Credit - Paradise Lost

"When a wise man points at the moon the imbecile examines the finger." - Confucius

Looking at the "tax bomb" falling from the "Panama Papers" and awaiting for the radioactive "fallout", we could not resist but use for our title analogy "Paradise Lost" being an epic poem in blank verse written by 17th century English poet John Milton (1608-1674). The poem deals with the biblical story of the "Fall of Man" and the temptation of Adam and Eve by the fallen angel Satan and their expulsion from the Garden of Eden. What we find of interest is that previously we already referred to the "devilish nature" of central bankers such as Mario Draghi portrayed as "The Generous Gambler" back in 2011, which was no doubt to us, a similar reference to the Devil as the one used in John Milton's masterpiece. We re-iterated our reference to the "fallen angel" which probably inspired this great text from Charles Baudelaire in our September 2014 post entitled "Sympathy for the Devil", a reference this time around to the 1968 Rolling Stones title. What we find of interest, given the very impressive rally in credit, which will no doubt continue at least in Investment Grade thanks to Japanese flows, is Milton's criticism of idolatry which is deeply embedded, not only in his poem but, as well in today's financial markets with investors on-going worship of central bankers. In the opinion of Milton, any object, human or non-human, that receives special attention befitting of God, is considered idolatrous, central bankers are no exception. In similar fashion we already touched on the "Omnipotence Paradox" back in November 2012:

"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its world plan." - source Wikipedia.

The idolatry and evilness of central bankers have been a recurring them we have used on numerous occasions, particularly in our June 2014 post "Deus Deceptor":

"In terms of blasphemy and the "evil" intent of the central bankers both Descartes and the Cartesian scholars were wrong for the simple reason that central bankers are not omnipotent. Although, our "Deus Deceptors" of the central banking world, have indeed managed to altering mathematics (probability of default risk for the time being) and the fundamentals of logic, no doubt about that." - source Macronomics, June 2014

We also added a quote at the time when it comes to the idolatry in central bankers:

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

 Looking at deflationary pressure rising with Eurozone PPI falling 4.2% in February, being the largest YoY drop in producer prices since 2009, one might wonder if indeed "Paradise" will not be lost in 2016? In our February 2016 conversation "Common knowledge" we also added:

"The concept of "Common knowledge" is central in game theory. If a deity status is only attained if it is not able to lie (SNB, BOJ, ECB, FED...) then central bankers are not omnipotent except the BIS...

When it comes to "Common knowledge" and growth outlook, it seems we always follow the same trajectory:We start with an overall 3% consensus for US growth and US 10 year yield end of the year targets of between 2.50% to 3%, then after a couple of months, it gets revised down to 1.50% / 2% and US yields get revised accordingly towards the same objective." - Macronomics, February 2016

Given the Atlanta Fed latest GDPNow model forecast for real GDP growth in Q1 2016 is 0.7%, it seems that once more we follow clearly the same usual pattern.

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

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

We hope, at some point, this will become "Common knowledge" and that some sell-side pundits will stop defying this simple yet compelling "Wicksellian" logic.

So in this week's conversation, we would like to focus on "credit" and ask ourselves if indeed given the significant rise in the number of fallen angels (number of at-risk companies) to 22% of firms with Moody’s second-highest junk grade according to Bloomberg, if "Paradise" is "Lost".

Synopsis:

• Credit - Investment Grade? Paradise isn't lost
• Credit - US High Yield? Paradise is lost
• Final chart: Paradise Lost? A record number in "fallen angels"

• Credit - Investment Grade? Paradise isn't lost

In our recent conversations, we stressed that Japanese flows did matter, particularly when it comes to credit flows. Whereas inflows in recent week have been significant, particularly in US High Yield (+$13.3bn over the past 5 weeks), given the rising number of "fallen angels", we would rather continue from an allocation perspective to focus on "quality" than chasing High Yield. When it comes to "Paradise", we do think that, in particularly in US High Yield, "Paradise" is "Lost" particularly when one focuses on the deterioration in "credit metrics". We will look at this specifically in our second bullet point.

As we pointed out in early March in our conversation "The Paradox of value", the US investment grade market was no doubt the only game in town when one looks at the performance of the asset class relative to US High Yield. This was highlighted in Bank of America Merrill Lynch Monthly HG Review from the 1st of April entitled "End of the rollercoaster ride":

"March ’16: End of the rollercoaster ride

If you just returned from your sabbatical you would be forgiven to think that not much happened while you were out, as stocks returned +1.35% in 1Q, HY +3.25% while HG was the best performing major asset class at +3.92%. In fact all the asset classes we track in this report had positive returns in 1Q including Treasuries (+3.35%). Of course these quarterly numbers mask the big volatility during the quarter that saw equities reverse a correction and high grade credit spreads retrace a 27% spread widening. Thus March was a great month for most asset classes with equities up 6.78%, and leading the performance table, followed by HY (+4.42%) and HG (2.71%) while Treasuries returned +0.14%.

There were multiple reasons for the big turnaround in the markets after the lows on February 11th, including reassurance by the governor of the PBOC that China wants to see a more stable exchange rate, talks between OPEC and non-OPEC members putting a floor under oil prices and a sharp rebound in US economic data alleviating recession concerns. Then later followed global central bank action (BOJ, ECB, Fed).
HG credit spreads tightened 35bps in March for a big excess return of 253bps. For 1Q credit spreads tightened 3bps with excess returns of 18bps.

