Macro and Credit - Fuel dumping

"One of the tests of leadership is the ability to recognize a problem before it becomes an emergency." -  Arnold H. Glasow, American author

Looking at the Dow Jones and the S&P 500 having their worst month since 1931, with cracks clearly showing up in credit markets with weaker oil and outflows from Leveraged Loans, with the Fed hiking by another 25 bps, leading to markets being dazed and confused, when it came to selecting our title analogy, given our fondness for aeronautics ("Dissymmetry of lift" in August 2018, "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014), when it came to our title analogy we decided to go for "Fuel dumping". "Fuel dumping" (or a fuel jettison) is a procedure used by an aircraft in certain emergency situation before a return to the airport shortly after takeoff, or before landing short of its intended destination (or inflation target...) to reduce the aircraft's weight (the Fed's balance sheet with its QT policy, now up to $50 billion per month). 

Aircraft have two major types of weight limits: the maximum takeoff weight and the maximum structural landing weight, with the maximum structural landing weight almost always being the lower of the two. This allows an aircraft on a normal, routine flight to take off at the higher weight, consume fuel en route, and arrive at a lower weight. If a flight takes off at the maximum takeoff weight and then faces a situation where it must return to the departure airport (due to certain mechanical problems, or a passenger medical problem for instance), there will not be time to consume the fuel meant for getting to the original destination, and the aircraft may exceed the maximum landing weight to land at the departure point. If an aircraft lands at more than its maximum allowable weight it might suffer structural damage, or even break apart on landing. At the very least, an overweight landing would require a thorough inspection for damage. 

As a matter of fact, long range twin jets such as the Boeing 767 and the Airbus A300, A310, and A330 may or may not have fuel dump systems, depending upon how the aircraft was ordered, since on some aircraft they are a customer option. As a rule of thumb for the Boeing 747, pilots quote dump rates ranging from a ton per minute, to two tons per minute, to a thumb formula of dump time = (dump weight / 2) + 5 in minutes. In similar fashion, when it comes to the Fed's QT, there is no real rule of thumb when it comes to the pace of the reduction of its balance sheet. We read with interest Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the Wall Street Journal yet it seems that as we pointed out in our October conversation "Explosive cyclogenesis":

"As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe  we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".

But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks.

Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense". "- Macronomics, October 2018

The big question we think when it comes to Fed having both QT and rate hikes at the same time aka "Fuel dumping" is can you allow interest rates to rise without contracting the monetary base? Clearly the Fed put is still way "out of the money".

In this week's conversation, we would like to reflexionate more on 2019 given the Fed has been clearly telling you, it hasn't got your back anymore and you are on your own...

Synopsis:

• Macro and Credit - 2019: "Mean" mean reversion?
• Final charts  - What the Fed see and what they don't...  

• Macro and Credit - 2019: "Mean" mean reversion?

In our previous conversation we pointed out the weakness seen in credit, given the rise in dispersion witnessed during the course of 2018, leading to cracks showing up in cyclicals and with now leveraged loans weaknesses under scrutiny. Like any behavioral psychologist we indicated in numerous conversations that we would rather focus on the "flows" than on the "stock" given in our credit book, liquidity is what "matters" and when it comes to fund flows, in some segments of the credit markets "outflows" have been significant.

In our credit book, "flows" matter and when it comes to fund flows in credit land there has been plenty of "fuel dumping" as reported by Bank of America Merrill Lynch in their Follow The Flow report from the 14th of December entitled "The CSPP party is definitely over":

"More outflows and no more CSPP

Only three weeks to go before the end of the year, and outflows continued in Europe. Last week we saw a significant risk reduction across European IG, HY and Equity funds. Investors reached for safer assets with strong inflows in Govies and Money Markets. Even Global EM debt funds recorded outflows amid the recent sell off. It seems that this year will end on a negative note as investors are cutting positions across risk assets amid uncertainty around the macro and trade wars front. Italian politics are not helping either, contributing in a flight away from credit and equity funds.

Over the past week…

High grade funds suffered their largest outflow of the year, making this week the 18th week of outflow over the past 19 weeks. High yield funds also recorded a sizable outflow as well, the 11th in a row. Looking into the domicile breakdown, Euro-focused funds led the negative trend, followed closely by Global-focused funds. US focused funds experienced a more moderate outflow.

Government bond funds recorded an inflow this week, the 2nd in a row. Meanwhile, Money Market funds saw a large inflow, putting an end to 4 consecutive weeks of outflows.

European equity funds recorded a sizable outflow, in sharp contrast with the moderate outflow recorded last week, and making it the 14th consecutive week of outflows. During the past 40 weeks, European equity funds experienced 39 weeks of outflows.

Global EM debt recorded an outflow this week, the 10th in a row. Commodity funds recorded a marginal inflow.

On the duration front, mid-term IG funds led the negative trend by far, short-term funds also suffered, while the deterioration was more moderate for the long-end of the curve." - source Bank of America Merrill Lynch

 When the trend in outflows is not your friend...

As per our November conversation "Zollverein", when we talked about the vulnerability of leveraged loans, clearly they have been under the spotlight and some credit investors have indeed resorted in "fuel dumping" so to speak. As per LeveragedLoan.com outflows have been significant and accelerating in the asset class:

"Leveraged loan funds log record $2.53B outflow

U.S. loan funds reported an outflow of $2.53 billion for the week ended Dec. 12, according to Lipper weekly reporters only. This is the largest weekly outflow on record for loan funds, topping the prior mark of negative $2.12 billion from August 2011.

This is also the fourth consecutive week of withdrawals, totaling a whopping $6.63 billion over that span. With that, the four-week trailing average is now deeper in the red than it’s ever been at $1.66 billion, from negative $1.01 billion last week.

Mutual funds were the catalyst in the latest period as investors pulled out a net $1.82 billion, the most since August 2011. Another $704.9 million of outflows from ETFs was the most ever.

Outflows have been logged in six of the last eight weeks and that has taken a big bite out the year-to-date total inflow, which has slumped to $3.7 billion after cresting $11 billion in October.

