Macro and Credit - White Tiger

"Earnings don't move the overall market; it's the Federal Reserve Board... focus on the central banks, and focus on the movement of liquidity... most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets." - Stanley Druckenmiller

Watching with interest the trade war between the United States and China ratcheting up with Beijing cancelling its plans to send two delegations to Washington, given the season of fall is upon us, when it came to selecting our title analogy, we decided to go for "White Tiger". The White Tiger is one of the four symbols of the Chines constellations. It is sometimes called the White Tiger of the West and represents the West in terms of direction as well as the autumn season.  It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, or if there was peace throughout the world. Obviously for those who remember our June conversation "Prometheus Unbound", we argued the following:

"It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by Graham Allison former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:
- source Macronomics June 2016 

"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War" -

In similar fashion, more recently maverick hedge fund manager Ray Dalio came to a similar prognosis in his recent musing entitled "A Path to War" on the 19th of September:

"The economic/geopolitical cycle of economic conflicts leading to military conflicts both within and between emerging powerful countries and established powerful countries is obvious to anyone who studies history.  It’s been well-described by historians, though those historians typically have more of a geopolitical perspective and less of an economic/market perspective than I do.  In either case, it is well-recognized as classic by historians.  The following sentence describes it as I see it in a nutshell:

When 1) within countries there are economic conflicts between the rich/capitalist/political right and the poor/proletariat/political left that lead to conflicts that result in populist, autocratic, nationalistic, and militaristic leaders coming to power, while at the same time, 2) between countries there are conflicts arising among comparably strong economic and military powers, the relationships between economics and politics become especially intertwined—and the probabilities of disruptive conflicts (e.g., wars) become much higher than normal.

In other words economic rivalries within and between countries often lead to fighting in order to establish which entities are most powerful.  In these periods, we have war economies, and after them, markets, economies, and geopolitics all experience the hang-over effects.  What happens during wars and as a result of wars have huge effects on which currencies, which debts, which equities, and which economies are worth what, and more profoundly, on the whole social-political fabric.  At the most big-picture level, the periods of war are followed by periods of peace in which the dominant power/powers get to set the rules because no one can fight them.  That continues until the cycle begins again (because of a rival power emerging).

Appreciating this big economic/geopolitical cycle that drives the ascendancies and declines of empires and their reserve currencies requires taking a much longer (250-year) time frame, which I will touch on briefly here and in more detail in a future report.
Typically, though not always, at times of economic rivalry, emotions run high, firebrand populist leaders who prefer antagonistic paths are elected or come to power, and wars occur.  However, that is not always the case.  History has shown that through time, there are two broad types of relationships, and that what occurs depends on which type of relationship exists.  The two types of relationships are:

a) Cooperative-competitive relationships in which the parties take into consideration what’s really important to the other and try to give it to them in exchange for what they most want.  In this type of win-win relationship, there are often tough negotiations that are done with respect and consideration, like two friendly merchants in a bazaar or two friendly teams on the field.

b) Mutually threatening relationships in which the parties think about how they can harm the other and exchange painful acts in the hope of forcing the other into a position of fear so that they will give in.  In this type of lose-lose relationship, they interact through “war” rather than through “negotiation.”

Either side can force the second path (threatening war, lose-lose) onto the other side, but it takes both sides to go down the cooperative, win-win path.  Both sides will inevitably follow the same approach.

In the back of the minds of all parties, regardless of which path they choose, should be their relative powers.  In the first case, each party should realize what the other could force on them and appreciate the quality of the exchange without getting too pushy, while in the second case, the parties should realize that power will be defined by the relative abilities of the parties to endure pain as much as their relative abilities to inflict it.  When it isn’t clear exactly how much power either side has to reward and punish the other side because there are many untested ways, the first path is the safer way.  On the other hand, the second way will certainly make clear—through the hell of war—which party is dominant and which one will have to be submissive.  That is why, after wars, there are typically extended periods of peace with the dominant country setting the rules and other countries following them for the time it takes for the cycle to happen all over again." - source Ray Dalio

Because the color white of the Wu Xing theory also represents the west, the white tiger became a mythological guardian of the West on the mythological compass. The White Tiger is as well considered in China as the ruler of the Autumn and the governor of the metallic elementals (hint for you gold bugs out there...) but we ramble again. Will the age of reason disappear with the White Tiger? We wonder.

In this week's conversation, we would like to look at the gradual path towards recession in the US and how does the credit cycle will end.

Synopsis:

• Macro and Credit - Credit cycles die of "old age". 
• Final chart - Hey Fed, NAIRU this!

• Macro and Credit - Credit cycles die of "old age". 

While many pundits have been focusing on the continuation of the flattening of the yield curve, as we pointed out in our most recent conversation again, credit cycles die because too much debt has been raised. What the most recent Fed quarterly survey Senior Loan Officers Opinion Survey (SLOOs) tells us is that financial conditions remain very benign still. Yet, no one can ignore the hiking path followed by the Fed and that already some part of the economy such as housing are already feeling the heat and the gradual tightening noose of financial conditions. 

From a "White Tiger" perspective, a full-blown trade war between China and the United States would push US companies to pass on prices increases onto the US consumer. Any acceleration in inflation would lead to the Fed to be more aggressive with its hiking stance. The rhetoric of Fed members in recent week has become decisively more “hawkish”.

First question we are asking ourselves is when does the US consumer gets "maxed out"? We are already seeing credit card usage surging as well as the return of housing equity extraction thanks to the return of HELOC. On this subject we read with interest Wells Fargo Economics Group note from the 18th of September entitled "Consumer outlook in a rising rate environment":

"Executive Summary

Conventional wisdom has it that rising interest rates are bad for consumer spending because swelling financing costs put a squeeze on a household’s capacity for other outlays. What if conventional wisdom is wrong? Our analysis finds that a rising interest rate environment does not immediately snuff out consumer spending growth.

As the current expansion stretches further into its tenth year, the economy is on track to eclipse the expansion of the 1990s as the longest on record. In this report we consider the outlook for consumer spending against this backdrop of a record-setting expansion and consider how long the good times will last. Our base-case scenario, spelled out in this special report, anticipates a modest pick-up in consumer spending, at least in the near term. Eventually, like all good things, the longest economic expansion on record will come to an end and consumer spending will come back down with it. That will likely occur alongside financial conditions that warrant rate cuts by the Fed. The precise timing of these events is tough to get right, but by signaling this drop-off in activity in late 2020, we are essentially saying that while the end of the party is not imminent, no cycle lasts forever.

- Source Bloomberg LP, The Conference Board, University of Michigan and Wells Fargo Securities

As per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return:

- source Macrobond (click to enlarge).

