Macro and Credit - Alprazolam

"Anxiety does not empty tomorrow of its sorrows, but only empties today of its strength." - Charles Spurgeon British clergyman

Watching with interest the historical defeat of Prime Minister Theresa May relating to Brexit, in conjunction with the Chinese central bank injecting a net 560 billion yuan ($83 billion) into the Chinese banking system, the highest ever recorded for a single day given the weakening tone of the economy, when it came to selecting our title analogy we decided to go for a medical reference to "Alprazolam". "Alprazolam", also the trade name for Xanax among others, is the most commonly used benzodiazepine in short term management of anxiety disorders, specifically panic disorder or generalized anxiety disorder. It seems to us that the Chinese authorities have decided to act decisively on the very weak tone taken on their economy and the slowdown in global trade and its impact. Due to concern about "misuse", some strategists like us would not recommend "Aprazolam" as an initial treatment for panic disorder such as the MSCI China index down 23% over the past year. With the University of Michigan’s consumer confidence index falling to a more than two-year low of 90.7 in January, down from 98.3 in December, and well below expectations of 97.5, we wonder if our quote above is correct in asserting that anxiety does indeed empties today of its strength, namely consumer confidence. After all, clinical studies have shown that the effectiveness of Alprazolam is limited to 4 months for anxiety disorders but we ramble again...

In this week's conversation, we would like to look at the rising cost of attrition on the global economy, with the continuation of the stalemate in Brexit, US vs China trade/tech war, yellow jackets in France and of course the government shutdown in the United States. While Alprazolam has brought some solace to the December angst for investors, it remains to be seen how long the effect will last on the recovering "patients".

Synopsis:

• Macro and Credit - Does A for attrition equate R for recession?
• Final charts -  Mind the liquidity shock...

• Macro and Credit - Does A for attrition equate R for recession?

As we indicated in our previous conversations, "Bad News" has been the new "Good News" at least for asset prices in general and high beta in particular, the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture. 

We indicated more downside risk at least from a European perspective and we continue to have a very negative view on France given the continuation of the unrest and the "yellow jackets" movement not giving any respite to president Macron. 

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."

In the AFTE latest survey, there is now a clear trend in the deterioration in their operating cash situation showing up:

- source AFTE

The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average).

On this "attrition" subject we read with interest Bank of America Merrill Lynch's take from their Cause and Effect note from the 18th of January entitled "Investing in the age of the attrition game":

"Attrition bites in Europe

The “yellow vest” protest in France, which has resulted in the “worst riots since 1968” is now its 9th week. Not only it has shown no sign of ending, the number of demonstrators rebounded sharply over the past two weeks (Chart 6).

What began as a protest against fuel hikes has morphed into a broader movement of discontent with the government. President Macron has so far has refused to restore the wealth tax, one of the key demands of the protesters. This could turn into another war of attrition, especially with the fast approach of the EU parliamentary elections (May 23-26). French consumer confidence has tumbled sharply and is approaching levels reached during the Eurozone crisis (Chart 7).

The slowdown within the Eurozone is spreading. Both Italy and Germany are already in a recession (“the “R” club is recruiting”, January 11). For Italy, despite the passage of the 2019 budget bill, our European economics team has observed that the busy electoral calendar and decrees (not least those implementing pension reform and an income support scheme) could challenge the current ruling majority in the first half of the year. In Spain, a new far right party is emerging and the government lacks parliamentary support to pass a 2019 budget. The latest manufacturing PMI surveys show that new orders for Germany, France, Italy and Spain, the four largest economies in the Eurozone, were all below 50 (contractionary) in December, the first time in four years (Chart 8).

In our view, the greatest risk facing Europe is that the slowing economy fuels further populist discontent, creating a vicious circle." - source Bank of America Merrill Lynch

The numerous "attrition wars" being fought on a global scale are indeed clear headwinds regardless of the latest injection of "Alprazolam". As we indicated in our previous conversation "Respite",

"As we stated in various conversations including our last, we tend to behave like any good behavioral psychologist in the sense that we would rather focus on the flows than on the stock. On that note we continue to monitor very closely fund flows when it comes to the validation of the recent "Respite" seen in the market and it is not a case of confirmation bias from our side. 

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian". 

A flattening curve in our book is not positive for banks and cyclicals such as housing and autos have already turned.  Also as briefly pointed out, a sustained shutdown is likely to be another drag on US growth which will therefore push the Fed's hand further into "dovish" territory". In that context, and if inflows return into credit markets, then high beta credit as well as Investment Grade could continue to thrive in the near term given Fed Chair Powell indicated in the latest FOMC minutes a willingness to be patient with future rate hikes. 4Q US GDP might disappoint we think." - source Macronomics, January 2019

We also discussed in our conversation the importance of the return of "macro" and the need to "monitor" fund flows for any signs of stabilization in "credit markets" as well as the need to track oil prices relative to US High Yield given its exposure.

