Macro and Credit - Thermidor

"The seed of revolution is repression." - Woodrow Wilson, American president

Watching with interest the disappointment unfold thanks to Bank of Japan's holding pattern, pushing us to quickly take our loss and cut our small short yen exposure, while looking at the news that France was about to harvest the least wheat in 28 Years, it reminded us for our title analogy, the French Republican Calendar implemented during the French revolution and used by the French government for about 12 years from late 1793 until 1805, with Thermidor (or Fervidor) starting the 19th or 20th of July and coming from the Greek "thermon" meaning "summer heat". On many printed calendars of Year II (1793–94), the month of Thermidor was named Fervidor (from Latin fervens, "hot"). Looking at the performance of European banks stocks since the beginning of the year and following the publication of the "stress tests", we do think indeed that our title is indicative of a build up in "summer heat", at the same time it is as well indicative of the significant performance in credit which was yet given another boost thanks to the latest Bank of England raft of decisions. 

What is of interest in the Republican calendar was the tentative in the alteration of time measurement we think:

"Each day in the Republican Calendar was divided into ten hours, each hour into 100 decimal minutes, and each decimal minute into 100 decimal seconds. Thus an hour was 144 conventional minutes (more than twice as long as a conventional hour), a minute was 86.4 conventional seconds (44% longer than a conventional minute), and a second was 0.864 conventional seconds (13.6% shorter than a conventional second).
Clocks were manufactured to display this decimal time, but it did not catch on. Mandatory use of decimal time was officially suspended 7 April 1795, although some cities continued to use decimal time as late as 1801." - source Wikipedia

This was part of a larger attempt at decimalisation in France (which also included decimal time of day, decimalisation of currency, and metrication). When we look at the effects of Negative Interest Rate Policy aka NIRP, we can only think about the attempt of central bankers towards "decimation" of European bank stocks, decimation meaning to destroy a great number or proportion of. On a side note France introduced "decimilisation" of the franc in 1795 to replace the "livre tournois", abolished during the French Revolution whereas the United States introduced decimal denomination from the outset of home minted currency in 1792 with the dollar being equal to 100 cents.

Of course our use of a French revolutionary calendar term is as well a reference to our previous conversation from September 2012 "Pareto Efficiency" where we indicated the following when it comes to "wheat prices" and "revolutions":

"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.

Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.

The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788), of course any similarities with this year's meteorological events are purely fortuitous given we are rambling again...Are we?" - source Macronomics, September 2012

Now, going towards 2017 with first the Italian referendum in October, then with some important elections taking place next year in both France and Germany, we are wondering if indeed "Thermidor" will not lead to yet another summer of discontent in 2017 given the the significant rise of populism tied to the "War on Inequality" mentioned recently by Michael Hartnett's team in the latest Bank of America Merrill Lynch Thundering Word note from the 29th of July entitled "Fiscal Flip...Get Real":

"Long View

The policy baton is passing from Monetary to Fiscal stimulus in 2016/17. Central bank
rate cuts ending. New policies to address populist desire for "War on Inequality"
emerging. Policy response will be combination of:
1. Redistribution…stagflationary: winners…TIPS, munis, low-end consumption (retail,
payments, tax services); losers…brokers, luxury, growth stocks; yield curve bear
flattens.
2. Protectionism…deflationary: winners…government bonds, gold, volatility, high
quality defensive stocks; losers…banks, multinational companies; yield curve bull
flattens.
3. Keynesianism…reflationary (with “helicopter money): winners TIPS, commodities,
banks, value; losers…bond substitutes; yield curve bear steepens.

Fiscal flip reflects policy intent to reduce deflation, wealth inequality and wage
insecurity. Success means rotation from “deflation” to “inflation” assets; note real
assets (commodities, collectables & real estate) now at all-time lows relative to financial
assets (stocks & bonds) – Chart 1.

- source Bank of America Merrill Lynch

Could this rotation from "deflation" to "inflation" trigger indeed a surge in commodities? We wonder...

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”

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 shown by the latest yet unsurprisingly dismal US GDP print. This of course leading to a "pre-revolutionary" mindset setting in, leading to the rise of "populism" and the deafening sound of "helicopter money" and fiscal profligacy as the "elites" and their central bankers are starting in earnest to "panic" somewhat. We will touch more on this in our conversation.

In this week's conversation we would like to reiterate, like many others our concern relating to the continuation of tightening financial conditions as per the US Senior Loan Officia Survey relative to the rally seen so far in US High Yield thanks to massive inflows from the retail crowd. While we remain tactically short term bullish, or "Keynesian", we do feel fundamentally "medium term" bearish" or "Austrian" given current "credit valuations" do not reflect the deterioration in economic fundamentals. On that note we were not surprised at all by the latest US GDP print, given in January 2016 in our conversation the "Ninth Wave" we indicated:

"Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.
We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should "risk" decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy." - source Macronomics, January 2016

When it comes to our positioning relative to the US recessionary crowd, we believe that a flattening of the US yield curve is never a good sign, particularly for the financial sector which has been vaunted by some as a "compelling" buy.

Why is so?

Underperformance by the banking sector always is a bad sign for markets and the economy; it suggests that the credit mechanism is clogged, with knock-on effects for the rest of the economy, that simple.

Synopsis:

• Macro and Credit - Is it High Noon for US High Yield tourists?
• Macro and Credit  - Investing Greed leaning towards Investment Grade
• Final chart: Bank stocks under pressure? Blame central banks

• Macro and Credit - Is it High Noon for US High Yield tourists?

For tracking credit availability, you need to use the central banks’ credit surveys. The most predictive variable for default rates remains credit availability. 

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

As we pointed out in our November conversation "Ship of Fools", credit investors are often too complacent when it comes to assessing the stage of the credit cycle and when it comes from the retail crowd aka the US High Yield tourists, they have been pouring "inflows" at a very late stage of the "game":

"Furthermore, despite their alleged high degree of sophistication, credit investors have a very weak predictive power on future default rates. This was largely discussed by our Rcube friends in their long March 2013 guest post entitled "Long-Term Corporate Credit Returns":
Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this manic-depressive behaviour (which can also be related to Minsky’s model of the credit cycle)." - source Rcube
From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.

"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 mal-investment, and sows the seeds of the next credit crisis." - Macronomics, November 2015

Lather, rinse, repeat. 

While it isn't yet "high noon" per se for the US High Yield tourists, the latest publication of the US Senior Loan Officer Survey confirms clearly a deteriorating trend in financial conditions which is indeed down the line (most likely in 2017) a recipe for a serious "repricing" of the asset class as a whole. To re-iterate our November call, we remain short-term "Keynesian" bullish / long term "Austrian" bearish when it comes to assessing the current stage of this credit cycle. This should provide sufficient proof for us not being labelled "perma-bears" or having a "pessimism bias" but, rather a "realistic bias" we think.

