Macro and Credit - The Dead Parrot sketch

"Fake is as old as the Eden tree." - Orson Welles

We read with interest the latest minutes from the FOMC and in continuation with our previous themes of revivals of defunct model, obviously once again their "beloved" Phillips curve model came to the forefront of their discussions, not only at the Fed but at the ECB as well. Therefore, when it came to selecting this week's title analogy, we could not resist but use a reference to Monty Python's flying Circus Dead Parrot Sketch which first aired on the 7th of December 1969. The sketch portrays a conflict between disgruntled customer Mr Praline (played by Cleese) and a shopkeeper (Michael Palin), who argues whether or not a "Norwegian Blue" parrot is dead. It pokes fun at the many euphemisms for death used in British culture. Obviously, one could be disgruntled at our central bankers and the lack of inflation within their inflation mandate. In the meantime some sell-side pundits and most recently central bankers have continued to discuss if the Phillips curve is "dead" or simply "resting" like a "Norwegian Blue" parrot. We rest our case. We find it amusing that a joke dated c. CE 400, recently translated from Greek, shows similarities to the Parrot sketch. It was written by Hierocles and Philagrius and was included in a compilation of 265 jokes titled Philogelos: The Laugh Addict. Probably yet another case of "barbaric relic" given the affection for gold from our central bankers but we ramble again...

In this week's conversation, we would like to look at the ongoing 2007 party like in credit that keeps going while there is indeed the need to be more discerning (beta wise that is) we think at this stage but first we will take another potshot at the Phillips curve cult members.

Synopsis:

• Macro - The Norwegian Blue parrot really DID exist but not anymore...
• Credit - Smarten your beta
• Final chart - Credit Mad Men

• Macro and Credit - The Norwegian Blue parrot really DID exist but not anymore...

The latest FOMC notes from the July minutes do indicate how puzzled our central bankers have become on the validity and efficiency of their Phillips curve framework. Back in May this year in our conversation "Wirth's law" we discussed the wage conundrum in the US, pointing out that real wage growth had so far eluded the Bank of Japan and are still eluding the United States, hence the dismal prospects for inflation expectations given high qualification jobs in many instances have been replaced by low qualification jobs (yes training matters...). Also, 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.

Following our recent musings our friend Kevin Muir, the author of the excellent and very entertaining blog the Macro Tourist reached out and asked several questions relating to the Norwegian Blue parrot aka the Phillips curve:

"Hey Martin.  I just your latest two pieces.  I really enjoyed them.  

What is your belief about the Phillips curve?   Is it dead?  Shifted down?  

I know you discussed your views about the mismatch in skills, but the curve does indeed seem to be obsolete.

I know to some extent it doesn't matter what we think- the Fed's reaction function is what matters.  But I am curious about your personal thoughts.  

I am beginning to think that Yellen's training as a labour economist is making her more hawkish than she should be.  As you point out, they think inflation is coming.  So they are tightening.  

I realize you are probably more bearish on the economy than me, so it is easier to say the Phillips curve is not kicking in, and the economy is rolling over, so the point is moot.

But if we get a global economic upswing that drags the US along, will we see real wage growth?  

Thanks, Kev." - source Kevin Muir, author of the Macro Tourist

Of course real wages are that's the most important point for inflation expectations, real wage growth matters and matters a lot. We pointed out a few things to Kevin such as the fact that a business owner is always a "deflationista", in the sense that he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. No offense to our central planners of the world but true capitalism is inherently "deflationist" when it comes to prices. For the simplicity of our reasoning, we are not taking into account oligopolies, cartels and other shenanigans being played these days in many instances (ZIRP, NIRP, etc.). Real prices always fall and inflation is simply organized theft which is willingly pursued and supported by our central bankers, at 2% or even 4% (should they decide to try and fail in tweaking their sacrosanct target).

As well, we pointed out to Kevin the excellent work of (unfortunately little known to so many) French economist Jean Fourastié relating to real wages, real prices and productivity. One particular book comes to mind "Pourquoi les prix baissent - Why prices fall". published in 1984. We do not know if this book is available in English, but, in our humble opinion it is a must read book and should be on the required reading list of any serious central banker or aspiring economist.

For Fourastié, real prices could only be observed by dividing the prices of any product by hourly wages (link in French). The inverse of real prices calculation measures purchasing power parity. What is the most important economic fact in the last 300 years? Most probably the fall in "real" prices for wheat prices with hourly wages on the Y axis:

- source Jean Fourastié

Also in our previous conversation from September 2012 "Pareto Efficiency" we indicated the following when it comes to "wheat prices" and "revolutions":

"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.

  Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.

When it comes to volatility in wheat prices and the ultimate effect of manipulating prices or when "real" prices become "fake" prices or "manipulated" prices, we reminded ourselves with our May 2016 conversation "When Doves Cry" and the fascinating account on the "assignat" which was a type of a monetary instrument used during the time of the French Revolution (money printing on a grand scale with dire consequences...), in a book written by French economist Florin Aftalion in 1987 entitled "The French Revolution - An Economic Interpretation":

At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point". 

The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital. With QE becoming a global phenomenon with South Korea's president indicating that the country needs to look at possible 'selective' QE and Negative Interest Rate Policy becoming rapidly the "norm", one might wonder how on earth "capital" is going to continue to be "accumulated", particularly when one looks at negative yielding assets.

To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB. And when it comes to the "ultimate value" of the "assignat" (and the end result with NIRP...), a simple picture clearly display the trajectory of their final value:

  -source Macronomics, May 2016 

Hence the importance of using observable "real prices" and the impact monetary inflation can have on hourly wages and purchasing power when you want to assess the levels of inflation (Venezuela comes to mind...). We also reminded ourselves of Adam Smith's quote in relation to real "price" formation:

"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased." - Adam Smith

But moving back on the subject of the Norwegian Blue parrot, we read with interest Barclays Global Economics note from the 18th of August entitled "Questioning the reliability of the Phillips curve:

"Inflation discussion dominates July minutes

• The FOMC deliberated at length the risks to the inflation outlook, including the effectiveness of its current Philips curve framework in forecasting inflation.
• Although the minutes reveal increased concern about the inflation outlook, we did not sense that the committee is ready to pause rate hikes at this point.
• The committee sounded confident about labor market progress, but financial stability and further easing in financial conditions were a concern.

Three broad themes that stood out from the July FOMC minutes, in our view, are the increased concern among committee members about the inflation outlook; strong consensus that labor market progress has been significant; and worries about financial stability, given easy financial conditions despite monetary policy tightening. Even if the committee may have wanted to strike a balanced tone between its concerns about inflation (which would argue for a more cautious tightening path) and those about financial stability (which would argue for continuing on its path), markets seemed to read the minutes as dovish and lowered the probability of a December hike significantly, from 44% to 36%.

Also notable in these minutes was the change in tone with regards to federal government policy. Earlier in the year, committee members viewed fiscal policy as a potential upside risk to the growth and inflation outlook, but in the July minutes, those expectations were toned down or reversed. A few in the committee pointed out that “the likelihood of near-term enactment of a fiscal stimulus program had declined further or that the fiscal stimulus likely would be smaller than they previously expected,” while several others commented that policy uncertainty (including fiscal policy, trade, and health care) “was tending to weigh down firms’ spending and hiring plans.” This downgrade on the policy front was balanced to some extent by an upgrade of the external sector, as a brighter international economic outlook was seen as boosting prospects for US exports.

We maintain our call for a December hike, but see recent inflation data and the discussion in the FOMC minutes as having lowered the likelihood of its happening. In our view, continued misses on the inflation front would not make it tenable for the FOMC to hike in December. Further disappointment in this front could pause the path for the federal funds rates until the FOMC feels confident that its price stability mandate is within reach.

