Macro and Credit - Easy Come, Easy Go

"There are many harsh lessons to be learned from the gambling experience, but the harshest one of all is the difference between having Fun and being Smart." - Hunter S. Thompson

Looking at the return of the "D" trade, "D" for "Deflation" that is with the return of the strong "bid" for bonds, marking the return of the duration trade on the back of "goldilocks" for "Investment Grade" which we foresaw, pushing more inflows into fixed income relative to equities, when it came to selecting our title analogy, we decided to go for a cinematic analogy "Easy Come, Easy Go". It is a 1947 movie directed by John Farrow, who won the Academy Award for Best Writing/Best Screenplay for Around the World in Eighty Days and in 1942, and was nominated as Best Director for Wake Island. "Easy Come, Easy Go" is the story about Martin Donovan, a compulsive gambler. His gambling habits leave him constantly broke and under arrest from a gambling-house raid. He places bets as well for the tenants of his boardinghouse, who lose their money and ability to pay the rent. Martin, came upon a sunken treasure but his philosophy is "easy come, easy go," promptly squanders all the loot. Looking at the various iterations of QE and the return to more dovishness from central bankers around the world, which lead no doubt to rise of so called "populism" with the asset owners having a field day, particularly the renters through the bond markets, over "Main Street", it is clear to us that the "treasured" support provided by central bankers to politicians has been all but "squandered". For example, French politicians have done meaningless structural reforms leading to unsustainable taxation creating the rise of the "yellow jackets" movement hence our pre-revolutionary stance. As we say in France, c'est la vie.  As in the move, with Martin's daughter Connie not knowing what else to do, she tries to solve her dad's debts by taking bets on a horse race. In similar fashion, central bankers have decided to add more dovishness on more debt, resulting in even more debt being created. Caveat creditor but we ramble again...

In this week's conversation, we would like to look at the return of Bondzilla the NIRP monster made in Japan given Japan's Government Pension Investment Fund GPIF is likely to come back strongly to the Fixed Income party.

Synopsis:

• Macro and Credit -  Once again the money is flowing "uphill" where all the "fun" is namely the bond market.
• Final charts - The deflation play is back in town

• Macro and Credit -  Once again the money is flowing "uphill" where all the "fun" is namely the bond market.

In our most recent conversation we pointed out again that we advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. To repeat ourselves, we continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength. You have to become much more selective we think in the issuer profile selection process.

"Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan" as we pointed out again in our most recent conversation. We also indicated as well:

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective.

Not only Japanese Lifers have a strong appetite for US credit, but retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years so watch also that space.

For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk. " - source Macronomics, March 2019

"Bondzilla" the NIRP monster should not be underestimated in our macro allocation book. On this particular point we read with interest Nomura's FX Insights note from the 29th of March entitled "GPIF: sustained aggressive foreign buying more likely":

"Annual plan for new FY unveiled

The Government Pension Investment Fund’s (GPIF) annual plan for the new fiscal year suggests the fund can manage its portfolio more flexibly. This should allow the fund to continue purchasing foreign bonds aggressively, while reducing exposure to negative yielding domestic bonds. This shift is also likely to lead a higher share of foreign bonds in the updated target portfolio, which will be announced by end-March 2020. Given the significant size of the GPIF’s AUM, this flexible stance will be crucial for Japan’s financial market and yen-crosses. We expect pension funds’ foreign bond purchases to support yen-crosses during the new fiscal year.

The GPIF announced its annual plan for the new fiscal year. In the annual plan, the GPIF noted that it will manage its portfolio according to the basic portfolio, as usual. However, the GPIF added two important points for its portfolio strategy in the new fiscal year, in relation to the allowable range of the target portfolio.

First, the GPIF repeated that automatically reinvesting redemptions from exposure to domestic bonds may not be appropriate in the current market environment. Thus, for now, the fund will manage its domestic bond portfolio more flexibly in relation to the allowable range. The fund will maintain the total amount of domestic bonds and cash within the allowable range of domestic bonds (25-45%). The GPIF has already announced the temporary deviation in domestic bond exposures from the allowable range last September and thus, this point is not entirely new (see “Equity flows supporting yen-crosses”, 26 September 2018). However, flexibility has now been extended into the new fiscal year that commences next week, and the fund can continue to reduce exposure to domestic bonds for a longer amount of time.

Second, the GPIF added a new sentence, stating: “the fund will examine the application of allowable range for asset classes as necessary, as the fund is formulating its new target portfolio (Figure 1).

In April 2014, the GPIF stated that it would flexibly manage its portfolio in relation to the allowance rage, as it started reviewing its target portfolio for the next medium-term plan (see “GPIF: Time for whale-watching”, 4 December 2018). Owing to the increased flexibility, the fund could begin investing in equities and foreign bonds before it announced the new target portfolio in October 2014. Although the communique this year differs from five years ago, this additional comment could provide the fund with more opportunity to manage the portfolio more flexibly in the new fiscal year.

We think these statements are significant for Japan’s financial market and yen-crosses this year. As of end-December, the share of domestic bonds had declined to 28.2%, closer to the lower bound of the current allowable range (25%, Figure 2).

In contrast, the share of foreign bonds increased to 17.4%, closer to the upper range of the current allowable range (19%). The fund has recently been purchasing foreign bonds aggressively, as it likely judges negative-yielding domestic bonds as unattractive (Figure 3). Historically, the pace of foreign bond purchases in Q4 last year was at the highest pace (see “Three important JPY flow stories”, 1 March 2019). Without the two additional points above, the GPIF would need to start liquidating foreign bonds, while accumulating exposures to domestic bonds again.

However, as the fund can manage its portfolio more flexibly in the new fiscal year, it should be able to continue purchasing foreign bonds, even if the share exceeds the upper limit (19%).

As the BOJ’s negative rate policy will be extended further, in our view, we think it would be reasonable for the GPIF to continue reducing the fund’s exposure to domestic bonds, while shifting into foreign bonds. At the moment, both domestic and foreign equity shares central of the GPIF’s target portfolio are at 25%, but the central target for foreign bonds is just 15%. Thus, there is room for the fund to further shift from domestic bonds into foreign bonds.

The GPIF will release its new basic portfolio by end-March 2020, while the announcement could take place by end-2019. We see a strong probability that the GPIF would raise the share of foreign bonds then, and its flow could lead to JPY selling.

As of end-December, total AUM managed by the GPIF was at JPY151.4trn (USD1.4trn), and 5% portfolio shift into foreign bonds could generate JPY7.6trn (USD65-70bn) of JPY selling.
In comparison with 2014, market interest in the GPIF portfolio change seems much lower (Figure 4).

Nonetheless, we believe the annual plan released today shows the fund’s investment in foreign bonds will remain significant this year, and the diversification should support cross-yens well (Figure 5).

- source Nomura

So, from an allocation perspective, you probably want to "front run" the GPIF and its lifers friend, given they play "Easy come, Easy Go" particularly well in adding US dollar credit exposure we think.

When it comes to flows, and all the "fun" going into the bond market, it is already happening as per Bank of America Merrill Lynch's note from the 29th of March entitled "Bonds over stocks":

"Dovish central banks revive the bond market

As global central banks continue on their dovish path, more money is flowing into credit and fixed income funds more broadly.

It feels that this trend is here to stay amid low inflation and lack of growth in Europe, and continued political headwinds (Brexit, trade wars). As macroeconomic data trends are bottoming out and central banks continue to remain dovish, we think that credit gap wider risks are limited.

Over the past week…

High grade funds recorded an inflow for the fourth week in a row, albeit at a slower pace than last week. However we note that one fund suffered an outflow of almost $1bn. Should we adjust for that the inflow would have been more than $2.7bn.

High yield funds enjoyed their fifth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the inflows, with the other half favouring US-focused funds more than European-focused funds.

Government bond funds saw inflows for a second straight week, while the pace has been ticking up over the past couple of weeks. Money Market funds recorded an outflow last week, the strongest over the last five weeks. All in all, Fixed Income funds enjoyed another week of strong inflows.

European equity funds continued to record outflows; the seventh in a row. Note that the pace of outflows shows no sign of slowing down.