When it comes to assessing global credit conditions, we share our concerns with UBS and read with interest their latest Global Credit Strategy note from the 2nd of August entitled "Q2 Lending Conditions: Why did lenders tighten?":

"Q2 Lending Conditions: Why did lenders tighten?

A critical linchpin in our frameworks for assessing credit spreads, defaults and the read-through to macro implications is the state of lending conditions. And, to cut to the chase, recent releases could aptly characterize current conditions as increasingly uncomfortable, albeit not alarming. The improvement in our non-bank liquidity indicator since March has stalled, with the latest reading rising from 7 to 9.1 – principally due to less robust issuance of lower-quality high yield debt since April. In our view, this gauge is superior to the Fed's SLOS survey tracking bank liquidity conditions given nearly 80% of corporate funding is done via non-banks. That said, our non-bank indicators have now largely converged with the Fed's bank liquidity gauge, with net tightening of credit standards on C&I loans to SMEs increasing from 5.8 to 7.1 in the latest survey (Figure 1).

Notably, we do not believe the latest SLOS survey results were significantly affected by the UK's Leave vote (as banks received the survey on June 28, and responses were due by July 12). For C&I lending conditions, the rationales given from bank loan officers for shifts in lending standards continued to be dominated by net tightening attributed to a weaker economic outlook and industry problems versus net easing due to competition; however, in terms of shifts there were fewer officers reporting industry specific problems (e.g., energy, but prior to the latest decline in oil prices) as a reason for tightening, more respondents citing lower risk tolerance and higher regulatory concerns as rationale for tightening, and more noting increased competition as a driver of easing (Figure 2).

And lower risk tolerance and greater regulatory pressures would be consistent with sentiment from the latest Shared National Credits (SNC) review, which continues to highlight concerns related to an elevated level of special mention and classified (i.e., higher risk) loans which may increase defaults this cycle and the prevalence of incremental facilities allowing greater sharing of priority claims which may lower recovery rates1 . In terms of our key forecasts, our HY spread forecast increases from 660bp to 666bp (vs 566bp current), our HY default forecast is unchanged at 5 – 5.5% by mid-2017, and our credit-based probability of recession rises to 33% from 31% (over the next 12mos).

Why the discomfort? First, the persistent albeit moderate tightening trend in C&I liquidity conditions bears watching as the relationship is not linear; i.e., further increases in net tightening from current readings will disproportionately increase spreads, defaults and recession risks in our models, respectively, when compared with commensurate decreases in net tightening (e.g., see recession gauge sensitivities on net tightening – Figure 4). 

Second, our prior concerns related to significant easing of lending standards and rising credit risks in other sectors seem to be trending in the wrong direction2. In particular, lending standards for commercial real estate (CRE) loans contracted further, with aggregate (debt-weighted) net tightening of 27% from 20% the prior quarter (CLD to 31% from 25%, nonfarm nonresi to 18% from 12%, and multifamily to 44% from 36%). While not cited, we believe the tightening reflects increased regulatory scrutiny (e.g., 2006 CRE guidance, risk retention requirements) as well as concerns around lax lending standards and lofty valuations. 

At current levels, the significant tightening observed in CRE standards, which is historically reasonably well correlated with C&I standards (as we have detailed previously), is near historical extremes (as per Figure 4).

Aside from commercial lending, the mosaic from consumer and residential sectors has been more benign in prior surveys. However, there were some signs of less easing in consumer loans – with net tightening in auto loan standards moving from -6.3 to 0 (while in credit cards net tightening was -5.6 vs -5.7 the prior quarter). Banks reported higher spreads on auto loans, and higher spreads and lower credit scores for credit card loans. For residential loans, the SLOS survey overall signaled marginally less easing – i.e., the second derivative is negative. However, like C&I loans, residential lending is primarily driven by non-bank lending (Figure 5).

In turn, the Fed's SLOS survey results should be taken with a grain of salt. One alternative, which encompasses non-bank lending, is the AEI's change in its National Mortgage Risk Indices (NMRI) 3 . This metric, updated monthly and based on actual loan origination risk metrics, suggests that while banks are reducing risk in residential originations (for FHA/VA/RHS primarily), non-banks are increasing risk in a bigger way – causing a net easing of credit conditions in resi. This point illustrates that non-bank lending standards are increasingly (if not more) important than bank lending conditions in some asset classes and, in particular, in instances when the signals can diverge. And, in this instance, continued easing in residential mortgage credit conditions is one development which is helping offset the more persistent, marginal to moderate tightening in lending standards across other asset classes. In short, for now the prognosis is increasing discomfort, but not alarm." - source UBS

Whereas the SLOS survey doesn't yet point out to "High Noon" for our US High Yield tourist friends from the retail space, we do think that the evolution of tightening financial conditions is a harbinger for things to come in 2017, namely spread widening and a rise in defaults. We do agree with UBS and share their increasing discomfort. 

As well, on the deterioration of the credit cycle, we read with interest Oaktree's insights in their special edition "Navigating cycles":

"Bruce Karsh: How does this credit cycle resemble and differ from past credit cycles?  

Rajath Shourie, Co-Portfolio Manager, Distressed Opportunities: The down-leg of the current cycle feels most like the down-leg we experienced in the early 2000s, when too much capital came into a popular industry; that industry blew up; and the dislocation spread to other industries. In the early 2000s, telecom was the darling industry that went bust. Today it is energy. In the early 2000s, a majority of the high yield bonds issued by telecom companies defaulted, and unless oil prices make a major recovery, today’s exploration and production companies are likely to face a similar fate.

Jordon Kruse, Co-Portfolio Manager, Global Principal: I’ll focus on a comparison of the current downleg to the one we experienced in 2008-09. They are similar in that both followed long periods of significant debt issuance, but different in that there is far less systemic risk today than there was in 2008-09. A major driver of that risk was the substantial amount of bad mortgage securities held by large financial institutions that played a major role in the financial system at large.

Bruce Karsh: What is your expectation for defaults this year?  

Sheldon Stone: The 2016 default rate for U.S. high yield bonds is projected to increase to between 5 and 6%. This compares to the 2015 default rate for U.S. high yield bonds of 2.8% and the 30-year average of 4%. While this 2016 estimate is higher than what we’ve seen since 2009, it is not meaningfully higher than normal observations. As you would likely guess, defaults this year already have been—and will be—heavily impacted by oil prices. I believe that easily two-thirds, or maybe even three-quarters, of the defaults this year will stem from energy-related issuers. 

... 

Bruce Karsh: Outside of China, what factors do you think are exerting the greatest impact on the current market environment?  

