Macro and Credit - The Butterfly effect

"The foolish are like ripples on water, For whatsoever they do is quickly effaced; But the righteous are like carvings upon stone, For their smallest act is durable." -  Horace

Watching with interest the retreat in government bond yields, thanks to overall dovishness from our "Generous gamblers" aka central bankers including recently ECB's Le Chiffre (Mario Draghi), leading to renewed inflows into High Yield and equities in the US making new records in the prospect, with a continuation of the bull market in complacency, we reminded ourselves for our title analogy of the much used "Butterfly effect" narrative. While the "Butterfly effect" is the concept that small causes can have large effects and was initially used in weather prediction, in chaos theory, the sensitive dependence on initial conditions in a nonlinear system such as financial markets can lead to large differences in a later state of a credit cycle. The name was coined by American mathematician, meteorologist and chaos theory pioneer Edward Lorenz.

Our chosen analogy is also a veiled reference to US Treasuries Butterfly, given we think it is showing us that the US economy to some extent is tracking Japan. The butterfly spreads formed by the gaps between short, medium and long term US Treasury yields has been narrowing with Japan as of late:

- source Bloomberg 

In this week's conversation, we would like to look at what continues to provide inflows and support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan". 

Synopsis:

• Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets
• Final charts - Financial conditions? The punch bowl is still plentiful.

• Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. 

While 2016 was a record year in terms of foreign bond purchases by Japanese Lifers, 2017 was more tepid thanks to European elections risk, but according to Nomura in their JPY Flow Monitor note from the 21st of July, Insurance companies bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row:

"Insurance companies: Insurance companies kept purchasing foreign bonds in June, but momentum remained relatively weak (Figure 1). They bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row. They tend to be net buyers of foreign bonds in June, and the amount of net purchases was not significant (see “JPY: Season of seasonality”, 2 March 2017). Their investment in JGBs slowed to JPY171bn ($1.5bn). We expect lifers to keep purchasing foreign bonds, as major lifers’ investment plans suggest JGB yields will remain unattractive (see “BOJ review: Waiting longer for tailwinds”, 21July 2017).

Banks: Banks were net buyers of domestic and foreign bonds in June for the second month in a row (Figure 2).

They were large net sellers of bonds in April, but as seasonality shows, they resumed purchasing bonds in May and June. Foreign bond investment has slowed from May, but the FX impact was limited, in our view.

Pension funds: Trust banks, which manage pension funds’ money, kept purchasing foreign securities in June for the third month in a row (Figure 3).

The pace of net purchases slowed to JPY132bn ($1.2bn) though. Pension funds were also net buyers of domestic equities for the first time in five months. They bought JPY236bn ($2.1bn) of domestic equities, the biggest amount since August 2016. They were net buyers of JGBs too (JPY411bn or $3.7bn). The GPIF’s latest portfolio data up to end-March showed the fund’s portfolio is closer to its target portfolio. However, it accumulated short-term assets at a high level, and the president of the fund said the accumulation of short-term assets is to enhance available capacity for the next investment. Diversification from short-term assets into portfolio assets should continue for the time being as European political uncertainty has diminished. We expect pension funds to be dip buyers of foreign bonds and equities." - source Nomura

Not only for Japanese Lifers, but also for retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years as per Barclays JPY Monthly Flows noted from the 20th of July:

• "Japanese institutional investors continued to buy foreign bonds, but net outflow slowed down from last month. By investor type, banks and trust banks remained net buyers of foreign bonds. Meanwhile, life insurers continued to purchase foreign bonds. Foreign equity investments also decreased slightly in June, led by banks and bank trust account. Weekly data indicates that a net purchase of foreign bonds by Japanese investors turned positive again in the first week of July amid yield curve steepening globally since the end of June. Regional breakdown of foreign bond flow shows that Japanese investors turned net buyers of US, German and French bonds in May (Figure 1).

• Among retail investors, toshin funds remained popular while net issuance of foreign-currency-denominated uridashi bonds decreased somewhat in June. In bonds, INR- and RUB-denominated uridashi bonds continued to attract solid demand from investors. As for toshin funds, BRL-denominated funds increased for the first time since January this year and TRY- and INR-denominated funds continued to tick higher. Margin FX investors reduced their net long positions in USDJPY and AUDJPY notably and increased their short EURJPY and GBPJPY positions.

- source Barclays

Clearly, for Japanese retail investors, it has all been in recent years about low bond volatility and "king dollar". We continue to believe that when it comes to global flows, Japan matters and matters a lot. Japanese yen is indeed the source of the carry trade on a global basis and this has very significant implications from a tactical perspective when it comes to foreign bonds overall. Since the implementation of NIRP in 2016, Japanese Lifers went into "overdrive" in their purchases of foreign bonds. No surprise therefore that, when it comes to the "Butterfly effect", Bondzilla's appetite has been increasing at a rapid pace. 

You might be wondering where we going with the reference to the Butterfly effect and the importance of Japan but for US credit markets, Japan matters as well and matters a lot. Back in March 2017 in our conversation "Outflow boundary", we indicated the following:

"The big question, as we await the allocation decision from our Japanese friends, if there will be enticed again by foreign bonds like they have in recent years. The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment." - source Macronomics, March 2017

For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments.  

One thing that appears clear to us is that USD corporate credit in recent years has been supported by a large contingent of foreign investors in particular Japan. Reading through UBS Credit Strategy note from the 21st of July entitled "Where are we in the credit cycle?" we were pleasantly surprised that indeed, Bondzilla the NIRP monster is "made in Japan" and it is as well a critical support of US credit markets:

"Our deep dive analysis isolates Japan as the critical support for US credit"

- source UBS

Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk. 

The latest dovish retreat from our "Generous gamblers" (Fed and ECB) has created a "Rebound effect" as posited last week in the sense that is has not only prolonged the goldilocks state in credit markets with spreads tightening further for a longer period in this credit cycle, but, equities wise, it has provided additional strong support as well. Summer 2017 has led to record stock indices and all time spread tights in many instances. For now it seems it is "carry on" and we are indeed in the final melt-up of this last inning of the credit cycle risky assets wise. For many it continues to be the most hated bull-market in history. So far it seems our gamblers are reluctant in removing too early and too fast the credit punch bowl. For the moment the credit love boat is still sailing strong during this summer lull and unless we see some exogenous factors coming into play, it is difficult to see what could be a catalyst for a reversal before September where the Fed and the ECB could decide to tighten the financial conditions spigot as per our final charts.

• Final charts - Financial conditions? The punch bowl is still plentiful.

As we have seen recently, the Butterfly effect from the hawkish comments from Le Chiffre aka Mario Draghi led to a mini-tantrum in the Euro government bond space. Obviously the recent tone down in the rhetoric from both the Fed and the ECB has led to a continuation of "goldilocks" for risky assets thanks to record low volatility. Given the current financial conditions on both side of the Atlantic, it remains to be seen if our "Generous gamblers" will maintain further their dovish rhetoric in September. Our charts below come from Nomura and displays the US and Euro area financial conditions and comes from their recent Japan Navigator notes:

"Euro area and US policymakers are likely concerned about riskier asset rally;

Japanese policymakers may welcome it

This week 40yr and 2yr JGB auctions will be held. Japanese CPI data will be released.

