Macro and Credit - The recurrence theorem

"Some things never change - there will be another crisis, and its impact will be felt by the financial markets." - Jamie Dimon

Looking at the elevated volatility in Emerging Markets in conjunction with continued outflows and pressure on the asset class, on the back of rising US yields and a strengthening US dollar marking the return of "Mack the Knife", with losses not limited to the currencies but with Emerging Markets Yields continuing surging throughout, when it came to selecting our title analogy we reacquainted ourselves with French mathematician Henri Poincaré's 1890 recurrence theorem building on the previous work of fellow mathematician Simeon Poisson. In mechanics, Poincaré recurrence theorem states that an initial state or configuration of a mechanical system, subjected to conserved forces, will reoccur again in the course of the time evolution of the system. The commonly used example to explain the theorem is that if one inserts a partition in a box, pumps out all the air molecules on one side, then opens the partition, the recurrence theorem states that if one waits long enough that all of the molecules will eventually recongregate in their original half of the box. The theorem is often found mixed up with the second law of thermodynamics to the effect that some will loosely argue that there exists a very small probability that an isolated system will reconfigure to a more ordered state (thus effecting an entropy decrease).The theorem is commonly discussed in the context of dynamical systems and statistical mechanics. When it comes to pressure and outflows, as we mused in our last conversation, one would argue that continued capital outflows pressure is contained until it isn't. 

In this week's conversation, we would like to look at the return of "Mack the Knife" in conjunction with rising oil prices and what it entails. 

Synopsis:

• Macro and Credit - US yields - It's getting real!
• Final chart - US core CPI tends to rise in the two years leading up to a recession

• Macro and Credit - US yields - It's getting real!

While US 10yr Real Yields are a key macro driver, the US dollar so far in 2018 has dramatically diverge from yields. "Mack the Knife" aka the King Dollar also known as the Greenback in conjunction with US real interest rates swinging in positive territory has recently put some pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation:

"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics

With the start of an unwind in global carry trade,  "Mack the Knife" aka King Dollar is making a murderous ballad on the EM tourists and carry players alike. Back in July 2015 in our conversation "Mack the Knife" we indicated the following as well:

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - source Macronomics, July 2015

The question for continued pressure on Emerging Markets when it comes to "Mack the Knife" is are we beginning to see a reconnect between the US dollar and yields? The jury is still out there. Rising Breakevens tend to be negative for the US dollar. Also what matters for US equities given they have remained relatively spared so far would be a meaningful widening in credit spreads. This would be accompanied of course by higher volatility.

Right now, as we pointed out last week, dispersion is the name of the game in both credit and Emerging Markets with the usual suspects and weaker players getting the proverbial trouncing as of late such as Turkey and Argentina. We also indicated recently that the continuous rise of volatility in Emerging Markets would lead to additional outflows given the Hedge Funds were the first to reduce their beta exposure. Some investors might follow suit and follow a similar pattern of "derisking" it seems. On the subject of continuous volatility on EM assets we read with interest Barclays take from their Emerging Markets Weekly note from the 17th of May entitled "Shaken and stirred":

"Volatility in EM assets remains elevated. As 10y UST yields have moved further above 3% and the USD has resumed its strengthening trend, total returns in EM assets have taken a further hit – which in turn continues to weigh on flows: YTD returns in EM credit and EM local markets now stand at -3.7% and -2.4%, respectively (Bloomberg Barclays USD EM Agg and EM local-ccy government bond indices), while EM dedicated bond and equity funds had their worst week of outflows last week since the volatility spike in February (see EM flows: Outflows materialize, 11 May 2018). Economic data has hardly helped to improve sentiment, with weaker European and Chinese activity data feeding concerns about weakening global growth momentum.

The market’s focus remains firmly on those countries with external vulnerabilities and financing needs, especially Turkey and Argentina. Even though current account balances can only provide a partial reflection of external positions and vulnerabilities, there has been an interestingly clear correlation between current account dynamics (changes, rather than levels) and asset performance both in EM credit (Figure 1) and local markets (Figure 2).

Although we have argued in the past that aggregate vulnerabilities have improved in EMs since the 2013 ‘taper tantrum’, they have deteriorated over the past year (see the EM Quarterly Outlook: The going gets tougher, 27 March 2018). Furthermore, the confluence of Fed balance sheet reduction, increased UST issuance, effect of US tax law changes on the repatriation of offshore USDs alongside a wider US CA deficit has implied a potentially more challenging capital flow environment for EM.

As the flow environment for financing in international markets has become more difficult, countries’ plans (or necessity) to tap primary markets have also been in the spotlight. While EM sovereign Eurobond supply has run at a record pace in January to April, recent issuance volumes have fallen short of expectations (including the recent Ghana and South Africa bond issues). We would interpret the latter point as a market positive, however. Given the frontloading of issuance in Q1, there are few countries with sizeable issuance needs for the remainder of 2018. Based on our updated supply expectations for individual countries shown in Figure 4, we now expect an additional USD 41bn of supply in 2018.

