Macro and Credit - The Decoy effect

"In a time of universal deceit - telling the truth is a revolutionary act." - source unknown

Looking at our home team (France that is) getting away with the Football World Cup for a second time in 20 years (1998-2018) hence our lack of recent posting, 8 being a lucky number it seems, we were drawn again to the parallel with 1998 with the ongoing Emerging Markets (EM) woes, whereas this time around, Asian countries are in much better shape, including Russia, while the usual suspects (Turkey, Argentina and Brazil and even South Africa) are still feeling the summer heat from the Fed's liquidity drain thanks to QT. With the escalating rhetoric of trade war between China and the US and the strong arm negotiating tactics from the Trump administration, when it came to select our title analogy, we decided to go for a marketing one, namely the "Decoy effect". In marketing, the decoy effect (or attraction effect or asymmetric dominance effect) is the phenomenon whereby consumers will tend to have a specific change in preference between two options when also presented with a third option that is asymmetrically dominated. An option is asymmetrically dominated when it is inferior in all respects to one option; but, in comparison to the other option, it is inferior in some respects and superior in others. In other words, in terms of specific attributes determining preferences, it is completely dominated by (i.e., inferior to) one option and only partially dominated by the other. When the asymmetrically dominated option is present, a higher percentage of consumers will prefer the dominating option than when the asymmetrically dominated option is absent. The asymmetrically dominated option is therefore a decoy serving to increase preference for the dominating option. The decoy effect is also an example of the violation of the independence of irrelevant alternatives axiom of decision theory. Of course, it is a great tool to use when one relates to trade negotiation we think but we ramble again...

In this week's conversation, we would like to look at the rise in inflation, and trade war escalation and the impact in can have on global growth as well. Also, overweight US relative to Emerging Markets (EM) and the rest of the world, continues to be the trade du jour, with FANG still racing ahead in the rally game. 

Synopsis:

• Macro and Credit - Deglobalization goes hand in hand with inflation
• Final chart - Credit versus Equities - "until death do us apart"

• Macro and Credit - Deglobalization goes hand in hand with inflation

While we thought the ratcheting up of the trade war narrative would be bullish for gold, latest price action with the continuation of the surge in the US dollar has put a dent on this scenario playing out so far. Real interest rate, US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple. 

Given it seems that US inflation expectations are moving upwards it seems, we like US TIPS 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. At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument eventually. Also, 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. 

If inflation creeps up, then companies will suffer margin compression and will be forced to raise prices which will lead to wage increases to compensate that higher price level. We have pointed in the past that trade wars could lead to a stagflationary scenario playing out, meaning lower growth and higher inflation. Are tariffs really the culprit leading to higher inflation? On that subject we read with interest UBS Global Strategy note from the 18th of July entitled "What will drive TIPS in the 2nd half?":

"What about tariffs? Do they matter? It matters much more for growth than inflation

As discussed by our economics team and shown in Figure 4, Laundry equipment prices have jumped by 12% above their January level following the implementation of 20% tariffs in early February.

That said, its impact on headline inflation is very small because of its less than 0.08% weight in CPI. Nonetheless, this clearly shows tariff do have an effect on near-term inflation. Since these early tariffs, US has implemented additional 25% tariffs on $50bn of products from China and the President has proposed 10% tariffs on an additional $200bn of imports from China with other investigations going on in parallel. Thus the scope of tariff tensions is much larger now. We estimate that the current set of announced tariffs would push up consumer prices by roughly 15bp, but with notable uncertainty on both the upside and downside. We discussed ramification of various upside tariff scenarios on growth/inflation and financial markets in Trade Wars- What is the impact on growth, inflation and financial markets? A Top Down View. Albeit, we view this document more as the upside risk scenario than our current baseline; based largely on a lower effective autos tariff and smaller Chinese retaliation is somewhat less.

Specifically, in the aforementioned note, we discuss the following scenarios and their impact on GDP inflation. The 1st scenario is ("Escalation") 25% car tariff (US/global retaliation plus an additional 10% tariff on $200bn US-China trade with proportional retaliation. In the 2nd scenario ("Trade War"), we assume 30% tariffs on virtually all US/China trade + earlier car tariff disruption. In Figure 5, we see that under the trade "Escalation" scenario, we would see near-term inflation rise by 31bp and real GDP fall by 100bp.

In Scenario 2 – "Trade War", we see inflation rising by 71bp and real GDP falling by 245bp. A key takeaway is that the hit to real growth is much larger than rise in inflation on trade tariffs. For details on these estimates, please see the Q-Series. Next, we consider what is the TIPS market priced for and how they could react to escalating trade tensions.

Is the TIPS market pricing in trade dynamics correctly?

The TIPS market is right in reacting trade war by not widening breakevens but by lowering long-end real yields. 5y and 10y real yield have declined by 3bp and 9bp since early June while 5y and 10y BEIs barely moved (Figure 6).

On the inflation impact, we think the market already seems to be priced for our escalation scenario. In Figure 7, we see that 2y ex-energy inflation (which is close estimate to implied core inflation) has risen quite sharply this year. It's near 252bp if you assume  240bp as consistent with target CPI inflation.

The market is implying that the US may have up to 10-15bp/annum of trade related inflation over the next two years. In our trade escalation scenario, we see 31bp inflation uptick over 1-year. This would imply about 15bp tick-up in 2-year core inflation and market seems to be pricing such an uptick. Thus, the market is fairly priced for the inflation uptick. For growth hit due to trade "escalation", we should have seen a bigger decline in real yields. 2y yields are basically unchanged over the past few months, which suggest the market is not assuming a growth hit at this juncture. Thus, for increasing trade concerns, we recommend receiving front-end real rates, or set up 2s5s real curve steepeners which we discuss later in the note. In general, the market is not priced for a "trade war" scenario on both real yields and breakevens." - source UBS

It seems to us that the market has been a little bit too complacent for a trade war scenario playing out. At least with TIPS with the embedded deflation floor, you have some downside protection should the global slowdown scenario play out thanks to escalating tensions. With this known unknown, we do think that the long end of the US yield curve (30 years) at current levels remains enticing from a carry and roll down perspective. We have recently started to add exposure to it on a side note.

But, in respect to the inflation risk, US inflation is creeping up, no doubt about it. This is clearly illustrated by Wells Fargo in their Economics Group note from the 11th of July entitled "Producer Prices: More Inflation to Come":

"Producer prices for final demand rose 0.3 percent in June, which was slightly stronger than expected. Core prices continue to climb higher as U.S. producers are facing rising input costs.

Broad Increases in Producer Prices in June

• Inflation continues to gradually climb higher, with the producer price index advancing 0.3 percent in June. Gains were broad based, with food being the only major category to see prices slip.
• Excluding food, energy and trade services (measured by margins), prices increased 0.3 percent. That pushed the year ago rate of our preferred measure of core PPI back to 2.7 percent, which is up from 2.1 percent last June.

Processing Input Cost Increases

• Input costs continue to rise as capacity has become more constrained and businesses are grappling with tariffs. Processed intermediate goods increased 0.7 percent in June and are up 6.8 percent over the past year. While higher energy costs have led the pickup, non-energy materials for manufacturing and construction are up 6.5 percent since last June. Service inputs are up, led by fuel and labor shortages driving transport costs higher.

- source U.S. Department of Labor and Wells Fargo Securities 

June PPI report showed an acceleration in the price appreciation with year over year PPI at 3.4% and year over year core PPI coming at 2.8%. With year over year CPI up to 2.9%, meeting estimate, Core CPI printed at 2.3% beating expectations. It might be the case of the US economy running hotter than anticipated? We wonder. Wage growth are essential to validate this prognosis we think. For some other pundits such as Knowledge Leaders Capital, "The Inflation Story is Alive and Well in Five Charts".

As we pointed out in our previous conversation "Attrition warfare":

"The rise of the US dollar in conjunction with trade war escalation and rising oil prices could indeed decelerate even more global growth and led to a stagflationary outcomes. Some signs are already there. We are very closely looking at the rise of gas prices in the US and monitoring closely the US consumer. If indeed, the US consumer starts retrenching as pointed out recently by another note from David P Goldman on Asia Times on the 30th of June then all bets are off.

