that volatility and velocity have become slower more rapidly, thanks to central banks meddling. Also, in similar fashion secondary trading in bonds have become slower, while yields continue to trade tighter. As posited by a good friend at an execution desk in a large private bank, it's a good thing primary markets are so ebullient, because secondary trading has become much slower with spread tightening so much, reducing the need to rotate existing position, while inflows are pouring into anything with a yield in true 2007 fashion but we ramble again.

In this week's conversation we would like to look again at the wage conundrum in the US, given when it comes to "inflation" and "Unobtainium" (another cryptocurrency using Bitcoin's source code) we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine" :

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014

Back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own. 

Synopsis:

• Macro and Credit - Attempts in exploiting the Phillips curve have failed
• Final chart - Trumpflated

• Macro and Credit - Attempts in exploiting the Phillips curve have failed

Back in June 2013 in our conversation "Lucas critique" we quoted Robert Lucas, given he argued that it was naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:

"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes." - Robert Lucas

We argued at the time that Ben Bernanke's policy of driving unemployment rate lower was likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  We also indicated in our past musing the following:

"In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - Milton Friedman

The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed"

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion. 

What is happening in the United States has already been laid bare in Japan given over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

When it comes to the repeating interrogations of some sell-side pundits on this matter we read with interest Bank of America Merrill Lynch US Economic Viewpoint note from the 11th of May entitled "What's up with wages?" as it seems to us many still doesn't get it:

"Wage wars

The unemployment rate is 4.4%, companies have the most job openings available since 2001 and workers are quitting at the fastest rate since 2007. All else equal, this seems like an equation for “normal” pace of wage growth of 3.5-4.0%. But instead we are averaging a mid-2% pace for wages. In this piece, we address the theoretical and empirical reasons for the slow response in wages. We also look at wage dynamics on an industry level, relying on the expertise of BofA Merrill Lynch equity research analysts. Our bottom line is that wages should continue to head higher, but it will likely remain slow and uneven between industries.

There is the theory

The standard model for estimating wage inflation (or price pressure more broadly) is the Phillips Curve. The idea is pretty simple – if the unemployment rate is above NAIRU (non-acceleration inflation rate of unemployment, aka full employment), wage inflation should decelerate. As the unemployment rate approaches NAIRU, the pace of deceleration slows and once we cross through full employment, wage inflation begins to accelerate. This makes sense in theory, but less so in practice, leading to many claims of the death of the Phillips Curve (Chart 1).

In our view, it still provides a viable framework but we should accept that the Phillips Curve is relatively flat implying slow response of wage inflation to moves in the unemployment rate.

The pace of wage inflation is also influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 – 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase.

And then the data

We can examine the relationship between the unemployment rate and wage growth using historical data. We do this in two ways – descriptive (correlations) and empirical (regressions) analysis. The simplest is just to compare unemployment slack – defined as the unemployment rate less NAIRU – versus wage growth (Chart 2).

There is a general relationship where an increase in labor market slack depresses wage growth and a decline in slack underpins it, but from the quick glance of the eye, the relationship has fallen apart since the Great Recession.

We can also look at the JOLTS survey to gauge the degree of wage pressure in the system, by examining openings and quit rates. When times are good and the labor market is tight, workers have the ability to voluntarily quit jobs, often for a better opportunity and higher pay. According to the JOLTS survey, the quit rate is running at 2.1% (quits level as a % of total employment), hovering close to cycle highs. Using a longer history derived by Haltwanger et al, the current quit rate is consistent with wage growth of about 3.5% yoy based on the historical relationship (Chart 3).

It is standard to examine job openings in the context of the unemployment rate, which is depicted as the Beveridge Curve. This shows the relationship between the unemployment rate and the job vacancy rate (proxied by job openings). A shift out in the curve implies a higher level of unemployment rate for a given vacancy rate, implying less efficiency in the labor market and deterioration in the matching process. The curve clearly shifted out after the recession but seems to be turning back in most recently, implying more efficient job matching which in turn could underpin wages (Chart 4).

