Macro and Credit - When Doves Cry

"Bad logicians have committed more crimes involuntarily than bad men have by design" - Pierre Samuel du Pont de Nemours, French writer, economist, publisher and government official. 

During the French Revolution his two sons and their families immigrated to the United States. His son Éleuthère Irénée du Pont was the founder of E.I. du Pont de Nemours and Company. He was the patriarch and progenitor of one of the United States' most successful and wealthiest business dynasties of the 19th and 20th centuries.

While taking some much needed R&R (Rest and Recovery) far away basking in the sun, and in the process, we attended a few "board meetings" (windsurfing that is...) which explains our recent lack of weekly musings dear readers, not only did we manage to follow the news and Bank of Japan's predicament, which created yet some additional "sucker punches" and VaR nightmares for the short yen crowd and Nikkei holders, but, we also learned about the sudden disappearance of the maverick musician Prince, being for us the ultimate guitar hero hence yet another reference to the "artist" in our title analogy. Our "Prince" song analogy and central bankers reference follows previous analogies: "All that glitters ain't gold" in 2013 as our 2015 post "While My Guitar Gently Weeps". 

On a side note, about Prince being the "ultimate guitar hero" we would like to point towards the year 2004, when George Harrison was inducted posthumously into the Rock and Roll Hall of Fame as a solo artist. "While My Guitar Gently Weeps" was played in tribute by Tom Petty, Jeff Lynne, Steve Winwood, Steve Ferrone, Marc Mann, and Dhani Harrison, and concluding with arguably one of the most  memorable guitar solo by fellow inductee Prince. 

"When Doves Cry" was the lead single from Prince's 1984 album Purple Rain. While listening to this seminal title, we also managed the read a 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" hence our opening du Pont de Nemours quote. In similar fashion to our quote and chosen title, and our reference to the dreaded "assignat", we think our "generous gamblers" aka central bankers are indeed "bad logicians". 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 as illustrated by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 29th of April entitled "Show me the yield":

"Reaching for yield in a negative-yielding world 

Negative yielding assets now represent 23% of the global fixed income market, growing substantially from 13% at the beginning of the year. As commodity prices have stabilised and macro risks have receded - at least for now - risk sentiment has improved. Amid scarcity of yield investors are moving to higher yielding pockets of the FI world. This will be further aggravated in the months to come as credit investors will find less and less paper to buy as the ECB becomes essentially a competitor to them.

The ECB corporate bond QE is a clear win for cash bonds. However, synthetics have been lagging over the past month. This has been the case in parts of the market – highgrade non-banks - that the ECB will start buying in June, but also in places the ECB will not touch – like high-yield. While the high-yield non-fins index is almost 70bp tighter, since the day post the ECB corporate-QE announcement, the Crossover index is less than 10bp tighter." - source Bank of America Merrill Lynch

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: Le marché des changes de Paris à la fin du XVIIIe siècle (1778-1800) -1937 

As far as we are concerned, we continue to enjoy our exposure to gold miners "When Doves Cry". We did warn you well advance of the direction markets would be taking at the end of 2015 and why we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that if there was huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up. Of course, both did in Q1 and will continue to do so in Q2.

In this week's conversation, we would like to point out that thanks to "Doves Crying", given the continuation of NIRP, Investment grade credit in particular appears to us more favorable as an asset class versus equities thanks to the on-going support from Japanese investors.

Synopsis:

• Macro and Credit - Investment Grade Credit or when Haruhiko Kuroda got your back
• Macro and Credit  - The consequences from a flow perspective for credit
• Final chart: When "doves" get a break from the "breakeven"

• Macro and Credit - Investment Grade Credit or when Haruhiko Kuroda got your back

As indicated in early April in our conversation "Paradise Lost", Investment Grade Credit, at least in the US appears to us more appealing from a flow perspective thanks to "flows" and on-going support from Japan's large institutional basis:

"As we move into the second Quarter, not only does Investment Grade appear enticing, but, from an allocation perspective US TIPS still remain particularly attractive. But, moving back to Investment Grade, we do believe that "Paradise" is not "Lost" and if indeed as we pointed out, Mrs Watanabe, Japan's GPIF and its pension friends are looking for yield abroad in a more aggressive fashion then indeed adding duration with less credit risk than High Yield makes sense" - source Macronomics, 5th of April 2016

In fact it seems to us that from a "flow" perspective, the rotation from equities to credit is no doubt a validation of our stance as pointed out by Bank of America Merrill Lynch from their Follow the Flow note from the 29th of April entitled "Outflows accelerate from equity funds":

"More inflows into credit…more outflows from equities 

The ECB corporate QE has been the catalyst for a U-turn on credit flows. The sudden course of action the ECB ignited for credit might have also caused another consequence for flows: with inflation expectations still anchored, equities have seen more outflows.
Flows in credit continued for another week. High grade fund flows, even though they slowed down, remained positive for a seventh week. However, inflows into high yield almost doubled w-o-w.

On the contrary European equity funds have suffered another week of outflows. The asset class recorded its biggest outflow in 80 weeks, losing close to $4.8bn of assets. This was also the 12th consecutive outflow week for the asset class, bringing the YTD cumulative outflows from equity funds to more than $24bn.

Government bond funds recorded a third week of outflows in a row, while money market funds recorded their largest outflow in four weeks. 