Sheldon Stone: The obvious ones are low energy and commodity prices; however, those are linked to China. The other one worth highlighting is liquidity. Current trading markets are significantly less liquid, causing rapid changes from a buyer’s market to a seller’s without large trading volumes. We estimate that today, banks are carrying about 20% of their 2007 peak inventory of senior loans and high yield bonds.  As a result, banks are now looking for trades to cross, rather than putting their capital at risk.  It doesn’t take much selling these days to move bond prices a fair amount. 

Rajath Shourie: I completely agree with Sheldon. Prices have recently been declining dramatically because there’s a buyers’ strike at play, not because there is a lot of supply from forced sellers." - source Oaktree insights, July 2016

When it comes to "liquidity, to that effect we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":

Today investors face the same "optimism bias" namely that they overstate their ability to exit.

“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain such as the gains seen in single A credit in the United Kingdom following's the Bank of England early "Christmas present" for the speculating crowd. Yes indeed, the fun is "uphill", in the bond market.

When it comes to "Thermidor" or "investment heat", when it comes to "investment grade" credit, the summer heat is truly "on". This leads us to our second point below.

• Macro and Credit  - Investing Greed leaning towards Investment Grade

While we have been predicating for the right reasons to stick with quality Investment Grade credit since the beginning of the year (particularly as per our last post on Senior Unsecured bank credit rather than equities...), even recommending a long duration exposure to the asset class, the ECB playing the "corporate credit game" now being followed as of late by the Bank of England points towards even more "fun" running uphill to this particular segment, or, to put it bluntly, "Investment Greed" is leading to "Investment Grade". When it comes to "flows", the "summer heat" is indeed "on" during our "Thermidor" period rest assured as pointed out by Bank of America Merrill Lynch in their latest Follow The Flow note from the 5th of August entitled "Largest inflow into IG funds ever":

"Large outflows from equities; large inflows into IG 

Inflows into high-grade have accelerated. Over the past four weeks inflows have been almost doubling on a w-o-w basis. However, while inflows into credit have been strong, equity funds have been suffering continuous outflows over the past 26 weeks. Should the recent trend continue, the inflows that came into the asset class since 2015 would be erased in the next 10 weeks or so (Chart 1).  

High grade funds recorded their 21st week of inflows and the highest ever since the start of our data set (table 1).

Flows into the asset class have doubled w-o-w, and propelled the year to date cumulative inflow to over $13bn. High yield funds however reported a substantial outflow, the first in five weeks. The outflows were a mix of global, US and European-focused funds. More in chart 13. 

Government bond funds flows switched to positive after two weeks of outflows. Money Market funds flows also turned positive after three weeks of outflows. 

Flows into equity funds remained in negative territory for the 26th consecutive week. Almost $80bn has left the asset class over that period." - source Bank of America Merrill Lynch

So much for the much lauded "Great Rotation" story from "equities" towards "bonds". When it comes to having some "fun" uphill, Fixed Income is still "the place to be" and when it comes to "greed", Investment Grade credit rules the game for now thanks to central banks joining as well the "party".

While equities are making news highs while flows are making new lows, we think that we haven't seen yet the lows of the current credit rally in investment Grade à la 2006. On this particular point we agree with JP Morgan's take in their Credit Market Outlook and Strategy from the 28th of July when it comes to US Investment Grade:

"Credit has not reached a low in spreads while equity indices are at all-time highs 

One of the interesting cross market dynamics recently is that equity markets are reaching new highs while HG bond spreads have been range bound well off of their tightest levels. This month the Dow and S&P reached new peaks and the Nasdaq came close. The JULI spread is at 171bp, 83bp above the pre-crisis low of 89bp (29th July, 2005) and 49bp above post crisis low of 122bp (24th June, 2014). There are several logical explanations for this divergence in performance, but we still believe the trend is for tighter spreads.

The most important explanation is that HG bond yields rather than spreads are the key valuation metric for many now (particularly overseas investors), and they are almost at a record low. The JULI yield is 96bp lower YTD and at 3.32% as of Wednesday it’s just 6bp off its record low of 3.26% reached on July 8th of this year.
The second explanation is the much higher weighting of banks in credit (24.4%) vs in the S&P (5.2%). The banks index of the S&P is not at its post crisis peak – it is 16.4% below the peak reached on 22nd July, 2015.

JULI Financials are at 172bp, 96bp above where they were when JULI spreads were at a pre-crisis low and 54bp above the JULI post-crisis low point. Banks have lagged in both equity and credit markets, but it matters more in credit markets. The third explanation is that 30.5% of the JULI comes from issuers outside the US. Of this 29% is EM and 71% is DM. This subset of the JULI is at a spread of 183bp, which is 93bp and 38bp above where it was vs the pre and post crisis low spread points for the index. Excluding EM these figures are 81bp above and 54bp above for Yankee
issuers." - source JP Morgan.

Whereas we think equities have much more less room to rise in the US, we do think we are going to see additional melt-up in and records been broken in the US. When it comes to "valuation" and "rotation", we do think that in this "japanification" and "Thermidor" period, the trend is indeed, your friend and there is more "fun" to come given "greed" is still running high in the context of "financial repression". 

While we keep noticing the deterioration in "financial conditions" as pointed out by the US Senior Loan Officers Surveys (SLOS), we still recommend a "rotation" towards "quality". This recommendation was made again in our previous conversation when it comes to bank exposure and "senior unsecured credit" was less volatile than merely chasing "beta".

When it comes to "greed" and "Investment Grade" credit, we continue to favor US Investment Grade credit and we do think that having the ECB, the Bank of England and the Bank of Japan, competing with their local investment base when it comes to chasing assets, we do think that once more US credit will strongly benefit from investors in September after the summer lull or "Thermidor" period. 

We therefore agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 29th of July entitled "Kuroda and Draghi and Yellen":

"Fed+ECB+BOJ>0 

On balance we view recent developments in global monetary policies from the major central banks as positive for the US HG corporate bond market. At this week’s FOMC meeting the Fed was not as hawkish as investors had feared – specifically they did not prepare investors for a September rate hike. Recall that last year - prior to starting the rate hiking cycle at their December meeting - the Fed had warned the market of that possibility explicitly in the statement from their previous (October) meeting.
In Europe, as our European credit strategist, Barnaby Martin, highlights (see: Resistance is futile), the ECB appears on a mission to deflate credit spreads in the European corporate bond market. This has to drive even more European investors into the US corporate bond market – probably when they come back from vacations in September (Figure 3). 

Furthermore, unlike the BOJ the ECB has plenty of ammunition left that – if deployed – would help drive US credit spreads tighter. This includes changes to its capital key (Figure 4) that would direct QE purchases away from bunds toward assets that have more credit risk (see: Brexit pushing Draghi out the curve?).

