Macro and Credit - The Swiss Wall

"When things are steep, remember to stay level-headed." - Horace

Looking at the consequences of a finally Dovish Fed leading to a significant rise in gold and gold miners, with a continuation of the rally in risky assets, given we have been vacationing in the French Alps, it reminded us, this time around for our title analogy about a steep and difficult piste in the Portes du Soleil ski area, on the border between France and Switzerland called Le Pas de Chavanette, also called the Swiss Wall. 

This particular slope is classified in the Swiss/French difficulty rating as orange, which means that it is rated as too difficult to fit in the standard classification of green (very easy), blue (easy), red (intermediate) and black (difficult). It has a length of 1 kilometre and a vertical drop of 331 metres, starting at 2,151 metres above sea level. In similar fashion, if indeed the Atlanta Fed's Q1 US GDP estimate is estimated at 0.9% and the Fed continues with its "normalization" process, while there are some early signs of credit slowing, then in similar fashion to those who have experienced skiing on the much dreaded Swiss Wall (like ourselves) will know that this particular "slope" or normalization process, can quickly become hazardous, to say the least. The scary Swiss Wall starts in a narrow pass on the mountain top with an inclination of 40 degrees. The initial 50 metres have to be skied or boarded by everyone taking Le Pas de Chavanette. Especially without fresh snow, the slope gets icy quickly, turning the area between moguls into ice sheets. Not making a turn in these situations means that you miss the next mogul, and pick up too much speed to make the next one after that, starting off a tumble that ends a couple of hundred metres down the slope, while hitting a few dozen icy bumps in the course. By having kept interest rates, too low for too long, and given the Fed's propensity of being often behind the curve (or the slope), means, when it comes to our chosen analogy that markets could potentially tumble, hence the defensive outflows seen as of late from High Yield where the punters (or skiers) are aware of the difficulties that lie ahead of them. In similar fashion, on the Swiss Wall, after the initial very steep stretch, the choice can be made, up until the rocky passage in the direct path, to escape to the less steep left hand side of the slope, where a stumble is less dangerous. The direct path down Le Pas de Chavanette, to the right hand side and down the rocky passage, should only be taken by very experienced skiers and riders who know how to handle moguls, as it is effectively a continuation of the first 50 metres. As the slope eases out, it is easier to negotiate the moguls and make a single run down to the end, although the inclination and bumps still call for significant dexterity and physical strength. It remains to be seen, which path the Fed will decided to take and how experienced skiers they are when it comes to take the very slippery slope of the interest rate normalization process. In similar fashion to skiers venturing on the Swiss Wall, wearing protective gear like a helmet and a back protector is highly recommended. Same things goes in these "inflated" markets we think.

In this week's conversation we would like to look at how global financial risks can be driving spreads, in conjunction with near term political risks.

Synopsis:

• Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous
• Final chart - USD likely to weaken given current position in historical tightening cycle

• Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous

While there has been a continuation in the performance of risky assets and in particular equities on the back of the Fed's rate hike and a somewhat more dovish tone, in terms of outflows, there has been a continuation of a defensive stance building up in credit, leading to a rotation from High Yield towards Investment Grade. We do remain short term "Keynesian" when it comes to credit and in particular Investment Grade, yet we are cautious on a longer time frame due to the leverage accumulated thanks to cheap credit which funded buybacks on a grand scale, weakening in the process corporates' balance sheets. In similar fashion to skiers on the Swiss Wall, as of late investors have chosen to take the less steep left hand side of the slope, where a stumble is less dangerous. This can be seen in fund flows as reported by Bank of America Merrill Lynch from their Follow the Flow note from the 17th of March 2017 entitled "Quality yield inflows as political risks near":

"Cautious flows 

Heading to the Dutch elections, investors preferred to look for quality yield. Inflows into high grade bonds strengthened considerably, while outflows hit HY funds particularly hard. Equity funds suffered light outflows, as equity investors wanted to be light heading to the Dutch elections. However, we feel that post the strong risk-on moves yesterday, part of these flows should reverse back to high yield and equity portfolios. 