Before we go into more details of Wells Fargo's note, there are a couple of points we would like to make. Despite decreasing significantly from its peak prior to the Great Recession, household debt still remains quite elevated, stabilizing around 77%. Also back in March in our long conversation "Intermezzo", when it comes to consumer credit, as pointed out by famous French economist Frédéric Bastiat, there is always what you see and what you don't see. We pointed out the following from Deutsche Bank's State of the US Consumer report from the 26th of February entitled "Robust Consumer with Pro-cyclical and Seasonal Tailwinds on the Horizon":

"Items to watch

Lower income consumers are more levered than they appear: The aggregate deleveraging post-crisis has largely benefited from mortgage leverage sitting at its lowest level since 2001. However, other consumer leverage (card, student, auto, and personal) continues to grind higher into 2018 and is now at all time highs (~26%). Excluding disposable income for the Top 5% income bracket of US consumers, consumer debt levels are closer to 43% of adjusted disposable income—almost double the reported measure of ~26%. The latest triennial Fed Survey of Consumer Finances highlights this dynamic, with the bottom 40% income households running at ~50% non-mortgage DTI, which is ~10% more than LT averages.

The subprime/low income consumer is stretched: Sluggish wage growth and rising healthcare and rent expenses as a percentage of income (non-debt obligations near 25 year highs) among lower income households have stretched subprime consumers as they look to augment rising expenses with debt. 

Banks have met this increased demand by providing deeper credit access to subprime (increased participation, especially for cards), leading to higher leverage and an increased severity risk of loss as delinquencies start to diverge for lower quality consumers. Like DTI, adjusting debt payment burdens to exclude the top 10% income brackets almost doubles the reported Fed figure (9.6% PTI vs. 5.8% reported PTI by the Fed).

Socio-economic divide driving credit cycle: While aggregate consumer fundamentals remain robust, subprime consumers are seeing rising delinquencies and losses starting to normalize much faster than other credit tiers: +90-day DQs within subprime cards have rose+300bps Y/Y in 3Q17 vs. only~30bps on average for near prime/prime borrowers. ~45% of Americans would have difficulty paying a surprise medical bill of ~$500 (Kaiser Foundation), while ~50% of US consumers live paycheck to paycheck (FITB). Taken all together, a disconnect between the lower credit tier borrowers and the economic cycle is starting to emerge." - source Deutsche Bank

The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles.

But let's return to Wells Fargo's take:

"A Consumer Spending Framework in the Context of Rates

As we would at any time in the business cycle, we consider the macro drivers of consumer behavior. Consumer sentiment and confidence, by about any measure, are at or near high levels last seen around 2001; which, not coincidentally, was in the late stages of that prior long-lasting expansion (Figures 1 & 2). We also look at the purchasing power in consumers’ wallets, be it in the form of personal income, which is at last picking up (albeit in only a modest way) or in access to capital through borrowing, where measures of revolving consumer credit growth indicate a levelling off more recently. Finally, we tally the actual spending numbers reflected in the personal income and spending report and the monthly retail sales numbers, both of which have been on a roll in recent months.

In an effort to better inform a consumer outlook, it is essential to have a framework for thinking about these fundamentals and how households will manage finances at this late stage of the cycle. The trouble with considering this period in the context of what has happened in prior cycles is that for a long stretch in the current cycle, from December 2008 until December 2015, the Federal Reserve maintained a near zero interest rate policy (ZIRP), and at various points during those years was engaged in a broad expansion of the balance sheet through quantitative easing (QE), (Figures 3 & 4).

- source Federal Reserve System and Wells Fargo Securities

The Fed has historically purchased Treasury securities to expand the monetary base, although the monetary policy “medicine” applied during that era, including the purchases of mortgage-backed securities and other assets, had not been tried before, at least not in the United States.

Central bank actions, no doubt, are a factor in the remarkable duration of the current cycle, and on that basis any informed outlook for consumer spending ought to not only consider these macro drivers (like confidence, access to capital and willingness to spend) but to consider them in the context of Fed policy.

To that end, we went back to just before the 1990s expansion began in 1989 and divided the years since into four broad categories based on what the Federal Reserve was doing with monetary policy at the time: (1) lowering the fed funds rate, (2) a “stable” rate environment, (3) raising the fed funds rate and (4) ZIRP with QE.

The date ranges for each of these periods is spelled out in Table 1 below.

Most of the time periods are straightforward, although the one period that might invite critique is that we have characterized the time period from March of 1995 through January 2001 as “stable” (revisit Figure 3).

One could reasonably observe that the fed funds rate actually moved up and down during that nearly six-year stretch. Our argument for calling it “stable” is that this period was essentially from the “mid-cycle” slowdown until the end of that expansion. Admittedly, there were adjustments up and down throughout the period, but from the start of the period to the end, the funds rate finished just 50 basis points higher. Reasonable minds could disagree, but in our view, the idea of thinking of that period as four unique rate cycles would unnecessarily complicate our analysis.

With our various Fed cycle dates established, we looked at our macro drivers for consumer spending through the lens of the Fed policy that was in place at the time. For each interest rate backdrop, we calculated the average levels for various measures of consumer confidence, the average annualized growth rate of personal income, the average net monthly expansion in consumer credit and finally the average annual growth rates of both real personal consumption expenditures and of nominal retail sales.

A key takeaway from our exercise, depicted in Table 2 below, is that measures of consumer fundamentals tend to do best in periods of stable interest rates. Interestingly though, a rising rate environment is almost as good for these same consumer fundamentals.

Perhaps that is not altogether surprising, considering that the Fed is apt to raise rates when the economy is at full employment and inflation is heating up beyond the Fed’s comfort zone. Those factors tend to exist when the economy is doing particularly well or even overheating.

The inverse of that dynamic may explain why the worst rate theme for consumer spending is during periods when the Fed is lowering rates. Personal income and spending as well as nominal retail sales all performed worst during periods when the Fed was cutting rates. Interestingly, the lowering of interest rates does not compel consumers to increase their appetite for credit, at least not immediately. The average net monthly increase in consumer credit came in a distant last during periods when the Fed was actively lowering rates.

2020 Vision

So what sort of Fed policy theme should we consider looking forward? To judge from the Fed’s dot plot, a visual rendering of policymakers’ own forecasts for the fed funds rate, the FOMC is closing in on its neutral rate for fed funds. With most dots clustered around 3.00 to 3.25% and the current fed funds rate at 2.00%, there are only four or five quarter-point rate hikes left to go in the current cycle, barring some change in forward guidance from the Fed (Figure 5).

Our forecast anticipates two more hikes this year and another three next year. After that it stands to reason we would be in a stable rate environment slightly above the neutral rate until the Fed’s understanding of r* changes (favoring another hike) or until conditions warrant a cut. In a separate special report1, we explained our use of an analytical framework we recently developed to inform our view of Fed policy going forward and why we look for the FOMC to raise rates another 125 bps before it cuts rates at the end of 2020.

