Macro and Credit - The Monkey and banana problem

"There are three growth industries in Japan: funerals, insolvency and securitization." - Dominic Jones, Asset Finance International Nov., 1998

Looking at the evolution of markets and convolution in which central bankers have fallen, we reminded ourselves for our chosen title analogy of the "Monkey and banana problem", which is a famous toy problem in artificial intelligence, particularly in logic programming and planning. The problem goes as follows:

"A monkey is in a room. Suspended from the ceiling is a bunch of bananas, beyond the monkey's reach. However, in the room there are also a chair and a stick. The ceiling is just the right height so that a monkey standing on a chair could knock the bananas down with the stick. The monkey knows how to move around, carry other things around, reach for the bananas, and wave a stick in the air. What is the best sequence of actions for the monkey?" - source Wikipedia

While there are many applications to this problem. One is as a toy problem for computer science, the other, we think is a "credit impulse" problem" for central bankers. The issue at hand is given financial conditions are globally tightening, as shown as well in the US in the latest publications of the Fed Senior Loan Officer Survey and the bloodbath in European bank shares, the problem is how on earth our central bankers or "monkeys" (yes it's after all the Chinese year of the fire monkey...) are going to avoid the contraction in loan growth? As put it bluntly by our friend Cyril Castelli from Rcube, the European credit channel is at risk as banks' share of credit transmission is much higher in EU than US, which of course is bound to create a negative feedback loop and could therefore stall much needed growth:

- source Rcube - @CyrilRcube

Another possible tongue in cheek purpose of our analogy and problem is to raise the question: Are central bankers intelligent? Of course they are, and most of them have to deal with complete lack of political support (or leadership). It seems we have reached the limits of what monetary policies can do in many instances.

Although both humans and monkeys have the ability to use mental maps to remember things like where to go to find shelter, or how to avoid danger, it seems to us that in recent years central bankers have lost the ability to avoid danger. While monkeys can also remember where to go to gather food and water, as well as how to communicate with each other, it seems to us as of late, that central bankers are losing their ability to communicate, not only with each other but, as well with markets, hence our chosen title. Could it be that monkeys have indeed superior abilities than central bankers given their ability not only to remember how to hunt and gather but to learn new things, as is the case with the monkey and the bananas? Despite the facts that the monkey may never have been in an identical situation, with the same artifacts at hand (printing press), a monkey is capable of concluding that it needs to make a ladder, position it below the bananas, and climb up to reach for them. It seems to us that despite the glaring evidence that the "wealth effect" is not translating into strong positive effects into the "real economy", yet it seems central bankers have decided to all embrace the Negative Interest Rate Policy aka NIRP as the new "banana". One would argue that, to some extent, central bankers have gone "bananas" but we ramble again...

In this week's conversation we will voice our concern relating to the heightened probability of a credit crunch in Europe thanks to banking woes and the unresolved Italian Nonperforming loans issue (NPLs). We will as well look at the credit markets from a historical bear market perspective and muse around the relief rally experienced so far.

Synopsis:

• Macro and Credit - The risk of another credit crunch in Europe is real
• Why NIRP matters on the asset side of a bank balance sheet
• Credit spreads and FX movements - Why we are watching the Japanese yen
• Final chart: US corporate sector leverage approaching crisis peak

• Credit - The risk of another credit crunch in Europe is real

The fast deterioration in European bank stocks in conjunction with the rising and justified concerns relating to Italian NPLs, constitute a direct threat to the "credit impulse" needed to sustain growth in Europe we think. As we pointed out on numerous occasions, the ECB and the FED have taken different approaches in tackling their banking woes following the Great Financial Crisis (GFC). In various conversations we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):

"We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):

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

Exactly. The issue with Italian NPLs is that the tepid Italian growth of the last few years is in no way alleviating the bloated balance sheets of Italian banks which would help sustain credit growth for consumption purposes in Italy as evidently illustrated in a recent Société Générale chart we have used in our conversation the "Vasa ship": 

"As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs" - source Macronomics, February 2016

- source Société Générale.

So, all in all, the ECB is going to have to find a way to shift these impaired assets onto its balance sheet, if it wants to swiftly and clearly deal with the worsening Italian situation. While some pundits would point out that the new "bail-in" resolutions in place since the 1st of January are sufficient to deal with such an issue, we do not share their optimism. This is a potential "political" problem of the first order, should the ECB decides to deal with this sizable problem à la Cyprus. Caveat emptor.

You could expect once more politicians and the ECB to somewhat twist the rule book in order to facilitate through this "securitization" process and an ECB take up of part of the capital structure (Senior tranches probably) of these new NPLs CDOs. A new LTRO at this point might once again alleviate funding issues for some but in no way alter the debilitating course of the credit profile of the Italian banks. On a side note we joked in our last conversation 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

But, when it comes to the "credit impulse" and its potential "impairment" in Europe thanks to bloated banks balance sheets, and equities bleeding, we read with interest Deutsche Bank's take in their note Focus Europe note from the 19th of February entitled "Moving down a gear":

"The balance between the growth drivers and detractors is being tipped towards the negative as the questioning of confidence in European banks threatens to result in a less beneficial credit impulse. In last week’s Focus Europe we presented a scenario analysis to demonstrate the sensitivity of euro area GDP growth to the provision of bank credit. We did this via the credit impulse relationship. Our earlier assumption of 1.6% real GDP growth in 2016 was consistent with 2% credit growth. If, on the other hand, banks issue no net new credit this year, domestic demand would fall, confidence deteriorate and financial markets tighten. With no reaction from the ECB, 2016 GDP growth would fall to about 0.5%

The recent fall in bank equities and rise in bank debt costs combined with increasing economic risks, the balance of probabilities suggests that lending standards will tighten relative to what we expected previously. Therefore, to some degree the provision of bank credit, and hence economic growth, will suffer. The revision we are announcing is an attempt to capture this effect. There are considerable uncertainties as to the scale of the problem, but we feel a modestly weaker lending impulse is now a more appropriate baseline.