Commodity fund flows went back to positive territory after taking a breather last week, supported again by inflows into gold funds. The asset class is currently the best performer, with year to date % of AUM inflow at 15%, far ahead of all other asset classes.

Global EM debt flows reflected the bullish turn of the market on EMs, recording the tenth consecutive week of positive flows.
On the duration front, short-term funds recorded a marginal inflow, keeping a positive sign for the last four weeks. The mid-term IG funds continue to record strong inflows for a ninth week. But it looks like investors have started to embrace duration to reach for yield, as inflows into longer-term funds have recorded a cumulative 0.8% inflow in the past two weeks. " - source Bank of America Merrill Lynch

Whereas 1999, which was as well a Prince's 5th album from Prince, saw record inflows into equity before the 2000 internet bubble burst, it seems to us that this time around, our "crying doves" are instigating an "epic bond bubble". The recent decision by the ECB will no doubt boost the rally into credit in Europe into "overdrive" and as expecting we are already seeing more and more large corporate issuers issuing de facto "zero coupon" thanks to our "Generous Gambler" aka Mario Draghi. 
As we pointed out in our previous missive before going for our R&R, it seems to us that the ECB is failing because it is enticing the money "uphill" namely into "bond speculation" where all "the fun is",  not downhill, to the real economy. Flow wise this exactly what is happening. The "fun" is in the bond market and particularly in the European investment grade market as explained in Bank of America Merrill Lynch previous Follow the Flow note from the 24th of April entitled "Global QE - here we go":

"CSPP: clearer, bigger, broader 

The ECB was bolder than expected. With an eligible pool of assets that seems to be broader than initially thought, the ECB is now in the driving seat. Investors are “front running” the ECB, by buying more credit at the expense of equities. With inflation expectations still pointing to the downside, investors were directed to high-grade paper, while government, money market and equity funds saw outflows.Over the past eight weeks high-grade and high-yield funds have seen combined inflows of $10.6bn vs. more than $17bn of outflows from equity funds. Credit has still has room to go, as the YTD flow number remains in the negative territory as $11bn have left on aggregate from the asset class. The main target of the CSPP – namely investment grade credit – recorded its sixth week of positive flows with a significant volume compared to the previous week.High yield on the other hand saw only modest inflows, the second in a row. We also note that latest EPFR monthly data reveal that investment grade funds had their first monthly inflow in 10 months, and high yield funds their first in 4 months. 

Elsewhere in fixed income, government bond funds recorded another weekly outflow, the second in a row, while monthly flow numbers were also pointing to the downside for March. Money market funds had their first outflow in three weeks.
Equities fund flows were yet again negative, and have been so for the last 11 weeks. The asset class now approaches $20bn of outflows since the start of the year, the biggest among all asset classes we track with EPFR. On a monthly basis, in March equities had their biggest outflow in 17 months and the second in a row. 

 - source Bank of America Merrill Lynch

Whereas the issue with the assignats was that in no way it was capable of facilitating the sale of public lands (us thinking about Greek "privatisation" and the original goal of getting 50 billion euros, now reduced to 15 billion euros) in no way the ECB's recent policy will facilitate the "accumulation of capital", on the contrary, capital will eventually be destroyed. In similar fashion Pierre Samuel du Pont de Nemours explained on the 25th of September 1790 in front of the French National Assembly the mechanisms which enabled shrewd speculators to use devalued assignats to buy "biens nationaux" (collateral being the church's real estate) for next to nothing as written by Florin Aftalion in his book:

"Events were to prove him right, as huge fortunes were amassed by these same means. He also announced that, in the last analysis, the Assembly would be asked for much more than the issue of 1,900 billions that was necessary for the settlement of the exigible debt. In this case too, Dupont was to be proved right" - source Florin Aftalion, "The French Revolution - An Economic Interpretation" 

With NIRP and cheap credit, bond speculation, buybacks and takeovers can operate on a grand scale and generate outsized returns for the "shrewd speculators" on Spanish Real Estate and now on Italian Real Estate. Easy as 1, 2, 3...

Thanks to the ECB's latest and with Bank of Japan sticking with NIRP, Japanese investors are now facing an even bigger competition from the ECB to get hold of foreign bonds. In relation to having Kuroda's backing when it comes to investing in global investment grade, we read with interest Bank of America Merrill Lynch's Credit Market Strategist note from the 29th of April entitled "2bps per month":

"What can Kuroda do for you?

From the perspective of US HG corporate bond investors - probably not much more than presently. Easy BOJ monetary policy benefits the US corporate bond market in two main ways. First, and most importantly by far, through negative interest rates and QE the BOJ has more or less purged the Japanese fixed income market for yield. As result Japanese fixed investors - such as insurance companies and banks - are in a very challenging position where they are forced to buy foreign fixed income instead (Figure 10). 

For example Nikkei in an article on Thursday titled: "Japan insurers flock to foreign bonds as BOJ kills golden geese" estimated that the top-10 Japanese Life Insurance companies alone plan to buy $46.6bn of foreign bonds in the current fiscal year (that began April 1st). This is a big and long lived positive development for US corporate bonds. Second as we saw this week the BOJ affects global risk sentiment, but this effect should be relatively small and short lived. With JGBs trading at negative yields out to 10-years in maturity (Figure 12), and 30-year JGBs at just 33bps (Figure 13), there is very little the BOJ can do to drive even more Japanese investors into the US HG corporate bond market.