In forming our outlook for the consumer, we take the findings of our rate-environment study and overlay them with our expectations for Fed policy over the next couple of years. If things play out the way we anticipate, monetary policy is entering an era of transition unlike anything the economy has seen in more than a decade. For a number of factors including the longevity of the cycle, growing fiscal budget imbalances and a potential fallout from the global economy, we indicated in our initial 2020 forecast that by the end of our forecast horizon the Fed would likely begin cutting the fed funds rate.2 A rate-tightening environment is expected to prevail at least through the first part of 2019, which will be followed by a stable rate for another year or so before the Fed begins to signal eventual rate cuts.

For the consumer, this Fed forecast implies a pick-up in the pace of consumer spending in the near term before an eventual slowing the further out we go in the forecast period. Full year PCE growth was 2.5% in 2017. By the time we close the books on the current year, we expect the comparable number for 2018 to pick up to 2.6%, prior to quickening to 2.7% in 2019 and slowing to just 2.2% in 2020 (Figure 6).

- Source: Bloomberg LP, Federal Reserve Board, U.S. Department of Commerce and Wells Fargo Securities

Outlook

Consumers may be better prepared to endure a slowdown than in the past. The saving rate, currently at 6.7%, is rather elevated given the late stage of expansion, while real median household income surpassed its pre-recession peak in 2017. With the unemployment rate currently matching low levels last seen in the late 1960s, there remains little slack in the economy. The labor market is expected to grow increasingly tight, with the unemployment rate trending to as low as 3.3% by 2020. Similarly, inflationary pressures that continue to gradually build over our forecast horizon will put downward pressure on real income gains.

The length of the current expansion is expected to surpass that of the 1990s, taking the title as the longest expansion on record. While monetary policy changes act as signals to markets about the health of the economy and/or concerns about inflation expectations, we must be sensitive to policy movements and their implication for consumer spending. Our initial 2020 forecast expects the Fed to surpass its neutral rate, prior to beginning to cut policy by the end of 2020. With this signal of a slowdown in activity, we are essentially saying that this expansion will eventually draw to a close. The rate cutting environment will act as a last call announcement – and for the consumer sector it serves as a valuable indication for longevity of this expansion." - source Wells Fargo

Whereas we agree with the timing, we disagree with the perceived health of the US consumer, as per the above points illustrated in a previous Deutsche Bank research note. There is more leverage than what can be seen, not only when it comes to the US consumer but as well when it comes to the distorted balance sheets of many US corporates after years of a buy-back binge and a fall in the quality of the overall rating for the Investment Grade category much closer to "junk" than in the previous cycle.

Overall the timing for the end of the credit cycle could indeed be in the region of 2020. This is as well Ray Dalio's most recent view and also Christopher R. Cole, CFA from Artemis Capital Management as per his July  2018 letter entitled “What is water?”:

“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents. The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets. Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.Despite this trend, U.S. equities will very likely escape 2018 without a crisis or volatility regime shift because of the one-time wave of corporate liquidity unleashed by tax reform. Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” – Source Christopher R. Cole, CFA from Artemis Capital Management

The whole note written by Christopher R. Cole is worth a read particularly on the subject of passive management and liquidity. His quote from above resonates as well with our opening quote from maverick investor Stanley Druckenmiller.

 As well in his note, Christopher R. Cole indicates when he thinks we will most likely have another crisis on our hands:

“When does this all end? If or when the collective consciousness stops believing growth can be created by money and debt expansion the entire medium will fall apart, otherwise it is totally real… and will continue to be real.

A crisis-level drought in liquidity is coming between 2019 to 2022 marked by a perfect dust storm of unprecedented debt supply, quantitative tightening, and demographic outflows.

Quantitative easing has caused the natural relationship between corporate debt expansion and default rates to break down. U.S. debt is at an all-time high of $14 trillion (45% of GDP) and high yield default rates are near all-time lows at 3.3% (MarketWatch, 13d). This is not sustainable. Years of cheap money has led scores of investors to buy debt at levels that do not reflect credit risk. The poster child is the 2017 issuance of 100-year Argentina bonds (USD denominated) that were oversubscribed 3.6x with a 7.9% yield. It is hard to find a decade where Argentina has not defaulted, much less a century. That medium of bond market demand has already begun to show signs of cracking.” – Source Christopher R. Cole, CFA from Artemis Capital Management

Fiduciary duty anyone? Credit cycles tend to die of old age and too much debt. We have entered the season of the White Tiger we think. Only a few innings left. 

On the current evolution of the credit cycle we read with interest Bank of America Merrill Lynch's take in their High Yield Strategy note from the 21st of September entitled "The Evolution of the Credit Cycle:

"The Evolution of the Credit Cycle

As we continue to study the state of the current credit cycle, the accumulated evidence sides with the argument that it has more room to develop, as long as few more years. Previous cycles have lasted anywhere between 6-8 years, on average, and this observation would make it an unusual development to see the current cycle extend for much longer. However, we also note that more broadly, this economic cycle has been an unusual one in many respects, including how long it took the US GDP to return to trend growth rates, the unemployment to decline, and the inflation to recover. And if those major macroeconomic variables took an unusually long time to return to normal levels, then why should we expect the credit cycle to be an average one?

Away from this argument, we also continue to believe that the commodity episode in 2015-2016 represented a partial cycle in and of itself. Among the most conclusive pieces of evidence in support of this view, we present the charts in Figure 3 for debt growth and Figure 4 for capex.

In both cases, we highlight cyclical turns, as defined by catalyst events as the starting points and subsequent observed peaks in trailing 12mo HY issuer default rates as ending points.

Both graphs suggest that previous cyclical turns have occurred at similar points on each respective line, had similar impact on each measure, and had left them at similar levels after defaults receded. Both graphs also suggest that a cyclical turn at current levels and given their recent trends would be inconsistent with historical experiences going into previous default cycles.

And yet, inconsistent does not imply impossible, particularly in light of trade tariffs that are being threatened and imposed by the Trump Administration. It remains our view that at the end, these policies are unlikely to survive the test of time, however it is difficult to say how much time it would take to prove them wrong and how much damage they could do in the meantime.

The exact timing of cyclical turns is an inherently uncertain exercise and we do not claim to possess superior skills to do so. Instead, our approach relies on using all available data and analytical tools to help us make a judgment on a relatively short next-12mo time horizon, and continue doing so as time progresses and new data becomes available. As such, we made a call that this cycle was unlikely to turn at this point last year. With all the evidence we accumulated since then, we believe this view still holds today.

Our default model continues to suggest low likelihood of a meaningful spike in defaults over the next year, based on its latest inputs. It currently projects a 3.25% issuer weighted rate during this time period, marginally lower than the actual realized 3.41% rate as calculated by Moody’s (Figure 5). A 3.25% issuer default rate would be consistent with 2.0% par-weighted rate. 