Some in the FOMC question the validity of its current inflation framework

The committee recognised continued misses on its inflation forecast and suggested that it would likely remain low over the second half of the year. But it also continued to assign much of the recent decline to idiosyncratic factors. While the discussion about the near-term outlook seemed broadly unanimous, there was more disagreement about the medium run. “Many” participants saw risks that inflation would remain below 2% for longer than they currently expected, and “several” saw risks to inflation as tilted to the downside. Similarly, while the committee agreed on the importance of long-term inflation expectations, not all agreed that they remained stable, and “a few argued that continuing low inflation expectations may have been a factor putting downward pressure on inflation”.

But perhaps a bigger surprise came when a number of participants challenged the way in which the Fed analyzes and forecasts inflation. They argued that “much of the analysis of inflation used in policymaking rested on a framework in which, for a given rate of expected inflation, the degree of upward pressures on prices and wages rose as […] employment of resources increased above long-run sustainable levels” – basically, a description of a Phillips Curve (PC) type of framework. A few participants argued that it was not particularly useful in forecasting inflation, while most said it remained valid despite its recent flatness. While we would agree with the latter group, we find the very opening of this discussion as evidence that concerns about the persistent misses on the inflation mandate are starting to weigh on the committee. While many have criticised the PC before, no clear candidate has emerged as a way to analyze inflation in a monetary policy setting, a fact that will, in our view, limit how far this discussion can go within the committee.

Instead, a common theme among policymakers in recent years has been to find exceptions that could have led to a temporary and transitory flattening in the PC. These minutes were no exception, as they listed a number of reasons for the coexistence of low inflation and low unemployment, including less responsiveness of prices to resource pressures (stickier prices), a lower natural rate of unemployment, more slack in the labor markets that may not be captured by the unemployment rate, nominal wage growth and inflation reacting with a lag to labor market tightening, and a loss of firm pricing power from global developments and from technology.

While we do not think the Fed reached the conclusion that its inflation framework was invalidated by the recent softness in inflation, having this discussion at all raises the risk of a shift in the reaction function away from a focus on resource utilization and the PC. But it could also drive the FOMC to look for areas where it may have mis-measured the amount of spare capacity in the economy, for instance in the recent increase in the labor force participation rate of prime age women (see Rising participation among prime age workers, August 11, 2017). As discussed in Wage growth is not as weak as it seems, August 4, 2017, we share the committee’s view that the rate of increase in nominal wages is not low in relation to the rate of productivity growth and the modest rate of inflation. Overall, this shift in emphasis could likely imply fewer rate increases over the forecast horizon, given the weakness in incoming inflation data since earlier this year. We continue to expect an announcement on balance sheet normalization at the September meeting and a third rate increase this year in December, but we have reduced our subjective probability about a rate increase later this year to about 50% (down from 60% previously)." - source Barclays

To be fair to the Phillips curve cult members and also to Monty Python, the Norwegian Blue parrot did really exist as pointed out by a Daily Mail article in may 2008:

"Adding to the absurdity was the fact that parrots - being tropical birds - don't come from Scandinavia.

Or do they? For now, in a development putting the sketch in a completely different light, it turns out that the Norwegian Blue did exist.

Dr David Waterhouse, a fossil expert and Python fan, has found that parrots not only lived in Scandinavia 55million years ago, but probably evolved there before spreading into the southern hemisphere.

His discovery was based on a preserved wing bone of a previously unknown species, given the scientific name Mopsitta Tanta - and now nicknamed the Norwegian Blue.

The dead parrot script, voted Britain's favourite alternative comedy sketch by Radio Times readers in 2004, was written by Cleese and Graham Chapman and first broadcast in 1969.

As he returns the ex-parrot to Palin's pet shop, Cleese is assured it is just resting or stunned, being "tired following a prolonged squawk" and "pining for the fjords".

Cleese bangs it on the counter, trying to wake it up, screaming: "Hello, Mister Polly Parrot! I've got a lovely fresh cuttlefish for you!" But it is definitely expired.

Dr Waterhouse, 29, said of Mopsitta Tanta: "Obviously, we were dealing with a bird that is bereft of life, but the tricky bit was establishing it was a parrot."

He was studying for a PhD at the University of Dublin in 2005 when he visited a museum in Jutland and spotted a fossilised 2in-long humerus - appropriately enough, the funny bone - among bird remains which had been found near an open-cast mine.

Research has now confirmed the bone was part of an upper wing from a bird in the parrot family. Although the mine was in Denmark, the birds would also have lived in what is now Norway."

[ ...]

"However, the Pythons were wrong about one thing...the Blue could hardly have pined for the fjords.

"This parrot shuffled off its mortal coil around 55million years ago, but the fjords in Norway were formed during the last Ice Age and are less than a million years old," said Dr Waterhouse." - source Daily Mail

So dear Kevin, to answer your question we think that the Phillips curve, in similar fashion to the Norwegian Blue parrot did exist but is now simply "resting" in a Monty Python way. Same goes for the ECB's view on the Phillips curve as per Barclays recent note:

"The ECB’s accounts focused on a flat Phillips Curve and financial stability

The ECB’s accounts of the August meeting explored the Phillips Curve relationship in detail. Given the latest data, the accounts “acknowledged the strengthening of the economic expansion and confirmed that the risks to the growth outlook were broadly balanced”. At the same time, the accounts contain a very detailed discussion of the flattening Phillips Curve relationship, including due to labour market reform, hysteresis effects from prolonged high unemployment, the backward looking nature of wages, as well as the deleveraging process in the euro area. Nevertheless, the GC argued that the Phillips Curve relationship likely remained intact, but that “patience, persistence and prudence” were needed as this process would likely take time and be contingent on “very substantial degree of monetary accommodation”. While the statement explicitly mentions firm survey evidence of emerging labour shortages, a decomposition of the euro area wide European Commission survey (Figure 1) suggests that this is mainly driven by Germany (Figure 2), where, despite a 3.8% unemployment rate, wage pressures remain to be seen. Overall, the discussion is in line with underlying inflation on a moderate recovery trend and is unlikely to accelerate in the near term (Euro area inflation: Core improves but doesn't shift gear, 31 July 2017)."

All in all, with "patience, persistence and prudence" like the shopkeeper in Monty Python's sketch, we might see the Phillips Curve come back to life, but for the moment it is pretty much as the Norwegian Blue parrots, they really DID exist - but now they are all 'stiff, bereft of life and ex-parrots'.

This ends our numerous potshots we have taken in 2017 relative to the Dead Parrot aka the Phillips curve. In our credit point below, we have in recent months suggesting rotation towards higher quality credit and also recommended playing more defensively at this stage of the credit cycle while we continue monitoring the trend in credit conditions in particular consumer credit.

• Macro and Credit - Smarten your beta

Back in June in our conversation "Potemkin village", we posited that as the Trumpflation narrative was fading, so was the beta narrative. In fact our tool DecisionScreen told us the same at the time when it came to its signal switching to slightly negative for US High Yield. The aggregated rule we use is made up of the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score) and US GOV 10 year yield (1Y Z-Score). The beta trade is also a function of investors’ perception about the pace of QE. Our central planners might be using a dead parrot for guidance, but, anyone is trying to guess the change of the rhetoric, should the doves finally become hawks in the near term given financial stability matters and matters a lot for this crowd. We continue to remain slightly negative on US High Yield and we monitor closely the shape of the CDX High Yield curve, particularly the front-end, to see whether the curve is starting to flatten or not.

On the subject of smartening your beta we read with interest Barclays US High Yield note from the 18th of August entitled "Choose your Beta Wisely":

"Some of the fear that gripped risk markets due to geopolitical events just a week ago looks to have subsided. But the pick-up in volatility during that episode, has many investors more closely considering the tie between credit and equity markets. On the surface, there appears to be a dislocation between SPX and high yield valuations, but we expect the relationship to revert to its historical beta once the earnings-related volatility subsides.