Sector wise excess return performance in March was led by Metals & Mining (+584bps), Oil &; Gas (+575bps) and Pipelines (+557bps) on the rebound in oil and commodity prices, while the worst performing sectors included REITs (+103bps), Banks/Brokers (+141bps) and Industrial Products (+146bps). For 1Q the best performing sectors were Metals & Mining (+714bps), Pipelines (+178bps) and Media-Cable (+177bps) and while at the other end of the performance spectrum we find Multi-line Insurance (-311bps), Life Insurance (- 200bps) and REITs (-85bps)." - source Bank of America Merrill Lynch

What we also find of interest is the performances in the 1st quarter of US TIPS from a diversification perspective:

- table source - Bank of America Merrill Lynch

In fact, we recommended (a little bit early) looking at US TIPS back in October 2015 in our conversation "Sympathetic detonation" from a great diversification perspective:

"Given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

In March again in our conversation "Unobtainium" we commented that we continue to like US TIPS:

"We continue to like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?" - Macronomics, 19th of March 2016

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 as pointed out by Bank of America Merrill Lynch in their report:

"Early for excess returns, late for total returns

With the biggest three month reversal of high grade credit spread widening behind us (27% spread widening and complete reversal over a three month period), and a more benign rates outlook, we provide updated return forecasts for the remainder of the year.

Our year-end spread target of 150bps (compared with 170bps currently), and outlook for a much flatter spread curve, imply excess returns of about + 400bps this year – which is mostly ahead of us as YtD excess returns are just +18bps (Figure 8). 

In terms of total returns, due to the big decline in interest rates we are already about two thirds through the roughly +6% we now expect for 2016. For 2016 we identified 30-year corporate bonds as a sector that should generate equity-like returns (see: 2016 US High Grade Outlook) – now following a return of about +7% YtD, we expect another roughly +3% by year-end (Figure 9).

Rest of the year

In Figure 11 below we summarize the returns for the remainder of 2016 implied by our full-year forecast. We look for total and excess returns of 2.13% and 364bps, respectively, for the remainder of 2016.

Hence, we look to realize about a third of the total return during the remaining three quarters of the year as well as almost our entire excess return forecast for the year. Just like for the full year, we look for spread curves to flatten and the back-end to outperform both on the total and excess return basis."  - source Bank of America Merrill Lynch

But then again, you might rightly ask why our obsession with Japanese flows and why looking at taking on long duration exposure?

With Bank of Japan implementing NIRP, we believe that when it comes to Investment Grade "Paradise" is not "Lost" and you should be inclined being overweight duration and quality wise going for Investment Grade corporate credit. This is clearly illustrated by Bank of America Merrill Lynch Liquid Insight note from the 4th of April entitled "The Japanese flow playbook":

Land of the rising global bond buyers

A favorite flow theme recently has been Japanese buying of foreign bonds: Japanese investors have bought around $75bn in foreign bonds over the last six weeks, their strongest stretch in three years.

While we have recommended US investors consider JGBs to monetize the cross currency basis (see Getting sheet smart), looking at it from the other angle requires us to consider a few more variables. This is because Japanese investors appear more willing to take FX and duration risk while US investors going the other way are usually purely interested in monetizing the basis. Japanese investors essentially can consider four options: (1) buy bonds currency unhedged; (2) finance it through repo; (3) FX and duration hedge completely through the cross currency basis swap market; or (4) employ a rolling FX forward hedge." - source Bank of America Merrill Lynch

Now if many bond investors are in the "purgatory" or "hell" of "negative yielding" government bonds in both Japan and Europe, they can take solace in the fact that Japanese investors got their back thanks to NIRP. Increasing flows, meaning effectively that Paradise is US Investment Grade Credit particularly in the long end of the curve. 

Some would then ask us about our views on European Investment Grade. 

Given US investment-grade corporate credit yields currently stands at 3.95% (almost their highest point since the 2013 taper tantrum) versus European investment-grade credit currently yielding around 1.4%, we believe European Investment Grade to be less enticing than European High Yield from a relative value perspective (less leverage in European High Yield than in the US). Whereas the ECB is in effect providing a technical "bid" to the asset class, from a convexity risk perspective, we believe European Investment Grade to be clearly less enticing than US Investment Grade credit. This is clearly illustrated by the recent A1/AA rated Sanofi new issue which saw €7bn of demand for a combined €1.8bn deal. The 3 year tranche was priced at midswaps +17bps, offering a paltry yield of 0.05% and a coupon of zero. While some might be desperate, we'd rather pass on this kind of offering. After all, 5 year swap rates are still marginally positive at around 0.015%. Then again with the ECB being the new buyer on the "credit block", the convexity risk doesn't make European Investment Grade of high quality particularly attractive to say the least. When it comes to "japanification" and the attractiveness of Investment Grade corporate credit, we read with interest Société Générale Multi Asset Snapshot from the 4th of April entitled "It's time to overweight corporate credit":

"US corporate credit undervalued and under-owned

The recent bout of market volatility has pushed valuations across the $7 trillion global corporate credit markets up to even more attractive levels. This is clearly reflected in the following market moves:

• US investment-grade corporate credit yields currently stand at 3.95%, almost their highest since the 2013 taper tantrum; this is still more than double the benchmark 10-year Treasury yield.
• US high-yield credit yields exceeded 9% for the first time since the 2011 European credit crisis in February, and have since fallen to 7.7%.
• US high-yield spreads more than doubled to a multi-year high of 775bp on 11 February from 315bp in May 2014, and now stand at around 600bp.
• US high-yield credit funds have seen net outflows of $64bn since May 2014, equivalent to nearly a fifth of total AUM

The increase in US high-yield credit spreads now reflects a substantial rise in defaults (see chart below). Moody’s forecasts the US speculative default rate to reach 5.4% by the end of 2016 compared with 3.6% in February.

US corporate credit stands to significantly benefit from any improvement in market sentiment throughout the rest of the year. The extent of the weakness we have seen, driven by the persistently low oil prices and exacerbated by the scale of fund redemptions, leaves US corporate credit, especially high yield, with significantly improved risk-reward for 2016." -source Société Générale.

Whereas we agree with Société Générale's take on the relative attractiveness of US Investment Grade corporate credit, while the dovish stance of the Fed has generated significant inflows into US High Yield in conjunction with a significant compression in High Yield spreads, we'd rather stick to our quality and duration call than chasing this rally. This leads us to our second point, namely is "Paradise Lost" in High Yield?