The change due to market conditions last week was a decrease of $1.231 billion, the largest drop for any week since December 2014. Total assets were roughly $99.3 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $10.9 billion. — Jon Hemingway" - source LeveragedLoan.com

If this isn't "fuel dumping" then we wonder what it is:

"In just the past four trading days, investors have pulled $2.2 billion from all loan mutual funds and exchange-traded funds. That brings withdrawals from the asset class to almost $9 billion since mid-November" - source Bloomberg 

- graph source Bloomberg

It looks like more and more to us the "credit aircraft" may have exceeded the maximum landing weight to land at the departure point given the posture of the Fed with its hiking stance and with its QT on "autopilot".

For Bank of America Merrill Lynch in their Weekly Securitization Overview note from the 14th of December entitled "Mission accomplished; damage assessment", the price action in Leveraged Loans should be watched closely and we agree as we posited back in our November conversation "Zollverein":

"We consider the recent free fall price action for leveraged loans (Chart 5) underlying collateral of CLOs and specifically noted in the FOMC’s September minutes as posing “possible risks to financial stability.” The end result of the Fed’s hawkishness is that less, not more, rate hikes are now expected than in September (see below), so the interest in floating rate instruments such as leveraged loans, and CLOs, has declined. That explains part of the weakness. Another important part of the latest sharp re-pricing of loans is simply that they had lagged the spread widening/risk re-pricing seen in other sectors. This week saw some major catch-up." - source Bank of America Merrill Lynch

 Clearly some pundits are concerned about the "liquidity" factor of Leveraged Loans and decided that "Fuel dumping" was the right strategy given the growing cracks seen in credit with the significant underperformance of US High Yield thanks to weaker oil prices and its exposure to the Energy sector (we have touched on this subject in recent posts). No surprise to see Lisa Abramowicz on her twitter feed commenting on US High Yield spread blowing out today:

"U.S. high-yield bond spreads rose yesterday the most on a percentage basis since August 2011."

- source Bloomberg - Lisa Abramowicz - twitter

Obviously with its QT akin to "Fuel dumping", the Fed has been successful in tightening further financial conditions.

But in relation to Leveraged Loans and the deterioration in both price and flows, comes the question about its impact on the US economy as a whole. On that point we read with interest Wells Fargo's take from their Economics Group note from the 18th of December entitled "Leveraged Loans - A Deathknell for the US Economy?":

"Executive Summary

The leveraged loan market, where the bank debt of non-investment grade companies is traded, has experienced rapid growth over the past few years. But weakness in the market in recent weeks may bring back unpleasant memories of the sub-prime loan debacle a decade ago. Does this recent weakness in the leveraged loan market have negative implications for the macro U.S. economy?

In our view, the leveraged loan market, taken in isolation, is not likely to bring the economy to its knees anytime soon. But its recent weakness may reflect a broader economic reality about which we have been writing. Namely, the overall financial health of the non-financial corporate sector has deteriorated modestly over the past few years. If the Fed continues to push up interest rates and if corporate debt continues to rise, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth

Stress Appears in the Leveraged Loan Market

The leveraged loan market in the United States has mushroomed to more than $1 trillion today from only $5 billion about 20 years ago (Figure 1).

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Growth has been especially marked in the past two years with the amount of leveraged loans outstanding up more than 30% since late 2016. But the market has weakened recently. The amount of leveraged loans outstanding declined by nearly $20 billion between late November and mid-December, while prices of loans fell about 2 points over that period (Figure 2).

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities 

Before discussing macroeconomic implications, we first offer a quick primer on the leveraged loan market. A leveraged loan is a loan that is made to a company with relatively high leverage (i.e., companies with high debt-to-cash flow ratios). Usually, these companies are rated as less than- investment grade. Years ago, banks would hold these loans on their balance sheets, but in the  past few decades an active market has developed in which these loans are bought and sold. Often, an investment bank will buy leveraged loans from commercial banks to bundle them into structured financial instruments that are known as collateralized loan obligations (CLOs). CLOs trade like bonds, and they improve the liquidity in the leveraged loan market.

Leveraged loans are floating-rate financial instruments, so investors piled into the market over the past two years when the Fed was in rate-hiking mode. However, some investors have started to sell their holdings of leveraged loans recently as doubts have risen about how much higher short-term interest rates actually will rise. Moreover, the evident deceleration occurring in the economy could negatively affect the ability of some highly levered companies to adequately service their debt obligations, which has also contributed to some nervousness in the leveraged loan market. Could the recent weakness in the leveraged loan market have implications for the U.S. economy?

Does the Leveraged Loan Market Have Broader Macro Implications?

When banks sell their leveraged loans, they then have room on their balance sheets to make new loans. If weakness in the leveraged loan market negatively affects the ability of commercial banks to offload their leveraged loans, then growth in bank lending could slow. Everything else equal, slower growth in bank lending could lead to slower economic growth, which could then lead to further weakness in the leveraged loan market, etc. In short, a vicious circle could be set in motion. Is there any evidence to support the notion that weakness in the leveraged loan market has led to slower growth in bank lending?

Figure 3 plots the leveraged loan price index which was shown in Figure 2 along with the year-over-year growth rate in commercial and industrial (C&I) loans.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

The price of leveraged loans collapsed in 2008, and C&I loan growth subsequently nosedived as well. But the U.S. economy at that time was beset by the deepest financial crisis and recession it had experienced in more than 70 years. The weakness in the leveraged loan market in 2008 may have contributed to the swoon in C&I lending that transpired in 2008-2009, but there probably were more important factors that were causing the sharp drop in C&I lending at that time. 

Indeed, over the past two decades there have been two episodes of weakness in the leveraged loan market that have not been associated with marked deceleration in C&I lending. Between early 1997 and late 2000, prices of leveraged loans fell about 10 points. But growth in C&I lending held up reasonably well during that period, before turning negative as the economy fell into recession in early 2001.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

More recently, leveraged loan prices fell 8 points between May 2015 and February 2016. Growth in C&I lending edged down a bit, but we would not characterize that episode as one of “significant” deceleration in C&I lending. In short, there does not appear to be overwhelming evidence to support the notion that weakness in the leveraged loan market leads to significantly slower growth in C&I lending.