Credit (-0.2pp). Our previous baseline forecast of 1.6% GDP growth was consistent with an acceleration in bank credit growth from broadly zero in 2015 to about 2% this year. The improvement in credit conditions in the last Bank Lending Survey implied a modest upside risk relative to forecasts. The last Bank Lending Survey was conducted in December and published in January. There were no indications at that point of concern about capital, liquidity or risk. However, as we said above, the balance of probabilities implies that lending standards will now tighten. We are conservatively allowing for a scenario in which the contribution to GDP from bank credit is now 0.2pp weaker than our previous baseline.

The ECB can help minimize the damage… 

The onus is on the ECB to achieve two things at the next meeting on 10 March. First, to set an appropriately accommodative policy stance given the worsen outlook for both growth and inflation. Note, since December, our headline and core HICP inflation forecasts for 2016 have fallen from 0.9% and 1.3% to 0.2% and 1.1% respectively (see page 2 for updated country inflation forecasts).
Second, to set a policy stance that does not compound the pressures on a banking system that may be perceived as being more vulnerable.
We presented a detailed discussion of the ECB’s options in last week’s Focus Europe (pages 8-10)2. Suffice to say, the choice of policies will be affected by conditions in the banking system. Our expectation prior to this episode of banking stress in recent weeks was a 10bp deposit rate cut and a temporary acceleration in the pace of purchases. The bank stress implies that a further deposit rate cut may be unwise without a system of exemptions. A refi cut, for example targeted at TLTROs, would be more effective.

The bank stress also implies the ECB should offer some kind of supplementary liquidity tender. Excess liquidity is running at about EUR700bn, but if there was any sense of fragmentation re-emerging between strong and weak banks, it would be in the ECB’s interest to remove all doubt about bank access to liquidity. Finally, the justification for more QE has increased given the widening of credit and sovereign spreads. More QE would reduce the risk of a negative feedback loop between banks and sovereigns.

The ECB is conducting a technical review of the asset purchase programme (APP). This might result in some changes. In terms of broadening the eligible asset base, we suspect the ECB will remain in the sovereign/quasi-sovereign space for now. Corporate bonds are possible but not very impactful.

Purchasing unsecured bank debt might not be inconsistent with the Treaty but would be complex and politically controversial. Stresses would have to increase markedly to bring this option onto the table. 

There is no relaxation of regulation, however. Both Mario Draghi, President of the ECB, and Daniele Nouy, head of the ECB Single Supervisory Mechanism (SSM), were consistent in their messages this week that (a) the new regulatory regime is resulting is a more stable and sustainable banking system - there is no sense that regulation is a net cost - and (b) “all else unchanged” there will be no significant additional capital requirements imposed on banks.
Benoit Coeure, ECB Executive Board Member, said that if bank profits are under pressure the onus would be on governments to implement structural reforms and growth-friendly fiscal policies. In short, no change in ECB message.

…but negative feedback loops cannot be ruled out either 

Last week we showed how sensitive the economic cycle can be to the bank credit cycle. This negative dynamic can become self-reinforcing. One direction is via the private sector and another is through the public sector. A tightening of lending standards weakens demand, undermining growth and asset quality, triggering a second-order tightening in credit. At the same time, weaker demand undermines sovereign sustainability which can tightening bank funding cost and additionally contribute to second-order tightening. 

Fiscal dynamics have deteriorated. The primary balance gap is the difference between the debt-stabilising primary balance and the primary balance. It captures the underlying dynamic of the public debt-to-GDP ratio. A negative gap means the public debt ratio is falling. Our previous forecast was for a primary balance gap of -0.6% of GDP in 2016, the first genuine decline in the public debt ratio since the start of the crisis. Following the growth and inflation revisions, the primary balance gap is expected to be positive again. In other words, the benefits of lower funding rates thanks to ECB QE are not enough to compensate for the loss of economic momentum. Moreover, if the scenario of zero net new bank credit were to materialize, 2016 could see the primary balance gap rise back to levels not seen since 2012. That would imply a euro area public debt-to-GDP ratio of about 98%." - source Deutsche Bank

Whereas indeed we are waiting to Le Chiffre aka Mario Draghi to come up with new tricks in March to alleviate the renewed pressure on European banks, where we disagree with Deutsche Bank is that providing a new TLROs would provide much needed support for funding in a situation where some banking players are seeing their cost of capital rise thanks to a flattening of their credit curve (in particular Deutsche Bank as per our previous conversation), this intervention would in no way remove the troubled growing impaired assets from the likes of Italian banks. It is one thing to deal with the flow (funding) and another entirely to deal with the stocks (impaired assets). Whereas securitization of the lot seems to be latest avenue taken, you need to find a buyer for the various tranches of these new NPLs CDOs. Also more QE. will not deal with the stocks of impaired assets unless these assets are purchased directly by the ECB. 

When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys. In their latest survey, while it is difficult to assess for now a clear trend in the deterioration of financial conditions for French corporate treasurers, it appears to us that NIRP has already been impacting the margin paid on credit facilities given a small minority of French corporate treasurers are indicating that, since December, there is an increasing trend in margin paid on the aforementioned credit facilities:

"Does the margin paid on your credit facilities has a tendency, to rise, fall or remains stable?"

- source AFTE

Going forward we will closely be monitoring these additional signals coming from French corporate treasurers to measure up the impact on the overall financial conditions as well as the impact NIRP has on the margins they are getting charged on their credit facilities. For now conditions for French corporate treasurers do not warrant caution on the microeconomic level.

While we have recently indicated our medium to long term discomfort with the current state of affaires akin to 2007 in terms of credit markets, the recent "relief rally" witnessed so far is for us a manifestation of the "overshoot" we discussed last week. Some welcome stabilization was warranted, yet we do feel that the credit cycle has turned and that you should be selling into strength and move towards more defensive position, higher into the rating quality spectrum that is and rise your cash levels.

When it comes to enticing banks to "lend" more, as far as our analogy is concerned we wonder how the "monkey" bankers are going to react if indeed additional NIRP is going to remove more "bananas".

This brings us to our second point, namely that the flatter the yield curve, the less effective NIRP is.

• Why NIRP matters on the asset side of a bank balance sheet

Whereas, Europe overall has been moving more into the NIRP phenomenon, with over $7 trillion worth of global government bonds now yielding “less” than zero percent, the FED in the US is weighting joining the NIRP club in 2016 apparently, NIRP being vaunted as the new "banana" tool in the box to stimulate the "monkeys".