Flow wise, Bank of America Merrill Lynch in their Follow The Flow note from the 18th of January entitled "Just a bounce?" question the most recent positive tone in financial markets given the weakening mood coming out from the macro data:

"Light positioning and known-unknowns

This year started on a positive note. Despite further weakness on the macroeconomic data front across the globe (more here), risk assets have staged a strong bounce higher. This is not because everything is in the price and we already know that macro is slowing and that the synchronised recovery has turned to a synchronized slowdown. It is the fact that positioning has been very light at the end of last year and thus cash balances have been put to work in January. With slower primary and tighter spreads last week it feels that the outflow trend is slowing down. However we are skeptical for how long markets can keep ignoring the continuing deterioration in macro. We feel this rally will not last, and thus we would use this bounce higher to reduce risk.

Over the past week…

High grade funds suffered another outflow, making this the 23rd week of outflows over the past 24 weeks. However, this week’s outflow is the smallest observed over that period. High yield funds recorded another outflow, the 16th in a row, but also the smallest in a while. Looking into the domicile breakdown, Globally-focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Actually Europe-focused funds have recorded small inflow, the first in 15wks.

Government bond funds recorded a small outflow this week. Meanwhile, Money Market funds recorded an outflow as risk assets moved higher. All in all, Fixed Income funds recorded an inflow, the second in a row.

European equity funds recorded another outflow this week, the 19th consecutive one. During the past 45 weeks, equity funds experienced 44 weeks of outflows.

Global EM debt funds continued to record inflows, the second weekly one. This confirms the improving trend observed recently as a dovish Fed has weakened the dollar. Commodity funds recorded another (albeit marginal) inflow, the 6th in a row.

On the duration front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while long-term funds experienced a decent inflow, continuing the recent trend of strength on the back-end of the curve." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch that, the significant rally in high beta should entice you to become more "defensive" and favor "quality" (rating) over "quantity" (yield). In the ongoing attrition game, it is more a question of capital preservation than capital appreciation we think.

Moving back to the "attrition game" and Bank of America Merrill Lynch's note from their Cause and Effect from the 18th of January entitled "Investing in the age of the attrition game", regardless of the positive liquidity injection from the PBOC and dovish tilt of the Fed, earnings as well are slowing down and there is more risk to US consumer confidence with the shutdown:

"Shutdown raises trade war risk

What does a destabilizing gridlock in Washington mean for the US-China trade war? Given the peril of fighting two battles at the same time, it seems reasonable to assume that the incentive for Trump to close a deal with China sooner than later has gone up. The fact that he has been talking up the prospect of a deal with China in recent weeks (“I think we’re going to be able to do a deal with China,” January 14) is consistent with this hypothesis. The market has taken these upbeat remarks at face value and has been driving up EM assets, the main casualties of the US-China trade war last year.

However, it takes two to tango. Trump’s loss of full control of Congress may be viewed by Beijing as justifying a less conciliatory stance. With the shutdown in Washington and growing expectations that the Mueller report will be out soon, Beijing may decide that it is not in a hurry to close a deal. Trump set a precedent by agreeing to a 3-month extension for the next round of US tariff. Beijing might think that the Americans could be forced into giving another extension if there is no deal by March 1.

The recent US slowdown could be giving China another reason to wait. Despite the reductions in reserve requirements to decade lows (Chart 3), Chinese credit growth has so far shown no signs of picking up (Chart 4).

Beijing might have eased monetary policy even more aggressively last year if it weren’t for the fact that rate hikes by the Fed was pushing down the renminbi (Chart 5).

A much weaker renminbi might have further complicated the US-China negotiation. The fact that the Washington shutdown is increasing the chance of a Fed pause, giving China a wider window to ease policy, could also reduce the urgency for Beijing to close a deal with Trump." - source Bank of America Merrill Lynch

Unless there is a rapid resolution between the United States and China on the trade/tech war narrative which has led to a significant rally in Emerging Markets so far this year on the back of a weaker US dollar, then indeed there is a high probability that the effect of the "Alprazolam" will fade and the bounce experienced so far could end rapidly and abruptly.

Bank of America Merrill Lynch added the following in their report:

"Market implications

Developments over the past two months suggest to us that political risks are rising.
This puts us at odds with current market consensus.

The contrast between our views and those of consensus is giving us confidence in our investment thesis for 2019:

The USD is vulnerable. We view the escalation of the gridlock risk in Washington as posing the greatest risk to the decoupling trade and to the USD. We are soon approaching a key support level that, if broken, will usher in further USD weakness (USD topped and target reached, but is this it? January 16). We like selling the USD especially against the JPY and the CHF. The EUR has been unable to capitalize on the USD’s retracement this year, reflecting concerns about the growth outlook for the Eurozone. If Eurozone political tension continues unabated, we may have to revisit our bullish EUR/USD forecasts.

