Macro and Credit - The Seventh-inning stretch

"It's easier to resist at the beginning than at the end." -  Leonardo da Vinci

Watching with interest the better than expected US 1st quarter GDP print up 2.3%, vs 2.0% expected despite a slowdown in consumer spending, with wages and salaries up 2.7 percent in the 12 months through March compared to 2.5 percent in the year to December, and (PCE) price index excluding food and energy increasing at a 2.5% being the fastest pace since the fourth quarter of 2007, leading many pundits to usher more and more the dreaded "stagflation" growth (real negative growth), when it came to selecting our title analogy we decided to tilt our choice towards a baseball one given the growing signs of the lateness of the credit cycle. The Seventh-inning stretch is a tradition in baseball in the United States that takes place between the halves of the seventh inning of a game. Fans generally stand up and stretch out their arms and legs and sometimes walk around. As to the name, there appears to be no written record of the name "seventh-inning stretch" before 1920, which since at least the late 1870s was called the "Lucky Seventh", indicating that the 7th inning was settled on for superstitious reasons. While all thirty Major League franchises currently sing the traditional "Take Me Out to the Ball Game" in the seventh inning, several other teams will sing their local favorite between the top and bottom of the eighth inning. In the current state of affairs of the credit cycle, as we pointed out in our last musing, the debate on where we stand in regards to the credit cycle is still a hotly debated issue particularly with the US 10 year Treasury Notes passing the 3% level before slightly receding as of late.

In this week's conversation, we would like to look at potential headwinds for credit markets in the second half of 2018 given the markets have become much more choppier in 2018 thanks to higher volatility and rising yields. 

Synopsis:

• Macro and Credit - Switching beta for quality? 
• Final chart -  More and more holes in the safe haven status of the CHF cheese

• Macro and Credit - Switching beta for quality? 

As we pointed out in our early April conversation "Fandango" when we quoted our friend Edward J Casey, Flows and outflows matter more and more as many are dancing closer and closer towards the exit it seems in this gradually tightening environment thanks to the Fed's hiking path. Rising rates volatility have whipsawed credit markets in 2018, upsetting therefore the prevailing "goldilocks" environment which had been leading for so long in credit markets thanks to repressed volatility on the back of central bankers meddling with asset prices. With rising dispersion as we have pointed out in our recent musings, credit markets have become more choppy and less stable to that effect, more a traders market one would opine. It has become therefore more and more important as pointed out by our friend to monitor fund outflows but as well foreign flows coming from Japanese investors to gauge the appetite of investors for specific segments of the credit markets. It appears to us more and more that there is somewhat a growing rotation from high beta towards more quality, moving up the ratings spectrum that is.

When it comes to assessing flows, we read with interest Bank of America Merrill Lynch's Follow The Flow note from the 27th of April entitled "Pressure On, Pressure Off":

"Another week of the same? Not exactly.

While HY and equity flows remained on the negative side it seems that the "risk off" flows trend is turning. Last week’s outflow from government bond funds was the first in 15 weeks.

Note that the asset class has seen a significant inflow trend so far this year on the back of the rise in yields and but more importantly on the back of a bid for "safety". With rates vol still close to the lows and spread trends improving on the back of a more moderate primary and with geopolitical risks and trade war risks moderating, we think that high grade fund flows trends are set to continue to improve.

Over the past week…

High grade fund flows were positive over last week after a brief week of outflows.
High yield funds continued to record outflows (24th consecutive week). Looking into the domicile breakdown, US and Globally-focussed funds have recorded the vast majority of the outflows, while the European-focussed funds flow was only marginally negative.

Government bond funds recorded their first outflow in 15 weeks and the second of the year. All in all, Fixed Income funds flows were negative for a second week.

European equity funds continued to record outflows for a seventh consecutive week. Over those seven weeks, the total withdrawal from the asset class funds was close to $19bn.

Global EM debt funds saw outflows for the first time in four weeks. Commodity funds on the other hand continued to see strong inflows for a fourth week.

On the duration front, long-term IG funds were the ones that suffered the most last week, as outflows were recorded on that part of the curve. Mid-term and short-end funds both recorded inflows." - source Bank of America Merrill Lynch

Are we seeing the start of a risk-reduction trend in high beta namely high yield in favor of quality, namely investment grade thanks to the support of foreign flows following the end of the Japanese fiscal year with investors returning to US shores on an unhedged currency risk basis? We wonder.

It would be hard not to take into account the change in the narrative given the Fed is clearly becoming less supportive, though we would expect Mario Draghi to remain on the accommodative side until the end of his tenure at the head of the ECB. While clearly credit markets investors have recently practiced a "Seventh-inning stretch" as we pointed out last week, we do not think the credit cycle will be decisively turning in 2018 given financial conditions remain overall still very loose.

But, no doubt that the credit game is running towards the last inning with leverage above average and credit spreads at "expensive" levels particularly in Europe where as of late Economic Surprises have experienced a significant downturn. On the subject of leverage and inflows into credit markets we also read with interest Société Générale's Equity Strategy note entitled "Rising yields and debt complacency spell trouble for equity markets" from the 23rd of April:

"Leverage is high as spreads have narrowed substantially

Both in Europe and in the US we observe that leverage levels are above their respective historical averages. While on a net debt to EBITDA ratio, US companies (1.6x) appear less leveraged than European companies (2.0x), both regions are at levels only seen during the worst of the TMT bubble (2001-03), or the financial crisis (2008-09). Indeed, it seems as though companies have tried to take advantage of the low yield environment by leveraging their balance sheets (Apple is good example of this). However, while the balance sheet of an IT company is not significantly at risk from higher bond yields (cash rich), some other segments of the market may be more at risk.

Since 2009, the corporate bond market has benefited from massive inflows. Despite the change of volatility regime and releveraging of corporate balance sheets, credit spreads are still ultra low. SG credit strategists expect more challenging conditions for the credit market in the second half of the year, with the end of the EU’s Corporate Sector Purchase Programme (CSPP) and rising government yields.