US HY Still Looks Dislocated Versus S&P 500; Less So Versus Russell 2000

To start in Figures 1 and 2, we simply plot US HY Index spreads versus the S&P 500 ("S&P") and Russell 2000 ("RTY").

While not perfect comparisons, we believe asset allocators and specialists alike often look to the two broader indices to help formulate a first cut opinion on cross-asset performance and relative value. In terms of a short-term signal worth further dissection, we find that US HY spreads look modestly dislocated (wide) relative to its relationship with the S&P since the beginning of 2016. The relationship looks more in line when comparing US HY to the RTY. These findings are consistent with the broader narrative of small-cap equities and other higher-beta risk assets underperforming in August.

What could further explain the divide? Constituents differences and relative sector weightings provide a clue. Among the set of issuers in the High Yield Index, 62 are also in the S&P and 224 are also in RTY, with each group accounting for roughly 18% of par outstanding in the High Yield Index. Not surprisingly, the quality breakdown shown in Figure 3 suggests that the S&P cohort is higher in quality relative to the RTY constituents.

While neither cohort is exactly comparable to the High Yield Index, the quality weights of the High Yield Index align slightly better with the RTY than the S&P, which may help to explain the dislocation seen in Figure 1. That said, higher-quality credits have actually underperformed on a beta-adjusted basis recently, as noted in this week's Tuesday credit call. As a result, we find the magnitude of high yield's underperformance with respect to the S&P somewhat surprising considering that high yield is underweight higher quality.

Figure 4 shows the differences in sector exposures relative to the High Yield Index for both equity index's matched cohorts.

With the exception of energy, the S&P cohort is actually more closely aligned with respect to index weights than the RTY cohort. That said, the S&P's relative underweight with respect to energy has been a key driver of its outperformance relative to both the RTY and US HY in 2Q17, when E&P companies were faced with a litany of issues. However, adjusting for the differences in sector exposures using the weightings of the S&P cohort, we find that the High Yield Index would still have widened by the same 31bp in the aftermath of the recent sell-off despite its outsized energy exposure.

Quantifying How Sensitive Credit Returns Are To Equity Returns Now

While optically, high yield may appear modestly disconnected with respect to the S&P 500, it's worth noting that this relationship is somewhat fickle. In Figure 5, we track the trailing 6-month betas of daily total returns of the US High Yield Index versus the S&P and RTY.

As shown, both have gyrated significantly over time, suggesting that there is not a single best fit to explain the relative performance of credit and equities beyond short periods of time. At the moment, the betas are all generally towards the lower end of their two-year range, though slightly higher for the S&P than the RTY. This likely reflects the relatively more benign macro and volatility backdrop that has persisted for most of the last 12 months now that many of the stresses around weak commodity prices in 2015 and 2016 have become better understood and digested.

While it is true that the credit/equity relationship has been far from stable, it is interesting to note that the High Yield Index has consistently displayed higher sensitivity with respect to the S&P than the RTY. In other words, in order to design a "true" delta neutral portfolio, one would theoretically have to short more units of the S&P than the RTY against a long High Yield Index exposure. Of course, determining the "correct" market neutral hedge ratio is complicated by the changing face of the equity/credit relationship. Nonetheless, using the rolling 1-year historical total return beta to equities as the hedge ratio, we find that the return of the hedged portfolio is closer to zero using the SPX (Figure 6). 

A simple regression of weekly returns of the SPX and RTY against HY returns over the past five years would suggest that high yield displays a marginally better fit with respect to the S&P (R-squared of 36%) than the RTY (33%). Over the past month, however, high yield performance has more or less tracked its beta to the RTY month-to-date total returns through Wednesday's close (0.16x) has been closer to its historical beta to RTY (0.21x). Meanwhile, the ratio of high yield to SPX returns (-6x) suggests that its relationship to SPX (characterized by a total return beta of 0.32x to S&P) has recently broken down. For the reasons stated above, this divergence has less to do with its outsized commodity exposure, and has more to do with idiosyncratic stories and earnings-related volatility. But looking forward, we believe that high yield will perform more in line with its historical beta to the SPX once these concerns subside" - Barclays

Of course it should perform in line with its historical beta to the SPX. It remains to be seen how long US High Yield and the S&P 500 maintain their "elevated" valuation level. This of course, partially depending on the trajectory that will be taken by oil prices in the second part of the year.

As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remain very strong as per the below chart from MacroCharts.pro we also used in the past (data up to the end of July):

Correlation 0.966, R2 0.933, 139 months in sample - source MacroCharts.pro

In case you are asking, it shows you that High Yield, isn't that much of an "alternative" asset class, as put forward by some pundits.

When it comes to credit, defaults and leverage matters but pointing out the "low default rate" in Europe or elsewhere like some pundits do, it is we think "oversimplistic". Leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash we think should you want to play the "hedging" beta game. Just a thought. When it comes to the maddening crowd our final chart displays WPP cds prices move following their profit warning and the warning it delivered for both credit and equity players.

• Final chart - Credit Mad Men

 Our final chart comes from DataGrapple's latest blog entry entitled "Do as I say, not as I do" and displays WPP CDS 5 year price evolution. The comments they made are very interesting from the point of view of credit investors but as well in the light of  WPP's "forward guidance" and the very challenging situation for retail. One might wonder if the situation will be contained...

"WPP blames “Uncertainty and short-termism reducing investment in favor of buybacks/dividends, although market levels lowering attraction” as a reason for the lack of dynamism of the advertising market. Companies are cutting costs to keep dividends & buy-backs very close to 100% of operating profits. At the same time WPP intends “Use of our substantial cash flow to enhance EPS through acquisitions, share buy-backs and debt reduction”. This was not enough to avoid the 10% drop in WPP’s share price today. WPP credit default swap did not react as much. The CDS is only 3 bps wider at 63 bps. Looking at the attached grapple, we see that the credit market is much more cautious on WPP for some time. The CDS is 40% wider than its lows mid-June. The company intends to use cheap debt to increase its net debt to twice its EBIDTA. The uncertainty of WPP’s EBITDA is a new challenge for credit investors. However, today was more an equity story with an interesting analyst presentation with a lot of data. WPP confirmed for instance the stress on the retail sector which is cutting on ads, -3% yoy.
Meanwhile, the credit index market was quiet. The credit index index option market was busier with some investors looking at options rather than outright hedges for the months to come." - source DataGrapple

As we pointed out recently, credit options are still a cheaper way in hedging your credit bets than going outright long the CDS index from a negative carry perspective. Volatility might indeed return in September thanks to additional US political uncertainties and other exogenous factors. It remains to be seen if contrary to the Phillips curve, volatility is not a dead Norwegian Blue parrot after all, we don't think it is but we ramble again...

"What the eyes see and the ears hear, the mind believes." - Harry Houdini

Stay tuned!

Macro and Credit - The Ghost of Christmas Past

"These are the shadows of things that have been. That they are what they are, do not blame me!" - The Ghost of Christmas Past, A Christmas Carol by English novelist Charles Dickens, 19th December 1843

While discovering with great pleasure that we had won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our recent "Cinderella's golden carriage", we reminded ourselves for this week's title analogy of the sayings of the Ghost of Christmas Past that came to haunt Ebenezer Scrooge in Dicken's 1843 masterpiece "A Christmas Carol". This angelic spirit showed Scrooge scenes from his past that occurred on or around Christmas, in order to demonstrate to him the necessity of "changing his ways", as well as to show the reader how Scrooge came to be a bitter, cold-hearted miser. Looking at where some High Yield Energy spreads are close to ending the year with the continuous downward pressure on oil prices and most of the commodity sector, is indeed, an illustration of the Ghost's philosophy. Credit spreads are what they are and do not blame us for having commented over the last few years over the deterioration of the credit cycle. If the Ebenezer Scrooges of the credit world have been hurt in the latest sell-off in the High Yield space, they had it coming. Low spreads of yesterday are indeed the shadows of things that have been to paraphrase Charles Dickens.