Global EM debt funds recorded their fifth consecutive week of inflows. Note that last weekly inflow was the largest in seven weeks. Commodity funds saw another inflow last week, the fourteenth over the past sixteen weeks.

On the duration front, short-term IG funds underperformed whilst mid and long-term IG funds recorded strong inflows amid a broader reach for yield trend." - source Bank of America Merrill Lynch

Follow the flow as they say, but follow Japan when it comes to credit markets exposure, given that they are no small players when it comes to global allocation.

So should you play "defense" allocation wise or continue to go "all in"? On that very subject we read with interest Morgan Stanley's Cross Asset Dispatches note from the 31st of March entitled "Improving the Cycle Indicator – Countdown to Downturn":

"Cycle inflection argues for more cautious portfolio tilt – pare back exposure in US stocks and HY, add allocation to US duration, RoW stocks

But just because a shift in our cycle indicator is imminent, it doesn't mean that broad asset rotation needs to occur now:

Looking at the optimal allocation for the ACWI/USD Agg porfolio, we find that weighting between global equities and bonds doesn't really change materially until a downturn starts. However, rotation within asset classes occurs throughout expansion and into the cycle turn – for example, US equities see weighting fall throughout expansion in favour of RoW stocks, and fixed income portfolios rotate towards long-duration away from intermediate maturities over the same time. In other words, downturn may trigger the broad cross asset allocation, but investors should still look to tilt more defensive within asset classes throughout expansion.

What would this defensive tilt look like? Examining the optimal allocations for: i) USD Agg/ACWI; ii) Multi-asset; and iii) USD Agg portfolios through various cycles over the past 30 years, using realised next one-year returns, these shifts need to occur for a more defensive positioning:

• Pare back equity risk, especially US versus RoW: Optimal weight to stocks tends to fall from expansion to downturn as stocks go from seeing a boost in returns to a drag.
• Reduce US HY to max underweight: Allocation to lower-quality (BBB and HY) corporates typically collapses in expansion, given the unattractive returns profile; downturn only sees performance deteriorate further, taking HY (and BBB) to its lowest weighting in the cycle.
• Tilt towards long-duration in late-cycle, add cash: UST and cash combined have the largest allocation in downturn.

These are largely in line with our current recommendations, based on our cross-asset allocation framework of which the cycle indicator forms one of the three pillars, along with long-run fair value models and short-run expectations from our strategy colleagues.

With long-run capital market assumptions which are below average for most assets, unenthusiastic 12-month forecasts from our strategists and a cycle model that's about to turn, we reiterate our stance to be EW in stocks, with a preference for ex-US equities, EW in bonds, with a tilt towards USTs, and UW in credit, in particular low-quality corporates. For investors looking for late-cycle hedges, we also recommend vol trades like buying credit puts, USDJPY puts and long Eurostoxx calls versus S&P calls to take advantage of dislocations in the vol space." - source Morgan Stanley.

Of course everyone is looking at the inverted US yield curve as a good predictor of a downturn to show up and markets are already pricing rates cut from the Fed. From a lower volatility positioning, it makes sense to be overweight US Investment Grade and adding duration and somewhat reduce exposure to US High Yield. In Europe, when it comes to financials, credit continues to benefit from the ECB support, financial equities, not so much, regardless of the price to book narrative put forward by many sell-side pundits. We continue to dislike financials equities and rather play exposure through credit markets, even high beta offers better value. 

But what about the cycle? Is it already turning in the US given the inversion of the US yield curve? On that specific point Morgan Stanley in their note pointed out the following:

"New cycle indicator, still same old cycle (for now)

Our revamped US cycle indicator suggests that the market is still in expansion. But our model also says there's a high chance (~70%) of a shift to downturn within the next 12 months.

Our market cycle indicators are a central part of our cross-asset framework, launched with our initiation of coverage nearly five years ago. While prior builds have served us well over this time, generally pointing to continued cycle expansion amid bouts of volatility, we have looked to continually improve these indicators. This is the latest iteration.

The main changes to the methodology revolve around index composition, weighting system and the way we systematically categorise cycle phases, relying on breadth of change across metrics instead of moving averages. The result is, in our view, an improved cycle indicator which can better flag turns in real time, with greater confidence and less lag. Currently, the revised US cycle indicator ('v2019') ( Exhibit 22 ) points to continued expansion, driven by many key macro indicators being above-trend ( Exhibit 23 ).

…but a market cycle peak is imminent

We don't think that this expansion can be sustained for long:

Exhibit 26 shows our real-time downturn probability gauge, which estimates the chance of our cycle model inflecting to downturn from expansion within the next 12 months, based on historical experience.

What this chart suggests is that, given the level of the cycle indicator, the chance of a shift to downturn over the next 12 months is elevated at close to 70%, up from ~60% from end-2017 when we last checked up on the cycle.

What's been behind this prediction? The strong unbroken run of improving data over the last year has been the main 'culprit':

Since April 2010, we've not had a six-month period where a majority of the components of the cycle indicator were not improving; it is, to our knowledge, the longest streak in history ( Exhibit 27 ).

Historically, such an environment of data improvement breadth and depth (with the likes of unemployment rate and consumer confidence hitting extreme levels in recent months) has meant a high probability of cycle deterioration in the next 12 months – after all, what goes up must come down. Indeed, the latest disappointing consumer confidence data pushes the number of cycle indicator components deteriorating over the last six months to seven now – enough to be considered 'critical mass'. If such deterioration persists, our rules-based approach to identifying cycle phases could very well call a switch from expansion to downturn as early as next month. At any rate, our market cycle indicator and the probability gauge are very clear – an inflection from expansion to downturn is on the horizon." - source Morgan Stanley

As we indicated on numerous occasions, the cycle is slowly but surely turning and rising dispersion among issuers is a sign that you need to be not only more discerning in your issuer selection process but also more defensive in your allocation process. This also means paring back equities in favor of bonds and you will get support from your Japanese friends rest assured.

It doesn't mean equities cannot rally further, there is still the on-going US-China trade spat yet to be resolved. Right now Macro continues to deteriorate, particularly in the Eurozone with its Manufacturing PMI falling to 47.5 (49.3 - Feb). Germany and Italy were notable contributors to the stronger decline:

• Germany : 44.1 vs 47.6-Feb
• France : 49.7 vs 51.5-Feb
• Italy : 47.4 vs 47.7-Feb
• Eurozone : 47.5 vs 49.3-Feb 

This is a reflection of world trade growth further slowing as highlighted by DHL's Global Trade Barometer from March 2019:

"Key findings:

• Overall GTB index for global trade falls by -4 points to 56 compared to December, signaling only a slight growth and coming ever closer to stagnation.
• Prospects weakening for most surveyed countries – but remain above neutral 50, still indicating positive growth, apart from South Korea
• Outlook for global air trade is sluggish, dropping by -3 to 55 points. Growth of global ocean trade is also slowing down, reflected in an index value of 56, a decrease by -5.

According to the latest three-months forecast by the DHL Global Trade Barometer (GTB) global trade is foreseen to grow only slowly. The overall growth index decreased by -4 points compared to the last update in December, scoring 56 points in March. The slowdown is especially attributed to the significant decelerating growth prospects of India (-18) and South Korea (-12).

Also in the US, trade growth is expected to lose momentum (-5 points), whereas the GTB forecasts for China (-1), Germany (+2), Japan (-2) and the UK (+2) are largely in-line with the previous update.

The outlook for global air trade is sluggish, dropping -3 to 55 points. All surveyed countries are forecasted to slowdown in air trade except for Germany (+9). The largest declines are expected for South Korea (-14), India (-13) as well as Japan (-5). China and US dropping moderately with -3 and -2 points. Moreover, the index for South Korea and UK air trade drops below 50 points, suggesting a contraction of air trade growth.

Global ocean trade outlook is also modest, seeing decelerated growth (-5 points to 56). The largest downturns are found in India (-20), South Korea (-10) and US (-7). German ocean trade further weakened, as the country’s index falls slightly by -2 to 46 points. China (-1 point) is forecasted to decelerate slightly. Meanwhile, ocean trade in the UK (+4 points) and Japan (+2 points) is picking up some steam." - source DHL - Global Trade Barometer, March 2019

With China’s Caixin March manufacturing PMI beating expectations at 50.8 from 49.9 last month (50.0 expected), optimism that China can once again provide the heavy lifting for global growth has been renewed, hence the latest positive tone from financial markets. 