To repeat ourselves, rising energy prices could be the match that lights the bear market. Continued inflationary pressure coming from energy prices will eventually lead to financial markets "repricing" accordingly. We are already seeing blood in some selected EM with rising inflation in double digits (Turkey for example). It is probably understandable why the Trump administration is reaching out to OPEC for them to slowdown the steady rise in oil prices with elections coming later this year.

While escalation in the trade war would no doubt affect Developed Markets and Europe in particular, Emerging Markets which have been more recently on the receiving end of tighter liquidity and rising US dollar would as well be seriously impacted by a stagflationary income."- source Macronomics, July 2018

This raises the question about inflation and the US consumer in general and the price at the pump in particular. What is the pain threshold one might rightly ask? On that subject we read with interest Bank of America's take in their US Economic Watch from the 11th of July entitled "High pain tolerance at the pump":

"Higher gas prices a partial offset to tax cuts benefits

Gasoline prices are up around 50 cents since the start of the year and currently hovering nationally around $3, owing to tightening global oil supply and demand balances. Our calculations suggest that the recent rise in gasoline prices increases the average cost to the consumer by $30 per month. So far, this has had limited impact on overall consumer spending as most consumers have been able to offset higher prices at the pump with the extra income from tax cuts. According to the Tax Policy Center, the median consumer is receiving roughly an extra $78 per month due to tax cuts this year.

The breakeven price: $4/gallon

At what point would higher gas prices fully offset the tax cuts? We would likely need to see oil prices jump another $60 per barrel (bbl), adding about $1 per gallon to gasoline prices. This would increase the cost of gasoline almost $60 per month, effectively wiping out the extra income from tax cuts for most consumers.

Of course there could be effects beyond these simple calculations. A common rule of thumb from Hamilton (2008) is that an oil “price shock” is when prices go above the highest level in the last three years. That seems to be happening now, although we are still below the highs of 2011-14 (Chart 1).

Francisco Blanch and team see upside risk to their crude oil price outlook should sanctions on Iranian oil exports prove binding. Higher gasoline prices could lead to “sticker price shock” at the gas pump, causing consumers to pull back spending more than one-for-one. An additional downside risk comes from the fact that the “gasoline tax” is regressive and has a bigger percentage impact on low income families (Chart 2).

From the oil rig to the gas station

Translating moves in crude oil prices to gasoline prices is fairly straight forward. According to the Energy Information Administration, crude oil represents about half the retail cost of gasoline. Indeed, looking at the relationship between the % mom in Brent oil prices and % mom in gasoline prices, we find a coefficient of roughly 0.5 suggesting that a 10% increase in the price of crude oil would be associated with a 5% increase in the price of gasoline (Chart 3).

Currently, a $60 boost would amount to a 75% increase in crude oil or 37.5% increase in gasoline prices. With gasoline currently near $3, such a shock would increase prices at the pump by over an additional $1.

From the gas station to the consumer’s wallet

Vehicles on the road in the US consumed, on average, 55 gallons of fuel per month in 2016 according to the Federal Highway Administration (Chart 4).

To put this into context, for a compact car or a medium size sedan, this works out to be a full tank of gas per week. Demand for gasoline is relatively inelastic so we can safely assume no demand response from an oil price shock in the short run. Therefore, the run up in gasoline price since the start of the year would cost the average consumer around $30 per month.

We think most consumers have been able to offset the latest increase in gasoline prices. According to the Tax Policy Center, with the exception of the bottom quintile, taxpayers are receiving at least a $30 tax cut per month due to the Tax Cuts and Jobs Act (Table 1).

However, further boost in gasoline prices could ultimately offset most of the tax cut benefits. For example, another $1 per gallon at the gas pump would cost another $60 dollars per month. All told, the extra $90 per month spending at the gasoline station would be enough to offset tax cuts for majority of consumers.

From the consumer’s wallet to consumer behavior

While demand for gasoline is relatively inelastic, marginal propensity to consume out of gasoline (dis)savings is likely greater than 1. That is, a rise in gasoline prices will force consumers to substitute away from other categories more than one-for-one and vice versa. For example, Gicheva et. al. (2007) find that gasoline expenditures rise one-for-one with gasoline prices but consumers substitute away from food services toward  groceries in order to partially offset higher gasoline expenditures. Moreover, they find that even within grocery spending, consumers substitute away from regular price products and towards promotional items. On the flip side, Alexander and Poirier (2018) calculate that the marginal propensity to consumer out of the gasoline savings in 2014- 15 was greater than 1 with most of the spending going toward discretionary spending. The upshot is that most consumers have so far absorbed higher gasoline prices in stride but further increases at the gasoline stations could start to broadly hurt consumer demand." - source Bank of America Merrill Lynch

While everyone and their dog is focusing on the flattening of the yield curve, we would rather focus on inflation creeping up and in particular oil prices as a potential lethal trigger for asset prices and a bear market to ensue. Clearly we are not there yet, but we think that the "decoy effect" of the flattening of the yield curve hides the fact that trade war rhetoric is weighting on both consumer sentiment as well as leading to higher PPI. At some point these factors will weight on growth. The continuous surge in the US dollar means that EM are still in a painful situation. In that context, cash has returned as a valid yielding tool in the allocation toolbox and so are US Tips. As we stated above the long end of the US yield curve remains enticing.

Maybe the second part of the year will favor the return of the duration trade versus the high beta. This is what Bank of America Merrill Lynch mentions in their Credit Derivatives Strategist note entitled "A bull and a bear" on the 19th of July:

"European growth headwinds, trade wars and Italian risks are taking over last year’s goldilocks. With manufacturing PMIs in Italy, Spain and France at 53 and inflation risks to the downside, this is still an environment of a patient ECB on rates. Investors are concerned about an inflation shock; we think we are far from there. The potential for an
“Operation Twist” and slower macro can flatten the curves both in cash and synthetics. We think that the CDS market is offering an attractive entry point for longs on the backend of the curve. We screen for the best singles to sell protection.

To offset our bullish view on duration we hedge the market direction with bearish risk reversals in Crossover. If trade wars escalate, growth could be hit more, and higher beta pockets would be more exposed. The recent flattening of the implied vol skew and spread tightening finds bearish risk reversals (own puts/payers vs. selling calls/receivers) attractive to own.

Softer macro = lesser risk of a hawkish ECB

Macro indicators have slowed down in Europe this year versus the high run-rate of last year. In particular, manufacturing PMIs across Europe have headed lower and inflation is only slowly recovering.

But what a slower macro backdrop means for yields and yield curves more specifically? We are using the OECD Major 7 Leading Indicators and we try to define the relationship between the economic cycle and the cycle of yield curve. In chart 3 we present a z-score analysis (in order to normalise patterns for the underlying vol and levels) and we find that there is meaningful correlation between the macro cycle and the cycle of the yield curve.

When the macro indicators improve (deteriorate) yields tend to steepen (flatten). This reflects the higher growth potential and thus the stronger outlook for inflation going forward and that ultimately is priced in via higher back-end yields and steeper curves. Should the ECB remain dovish, yield curves are more likely to continue to be under pressure, we think." - source Bank of America Merrill Lynch

Whereas the first part of the year has been great for high beta in credit and US equities, with Investment Grade lagging. There could be a possibility if the trade rhetoric escalates to see lower growth, meaning a return of the duration trade in the second part we think. One thing for sure 2018 has seen a clear divergence between equities and credit as we shall see in our final chart.

• Final chart - Credit versus Equities - "until death do us apart"

In 2018 US high beta has had a better success than US Investment Grade credit which has been punished. EM equities have suffered as well relative to US equities in stark comparison to what unfolded in 2017. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 18th of July entitled "Going separate ways":

"Credit and equities are two sides of the same coin. However, while equities by now have rallied to within 2% of the highest close of the year (S&P 500), high grade credit spreads are 33bps, or 37%, off the 90bps tights from earlier in the year (Figure 1).