• Credit - US High Yield? Paradise is lost

Whereas Société Générale in their report has put a positive spin on the appealing levels of US High Yield we must confess that we do not share their enthusiasm and, that the recent record inflows in short order in the asset class could be short lived. We have in numerous conversations pointed out the clear deterioration of elemental credit metrics in the asset class and we'd rather be safe with Investment Grade than sorry with US High Yield. On that matter we would side with Bank of America Merrill Lynch's take from their Fixed Income Digest note from the 1st of April entitled "Don't go with the flows":

"Flow to low quality might not last

The main forces that we believe will drive the bond market are: modest economic growth and a slight rise in inflation. We continue to favor high quality: investment grade corporates, munis, TIPS and fixed-to-floating rate preferreds.

We believe that modest economic growth and slightly higher inflation will be the main driver of bond market returns for the rest of the year. That leads us to continue favor high quality: investment grade corporates, munis, Treasury Inflation Protection Securities (TIPS) and fixed-to-floating preferreds.Those sectors are doing well so far this year, as Table 1 shows.

But non-US bonds and US high yield (HY), which are mostly low quality, are also doing well. Based on the BofA Merrill Lynch Global Bond Indexes, HY corporates have enjoyed a 3.2% YTD return.

Strong performance of low quality might not continue 

We doubt that low quality will continue its strong run. More than half of the better than 9% returns on both non-US developed country sovereign debt and local currency emerging market (EM) debt has come from the weakening in the US dollar. We expect the dollar to strengthen in the second half of the year as the Fed resumes raising rates.We are also turned off by the average yield of 0.39% on developed country sovereign debt. In the EM world, we favor corporate debt, most of which is denominated in dollars.

We believe that US HY will perform well over the longer term, but we have doubts about the staying power of the recent rally. The jump in oil prices from mid-January through March has been key driver of the HY market, but the rally has extended to non-energy names. Michael Contopoulos, high yield strategist, notes earnings for non-commodity companies have been weak, and they might face challenges in generating the cash flow needed to service their debt obligations. Defaults have been rising and we expect them to rise further.

What we like and why

The case for TIPS is simply that even the modest rise in inflation that we expect for the rest of the year exceeds what is priced into the market. We expect consumer price inflation to rise from its present pace of 1.0% to 2.0% at the end of the year. The breakeven inflation rate for TIPS versus nominal Treasuries is 1.65%.
We also suggest investment grade corporates as an alternative to nominal Treasuries. They are high quality and offer better yields than Treasuries. The average yield on the BofA ML index is 3.2%, a spread of about 170 basis points over Treasuries.
Among preferreds, we still see better value in $1000 pars than $25 pars, but the advantage narrowed somewhat in March when $1000 pars outperformed. We also still favor fixed-to-floaters, although the paucity of new issuance in that sector, and our subdued outlook for bond yields, argues for holding fixed-rate preferreds as well.
The appeal of munis remains their tax free income. For investors in the 25% federal tax bracket and higher the yield on AAA rated munis exceeds the after-tax yield on 10-year Treasuries. In-state munis also stack up well against similarly-rated corporate bonds for those in higher federal tax brackets and those who face high state income tax rates." - source Bank of America Merrill Lynch

While we have pointed out on numerous occasions, that while defaults and leverage matter for High Yield, clearly earnings matter even more and looking at the weaker tone in EBITDA, US High Yield defaults rates have only one way to go but higher. On the subject of US High Yield we would tend to conclude that the latest rally might be short lived and that indeed when it comes to the asset class, we think it is "Paradise Lost". We would have to agree once more with Bank of America Merrill Lynch's High Yield research team with their take from their High Yield Strategy note from the 1st of April entitled "Spring is here, but a fall is coming":

"Spring is here, but a fall is coming

We’re afraid not. Contrary to a true ‘risk rally’, it is the higher quality names that have tightened the most. In fact, when looking at the tightest 50% of non-commodity names we see that they have tightened over 25% from February 11 levels compared to widest 50% names tightening just 16.9%. And with the US HY default rate increasing by 105bps during this time period – a pace we have never seen outside of a recessionary period – we expect this reluctant rally to ultimately fade should retail pull out. Even ex- Commodities, the default rate has risen 48bps since January and is threatening to breach the 2%-handle for the 1st time since 2013 (tab 2.01). Given more than half of our HY sectors have negative year-over-year EBITDA (section 6), a closing of the capital markets (more on that below), and ex-Commodity downgrades outpacing upgrades by a factor of 2 to 1, we expect defaults outside of Energy to continue gaining momentum and for spreads to eventually be forced wider by the mounting credit losses. 

Issuance doldrums

With $34.67bn priced, Q1 2016 saw a 3rd consecutive quarter of less than 3% in new supply relative to the amount of all high yield paper outstanding. The only other time span in which we have seen an extended issuance drought of this magnitude was Q3 2008 to Q3 2009, a period not fondly remembered by high yield investors. And although issuance has increased in each of the last four months and volumes were boosted by a $5.2bn offering from Western Digital, the most recent month still saw the 5th lowest March issuance relative to outstanding supply on record, and the smallest amount since 2009. Even more concerning is the lack of triple-C issuance, where for the 3rd consecutive quarter less than 15% of all HY supply was triple-C rated.

We remain concerned that these risky companies will be unable to obtain funding in the context of poor earnings, forcing them to potentially default on future principal and/or interest payments." - source Bank of America Merrill Lynch.

When it comes to US High Yield forecast, Bank of America Merrill Lynch at the end of March 2016 was expecting 850 bps in spread which would equate to a total return at year end of -3.63%. 