Mutual Fund Watch - exceptional outflows from credit

The latest outflows from European credit funds are exceptional in the sense that they mark a clear break from previous trends. This is easily observed in the charts below: the four-week trailing series are well below zero (overall net outflows over the last four weeks) and have crossed the lower band of two standard deviations below the long-term average. That is exceptional, especially given that we find the same picture in the US.

The outflows from European credit funds follow a similar pattern to that seen in the US. The four-week trailing series for the US have also fallen below zero (overall net outflows over the last four weeks) and have crossed the lower band of two standard deviations below the long-term average. In the case of investment grade (IG) credit funds in the US and Europe, the turnaround comes after a prolonged period of strong cumulative net inflows. The series therefore appears to be peaking at very high levels.

- source Société Générale

As we discussed on many occasions on this very blog, when it comes to US credit markets foreign flows matter, particularly flows coming from Japan. During the hiking period of the Fed in 2004-2006, Japanese Lifers and other investors gave up FX risk and took one more credit risks. Given the start of the new fiscal year in Japan, it is paramount to find out their intentions in relation to their foreign bond appetite. On this particular point we read another Bank of America Merrill Lynch note from their Credit Market Strategies series from the 27th of April entitled "Drinking from the firehose":

"Unhedged foreign bonds for life

Every six months Japanese life insurance companies update on their investment plans for the half of their fiscal years that just started. Hence we have now heard plans for the fiscal first half that began April 1st (Figure 10).

The color is very much consistent with last year and our discussion above – to reduce yen holdings in favor of foreign holdings and alternative investments (see our most recent updates: Foreign bonds for life 26 April 2017, Lifers on the hedge 24 October 2017).
Increasingly Japanese lifers plan to directly reduce currency-hedged foreign holdings, explicitly due to the rising cost, which should lead to more selling of shorter-maturity US corporate bonds (than have rolled down). That translates into increasing currency-unhedged holdings of foreign assets, which means an up-in-quality shift in Japanese

Reaching for investors

The recent spike in interest rates to 3% on the 10-year is the bond market reaching for investors (Figure 11).

While we have no real-time information on domestic insurance and pension buying – which we expect is increasing - we have detected a significant acceleration in foreign buying the past seven business days (Figure 12).

On April 17th our measure of foreign buying was down 59% year-to-date compared with the same period last year - but by now the decline is just 46%. In fact foreign buying over the past seven days is the strongest we have seen since February last year (Figure 13).

Of course, since a lot of this foreign money is likely currency unhedged (see: Unhedged foreign bonds for life 23 April 2018), which comes from a smaller budget, there is a limit to how long this pace can persist. However, increased yield-sensitive buying gives hope that the market is going to be better able to absorb the big seasonal increase in supply volumes we expect in May. This especially if inflows to bond funds/ETfs do not continue to deteriorate (Figure 14).

Defensive flows

US high grade fund and ETF flows weakened for risk assets such as stocks, high yield and EM bonds this past week ending on April 25. On the other hand inflows increased for safer asset classes such as high grade and government bonds. The overall impact on overall fixed income was a decline in inflows to $3.12bn from $4.36bn. For stocks flows turned negative with a $2.43bn outflow following two weeks of inflows, including a $6.23bn inflow in the prior week (Figure 15).

Inflows to high grade increased to $3.33bn from $0.86bn the week before. Inflows increased across the maturity curve, rising to $1.16bn from $0.26bn for short-term high grade and to $2.17bn from $0.60bn outside of short-term. Most of the increase was from ETFs that tend to be dominated by institutional investors. ETF inflows rose to $2.48bn from $0.38bn. Inflows to funds increased more modestly, rising to $0.85bn from $0.47bn (Figure 16).

Inflows to government bond funds were higher as well, coming in at $1.66bn this past week, up from a $0.85bn inflow in the prior week. High yield, on the other hand, had the largest outflow since February of $1.60bn, compared to a $2.67bn inflow the week before. Similarly inflows to leveraged loans weakened, decelerating to $0.16bn from $0.49bn, while global EM bond flows turned negative with a $0.72bn outflow following a $0.61bn inflow a week earlier. The net flow for munis was flat, up from a $0.68bn outflow in the prior week. Finally, money market funds had a $3.16bn inflow this past week after a $31.57bn outflow a week earlier." - source Bank of America Merrill Lynch

If the trend is "your friend" then it seems that it is becoming more defensive in credit markets, with rising dispersion on the back of investors becoming more discerning when it comes to their credit risk exposure. We might have seen a "Seventh-inning" stretch, but when it comes to earnings for Investment Grade credit, the results so far have pointed towards a notable acceleration in earnings growth, supported as well by a weaker US dollar benefiting the global players. 

The big question on our mind in continuation to what we posited last week is relating to the might overstretched short positioning in US 10year notes. We indicated in our previous musing "The Golden Rule" the following when it comes to our MDGA (Make Duration Great Again) stance:

"We don't think yet with have reached the "trigger point" making us bold enough to dip our investing toes into the long end of the US yield curve particularly as we are getting closer to the 3% level on the 10y Treasury yield" - source Macronomics, 22nd of April 2018

We continue to watch this space very closely, given the short-end of the US yield curve is becoming more and more enticing with the return of "Cash" being again an asset in a more volatile environment, we continue that the Fed's control of the long end is more difficult to ascertain. The most important question that will be coming in the next quarters as the Fed continues its hiking path will be about substituting credit risk for interest risk. Bank of America Merrill Lynch in their High Yield Strategy note from the 27th of April entitled "When Rates Arrive, Credit Risk Leaves":

"This week marks the second time in this credit cycle that the 10yr Treasury yield has touched on 3%. The previous instance was in Dec 2013, when the benchmark peaked at 3.02%, before turning the other way and rallying all the way to 1.36% by mid-2016. We continue to believe that the 10yr yield struggles to go higher from these levels and remain willing holders of some incremental duration risk.

One of the arguments around rates here with the 10/2yr yield curve at 50bps is that historically the Federal Reserve has refrained from intentionally inverting yield curve into deeply negative territory. We can observe such a behavior in Figure 1 on the left, where we plot the fed funds rate against the 10yr Trsy yield, or Figure 2 on the right where the former is plotted against the 10/2yr yield curve itself.