Given the timing of the beginning of this decoupling in May, clearly one of the drivers was the Italian risks that developed during the month. Given the outsized importance of the financial sector in credit, and the reliance on funding markets and bank balance sheets in fixed income, such sovereign risks should intuitively drive a wedge between debt and equity market performance. However, we think the most important driver of credit market underperformance is the shift in US monetary policy from quantitative easing – QE – toward quantitative tightening - QT (see: On the road from QE to QT, redux 15 June 2018). Mechanically that means less demand and associated widening pressures on credit spreads during times with supply pressures, as we have seen a number of times this year. From that perspective we consider the wider credit spreads an early indicator of more struggles to come as the level of global monetary policy accommodation declines in coming years." - source Bank of America Merrill Lynch

So the big "decoy effect" might be at play, are equities too high relative to credit or credit too wide relative to equities? We wonder.

"It is discouraging how many people are shocked by honesty and how few by deceit." -  Noel Coward, English author

Stay tuned ! 

Macro and Credit - Bracket creep

"Declining productivity and quality means your unit production costs stay high but you don't have as much to sell. Your workers don't want to be paid less, so to maintain profits, you increase your prices. That's inflation." - W. Edwards Deming

Watching with interest the latest US CPI posting its biggest gain in 11 months to 1.8% in a US economy plagued by "fixed income" (lack of wage growth) and "floating expenses" (healthcare and rents), when it came to selecting our title analogy we reminded ourselves of the term Bracket creep, particular following the landmark tax reform passed on Christmas Eve to replace the 30-year-old, complex U.S. tax system. Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation. Given most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple.

In this week's conversation, we would like to look at rising inflation expectations and what it entails from a US TIPs and other linkers perspective as well as what are Japanese friends are up to from an overall flow allocation.

Synopsis:

• Macro and Credit - The return of the inflationistas
• Final chart - The "Bid 'Em Up Bruce" stage is now

• Macro and Credit - The return of the inflationistas

While inflation has been the elusive piece of the puzzle for many of our dear central bankers around the world, the latest print of core US CPI is marking the return of the "inflationista". This obviously should be welcomed good news for the members of the FOMC, but be careful what they wish for. As we indicated back in June 2015 in our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation. Also remember that in the headline CPI, rental prices represent 25% in the calculations and overall housing 42%. We will eagerly watch rental prices in the coming weeks and months. Back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008 as a reminder.

Yet as posited by Wells Fargo in their Economics Group from the 12th of January in their note entitled "CPI: Beyond the Headline, Inflation is Strengthening", consumer prices are it seems indeed edging up:

"Consumer price inflation edged up 0.1 percent in December despite a fall in gasoline prices. Reversing last month’s weakness, core inflation rose 0.3 percent and is up at a 2.5 percent pace over the past three months.

Gasoline Savings Going Elsewhere

Inflation cooled in December with the Consumer Price Index (CPI) increasing 0.1 percent. That followed a 0.4 percent gain in November.

The tamer increase stemmed from a pullback in energy costs as gasoline prices fell 2.7 percent over the month. That overshadowed a modest rise in energy services (electricity and utility gas). It was not until late in the month that unusually low temperatures led to a jump in natural gas prices. Although not quite halfway through the month, spot prices for natural gas are up about 6 percent from their December average. Therefore, we suspect energy services could provide an even larger lift to headline inflation next month.

For December, food prices rose 0.2 percent. That marks the largest increase since July and suggests that more stable prices for food commodities and rising labor costs for food services workers may be reasserting some modest upward pressure on the sector.

Core Inflation Rebounds

Core inflation bounced back after a weaker-than-expected reading in November. Excluding food and energy, prices were up 0.3 percent. Core goods prices posted a rare increase and moved 0.2 percent higher.

Leaner auto inventories after last year’s natural disasters spurred demand to replace vehicles and slower production growth more generally has given some support to prices. After falling from February to September, new and used vehicle prices have risen the past three months, including the largest monthly gain in December in more than six years. A 1.0 percent jump in prescription drug prices also pushed core goods inflation higher. Stronger core inflation was also driven by services. Shelter costs advanced an above-trend 0.4 percent in December. Rent of primary residences and owned residence both rose more than in November, while lodging costs partially reversed last month’s drop. Costs for medical care services also rebounded after a sharp decline in physician services in November.

Getting Back to the Fed’s Target

Inflation has been the darkest cloud hanging over the Fed’s efforts to normalize policy. Over the past year, inflation has risen 2.1 percent, a touch lower than November’s 12-month change and noticeably below the pace set earlier in the year. Yet the recent trend looks stronger. Over the past three months headline inflation is up at a 2.6 percent annualized pace. Similarly, core inflation, which is up 1.8 percent on a year-ago basis, has risen at a 2.5 percent pace over the past three months. This should help to allay some FOMC members’ fears that inflation is stuck at undesirably low levels. We expect to see a noticeable pick up in the year-over-year change by this spring. Although that will stem in large part from base effects following weakness last year, the trend remains upward." - source Wells Fargo.

Back in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves if indeed the game was turning and if we should switch camp from the "deflationista" towards the "inflationista" camp:

"Given China's most recent uptick in its PPI to 6.9%, we are indeed wondering if this is not a sign that we should change allegiance slightly towards the "inflationista" camp and start fearing somewhat the possibility of the return of the Big Bad Wolf aka inflation. We will be monitoring closely this latest China "inflation impulse". China's rising costs via exports could boosts inflation expectations in the US. These higher inflation expectations in the US would mean a steeper yield curve with a rise in long-duration yields overall and it would lead to higher rates volatility down the line. A bear market needs a wolf and this wolf would materialize in a return of inflation we think." - source Macronomics, October 2017 

As pointed out by Christopher Cole from Artemis Capital in his must read note "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. But flow wise, as we have pointed out in numerous conversations, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" so far. It seems the bond kings such Bill Gross and Jeff Gundlach as of late have picked up their side and are steering towards the "inflationista" camp whereas Dr Lacy Hunt, from is latest  quarterly note for Hoisington continues to sit tightly in the "deflationista" camp it seems. One might therefore wonder where we stand.

Also, 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", but that was because of the following:

"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 are moving upwards it seems, 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 and we have been adding...). 

We 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? 

At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument. We highly recommend our friend Kevin Muir aka The Macro Tourist post on a refresher on how breakeven works: "BREAKEVEN REFRESHER LESSON" for those not familiar with the concept. 

We would also like to add that if indeed the rise of inflation expectations is a global phenomenon, then our UK friends have an advantage with Gilt Linkers given they do not have an embedded deflation floor so, they should outperform US TIPS on a relative basis. 

Also, as all eyes are looking at the significant surge in oil prices in recent months as per our March 2016 conversation "Unobtainium":

"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, we do not think it is such a surprise to see a rise in inflation expectations in that context." - source Macronomics, March 2016

Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach of the "inflationistas" for the long end of the curve. We live in a world in which the public sector has never been so indebted (The world's global debt just reached $233 trillion in 3Q 2017). Demography is as well playing its part in rendering the US Yield curve "inelastic" therefore the volatility of the US yield curve is clearly in the front-end of the curve. We continue to witness a bear-flattening of the US Yield curve with the Japanese investment crowd and in particular Lifers continuing to be dip buyers. This is confirmed by Nomura from their JPY Flow Monitor report from the 12th of January entitled "Net buying continued but at a slower pace":

"Lifers sold foreign bonds, but seemed to maintain its recovery trend

Investment by life insurers, which are prominent medium- and long-term investors, remained lackluster. They were net sellers in November at JPY234bn and in December at JPY124bn ($1.1bn). Higher FX hedging costs for US bond investment may slow their foreign bond investment, but we do not believe that the recovery trend has ended, (see “US curve flattening and Japanese lifers”, 7 December 2017). Barring another resurgence of geopolitical risks, we believe there is a good possibility that lifers will resume their net buying at a high level due to pent-up demand. The recent rises in US and European yields should encourage them to consider foreign bond buying. Lifers’ FY17 investment plans show that the structural shift away from yen bonds and toward foreign bonds continues (see “JPY: Lifers upgrade EUR/JPY forecast”, 25 October 2017). Despite this, at JPY1834bn, lifers’ cumulative foreign bond investment from April through December 2017 is below the average since FY05 (JPY1959bn; Figure 3).

