Macro and Credit - Voltage spike

"The trouble ain't that there is too many fools, but that the lightning ain't distributed right." - Mark Twain

Watching with interest continuous records being broken in the surge in equities indices in conjunction with continuing flows in credit and tightening credit spreads, we reminded ourselves for our title analogy of what a "Voltage spike" is. While an energy spike, is measured not in volts but in joules; a transient response defined by a mathematical product of voltage, current, and time, the current melt up in asset prices is measured daily by the indices reaching new record highs. Yet, hard macro data at least in the US continues to be on a soft side hence the continuation in the flattening of the yield curve.

In this week's conversation, we would like to look at the flattening of the US rates market which followed a somewhat disappointing Nonfarm payrolls number last Friday.

Synopsis:

• Macro and Credit - Is the rates market pricing the end of the US cycle?
• Final charts - Econ 101 - Higher demand leads to tighter credit spreads

• Macro and Credit - Is the rates market pricing the end of the US cycle?

The slightly weaker tone coming as of late from the US job market has led to somewhat a "Voltage" spike" in the sense that there is indeed a growing disconnect between what the US rates curve is currently telling us and the unabated run in risky assets as investors have truly decided to "carry on". 

As we have clearly highlighted in our recent musings, as the credit cycle is slowly but surely turning, we do expect a significant final melt-up in asset prices. Until inflation rears again its ugly head and central banks have to counter it by hiking aggressively, it is difficult with current inflows and apart from an exogenous event to be bearish in the short term. Therefore we remain "Keynesians" as the animal spirits switch to "euphoria", yet we are also medium term "Austrians". As we have repeated in numerous conversations, we are more concern with the second part of 2017., Italian elections in the 3rd quarter will be important to scrutinize particularly in the light of unresolved issues with the Italian banking sector and their nonperforming loans (NPLs) woes. 

Clearly as of late, some financial pundits have been puzzled by the significant rally in both bonds and equities in a sort of goldilocks scenario playing out for the leveraged crowd and "risk-parity" players alike. This "Voltage spike" warrants close monitoring and maybe some sort of "surge protection" being set up given the level of complacency in this low volatility environment. In relation to the growing disconnect between the US yield curve and equities, we read with interest Bank of America Merrill Lynch's Global Liquid Markets Weekly note from the 5th of June entitled "Let's hope the rates market is wrong":

• The rates market is pricing in a high risk of the end of the US cycle. The stability of rates markets could be a warning rather than a reassurance for carry trades.

• •Either way, the high implied end of cycle risk in US rates is not just at odds with equities, but is a risk for commodities, EM, breakevens and the periphery. Internal inconsistencies

The rates market is pricing in a considerable chance of the US economy rolling over. The fact that UST 10y rates have traded in a very tight range for the last two months has been interpreted as a reassuring signal for carry trades everywhere. In fact it should be a warning signal. Rates are where they are, not because the world economy is in a sweet spot with growth neither too hot nor too cold, but because the market is caught between having to reprice rates lower (a high implied risk of rate cuts for next year) or higher (price out end-of-cycle risks, price in an active Fed and a deteriorating supply-demand gap for fixed income). If the US rates market is right, then the rest of the FICC space, let alone equity markets, are mispriced.

Commodities don’t do well in a slow-down

Commodities are cyclical, and our bullishness in crude is predicated in part on the cycle remaining intact – but moving beyond this tautology, we analyse the performance of commodity strategies below. Commodity beta works best in high and rising nominal rates macro regimes, but underperforms in rising real rate environments. Commodity alpha strategies on the other hand would be at risk in a scenario where inflation fails to get traction. Commodity alpha is therefore exposed to the global reflation trade being aborted, while commodity beta would be at risk even if the cycle remains intact, but the Fed moves ahead of the curve.

EM is goldilocks squared

In our recent discussions on EM we have primarily focused on the risks to EM from higher rates, given our short duration bias. However, the end-of-cycle risks priced by the US rates market are an even bigger risk to EM. For the EM carry trade to remain successful, rates need to stay low, which given the secular shift in supply demand dynamics for fixed income, and the US in particular, is a tall order, longer term. Crucially, however, pricing out the end-of-cycle risks in US rates, by themselves, would be a challenge to EM. And not pricing them out would suggest that the cyclical support for a bullish EM story falls away.

EUR breakevens are hoping for global reflation

Following the US election, long-dated EUR breakevens repriced as aggressively in the euro area (EA) as in the US and remain close to the ECB’s target. We have been bearish breakevens all year, since we believe the ECB is exiting policy accommodation prematurely and do not see any reason to be optimistic about a trend change in the EA’s inflation dynamics. But if the cycle in the US is slowing down, as suggested by the US rates market, then there is even less reason to be hopeful that this repricing of EA inflation risks to be sustained – leaving aside the fact that even for the US our economists see headline inflation slow considerably. The EA remains leveraged to global growth (Chart 2).

Periphery, still caught between a rock and a hard place

We have been bearish the periphery since last autumn, arguing that the ultimate victim of a more hawkish ECB would not be the Bund market, but BTPS. The periphery faces a mechanical repricing as the ECB steps away from artificially supporting prices, as well as higher risk premia given questionable debt dynamics on an inflation trajectory below the ECB’s target. However, what has supported the periphery so far is the fact that activity data has outperformed on a global basis. But as argued in the inflation discussion above, the euro area remains a highly leveraged bet on global growth. If the cyclical outlook in the US deteriorates as implied by the rates market, the last remaining argument for being constructive on the periphery would fade very quickly." - source Bank of America Merrill Lynch.

Obviously the price action particularly in the long end of the US yield curve in conjunction with serious inflows into Investment Grade credit as well, has put back into the forefront the MDGA trade (Make Duration Great Again) which we mentioned back in April in our conversation "Narrative Paradigm".  Clearly, if indeed the bond markets is not buying the "reflation" story anymore and US data continue to veer on the soft side, then indeed from a tactical allocation, it makes sense to turn more positive on the duration front.

In this credit cycle, clearly investors not only have taken on more duration risk but, given the performance of beta and in particular the beta segment such as in High Yield CCC, credit risk has been embraced in full making sensitivity to price movements much more significant to "Voltage spike". We agree with Bank of America Merrill Lynch's take from their note in relation to the growing disagreement between rates and equities, someone eventually is wrong:

"Not sustainable

Rates and equities are pricing two very different scenarios for the US and the world economy more generally. Rates are pricing a very slow pace of Fed hikes and the end of the tightening cycle after only one more hike next year, with a relatively high probability for a US recession. Equities, on the other hand, are the only Trump trade still alive and, at all-time highs, are pricing fast growth ahead. Implied market volatility is also at historic lows, suggesting no concern about a sharp adjustment. US data is mixed and do not give a clear indication of whether rates or equities will have to adjust. The FX market is more consistent with what the rates market is pricing, or the USD should have been stronger, in our view.

However, this is clearly not sustainable, in our view. We expect a reality check in the months ahead, most likely after the summer. We have been warning that although market volatility could remain low this summer, it will increase right after, as this fall is packed with events—more Fed hikes (or not), unwinding Fed balance sheet, possible Yellen replacement, US tax reform, ECB QE tapering and policy sequence, German and possibly Italian elections, and Brexit negotiations. In a good case scenario, the USD will have to appreciate against the JPY and rates will sell off. In a bad case scenario, equities and EM assets will sell off." - source Bank of America Merrill Lynch

We do share similar concerns for the second part of 2017. For the time being, markets have climbed numerous wall of worries so far in 2017 (French elections) and apart from an exogenous factor such as a geopolitical event, it is hard to turn significantly bearish. As John Maynard Keynes aptly put it: 

"The market can stay irrational longer than you can stay solvent."

While no doubt in our minds that eventually the "perma-bear" crowd will be right, namely that China will face some credit crisis at some point, markets will tank and what is overvalued will deflate accordingly, credit will widen and distress credit will show up again, at the moment, we do think we are moving towards the "euphoria" stage. 