While typing this very note, we watched with great interest Central Bank of Azerbaijan (CBAz) decision to devalue the AZN by another 35% to AZN1.55/$ and deciding to shift to a fully floating exchange rate starting from December 21. We pointed out in our recent conversation "Cinderella's golden carriage" that in similar fashion to AAA ratings, currency pegs are as well a dying breed:

"In similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":

"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics

 - source of the table - Société Générale 

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been", hence our recent HKD peg break case that earned us some praise from Saxo Bank.

Before we move on towards our usual ramblings, it is that time of the year where we would like to take the time to wish you dear reader and your family a wonderful Christmas and a happy and prosperous New Year. On that special occasion, we would like to extend our thanks for the support we received on our blogging journey and to our growing number of our readers (thanks for your praise in 2015). We would also like to thanks our good friends from Rcube Global Macro Asset Management for their numerous qualitative and quantitative contributions throughout 2015. We also would like to extend our thanks to our good cross-asset friend "Sormiou" for providing us with his great insights on the subject of volatility and his regular comments, and interesting exchanges we had during the course of 2015. We are looking forward to hearing more of him in 2016 given the clear potential for more volatility to come in that respect. We also hope we will hear more from you dear reader in 2016. Don't hesitate to reach out and comment!

As we move towards the last few days of yet another eventful year full of "sucker punches" such as the CHF move thanks to yet another peg blowing out courtesy of the SNB and the Yuan "surprise" of the summer thanks to the PBOC, we would like this week in our closing conversation for 2015 to continue looking forward towards 2016, as we think, the rising instability will generate interesting proposals for the "contrarian" punters. Also we do think that our "outrageous" prediction prominently featured in Saxo Bank's recent publication is by no mean "outrageous", more on this later in the conversation. Similar  "convex" trades abound, as central banks' magic spells are losing their strength, and these "macro" trades will go hand in hand with "volatility" in 2016. To reiterate ourselves, there lies the crux of central banks interventions, there is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis.

Synopsis:

• 2016, will be all about "risk-reversal" trades
• The EM 2016 outlook - its weaker than you think
• Final chart - Short Hong-Kong? Go long Japan "tourism"

• 2016, will be all about "risk-reversal" trades

It seems to us that many investors today are "living in the shadows of things that have been", namely that they live under the "pretence" that the "central bank put" is still in play. This "pretence", we think is particularly entrenched within the "equities" crowd who suffers from "overoptimism", whereas us, in the "credit" crowd, we suffer from "overpessimism". Overall, investors, suffer from deep bipolar disorder but, that is another subject.

Furthermore, as we have shown in our last conversation "Charles' law", rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky, and they also have induced a reach for yield, pushing many "players" outside of their "comfort zone" leading to "yield compression" on a "grand scale" as displayed in the below chart from Bank of America Merrill Lynch's Global Equity Derivatives Outlook for 2016 published on the 9th of December:

"Reaching for yield in Europe given QEWith almost €3trn of negative yielding govt debt (~45% of the total outstanding), the hunt for yield in Europe is as strong as ever. With such low (negative) returns on safe haven assets, central banks have pushed income-seeking investors further out on the risk curve, resulting in a policy-induced contraction in yields across asset classes (Chart 26). 

With Mario Draghi unleashing QE in 2015 and leaving room to further expand it in 2016, the hunt for yield will likely gather steam, in our view. Indeed, the higher yields on offer in both EU equities and HY credit relative to safe haven assets are among the key investment reasons cited by our equity & credit strategists in their 2016 outlooks.

Yield is only half the story: need to weigh vs. asset riskYield vs risk framework: With a lack of assets offering reasonable yields, investors often focus excessively on (just) the yield on offer with less attention to the associated investment risk." - source Bank of America Merrill Lynch

Indeed, "yield hogs" are still on the "yield trail" and have been enticed by our generous gamblers to play on the "beta" game a little further up the risk scale.

What is once again "striking" to us, as me move towards 2016 is the "consensus" in many positions, which we think that from a "positioning" perspective and contrarian approach could be enticing. Could it be that when everyone is thinking the same, that no one is really thinking? We wonder.

In terms of "risk-reversal" punts, we read with interest Bank of America Merrill Lynch's Futures and HF positioning report from the 20th of December entitled "Leveraged Funds bought record S&P 500 –tugging a war with Asset Manager":

"Futures positioning across asset classes (CFTC data) 

Equities (disaggregated data)
S&P 500 (consolidated) – Leveraged Funds (LF) decrease short by $34.6bn over four week to -$16.6bn – a record buy since the consolidated TFF data started in June 2010. Asset Manager/Institutional (AI) decrease long by $6.1bn last week to $40.5bn. AI net position is near 3-year low (3.2%tile); LF near 3-year high (98%tile).
NASDAQ 100 (consolidated before June 2013) - Asset Manager/Institutional increase long by $0.2bn to $10.1bn. Leveraged Funds increase long by $1.5bn to $4.0bn.
Russell 2000 - Asset Manager/Institutional increase short by $0.7bn to -$6.4bn. Leveraged Funds decrease short by $0.6bn to -$0.9bn. One-year z-score is above two for LF (i.e. contrarian bearish). Total Open Interest is near a 3-year high (95.5%tile). 

Interest Rates (disaggregated data)
CBT US Treasury - Asset Manager/Institutional decrease long by $1.3bn to $19.3bn. Leveraged Funds decrease short by $3.0bn to -$1.4bn. Other reportables (sovereign) net
position is near a 3-year low (1.9%tile), with one year z-score below two.
10-yr T-notes - Asset Manager/Institutional decrease long by $2.6bn to $28.1bn. Leveraged Funds increase short by $0.7bn to -$28.8bn.
2-yr T-notes - Asset Manager/Institutional bought $4.1bn and flipped to a long for the first time since Nov. 3rd, with one-year z-score above two (abnormally bullish sentiments among AI). Leveraged Funds decrease long by $0.9bn to $11.2bn, with one year z-score below two (i.e. abnormally bearish sentiments among LF). 

FX (disaggregated data)
EURO - Asset Manager/Institutional increase short by -$1.4bn to -$2.2bn. Leveraged Funds decrease short by $1.7bn to -$17.3bn.
JPY - Asset Manager/Institutional (AI) decrease short by $0.9bn to -$3.7bn. Net position stays near 3-year low for AI (5.7%tile) and sentiment is on a buy signal (one-year z-score rallying from the Nov. 3rd low). Leveraged Funds decrease short by $2.7bn to -$5.7bn.
AUD – Asset Manager/Institutional decrease short by $0.2bn to -$1.9bn. Leveraged Funds bought $1.2bn and flipped to a net long for the first time since Oct. 2014; z-score is above two (contrarian bearish). Meanwhile, net positon for Other Reportables -(sovereign) remains near 3-year low (6.4%tile)." - source Bank of America Merrill Lynch

Whereas Asset Managers and Leveraged Funds agree on the Russell 2000 short position, which is of no surprise given its correlation with High Yield, what seems to us very interesting is the significant positioning of the Leverage community in being short 10 year T-Notes to the tune of -$28.8bn as per the chart below from Bank of America Merrill Lynch's report:

 - source Bank of America Merrill Lynch

Given the recent US Q3 GDP print at 2% (well below 3.9% growth in Q2) and given the current high level of inventories we highlighted recently in our conversation "Cinderella's golden carriage", it seems to us that US GDP is weaker than expected and is going to be "weaker for longer". On a side note, we have increased our US long duration exposure for this very reason. As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"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."

From a "risk-reversal" perspective, we think, the current sizable "short positioning" from the "Leveraged crowd", offers a good contrarian punt, given the "weaker" outlook as of late of the US economy. 