How it ends?

In our last year’s outlook on the prospects of this credit cycle, we listed three key risks to its longevity: (1) inflation spike; (2) trade contraction; and (3) sector distress. We think all three remain valid and potent sources of known risks going forward as well. In our judgment, the spike in inflation remains a lower probability risk, followed by trade contraction, somewhat higher on our scale of likely developments, and still inside of a tail risk zone.

A contraction in one of the key industry sectors is a higher probability outcome, in our opinion, albeit not an imminent one. Previously, we published our thoughts on capital allocation trends across various sectors, and identified healthcare as the most overextended sector in terms of the amount of capital raised in recent years.

A higher capital formation could lead to higher capex, higher production capacity, higher supply, lower prices, and an eventual need to remove excess capacity. The latter stage often goes hand in hand with a need to eliminate excess debt that was used to finance excess capex.

Other sectors that we found to be overextended on this scale include autos, utilities, and food producers, although these three are relatively small compared to healthcare.

And at the end of this conversation on risks, we think it is also important to remind ourselves that previous cycles have ended with a surprise event, a “black swan” of sorts, which, by definition, was unexpected by the consensus and meaningful in its impact. We do not see any particular reasons as to why the next one would break out of this mold." - source Bank of America Merrill Lynch

From our "White Tiger" perspective, an inflation spike is something very much on our radar, hence our close attention to market gyrations in oil prices and geopolitical risk, the famous known unknowns which have been building up recently in world which has decisively moved from cooperation to noncooperation.

As we have stated above, many pundits are focusing on the flattening of the yield curve, from an employment and non-accelerating inflation rate of unemployment (NAIRU), Monetary policy conducted typically involves allowing just enough unemployment in the economy to prevent inflation rising above a given target figure, we think the Fed will once again be behind the curve as per our final chart.

• Final chart - Hey Fed, NAIRU this!

In our previous conversation we discussed the great work of American economist Irving Fisher, in relation to NAIRU,  the concept arose in the wake of the popularity of the Phillips curve which summarized the observed negative correlation between the rate of unemployment and the rate of inflation (measured as annual nominal wage growth of employees) for number of industrialised countries with more or less mixed economies. This correlation (previously seen for the U.S. by Irving Fisher) persuaded some analysts that it was impossible for governments simultaneously to target both arbitrarily low unemployment and price stability, and that, therefore, it was government's role to seek a point on the trade-off between unemployment and inflation which matched a domestic social consensus, the famous dual mandate of the Fed. We won't go into more details about our fondness of the Phillips curve, it's a subject we have discussed on this very blog on many occasions. Our final chart comes from Deutsche Bank's US Economic Perspectives note from the 20th of September entitled "How the Powell Fed can make history" and shows that the Fed has never succeeded in returning unemployment to NAIRU from below without a recession ensuing:

"With unemployment now noticeably below standard measures of its natural level of full employment and likely to tighten further and with wage and price inflation returning to desired levels and likely to continue upward, the Fed has a delicate task on its hands. It needs to begin to close the gap between growth of aggregate demand and aggregate supply in the economy — in other words, to slow and eventually reverse the tightening of the labor market before it risks pushing up inflation and inflation expectations excessively. The question is whether it can do so without pushing the economy into recession and causing unemployment to surge upward, overshooting its natural rate.

Many in the market already see the storm clouds of recession gathering in the distance, a narrative that has found an ally in the flattening yield curve. Talk of a downturn by 2020 is increasingly in vogue and for good reason: a soft landing in unemployment from below NAIRU has never been achieved before. In the modern history of US national economic statistics since the late 1940s, every time the unemployment rate has overshot to the downside, policy firming by the Fed has helped drive the economy into recession (Figure 1).

We think the Powell Fed can make history by achieving the unprecedented outcome of a soft landing from below sans recession." - source Deutsche Bank

Contrary to the elements put forward in this very interesting note, we think that once again this time isn't different. On a final note we thought we had run out of arguments against the cult of the Philipps curve as per our conversation "The Dead Parrot Sketch" back in August 2017, we did read additional arguments against the Phillips curve cult in Saad Filali's take on Seeking Alpha in his article "There Is No Inflation: Too Much Supply, Not Enough Unions", which we found of great interest.  It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, it could be said that the white tiger only appeared when the BIS ruled with absolute virtue as per their very interesting most recent quarterly survey, but we digress...

"Liquidity is oxygen for a financial system." -  Ruth Porat

Stay tuned!

Macro and Credit - The Golden Rule

"After World War II, there were a lot of pension funds in Europe that were fully funded, but they were pressured to hold a lot of government debt. There was a lot of inflation, and the value of all those assets fell. Those pension funds couldn't honor their promises to the people." -  Edward C. Prescott, American economist and Nobel Prize in Economics.

Looking at the technical "relief rally" in all things "beta" including US High Yield thanks to the tone down in the geopolitical narrative but with the pickup of the trade war rhetoric between the United States and China, when it came to selecting our title post analogy, we reminded ourselves of the "Golden Rule". The Golden Rule (which can be considered a law of reciprocity in various religions) is the principle of treating others as one would wish to be treated. It is a maxim found in most religions and cultures:

• One should treat others as one would like others to treat oneself (positive or directive form).
• One should not treat others in ways that one would not like to be treated (negative or prohibitive form).
• What you wish upon others, you wish upon yourself (empathic or responsive form).

The concept occurs in some form or another in nearly every religion and ethical tradition and is often considered as the central tenet of "Christian ethics".  It can also be explained from the perspectives of psychology, philosophy, sociology, human evolution, and of course economics hence our reference in relation to growing trade tensions. 

In this week's conversation, we would like to look again at where we are within the credit cycles, given as we pointed out in recent musings cracks have started to show in some parts and everyone is asking oneself when the downturn is given the relentless flattening of the US yield curve.

Synopsis:

• Macro and Credit - Have we reached the end of the credit cycle yet?
• Final charts -  The return of Macro to the forefront thanks to higher interest rates

• Macro and Credit - Have we reached the end of the credit cycle yet?

We have been discussing at length like many various pundits about the credit cycle and the fact that it was slowly but surely turning thanks to the Fed's change of narrative. We even posited that the Fed is the credit cycle in one of our musings. Back in October in our conversation "Who's Afraid of the Big Bad Wolf?", we indicated that for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation". With the continuing surge in oil prices in conjunction with commodities prices, we also pointed out as well in this prior conversation that credit cycles die because too much debt has been raised and therefore it remains to be seen if rising "inflation expectations" could indeed be the match that lights the ignite the explosion of the credit bubble hence the importance of gauging where we stand in this credit cycle. The increasing trade war narrative has proven in the first quarter to be "bullish" gold as we anticipated thanks to the "Golden Rule" being put forward between the United States and China. Following years of financial repression the house of straw of the short-vol pigs was blown off by the explosion of volatility following the Fed's decision to put a lower strike on its "put" for asset prices, which had been a deliberate part of their move in recent years. We have become increasingly wary of the situation of the US consumer hence us adopting more scrutiny on the rising price at the gas pump with an already strained US consumer balance sheet thanks to rising rents and healthcare and slowly rising wages with dwindling savings and rising usage of credit cards to maintain the lifestyle. 