Given that c.USD104bn has been issued YTD already, this would result in 2018 full-year supply of USD155bn. In this context, we think there is an interesting divergence between Turkey and Argentina: Argentinean authorities have indicated that they do not want to issue any more in international markets in 2018. Remaining financing needs for this year are c.USD5bn on our estimates, which could potentially be covered by an initial disbursement of the requested IMF programme, or by local currency issuance. In contrast, Turkey’s fiscal measures (including this week’s announcement to reduce the special consumption tax on fuel products) will likely keep incentives to raise financing in international markets in place, even in a less receptive market.

Supply-redemption dynamics in EM credit are not the only silver lining for markets. While recent China data has been weak, we see signs of a shift in priorities towards growth, with deleveraging de-emphasised (see China: Softer FAI and retail sales; signs of pro-growth priority and trade tension de-escalation, 15 May 2018). This should in turn support commodities and while well-supported oil and commodity prices have not been able to prevent the sell-off in EM assets, they should at least provide some fertile ground for differentiation.

With regard to oil prices, Venezuela’s election on Sunday 20 May may be of particular importance (see The ship is taking on water, 15 May 2018). Even if President Maduro is reelected, against a backdrop of the main opposition parties boycotting the process and the government’s control over the electoral system, the vote could still be a catalyst for fractures within the regime. Meanwhile, Venezuela oil exports have been disrupted, amid legal action against PDVSA and a broader decline of oil production – one of the likely drivers of the recent increase in oil prices, in addition to US sanctions on Iran.

EM oil exporters naturally benefit from the surge in oil prices. In Iraq, however, this is overshadowed by uncertainties following last week’s legislative elections (and we recommend switching out of Iraq and into Angola and Gabon in our top trade recommendations this week). Full results are yet to be announced but the partial count indicates a clear defeat of current PM al-Abadi favouring cleric Muqtada al-Sadr who has called for the end of corruption and opposed both the US and Iran. The emergence of the Saeroun and Fateh coalition as winners would complicate political negotiations to form a coalition government and it is still unclear whether PM Abadi will be able to secure a second mandate. Ultimately, we believe coalition talks may be protracted, adding uncertainty to the outlook, also with respect to the IMF talks to finalise the third review under the three-year Stand-By Arrangement. The 2018 budget and transfers to the semi-independent region have represented contentious issues which could be exacerbated by negotiations between Kurdish political parties and Baghdad over government formation." - source Barclays

When it comes to "dispersion" we continue to view favorably Russian local bonds in that context, thanks to the support of oil prices on the ruble and central bank easing that will continue.  On the subject of "dispersion" and weaker players in the EM space, we read with interest UBS take from their EM Equity Strategy note from the 18th of May 2018 entitled "This is not a 'Crisis': It is Rising Yields + a Strong $":

"The central story here, in our view, is that the recent 'less friendly' global market environment has allowed investors to 'pick away' at some of the weaker EM stories, especially via FX (Figure 5 below), as the dollar has continued to rebound. These are the EMs that typically do well when the dollar is weak, as the 'carry trade' holds sway. In the face of recent dollar strength, the result has been significant localized EM FX weakness (Figure 6).

Further, several of these so-called 'weaker' markets have also faced idiosyncratic domestic concerns:

• Turkey (-25% in USD, year-to-date): fears over central bank independence, concerns around monetary policy, widening current account deficit;
• Brazil (+1.7%): weaker than expected economic recovery, uncertainty ahead of the October elections;
• India (-6.8%): higher oil prices and higher inflation with residual concerns over whether Prime Minister Modi's BJP will be re-elected in 2019;
• Indonesia (-16.7%): current account worries and a slow policy response by the Bank of Indonesia;
• The Philippines (-12.6%): domestic overheating.

To this list, we could add South Africa (-6.3% year-to-date, on a minor hangover from the euphoria of Ramaphosa's elevation to the presidency as the market begins to understand the substantial policy challenges ahead) and Mexico (also - 6.3%, as the July 1st 'first-past-the-post' Presidential election approaches with a shift to the left seeming almost inevitable now).

Further, the dramatic weakness of financial markets in Argentina in recent weeks has added to the sense of 'crisis' in emerging markets, even though technically (from an equity perspective) the country is still, for now anyway, in the MSCI Frontier index. MSCI Argentina is down just over 25% so far this year, almost entirely due to the plunge in the peso (from ARS/USD18.35 to 24.40), which has forced a double-digit rise in interest rates to 40%.

However, the major theme of this report is that, in our view, this is far from being an EM 'crisis'. Several EM equity markets continue to do well such as China, by far the biggest EM with a weight of over 31% in the EM benchmark (+5.1% year-to-date, aided by a resilient CNY, even as other EM currencies have fallen sharply), Taiwan (+2.2%), Russia (+4.1%, which has become a relative 'safe haven' again recently as Brent oil prices hover close to $80/bbl) and parts of the ASEAN and Andean regions, notably Colombia (+10.8%) and Peru (+7.7%).