Another key source of wage growth is job-to-job transitions. Theory suggests that a worker will switch jobs when a better match comes along and that should lead to higher wages. Evidence bears this out. NY Fed economists find that even after controlling for worker characteristics, those who came into their current job through a job-to-job transition have higher wages than those who experience a period of nonemployment. In the past, the unemployment rate and the job-to-job transition rate have co-moved. But during the current recovery this relationship has weakened as the unemployment rate has returned to pre-recession levels while job-to-job transitions remain subdued (Chart 5).

The modest recovery in the job-to-job transition rate could explain the lackluster wage growth we have experienced during the recovery. It’s hard to know with certainty the reason for subdued job switching, but mismatch between jobs and worker skills may be holding back job switching and thus wage growth."  - source Bank of America Merrill Lynch

Obviously we are part of the crowd claiming the death of the Phillips curve. Back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property.

At the time we concluded our conversation as follows:

"In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017

Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. For instance, Labour Market Training targeted to unemployed job seekers has a long tradition in Sweden. It is all about upskilling unemployed adults in the end. Since the mid-1990s in Sweden, it has become a central labour market policy instrument. The purpose of labour market training is to provide unemployed persons basic or supplementary vocational training. Another objective is to promote both occupational and geographical mobility to support structural changes in the economy and to strengthen the position of disadvantaged groups in the labour market (source Eurostat, 2012). As we indicated before about the limitations of the Phillips curve is that if unemployed workers lose skills, then employers prefer to bid up of the wages of existing workers when demand increases.

Furthermore we disagree with Bank of America Merrill Lynch but they do recognise that using the Phillips curve for modelling purposes has its limits:

"Models are useful but they also have their limits. This was quite salient during the Great Recession. Chart 6 shows the forecast of a simple wage Phillips curve and actual average hourly earnings wage growth from 2008-2015.

The model predicted an earlier drop in wage growth during the recession and a relatively quick rebound during the recovery. In actuality, we got the reverse: wage growth declined at a slower pace and has only steadily picked up since the recession.
Models are built on past relationships. Once those relationships change, the models become less reliable. Structural shifts (e.g. demographics, mismatch) in the labor market could be affecting wage growth. The unemployment rate gap can’t capture all these complexities of the US labor markets. But the wage Phillips Curve is the “best bad” model we have.
Given our forecast for the unemployment rate (bottoming at 4.2%), our models suggest average hourly earnings should reach 3% by early next year while the ECI gets there by early 2019 (Chart 7).

- source Bank of America Merrill Lynch 

Unfortunately as posited by Robert Lucas it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data and yes indeed, demographics mismatch is putting clearly a spanner is this outdated Phillips curve model we think.

Clearly the relationship between labor market slack and wage growth is weakening. Japan is a good example of this "deflationary" curse were the labor market has become very tight as indicated by Société Générale Asian Themes note from the 12th of May entitled "Government of Japan to finally implement labour reforms":

"Current state of Japan’s labour market

Japan’s labour market is at its tightest level since the early 1990s 

Japan’s unemployment rate fell to below 3% to 2.8% in February 2017, and the job/applicant ratio has reached a high level of 1.45. Both measures have improved significantly since Prime Minister Abe took office in December 2012 and started Abenomics. The unemployment rate was at 4.3% and the job/applicant ratio was 0.83 in December 2012. Japan’s NAIRU (nonaccelerating inflation rate of unemployment) was previously believed to be at roughly 3.5%; however, the unemployment rate has remained continuously below that level over the past year. The job/applicant ratio has increased to levels not seen since the early 1990s. Looking at the breakdown, compared with the start of Abenomics in December 2012, the number of job openings in February 2017 has increased by 31.1%, while the number of job seekers has decreased by 24.0%."

- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June 2016 in our conversation "Road to Nowhere":

"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016

We concluded at the time:

"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.

Yet for Japan, for some pundits, there might be hope given the intent of the Japanese government to implement labour reforms as indicated by Société Générale in their note:

"The government has proposed a set of labour reform plans to alleviate pressures from labour shortages

The government has announced a set of labour reform plans that it considers crucial for the sustainability of Japan’s labour market. The key focus is the concept of ‘equal wage for equal work’ and limiting overtime. These measures to improve working conditions should motivate marginally attached workers to return to the labour market. Addressing labour reform is an important tool for preventing Japan’s potential growth rate from declining due to declining labour inputs in an ageing society.