So, one might rightly ask oneself, when does it all end given that as per the below recent Bloomberg chart, displaying US Economic Surprise indexes for both hard data and soft data trending lower:

- source Bloomberg

Many wonder if this time it will be different with the continuing flattening of the US yield curve. On this subject we read with interest Bank of America Merrill Lynch's Securitized Products Strategy Weekly note from the 20th of April,. First here is the summary of their findings:

"This time is different: late cycle mortgage lending, higher rates, and a flatter curve

This week’s yield curve flattening, to a post-crisis low of 43 bps on the 2yr-10yr spread, is raising concerns that the current cycle is coming to an end and recession is now on the not too distant horizon. It’s more than 9 years since the stock market low of March 2009, so it is clearly late in the cycle. However, we continue to believe that this cycle has at least a couple of more years before it ends and credit spreads, along with securitized products spreads (see “Bullish for Q2” for corporate-securitized products correlation discussion), widen materially.

In fact, although the path for spreads will be bumpier than what was seen in 2017, we think there is potential for spreads to tighten further in Q2 and beyond. As discussed last week, we think the 10yr breakeven inflation rate is likely to head higher in Q2, moving above 2.20% or even 2.30%, as oil experiences upward seasonal pressure. Given correlations, we see this as good news for securitized products spreads. (This week’s jump to an intraday high of 2.19% on the breakeven rate suggested that 2.20%-2.30% is not a particularly aggressive target.)

We acknowledge the tightness of spreads, but we caution against being too early to position for major spread widening in the near future. Although we see tightening potential for spreads, due to the tightness of spreads, we maintain our neutral view for securitized products.

We compare this cycle to the last cycle on two fronts:

First, and more broadly, we consider metrics such as the 2yr-10yr spread, the BofAML Global Financial Stress Indicator and the BofAML Liquidity Stress Indicator: all three indicators suggest little imminent stress. We see the current period as similar to May 2005. As a reminder, that was 2 years before credit spreads began to widen and over 3 years before full blown crisis and recession. Given the slow pace of monetary policy tightening in this cycle, we think the risk is that this cycle takes longer to end than the last one did when at a comparable point on the metrics just mentioned.

Second, and more specific to mortgages, we compare today’s mortgage lending environment to what was seen in the pre-crisis period and in the aftermath of the massive 2003 refi wave. The changes are dramatic. Non-bank lenders’ market presence is on the rise while banks are retreating; another refi wave has ended but primary secondary spreads are generous relative to 2005; most importantly, there is little to no evidence of a meaningful shift to the risky mortgage lending practices that precipitated the 2008 crisis. At a minimum, this cycle has a notable absence of the primary driver of what caused the crisis in the last cycle. If there is a trigger event for another broader downturn, it will have to come from a sector other than mortgages and housing. Perhaps it will be the corporate sector or the government sector but we would not dismiss the economic robustness derived from an exceptionally healthy mortgage market. Again, we think the risk is that years of healthy and disciplined mortgage lending prolongs this economic cycle."  -source Bank of America Merrill Lynch

We would have to agree, if indeed there is a trigger event for another broader downturn, then indeed, this time it will be different in the sense that it won't be coming from the housing sector and the mortgage markets. Many like ourselves are pointing out towards the excess leverage building up in the corporate sector thanks to a credit binge tied up to ZIRP and NIRP policies and credit markets. If US High Yield can be seen as being relatively expensive then European High Yield is a base case definition of what "expensive" can be defined as. We are closely monitoring fund flows given as of late there has been some rotation from credit funds towards government bonds funds as described by Bank of America Merrill Lynch in their Follow the Flow note from the 20th of April entitled "Trade wars flows":

"Rising geopolitical risk is pushing more money into govies

Over the past couple of months government bond funds in Europe have recorded sizable inflows. We think trade wars and rising geopolitical risk has been translated into deflationary pressures that feed primarily into a bid for “risk free” assets. IG fund flows in Europe have been slower to improve because of the trade uncertainties. However, inflows into Euro only IG funds over the last week were nonetheless positive.

Over the past week…

High grade fund flows were negative over last week after two weeks of inflows. While the breakdown by currency shows a marginally positive number for the eurofocussed funds, the dollar ones have driven the overall trend. Monthly data also were negative for a second month, March figures show.

High yield funds continued to record outflows (23rd consecutive week), and similarly the monthly data also displayed a fifth consecutive month of outflows. Looking into the domicile breakdown, US and Globally-focussed funds have recorded outflows, while the European-focussed funds flow was slightly positive. Note that this was the first week of inflows into euro-focused funds after 13 weeks of outflows.

Government bond funds recorded their 14th consecutive week of inflows just as the monthly data were rolling on to the fifth consecutive month of positive flows. All in all,
Fixed Income funds flows were on negative territory last week. Monthly data reveal that just like February, March was also characterised by outflows.

European equity funds continued to record outflows for a sixth consecutive week; driving the year-to-date cumulative flows below zero. The trend also transpired on the March number, which was the most negative since August ‘16." - source Bank of America Merrill Lynch

While it has been difficult to "Make Duration Great Again" given the recent rise in the 10 year yield in US Treasury Notes, from a contrarian perspective and given the significant short positioning in the long end, there will come a point when fundamentals might reverse the confidence in this overstretched positioning which would entail significant short covering. We are not there yet. 

Returning on Bank of America Merrill Lynch note on the relationship between a flattening yield curve and credit spreads, here is what they had to say on the subject:

"Yield curve flattening and credit spreads

The 2yr-10yr spread narrowed to a post-crisis low of 43 bps this week, raising concerns that the current cycle is coming to an end and recession is on the not too distant horizon. We see the recent flattening of the yield curve as consistent with expectations laid out in our 2018 Year Ahead outlook, published in November 2017. We expect the 2yr-10yr spread to reach zero and turn negative in the first half of 2019, and recession and material credit spread widening to occur 12-18 months later, in other words, mid to late 2020. Given the slow pace of monetary policy tightening in this cycle, we think the risk is that the process takes longer than we expect.

Chart 1 and Exhibit 1 provide some perspective on this view.