Could it be that we will see weaker growth for longer? In that case bonds could continue to perform in that environment where bad news is good news again thanks to the renewed "Easy Come, Easy Go" stance from central banks.

We can therefore expect US Treasury Notes 10 year yield to fall further in that context. It seems that bond bears were a little bit too hasty in 2018 in the demise of the long duration trade.

We have been asked recently by one of our readers on  the rise in interest rate volatility seen recently through the MOVE gauge index responding by posting its biggest two-day gain since 2016. We replied that it didn't change our recommendation of playing "quality", Investment Grade that is, over "quantity", US High Yield. On that specific point we read with interest Barclays US Credit Alpha note from the 29th of March entitled "Rates Moves Dictates Credit Moves":

Rates Moves Dictating Credit Moves

Interest rate volatility remains high, with consequences for the credit market, as spreads have widened modestly. In addition to the decline in yields, the 3m10y Treasury spread has inverted, and the market is implying a rate cut by the Fed for the first time since the beginning of 2013. The last time 3m10y was inverted and the market implied a significant rate cut was in late 2006, as the prior economic cycle reached maturity. As Figure 2 shows, equities rallied at that point, and credit spreads held in despite concerns about a weaker economy.

An obvious question is whether the current inversion signals the end of the cycle, since, in the past, recessions have occurred on average four quarters after the 3m10y inverts. However, the 2y10y curve has typically already been inverted, which is not the case today. We believe more caution is warranted based on recent curve moves, consistent with our forecast for wider spreads at year-end.

Digging deeper into the relationships of credit markets around the 3m10y inversions in 2000 and 2006, we notice significant differences compared with this year. In both instances, high yield was outperforming investment grade and the BBB/A spread ratio was flat or lower. This seems to support our short-term view that BBBs should outperform their beta.

We had also been advocating owning BBBs versus BBs recently, and the gap between those spreads has moved almost 20bp higher from the recent lows. While a sizable move, it still does not make BBs look particularly cheap. However, we think that differences in trading conventions for the high yield and investment grade markets are behind a lot of the BB underperformance and expect some bounce-back for BBs in spread terms as soon as rates stabilize. Traders are quoting BB prices broadly flat over the past week, as rates rallied and spreads moved 20bp wider. In contrast, BBB bonds are quoted more or less unchanged on spread, but their prices jumped more than a point. Underscoring the technical nature of the move, we note that even within capital structures that have both BBB and BB rated bonds, such as Charter Communications, the basis spiked. As a result, we believe there could be some near-term tactical spread outperformance for BBs." -source Barclays

We could see a continuation in the high beta rally yet it doesn't seem to us vindicated by recent flows, so we would rather stick with our defensive call for the time being.

Given all of the above, we are more inclined towards credit markets and "coupon clipping" and playing it safe through Fixed Income and credit markets as warranted by current fund flows we are seeing and Japanese support coming from overseas. As well our final chart displays the defensive positioning as we enter the second quarter.

• Final charts - The deflation play is back in town

Looking at the dismal macro data which has tilted central banks towards a much more dovish stance, the positioning and fund inflows for the second quarter appear to be more geared towards "deflation assets". Our final chart comes from Bank of America Merrill Lynch The Flow Show note from the 28th of March entitled "Pavlov's Dog Bites Fed" and shows "Deflation vs Inflation flows":

"Positioning into Q2: consensus starts Q2 long “secular stagnation” & “deflation”; YTD $87bn inflows into “deflation assets” e.g. corp & EM bonds & REITs, and $42bn redemptions from “inflation assets”, e.g. EAFE equities & resources (Chart 4); investors are discounting neither recession (they love corporate bonds) not recovery (they don’t like cyclical equities).

Weekly flows: $8.6bn into bonds, $0.4bn into gold, $12.5bn out of equities.

Credit inflows: $5.2bn into IG, $2.2bn into EM debt, $0.9bn into HY.

Max deflation: record redemptions from TIPs ($1.3bn).

Equity outflows: $7.7bn out of US, $4.8bn out of EU, $2.0bn out of EM.

Cyclical outflows: $1.5bn out of financials, $0.4bn out of consumer, $0.2bn out of
tech.

Q2 catalyst: Positioning & Policy were positive catalysts in Q1; Profits will be the catalyst in Q2; we say consensus global EPS numbers remain too high (BofAML Global EPS model forecasts -9% EPS growth in the next 12 months vs. analyst consensus 0% - Chart 5).

Q2 scenarios: evolution of BofAML global EPS model forecasts will determine whether Stagnation, Recession, Recovery the dominant Q2 outcome.

Stagnation: global EPS forecast stagnates @ -5-10% as US growth dips below 2%, global PMIs vacillate around 50, US rates fall toward anchored/negative Japanese & Eurozone rates, secular “Japanification” trade of past 10 years hardens; the big tell...credit bid, volatility offered; the big trades...long 30-year UST, biotech, short resources, volatility.

Recession: global EPS forecast drops to -15% as surge in US unemployment claims indicates US consumer joining manufacturing recession in China, Japan & Eurozone where PMIs drop to 45; the big tells...oil <$50/b, JNK <$33, INJCJC4 >300k; the big trades...short tech & corporate bonds, long T-bills, US dollar & VIX.

Recovery: global EPS forecast turns positive as “green shoots” in Asian exports (Chart 1) & Chinese growth blossom, while lower US rates boost US housing data; credit spreads prove once again they are better lead indicator for risk assets than government bond yields (Chart 6); the tells...SOX >1450, XHB >$42, KOSPI >2350, yield curve steepens; the trades...long global banks, short bunds & US dollar.

Next up: big 5 datapoints in coming week to set course for Q2 (see table 1); tactically we are in Q2 “Recovery” camp; H2 we expect big top in markets before debt deflation/policy impotence leads risk assets lower."  - source Bank of America Merrill Lynch

"Easy Come, Easy Go", we believe that US equities face headwinds coming from a more defensive stance from CFOs ready to defend their balance sheet and start reducing buybacks, CAPEX and even dividends in some instances. This would be more beneficial in that context to credit investors. Earnings are already facing EPS "headwinds". The continuation of the rise in oil prices though is still supportive for US High Yield. Yet, given the "high beta" nature of High Yield, we would prefer to play it safe rather than going all in à la Martin Donovan. 

"There is no gambling like politics."- Benjamin Disraeli, British statesman

Stay tuned ! 

Macro and Credit - The Canton System

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Watching the intensification of the trade war rhetoric, with additional dollar weakness, and a softening tone in US macro data, when it came to selection our title analogy, we reminded ourselves of the 1757-1842 Canton System which served as a mean for China to control trade with the West within its own country by focusing all trade on the Southern port of Canton (now called Guangzhou). This policy arose in 1757 as a response to a perceived political and commercial threat from abroad on the part of successive Chinese emperors. To some extent, one could argue that the Trump administration would like to reassert its control on trade like the Chinese emperors did back then, hence our chosen analogy this week. For the history buffs out there, the 1842 Treaty of Nanking put an end to the Canton System.

In this week's conversation, we would like to look at the relationship between interest rates and the price of credit, in conjunction with the relationship between credit and cycles as well as into the trade war narrative building up.

Synopsis:

• Macro and Credit - Credit relationships and cycles and trade wars should not be taken lightly.
• Final chart - Deglobalize me...

• Macro and Credit - Credit relationships and cycles and trade wars should not be taken lightly.