In similar fashion, the "consensus" trade of being "short" the Euro versus the USD, appears to us overly "crowded". In that sense, Steen Jakobsen's CIO of Saxo Bank's call of EURUSD flying towards 1.23 in the latest Outrageous Predictions for 2016  is not that "outrageous" we think, particularly if you factor in that for the 12 months to October, the cumulated current account surplus represented 2.9% of eurozone gross domestic product, compared with 2.4% for the 12 months to October 2014. The latest October figure for the current account surplus came at €19.8bn, which is €9bn more than at the same period in October 2014 (€10.8bn).

Here is below the significant positioning of the Leverage community in being short EUR/USD to the tune of -$17.3bn as per the chart below from Bank of America Merrill Lynch's report:

 - source Bank of America Merrill Lynch

It certainly looks crowded to us, and are the shadows of things that have been, given that as of late,  Le Chiffre aka Mario Draghi, hasn't been on his best "bluffing/betting" behavior.

When it comes to Emerging Markets woes which have been well commented by all the usual suspects, when it comes to our prognosis for 2016, we think that there is indeed more pain to come rather than to expect a "relief rally" from an "outrageous prediction" perspective. Our "reverse osmosis" macro theory we touched on again recently is still playing out. This brings us to our second point.

• The EM 2016 outlook - its weaker than you think

While the "commodity rout" is well documented, we think that in 2016, we will the materialization of defaults and restructuring in the EM world given the exposure of the banking sector in these countries to the sector. In relation to this exposure, we would like to point out to a Bank of America Merrill Lynch report published on the 16th of October and entitled "China spillovers and the leverage channel":

"The commodity channelCommodity exporters – Malaysia, Thailand and Indonesia (see Chart 2) – have been disproportionately impacted, largely as commodity prices slump on weaker demand, as China rebalances away from investment-driven growth. 

Casualties include coal, base metals (iron and copper) and palm oil. Coal prices, for instance, have fallen some 62% since January 2011. Falling commodity exports hurt the current account balance, fiscal revenue and also the wages of lower income, rural households.
Lower export revenues and the declining terms of trade have weighed on the growth of commodity exporters. Indonesia’s GDP growth is at its weakest since the Global Financial Crisis, at +4.7%. Infrastructure spending is failing to offset slumping commodity exports so far, given the slow progress. Malaysia's GDP growth will likely slow markedly in the second half of the year, as slowing exports spill over to weaker consumer and investment spending.
The IMF highlighted in its latest October WEO report that the weaker outlook for commodity prices implies that the annual growth in output for net commodity exporters will decline further, by almost 1% point, in 2015–17 compared with 2012–14. The reduction in growth for energy exporters is projected to be larger, at about 2.25ppt over the same period.

 

The leverage channelConcerns over financial system vulnerabilities have risen, given the commodity downcycle and the sharp depreciation of currencies in emerging economies, particularly commodity exporters. The latter has implications for foreign-denominated debt. Economies with high foreign currency borrowings and high exposure to commodities are particularly at risk of loan defaults and banking system losses.

We identify loan exposures to the commodity sector, defined as loans extended to the agriculture, forestry & fishing, and mining & quarrying segments. Singapore (9.2% of GDP), India (7.2%), Malaysia (3.7%) and Indonesia (3.4%) have the largest share of bank loans to the commodity sector, as a proportion of nominal GDP (see Chart 3).

As a share of total corporate debt, Thailand and Indonesia rank highest, with about 31% and 30% of corporate debt borrowed by commodity producers. China (26% of total), India (26%) and Malaysia (18%) also have relatively sizeable amounts of debt borrowed by energy and metals & mining companies (see Chart 4). This is worrying and may have profound implications on financial stability, as commodity demand and prices remain under pressure. Based on IMF data, ASEAN countries Indonesia (52% of total corporate debt), the Philippines (28%), Malaysia (18%) and Thailand (16.5%) have the largest share of foreign-currency non-financial corporate debt out of total company borrowings in Emerging Asia.

Our Asia Pacific financials team recently highlighted that Hong Kong banks would be the most directly impacted by a China hard-landing. Many Chinese firms borrow funds offshore in Hong Kong and firms in Hong Kong are also reliant on cross-border businesses (tourism, trade, shipping, etc.). Among banks in the rest of Asia, Singapore banks DBS and OCBC have the largest loan book exposure to HK/China, accounting for 36% and 26% of total loans, respectively. The exposure of UOB, Taiwanese financials, Public Bank in Malaysia, and Australian banks are generally much smaller, in the 4% to13% range. Banks in other markets have insignificant exposure, but could be indirectly impacted by any slowdown in their domestic economies. 

Defaults and restructuring of commodity-related firms may be early indicators of potential financial stress for banks. High gearing and foreign currency-denominated debt appear to be a characteristic of commodity producers and trading companies. Commodities are priced in US dollars and are, therefore, hedged, goes one argument. Exploration and mining often require heavy capital investment and, hence, large-financing requirements. Commodity trading companies are also highly geared by their very nature. The China contagion may be far from being over, as the financial stress on commodity and debt-laden firms starts testing banks." - source Bank of America Merrill Lynch.

The path of normalization of the Fed has continued to exert additional pressure on already strained EMs thanks to Global Tightening Financial Conditions triggered by the US Dollar "margin call" thanks to the tapering of the Fed and now with the latest small increase in rates.

When it comes to the Fed's hiking cycle, the Fed is not only hiking in an environment of slowing earnings in the US, it is also hiking in an environment where Asian growth is slowing as displayed by Deutsche Bank in the below chart from their report from the 17th of December entitled "Asia Macro in a non-zero world":

"Business cycles in the region are in much weaker shape, with growth slowing – not accelerating – into this Fed hike (Chart above). Export growth has been printing in negative territory across Asia, a far cry from the double-digit growth seen when the Fed last raised rates (2004). Asian central banks will not be able to keep up with even a gradual Fed this time, and front-end rate differentials will narrow. The only central bank we think could hike rates is the Philippines. Elsewhere, rates in China, Taiwan, Korea, and Thailand could be very close to, or even below, US rates by end-2016. The market appears underpriced for this divergence." - source Deutsche Bank

Furthermore, when it comes to EMs' growth, this time it's different as their growth have been much tepid as of late. On the subject of the outlook for EMs, we read with interest LCM's take from their Cross Asset Weekly Report from the 15th of December entitled "Themes for 2016":

"EM: How Will It End?This is a good transition for our second point: the EM situation. We wonder how it could end because we do not see any positive outcome for them. In the developed world, the most flexible economies that have enjoyed the highest accommodative financial conditions of history have needed several years to recover after the US centric financial crisis. How long will need an EM country under
financial repression to recover from an EM centric financial and economic crisis? We do not know precisely but we suspect much longer than the US.
The chart below gives an indication of the negative pressure on the whole EM universe. If we exclude the global crisis of 2009, never before so many EM countries have failed to generate an economic growth rate above 3-4%. 

High economic growth is becoming scarce for these countries so clearly, we can talk about a new paradigm for them. On the right, the chart shows that a consequence of that lower growth is a higher accumulation of the public debt, leading to a rise of the Debt/GDP ratio towards its 90’s level. The current crisis seems deeper than the 97/98 crisis which was initiated by a financial crisis. 

This time, it is not a financial crisis that triggers the economic crisis but an endogenous economic crisis that arises following excess investment in assets that turned unproductive (real estate and manufacturing for China and commodity-related sectors for LatAm, the Middle East and Russia). This is a big difference. This economic crisis is not the result of a fundamental financial vulnerability that would have been exploited by investors. There has been no US$ interest rates shock, no speculative attacks on countries. The weakness comes from the real economy and the depreciation of the currency is the consequence of that weakness, not the cause. 

We show with the following chart the Budget balance for 2015 of selected EM countries and their short term cost of funding (5-year sovereign bond yield). There is a clear discrimination: Brazil suffers unaffordable rates whilst Chile and Peru, its neighbours that are also affected by weaker growth, maintain access to global markets. 