Whereas as in our late 2015 musings it was evident that the shape of the high yield credit curve was pointing out to trouble ahead for credit in early 2016 and by extension equities thanks to the rapid depreciation in oil prices and weaker earnings, as things currently stand, regardless of the narrative of some doomsday pundits, it is hard for us for time being to see the catalyst. If inflation rears back its ugly head, it will be a different story for many asset classes rest assured. 

Looking at several indicators we track such as indicators of aggressive issuance such as the ones published by Bank of America Merrill Lynch, clearly CCC issuers have regained access to the primary market for the time being including shale players it seems (16.4% face value of the market):

- source Bank of America Merrill Lynch High Yield Chartbook

Another indicator we look at is Cov-Lite issuance as a percentage of market size. Since 2014, the market seems to have been cooling-off slightly (we are not talking about the much discussed subprime auto-loans here):

- source Bank of America Merrill Lynch High Yield Chartbook

Inflows are still pouring in Fixed Income including in the beta play such as High Yield simply because the percentage of negative yielding assets remain elevated at 17% based on Global Fixed Income Index (GFIM):

- source Bank of America Merrill Lynch High Yield Chartbook

High Yield fundamentals have improved with nearly all issuers reporting Q1 earnings and EBITDA growth is much better with ex-commodities earnings improving 16.9% year over year, the 3rd consecutive double digit gain according to Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch High Yield Chartbook

The on-going "Voltage spike" clearly shows that 2017 is playing out as a reverse 2016, namely strong performance in the first half of the year and much more caution for the second part. That's our scenario and it seems to be playing out accordingly so far. We do share with Bank of America Merrill Lynch's High Strategy team their cautious stance for the second part as indicated in their strategy note from the 2nd of June entitles "Looks aren't everything":

"High yield fundamentals continue to improve

With nearly all issuers having reported Q1 earnings, we once again take the opportunity to examine credit fundamentals across the high yield universe. For the 5th consecutive quarter, year over year revenue growth improved and jumped from 2.36% to 8.90%, the best reading in 3 years. Energy saw the biggest improvement with 31% top line growth, although Technology (+21%) and Commercial Services (+11%) saw double-digit gains as well. On the opposite end of the spectrum, Transportation, Capital Goods, and Media saw declines of 11%, 4%, and 1% respectively (Chart 1).

EBITDA growth proved resilient as well with ex-Commodities earnings improving 16.9% year over year, the 3rd consecutive double digit gain. This translated into a modest natural deleveraging across the ex-Commodities universe, where net debt to EBITDA levels fell to 4.18x compared to 4.52x at their peak last year. Finally, the US HY issuer weighted default rate continued to fall and now stands at 4.53%, just slightly above our 4.0% forecast for the end of 2017. Given this improving fundamental backdrop—the best we have seen in several years—do we think high yield’s 15 month long rally will extend into the 2nd half of this year?

Don’t eat the forbidden fruit

We view this as unlikely. Although healthy fundamentals may create temptation to invest in riskier pockets of the market, we think political uncertainty and an economy that struggles to gain momentum will likely cause a selloff later this summer. With 0.5% real wage growth, falling used car prices, negative C&I loan growth, and little capex investment, we find many similarities between today’s economy and that of 2013/2014 and question the ability for additional compression in such an environment. Additionally, given rich valuations, we think upside is limited here, particularly in high beta/lower quality paper. Instead, our bias is to reduce exposure to CCC risk and move profits into higher quality paper." - source Bank of America Merrill Lynch

As we indicated last week, we monitor very closely consumer credit trends in the US for the time being. Also we have voiced our concerns as well in various conversations with the negative trend in C&I loan growth more indicative on how the "real economy" is behaving. Given the significant outperformance of beta in the credit space and in particular the CCC bucket, we do have difficulties in seeing more upside from there but clearly Keynes earlier quote comes to mind in a NIRP world. 

In our book, when it comes to the slowly but surely turning of the credit cycle, the sequence always starts with a flattening of the US yield curve, then, financial conditions grind tighter and some highly leverage players credit start widening, before the impact reach more players and credit spreads start to widen, defaults rates start creeping up and then of course the rosy tainted glasses eternal optimist crowd in the equity space finally gets the story right, and equities reprice in the end. Obviously, we are not there yet. Liquidity providers aka central bankers are still deeply involved in the "wealth effect" game, which makes this current "bull market" still the most hated in history particularly with the latest "Voltage spike" we are seeing with new record levels being reached.  

Credit wise we continue to expect credit spreads to go tighter, that is until the flow of liquidity provided by our generous gamblers diminishes. Clearly we are not there yet as per the final chart below.

• Final charts - Econ 101 - Higher demand leads to tighter credit spreads

When it comes to looking at additional indicators of interest when it comes to "Voltage spike", while we already discussed some fundamental indicators, we continue to look at inflows in the asset classes as an indication of the direction of credit spreads. Our final chart comes from Bank of America Merrill Lynch Credit Market Strategist note from the 2nd of June entitled "All news is good news" and displays the record inflows being the driving force for tighter credit spreads:

"Econ 101

Economics 101 dictates that under certain assumptions higher demand creates higher prices (tighter credit spreads) and increased supply. The US high grade corporate bond market satisfies these assumptions, as inflows to HG bond funds and ETFs are tracking a record $130bn YtD, up about $85bn from the same period last year (Figure 27).

Supply for the first five months of the year is $650bn, just $25bn above last year’s pace. Acknowledging that this story is highly simplified, it nevertheless represents one of the key reasons high grade credit spreads have tightened 11bps this year to 119bps – making good progress on the path to our year-end target of 105bps (Figure 28).

 - source Bank of America Merrill Lynch

Given Bondzilla the NIRP monster is "made in Japan" and is finally back after 5 months of uninterrupted selling with the most recent weekly capital flows data showing Japanese investors bought 732 billion yen ($6.6 billion) of foreign bonds last week, bringing total buying in the past four weeks to 3.696 trillion yen ($33.3 billion) you shouldn't be surprised by the "Voltage spike" in US Treasury yields and credit either. So get ready to MDGA, just a thought...

"I just go where the guitar takes me." -  Angus Young AC/DC

Stay tuned!

Credit - The Third Punic War

"The worst pain a man can suffer: to have insight into much and power over nothing." - Herodotus, Greek historian

While coming close to "Grexithaustion" thanks to the never ending Greek tragedy, which seems to be a manifestation of Henri Poincaré's "recurrence theorem" we discussed in our last conversation "Eternal Return", we decided to use this week a reference to Rome's Third Punic War as this week's title analogy. In similar fashion to Carthage, Greece has been asked increasing unrealistic demands from their "debt masters" leading at the time to Carthaginians defecting the negotiations in true John Forbes Nash fashion, which led to the Third Punic War and the eventual destruction of Carthage:

"In 149 BC, Rome declared war against Carthage. The Carthaginians made a series of attempts to appease Rome, and received a promise that if three hundred children of well-born Carthaginians were sent as hostages to Rome the Carthaginians would keep the rights to their land and self-government. Even after this was done the allied Punic city of Utica defected to Rome, and a Roman army of 80,000 men gathered there. The consuls then demanded that Carthage hand over all weapons and armour. After those had been handed over, Rome additionally demanded that the Carthaginians move at least sixteen kilometers inland, while the city itself was to be burned. When the Carthaginians learned of this they abandoned negotiations and the city was immediately besieged, beginning the Third Punic War." - source Wikipedia

Being history buffs ourselves we find it amusing from a "light" historical comparison, that while Greece is being increasingly punished, by the defacto leaders of Europe namely Germany, its closest neighbor France is already slipping the structural reforms trail, passing "cosmetic" laws such as the Macron law in order to avoid the wrath of the European Commission and powerful neighbors using in the process article 49.3 to bypass parliamentary vote. 