As with the equity markets, the dramatic differences in currency performance across EM so far this year are very clear from Figure 6.

By de-composing the drivers of 2018 total returns in individual markets in Figure 7 below, we partly combine the results from the two previous charts. The blue bars below show the contributions of currency movements to total returns; these are significantly negative for many markets, especially Turkey, Brazil, Russia, India, Poland and the Philippines.

It is also notable how, for most markets, there has been a negative contribution to returns from the P/E ratio, showing the breadth of the de-rating of EM equities so far this year; Peru (given very strong earnings expansion) is a small but truly remarkable example. In the other direction, sharply lower earnings in Greece and Egypt have translated into a significant re-rating in both this year. For EM as a whole, decent earnings growth (+6%) has been fully offset by currency weakness and a lower P/E ratio to leave the 2018 total return close to zero.

'Correction Counter' Update: The Dollar Rears its Head

With the recent minor break of the early-February post-correction low for MSCI GEMs, we update our 'correction counter' from earlier in the year (Figure 8).

The interpretation of this data is more important than the actual figures themselves. In our February report, we noted that the fall in the EM Currency Proxy accounted for a smaller share (14%) of the early 2018 correction in EM equities than its average share (22%) in previous bull market corrections back to 2003. Therefore, one reason, in our view, why the early 2018 correction (-10.2%) was less severe than the average of previous 'bull market corrections' (-17.2%) was the lack of a major USD rally or, alternatively, the resilient behaviour of EM currencies.

This is no longer true, given that the recent action involves more FX weakness in EM, compared to the initial correction. The updated table shows that this FX factor now accounts for much more (28%) of the newly-defined correction (-10.8% to May 5th). Even more tellingly, after EM rallied to an interim peak in mid-March, MSCI GEMs is down 5.6% since then and, with the EM Currency Proxy down by 2.8% over this period, FX weakness has accounted for exactly half of the EM pullback over the past two months. The US dollar has 'reared its ugly head' for EM equities in recent weeks." - source UBS

There goes the murderous propensity of "Mack the Knife" on EM equities. In similar fashion to the recurrence theorem, the US dollar has indeed "reared its ugly" head and reoccurred again in the course of the time evolution of the "financial system" or, to some effect our macro reverse osmosis theory once again playing out as discussed in our recent ramblings. Add to the mix rising oil prices, and if oil stays above $80/bbl (Brent) this will clearly hurt growth in all major net oil importing countries. That's a given.

Moving back to the subject of US yields and real rates, we think they matter a lot for the direction of the US dollar. On this subject Nomura published a very interesting Rates Weekly note on the 18th of May entitled "Did UST sell-off awaken bond vigilantes?":

"10yr Treasuries break 3% with conviction

The 3% level on 10s has been frustrating to break through of late, having failed once in late April and again last week. However, as with all things related to three, the third time is usually a charm as 10yr USTs are now clearly on the other side of 3%.

All along through this process to higher rates we have sensed a great level of investor skepticism about how high rates could go and how long they would stay at higher levels. This is one reason why we are not overly concerned that spec accounts have a historical short in place. For once, as far as we can recall, specs are being proven right; so why cover now unless the economy and/or financial conditions unravel? The bigger risk we think is that those under-hedged and exposed to convexity start paying rates now.

Overall the market seems too dismissive of how high rates could go in this cycle. We think the Fed has conviction and may continue with its quarterly hikes until “something breaks.” Even then, the Fed might have a hard time throttling back if the real economy is doing well but the financial economy suffers a blow that results in lower valuations. Meanwhile, the perfect storm of more UST debt and less foreign buyers may lie ahead.

We explore some drivers that may impact our overall US rates views. Overall we expect duration dynamics to matter more now than the curve; meanwhile spreads and vols will likely have stronger correlations to higher rates and real rates could hold the key ahead.

Even if this sell-off takes a pause, we continue to see 10s moving towards our 3.25% target and are positioned paid on 5y5y US-IRS and in similar conditional expressions.

US rates views update: Still bearish but now real rates hold the directional key

Duration: 3%, besides being a nice round number, has been a hard nut to crack as the last time we crossed this level was during 2013, a year made famous by taper tantrum. For us, a move beyond 3% was always the next logical step as the Fed is hiking rates and shrinking the B/S during a period of decent growth and more UST supply.

The 3% nominal level seems to be all the focus, but in actuality the next big step for US rates is what happens with real rates. Fig. 1 highlights a few regimes for the 10yr real rate vs the real Fed Funds rate (see note for calculation).