The issue of course at hand is that NIRP does matter and particularly when it comes to the asset side of a bank balance sheet as put forward by Deutsche Bank in their note from the 22nd of February entitled "Three things the market taught me this year":

"Negative rates – much more complicated

Negative rates look powerful at face value. Bank profits can be protected by exempting excess liquidity while market rates are pushed down. The turmoil in Japan points to three considerations that mute this view.
First, the impact of negative rates on the asset side of banks’ balance sheet can matter much more than the charge on excess liquidity. Banks that own large amounts of fixed income assets relative to the size of their total balance sheet (and their excess liquidity) are hit the hardest as returns on these assets drop. Japan and the US stand out as economies where the cost to the banks is biggest, Switzerland and Sweden the least, while Europe is somewhere in between:

Second, super-flat yield curves reduce the impact of negative rates. When bonds don’t offer risk premia, a perfect Keynesian liquidity trap exists: fixed income is the same as cash, and negative rates instantaneously transmit to the entire yield curve. The portfolio rebalancing into riskier assets declines as the marginal holders of zero-yielding bonds are naturally risk-averse. Japan’s yield curve, the flattest in the world, failed to steepen when the BoJ cut rates earlier this month – all yields just shifted down. Sweden, the UK and Europe stand out as yield curves where there’s still more risk premium to be squeezed, Japan, Canada and Norway the least:

Third, sub-zero rates can send a negative forward-looking signal. Until the technological and institutional framework is designed to pass negative rates to depositors without triggering banknote withdrawal, there will eventually be a (negative) lower bound. As this is approached the signaling cost of easing being exhausted may be bigger than the benefit of lower rates. At the extreme  cash and bonds turn into “Giffen goods”: the substitution effect of lower return is more than offset by expected lower future income. Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. The limitations of additional BoJ easing in addition to changing Japanese hedging behaviour, are some of the factors, that have led us to revise our USD/JPY forecasts for this year. We now think 2015 marked the peak in USD/JPY for this cycle and forecast a move down to as low as 105 this year." - source Deutsche Bank

Exactly, this negative feedback-loop, doesn't stop the frenzy for bonds and the "over-allocation process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP. This push yields lower and bond prices even higher. This is exactly what we discussed in our conversation "Le Chiffre" in October 2015:

"The big benefactors of the Fed and Le Chiffre's gaming style, particularly since is brilliant 2012 bluff in the European Government bond poker game have been bonds. We came across this very interesting chart from Deutsche Bank (h/t Tracy Alloway from Bloomberg on Twitter) which clearly illustrates "overconfidence" and "over-allocation" to the bonds relative to the trend which are $755bn above the normal trend. This is entirely attributable to the distortions created by QEs:

 - source Deutsche Bank (h/t Tracy Alloway).

Furthermore the significant repricing in European equities (where many pundits had been "overweight" at the beginning of the year) has led to a significant switch from equities to bonds as indicated by Bloomberg in their article from the 22nd of February entitled "They'd Rather Get Nothing in Bonds Than Buy Europe Stocks":

• "Estimates for Euro Stoxx 50 dividend yield at 4.3 percent
• The region's government debt is yielding 0.6 percent

The cash reward for owning European stocks is about seven times larger than for bonds. Investors are ditching the equities anyway.
Even with the Euro Stoxx 50 Index posting its biggest weekly rally since October, managers pulled $4.2 billion from European stock funds in the period ended Feb. 17, the most in more than a year, according to a Bank of America Corp. note citing EPFR Global. The withdrawals are coming even as corporate dividends exceed yields on fixed-income assets by the most ever:

Investors who leaped into stocks during a similar bond-stock valuation gap just four months ago aren’t eager to do it again: an autumn equity rally quickly evaporated come December. A Bank of America fund-manager survey this month showed cash allocations rose to a 14-year high and expectations for global growth are the worst since 2011.
If anything, the valuation discrepancy between stocks and bonds is likely to get wider, said Simon Wiersma of ING Groep NV.

 “The gap between bond and dividend yields will continue expanding,” said Wiersma, an investment manager in Amsterdam. “Investors fear economic growth figures. We’re still looking for some confirmations for the economic growth outlook.”
Dividend estimates for sectors like energy and utilities may still be too high for 2016, Wiersma says. Electricite de France SA and Centrica Plc lowered their payouts last week, and Germany’s RWE AG suspended its for the first time in at least half a century. Traders are betting on cuts at oil producer Repsol SA, which offers Spain’s highest dividend yield.
With President Mario Draghi signaling in January that more European Central Bank stimulus may be on its way, traders have been flocking to the debt market. The average yield for securities on the Bloomberg Eurozone Sovereign Bond Index fell to about 0.6 percent, and more than $2.2 trillion -- or one-third of the bonds -- offer negative yields. Shorter-maturity debt for nations including Germany, France, Spain and Belgium have touched record, sub-zero levels this month." - source Bloomberg

In that instance, while the equity "banana" appears more enticing from a "yield" perspective, it seems that the "electric shock" inflicted to our investor "monkey" community has no doubt change their "psyche".

The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box): When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock" hence the reach for bonds.

When it comes to our outlook and stance relating to the credit cycle we would like to point out again towards chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis where they highlight the work of Hyman Minsky's work on the equity-debt cycle and particularly in the light of the Energy sector upcoming bust:

"His cyclical theory of financial crises describes the fragility of financial markets as a function of the business cycle. In the aftermath of a recession, firms finance themselves in a very safe way. As the economy grows and expected profits rise, firms take on more speculative financing, anticipating profits and that loans can be repaid easily. Increased financing translates into rising investment triggering further growth of the economy, making lenders confident that they will receive a decent return on their investments. In such a boom period, lenders tend to abstain from guarantees of success, i.e; reflected in less covenants or in rising investments in low-quality companies. Even if lenders knowsthat the firms are not able to repay their debt, they believe these firms will refinance elsewhere as their expected profits rise. While this is still a positive scenario for equity markets, the economy has definitely taken on too much credit risk. Consequently the next stage of the cycle is characterized by rising defaults. This translates into tighter lending standards of banks. Here, the similarities to the subprime turmoil become obvious. Refinancing becomes impossible especially for lower-rated companies and more firms default. This is the beginning of a crisis in the real economy, while during the recession, firms start to turn to more conservative financing and the cycle closes again" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

The issue with NIRP and the relationship between credit spreads and safe-haven yields is that while the traditional pattern being lower government bond yields and a flatter yield curve is accompanied by wider spreads in "risk-off" scenarios, given more and more pundits (such as Hedge Funds)  have been playing the total return game, they have become less and less dependent on traditional risk-return optimized approach as they are less dependent on movements on the interest rate side. The consequence for this means that classical theories based on allocation become more and more challenged in a NIRP world because correlation patterns change in a crisis period particularly when correlations are becoming more and more positive (hence large standard deviations move).