When it comes to unhedged investments, If USD/JPY trades below 112, this would trigger demand to buy USD on dips (sell JPY), in our view. Major lifers forecast USD/JPY in a core range of 109-115. According to major lifers’ H1 FY17 financial statements, their hedged ratio was 58.0% at end-September 2017, down slightly from end-March (60.2%), but this level was still high (see “JPY: Modest decline in lifers’ hedge ratio”, 24 November 2017). With the Fed raising rates, higher hedging costs should push lifers into reducing their hedged ratio (thus creating pressures pushing up USD/JPY). Lifers still have substantial room to unwind FX hedges, which should keep USD/JPY steady." - source Nomura

With government bond yields ratcheting up, this means more buying at some point FX unhedged from the Japanese investment crowd and still a strong demand for US credit given it is still a TINA trade (There Is No Alternative). When it comes to the on-going "bear-flattening" of the US yield curve, yes,  one could see a rebound with some tactical steepening in the 2s10s part of the curve as pointed out by Nomura in their FX and Rates Trade Ideas note from the 11th of January:

"In the US strategy outlook for 2018 (see link), we listed several reasons why we do not expect a full flattening of the US curve, or an inversion any time soon. It is inconsistent, in our view, for curves to pancake at this time given outright levels of rates are low (versus prior periods), global QE is fading, debt issuance is rising and the economy is growing. We expect these and other factors driving the US curve to result in sharp countertrend moves at times in 2018. We envision some bull and/or bear steepening factors ahead.

1. Bullish front-end factors: The front-end has quickly discounted the 2018 hiking path. US momentum looks solid but any sort of miss in US data could prompt a front-end rally. The front-end has also built up a sizable short base as seen in Figure 1.

2. Curve correlation factor: The curve versus the level of rates (Figure 2) is shifting quickly from the prior bull flattening/bear steepening regime.

Thus, those expecting the long end to outperform on any sort of risk-off (which is a common rationale we hear from investors long 10s plus) is misplaced, as 2s would now rally more in a risk-off.

3. Bearish long-end factors: As seen in Figure 3, one reason why the curve flattened in 2017 was 10-year rates were stuck in a range, while the Fed was hiking short-end rates.

This year will be unlike last year because Fed QT in ongoing, US tax reform passed (and deficits/debt loads are likely to expand) and global QE buying is slowing.

4. Curve momentum factor: We take the 3-month moving average of the curve as an indicator of momentum and take the rolling 1-week change to gauge its speed. As seen in Figure 4, the US curve momentum has hit its limit and is due for a rebound.

We recommend investors go short 10s on the curve (2s10s) and the broader butterfly in Q1 2018. For the 2s10s UST trade, our first steepening target would be half the flattening seen since November 2017 (roughly 15bp above current levels) before we re-assess." - source Nomura

While we might see indeed some rebound in the 2s10s part of the US yield curve, the continuation of the velocity in the "bear-flattening" of the US Yield curve which has started a while back is depending on renewed appetite from "Bondzilla" the NIRP monster "Made in Japan" we think.

But moving back to the attractiveness of US TIPS, we do think that, from an allocation perspective, they are of renewed interest. On that subject we read with interest another Nomura note, their Inflation Insights from the 11th of January entitled "Tip(s)-toeing into the US BEI pool":

"Avoid jumping but gradually wade into BEI waters

The macro case for adding long US inflation positions has strengthened with higher price pressure from the recovery in world trade, which has been a driver of higher commodity prices, especially for oil. These higher input costs coupled with what still remains a relatively accommodative global monetary stance (keeping real rates contained for now) is leading to wider TIPS breakevens inflation (BEI). Yet, this has been an orderly move and there are few relative value disruptions to take advantage of (i.e., cash/swap basis and curve disruption). A long US BEI position is therefore mostly a directional macro trade. 

We recommend investors stick with the macro trade, with limited risk and an oil hedge. We get long 5y breakeven rates at 1.95%, targeting 2.20% at the end of February (20bp net of negative carry) and pay for some oil price protection. We expect core inflation to strengthen in December. However, we would not hesitate to take losses if the December print meaningfully surprises to the downside. Globally we still prefer long euro BEIs.

US TIPS breakevens showed a strong performance into and out of year-end

The US 5-year breakeven inflation rate performed remarkably well into and out of yearend, increasing by about 15bp since mid-December 2017 (about 12bp net of the negative inflation carry). This is a solid performance that contrasts with the lack of movement between October and December. Inflation carry should remain negative in February, pushing forward breakeven rates higher at an increasing pace given the magnitude of the negative carry and the low number of days in the month (Figure 1).

The inflation carry profile therefore accentuates the skew to long breakeven positions into the CPI number on 12 January: a substantial positive surprise is needed for long positions to perform, while a small negative surprise would be enough to postpone long positions by a month. Note that our US economists’ forecasts for the December headline CPI are in line with both consensus and short-term inflation markets, although their forecast on core is higher (see US CPI Preview: A Potential Jump in Core).

Timing aside, the medium-term outlook for US TIPS BEIs appears favorable

As we highlighted in the TIPS section of Fixed Income Insights: 2018 Themes - US Strategy Outlook, “while valuation did not argue for a massive TIPS BEI long, the US may be the first place to benefit if the ‘reflation’ trade 2.0 is driven by Trump administration’s tax plans and fiscal stimulus”. Beyond the hurdle of short-term carry implications, various factors are forming a positive framework for US inflation valuations.

Global inflation is picking up and that should be supportive BEI wideners

The first positive technical stems from the behaviour of our Global Inflation Factor (GIF, a factor extracted from internationally-set prices such as commodity prices and manufacturing prices obtained from manufacturing surveys, which remain a large fraction of world trade). As the right chart in Figure 2 shows, global inflation picked up at the end of last year.

Furthermore the strong momentum on the price of manufacturing goods is further supported by the recent strength in energy and food commodity prices. Goods price momentum is particularly visible in Europe and is reflected in the right chart in Figure 2. The chart scaling shows this is why our favored long so far has been in euro inflation wideners. Yet, stronger momentum on commodity prices favors US TIPS breakevens, despite some discrepancy between wholesale and retail gasoline prices, probably due to margin changes after the weather-related disruptions of last year.

Valuations are balanced and not only driven by the hope of reflationary policy

The second factor supporting a long US inflation breakeven trade is a more balanced valuation framework/background. The left chart in Figure 2 shows this dynamic. In a reestimated version of a statistical model developed by Fed researchers (see IFDP notes, Dec.2016, "drivers of inflation compensation: evidence from inflation swaps in advanced economies", M.Rodriguez and E.Yoldas), the model is estimated over the 2008-2016 period, then projections are simulated since September 2016.

We find the large discrepancy that occurred between their model and actual inflation valuations that built up after the US Presidential election very informative. It validates our view at that time of some re-building of the specific inflation premium. Note that the risk premium captured by the model is generic and pertains to risk aversion, not inflation specific forces. Inflation valuations after October 2016 seem to have priced in too promptly the impact of expected reflationary policies, particularly on the fiscal side.

One year later, the US tax reform package has finally been voted on and passed. Yet, the fact that the discrepancy between the trajectory of breakevens and the fundamental factors (as implied by the model) is now small suggests there is room for upside that is motivated by expectations beyond just fiscal policy. We think the backdrop for US inflation is therefore much more balanced than was the case at end-2016 after the election.

The issue of timing and carry limits our exposure and enthusiasm

Investors should still scale into BEI wideners, as there are a few issues associated with an unconditional bullish stance on US inflation. We have already described the first issue in terms of seasonal carry not being ideal. There is also the issue of the near-term inflation profile which, according to both economists and markets, will not be very supportive.

As Figure 3 shows, year-on-year inflation is expected to fall between now and the end of Q1 2018, reaching a low of 1.8% in February 2018.