EM rally won’t last forever. EM is rallying on Trump’s upbeat comments on the prospect of a trade deal with China. We think the risk of a no deal by March 1 is higher than expected. We also think that the inability of the EUR to gain against the USD will limit the room for further gains in commodity prices and EM. We think EM investors should not wait too long before taking some money off the table. We continue to believe that in 2019 investors need to think strategically but act tactically.

US rates vol looks cheap. Rates vol has fallen sharply year-to-date as risky assets stabilized (Chart 9).

We see the sell-off as possibly overdone given the binary nature of the political risks we highlighted in this report and the increasingly binary decision the Fed is facing. The worsening supply-demand dynamics as we head into possibly debt ceiling crisis #2 will likely provide strong support to rates vol." - source Bank of America Merrill Lynch

Any spike in rates volatility would obviously be negative for asset prices given carry players, risk-parity investors and other pundits love one thing, and that's low rates volatility. Any return of volatility on the aforementioned would definitely trigger another bout in "risk-off" rest assured.

How convinced are we with the strong rally seen so far from the December "oversold" situation? Not very much, we would argue. Sure, we have seen a welcome respite with the central banking cavalry arriving late, once again to an already damaged macro situation. Given the amount of known "unknowns" and the weaker tone in the overall macro picture, yes bad news are good news again for asset prices, but, we do think that buying some protection to the downside with potential bouts of volatility is a wise move.

Remember 2018 has marked the return of "cash" in your allocation toolbox and it should be used more extensively in 2019 given the risk for even more volatility events than in 2018. Bank of America Merrill Lynch in their High Yield Strategy note from the 18th of January entitled "When Cash Becomes King" makes some compelling arguments about the current tactical rally we are seeing:

"Low-risk yields appear compelling in this macro setup

The rally in leveraged credit has taken a pause in recent sessions, with our DM USD HY index oscillating around 450bps, more or less where it stood a week ago. The same could be said of rates as well, where the 10yr remained range-bound over the past week, spending most of its time around 2.70-2.75%. Even equities exhibited low volatility, by recent standards, with S&P500 moving 10-20pts in most sessions, a sea-change from 80-100pt sessions around year-end.

So, can this be considered an all-clear signal? Perhaps. It undoubtedly adds one reason to think so, although it is hard to make it sound convincing in and of itself. We prefer to rely on more tangible events, something that would not be forgotten tomorrow if volatility were to return.

Among such new developments, we counted the following:

• China: has responded strongly to apparent signs of weakness in its economy by cutting bank reserve requirements, policy rates, and business taxes. The extent of cuts in reserve requirements now exceeds those witnessed in 2008 and 2015. Business taxes were cut to the tune of $30bn/year; for some perspective US corporate tax cuts of 2017 amounted to $600bn/10yrs, or $60bn/yr for an economy that is 1.5x larger. In other words, very meaningful policy actions out of China.
• Earnings: banks opened the reporting season with a bang despite notable shortfalls in FICC results; their other businesses appeared to be doing well. Tax-reform bump is likely to begin coming out of numbers only next quarter, and will potentially reach its peak in Q2-Q3 of 2019. So US earnings could stay artificially elevated for a couple more quarters, in our view.
• Sectors: financials led, while utilities and staples trailed in the whole S&P500 round-trip between Dec 14-Jan 15. The argument goes that financials underperform and defensives outperform into a downturn. And yet the fact that utilities underperformed through a potential PCG bankruptcy does not help the case of this not being a cyclical turn.

On the other side of the ledger, the following reasons support continued caution:

• China: would probably not be throwing this much stimulus if its economy was performing in an acceptable way. The leadership there must know something we don’t know, in our view.
• Earnings: our model for US EPS has experienced further deceleration in recent weeks, and points to +6% growth over the next year. While this is not a level consistent with a cyclical downturn, we note that earnings went from 20%+ actual yoy growth rate in Q3, to earlier estimates around +10-12% to +6% today (Figure 1). So the trajectory and the remaining cushion are a concern.

• Wide IG: with spreads elevated in the IG space, HY looks tight. BBs offer only 100bps premium over BBBs (Figure 2). While not unheard of, we think this is too tight in today’s market environment given the shift in risk sentiment that has occurred over the past several months. Historical relationship between BBBs and BBs implies the latter should be 60bps wider given where the former is, ex PCG.