In similar fashion to Bank of America Merrill Lynch, UBS in their Global Credit Strategy note from the 31st of March entitled "Does this credit rally still have legs?" concur with them, in the sense that they do not believe either the recent rally in US High Yield can last contrary to the beliefs of Société Générale mentioned above:

"Structurally, the HY rally is not sound

However, the reasons behind the recent credit rally give us room for pause, particularly in high-yield. Rising oil prices have created a technical bid for the market, which is not sustainable without further increases in oil. On the former, one can see clearly in Figure 7 how high-yield flows have moved in lockstep with oil prices since they began falling in mid-2014, while high-grade demand has remained resilient. US high-yield remains largely a bet on oil prices, while high-grade has more staying power due to new inflows from abroad.

In addition, high yield spread tightening has occurred with anemic primary market issuance. Hence, the main theme is rising oil prices + new fund inflows + limited supply = higher prices. However, this is not solving fundamental credit risk and re-financing issues that will creep up on this market over the next several years7. Figures 8 & 9 below detail weekly high-grade and high-yield spreads vs. weekly issuance respectively. The dotted line is the average weekly issuance one would expect based on seasonal factors from our interactive issuance model and total AUM outstanding.

One can see how high-grade spreads have continued to tighten despite above-average weekly supply hitting the markets, which is a positive signal for US IG that robust demand exists for new paper. In contrast, HY issuance has remained tepid; it has been below average in almost every week of 2016. The recent $5.6bn Western Digital deal may change that fact for this week, but one week does not make a trend. Current primary market conditions are not healthy for high-yield.

The bid for yield vs. credit risk

There is a clear divide taking shape in credit. The bid for yield is lifting high-grade, 

while credit risk is thwarting high-yield. How will we know if the bid for yield or credit risk will win this tug of war? In the short-run, it is impossible to abstract away our discussion from oil prices. Oil prices will continue to drive near-term inflows and outflows from the asset class. But away from oil, we will be watching several key data points. The bid for yield theme will gain credence if high-yield issuance picks up in coming months, particularly for those lower quality issuers rated B & CCC. On the flip side, if lending conditions continue to deteriorate from banks (such as the Q1 Fed Senior Loan Officer Survey released in May), and non-banks (such as the monthly CMI Index of Trade Credit, whose March survey should be released March 31st) and corporate earnings continue to fall through 1H ‘16, we fear that credit risk will begin to encroach on B and possibly even BB-rated firms as the year progresses." - source UBS

 This does indicates that when it comes to US High Yield, if lending conditions continue to falter then this will clearly signal "Paradise Lost" for US Yield no matter how some pundits would like to spin it.
What is another concern about the lateness in the credit cycle is the significant rise in the number of "fallen angels" (issuers migrating from Investment Grade to High Yield).

• Final chart: Paradise Lost? A record number in "fallen angels"

Whereas the latest news around oil prices and the correlation with US High Yield in particular points to caution in the aforementioned rally we would not be chasing, what is another indicator you need to track apart from the Senior Loan Officer Survey and issuance, is the velocity in the rise of "fallen angels". To that effect, we would like to point out to JP Morgan Default Monitor note from the 31st of March relating to High Yield and Leveraged Loan Research for our final chart:

"In March, there were three Global fallen angels affecting $8.2bn, which followed February’s 30 fallen angels totaling $115.8bn, a record month both in terms of number of issuers and amount of volume affected. And there was only one rising star totaling $600mn in March, which followed one rising star for $260mn in February, the year’s first upgrade to investment-grade. Year to date, Global fallen angel volume totals $140.4bn, compared with $143.1bn during all of last year and a record high of $150.2bn in 2009. Excluding International bonds, US fallen angels YTD total 26 companies (20 Energy) and $107.9bn in bonds ($85.2bn Energy, 79% of the total, $15.3bn Metals/Mining, 14%). For reference, there was $45.5bn of US fallen angel volume for all of 2015, which was a high since 2009’s record $141bn. In terms of EM fallen angels, there have been 10 YTD totaling $27.3bn, which compares to last year’s $90.4bn of EM fallen angels." - source JP Morgan

In Milton's poem, the evil army loses against God and the Devil's reign in Hell starts with his band of loyal followers, composed of "fallen angels", which is described to be a "third of heaven", but that's another story...

"Go to Heaven for the climate, Hell for the company." -  Mark Twain

Stay tuned!

Macro and Credit - Unobtainium

"Progress is impossible without change, and those who cannot change their minds cannot change anything." - George Bernard Shaw

Watching with interest the significant compression in credit spreads thanks to "Le Chiffre" aka Mario Draghi going "all in", which to some extent, is putting pressure on Haruhiko Kuroda and the Bank of Japan, to raise the stakes once more in this global game of liar's poker, given their respective ability in reaching their inflation targets and both their repeated failures, we reminded ourselves for our chosen title analogy of "Unobtainium", being any fictional, extremely rare, very costly, or impossible material, or (less commonly) device needed to fulfill a given design (inflation) for a given application (QE+NIRP). The word "Unobtainium" derives humorously from unobtainable (inflation) followed by the suffix -ium, the conventional designation for a chemical element. 