The FOMC meets.

This week’s ECB announcement and market reaction have strengthened our conviction that the global yield upcycle that started from the euro area in late June has faded. We believe bond markets will move substantially only in September, when the Fed and ECB are likely to tighten policy, but only if riskier asset markets remain bullish despite Fed and/or ECB action. During this period, yields are likely to trade in a fairly narrow range, with risks on the downside, in our view. Riskier asset markets may strengthen and prevent yields from rising, but they tend to destabilize in the summer, particularly because US growth expectations are unlikely to rise.

UST yields have begun to fall. Although the market had become bearish owing to momentum from the euro area government bond (EGB) market, it lacked bond-negative factors (Figure 1).

There have been fairly strong concerns over US growth and inflation, and August data will likely be interpreted with scepticism – at the very least, a single month’s worth of data are unlikely to dispel these concerns, in our view.

We believe the ECB and Fed will look to tighten policy further if the output gap continues to improve and the riskier asset rally continues, even as they express concern about slow inflation growth, in our view. However, the Fed and ECB are unlikely to have an opportunity to jawbone until the Jackson Hole symposium in late August. Although the BOJ has emphasized its dovish stance, we believe it has basically the same stance as the Fed and ECB, and is unlikely to adopt an easing stance again as long as the output gap continues to improve. However, if JPY strengthens on risk aversion this summer, the market’s easing expectations may rise again, if only temporarily.

Compared with the Fed and ECB, the BOJ appears more tolerant about an increase in JPY carry trades and a riskier asset rally, and appears to be concerned about how much it can increase its JGB purchases further, rather than ETF buying, in our view. That said, if the BOJ revises its policy framework in such a way as to (erroneously) cause risk aversion, the negative impact on the appointment of the next governor should be substantial. Therefore, we do not expect policymakers to change the upper end of the target 10yr JGB yield range (0.11%) in the near term." - source Nomura

There you go, for now the ECB and the Fed have been mindful of the "Butterfly effects" in risky asset markets, hence the tone down of the rhetoric and insisting on a gradual process in removing the proverbial punch bowl, while the Bank of Japan (BOJ) has so far been in a holding pattern, ensuring in effect that investors in Japan as well continue to play out the low volatility leveraged "carry" play into overtime. No wonder the "Butterfly effect" is made in Japan, maybe it's related to the famous Opera play Madame Butterfly by Giacomo Puccini where the hero was so excited to marry an American that she had earlier secretly converted to Christianity or like Bank of Japan to central bankers' current religion we wonder. It didn't end well for Madame Butterfly in the end but we ramble again...

"See, the night doth enfold us! See, all the world lies sleeping!" - Giacomo Puccini

Stay tuned !

Macro and Credit - The Ninth Wave

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself." - Stefan Zweig (1881-1942)

While chuckling about the gullibility of some investors pundits who were somewhat surprised by the Bank of Japan' latest move in implementing Negative Interest Rate Policy (NIRP), given as per the SNB move in 2015, they should know by now that central bankers always lie, we reminded ourselves The Third Wave experiment when thinking about our title analogy. While you might be already wondering why our title is the Ninth Wave and not the Third Wave experiment, it is fairly easy to explain. 

The Third Wave experiment was conducted by school history teacher Ron Jones during the first week of April 1967 in Palo Alto in California in order to explain his students how the German population came to accept the actions of the Nazi regime during World War II. Jones started a movement called "The Third Wave" and told his students that the movement aimed to eliminate democracy (in our central banks case: "interest paid"). Jones experiment (in similar fashion to current central banks experiments with QEs and NIRP) on the fourth day of the experiment quickly decided to terminate the movement because it was slipping out of his control. The experiment was all about explaining the rise of fascism. In our current environment, our central bankers "deities" are indeed experimenting with some form of "fascism" with their intent in imposing "financial repression" and discipline to the markets, we think.

So why our title?
Jones based the name of his movement, "The Third Wave", on the supposed fact that the third in a series of waves is the strongest, an erroneous version of an actual sailing tradition that every ninth wave is the largest hence our chosen title.

But, back in November 2011 we discussed a particular type of rogue wave called the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:

"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011

We voiced our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars? It is a possibility we fathom." - Macronomics - June 2013

At the time we stated that we were in an early stage of a dollar surge.

Back in December 2014 in our conversation "The QE MacGuffin" we added:

"The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil."

What is of interest of course is that indeed the Third Wave experiment analogy has been somewhat validated by Goldman Sachs in a recent research report as per below chart:

- source Goldman Sachs.

This ties up nicely with our "reverse osmosis" theory we mentioned again in our previous conversation "Under pressure"(This global macro hypothesis was first described in our August 2013 conversation "Osmotic pressure").

But if the sailing tradition that every ninth wave is the largest is true, then again, our chosen title is the correct one.
The Ninth Wave happens to be as well a splendid painting from 1850 by Russian Armenian marine painter Ivan Aivazovsky. Overall, our title refers to the nautical tradition that waves grow larger and larger in a series up to the largest wave, the ninth wave, at which point the series starts again. This of course goes with our earlier quote from Stefan Zweig. Zweig's quote does ring eerily familiar with the reckless abandon in which central bankers of the world are engineering the biggest bond bubble (or wave) ever seen, and the Ninth Wave might eventually turn out to be Wave 3 squared result but we ramble again...

In this week's conversation we will once again reiterate our advice to start playing "defense" in credit and move higher into the capital structure and in the ratings spectrum. We will also look at the debilitating global growth outlook as well.

Synopsis:

• Credit - Time to play defense on any "relief" rally
• US Investment Grade Credit - Why you want to "front-run" Mrs Watanabe
• Macro -  Growth outlook? It's weaker than you think
• Final chart - Why a flatter yield curve is not good for the financial sector

• Credit - Time to play defense on any "relief" rally

As we pointed out recently, half the High Yield universe by market value today trades at 310bps, while the other half is at 1050bps. While the distressed list has a disproportionate representation of commodities (33%), this dispersion doesn't bode well for US High Yield, given default and distress ratios are increasing, even outside commodities. 

We commented recently that the higher the "distressed glut", the lower will be the recovery rate. Also, the number of distressed bonds is rising in Europe and of course our favorite "CCC credit canary" issuance levels has plummeted. When it comes to issuance levels and US High yield, year-to-date issuance is down by -16.3% according to SIFMA.

While looking more into issuance levels, we looked at the data provided by Dealogic through the blog Credit Market Daily from Dr Suki Mann, former UBS European Credit Market Strategist. When one looks at High Yield corporate bond issuance, one can clearly see that the issuance levels, given market gyrations have fallen from the proverbial cliff in January:

- graph source creditmarketdaily.com 

As we repeatedly pointed out in our missives, like any behavioral psychologist, we tend to focus on the process rather than on the content. Whereas every pundits and their dog focus these days on the correlation of oil and the relationship with equities, and fathom on a potential rebound of both, we prefer to stick to what we are seeing which is the evident deterioration in the broader credit picture and the implication for equities. The "process" is playing out we think. While yes we can expect indeed a short-term "Keynesian" rebound, we do remain medium to long term "Austrian" bearish and cautious in the grand scheme of things.