On the right, we see that the Government bond yields of Brazil and Russia have reached very high levels. Contrary to Turkey, these countries are already in recession making the situation desperate. The financial system is under great pressure, NPLs are on the rise, the risk for them of running out of a US$ financing is a reality. Equity valuation is therefore intriguing as Brazilian banks trade at 0.7 times their book value and Russian banks at 1.0 times their book value. In other words, this does not look to be a capitulation phase. The situation is critical but investors have not thrown in the towel and this is why in our opinion the downside for the most fragile EM equities is intact.

The underweight position on EM assets is supposedly consensual but as we discussed in our weekly note #115 “Story Positioning”, we do not believe this lie. PMs are not underweight EM assets because they cannot short an oversold asset; it is inconceivable for them.
This negative trend is therefore intact because the investor participation rate is very low. The EM currencies are depreciating because of two events: 1) the US dollar rise with the expectations of higher real rates and 2) because of financial outflows resulting from a deterioration of the EM external position and a loss of investor confidence. 

 - source LCM, Bloomberg

The new story among EM countries is the weakness of the rich Middle East countries. Their economic disarray looks like 1998 as they return to deficit in terms of budget balance and current account position. It is clear that they can afford it after having benefited for several years from the oil rent but as is often the case, the deterioration is faster and stronger than the improvement. The currency peg of these countries may be tested. We should therefore keep an eye on this region because being anchored to the winner when you are a loser is of limited interest. 

The consequences of the reduced amount of petrodollars flooding to developed and emerging markets are unknown but in the EM case it helps to further reinforce the vicious circle they suffer. The later, slower and weaker recovery scenario that we mention is obvious and this is why on financial markets investors should not expect too much from EM assets.

The accumulation of debt adds another challenge to EM countries that could act as an accelerating factor for the economic crisis. Within the EM world we continue to distinguish three groups: 1) commodity exporting countries 2) China and 3) the rest (mainly EM Asia ex-China). This EM crisis started with the first group as the decline of commodity prices quickly revealed their intrinsic weaknesses. Now it is moving to Asia and because there remain many unanswered questions, it should be a recurring topic for 2016.
For markets, this change of focus from LatAM/Russia to China does not mean that the situation is fixed but that it is extending. This is the problem and this is why 2016 could be another bad year for EM assets. The corporate bond defaults remain limited, the help of the IMF has not been required, so we have not as yet seen the classic indicators of capitulation that increases the reward/risk ratio of being contrarian." - source LCM, Cross Asset Weekly Report, 15th of December 2015.

While these are the shadows of things that have been in 2015, we have to agree, with LCM. We do not think we have yet reach the "capitulation" point that would make the asset class an "enticing" investment proposal.

In terms of "enticing" proposal, we would like to end up on a more "positive" note in our final point of our conversation, with the "attractiveness of the Japanese tourism sector.

• Final chart - Short Hong-Kong? Go long Japan "tourism"

We think that the Hong-Kong woes which we have again highlighted in our conversation "Cinderella's golden carriage" have greatly benefited Japan and will continue to do so in 2016. This has been furthemore highlighted by the WSJ in their article from the 17th of December entitled "Hong Kong Retailers Lost in Currency Translation":

"Retail goods in Tokyo are on average 34% cheaper than in Hong-Kong. Hong Kong retailers lost in currency translation as Chinese shoppers turn to Japan amid cheaper prices and yen." - source The Wall Street Journal

Given Japan has been the big beneficiary as highlighted in our previous conversations when looking at air travel surge towards Japan from China mainland, it makes sense we think, to continue to play this theme in 2016. On that note we read with interest Société Générale's Best Trade Ideas for December and January and would like to point out to additional points made in their research note on the subject of Japanese tourism:

"Japanese tourism is a long-term theme and its development is a pillar of Abe’s growth strategy. The government objective of reaching 20m visitors by 2020 is within reach. 

Consumer demand, a tailwind for Asian equities. Tourism expansion in Japan results from a combination of factors, including a weaker yen and government policy encouraging foreign visitors flows (for instance through easing visa deliveries). Rising wages and robust Asian consumer demand is another key element. In the past three years, the bulk of Japan’s tourism growth is attributable to Asian visitors. 

Exposure to tourism through SG Japan Tourist Basket. The basket, launched in March 2015, has been constructed along liquidity and diversification constraints. Sectors represented in the basket include transportation, appliances (30%) and retail trade (25%). Given the liquidity constraints, the basket consists of a combination or “pure” and “less pure” players, with a significant overall flavour of outbound travel.

- source Société Générale

When it comes to Honk-Kong's retail woes thanks to its US dollar peg, Japan is indeed the prime beneficiary, particularly when one notices that luxury watches exports from Switzerland to Hong-Kong have fallen by 28% according to Bloomberg.

In relation to Hong-Kong's currency peg, we are left wondering if indeed the fall in "luxury watches" is not indicating that "time" is running out? Is our prediction for 2016 so "outrageous"? We will soon find out...

"Every adversity, every failure, every heartache carries with it the seed of an equal or greater benefit." - Napoleon Hill, American writer

Stay tuned!

Macro and Credit - Charles' law

"There is no such thing as talent. There is pressure." - Alfred Adler, Austrian psychologist

Watching with interest the demise of some Distressed/High Yield funds thanks to "price action" and "low liquidity", with continuous pressure as well on some other asset classes in true "Risk-Off" fashion, we reminded ourselves for this week's title analogy of Charles' law, or the law of volumes. Charles' law simply states that a gas tends to expand when heat is applied to it. This law was published in 1802 by French chemist Joseph Louis Gay-Lussac, who credited Jacques Charles for all his work on the subject. Jacques Charles was a French scientist and inventor whose most notable work came during the late 18th century. Charles was presumably the first to discover that hydrogen could be used as a lifting agent in balloons. More recently, central bankers discovered that liquidity injections could be used as a lifting agent in "asset prices" ("Cantillon Effects"). In similar fashion, in our "macro" world, credit spreads "expand" (widen) when heat is applied to it. In physics, when the combustion starts, it is difficult to stop, same happens in credit and macro, when the credit cycle is turning, leading as well to "capital outflows" and surge in yields. When it comes to lifting agent, balloons, and combustion, we remember what happened to the LD129 Zeppelin Hindenburg on the 6th of May 1937 but, that's another story...

In this week's conversation, we would like to look at the continuous effect of positive correlations and large standard deviations move we discussed in August. Given the rise in volatility, we will also look at why we think "volatility" is the asset class to own as we move towards 2016 and the gradual erosion of central banks' credibility in 2016.

Synopsis:

• The opportunities in unprecedented turbulences
• "Negative carry" - Central banks' credibility is effectively suffering from "time decay"
• Final chart - CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies

• The opportunities in unprecedented turbulences

As we posited back in August, rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky. We argued at the time:

"There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, August 2014

And we concluded:

"Expect more violent moves going forward as a consequence. For us, there is no "Great Rotation" there are only "Great Correlations"..." - source Macronomics, August 2014

The 3rd of December was a good illustration of the "instability" due to rising "positive correlations" which inflicted havoc on "balanced fund". Below are two charts illustrating the large standard deviations move in Europe following the ECB - graph source Bloomberg:
EUR/USD:

German 10 year Bund:

- Graph source Bloomberg

To illustrate further our prognosis of "rising instability" à la Charles' law, we read with interest Bank of America Merrill Lynch's take in their Global Equity Derivatives Outlook for 2016 published on the 9th of December:

"As we highlighted in our 2015 outlook, the most distinguishing feature of markets today is not the general trend in volatility, but the unprecedented turbulence.