• Illiquidity gap: while liquid bonds have rallied and retraced a good chunk of Dec losses, illiquid paper remains marked at discounted levels (Figure 3 and Figure 4). This behavior is inconsistent with a sustainable turn in market sentiment, i.e. investors must become comfortable bidding for illiquid stuff to demonstrate their conviction. Buying HYG does not cut it.

• High dispersion: only 1/4 of all HY bonds trade within +/-100bps of overall index level; under normal circumstances, 40-50% of them trade this way. High degree of dispersion could be a function of illiquidity gap described above. Regardless of its origin, dispersion tends to increase (percent trading at index levels drops) at times of market downturns. The current levels of dispersion are consistent with 500- 525bps HY spreads and 1,300-1,400bps CCC spreads.
• Default estimates: With most factors now fully refreshed with Dec levels, the model continues to point towards 5.5% issuer-weighted and 4.25% par-weighted default rates. Such credit losses, if materialized, imply meaningful pickup over realized levels (2.8%) and point towards wider HY spreads (500bp as a risk-neutral level).

While these data points are not yet known, and could change our thinking as they come in, we remain mindful of a scenario where this episode eventually proves itself to be a cyclical turn. As such, we find current HY valuations to be somewhat out of balance, in terms of likely ranges going forward, i.e. we think probability is higher to see spreads in high-500s rather than low-300s; these two are otherwise equal distance away from here. Given this view, we are reducing our model portfolio beta to a modest underweight at this point, which we intend to move towards a more substantial underweight if  spreads continue to grind tighter from current levels.

Think about what you believe are reasonable return expectations from here, and compare them to low-risk alternatives: Libor is at 2.75%, short-duration IG is at 3.70% yield, and short duration BBs are at 5.20%.

In the environment where the next few months carry a reasonable chance of marking the turning point in this credit cycle, we find such yields increasingly attractive. Even if the cycle overcomes all obstacles and rolls on, you can blend-average the above into 3.5-4% portfolio, with a strong likelihood of actually realizing this return, in our view.

So we are probably entering a period of time when cash is becoming king again. HY may end up showing bouts of strong performance during this time, just as it did in early January, and we remain open-minded to tactically shifting our views when opportunities present themselves. We just struggle to see how it could happen from 450bps overall index levels or from 100bps BBs-BBBs differential." - source Bank of America Merrill Lynch

Being underweight high beta is we think indeed a good recommendation at this stage. Stay nimble and get tactical. Buying HYG might not cut it for Bank of America Merrill Lynch from a "liquidity" perspective, but, from our side and as a useful "macro" defensive tool for credit exposure "hedging", we believe synthetic exposure through credit indices such as Itraxx Main Europe 5 year and CDX IG for the lucky few of you benefiting from an ISDA agreement provide sufficient liquidity to sidestep any Investment Grade liquidity concerns. The US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks as a reminder. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to more turmoil with "European" banks, though we do not expect Mario Draghi to rock the ECB boat before his departure and it is highly likely the ECB will provide additional LTRO funding to the ailing banks in the European banking system, some more "Alprazolam", one would opine.

On that note, if indeed we are back into a "macro" world when it comes to "trading" then, using the rights "macro" instruments such as synthetic credit indices and options on credit indices might provide mitigation to heightened volatility over the course of 2019 and sufficient liquidity if indeed there is a "liquidity shock" when the "Alprazolam" effect will truly fade.

• Final charts -  Mind the liquidity shock...

While as we pointed out like many pundits that "liquidity" is a concern given how credit markets have swollen in recent years thanks to buybacks supported by very large issuance levels, then looking at the CDS market as a proxy for risk ahead is again warranted as pointed out by Bank of America Merrill Lynch in their Credit Derivatives note from the 16th of January entitled "The basis for a correction" with the below chart pointing out to the underperformance of bonds relative to the CDS market:

"Macro data continue to disappoint; we remain cautious

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to the year for risk assets, we think that volatility will remain a key theme for another year. Large swings and lack of clarity underpin our bearish stance on spreads and beta in the following months; we continue to advise a defensive positioning. The deterioration in macro indicators will keep market sentiment fragile, in our view.

It feels like 2015-16

2018 is likely to be remembered as the worst year since the 2008 crisis. Performance was poor and funds suffered outflows. The performance over the past 12 months resembles that of 2015-16. However, this year started on a much more upbeat note than. 2016. Nonetheless, we are concerned that several factors are reminiscent of the drivers that pushed spreads wider in January and the early part of February 2016. A macro slowdown, lack of inflation in Europe and tightening conditions that risk assets were dealing with back then are still adversely affecting markets.

Gap risks and basis

We also think that CDS is too tight to cash bond spreads and negative basis is supportive for more downside risk in the synthetics space. The “gap” wider risk for the CDS market makes us less comfortable at current levels and, as we see fewer catalysts to reverse this market weakness we would use the recent move tighter as reason to reset shorts, especially by selling receivers to own payers. We also screen for negative basis opportunities.