Back in October 2016 in our conversation "An Extraordinary Dislocation" we reminded ourselves of the Wicksellian Differential and the credit cycle (linked to the leverage cycle):

"When the natural rate of interest is lower than the money rate which is the case today (rising Libor), the demand for credit dries up (our CCC credit canary are being shut out of credit markets) leading to a negative disequilibrium and capital destruction eventually. In a credit based global macro world like ours, the Wicksellian Differential provides a better alternative estimation of disequilibrium than the more standard Taylor Rule approach of our central bankers." - source Macronomics, October 2016

Also we find interesting that Wicksell used the housing sector to illustrate his theory, particularly in the light of the start of some housing prices weakness seen such as in London for instance. We added at the time of our musing:

"Why is the Wicksellian Differential so important when it comes to asset allocation? Either profits increase due to an increase in the return of capital and/or a fall in the cost of capital (buybacks funded by a credit binge). This is clearly reminded by Credit Capital Advisors' note from July 2012 entitled "Navigating the business cycle: A new approach to asset allocation":
"The calculation of the Wicksellian Differential is however an ex-post measure, so is unhelpful for investors to use as an investment trigger, hence an ex-ante model needs to be constructed based on the underlying drivers of growth in the Wicksellian Differential, which is of course leverage. However, an ever-increasing amount of leverage is clearly unsustainable and will cause expectations to shift at some point, resulting in a period of deleveraging and falling profits. As a result, an investment trigger can be set up based on the dynamic relationship between leverage ratios and the rate of profit, which requires constant recalibration as new data is made available.

The relationship between each leverage ratio and the rate of profit is unique and dynamic through time. For example, the slowdown and fall in the consumer leverage ratio caused the Wicksellian Differential to reverse between 1990 and 1992. Furthermore, during the tech bubble between 1996 and 1999, corporate leverage fell followed by consumer leverage, causing the rate of profit to fall. This highlights that there was no real basis for rising equity returns during the tech bubble as the rate of profit growth was falling. Thus the dotcom bubble ought to be seen as akin to John Law’s South Sea bubble, which was purely based on a rather large misconception. The extent of the credit bubble leading up to the recent financial crisis is highlighted by the substantial rise in consumer leverage, the rate of which began falling at the end of 2006, highlighting the downturn in the rate of profit growth in 2007, and thus a shift to bonds. Finally consumer leverage rose again in 2009, signaling a recovery in profits, although the recovery was short-lived. In 2011 the trend fell again, and the 2012 signal highlights a continuing slowdown in the underlying trend of profit growth. 

There are of course other factors that impact profits, such as significant changes in the general price level and in output per worker, as well as other known variables such as the tax rate; however, the most important driver with respect to the turning points is the realisation that a period of credit expansion has become unsustainable, leading to changing expectations." - source Credit Capital Advisors, July 2012

And of course dear readers, we have long been warning that the credit cycle was slowly but surely turning thanks to credit "overmedication"."  - source Macronomics, October 2016 

We are starting to feel some keen interest in becoming contrarian again when it comes to a "long US duration" exposure (MDGA - Make Duration Great Again). Once more, it is fairly simple to explain particularly in the light of the most recent Atlanta Fed forecast for Q1 2018 coming at a paltry 1.9% (below consensus) and remember these guys have been right on cue on numerous occasions in the past Q1 weak US GDP prints:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."

With record net short duration exposure thanks to Treasury Futures Net Aggregate Speculative Position at around $3.8 trillion, one could argue that, when everyone is thinking the same, then maybe no one is really thinking. 

In the light of our reminder of the "Wicksellian Differential", bond maverick Jeff Gundlach recent webcast caught our attention as pointed out by Zero Hedge in one of their recent post:

"The highlight of Gundlach's webcast, was his remarkable indicator for the "fair value" of nominal 10Y yields, which he calculates simply as the average of Nominal US GDP and the yield on the German 10Y bund. As shown in the chart below, there is an uncanny correlation between the two series, which would suggest that all one needs to trade the 10Y is to know the latest GDP estimate and where the German Bund is trading.

- source DoubleLine - Zero Hedge

If the Atlanta Fed is right again on its call on a weak Q1 2018, (and we have seen this movie before given that since 1980 there have been 15 instances where growth came in below a 2% SAAR in Q1), then again, tactically playing a rally in the long end looks more and more enticing to us from an"asset allocation" perspective" given the huge consensus which has built up in being short duration and the most recent weaken tone in US macro data (retail sales dipping 0.1% sequentially in February for third month in a row). If it was not for the increased deficit spending by the US administration, we would be jumping in and buying US duration at this stage. 

But moving back to the subject namely the relationship between interest rate and credit, and somewhat the Wicksellian Differential, we read with interest Wells Fargo note from the 28th of February entitled "The Evolution of Irrationality" and relates to the relationship between the complex economic relationships that drive the credit cycle:

"The credit cycle, much like the business cycle, is driven by complex economic relationships. Understanding the emotional component in these cycles can equip investors to better identify turning points in the cycle.

“Many liquid assets which are close substitutes for money… [are] only inferior when the actual moment for a payment arrives.” – Radcliffe Report (1959)

For the Radcliffe Commission, the growth of credit rises with euphoria. As animal spirits take hold, investors seek out opportunities, producing more credit in the system. We only have to look at the “dot.com” bubble and the subprime housing bubble to see the wisdom that credit risk grows with prosperity. What makes the current scene so challenging is to value new instruments against the administered interest rates of central banks. We know the central bank rates are not normalized, but what do we know of the anticipated market returns for new investment opportunities?
As illustrated in the below graph, when the moment of payment arrived in southern European debt in 2014, liquidity and credit quality came under a cloud. As a result, bond yield spreads tightened considerably within a very short period of time.

Interest Rates and Credit Allocation Over the Cycle

As illustrated in the below graph, credit benchmarks differ significantly over the business cycle—to emphasize the problem, these credit benchmarks are very procyclical.

Initially, both the creditor and the debtor start the allocation process with an apparently economically legitimate project, where risk/return has a sense of balance. However, as the first projects demonstrate success, more projects are financed. Moreover, as credit becomes more available, the expected rates of return diminish. It is no surprise to see an inverse relationship between demand for C&I loans among firms and the credit standards required by banks to offer loans. Credit agencies are certainly aware of the behavior of investors over the business cycle and try to mitigate credit risk by tightening standards as demand soars.

Credit For Income or Capital Gain

For J.P. Morgan, the success of the railroads depended on traffic flow—when he looked at the railroad industry, it was badly overbuilt. But for Jay Cooke, the key concept was the promotional sale of bonds to European investors with limited knowledge of American geography.
Upon what basis is credit advanced? The problem is that at the start of many innovations, credit is advanced in anticipation of an income flow to pay off that credit. The initial investors often get their return. However, as time moves on, credit is advanced in an effort to realize capital gains, but they are less available while the risk rises. This phenomenon is represented in the bottom chart, which depicts the run-up in home prices in the mid-2000s.

Many individuals were under the impression that home prices could not fall and treated the homes as an investment opportunity with little downside. Irrational exuberance coupled with inexperienced investors contributed to the subprime housing bubble, which devastated the global economy. Credit relationships and cycles should not be taken lightly." - source Wells Fargo

Wicksell using the housing sector to illustrate his theory was clearly a good indicator, particularly with US home prices now 6.3% higher than their peak in July 2006 and 46% above their trough in February 2012. In our last conversation we did also put a very interesting chart from Wells Fargo and concluded:

"On a more cautionary note, plans to buy a car or a house both rose much less during the month, although the proportion of consumers stating that now is a good time to sell a house jumped 7 points to 73 percent." - source Wells Fargo

"In this ongoing "intermezzo" period giving us that 2007 feeling, what is really striking to us is that the amount of leverage for the US consumer is not what it seems, and no matter how strong the willingness of the Fed to hike is, it appears to us that much sooner than in previous hiking cycle, the Fed is going to "break" something. As per the above chart, it seems to us that Main Street has a pretty good forecasting record in calling housing market tops it seems, much better than some sell-side pundits but we ramble again..." - source Macronomics

Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street. Maybe after all, they are spot on and now is a good time to sell in the US, just a thought. As we have stated before, the Fed will continue its hiking path, until something breaks, and we have already seen some small leveraged fish coming belly up when the house of straw build up by the short-vol pigs blew up. We keep pounding this but, Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount this year as the credit noose tightens. 