For instance, we reacquainted ourselves with what is happening in the Securitization world as of late, reading through Bank of America Merrill Lynch latest Securitization Weekly. We particularly read with attention their latest note from the 29th of January:

"Overview – Things are bad, at risk of getting worse

The bounce in oil should provide some near term upside/relief in securitized products (SP) credit, but will it last? Financial stress receded this week, but it is unprecedented for the Fed to be tightening at current elevated levels. As cheap as SP credit has gotten, we think additional downside risks are too high; stay long duration in agency MBS.

Last week, we compared the price pattern of ABX, the subprime index, back in 2007- 2009 with oil in 2014-2016 (Chart 1).

Our interest in oil stems from the correlation between securitized products credit prices and oil over the past year , as well as the correlation between oil and inflation breakevens, which underlies our recommendation to buy long duration agency MBS.

The ABX-oil comparison last week suggested to us that oil had the potential to decline down to the low 20s by March-April of this year. Naturally, oil rallied this week on that analysis, as news of some potential tightening of supply hit the market. Our experience with ABX tells us that these types of rallies are not unusual within the context of precipitous price declines and that fading the oil rally most likely makes sense. Given the correlations cited above, this suggests that selling or at least fully hedging riskier securitized products credit also makes. If oil goes lower, prices on mezzanine risk transfer, CMBS and CLOs are also likely to go lower, even though they are already at the cheapest levels in recent history.
To make matters worse, and to heighten the potential for some chaotic price declines, there is the matter of Fed policy. As we discuss next, given elevated levels of financial stress, we think the Fed’s decision to start tightening monetary policy in December created significant risks for financial markets. This week’s decision provided little indication to us that this risk will meaningfully alter policy decisions going forward. This suggests to us that downside risks for securitized products credit remain elevated, even after significant price declines in recent weeks and months.
This week’s rally in oil prices may be a precursor of some near term strength for mezzanine risk transfer, CLOs and CMBS, subject to the constraints mentioned above. We recommend either reducing or hedging exposures into such strength and moving up in quality to high quality, short spread duration sectors such as auto ABS. Meanwhile, we continue to recommend long duration agency MBS, with an added emphasis on prepayment protected stories with the 10yr yield dropping below 2.0%

Global financial stress on the rise

In Chart 5, we focus on the rise in financial stress since mid-2014, and show the 50-,
100- and 200-day moving averages.

The stress periods are seen as somewhat episodic, with stress rapidly elevating, and then subsiding, moving more or less back to the trend line defined by the 200-day moving average, which itself is steadily trending higher. The daily peak for the last two years was seen recently on January 20, and stress appears to now be subsiding, probably moving back to the 200-day moving average over the near term. Declining financial stress should be good for financial assets over the near term, including securitized products mezzanine credit. It probably will also give the Fed more comfort in hiking rates in March. This is where we see potential for additional downside in securitized products.

Consider the 2007-2009 experience for financial stress. Chart 6 shows a similar view to the ABX-oil view in Chart 1, benchmarking 2014-2016 versus 2007-2009.

The current cycle, where the January 20 peak was 0.65, appears benign relative to the super stressed levels of late 2008, when the GFSI hit a peak level of 3.01, almost 5x the current level. But just a week before the September 15, 2008 (the start of the global financial crisis), and for the prior year for that matter, the GFSI registered levels near 0.60, or right at about current levels. We have little reason to anticipate a shock to the financial system on the order of the financial disruptions during the GFC. But we think it is important to recognize that the pre-GFC financial stress is comparable to today’s levels, suggesting system vulnerability to shocks or policy errors.

It is in this context that we view the Fed’s tightening of monetary policy as very risky for financial assets. As Chart 7 shows, in 2007, with comparable levels of financial stress, the Fed was aggressively easing, not tightening; now, the Fed is tightening.

Tightening may be the correct policy for the Fed’s economic mandate, but that doesn’t mean financial assets will approve. Moreover, what makes matters more disconcerting for us this time is that, given the change in the political climate relative to the financial sector since 2008, it seems unlikely that there would be a strong (if any) policy response to financial system stress. The days of the Fed put, which arguably has been in effect since October 1987, appear to be over."

To get some sense of what might accompany higher levels of financial stress, we look at the relationship between oil and the GFSI over the past two years in Chart 8.

We actually show the inverse of oil, so oil in the 20-25 range corresponds to an inverse in the 0.4-0.5 range. Very roughly, Chart 8 suggests that if oil drops down to the 20-25 range, the GFSI could head up the 1.0 vicinity. This was the stress level last seen in 2011, which was “solved” by QE3. Would QE4 come in response to a return to comparable levels of financial stress? It’s possible, but given the recent track record, the Fed seems more likely to keep moving in the opposite direction of tightening. This scenario is not likely to be a good one for securitized products credit, in our view."- source Bank of America Merrill Lynch

While we agree with most of the points made by Bank of America Merrill Lynch made in their note, while we reading their interesting note a graph caught our attention, reminiscent of the heyday of 2007, namely the price action in both ABX prices and CMBX prices:

 - source Bank of America Merrill Lynch

Given all of the above, we strongly advocate selling "high beta" into strength and moving towards a more defensive position such as long duration and US high quality Investment Grade "domestically" exposed credit and/or very long dated US treasuries (30 years) or playing it via ETF ZROZ (for retail players).

If you want more compelling "arguments" validating our defensive stance we strongly recommend you read the latest note from Bahl & Gaynor - "It's not what you own that kills you… it's what you owe"

So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor.

As per Bank of America Merrill Lynch Credit Market Strategist note from the 29th of January entitled "The great rotation into US credit", we agree with the points they are making:

"After the ECB meeting last week, and US data and BoJ this week, we think that the widening yield differential between US and foreign fixed income will re-ignite foreign demand, as US corporate bonds look increasingly relatively attractive (Figure 6).

Apart from the effects of US data strength, a lot of this relative re-pricing happened because actual and expected foreign monetary policy easing tends to widen yield differentials with US Treasuries (Figure 7).

Obviously it may take a little time before yield sensitive foreign investors transition from the initial stage of finding the new lower absolute yields unattractive, to appreciating that US corporate credit now looks much more attractive on a relative yield basis, and increase their buying (Figure 8).

Corporate yield differential between USD and EUR

While at the time of writing our index system had not updated for Friday’s market movements post the BoJ, as of yesterday (1/28) US and EUR 10-year corporate bonds yielded 4.10% and 1.94%, respectively, for a yield differential of 2.16% - up from 1.98% last week:

Post-BoJ Japanese corporate bond yields and spreads

Due to a favorable time zone our Japanese corporate bond index has in fact updated for the post-BoJ Friday session. We see that in reaction to BoJ negative interest rates, yields declined 6bps to 0.25% while spreads widened 1bp to 29bps (Figure 11).