Over the past week… 

High grade funds continued on the same positive trend of late for the eighth week in a row; and recorded an inflow as strong as the one a week ago. Monthly data reveal that February flows were the strongest in 6 months. High yield funds flow dipped into negative territory; making last week’s outflow the largest in 32 weeks. Looking into the domicile breakdown, among the European HY domiciled funds the ones that focus on US and European HY were the ones that recorded the vast majority of the outflows, while outflows from globally-focused funds were marginal. HY monthly flows remained positive for a third month in a row. 

Government bond funds flows remained on negative territory for another week, recording a sizable outflow, the largest in 12 weeks. Money market funds weekly flows remained positive for a second week. Overall, fixed income funds flows flipped back to negative after 11 weeks of inflows. However February data reveal that FI funds recorded the strongest inflow in six months. European equity funds flows flipped back to negative territory, recording relatively mild weekly outflows. Monthly flows remained relatively muted in February for a third month in a row for the asset class.

Global EM debt fund flows continued on a positive trend for a 7th week. The asset class has seen ~$14bn of inflows YTD. Commodities funds flows flipped back to positive. On the duration front, strong inflows continued in short-term IG funds for the 13th week in a row. Mid-term funds posted a small outflow, while flows in long-term funds flipped to a marginal positive figure after three weeks of notable outflows. " - source Bank of America Merrill Lynch

There has been definitely a scare in The Swiss Wall of investing when it comes to High Yield as reported by Bank of America Merrill Lynch in their High Yield Flow Report entitled "The outflows continue":

"Largest outflows from HY since Ukraine; 3rd largest ever 

US HY recorded a $4.06bn (-1.7%) net outflow last week, the largest since August 2014 and 3rd largest of all time. This brought the YTD total back into negative territory at - $3.3bn (-0.9%) through Wednesday. Whereas last week’s $2.8bn in redemptions were driven mostly by HY ETFs, open-ended funds bore the brunt of this session’s outflows with a $3.1bn (-1.6%) net loss. Similar to the aggregate high yield figure, this was the largest outflow from open-ended funds since the Ukrainian plane crash in the summer of 2014.

Although there has not been one cataclysmic event to cause the recent burst of outflows, they have likely been driven by a combination of higher rates, renewed fears over another dip in oil prices, and a fatigued rally that pointed towards a reluctance to continue investing in high yield. These withdrawals have pulled down returns in March, which currently stand at -1.4% through the 15th. Non-US HY also recorded a sizeable outflow totaling -$1.64bn (-0.6%) last week, their first period of net redemptions since November." - source Bank of America Merrill Lynch

If indeed investors (or skiers) have been on the cautious side prior to the FOMC rate hike decision, hence their rotation towards a more defensive position, we are awaiting to see if the Japanese investors crowd such as the gigantic GPIF and Lifers will come back to play with their foreign bonds allocations as they should be enticed by higher yielding US investment grade once more. What we also find of interest relating to our analogy is that investors and skiers alike, given the Fed's dovish tone, are encouraged by some sell-side pundits to take the right hand side and down the rocky passage of the Swiss Wall of investing namely in "equities". So far this year as indicated by Bank of America Merrill Lynch in their Fixed Income Weekly Strategy note from the 17th of March, this strategy has been vindicated:

 - source Bank of America Merill Lynch

Yet, from a valuation perspective and given current US valuation levels reached, from a skiing perspective and thanks to the Fed's dovish tone as of late, we would therefore rather go for EM equities if we had to make this choice down the slope of the Swiss Wall of investing. The bullish "skiing" stance down the Swiss Wall of investing is as well put forward by Bank of America Merrill Lynch in their Relative Value Strategist note from the 13th of March entitled "In the realm of diminishing returns":

"Don’t be a hero 

Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights. And after the strong jobs report, we think the near-term path of spreads is likely to lead them further towards these lows, post-FOMC and the March CDX roll. That said, in our view credit as an asset class is now past its prime; at these valuations, we believe we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. In our view, if there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, it is now. 