Progress until now and further progress on labour reforms should help Japan’s economic recovery continue

The various labour policies the government has implemented since the start of Abenomics have started to bear fruit. The number of women in the labour force continues to increase, younger generations are securing jobs, and the government has started to address the issue of accepting foreign workers as well. These measures have already helped to counteract the decline in the ageing workforce to a certain extent. Implementation of additional reforms will likely further help the sustainability of Japan’s labour market over the medium to long term. In turn, alleviating the downward pressure on labour input should boost the potential growth rate and strengthen Japan’s economic recovery." - source Société Générale.

 Back in our January conversation "The Ultimatum game", we indicated the following:

"Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years." - source Macronomics, January 2017.

The issue of course we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year.

When it comes to Japan and wages per worker, more recently it decreased for the first time in 10 months (-0.4%), contrary to expectations for an increase. It remains to be seen how the Japanese government is going to slay the deflationary demon plaguing its economy.

• Final chart - Trumpflated

For inflation expectations to remain anchored, acceleration in wages are essential for both the US and Japan. When it comes to assessing the "Trumpflation" trade, as of late it has been fading. Since the beginning of the year we have been fading the strong dollar investment crowd and we continue to expect further weakness. Our final chart comes from Credit Suisse Global Equity Strategy note from the 18th of May entitled "Reassessing the reflation trade". It shows that the reflation trade index which had propelled much higher stocks on hopes for a global reflationary play is moving back into negative territory:

"The deflating of the reflation trade

As the first chart below illustrates, this combination of an improving global cycle, significant year-on-year commodity price rises and the election of Donald Trump drove expectations of a broad-based reflation in the global economy. The reflation surprise index (proxied here simply by adding the Citi economic and inflation surprise indices for the US) rose to a post-2011 high in the first quarter following an extended period in negative territory. Now, however, the reflation surprise index is back into negative territory as US macro surprises roll over, and inflation starts to surprise on the downside, rather than the upside, as earlier rises in commodity prices fall out of the annual comparison.

US small caps, the US dollar and US nominal yields have all given up much of their post- US election gains. Similarly, GEM equities have gained back their losses over the same period." - source Crédit Suisse

As we indicated in previous conversations, markets were trading on great expectations and hope. It looks to us that for the time being, there is a need to get reacquainted with more realist expectations from the new US administration.

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley

Stay tuned!

Credit - Lucas critique

"Excess generally causes reaction, and produces a change in the opposite direction, whether it be in the seasons, or in individuals, or in governments." - Plato 

While we mused around Goodhart's law, prior to taking a much needed break, unfortunately interrupted by the unavoidable and repetitive French strikes, we thought this week, on the back of a friend's recommendation, we would make a reference to Lucas critique, named after Robert Lucas' work on macroeconomic policymaking. Robet Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:

"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.

For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia

So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  

In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:

"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia

In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.

The issue with NAIRU:

"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia

In respect to our chosen title, and looking at the evolution of inflation expectations, via TIPS, we still believe deflation is currently the on-going problem, not inflation as indicated by Bloomberg's chart displaying 10-year TIPS which have turned positive:

"Treasuries have dropped far enough during the past six weeks that investors no longer have to pay for the privilege of guarding against inflation when they buy 10-year notes.

As the CHART OF THE DAY illustrates, 10-year Treasury Inflation-Protected Securities yielded more than zero for the past two days. The last time that happened was in November 2011, according to data compiled by Bloomberg. Yields on the notes, known as TIPS, fell as low as minus 0.93 percent last December. Investors who bought the securities and held them to maturity were assured of receiving less than they paid before any adjustments to principal and interest payments, reflecting changes in consumer prices. “The idea that you’re going to have inflation, I think, is coming off,” Ira F. Jersey, director of U.S. rates strategy in New York at Credit Suisse AG, said yesterday in an interview on Bloomberg Radio.