What we also find of interest in our chosen title is that there is a cryptocurrency named Unobtainium, which uses Bitcoin's source code with some modifications to the monetary policy. UNO aka Unobtainium is a SHA256 Proof of Work cryptocurrency unique for low inflation, scarcity, a fair launch and distribution. Just 250,000 Uno will ever be mined over 300 years. Unobtanium is merged mined with Bitcoin, resulting in a secure high-difficulty blockchain that is 3x faster than Bitcoin. Uno is rare not only in the number coins issued, but also in it's fair launch and distribution. Uno was not pre-mined. There is no POS inflation. On that matter we find it very amusing to read about the proto-currency known as RSCoin in recent column by Ambrose Evans-Pritchard on the 13th of March in the Telegraph in his article entitled "Central banks beat Bitcoin at own game with rival supercurrency" as a better alternative to Bitcoin and it's smaller rival "Unobtainium":

"The RSCoin is deemed more likely to gain to mass acceptance than Bitcoin since the ledger would remain exclusively in the hands of the central bank, with the 'trust' factor of state authority. It would have the incumbency benefits of an established currency behind it....RSCoin may be irresistible for central banks. Dr Danezis said it is allows them to turn the money tap on and off with calibrated precision, and lets them track the sort of counterparty liabilities that nearly blew up the financial system during the Lehman crisis. "There would be instant visibility. They could react very quickly in an emergency, " he said.
Ultimately it could achieve some of the objectives of 'narrowing banking' proposed by Adam Smith, or the Chicago Plan put forward by US economists in the 1930s - but never enacted - to transfer control of money creation from private banks to the state. Arguably, this would make the financial system safer and less prone to boom-bust cycles." - source The Telegraph, Ambrose Evans Pritchard, 13th of March 2016

We find it particularly hilarious that RSCoin is deemed more likely to "mass acceptance" thanks to the 'trust factor of state authority'. To paraphrase Hayek's 1988 book, one could argue that RSCoin will not likely be more successful than Bitcoin because having the "trust factor" of the central bank would be a "fatal conceit", but we ramble again...

On a side note, before we move on our weekly musing, we find as well very entertaining that China and its Popular Bank of China (PBOC) are thinking about the implementation of a "Tobin tax" given one of our latest musing was the "reverse Tobin tax". This was reported by Bloomberg on the 15th of March in their article "China Tobin Tax Riles Analysts as Citi Warns of Foreign Exodus":

"China’s central bank has drafted rules for a tax on foreign-exchange transactions, a plan that still needs central government approval, people with knowledge of the matter said on Tuesday. The initial rate may be kept at zero to allow authorities time to refine the rules and to deter speculators by letting them know that there is a system in place, said the people, who asked not to be identified as the discussions are private. 

The People’s Bank of China has been fighting to drive out traders who take advantage of the difference in the yuan’s rates at home and abroad. The PBOC drove the currency’s offshore borrowing costs to records in January, increasing short-selling costs, and instructed banks on the mainland to restrict sending yuan overseas. 

Among the biggest Tobin tax concerns cited by analysts is that the levy would sap market liquidity. One gauge of the ease of trading the yuan -- the currency’s bid-ask spread against the dollar -- was about 0.05 percent on average in March, versus 0.01 percent for the dollar-yen rate, according to data compiled by Bloomberg Intelligence." - source Bloomberg

As a reminder from our conversation, the Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system which ended on August 15 of 1971. Also we would like to point out, that this additional precautionary measure from the PBOC, does seem to us overstretched as we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"It seems to us that speculators, so far has not been able to  gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals." - source Macronomics, 1st March 2016.

For us, this announcement from the PBOC is posturing and ambitions to deter further speculation and prevent speculators to gather together, ensuring in effect that renewed attacks will be postponed and inflict sufficient damage to the "short crowd". It seems to us that, shorting the yuan is indeed a very costly "Unobtainium" for now. End of our side note.

In this week's conversation, we would like to look at inflation expectations and what it means in terms of allocation and credit given the significant tightening move seen in recent weeks.

Synopsis:

• Macro and Credit - Is inflation really rearing its ugly head?
• Macro and Credit  - The bond yield curves are now fully inelastic
• Final chart: Demography is destiny

• Macro and Credit - Is inflation really rearing its ugly head?

Back in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:

"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", and of course it has worked again like a charm in 2016:

"If the policy compass is spinning and there’s no way to predict how central banks will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up."

Given it seems that US inflation expectations jumped after a renewed dovish Fed, one could argue that the compass in the US has somewhat stopped spinning hence the move in US breakevens and TIPS, in conjunction with the continuous support for Gold Miners (yes we are still long...). 

We continue to like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?

What we also find of interest is that some have argued that with inflation supposedly "rearing its ugly head", US Treasuries are vulnerable in this situation. No doubt the dovish stance of the Fed is going to wreak havoc on the short end of the curve, but we do think the very long dated part of the curve (30 years) still offer some good carry and roll-down in a growing NIRP world (yes we are still long, very long US duration as well, if you'd like to ask). 

But when it comes to "inflation" and "Unobtainium", we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine":

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

A very interesting 2015 paper by the Bank of Israel ( (Sussman, N and O Zohar 2015, “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015.) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area. Therefore, given the recent significant surge in oil prices towards the $40 mark, we do not think it is such a surprise to see a rise in inflation expectations in that context. This latest rise in inflation expectations could after all be transitory as well as the sudden rise in oil prices, particularly in the light of the tight relationship between the US dollar and oil prices. We think that the latest dovish stance of the Fed all has to do with their concerns relating to the "velocity" of the US dollar and the "unintended consequences" a too rapid rise of the "Greenback" could have on Emerging Markets (EM).

When it comes to the assessing the transitory nature of the rise in inflation expectations, we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 18th of March entitled "Yellen: The lady doth protest too much" where they disagree with the impact of the change in oil prices moves on inflation expectations we mentioned above:

"Key takeaways

• The Fed's dovish commentary on inflation is getting stale very fast.

• The evidence for a pick-up in wage and core price inflation is not just a couple data points, but is broad based.

• Markets are only beginning to come to terms with the reality of a steady upward move in inflation.

Our core disagreement with the Fed 

Once every year or two a significant gap develops between our thinking relative to the Fed. For example, early last year, we were struck by the Fed’s apparent complacency about the strong dollar. Fed officials seemed to dismiss the dollar, arguing that the US is a relatively closed economy and a strong dollar could be viewed as a vote of confidence in US growth rather than as a shock to US growth. That view seemed increasingly out of touch given both the size of the dollar move and the fact it continued to strengthen in the face of very weak US data. The Fed did not capitulate until March when they acknowledged the weaker outlook and moved out the expected timing of the first hike.
Today, a similar sized gap in thinking has emerged; this time around the outlook for core inflation. Despite stronger data, the FOMC continues to question whether core inflation is really picking up. “Inflation is expected to remain low in the near term …but to rise to 2% over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” Asked about the pick-up in core inflation during the press conference, Chair Yellen vaguely talked of volatile components. The forecasts were similarly dovish: even though year-over-year core has already jumped from 1.3 to 1.7% YoY, the median forecaster continued to look for 1.6% inflation this year and the median forecast for next year actually dropped from 1.9% to 1.8%.