C&I lending accounts for less than 20% of total bank credit. Perhaps other components of bank credit, such as the securities holdings of banks, residential and non-residential real estate lending or other types of consumer lending, may show more sensitivity to the leveraged loan market than C&I lending. However, Figure 4 shows that growth in overall bank credit generally has had a low degree of correlation with prices of leveraged loans as well.

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Although we acknowledge that the weakness in the leveraged loan market has the potential to eventually weigh on bank credit, there appears to be very little fallout thus far. Indeed, the amount of C&I loans outstanding as well as total bank credit have both risen in recent weeks.

In our view, the weakness in the leveraged loan market at present reflects a broader economic reality about which we have been writing in recent months. That is, the overall financial health of the non-financial corporate sector has deteriorated over the past few years. The phenomenal growth in the leveraged loan market since 2016 reflects both demand-side and supply-side factors. In terms of demand, investors have been attracted to the relatively high returns that leveraged loans and CLOs offer. On the supply side, the marked increased in leveraged loan issuance over the past few years speaks to the steady rise in non-financial corporate debt, especially among non-investment grade businesses, that has occurred.

Taken in isolation, the leveraged loan market is not likely to bring the economy to its knees anytime soon. But recent weakness in the leveraged loan market may be symptomatic of rising concerns that investors may be having about the outlook for the financial health of the business sector. Spreads on speculative-grade corporate bonds have widened in recent weeks, and investment grade spreads have also pushed out. As we have written previously, we do not view the overall financial health of the American business sector as “poor” at present. But investors apparently are starting to react to its modest deterioration. If the Fed continues to push up interest rates and if corporate debt continues to rise, which would put upward pressure on spreads, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth." - source Wells Fargo

After the Great Financial Crisis (GFC), many banks retreated from the Leveraged Loans business thanks to heightened regulatory oversight. In this context, Nonbank direct lenders, business development companies as well as collateralized loan obligation funds and private equity affiliated debt funds all stepped in and funded acquisitions and private-equity buyouts as the M&A market rebounded in recent years. US banks one would argue are in a much healthier "leverage" situation than their European peers, though when it comes to the Leveraged Loan market both in the United States and Europe have seen the rise of "disintermediation" aka shadow banking stepping in. Where we slightly disagree with Wells Fargo's take is indeed the rise in "disintermediation" as banks have been facing rising competition from even "new" competitors entering the private lending space.

Yet, when it comes to C&I loans, change in the last three months have been significant we think:

- graph source Bank of America Merrill Lynch

As we mused in our conversation "Ballyhoo" in October, using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions. We argued that the velocity seen in greater tightening of financial conditions could be seen as a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions hence the outflows and the acceleration in "Fuel dumping" or outflows from "credit" to the benefit of the US long end of the yield curve as well as US money market funds, in essence some good old "crowding out".

This velocity we think is important given the combination of rates hike and balance sheet reduction given many pundits are already talking about "policy mistake" being made by the Fed. The whole question is about the transmission of the velocity of tightening financial conditions towards the real economy. We have already seen significant weakness in various US cyclicals (Housing, autos, etc.). On the subject of this transmission mechanism we read with interest Bank of America Merrill Lynch's take in their US Economic Watch note from the 19th of December entitled "Fed up":

"Getting ahead of the shocks

One of the many factors the Committee has considers in their policy reaction function is the impact of financial conditions on the real economy. As was clear from the press conference, “The additional tightening of financial conditions we have seen over the past couple of months along with signs of somewhat weaker growth abroad have also led us to mark down growth and inflation growth a bit.”

To understand the transmission of financial conditions onto the economy, we run various financial shocks through FRB/US, the Federal Reserve Board’s large-scale general equilibrium macroeconomic model. These shocks are 100bp increase in the conventional mortgage rate, 100bp increase to the interest rate on new car loans, 50bp increase in credit spreads (proxied by an 50bp increase in BBB term premium) and a 10% decline in household equity wealth. Note that the shocks to the mortgage rate, car loan rate, and BBB term premium have been approximately calibrated to the moves seen since the start of the year while the equity shock has been roughly calibrated to the decline since peak of the equity market over the summer (Chart 1 and Chart 2).

The shocks are run individually through FRB/US and sustained through the simulation period.

The results of the stylized exercise are presented in Table 1. There are several points worth noting:

• Financial conditions work through the economy with a lag. With the exception of the mortgage rate shock, the peak drag to growth from tighter financial conditions hits the economy 2 to 3 quarters after the initial shock.
• The impact of the individual shocks is fairly muted. For example, a 10% decline in household equity would roughly translate to less than 0.1pp drag to growth in the 2H of year 1 after the shock hits. But add up the multiple shocks, there’s a meaningful slowdown in growth that leads to higher unemployment rate and lower core inflation.
• Higher borrowing costs for businesses have the greatest and most persistent impact on the economy. A 50bp widening in the credit spread acts as a roughly 0.1pp drag in year 1 and 0.1-0.2pp in year. This is consistent with Fed research which shows that the primary transmission of tighter financial conditions works through weaker business fixed investment.2
• The cumulative tightening we’ve see over the past year is roughly equivalent to 33bp of Fed tightening. Another way to interpret these results is tighter financial conditions would prescribe the Fed to ease up on the pace of rate hikes by roughly one fewer hike, consistent with the latest median dots.

What about weaker global growth? The direct impact should be fairly muted given that the external macro linkages are only a small share of the US economy. However, weaker global conditions will filter through tighter financial markets, primarily through higher borrowing rates for businesses and to a lesser extent a decline in household equity wealth that will act as a headwind for the economy." - source Bank of America Merrill Lynch

While global trade has been decelerating thanks to the trade war narrative, the spike in "real rates" in early October triggered the repricing of US equities. Our timing using another "aeronautics" on the first of October in our post "The Amstrong limit" was probably lucky:

"Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment." - source Macronomics, October 2018.

We wondered at the time if we had reached the "boiling point". In retrospect we did.

The big question many pundits are asking is should the bold pilots at the Fed continue with QT on autopilot. Back in February 2013 in our conversation "Bold Banking" we used another aeronautics reference:

"While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of the demise of "Czar 52" on the 24th of June 1994 which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".

So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?

A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not  French president Hollande in that instance but we digress...).

When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate." - Macronomics, February 2013

For now the pilots once again at the Fed seem pretty confident in the strength of the US economy, on our side we do not think their optimism is warranted as per our final charts.