Rising fragility; moving deeper into uncharted waters
In 2016 we expect volatility to maintain its gradual upward trend, however, to continue to be punctuated with violent but short-lived shocks owing to poor liquidity, extreme positioning and a market still heavily manipulated by (and dependent on) the central bank put. Despite below-normal levels of volatility across asset classes, we are in uncharted waters in terms of a lack of stability: 

• Markets are setting records in terms of jumping from calm to stressed & back
• Our indicator of cross-asset market fragility is near its highs (Chart 1)

• CB liquidity is tightening, making markets more accident prone (Chart 7)

Asset managers are struggling, with the poorest hedge fund performance relative to the risk they are taking since 2008, despite overall market volatility being only 1/4th of 2008 levels. Their poor performance is better explained by the extreme levels of market fragility, which by our metric is at 80% of its 2008 highs (Chart 1 above).

Unfortunately, we don’t see conditions improving and only becoming more acute as liquidity continues to deteriorate, asset valuations become increasingly stretched, and the Fed navigates the unwind of the greatest policy experiment in history. " - source Bank of America Merrill Lynch

We don't see conditions improving either in 2016 and last Monday was once again an illustration of "Blue Monday" in the works we think. With liquidity deteriorating and hydrogen having been used by our "generous gamblers" as a lifting agent in  "asset balloons", there is indeed no surprises in seeing a significant rise in idiosyncratic risk leading to significant price movements. 2015 saw an increase in the number of "sucker punches" inflicted to the "cross-asset" crowd. By no means 2016 is going to be different.

When it comes to High Yield's jitters, we have long seen it building up as we carefully studied the credit cycle, it doesn't come to us as a surprise. As a reminder, this is what we have repeated in numerous conversations:

"The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

But, from a short term tactical "contrarian" perspective, we are seeing in US High Yield and Equity / Credit volatility some early signs of "capitulation" (volumes, implied volatilities for ETFs) which, would make for the "adventurous" punter some interesting entry point, to play a short term rally in the making.

Following Friday's move, we have noticed a multiple of "alarmist articles/headlines" from various pundits which have been late to the "party" on the matter of US credit. We believe it is a short term contrarian sign from our behavioral psychologist mantra, given we prefer to focus on the process rather than the content. For instance, we are seeing real signs of capitulation, via flows and implied volatilities on listed options on both principal liquid ETFs.

Volumes for iShare HYG:

- graph source Bloomberg

Implied Volatility 3 months HYG US:

- graph source Bloomberg

Spread volatility Russel / volatility HYG : 

It represents some good entry points for a tactical short term long/short strategy. The implied volatility on credit is trading on comparable levels with "mid-cap" equity volatility.  We believe it is an interesting "capital structure trade" that warrants attention, either from a "directional" perspective (selling straight "Put" options on HYG / buying straight "Put" options on RTY/SPX) or through a "pure" volatility strategy. 

In fact as we were typing this very post, we noticed a rebound on the aforementioned HYG. To paraphrase our November 2015 conversation "Ship of Fools", this time around on HYG we remain tactically short-term "Keynesian" bullish but, remain long term "Austrian" bearish given the lateness in the US credit cycle.

More and more in 2016, we believe there will be many opportunities in unprecedented turbulences movements we have seen so far in 2015. 2016 will be a year in which "tactical" global macro "convexity" trades such as the one highlighted above will be plentiful. Volatility will therefore be one of the core asset class to own, in various "cross-assets" (FX, rates, commodities, credit, etc.). On that point we agree with Bank of America Merrill Lynch's take from their latest Global Equity Derivatives Outlook:

"Successfully trading a less stable worldWhile many are struggling with this new market dynamic, we believe there are smart ways to combat it – and even profit – by monitoring cross-asset risk, and taking advantage of the inflection point in asset correlations. For example:• Gaps in cross-asset volatility can aid in differentiating between “local” and global risks, to determine when to fade the market or add a hedge• Shocks create entry points for cross-asset RV between leader and laggard assets which has been successful in generating alpha• Risks implied by derivatives, including correlation, often are unlikely to realize as stress unfolds, allowing for cheap directional trades• Cheaper hedges can be constructed by harvesting underpriced volatility through proxy puts overlaid on standard put spreads• Strategies that collect the volatility risk premium, for example through call overwriting, while dynamically managing these risks can add alpha" - source Bank of America Merrill Lynch

Although "volatility" is a "negative carry" proposal, the events of the 3rd of December on the German Bund following the ECB, which were close to a 7 standard deviation move, have shown how quickly your "carry" can be wiped out. But, as liquidity is being drained by the Fed and given the increasing signs of global financing conditions tightening, if the "trend" is your "friend", then we are bound to see a surge in volatility in 2016. This trend is pointed in the same report from Bank of America Merrill Lynch:

"A trend of rising vol as liquidity drains
Our Economics of Volatility1 framework has been anticipating the 2015 starting point to a turn in volatility for the last two years2. From here on we expect to see a rising trend in equity volatility levels, a trend that could last 1-2 years, transporting us from the low volatility regime of the last 3 years towards a sustained high volatility regime.
Our expectation for a turn in the volatility cycle follows from a clear turn higher in 5Yr real rates in 2013, and allows for a 2-year lag (Chart 6).  

High volatility regimes may resemble periods like 1998-2003 or 2008-2011, as two examples. Transition periods can also take various forms. Unlike the 1996-1998 transition period which was gradual and well behaved, the 2008-2009 transition was short and violent, as a suppressed and overdue re-pricing of risk finally manifested itself. It’s hard to predict the exact form the next transition will take. While our base case is for an orderly transition, we are wary of the possibility of unpleasant surprises resulting from an unwinding of the highly unusual monetary policy of the last 7 years.

Unwinding extreme easy monetary policy is a tightening
The monetary tightening cycle which started with the 2013 taper has continued its progress, reflected in rising 5yr real rates. This in turn has driven a significant tightening in global liquidity as capital flows from developed to emerging markets start to reverse, evidenced in a slowdown and reversal of FX reserve accumulation."

Tightening liquidity combined with fragility: equity markets are accident proneChart 7 (earlier in our post) shows a measure of global US$ liquidity derived from the momentum of the Fed’s balance sheet. Historically we see that tightening cycles have typically started at high liquidity levels. The current cycle in fact started in anticipation of the tapering of the open-ended QE3 program in 2013, with the impact evident in the sharp turn in the 5Yr TIPs rate (Chart 6), and the subsequent fall in US$ liquidity. Given how far liquidity has already dropped, it is going to be interesting to watch the impact of the more traditional part of the tightening cycle – actual rate hikes – which are expected to start imminently. Combined with our view of an increased likelihood of local shocks due to deteriorating trading liquidity, we may find the markets more accident prone in 2016 than they have been in some time. "- source Bank of America Merrill Lynch

This "reversal" of capital flows in Emerging Markets is exactly the manifestation of our "reverse osmosis" macro theory playing out we think. As a reminder from our August 2013 conversation "Osmotic pressure":

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - source Macronomics

Of course as the Fed is on the "normalization" path as anticipated by market participants, stemming capital flows will continue to be increasingly difficult, particularly for the hard hit commodity players and as well China, trying to "deflate" its "hydrogen fueled "credit" balloon.

Whereas volatility is a "negative carry" proposal, so is central banks' credibility which is effectively suffering from "time decay" we think. 2015 has already shown the weak hand for some of the central banks "punters" such as the SNB and the PBOC losing its cool during the summer. "Le Chiffre", aka Mario Draghi, as well, our "poker prodigy" has shown some weakness in his "bluffing" abilities as of late. We wonder if 2016 will not see further "erosion" in their "ability" to steer markets. This brings us to our second point.

• "Negative carry" - Central banks' credibility is effectively suffering from "time decay"

Whereas "volatility" is a "negative carry" proposal" as posited earlier one, as we move towards 2016, it remains clear to us that 2015 saw many players at the "poker" table fold earlier (such as the SNB). On the 3rd of December, our "Le Chiffre" bluffing abilities suffered as well at the "poker table." As we move towards 2016, we are wondering wether 2016 will see additional weaknesses from our powerful "omnipotent" central bankers. For sure, we think their abilities will be tested even further, given the high deflationary forces at play, particularly with the further weakening of the CNY/Yuan, which will represent yet an additional "headache" for our enduring "gamblers".