The Federal Reserve’s preferred inflation gauge shows the pace of price increases has slowed even though the central bank is buying bonds and holding its key interest rate near zero to aid the U.S. economy. The indicator, the personal consumption expenditure deflator, rose 0.7 percent in April from a year earlier. The increase was the smallest since 2009.

Lower prices for Treasuries may do more to explain the above-zero yield for 10-year TIPS than the inflation outlook, Jersey said. Ten-year notes that aren’t indexed had a negative return of 4.2 percent from May 1 through yesterday, according to data compiled by Bloomberg."  - source Bloomberg

As a reminder in relation to the Taylor Rule and inflation expectations, as indicated in a Bloomberg article from the 15th of November 2012 by John Detrixhe entitled "Citigroup Seeing FX Signals of Early End to Stimulus: Currencies":

"Traditional measures of monetary policy such as the Taylor Rule that are based on growth and inflation suggest the Fed should end its stimulus efforts. John Taylor, an economist at Stanford University, published the formula in 1993. It signals the Fed’s benchmark should be 0.65 percent, or 40 basis points above the upper range of the current target interest rate for overnight loans between banks, assuming an inflation of 1.7 percent, unemployment of 7.9 percent and a nonaccelerating inflation rate of unemployment, or NAIRU, of 5 percent. NAIRU is the lowest unemployment rate an economy can sustain without spurring inflation.

About a year ago, the Taylor Rule model indicated policy rates should be minus 0.47 percent. The Fed has a target for price increases of 2 percent. The consumer-price index increased by that much in October 2012 from a year earlier, the Labor Department said on November 14. If “unemployment rate gets below 7 percent, you could have a Taylor Rule that suggests rates should go up and the question becomes do they overturn the Taylor Rule?” Steven Englander, Citigroup’s New York-based global head of G-10 strategy said. “When perceived commitments are at stake, it’s a nightmare.” - source Bloomberg

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion, but we ramble again

Therefore in this week's conversation, after a quick market overview, we would like to touch again on the deflationary forces at play, given, as Plato's quote rightly said, excess generally causes reaction, and produces a change in the opposite direction .Our "omnipotent" central bankers, and investors alike should pay more attention to this quote...

In our quick market overview, we will not delve too much into the recent surge in rates volatility which has spilled over other asset classes given we have tackle this issue in our post from the 13th of June entitled "The end of the goldilocks period of low rates volatility / stable carry trade environment". 

The recent move in the MOVE and CVIX indices are now starting to spillover to the equities sphere. We have added the VIX index to our previous chart - source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

The spike in volatility in Japan has been preceding the widening move in CDS Spreads of the Itraxx Japan, a move we saw coming:

"Should the volatility in the Japanese space continue to trend higher, which is currently the case, we would expect credit spreads to continue to widen, particularly for Japanese financials." - Macronomics, Japanese Whispers, 25th of May 2013.

Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Itraxx Japan 5 year CDS since January 2010 until today - source Bloomberg:

Back on the 25th of May the Itraxx Japan CDS, we indicated that a surge in volatility in Japan would lead to a surge of Japanese credit risk. The Itraxx Japan has surged from 82 bps to 111 bps in the continuation of this surge in equity volatility.

More interestingly the surge in bond volatility has led to some serious outflows in the fixed income space. For instance, as indicated by Credit Suisse, the ICI fund flow data which was out for week ended June 5; showed equity mutual fund outflow of -$942m;  the big number was bond outflow of - $10.9bn. It was second-largest bond mutual fund outflow in history of weekly ICI series, which extends back to Jan 2007:

"The Investment Company Institute estimated that bond mutual funds posted a huge net outflow of $10.9bn in the week ended June 5. This was the second largest weekly outflow in the history of this series, which extends back through 2007. The largest outflow recorded was during the darkest days of the financial crisis, in the week ended October 15, 2008 (-$17.6bn). Investors apparently didn’t rotate into equity mutual funds in early June, as equities also saw a net outflow, albeit a much smaller one. In the week ended June 5, investors withdrew a net of $942mn from equity mutual funds.  Hybrid mutual funds posted a small net inflow of $347mn in that week." - source Credit Suisse

So much for the "great rotation" story: 

"Since the beginning of the year we have not bought into the story of the "Great Rotation" from bonds to equities. One of the reason being on one hand demography with the growing numbers of baby boomers retiring, the other one being pension asset allocation trends." - Macronomics, "Goodhart's law".