In similar fashion, while Rome was letting Numibia continue abusing its Carthaginians neighbors, it was busy imposing more and more harsher treatments on its rival Carthage.

As we stated on numerous occasions, France is the new barometer of risk, as it seems the country seems impossible to reform. As stated in our March "China syndrome" conversation:

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

Whereas "The Third Punic War", this time being is being waged on Greece, while captivating numerous pundits, for us it is a side show as many more risks are indeed brewing, when it comes to "instability" given once more, the Fed has failed to act early. and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:

"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 

• Wave number 1 - Financial crisis 
• Wave number 2 - Sovereign crisis 
• Wave number 3 - Currency crisis

If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"

If The Fed normalizes, get ready for a big US dollar Margin call, carry traders and leverage players beware...We touched on the issue of the rise of the US dollar in our September conversation "The Tourist Trap" where we argued:

"All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates." - Macronomics, September 2013

Therefore in this week's conversation, rather than focusing on the Greek tragedy, we would rather focus our attention to some macro and micro aspects that warrants, we think a closer attention.

Synopsis:

• Bear markets for US equities generally coincide with a tick up in core inflation
• France from a "corporate monitoring health" is deteriorating "slowly" but "surely"
• Beware of the Repo drought
• US Interest Rates and the US Corporate pensions gap
• Final chart: In High Grade Credit, liquidity is coming fast at a premium

What we find of interest is that "Bear markets for US equities have usually coincided with high global core inflation". The recent acceleration in wage upside pressure as well as in rent pressure could indeed surprise to the upside, particularly due to the rebound in oil prices since March (+40%). This should translate into the headline CPI where rental prices represent 25% in the calculations and overall housing 42%:

"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008" - Macronomics, 5th of June 2014

- source TradingEconomics.com

Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with higher core inflation makes us more and more cautious on the sustainability of the US equities rally. So we will eagerly watch that space in the coming weeks and months.

• France from a "corporate monitoring health" is deteriorating "slowly" but "surely"

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

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

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers.

In our end of May conversation "Optimal Bluffing", we advised our readers to start following these debilitating micro trends to assess the health of the French corporate sector. 

The latest survey published on the 12th of June points to a continued deterioration in the Terms of Payments, which indicates that the improving trend since mid-2012 has turned decisively negative:

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

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

Delays in "Terms of Payment" as indicated in their June survey have reported an increase by corporate treasurers. Overall +18% of corporate treasurers reported an increase compared to the previous month (+19.8% revised), bringing it back to the level reached at the end of 2013. The record in 2008 was 40%.

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

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

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

Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's came at -13%, April at -0.5% and May was revised from -9.5% to -6.1% with June coming at -3.7%

We will restate what we mentioned back in our March 2015 conversation "Zugzwang":

"The French government policy is based on "hope" and their strategy is based on "wishful thinking". No matter what, we do not see unemployment falling with these deteriorating conditions."

Like any behavioral therapist would do we focus on the process, rather than the content. Hence our dubious faith in the much vaunted "cosmetic" structural reform coming from the Macron law, given that now French President Hollande is effectively on the campaign trail.

As we indicated in our conversation as well is that there was a large contingent of public servants supporting François Hollande representing 22% of the working population compared to 11% in Germany. To validate our prognosis, we find it amusing that Public Service Minister Marylise Lebranchu has announced on the 16th of June 2015 that public servants would see their salary increases as of 2017 without any mention of course of the budgetary impact it would have! Also, she mentioned that while salaries have been currently frozen thanks the stability of the index used for deciding on salary increases which depends on the economic situation, it is a possibility that in spring 2016, there could be an increase prior to the 2017 presidential elections....
The impact of a 1% increase would cost an additional €1.8 billion euros according to the Court of Auditors.

"The Court of Auditors (in French Cour des comptes) is a quasi-judicial body of the French government charged with conducting financial and legislative audits of most public institutions and some private institutions, including the central Government, national public corporations, social security agencies (since 1950), and public services (since 1976).)" - source Wikipedia

Meanwhile the French Government has announced that in order to reduce French unemployment, it would create another additional 100,000 "subsidized" jobs. Most of these jobs are for low qualified persons at a cost of €3 billion for the 346,083 benefiting from it according to the 2015 budget equating to 27% of the budget of the Minister of Labor. These additional 100,000 will cost €300 million to the budget in 2015 and €700 million in 2017 according to the Minister of Labor. It would have been much better to use these spendings in training such as what Germany does with its very successful "apprenticeship" programs which explain Germany's very low unemployment youth. So you have 100,000 low skilled public jobs created out of 5.99 million of unemployed people in France as per April 2015 data. According to DARES, which is the department in charge of analyzing the labor market in terms of statistics at the Minister of Labor, only one third of these "subsidized" job lead to full employment 6 months later. 

Whereas the Third Punic War is coming to a close, we still believe that France warrants close monitoring given its impossibility to reform. Whereas Rome was having none of it with Carthage like Germany with Greece, the current indulgence displayed with French's lack of progress is reminiscent of Rome's attitude towards Numibia we think.

Moving on to our next point, which deals once more with credit in general and repo in particular, we think it is an important point to follow when it comes to assessing the dwindling "liquidity" picture.

• Beware of the Repo drought

When it comes to the Third Punic War and Rome's insatiable demands, the reduction in liquidity is a direct consequences of the overwhelming regulatory burden set on banks which, in retrospect is having once again "unintended" consequences particularly in the Repo market in Europe.

As a reminder:

Basel III proposals - BIS ratios to manage liquidity risk:

The Liquidity Coverage Ratio (LCR).

The LCR requires that a bank has sufficient liquidity to survive for 30 days under a stressed scenario when global financial markets are assumed to be in crisis, all wholesale funding has dried up, unsecured lines of credit provided by other financial institutions are withdrawn and banks experience partial deposit flight. To mitigate this risk, the LCR requires that banks hold a liquidity buffer of high quality, liquid, central bank repo eligible, unencumbered assets, which are at least equal to the amount of net cash outflows a bank may face over a 30-day period.

The on-going deleveraging in the European Banking space is leading to a reduction in the financial "grease" of financial markets, namely repo markets. On that subject we have read with interest Citi's not from the 8th of June entitled "Declining Financial "Grease" Hits Market Liquidity from their European Banks Insights:

"Repo Under Pressure — Repo markets are often considered the “oil that greases the financial markets”. The leverage ratio has become the binding constraint for many wholesale banks, which have pulled back from balance-sheet-intensive, low-return repo. We estimate gross repo at global wholesale and custody banks has declined by c11% over 2012-14, with European banks bearing the brunt (down 16%, Figure 1).

This broadly matches the c13% decline in total repo (Figure 3).

Velocity But No Depth — Although market ‘velocity’ (traded volume) has increased, market ‘depth’ has declined. For example, the market depth of 10yr UST is US$125m vs peak levels of US$500m in 2007, while the US Treasury market is nearly three-fold over the same period:

Increasing frequency of “flash crashes” and “air pockets” may be here to stay (see The liquidity paradox). Whilst the strongest declines in repo books have come from DBK, UBS and RBS, the likes of the major French banks, HSBC and Barclays look less efficient even if the latter has made significant progress over the past 3 years.