Regardless of the angle we take, the picture appears to be convincing in that over the past three policy tightening cycles, the Fed tried hiking once, or at most twice into a flat yield curve, and then it would cease further action. We think it is both natural and reasonable to expect this behavior to be repeated in the current policy tightening episode.

And if that is the line the Fed is unlikely to cross then our distance to that line could be only 3-4 hikes away from here, with the benefit of doubt that the curve does not flatten basis point for basis point of each hike. In this case, the Fed’s own longer-term median dot projection, at 2.75% or 4 hikes from here, may be closer to reality than it gets credit from consensus, which prices in 5-6 hikes.

A different aspect of the question on positioning between credit vs interest rate risk could be gleaned from Figure 3 and Figure 4 below.

These two graphs help us contrast the opposite extremes on the risk spectrum: the one on the left plots proportion of total BB yield contributed by its rates component, while the one on the right shows proportion of CCCs OAS coming from distressed credits. The two datasets are naturally inversely correlated (r = -30%), although they measure non-overlapping parts of the credit space.

Extreme observations on these graphs help us calibrate our risk allocation scale between heavily weighting rate duration risk or credit risk. Naturally, there is rarely a choice that includes both simultaneously, except for valuation deviations in smaller market segments. In the grand scheme of things, investors are mostly facing a choice of one over another.

So for example, between 2009 and 2016, rates represented only a modest part of overall BB yield, suggesting that their proportion could increase through either rising rates into stable spreads or tightening spreads into stable rates. In either case investors would be better off by overweighting credit over interest rate risk exposures.

Figure 4 further provides an additional layer of precision by highlighting extreme peaks of distressed contributions to CCCs spreads, which occurred in early 2009, late 2011, and early 2016. In all three cases, of course, an overweight in credit risk was the optimal strategy.

The opposite was true in early 2007 or late 2000, when both lines were at the other end of their historical range (i.e. an outsized contribution from rates to BB yields and modest contribution from distressed to CCC spreads). With the benefit of hindsight, both extremes provided clear signals to overweight the rate over credit risk.

Even when the lines were not at their extremes, in early 2011 or late 2014, they were leaning on the side of being long rates over credit. In other words, when rate risk dominates the picture, credit risk tends to fall into obscurity. Our preference is to lean against such consensus views, all else being equal, i.e. we would be inclined to take on relatively more risk that is on everyone’s mind, and take less risk that is out of scope and thus probably underpriced.

Today, both lines are tilted on the same side of distribution, i.e. rates contribute relatively more than their historical average and distressed contributes relatively little. While levels are far from supporting any extreme positioning tilts, they do point towards modest overweight in rates over credit risk. Our preference for excess returns in BBs with some element of total return exposure fits this description well. We continue to maintain a market weight in CCCs, although we are watching the deterioration in our default rate estimates closely. Any further increases in expected defaults could lead us to take a more defensive view on lower quality." - source Bank of America Merrill Lynch

Sure by all means, massive increase of US government supply represents a serious headache for a bold contrarian investor, yet we do think that we are getting very closer to the points where the US long end of the curve will start to be enticing from a carry and roll-down perspective, particularly when inflation expectations are surging and negative real US GDP growth might provide support the dreaded "stagflation" word. In our book, flat or inverted yield curves never last for a very long time, and often appear near the peaks of economic cycles. Sure we are marking a pause similar to a "Seventh-inning stretch" but, this is the direction the Fed is clearly taking. In this Fed hiking context, rising interest rates has favored a Barbell strategy because reinvestments are implemented at regular times, which allowed you to benefit from higher rates. Once the yield curve is almost flat, the Barbell strategy will become meaningless and the time will come to reconsider your asset allocation policy and to lean toward the median part of the yield curve (belly). As discussed in our conversation "Rician fading" from December the question is whether we are in a in a bull flattening case or in a bear flattening case: 

• In a Bull Flattener case, the shape of the yield curve flattens as a result of long term interest rates falling faster than short term interest rates.  This can happen when there is a flight to safety trade and/or a lowering of inflation expectations.  It is called a bull flattener because this change in the yield curve often precedes the Fed lowering short term interest rates, which is bullish for both the economy and the stock market.
• In a Bear Flattener case short term interest rates are rising faster than long term interest rates.  It is called a bear flattener because this change in the yield curve often precedes the Fed raising short term interest rates, which is  generally seen as bearish for both the economy and the stock market

In the case of bear flattening, Japanese lifers tend to gravitate towards foreign bond investment. Bull flattening encourages Japanese lifers to move away from foreign bonds and they are left with no choice but to park their money in yen bonds. To that extent, we think that the ongoing "Bear Flattener" is still supportive of US credit, but most likely towards quality, being Investment Grade that is. During the bear flattening in 2013-14 (as the taper tantrum subsided), Japanese lifers accelerated their UST investment. This could certainly push us in short order to put back our MDGA hat on and dip our toes into the US long end part of the curve but we ramble again...

Given ongoing volatility brewing in the US yield curve and the dreaded 3% level touched by the US 10 year Treasury Notes, the world is turning towards alternative “safe havens”…instruments that act as a store of value in volatile times, instruments that can be used as collateral to raise funding and post margin in derivatives transactions and instruments that lubricate the financial system. For years, the US Treasury bond has been seen as the safe haven - a high-quality asset that rally in times of market stress and offer diversification for investors’ risky portfolios. Obviously 2018 has shown growing pressure on the "safe haven status" coming from the Fed's balance sheet reduction, higher US Libor rates and the jump in the US budget deficit. The supply of Treasuries that the private sector will need to digest will be much greater than during the Fed’s QE mania. Could Japanese investors come to again to the rescue given they sold a record amount of U.S. dollar bonds in February as the soaring cost of currency-hedging undercut yields? We wonder as it seems their appetite seems to be more credit related eg non-government bonds related. For now cash in the US seems to have been emerging as a safe haven according to Bank of America Merrill Lynch European Credit Strategist note from the 26th of April entitled "What is the safest asset of them all?":

"Cash as an emerging asset class in the USRalf Preusser, our global rates strategist, makes an excellent point, namely that the typical haven characteristic of Treasury debt is being hindered by the appealing rates of return on cash in the US. As Ralf points out, historically during periods of market turbulence, money would flow from risky assets (such as stocks) into US Treasury bonds. But with $ Libor at 2.36%, support for Treasury debt is diminishing (consider that 5yr Treasury yields are 2.84%). In other words, the rise of “cash” as an asset class is altering the traditional allocation decisions of multi-asset investors in times of market stress.