Chart 1 shows that today’s 2yr-10yr spread level of roughly 45 bps was observed in May 2005. We also see that today’s asset swap spread of roughly 300 bps on the ICE BofAML High Yield Index (H0A0) is comparable to the index spread in May 2005. (We use this high yield index for our securitized products discussion just because it allows us to make the longer term comparison.) The takeaway from this chart is that it took approximately two years for the curve to first fully flatten and then re-steepen. Similarly, it took approximately two years before credit spreads finished tightening, reaching a tight of 185 bps (over 100 bps tighter than the May 2005 level!), and began cyclical widening.

This is the primary basis for our view that material spread widening in the current cycle won’t occur until at least approximately mid-2020. In other words, we place a heavy weight on the yield curve as an indicator of where we are in the credit cycle. The first significant event that we would need to see for us to become more cautious on spreads is to have the curve fully flatten or invert. But even then, the 2005-2007 experience tells us that it could take over a year after flattening or inversion occurs before spreads materially widen.

Exhibit 1 shows a view of yield curve movements relative to the Fed Funds rate, along with rough projections. The primary observation for this cycle relative to the last cycle is that the Fed is tightening at about half the rate of the last cycle. Given this, we think the risk for this cycle is that the flattening and re-steepening/spread widening process takes longer than the last cycle.

Yield curve flattening and financial and liquidity stress indicators

Chart 2 and Chart 3 provide an additional view of today’s world relative to 2005, using the BofAML Global Financial Stress IndicatorTM and the BofAML Liquidity Stress IndicatorTM.

Both Global Financial Stress and Liquidity Stress are negative (indicating below average risk), have been trending lower since early 2016, and are currently comparable to the levels of May 2005. Both indicators moved up substantially only when the yield curve re-steepened in late 2007. Our takeaway here is that the low levels on the Stress Indicators are confirming our view that a 2yr-10yr spread of roughly 50 bps is  not necessarily indicating imminent stress. In other words, there is still ample monetary policy accommodation.

Mortgage lending in this cycle: low risk lending and the rise of non-bank lenders

While broad macro developments are currently similar to 2005, the mortgage market, arguably the trigger of the 2008 recession and crisis, is very different. In particular, mortgage market risk is far lower today than it was 13 years ago. To at least partly understand pre-crisis developments in mortgage lending, it’s useful to recall the role played by the massive 2003 refinancing wave.

Chart 4 shows the MBA refinancing index along with the primary-secondary spread back to 2000.

In some respects, the great refi wave of 2003 was the genesis of the mortgage crisis that followed. Lending capacity rapidly expanded to respond to the opportunity presented in 2003: refinancing volumes were unprecedented and margins, as measured by the primary-secondary spread (30yr mortgage rate-FNMA MBS current coupon yield) that peaked at 60 bps, were relatively attractive. When mortgage rates moved higher in 2004, refinancing volumes – and margins – collapsed. With massive capacity and minimal volume/margin in higher quality lending, the industry turned to higher margin, riskier lending as the alternative; we’ll come back to that in a moment.

But first, fast forward to 2018 in Chart 4 After years of low interest rates in the post crisis period, most that could refinance have refinanced: the MBA refi index is now at the lowest levels of the millennium. Chart 5 shows that purchase lending activity is on the rise, although it is still well below the levels of the pre-crisis era.

Going back to the primary-secondary spread in Chart 4, although it’s declined in recent years, we see a still relatively high margin on this low volume lending activity: currently about 75 bps, well above the levels of the pre-crisis period. The margin suggests no need to stretch on lending standards, but the volumes suggest that bankers have to work hard to get their share of the pie.

Next, consider some of the changes that have taken place or are underway.

Chart 6 and Chart 7 show the composition of lending in 2005 and 2017, respectively.

In 2005, 54% of production was ARMs, 36% was “expanded credit,” and 43% was government/conventional. In 2017, the composition shifted to 12% ARMs, 2% “expanded credit,” and 80% government/conventional lending. Clearly, the post-crisis regulatory changes and financial penalties associated with pre-crisis lending practices have changed lending behavior to higher credit quality.

Table 1 shows a lending and servicing snapshot for 2017, including YOY changes. Bank lenders experienced above average declines in lending volumes in 2017 while a number of the top 10 non-bank lenders actually experienced growth in originations.

On servicing, the shift away from the banks to the non-banks is even more pronounced. Bank servicing portfolios declined in aggregate while non-banks experienced double digit or even higher growth rates. Banks are conceding market share.

Overall, while the post-crisis refinancing lending opportunity has passed, and non-bank lenders are increasing their presence in the market, lending standards remain strong. The Urban Institute aggregate measure of the risk of loans closed shows that although credit risk has been rising in recent years, especially in the GSE segment, it remains well below pre-crisis levels (Chart 8).

If there is a trigger for the next crisis or even mild recession, we do not see it coming from the mortgage market. Similar to the indications from the Global Financial Stress and Liquidity Stress Indicators, there are no indications of current stress potential coming from the mortgage market." - source Bank of America Merrill Lynch

We would like to make a couple of remarks on the above. The shift to non-bank eg the "Shadow banking" has been significant. Banks have been less active in that space. Banks under higher regulatory pressure and oversight have reduced their activity and focused mainly on the higher quality segment of the mortgage market.  Also following the housing bust, US Homeownership Rates have come down significantly from a peak of 68% meaning US households could less afford buying a new home and have resorted to renting. Both Healthcare and rents now take a large chunk of the average American household income on a monthly basis. So, overall mortgage activity has become more muted for large banks. As always, there is risk you see and what you don't see to paraphrase Bastiat. It works as well for the US Mortgage market as indicated by the Brookings Institute in their article from the 8th of March entitled "The mortgage market risk no one’s talking about, plus a proposal to redesign the system":

"Nonbank mortgage originators and servicers—i.e.  independent  mortgage companies that are not subsidiaries of a bank or a bank holding company—are  subject to far greater liquidity risks  but  are  less  regulated than bank-lenders and servicers.  As of 2016, non-bank financial institutions originated close to  50 percent of  all  mortgages  and 75 percent of  mortgages with explicit government backing.

...
The research also  suggests that mortgages originated by nonbanks are of lower credit quality than those originated by banks, making nonbank lenders more vulnerable to  delinquencies triggered by a fall in house prices through  the  higher costs of servicing delinquent loans.  A  larger fraction  of  nonbank originations are insured by the Federal Housing Administration (FHA) or Department of Veterans Affairs (VA), which tend to be more likely to default than other types. Among  mortgages  in  Ginnie  Mae  pools, the data  indicate that mortgages originated  by nonbanks are twice as likely as bank-originated mortgages to be two  or  more  months  delinquent."  -source Brookings

Basically, as a reference to Nassim Taleb's latest book, banks have less skin in the game today in the mortgage market than they used to. So if housing is less the issue than in the prior cycle, then what is and what should we watch for when it comes to assessing the state of the credit cycles? 