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to this year, we think that volatility will remain a key theme in 2019 too. Large swings and lack of clarity underpin our stance to remain bearish spreads and beta in the coming months; we continue to advocate defensive positioning. We expect the deterioration of macro indicators to keep markets sentiment fragile, and until we see the cycle trough, we remain skeptical on how well higher risk/beta pockets will perform." - source Bank of America Merrill Lynch.

So enjoy "Alprazolam" effects while they last as we concluded in similar fashion our previous conversation. Remember that those taking more than 4 mg per day of Alprazolam have an increased potential for dependence. This medication may cause withdrawal symptoms upon abrupt withdrawal or rapid tapering, which in some cases have been known to cause seizures, as well as marked delirium.  The physical dependence and withdrawal syndrome of Alprazolam also add to its addictive nature. Alprazolam is one of the most commonly prescribed and misused benzodiazepines in the United States, benzodiazepines are recreationally the most frequently used pharmaceuticals due to their widespread availability. Alprazolam, along with other benzodiazepines, is often used with other recreational drugs such as QEs but we ramble again...

"A crust eaten in peace is better than a banquet partaken in anxiety." - Aesop

Stay tuned !

Macro and Credit - The Pollyanna principle

"Skepticism: the mark and even the pose of the educated mind." - John Dewey, American philosopher

While watching with interest the much more positive tone in credit markets in recent weeks, with the rally in High grade credit erasing in effect the losses for the year after having spent virtually the entire year in negative territory, we reminded ourselves for our chosen title analogy of the Pollyana principle. The Pollyanna principle, also called the positivity bias is a tendency for people to remember pleasant items more accurately than unpleasant ones. Research in psychology indicates that our mind tend to focus on the optimistic at the subconscious level while, at the conscious level, it has a tendency to focus on the negative. Our subconscious bias towards the positive is described as the Pollyanna principle and the name derives from 1913 novel Pollyanna by Eleanor H Porter. This novel describes a girl who plays the "glad game" (like the sell-side pundits) trying to find something to be glad about in every situation (oil prices lower, Fed's cautious stance, the ECB's generosity, etc.). The issue with the Pollyanna principle, such as with unabated liquidity injections by central banks is that researchers Margaret Matlin and David Stang provided substantial evidence that the more people expose themselves to positive stimuli and avoid negative stimuli, the longer they take to recognize what is unpleasant or threatening than what is pleasant and safe, and they report that they encounter positive stimuli more frequently than they actually do. Of course, any similarities with today's financial markets would be as the saying goes totally fortuitous.

In this week's conversation, we would like to reiterate our focus on NIRP in Japan and in particular the Japanese yen and flows, given as we posited in our previous conversation "The Monkey and banana problem", when it comes to "risky assets" yen matters more and more.

Synopsis:

• Macro and Credit - Japanese investors' life under NIRP
• Macro and Credit - In Europe, pricing is not the problem. Credit isn't growing.
• Final chart: Front-running Mrs Watanabe and the ECB

• Macro and Credit - Japanese investors' life under NIRP

While we pointed out in numerous conversations on our concerns on the Japanese yen in particular and Japanese flows from the Government Pension Investment Fund (GPIF) and his pension friends, we think, that from a global flow perspective and "risky assets" Japan matters and even more under Negative Interest Rate Policy (NIRP). 

More recently in our conversation "the Paradox of value", we indicated that courtesy of Bank of Japan's latest trick, US Investment Grade credit would benefit from increased allocation from Japanese large funds such as the sizable GPIF. Japanese investors are more likely to continue buying US Treasuries while as we have shown in our previous conversation NIRP has effectively "killed" the Japanese Money Market funds industry with all 11 Japanese asset managers closing their money market funds (MMF) and returning assets to investors,

Given the behavior of the Japanese long bonds discussed in our previous conversation, it is clear to us that the "carry" game played by "leveraged" players has gone into overdrive. This is particular clear to us in the USD/JPY basis and currency hedging costs as explained by Nomura in their report from the 22nd of March entitled "Key investor behaviour under negative policy rates":

"Impact of changes in USD/JPY basis and currency hedging costs

Currency basis swaps fell deeper into negative levels in reaction to the BOJ’s adoption of negative policy rates. This, coupled with a fall in JPY LIBOR since the BOJ rate cut, has raised basis swap costs for Japanese investors. As this coincided with a fall in UST yields, super-long JGBs looked more attractive than currency-hedged 10yr USTs at one point.

However, the current rise in UST yields and the drop in super-long JGB yields have made currency-hedged 10yr USTs look more attractive again. Investor stances should change depending on the relationship between super-long JGB and foreign bond yields after excluding the impact of currency-hedging costs.