But if indeed, the behavior of credit is affected in relation to safe-haven yields by changes in correlations, then you might rightly ask yourself about the relationship of credit spreads and FX movements given the focus as of late has been around the surge in the US dollar and the fall in oil prices in conjunction of the rise of the cost in capital since mid 2014.

In our next point we think that, from a credit perspective, once more you should focus your attention on the Japanese yen.

• Credit spreads and FX movements - Why we are watching the Japanese yen

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

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

However, NIRP doesn't reduce the cost of capital. NIRP is a currency play. This is clearly the case in Japan and has been well described in Deutsche Bank's note from the 22nd of February entitled "Yen hedging cycle risks rapid reverse":

"A lot of negative things have been said about negative rates, not least in Japan. Negative rates do not work by reducing financing costs materially, providing a ‘price of money’ stimulus. If negative rates do support activity, they primarily work through the exchange rate, adding to the portfolio substitution into risky asset.
For Japan the biggest problem is that macro policies have been directing capital toward risky assets for the last 4+ years. There are inevitably diminishing returns to this strategy, not least because ‘value’ matters. Value matters when it comes to the underlying domestic and foreign ‘risky’ asset, and the value of the exchange rate. Specifically on the latter, the yen even after the recent appreciation is still close to 20% cheap in PPP terms.

It is also cheap on a FEER and BEER basis, helped by a terms of trade shock that is seen lifting the Current Account surplus to near 5% of GDP in 2016. Figure 2 shows that in the last year, Japan has had the most favorable terms of trade shock of any major economy.

While FDI can recycle up to half of the C/A surplus, the question is whether other BoP components, notably net portfolio flows, will do the rest of the recycling, and at what exchange rate. For much of 2013 – H1 2015, vehicles like the GPIF were used to recycle (a much smaller) C/A surplus, that even briefly went into deficit in 2014. By June 2015, the GPIF’s portfolio of riskier assets inclusive of domestic stocks (22.3%), international bonds (13.1%), and international stocks (22.3%) was well within the desired base/benchmark ranges (see Figure 3).

For the latest data available for Q3 2015, GPIF domestic and international equity holdings declined led by weaker equity prices and a stronger yen – price action that underscores the risky nature of these investments.

As the C/A surplus grows and the above ‘structural’ pension shift toward capital flows abroad diminishes, there is a danger that we have already entered the realm where yen strength becomes self-fulfilling, as many of the hedging activities that were associated with a weak yen in the first four years of Abeconomics go into reverse.

Prior to Abeconomics, hedging on Japan equity flows was limited. Since 2011 when BOJ policy encouraged yen weakness, foreign inflows into Japan equities typically included much higher currency hedge ratios, while fully hedged instruments became popular. Precise numbers are not available, but it is estimated that as much as a quarter of the stock of foreign holdings of Japan equities of Y183tr has a currency hedge – a hedge that quickly becomes much less attractive with a stronger yen.

In contrast, for Japan investments abroad, FX hedge ratios declined. This particularly relates to USD investments, where expectations of USD gains increased rapidly in the Abeconomics years, and FX hedges on USD investments dropped. At the end of Q3 2015, Japan had a total of Y770trillion non-Central Banks assets abroad, inclusive of Y418tr portfolio assets, of which Y153tr are equity and investment fund shares, and Y266tr are debt securities. Even if much of the investment abroad has only limited hedges, one observation is that a very small adjustment in hedge ratios can have a huge flow impact. A shift in the hedge ratio on foreign fixed income assets by 10% is roughly equivalent to a year’s C/A surplus. Secondly, to the extent that hedge ratios are very low, as is the case for, say, the GPIF, there are sizable potential losses for funds recently adding to foreign exposure, and an emerging disincentive to invest in the most risky assets abroad.

Of the large players that actively hedge FX exposure, the life insurance companies’ activities can most closely be tracked through quarterly statements, and the time series can provide a useful standard to benchmark recent activity. Life insurance companies as of Q3 2015 had some Y65tr in foreign securities. As per Figure 4, their currency hedge ratios on dollar-based investments are estimated to have dropped to ~46% by the end of Q3 2015, the lowest levels recorded since the Great Financial Crisis in 2008. The hedge ratio is down from a peak of 79% in September 2009.

Life insurance company hedge ratios have likely reached a cycle nadir at the end of 2015, as concerns about JPY appreciation start to rise.

Among the other largest participants that have foreign portfolios of comparable size to the Lifers, both Toshins (foreign securities of ~77tr) and particularly public pension funds ( ~ Y57tr foreign securities) have very low currency hedge ratios and are heavily exposed to currency risk. Japan investments abroad, so actively encouraged by policymakers, are slowly being shown to have a familiar ‘catch’ – interest parity! Nominal yields may be more attractive abroad, but the long-term currency risks are enormous, at least when placed in the context of a yen that is still significantly undervalued.

A crucial element of hedging activity is the expected exchange rate. Here three bigger macro forces are at play for the remainder of 2016: i) Japan/BOJ policy; ii) the Fed; and iii) China FX policy. Firstly on BOJ intervention, the market should not expect any official BOJ intervention barring extreme FX volatility. It would run counter to G20 rules and risk a serious rift with the US. On rates policy, adding significantly to NIRP looks increasingly unpalatable, with our Tokyo Economics team expecting only one more 10bp cut in Q3. The next set of actions will likely need to revolve around ‘qualitative QE’ and the buying of more risky assets, notably securitized products.