In our experience Japanese investors have been heavy buyers of US corporate bonds since 2012 – initially mostly on a currency hedged basis but increasingly unhedged. Clearly we expect more buying, especially after the April 1st start of the new fiscal year in Japan. However, today’s -7.5bps move in the cross currency basis swap initial negates the additional yield advantage to US credit created by the BoJ’s action." - source Bank of America Merrill Lynch

If you want to somewhat "front-run" the GPIF and Mrs Watanabe, increasing allocation to US domestically exposed high quality Investment Grade credit makes sense as per Bank of America Merrill Lynch's note:

"US strength, global weakness. 

Our preliminary analysis of the 4Q earnings reporting season for US HG companies shows little evidence that the US economy is going into recession. Specifically for global high grade companies that derive more than 50% of revenue from abroad we are tracking -5% earnings growth for 4Q, a small deterioration from the actual reported number of -2% in 3Q. However, for domestic companies without foreign revenue earnings growth is tracking +8% in 4Q, which is strong even if down a bit from +10% in 3Q. In terms of topline growth we are tracking -5% for the global companies and +8% for their domestic counterparts – both numbers virtually unchanged from 3Q." - source Bank of America Merrill Lynch

Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.

When it comes to following the flow and once again on why we focus on the process rather than the content, you have to "follow the flow" and when it comes to the implementation of NIRP, think clearly about the "implications".

• US Investment Grade Credit - Why you want to "front-run" Mrs Watanabe

Back in March 2015 in our conversation "Information cascade", we stressed the importance of following what the Japanese investors were doing in terms of flows:

"Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets." - source Macronomics, March 2015

One should therefore not be surprised of the latest actions of the Bank of Japan in implementing NIRP which has already been implemented in various European countries and enforced as well by the ECB. As a reminder from last year conversation, this is the definition of "Information cascade":

"An information (or informational) cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts. A cascade develops, then, when people “abandon their own information in favor of inferences based on earlier people’s actions”." - source Wikipedia

The Bank of Japan has merely engaged in the same acts as others. "Information cascade" is a trait of behavioral economics. You get our point when we state that we behave like behavioral psychologist when analyzing market trends and central banks "behavior".

When it comes to Mrs Watanabe, Toshin funds are significant players and you want to track what they are doing, particularly in regards to the so-called "Uridashi" funds. The Japanese levered "Uridashi" funds (also called "Double-Deckers") used to have the Brazilian Real as their preferred speculative currency. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted previously for 46 percent of double-decker funds in 2009 with close to a record 80% in 2010 and now down to only 22.8%.
As our global macro "reverse osmosis" theory has been playing out, so has been the allocation to the US dollar in selection-type Toshin as per Nomura JPY Flow Monitor report from the 15th of January 2016:

"We expect toshin momentum to remain strong in 2016, as suggested by the recent recovery. The maximum amount of risky asset investment under NISA per year has been raised since the beginning of the year. Risky asset investment via NISA tends to be especially strong in January, which will support toshin momentum in the near future. Risk sentiment among retail investors remains the key driver of toshin momentum too, and the latest Nomura Individual Investor Survey suggests a further recovery in retail investors’ appetite for risk assets. The survey also shows a strong preference for USD among foreign currencies, suggesting retail investors are likely to be dip buyers of USD assets via toshins.

The share of US assets in total foreign currency-denominated toshins continued to rise to 58.9% in December from 58.8% the previous month, the highest share since December 2001. US assets held via toshins declined to JPY17.1trn ($143bn), but non-US asset exposure declined more rapidly, especially exposure to EM assets. Interestingly, the share of EUR assets increased to 8.2% from 7.9% the previous month, while outstandings held in EUR-denominated assets inched up to JPY2.4trn ($20bn) from JPY2.3trn. November BoP data showed a recovery in Japanese investment in EUR-denominated securities, and the stabilisation in toshin companies’ exposure to EUR assets is worth monitoring, as it may show a gradual recovery in Japanese investors’ preference for EUR." - source Nomura.

Of course the woes of the Brazilian Real have been exacerbated by Mrs Watanabe and her growing dislike for her preferred carry trade since 2009...

Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP.

Whereas this is our assessment, when it comes to "front-running" the risk appetite of the Japanese crowd, although the "Ninth Wave" painting has warm tones in similar fashion than the upcoming "Japanese" allocation, which reduce the sea's apparent menacing overtones and tone of the market, the "macro" picture overall remains menacing as per our next bullet point.

• Macro -  Growth outlook? It's weaker than you think

We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should the reverse decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy. Particularly given the messages sent by various markets as illustrated recently in Bank of America Merrill Lynch's GEMs Inquirer note from the 28th of January entitled "The Dark Messages of the Markets":

"Mkts consistent with a double digit contraction in EMs EPS

We respect the messages embedded in diverse markets. We highlighted the signals from Dr. Sotheby’s (BID), Dr. Haliburton (HAL), and Dr. Copper, all falling more than 50% from their recent highs – which could reflect weak demand from plutonomists (rich people), energy capex, and Chinese infrastructure – the key drivers of global growth in the past fifteen years.

Additionally, other indicators including transport stocks, the Baltic Dry Index, high yield bond spreads, the KOSPI, cubicle makers, shipping companies, palladium prices, the stock-bond ratio, are all suggesting a severe earnings recession in Asia and emerging markets. How severe? For EMs, USD EPS growth could contract about 15% in 2016. Consensus is at plus 8.4% EPS growth for 2016 for emerging markets (and 6.5% for Asia ex-Japan). (We combine all these growth-sensitive market prices into one indicator to divine EPS growth). Its message is consistent with Nigel Tupper’s global earnings revisions index. From these levels, both have been associated with policy easing, not tightening. We remain suspicious of cheerful consensus growth forecasts, which display a persistent upward bias, and are likely to be revised down. The Wu-Xia synthetic Federal funds rate (Bloomberg: WUXIFFRT Index) LEADS EM equities by 18 mths, and has been tightening since mid-2014, and the Fed forecasts further tightening by 100bps this year.

Valuations not close to cheap in Asia/EMs

Asia ex-Japan is trading at an EV/Net income of 19.9x, compared with an average of 21.7x over past 21 years. This is 0.2 standard deviations below the mean. At market lows, it normally gets to levels around 13x. We would caution against getting too excited by the 1.2x PB in ex-Japan Asia (and EMs) – the ROEs in both region are under pressure, and flattered by a rise in corporate leverage. We need to see a stand-still (or a reversal) of US monetary tightening for us to re-assess our negative views. And/or, much better value." - source Bank of America Merrill Lynch

The question therefore you need to ask yourself is if the FED is going to eventually "blink" during the course of 2016. Because, as put bluntly in Bank of America Merrill Lynch's note, all the Doctors put together do not point towards a "bullish" outcome for growth:

- source Bank of America Merrill Lynch

Financial conditions since mid 2014, that's what credit is telling you, that's what oil prices are telling you and that's what the 3 doctors have been telling you. The damage has been done and while we can understand why the FED has decided to defend its "credibility", we all know looking at the lofty valuations touched, that they should have tightened much earlier one rather than boosting further up "asset prices" for the "plutonomists" to paraphrase Bank of America Merrill Lynch.