Even if the BOJ stepped up their buying of Japanese corporate bonds the impact would be limited, as the size of that market is just 3% of the size of the USD HG corporate bond market - an order of magnitude smaller than the EUR denominated HG market (Figure 11).

Hence, given the limited ability in the first place of the BOJ to provide further tailwind to the US corporate bond market, we expect that the surprising non-action by the BOJ at this week’s meeting will only work through the second channel - market sentiment - a likely small short term negative.Japanese investors being forced out the curve
The more interesting question is what foreign bonds Japanese investors buy. While clearly the US HG corporate bond market is the main game in town, the big rally in US credit spreads over the past two-and-a-half months works to push Japanese investors to take more risk in order to preserve yields. That means either moving out the curve in credit, or dialing down their currency hedges. Within HG this means chiefly longer maturities and also, but likely to a lesser extent given ratings mandates, down in quality.
However, beyond our own asset class we think many large Japanese investors will increasingly be looking at higher yielding asset classes - chiefly structured products for investment grade ratings, but in the case of less ratings constrained money also higher quality HY.
To understand corporate bond math for Japanese investors consider that in order to buy US corporate bonds they need USD funding. One way to get that on a fully currency hedged basis is through a JPY/USD cross-currency basis swap for the life of the bond. However, because funding in USD is relatively scarce that comes at a steep cost. But as that annual premium tends to increase relatively little, or even decrease, with maturity of the contract, and  However, beyond our own asset class we think many large Japanese investors will increasingly be looking at higher yielding asset classes - chiefly structured products for investment grade ratings, but in the case of less ratings constrained money also higher quality HY. To understand corporate bond math for Japanese investors consider that in order to buy US corporate bonds they need USD funding. One way to get that on a fully currency hedged basis is through a JPY/USD cross-currency basis swap for the life of the bond. However, because funding in USD is relatively scarce that comes at a steep cost. But as that annual premium tends to increase relatively little, or even decrease, with maturity of the contract, and because the US corporate spread curve is relatively steep, currency hedging costs as percentage of US corporate spreads declines with maturity (Figure 14). 

On adding the negative basis swap to the US corporate spread curve in Figure 14 we translate USD spreads into currency hedged JPY spreads on a 3-month Libor basis (Figure 15, Figure 16).

We also show in these figures credit spreads in the Japanese corporate bond market on a 3-month JPY Libor basis - because the quoting convention in Japan is on a 6-month Libor basis we add the 3-6 month LIBOR swap for the average four year maturity of the Japanese corporate bond market. Note that, because of the small size of the Japanese corporate bond market - and the lack of long paper - we assume a flat spread curve for simplicity.

Other ways for Japanese investors to reach for yield

Instead of extending out the maturity curve Japanese investors that have ratings flexibility can reach down the credit curve and even into higher quality high yield (Figure 17). In particular BB-rated HY bonds are one of the most effective sectors that offer significant yield-pick-up.

Alternatively, since a significant proportion of Japanese money is ratings constrained we suspect that a lot of investors will instead reach for yield in investment grade rated securitized products.Finally it is increasingly obvious that a lot of Japanese investors are dialing down their currency hedges in order to increase yields. That of course leaves them exposed to some extent to this year’s big appreciation of the yen Japanese, and we would expect that some investors are forced to pull out of US corporate bonds for that reason even as other investors put more money to work.
As our rates strategists discussed (see: Liquid Insight: The Japan flow playbook 04 April 2016), an alternative hedging strategy is to roll three month forward exchange rate contracts - a strategy that does not eliminate all currency risk and thus pays more a fully hedged strategy. The idea is to exchange JPY to USD in the spot foreign exchange market, buy US corporate bonds and at the same time enter a 3-month forward contract to sell USDs back to JPY in three months at a fixed price. While this currency hedges the first three months of the trade, if the Japanese investor wants to keep holding the US corporate bond after that he/she must at the time roll into a new 3-month forward contract – hence there is currency risk. The cost of this strategy is around 130bps annually, and thus a yield of around 3.4% on a 10-year US corporate bond becomes a roughly a 2.1% yield in JPYs using this approach. Figure 18 shows the significant yield advantage offered by such partially currency hedged spread curves over their fully hedged counterparts. 

- source Bank of America Merrill Lynch

Of course as well as in Japan, doves have been crying given that they much vaunted currency depreciation scheme has been put in reverse as of late. But given the mounting evidence of a global slowdown, one would expect the Bank of Japan to return to the QQE game during the second part of this year. Now that the ECB is directly in competition of the likes of Mrs Watanabe, Japanese insurance companies, the GPIF and their pension funds, one would expect that the "fun" uphill, namely bond speculation, continues to run unabated, for the real economy, we are not too sure...

When it comes to credit, we expect some more tightening in the second quarter thanks to "Doves crying", ECB's buying spree and Japan's foreign appetite for risky assets.

•  Macro and Credit  - The consequences from a flow perspective for credit

The consequences are that from a "flow" perspective, we are going to see a continuation of the "Great Rotation", namely from "equities" to "fixed income" until we get another merry go round of QEs. but that's another story. For the time being thanks to the ECB and its global corporate bond buying binge, it is forcing at sword point investors and particularly Japanese investors to switch to overdrive, leading a clear widening gap between equities and bonds as pointed out by Bank of America Merrill Lynch's Credit Market Strategist note entitled "2bps per month" from the 29th of April 2016:

"Mind the gap, redux 

One of the more striking decouplings last year occurred mid-August between spiking credit spreads and declining equity vols, before the equity market finally caught up (see: Situation Room: Mind the gap 13 August 2015). We are now seeing the opposite, as credit spreads are tightening hard in April while equity vol has been relatively constant (Figure 22).  