This year-on-year inflation downtrend should occur despite the robust core inflation rate forecast by our economics team at of 0.20% /month between December 2017 and December 2018, which is higher than average core inflation over the past two years. Some negative surprises on inflation are definitely not out of the question, although our economists see upside risks to the next core inflation print (see Economics Insights - US: December CPI Preview).

In February 2017, the 1-year inflation swap rate was about 2.35% and effective inflation over the period consistent with the swap rate was 2.13%, a 20bp shortfall mostly due to the unexpected fall in inflation (mostly from transitory factors but real drivers of inflation nonetheless) between February 2017 and June 2017. A quick glance back at forecasts back in February 2017 shows an underestimation of inflation by up to 60bp for some months. The reason for the underestimation is not yet fully apparent (see Special Report - Why Does the Fed Appear Insensitive to Soft Inflation Data?), and we have pointed to evidence of less-anchored inflation expectations in Inflation Insights - Reality check. The persistence of uncertainty on the inflation mechanism in the US, acknowledged by the Federal Reserve, suggests some caution is warranted on outright long US inflation stances.

Sharing between real and inflation components of yields

Keeping inflation anchored is a key condition for smooth monetary policy normalization. 

Any sort of increase in nominal interest rates that would be accompanied by falling inflation compensation would in fact entail a much tighter real stance via higher real rates pushing up overall yields. This would risk putting the economy on a very volatile path.

A key part of our analysis has been to favour inflation markets where the fostering of expectations was supported by low real yields, and this is why we have favored the euro market, where 2-year real rates are now close to their historical lows (Figure 4).

Short-term real rates in the US have increased much more rapidly which, by contrast, makes the increase in inflation valuations very dependent on economic optimism, not on policy accommodation. The stabilization in real yields suggests this element of vulnerability of the long US inflation trade is less acute now than a few weeks ago.

Still, it remains the case that the increase in inflation compensation is highly dependent upon a modest path in the recovery of real yields (see Inflation Insights - A tale of two modes).

Trade Idea: Scaling into long US 5-year TIPS breakevens

Oil prices are rising, valuations are balanced, the next CPI print is likely to surprise markets to the upside: there are many reasons to go long US inflation despite the negative seasonals.

The focus in the rally has been on cash instruments rather than derivatives, which is consistent with EPFR data showing strong inflows into TIPS ETF based funds. Also, in the latest BEI rally, the 5-year point has outperformed the 10-year point probably due to higher oil prices. Yet as during previous rallies, the 5-year breakeven rate relative to 3- year and 7-year has not outperformed, see Figure 5.

As a result, the case for relative value on the US inflation curve is limited, in our view.

The case for long US breakeven inflation exposure is therefore mostly a macro trade, with few elements of relative value selection that could “enhance” the trade. Longs need to fight less than ideal carry profiles, prospects of volatile oil prices and the Fed’s hiking path ahead. We cautiously go with the macro arguments by scaling into a long 5y TIPS breakeven trade with limited risk exposure (limited notional and some oil price hedges)." - source Nomura

Indeed it is a "macro" trade. We like these. We would also like to repeat what we have pointed out in our conversation "Hypomania" in February 2017 relative to rising oil prices given the relationship with recessionary pressure in the US. 

"As we pointed out as well in 2014, in our conversation "The Molotov Cocktail", past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years." - source Macronomics, February 2017.

As well there is a very important relationship between "gold" and "Tips" when it comes to their reaction to the velocity in rising inflation expectations as we indicated in last year's conversation:

"There is of course an explanation around this which was very clearly put forward by David Goldman in Asia Times on the 17th of February in his article "A mistery solved: Why real yields are falling despite higher growth":

"Economists often think of real yields as the “real interest rate,” or baseline rate of return, in a macroeconomic model. From this standpoint the low level of TIPS yields is a mystery: when economic growth is rising, the real interest rate should rise. The expected short-term interest rate has been rising as the Fed sets about normalizing rates, and the rising short-term rates affect real yields. The fall in TIPS yields in the face of Fed tightening and stronger growth presents a double challenge to the conventional wisdom.

The conventional way of looking at real yields ignores the way markets treat risk. Government debt (and particularly the government debt of the United States) is not just a gauge of economic activity, but a kind of insurance. If the world comes crashing down, you want to own safe assets. Investors hold Treasuries in their portfolios not just for the income, but as an insurance against disaster. And TIPS offer a double form of insurance: If economic crisis takes the form of a big rise in the inflation rate, TIPS investors will be paid a correspondingly higher amount of principal when their bond matures. That explains why TIPS yields sometimes are negative: investors will accept a negative rate of return at the present expected inflation rate in return for a hedge against an unexpected rise in the inflation rate.

The yield on TIPS has tracked the price of gold with a remarkable degree of precision during the past 10 years, as shown in the chart below. Gold tracks the 5-year TIPS yield with 85% accuracy. That’s because both gold and TIPS function as a hedge against unexpected inflation.

During the past year, for example, we observe that the relationship between gold and the 5-year TIPS yield has remained consistent, while the relationship between the expected short-term rate (as reflected in the price of federal funds futures for delivery a year ahead) has jumped around. There are lots of local relationships between federal funds futures and the TIPS yield, but the overall relationship is highly unstable." - source Asia Times - David Goldman

The rest of his article, is a must read we think. but if indeed there are rising inflation expectations, then it makes sense for real yields to continue to fall, which can be assimilated to the cost of the insurance for "unexpected outcomes" is rising. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations is going up." - source Macronomics, February 2017

The recent surge in both US Tips, gold and gold miners are a consequence of the rapid surge in "inflation expectations" hence the interesting case for going both long gold/gold miners and US TIPS in that particular context we think, while there might also be a seasonal factor too it given we witnessed a similar situation in December 2016. There is a well continued weakness in the US dollar which is positive for Emerging Markets equities relative to US equities from an overweight allocation perspective. Right now risk assets continue to push higher, this in conjunction with rising inflation expectations should trigger a more hawkish change of narrative from central banks. As we pointed out in our final post of 2017, "Rician fading", once the tax deal was a done deal, US corporates with more clarity ahead could resume/start some M&A typical in the late stage of the credit cycle game in the first part of 2018.

• Final chart - The "Bid 'Em Up Bruce" stage is now

 As a tongue in cheek reference to the mighty Bruce Wasserstein aka "Bid 'Em Up Bruce",  the M&A legend, our final point of this conversation highlights another sign of late cycle behavior, namely corporate M&A. This final chart displays M&A in the corporate sector since 1999 relative to the credit cycle seen since 1999. It comes from Nomura Japan Navigator note from the 9th of January entitled "Equities move on factors other than yields and exchange rates":

Unlike the pattern over the past three years, 2018 began with substantial risk-on momentum. China’s short-term money rates stopped climbing, allaying market concerns, and commodities and EM equities gained upward momentum. The closing of positions out of concern that the year would start with the anomaly of a risk-off flow and the winding down of selling for a loss ahead of the implementation of US tax cuts also played a role, in our view. In addition, the passage of the US tax cut legislation provided an opportunity for investors and companies to resume investments once uncertainty had been dispelled. We view corporate mergers and acquisitions as a key engine of growth during the latter part of an economic recovery, and had been concerned about their lackluster pace despite the strong credit market in 2017 (Figure 2). This should pick up now.

At the start of the year, many economists and analysts set out the major themes for the year, regardless of their probability, and we expect corporate M&As to become a market theme, at least temporarily. This year, in our view, while the stock market will place more weight on the corporate sector’s capital investment and M&As, we think the rates and FX markets will focus on policy changes by central banks, with the start of monetary tightening by the BOJ and ECB clashing with the end of Fed rate hikes. We think this explains the disjointed movements across markets." - source Nomura

Is this cycle different when it comes to late cycle behavior such as heightened M&A activity? We do not think so, and it is a consequence as well of the "Bracket creep". Get your LBO screener ready folks...

"The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation." -  Vladimir Lenin

Stay tuned! 

Macro and Credit - Who's Afraid of the Big Bad Wolf?