We will touch more on the deflationary forces at play and the importance of demography after our overview.

When one looks at the relative performance of the S&P 500 versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF) continue to underperform developed markets  - source Bloomberg:

The absolute spread between the S&P 500 and MSCI Emerging Markets has touched a record low level.

"QE tapering"soon? We do not think so. Markets participants have had much lower inflation expectations in the world, leading to a significantly growing divergence between the S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play,  graph source Bloomberg (5th of June 2013):

While some central bankers are busy trying to ignite inflationary expectations with various QE programs, the YTD movements in 5year forward breakeven rates which have been falling are indicative of the strength of the deflationary forces at play - source Bloomberg:

We recently commented that Investment Grade is a more volatility sensitive asset to interest rate changes meaning a surge in the MOVE index is leading to increasing volatility in the investment grade bond space where record lows yields on long bonds can lead to some vicious losses on highly interest sensitive long bonds (Apple 30 year bond being a good example of the repricing risk)., High Yield is a more default sensitive asset. The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened dramatically recently. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

We recently commented on the latest sell-off in the ETF High Yield credit space with our good cross asset  friend in our conversation "High Yield ETF - The Fast and The Furious":

"If you do not believe in the "tapering QE" scenario, which led to a recent surge in US yields on government bonds and this recent sell-off on credit, then the relative value of High Yield, is starting to be compelling again (6.50% in YTM - yield to maturity versus S&P 500)." - source Bloomberg.

So if you do not believe in the "tapering", like ourselves, and like Mr. Jeff Gundlach, maybe at these levels the ETF HYG is starting to be compelling again. Mr Gundlach's opinion is that the Fed is likely to step in and actually increase QE to try and hold rates down, given mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3% today.

Moving on to the subject of the deflationary forces at play, shipping has always been for us, the best significant example of the reflationary attempts of our "omnipotent" central bankers. For instance, containership lines have announced eight rate increases, totaling $3,650, but have failed to maintain the momentum because of the weak global economy and the excess capacity which has yet to be cleared in similar fashion to the housing shadow inventory plaguing US banks balance sheet, graph source Bloomberg:

"Containership lines have announced eight rate increases, totaling $3,650, on Asia-U.S. routes since the beginning of 2012. The increases have largely failed to hold because of excess capacity and a weak global economy. As such, benchmark Hong Kong-Los Angeles rates have only risen by 36% since the end of 2011 and are down 11.6% ytd. In a Bear Case scenario, operators will continue struggling to sustain rate increases. The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark was broadly unchanged in the week ending June 12, remaining below the $2,000 mark for the third time in 2013. Rates are down 27.5% yoy and 11.6% ytd, even with three rate increases, as slack capacity pressures pricing. Carriers are expected to raise rates by $400 per 40-foot equivalent on containers from Asia to the U.S. West Coast, and by $600 to all other destinations, effective July 1. " - source Bloomberg.

Of course high unemployment which continues to plague developed economies will continue to weight on the economic recovery in general and shipping in particular, graph source Bloomberg:

"Unemployment within the euro zone is expected to increase to 12.2% in 2013 from 11.4% in 2012, and remain broadly unchanged at 12.4% in 2015, according to consensus forecasts. Falling unemployment is crucial for expanding global demand for goods, soaking up excess capacity and firming shipping rates. The recovery in the shipping industry will not be fully realized without improving unemployment trends." - source Bloomberg.

Deflationary forces at play in the shipping space? You bet!

This is what was indicated by Rob Sheridan and Isaac Arnsdorf in their Bloomberg article from the 7th of June - Panamaxes Have Longest Losing Streak as Glut Magnifies Downturn:

"Rates for ships hauling coal and grains posted the longest losing streak on record as the merchant fleet’s largest glut magnified seasonal declines in demand from South America and India.