• Final charts  - What the Fed see and what they don't...  

With Philadelphia Fed manufacturing index undershooting in similar fashion to the New York Fed released this week as well, one might indeed be wondering if "Fuel dumping" is warranted given the heavy load of the US airplane in terms of corporate debt binge. Our final charts comes from Wells Fargo Economics Group note from the 19th of December entitled "Where the Fed May Be wrong" and in their note they are pondering whether or not the Fed is making a "policy mistake":

"Caught Between A Rate Hike and A Hard Place

Recessions are typically triggered by policy mistakes and the Federal Reserve may very well be on the road to making one. The policy statement that accompanied the Fed’s latest rate hike attempted to allay fears the Fed would tighten too much by acknowledging the economic outlook has diminished and that the balance of risks was now roughly even. FOMC participants also slightly lowered their expectations for the federal funds rate and now call for just two rate hikes in 2019 and one more after that, while the drawdown of the Fed’s balance sheet is expected to remain on auto-pilot at $50 billion a month in 2019.

The financial markets provided some powerful real-time feedback to the Fed. Stocks had rallied just before the Fed’s decision was released, gave back their gains after digesting the policy statement and then sold off heavily during Chairman Powell’s testimony. The yield curve also flattened further and remains inverted between the two- and five-year notes. The markets shot down the Fed’s dovish tightening because they feel economic growth may not be as strong as the Fed believes and is certainly not strong enough to hold to the notion that monetary policy, in its entirety, remains short of neutral.

Economic growth may not be as ‘strong’ as the Fed believes. The strength in the U.S. economy has been narrowly focused, with the energy and technology booms accounting for a disproportionate share of economic growth. Both sectors now appear to be slowing, with the former struggling under the weight of sluggish global economic growth and lower oil prices, while the latter is facing an onslaught of government oversight concerning privacy concerns and anti-trust matters. Growth in the more cyclical parts of the economy is also slowing, with demand for home sales and capital goods flagging for the past few months.

The Fed’s confidence about the strength of the economy may be grounded in the satisfaction that the unemployment rate remains so low at just 3.7%. The unemployment rate is a lagging indicator, however, and monetary policy works with a long and variable lag. Moreover, the IT revolution and growth in online job search platforms have likely changed the way job seekers interact with the labor force. This may help explain why the surge in job openings has not led to a resurgence in wage increases.

The Fed may also be underestimating the impact the drawdown of the Fed’s balance sheet and continuation of enhanced forward guidance are having on global liquidity. Both policies were projected to have strong positive effects when they were implemented. Why wouldn’t they have an equally strong impact now that they are headed in the other direction? Moreover, the high degree of certainty the Fed has displayed that these policies will continue, effectively on auto-pilot at a time that growth is decelerating, has sent a foggy message to the financial markets, which has likely increased uncertainty— hence the rush out of stocks and into bonds and the dollar." - source Wells Fargo

It might be the case that the pilots at the Fed are slightly over-relying on "auto piloting" QT aka "Fuel dumping" while interpreting incorrectly the readings from their pilot cabin's instruments, but we ramble again...

We wish you all a Merry Christmas and a Happy New Year. Don't hesitate to reach out to us in 2019, a year in which we hope to celebrate the 10 year anniversary of this very blog. Thank you for your praise and support.

as the old pilot saying goes:

"There are old pilots and there are bold pilots; there are no old, bold pilots!" 

Stay tuned !

Macro and Credit - White noise

"The real man smiles in trouble, gathers strength from distress, and grows brave by reflection." -Thomas Paine

Watching with interest, the return of volatility and consequent rise in Italian Government bond yields, in conjunction with trouble brewing yet again in Spain, following the continuous pressure and Turkey and other Emerging Markets, when it came to selecting our title analogy we decided to go for a signal processing analogy namely "White noise". In signal processing, white noise is a random signal having equal intensity at different frequencies, giving it a constant power spectral density. The term is used, with this or similar meanings, in many scientific and technical disciplines, such as physics, acoustic engineering, telecommunications, and statistical forecasting. White noise refers to a statistical model for signals and signal sources, rather than to any specific signal. White noise draws its name from white light, although light that appears white generally does not have a flat power spectral density over the visible band. White noise is as well interesting thanks to its statistical properties. Being uncorrelated in time does not restrict the values a signal can take. Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off). In statistics and econometrics one often assumes that an observed series of data values is the sum of a series of values generated by a deterministic linear process, depending on certain independent (explanatory) variables, and on a series of random noise values. Then regression analysis is used to infer the parameters of the model process from the observed data, e.g. by ordinary least squares, and to test the null hypothesis that each of the parameters is zero against the alternative hypothesis that it is non-zero. Hypothesis testing typically assumes that the noise values are mutually uncorrelated with zero mean and have the same Gaussian probability distribution – in other words, that the noise is white. If there is non-zero correlation between the noise values underlying different observations then the estimated model parameters are still unbiased, but estimates of their uncertainties (such as confidence intervals) will be biased (not accurate on average). This is also true if the noise is heteroskedastic – that is, if it has different variances for different data points. While causation of Emerging Markets sell-off can be attributed to  "Mack the Knife" aka rising US dollar and positive US real rates, it doesn't imply correlation with the sudden surge in Italian government bond yields, following the rise of a so called "populist" government at the helm of Italy. It is not that Italian issues went away, it is that there were just hiding in plain sight thanks to the strong support of the ECB with its QE program. Now that a less accommodative government has been elected in Italy, the status quo of the sustainability of the European project and European debt are being questioned again. The constant power spectral density of the ECB's QE is fading, hence the aforementioned reduction in the "White noise" and stability in European yields we think. We recently argued the following on our Twitter account: 

"Both rising US dollar and Gold may mean we have entered a period where non-yielding assets are preferable to assets such as some sovereign debts promising a yield yet future size of payment and or return of principal are starting to become "questionable". - source Macronomics, 24th of May.