So we continue to expect accelerating foreign purchases of US corporate bonds during the last part of the year driven by Europe, while Asian buying remains steady – which means strong.

(Reverse) Yankees are coming 

In additional to accelerating European demand for US corporate bonds starting in September, we should we expect accelerating reverse Yankee issuance (i.e. US companies coming abroad in non USD currencies). Given what the ECB is doing this is certainly the case for the EUR market (Figure 5), but with global yield starvation we expect increasing reverse Yankee issuance in other currencies too (Figure 6). 

That should further support USD credit spreads just like we saw for the banking sector this month post-earnings." - source Bank of America Merrill Lynch

If indeed "greed" is "good" then obviously there is more room when it comes to spread tightening in US Investment Grade thanks to somewhat to some "crowding out" due to to central bankers competing with investors in this "unhealthy" yield chasing game. We can as well anticipate a significant return of the Japanese investor crowd to foreign bond markets while the Bank of Japan, while on hold, is preparing for some more "unconventional" bazooka in September when we will eventually revisit our short yen exposure.

When it comes to "crowding out" and the ECB, we read with interest Bank of America Merrill Lynch's European credit strategist Barnaby Martin note "Resistance is futile" from the 28th of July highlighting how central banks are pushing outside of their comfort zone "yield hogs" towards more credit risk and/or higher duration exposure:

"Honesty doesn’t pay 

Spreads took another leg tighter last Monday as CSPP ISINs were disclosed. We sense “doubters” threw in the towel. But we think disclosure rubs both ways. While the aim is to facilitate securities lending – and aid credit market liquidity – we fear the sheer size of CSPP buying has heightened investors’ nervousness over credit market liquidity.

As chart 1 shows, investors are already starting to have concerns over the growth of negative yielding corporate debt across the globe. Note the weakness in European corporate bond spreads over the last 2 days despite equities being up…

How has credit market liquidity fared through CSPP life?  

Chart 2 shows the average bid-offer spread (in bp) for investment-grade corporate bonds. We split the universe up into  CSPP eligible,  non-eligible (non-banks) and  CSPP purchased bonds. 

We think that the picture shows some encouraging but also some concerning developments: 

• What’s clear is that the announcement of CSPP on March 10th initially caused mass confusion in the market. Bid-offers surged and liquidity deteriorated meaningfully in non-financial bonds. Yet, bid-offers remained steady in parts of the market that were expected to be untouched by Draghi (note the calm in  non-eligible bid-offers).
• From March 10th until CSPP buying began (June 8th), credit market liquidity improved noticeably. Bid-offers tightened for all parts of the market as CSPP was deemed to be the policy that would rejuvenate the corporate bond market.
• But since June 8th, bid-offers have widened and liquidity has deteriorated again. True, Brexit took place on June 23rd, but nonetheless there has been a drift higher in bid-offers since Draghi started buying credit. And if anything, liquidity seems to have deteriorated further for  eligible and  purchased names, post the ISIN publication last week.
So while the aim of CSPP disclosure was to preserve credit market liquidity, the initial signs seem to point to something more worrying: that the ECB’s dominance in corporate bond buying is in fact becoming counterproductive for market health.
We think that this will be another reason why investors will want to accelerate their movement into non-eligible parts of the credit market post the summer break. Not only are non-eligible sectors relatively attractive spread-wise now, but they also offer an attractive combination of yield and volatility, we think, compared to CSPP purchased sectors" - source Bank of America Merrill Lynch

In similar fashion than the Bank of Japan has completely destroyed the liquidity in its Government Bond Market (JGBs), the ECB is as well in the process of wreaking havoc in the liquidity of the Corporate bond market and has now been joined in a similar process by its neighbor the Bank of England. 

When it comes to the "Thermidor" period, we do live in pre-revolutionary times we think and wonder how long markets are going to cope with this financial repression.

On a final note and in our final chart and in continuation to last week's conversation surrounding bank "valuations", we would like to point out how interest policies of our "omnipotent" central bankers and now with NIRP are destroying slowly but surely "bank capital".

• Final chart: Bank stocks under pressure? Blame central banks

We will not re-iterate why we dislike banks stocks and in particular European banks stocks given the "japanification" process and the significant on-going deleveraging. If there is indeed some clear culprits when it comes to "capital destruction" thanks to Zero Interest Rate Policies (ZIRP) and now with Negative Interest Rate Policies (NIRP), the blame is entirely on the shoulders of our "generous gamblers" aka central bankers and their experiments. 

This is clearly illustrated in our final chart displaying the correlation between interest rate policies and bank stocks as pointed out by this chart from Bank of America Merrill Lynch from their Credit Derivatives Strategist note from the 5th of August entitled "Corporate ‘QE²’ - When CBPS met CSPP":

- source Bank of America Merrill Lynch

As a "bonus chart" we will point out to yet another chart from Bank of America Merrill Lynch's European credit strategist Barnaby Martin note "Resistance is futile" from the 28th of July chart displaying that the "fun" has been going "uphill", namely to the bond market and in particular German Bunds:

- source Bank of America Merrill Lynch

For the "real economy", downhill that is, we are not too sure they are getting their share of the "fun", which does indeed explain the rise in inequalities, populism and the rising prevailing "pre-revolutionary" mood in many parts of the world.

Back in November 2014 in our conversation "Chekhov's gun" we argued the following:

"Our take on QE in Europe can be summarized as follows: 

Current European equation:  

QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 

“Hopeful” equation:  

QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend." - source Macronomics, November 2014

Obviously our "Hopeful equation" suffered from "Optimism bias" and we argued at the time:

"Our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015) " - source Macronomics, November 2014

Increasingly it looks to us that we are moving towards the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). That's our take and our "realist bias" for now unless of course we finally get a wake-up call from the political class leading to the realization of our "Hopeful" equation but we would not bet on it for the time being.

"Those who make peaceful revolution impossible will make violent revolution inevitable." - John F. Kennedy

Stay tuned!

Macro and Credit - Confusion

"When a man's knowledge is not in order, the more of it he has the greater will be his confusion." - Herbert Spencer, English philosopher

Looking at the reversal of our previous thoughts relating to the potential for yen weakening and Nikkei surging in the process given our expectations for new tricks from the Bank of Japan, while disappointed on our recent call, we did not trigger and added on going long Nikkei hedged this time around given the on-going "Confusion" in both macro data and weaker flows at least in gold miners for the time being, we decided that for our chosen title analogy, given our fondness for the music from the 80s and in particular for New Order that our title should reflect our state of mind as well as August 1983 maverick single from the British group. On a side note, we have made a previous reference to New Order's music in our July 2015 conversation entitled "Blue Monday".