Real rates were in a tight range during the last cycle as well, it was only once the Fed was mid-way through its hiking campaign that market real rates began to rise. The past ten years of financial repression (driven by the Fed’s QE and then Global QE) has kept 10yr real rates in a tight range. Just like the 10yr UST was held captive by the taper-tantrum high of 3%, 10yr TIPS have been unable to break and stay above 0.90-1.00% levels. We believe the Fed is on track to deliver many multiple hikes (which could drive real rates higher in the process too).

3%, well specifically the 3.05%, has been a technical level on which markets seem to have been obsessed with. The market cleared that level for the first time on Tuesday this past week and intra-week the 10yr hit an intra-day high of 3.12% before settling into the end of the week around 3.07%. We usually refrain from being super technical, with both what these levels mean and we do not like to be handicapped by chart formations; however markets often pay attention to these wrinkles. Fig. 2 shows that 10s once again broke out of the range and this time term premia is also rising with the move too.

Net net, we believe it will take a serious breakdown in all the trade talks, geopolitical tensions and/or economic data to weaken (where instead our economists are projecting stronger growth and higher inflation ahead) for 10s to start a massive rally now. It is also interesting to see that stocks, although down on the day 10s broke 3%, took it in stride. In Fig. 3 we list the top 3 two-day yield changes in 2018 vs the S&P500 reaction. If stocks do not correct meaningfully, the full UST yield curve should rise as Fed hikes.

Curve: Earlier in the year we opportunistically traded the curve before going neutral on curve spreads in late Q1 (after the last micro-steepening). Recently the sell-off has also coincided with some bear-steepening. We think this is a healthy development that serves as a reminder that the curve is not pre-destined to fully flatten in this cycle, at least not at these yield levels. The Fed is raising rates but also shrinking its bond holdings, at a time when US fiscal stimulus is resulting in a spike in govie issuance. The curve never fully flattened in Japan during its low rate experience (Fig 4).

We argue that we need a higher overall level of rates (and many more Fed hikes) before we go fully flat too.

Spreads: 10yr swap spreads have begun to see a stronger correlation with the level of 10yr USTs in the current cycle, especially since last September (Fig. 5).

In past hiking cycles, 10yr spreads tended to have a positive slope relative to 10yr UST yields. We expect this correlation to be maintained, similar to the dynamics at the end of the ’04-06 cycle. Also with higher yields, 10yr spreads are more likely to widen due to convexity hedging activities from mortgages portfolios. Less need for corporate issuance due to overseas dollar repatriation would also reduce the tightening pressure on belly spreads." - source Nomura

The continued pressure on EMs can only abate if the US dollar finally mark a pause in its recent surge. A toned down trade war rhetoric would obviously continue to be supportive of a rising dollar and support stronger US growth in the process. The trajectory of the US dollar when it comes to the recurrence theorem for EM is essential. Morgan Stanley in their EM Mid-Year Outlook published on the 18th of May reminded us in the below four graphs what to look for when assessing the US dollar in terms of being bearish (their take) or bullish:

"Why USD Is in a Long-Term Bear Market

 - source Haver Analytics, Bloomberg, Macrobond, Morgan Stanley Research

With mid-term elections coming soon in the US, it is clear to US that the administration would not like to rock the boat and therefore would favor "boosting" the US growth narrative. This would entail further gain on both US yields and the US dollar in the near term we think. 

Also of interest when it comes to growth outlook, UBS made an important point in their EM Economic Perspectives note of the 17th of May entitled "EM by the Numbers: Where is EM's growth premium over DM?":

"EM growth spread over DM has fallen close to its lowest decile since 2001

Strong Chinese growth and low US inflation strongly supported EM asset markets over the last two years. But the growth levers have slowly been shifting in the background. Having registered a cycle high in early 2017, EM growth has moderated sequentially since, while DM growth has picked up. The levels were strong enough in both to keep the market uninterested as to how far EM growth was above DM growth. Now, however, sequential EM growth has slowed to 20th percentile of its distribution since 2001, and, more importantly, the premium of EM growth over DM has shrunk to the bottom decile of its historical distribution.

The spread between EM and DM is an important input in the call of relative stock market returns in the two regions. In y/y terms, this spread is now at 15th percentile of its distribution since 2001. In q/q terms this spread has shrunk to the sixth percentile of its historical distribution." - source UBS

Whereas EM equities clearly outperformed DM in 2017, it might be that 2018 could make the reverse with DM outperforming. Reduced carry has obviously been a headwind for EM equities as discussed above. If the US dollar strength can persist then indeed, US equities will continue to outperform EM equities on a relative basis we think.

For our final chart, as we posited in numerous conversation, we have often repeated that for a bear market to materialize, you would need an "inflation" spike as a trigger. 

• Final chart - US core CPI tends to rise in the two years leading up to a recession

Positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, higher inflation will coincide with lower growth, therefore bonds will not be a good hedge for an equity portfolio. As we pointed out in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this the biggest near term concern of markets right now we think. Our final chart comes from CITI Emerging Markets Strategy Weekly note from the 17th of May entitled "Fragile 5 now down to Fragile 2" and shows that US core CPI tends to rise in the two years leading up to a recession:

"US rates with more upside. 