Chart 5 highlights this point. We show the rolling 1yr correlation between total returns on 10yr Treasury bonds and the total returns on the Dow Jones stock index (daily returns). We overlay this with the evolution of 3m $LIBOR.

As can be seen, a decade ago the correlation between Treasury bond returns and stock returns was significantly negative (-60%). Treasuries performed their function as a place of safe harbor, and a store of value, around the time of the Global Financial Crisis. But since then the negative correlation has dwindled and is now just -28%.

Moreover, the chart shows that the changes in Treasury/stock correlation have closely followed the evolution of 3m $LIBOR, as Ralf has pointed out. Higher LIBOR rates have coincided with weaker Treasury/stock correlations. In other words, “cash” has started to become an attractive place to park money in times of market stress, and especially so since mid ’17 – when $LIBOR began to rise more vigorously.

In addition, Chart 8 above shows that the rolling 1y beta between Treasury bond returns and stock returns has also declined since the start of 2017, highlighting the reduced sensitivity of US rates to fluctuations in the stock market.

The competition from “cash”, therefore, seems to be challenging the traditional safe harbor characteristics of US Treasuries." - source Bank of America Merrill Lynch

Or put it simply when the king of the last decades, balanced funds are becoming "unbalanced" thanks to rising positive correlations we have been discussing many times. As we move towards the second part of 2018, it seems to us that clearly any tactical rally/relief should entice an investor in reducing his beta exposure and adopt overall a gradual more defensive stance credit wise. Safe havens it seems, and even the US dollar have so far been more elusive in 2018 apart from the "barbaric relic" aka gold's performance during the first quarter of this year.  Talking of "safe havens" as per our final chart below, even the defensive nature of the Swiss currency CHF has become questionable.

• Final chart -  More and more holes in the safe haven status of the CHF cheese

Given the aggressive nature of central banking interventions in recent years, the SNB has also shown in its nature by becoming somewhat a very large hedge fund, particularly in the light of its large equities portfolio. It is therefore not really a surprise given the aggressive stance of the SNB to expect further intervention on its currency, preventing in effect its safe haven magnet status of the past. Our final chart comes from another Bank of America Merrill Lynch report World at a Glance entitled "After 3%" and displays how the CHF have lost its safe haven allure:

"CHF is certainly finding no friends at the SNB and during this latest bout of weakness, board members have shown little appetite to prevent further losses. Indeed, at the time of writing, SNB President Jordan has stated that a move above 1.20 in EUR/CHF “goes in the right direction”. The SNB’s motivations are clear – they still see CHF as highly valued and in our view want to see EUR/CHF trade meaningfully and sustainably above 1.20 before changing their characterization of the currency. Against the backdrop of the protectionism and trade wars, “vigilant” and “fragile” have been key buzzwords used by the SNB and they remain concerned that CHF may succumb to safe haven inflows on geopolitical tremors.

We would challenge the SNB assertion that the CHF is a safe haven currency. As the chart below highlights, CHF has meaningfully under-performed the two other major safe haven assets (gold and JPY) over the past 15 months.

We believe the existence of the SNB put will likely prevent sustained CHF appreciation during risk-off periods as the SNB continues to make it clear that it is prepared to use intervention as a tool in order to prevent sustained CHF appreciation." - source Bank of America Merrill Lynch

Whereas we have seem in credit recently a short term bounce, in this "Seventh-inning stretch", we think that gradually one should adopt a more cautious stance in regards to credit markets and be more discerning at the issuer level given rising dispersion. The change of narrative also means that "cash" in the US is back in the asset allocation toolbox after years of financial repression thanks to QE, ZIRP and NIRP. It remains to be seen if 2020 will mark the 9th inning or if it will be early 2019, as far as we are concerned, the jury is still out there.

"Switzerland is a country where very few things begin, but many things end." - F. Scott Fitzgerald

Stay tuned!

Macro and Credit - The Vasa ship

"In the ocean of baseness, the deeper we get, the easier the sinking." - James Russell Lowell, American poet.

When in Paris on the 5th of January to present our winning Saxo Bank community from their latest Outrageous Predictions for 2016 to their French clients, we had a very interesting meeting with Steen Jakobsen, their chief economist, who at the time, suggested we look into the Vasa ship as an interesting analogy for a post title. This time around curiosity did not kill the cat, and we waited, we must confess, for the right time to use this very interesting analogy in our musings. Given the on-going onslaught in risk asset classes (except for our comforting long US bonds, long gold miners and other positions) and also because, as always, credit leads equities (this means to lower levels that is), we decided it was the right time to use Steen's suggestion in this Macro and Credit related musing of ours.

So why the Vasa ship for our chosen title?

The Vasa ship was a Swedish warship built between 1626 and 1628 on the orders of the King of Sweden Gustavus Adolphus as part of the military expansion he initiated in a war with Poland-Lithuania (1621–1629). The ship is famous for having foundered and sank after sailing only about 1,300 m (1,400 yd) into her maiden voyage on 10 August 1628. Richly decorated as a symbol of the king's ambitions for Sweden and himself, upon completion the Vasa ship was one of the most powerfully armed vessels in the world (like the Bank of Japan). However, it had a massive design flaw. Vasa was dangerously unstable and top-heavy with too much weight in the upper structure of the hull (total amount of debt in the world). Despite this lack of stability she was ordered to sea and foundered only a few minutes after encountering a wind stronger than a breeze. In similar fashion, Bank of Japan's attempt in playing the Negative Interest Rate Policy game (NIRP) card sounds to us eerily familiar with the tragic fate of the Vasa ship. Kuroda's attempt foundered straight from inception with the Japanese Yen rising to 114 and the Nikkei rout continuing seeing the Nikkei lose another 2.31% on the 10th of February to 15,713.39.