• Global wholesale and custody banks have reduced their gross repo books by c11% between end-2012 and end-2014. European banks’ repo outstandings fell by 16% vs US banks’ by 6%, mirroring the shift in FICC market share in favour of US banks.
• In USD-terms, DB has downsized most aggressively (c40% in USD or c34% EUR) and is looking to further optimise its Prime Finance business, per its recently announced Strategy 2020.
• The French banks are the notable exceptions amongst European banks. BNPP and SOGN in particular have grown their repo books by 41% and 13%, respectively, which has not necessarily translated to higher sales & trading revenue market share over the same period

The decline in US repo may also be driven by greater rationalisation by European banks, partly in response to stringent upcoming US FBO requirements. Repo or ’financial grease’ is likely to fall further & correspondingly, risks are likely to increase, in our view." - source Citi

This is not a surprise to see a continued deleveraging of European banks through the Repo markets. We have touched on the difference between the deleveraging between US banks and European banks extensively about the profitability in our conversation "The Pigou effect" as well as in our conversation "The Secondguesser":

"When it comes to Europe and in particular many points to cheap valuation in the European banking space. As we have argued in our conversation "The Pigou effect" in February this year, we have argued around the "japanification" process of Europe:
This "japanification process can be seen with the rapid disappearance of "positive" yields in the European Government space with German Bunds closing on the zero bound.
We have also long argued that regardless of QE, ZIRP and AQR, European banks would be facing continued deleveraging and that both bondholders and shareholders alike would in many instances get punished for their holdings. The reason is that European banks, in many cases still destroy value." - source Macronomics, April 2015

"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe."

Given the amount of deleveraging that still needs to occur in the European banking space, this divergence between the profitability of US banks versus European banks will continue to grow and it will be reflected into the Repo markets rest assured.

As indicated previously, in the US QE was more effective for a simple reason: stocks vs flows:

The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between US banks versus European banks.

On numerous occasions the very important concept namely the accounting principles of "stocks" versus "flows":

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.

Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE.

The problems facing Europe and Japan are driven by a demographic not financial cycle. European banks will continue to destroy value given the amount of deleveraging that still needs to take place and do not appear to us, at least in the equities space as an enticing investment proposal when it comes to long term returns and stability.

As further reasoning behind our assertion and as highlighted in Citi's report, Banks' market revenues are well correlated to "Repo":

Banks’ trading market share appears to be reasonably well correlated with repo, as highlighted in the above charts.
European banks have already lost market share in Sales & Trading, particularly in FICC but also in Equities. Although we do not discount the effects of re-pricing and optimisation, as banks continue to increase balance sheet efficiency, further reductions in repo (as well as in other products) may drive further consolidation." - Source Citi

Lower repo, lower Net Interest Margins, lower profitability and Return On Equity (ROE). That simple.

On top of that we read that Fitch Ratings has released a report, “Corporate Bonds and Fire Sale Risk: Repo Collateral Pools Highlight Liquidity Issues ” that examines the composition of corporate bonds that are pledged as collateral in the tri-party repo market and the potential for forced sales of securities during periods of market stress and here is a summary of the findings:

"•A significant maturity mismatch exists between the short-term repos, over 70% of which mature in 5 days or less, and the long-term corporate bonds being financed. This could create risks as a withdrawal of repo funding can lead to the forced selling of collateral.

•Dealers post a significant amount of bank and other financial institution notes and bonds as collateral, exposing them to wrong way risk. About 29% of the corporate collateral that Fitch studied was from banks and other financial institutions.

•Liquidity is low in some of the bonds posted as collateral, as determined by trading frequency. Almost 30% of the bonds in the Fitch study traded on less than half of trading days in 2014." - source Fitch

It will interesting to see how the LCR included in the BASEL III proposals is going to "operate" given the dwindling Repo markets and the consequences on more friction and less grease in the financial markets during the next financial crisis. 

Given the balance sheet intensive nature of fixed income trading and the elimination of the favorable risk-based capital treatment of repo and banks' holdings of Treasuries and agencies under the risk-based capital rules in the US, we do not think the United States will be spared, though less exposed than Europe.

The bond market repo activity is facing an increasing number of failures (fails to deliver are on the rise exponentially) due to the large FED holding, which has ripple effect on the overall bond market activity, hence increased volatility.

A smoothly functioning repo market is vital to the health of markets. Remember financial crisis are always triggered by liquidity crisis.

• US Interest Rates and the US Corporate pensions gap

Or why the Fed has painted itself into a corner...and has to raise interest rates.

In our November 2014 conversation "The Golden Mean" we argued the following:

"What our "wealth effect" planners at the Fed should take into account is that rising stock prices may do relatively little to bolster the finances of corporate pension funds. Bonds matter because increases in projected distributions put even more pressure on yield hunting leading to an increase in duration risk exposure and high yield exposure. Volatility in funds’ asset value and relatively low interest rates have made managing pensions increasingly difficult for corporate managers, one of the solution they have found is shifting into bonds and away from stocks. Of course if the "magicians" at the Fed had respected the "Golden Mean" and prevented past and present excesses, funding gaps and overall pension pressures would have been avoided in the first place, but we are ranting again..." - source Macronomics

As a reminder from our conversation "Goodhart's law" in June 2013:

As indicated by CreditSights in their 29th of May 2013 Asset Allocation Trends - 2012 Pension Review:
"Key among the prevailing market realities in the post-financial crisis environment has been the extended period Quantitative Easing and the continuation of the Fed's prevailing zero interest rate policy and in the latest year's plan asset allocation data there was evidence of the effect this was having. As noted above, historically low interest rates have not only inflated the calculated liabilities of pension plans via the downward pressure on interest rates, they have also deflated assumed plan asset return rates as fixed income has increased as a percentage of plan assets." - source CreditSights.

We remember as well the observations from our good credit friend in 2013 from our conversation "Simpson's paradox" in July 2013 following the "Taper Tantrum as the Fed tries to re-establish somewhat the "Golden Mean":

"Economic growth in a society based on consumption requires credit. In order for credit to grow, or in other words banks to lend, collateral must be available. Since the 2007-2008 financial crisis, high quality collateral has slowly but surely become less available. If Central Banks continue to buy various government bonds (and US Treasuries are among those bonds), the available collateral will trend lower and the economy will stall, or worst spiral down as a credit crunch will occur at some point. So the FED has no other choice than to slow and even stop its QE if it wants the game to go on."

Hence the importance of maintaining "grease" or repo in the financial system!

In our conversation "Supervaluationism" we indicated a CITI report showing that outflows from Equities to Fixed Income have been lessened by the proposed update in mortality tables:

"What could curtail outflows from pension funds from Equities to Fixed Income could come from Updated Mortality Tables according to another CITI report from the 10th of April:
"The Society of Actuaries released drafts of proposed new mortality tables (RP- 2014) and mortality improvement scales (MP-2014) that provide the basis for determining pension liabilities. These are significant updates.-The new tables and schedules increase life expectancy at age 65 by 2.0 years for males (from 84.6 years to 86.6 years) and by 2.4 years for females (from 86.4 years to 88.8 years).-The previous set of mortality tables was published in 2000 (RP-2000), and the most widely used mortality improvement scale (Scale AA) dates back to 1995.We have estimates that longer life expectancies resulting from the updated mortality tables will increase the value of pension liabilities by 3% to 10% depending on the nature of the plan and prior assumptions.-If we take Aon Hewitt's estimate of a 7% increase in plan liabilities, that would reduce funded status by approximately 6%, or about half of the improvement experienced in 2013.-Plan durations should extend, but we do not have good estimates of how much.With lower funded statuses using the updated tables, it is likely that de-risking flows from equities to fixed income will be lower than they otherwise would have been under the previous mortality regime." - source CITI" - Macronomics, February 2015

The Society of Actuaries updated the mortality tables end of October 2014. These tables are used by pension plans to project the life expectancy of plan participants and beneficiaries to reflect that people are living longer. For example, average life expectancy for a 45-year-old has increased from 83 to 87. When fully implemented over the next few years, the new tables are expected to increase pension plan liabilities by an average of 6-9%. The issue of course is that these pension plans remain underfunded.