No doubts that years of QE, ZIRP and NIRP have turned the market upside down and played with asset prices and grew a large disconnect in some instances from fundamentals. The level of interest rates does indeed matter for the credit cycle and things are slowly but surely turning towards the end of an already very long cycle. On the relationship we read with interest another interesting piece from Wells Fargo from their Economics Group published on the 7th of March and entitled "Interest Rates as the Price of Credit: Altered Fundamentals":

"Interest rates are connecting fibers between the real economy and credit markets. In recent years, the price of credit has been manipulated to spur the real economy, but has altered capital allocation along the way.

Back to Normalization: Administered Rates to Market Rates

Credit allocation has been distorted in recent years in an attempt to spur the real economy. Alterations of market prices, whether in credit or product or exchange markets, creates a tension, an observable disequilibrium between markets that must be resolved over time. For the 1970s, wage-price controls created the disequilibrium. In the early 1990s, the tension in the Exchange Rate Mechanism led to a large, sharp adjustment in exchange rates.
In recent years, the era of administered rates has created a credit disequilibrium and thereby provides little guidance on what should be the proper level of interest rates to price financial capital and thereby judge the viability of real world activity. As illustrated in the top graph, we have moved to a new economic environment since the fall of 2017. We are searching for a new equilibrium in interest rates, exchange rates and real markets.

Altered Fundamentals: Altered Market Prices

Since November, there has been a distinct shift in the fundamentals underlying the search for equilibrium in credit markets. Expectations for economic growth, inflation and exchange rates have moved, so why not market interest rates?
Growth expectations have risen. Inflation expectations have risen. Expectations on the dollar’s value have declined. Net result? Interest rates have risen.

Altered expectations of growth and inflation have moved investor expectations of monetary policy actions.

The probability of Fed action in March moved from 65 percent in January to 99 percent in February.

Modeling Interest Rates: Setting The “Normal” Benchmark

The Great Recession has “added fun” to interest rate modeling. The most widely utilized estimation method is OLS, and one major assumption of OLS is that the underlying data is stationary and has no structural breaks. However, if the data is non-stationary or/and have breaks, then OLS estimations are not reliable. As we have discussed in the past, almost all major macroeconomic variables, including interest rates, experienced structural breaks during the Great Recession. Furthermore, both the 10-year and two-year series have non-linear (declining) trends since the 1980s (bottom graph).

Thus interest rates and the growth rate of the economy, which is also a declining rate, are not constant overtime.
Another major hurdle for modeling interest rates is the fed funds rate’s behavior since 2008. The fed funds rate hit the 0-0.25 percent range on December 2008 and stayed there until December 2015. Unusual fed funds rate behavior, along with structural breaks in interest rates, pose great challenges for modeling. “Add factors” are the best friends of analysts since the Great Recession and it does not seem likely to change in the near future. One thing is very clear for us, and that is due to breaks/altered fundamentals finding a “normal” is similar to “waiting for Godot.” " - source Wells Fargo

The battle rages on between the two camps, namely the "deflationista" who thinks we have yet to see the lows in US yields versus the "inflationista" camp who thinks the secular downtrend in yields is broken and that the only way is up. 

As shown by the burst of the short-volatility bubble in February, there has been a change in the narrative leading to less financial repression which had been a clear sign of central banking intervention in recent years. Now obviously, everyone and their dog are talking about the end of financial repression and normalization of interest rates with the Fed leading the central banking pack. This is leading to renewed real "price discovery" in some segments of financial markets. On that note we read another interesting note from Wells Fargo in continuation of their previous one from the 14th of March and entitled "Ending the Financial Repression Era":

"Markets seek an equilibrium after years of financial repression but the path to equilibrium means backtracking through the minefields of mispriced real and financial assets based upon administered rates.

Back to Normalization: Part II

Economic fundamentals have been moving since 2016 in the direction of higher economic growth, higher inflation, a weaker dollar and larger Treasury fiscal deficits. In this difficult context, central bankers now wish to move away from an environment of administered prices (interest rates and bond prices). However, for investors the problem is policymakers. Financial markets are moving from one disequilibrium point with interest rates held below market values (and below inflation, see below graph) to generate growth, to another nexus of interest rates, growth and inflation that remains undefined given the uncertainty about the equilibrium of real interest rates, the potential growth rate of GDP and the Fed’s commitment to a two-percent inflation target.

Finally, as the year moves forward, we must ask ourselves if the central bank is committed to market-setting interest rates or are we simply moving from an era of close-to-zero interest rates to an era of slightly higher rates, while still being administered by the central bank?

“John Bull Can Stand Many Things, But He Can’t Stand 2 Percent”

For John Stuart Mill, the problem was that “a low rate of profit and interest… makes capitalists dissatisfied with the ordinary course of safe mercantile gains.” That is, capitalists push the envelope of risk to achieve higher returns commensurate with their perceived target or normal rates of return. For today, the pursuit of yield has taken investors to a very broad range of asset classes where the accurate measure of risk/return has been altered by the low administered interest rates set by central banks.
In recent years, the era of administered rates provided little guidance on what should be the proper level of interest rates to price financial capital and thereby judge the viability of real world activity. As illustrated in the below graph, sovereign yields in European debt appear remarkably low, and in some cases are below U.S. Treasury yields. Some observers see this as odd.

Our view is that these low yields reflect the policy of the ECB in buying both sovereign and corporate debt. But here is the rub. When the ECB normalizes interest rates, what then happens to business finance, real growth and the euro exchange rate? Again, we are moving from an era of administered rates to an era of market rates—or perhaps less administered rates. 

What About Real Interest Rates and Inflation Discounts?

In the bottom graph, we see the pattern of current market pricing for the nominal and real component of interest rates. There is one positive signal here. The rise in the real component is consistent with market expectations for an improved economy since early 2017.

In this case, higher real interest rates would be consistent with higher expectations for the real return on capital—a very positive sign indeed." - source Wells Fargo

Given current positioning, everyone is expecting an acceleration in US growth in conjunction with inflationary pressure from rising wages. What if indeed the growth is not as strong as one would expect? On top of a weaker US dollar, the recent surge in the trade war narrative will continue to weight not only on the US dollar but, can add to the inflationary pressure building up in the US. This indeed is a poor recipe for risky asset prices and for a continuation of the support from the US consumer given we noticed that consumer credit has been slowing in January, undershooting the consensus. Nonrevolving credit accounted for nearly all of the consumer credit growth to begin 2018 according to Wells Fargo. Non-revolving credit rose at a 5.6% annual rate, or $13.2 billion, compared to December's rate of $13.1 billion. Total non-revolving credit is now $2.83 trillion. If the US government is going for the "Canton System and we get an all-out trade war, this could spark more threatening inflation and impact the US consumer in full. This would put the Fed in bind as inflation would be rising above the Fed’s comfort zone while real GDP growth would likely be slowing, pushing some economists to already use the dreaded word "stagflation". The most recent US unemployment and wage numbers have provided additional support to the "Goldilocks environment" narrative yet recent softness in some economic data in conjunction with rising trade tensions could indeed put a spanner into this narrative in very short order. Global growth looks fine until it doesn't thanks to a change in sentiment, and that could come quickly through trade war escalation with the US and the rest of the world as indicated by Barclays in their Global Synthesis note from the 9ht of March entitled "Goldilocks is nervous":

"Global growth still fine, but potential ‘trade war’ poses risk

"Recent data suggest there has been some modest deceleration in global manufacturing. Yet, this comes off elevated levels, following many months of increases. Notably, services PMIs picked up in both EM and DM economies, offsetting the manufacturing weakness. This week's robust US labour market report seems to confirm the Goldilocks scenario of a robust expansion with little underlying price pressure. Next week, February IP prints in the US and Europe, machine orders in Japan and investment numbers in China should provide further signals about the health of the global economy. However, with fiscal stimulus still ahead and financial conditions still supportive, the risks to global growth seems limited. That said, a serious deterioration in global trade relations could change that"

- source Barclays

When it comes to the US dollar, we think it can continue to weaken if US tariffs trigger a broader trade war and global crisis risks. It might be seen as being Goldilocks for the US economy but when it comes to credit markets, it has been "Goldilocks" for a while, but, since early 2018, the price actions and fund flows for both Investment Grade and US High Yield (17th consecutive week) have shown a weaker tone.