While Emerging debt seems to be flow wise the new darling of investors (or "yield hogs"), and when it comes to US High Yield disregarding "safety" for "yield", as pointed recently by BlackRock's recent chart of the week, it seems for them that double-digit returns going forward will be a thing of the past it seems:

- source BlackRock

Given the upcoming European Banking Association "stress tests", we would like to look this week to re-iterate our preference for credit instruments rather than equities when it comes to European banks. We will as well look at Japan again given the details of the fiscal stimulus so far have disappointed the "central banking addicted" investor crowd and the much anticipated decisions coming from the Bank of Japan as well as the FOMC hence the on-going "Confusion".

Synopsis:

• Macro and Credit - European banks - So you wanna play "beta"? Stick to senior credit
• Macro and Credit  - Japan looking for a "helicopter stall"
• Final charts: Europe, "Mind the Gap" - Dividend yield is high relative to Earnings yield

• Macro and Credit - European banks - So you wanna play "beta"? Stick to senior credit

As we pointed out on numerous occasions, when it comes to the attractive "valuations" levels pointed out by some "confused" pundits, when it comes to assessing this "value play", we have long been recommending you stick to "credit". In fact, that's exactly we pointed out in our November conversation "Fluctuat nec mergitur":

"In this "beta" chasing game, some pundits would point out to the attractive "valuations" level of European banks. We continue to dislike the sector as the deleveraging and low profitability of the sector makes us prefer to play it through credit instruments à la "Japan".
Equities wise, we believe the banking sector will continue to underperform "high beta financial credit", regardless of the bullish and overweight stance of Société Générale's Equities team

No matter how our "equities friends" want to "spin it", we are not "buying it" and we will stick to "credit" when it comes to banking exposure in this "japanification" on-going process. There is much more "deleveraging" to go in Europe, in 2016" - source Macronomics, November 2015

And of course no "Confusion" there, we were right from the onset of 2016 on this very subject. To further make our point clearer, we read with interest Deutsche Bank's European Banks Capital Structure note from the 27th of July:

"Unlike the sell-off early in the year, the market has generally differentiated quite well between bank credit and equity. The former has been supported by historically high capital ratios and strong liquidity buffers, whereas the latter has suffered from downward earnings pressures.

This is clearly illustrated by Figure 28 and Figure 29.

While the Stoxx Europe Banks equity index is down 27% YTD, the iBoxx EUR Banks Senior index spread is now at 108bp, exactly where it was at the end of 2015. Moreover, while equities are down 13.4% since the Brexit vote, senior credit is 5bp tighter.

Even at the bottom of the debt capital structure, Additional Tier 1 (AT1) securities have done remarkably well relative to equities when compared to their performance in the market sell-off in February. This is shown in Figure 30 and Figure 31.

In total return terms, EUR AT1s are down 2.6% YTD whereas the total return on equities over that period is -24.5%. Since the Brexit vote, it has been 0.1% and -11.8%, respectively.

In February, however, concerns that some banks might miss an AT1-coupon payment led to an abrupt sell-off in those instruments, partly due to the (self-fulfilling) fear that such an event might spark massive volatility across the AT1 market. This was compounded by a lack of clarity about when the so-called Maximum Distributable Amount (MDA) restrictions kick in, preventing banks from paying discretionary coupons among others. As we explained in our report at the height of the sell-off, AT1s are contingently junior to equity both in payouts and capital, which increases their sensitivity to market moves once a certain stress level has been reached. A missed AT1 coupon is lost forever whereas dividends are retained for the benefit of shareholders (in fact just like the unpaid coupon).

Since then, the European Commission has cited precisely this argument as a reason to introduce more transparency and less rigidity into the application of the MDA rules by splitting the so-called Pillar 2 SREP capital buffer into a disclosed formal requirement and a guidance component where the breach of the latter should not constitute an MDA trigger (the “guidance” part would sit at the top of the capital stack rather than below the Combined Buffer, making the latter less likely to be breached and thus trigger MDA restrictions). This was confirmed in early June by the ECB stating that it will refine its SREP methodology in this fashion. This has reduced ambiguity and lowered AT1 coupon risks, bringing down volatility of these instruments as highlighted in Figure 30 and Figure 31.

AT1s need new buyers and we think that the relative resilience of this asset class this time around could bode well for future demand for the product. This is in contrast to February when the P&L damage to many accounts resulted in some key investors withdrawing from this market."  - source Deutsche Bank.

Where we disagree with Deutsche Bank entirely is that regardless of the future demand for AT1s, from a risk/reward perspective, we will re-iterate that we think that CoCos offer very poor value, no "Confusion" there from our perspective. Any serious trader out there will always tell you that you never ever want to be "short gamma". This is exactly what we pointed out in our February conversation "The disappearance of MS München" dealing with risk, VaR and much more:

"It is still time for you to play "defense", although we did warn you well advance of the direction markets would be taking at the end of 2015 and why we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up (it did...). Although some like it "beta" or more appropriately being "short gamma" such as the "value" proposal embedded in Contingent Convertibles aka CoCos (now making the headlines), we prefer to be "long gamma" but we ramble again..." - source Macronomics, February 2016

When you buy CoCos, you are effectively the "insurer", bear that in mind. Banks are benefiting from your generosity given you are providing the "crash protection" insurance and to do so they entice investors by offering higher coupons. There is no free lunch there...

Credit wise, we have been advising for a while to play the "quality" game rather than the "beta" game for investors willing to get "carried away and play the lower capital structure part of European banks credit. It comes to us as no surprise from reading Deutsche Bank's note that indeed senior unsecured bonds have had the best performance across the bank capital structure:

"Figure 32 and Figure 33 summarise relative spread performance across the bank debt capital structure. 

Compared to a year ago, bank EUR bond benchmark spreads are wider at all levels of seniority but their changes differ meaningfully:

• Covered bonds: 9bp wider (at 54bp now)

• Senior unsecured bonds: 1bp wider (at 108bp)

• Tier 2 bonds: 47bp wider (at 244bp)

• AT1 bonds: 292bp wider (at 870bp)

While this compares unfavourably with corporate non-financial senior bonds (16bp tighter at 94bp), senior unsecured bonds have had the best performance across the bank capital structure (including equity as shown before). Banks have been able to obtain term funding at relatively stable levels but their capital instruments have sold off meaningfully in spread terms due to broader concerns about compressed profitability and also potential solvency in weaker parts of the banking system.