Here we take a closer look at the gap between the FOMC and our own thinking. We think the Fed’s views are stale in several respects. We also argue that the FOMC is more willing to allow inflation to overshoot the 2% target than they are suggesting. Looking ahead, we think this meeting outcome will be the high point for Fed dovishness this year and we reiterate our long-standing call for hikes in June and December. 

It was a new day yesterday 

A key Fed concern is that weakness in oil prices will pass through to the core over time. However, most studies find very weak or nonexistent pass through. The worst of the oil price drop now appears behind us: prices seem to be finding a floor, with Brent up about 40% from its 20 January low. As base effects fall out of the data, headline inflation should continue to converge to the core (Chart of the day above).
The Fed is concerned that the strong dollar will continue to drive import prices lower as the lags play out. Presumably they are also concerned that if they are too hawkish the dollar could surge again. In our view, the period of rapid dollar appreciation is fading into history (Chart 1).

As a result, consumer import price deflation has already slowed sharply. For much of last year, consumer import prices were falling at 1.3% YoY, but the rate of decline has now dropped to just 0.2%. In our view, this is a major factor in the recent pickup in core goods price inflation. 

Yellen and company seem skeptical about any pick in wage growth: “in the aggregate data, one doesn't yet see any convincing evidence of a pickup in wage growth. It's mainly isolated to certain sectors and occupations.” She also pointed to the pickup in the participation rate as a hopeful sign. In our view, the evidence of a pickup in wages is compelling. The growth in average hourly earnings in the last 12 months is higher than the prior 12 months for seven out of 10 major industries. Overall compensation growth has accelerated relative to a year ago for all the major compensation gauges except the employment cost index. A lot of second-tier measures, such as surveys from the Fed, have also picked up modestly. 

At her press conference Chair Yellen was asked why she was skeptical about the recent inflation numbers. She said, “I see some of that as having to do with unusually high inflation readings in categories that tend to be quite volatile without very much significance for inflation over time.” We agree that there are a few special factors in the numbers, but not enough to cancel out the inflation signal. The Fed has developed “trimmed mean” measures of core inflation that strip out all volatile items rather than somewhat arbitrarily eliminating all food and energy items (Chart 2).

The trimmed CPI measure is still up at a solid 2.5% annual pace in the last two months and on a year-over-year basis has been accelerating since May 2015. A similar story applies for the trimmed PCE: it is rising at a 2% annual pace in the last two months and has been drifting higher since last January. In our view, these are trends, not noise. 

The one dovish aspect of the Fed view we agree with is the risk of inflation expectations unhinging to the downside. Measuring inflation expectations is difficult. Survey measures have an upward bias and market-based measures can be heavily distorted by technical factors. Nonetheless, after six years of weakness in wage and price inflation it would be surprising if inflation expectations for real people had not fallen. We believe confidence in the Fed’s inflation-creating ability surely is under pressure and is already impacting wage and price setting. Despite this headwind, however, wage and price inflation is already starting to pick-up. This suggests the economy is already at full capacity.

Living in the past 

This brings us to our final point. Chair Yellen has been adamant that the Fed has not changed its inflation target: it is still 2% and it is still symmetric; they are just as concerned about above-target inflation as below-target inflation. We are skeptical. In our view, there is a very strong economic case for “really risking” overshooting the target. Recall that the reason the Fed’s target is 2% rather than zero is that the Fed wants to minimize the risk of deflation and avoid hitting the zero lower bound for the funds rate when fighting recessions. Recent experience argues strongly for a higher inflation target:
• the Fed and other central banks have been stuck at zero for many years,
• inflation has been chronically low
• inflation expectations have fallen below the Fed’s target
• and the equilibrium real rate has probably dropped.
With the benefit of 20-20 hindsight we think the Fed would have adopted a higher target: say 3%, instead of 2%. The problem is that resetting the goal would require a very complicated debate at the Fed, raise concerns about a slippery slope (if 3%, why not 4%?) and would likely subject the Fed to even bigger political attacks. In our view, the politically correct answer is to keep the target, but err on the side of overshooting and then wait for the inevitable recession to knock inflation back down to target.
The bottom-line of all of this, in our view, is ongoing upside risks to inflation breakevens as the markets recognize the Fed can create inflation after all." - source Bank of America Merrill Lynch

It seems to us that Bank of America Merrill Lynch is focusing on the content, like any good behavioral psychologist we prefer to focus on the process. If indeed, the Fed has recently preferred a slowdown in the "velocity" of the surge in the US dollar for obvious external EM concerns, hence its dovish tone, what has also been a concern has been the overall global tightening of financial conditions. What is also of interest is that the surging dollar in recent years and falling US treasury yields have happened in conjunction with falling commodity prices and particularly a sharp drop in energy prices. This has therefore reinforced the possibility of coordinate actions from central banks which could have happened given the US dollar has dropped as much as 3 percent since the G-20 meeting held in Shanghai which ended on February 27. Whereas the Fed's latest dovish tone aims at somewhat lessen the impact of a rapidly surging US dollar, clearly to us the ECB's ambition of purchasing corporate bonds, is a clear demonstration of its willingness in suppressing a surge in credit spreads and a flattening of the credit curves which would in effect trigger a rise in the cost of capital and funding for banks and other players, and trigger a renewed credit crunch in Europe in the process. Not only has the US dollar fallen relative to other currencies, but in Europe credit spreads have fallen very rapidly to much lower levels thanks to the ECB "credit put".