Great or not, the rotation is here 

If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit. In particular, we like being long S&P 500 vs. short in a HY cash index product (hedged for rates). Over the last 7y, in excess return terms, corporate bonds have failed to consistently generate returns that would overcome the losses during bad times. The upside vs. downside payoff looks far better in equities and CDX than in corporate bonds. Going forward, if the economy remains on this trajectory, the equity market is likely to continue outperforming credit. The prospect of higher rates is more favourable to equities, while in HY, negative convexity will likely cap any significant capital appreciation here on. On the downside, certain tax policy proposals which aren’t being priced in, namely borderadjustment tax and the elimination of interest-rate deductibility, are likely to have a significant negative impact on both equities and credit if implemented. Within credit, we think high yield companies are more susceptible than HG names and a short in HY cash is likely to provide a good offset to a SPX long from a policy risk perspective. 

Upside, downside, and in between 

For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either. For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads. Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch

We do agree with Bank of America Merrill Lynch, that, for bolder skiers, going for the synthetic option for playing High Yield makes sense first because of the liquidity factor provided by the index, second because of the lower duration factor compared to cash.

Of course, like any difficult slope, it can always get trickier on the ever changing Swiss Wall of investing. The rally can continue thanks to a dovish tone from the Fed which would be supportive of EM asset classes and put pressure on the crowded long US dollar positions. When it comes to credit, we do agree with Bank of America Merrill Lynch's take, that we are getting closer to the lower bounds of credit spread, even with the technical support of lower supply in the primary markets:

"In the realm of diminishing returns 

Credit spreads, unlike stock prices, have a lower bound (notwithstanding the recent spurt of negative spread bonds in Europe). We’re aware that we trot this statement out every now and then, as credit benchmarks approach previous tights, but it is a point worth bearing- the payoff in credit becomes more asymmetrical at tighter spread levels. Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights, reached in June of 2014. And after the strong jobs report for February, the near-term path of spreads is likely to lead them further towards these lows. Over the coming weeks, we think there is potential for spread compression, post-FOMC and also into the March CDX roll. 

In last week’s HY Wire, we noted the similarities between now and the first half of 2014. Of course, back then geopolitics and oil prices poured cold water on the rally by the third quarter and that set the stage for high volatility and poor returns for the next two years. For this year too we think the second half has the potential to turn sour as disappointment with legislative progress in Congress starts weighing on the market. As we wrote last month, it seems as if all the good has already been priced in, with little to account for the bad. That said, it is difficult to pinpoint what will eventually make the market turn and more importantly, when. There’s also the possibility, that the underlying strength in the economy and confidence keeps risk assets buoyed for much longer. 

In our view what is perhaps more certain, is that credit is now past its prime; at these valuations, we think we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. This is well reflected in our HY returns forecast for the year – around 6% - and even better in our year ahead title – ‘Don’t be a hero’. If there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, we think it is now. 

• If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit – consider long S&P 500 vs. short in HY cash.
• For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either.
• For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads.
• Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch

In our Swiss Wall of investing, when there is plenty of snow, the path downhill is easier on both side of the slope. But, as conditions changes and when the snow melts away at the end of the season, leading to some icy parts forming, not only it gets trickier even for the experienced skier like ourselves, but you need to chose your path more wisely according to the weather conditions. At this stage of the credit cycle, it becomes easier we think to stumble, no matter how experienced you think you are. What we have learned from both our investing experience and skiing the Swiss Wall is the need to stay humble and avoid being overconfident. From one day to the next, the Swiss Wall is never the same slope, this is why it makes it very challenging at this stage of the credit cycle. Even if Emerging Markets (EM) looks currently more enticing from an allocation perspective compared to Developed Markets (DM), as put forward by Bank of America Merrill Lynch in their EM Corporate Weekly note from the 14th of March 2017 entitled "Beware of fat tails", "Global financial risk" is the most important short term driver of spreads (icy patches):