This time it appears that one of the key reasons for the decoupling is very favorable excess demand conditions in the high grade corporate bond market, as an influx of foreign investors meet less than expected supply. The foreign demand part of the equation is becoming particularly obvious as some of the biggest Japanese investors – including life insurance companies – have recently publicly announced expanded investments in foreign bonds for the new fiscal year that began April 1st." - source Bank of America Merrill Lynch.

Excess demand + weak supply+ Foreign buying from Japan = continuation of credit spreads tightening. A very simple equation, making credit more enticing versus equities for the time being we think from an asset allocation perspective.

When it comes to Japan's life insurance companies, they intend to increase their credit risk exposure compared to 2015 according to Nomura's note entitled "Major Life Insurers FY16 Bond investment" from the 4th of May:

"Comments suggest lifers are looking to credit risk to improve returns 

n comments on bonds other than domestic bonds, Insurer B said, “In addition to ramping up JPY-denominated investments such as infrastructure projects, we will consider buying major banks’ subordinated debt compliant with Basel III.” Insurer C said, “We will slow our purchases of super-long JGBs and buy more credit instruments as we expect yen bond yields to remain low,” and Insurer E said, “We plan to invest in AT1 bonds issued by major banks. These instruments do not have a long history, but have adequate market liquidity. We bought these bonds in FY15. Falling domestic rates mean that the only way we can secure investment returns is to take duration risk or credit risk.” Insurer F noted, “We will not buy JGBs, and will only buy corporate bonds,” while Insurer G said “We plan to limit reinvestment in domestic bonds to a low amount, focusing on domestic bonds with relatively high yields, primarily corporate bonds.” These comments suggest many lifers plan to take credit risk to improve return. 

Lifers are investing in a wider range of options 

Lifers commented on regions (markets) and the types of bonds that they target for investment. According to Insurer A, “We significantly increased balances of both hedged and unhedged bonds in FY15, particularly US bonds, and have not changed our stance in FY16. However, we plan to reduce the weighting of UST investments owing to higher hedging costs, and diversity into euro area bonds. We will invest flexibly based on yields and hedging costs.” Insurer B said, “For currency-hedged foreign bond investments, we plan to buy not only government bonds, but also corporate bonds, diversifying our investments in terms of bond type and maturity.” Insurer C stated, “We plan to invest in a wider range of regions, including peripheral countries in addition to core countries, and will also lengthen the duration of our investments. We will also look to corporate bonds. We aim to improve return by increasing investments in foreign credit assets.”

Insurer E commented, “We will focus on US bonds rather than EU bonds, whose yields are declining, and invest in credit instruments such as USD-denominated notes issued by domestic mega-banks and others.” Insurer F said, “We expect the Fed to raise rates twice in FY16 and currency hedging costs to rise accordingly, so we will invest in corporate and other higher-yielding US bonds. In the euro area, we will invest in peripherals.”
Insurer G noted, “We have primarily invested in USTs and EUR bonds, but we have diversified to include Australian and Mexican bonds, among others. Government bonds made up a high percentage of our foreign bond investments, but we will increase the weighting of credit instruments.” Insurer H stated, “We will continue to buy certain amounts of investment-grade US corporates, in addition to USTs. European bonds, including corporates, will also remain an option.”
Insurer G noted, “We have primarily invested in USTs and EUR bonds, but we have diversified to include Australian and Mexican bonds, among others. Government bonds made up a high percentage of our foreign bond investments, but we will increase the weighting of credit instruments.” Insurer H stated, “We will continue to buy certain amounts of investment-grade US corporates, in addition to USTs. European bonds, including corporates, will also remain an option.”

As bond yields continue to fall globally, lifers will likely look to add investments in a wider range of markets, in our opinion." - source Nomura

Because, Mrs Watanabe, Japanese Life insurers, GPIF and pension funds will continue to shift their portfolio allocation from JGBs into foreign assets and in particular credit, we believe the acceleration of the move will be Japanese yen negative and the current level of USD-JPY below 107, looks enticing we think to re-initiate a short on the Japanese currency. Maybe at some point the Japanese Yen will end up like the dreaded French Revolution "assignat"...

For our final chart below, while we have discussed on numerous occasions the attractiveness of US Tips in the current environment, when it comes to US breakeven levels, it seems to us that the Fed and its "doves crying" have been shedding "crocodile tears" and are indeed getting a welcome respite from US breakevens.

• Final chart: When "doves" get a break from the "breakeven"

As we discussed back in March in our conversation "Unobtainium", we argued that the FOMC was more willing to allow inflation to overshoot, hence our preference at the time for US TIPS and Gold Miners:

" If indeed the slope of the bond yield curve which was negatively correlated to short term rates, is now fully inelastic from a strategy perspective, we believe being long US TIPS (given their embedded deflation floor), long gold miners and long US long bonds still represent a relatively attractive "allocation". - source Macronomics, March 2016

When it comes to our final chart and inflation expectations, we would like to point out towards Bank of America Merrill Lynch's chart from their Securitization Weekly note from the 29th of April 2016 indicating that the 10 year breakeven inflation rate is somewhat validating the "inflation accommodative" stance of the Fed 

"The 10-year breakeven inflation rate seemed to break out to the upside of the downward channel that started with taper talk in mid-2013 (Chart 1).  