In our conversation of November 2013 entitled "Squaring the Circle", we also argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months. It has proved a timely indicator of potential global stock markets reversal. Whenever its price reached 50 or so with sky high valuations, a reversal has never been far away. 

Finally, when it comes to our positioning relative to the US recessionary crowd, we believe that a flattening of the US yield curve is never a good sign, particularly for the US financial sector which has been vaunted by some as a "compelling" buy. We will dispel this belief in our final chart.

• Final chart - Why a flatter yield curve is not good for the financial sector

We have been fairly vocal on our take on the direction that US long bonds would take given our deflationary incline. We have in fact hinted on numerous occasions that we had  been increasing our long duration exposure in conjunction with playing the rebound in gold miners (yes, disclosure we are as well, long ABX aka Barrick Gold). 

But if the 3 Doctors listed above don't tell you enough about the state of affairs, then, maybe the state of the US yield curve might tell you a little bit more. To that effect, we would like to point out the shape of the yield curve for our final chart extracted from Bank of America Merrill Lynch latest Securitization Weekly from the 29th of January:

"This week gave some indications of what this somewhat bleak view of ours might mean for rates and the yield curve (Chart 9): as of writing, the 10yr stands at 1.94, the lowest level since April 2015, and the 2yr-10yr spread of 115 bps is the lowest since early 2008. 

This is consistent with what we are looking for this year and why we have persistently recommended a long duration exposure in agency MBS, down in coupon (DIC) in passthroughs and Zs in CMOs. Following on the above discussion, we still see things as follows: the Fed likely will continue to push up short rates and thereby lower growth expectations, anchoring the back end of yields, and flatten the yield curve even more. The only change from this week is that, with new lows in treasury yields, we emphasize the need to own relatively stable long duration assets." - source Bank of America Merrill Lynch

Yes indeed, flatter is not good. And if, like us, you think that US Financials are the second derivative of an economy, meaning that putting on the "beta play" would only be justified by an acceleration of the growth outlook (loan growth) then, we think, there is nothing compelling in playing the "supposedly" value play in US Financials (When it comes to Europe, you already know our stance, stay out of it).

To complete our rebuttal of the "attractiveness" of US Financials, we would like to point out towards  Reorient Group strategist David Goldman's take in their note from the 21st of January entitled "Where to Hide?":

"Underperformance by the banking sector always is a bad sign for markets and the economy; it suggests that the credit mechanism is clogged, with knock-on effects for the rest of the economy. As we observed in our Jan. 18 Week Ahead report, the deterioration of credit conditions and the flattening of the yield curve have left the banks with sharply reduced earning potential. The banks invest more in Treasury securities than in business loans, and the flattening yield curve crushes the differential between their cost of funds and the yield they earn on Treasuries.

Banks’ net interest margin is already at the lowest level in history.

- source Reorient Group

So, before you decide to jump again on the "beta" wagon, think very clearly on how US Financials can be "profitable" in such a deflationary environment and a significant flattening of the yield curve.
There might be at least some solace in US Financials versus European Financials (in particular Deutsche Bank and Italian banks woes), but apart from that, we don't see any "screaming buy" in the former and "zero interest" in the latter.

"Growth is the only evidence of life." - John Henry Newman, British clergyman

Stay tuned!

Credit - Zugzwang

"I have with me two gods, Persuasion and Compulsion." - Themistocles

Watching with interest the escalating tensions between Greece and Germany while a payment was made in favor of "special creditor" IMF, we reminded ourselves, for this week's analogy in our chosen title of a situation called Zugzwang (German for "compulsion to move") found in chess and other games given Greek Finance minister Yanis Varoufakis is an expert in game theory. We found it of special interest because in German chess literature, one player is put at a disadvantage because he must make a move when he would prefer to pass and not to move. The fact that the player is compelled to move means that his position will become significantly weaker. The term is also used in combinatorial game theory, where it means that it directly changes the outcome of the game from a win to a loss. Positions with "zugzwang" occur fairly often in chess endgames, a topic we have discussed in a previous chess analogy surrounding European woes in our conversation "The Game of The Century" where we discussed at the time the great chess master abilities of German Chancellor Angela Merkel :

"By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...). Question being for us now, can Europe survive in the current form (number of countries) without making material sacrifices in true Bobby Fischer fashion? One has to wonder." - Macronomics, July 2012

As we indicated in our conversation "Eastern promises" on the 9th of June 2012, we think we are clearly approaching the end of the great European "chess" game and ultimately the only possible Nash equilibrium for Germany will be to defect:

"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

The ability to play these endgames well is a major factor distinguishing "masters" from "amateurs". In what was labeled "The Game of the Century" and in reference to our previous 2012 chosen title, Bobby Fischer 13 years old at the time, won the game against Donald Byrne, one of the leading American chess masters, by making material sacrifices at the time. 

On a side note and in continuation to our previous chess reference, the same Bobby Fischer used "Zugzwang" twice against Mark Taimanov in 1971 in the World Championships Candidates match. Mark Taimonov was crushed and lost 6 to zero to Bobby Fischer. The Soviet government was deeply embarrassed, and found it "unthinkable" that he could have lost the match so badly to an American without a "political explanation". In response, Soviet officials took away Taimanov's salary and no longer allowed him to travel overseas. The Soviet government later "forgave" Taimanov, and lifted the sanctions against him following Fischer's 6–0 later win the same year against Danish Bent Larsen known for his "unorthodox" style of play,  which paved the way for Bobby Fischer's achievement in reaching the first World Chess Federation (FIDE) number-one-ranked player. Bobby Fischer held the number one slot for 54 months. Maybe Greek Finance minister Yanis Varoufakis will suffer the same "orthodox" measures than Mark Taimanov, in the short term but we ramble again...

In this week's conversation we will look at France, as from our point of view, it continues to be for us as the new barometer for Euro Risk. We will also continue look at the US earnings picture, which appears to us more and more vulnerable to setbacks thanks to a rapid rising US dollar.

Synopsis:

• France appears to us as the weakest link in Europe at the moment
• Being "short" Euro is one of the most crowded trade
• Europe continues to be a "flow" driven market
• King Dollar even rules the Fed
• Final note "There is an anomaly in US share prices and UST yields"

• France appears to us as the weakest link in Europe at the moment

French politicians are benefiting from low rates on French debt issuance courtesy of on-going "japanification", but, on the economic and political front, France is showing increasing signs of growing stress as pointed out in our last conversation "China syndrome":

"Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term."

When it comes to complete credibility failure we have to agree with Louis Capital Market's Cross Asset Strategy note from the 9th of March entitled "Will China Resist America Pressure?" in relation to France's incapacity to reform:

"Last week In France we were amused to hear Pierre Moscovici of the European commission explaining to France that the economic policies implemented up to now were not of a satisfactory or adequate quality. The irony is not lost on us. Moscovici was still France’s Minister of Finance four months ago and a man in charge of deciding and implementing the country’s economic and budget policies. To see four months on telling his ex-boss that policies he most probably was involved in are inadequate is simply farcical.
Finance was promoted to head the world economic decision centre and to explain to countries what kind of reforms they should implement or what kind of macroeconomic policies they should run. In France, the nomination of Christine Lagarde as head of the IMF was seen as another farce.
It is striking to see these days the incapacity of France to adjust its economic policy, and in particular its fiscal policy. The charts below are impressive because they show that in Spain public expenditures have adjusted to the new economic reality of the country whilst in France, the public spending trajectory has not adjusted at all.