"Global financial risk most important ST driver of spreads 

Ahead of the upcoming risk events (FOMC, Dutch & French Elections), we analyze past short-term drivers of EM credit spreads. Using a simple econometric model, we find that changes in UST yields, commodity prices, and global financial stress are able to explain more than half of the variation in credit spreads. Changes in BofAML’s Global Financial Stress Index (GFSI) are the most important driver (a one standard deviation increase in the GFSI is associated with +6 bps wider EMCB OAS). The second most important factor is changes in UST yields, followed by commodities. Our analysis also finds that these three factors can only explain 84 bps of spread tightening for our EMCB index since July 1st, compared to an actual tightening of 111 bps. This residual can likely be explained by technical factors which we do not explicitly include in our model. 

In Focus: quantifying the drivers behind spreads 

EM corporates are facing two different currents: on the one hand, technicals remain strong and credit fundamentals are improving on the back of higher commodities and GDP growth. On the other hand, valuations look expensive and a rise in external risks could lead to a re-pricing of credit spreads. In an attempt to quantify the historical impact of external factors on spreads, we run a simple multivariate linear regression model. We gathered weekly data from Jan 2012-Mar 2017 for our EM corporate indices as well as several external factors. Our baseline specification is the following:

Where UST5Y is the weekly bp change in 5Y UST yields, Commodities is the weekly percentage change in the S&P GSCI index, and GFSI is the weekly unit change in BofAML’s Global Financial Stress Index which is a measure of global cross-asset risk. 

Global financial risk biggest driver of spreads 

Results from our model suggest that BofAML’s GFSI index has the biggest impact on spreads: a three standard deviation weekly increase in the GFSI index is associated with spreads widening by 18 bps. EM HY is more correlated with changes in the GFSI than EM IG: a 3SD increase is associated with +36 bps of widening for EM HY vs. +12 bps for EM IG. LatAm is more correlated with the GFSI than other regions (Chart 3) with an est. spread widening of 25 bps given a 3SD move compared to +11 bps for Asia.

By sector Basic Materials and Real Estate are most correlated with the GFSI while Capital Goods are the least (Chart 4).

The last time the GFSI index rose by 3SD was February 12th 2016 (China and commodity selloff). Note that the GFSI has a correlation of 0.67 with the VIX. The latter did not show as much explanatory power in our regressions, which is why we prefer the GFSI. It is also a broader measure of risk appetite. 

Higher commodities associated with tighter spreads 

As expected, a 10% (4 SD) increase in commodity prices is associated with spreads tightening by 10 bps, holding other factors constant. EM HY is more sensitive to changes in commodities than EM IG, while LatAm is more sensitive than other regions given the larger share of commodity issuers (47%). On a sector basis, Energy, Basic Materials, and Transportation are most negatively correlated with commodity prices. 

EM HY has most negative correlation with UST yields 

In contrast to the positive correlation between the GFSI and spreads, changes in UST yields are negatively correlated with changes in spreads. A 50 bps (4.7 SD) weekly increase in 5Y UST yields is associated with OAS spreads tightening by 16 bps (beta of - 0.33), holding other factors constant (Chart 3). This implies that average yields would rise by 34 bps if 5Y UST yields rise by 50 bps. We also tested to see whether is a difference in the estimated beta depending on whether UST yields are rising or falling, but didn’t find any statistical significance. EM HY has a more negative beta than EM IG (-0.6 vs. -0.3) while Asia has the least negative beta across the regions (-0.2 vs. -0.4 for LatAm and EEMEA). On a sector basis, energy and consumer goods have the most negative beta, meaning spreads stand to tighten the most in a rising UST environment. 