The fatal order to sail was the result of a combination of factors. One being the king's impatience in seeing the Vasa ship becomes its flagship of the reserve squadron at Älvsnabben in the Stockholm Archipelago. The other was the king's subordinates lack of political courage to openly discuss the ship's structural problems or to have the maiden voyage postponed. Although an inquiry was organized by the Swedish Privy Council to find those responsible for the disaster, but in the end no one was punished for the fiasco. In similar fashion we think the central bankers at the Bank of Japan, the Fed, the SNB, the ECB responsible for the mess we are in will not be punished for the upcoming fiasco but we ramble again...

In this week's conversation we will look again at the dangerous evolution we are seeing from idiosyncratic "sucker punches" towards "systemic" risk. We will also look at why in similar fashion to the Vasa ship, new monetary policies such as NIRP will fail because of dangerously unstable markets and their top-heavy load (global world debt).

Synopsis:

• Central bankers' tricks are losing their "magic"
• Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"
• Final chart - Don't catch falling knives

• Central bankers' tricks are losing their "magic"

As we pointed out recently in our conversation "Under pressure", our Generous Gamblers aka our central bankers are losing their magic we think:

"Additional easing monetary policies, but as shown recently in the various iterations of QE in the US, the Fed is getting "less bang for the buck". Basically the "magic" of our "Generous gamblers" is losing its power on driving asset prices to new heights. "Overmedication" could in fact lead in the end to "overdoses", we think." - source Macronomics, January 2016

 We also added:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.
The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. 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, January 2016

It was bound to happen as per the Vasa ship (positive correlations leading to instability). From the inception of "unorthodox" monetary policies, the biggest issue which has yet to be addressed as brilliantly pointed out by William R. White, the chairman of the Economic and Development Review Committee (EDRC) at the OECD in Paris in a Bloomberg interview in similar fashion to the Vasa ship which was dangerously unstable because of too much weight in the upper structure of the hull, is the total amount of debt in the world.

In the light of Mr. William White's great interview we would like to rehash the quotes we have used in our March 2012 conversation "Shipping is a leading deflationary indicator"particularly in the lights of the very concerning comments made by AP Moller-Maersk's CEO on the current state of affairs of his company, seeing a situation worse than 2008:

"He who rejects change is the architect of decay. The only human institution which rejects progress is the cemetery."
Harold Wilson
"He who rejects restructuring is the architect of default." - Macronomics.

This is why Mr White's comments are so to the point. The longer you delay the restructuring, the lower will be the recovery value.

But, when it comes to central bankers losing their magic, the latest "results" in the markets from the Bank of Japan's implementation of NIRP speak for themselves. This is does not come as a surprise whatsoever. It was bound to happen and it is clearly pointed out by Bank of America Merrill Lynch in their FX Vol Trader note from the 10th of February entitled "Central Banks puts expire":

"Key takeaways

• As confidence in central bank puts erode, market participants are adjusting by paying for their own protection.
• Hedge demand has pushed vols indiscriminately higher. We view this as excessive and prefer to fade the move.

Markets adjusting to less stimulus

The painful adjustments taking place across global financial markets can partially be attributed to the re-pricing of central bank expectations. With Fed QE quickly becoming a distant memory and both the ECB and BOJ failing to deliver expansion packages, the market has been forced to learn to stand on its own two feet. As implicit central bank puts expire, the market must now pay for protection out of pocket, reflected in the structural shift in long-dated EURUSD and USDJPY risk reversals, which have both turned for USD puts (Chart 1). 

Like most forms of insurance, by the time the accident is being assessed, further coverage will be expensive. The demand for options has pushed FX vols towards the highs of the past couple of years. In our view, the indiscriminate demand for vol across all currencies and tenors is excessive and we prefer to fade the move." - 

Markets anxious, buying vol indiscriminately

Concerns about the health of the US economy and the European banking sector wreaked havoc on global markets this week. The broad anxiety is reflected in the indiscriminate vol purchases across currencies and tenors (Page 5, Table 3).

Gamma in general is performing, but our core view has been that barring some sort of crisis, it will be difficult to sustain volatility without a core divergence story." - source Bank of America Merrill Lynch

Also, as we posited in back in November 2014 in our conversation "Chekhov's gun", the changes in the communication of monetary policy have indeed taken a turn for the worse. This was clearly demonstrated by the SNB in 2015 and the surprise NIRP implementation by the Bank of Japan:

"What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:

"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members.

Kuroda abandons forward guidance

It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time.Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants.But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ’s toolkit.When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making “steady progress” towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed

The BOJ governor’s decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market—including forward guidance—is essential when winding down such a policy, as the IMF has repeatedly warned.There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharplyhigher.The Fed’s intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation.In summary, the BOJ’s shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed." - source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured." - source Macronomics, November 2014

Exactly! The Bank of Japan has painted itself in a corner (and soon the Fed will as well). The shock announcement of NIRP has led to an unexpected outcome and more "sucker punches" delivered in the form of falling Japanese equities and a sudden "risk reversal" on the Japanese yen. Remember, we told you in December in our conversation "Charles law" significant "risk reversal" opportunities would happen in 2016:

"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." - source Macronomics, 15th of December 2015

When it comes to the latest "sucker punch" delivered to the Japanese yen courtesy of Kuroda's NIRP, we read with interest Richard Koo, chief economist at the Nomura Research Institute in his latest note from the 2nd of February:

"Negative interest rates an act of desperation driven by failure of past accommodation

In my view, however, the adoption of negative interest rates is an act of desperation born out of despair over the inability of quantitative easing and inflation targeting to produce the desired results. That monetary policy has come this far is a clear indication that both ECB President Mario Draghi and BOJ Governor Haruhiko Kuroda have fundamentally misunderstood the ongoing recession.
To begin with, despite the all-out efforts of central banks in Japan, the US, the UK and Europe, neither quantitative easing nor inflation targeting were able to achieve their initial objectives.
The BOJ has now pushed back the date when it expects to achieve its inflation target from “around the second half of fiscal 2016” to “around the first half of fiscal 2017,” which would be fully four years into the Kuroda/Iwata era.