On this matter we read with interest UBS Global Macro Note  "Credit Perspectives - Caution or Carry?" from the 19th of April in particular relating to the more advanced stage in the US of the credit cycle:

"Q: Where are we in the US credit cycle?

The US credit cycle is later-stage, but unlikely to end in 2018. Later-stage credit indicators are present. Corporate leverage is very high, covenant protections are very loose, lower-income consumer balance sheets are weak, and NYSE margin debt is elevated. But the market trades off changes in conditions, not levels. To this point, we do not see an inflection to suggest the credit cycle is turning. Our latest credit-recession model pegs the probability of a downturn at 5% through Q4'18. Corporate EBITDA growth is running at 5-8% Y/Y, enough to keep leverage and interest coverage from deteriorating. Lending standards and defaults are only tightening and rising, respectively, in select pockets, and the scale of tightening is not enough to engineer broad stress. Last, but not least, a quick shot to growth from significant fiscal stimulus in 2018 should keep the cycle supported.

Q: How will demand for US corporate credit evolve?

We expect overall US credit demand to slow, with an up-in-quality bias developing and continued demand for floating-rate product (leveraged loans, IG floaters). Rising USD funding costs are reducing the appeal of US credit to European and Asian investors. These funding costs are now 2.5% for Japanese investors and 2.8% for European investors (3 month FX swaps). With 3 more Fed hikes in 2018, these hedging costs will climb to 3-3.25% by year-end. We do not expect supportive unhedged foreign flows to materialize due to significant US policy uncertainty, higher capital charges on unhedged positions (especially Solvency II), and regulatory pressure (Taiwan). US IG is better positioned than US HY, as current yields of 3.8% should attract some additional domestic insurer and pension interest. Modestly rising credit risk in HY may also divert some flows back into IG. But US HY outflows are likely to continue, given Fed hikes, tight spreads, below average earnings growth, and declining equity valuations of HY-rated companies.

Q: How will Fed hikes impact the US credit cycle?

4 Fed hikes in 2018 will age the credit cycle and create pockets of volatility. The increase in LIBOR is resetting interest rates higher on $3.2tn of US business loans (1/3 of the total stock) and is reducing the appeal of US fixed-income to non-US investors. Higher interest rates are filtering through to US consumer loans; they are raising funding costs for non-bank lenders who utilize floating-rate bank credit to facilitate lower-quality auto and mortgage lending. But in the context of still strong US growth, the cycle has a buffer. Floating-rate leveraged loan issuers have interest coverage ratios still above 3x (EBITDA/Interest expense) and can withstand 3 additional Fed hikes in 2018. A strong job market will keep consumer delinquencies contained to the subprime space. And rising LIBOR is currently a benefit to large US banks, which can still access cheap funding via retail deposits, while receiving a higher interest rate on their loan portfolios.

We prefer US IG over US HY on a total and excess return basis. US HY spreads of 323bps are expensive vs. our blended model estimate of 429bps, while IG spreads are more aligned (105bps current vs. our blended model estimate of 116bps). We have a slight preference for BBB credit, given higher carry, and also that a declining non-US bid will hurt A-rated demand, while domestic demand could support BBBs. In US HY, we maintain our preference for B-rated credit. CCC's are vulnerable given declining equity valuations, while BB HY will struggle with higher duration fears. We prefer US leveraged loans over US high-yield given our call for 6 Fed hikes by 2019, and much stronger demand for loans and CLOs from US and non-US investors alike. By tenor, we prefer 5- 10yr IG, acknowledging slightly better valuations in the short-end than before. We still believe it is too early to position in 1-5yr IG credit, given lower carry, additional Fed hikes and negative repatriation technicals around large buyback/M&A announcements. We are also cautious on 10+ US IG credit, particularly in higher quality names, given very flat curves relative to expectations.

We understand the levels of conditions are weak, but the changes are critical to capturing inflection points. US earnings momentum, lending standards (C&I, consumer), and consumer defaults will be on our radar. The Fed and BOJ will be important. A Fed more tolerant on inflation will boost our view on risky credit; a change in the BOJ's yield target would be a negative for US credit. The resolution of the ATT/TWX antitrust case will also set the tone for future M&A supply.

A cyclical recovery won't be enough to tighten spreads. For US IG, spreads near current levels (105bps) are justified largely by "soft data", in particular strong ISMs. With a fading foreign bid, increasing duration fears and more M&A activity on the horizon, we think IG spreads will widen to 115bps in the near-term. The one positive is that US IG has already cheapened YTD, which will attract domestic investor interest and reduce material downside.

US HY now screens expensive, as spreads at 323bps are inconsistent with both structural credit risks and increased equity volatility. In addition, we believe significant outflows YTD have whittled down cash balances for fund managers. Aggregate fundamentals remain stable, but tenuous at lower ratings, with leverage elevated and interest coverage weak. We expect HY spreads to shift wider to 400bps.

The credit cycle isn't turning yet. Our credit-based recession gauge highlights a 5% chance of recession through Q4'18, far from the 40-50% that signals a red flag. Earnings growth, lending standards, and bank NPL trends are "good enough" to sustain the cycle. However, interest coverage will likely become less favourable as 3 more Fed hikes in '18 and '19 will flow through to $3tn in floating-rate business debt.

Fixed-rate US HY coupons are stable as firms are not yet refinancing into higher rates. For floating rate leveraged-loans, coupon payments have been range bound, as re-pricings and tighter spreads have offset higher LIBOR. But we expect higher interest payments for loan issuers later in 2018, as the Fed hikes 3 more times, and spreads can't tighten as much to offset higher LIBOR.

Despite rising interest costs, floating-rate US loans have resilient enough interest coverage to sustain 3 more Fed hikes in 2018. This dynamic, plus growing demand for floating-rate credit, underlies our preference for US Loans over US HY. 3 additional Fed hikes in 2019 will prove more problematic. This will push loan coverage ratios to low levels (inferior to 3x) for B-rated firms and pressure free cash flow. Earnings growth will need to rise to reduce this future risk.

US leveraged loan supply hit $500bn in 2017, over 50% for M&A and LBOs, and reported 1st lien leverage is 3.9x – the highest on record. EBITDA add-backs averaged 20-21% in 2017, and are averaging 26% for large PE sponsor deals YTD – suggesting leverage is underreported and rising. A conservative view would push average 1st lien leverage closer to 5x on M&A deals.

The non-US bid into US IG credit will slow in 2018. Non-US investors are paying 2.5% (Japan) & 2.8% (Europe) to hedge their US fixed-income allocations. We do not believe foreign investors will remove FX hedges, given broad uncertainty on the trajectory of the US dollar. As the Fed keeps hiking, these costs will rise further and US IG will become less attractive than long-duration sovereign alternatives and even EU IG credit by year-end.