On the one hand, regulation has brought explicit bail-in risk to bank creditors. On the other, regulatory policy over the last few years has ensured that banks have effectively been run for creditors. We have seen continued build-up of capital, de-risking of balance sheets and strengthening of liquidity profiles, all of that being bank credit positive. While we have shown that some banks are under obvious asset quality and capital pressures, major European banks have maintained reasonably strong credit profiles and this is why their credit has been relatively insulated from the equity turmoil." - source Deutsche Bank

Of course, this should not come as a surprise in the on-going "Japanification" process of the credit markets with the ECB as of late joining the bond buying spree. There is no "Confusion" there for this process to happen because it has all to do with central banks meddling with risk premiums and asset prices. They are indeed the first culprits in asset prices manipulation. This was as well clearly illustrated in Deutsche Bank's report:

"Investors have a behavioural bias towards absolute return targets. Even as ever lower rates and quantitative easing inflate asset prices and expected future market returns necessarily fall, they are reluctant to fully adjust their targets to the new reality. They reach for yield, moving down the risk spectrum to hit their return targets in a low-yielding world.
They take on more duration and credit risk, squeezing risk premia on the way. In the case of some term premia, for instance, these can turn negative as hold to- maturity considerations are overshadowed by a hope for a short-term capital gain or at least avoidance of the negative carry of shorter-duration instruments. (Locally, there seems to be particular aversion to negative yields although the initial resistance has been broken even in corporate bonds) Many investors, such as insurers and pension funds, also seek yield in less liquid and/or structured products, the latter often with greater tail risks.
Reaching for yield is an inherent part of the portfolio substitution channel that transmits QE to the financial conditions in the wider economy. As direct central bank purchases of sovereign and corporate bonds removed some downside risk, at least for now, they naturally contributed to a further drop in required risk premia. Investors then reach for yield in riskier asset classes.
There is nothing wrong with the willingness to accept lower risk premia. However, reaching for yield has limits and there is a risk of a yield over-reach.
To an extent, central banks trade off monetary and credit easing for potentially less financial stability down the road. At some point, however distant, reversal of the reach-for-yield phenomenon (repricing of risk premia) might be quite abrupt and lead to a sharp tightening of financial conditions, with macroeconomic and financial-stability consequences. But that is a worry for another day.
The financial sector has been a collateral victim of this environment. As maturity transformers, banks are notable earners of term premia, liquidity premia and credit risk premia. Consequently, their diminishment has been a drag on bank profitability. Given the difficulty in passing negative rates on to depositors, the competitive nature of the (in parts overbanked) industry and soft demand for credit, European banks seem to have been unable to reprice loans to preserve their margins. Also, eurozone banks increasingly compete with markets in which the ECB has been buying non-bank corporate bonds, driving spreads down relative to banks’ own cost of market funding despite bank bonds’ better ratings. The 3-6-3 banking rule most certainly does not apply here. Given the state of the economy, demand for credit and potential capital constraints, the required increase in loan volumes to compensate for tighter margins seems unlikely to be reached soon.
Low rates and QE have also had benefits for banks, such as lifting the value of sovereign holdings and improving asset quality relative to the counterfactual (of no such policies). Also, the ECB’s TLTROs or BoE’s Funding for Lending have been designed to provide funding cost benefits to banks, which should be positive for earnings if not fully competed away. Overall, however, the extraordinary rate environment has been deeply damaging to the prospects for bank profitability and it might potentially be structural if the “secular stagnation” hypothesis turns out to be correct.

Figure 5 summarises the dramatic shift in the rate environment over the years, spelling rather dire prospects for the European economy.

Banking in low-growth, low-inflation and flat-curve environment is simply a challenge. Globally, flattening curves and rates falling towards or below zero at ever longer maturities have been a vote of ever lower confidence in the adequacy of current policies to restore inflation and growth.
While one could have a long metaphysical discussion about whether 30-year bond yields near or below zero reflect true economic risks or duration overreach, their levels are not driven purely by QE purchases. Swiss 30-year government bonds have a negative yield even if the SNB is not buying. Clearly, peripheral sovereign credit has been a great beneficiary of ECB QE.

We review these market phenomena because they matter for the bank lending business as well, in addition to some of these bonds sitting directly in banks’ liquidity portfolios. In the corporate space, reaching for yield has been equally relentless. As we calculated recently, 3 over a third of AAs and As and nearly a quarter of BBBs, by amount outstanding, among non-financial corporate EUR bonds traded with negative ask yields.
Most recently, we have seen the first non-financial corporate (AA-rated Deutsche Bahn) issue a zero-coupon EUR bond with a yield of -0.006%. “Income” is disappearing from “fixed income”. These developments have pushed many bond investors down the credit quality spectrum but with BB yield at 3.06%, “high yield” is becoming a bit of a misnomer too, at least relative to its history.

All this weighs heavily on banks’ credit intermediation business. With interest rates on loans to households and firms on a multi-year downward trajectory, helped also by the ECB’s TLTROs, lending margins have been falling. Margins in our selected eurozone countries are mostly at 50-70% of their 2010 levels, with many worrying that the downward trend has more to go. Note that this
refers to new business only. There will be a further lagged response on the full loan book’s net interest margins (NIM) as it gets gradually repriced, eroding net interest income more.
In a negative-rate world with limited hopes for a change any time soon, NIM pressure is here to stay. Indeed, the collateral damage to bank stability and ultimately to economic growth from the negative-interest-rate policy has increasingly been seen as an impediment to more aggressive rate cuts by the ECB. At the same time, it has to be accepted that in a negative-rate world with much higher capital ratios than before the crisis, returns on bank equity below 10% might well be a fair compensation to shareholders. Current profitability measures cannot be compared to the “old days” of high interest rates and thin equity cushions.
To get on a higher earnings path, banks also have to continue to adjust their business models and cut costs. In banking systems with clear inefficiencies and overcapacity, especially as more European corporations raise funds via markets rather than banks, consolidation among smaller players and downsizing by some larger players may need to accelerate. There is a common interest in Europe in having a stable and adequately profitable banking system that promotes sustainable growth. That also requires overcoming some legacy challenges in pockets of potential instability." - source Deutsche Bank

Death by a thousand rates cuts and cost cutting, thanks to the stupidity of NIRP which is slowly but surely weighting on bank profitability and destroying NIM. At least from a credit investing perspective you have the ECB as your "buyer of last resort", avoiding in effect default risk to materialize for the time being but, just postponing the end result we think.

On a side note, we might be sounding yet again like a broken record but, for instance loan growth in Italy is constrained because Italian banks are "capital impaired" (to say it in a politically correct way...). Forget "bail-in" because if you do crush the retail crowd you can rest assured that Renzi's days will be over and that the whole European project would unravel with Italy threatening to leave the European project with a new majority such as the Five Star Movement. Even the leader of the populist movement is acutely aware of the risk "bail-in" would have on Italian savers.