The chart below is crystal-clear: the pace of growth of public spending is intact! France and Germany are insistent upon the Greek government to maintain its previously defined fiscal consolidation objective. Yet, France has shown its incapacity to enter any fiscal consolidation. It is a shame to see the lack of effort on the expenditure side in France. However, this subject is of little importance, because confidence is so high in financial markets and because the ECB is financing states for free. The reality is that the ECB refuse to consider that they finance governments – however their actions give them away. With its government bond purchases, the ECB has ensured a low financing cost to investment grade countries, no matter what decision is taken on the budgetary front. The Germans were against QE, because they considered it to be an act similar to lending money for free without counterparties to secure risk. To put it simply their reasoning is true.

France will be the only important country in Europe to see a deterioration of its budget deficit in 2015 compared to 2013. It seems that the French government is betting on the economic recovery to get a cyclical rebound of its revenue that will prevent it from making the painful adjustment on the spending side. The opportunity for France clearly lies in its access to a very low financing cost for its public debt that – mechanically – will lower also its debt service in the budget.
Francois Hollande can send his thanks to Mr Draghi as the current context offers significant opportunities for France. French civil servants would have never accepted a decline in their remuneration as was seen in Southern Europe. These painful decisions have been avoided in France and the government is now ready to boast about the cyclical upswing France is enjoying. Such events leave us speechless." - source Louis Capital Markets

Of course the reason why French civil servants would have never accepted a decline in their remuneration is fairly simple to assess. It is the only support left to French president François Hollande! With only 25% of approval rate, there is indeed a large contingent of public servants still supporting the French president as they represent 22% of the working population versus 11% only in Germany. Please also note that 44% of the French National Assembly is made of public servants which explains the lack of "willingness" in implementing "structural reforms and only 3% of businessmen. In the UK you only find 9% of public servants in the House of Commons and 25% are businessmen. The big difference between the United Kingdom and France is that, in the United Kingdom, the particular problem of public servant eligibility was dealt with an absolute ban by the House of Commons Disqualification Act of 1975 and it was justified on the basis that civil servants should keep their political views a private matter. To do otherwise was deemed to impugn the neutrality of the British public service and its ability to serve government of whatever political persuasion. Civil servants therefore are required in the United Kingdom to resign before announcing their candidature. In France, put it simply, with their "bulletproof" status, they never lose, but, that's another matter...

On that particular point around the impossibility of major reforms, we read with interest Bank of America Merrill Lynch's note on France written by their European Economist Gilles Moec published on the 16th of March and entitled "France: doing more than it seems, but less than is needed":

"Tough fiscal and political equation
For this to be neutral for the fiscal balance, we think such a move should be offset by a reduction in public spending. Actually, Paris needs to do more than a mere offset, since the European institutions are still demanding a net fiscal tightening, in our view. This is where the political rigidities of the French centre-left kick in. Although the current administration has clearly embraced a reformist course, and is ready to confront its increasingly restive left wing minority in parliament, this imposes limits to the government’s room for manoeuvre. The administration needs to carefully choose its battles. The government can - and will - slow down spending, but changing the very structures of the public is out of reach in our view.
Cycle to help
Fortunately, a series of external factors are making the government’s job easier. The drop in oil prices will support consumer spending – which has already showed sign of recovery in the last few months. The decline in the exchange rate of the euro will be a major boost for growth, since the particular sensitivity of French exports to currency gyrations offset the low share of foreign trade in GDP. Still, while this should help keeping Paris on the right side of the European rules, we expect only peripheral progress on structural issues." source Bank of America Merrill Lynch

For the reasons stated above, we have to agree, changing the very structure in public spending is clearly out of reach. The game is not only locked but, it is rigged and the burden of taking France out of the proverbial doldrums has been put on the corporate sector. The issue of course is that the French corporate sector boasts a low and declining profitability thanks to important labor cost as indicated in Bank of America Merrill Lynch's note:

"Faced with low and declining profitability, firms have to choose between three solutions. First, run down headcounts and/or pay until the share of profits in value added is restored. Second, cut down on capital expenditure. Third, maintain headcounts/pay, and capex at the cost of higher debt. In the short run, the third solution is from a collective point of view the best one, since it is the only one which is consistent with some protection of aggregate demand (unless fiscal policy can offset the lack of private demand, at the cost of higher public debt), but obviously this is feasible only if interest rates are sufficiently low and banks have enough appetite to lend. Such option was not open in Spain for instance, where the initial level of corporate debt was high, interest rates were very high on account of the sovereign crisis and banks were not in position to lend. A “crash adjustment” of profitability was the only option (Chart 1)

Among the four largest economies of the Euro area, France is the only country where the investment rate of the non-financial corporate sector in 2008-2014 has exceeded the level of 1999-2007 (Table 2). 

Moreover, the investment effort exceeded gross saving, which is a broader measure of profitability, taking into account the impact of net interest and tax. In 2014, investment exceeded saving by 30% (from 11% in 1999-2007), while in Germany and Spain investment was lower than gross saving (in other words the corporate sector there is in a net lending position) and in Italy recourse to external funding fell (Table 3).

This reflects the resilience of the French banking sector throughout the crisis which was able to meet the demand for credit from the firms. Since Q1 2013, corporate debt as a percentage of corporate output has been is higher in France than in Spain (Chart 2). 

In Q3 2014, the ratio stands at 249% in France, very close to the peak level it had reached in Spain (251% in 2009).

This level of corporate debt is however much more sustainable in France than it ever was in Spain. While in the periphery market rates, and bank interest rates margins shot up during the crisis, imposing a major burden on firms when refinancing their debt, in France the banking sector consented to a major drop in lending rates, while the sovereign bond market was likely never seriously under attack (Chart 3). 

This means that, in spite of the significant increase in the stock of debt, net interest payments have been falling. In Q3 2014, net interests stood at only 4.2% of gross operating surplus, significantly below Spain (Chart 4).

Is there a "zombification risk"?
Still, this can’t be a sustainable growth model, for three reasons. First, even if with QE is ECB has become very credible on the “low for long” interest rates policy stance, interest rates cannot remain below equilibrium in France forever.

Second, companies cannot likely maintain a decent level of capex if their expected profitability does not recover at some point. Third, cheap credit can trigger a process of “zombification” of the corporate sector by keeping fundamentally unsound businesses alive, which down the road would damage growth potential by keeping resources skewed towards the least productive sectors.

In France the number of corporate bankruptcies never exceeded the 1993 peak. This contrasts with the explosion in corporate failures seen in Spain (Chart 5 and Chart 6). 