It seems some pundits have decided to quietly exit the credit dance floor. This is indicated by Société Générale in their Mutual Fund and ETF Watch note from the 15th of March entitled "Outflows from credit funds - Another sign that the good times may be over":

"We monitor the flow of funds into and out of mutual funds and ETFs in all asset classes.

• Exceptional outflows from credit funds. The latest outflows from high yield and investment grade credit funds mark a clear break from previous trends. For US high yield credit (HY), cumulative net outflows started in 2016 (chart below left) but have accelerated over the last month, with HY ETFs also seeing outflows. In the case of investment grade (IG) credit funds in the US and Europe, the turnaround comes after a prolonged period of strong cumulative net inflows. The series therefore appears to be peaking at very high levels (chart below right). So far, these outflows have had little impact on performance.

• Credit – an indispensable asset... Since 2010, the hunt for yield has turned credit into an indispensable asset, resulting in a fourfold increase in credit funds’ assets under management in the US and Europe (to $1,075bn, EPFR coverage). As a result, most investor portfolios are now heavily overweight on credit versus other asset classes compared to history. Within credit funds, the strongest implied overweight position is for European investment grade. But, increasingly this is a point of weakness. When the wind turns, these OW positions point to potential selling pressure.

• ... soon to be an undesirable asset? The latest outflows from credit may be a further sign that the golden years are increasingly behind us. In the editorial, we highlight several other reasons to be worried. Risk premiums indicate that credit is expensive compared to almost all asset classes. Rising rates are bringing closer the point at which credit is no longer indispensable for covering contractual obligations. No marginal buyers seem to exist to replace the ECB when it stops purchasing credit (CSPP) in September 2018. Meanwhile, worries about a pick-up in credit defaults seem premature, even if corporate leverage has risen and economic and earnings momentum seem to have peaked. That said, the credit market certainly looks stretched and it may take very little to puncture current complacency. And when credit gets hurt, equity is typically not far behind."

- source Société Générale

All in all it might feel like "Goldilocks" on the macro side for Main Street with expectations of higher wages, for Wall Street it seems, the only "easy day" seems more and more to be yesterday with the "Credit Goldilocks" narrative truly fading as of late...

While on numerous occasions we voiced our concerns for that 1930s with the rise of populism, which has once again been vindicated by the recent Italian elections, it seems that with the US Canton System we are moving from cooperation to noncooperation and lower cross-border capital flows. This could be a troubling development as per our final chart below.

• Final chart - Deglobalize me...

Back in January this year, in our conversation "The Twain-Laird Duel" we looked at the recent rise in the trade war rhetoric and we argued the following:

"Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing..." - source Macronomics, January 2018

Our final charts comes from Bank of America Merrill Lynch "The European Credit Strategist note from the 15th of March entitled "NIRP manias - the part 2" and ask the question if globalization is dead, displaying Global cross-border capital flows and the rise of "populist" votes since 2000: 

"Is “globalization” dead?

Draghi’s dovishness comes at an opportune time, as populism has been an all too familiar theme lately. But populism is now becoming synonymous with protectionism. Does this mean that the story of globalization is reversing? Cross-border capital flows are undoubtedly lower than in 2007, but much of this reflects the prudent retrenching by banks from global lending. Other signs are more encouraging, though. World trade is still low, but is forecast to improve relative to world GDP. Foreign direct investment has recovered much of the post-Lehman bankruptcy drop, and global migration rates have noticeably jumped over the last decade. Thus, it may be too early to hail “deglobalization”, we think. Instead, a lesser, but steadier and more fruitful form of globalization is emerging.

“Marginalized” workers around the world want a fresh political agenda that is more inclusive, and prosperous, for them. Understandably, ideas around “Frexit” and “Italexit” play no part in this given their wealth destructive consequences (see here for how Eurozone breakup fears have receded). Instead, the current brand of populist politics is more inward looking and seeks to play on voters’ fears about globalization and migration. Populism, therefore, has become more about protectionism: putting up barriers to entry and reworking free trade."- source Bank of America Merrill Lynch

As a reminder, the Canton System arose as a response to a perceived political and commercial threat from abroad, it seems to us that the US Government under Trump is keen on imposing further restrictions on foreign trade with China particularly in their sight, is Germany next? We wonder and ramble again...

"The United States can't keep a completely open system if the rest of the world is less open. The United States may have to take a leaf out of the book of Japan, China, and Germany, and have protectionism inside the system." -  Robert Mundell

Stay tuned!

Macro and Credit - Volition

"The true test of a leader is whether his followers will adhere to his cause from their own volition, enduring the most arduous hardships without being forced to do so, and remaining steadfast in the moments of greatest peril." - Xenophon

Looking at the dizzy heights being reached in equities with uninterrupted flows into US Investment Grade with yet another warning coming from the wise wizard from the BIS, namely Claudio Borio in the latest quarterly report, when it came to selecting our title analogy, we reminded ourselves of the term "Volition" from psychology given our fondness for behavioral economics. Volition or will is the cognitive process by which an individual decides on and commits to a particular course of action such as the normalization process undertaken by the Fed. It is defined as purposive striving and is one of the primary human psychological functions. Volition means the power to make your own choices or decisions. As an example of the classical concept of volition, comes from Eliezer Yudkowsky while discussing friendly AI development and "Coherent Extrapolated Volition" in 2004. The author came up with a simple thought experiment: imagine you’re facing two boxes, A and B. One of these boxes, and only one, has a diamond in it – box B. You are now asked to make a guess, whether to choose box A or B, and you chose to open box A. It was your decision to take box A, but your volition was to choose box B, since you wanted the diamond in the first place. Now imagine someone else – Fred – is faced with the same task and you want to help him in his decision by giving the box he chose, box A. Since you know where the diamond is, simply handling him the box isn’t helping. As such, you mentally extrapolate a volition for Fred, based on a version of him that knows where the diamond is, and imagine he actually wants box B. In developing friendly AI, one acting for our best interests, we would have to take care that it would have implemented, from the beginning. The question one might rightly ask is relating to the volition of the Fed, is it really for our best interests? One might wonder.

In this week's conversation, we would like to look at the volition of the Fed in its normalization process and the potential upcoming impacts in 2018 should the Fed, once again be behind the increasing flattish curve.

Synopsis:

• Macro and Credit - When the going gets tough
• Final chart -  The Fed can't escape Newtonian gravity

• Macro and Credit - When the going gets tough

Back in April 2017 in our conversation "Narrative paradigm" we argued that when it comes to credit market the only easy day was yesterday. Given the significant role of beta thanks to cheap credit and the "carry play" supported by low rates volatility, it becomes increasingly difficult for us to be supportive of at least the European beta play with the level touched by European High Yield. We also indicated recently that we were expecting a significant pick-up in M&A activity in 2018. This means that some investment grade issuers could experience some sucker punches in the form of blowing out credit spreads in 2018 hence the need of reaching out for your LBO screener à la 2007. A raft of M&A transactions in 2018 would clearly reinforce the view of the lateness in the credit cycle. In terms of change of narrative and in continuation of the "synchronicity" we mentioned in our previous post, the Fed's volition should not be taken lightly.

Also, regardless of the economic narrative put forward by many, including November payrolls rising by a seasonally adjusted 228K and beating expectations of 200K, leaving the unemployment rate in the US to 4.1%, rising wage pressure remains relatively absent. On top of that, surging consumer confidence and modest income growth should trigger much stronger loan demand in our "credit book". One could argue that the credit impulse in the US is tepid at best, no offense to the volition of the Fed. This is indicated by Wells Fargo in their Interest Weekly note from November 29th entitled "Mixed Credit Trends Among Businesses and Consumers":

"In the ninth year of the current economic expansion, credit standards point to a varied, but stable, outlook. Recent data suggest business lending demand has fallen, while consumer demand has seen modest gains.

Banks Optimistic (Yet Cautious) Approach to Lending

Banks continue to relax lending standards on business, commercial and industrial (C&I) loans and mortgages, as banks’ willingness to make loans has gained some stability. A slowdown in banks’ willingness to lend is customary with late cycle expansion. As seen in the below graph, banks’ willingness to extend credit follows a cycle-like trend.

At the start of an economic expansion, banks appear very willing to extend credit. But as the cycle matures, they become less willing to extend credit, and, in turn, tighten their standards in a cautionary nature.