We view this as big news, as it seems to be saying that the Fed will tolerate or even wants further gains in inflation expectations. Data dependency says that is subject to change, but for now, we assume that we have transitioned to a new accommodative phase for the Fed. This should be good news for securitized products credit and create upside risk for the near term." - source Bank of America Merrill Lynch

If indeed "breakeven" are "breaking out", this is indeed showing than "when doves cry", it seems their are shedding "crocodile tears" given they'd rather tolerate inflation than deflation.

"There seems to be no limit to which some men will go to avoid the labor of thinking. Thinking is hard work." - Thomas Edison  

Stay tuned!

Chart of the Day - Chinese Iron Ore back to 2010 levels

"But it is possible that, in the days ahead, these years we have lived through may eventually be thought of simply as a period of disturbance and regression." - Hjalmar Branting, Swedish statesman 

Back in May 2012, we argued that Australia at some point could be facing the "Iron Ore" conundrum given its exposure to Iron Ore. Although we had it wrong in relation to our negative stance on the Australian dollar, the Australian dollar has been so far remarquably steady compared to the US dollar - source Bloomberg:

When ones look at the significant drop in Iron Ore inventory at port since 2009 coming back to 2010 levels, one can wonder what can be expected in 2013 for Chinese growth given the recent weakness seen in China's PMI - source Deutsche Bank, Shipping Weekly, 4th of March 2013:

While Chinese iron ore imports were up 21% y/y, they were down 4% m/m after a strong December according to Deutsche Bank:

Yet this recent rally can be challenged according to a recent Bloomberg article from the 7th of March - Iron Ore Surge Prompted by Demand, Speculation, China Says:

"A recent surge in iron ore prices was caused by changes in demand, market speculation and “unreasonable” pricing methods, China’s top planning body said. The biggest mining company said it hadn’t curbed supplies.
Chinese steelmakers re-stocked iron ore during the traditional “winter reserve” period and ramped up purchases as confidence in the economy improved, leading to an explosive increase in demand in the short term, the National Development and Reform Commission said in a statement on its website.

Chinese steelmakers re-stocked iron ore during the traditional “winter reserve” period and ramped up purchases as confidence in the economy improved, leading to an explosive increase in demand in the short term, the National Development and Reform Commission said in a statement on its website.
The three largest mining companies and certain traders either delayed or controlled deliveries to make up for their previous losses, creating a false impression of temporary short supply, according to the NDRC. Some mining companies also bought iron ore from the market to drive up prices, it said. - source Bloomberg

Iron ore exports to China from Australia are indeed a strong indicator of Chinese industrial activity, and given it fell by 14.8% in February from 18.38 million tonnes in January to 15.66 million tonnes in February, one can wonder if the Chinese holiday season or the cyclone disruptions are entirely responsible for the slowdown or if there is more to it given Korea data could indeed herald surprise China exports drop according to Bloomberg:

"South Korea’s biggest export drop in seven months suggests China will surprise the market and also report fewer shipments in February, lessening the case for monetary tightening in the world’s second-biggest economy, according to Nomura Holdings Inc. 
South Korea is the only one of Asia’s 10 biggest economies to report February trade data thus far. Given that China is its biggest export market, Korea’s sales drop signals that its larger neighbor is poised to report weaker-than-expected shipments, said Zhang Zhiwei, Nomura’s chief China economist. The CHART OF THE DAY tracks monthly changes in the two nations’ overseas sales since 2008. South Korea said exports in February declined 8.6 percent from a year earlier, the second drop in three months. Based on that result, Zhang predicts China will announce tomorrow a 10 percent decrease when February figures are released in Beijing. Nomura’s economist is among only six of 33 analysts surveyed by Bloomberg that predict a drop. The median estimate is for an 8.1 percent increase. “The data suggests China’s recovery is not so strong,” Hong Kong-based Zhang said. “We still call for the People’s Bank of China to tighten policies, hike interest rates and regulate shadow banking activities this year. But recent weak macro data will only make the central bank delay it.” 
China this week affirmed its 2013 growth target at 7.5 percent after the economy grew 7.8 percent in 2012, the slowest pace in 13 years. China will report a February trade deficit of $28.5 billion, according to Zhang. That would be the first shortfall in a year and compares with an average monthly surplus of $16 billion in the past three years. Growth rates for exports and imports in the first two months are distorted by changes in the timing of the weeklong Chinese New Year holiday, which fell in February this year and January in 2012. Nomura’s forecasts tie in with the new export orders component of China’s official Purchasing Managers’ Index, reported on March 1, which fell to a six-month low of 47.3 in February. The broader PMI sank to a five-month low of 50.1, according to data from the National Bureau of Statistics and China Federation of Logistics and Purchasing. A reading of 50 marks the divide between expansion and contraction." - source Bloomberg.

Could the recent slowdown and price manipulations for Iron Ore spell trouble as well for neighbor Australia given its dependency to Iron Ore exports? We wonder.