"If you live among wolves you have to act like a wolf." - Nikita Khrushchev

While still being mesmerized by the "goldilocks" environment for credit thanks to low interest rates volatility, in conjunction with new records being broken in the equities sphere, when thinking about what our title analogy should be, we reminded ourselves of the popular song "Who's Afraid of the Big Bad Wolf?" written by Frank Churchill originally featured in the 1933 Disney cartoon Three Little Pigs. It was sung by Fiddler Pig and Fifer Pig as they arrogantly believe their houses of straw and twigs would protect them from the Big Bad Wolf. With the continuation of the beta game played by the "yield hogs", obviously the Big Bad Wolf would be a sudden burst of inflation, which would no doubt take down their "credit" houses of straw and twigs. This would clearly change the central banking narrative and put an end to the "goldilocks" environment we are seeing. We do not think we are there yet, but as we pointed out in our recent musings, for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation". In the Disney cartoon, an angry Practical pig did warn his two brothers though:

"You can play and laugh and fiddle. Don't think you can make me sore. I'll be safe and you'll be sorry when the Wolf comes through your door!"

Overall, we'd rather be seen as "Practical yield pigs" than "perma bears". As such we do think that a surprised return of inflation could indeed be a catalyst for a "repricing" of the bond "bubble". 

In this week's conversation, we would like to look at if indeed it's not the Fed which is responsible for its lackluster record in reaching its 2% inflation target. In terms of asset prices "inflation", one could argue that the Fed's record is "untarnished". 

Synopsis:

• Macro - Low inflation? Blame the Fed 
• Credit - Credit cycles die because too much debt has been raised
• Final chart - Senior officer loan survey leads default rates

• Macro - Low inflation? Blame the Fed 

In our most recent musing, we mentioned that inflation in the US was suffering from an autocorrelation problem. What we have long posited is that while wanting to induce inflation, QE induces deflation and that's exactly what the Fed has been doing. This is what we discussed in March 2015 in our conversation "The China Syndrome". At the time, we quoted CITI's Matt King's 27th of February note entitled "Is QE Deflationary":

"It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?
Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”
Clearly this is not what’s supposed to happen. QE, and stimulus generally, is supposed to create new demand, improving capacity utilization, not reducing it. But as we pointed out in our liquidity wars conference call this week, it feels ever moreas though central bank easing is just shifting demand from one place to another, not augmenting it.
The same goes for the drop in oil prices. In principle, this ought to be hugely stimulative, at least for net oil consumers. And the argument that it stems solely from the surge in US supply, not from any dearth of global demand, seems persuasive as far as it goes.
But in practice, the wave of capex cuts and associated job losses in anything even vaguely energy-related feels much more immediate than the promise of future job gains following higher consumption. The drop in oil prices, while abrupt, in fact follows a three-year decline in commodity prices more broadly. It’s not just oil where we seem to have built up excess capacity: it’s the entire commodities complex." - source CITI

Also, stronger USD leads to higher deflationary risk leading to lower long-term bond yields. Even though exports are only 13% of the US economy, remember that 40% of S&P 500’s earnings now come from outside the US. But when it comes to "anchoring" inflation expectations and the threat of the Big Bad Wolf, it seems that the Fed has failed as pointed out by BNP Paribas in their note from the 12th of October entitled "US: Blame the Fed for low US inflation":

• Too hawkish rhetoric too early and too little attention to inflation expectations are the main reasons why core inflation is nearer to 1% than 2%. It’s the Fed’s fault.

• The taper tantrum lowered inflation expectations a lot, and the 2015 and 2016 rate hikes both came when data were signalling a rise was inappropriate.

• Inflation expectations are not at a level that is consistent with hitting 2% inflation – we reckon break-evens would need to be 2.5% to be consistent with that; we’re well short.

• The Fed is a poor inflation forecaster and its reaction function is foggy, hence the need to heavily flag its moves. Bond rallies after rate hikes question the wisdom of the hikes.

Over-inflation of asset prices but too low inflation

Fed policy has achieved full employment – in fact, it has gone a bit beyond it. But after more than eleven years since its first cut in 2007, core inflation is 1.3%; at the same time it has overinflated asset prices. The Fed has not managed this alone – the “everything bubble” owes much to fellow central bankers who have helped pump up the liquidity that inflated financial assets.

What flattened the Phillips curve? The Fed.

However, we believe it is the Fed’s fault that US inflation is too low. Despite only four hikes in just under two years the Fed has subdued inflation expectations and therefore inflation. The Fed’s rhetoric has constantly been about raising rates, from way too early in the cycle and its rate hikes have too often been path dependent rather than state dependent.

Not enough attention given to inflation

The FOMC has too often ignored inflation when hiking. When Bernanke started the taper tantrum, core PCE inflation had descended from 2% in early 2012 to 1.4% – no wonder the market took fright. In the six months preceding the first hike, core inflation averaged only 1.3%.

Too ready to talk about hikes too early

Before the taper tantrum, the Fed had often signalled a desire to raise rates. By December 2012, it was saying that it would not hike until the unemployment rate was below 6.5%, well before full employment was reached. The same statement suggested an asymmetric inflation target: “The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective”.

The Fed has hurt inflation expectations

Inflation expectations are central to the inflationary process. The rate of increase of both wages and prices has decelerated this year– at least before hurricane effects gave them a boost. The Fed puts the inflation deceleration down to “idiosyncratic factors”. But the shocks have been so widespread and long-lasting that something else seems to be at play, especially when the deceleration also affected wages. Inflation expectations have generally declined since 2013 and we believe this has played a role in 2017’s disappointments. The end of 2013 is when the Fed started its tapering process. We don’t see this as a coincidence.

Fed driving expectations

Chart 1 shows the ASTIX measure of inflation expectations from the Philadelphia Fed.

Prior to the recession, real rate expectations and inflation expectations were positively correlated: as inflation expectations rose, so the Fed would tend to raise real rates. Since the crisis, spells of negative correlation have increased, suggesting that monetary policy is driving expectations, rather than being driven by them. We can see that QE1 and, especially, QE2 reduced real rate expectations and raised inflation expectations. Chart 2 shows this happened in markets too.

Taper tantrum drove down price expectations

The taper tantrum accompanied a big fall in inflation expectations and a rise in the expected real rate (Charts 1 and 2). We would be very critical of the Fed ignoring the much tighter monetary conditions caused by the taper tantrum when deciding to taper later that year. Not for the last time, once the Fed has been set on a course in this cycle, it has put its data blinkers on.

Fed failed to grasp import of taper tantrum

Since everyone knew that rate hikes could not start until tapering had finished, the act of tapering had a strong signalling effect. That was one of the reasons for the 2013 taper tantrum, sparked by two Ben Bernanke speeches in May and June, when unemployment was still 7½% or three points above full employment. The one-year one year (1y1y) forward rate rose almost immediately – from 0.25% to 0.50%. Bernanke had signalled that rate hikes were coming.

Fed paid too little heed to 2015 financial conditions

The reaction to Bernanke’s speeches suggests the market saw a move as premature. Before QE ended, the 1y1y had advanced, topping 1%. Rate policy had been tightened even though the policy rate was unchanged. Policy also tightened through other dimensions; the dollar appreciated and by December 2014 was up 9.2% y/y on the broad index. As rate hike expectations mounted and expectations of ECB QE built, by December 2015 there had been a further rise of 10.3%. This had a major effect on growth, inflation dynamics, including through growth, commodity prices and on expectations, we would argue. We don’t think the Fed paid enough attention to financial conditions, interpreting monetary policy too narrowly as the short rate, otherwise the December 2015 hike might not have happened.

First hike too date driven – hence no more for a year

The run-up to the first hike in December 2015 hardly suggested monetary conditions needed tightening. GDP growth in Q4 was only 0.5% aar; the ISM was sub-50 and core inflation was 1.3%. A data-dependent Fed probably would not have hiked in December, but the Fed appeared cornered by credibility concerns and delivered the first hike. Almost immediately, FOMC rhetoric switched and became much more data dependent, with the Fed backing off its hiking stance. By August, 2016 the 1y1y had declined by about 70bp from the December 2015 high. Bond yields rallied, with expected real rates falling and break-evens rising.