The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":

"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016

Also, back in our February conversation "The disappearance of MS München" we joked in around these new NPLs CDOs being the new "Big Short":

"If you want to make it big, here is what we suggest à la "Big Short," given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honor the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs." - source Macronomics, February 2016

Reading through Deutsche Bank report, indeed, the Atlas plan was doomed from inception:

"With the aforementioned gap between market and book valuation of NPLs, disposals have been slow as banks are reluctant to book losses given their capital positions. In February, to facilitate disposals, the government introduced a scheme of state guarantees (GACS) of IG-rated senior tranches of NPL ABS at a cost linked to a basket of equally-rated Italian corporate CDS. While this introduced a handy hedging service, from the very start it stood little chance of solving the actual problem. To comply with EU State-Aid rules, these guarantees had to be offered at “market prices”. If that is the case, then by definition no amount of tranching and hedging can overcome the fact that if the securitisation vehicles acquire NPLs above their market values, investors in the junior tranches are unlikely to see the expected returns meet their targets. In reality, the scheme does offer guarantees that might not be readily available in the market otherwise and their pricing may be seen as marginally attractive. It just is not a silver bullet and can only be part of a bigger solution.

With no private buyers forthcoming, it has been increasingly clear that a comprehensive solution will require government involvement. The government coordinated the set-up of the €4.25bn Atlante fund by mostly private investors, which has been available for backstop recapitalisations (up to 70%) and NPL purchases (at least 30%). Its size, however, has been inadequate for the size of the NPL problem in Italy and at this point some €1.75bn remains available after recapitalising Banca Popolare di Vicenza (€1.5bn) and Veneto Banca (€1bn). It does not look like Atlante could dispose of those equity stakes soon, at acceptable prices, to free up resources for further purchases.
There have been reports that efforts are under way to set up Atlante 2 (to be called Giasone) with additional €2-3bn, particularly aimed at addressing NPL concerns around the largest troubled bank Monte Paschi. Even if such efforts succeed, however, the size of these private funds would be insufficient for a comprehensive solution." - source Deutsche Bank

Of course, these solutions are as we said earlier, an exercise of dubious intellectual utility. We might even suggest Italian banking authorities name Atlante Fund "iteration n" simply Danaus or Danaids (also Danaides or Danaïdes) because in Greek mythology the Danaids were condemned to spend eternity carrying water in a sieve or perforated device. In the classical tradition, they come to represent the futility of a repetitive task that can never be completed such as setting up private funds to resolve Italian NPLs.

Nonetheless, the ECB's credit buying spree is still supportive of credit versus equities when it comes to the European banking sector as a whole.

Moving on to our next "Confusion" point, we believe Japan, once more will have to play catch up to the tune of the ECB and stealth devaluation from China in order to revive "animal spirits", namely its stock market through yet another round of "unconventional" measures.

• Macro and Credit  - Japan looking for a "helicopter stall"

With Friday’s Bank of Japan meeting, every pundit is expecting "shock and awe" once more to induce yet another weakening bout of the yen as well as a rally in the Nikkei. In our last missive we indicated that re-initiating a short position on the Japanese yen could be of interest. While initially our timing was poor and faced an initial set back, we still believe Bank of Japan will again come to the rescue of its massive ETF equity exposure on its own local index.

What we find of interest in the discussions surrounding "helicopter money" and Japan is the analogy that can be made with Mario Draghi much discussed "bumblebee" reference in his 2012 speech that led to his "whatever it takes moment":

"And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing."- Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London, 26 July 2012.

The issue with bumblebee according to 20th century folklore, the laws of aerodynamic prove that they should be incapable of flying:

"The calculations that purported to show that bumblebees cannot fly are based upon a simplified linear treatment of oscillating aerofoils. The method assumes small amplitude oscillations without flow separation. This ignores the effect of dynamic stall (an airflow separation inducing a large vortex above the wing), which briefly produces several times the lift of the aerofoil in regular flight. More sophisticated aerodynamic analysis shows the bumblebee can fly because its wings encounter dynamic stall in every oscillation cycle" - source wikipedia

 When it comes to "helicopter money" and vortex stall and Japan, we touched on this very subject in our May 2014 conversation "The Vortex Ring":

"In a "helicopter stall" or vortex ring state, the helicopter descends into its own downwash. Under such conditions, the helicopter can fall at an extremely high rate (deflationary bust).
For such structural failure or crash to occur you need the following three factors to be present as indicated by Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'":

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

• There must be little or no airspeed.

• There must be a rate of descent.

• There must be power applied.

Note that all three of these must be going on at the same time." - source Macronomics, May 2014

We also argued at the time:

"It is not only the Fed and its central bankers which have a tendency to overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to convince he had done enough to spur 2% inflation and that his policies will be enough to pull Japan out of 15 years of deflation, risking in effect another Vortex Ring state for the Japanese markets." - source Macronomics, May 2014

Given the relative dismal results induced by QQE on the Japanese results, we expect more of the same from Japan as posited by our friend Michael Lebowitz from 720 Global in his latest missive called Kyōki (Insanity):

"Eventually, due to the mountain of money going directly in to the economy, inflation will emerge. However, the greater likelihood is not that inflation emerges, but that it actually explodes resulting in a complete annihilation of the currency and the Japanese economy. In hypothetical terms as described here, the outcome would be devastating. Unlike prior methods of QE which can be halted and even reversed, helicopter money demands ever increasing amounts to achieve the desired growth and inflation. Once started, it will be very difficult to stop as economic activity would stumble." - source Michael Lebowitz, 720 Global

This is exactly what will eventually happen to the Japanese "bumblebee", under a Vortex ring state thanks to "helicopter money" a country can fall at an extremely high rate (deflationary bust).

We totally agree with our friend Michael Lebowitz about the dangers of "perpetual bonds", or bonds with no maturity date as well with is astute reference to the French money printing exercise ultimately leading to economic ruin and a leading factor fueling the French revolution. All of this is described by French economist Florin Aftalion in his 1987 book entitled "The French Revolution - An Economic Interpretation"

This is what we discussed in May 2016 in our conversation "When Doves Cry" when it comes to "assignat" and "helicopter money" leading to a Vortex ring state (helicopter crash...or deflationary bust leading to "hyperinflation"):

"At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point". 

The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital." -  source Macronomics, May 2016

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point".