Failure of monetary easing symbolizes crisis in macroeconomics

This failure clearly demonstrates that the Japanese economy envisioned by Mr. Kuroda and Mr. Iwata at the time of their appointments when they pledged to step down if they failed to achieve 2% inflation in two years was very different from the reality. In short, their models were wrong.
The same mistake has been made repeatedly in the US, the UK and Europe. In each case the monetary authorities undertook extreme quantitative easing measures in an attempt to achieve inflation targets, yet price growth continues to run far below the target levels.

In view of the fact that some of the most talented, well-educated economists in these countries are working for these central banks, it is hard not to conclude that this global policy failure is less a reflection on the abilities of Mr. Kuroda and Mr. Draghi than a signal of a crisis in the discipline of macroeconomics itself.

Conditions in today’s real economy do not conform to macroeconomic assumptions

The definitive difference between the economics that they (and we) studied as university students and the actual economic experience of the US and Europe since 2008 and Japan since 1990 is that traditional economics assumes the private sector is everywhere and always trying to maximize profit. But today the private sector is trying to clean up its balance sheet by minimizing debt.
In terms of financial markets, traditional economics means there will always be borrowers as long as interest rates are lowered far enough. In today’s world, there are no borrowers no matter how low interest rates are taken.
Traditional economic theory and econometric models assume the private sector is always forward-looking and is always seeking to maximize profit. As such, there will always be someone willing to borrow money to invest as long as real interest rates are low enough. Given that assumption, the focus of economic policy is naturally going to be on the central bank’s monetary policy.
And if we assume that the private sector is always trying to maximize profit, fiscal policy (under which the government borrows money to spend) wastes precious private-sector savings and raises the risk that the private sector—which can use funds more effectively than the government—will not receive all the money it needs. That is the primary reason why fiscal deficits are so unpopular.

Traditional economics never envisioned a debt-minimizing private sector

The private sector will always seek to minimize debt after the collapse of a debt-financed bubble. Yet traditional economics not only did not foresee this kind of situation, but does not even have a term to describe it.
Traditional economics did not envision the sort of world we have been living in since 2008 because such conditions were never observed in western economies between the 1940s, when the discipline of macroeconomics as born, and 2008.
Until 2008, in other words, there were always willing private-sector borrowers in the US and Europe who responded to changes in interest rates. In such a world, monetary policy is effective and fiscal stimulus generally frowned upon since it has the potential to crowd out private investment.

Interest rates no longer relevant once people start minimizing debt

But after a debt-financed bubble collapses, the debt remains while asset prices fall, leaving many borrowers technically insolvent or at least struggling.
This is a frightening situation for a company to be in, inasmuch as its banks can shut it down at any moment. After all, banks are not allowed to roll-over loans to bankrupt borrowers, and all financing, including trade credits could disappear once the creditors and suppliers realize the true state of the borrower’s balance sheet. For a household, too, it is a dangerous state of affairs in which assets that had been set aside for emergencies or retirement suddenly disappear. The overriding priority for these businesses and households, therefore, is getting out of this situation as quickly as possible.
Emerging from this debt overhang requires businesses and households alike to focus on saving more and paying down debt. Whether interest rates are zero or even negative, people will continue minimizing debt until they have dug themselves out of the hole. The probability of their behavior changing because of a shift in interest rates is negligible.
When this state happens throughout the private sector, not only do private-sector borrowers disappear, but the private sector in aggregate may begin saving instead of borrowing.

Central bank cannot control inflation during a balance sheet recession

Once the private sector begins saving (and paying down debt) in aggregate, the money multiplier turns negative at the margin. The money supply—the money available for the private sector to use—not only does not increase but can actually decrease, regardless of how much base money the central bank supplies.
When the balance-sheet-constrained private sector chooses to minimize debt in spite of zero interest rates, the liquidity supplied by the central bank cannot come out of financial institutions and enter into the real economy due to lack of borrowers. I have dubbed this state of affairs a balance sheet recession, a term that is now heard quite frequently. Unfortunately, the vast majority of people—including Mr. Kuroda and Mr. Iwata—remain unaware of this economic malaise.
Those who do not recognize that balance sheet problems are keeping potential borrowers from borrowing believe the recession is attributable to insufficient monetary easing by the central bank. That leads them to espouse policies such as quantitative easing and negative interest rates. But no matter how far these policies are pursued, there is no reason why the economy should recover until the private sector overcomes its balance sheet problems and turns forward-looking again.
Professor Paul Krugman, who was the first to recommend that this state of affairs be addressed with inflation targeting and quantitative easing, has proposed that a 4% target should be adopted if a 2% target does not work. But the current situation is not one that can be addressed with such trivial adjustments. Interestingly, even Professor Krugman has come to admit that non-conventional monetary easing adopted up to now were “not a game changing tool.” (“Krugman: ‘Meh’ is grade Fed gets on QE,” published on Nov 9, 2015 on Market Watch.)

The theory that inflation is a monetary phenomenon that can be controlled by the central bank, since the central bank controls the supply of money, is valid in a world in which there is an ample supply of private-sector borrowers. But it is mere nonsense in the post-bubble-collapse world of a balance sheet recession, where this condition is not satisfied.
Gulf between real world and economy as envisioned by economists continues to widen
In that sense, the economies of Japan, the US, the UK and Europe now fall completely outside the realm of traditional economics, yet the vast majority of policymakers and economic agents continue to operate as though this were not the case, and the textbook world envisioned by economists still existed. This misunderstanding has complicated the situation greatly.
In other words, the equity and forex markets have responded directly to central banks’ negative interest rates and quantitative easing, but businesses and households in these countries refused until quite recently to borrow any money at all. The implication is that the exchange rates and share prices set by these markets are on very shaky ground.
As noted in the last issue of this report, forex traders over the past seven years have orchestrated heavy sell-offs of the currencies of countries announcing quantitative easing programs based on the assumption that the money supply in those countries would increase far more than the money supply of non-QE nations. But in reality, the money supply in all countries has been essentially stagnant as businesses and households continue to pay down debt.
In the same way, stock prices have appreciated each time further monetary easing measures have been announced, based on the assumption that those measures would increase the money supply and lift the economy. But the money supply has not grown meaningfully in any of these countries.
Although the forex and equity markets responded sharply to the BOJ’s negative interest rate announcement, the changes in the real economy that would justify such moves and nowhere to be seen. At some point, therefore, I would not be surprised to see a reaction in the forex and equity markets that helped to fill the gap between expectations and the real economy" - source Richard Koo, Nomura Research Institute

In similar fashion to the ill-fated design of the Vasa ship, the Bank of Japan has induced much more volatility in an already fragile situation. The best illustration of an economy "rebooting" after a total collapse of its financial sector remains Iceland we think. The pill was hard to swallow but in the end both inflation (2.10% as of January) and unemployment have been tamed (from 9.20% in May of 2010 to a low of 2.30% in December 2015):
.