Fed had to press market to price in Dec 2016 hike

Things changed in mid-2016, with the ISM rallying. The Fed increasingly talked up the possibility of hikes, with Dudley saying in August that a September hike was possible. That didn’t happen, but when Dudley said on 19 October that he expected a 2016 hike, the market’s probability of a December hike rose to 75% on 26 October versus 47% on 26 September.

Hikes caused inflation expectations to fall further

The result was a sharp rise in bond yields, again largely driven by the expected real yield. The delivery of the December 2016 hike, as with the first hike, was a trigger for real rates to start to decline, after an abbreviated period. By spring, break-evens followed. The March and June 2017 rate hikes each saw bond yields and break-evens decline, along with ASTIX inflation expectations, which would suggest the market judged these hikes unnecessary.

 Difficult to see what can stop a December 2017 hike

The FOMC on 20 September gave a clear signal of a desire to hike in December. The September drop in the unemployment rate and the 0.5% m/m rise in average hourly earnings will probably have reinforced that. Despite core inflation at only 1.3% and inflation expectations seemingly too low to hit the 2% target for core PCE, it looks increasingly likely that the Fed will hike in December, short of another downward surprise to inflation.

Too late to avoid a policy mistake?

We doubt the wisdom of this and have sympathy for St. Louis Fed President James Bullard’s view that we are heading for a policy mistake. We also see support for Minneapolis Fed President Neel Kashkari’s point that the reason the Fed is undershooting its targets is the Fed itself. It has tightened too early and has dampened inflation expectations. This now leaves it in a quandary, we believe. To lift inflation to target, it will have to keep rates soft and risk even further asset overvaluation, while taking unemployment to too low levels risks a bust and a rise in unemployment that delivers recession and ends with the economy close to deflation. However, if the Fed were to raise rates with inflation so low, it would run the risk of further suppressing inflation expectations. This is a bind that has been caused by too many mistakes in the past and it appears difficult to thread a satisfactory way through." - source BNP Paribas

What the Fed has effectively been doing is playing the hand of aging populations by creating inflation in asset prices and in particular bond prices. Aging savers buy future goods (securities) rather than present goods. As we wrote previously, the issue we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year but also in terms of cumulative flows in bond mutual funds and ETFs as displayed in the below chart from Deutsche Bank from their Global Market Strategy note from the 20th of October untitled "Jumping equilibrium?":

- source Deutsche Bank

But is the game turning? Should we switch camp from the "deflationista" towards the "inflationista" camp? We wonder.

Back in our October 2012 conversation "QE - To infinity...and beyond" we quoted Richard Koo, chief economist at the Nomura Research Institute regarding the challenges of moving from QE to QT:

"Perceived limits on fiscal policy increase pressure on monetary policy

In spite of these experiences, the baseless view that fiscal policy has reached its limits has come to dominate the debate in many countries, including Japan. That, in turn, has placed a great deal of pressure on central banks and led them to inject a sea of liquidity into the market when there is no reason why more liquidity should have any effect. This liquidity will create no problems as long as there is no private demand for loans, since the funds essentially sit in the financial system. The problems come when private demand for loans returns to normal levels and those funds resume circulating. 

Central banks must tighten aggressively when loan demand picks up 

As soon as private loan demand recovers the central bank will have to mop up the excess liquidity, which is currently running at two to three times the normal level. Otherwise prices could double or triple. But to do so the central bank must sell the bonds it bought, putting upward pressure on interest rates just when the private sector is ready to borrow money again. The Fed, for example, will have to sell $1.4trn in bonds when conditions in the private sector return to normal, at a time when the economy is recovering and businesses and households are becoming sensitive to interest rates. And if the market decides that the central bank is not mopping up excess liquidity fast enough, that alone could lift private inflation expectations and send bond yields sharply higher. In short, the central bank finds itself in a difficult position whether it sells the securities or not. Either way a major ordeal awaits both the central bank and the bond market. Once this point is reached, the central bank will probably attempt to reduce the “real value” of liquidity in the market by sharply raising the statutory reserve ratio for commercial banks, a tactic frequently employed by the People’s Bank of China. But all these measures will have significant negative implications for the economic recovery. While QE will do little damage at a time when private loan demand is weak or nonexistent, like today, it requires the central bank to engage in aggressive tightening just when the private sector is beginning to recover." - source Nomura - Richard Koo.

Given China's most recent uptick in its PPI to 6.9%, we are indeed wondering if this is not a sign that we should change allegiance slightly towards the "inflationista" camp and start fearing somewhat the possibility of the return of the Big Bad Wolf aka inflation. We will be monitoring closely this latest China "inflation impulse". China's rising costs via exports could boosts inflation expectations in the US. These higher inflation expectations in the US would mean a steeper yield curve with a rise in long-duration yields ovcrall and it would lead to higher rates volatility down the line. A bear market needs a wolf and this wolf would materialize in a return of inflation we think.

Obviously the return of the Big Bad Wolf aka inflation would trigger a return of bond volatility. On this subject we read with great interest Christopher R. Cole, CFA from Artemis Capital Management latest note entitled "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987". It was very interesting in Christopher Cole's must read note to see his reference to the Ouroboros, the ancient symbol of a snake consuming its own body. We have used a similar reference as a title analogy recently in our September musings also called "Ouroboros". For us the Ouroboros represents the eternal return or cyclicality especially in the sense of something constantly re-creating itself like credit cycles. For Christopher Cole at Artemis the Ouroboros represents the dangerous feedback low between ultra-low interest rates, debt expansion, asset volatility, and financial engineering that allocates risk based on volatility. What is of interest to us, when it comes to the Big Bad Wolf and the Ouroboros mythical snake are the points made by Christopher Cole from Artemis relating to volatility always coming from debt markets:

"The death of the snake...

Volatility fires almost begin in the debt markets. Let's start with what volatility really is. Volatility is the brother of credit... and volatility regime shifts are driven by the credit cycle.

Volatility is derived from an option on the shareholder equity, but equity itself can be thought as a perpetual option on the future success of a company. When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions will lead to higher equity volatility. When credit is easily available and rates are low, volatility remains suppressed, but as credit contracts, volatility rises.

In the short term we do not see the credit stress required for a sustained expansion of volatility, but this can change very quickly. Storm clouds are gathering around 2018-2020, as rising interest rates, rich valuations, and corporate debt roll-overs all converge as potential triggers for higher stress and volatility. The IMF warned that 22% of US corporations are at risk of default if interest rates rise. Median net debt across the S&P500 firms is close to a historic high at over 1.5x earnings, and interest coverage ratios have fallen sharply. Between 2018-2019 an estimated $134 billion of high yield debt must be rolled-over, presenting a catalyst for higher volatility in the form of credit stress.

Reflexivity in the Shadow of Black Monday 1987

Thirty years ago, to the day, financial markets, around the world crashed with volatility never seen before or equaled again in history. On October 19th, 1987 the Dow Jones Industrial Average fell more than -22%, doubling the worst day from the 1929 crash. $500 billion in market share vaporized overnight.

Entire brokerage firms went bankrupt on margin calls as liquidity vanished. It was not a matter of prices falling, there were no prices. You couldn't exit a position. Trading desks refused to pick up the phone. Black Monday appeared to come out of nowhere as it occurred in the middle of a multi-year bull-market. There was no rational reason for the crash. In retrospect, financial historians blame portfolio insurance, ignoring the role of interest rates, inflation, and the Federal Reserve. The demon of that day still haunts markets, and 30 years later the crash is still not well understood. Black Monday 1987 was the first post-modern hyper crash driven by machine feedback loops, but it all started in a very traditional way.

Be careful what you wish for... Today every central bank in the world is trying to engineer inflation, but inflation was the hidden source of the 1987 financial crash. At the start of 1987 inflation was at 1.5%, which is lower than it is today! From 1985 and 1986 the Federal Reserve cut interest rates over 300 basis points to off-set a slowdown in growth. That didn't last for long. Between January and October 1987 inflation violently rose 300 basis points. Nominal rates jumped even higher, as the 10-year US treasury rose 325 basis points from 6.98% in January 1987 to 10.23% by October 1987.