On the Fed, we expect USD/JPY to remain sensitive to Fed expectations, but not to the point where more Fed tightening is likely to lead to new USD/JPY highs. The yen has a history of doing well in 5 of the last 7 Fed tightening cycles, although it did weaken in the two big USD upswings." - source Deutsche Bank

As we posited in our conversation "Information cascade" back in March 2015, you should very carefully look at what the GPIF, and their friends are doing:

"Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets." - source Macronomics, March 2015

We also added more recently in our conversation "The Ninth Wave" the following:

"So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor.
When it comes to Mrs Watanabe, Toshin funds are significant players and you want to track what they are doing, particularly in regards to the so-called "Uridashi" funds. The Japanese levered "Uridashi" funds (also called "Double-Deckers") used to have the Brazilian Real as their preferred speculative currency. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted previously for 46 percent of double-decker funds in 2009 with close to a record 80% in 2010 and now down to only 22.8%.
As our global macro "reverse osmosis" theory has been playing out, so has been the allocation to the US dollar in selection-type Toshin
Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP." - source Macronomics, January 2016

So from a "flow" perspective and like any trained "monkey" looking to reach out for "bananas", at least the slippery type, whereas other "monkeys" are focusing on the US dollar and Oil related woes, we'd rather for now focus our attention onto the Japanese yen, and the allocation implications of a stronger yen. For us, like others, a PBOC devaluation move on the Yuan would send a deflationary impulse worldwide but, in terms of risk assets, it would have serious consequences on Japanese asset allocations and would lead to an acceleration in capital repatriation (this would mean liquidation of some existing positions rest assured) as indicated in Deutsche Bank's note:

"Even modest JPY gains against the USD should translate to a strong yen against all the other G10 currencies and EMG Asia FX, not least because of global macro risks elsewhere. Nothing is capable of lifting the yen trade weighted index more than a speed up in the Rmb’s depreciation rate, leading to knock-on devaluations in EM Asia. This risk alone should encourage higher Japan hedge ratios for investment abroad, inclusive of the stock of Japan FDI assets abroad. A risk-off China shock would tend to concentrate JPY gains against currencies of other G4, but initially would likely include additional yen strength against all currencies. It should also drive the Nikkei sharply lower.

The Nikkei and yen have a long and sometimes tortured history of moving in lock-step. A stronger yen has hurt the Nikkei for obvious reasons, but a weaker Nikkei also tends to lead to a repatriation of capital and a stronger yen. Interestingly, the current Nikkei levels are already consistent with a USD/JPY below Y105."  - source Deutsche Bank

When it comes to the year of the Fire Monkey, the slippery banana type, no doubt could come from Japanese investors hurt by the violent appreciation of the Japanese yen, which has indeed been a significant "sucker punch" when it comes to the large standard deviation move experienced by the Japanese yen versus the US dollar. If Mrs Watanabe goes into "liquidation" mode, things could indeed become interesting to say the least.

When it comes to Minsky and the equity-credit cycle, whereas central banks can affect the amplitude and the duration of the cycle, in no way can they alter the character of the cycle. In our final chart, we once again indicate our 2007 feeling thanks to the rise in leverage, tightening financial conditions with the issuance markets closing down on the weaker players, which bode poorly from a risk-reward perspective.

• Final chart: US corporate sector leverage approaching crisis peak

Like many pundits, we have voiced our concerns on the increasing leverage thanks to buybacks financed by debt issuance and the lack of the use of proceeds for investment purposes. Our final chart comes from the same Deutsche Bank note from the 22nd of February entitled "Three things the market taught me this year" quoted previously and displays the US corporate sector leverage which is approaching crisis peak:

"US deleveraging – not that great

US consumer deleveraging stands out as one of the major achievements of the Yellen Fed. Yet the corporate picture looks much less impressive. Total amount
of US corporate debt has approached the highs seen in the financial crisis (chart 3). 

Not only that but the bulk of the leverage has been directed towards corporate stock buybacks (chart 4), explaining how low investment but high borrowing have existed at the same time. Persistent volatility in the US credit market has highlighted vulnerabilities that weren’t a concern last year.

- source Deutsche Bank

While a respite is always welcome, when it comes to the rally seen recently, as far as the Monkey and banana problem is concerned as everyone is hoping from additional tricks from our "Generous gamblers" aka our central bankers, this rally might have some more room ahead but then again, it doesn't change our belief in the stage of the credit cycle and our focus on what's the Japanese yen will be doing.

"Life is full of banana skins. You slip, you carry on." - Daphne Guinness, British artist

Stay tuned!

Guest Post - US Dollar Upside & Under-priced Financial risks

"Only those who will risk going too far can possibly find out how far one can go." - T. S. Eliot, American poet

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards US Dollar Upside risks and under-priced financial risks:

(Notes to Readers Source for all charts: Rcube, DataStream, Bloomberg, Fred, BIS)

Has the second upleg in the US dollar already started? Is the FED, reassured by the recent batch of positive data, about to raise interest rates into what still looks like a slowdown. If so, how will emerging market corporate borrowers and global investors react to both a rising US dollar and rising interest rates?

Because the dollar remains the undisputed global unit of account in debt contracts, a significant rise in the US currency automatically tightens financial conditions for non‐US based borrowers. This is why the supply of dollars measured by the twin deficits is such a great leading indicator for EM assets. We believe that this mechanism is probably the most misunderstood and underestimated financial risk today.

As the dollar rises, and global financial conditions consequently tighten, global growth slows down, re‐enforcing the dollar strength. This negative feedback loop is where our scenario diverges from the consensual bullish outlook currently held by investors.

As we have repeated many times, 9 trln US dollars have been borrowed by non‐US corporates over the last decade, more than half by EM‐based companies.

Bond issuance by nonfinancial corporations outside the United States have been rising at 15% per year on average for more than 7 years in a row. This is historical.

A large part of that borrowing has been contracted by commodity or commodity related sectors.

The vicious part of the current cycle is that these companies are now facing a double hit. As the Chinese investment cycle slows down…..

commodity prices weaken.

In parallel, monetary policy divergences boost the US currency, which mechanically depresses commodities.

The impact of China’s slowdown on global growth further accentuate the dollar rise. This negativefeedback loop has been in place since 2011 (mostly centered around EM currencies) and has started to accelerate in Q3 last year. Japanese and European QEs have been obviously adding fuel on the fire.