As the central banks put is fading, what basically has been hiding in plain sight, has been the sustainability of the European project. Investors are therefore moving back into assessing the "return of capital" rather than the "return on capital". It seems to us that the "White noise" which in effect had hidden the reality of "risk" thanks to volatility being repressed thanks to central banking meddling is indeed making somewhat a comeback to center stage yet again given the recent bout of volatility seen on Italian bond prices and yields. When it comes to Italy's latest political turmoil we have to confide that we are not surprised whatsoever. We warned about this playing out exactly last year during our interview on "Futures Radio Show" hosted by Anthony Crudele:

"The biggest risk in Europe is still Italy because the growth is not there" - source Macronomics, May 2017 on Futures Radio Show.

On the anniversary of us voicing our concerns on Italy in this week's conversation, we would like to look at debt sustainability with rising rates as well as the risk of deceleration we are seeing in global growth as of late. 

Synopsis:

• Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 
• Final chart - Decline in PMI's doesn't bode well for the US bond bears

• Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 

The latest ructions in both Emerging Markets and Italian Government bond yields are a reminder that once "White noise" starts to dissipate with QT and a fading central banks put, then indeed solvency issues can return with a vengeance, such is the case with Turkey and fears on Italian debt sustainability. It is a subject we already touched in a long conversation we had back in September 2011 in our post "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!". In this conversation we quoted the work of Dr Jochen Felsenheimer, prior to set up "assénagon" and now with XAIA Asset Management, was previously head of the Credit Strategy and Structured Credit Research team at Unicredit and co-author of the book "Active Credit Portfolio Management:

"Competing systems between countries in a world of globalisation and fully integrated capital markets restrict a country's room for manoeuvre in that mobile factors of production seek out the state infrastructure which give them the best possible reward. The state can only counter the migration of workers and relocation of whole production sites with economic measures, for example the creation of an effective infrastructure (e.g. education) or tax incentives. Accordingly, a government's outgoings - and also its income - are not just determined by domestic economic developments, but also by other countries' economic strategies. Countries are in competition with each other - just like companies. And this is particularly true within a currency union, which is fully reflected in the different tax policies of the individual member states." - Dr Jochen Felsenheimer.

At the time we added that the name of the current game was maintaining, at all cost, rates as low as possible, to avoid government bankruptcies hence the ECB's QE. Dr Jochen Felsenheimer which we quoted at the time also made the following comments in the letter we quoted extensively in our conversation in 2011:

 "In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer

The ECB has been able to provide protection against a run, alas temporarily. While the ECB acted as a lender of last resort, doing so exacerbated political tensions and is not a lasting solution as we can see unfolding right now in Italy. 

The concept of "solvency" is very sensitive to the government’s cost of funding (Turkey), and therefore to swings in market confidence.  A government with even a very large level of debt can appear entirely solvent if funded cheaply enough, which is the case for various European countries we think. There is no reassurance that solvent government will always be kept liquid, forget "leverage", end of the day in credit markets "liquidity" matters and we should all know by now that "liquidity" is indeed a "coward". We commented at the time in 2011 that liquidity, matters, because the major implication of the disappearance of risk-free interest rates is that it weakens in the process the quality of the "fiscal backstop" enjoyed by banks, particularly in peripheral countries which have extensively played the "carry trade". Therefore the sovereign/banks nexus has not been reduced by the ECB's actions, on the contrary. Net Interest Margins (NIM) for peripheral banks has been replaced by "carry trades" thanks to the ECB. There is a direct relationship between the credit quality of the government and the cost and availability of bank funding. You probably understand more our Twitter quote from above regarding the risk for the "return of principal" when it comes to some sovereign debt which again are starting to become "questionable" hence the "repricing" for some Emerging Markets and Italy as well.

If indeed we are moving towards a repricing of risk on the back of "solvency" issues it is because the "risk-free" status of some European government bonds is coming back into center stage. We can see it in the credit markets as pointed out by Bank of America Merrill Lynch European Credit Strategist note from the 24th of May entitled "Corporates safer than governments":

"The not so dolce vita

2017 was a year of “buy the dip” galore in Euro credit markets. Few of the risks that bubbled to the surface last year caused spreads to sell-off for any notable length of time. In fact, the longest consecutive streak of spread widening in 2017 was a mere 3 days (Aug 9th – 11th). What held the market together so well? The constant stream of retail investor inflows into European credit (IG inflows in 49 out of 52 weeks).

This year, however, it’s been more of an uphill struggle for spreads. “Buy the dip” behaviour has been decidedly absent whenever risks have weighed on the market (note that spreads widened for 7 consecutive days in March). And new issuance continues to knock secondary bonds, something that was rarely seen last year.

What happened to TINA (There Is No Alternative)?

What’s changed, then, from 2017 to now? Simply, that the retail inflows in Europe have been much more muted over the last few months…and these were the “glue” of the credit market last year. What about TINA…and the reach for yield? We think the Euro credit inflow story is partly being disrupted by the attractive rates of return available on “cash” proxies in the US market. As Chart 1 shows, given the cheapening in the frontend of the US fixed-income market, US bill yields now offer more attractive returns for investors than the dividend yields on US stocks – something that has not been the case for over a decade.

Accordingly, we think some European retail inflows may be leaking into the US market at the moment, especially given the recent USD strength.

QE…and a classic liquidity trap?

But we don’t think this dynamic will stymie the inflow story forever. In fact, we remain confident that retail inflows into European credit funds will pick up steam over the weeks ahead.

As Chart 2 shows, domestic savings rates across major Euro Area countries have been rising noticeably of late, while declining in other countries such as the US and UK. Even with all the restorative work that Draghi and the ECB have done, European consumers’ penchant for conservatism and saving has not moderated.

In a classic “liquidity trap” scenario, we wonder whether low/negative rates in the Euro Area may simply be encouraging a greater effort by consumers to save for the future (and note that the Fed and BoE never cut rates below zero).

Whatever the driver, more money is being saved in Europe, and yet the prospect of material rate increases by the ECB remains a distant thing: the market has pushed back lately on rate hike expectations, with cumulative ECB depo hikes of 40bp now seen in over 2yrs time.

In this respect, Draghi is still fighting a “war on cash” in Europe. We believe this was the pre-eminent reason retail inflows into credit were so consistent last year…and we believe that this story is far from over.