After US CPI release last week we had wondered whether or not the EUR was in a bottoming process. While it had been trading better for a few days, the move higher in US rates has led to renewed USD strength. To be clear, we have been expecting higher US rates based on our belief in late-cycle behavior. Figure 4 shows that core inflation typically rises by 50bp in the last two years of an expansion.

Over the same two-year period, 10-year US Treasury yields tend to go up in the first year before retreating as rate cuts get priced by the market. Higher yields are therefore not surprising to us." - source CITI

If indeed a rising US Core CPI is a leading US recession indicator then again, we would have another demonstration of the recurrence theorem one could argue...

"Any idiot can face a crisis - it's day to day living that wears you out." -  Anton Chekhov

Stay tuned!

Macro and Credit - The Roots of Coincidence

"Coincidence is God's way of remaining anonymous." -  Albert Einstein

Watching the unabated inflows into Investment Grade funds, the 44th in a row, with pundits reaching for quality yield other quantity (High Yield), hence our "Great Rotation" narrative, when it came to selecting our title analogy we reminded ourselves of the 1972 book "The Roots of Coincidence" by Arthur Koestler. In his introductory book to parapsychology, including extrasensory and psychokinesis, Koestler postulates links between modern physics and their interaction with time and paranormal phenomena. His book was influenced by the work of Carl Jung and the concept of "synchronicity" which on a side note gave the title of the fifth and final studio album of English rock band the Police, the band's most successful release (the album Ghost in the Machine was also inspired by another Koestler's book). In his book, Koestler claims that paranormal events could be explained by theoretical physics. According to him, distinct types of coincidence are linked to serendipity aka "luck". You might be wondering already where we are going with this but we find it rather surreal to read the following essay by the New York Fed entitled "The Low Volatility Puzzle: Are Investors Complacent?" on the 13th of November in which the authors discuss the low volatility conundrum without a single time indicating the reason number one of the low volatility regime, namely their main employer and their buddies in other central banks being the main culprits in price manipulation on a grand scale. Overall this is akin to a circular reference pushed towards paroxysm we think, only for them to come to the conclusion in their paper that maybe central banks are responsible, maybe they are not hence our "Roots of Coincidence reference. No offense to the authors of the above Fed of New-York article but the low volatility regime is not a "paranormal phenomena" and the "Roots of Coincidence" has been the action of the central banks acting in "synchronicity". Whenever you have the S&P falling by 1% it seems you immediately get a Fed board member reassuring investors about the "free put" offered to them. The situation is similar in Europe and even worse in Japan where the Bank of Japan (BOJ) has become shareholder "numero uno" of many Japanese large caps via their ETFs guzzling. Maybe we are indeed not that intelligent and we don't really "get it", but when we read articles such as these, we are starting to question ourselves about the sanity of our central planners but we ramble again...

In this week's conversation, we would like to look at "roots of coincidence" in the ongoing "Goldilocks" given observable market conundrums that makes this current low volatility regime "paranormal" and therefore unsustainable.

Synopsis:

• Macro and Credit - The incidence of  central banks' "coincidences"
• Final chart -  Cracks in the credit narrative - are we there yet?

• Macro and Credit - The incidence of  central banks' "coincidences"

Last week we rebuked the "Minsky" moment in the High Yield market but, we did indicate we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. Yet the "roots of coincidence" have solely been based on central banks intervention in "price manipulation" leading to acute financial volatility repression and severe distortions. There is not a single day when there isn't the usual "permabear" pointing out to the severity of the distortion as we wait for that famous "Minsky" moment. To repeat ourselves, in our book, the match that will light the bear market narrative will simply be a significant rise in inflation expectations. We are not there yet. We don't pretend to have extrasensory  powers but we do believe that 2018 could mark the end of Goldilocks and lead to a significant rise in volatility, and we are particularly cautious for the second part of 2018, at least that's what our credit antennas are telling us but we digress. We have continuously been beating the credit drums about switching from quantity (High Yield) towards quality (Investment Grade). We continue to believe that when it comes to credit risk premia when it comes to European High Yield, we think that now there are more risks than rewards (Altice and their SFR woes being a case for caution), particularly when one looks at the flattening of the US Yield curve. Duration wise we'd rather own 5 year US Treasury Notes than an equivalent 5 year European High Yield fund or ETF. Sure, some pundits would probably like to point us towards convexity risk in Investment Grade, at least in the US you have somewhat more of an interest rate buffer than Europe (Veolia latest three year issue at negative yield anyone?). Also we started the year being US Dollar bears, and our contrarian stance has been validated so far regardless of the recent dead cat bounce. We continue to see headwinds for the US dollar even with tax cuts kicking in. This means that we would rather favor EM equities still over US equities in 2018. 