If rates start rising, on top, all non US‐based borrowers will be facing higher borrowing costs (weaker local currencies and higher US reference rates), at a time when the redemption wall will hit borrowers. The BIS estimates that about 700bln us dollars need to be refinanced every year in the next three for EM corporations. This is already massive but imagine what might happen if suddenly global investors risk appetite deteriorates.

During the commodity boom years (China’s investment bubble 2000/2011), EM corporate credit risk improved meaningfully, allowing them to borrow massively. As a result, deposits at local banks surged, creating a domestic lending boom to borrowers that could only rely on bank loans for credit. The risk now is that as the cost of the existing stock of debt rises (higher yields, weaker currencies and deteriorating credit risk), large companies draw their deposits at local banks to pay down their maturing debt (even more so if the rollover window closes down). This mechanically tightens the local credit channel because banks’ loan to deposits ratios surge, forcing them to significantly cut lending. The tightening is already observable:

Since 2000 the average duration of emerging market corporate bonds has doubled, moving from less than 6 years to more than 12 years today. This means that investors who have poured more than 2.5 trn US dollar into these bonds are now much more sensitive to US rates than in the past.

So the main question that we have to answer is where is the US dollar heading from here?

We believe that a disorderly unwind of the 9trn carry trade is not a remote possibility any longer but a real threat.

Dollar yen has once again broken out on the upside after a 5 months consolidation.

Commodity currencies are also accelerating lower.

EM currencies’ down trend is intact.

The supply of dollar is shrinking at a time when the demand for it is surging. Notice how in the past 50 years, each time the supply of dollar shrunk, the most leveraged economies peaked. Latin America in the early 80s, Japan in 1990 , Asian economies and Russia in 1997/98 and in 2007 the US housing crash. We believe EM corporates are the most likely candidate this time around.

This is bearish for EM assets

990 on the MSCI EM is a key level. We believe that if the index breaks below, 900 will be tested and broken soon after.

The risk regime we are in at the moment has been showing signs of fatigue since last summer.

Corporate credit spreads have bottomed in July last year,

so did currency and interest rates implied volatilities.

Equity market breadth is slowly deteriorating, while valuations are historically very high. As an example German mid‐caps that we consider as a global benchmark because of their exporting feat trade at 2.5 times book value. Last time they reached that level was in 2007 and 2000.

The pattern of financial intermediation has radically changed over the last 10 years. The most important protagonists for credit availability are now private investors as opposed to banks. This is why we believe that investors’ sentiment has become so important for forecasting risky assets’ expected returns.

The signs of changing risk behavior mentioned above should be taken seriously. Already, financial conditions are slowly tightening while economic momentum is decelerating.

Our VIX model has its fair value more than 100% above spot level. This is the largest mispricing in

more than 30 years.

Long Dollar remains a key investment theme, together with the conviction that risk is now severely underpriced. We are therefore buying VIX forwards (4th contract), in addition to adding a long USDJPY to our long USDNZD.

"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury

Stay tuned!

Credit - Actus Tragicus

"We live in an age of mediocrity." - Lauren Bacall

Looking at the dismal European data coming out of Europe with a plunging German Zew index in the October survey declining 10 month in a row ( -3.6 this month from 6.9 in September),  with German industrial output falling by 4% during the course of August (the biggest drop since January 2009) and weaker inflation in Europe with Spanish September HICP inflation coming in at -0.3% YoY, and French HICP inflation falling to 0.4% YoY (from 0.5% YoY in the previous month), with prices down 0.4% MoM and Eurozone Industrial Production coming at  -1.8% (below the expected -1.6%) in conjunction with new record lows on the German 10 year yield coming at 0.85%, we decided therefore to use another musical analogy, this time around drifting towards one of our favorite classical masterpieces, BWV 106, also known as Actus Tragicus, being a sacred cantata composed by Johann Sebastian Bach in 1708 when he was 22 years old in Mühlhausen and intended for a funeral. In the end it might be the most appropriate funeral cantata that could be used for the euro at some point given the growing dissent in both Italy and Germany, as well as the very open opposition between Mr Mario Draghi and Mr Jens Weidmann. Very few musical pieces touch our soul, arguably the first movement of BWV 106 aka "Actus Tragicus" is one of them, but we ramble again...

The tragedy playing out, of course, is the growing divergence between asset prices and economic fundamentals with central banks meddling with the most important variable in the capitalist system namely interest levels, more simply the "price of money", leading of course to "mis-allocation" of capital in the grand scheme of things. While large corporates in Europe have had no problem in gaining access to "credit", SMEs in Europe have been starved by the precipitation of the credit crunch leading to massive unemployment which has been accentuated by European banks deleveraging thanks to the EBA's fateful decision of "forcing" bank to reach 9% core tier one level by June 2012. We will not come back to that much commented and evident outcome which we have discussed at length on this blog.

What is of course of interest (and once again no surprise to us) is to see a continuation of the rally in US treasuries, which we had foreseen thanks to our contrarian stance which we indicated well in advance given our deflationary "bias" and our  "somewhat" understanding of the macro outlook. Since early 2014 we have indicated our long duration exposure, which we have partly played via ETF ZROZ as an illustration of us playing and understanding the "macro" game.

In this conversation, once again we have decided to focus on the credit cycle and where we stand when it comes to look at the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

Last month we indicated the following in our conversation "Sympathy for the Devil":

"Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day." - Macronomics, 9th of September 2014

We also argued:
"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters."

Interestingly enough, high-yield outflows have continued for a 6th week in a row according to Bank of America Merrill Lynch's most recent Follow the Flow note published on the 10th of October and entitled "More in safety, less in yield":
"High-yield funds outflows continue for the sixth week
Even though US-domiciled HY funds flows bounced back, Euro-domiciled funds continued to see more outflows; the sixth week in a row. High-grade credit and money-market fund flows were on the positive side though, with the latter seeing the largest inflow so far this year. Note that over the past week, government bond funds saw a $1.9bn inflow, the largest in eight weeks.
Credit flows (week ending 8th October)
HG: +$1.5bn (+0.2%) over the last week, ETF: -$117mn w-o-w
HY: -$1.2bn (-0.5%) over the last week, ETF: -$114mn w-o-w
Loans: -$112mn (-1.3%) over the last week
Same patterns for another week in European credit funds, with more inflows into high-grade funds and more outflows from high-yield. "However, fund flows into W.E. regional funds (that we believe are more €-bond focused) have seen another inflow (of $478mn) last week. On the duration front, high-grade credit flows have been concentrated in the mid and long-term funds, with outflows continuing from the short-end for a second week.