One thing for sure, the recent weakness in Korea's exports courtesy of Japan's agressive monetary stance has put the Japan-Korean risk gap near parity has indicated by Bloomberg:

"The push by Japan, the world’s most-indebted government, to weaken its currency to boost exports and end deflation may reduce its perceived default risk below South Korea’s, where won gains are having the reverse effect. The CHART OF THE DAY tracks the cost of insuring the five- year sovereign bonds of Japan and South Korea since August. Thespread between the two credit-default swaps fell to 1.2 basis points on Feb. 5, the narrowest since Oct. 11, the last time it was more expensive to insure against a Korean default, data compiled by CMA show." - source Bloomberg

Korea losing its competitive edge towards Japan thanks to a weakening Japanese yen could indicate weaker than expected Chinese growth as well as impacting Australia in the process.

"Worry is interest paid on trouble before it comes due." - William Ralph Inge, English clergyman



Stay tuned!

The decline of Japanese companies illustrated by the CDS market

"What is at a peak is certain to decline. He who shows his hand will surely be defeated. He who can prevail in battle by taking advantage of his enemy's doubts is invincible." - Cao Cao

The CDS market is a clear illustration of the surge of Chinese and Korean corporates versus the slow decline of Japanese corporates - source Bloomberg:

The Itraxx Ex-Japan CDS index above (Blue line) is primarily weighted in Chinese and Korean corporates whereas the Itraxx Japan CDS (Red line) is very much weighted by the following sectors: Technology, Utilities, Shipping and Steel which are currently under tremendous pressure.

"Nature's laws must be obeyed, and the period of decline begins, and goes on with accelerated rapidity."  - Warren De la Rue, British Scientist.

Stay tuned!

Credit - From Hektemoroi to Seisachtheia laws?

Seisachtheia (Greek: σεισάχθεια, from σείειν seiein, to shake, and ἄχθος achthos, burden, i.e. the relief of burdens) was a set of laws instituted by the Athenian lawmaker Solon (c. 638 BC–558 BC) in order to rectify the widespread serfdom and slaves that had run rampant in Athens by the 6th century BC, by debt relief. - source Wikipedia

"Under the pre-existing legal status, according to the account of the Constitution of the Athenians attributed to Aristotle, debtors unable to repay their creditors would surrender their land to them, then becoming "hektemoroi", i.e. serfs who cultivated what used to be their own land and gave one sixth of produce to their creditors.

Should the debt exceed the perceived value of debtor's total assets, then the debtor and his family would become the creditor's slaves as well. The same would result if a man defaulted on a debt whose collateral was the debtor's personal freedom.

The seisachtheia laws immediately cancelled all outstanding debts, retroactively emancipated all previously enslaved debtors, reinstated all confiscated serf property to the hektemoroi, and forbade the use of personal freedom as collateral in all future debts. The laws instituted a ceiling to maximum property size - regardless of the legality of its acquisition (i.e. by marriage), meant to prevent excessive accumulation of land by powerful families." - source Wikipedia.

As many in Europe are awaiting the much anticipated results in France for the second round of presidential election, we thought, given Greece is as well having important elections on the very same day which could well decide its European fate, we would like this time around refer to the Athenian policy followed by Solon. Debt relief existed in many ancient societies and many religions. More recently Brady Bonds were a way of tackling the Latin American debt crisis. We do expect to see more debt to equity swaps for some weak peripheral banks but we ramble again. In this long credit conversation, we will look at an updated Eurozone scenario courtesy of our Rcube Global Macro Research friends. But first a much needed long credit overview with a focus on upcoming downgrades, Basel III regulations indicating clear additional "unintended consequences"...

The Credit Indices Itraxx overview - Source Bloomberg:

The cost of insuring against default in Europe is on the rise again as we towards an increasingly risk-off scenario in 2011 redux fashion. First weekly increase in three weeks and 3 days of consecutive rise in three days. Itraxx Crossover 5 year CDS index of 50 High Yield companies rose to 648 bps whereas Itraxx Main Europe 5 year CDS index (125 investment grade entities in Europe) rose to around 142 bps compared to around 138 bps a week ago.

As far as the financial sector is concerned, since February Moody's has put 114 European banks on downgrade review, meaning "Real Money" is bracing for a "May impact". There is some solace for our European banks as 17of the largest banking names are as well in the "iron sight" of the rating agency: Citigroup, Bank of America, Goldman Sachs, JPMorgan Chase, the Royal Bank of Canada and Morgan Stanley.
At the same time European Union Finance ministers are in a bind. On the 3rd of May they failed to reach an agreement to toughen bank capital rules facing stiff British resistance and aiming for a deal on the 15th May at the next meeting. The Basel Committee on Banking Supervision deadline is 1st of January 2013. Denmark is holding the current EU rotating presidency is offering a compromise with a risk buffer of 5% on banks' domestic and non-EU exposures against the initial 7% core capital requirements of their risk-weighted assets proposed by Michel Barnier, the EU's financial services chief.

But the challenge for the financial sector does not end thanks to cheap term-funding provided by the ECB twice. As Nomura indicated in their note Eurozone and Basel III - Fears for Tiers, from the 4th of May:

"Subordination is a recurring aspect of the eurozone debt crisis. This has taken the form of private sector investors in government debt being junior to not just the IMF into a debt restructuring, but also to the ECB and its SMP. It also takes the form of unsecured bank creditors being effectively subordinated by the growing reliance of banks on secured funding, as assets are pledged as collateral and balance sheets grow increasingly encumbered. The ECB's 3yr LTRO collateralised loan facility has accelerated balance sheet encumbrance and exacerbated a shortage of collateral in Europe. Unsurprisingly, eurozone monetary data confirm that banks are still struggling to raise term-funding.