As currency-hedged foreign bonds look less attractive than they did before (although they have become less expensive recently), investors may opt for markets with lower currency hedging costs (e.g., EUR over USD) and/or look to add risk exposure in their currency-hedged non-domestic credit investments, in our view.

- source Nomura

Indeed, not only have Japanese institutional increased their duration risk by buying longer-dated JGBs, they will as well most likely increase their credit risk exposure by raising aggressively their foreign investments we think. Therefore it is very likely that their interest in foreign corporate bonds will increase, in particular from the likes of lifers as indicated by Nomura in their report:

"Lifers may react to higher currency hedging costs by taking on foreign credit risk or increasing the weighting of unhedged foreign bonds
Lifers have continued to increase currency-hedged foreign bonds as an alternative to their yen bond investments, but currency-hedged foreign bonds do not look attractive as before due to higher currency hedging costs, particularly after the 29 January BOJ policy board meeting. Judging from cases in which currency hedging costs rose when the Fed was raising rates in 2004-2007, lifers could either take more credit risk overseas or increase the weighting of unhedged foreign bonds in their portfolios, in our view.

In February, lifers’ foreign bond investment was the highest level since April 2008 Currency-hedged foreign bonds look increasingly attractive now as super-long JGB yields fall. Lifers’ foreign bond investments reached JPY1,003.9bn in February, the highest level since April 2008 (no breakdown of whether they are hedged or unhedged, nor whether government and non-government bonds is available). We believe lifers’ demand for foreign bonds as an alternative investment to yen bonds, whose yields have fallen dramatically, may increase.
According to a Bloomberg report, one major lifer had no choice but to shift the focus of its bond investment to foreign bonds from yen bonds, and that it will raise the weighting of unhedged foreign bonds if the Fed continues with its rate hikes. Another insurer said it would increase the weighting of foreign bonds making up its investments as part of its effort to increase risk assets.

Its foreign bond investments are currently evenly divided between currency hedged and unhedged, but it is considering increasing hedged investments as JPY is currently strengthening.

Impact on pension funds

Corporate pensions have increased their weighting of foreign securities, investment trusts, cash and deposits and call loans under QQELooking at corporate pensions’ investment trends since the BOJ adopted QQE (April 2013), we find that they increased the weighting of foreign securities, investment trusts, cash and deposits and call loans while the weighting of JGBs in their portfolios has been almost unchanged or fell slightly.While they increased their weighting of risk assets such as foreign securities and investment trusts or alternative assets, they also seem to have increased the weighting cash (or cash equivalents).We believe the BOJ’s adoption of negative rates will make it more difficult for pension funds to hold cash and deposits and call loans, in our view. During the QE period from March 2001 and March 2006, the weighting of JGBs, cash and deposits, and call loans fell, while that of foreign securities and investment trusts rose. 

We will watch to see if they will further increase their investments in foreign securities and investment trusts." - source Nomura

We will as well track as well to see if indeed Japanese institutional investors do follow the Pollyanna principle and continue with their foreign investment binge (most likely).

As we pointed out in our previous conversation "The Monkey and banana problem", NIRP doesn't reduce the cost of capital. NIRP is a pure currency play:

"Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings and in similar fashion in Europe previously the focused had been on the strength of the Euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward. Once again we take our cue from chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis:

"Many credit hedge funds not only implement leveraged investment strategies but also leveraged funding strategies, primarily using the JPY as a cheap funding source. A weaker JPY accompanied by tighter spreads is the best of all worlds for a yen funded credit hedge fund. However, these funds should be more linked to the JPY than the USD. One impact is obviously that the favorable growth outlook in Euroland triggers a strong EUR and tighter spreads of European companies (which benefit the most from the improving economic environment). However, the diverging fit between EUR spreads, the USD and the JPY, respectively, underpins the argument that technical factors as well as structural developments dominate fundamental trends at least in certain periods of the cycle. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

On the subject of "carry" play and leveraged funding strategies primarily using the JPY as a cheap funding source, it does look that NIRP is providing such an opportunity as highlighted by the astute Christopher Wood from CLSA in his Greed and Fear note from the 24th of March 2016:

"GREED & fear heard this week that it is now possible to earn about a 100bp spread by swapping dollars into yen to take advantage of negative JGB yields. This probably explains why foreign buying of JGBs is rising. Foreigners have bought a net Y3.6tn worth of Japanese bonds so far this year, after buying a net Y7.6tn in 2015. But it has to be wondered quite where such a process will end. GREED & fear has no idea. But the consequences will certainly not be positive. Meanwhile, GREED & fear is grateful to a London-based colleague for pointing out the remarkable fact that the price of the 20-year JGB has risen by 12% in yen terms and 19% in US dollar terms so far this year." - source CLSA

So, if one thinks about the Japanese yen "carry leveraged community play" and the Pollyanna principle, it seems to us that the more investors expose themselves to this kind of "dangerous basis play", the longer they take to recognize what is unpleasant or threatening it can become.