More in safety, less in yield
Flows have been pointing to “safe” yield rather than any yield, lately. Over the past weeks, the trend has been notable, with more funds added in high-grade credit and government bonds, rather than high-yield credit and equity funds. YTD flows into high-grade and government bond funds have been in ~$65bn, while flows into highyield and equity funds have been a mere $22bn. Put that also on top of the record inflow into money-market funds last week  takes the 2014 YTD figure to $60bn." 

- source Bank of America Merrill Lynch

So much for the "Great Rotation" story of 2014 from bonds to equities...

Of course while the "Actus Tragicus" continue to play out in Europe in the "real economy", US and Europe Investment Grade credit continue to benefit from the flattening of the yield curve. The evolution of flows of course validates the "Great Rotation" namely the gradual move of investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit as we concluded our last conversation.

And what has happened in the last few years courtesy of Central banks generosity has been the multiplication of carry trades in various segments of the market. The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is likely coming to an end as we move in the US towards the upper quadrant of the "Global Credit Channel Clock".

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...).

As we posited in our conversation on the 13th of June 2013 "The end of the goldilocks period of low rates volatility / stable carry trade environment?":

"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."

Looking at the continuation in both outflows from the equities space and the very strong compression in  the long end of core government bond space (US Treasuries and German Bund), it much more likely for us that we are indeed at risk of a significant "repricing" in the equities space.

Facts are as follows:
Commodity markets and the performance of global cyclicals versus defensives continue to point to a very, very subdued global growth environment.
Another "great anomaly" that investors should take into account is that low volatility stocks have provided the best long-term returns such as "Consumer Staples".

When it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". Investors should had bought Treasuries if they had anticipated the Federal Reserve reduction in its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market (The yield declined by 126 basis points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year).

Of course our positive stance on Investment Grade Credit which we discussed again in August 2014 in our conversation  "Thermocline - What lies beneath" has been confirmed:
"For those that need to seek comfort in a safe haven, we believe Investment Grade credit while tight from an historical point of view, still benefits from positive exposure thanks to the Japanification process. In that sense, we expect the Fed to keep a dovish tone in this muddling through economic situation in the US meaning that the releveraging process taking place in the US is still positive for credit." - Macronomics, 19th of August 2014.

While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable as highlighted again last week:

"This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":

"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.

-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura

Of course the current interest rate differential between the US and Europe, supported by a weakening Euro and negative interest rates in the front-end of some European government bond yield curve points towards a larger allocation to US fixed income we think.

On that point we disagree with the latest take from Bank of America Merrill Lynch' s credit team in their recent Credit Market Strategist note from the 10th of October entitled "Breaking up is so easy to do" given they don't see an acceleration into US fixed income:
"Breaking up is easy to do. US-European interest rate differentials are near historical highs whereas credit spread differentials remain near – though notably off - historical lows. With the economies out of sync, and resulting opposite central bank policies, our global interest rate strategists expect the rates differential to increase even further. As our European credit strategist, Barnaby Martin, maintains a constructive outlook for EUR IG, and we are tactically short US IG, clearly we expect the US-EUR spread differential to widen further. 
The push-back. 
Investors’ biggest push-back against this outlook is that, with US yields much higher than global yields we should expect a global allocation change and/or diversion of flows into US fixed income – including credit. The direct effect of such flows would be to dampen interest rate differentials and add strength to US credit at the expense of European credit. Furthermore, as interest rate risk is the key uncertainty for US credit, these flows would provide additional indirect support for US spreads. Hence any divergence between interest rates, credit spreads would be more limited than we are looking for. We think that, while global weakness asserts downward pressure on US yields, the mere existence of wide global yield differentials do not.
Our push-back against the push-back. 
We find it unlikely that the existence of big global yield differentials will accelerate inflows to US fixed income for two reasons. First, while we would indeed expect inflows in a high return environment of both high and declining US yields, with rising US interest rates – which our interest rate strategists expect – returns are much less attractive, despite the higher yields. Second, there appears to be little mean-reversion in interest rate differentials – at least between US and German interest rates. In fact in a statistical sense they appear well characterized as random walks – i.e. can wander far from current levels, in either direction. Thus, even though the difference between US and European interest rates is high, from a statistical point of view we are just as likely to see further meaningful increases from here, as we are to see meaningful decreases." - source Bank of America Merrill Lynch

Unfortunately, we think that flow matters and interestingly another note from Bank of America Merrill Lynch from their Liquid Insight team from the 10th of October entitled "Investing in a sub-zero world" makes some interesting contrarian points which we agree with when it comes to the amount at stake when it comes to "financial repression" in Europe:
"We take a look at the broader challenge to portfolio managers posed by negative yields. Since the ECB decided to first venture into negative rates in June 2014, 30% of the EUR domestic government bond market now trades at negative yields (by notional). For German government bonds this number is 46%. Investors need to move as far as the 4y part of the curve to see positive yields. Expressed another way: investors are willing to pay euro area governments to look after €1.3tn (when including bills). To avoid paying negative rates, investors have to either take more duration risk or more credit risk" - source Bank of America Merrill Lynch

From the same note:
"€1tn looking for a new home
We focus on the impact of negative yields on bank treasury and central bank portfolios for a number of reasons: (1) both tend to get managed against relatively restrictive benchmarks in terms of duration and credit risk; (2) both will therefore be disproportionately affected by negative rates compared to a mutual fund or an insurance company; (3) both have anecdotally reacted strongly to the rate cuts in June and September.
Table 1 shows our estimates of what a typical central bank, peripheral bank, core bank, and non-euro-area bank treasury portfolio looks like. 

Table 2 shows what has likely happened to the weighted average yield of these portfolios since the beginning of June, when the ECB had not yet ventured into negative rates, as well as the amount of assets in each portfolio that now trade at negative yields.