On this specific matter we read with interest CITI Equity Strategy note from the 11th of June entitled "Pension Comprehension in 2014":

• "Despite the S&P 500’s 11.4% gain in 2014, low interest rates and higher longevity tables pressured corporate pension and Other Post-Employment Benefits (OPEB) funding status in 2014. Notwithstanding the S&P 500 tripling off of its 2009 lows, corporate pension funds remain underfunded with a $389 billion underfunded status in 2014, still fairly close to 2012’s peak of $452 billion. Surprisingly, pension funding dropped to 81% of obligations at the end of 2014, down from 88% in 2013, but it was up from 77% in 2012.
• Funding status comparisons are not apples-to-apples in 2014. The Society of Actuaries’ update to private pension plan mortality tables (Retirement Plan-2014 “RP-2014”) led to a one-time significant increase in pension liabilities. While adoption of RP-2014 is at the discretion of the plan sponsor, US GAAP requires a “best estimate” for assumptions and the current tables were well accepted. Accordingly, this “one-time” hit to funded status aligned liabilities with the actuarial organization’s best estimates.
• Robust free cash flow, earnings and cash holdings alleviate some of the unease surrounding pension funding. Investors have been concerned about pension funding levels since 2007-08, but corporate cash flows provide comfort as companies have the ability to make large contributions to pension funds.
• After edging higher in 2013, the discount rate fell back to 3.92% in 2014, causing pension obligations to swell. The present value of corporate pension obligations is heavily influenced by interest rates and thus lower yields typically cause deterioration in funding status. While forecasts for higher yields in the future should lead to decreased concerns over the underfunded status of US pensions, OPEB accounts remain significantly underfunded as corporations attempt to shift these costs on to individuals. The value of OPEB underfunding at the end of 2014 grew to $196 billion vs. $181 billion in 2013.
• All ten S&P 500 sectors remain underfunded, with Energy continuing to be the least funded sector. Health Care and Industrials saw the largest drop in funding status amongst the sectors. As the overall S&P 500 pension funding status has declined, it is worth noting that only 21 companies within the S&P 500 were fully funded at year-end 2014, with nearly half of the overfunded companies coming from the Financials sector. Notably, the number of fully funded companies was down sharply from 51 companies in 2013.
• S&P 500 pension plans’ allocation to equities slid down to 44.5% in 2014 from 46.9% in 2013. The equity allocation increased most within the Consumer Discretionary and Utilities sectors in 2014, while Consumer Staples, Health Care, and Telecom Services saw a sharp pullback along with Industrials and Energy.

The drop to 81% of obligations at the end of 2014, could be link, we think to the amendments in Mortality Tables which is in fact increasing liabilities of the pensions over the long term by an average 6 to 9% as stated above.

"Pension under-funding continues to be a major issue for S&P 500 constituents even after some of the intense investor scrutiny back in 2008 and 2009 softened to some extent in 2011 as markets improved. Nonetheless, very respectable equity market gains over the last six years have not substantially alleviated pension pressures.

The S&P 500 was up more than 201% at the end of 2014 since the low in 2009 but the aggregate underfunded status of $389 billion in December 2014 is now 26% higher than the $308 billion under-funding peak seen in December 2008 (see Figure 1).

While the funding status in 2013 improved by more than $225 billion versus 2012 alongside strengthening equity market performance and a higher discount rate, this trend reversed in 2014. Specifically, revised longevity tables and lower interest rates contributed to the reduction in 2014’s pension funding status." - source CITI

So we are wondering where is indeed that famous "wealth effect" thanks to QE and ZIRP for US future retirees. Definitely not in US pension plans.

The reason? The lack of conviction from Pension funds in believing in the much vaunted "Great rotation" story as discussed by CITI in their report:

"Pension funds have been unwilling to allocate assets towards stocks after two major equity pullbacks in the past 15 years clobbered pension programs leaving allocators and consultants relatively risk averse with liability driven investing taking over the mindset. Moreover, current ERISA requirements call for companies to keep enough short-term cash and equivalents available to pay out current pension liabilities. Fortunately, corporate cash flow, free-cash flow, earnings and cash holdings are at or near record highs making required cash contributions to pension funds a much more manageable expense for S&P 500 constituents. Note that the funding status at 81.2% declined from the 87.9% level seen in 2013, which was the best reading in six years, but remained markedly better than 2012’s 77.3%, which was the weakest point since 1991." source CITI

Cash is king it seems...

But moving back to the Fed's "pensions plan" conundrum lies in the nefarious effects of ZIRP as clearly indicated by CITI's report:

"Meanwhile, persistently low interest rates on long-term bonds translate into lower discount rates for determining pension obligations, making the actuarial assumptions for the present value of these obligations appear larger than if discount rates were more in-line with the long-term average." - source CITI

Exactly, with updated mortality tables and continued ZIRP, US corporate pension plans are struggling in achieving their targeted rates.

They also added:

"S&P 500 constituents’ pension plan allocations to equities edged down to 44.5% in 2014 from 46.9% in 2013, yet remain better than 2008’s 43.7% (see Figure 8) and far below 2007 levels of 61.3%. 

However, much of the gains from 2008 would have been attributable to the increased value of equity assets within corporate pension portfolios relative to overall holdings rather than new equity-oriented allocations. Interestingly, flows returned to bond mutual funds, as released by ICI, which saw more than $43 billion flow into bond funds last year (and inflows of roughly $40 billion so far this year), US pension funds followed suit with fixed income allocation increasing by more than 3% (see Figure 9).

Moreover, defined benefit plan managers were net buyers of bonds in the last three quarters in 2014 but they have not started to buy equities just yet (see Figure 10). 

The shift to equities increased most notably within the Consumer Discretionary and Utilities sectors in 2014, while Consumer Staples, Health Care, and Telecom Services saw a steep decline in allocation along with Industrials and Energy over the past year. Fascinatingly, the funded status deteriorated for every sector in 2014, with Health Care and Industrials highlighting the weakest sectors but once again, the actuarial adjustments may be playing a role here as well. The 2014 data compares unfavorably to 2013 data, where the funded status for all ten sectors improved. However, the key difference may have been the effect of the near 30% return for the S&P 500 in 2013 versus the more modest 11.4% gain experienced last year.

As Figure 11 shows, the greatest under-funding can be found in the Energy sector followed by Telecom Services and Materials as well as old-line Industrial/manufacturing equities that have accrued large pension obligations due to long-term operations. However, in order to fund pension obligations, these companies must begin to get pension expenses under control lest their products lose competitiveness versus international peers due to higher prices.

The expected pension return rate for S&P 500 constituents continued to decrease in 2014 (see Figure 12), sustaining the trend which has been in place since 2001.

We are not that surprised by the continued decrease in pension return rate expectations in 2014 given low yields from “safe” Treasury instruments which are looking riskier now." - source CITI

The law of diminishing returns it seems...Note as well the impact the Great Financial Crisis (GFC) has had on the funding status for Telecom Services. One word: brutal.

Of course our "wealth effect planners" at the Fed are indeed in a bind given the asset side of the pension story as clearly illustrated by CITI in their most interesting report:

"Bear in mind that the stock market is crucial to the asset side of the pension story (see Figure 18).

Since we envision only modest mid-single digit gains from current levels through mid-2015, it will not close the gap entirely. The most significant impact on pensions will come when interest rates move higher, thus reducing the present value of future pension obligations, which will accelerate the timeline of fully funded status. With roughly $755.1 billion of pension assets in stocks currently (assuming the year-end 2014 figure appreciated by roughly 1% thus far in 2015 using the S&P 500 Index as a benchmark), there would need to be a more than 50% upward move in equity markets to close the $390 billion funding gap without an increase in discount rates to decrease the pension obligation. Thus, it will be more of a gradual move even as significant progress has been made in spite of investor anxiety over the pension issue from time to time." - source CITI

So go ahead dear Fed, damn if you do raise interest rates, damn if you don't. When it comes to US pension plans and their large exposure to credit and given the lack of liquidity and the dwindling repo market, it seems there are indeed larger issue at stake, no offense to our Greek readers, than the closure of the Third Punic War in Europe it seems.