The challenge that many banks face in raising term-funding is particularly problematic as over the coming years the eurozone banking sector will need to implement the Basel III liquidity framework. This forces institutions to increase the maturity of their funding profile. (The EBA estimate the Basel III funding shortfall at EUR1.9trn, which is around 75% of the size of the European senior debt market, and we use simplifying assumptions to calculate the demand for term-funding from the eurozone banks at around EUR4.9trn.) Early adopters of Basel III (most notably banks in Australia and New Zealand) have shown that this process leads to sharply rising bank funding costs, wider lending rate spreads to the policy rate, and as a consequence a lower "neutral" central bank policy rate. This latter point in turn has notable consequences for the conduct of monetary policy and the behaviour of yield curves, which tend to flatten and shed curvature at lower yield levels.

We already expected Basel III to spur these changes over the coming years, but the impact will be magnified if the unsecured financing markets do not recover. This will increase the extent to which Europe experiences a war for deposits among banks, the extent to which lending rates rise and the extent to which balance sheets shrink."

Basel III proposals - BIS ratios to manage liquidity risk:
"-The Liquidity Coverage Ratio (LCR).
The LCR requires that a bank has sufficient liquidity to survive for 30 days under a stressed scenario when global financial markets are assumed to be in crisis, all wholesale funding has dried up, unsecured lines of credit provided by other financial institutions are withdrawn and banks experience partial deposit flight. To mitigate this risk, the LCR requires that banks hold a liquidity buffer of high quality, liquid, central bank repo eligible, unencumbered assets, which are at least equal to the amount of net cash outflows a bank may face over a 30-day period.
-Liquidity buffer.
The liquidity buffer can comprise a minimum 60% of Level 1 assets (cash, excess reserves with a central bank, government, multilateral and selected agency debt) and a maximum 40% of Level 2 assets, which are highly likely to be spread products with for instance a 20% Basel II risk weighting. However, regulators are still debating what assets can be classed as eligible Level 2 assets (in Europe the EBA is suggesting a broader definition that would include highly liquid RMBS and – potentially – non-repo eligible assets such as listed equities and gold).

-The Net Stable Funding Requirement (NSFR).
This is a longer-term liquidity ratio and is aimed at ensuring that banks have sufficient liquidity to meet their funding needs during a stressed scenario for a period of 12 months. In short, a bank’s "stable funding" over a 12-month timeframe must be greater than the amount of required funding (cash requires less stable funding than unencumbered loans to retail and small business customers, which have a residual maturity of less than one year)." - Source Nomura - Eurozone and Basel III - Fears for Tiers, 4th of May.

We think upcoming downgrades means more collateral posting and more haircuts on collateral that can be pledged for funding at the ECB and dwindling "quality assets" therefore even lower German Bund Yields...

"Unintended consequences" as indicated by Nomura in their note:
"-Increased bank demand for government bonds. Banks will need to structurally increase their exposure to government bonds as they accumulate the liquidity buffer.
-Banks disincentivised from relying on short-term funding. In calculating the LCR and NSFR, banks are penalised for relying on short-term wholesale funding as only a portion of this liquidity can be used in calculating liquidity thresholds. Banks are therefore incentivized to issue longer-term debt or take in longer-term deposits.
-Increased demand for fixed deposits. Banks are incentivised to increase the proportion of their deposit funding, which is fixed for a long period of time, and are disincentivised from relying on financial sector deposits, which are ineligible.
-The LTRO is not a long-term solution. Only normal central bank liquidity provisions focused on open market operations can provide liquidity that is Basel III compliant. Non-standard liquidity measures such as the ECB's LTRO operations cannot be included in the calculations.
-Bank funding requirements increase as less liquid assets are held on bank balance sheets. This directly conflicts with the desire of regulators in selected European countries such as the UK to increase bank lending to SMEs and the consumer sector. These loans are less liquid than investment in government bonds or credit products and hence will incur a higher Basel III funding requirement.
-First mover advantage. The bulk of the Basel III liquidity framework needs to be implemented over the next five years and in its entirety by 2019. However, there is a distinct first mover advantage.  In the eurozone alone, the scale of long-term funding needed is larger than the market can realistically provide at yields that are economically viable. Hence, the sooner a bank can increase its long-term debt issuance, raise its term deposit funding, or unwind its balance sheet before its competitors do the same, the cheaper its funding costs will be and the less pressure it will face to reduce its balance sheet. In this respect, the current effective subordination of unsecured creditors of eurozone banks due to the balance sheet encumbrance issue allied to a general aversion of creditors to increase exposure to banks is particularly worrisome as this impedes the ability of banks to obtain term-funding."