One could find comfort in the fact that the pace of business failure is in line with the position in the cycle, but this could be a case of reverse causality: the reason why the French output gap is not deeper could simply come from the fact that businesses are allowed to survive by an overly complacent banking sector.
However, since the French productivity performance has been decent lately - when compared with Germany - we think that the high survival rate of French companies has not yet impacted overall economic performance, but it's a risk for the future."  - source Bank of America Merrill Lynch

While the corporate sector has been clearly preserved compared to Spain from lower leverage and a lesser credit crunch, the corporate sector, in our views cannot continue to do the "heavy lifting" when public expenses continue to represent around 58% of GDP. Furthermore as it can be seen in Chart 2 from Bank of America Merrill Lynch, the French Corporate debt over corporate output has been steadily increasing and is now above Spain which has been rapidly deleveraging during the last few years.

The political issue of course is that in the incoming elections, the French socialist party is facing serious bashing and as we mentioned before, it's only support comes from the public sector employees as also underlined by Bank of America Merrill Lynch's note:

"This gradualist approach – which generates a pervasive sense in the foreign commentariat that “France is not doing anything” – reflects in our view the fact that i) the current administration campaigned in 2012 on a rejection of Sarkozy’s stance, seen as “too brutal” and ii) an increasingly restive traditionalist left wing of the socialist party imposes limits to the reforms.
Indeed, a peculiarity of the socialist party is that the core of its support does not come from the working class employed in the private sector (which has been increasingly deserting the left for the National Front) but public sector employees.

This puts a limit to how far the government can go in any structural overhaul of how the state operates, while the reformist turnaround of Hollande has created a wedge in the socialist party's parliamentary group.

The fairly limited deregulation offered by the “loi Macron” was forced through parliament thanks to the 49.3 procedure, which explicitly links the passing of a bill to the survival of the government. The left wing of the socialist party had no choice but to support the government on this, to avoid early elections in which they would probably have been wiped out.

The 49.3 procedure can be used only once in each parliamentary session (although the budget bill is excluded from this limit, which means that the government can almost certainly get a budget through). This means that the government must now choose its battles carefully" - source Bank of America Merrill Lynch

While the international scene is watching with caution the rise of the French National Front, the political story, we think is the slow dislocation of the unity of the left. Statistically speaking, what has been rising is more the number of non-voters (around 60%), rather than the "absolute" number of people voting for the National Front.

But, let's move back to France and its "micro-economic" picture. In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 13th of March points to a deterioration in the Terms of Payments, which indicates that the improving trend since mid 2012 has turned decisively negative:

The monthly question asked to French Corporate Treasurers is as follows:

Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their March survey have reported an increase by corporate treasurers. Overall +17.9% of corporate treasurers reported an increase compared to the previous month (+13.9%), bringing it back to the level reached in October 2014 (17.9%). The record in 2008 was 40%.

Overall, according to the same monthly survey from the AFTE, large French corporate treasurers indicated that they are still facing an increase in delays in getting paid by their clients. It is therefore not a surprise to see that the overall cash position of French Corporate Treasurers which had been on an improving trend since 2011 has now turned more negative overall according to the survey:

The monthly question asked to French Corporate Treasurers is as follows:

"Is your overall cash position compared to last month falling, remains stable or rising?"

Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's provisional figure came at -8.5%. 

This warrants significant monitoring in the coming months we think from a "corporate monitoring health" perspective.

• Being "short" Euro is one of the most crowded trade

According to Nomura's FX Positioning Index from the 13th of March, short Euro positioning is still close to record high of November but, looks like it close to stabilising: 

"EUR positioning was little changed the week ended Tuesday, falling just $0.1bn. Since then, specs have sold a further $1.7bn. Positioning is estimated currently at -$25.9bn which is still shy of the lows from November (-$28.1bn) and February (-$28.2bn)."

 - source Nomura

The very significant rapid depreciation of the Euro in conjunction with record low yields are for us clearly signs of the on-going "japanification" process at play in Europe and validates our deflationary bias. But, in terms of risk reversal for the Euro, there could be a pause depending on the FOMC outcome we think.   

In terms of bond yields as well we are getting closer to some floor in Europe (except for Greece...). On that specific "bond" matter we agree with Louis Capital Markets take:

"We have been OW bonds for a while, but would be back to a neutral position because the upside/downside likelihood appears more balanced now. As Mr Weidmann from the ECB said, if the implementation of QE by the ECB is a success, nominal bond yields will increase in the end. This is indeed our conviction and the charts below explain the reasons why.

The green line above should creep higher as inflation expectations normalise. Indeed, the above chart on the right shows that current real yields (extracted from long term inflation linked bonds) are extremely low in Europe (well below the level reached by US inflation linked bonds during QE3). There should, therefore, be a limit to the downside of real rates in Europe which in the end implies a limit to the downside of nominal bond yields in Europe.

We would also like to add to what Mr Weidmann said that if QE is successful, bonds yields should rise AND the euro should stabilise or rise.
This is the contradiction that is emerging these days among investors: if investors continue to be short on the euro, they cannot continue buying European equities, because if the euro continues to decline it will reflect the failure of QE and will validate a deflationary scenario for Europe.
Therefore, the next phase is to see the stabilisation of the euro to validate the recovery of the growth expectations in Europe." - source Louis Capital Markets

When it comes to the success of QE in Europe, as we have stated before, QE without additional policies is bound to fail. 

While from a flow perspective we believe in short term stabilization of the Euro, we agree that the continuation of the decline of the Euro will indeed ultimately reflect the failure of QE and the deflationary scenario playing out in Europe à la Japan.

• Europe continues to be a "flow" driven market

As far as European equities are concerned, it is indeed a flow driven market which has seen strong foreign investments, particularly by Japanese investors as indicated by Nomura in their JPY Intraday Comment from the 12th of March entitled "Strong foreign equity buying continues":

"Strong foreign equity buying continues
Japanese investors continued to purchase foreign assets at a high pace last week.
They bought JPY356bn ($3.0bn) of foreign equities, for the sixteenth week in a row, while purchasing JPY270bn ($2.3bn) of foreign bonds, for the seventh consecutive week (Figure 1).

Foreign equity investment flows remain strong, with net purchases of over
JPY1trn per month (Figure 2). 

Japanese investors purchased JPY1384bn ($11.5bn) of foreign equities in February, more than JPY1trn for the third consecutive month . The record pace of Japanese investment in foreign equities continues so far in March. Pension funds and retail investors were two major net buyers of foreign equities recently, and we expect them to remain strong net buyers of foreign equities as public pension funds shift their portfolios from JGBs and better economic conditions support risk sentiment among retail investors. Strong foreign equity investment by Japanese investors should support USD/JPY this year.

Foreign bond investment has also been relatively strong, while February’s MOFdata showed that banks were major buyers of foreign bonds. Their foreign bond investment likely involved smaller FX transactions than other investor types. Pension funds and toshin companies were also likely small net buyers of foreign bonds, while life insurance companies may still be quiet ahead of fiscal year-end. Life insurance companies sold foreign bonds in February for the first time in two months, albeit a small amount." - source Nomura

The Ides of March...or when Japanese investors are "Zugzwang" (compelled to invest) before the end of the fiscal year (31st of March).