Spreads have tightened more than predicted since July 

This regression also allows us to check whether the 111 bps tightening in EMCB spreads since July 1st 2016 is justified based on the actual changes in UST yields, commodity prices, and global financial stress. We find that the 103 bps increase in UST yields can explain 30 bps of the tightening in spreads, the 5% rise in commodities can explain 8 bps of tighter spreads, and lower financial stress can explain 46 bps of spread tightening. In total, our model calculates that EM spreads should have tightened by 84 bps since July 1st, implying that spreads overshot by 27 bps. However, the three variables in our model explain only 53% of the total variation in spreads, so it is possible that other factors which we don’t account for, such as technical factors or EM specific news account for the remaining spread tightening. High frequency data on technical factors are difficult to come across but we will explore this topic in future research." - source Bank of America Merrill Lynch

Now, if you remember our February 2016 conversation "The disappearance of MS München", we quoted Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis, when it comes to assessing warning signals that could weight on spreads:

"Depending on the type of crisis, there are different warning signals, such as significant current account imbalances (foreign debt crisis), inefficient currency pegs (currency crisis), excessive lending behavior (banking crisis), and a combination of excessive risk taking and asset price inflation (systemic financial crisis). A financial crisis is costly, as they are fiscal costs to restructure the financial system. There is also a tremendous loss from asset devaluation, and there can be a misallocation of resources, which in the end, depresses growth. A banking crisis is considered to be very costly compared with, for example, a currency crisis.We classify a credit crisis as something between a banking crisis and a systematic financial crisis. A credit crisis affects the banking system or arises in the financial system; the huge importance of credit risk for the functioning of the financial system as a whole bears also a systematic component. The trigger event is often an exogenous shock, while the pre-credit crisis situation is characterized by excessive lending, excessive leverage, excessive risk taking, and lax lending standards. Such crises emerge in periods of very high expectations on economic development, which in turns boosts loan demand and leverage in the system. When an exogenous shock hits the market, it triggers an immediate repricing of the whole spectrum of credit-risky assets, increasing the funding costs of borrowers while causing an immense drop in the asset value of credit portfolios." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis - Macronomics, February 2016

In world where positive correlations have been rising as discussed in last year's conversation and where global economies are much more intertwined, we have noticed in recent years much larger standard deviation moves, which have had significant large impacts on a very short period of time in various asset classes. In fact what is of interest from the quoted EM report from Bank of America Merrill Lynch comes from the volatility of spreads and kurtosis:

- source Bank of America Merrill Lynch

In similar fashion to the Swiss Wall of investing, as we move towards the end of the credit cycle, kurtosis is showing up, meaning that bursts of volatility can be faster and shorter in terms of time frame as we saw in the first part of last year with the Energy sector and spreads blowing out initially, and outperforming in the second part of the year. We continue to be very wary of the second part of 2017 which could play out as the reverse of 2016, namely we could move from "good performance" to "bad performance". The rally so far this year for many asset classes has been significant.

One thing appears clear to us is that the dovish tone of the Fed might indeed be linked to the recent weakness we mentioned last week in Commercial & Industrial (C&I) lending:

"Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth)." - source Macronomics, March 2017 

This "dovish" respite most likely explains the rebound in the Euro versus the crowded long US dollar and is providing an additional boost for EM asset classes in the process. Yet, we think the trend in C&I lending is worth following very closely. This is as well highlighted by Bank of America Merrill Lynch Credit Market Strategist note from the 17th of March entitled "HG sector outlook: long beta, leverage and inflows":

"Soft data is hard, hard data soft 

The Fed’s patience makes sense as hard economic data outside the labor market has been relatively soft. As we have highlighted (see: Situation Room: In wait and see mode 07 February 2017), loan demand has been soft recently – C&I lending for example has been flat since October while consumer loans on bank balance sheets have risen just 4% (Figure 36, Figure 37).

Clearly everybody is in wait and see mode pending details of actual fiscal policy expansion from the new administration – including especially tax reform. Until they deliver – and that is not a small task – it would be counterintuitive to see a marked hawkish shift at the Fed. In the meantime we remain bullish on high grade credit spreads." - source Bank of America Merrill Lynch.