The Fed tried to keep pace by raising rates throughout the year but it was not fast enough. The quick increase in inflation was blamed on the weak dollar, falling current account balance, and rising US debt-to-GDP levels. None of this hurt equity markets, as the stock market rose +37% through August 25th, 1987. Then the wheels fell off." - source Christopher R. Cole, CFA - Artemis Capital - "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987"

As pointed out by Christopher Cole in his must read note, the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. The only issue is once the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:

“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”

Also, in addition to Christopher Cole's points, credit investors have a very weak predictive power on future default rates. Credit investors are collectively subject to an extrapolation bias. When default rates are high, credit investors behave as if default rates were going to stay high for the next 5-10 years. They liquidate their portfolios in panic (or because they are forced to do so). This snowball effect leads to spread levels that have no economic rationale. Inversely, when default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to malinvestment, and sows the seeds of the next credit crisis.  Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns, that simple as pointed out by our good friend Paul Buigues:

"For us, credit is spread, not yield. A high-yield bond is a bet on the issuer’s creditworthiness combined with a bet on risk-free interest rates. Consequently, people who rely mostly on the low yield argument to justify their bearishness on high yield bonds should concentrate their hostility against Treasuries."

Or in Europe, given the levels reached on some European Sovereign bonds, they should concentrate their hostility against them, given the ECB is the most important buyer in town, for now...

As we have repeatedly pointed out, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy". As we pointed out in our conversation "Thermidor" in August 2016, this of course is leading to a "pre-revolutionary" mindset setting in, and the rise of "populism" with the deafening sound of "helicopter money" and fiscal profligacy as the "elites" and their central bankers are starting in earnest to "panic" somewhat. Could the rotation from "deflation" to "inflation" trigger indeed a surge in commodities? We wonder... After all the recent surge in the Chinese PPI could indeed be somewhat pointing towards some inflation surprises down the line.

If as indicated by Christopher Cole, volatility is the brother of credit, then obviously assessing the longevity of the credit cycle is paramount. We do agree with Christopher that, for the time being, we do not see the credit stress required for a sustained expansion of volatility. It's only when the Big Bad Wolf will rear its ugly face that we will change our "Practical yield pigs" stance. But if indeed the credit cycle matters from an Ouroboros perspective, then obviously one has to wonder how the death of the credit snake comes about as per our next point below.

• Credit - Credit cycles die because too much debt has been raised

When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion. 

On the issue of how the credit cycle could end, we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 13th of October entitled "The Evolution of the Credit Cycle":

"How it ends?

Our observations and model estimates so far have painted a relatively benign picture, suggesting that defaults could remain low for some time. Having adopted this as the base case, we now turn to discussion of factors that could potentially derail it and prove us wrong.

All cycles before this one have ended with a surprise event, a “black swan” of sorts, which, by definition, was unexpected by the consensus and meaningful in its impact. This one is probably not going to be unique in this respect. And while forecasting the exact event is a futile exercise, we can still think about the general set of circumstances that could potentially turn this credit cycle.

Broadly speaking we envision three kinds of developments that could play such a role:

1. Inflation returns. If low inflation and loose central bank policies have played a critical role in helping the markets get to this stage, it would be natural to expect them to play a certain role in reversing this move. At any given level of inflation, major central banks have proved time and again that they are more dovish than consensus expects them to be, and there are few signs to suggest that their behavior is about to change. With that it seems that only a genuine inflation surprise would wake them up and cause the kind of correlated policy tightening that few people currently expect to take place. So far, decent economic growth numbers in the US, Europe, and Asia have failed to spark any measurable inflation pressures. However, we are watching certain economic indicators closely, such as PMIs or Korean and Japanese exports (all at cyclical highs), which could prove to be early signs of an overheating. In the long run, we believe inflation will remain secularly squeezed by technology, but a temporary rise cannot be ruled out.

2. Distress in isolated sectors spreads. We have seen an example of this most recently in energy and commodities, where a 25% default wave nearly pushed the broad HY market into a full-blown default cycle. At the moment, there are few reasons to expect something like that to play out in the next year, with all known problematic segments, such as retail, wireline telecoms, and selected healthcare providers, representing tiny shares of the market (cumulative distress ratio is under 5% today). Again, we see few immediate reasons to believe that these known problems in narrow industries would spread elsewhere, but it’s usually helpful to think about broader vulnerabilities if things develop in some unexpected fashion. To that end, if we expanded the range of problematic sectors to broad retail, healthcare, wireline telecoms, and also brought energy/mining back into the fold, their combined size grows to 30% of the total HY market. An additional layer of risk is being created by extreme concentration of large IG issuers, where the top ten non-financial capital structures today represent 50% of the total size of the HY market, the second-highest on record except for 2002 (Figure 7).

A fallen angel of that magnitude would create a meaningful disruption on transition.

3. Geopolitics cause a trade contraction. The long list of unresolved global conflicts here is well known and does not require a recital here. Suffice to say that a flare up in any one of them could easily awaken the markets from their QE-induced hypnosis. And even outside the worst-case scenarios of an open military engagement, things could develop in a way such that the global economy suffers a shock. Consider the fact that S Korea is the single-largest source of Chinese imports, followed by the US and Japan. The same trio also appears on the other side of this trade superhighway, only as the largest destinations of Chinese exports. It is probably fair to say that some major global supply chains depend critically on these lanes staying wide open and unencumbered. One could draw a dotted line between where we are and a sharp contraction in this epicenter of global trade even if the world avoids the worst-case scenario on the Korean peninsula." - source Bank of America Merrill Lynch

Indeed, credit should be afraid of the Big Bad Wolf aka inflation. This would clearly generate renewed volatility in the rates space and obviously a reaction in the credit space. It seems for now the market doesn't seem much concerned by an inflation surprise, while the carry and beta game continue to be played significantly thanks to low volatility. We are part of the crowd that thinks that any small upside surprises in inflation could potentially affect markets materially. Such a surprise would trigger a surge in volatility. So who is afraid of the Big Bad Wolf? We are.

For our final chart, when it comes to predicting a move in the credit cycle and a surge in default rates as we pointed out in the past, you need to track the quarterly Fed's Senior Loan Officer Opinion Surveys (SLOOs).

• Final chart - Senior officer loan survey leads default rates

The most predictive variable for default rates remains credit availability. The SLOOS report is that it does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. Our final chart comes from Bank of America Merrill Lynch Collateral Thinking note from the 20th of October and entitled "Deconstructing the default rate". It displays that SLOOs leads default rate in general:

"Being in one of the longest running credit cycles in history, the question we get asked most frequently is: when will we get the next default cycle? While we believe we are in the ninth inning, there is also evidence suggesting that the cycle has some more room to run in terms of accumulation of debt and generation of profits. As such we don’t think that default rates have quite bottomed out yet and believe next year to be characterized by even fewer default losses than this year. Our belief rests on both the macro and micro indicators that we use to predict the direction of default rates in Loans as well as HY.

Specifically for the loan universe, which we define as the loans in the LCD index, we gauge the state of the macro environment through the senior loan officer survey. This survey determines the ease with which medium to large sized companies (annual revenue&$50mn) are able get bilateral loans from banks, and thus is a good broad level indicator of on-ground credit conditions. On a micro level, we capture the change in the credit risk of the Loan universe through migration rates. A combination of these two factors is able to explain almost all of the variation in default rates since 2009 with about a 12 month lag. Today, both those factors are largely supportive of loans- the survey shows financial conditions have been easing for two quarters in a row (Chart 3), while credit migration rates have not materially deteriorated to flash warning signs. We think this firmly sets the stage for a lower default rate in 2018." - source Bank of America Merrill Lynch

Of course, should the Big Bad Wolf rear its ugly face again, then obviously, all credit bets for high yield would be off with the return of heightened volatility, the dear brother of credit as pointed at by Christopher Cole from Artemis Capital. For now Fiddler Pig and Fifer Pig continue to arrogantly sing while the volume is pumping up towards 11 in true Spinal Tap fashion but we ramble again it seems...

"It never troubles the wolf how many the sheep may be." -  Virgil

Stay tuned!