- source TradingEconomics.com

The major issue that seems to lack the attention of our "Generous Gamblers", is that you have to choose your battle wisely. They cannot ignite inflation and reduce unemployment at the same time without an increase in wages and this would mean that corporate earnings would have to revert to the mean. Unfortunately CEOs seems to care these days more about their own bottom line rather through buybacks in order to trigger their alluring stock options. As we posited in the "Pigou effect" last year real wage growth is the Fed's greatest headache. We quoted Sir Jimmy Goldsmith at the time from the lengthy but great thoughtful reply called "The Response" (link provided) to the critics of his great his book "The Trap" which was eerily prescient:

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " - Sir Jimmy Goldsmith

And lowering the standard of living of one's own nation has indeed been the results of the repeated foolhardiness of the Fed and its zealous "put".

Real wage growth is the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

Of course, as underlined by William White in his stunning interview, another solution to make the marginal-utility-of-debt going positive would be to restructure private debts (Iceland) so that the ailing US households (14.24% of the population receiving Food Stamps) could indeed save more, invest and consume again, which is in essence the purpose of good allocation of debt to the real economy. Not into inane speculative endeavors which have been extensively encouraged by the various iterations of QEs and their inefficient "Wealth Effect" to the "real economy".


When it comes to understanding credit and the buildup in a liquidity crisis (which we reminded you a couple of days back that it always leads to a financial crisis) we would like to use again a previous extract from our conversation "Pigou effect"from Sir Jimmy Goldsmith in his work "The Response":

"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.

But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.
Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent." - Sir Jimmy Goldsmith - "The Response"

Since 2008, the losses have not gone away, as we reminded you as well, European banks even with LTROs and QEs Nonperforming Loans (NPLs) have not gone away and there is still around €1 trillion of NPLs sitting on their balance sheets....

If you think NPLs are going to go away when we have mounting signs of headwinds for European growth with December Industrial Production coming at -1.6%  (+0.2% expected) for France, Italy -0.7% (+0.3% expected) and even the UK -1.1% (-0.1% expected), then think again.

In the current environment where we are seeing financial conditions tightening rapidly across the world as pointed out recently by the BIS for Emerging Markets and by the latest Fed US Senior Loan Officer Quarterly Survey, it means lack of credit will slow growth and therefore will not help out whatsoever the reduction of these NPLs. Furthermore, the stupidity is compounded by NIRP because banks cannot be profitable with a massive reduction in Net Interest Margins (NIM). That simple. So please, spare us the "value beta play" mantra because so many are trading under book value (most of the time banks balance sheets are such a black box, that you have a hard time detecting you what's being hidden). We are not buying it.

This brings us to our second point related to credit given our "2007" feeling. Credit is always leading equities and what we have been commenting  throughout our musings as we watched the credit cycle unfold, is in effect happening and it's we think it is still a cause for concern as the contagion is in effect spreading.

• Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"

What we have been indicating during last summer were the many signs of the credit cycle maturing. The record wave of M&A in 2015 coincides clearly with the late stage of the cycle. This has been clearly illustrated by our friend Cyril Castelli from Rcube (he finally joined the twitter family and you can reach him there: @CyrilRcube):

"The M&A cycle leads the credit cycle. M&A mania =>weaker balance sheets =>tighter bank lending => wider credit spreads"

- source Rcube - @CyrilRcube

When it comes to the potential "overshoot" in US High Yield, our friend Cyril Castelli from Rcube illustrated as well this potential:

"Excess leverage explains the US high yield crash. High Yield always overshoot. It won't be different this time"

- source Rcube - @CyrilRcube 

We agree with our friend and given that initial spreads explain nearly half of 5yr forward returns, and that spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors, given credit investors like suffer from bipolar disorder and are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates, we will still tight until we see much more of an overshoot. Although, it doesn't mean that they are not "opportunistic" short term High Yield / distressed name out there but this necessitate some solid credit analysis in the first place. Relative value arbitrageurs did enjoy outsize returns ever since 2008 precisely because of the “uneconomic” distortions created in markets by central bank liquidity operations. The Barnegat fund, a New Jersey-based hedge which launched after the collapse of LTCM – the world’s most notorious relative value arbitrageur – returned 132.68 per cent in 2009, thanks to “the largest arbitrage ever” – in the US bond market, caused by the Fed’s quantitative easing. But this time around, it looks like the Fed is running low in terms of "ammunitions" particularly at the time where "idiosyncratic" risk is moving towards "systemic" risk.

This brings us to the continuous drift in credit. Not only are seeing a continuation of the flattening of the US yield curve, but credit is also affected given that according to CMA part of S&P Capital IQ, the 1 year CDX HY index is wider month to date by 81 bps and the basis (difference between the index and the single name constituents) is still very high at 79 bps apart:

- source CMA part of S&P Capital IQ

More interestingly, the continuous drift in credit is starting to point towards a more systemic risk environment as pointed out recently by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 8th of February entitled "The tide has turned":

"Connecting the dots

Does the recent weakness resemble the 2008 global financial crisis sell-off or the 2011/12 European crisis one? Are we still in an idiosyncratic risk world, or are recent developments pointing to a more systemic risk environment?
Our analysis shows that: (i) the recent sell-off in bank stocks and senior financials CDS, (ii) the continued weakness in EM/oil names and (iii) the fact that the recent sell-off is not driven by the tail anymore and it is more widespread, points to one conclusion: that the tide is turning. Risks are not idiosyncratic anymore; systemic risk is rising.

Currently the level of our selloff depth indicator - that has been steadily increasing over the past weeks - is the highest since the taper tantrum and is quickly approaching levels seen in 2008/9 and 2011/12.