Earnings for Panamaxes fell 0.1 percent to $6,078 a day, the 32nd drop in a row and the longest stretch in data going back to 1999, according to the Baltic Exchange, the London-based publisher of shipping costs on more than 50 trade routes. Panamaxes can carry about 75,000 metric tons of dry-bulk commodities." - source Bloomberg.

We still are seeing creative destruction at play and deflationary forces in the shipping space as the gradual excesses of too many ships built on ship credit are being dealt with, graph source Bloomberg:

"Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by 538% since June 2005. This is creating a more efficient fleet as older ships are replaced by newer models. For instance, Maersk is set to introduce triple-E ships that consume about 35% less fuel per container and are able to carry 16% more boxes. In May, the total number of scrapped container vessels surpassed tankers." - source Bloomberg

Global Economic growth remains weak and vulnerable as indicated by the dry bulk market:

"The dry bulk market continued to show weakness, as time charter rates fell for most carriers in 1Q. Dry bulk rates declined 36% yoy on average and were down 10% sequentially. Torm (down 14.2% yoy) and D/S Norden's (20.2% lower yoy) dry bulk rates decreased the least. D/S Norden noted dry bulk fleet growth has moderated, and scrapping will continue as long as rates remain low. The Baltic Dry Index declined 8.2% yoy in 1Q, and fell 16.5% from 4Q." - source Bloomberg.

In similar fashion to the extend and pretend game being played by banks relating to their real estate exposure and negative equity, some German banks, which total exposure to shipping loans amount to 125 billion USD with a nonperforming ratio of 65%, have resorted to avoid recognizing the losses by acquiring some ships in a bid to salvage their bad loans as reported by Nicholas Brautlecht in Bloomberg on June 13 in his article "Commerzbank Acquires First Ships in Bid to Salvage Bad Loans":

"Commerzbank AG, the German lender whose soured shipping loans prompted a ratings downgrade by Standard & Poor’s last month, is taking the helm as it tries to salvage some of the 4.5 billion euros ($6 billion) it holds in bad debt from the crisis-hit industry.

It plans to take over two feeder ships from debtors this month, holding off on a sale until values recover, said Stefan Otto, 42, the head of the shipping unit. The vessels, which can transport as many as 3,000 standard 20-foot containers, or TEU, are the first the Frankfurt-based bank will actively manage as part of a goal to reduce shipping losses and exit ship financing.

“We focus on ships where we see significantly more upside than downside in the future, and where it seems smarter to hold them for a limited time period and wait with the divestment until the value has increased,” said Otto in an interview, declining to reveal the value or the names of the ships.

The collapse of Lehman Brothers Holdings Inc. in September 2008 and the ensuing sovereign-debt crisis propelled the shipping industry into a slump from which it has yet to recover, suffocating demand and generating a glut of vessels. Commerzbank decided a year ago to wind down its shipping portfolio to stem the losses.

The company, which had shipping loans of 18 billion euros in the first quarter, became the world’s second-biggest financier of ships with the 2009 acquisition of Dresdner Bank. Norddeutsche Landesbank Girozentrale has a similar-sized loan portfolio, while leader HSH Nordbank AG’s ship loans stood at 27 billion euros in the first quarter." - source Bloomberg

Given that Container ships make up more than one-third of Commerzbank’s 18 billion-euro shipping loan portfolio and looking at the trend in Dry Bulk Cargo described above, and that Commerzbank has had its 5th capital increase in four years, you can expect additional pressure to come for Germany's second largest bank. By 2016, Commerzbank wants to further reduce its portfolio by 4 billion euros to about 14 billion euros, while a date for a complete exit is too difficult to predict according to Stefan Otto. Exit? What exit?

As we have argued in our conversation "Dumb buffers", taking ownership from debtors will not change the fact that Commerzbank's outlook due to its shipping exposure remains deeply concerning:

"Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Size matters? In shipping it does as indicated by Deutsche Bank in their 7th of June report on the Container Shipping industry, (a point we had made back in August 2012 in our conversation "The link between consumer spending, housing, credit and shipping"):

What are the competitive advantages of the ultra-large vessels?