On that subject, once more, Bank of America Merrill Lynch's 2016 Global Equity Derivatives Outlook makes some very interesting remarks relating to the "weakening" of the global markets "Central banks Put":

"Power of CB put shows risk of its lossCentral banks have had a tremendous impact on financial markets in the last seven years, which is never more apparent than when looking at the world through the volatility lens. As shown in Chart 12, cross-asset volatility reached all-time lows in the summer of 2014, falling even below the 2007 pre-GFC bubble lows, crushed under the weight of unprecedented monetary policy (or in the ECB case, the promise of policy). This is remarkable considering the size of the risk “bubble” created pre-GFC.

The result is that risk is not fairly priced based on fundamentals but rather is better explained by investors not wanting to stand in front of central banks as they embark on QE. As Chart 13 shows, when decomposing the 41 factors of risk covering 5 asset classes from our GFSI index into regions, both Europe and Japan (the two regions still actively engaging in QE) are the two regions with the most depressed price of risk.

This is despite being the two developed regions with some of the greatest fundamental risk.

Unprecedented CB – market co-dependenceCentral banks have never been more sensitive to financial market conditions as they are today. This hyper-sensitive reaction function has placed huge downward pressure on volatility, and has accentuated local shock behavior as investors have become accustomed to CBs verbally supporting the market at very low levels of stress compared to the past.

In the last three instances when our GFSI critical stress signal has triggered, during the taper tantrum in June 2013, the Oct 2014 growth tantrum, and the Aug 2015 China tantrum, central banks have stepped in to verbally support the market (Chart 14). 

In each case central banks have reversed market stress, creating a string of three false signals, which is historically unusual. From 2000-2012, the GFSI’s critical stress signal triggered 15 times, 12 of which resulted in a further escalation of risk and a pull-back in global equities of at least 5%. This illustrates the extent to which central banks have essentially capped risk at levels where it historically was likely to spill over. 

This has self-reinforced a “buy-the-dip” mentality which, together with the fact that investors have generally been underweight US equities this year, has caused the S&P to record larger returns on days the market was rising than when it was falling. Combined with the fact the S&P fell more days than it rose YTD but the market overall was up makes this historically unusual, occurring only 5 other years since 1928.

Pulling the safety net away will be riskyArguably one of the reasons central banks have been so sensitive to market risk is that they are fearful of a negative wealth effect resulting from a financial market sell-off hurting the real-economy, given they have little monetary ammunition left. Keeping rates low to avoid the rising costs of record high debt burdens could also be a motive. 

The US Fed’s fear was made particularly clear by Yellen’s decision to not hike in September, citing the sell-off in equities and China weakness, at a time when the S&P
500 was only about 10% below all-time highs. 

However, the challenge will be to remove this safety net given how dependent the market has become. And once the Fed begins its hiking cycle, it may be implicitly less able to provide the support for fear of being seen as making a policy mistake. This reduced power of the CB put will only help increase market fragility.

Central bank’s risk manipulation well explains local tails
A good way to explain why we have seen local tail risks arise so frequently since central banks began to heavily manipulate asset prices is with the following analogy, illustrated in Exhibit 1.

Essentially central banks, by unfairly inflating asset prices have compressed risk like a spring to unfairly tight levels. Unfortunately, the market is aware the price of risk is not correct, but they can’t fight it, and everyone is forced to crowd into the same trade. By manipulating markets they have also reduced investors’ inherent conviction by rendering fundamentals less relevant.
This then creates a highly unstable (fragile) situation that breaks violently when a sufficient catalyst causes risk to rise – overly crowded positioning meets a market with little conviction.

Catalysts can range from a “valuation scare” similar to Oct-14 or Aug-15 to a prominent investor stating that assets (e.g. bunds) are not fairly priced and are the “short of the century”. 

The unwinds from these crowded positions are violent, but almost equally violent in some cases are the reversals, which are driven from investors crowding back in when they realize central banks are still there providing protection. 

From this vantage point, it becomes clear that the biggest visible risk to financial markets is a loss of confidence in this omnipotent CB put." - source Bank of America Merrill Lynch

Exactly, 2016, will be all about "risk-reversal" trades. Given the extreme positioning and crowded positions in some asset classes, we expect to see much more "risk-reversal" pain trades aka "sucker punches" being delivered in 2016. From a global "macro" convex positioning, there are already many cheap "convex" overcrowded consensus trades, such as "short gold", "short oil", to name a few. From an "opportunistic approach, there is potentially tremendous "upside" in taking the opposite view via the option markets on various asset classes we think. 

Indeed, the "omnipotent CB put", that's why "Theta" is always "negative". Same goes with central banks' credibility. Whereas up until now, to be fair, thanks to the "omnipotent CB put", options sellers experienced lots of small wins, while getting lulled into a false sense of success and "security", in 2016 they might eventually suddenly find their profits (and possibly worse) obliterated in one ugly move against them as we pointed out in our previous conversation when using our "Cinderella's golden carriage" analogy. 

What would most likely dent even further "central banks' credibility" in general and the Fed in particular is indeed the biggest "deflationary" threat coming from China with a continuous "stealth devaluation" of its currency. This would indeed send a very strong "deflationary" impulse to Developed Markets (DM) and represents a major headwind for our "generous gamblers" as per our final chart.

• Final chart - CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies

We believe that a steady grind lower in Yuan/CNY will occur in 2016, this will put additional pressure on the rest of the world and won't be enough to counter "capital outflows" in China. This we think is a "big risk" for 2016 and amounts in effect to Charles' law playing out. On this subject, we would like to point out Société Générale's take from their Fixed Income Weekly note from the 10th of December entitled "EM deleveraging":

"CNY weakness is likely to de-anchor Asia ex-Japan (AxJ) currencies, creating a disinflationary shock in developed economies – bullish for bonds. ADXY is threatening to break YTD lows (Graph 3).  

Our Asian strategists warn that a currency war induced by CNY depreciation may take either a direct form, with policymakers trying to match CNY weakness, or an indirect one, with investors shorting Asian currencies as a proxy trade. If the depreciation in the CNY accelerates or volatility increases significantly, the risk is a destabilisation of the entire EM currency complex: an example of the butterfly effect we refer to in our 2016 FI Outlook.
When the PBoC fights excessive weakness to discourage capital outflows, it is a seller of bonds, especially Treasuries. However, the recent bout of CNY weakness has not seen any particular pressure on Treasury yields or USD swap spreads. If anything, the latter have recently recovered. That suggests lighter PBoC intervention, which might support the idea that it will be less proactive now that the IMF has given the green light on CNY inclusion to SDR." - source Société Générale

Finally, when it comes to Charles' law and our "reverse osmosis" macro theory and capital outflows from China, we would like to point out towards JP Morgan's chart below from their "China: Devaluation in 2016 - the why, the how and when it will occur" note from the 9th of December:

"Capital outflows will persist and will become an increasingly important driver of currency weakness. Capital outflows will persist for two reasons: firstly, growth headwinds are unlikely to dissipate, which, as chart 3 below highlights, should correlate well with further capital outflows.

The second factor will be continued corporate unwinding of dollar liabilities (we estimate another $400bn dollar liability needs to be deleveraged after recent rise of corporate hedging)" - source JP Morgan.

One thing for sure and as far as Charles' law is concern, in our "macro" driven world, trouble "expand" (widen) when heat is applied to it. Trouble will indeed expand to Asia, should the pressure on ADXY continues, rest assured.

"There are plenty of recommendations on how to get out of trouble cheaply and fast. Most of them come down to this: Deny your responsibility."- Lyndon B. Johnson, US President

Stay tuned!