• Final chart: In High Grade, liquidity is coming fast at a premium

With Repo levels falling and liquidity concerns in conjunction with oversupply in the primary markets, US Investment Grade Credit as we posited in our last conversation "Eternal return" is fast becoming a "crowded" trade we think and we are not the only one given's Bank of America Merrill Lynch's take from their Situation Room note from the 15th of June entitled "Bonds 0 - CDS 1":

"Liquidity at a premium
With Fed liftoff fast approaching and increasing long term interest rates, liquidity conditions in the high grade corporate market are worsening. Our view remains that the unintended consequence of the intended consequence of financial regulation (the decline in dealer balance sheets, Figure 10) is that liquidity conditions in the market deteriorate. 

However, so far this effect has been masked by inflows – hence the change as this year the credit market makes the transition from inflows to outflows. We are about to feel the true extent of the unintended consequence of financial regulation – namely the collapse in liquidity." - source Bank of America Merrill Lynch

In this context, and as per our last conversation "Eternal return", we expect volatility in the Fixed Income space to continue to rise. In our May conversation "Cushing's syndrome" we asked ourselves:

"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured.
 In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out." - Macronomics, May 2015

In these jittery markets, no wonder giant fund manager BlackRock has therefore been forced to "recalibrate" its VaR models as described in Bloomberg by Eshe Nelson in her article from the 15th of June entitled "Bond Swings so Extreme Even BlackRock rewrites Risk Measures":

"BlackRock is testing how risky its holdings are by running them through new worst-case scenarios that assume more volatility and varying correlation among asset classes. And strategists at JPMorgan Chase & Co., the world’s biggest debt underwriter, now see the need to calculate a “liquidity premium” for top-rated, longer-maturity government bonds in Europe, a new wrinkle for benchmark securities that are considered the safest assets available because of their deep markets.
The selloff is “questioning what is the right price given the current illiquidity in these asset classes,” said Nandini Srivastava, a global market strategist at JPMorgan in London. The difficulty in assessing the amount of risk “exacerbates the problem as you have investors on the sidelines thinking ‘Are these really the right prices and yield levels?’”

Volatility Surge
Yield volatility on 10-year bunds has climbed to nine-times its average during the past 15 years, giving traders a taste of the turbulence European Central Bank President Mario Draghi said June 3 they should get used to as the byproduct of record monetary stimulus.
A measure of 30-day volatility on bunds surged to 300 percent in May. It hadn’t gone above 100 before this year, in data compiled by Bloomberg going back to the middle of 2005. The market’s gyrations are being magnified by record-low yields: In the week of Draghi’s remarks, yields soared 0.36 percentage point, the biggest jump since 1998. The yield was at 0.82 percent on Monday at 1:30 p.m. in New York, up from a record of 0.049 percent on April 17.
“Investors should be pricing in more risk,” said Grant Peterkin, a money manager at Lombard Odier Investment Managers, which oversees 161 billion Swiss francs ($172 billion). “Given bonds steadily rallied for a long period of time, the low volatility suggested they were low risk, which potentially forced investors to buy more of them.”The danger is that this kind of instability may seep into other assets, he said. This could pressure companies as well as governments with rising borrowing costs. Yields on junk bonds around the world have collapsed to about 6.6 percent, versus their average of 9.7 percent since the end of 1997, according to Bank of America Merrill Lynch index data.

Risk Measure
Citigroup strategists are recommending investors measure their vulnerability by placing more emphasis on duration -- a gauge of a bond’s sensitivity to interest-rate changes -- and the amount a country has borrowed, in addition to volatility, according to Alessandro Tentori, head of international rates strategy.
BlackRock is testing how its holdings would perform in scenarios like the dislocation in peripheral debt in 2011 and 2013’s taper tantrum. It’s also looking at how they’d react to sharp moves in the Standard & Poor’s 500 Index.
“It’s challenging, particularly when the correlations change, that’s the most difficult thing,” Thiel said." - Source Bloomberg

Credit bubbles generated by ZIRP will not preserve equity, nor US pension plans rest assured as per the conclusion of  our November 2014 "The Golden Mean" conversation and Poincaré's recurrence theorem...

"The only good is knowledge, and the only evil is ignorance." - Herodotus, Greek historian

Credit - The Vortex Ring

"When a system is in turbulence, the turbulence is not just out there in the environment, but is a part of the organization or organism that you are looking at." - Kevin Kelly

While looking at the burst of turbulences last week in the credit and government bond high beta space, in conjunction with the expected results coming out of the European elections and given our fondness for "flying" analogies which we abundantly used in our conversation "The Coffin Corner", in this "Tapering" environment we reminded ourselves of the Vortex Ring when it came to choosing our post title. The famous Vortex Ring also known as the "Helicopter Stall" can happen easily under certain specific conditions particularly when approaching landing, as illustrated more recently in the movie Bravo Two Zero when the Special Operations 160th SOAR helicopter came crashing down in Abbottabad during Operation Neptune Spear after experiencing the infamous vortex ring state.

You are probably already asking yourselves where we are going with this analogy already but, given Ben Bernanke's various QE programs have been compared to "helicopter money", we thought a reference to a "helicopter stall" given the Fed's tapering stance would be more than appropriate for this week's chosen title. 

Therefore in this week's conversation we will review various states of central banks at play, between the Fed, Japan and the much expected ECB move in June.

In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust). 

For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":

"To get into vortex ring, three factors must all be present:

• There must be little or no airspeed.
• There must be a rate of descent.
• There must be power applied.

Note that all three of these must be going on at the same time."

• There must be little or no airspeed.

In our conversation"The Coffin Corner" we indicated the following:

"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy."

With the latest reading from the US GDP coming at 0.1% for the 1st quarter indicates for us little or no "airspeed" for the US economy and the aforementioned "economic" stability we mused on last year.

For Europe the latest inflation readings indicates little or no "airspeed" on top of the very weak economic growth reading making it paramount for the ECB to act sooner rather than later in order to avoid the Vortex Ring state.

• There must be a rate of descent.

Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via "helicopter"easing will require interest rate hikes, and will also necessitate asset sales by central banks, according to April's IMF Stability Report. The tapering stance of the Fed does include indeed a rate of descent of $10 billion a month.

Of course another rate of descent which we have been following has indeed been US Velocity. What we have found most interesting is the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3% - Graph source Bloomberg:

It has been downhill from 1997 with velocity falling linked to factor number three of the "vortex ring" namely "There must be power applied" (ZIRP in conjunction with the various iterations of QE).

Yet, the recent fall in unemployment has been masking the Fed's progress in avoiding the dreaded Vortex Ring as seen in the lack of breakout in the employment population ratio. The Fed has not been able yet to reach "escape velocity" from this vortex ring as displayed in the Bloomberg graph below indicative of the conundrum:

The lack of "recovery" of the US economy has indeed been reflected in bond prices, which have had so far in 2014 in conjunction with gold posted the biggest returns and upset therefore most strategists' views of rising rates for 2014 (excluding us given we have been contrarian). Those who read between our lines have done well so far in 2014 given we hinted  a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":

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

• There must be power applied.

When it comes to applying power, like many pundits, we have been baffled by the action in US Treasury bond buying from Belgium which increased its holdings in US debt by $201 billion in five months to $381 billion at the end of March this year, making it the third largest holder after China and Japan - graph source Bloomberg:

Helicopter pilot students, have a tendency to slow down, if they are afraid of overshooting their landing point, which can put the helicopter they are flying in a vortex ring state. In similar fashion, central bankers have a tendency to slow down if they are afraid of overshooting. 