The not so Dolce Vita

The ructions in Italy have contributed to another dose of high-grade spread widening over the last week: 8bp for high-grade and almost 20bp for high-yield. Testament to the weaker inflows at present, the move in credit is larger than that seen last March, pre the French Presidential election. Back then, the market was also on tenterhooks given Marine Le Pen’s manifesto pledge to redenominate France’s debt stock into a new currency, and to hold a referendum on EU membership.

5% of high-grade

For now, the ink isn’t yet dry on Italy’s first populist government – there are still the hurdles of designating a Prime Minister (at the time of writing), the President’s “blessing” on the government programme, and confidence votes in the Italian parliament. But assuming a 5-Star/Lega coalition government takes power, is this a source of systemic risk for Euro credit? We think not for the high-grade market. While Italy has a larger outstanding stock of sovereign debt than France, the picture is much different when it comes to high-grade. In fact, Italian IG credit represents just 5.4% of the market now…and that number continues to shrink as Italian corporates remain focused on deleveraging.

Where systemic risk from Italy may be of greater concern is in high-yield, as Italian credit represents 17% of ICE BofAML’s Euro high-yield index (we elaborate more on this here).

The plunge protection team

And true to form, the sell-off in the corporate bonds over the last week has been a much shallower version of what historically one would have expected to see. Chart 4 shows corporate bond spreads for peripheral financials versus 10yr BTP spreads.

They have been well correlated since early 2011. But credit spreads have moved much less over the last week than the move in BTPs would imply (and see here for a similar picture for Itraxx Main).

Populism…for real

The Le Pen populism experience quickly came and went for credit markets last year. Her insistence on drastic ideas such as “Frexit” appeared to stymie her support heading into the first round of the French Presidential elections. Her policies did not resonate with a French electorate that were broadly in favour of the EU and its institutions.

But political uncertainty, and populist sentiment in Italy, is likely to have longevity in our view. The hallmarks of populism – voter frustration and wealth inequality – are clear to see. Strong and stable governments have not been a hallmark of Italian politics since the proclamation of the Italian Republic in 1946: the country has had 65 governments.

The hallmarks of populism

Although the Italian economy has returned to growth over the last few years the magnitude of the recovery is still tepid. The IMF forecast Italy to grow at 1.5% this year, one of the lowest growth rates among Advanced Economies (the UK’s projected growth rate is 1.6% this year and Japan is forecast to grow at just 1.2%, according to the IMF).

In fact, the Italian electorate has seen little in the way of wealth gains since the creation of the Eurozone. Chart 5 shows GDP per capita trends for Italy and Germany. While GDP per capita is much higher in Germany, for Italy it remains marginally below where it was upon the creation of the Euro.

According to Eurostat, almost 29% of the Italian population were at risk of poverty or social exclusion in 2015 (and almost 34% of children were at risk). Hence the Citizenship Income mentioned in the 5-Star/Lega Government Contract.

Successive governments, of late, have focused on the fiscal side of the economy with less emphasis on structural reforms to unlock Italy’s growth potential. This has hindered private entrepreneurialism and the expansion of the corporate sector. As Chart 6 shows, Italy still has a large number of SMEs (and “micro firms”) making up its industrial base.

Sluggish long-term investment has partly contributed to this state of affairs. As Chart 7 highlights, capex intensity in Italy remains well below the levels seen between 2000- 2005, while the capex recovery has been a lot healthier in France and Germany.

A vibrant banking sector – that supports SME lending – is of course a prerequisite for greater levels of credit growth in Italy. And while Italian banks have made a lot of progress in reducing their NPLs recently (especially over the last few quarters), Chart 8 shows that there is still work to be done.

Italian banks continue to have the largest stock of non-performing loans across the European banking space. For more on the structural challenges facing Italy see our economists’ in-depth note here.

Such a backdrop is fertile ground for populist politics. Unlike in France, however, populist narratives are likely to fall on more receptive ears in Italy. As the charts below show, the Italian electorate is much less enamored with the EU than in other Eurozone countries.

Companies safer than governments?

The unknown in all of this will be the ECB. QE has been a powerful tool at controlling spreads and yields in the European fixed-income market over the last few years. But Draghi has not had to buy debt securities when Euro Area member countries have been less committed to fiscal consolidation.

And as Chart 11 shows, the ECB has been almost the only net buyer of Italian sovereign debt over the last 12m. Their impetus remains crucial.

Will higher political uncertainty in Italy alter the balance of the ECB’s asset purchases from here until year-end? Time will tell. However, in the credit market we’ve been struck by the extreme relative value gap that’s opened up between Italian credit and Italian sovereign debt during the last week. Italian credit spreads have held up incredibly well vis-à-vis BTPs, amid the volatility.

Chart 12 shows the volume of French, Italian and Spanish credits that are currently yielding less than their respective, maturity-matched, sovereign debt. Notice for Italy that close to a staggering 90% of credits now yield less than BTPs.

And while in periods of political uncertainty the market has often taken that view that corporates are “safer” than governments, this is by far a historical high for Italy (and for any Eurozone country for that matter). Moreover many Italian companies are actually “domestic” and thus have little in the way of a safety net from foreign revenues.

CSPP > PSPP?

How has there managed to be such a substantial outperformance of Italian credits over the last few weeks? We believe a large part of this is because the ECB has upped the intensity of its CSPP purchases lately, especially with regards to Italian issuers. This gives us confidence that the ECB remains committed to buying corporate bonds for as long as politically possible. See our recent note for more of our thoughts on CSPP, the “stealth” taper, and the programme’s longevity.

Yet, Chart 12 also suggests that credit investors should tread carefully with respect to Italian credits at present. While corporate credit richness versus government debt can persist, we learnt during the peripheral crisis of 2011-2012 that eventually tight credits will reprice wider vs. govt debt (the best example of this was Telefonica).

As a guide for investors, Tables 1 and 2 at the end of the note highlight which Italian credits trade the richest versus BTPs.

Respect the law

For the last year, the Euro credit market has not had to worry about the risk of Eurozone breakup. That ended last week, as the first draft of the 5-Star/Lega Contratto contained a reference to a Euro exit mechanism. However, in subsequent versions this was removed.

Nonetheless, as the front-page chart highlights, the market still appears nervous with regards to Eurozone break-up risk. Note the spread between 2014 and 2003 sovereign CDS contracts (The ISDA “basis”) remains high for Italy, and has ticked up again for Spain and France lately.