One thing for sure, there is a clear relationship between the USD/JPY 5 year basis spread and US credit spreads as displayed in the below chart from Nomura Japan Navigator no. 662 report from the 21st of March:

"While negative policy rates have created distortions in the JGB market, they have prompted a shift of investor funds into other assets more than the previous policy did. Recently, investors have looked to currency-hedged foreign bonds as alternatives to JGBs, particularly euro area government bonds, which have low hedging costs, and US credit, which can cover hedging costs. We believe these investor flows are likely pushing bond yields lower and credit spreads narrower overseas."

 -source Nomura

If negative rates do support activity, it primarily works through the exchange rate, adding to the portfolio substitution into risky asset via the previously mentioned yen carry play and the Pollyanna principle we think.

And when it comes to NIRP, it does not work by reducing financing costs materially, providing a ‘price of money’ stimulus. This brings us to our second point, namely that lowering the price of capital in Europe is not sufficient to trigger credit growth.

• Macro and Credit - In Europe, pricing is not the problem. Credit isn't growing.

While many pundits have lauded Mario Draghi's latest efforts and effectively decided to play the "glad game", we think differently of the efficiency of the measures taken by "Le Chiffre". In no way the latest raft of measures is dealing with the bloated balance sheets of Italian banks plagued by rising and significant nonperforming loans (NPLs). Also, why many pundits have illustrated the success of the ECB supremo thanks to the fall in corporate lending prices. Credit is not growing enough to provide a sustainable growth exit path to the European project.

On this matter we read with interest Société Générale European Banks note from the 21st of March entitled "ECB - new hope, new danger":

"A dangerous step forwards

We are entering a new phase of ECB influence. The focus of support has switched from funding to underwriting. That is how the TLTRO2 should be read – Draghi is encouraging banks to move 40bps up the risk curve by subsidising this ‘first loss’. This starts to take ECB policy debate into the area where it can have the greatest impact: supporting front book and (more crucially) back book credit quality. It’s a step forwards, but the ECB could be opening up a dangerous new chapter of irrational lending.

The end of ever more negative rates

We believe that the most important step forward has been the realisation that we are realistically sitting at or near the ECB rate floor. This has quelled concerns that the ECB would just keep blindly pushing rates into unknowable sub-zero depths. The drag grows substantially the further we plunge and the longer we stay there. Ending this revenue risk is a positive. The ECB toolkit is focused elsewhere.

The start of the Draghi Donation

Everyone says that credit supply is abundant, and demand is the problem. We disagree – good quality borrowers can get credit, but supply is still weak to lower tiers of borrowers. SME credit rejection rates are still high in periphery Europe. Banks are still hesitant on writing new NPLs, and so seemingly strong credit supply is misleading. The TLTRO2 Draghi Donation of 40bps can help banks to move up the credit risk curve. We would be more positive if it was supported by co-ordinated efforts to clean up the existing NPL stock." - Société Générale.

Once again the ECB's ambition of restoring the credit transmission mechanism in Europe has been failing and will continue to fail because as we pointed out before, contrary to the Fed, it hasn't dealt with the "stocks" namely the NPLs still intoxicating many Southern European banks. While the ECB has provided cheap funding, to repeat ourselves, in no way the ECB has modified the credit profile of these ailing banking institutions. These assets have yet to be dealt with hence the risk of "japanification" given the time taken in dealing with these issues à la Japan. This is clearly illustrated in Société Générale's report:

"For all its sins, it is impossible to argue that the potent cocktail of negative rate policy and funding support brought no benefits. The ECB have been bent on improving the credit transmission mechanism, particularly in the European periphery. Over 2013, the European lending market clearly had a two-speed game: cheap funding for the corporate sector in the core, pricey funding in the periphery. This game was driven by the vast differences in funding availability and cost for banks.

Looking across Europe, it is clear that lower rates can help in a limited capacity. There are still categories of lending that look too expensive and are likely to strangle growth. SME lending in particular is more expensive the further south you travel.

Pricing is not the problem

The improvement in pricing masks an altogether deeper problem. Credit isn't growing. Regardless of the better pricing dynamic, it is somewhat meaningless if corporate credit demand remains too anemic to support sustained growth.
In terms of volumes, Europe still runs as a two-speed game. Household good, corporate bad. Core good, periphery bad.
When looking at the two charts below, keep in mind that the Draghi Donation kicks in at 2.5% lending growth for banks that are growing. On total eligible lending, that is equivalent to €150bn of new lending over the next two years. In reality, the requirement is lower, as some  banks are still shrinking. It does not make much of a dent in the c.€600bn of ‘lost’ corporate lending since 2009.