It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets as displayed by the below graph plotting the performance of the Nikkei index, the USD/JPY currency pair and the inverse Itraxx Japan indicative of credit risk for corporate Japan:

If one looks at unemployment levels and inflation levels for a gauge of the respective situation of various central banks it seems that, while Japan has achieved full employment, it has failed for many years to spur inflation, while the US as well as the United Kingdom, have achieved to reduce their unemployment levels, Europe is still closer to the Vortex Ring State (deflationary bust) given it boasts very low inflation levels compared to the other G4 and record unemployment level, as displayed in this Barclays graph from their recent Market Strategy note entitled "Japan at the end of the post VAT hike tunnel" from the 26th of May:

"Monetary policy: Potential growth & expected inflation, quantity & quality

Opinion regarding deflation in Japan has long been divided between those who believe the problem cannot be solved by monetary policy alone, ie, potential growth is tied with inflation expectations, and those arguing conversely that inflation is a pure monetary phenomenon that can be controlled by monetary policy independently of potential growth. For some reason, the latter group appears to overlap almost completely with those claiming that the degree of monetary easing can be measured unambiguously via the monetary base (monetarists). We agree with the second group that deflation can be overcome by monetary policy without a change in potential growth, and believe that this is in fact occurring at present. However, we think that the driving force behind the BoJ’s present Quantitative and Qualitative Easing (QQE) is not the quantitative but the qualitative side.

Japanese market participants tend to subscribe to the former view. This may reflect a general feeling based on experience rather than the result of academic study. The nation has failed to quash deflation despite 15 years of sundry monetary easing measures, which may have convinced many that inflation expectations are being affected by factors that cannot be controlled by monetary policy, such as a decline in potential growth (including demographic trends). For those holding to this argument, the opposing view sounds like a vacuous theory ignoring a decade and a half of actual events. In particular, since the majority of those supporting the second view are “reflationists”, who believe monetary policy should give greatest weight to quantity, the two sides basically find themselves talking at cross purposes.

Those taking the former view, which is the market consensus, feel that events in 2001-06 proved that the size itself of the BoJ’s balance sheet has no impact. They claim therefore that if the QQE focuses solely on increasing this volume, it cannot achieve a change in inflation expectations. However, we think instead that the important point is the quality of the bank’s balance sheet; ie, the volume of risk in the bank’s acquired assets. We believe the effectiveness of the monetary easing by the Fed and BOE after the Lehman shock and the rapid turnaround in the Japanese economy after the launch of the BoJ’s QQE stemmed from their purchases of long government bonds and risk assets, pushing supply/demand above levels (in other words, pushing yields below levels) that the economic fundamentals would indicate as fair. The general social principle that economic policy should not intervene in the free market, which prior to the Lehman shock also applied tacitly to monetary policy and financial markets, prevented the BoJ from turning to asset purchases in JGB markets even in deflation-racked Japan. The serious crisis brought about by the Lehman collapse led to market intervention by countries worldwide and a shared belief that the ideology itself needed to change. With the success of this monetary policy approach in the US and UK, the BoJ also shifted its focus from quantity to quality, carrying out a market intervention of unprecedented scale with the QQE.

That is, QQE is a new monetary easing stance that had not been tried in over 15 years of deflation. Still, the markets perceived this to be little more than an extension of previous policy and assumed from past experience that it would have no effect on inflation expectations. A good number of market participants still dismiss the claim by BoJ Governor Haruhiko Kuroda and other BoJ executives that the bank’s 2% price stability target is achievable. Some likely hold the view that the BoJ itself is simply maintaining the 2% target in the hope of raising inflation expectations in the market.

In contrast, we think the bank is conducting an easing policy with entirely different effects than its earlier efforts, and we do not believe its past inability to beat deflation means that it will be unsuccessful this time as well. Furthermore, we suspect that the BoJ itself likely shares this view. Its confidence in the price stability target may well have deepened in light of ongoing developments in the Japanese economy. The statement from last week’s Monetary Policy Meeting noted anew that “QQE has been exerting its intended effects”. As we have explained, we see this not as calculated optimism designed to perk up the Japanese public but as a straightforward reflection of the bank’s actual belief at this time. As long as the bank maintains this stance, we think it is unlikely to alter its monetary policy. At the same time, we believe it will be relatively flexible in adjusting its current policy in the event of any upward or downward risk to the economy." - source Barclays.

When it comes to the US and the United Kingdom, it is interesting to note the very strong correlation between 10 year bond yields throughout the years as displayed in the below graph from Bloomberg comparing yields for UK gilts and US treasuries since March 1994:

And on a shorter time frame since 2011, UK 10 year yields versus US 10 year yields - graph source Bloomberg:

The question on everyone lips is of course who will blink first (raise rates that is), the Bank of England or the US Fed? One thing we are certain of, not anytime soon.

So in relation to the veiled question from our title and from Barclays take, the big question is of course can the "Vortex Ring" (aka deflationary bust) can be avoided by monetary policy alone?

We are still sitting tightly in the deflationary camp and expect further yield compression on US Treasuries. As such, we agree with the Wall Street Rant Blog on that subject:

"Many Government Bonds Yielding Less Than United States

I can't listen to a talking head, bond manager, strategist or seemingly anyone without hearing about how "Rates can only go higher from here". When in reality THEY CAN go lower! In fact, when you look around the world, on a relative basis, THEY SHOULD!" - source Wall Street Rant Blog

Indeed they should. To add ammunition to this, one should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower, in particular its upcoming reforms and asset shift scenarios as reported by Nomura in their recent report from the 23rd of May:

"The yen bond market remains range-bound as market participants’ interest in Abenomics and expectations of additional BOJ action fall. The consensus view is that the USD/JPY outlook is dependent on the US economy and yields. However, it is increasingly likely that the government’s June growth strategy will exceed market expectations, which have dropped markedly. We are focused on the likely scenario that the GPIF and other public pensions will start shifting from a yen bond bias in the near future. In our upside scenario, these reforms would lead to approximately JPY20trn in foreign securities investment in the next 12-18 months, potentially weakening JPY by about 10%." - source Nomura

Here are the two potential "re-allocation" scenarios according to Nomura's paper:

"As of end-

December 2013, the GPIF had JPY128.6trn ($1.3trn) in managed assets. Of 

the three associations, KKR had JPY7.8trn ($78bn), Chikyoren had JPY17.5trn ($175bn) 

and Shigaku Kyosai had JPY3.6trn ($36bn, all as of end-March 2013). Total managed 

assets for the four pension funds amount to almost JPY160trn ($1.6trn). The GPIF has 

attracted the most attention because of the sheer scale of its assets, but the three 

associations manage about JPY30trn or $300bn in assets.

The GPIF‟s weighting of Japanese bonds had fallen to 55% as of end-December 2013. It was reported that after the Industrial Competitiveness Council‟s follow-up section meeting on 8 April, the GPIF‟s head office explained that this weighting had dropped to 53.4% on the withdrawal of pension benefits. Thus the weighting of Japanese bonds is already below 55% and could be nearing the 52% floor of the allowable deviation. At the same time, the weighting of Japanese equities stood at 17.2% at end-December 2013, close to the maximum allowable deviation of 18%. Foreign bonds. weighting was 10.6%, close to the standard median value of 11.0%. At 15.2%, foreign equity's weighting is still some way from the maximum deviation (17.0%). Trends in the weightings of Japanese bonds and Japanese equities suggest that, as described in the FY14 investment plan, the GPIF has already been investing flexibly within the permissible range of deviation, and it may be investing such that the respective weightings do not approach the median value. As the strong equities/weak JPY trend has continued since end-2012 and the fund has changed its basic portfolio in June 2013, the GPIF.s portfolio is already shifting gradually from domestic bonds to risk assets.