Slower demand is one part of the equation, but we still expect IG supply to be robust in 2018 (+2.5% Y/Y). The M&A pipeline is large, and we expect more issuance could hit the market, conditional on favourable antitrust outcomes which have lowered closing rates. High multiples and still low rates suggest firms will finance with debt. Offshore repatriation may reduce issuance on the margin, but most IG firms do not have significant cash, either overseas or on balance sheets, to utilize.

The savings from corporate tax reform will only modestly delever capital structures, even assuming firms utilize 25% of their tax windfall to pay down debt. More importantly, credit spreads have already priced this; spreads per unit of net leverage are at all-time tights. Bottom-line, earnings growth needs to be much stronger to de-lever capital structures.

HY spreads have remained very resilient. Despite significant outflows in Q1, HY spreads were effectively unchanged. We believe Dec'17 coupon reinvestments and low issuance YTD (-22%) had replenished cash buffers. But given the outflows of Q1'18, cash buffers are low once again. We expect HY spreads to widen more aggressively if volatility picks up anew." - source UBS

As we pointed out recently, rising dispersion means that at the current stage of the credit cycle in the US, credit investors are becoming more discerning in their issuer process selection, meaning overall that active credit manager should continue to outperform as the credit cycle is gradually turning on the back of the Fed continuing its hiking trajectory. Sure, "beta" has rallied hard recently, but, one should think about gradually adopting a more defensive stance by starting to reduce high beta exposure towards safer places. While we pointed out in our conversation "Fandango" that some positioning appears to be stretched such as short the long end of the US yield curve, we don't think yet with have reached the "trigger point" making us bold enough to dip our investing toes into the long end of the US yield curve particularly as we are getting closer to the 3% level on the 10y Treasury yield. We are certainly watching any signs that would point out that the recent weaknesses seen in hard and soft US data has been temporary or not. 

While the "Golden Rule" is being vindicated by the Trump administration for the growing use of trade war measures, boosting gold price in the process, 2018 seems to be marking the return of "Macro" as a strategy following the unfortunate demise of many Hedge Fund players after years of financial repression thanks to lack of cross-asset volatility. As per our last charts below, Global Macro is making a come back thanks to rising volatility and dispersion across asset classes it seems.

• Final charts -  The return of Macro to the forefront thanks to higher interest rates

The final removal of the lid on volatility which has prevailed thanks to the strong central banking narrative has been fading and marked earlier on this year by the explosion of the short-vol pig house of straw that built up during many years. Our final charts come from Bank of America Merrill Lynch from their Global Liquid Markets Weekly note entitled "The gold big bang theory" from the 16th of April 2018 with one of the charts displaying the spike in vix which can be linked to the rising rate environment:

"Tighter Fed policy is helping lift OIS and LIBOR

We first argued in September 2017 (see Mind the unwind) that risk assets could suffer as a Fed balance sheet compression added on top of an already steady pace of US interest rate hikes. Six months later, the effects of tighter US monetary policy are starting to become visible in a number of markets and returns across major asset classes are negative for the year. The Fed has already been hiking rates at a steady pace for 9 quarters now (Chart 1).

Looking forward, with a tight labor market backdrop and rising commodity prices, our economics team believes that the Fed will likely complete three more hikes this year. In addition, we believe that Fed balance sheet tapering (see Missing the BEAT) has been an important contributor to the rapid widening in the 3m LIBOR-OIS spread (Chart 2).

In turn, higher interest rates are pushing up vol...

Just like ultra loose monetary policy was a balm for asset markets, this combination of rising rates and balance sheet tightening could well be having the opposite effect on bond and equity markets. As we have previously explained, rising interest rates tend to put upward pressure on macro volatility (Table 1).

This effect is often lagged but quite persistent, and macro volatility has been on the rise for some time now. In our view (see Forward vol looks cheap to carry as long as you believe markets are late cycle), the spike in the VIX can be partly traced to the rising interest rate environment (Chart 3).

But higher interest rates are not the only source of uncertainty at the moment for global markets.

...as US fiscal policy is entering a slippery slopeIn fact, just as monetary policy has tightened, the US Federal budget deficit is poised to balloon (Table 2) over the coming 24 months.

Our economists have previously argued (see Fiscal injection: round 2), that the US Federal government could face the worst cyclically adjusted fiscal deficit as a 5.1% of GDP in 2019 because of the continuous fiscal stimulus: tax reform, increase in budget caps, and greater infrastructure spending. Less bond demand from the Fed and a tightening interest rate path is meeting looser fiscal policy. And as the Fed stops reinvesting its bond proceeds, the market will have to absorb more US Treasuries (Chart 4).

Recent tax changes have also reduced the demand for dollar commercial paper from US corporates abroad.

Inflation is trending higher helped by oil prices

Of course, the tighter monetary policy path in the US and the normalization of interest rates is informed by the rising inflation pressures across the economy. On the one hand, the decline in the unemployment rate will likely support a steady increase in core inflation (Chart 5).

On the other hand, rising oil prices are already feeding into an increase in headline inflation (Chart 6).

Because we now expect Brent crude oil prices to hit $80/bbl over the coming months (see The ruble drop is bullish for oil) and US job growth is poised to remain steady, the Fed will likely continue to tighten policy.

Naturally, cross-asset info ratios have fallen

Tighter money policy will continue to impact macro volatility. With volatility on the rise, info ratios across major asset classes could well continue to roll over (Chart 7) in the coming months.

In our view, equities and bonds are unlikely to see the stellar rolling Sharpe ratios of the past few years as the Fed continues to drain liquidity. Moreover, we would argue that a tighter US monetary policy outlook is already acting as a drag on asset values. Year to date, cash returns of 0.4% compare favorably to S&P returns of -1.2%, Eurostoxx returns of -2.0%, or 10 year treasury returns of -2.1% (Chart 8).

So is the Fed ready to switch course? Not yet

True, leading indicators such as PMIs remain in positive territory across all major economies and inflation is on the rise. So the Fed is unlikely to change Yellen’s preset course for now under the new leadership of Powell. Yet, as money supply around the world continues to roll over on the back of tighter policy, asset returns could struggle (Chart 9).

The market is perhaps right to expect the Fed to hike interest rates roughly as scheduled (Exhibit 1).

 

But we still believe that escaping zero interest rate policy (ZIRP) will not result in a smooth path for asset markets." - source Bank of America Merrill Lynch

Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed?" we posited that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. If indeed we are moving from a cooperative world to a noncooperative world based on the Golden Rule in conjunction with a return of volatility then one should be wise to dust up the Global Macro playbook we think... 

"Monetary policy causes booms and busts." - Edward C. Prescott, American economist and Nobel Prize in Economics.

Stay tuned !