Unlike mutual funds which receive investors’ funds with the specific mandate to replicate (and preferably outperform) the risk-reward profile of a specific benchmark, or indeed an ALM manager who is trying to match specific liabilities, central banks and bank treasuries can be thought of as total return investors subject to a liquidity mandate. As such, they can be expected to take steps to avoid paying negative rates on the roughly €1tn of their holdings that have moved into negative rates since the beginning of June.

€400-600bn of additional demand for risk
Table 2 also shows how much demand for additional risk the ECB has potentially generated through its decision to cut rates into negative territory. 

If bank and central bank portfolios were to try and offset the hit to interest income since the beginning of June, this would generate demand for duration or peripheral risk or a mix of the two between € 400-600bn.
Clearly this number is an exaggeration of what bank treasurers and central bank portfolio managers are actually likely to do. Some will be uncomfortable taking so much additional duration and/or credit risk. Banks that are not capital constrained may decide not to accumulate zero risk-weighted assets but instead lend to the real economy. Other banks may decide to take steps to encourage deposit outflows to reduce investment needs.
Yet, what this exercise shows very clearly is that even in the absence of QE, the ECB is creating a pseudo-portfolio effect, achieved in the US and the UK through the outright purchase of government bonds. With the ECB now actively targeting a balance sheet expansion, we expect yields to move further into negative territory, aggravating the challenges for investors outlined above. Therefore, over time we may well see a migration into risk approaching these numbers above." - source Bank of America Merrill Lynch

We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...).

Of course the issue in Europe when it comes to the real economy has been weak aggregate demand plagued by high unemployment levels and the continuation of the "deleveraging" à la Japan.

The weaker macro outlook as part of the "Japanification" process is supportive of credit and the continuation of lower yields. On that specific subject we agree with Nomura's take from their latest Japan Navigator No. 590:
"As bond yields and stock prices apparently moved in line with the three-month cycle in the UST market until the first half of this week, we believed that investors should be positioned for lower stock prices and lower bond yields (bull flattening in the super-long space) until the 28-29 October FOMC meeting, which we view as the next turning point in monetary policy. However, the Fed demonstrated its dovish stance unexpectedly earlier in its 16-17 September meeting minutes, bringing rates lower substantially. Despite this, stock and crude prices continued to move lower this week. This suggests to us that the market has begun to expect changes in the real economy, i.e., a slowdown in the global economy, including the US, and potential easing by the Fed and other central banks, rather than looking at the excess liquidity-driven three-month cycle. This is only a tail risk at this point, but warrants due attention as it could have a substantial market impact. Indeed, we believe investors have added positions by pricing in this risk, likely adding momentum to risk aversion this week."

- source Nomura

Moving back to the subject of the credit cycle, JP Morgan's latest note from the 14th of October entitled "Where we are in the credit cycle?" highlights the situation based on credit fundamentals:
"A credit cycle is generally characterized by a rapid growth in the availability of credit, a decline in the cost of credit, and increased willingness of lenders to accept lower returns and to lend to riskier borrowers. At some point subsequent losses from this risky lending rise, and lenders retrench, leading to credit market stress and often a broader negative economic impact.

When companies have access to plentiful and historically cheap funding there is a risk that they use it in ways that support shareholders while making their credit profiles more risky. There are trends occurring in some credit markets that have historically been associated with a credit cycle that is reaching maturity. These include significant bond issuance, low spreads, a weakening of covenants, declining credit ratings, an increase in M&A activity, less favorable use of proceeds from issuance, and rising dividends and share buybacks. However, the starting point for deterioration is quite strong in some markets, and the extent of deterioration is not consistent across markets, and some are actually improving.
Monetary authorities globally are contributing to easy financing conditions for corporates through both low policy yields and a withdrawal of fixed income product supply through QE. A result of this is, since 2010, there has been a 33% increase in the outstanding amount of US corporate bonds, 166% increase in EM corporate bonds outstanding and 39% increase in European corporate bonds outstanding (figures exclude Financials). Some of this increase is substitution from other funding sources into the bond market. In EM markets some of it reflects a shift in funding from sovereign to state-owned (quasi-sovereign) issuers as well as substitution of syndicated loan facilities in 2012. In all regions low coupons have made the large debt burden more manageable from a cash flow perspective. Still, the rise in debt issuance has impacted leverage.
The key question is where we are in the credit cycle—are we at the 5th inning (for Americans, or halftime for Soccer/Football fans) or the 9th inning/close to full time? This varies by market, as shown below. The US HG market is perhaps the most advanced, exhibiting many signs of maturity. On the opposite end, Japanese credit metrics are improving sharply thanks to improved profitability driven by better growth and the weak yen.

-The credit cycle is not identical across market segments; we see the US High Grade market as most advanced in the cycle and the Japanese market as improving the most rapidly.

-In US High Grade markets the credit cycle is the most advanced, with increasing cash going to shareholders, rising leverage and increasing M&A.
-In US High Yield credit metrics are eroding modestly alongside new-issue quality, but robust corporate liquidity supports continued low default rates.
-In European HG leverage remains near historical highs, as the economic recovery has struggled to gain momentum. Companies are being conservative with dividends and M&A.
-In European HY markets companies are reducing debt but revenue is declining at about a similar rate, such that credit metrics are struggling to improve.
-In EM HG the rise in leverage has been driven by quasi-sovereigns where government policy remains a variable, but non-quasis have been stable.
-In EM HY credit fundamentals have weakened with slow GDP growth. There is still some pressure from commodity sectors, but maturities are light near-term.
-In Japan credit metrics are improving sharply with the pickup in growth and weak Yen. Companies are using the improved cash flow to pay down debt." - source JP Morgan

While the "Actus Tragicus" continues to play out in the deterioration in Europe of economic fundamentals putting additional stain on stretched equities valuation. In the credit space, at least in investment grade, thanks to the "Japanification" process, it continues to be "goldilocks" we think.

On a final note we leave you with the Chart of the day from Bank of America Merrill Lynch note from the 10th of October entitled "Investing in a sub-zero world" displaying our negative yields are indeed moving out the curve:

- source Bank of America Merrill Lynch

"Politicians fascinate because they constitute such a paradox; they are an elite that accomplishes mediocrity for the public good."- George Will, American novelist

Stay tuned!