"Breakeven point is substantially lower in the ultra-large vessels

Container ships have become larger because they can take advantage of economies of scale, diluting the operating costs of the vessel among a larger number of containers. We estimate the freight rates at which a 18k TEU vessels could reach cash breakeven in Asia-Europe trades (USD916) is 21% lower than a 8.5k TEU vessel (USD1,160) and 28% lower than a 6.5k TEU vessel (USD1,268) (calculations made at 18 knot speed, 90% load factor and bunker price USD650/ton)."  - Source Deutsche Bank.

In this deflationary environment, as we repeatedly pointed out, only the strongest will survive. In the shipping space,  Maersk Line, will be the biggest beneficiary we think and agree with Deutsche Bank:

"Given the current order book for new vessels in the sector, the operation of truly ultra large vessels, those larger than 14k TEU, looks almost like a de-facto oligopoly mainly in the hands of Maersk Line, MSC and CSCL, which together will have 78% of the capacity in the segment by 2016, versus a total market share of 33%. This data is based on the global order book as of 11 January 2013 (source Alphaliner) and it does not include the latest order for five 18,000TEU vessels made by CSCL, on which we comment in the specific company pages below in this report." - source Bloomberg

What are "inflationistas" of the world and "tapering believers" fail to take into account in their analysis is the importance of demography we think in true Lucas critique fashion. Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":

"The older a country’s population, the lower its inflation rate, posing a challenge for central banks in the world’s industrial nations, according to a UBS AG report.

Singapore-based economist Andrew Cates of the Swiss bank’s global macro team plotted average inflation levels over the last five years against changes in the dependency ratio, which compares the very old and very young to the working-age population.

The resulting chart showed nations that have aged in recent years typically faced very low inflation and, in the case of Japan, deflation. By contrast, those that have been getting younger, such as India, Turkey and Brazil, have relatively strong price pressures.

“Since ageing demographics will now start to feature more prominently in the outlook for many major developed and developing countries this is clearly of some significance for how inflation might evolve,” said Cates in a May 30 report.

The finding clashes with the view of economics textbooks, according to Cates, which tend to say a slowdown in population growth should put upward pressure on wages -- and therefore inflation -- as labor supply shrinks. Still, this ignores how demographics influence demand for durable goods and property, Cates said.

He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.

By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.

“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

On a final note, dormant inflation in the US is giving plenty of time to the Fed, as indicated as well by the current trajectory of TIPS, graph source Bloomberg:

"The Federal Reserve may be able to take its time in adopting a more restrictive monetary policy because inflation is relatively tame, according to Pavilion Global Markets Ltd.

As the CHART OF THE DAY illustrates, the U.S. core consumer price index’s increase since the latest recession ended in June 2009 is the smallest for any multiyear recovery since the 1970s. The gauge of prices excluding food and energy rose 6.3 percent through April, according to the Labor Department.

“There is no pressure on inflation that could lead the Fed to act more quickly than it would like” in scaling back a bond-buying program and raising interest rates, Pierre Lapointe, the Montreal-based head of global strategy and research at Pavilion, and two colleagues wrote yesterday in a report.

Core consumer prices were 7 percent higher at the same point in the previous recovery, which started in December 2001, as the chart shows. The biggest increase in the inflation gauge was 29 percent, posted in a recovery that began in April 1975.

These and other inflation statistics are at odds with the magnitude of losses in U.S. bonds, according to David R. Kotok, chief investment officer at Cumberland Advisors. The decline in 10-year Treasury notes sent their yield surging 60 basis points from this year’s low, reached on May 2, through yesterday. Each

basis point amounts to 0.01 percentage point. “The bond-market adjustment is too extreme and has created

bargains,” Kotok wrote. He added that Cumberland, a firm that’s based in Sarasota, Florida, is buying tax-free bonds and taking more interest-rate risk with its holdings." - source Bloomberg.

"We are not retreating - we are advancing in another direction." - Douglas MacArthur 

Stay tuned!