As we pointed out at the time and in relation to the ECB:

"To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB." - source Macronomics, May 2016

In similar fashion, the Japanese idea of "perpetual bond" is very close to the dreadful "assignat" and its dire consequences are well documented in Florin Aftalion's seminal book:

Source: Le marché des changes de Paris à la fin du XVIIIe siècle (1778-1800) -1937 

We also commented at the time in our May 2016 conversation:

"Of course as well as in Japan, doves have been crying given that they much vaunted currency depreciation scheme has been put in reverse as of late. But given the mounting evidence of a global slowdown, one would expect the Bank of Japan to return to the QQE game during the second part of this year. Now that the ECB is directly in competition of the likes of Mrs Watanabe, Japanese insurance companies, the GPIF and their pension funds, one would expect that the "fun" uphill, namely bond speculation, continues to run unabated, for the real economy, we are not too sure..." - source Macronomics, May 2016

But returning to "helicopter money", Japan and its much anticipated 28 trillion yen ($265 billion) fiscal package announced by Prime Minister Shinzo Abe, we have yet to see how the Bank of Japan is going to make good on Abe's promises. When it comes to Ben Bernanke idea of perpetual bond, this has been tried before in the form of the "assignat". If Japan issue a perpetual bond, to paraphrase du Pont de Nemours, Japan will have borrowed more!

On the issue of "perpetual bonds" we read with interest Nomura's Richard Koo's take in his latest note from the 26th of July entitled "Cost-benefit analysis of helicopter money":

"Four versions of helicopter money (3): government scrip and perpetual zero-coupon bonds

A third version of helicopter money involves government money printing or the replacement of the JGBs held by the BOJ with perpetual zero-coupon bonds.

The people proposing these policies hope that fiscal stimulus financed by government scrip or perpetual zero-coupon bonds, which are not viewed as government liabilities, will elicit spending from people who are currently saving because of concerns about the size of the fiscal deficit and the likelihood of future tax increases.

Economists refer to this reluctance to spend because of worries about future tax hikes as the Ricardian equivalence. If true, it implies that consumption will increase each time the government raises taxes since higher taxes mean lower deficit in the future. The fact that this phenomenon has never once been observed in the real world suggests it is nothing more than an empty theory.

Moreover, there are serious issues that must be confronted once the economy picks up and the liquidity supplied by the monetary authorities via government scrip or zero-coupon perpetuals must be drained from the system. Perpetual zero-coupon bonds are essentially worthless, which means the BOJ cannot sell them—no one in the private sector would be stupid enough to buy them.

That means the only way to mop up the excess reserves created via the issue of perpetual zero-coupon bonds is for the BOJ to ask the MOF to issue equivalent amounts of coupon-bearing bonds.

The same would be true when trying to mop up reserves created by government scrip. Once this scrip starts circulating, it becomes part of the monetary base, and draining it from the system will require the government to absorb it by issuing bonds. And in the case of both perpetuals and government scrip, the government that issued the bonds cannot spend the proceeds. If the government spends them, the liquidity that had been mopped up will flow back into the economy again.

Those recommending the issuance of government scrip or perpetual zero-coupon bonds say that one advantage of this approach is that it does not lead to an expansion of government liabilities (upon issuance). However, they will become massive government liabilities when the economy eventually recovers and they must be mopped up.

Helicopter money proponents silent on issue of mopping up reserves

In other words, the biggest issue with helicopter money—as with quantitative easing—is the question of how to drain these funds from the system. It becomes clear just how problematic both policies are when the difficulty of draining reserves is taken into account.

Yet in all the discussion about helicopter money and quantitative easing in Japan and elsewhere, almost no one has touched on the massive costs involved in mopping up the excess reserves created under these policies. Everyone emphasizes the benefits of these policies when introduced while ignoring that those benefits are small indeed when we examine the costs and benefits over the policy’s lifetime.

As one example of this bias, Waseda University professor Masazumi Wakatabe argued in a Nikkei column titled “Easy Economics” that helicopter money is preferable to quantitative easing inasmuch as it enables the government to undertake fiscal stimulus without increasing its liabilities.

I suspect that the helicopter money envisioned by Mr. Wakatabe involves the issuance of government scrip or direct central bank underwriting of perpetual zero-coupon bonds. However, he makes no mention whatsoever of how the liquidity created via these methods will be drained from the system once private-sector demand for loans recovers.

Helicopter money offers no benefits whatsoever over policy’s lifetime

As described above, the only way to mop up liquidity that has been created using these methods is for the government to issue bonds and not spend the proceeds. I think this would be more difficult from both a legal and practical perspective than winding down quantitative easing, which in itself is no easy task.

Moreover, the amount of government debt that must ultimately be acquired by the private sector is no different from a case in which the government had issued bonds to fund fiscal stimulus from the outset.

In short, whether fiscal stimulus is funded with government scrip and zero-coupon bonds or with the ordinary issue of government debt, the size of the government’s liabilities will be the same in the end. Helicopter money offers no benefits whatsoever when viewed over the lifetime of the policy, including the eventual need to mop up liquidity." - source Nomura

In similar fashion to "assignat" perpetual bonds are essentially worthless and there is indeed a heightened risk that Japan will face significant consequences to the value of its currency and eventually trigger a Vortex ring state (helicopter crash...or deflationary bust leading to "hyperinflation"), hence our long term very short view on the Japanese yen (our target might even scare you...).

Of course these are longer term risks that will eventually play out, closer to home and short term wise, there is growing dividend risk in Europe going forward.

• Final charts: Europe, "Mind the Gap" - Dividend yield is high relative to Earnings yield

 While European banks are slowly but surely dying thanks to NIRP and with Japan increasingly looking for its "helicopter stall", no "Confusion" there, in Europe what we think is of interest for our final chart is the growing gap between European Dividend Yield (DY) versus European Earnings Yield (EY). As indicated in the below graphs from Deutsche Bank Equity strategy note entitled "A new hope?" from the 25th of July , we agree with them that, going forward, given the level attained by the European payout ratio (55%), there is growing dividend risk going forward so "Mind the Gap":

"The European dividend yield (DY) is at a 20-year high relative to the corporate bond yield, suggesting equities have yet to catch up with the recent performance of corporate bonds. However, unlike the DY, the relative European earnings yield (EY) remains firmly within its four-year range, suggesting equities are not clearly cheap relative to corporate bonds. The real issue here is that the DY is high relative to the EY, which means that the payout ratio is elevated, pointing to downside risks for dividends." - source Deutsche Bank

As far as we are concerned, "hope" is never a good strategy. We cannot resist but to chuckle again and remember a comment we read in the past from a credit desk:

"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

So, yes indeed, mind the gap between DY versus EY, watch Japan and fade the sell-side pundits telling you that European banks are "cheap" from a valuation perspective (that's what many told you at the beginning of the year...). Like we posited before, the problems facing Europe and Japan are driven by a demographic not the financial cycle.

 As we concluded our April conversation "Shrugging Atlas":

"The very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016

The game is moving towards capital preservation we think...

"Confusion of goals and perfection of means seems, in my opinion, to characterize our age." - Albert Einstein

Stay tuned!