When it comes to wage inflation, which would entice us to validate the "recovery" mantra, we believe wage inflation remains "Unobtainium", an impossible material as posited by Zero Hedge in their article from the 18th of March entitled "Feeling Underpaid? This Is What Wage Inflation Around The World Looks Like" which is pointing to the similar Deutsche Bank report we read with interest "Inflation Sensation - a global inflation monitor" from the 16th of March. If US inflation is indeed rearing its ugly head, then the jury is still out there when it comes to monitoring wage inflation in the US:

"Wage developments are striking across the G10. While there are tentative signs of producer and consumer price disinflation bottoming in some countries, wage growth remains particularly weak. This may be because wages are a backward looking indicator of inflation pressure, but it may also be a sign of second-round effects influencing price-setting behaviour." - source Deutsche Bank

What seems so evident to us is that Central banks such as the ECB are pouring oil on the fire as they have trying to push long-term rates down after having succeeded in pushing short term rates to zero. 

In Europe, it is clear that the ECB's policy is having no lasting effect on prices and inflation. It is because the ECB can create all the money it wants, but it cannot command it to flow "uphill", in wages, hence the "Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hands:

 - graph source Deutsche Bank

As we pointed out in our recent conversation "The Monkey and banana problem":

"Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. This negative feedback-loop, doesn't stop the frenzy for bonds and the "over-allocation process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP. This push yields lower and bond prices even higher" - source Macronomics, February 2016

The results of the "Unobtainium" process is that money flows into Wall Street and less so into Main Street as a result. The latest decision by the ECB is putting the demand for credit products into "overdrive" while in no way the most recent TLTRO is altering the credit profile of ailing Italian banks and their balance sheets bloated by Nonperforming loans (NPLs). "Liquidity" via funding at zero cost doesn't resolve "Solvency". But, yes, the rally in credit has legs for the time being.

The "Unobtainium" process followed by our generous gamblers have not only enticed even more speculation downhill, in the government bond markets but now in the credit markets where we still favor quality and in particular US Investment Grade (for carry purposes...). All of this brings us to our next point, namely that bond yield curves behavior have changed dramatically.

• Macro and Credit  - The bond yield curves are now fully inelastic

Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach for the long end of the curve particularly because, we agree with Louis Capital Markets latest points made in their most recent cross asset note from the 16th of March entitled "How does it end?":

"Last week there was also a huge move on long term Japanese rates. The 10 year Government bond yield appears now to be well anchored in negative territory. How is this possible? In what world do we live? 

Below, we show the average 10-year bond yield for developed countries and it stands at an all-time low, below 1%. We live in a world in which the public sector has never been so indebted. However, it can borrow money at a rate that has never been so low.

Economic textbooks are filled with details of the term structure of interest rates and the message of the bond yield curve. Below right we show that these academic books should be used now for lighting fires because the historical relationships have fully broken down. Since 2009, we have faced a long lasting capitulation towards the idea that one day long term bond yields will recover their pre-crisis levels. Thus, while the slope of the bond yield curve was negatively correlated to short term rates, it is now fully inelastic: short term rates have been stuck to 0% since 2009 and long term bond yields have moved from 3% to 1%.

The fact that long term bond yields confirm that even in the long term the situation will never normalise poses two questions. Firstly, do bond markets fundamentally misunderstand the economic situation or are they correct in their expectations? The problem is that central banks, who decide the level of short term rates, have remained unclear about what will be the next “normal situation”? The case of Sweden, one of the first countries having experienced deeply negative rates, is worth mentioning. We show below the dynamic of the core CPI, of wages, of Employment and we add the main refinancing rate into the mix as well. The  first chart below shows absolute data and the second one, it is a z-score (in standard deviations around the mean).

Sweden: Key Economic Data  

We see that in Sweden, the employment situation has normalised, the core inflation rate has normalised, the wage dynamic is a bit weak but interest rates have never been so low in economic history. Why has the Swedish central bank decided on such a policy? Or to put it in another way, what is required to put rates back above 0%?

The Fed will meet in two days. We believe Fed Board members remain very uncomfortable with the current situation. We will not repeat what we have said for many months now, that slacks in the economy no longer exist and that inflation is back to trend. The problem is not the US economy, the problem is the US$ leverage in the emerging world and the declining EM currencies. The question for Fed members is clearly subjective. Should they grant more time to EM countries to make their adjustments or should they reload their monetary policy tool because the US economic cycle is reaching maturity? These are two different questions and up to now, Fed members have refused to choose, leaning however a little towards the first solution.

Our stance remains the same, because we are bullish on the US economy, we do not understand how 5y×5y forward USD rates can trade below 3%." - source Louis Capital Markets

Apparently, the Fed has chosen to throw a lifeline to EM countries and to give them more respite by tampering their "normalization" process, but as far as our "inflation expectations are concerned and in relation to "Unobtainium", when it comes to the US we remain "data dependent" and it remains to be seen if the US has indeed reached "escape velocity" when it comes to "wage inflation". We do not share the same optimism as LCM on that matter and believe the rise in "inflation expectations" to be for the time being a temporary phenomenon. Yet, 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". What is as well interesting is that the short-end of the US yield curve is prone to more volatility in similar fashion than long-dated Japanese and German government bonds have become as well significantly volatile thanks to NIRP. 

The volatility of of the US yield curve is clearly in the front-end of the curve as indicated by Bank of America Merrill Lynch in their Situation Room note from the 16th of March entitled "Marking the Fed toward the market":

"Marking the Fed toward the market 

The main story at the conclusion to the March FOMC meeting was that, by lowering the dot plot to two rate hikes this year, the Fed chose to mark their view on the near term path for the Fed funds toward market expectations. In other words, the Fed acknowledged, what the market has suspected for a long time, that it will be difficult for the Fed to hike rates in an environment of global weakness and deflationary pressures. Hence the big bull steepening move in the Treasury curve with 2-year yields 10.9bps lower while 30-year yields were comparatively little changed (-2.0bps). 