According to Nomura's report,  there was net buying of JPY31bn (USD255mn) in foreign currency denominated toshins on 10 March, according to NRI, the 56th consecutive business day of net purchases. We continue to closely look at Japanese flows when it comes to their European appetite.

• King Dollar even rules the Fed

Meanwhile the USD crowd remains near record high according to Nomura's FX Positioning Index from the 13th of March:

"According to the IMM data for the week ended March 10, non-commercial accounts increased their USD longs by $3.9bn. Our real time indicator suggests net longs increased by a further $1.2bn since. Net longs stood at $52.8bn by Tuesday and had increased to $54.0bn by Friday’s close, just shy of the all-time high of $55.6bn set the second week of January." 

- source Nomura

We do not believe in a June hike by the Fed and are adamant the Fed will remain rather dovish in the light of recent data disappointments regardless of the strong NFP data recently released. We are therefore content with our current long duration exposure which we added on recently.

On that point we agree with Nomura's latest take from their 13th of March note entitled "Fed - behind the curve or just right?":

"Cross Rates View
The start of the ECB bond-buying spree this week resulted in a further push to historical low yields in Germany, with Bunds breaking through the 20 bps barrier. Almost like clockwork, the UST auctions went over well as the overall EU curve flattening helped reverse the NFP-led selloff. Heading into FOMC next week, it will be another meeting in which they guide the market’s expectations that hiking will happen only when all factors give them enough confidence to do so later this year. The market has had a tendency recently to go into FOMC/Minutes expecting a hawkish event only to be let down. We think the recent reaction to such Fed events will be repeated next week, with the market adding to hedges ahead of time and unwinding them during the presser." - source Nomura

King Dollar: One currency to rule them all, even the Fed!

"Pace: Faster hikes should be self-restrained by an increasingly stronger USD

So far the pricing for a June hike has been a lot more uncertain compared with the 2004 cycle (Fig. 5),  and the Fed’s hiking pace is even more difficult to pinpoint—it should be anything but the well-telegraphed 25bp per meeting schedule we saw back in 2004. 

One key driver this time around is the total dichotomy of global monetary policy, wherein the Fed is about to embark on a hiking path, while the second-largest economic bloc, i.e., the Eurozone, has just started its easing program, while the BoJ is still in QQE. As a result, the FX adjustment is going to have a much more pronounced impact (Fig. 6) on both the financial markets and the U.S. economy. 

We are already seeing equity markets under a bit of pressure as the stronger dollar eats into corporate profits, especially given the heavy weighting of multinationals in the broader indices. As the effects of a stronger dollar trickle down to worsening trade and softer inflation prints, we expect the Fed to be very gentle, as a faster hike pace will have a compounded effect via FX tightening."

Terminal Rate – Higher debt loads call for a terminal rate much lower than before

The business cycle/equity rally is long in the tooth; and with other central banks easing while taper and the dollar act as tightening forces, the terminal rate will end up lower than in the past. The Fed has been ratcheting down terminal expectations (from 4.25% to 3.75%), but we believe that in the upcoming meetings it will avoid lowering this as much as the other dots. Instead we see it focusing more on lowering the dots in 2015 and 2016, because it doesn’t want to admit defeat just yet. Meanwhile, our Economics Team believes the terminal level will be closer to 3% when the Fed finishes tightening in this cycle, largely due to the dollar, as noted above (see link). We stated that the Fed will be lucky to get to 2-2.5% when all is said and done, largely because ratcheting up aggregate demand while performing debt deleveraging requires years of low real rates." - source Nomura

Exactly!
The large global debt overhang requires much smoother maneuvering from the Fed thanks to King Dollar although the Fed feels it needs "Zugzwang" due to latest employment data.

On the dichotomy between Economists' perception and consumers' reality we completely agree with Reorient Group David Goldman's take in their note from the 15th of March entitled "It's all about the dollar...even for the Fed":

"The fact is that consumer behavior with respect to gasoline purchases is not much different than with respect to other items in the consumption basket. The chart below shows year-on-year change in nominal purchases of all goods (excluding food services) and gasoline. The two lines have the identical shape; the only difference is that the absolute change in gasoline sales is much greater, reflecting the volatility of the gasoline price. Evidently American consumers do not feel as confident about the employment outlook as the economists. We observed last week that most of the new jobs created during the employment bounce of the past three months were in low-wage, labor-intensive industries (health care, hospitality, and retail), which explains why wage growth has been absent.

We have never been enthusiastic about quantitative easing: the drag on the US economy is regulatory and fiscal rather than monetary, and the Federal Reserve has had the unenviable task of promoting growth against these headwinds. But the prevailing view at the Fed that an economic rebound justifies higher rates—seemingly among the whole Board of Governors except for Chair Janet Yellen—is inconsistent with the data. The bond market has remained skeptical. The present 10-year Treasury yield of just over 2% reflects lower inflation expectations, consistent with falling commodities prices, and a modestly higher “real” rate (the yield on inflation-indexed securities)." - source Reorient Group, David Goldman

While the Board of Governors of the Fed might feel the "Zugzwang" urge, we remind ourselves that the fact that these players feel compelled to move means that their position will ultimately become significantly weaker. If their head prevails, at the FOMC, they will remain on hold and delay hiking interest rates in June until further data validates the "Zugzwang" we think.

• Final note "There is an anomaly in US share prices and UST yields"

Like many pundits, we believe the velocity of the rise in King Dollar represents a significant headwind for US corporate earnings and yet another important factor for the eager to trigger "Zugzwang" Fed. In that instance we read with interest Nomura's Japan Navigator comments from the 16th of March. US corporate earnings in April will be essential to watch!

"Concerns over US corporate earnings reports in April
Since last summer, we have been pointing out the anomaly in US share prices and UST yields that appeared at the start of the quarter, which remains in place (Figure 3). 

 This anomaly is: 1) overvalued stock prices correct before earnings season starts, which has been typical in recent quarters; and, 2) The Fed conducts policy based on its communications with the market, and adjusts its hawkishness depending on stock market conditions, which also drives movements in rates markets. Currently, the impact from strong USD on corporate earnings is a key theme, which should increase investor concerns over earnings announcements.

We believe the Fed will remove the “patient” wording in its next statement, but this alone is unlikely to change rate hike expectations. However, as this would means the Fed is maintaining its hawkish stance, investor risk sentiment should then deteriorate into next month’s corporate earnings reports.
Given this, it is worth considering a risk scenario in which the Fed sends an unexpectedly dovish message at its next meeting. While this would likely prompt bond yields to fall, risk sentiment could improve, laying the groundwork for higher share prices and bond yields in April-June.
In either case, this would not trigger the next upturn in yields, unless US economic indicators surprise on the upside." - source Nomura

So "bad news" (rate hike) could end up being good news for US Long bond holders like ourselves (holding pattern). After all that's exactly what we pointed out in the first bullet point of our conversation "Information cascade":

"Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently." - source Macronomics, 8th of March 2015

"What makes zugzwang such a painful death is that the deceased is executed not by a threat but by his own suicide" - Andrew Eden Soltis, American chess grandmaster.

Stay tuned!