Banks have reported increased competition from other bank and nonbank lenders, which in part, has led to the easing of standards. Continued loosening of lending standards of C&I and mortgage loans points to sustained confidence in the current state of the expansion. However, banks continue to tighten standards on credit card and auto loans, which may signal some caution in the consumer sector as the economic cycle ages.

Slowly Growing Consumer Demand for Loans

With an unemployment rate of just 4.1 percent, and in an environment of modest income growth and surging consumer confidence, theory would suggest robust loan demand. Loan demand, however, remains muted, pointing to a change in consumer sentiment towards debt. Credit card demand has remained unchanged, while we have seen a recent uptick in auto loan demand (below graph).

The rise in demand for auto loans is likely attributable to rebound effects in auto-sales due to damage from the recent hurricanes in Texas and Florida. Consumer demand for mortgage loans has slowed, which is expected to reverse as existing home sales edge higher off a recent slowdown.
Without an increase in income growth, loan demand should continue to increase modestly. Our forecast calls for an uptick in disposable personal income in Q2 2018, due to the effects of the proposed tax reform, followed by a slowdown in disposable personal income growth through the last year of our forecast (2019). Such slowing in income growth suggests consumers may increasingly turn to borrowing to fund their consumption habits in the future.
Demand for business loans remains weak, yet increased strength in business investment suggests that firms have turned to other sources of funding to fuel capital spending (below graph).

The loosening of lending standards, coupled with our positive outlook for business investment, should drive C&I loan demand higher in the near future. However, as the cycle continues to mature, we project equipment spending to slow, likely resulting in a reduction in business demand looking further ahead. The current credit climate insinuates stability within lending practices as growth continues in the ninth year of the current economic expansion."  - source Wells Fargo

While the Fed's volition is to continue with its hiking cycle, financial conditions remain loose and the lack of pressure on wages means that consumers are increasing their leverage through consumer loans in an environment where there is increased competition for business from other players. There are two ways we think the first part of 2018 could play out, "Goldilocks" or "Stagflation" with a sudden rise in inflation expectations that would provide support for a bond bear market narrative with rising interest rates volatility. This is of course without taking into account rising geopolitical risk aka the dreaded "exogenous" factors. We sidestepped various political "exogenous" risks in the first part of 2017 with various elections taking place in Europe in particular. It remains to be seen what will be the trigger of the return of volatility which has so badly wounded many large global macro funds in recent years thanks to its absence. As far as interest volatility is concerned it is at the lowest level in more than 20 years as displayed in the below Wells Fargo chart from their 2018 US Corporate Credit Outlook published on the first of December:

- source Wells Fargo

It won't last rest assured as it is getting late in the game we think and we are already seeing a "synchronized" change in the central banking narrative. Yet some "beta" players continue to be oblivious to the change in the central banking rhetoric. It doesn't mean that the "Goldilocks" environment won't last a little bit more in 2018 for credit, but, we think you should start thinking about playing "defense". This is why back in July we recommended to tactically going for duration again particularly in credit. This has been paying off nicely in 2017 (MDGA - Make Duration Great Again) as indicated by Bank of America Merrill Lynch Credit Market Strategist note from the 8th of December entitled "Year of Duration":

"Year of Duration

That 30-year corporate bonds, which we define in the following as 15+ years, have performed well in 2017 (+11.48% YtD) is no surprise. After all we expected “equity-like” 8-9% total returns in our 2017 outlook piece (see: 2017 US high grade outlook: Let’s do the twist 21 November 2016) on the back of a 27bps decline in 30-year corporate yields (actual: -48bps YtD, Figure 1).

However the surprise has been that credit spreads and Treasury yields were almost equally responsible for this decline in yields (25bps tightening in spreads and 30ps decline in 30-year Treasury yields as of yesterday, Figure 2).

This positive correlation between credit spreads and Treasury yields for such large moves is noteworthy and counterintuitive, but not unseen in the post-crisis years.

How did duration become king?

There are many reasons corporate yield curves are flattening so much including first and foremost that the Fed plans to hike rates actively in an environment of weak inflation data (Figure 3, Figure 4).

This was highlighted by today’s mixed jobs report for November where, although headline nonfarm payrolls were strong at +228k (vs. +195k consensus, Figure 5), average hourly earnings grew only 2.5% YoY (vs. 2.7% expected, Figure 5).

There are many other reasons for flattening yield curves including Treasury’s refunding announcement, where they committed to meet any increased issuance needs using shorter maturities (see: On funding and refunding), the ongoing shift in Europe out of cash and way out the curves (see: QE is dead, long live NIRP), macro risks, etc.

Re-iterate 10s/30s spread curve flatteners

Unusually - and a testament to extreme investor need for both yield and duration – we have seen the 10s/30s corporate spread curve (non-fin, commodities) flatten 8-9bps this year, despite the fact that the 10s/30s Treasury curve has flattened 22bps. More broadly this environment of both flattening Treasury and spread curves has been in place since spreads began tightening in early 2016 (Figure 7). However, the past six months has seen little flattening of the spread curve – but the lack of steepening is actually very impressive as the Treasury curve has flattened 27bps over the same period of time. Needless to say if the Treasury curve continues to bull flatten our recommended non-banks spread curve flattener will not work. We are probably even now reaching levels where further bull flattening actually leads to steeper spread curves. Our house view (see: Global Rates Year Ahead) remains that the Treasury curve is too flat and eventually will re-steepen, which should be very favorable for our spread curve flattener trade. The trade also works with higher interest rates as long as the curve does not flatten.

- source Bank of America Merrill Lynch

As we concluded back in early June in our conversation "Voltage spike", the MDGA trade (Make Duration Great Again) has made a very good come back as indicated by the ETF ZROZ we follow, which delivered a 10.53% return so far this year. For 2018, we continue to favor style over substance, quality that is, over yield chasing from a tactical perspective. As well in another conversation of ours in June this year entitled "Goldilocks principle" we indicated:

"The relentless flattening of the US yield curve shows that in the current inning of the credit cycle, and with a Fed determined in continuing with its hiking path, from a risk-reward perspective, we believe long duration Investment Grade still offers support to the asset class and not only from a fund flows perspective with retail joining late the credit party. On another note the "Trumpflation" narrative has now truly faded to the extent that the deflation trade du jour, long US Treasuries (the long end that is) is back with a vengeance, while inflation expectations has been dwindling on the back of weaker oil prices (after all they still remain "expectations" from our central bankers perspective). " - source Macronomics, June 2017

Our call has been vindicated as well as our contrarian stance against the "bullish" dollar crowd. We continue to believe we will see further weakness ahead for the US dollar in 2018. If we do see additional pressure on the leverage play thanks to the carry trade due to central banking's volition, then one should expect a rise in the Japanese yen we think. As well we continue to see value in the long end of the US curve. Also while gold prices have been weaker recently, the recent pullback as for goldminers looks to us enticing, particularly in the light of a growing risk in "exogenous" factors. If credit options are cheap, gold/gold miners options are "cheaper" as well from a convexity reward perspective in 2018. When it comes to the bull run in credit spreads it has not yet ended and probably will last longer than many might expect, until we hit 11 that is on the "credit amplifier" in true Spinal Tap fashion. We do not see any value left (apart from playing the "dispersion" game with active credit management) in European High Yield at these levels. What is left is "carry" and clearly not enticing enough for us from a risk reward perspective in 2018. We would rather continue playing the US Investment Grade long duration play when it comes to credit allocation. What about US equities being priced to perfection and US High Yield? Given the strong correlations of both asset classes (close to 1 regardless of what some pundits would like to tell us), it is all a matter of "earnings" and they have been so far holding fairly well.