As a result the likelihood of a hawkish monetary policy mistake derailing the US economy declined significantly and VIX dropped 11.0% as stocks rose 0.6%. Less economic uncertainty in turn is positive for credit spreads, while the decline in interest rates is negative. However, with longer term interest rates holding up well the net effect is positive and supportive of our bullish outlook for HG credit as well as the Treasury curve steepening move supports our view that the 5s/10s spread curve flattens. Sector wise today's Fed moves are more positive for industrials than banks, although relative valuations and last weeks's ECB moves mitigate that." - source Bank of America Merrill Lynch

Whereas the rally in the US Investment Grade has been significant, the ECB's latest "generosity" package has lead to a rush towards credit spread products, enticing investors to renew the "beta" game in the process, namely reaching for yield and credit risk in the process. If indeed the short end of the European government bond market has become irresponsive thanks to NIRP and has plunged most of European short term bonds into negative territory, the consequences of yield curves becoming "inelastic" is pushing punters towards the only "less perceived risky"decent game in town namely investment grade credit. This is validated by the flows seen in Europe as shown in Bank of America Merrill Lynch chart below from their Follow the Flow note from the 18th of March entitled "Front-running” the ECB…":

"…as investors rush to buy corporate bonds 

We have seen it in the past. When the ECB announced the government bond buying program, inflows accelerated into the asset class. With the help of the ECB, credit flows broke free from a long period of outflows. Last week’s positive inflow into high-grade and high-yield funds was the third consecutive and the biggest in 53 weeks.

This considerable shift in momentum was mainly thanks to a decisive shift in high grade. The asset class recorded its first inflow in ten weeks and the biggest for more than a year. High yield funds enjoyed another - the fourth in a row - week of inflows.

Elsewhere in fixed income, government bond funds recorded another outflow during the previous week.

Money market fund flows were also in the negative territory, recording a fourth consecutive outflow – the longest streak since March ‘15.

To the contrary outflows continued from equity funds. The asset class has suffered outflows for the last six weeks, which now sum up to $15bn. This is the longest period of outflows seen in equities since October ’14." - source Bank of America Merrill Lynch

The outflows from equity funds do not surprise us. This what we pointed out in our recent conversation "The Monkey and banana problem":

"The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box): When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock" hence the reach for bonds." - source Macronomics, February 2016

No doubt that the "European investor monkey community" is fearful of another "electric shock", so for now they'd rather play the "reach for bonds", ditching equities in the process. The beauty of the Skinner box...or from "Unobtainium" (Main Street) to "Obtainium" (Wall Street), but, we are ranting again...

This leads to our final point and final chart, that no matter how hard central bankers try to generate "Unobtainium", demography matters, end of the day, no matter how big your "printing press" is.

• Final chart: Demography is destiny

As we have pointed out, like many others before us, when it comes to the trajectory of bond yields and inflation expectations, demography matters. This is the point we made in our February 2015 conversation "The Pigou effect" relating to our long term deflationary stance. 

You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:

Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price!

"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."

The problems facing Europe and Japan are driven by a demographic cycle not a financial cycle. This once again illustrated in our final chart and table from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 18th of March:

"Demography is destiny 

The big picture
We borrow this week’s title from Dr. Joseph Coughlin of the MIT AgeLab, who was a featured speaker at this week’s BofAML Residential Mortgage and Housing Finance Conference. For financial markets, the key demographic reality is that populations across the globe are aging, some more rapidly than others. BofAML Chief Investment Strategist Michael Hartnett noted this in the recent piece, BofAML’s Transforming World Atlas: Investment themes illustrated by maps.Table 1 shows, by country, the percentage of populations that are 65 years old or over, as of 2015 and projected for 2050.

Japan is seen as the world’s leader in age, both now (26%) and in 2050 (37%). Europe (Germany, Italy, Spain) is not too far behind. The US, currently at 15%, is next, although countries such as China and Brazil will age more rapidly over the next 35 years and overtake the US in terms of the percentage of people above 65 years old. Not surprisingly, as populations age, productivity and consumption patterns change, with deflation conceivably an associated phenomenon. The bond market experiences of Japan and Germany relative to the younger US are perhaps illustrative. Chart 1 shows the history of 30yr bond yields in Japan, Germany, and the United States over the past 15 years. Japan has led the way lower while Germany has followed suit and narrowed the gap to JGB yields. US yields have moved lower but not to the same degree.

The question arises: will the US inevitably follow and see 30yr bond yields head below 1%? So far, US yields have proven to be somewhat more resilient than in Japan and Germany, and the different demographic outlook (less aging) argues for less downward pressure on yields than in Europe and Asia. Nonetheless, we should note that one of our conference presenters, Scott Minerd of Guggenheim Partners, made the case for a 1% 10yr treasury yield at some point in the not too distant future; currently, we are simply at the middle of the downward trend channel in rates of the past 30 years (Chart 2).

At a minimum, the aging of the global population suggests it is not unreasonable to think this is at least reasonably likely outcome at some point in the future. " - source Bank of America Merrill Lynch.

No offense to Bank of America Merrill Lynch but the title they used has not been authored by Dr. Joseph Coughlin of the MIT AgeLab but by August Comte, a French sociologist (1798-1857).

You probably understand by now, our inclination towards long dated US Treasuries. End of the day, if central banks cannot generate "Unobtainium" in the form of "renewed" inflations, what is not to like in the "carry play" offered in the long part of the US Treasury curve? We wonder.

"Low interest rates are usually attributed to low inflation, weak economic growth and super easy monetary policy. But there's another deep-seated factor that doesn't get much attention: demographics." - Greg Ip, Canadian journalist

Stay tuned!