The 2014 sovereign CDS contracts provide greater optionality for protection buyers, relative to the 2003 contracts, both in terms of whether the CDS contracts trigger upon a redenomination event and also in terms of their expected recovery rates.

Know your bond

If redenomination concerns remain, what should credit investors look for in terms of Italian corporate bonds? In the charts below, we run a simple screen from Bloomberg on the governing law of corporate bonds in our high-grade and high-yield indices. Chart 13 shows the analysis by country and Chart 14 shows the analysis by Italian credit sector.

We rank Chart 13 by the country with the highest share of foreign law bonds (to the left) to the lowest share of foreign law bonds (to the right).

For Italy, the Bloomberg screen suggests that just 10% of Italian corporate bonds (IG and HY combined) are domiciled under domestic law (Chart 13). This is a very different situation to last March when around 60% of French corporate bonds were domiciled under domestic law.

While a legal analysis of the redenomination risks of Italian corporate bonds is outside the scope of this note, what we learnt from the Greek crisis in 2011 and 2012 was that investor focus gravitated towards the governing law of bonds (where foreign law bonds were perceived by the market to be more secure)." - source Bank of America Merrill Lynch

Of course, as everyone know and given the latest news on the Italian front, the European technocrats in Brussels have shot themselves in the foot by interfering with Italian democracy which will led to bolster even more anti-european sentiment. In October 2016 in our conversation "Empire Days" we pointed out that the statu quo was falling in Europe and we also reminded ourselves what we discussed in our November 2014 "Chekhov's gun" the 30's model could be the outcome:

"Our take on QE in Europe can be summarized as follows: 

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014

It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "statu quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016

Obviously the path taken has been the road to growth / disillusion / social tensions and short-term road to heaven for financial assets as well as goldilocks period for credit. Now we are moving towards longer-term violent social wake-up calls in various parts of Europe. 

We really enjoyed our friend Kevin Muir latest excellent musing on Italian woes on his blog The Macro Tourist. He made some very interesting points in his must read note and we really enjoyed his bar-fighting economics analogy:

"Total French, Italian and Spanish assets are multiples of German assets. Italian Government BTPs are almost 400 billion and there are another 200 billion of other Italian debt securities. 600 billion represents almost 20% of German GDP. And that’s only Italy. What are the chances that an Ital-exit is confined to one nation?

Remember back to the 1930s. Nations that devalued early and aggressively generally did better economically during the ensuing depression - I like to call this bar-fighting economics - hit first and hit hard.

The ECB’s balance sheet expansion has put Germany in an extremely difficult place. They cannot afford to cut back on the expansion for fear of another Euro-crisis, yet the more QE they do, they more Germany is on the hook.

I hate to break it to Germany, but it’s even worse than it looks.

Don’t forget that ECB balance sheet expansion is only one the methods that imbalances within the European Union are stabilized. There is another potentially even more scary mechanism that occurs behind the scenes without much fanfare. Although the ECB is Europe’s Central Bank, each member nation still has their own Central Bank. Since monetary policy is set for the Union as a whole, there are times when capital leaves one European nation in favour of another. Individual Central Banks cannot raise rates to counter these flows, so the ECB stands in as an intermediary.
Let’s say capital flees Italy and heads to Germany, to facilitate the flows, the Italian Central Bank borrows money from the ECB while the German Central Bank deposits excess reserves with the GDP, thus allowing it all to balance. The individual country net borrowing/lending amounts are known as Target 2 Reserves." - source  The Macro Tourist, Kevin Muir

Target 2 issues have been a subject which has been well documented and discussed by many financial pundits. We won't delve more into this subject. But, as pointed out by Kevin Muir in his very interesting note, as a creditor Italy and being a very large one, Italy is in a much better position than the arrogant technocrats in Brussels think it is. In our book, it is always very dangerous to have a wounded animal cornered, it's a recipe for trouble. The latest European blunder thanks to the Italian president most likely instructed by Brussels to muddle with the elections result will likely lead to a more nefarious outcome down the line. Charles Gave on French blog "Institut des Libertés" made some very interesting comments when it comes to Italy's macro position:

• Italy now runs a current account surplus of 3.5% of GDP, 

• Italy has a primary surplus of 2 % of GDP, 

• Italy has extended the duration of its debt in the last few years and so is less vulnerable to a rise in long rates, 

• 72% of Italian debt is now owned by Italian entities

There has never been a better time for Italy to quit the euro. Come the autumn a fresh euro crisis is possible." - source Institut des Libertés - Charles Gave

Another expression we could propose relating to the excellent bar-fighting economics analogy from Kevin Muir and Target 2 would be as follows:

 "He who leaves the bar early doesn't pick up the bar tab" - source Macronomics

It is always about first mover advantage anyway, hence our previous positive stance on Brexit from a macro perspective when everyone and their dog were predicting a calamitous fall in growth following the outcome of the referendum.

When it comes to credit and Italian troubles, European High Yield needs to be underweight as it is at risk as pointed out by UBS in their Global Macro Strategy note from the 23rd of May entitled "How big a risk to EUR, credit and stocks":

"Credit: HY more exposed than IG to Italian stress

Italy is a risk but more so for HY cash vs. IG, in our view, where the Italian exposure is about 20% vs. 5%. As long as the risk of Italy challenging the integrity of Eurozone remains low (i.e. higher risk premium but no crisis scenario), we think the disruption in credit should remain mostly contained to Italian corps.

In a scenario of modest additional stress (c. 40bps BTP spread widening), we estimate that EUR IG and HY should widen 5-10bps and 25-30bps respectively from here, based on our fair value models and the recent performance. Our models are based on multi-linear regressions which also take into account other factors such as global growth, credit risk and conditions, as well as the ECB's CSPP.

In fact, peripheral spread widening of 30-40bps is likely the threshold when the relationship between corporate credit and peripheral spreads becomes non-linear, in our view (see Figure 5 and Figure 6). This is the threshold beyond which Italian risk should also affect EUR corporate credit markets more significantly outside of Italian issuers.