The big risk out there is, as we pointed out the return of the "Big Bad Wolf" aka inflation. This would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant repricing on the way. Inflation is our concern numero uno and this would we think be the trigger for higher volatility. This is as well the view of Deutsche Bank from their Asset Allocation note from the 4th of December entitled "What to make of volatility at 50-years lows":

"In our view the leading candidate for a shock that would lead to a sustained increase in vol is a sharp increase in inflation

As noted above, exogenous shocks have historically played a significant role in increasing and sustaining vol at higher levels. Shocks in general of course tend to be inherently unpredictable. Our economists forecast is for a gradual rise in inflation. But in the current context a sharp increase in inflation sticks out as a leading candidate for a shock that raises volatility in a sustained manner in 2018 given the extent to which it is priced in and the likely reaction of monetary policy:

• Slow inflation priced in. The slowdown in US inflation beginning in March this year had large impacts across asset classes and looks to be priced in (The Growth-Inflation Split, Sep 2017).
• Few expect a sharp pickup in inflation. The market and FOMC narrative around low inflation with widespread buying into structural declines and a breakdown of traditional relationships looks to have gotten carried away (Six Myths About Inflation, Oct 2017). This suggests few are expecting a sharp pickup in inflation.
• Four fundamental reasons to expect inflation to move up. First, the lagged impacts of inflation to the growth slowdown during the dollar and oil shocks points to a pick up. Second, the labor market continues to tighten and in our reading there is no reason to believe the traditional Phillips curve has broken down, just swamped by other factors. Third, the direct drag from the past appreciation of the dollar should begin to pass through. Fourth, idiosyncratic factors together have had a strong negative run but tend to mean revert over time. Acting in concert, the four factors clearly have the potential to create a sharp move higher in inflation.
• A sharp pickup in inflation is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle. Fed hiking to keep inflation in check has been a—if not the —leading driver of recessions historically. Market expectations of Fed hikes are currently of course far below the Fed’s guidance and a sharp pickup in inflation is likely to entail a significant re-pricing. We don’t see Fed rate hikes from current low levels as ending the cycle any time soon (Is Unprecedented Monetary Policy Easing Creating Secular Stagnation? Jul 2016). But we do see faster rate hikes against the backdrop of a sharp pickup in inflation as having the potential of raising and sustaining vol at higher levels as concerns about the end of the cycle grow." - source Deutsche Bank

Make no mistake, inflation is the "Boogeyman" for financial markets. From the long interesting report from Deutsche Banks, three graph stand out when it comes to heightened risk for large "sigma" events in 2018 given how coiled the volatility spring is:

- source Deutsche Bank

No matter how high your "interval of confidence" is, your VaR model is looking/asking for trouble, particularly your "liquidity" hypothesis. It is time to build some cheap "convexity" defenses as we posited above, not to mention the need for your LBO screener with rising M&A risk and the sucker punches they can deliver to your Investment Grade portfolio à la 2007. Just some thoughts for 2018.

When it comes to the relentless flattening of the US Yield curve as a harbinger for rising recession risk in a classical macro way, we read with interest Deutsche Bank's take from their Global Market Strategy note from the 1st of December entitled "The Fed, the Curve and Risk Assets in the Great Rate Normalization about the recession risk transmission:

"Recession risk transmission

The sharp curve flattening has given renewed life to worries that recession risks are on the rise. Given the flattening, our recession probability metrics – one using the outright slope of the 1s10s yield curve, and one that adjusts the 1s10s curve for the level of 1s – both suggest that November’s flattening was worth a ~6pp increase of the probability that a recession will begin in the next 12 months.

Holding all other inputs equal (the u-rate vs nairu, aggregate hours worked growth, core CPI ex-shelter, and the change in oil prices) puts the probability of a recession beginning in the next 12 months at 16.4% on the unadjusted model, and 26.4% when we adjust the curve for the level of front-end rates. This is still low.

The parallels between the current environment and the Greenspan conundrum are inevitable given the apparent insensitivity of long-end rates to the Fed’s hiking cycle – particularly in the context of a balance sheet unwind that many expected to put sustained steepening pressure on the curve. There is no “conundrum” in our mind – the Fed is simply hiking into a very low neutral rate, with no evidence that inflation is set to materialize to allow them to move faster. This cycle is following a somewhat similar path, however, to the mid 2000’s cycle from the perspective of recession probability.

Now 2 years into the current cycle, the recession probability is at a similar spot to mid-2006 (which was just months away from being within the 12 month window to the start of the great recession).

The risks presented by a flattening yield curve have a clear transmission mechanism to broader conditions as the Fed’s balance sheet shrinks. Before the Fed began to pare its balance sheet we discussed why a steep curve is important to a successful QE unwind – if the curve flattens too much, banks will have no incentive to hold securities over cash earning IOER, meaning non-banks will likely be the marginal buyers of securities no longer owned by the Fed, and deposits will leave the system. This in turn carries meaningful risks to loan growth, which had caught a fair amount of attention given the slowing earlier in the year. Our financial conditions index suggests that C&I growth should be accelerating, though that has not really materialized yet.

The lagged relationship between C&I loans and the Senior Loan Officer survey points to a pick-up in loan growth, but only into the ~5% y/y range, not the double digit range of years past. This has failed to materialize, however, and is a going risk amid the Fed’s balance sheet wind down.

It is still sufficiently early into the Fed’s balance sheet unwind that banks’ reaction function is hard to gauge – securities holdings have risen since the end of September, while cash holdings have been more or less stable and deposits have shown some recent volatility but might still be on an upward trend. So the limited evidence does not yet suggest that this is posing an imminent risk to the economy, but the flatter the curve gets, the more likely banks are to eschew securities for cash, increasing the risk that deposits leave the system, and banks have to pull back on lending."  - source Deutsche Bank

There you have it, no matter how strong the "volition" of the Fed is, the exercise is difficult to execute. While there is no imminent threat to the positive narrative from a fundamentals perspective, the relentless flattening of the Us yield curve is difficult to ignore on top of rising geopolitical exogenous factors. We could easily entertain a blow out of oil prices on the back of exogenous factor in an already tensed Middle East, which would no doubt spill into the inflation expectations surprises on the upside and lead to some repricing and heightened volatility. As we pointed out in our bullet point, when the going gets tough...volition or not.

In our last conversation, we pointed out that "volatility" conundrum was not a paranormal phenomenon, and no matter our strong the Fed's volition and "Forward Guidance" (or imprudence), what the US yield curve is telling us is that no matter how strong the Fed's volition is, they cannot escape Newtonian gravity:

"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." - source Macronomics, November 2017 

Our final chart below points towards the gravitational pull the Fed is facing.

• Final chart -  The Fed can't escape Newtonian gravity

No matter how strong the spells of the "wizards" at the Fed have been in recent years as pointed out by the wise wizard of the BIS aka Claudio Borio, the Fed's volition is one thing, Newtonian gravity is another. Our final chart comes from Bank of America Merrill Lynch's Weekly Securitization Overview from the 8th of December entitled "The gravity of the yield curve" and displays the 2Y10Y versus the US unemployment rate:

"Given the magnitude of recent yield curve flattening, we revisit our framework where we look at the 2y-10y spreads relative to the unemployment rate back to 1989 (Chart 1).

The flattener has moved more slowly than we anticipated back in 2014, dropping by about 50 bps per year over the last 4 years. Given where unemployment already is, and expectations that it will move lower in the year ahead, we see a strong gravitational pull lower on the curve. Moreover, given that the Fed likely has 4-5 rate hikes in store over the next year (including December 2017), while inflation readings remain low, dropping an additional 50 bps on the curve over the next year seems very achievable, particularly after the 30 bps drop in the 2y-10y spread in the past six weeks.

We note that flattening is not the house call: BofAML rates strategists believe the curve will steepen due to easier fiscal policy, higher deficits, and a higher inflation expectation and the Fed will require higher 5y-10y yields as a precondition to flattening or inverting the curve. We recognize that the flattening process has already taken longer than we expected a few years back, due to multiple “dovish” Fed hikes or pauses, and we acknowledge the potential for what we think would be steepening detours along the way.

Newton's law of gravitation resembles Coulomb's law of electrical forces, which is used to calculate the magnitude of the electrical force arising between two charged bodies. Both are inverse-square laws, where force is inversely proportional to the square of the distance between the bodies. In similar fashion, the relationship between the US 2Y10Y and the US unemployment rate could be seen as inverse-square laws when it comes to the ongoing flattening stance of the US yield curve but we ramble again...

"A man of genius makes no mistakes; his errors are volitional and are the portals of discovery." -  James Joyce

Stay tuned!