In chart 1 we present the % of the iTraxx Main portfolio (125 constituents in total) that has moved more than 10bp wider over a 4-week period, while the broader market (average spread of the pool) credit spreads are also heading north.
o The higher the % of the index that contributes to a sell off the more systemic is the nature of the move wider.
o The lower the % of the index that contributes to the market weakness the more the idiosyncratic is the nature of the sell-off.

• Bank stocks are back to levels seen in 2012. The recent sell-off of bank stocks has added more pressure to financials credit spreads. Risks remain to the downside for the sector. Bail-in fears (see underperformance of Italian names over the past couple weeks), the ECB looking at NPLs (an area of focus this year), EM exposed fins still under pressure, Brexit risks looming for the UK names and weak Q4 earnings season (in particular for DB and CS), keep fins CDS better bid. With bank stocks at these levels, iTraxx Senior Fins will remain the key hedging instrument against increasing pressure in high-beta banks paper.

• US non-manufacturing econ data - even though still on expansionary levels -are deteriorating at the fast pace since 2008/9 period (chart 4).

Additionally, our rates strategy team points that their model shows that the OIS curve (adjusted for the zero-bound effect) is already inverted and therefore may already be pricing a recession

 • Oil prices are back at the $30 area; same as in 2008 (chart 5).

• Equity markets are punishing high risk (vs. low risk) stocks. The underperformance is the highest in years; only slightly away from the 2009 lows (chart 6).

 • The iTraxx Main constituents (5y CDS spreads) distribution exhibits extreme levels of skewness and kurtosis. Both these metrics measure the asymmetry of the portfolio's distribution. High level of skewness and kurtosis are typical characteristics of a fat-tailed distribution that prices high level of idiosyncratic risk.

o The higher (more positive) the skewness the thicker the tail on the wide end.

  o The higher the kurtosis, the thicker the tail and the higher the concentration around the index level, leaving not many names in between.

However, both these metrics have started to move lower over the past couple of weeks.

This clearly indicates a shift in market risks: from predominantly idiosyncratic as in 2008/9 (few wide names underperform, on balance), to more systemic risks as in 2011/12 (a broader widening). Note that financials did not feature even on the 50 widest names back in 2008. However, they dominated the widest names list in 2012.

• Weakness is now a broader issue - it is not the widest names that underperform.

We analyse the performance of single names CDS since the recent tights (early December'15). We find that the names that have underperformed (in %-move terms) are not necessarily coming from the tail. In fact we see a widespread weakness in names across the credit spectrum (chart 9). 

 - source Bank of America Merrill Lynch

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

As we posited in our conversation "Le Chiffre" aka Mario Draghi and given the market's anticipation for the ECB's next moves:

"QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.

Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations". - source Macronomics, October 2015

It seems that at least the European credit Vasa ship's structural flaws come from deeply impaired banks balance sheet bloated by significant NPLs which have yet to be addressed. Italy in particular is a base case as illustrated by Richard Koo earlier in the failings of QE when one looks at the Aggregate retail loan books as displayed in Société Générale November 2015 European Banks note entitled "A wake-up call":

- source Société Générale.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs:

"Italian banks have already started setting up bad debt securitization platforms. Italy’s third biggest bank, Monte dei Paschi di Siena (MPS), sold a €1 billion portfolio of NPLs into a securitization vehicle financed by affiliates of Deutsche Bank in December. The state will now guarantee the senior debt of such operations. It is unlikely ever to have to honour the guarantee, as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans.
The guarantee should attract a much broader array of investors to bonds issued by such vehicles, even if the banks still have to hold onto most of the riskiest tranches. However, the price could put off all but those banks with the highest funding costs.  The state’s fee for the guarantee will be based on CDS of issuers with similar ratings to the SPV tranche. To make sure the banks are not tempted to sit back and forget about the underlying loans, the price will rise over time – initially being based on three-year CDS, then five-year, then seven. As research from Milan-based Banca Akros points out, that’s hardly encouraging, given the time it takes to realise collateral in Italy." - source Euromoney

It looks to us like a nice new Vasa ship in the making...

Before we move on to our traditional final chart, here is another one courtesy of our friend Cyril Castelli from Rcube (from his twitter page: @CyrilRcube) showing that not only is AP Moller-Maersk a leading deflationary indicator but as we discussed in our post "The Cantillon Effects", the use of fine art might is an effective means to measure "bubbles" as art is removed from the capital structure of the economy. The performance of Sotheby’s, the world’s biggest publicly traded auction house has always been a good leading indicator and has led many global market crises by three-to-six months:
"Art & Shipping stocks lead the economic cycle. Recent price action of Sotheby's & Maersk is similar to 2000 & 2008."

- source Rcube - @CyrilRcube

If you think that we are bound for a "strong economic rebound" then you might want to hold off buying AP Moller-Maersk and Sotheby's because as per our final chart shows, it is never great to catch falling knives.

• Final chart - Don't catch falling knives

Whereas we keep hearing about some tremendous values offered by some levels reached by some equities, given the points we have made on credit leading equities and credit moving from "idiosyncratic" risk to more "systemic" risk, we thought we would point out to Société Générale's take on "falling knives" in the below chart from their Global Style Counselling" note from the 9th of February entitled "We love a bargain but should you buy falling knives?":

"Performance of falling knivesWe start our analysis with a simple exercise, where we look at the relative performance of a strategy that buys companies that have seen 1) 20%, 2) 30%, 3) 40% and 4) 50% declines from their 12-month peak. As our portfolios might only include a handful of companies in some periods, we only take into account periods where we have at least 20 companies, and otherwise we assume a zero return. All portfolios are then rebalanced on a monthly basis, and our universe is based on FTSE World stocks since 1990.

As the chart below shows, despite some periods of strong outperformance (these periods are often referred to as the “dash to trash”), all portfolios eventually underperformed the market.

- source Société Générale 

Then again, you might want to check if indeed your "falling knife" doesn't boast the same structural flaws of the Vasa ship....

"Beware of little lending. A small leak will sink a great European ship." - Martin T. - Macronomics

Us thinking of Italy again...

Stay tuned!