To add more fuel to the "roots of coincidence" relating to the overall complacency in volatility we read with interest Société Générale's take from the Multi Asset Portfolio note from the 28th of November entitled "Be ready for the end of Goldilocks":

"Low volatility and liquidity withdrawal are key concerns

In a goldilocks scenario of low interest rates, abundant liquidity, stable growth and a focus on the “positive” Trump, investors continue to push asset prices, volatility and leverage to historical extremes. Yet, a low volatility carry environment with rather extreme positioning is a dangerous combination, which we recently likened to dancing on the rim of a volcano. 

Volatility remains low across asset classes, on the verge of further monetary policy normalisation

It is true that volatility is relatively expensive for some asset classes, as realised volatility is now lower than implied volatility. But overall, we still observe low volatility across asset classes. With asset prices reaching record high levels, and pushing volatility down, we as investors run the risk of reliving the parable of the boiling frog: the gradual heating is so comfortable that the frog does not perceive the danger and ends up cooked. It seems that markets for now are unwilling or unable to perceive the gathering threats.

We don’t believe that it is sustainable. Additional rate hikes from the Fed over the next two years in order to reach the 2.8% neutral rate should start putting pressure on the VIX, as has been the case historically, with contagion effects across asset classes.

Liquidity withdrawal will be the main story next year – switch from equities to bonds

Growth in both developed and emerging markets will continue to creep gradually higher, with the US setting the tempo but likely reaching a peak sometime during the course of next year. In this context, we expect the main central banks to further reduce the size of their balance sheets. A direct consequence will be liquidity withdrawal from the financial system, which will put upward pressure on sovereign bonds yields, especially at the back end of the curve through some normalisation of abnormally low term premium. We prefer sovereign bonds to equity, especially in the US.

Indeed, the last 50 years have been characterised by the secular downward trend in developed markets sovereign bond yields, exacerbated by the post-crisis waves of QE. The equity space benefited significantly from the lower interest rate environment, which pushed index prices up, and from the add-on from dividends in a recovering economy while investors searched for yield. Low bond yields pushed investors into riskier asset classes to enhance returns.

Going forward, as UST yields normalise, especially at the back end of the curve (we see 10y USTs reaching 2.80% by 3Q18), the competitive advantage of US equities will start to fade.

Positioning is stretched

Another sign of complacency can be found in positioning. Having a closer look at hedge funds’ net positioning across 24 assets, we try to understand throughout the years – in January of each year – the percentage of assets with extreme positioning. We define extreme positioning as a net position level higher or lower than one standard deviation away from the historical average.

The chart on the following page shows that in January 2017, 54% of hedge funds’ net positioning on the pool of assets under review can be considered extreme (currently at 54.2%). The main culprits are: VIX, as being short VIX future volatility has delivered tremendous return since 2016; US 5y, reflecting the anticipation of further Fed hikes and improved fundamentals; crude oil; and copper. The last time positioning was stretched on such a similar share of the assets under review happened to be in January 2007, or a few months before the global financial crisis.

Low correlation within assets can exacerbate a sell off

The low level of correlation within assets is also worrying in our view. For now, as mentioned previously, the goldilocks environment – lukewarm growth and contained inflation expectations – favours the expression of idiosyncratic risks or fundamentals versus big macro drivers. The average cross asset correlation has been on a downward trend, while the average equity correlation is reaching 20%, near its lows.

The low correlation is good as of now, as it brings some diversification benefit within a multi-asset portfolio – for example, the decorrelation between EM and global equity markets observed last quarter persists and partly justifies our 7% allocation within the multi-asset portfolio, alongside the supportive growth, yield and US dollar outlooks. However, it also gives a false sense of security, as the correlation regime can quickly reverse in case of risk-off events in the markets and exacerbate a market sell-off." - source Société Générale

When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward. 

As we move towards 2018, the big question on everyone's mind should be the sustainability of the low volatility regime which has been feeding the carry trade and the fuel for the beta game. The "Roots of Coincidence" thanks to our central bankers has led to some markets conundrums as highlighted by Deutsche Bank in their Global Financial Strategy note from the 28th of November entitled "Markets upsets: Rationally explaining five conundrums":

"Five market conundrums

Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)

90% or more of Japanese stock movements through August were explainable via a multiple regression model using US stock prices and forex. Forex movements could mostly be explained by US interest-rate movements.

Since Japan's 22 October Lower House elections, Japanese stocks including financials have diverged upward from our approximation model (see our 7 November Global Financial Strategy, “Rates declining after Lower House election; share prices remain high”). Japanese stocks fell sharply following the 9 November volatility shock, and by 15 November had returned to near our approximation model (Figures 3).

At that point, we noted that the focus was on whether stocks would revert to the trend implied by our model or diverge again (see our 16 November report, “Back to normal? Japanese equities return to model after volatility shock”). Recently volatility decreased, and stocks have begun to diverge upward from our model again.

Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)

Japan and US stock prices continue to rise. This reflects the impact of (1) fundamentals, in the form of strong Jul-Sep results announcements, and (2) a rise in P/E amid the Goldilocks market conditions created by low interest rates and USD weakness.

Obviously, share prices are equivalent to EPS x P/E, and the inverse of P/E is earnings yield. As shown in Figures 7, the earnings yield in Japan, the US, and Europe can mostly be explained by the term premium observed in bond-market (the yield premium for long-term bonds due to price fluctuation and illiquidity risk) and the risk neutral rate (average forecast short-term interest rate over the next 10 years).

A one standard deviation decline in term premium causes stock prices to rise 2.5% in the US, 1% in Europe, and 5% in Japan. A one standard deviation increase in forecast short-term rate results in increases of 2%, 2.75%, and 7.8%. The recent decline in term premiums have led to a rise in P/E via a decline in risk-free rate and equity risk premium.

Question 3: Ongoing yield-curve flattening

Flattening European and US yield curves are a source of frustration for investors who had forecast steepening. Fed fund rate hikes amid structurally low interest rate conditions have (1) raised the average forecast short-term rate, but (2) have conversely lowered the term premium (Figure 11).

Dominic Konstam from our Rates Strategy team estimates 2.25% as the fair end-2017 level for 10y yield.

Francis Yared from our Rates Strategy team sees US tax reforms as the main driver over the next 2-3 months. Our base scenario is for the passage of a mid-sized tax cut (increasing the fiscal deficit by $1.5trn) in early 2018. We expect long-term rates to rise due to the above factor and above-trend US economic growth. Matthew Luzetti from our US Economics research team estimates a neutral real short-term rate (neutral for economy) of 0.3% and a neutral real 10-year rate of around 1.5% (Figure 13).

If we assume the Fed achieves its 2% inflation target, this would imply a neutral nominal 10-year rate of around 3.5%, suggesting ample room for long-term rates to rise.

Peter Hooper from our US Economics research team, does not expect the change in Fed Chair to have a significant impact on monetary policy. Chair-designate Powell is likely to be strongly opposed to the Taylor Rule or other limitations on Fed behavior. Powell lacks the specialist economic and monetary policy knowledge of previous Fed Chairs, but has front-line financial and capital market experience. He may also be more receptive to arguments about a structural decline in inflation than Chair Yellen. However, it is unclear whether he would continue to support an approach that combines a regulatory and supervisory response to monetary disequilibrium (excessive risk-taking) and monetary policy to optimize inflation and employment. Also, his biggest point of difference with Yellen is likely his stance on deregulation for largest banks.

Question 4: Ongoing decline in interest-rate and stock-price volatility

As shown in Figure 17, interest rate and stock-price volatility are both at all-time lows.

In Figures 15-16, US interest-rate volatility is approximated using (1) the percentage of MBS held by general investors (other than the Fed or banks), (2) neutral interest rate minus real Fed funds rate, (3) net inflows to bond funds minus net inflow to stock fund, and (4) repo positions on dealers versus debt securities outstanding.

In our view, this model suggests that the fall in interest-rate volatility was led by (1) a decline in general investors' ratio of MBS holdings (they tend to buy volatility to hedge convexity risk), (2) a narrowing gap between the neutral interest rate and real Fed funds rate (which implies the required level of rate hikes; a contraction reduces future interest-rate policy uncertainty), and (3) fund inflows to bond funds (signifying expansion in bond index funds due to a graying population seeking stable income). Conversely, the decline in (4) due to tighter regulation should act to increase volatility.

In the stock market, we think a structural decline in volatility has resulted from (A) an increase in investors adopting a volatility targeting strategy (following volatility trends), (B) an increase in hedge funds and individual investors seeking option premiums and capital gains from selling volatility (shorting VIX or selling various option types) (Figure 19), (C) the shift of capital from active to passive funds (including AI funds), and (D) an increase in minimum variance investing as an alternative to bonds.

While we recognize the structural factors that are depressing volatility, we are also concerned about the risk of a sudden spike. We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility (Figure 17).

There is possibility of greater volatility amplitude than in the past because of the participation of less-experienced retail investors in addition to traditional volatility selling entities of hedge funds.

Question 5: Ongoing tightening in credit spreads

Since late October, widening corporate bond and CDS credit spreads (Figures 28-29) have been a subject of market debate. This trend has recently receded due to an excess liquidity and investors' search for yield.

The default rate (Figure 30) clearly shows that the corporate credit cycle reversed.

The recovery in energy prices and stiffer competition for bank lending (relaxed lending conditions) are supporting a turnaround in bad corporate loans and credit costs. The SLOOS data released on 6 November showed that banks' lending stance has eased (Figures 33-35).