Asset shift scenarios based on the new basic portfolio

We look at simulations for fund shifts following changes in the basic portfolios of the GPIF and the three public pension funds, in line with two scenarios, based on their current portfolios as described above. In Scenario (1), the four funds lower the weighting of Japanese bonds to 40% and allocate 8% of the money thus freed up to Japanese equity (from 12% to 20%) and 6% each to foreign bonds (11% to 17%) and foreign equity (12% to 18%), as Panel Chairman Takatoshi Ito recommended. Scenario (2) assumes more moderate changes, with the Japanese bond weighting lowered 10% to 50%, the Japanese equity weighting raised 4% (12% to 16%) and the foreign bond and foreign equity weightings raised 3% each (from 11% to 14% and from 12% to 15%). As we expect a compromise between the stance of President Mitani, who is cautious about portfolio changes, and Mr. Ito, who is more aggressive, a reduction in the Japanese bond weighting to about 50% is close to our main scenario for now. If the aggressive scenario (1) advocated by Mr Ito is realized, the GPIF.s balance of Japanese bond holdings would drop by about JPY19.6trn ($196bn), from JPY71.0trn ($710bn) at end-2013 to JPY51.4trn ($514bn). This JPY19.6trn decrease would translate into a JPY3.6trn ($36bn) increase in Japanese equity, a JPY8.3trn ($83bn) rise in foreign bonds and a JPY3.6trn ($36bn) increase in foreign equity. This scenario assumes that the weighting of short-term assets would recover to 5% of the basic portfolio, with short-term assets rising by JPY4.1trn ($41bn). Assuming that the ratio of short-term assets is fixed at the 1.8% level of end-2013 and that money is allocated to risk assets, the increase in respective assets would expand accordingly. When including the three public pension funds, the decrease in the Japanese bond balance would balloon to JPY26.8trn ($268bn), and the funds could allocate JPY5.8trn ($58bn) to Japanese equity, JPY10.8trn ($108bn) to foreign bonds and JPY6.0trn ($60bn) to foreign equity.

In Scenario (2), the GPIF.s and three public pension funds. balance of Japanese bond holdings would decrease about JPY11.1trn ($111bn). The GPIF.s Japanese equity weighting has already increased to 17.2%, so if we assume that it returns to the median after the basic portfolio change (16%), the balance of Japanese equity would fall about JPY0.5trn ($5bn). At the same time, the balance of foreign bonds would rise by JPY6.1trn ($61bn) and the balance of foreign equity would increase about JPY1.2trn ($12bn).

The above figures are rough estimates that do not take valuation gains or losses into account. Amounts may also differ considerably depending on fluctuations in short-term assets and investments within the permissible range of deviation. As noted above, our main scenario at this point expects changes in the basic portfolio to be around the scale of Scenario (2) in the near term. However, in what we can Scenario (2)-2, we assume that Japanese bonds account for 50% of the basic portfolio, the permissible range of deviation expands to }10“, the ratio of risk assets is kept higher than the median value to avoid a sharp drop in Japanese bonds as a result of a sharp acceleration in the inflation rate, and the weighting of short-term assets is kept at about 2% (permissible range of deviation from median value set at -10% for Japanese bonds, +5% for Japanese equity, +4% for foreign bonds, 4% for foreign equity and -3% for short-term assets). In this case, similar to Scenario (1) the balance of Japanese bonds held by the GPIF and the three public pension funds would decrease by JPY26.8trn ($268bn), the balance of Japanese equity would increase JPY7.4trn ($74bn), the balance of foreign bonds would rise JPY12.4trn ($124bn) and the balance of foreign equity would increase JPY7.5trn ($75bn). At first glance, Scenario (2) looks like a conservative change, but depending on the actual stance on investments after the basic portfolio is changed, the asset mix could be significantly changed as envisioned by Mr. Ito." - source Nomura

No wonder peripheral bonds in Europe have been benefiting from Japan's appetite as displayed by Bloomberg's recent Chart of the Day entitled "Euro-Area Periphery Hooked on BOJ stimulus":

"The CHART OF THE DAY shows Europe’s peripheral bond rally stalled this month as the yen strengthened versus the euro. Last week the Bank of Japan refrained from adding to the 60 trillion yen ($589 billion) to 70 trillion yen poured into the monetary base each year that has encouraged Japanese investors to put money into higher-yielding European assets.

“Peripheral yield spreads appear vulnerable to a correction following the strong rally and the yen tends to often strengthen on credit risk,” said Anezka Christovova, a foreign- exchange strategist at Credit Suisse Group AG in London.

“Japanese portfolio flows usually have an impact. Those flows could now divert elsewhere. We don’t expect any substantial action from the Bank of Japan in coming months and that could also lead the yen to strengthen.”

Japanese investors bought a net 1.41 trillion yen of long-term foreign debt in the week ended May 16, the most since Aug. 9, data from the finance ministry in Tokyo showed on May 22.

Flows into Europe may be tempered as yields in Europe’s periphery climb. The average yield spread of 10-year Portuguese, Greek, Spanish and Italian bonds over German bunds has risen 20 basis points this month to 270 basis points, after touching 239 basis points on May 8, the lowest since May 2010, based on closing prices.

New York-based BlackRock Inc., the world’s biggest money manager, said on May 8 it had cut its holdings of Portuguese debt, while Bluebay Asset Management said on May 9 it had seen the majority of spread tightening it was looking for.

Trading euro-yen based on movements in the bond-yield spreads of the euro area’s peripheral nations would have been a successful strategy, Credit Suisse strategists, including Christovova, wrote in a May 21 note." - source Bloomberg.

It is worth noting Japanese have bought a record $86 billion of US treasuries in the last 12 months according to Bloomberg data. It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998,  as per monthly data compiled by Bloomberg showed recently. So if the GPIF starts deploying its "allocation firepower" in June, maybe you ought to cling to your US treasuries a little bit longer, and maybe after all the Belgian central bank is just a very "astute" investor after all...

One thing for sure our "Generous Gambler" aka Mario Draghi has shown he is truly a magician when it comes to driving market expectations and given all of the above, maybe just a few tricks such as a rate cut and negative deposit rates will do the trick nicely to provide continued support for European government bond markets. Eurozone-residents' demand for foreign assets could be further extended and exacerbated if the ECB were to try introducing negative rates on deposits rather than the proverbial QE bazooka unless of course he goes for the €1 trillion option. The current account excesses which so far have been supportive of a strong euro versus the dollar have been the result of Eurozone residents wish of increasing savings as security against an uncertain future. The willingness of Eurozone residents to accept net receipts of foreign-currency assets  has weighted on the value of the euro in recent years and has forced the current account into surplus. Given that surplus it seemed unlikely for us until recently that the euro would fall much against other currencies unless credible fears of currency break-up re-emerge. Of course the latest European elections results could has well re-ignite fears in the coming months and allow for Mario Draghi to enjoy a depreciation of the euro without having to resort to the proverbial QE bazooka in conjunction with the help from the Japanese pension funds allocation.

In recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have significantly diverged as displayed in the below Bloomberg chart:

Mario Draghi is definitely the greatest central bank magician and probably an astute student of Sun Tzu and the Art of War we think:

"The best victory is when the opponent surrenders of its own accord before there are any actual hostilities... It is best to win without fighting." - Sun Tzu

It is as well probably worth taking Sun Tzu's wise quote in anticipation of the next ECB meeting:

"All warfare is based on deception. Hence, when we are able to attack, we must seem unable; when using our forces, we must appear inactive; when we are near, we must make the enemy believe we are far away; when far away, we must make him believe we are near."

On a final note, when it comes to avoiding the dreaded helicopter stall aka the Vortex Ring,  as per Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'" it is supposed very easy. It wasn't for the ace helicopter pilots of the 160th SOAR during Operation Neptune Spear, There is "no easy day", same goes with QEs:

"It is actually very easy to get out of vortex ring… at least in the incipient stage when the juddering and yawing starts. Some say it is impossible to get out of the fully developed state, but when you start to perceive signs of vortex ring, all you need to do is remove one of the three factors noted above. So, you push the cyclic forward to increase airspeed, or lower the collective to reduce power.  It is not possible to reduce the rate of descent to stop vortex ring, as that would involve increasing power.  In practice, pilots usually increase the airspeed, as unless the helicopter is very high, you don’t want to lower the collective and risk hitting the ground!" - source Helen Krasner - Decoded Science - January 8, 2013.

Unfortunately, getting out of vortex QE ring won't be that easy rest assured, particularly given we have not been in the incipient stage given Japan, the Fed and the Bank of England have all been repeated "QE offenders", but we ramble again...

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong

Stay tuned!