We keep repeating this, but it is still very much a game of survival of the fittest....Cash is clearly king in the Basel III framework and, as Nomura put it, will therefore could lead to a war for deposits in Europe...The British stiff resistance to the latest regulatory proposals come from the fact that banks are very large in the UK relative to their GDP:

"The upward pressure on deposit rates is likely to be unequal between countries. In particular, countries with banking systems that are large relative to the domestic deposit base may face particular upward pressure on deposit funding costs and/ or pressure to pare back balance sheet. Clearly, this is an issue in the UK, where the banking sector is extremely large relative to GDP and the pool of domestic savings. Excluding the Bank of England, the combined balance sheet of UK MFIs measured GBP8.3trn in March, more than five times the value of GDP, and deposits only consisted of 37.5% total liabilities." - Nomura

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) are falling below the lowest level reached in 2011, dipping below 1.60%. It's deflation (デフレ). - source Bloomberg:

Another fresh record low for the German Bund helped by the miserable recent PMI surveys in Europe and the rise in joblessness in Europe reaching 10.9% in the process with European politicians making a dash for a "Growth Pact". Wishful thinking definition: "the erroneous belief that one's wishes are in accordance with reality" - Collins English Dictionary.

As stated above in relation to Basel III, increased demand for government bonds from banks (60% of the liquidity buffer) means more German bund buying...
Prior to the LTROs, banks had been scaling back their exposure to European sovereign debt as well as Sovereign funds as indicated by Josian Kremer in Bloomberg on the 4th of May - Norway Dumps Ireland, Portugal Bonds on Euro Crisis Concern:

"Norway’s sovereign wealth fund sold all its Irish and Portuguese government bonds after rejecting the Greek debt swap and warned that Europe faces considerable challenges.

The $610 billion Government Pension Fund Global returned 7.1 percent, or 234 billion kroner ($41 billion), as measured by a basket of currencies, in the first quarter, the Oslo-based investor said today. Its equity holdings gained 11 percent while its fixed-income investments rose 1.6 percent.

The fund, which voted against Greece’s debt swap this year because it disagreed with being subordinated to the European Central Bank, also said it reduced debt holdings in Italy and Spain amid a broader strategy to cut investments in Europe. The fund added government bonds from emerging markets such as Brazil, Mexico and India."

When the trend is your friend...

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:

We recently commented peripheral banks in both Italy and Spain have been soaking up their domestic bonds courtesy of LTRO 1 and LTRO 2, the dramatic decline in foreign holdings of Italian and Spanish debt increases concentration of risk in these two countries banks.

Following our focus on Basel III unintended consequences, it is time to move on to the Eurozone Scenario update courtesy of our friends at Rcube Global Macro Research.

"As the positive impact of both the LTRO and the ESM on Eurozone sovereign spreads seems to be fading, we think that it is time to revisit our main scenario for the Eurozone. This year, it appears that Spain and/or Italy are going to be the culprits of a third summer of Eurozone distress."

As stated by Rcube in our note "The European Overdiagnosis" (20/01/2012):

"We believe in a muddle through scenario for the Euro, at least for the next few years. The Euro’s existence solely depends on the willingness of European authorities to pursue the experiment. In the short and medium‐term, there’s just too much political capital invested in the Euro project. Consequently, the path of least resistance will most likely consist in resuming last summer’s emergency summits, probably featuring Merkollande instead of Merkozy.

As Spain’s or Italy’s yields approach levels that triggered previous EFSF intervention, it is becoming clear that the size of the current firewall (€700Bn = €200Bn from the EFSF ‐ some of which is already being used, and €500Bn from the ESM) is largely insufficient. If Italy and Spain were to lose access to the bond market, the current setup would barely cover the PIIGS’ refinancing needs until the end of 2013."

Spain and Italy dwarf other PIIGS’ bond payments:

"In a way, Europe was fortunate that the first endangered countries (Greece, Ireland and Portugal) collectively amounted to only 7% of the Eurozone GDP. Now that Spain (10.6% of the Eurozone GDP) and maybe Italy (16.8%) are also reaching the point where they need assistance from the rest of Europe, the only solution will have to come from the ECB, maybe in a more direct manner than through LTROs. The taboo of large direct ECB interventions will probably fall at some point during the next quarters. The uncertainty surrounding the timing and modalities of these interventions will probably provide interesting trading opportunities.

That said, we have to keep in mind that, in the long‐term, these interventions will do nothing to restore a balance between Eurozone countries’ competitivity." (see Rcube's related comments in "The European Flutter" – The Eurozone’s Other Problem: Unit Labor Cost Divergence).

"Therefore, we believe that some countries will eventually choose to exit the Euro, not because they are forced to do so by the markets, but because it will be the only way to exit the negative spiral of austerity-driven recessions." - source Rcube Global Macro Research.

Rcube's Eurozone breakup model (where recovery values are based on relative Unit Labor Costs), currently gives us the following implied exit probabilities:

We can see that 5 year implied exit probabilities remain very elevated (and at all time highs for Spain).

"However, unlike many, we do not consider a Euro breakup as a doom and gloom scenario. The path leading to the breakup will indubitably be painful, but the end result could offer interesting buying opportunities." - Rcube Global Macro Research

We agree with our friends and clearly indicated it in our post "Equities, there's life (and value) after default!". Hence our "provocative" title "From Hektemoroi to Seisachtheia laws?".

"Indeed, when we look at historical examples of countries that broke their peg with a currency that was too strong relative to the competitivity of their economy, we can see that their equity market performances were quite juicy after their currencies reached to a new equilibrium level." - source Rcube Global Macro Research.

Argentina's stock market performance post peso - source Rcube:

Russia's stock market performance post ruble devaluation - source Rcube:

 Mexican stock market performance post peso devaluation - source Rcube:

Korean stock market performance post won devaluation - source Rcube:

"Devaluations are never easy." - Jeffrey Sachs

Stay Tuned!