Nevertheless, corporate debt levels remain high. There are signs in areas such as subprime auto loans, credit-card loans, and CRE (commercial real estate collateral) loans that credit and economic growth may be nearing an end."  -source Deutsche Bank

While financial conditions remain loose as indicated by Deutsche Bank, the hiking path of the Fed is the "Roots of Coincidence" in the start of some tightening of some lending standards. The question in relation to the change of the narrative is how long until the Fed breaks something? We wonder. Also, there is a heightened probability that the Fed finds itself once more behind the curve should renewed inflationary expectations materialize in 2018. It's not only the Fed which is in a bind of its own, the ECB should be worried from the heat coming from Germany and it's not only in real estate...

Credit wise for 2018 low spreads means potential negative excess returns in 2018 at least for European High Yield, making it particularly vulnerable to exogenous factors of the geopolitical type. There is no "Roots of Coincidence" once you reach the lower bound in credit spreads in the "beta" game, yet rising dispersion means better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018 and the need to reach for your LBO screener to avoid potential sucker punches in the form of sudden credit spreads blowing out in your face. As we pointed out in our previous conversation, dispersion is indicative of the lateness in the credit cycle and the beta game, and it means, as we posited that active managers should outperform in 2018. This is also indicated by Société Générale in their Credit Strategy Outlook for 2018 published on the 28th of November and entitled "The sword of Damocles unsheathed":

"Markets follow a predictable pattern in the relationship between dispersion (alpha risk) and direction (beta risk) as summed up Table 8 below.

We see dispersion rising in 1H 2018. At the beginning, this dispersion is not likely to drive spreads wider as a whole, but soon the market will go from phase 2 to Phase 3, with higher dispersion pulling spreads as a whole wider too." - source Société Générale.

There is no "Roots of Coincidence" there, dispersion as we posited last week is indicative of credit cracks in the narrative.

For our final chart, one might wonder what would be a better leading indicator to rising problems in credit markets.

• Final chart -  Cracks in the credit narrative - are we there yet?

So you have tightening credit standards for some segments of US consumer credit, while overall financial conditions remain loose, yet rising dispersion in conjunction with negative basis are a sign that some cracks are starting to show up in the credit narrative making many investor pundits wondering what would be a useful indicator for spotting additional problems coming up. Our final chart is from Société Générale Market Wrap-up note from the 27th of November entitled "The one leverage ratio that tells you when spreads will widen" and displays balance sheet leverage figures as an indicator of rising problems in credit markets:

"While focusing on EBITDA is useful, there is a better leading indicator for problems in credit markets – balance sheet leverage figures such as debt/equity or debt/assets. Chart 5 shows the non-financial debt/assets ratio in the US relative to spreads: the average ratio weighted by the market cap of the debt is shown in blue, the median ratio is shown in brown, and US corporate spreads using the Moody’s series are shown in grey.

"The high levels of leverage in 1999 on a weighted average basis preceded the spread widening in 2001-2002. The rise in leverage from 2005-2007 was a warning ahead of the credit sell-off of 2008. Since 2013, balance sheet leverage has been widening and has continued to rise despite the 2015 spread widening (which has now been fully reversed). Credit investors should focus on this leverage ratio when considering how markets will perform in 2018." - source Société Générale

There you go, no offense to the musings of the New-York Fed and their paranormal questioning relative to the low volatility regime issue, the credit mouse trap has been set by our central planners and they are indeed at the "Roots" of the everything has a low volatility "coincidence". We don't need extrasensory and psychokinesis powers to determine the main culprit we think but we are rambling and ranting again it seems...

"The worst possible turn can not be programmed. It is caused by coincidence." -  Friedrich Durrenmatt

Stay tuned !

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

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

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

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

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

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

Synopsis:

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

• Macro - Low inflation? Blame the Fed 

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

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

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

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

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

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

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

Over-inflation of asset prices but too low inflation

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

What flattened the Phillips curve? The Fed.

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

Not enough attention given to inflation

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

Too ready to talk about hikes too early

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

The Fed has hurt inflation expectations

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

Fed driving expectations

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

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

Taper tantrum drove down price expectations

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

Fed failed to grasp import of taper tantrum

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

Fed paid too little heed to 2015 financial conditions

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

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

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

Fed had to press market to price in Dec 2016 hike

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

Hikes caused inflation expectations to fall further

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

 Difficult to see what can stop a December 2017 hike

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

Too late to avoid a policy mistake?

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

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

- source Deutsche Bank

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

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

"Perceived limits on fiscal policy increase pressure on monetary policy

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

Central banks must tighten aggressively when loan demand picks up 

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

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

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

"The death of the snake...

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

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

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

Reflexivity in the Shadow of Black Monday 1987

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

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

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

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

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

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

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

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

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

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

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

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

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

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

"How it ends?

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

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

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

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

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

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

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

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

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

• Final chart - Senior officer loan survey leads default rates

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

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

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

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

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

Stay tuned!