Looking at the detail, too many periphery banking markets are still in reverse. At the eurozone level, the trend is weak positive – with an overall recovery at 0.5pct YTD. This masks growth in Germany, France and the Netherlands, offset by more contraction in Spain and Italy. The three markets that have delevered the most remain in contraction:

The problem of the 'right' credit supply

The root of the growth problem is always put down to credit demand. The standard conclusion is that credit supply is vibrant, but the corporate sector just does not seem to need the money.

We believe this is the wrong conclusion. Credit supply is only fine for the highest quality credits. This is a subset of lending demand, and one that is already ably serviced by direct issuance. Indeed, with an extension of QE into IG corporate bonds, we believe this part of the corporate lending market will be even better supported.
Credit supply dries up when banks are asked to take on some credit risk. Particularly in the periphery, banks are groaning under the weight of soured loans. The incentive to avoid adding to this stock is more powerful than the need to grow.
While the data do show that bank lending prices are coming down, a more granular survey of actual SME opinions reveals a more difficult lending context. In the periphery, SMEs are still highly likely to find credit availability either non-existent or too expensive:

Rejection rates are high. For many SMEs, the demand for lending is there, but lending applications are either rejected (in whole or part) or offered at much less favourable terms and discouraged. As shown below, rejection rates are as high as 60% of applications in Greece and 30-35% in Spain and Italy. This compares to <15 blockquote="" core="" european="" in="" markets.="" the="">

The Draghi Donation – a credit risk subsidy

Funding has never been the issue for the European banking sector. Banks have been swimming in virtually free, virtually unlimited funding for months, and the impact on lending volumes has been stunted. The focus of the ECB has shifted from improving funding to finding ways to clear the backlog of credit quality issues and NPLs, particularly in the periphery.
Even with abundant funding, banks are hesitant on writing loans which will eventually sour, adding to the elevated stocks of NPLs.
This has been a much more consistent focus of ECB messaging in recent months. To quote Benoit Coeure:
“To reduce uncertainty, both policymakers and financial institutions need to play their part. They need to ensure that the financial system is fit for purpose and able to finance the recovery. And they need to do so today, not tomorrow.” ...“All the preconditions are now there to accelerate NPL resolution… The challenge now is to speed up the process of writing off and/or disposal. There are various policy measures that can facilitate this process.”

The 40bps is to subsidise credit risk, not funding

In this context, we view the 40bps ‘Draghi Donation’ as an incentive for banks to move up the risk curve, and extend lending to a broader group of corporate customers. The credit demand needs to follow, but banks at least need to be open to extending their new loan books outside the very top end of the credit risk spectrum.
We view the subsidy as 40bps of first loss underwriting by the ECB, rather than an attempt by the ECB to cut corporate lending pricing through the credit transmission mechanism." - source Société Générale

The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!

Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going  exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:

"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016

This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".

One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure...

• Final chart: Front-running Mrs Watanabe and the ECB

As discussed in our conversation the "the Paradox of value", it looked like the US investment grade market was the only game in town but given the significant tightening of credit spreads in recent weeks, it also means that not only Mrs Watanabe will be playing it into overdrive, but over investors as well will be having a field day as per our final chart from Bank of America Merrill Lynch Credit Derivatives Strategist note from the 23rd of March entitled "How to trade credit in an ECB driven world":

"Front-running” the ECB

We have seen it in the past. When the ECB announces a government bond buying program, inflows accelerate into the asset class. With the help of the ECB, credit flows have broken free from a long period of outflows. Last week’s positive inflow into high grade and high-yield funds was the third consecutive and the biggest in 53 weeks.

We draw some parallels between the government bond buying program and corporate buying program. In March 2014 (more here), as inflation expectations started to deteriorate, market begun pricing the possibility that the ECB should have had to resort to more unconventional policies. In the following year or so government bond funds have seen significant inflows, with investors “front-running” the ECB government bond purchasing program.
In late February this year, investors’ expectations of an expansion of the QE program into corporate bonds instigated a strong rebound for credit spreads and a revival of the primary market. So far in three weeks, credit funds – high-grade and high-yield combined – have seen almost $5bn of inflows." - source Bank of America Merrill Lynch

Applying the Pollyanna principle to credit market inflows, one could indeed expect the yield compression to continue further. It looks we have moved back to early 2007 thanks again to the Fed's dovish stance and the ECB's additional generosity in conjunction with Bank of Japan enticing more duration and more credit risk... 

"Anyone who has begun to think, places some portion of the world in jeopardy." -  John Dewey, American philosopher

Stay tuned!