Given the uncertainties, we shift our preference for EUR HY vs. IG to neutral and prefer exposure to HY via its CDS index (Xover) which has a much lower Italian exposure at 7%. We recommend investors underweight Italian corps in IG and HY financials (largely Italian banks) and move up the HY curve from single B names to BB non-fins." - source UBS

We have recommended in our recent musings to reduce your beta exposure and to adopt a more defensive stance. If high beta is a risk and you don't like volatility, then again you are much better-off favoring non-financials over financials and you should probably maintain very low exposure to subordinated debt from peripheral financial issuers. At our former shop, a large European Asset Manager we recommended launching a Euro Corporate Bond Funds ex Financials. While the fund unfortunately did not gathered much attention AUM wise, performance wise it has been very good thanks to its low volatility profile and solid credit management. It is still boasting 4 stars according to Morningstar most recent ranking. Should Italian woes escalate high beta exposure will be hit much more, particularly financials. In that instance, for a long term credit investor, having less exposure to financials makes much more sense and we are not even discussing recovery values at this stage.  

Don't ask us about our opinion on having exposure to European banks equities again, because you will get the same answer from us. From a risk-reward perspective and long term investment prospect, it's just doesn't make sense whatsoever to get exposed to them regardless of the cheap book value argument put forward by some snake-oil sell-side salesman. You have been much more rewarded by sticking to credit exposure on European banks, rather than equities in Europe. End of the rant.

As well, we also pointed out in recent conversations that US cash had made a return into the allocation tool box and given the rise in political uncertainties and volatility, one should think about rising its cash level for protective measure. Cash can be "king" particularly with rising US yields and a strengthening US dollar marking the return of "Mack the Knife". Gold continue with it's safe harbor status. As we indicated in our earlier quoted tweet, both the dollar and gold can rise when we move in a situation where investors are moving from being more concerned about "return of capital". One would also be wise to seek refuge again in the Swiss franc (CHF) we think particularly versus the Euro (EUR). As well, a short covering on 10 year US Treasury Notes could be in the making (in size...). Watch that space because we think long end is enticing even zero coupon 25 years plus (ETF ZROZ) should we see an acceleration in the "risk-off" environment.

Moving back to "solvency" risk and sustainability of debt, namely "return of capital", as pointed out corporate credit in many instances could be "safer" than "sovereign" risk. Back in our conversation  "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!" we quoted again Dr Jochen Felsenheimer on macro and credit (our focus):

"In the end, all investors face the same problem - the whole world is a credit investment. And it is difficult to negotiate this problem with the classical theory of economics. Short selling bans, Eurobonds and ratings agency bashing will not provide a remedy here either." - Dr Jochen Felsenheimer

We added at the time that confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues. This brings us to the trajectory of European debt in general and Italy in particular. On this very subject we read Deutsche Bank's Euroland Strategy note from the 25th of May entitled "Pricing debt (un)sustainability" with great interest:

"Default risk pricing and bond relative value

Rising concerns over Italy’s debt sustainability can also be seen in the spreads between high coupon and low coupon bonds on the BTP curve. Over periods of stress, high coupon bonds which typically trade at a higher cash price tend to underperform lower coupon neighbours. One potential explanation for this is the risk that upon a hypothetical default the recovery rate will be based on the par value of the bond rather than the cash price an investor paid. Related to this, lower coupon, more recently issued bonds are also more likely to have CAC clauses compared to neighbours issued pre-2013.

Moreover, in times of stress participants seeking to release cash (for example insurers or pension funds with broad portfolios) might prefer to reduce holdings of higher price bonds (high coupon). Finally, even in normal times higher cash bonds may trade at a slight discount, reflecting the lower liquidity in some of these issues.

This effect is apparent in the charts below showing the positive correlations of z-spread (left) and yield differentials (right) between high and low coupon bond pairs and the IT-DE 10Y spread (which proxies for market pricing of BTP risk). As the BTP Bund spread has widened, high cash bonds across the curve (but particularly from 10Y+) have underperformed.

The non-linear dynamics of some of the bond pairs as spreads have widened are noteworthy. At the the 30Y point, the 44s-47s spread had remained elevated into the latest stress, with the 44s only beginning to underperform after the initial widening move. This may partially reflect the relatively large maturity gap between the two bonds, with 10s30s flattening at first outweighing the high cash price/low cash price effect on the bond spread.

- source Deutsche Bank

From a convexity perspective we find it very amusing that "yield hogs" when facing "redenomination/restructuring risk" see their high coupon bonds underperforming lower coupon neighbours, or to put it simply when non-linearity delivers a sucker punch to greedy investors...

While the "risk-off" mentality is prevailing thanks to Italian woes, confidence matters when it comes to "solvency" and debt "sustainability" yet, given the overstretched positioning in US Treasury Notes, if there is a continuation of troubles in European bond markets, then again, it will be interesting to see what our Japanese friends will do when it comes to their bond allocation. Our final chart deal with the current slowdown in the global economy which represents for us a clear threat to the US bond bears current positioning.

• Final chart - Decline in PMI's doesn't bode well for the US bond bears

While we have been reluctant so far to dip our toes back into the long end of the US yield curve, given the most recent surge in European woes and extreme short positioning, we think there is a potential for a violent short covering move. Our final chart comes from CITI Global Economic and Strategy Outlook note from the 23rd of May and displays the decline from recent peak in Manufacturing PMI pointing towards a slowdown:

There is more evidence that global economic growth is slowing. Some of the drags are likely temporary, such as some payback from unusually fast growth in H2 2017 (e.g. real retail sales in the US grew by 8% annualized in Q4), and adverse weather impacts across Western Europe, Japan and the US, while the positive effects of fiscal stimulus in the US will ramp up over the course of the year. But declining business sentiment, some tightening of financial conditions and the rise in oil prices are likely to have a more persistent (if moderate) dampening effect on global growth, notably on moderating momentum in business capex (Figure 2)." - source CITI

As far as White Noise is concerned, being uncorrelated in time does not restrict the values a signal can take (Italy back in crisis mode + slowing global economic growth). Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off) can makes confidence turn on a dime. For financial markets as well as consumers, end of the day "confidence matters" for credit growth. Have we reached peak consumer confidence?

"What we obtain too cheap, we esteem too lightly; it is dearness only that gives everything its value. " - Thomas Paine

Stay tuned!