We agree with the above, namely that before taking the more difficult path of the the Swiss Wall of investing with its normalization process, the Fed is clearly awaiting for more clarity from the new US administration. On a side note, we were quite surprised by the strong rally in gold/gold miners following the FOMC as we were expecting a more hawkish tone from the Fed on the back of ADP/NFP data releases.

From our continued contrarian position and Swiss Wall of investing perspective, we believe that the US dollar is likely to weaken further, contrary to the herd mentality, which has been taking a different path on this slope and a significant long position on the "greenback" as per our final chart below.

• Final chart - USD likely to weaken given current position in historical tightening cycle

While the trade war rethoric seems to be still in play following the most recent G20 meeting, we still believe as per our early 2017 conversations that the path on the Swiss Wall of investing is lower, not higher in the current environment. This is as well highlighted in our final chart from Barclays note Thoughts for the Week Ahead entitled "The Fed says carry on":

"We expect further near-term USD weakness, concentrated primarily against high-yielding currencies. History suggests that this point in the Fed’s tightening cycle is typically followed by further near-term USD weakness, stable equity prices and lower 10y UST yields (Figure 1). 

Although low-yielding G10 and EM currencies will likely struggle to materially strengthen further against the USD, the drop in cross-asset volatility (Figure 2) will likely support high yielders, particularly the ones with positive idiosyncratic stories (RUB, INR, IDR and BRL), in our view.

Additional USD consolidation is also likely, amid still elevated long USD and short UST positioning, according to CFTC data (Figure 3). 

- source Barclays

One could argue that, if everyone is thinking the same, no one is really thinking, because, if indeed the Fed's recent caution on the Swill Wall of investing appears to be warranted in the light of the recent Atlanta Fed 1st quarter GDP projection and slowing credit growth, there is indeed a possibility for our "bold skiers" to "tumble" if one takes into account their current stretched positioning but, we ramble again...

"Tis one thing to be tempted, another thing to fall." - William Shakespeare

Stay tuned!

Macro and Credit - Through the Looking-Glass

"Always speak the truth, think before you speak, and write it down afterwards." - Lewis Carroll

While parsing through the FOMC's latest "hawkish" statement, which somewhat reversed "The return of the Gibson paradox" as per our 2013 rambling, making our gold miners exposure on the receiving end of a proverbial "sucker punch", we reflected on the semantics (the study of meaning) and pragmatics (the ways in which context contributes to meaning) of the Fed's latest musing in similar fashion the character Humpty Dumpty discussed with Alice in Lewis Carroll's Through the Looking-Glass (1872), hence our chosen title analogy:

    "I don't know what you mean by 'glory,' " Alice said.    Humpty Dumpty smiled contemptuously. "Of course you don't—till I tell you. I meant 'there's a nice knock-down argument for you!' "    "But 'glory' doesn't mean 'a nice knock-down argument'," Alice objected.    "When I use a word," Humpty Dumpty said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."    "The question is," said Alice, "whether you can make words mean so many different things."    "The question is," said Humpty Dumpty, "which is to be master—that's all." - source, Lewis Carroll's Through the Looking-Glass (1872)

One could have had a similar discussion with Fed chair Janet Yellen on the very subject of the supposed upcoming rate hike in June or July we think:

"I don't know what you mean by 'incoming data consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective' " Alice said.
Janet Yellen smiled contemptuously. "Of course you don't—till I tell you. I meant 'there's a nice knock-down argument for you!' "
"But 'incoming data consistent with economic growth picking up' doesn't mean 'a nice knock-down argument'," Alice objected.
"When I use a word," Janet Yellen said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."

Indeed, the question is whether the Fed can make its words mean so many different things. What we also find of interest with our analogy is that Humpty Dumpty has been used to demonstrate the second law of thermodynamics. This law describes a process known as "entropy", a measure of the number of specific ways in which a system may be arranged (the Global Financial system as a whole), often taken to be a measure of "disorder". The higher the "entropy", the higher the disorder (hence our take on rising "positive correlation" and "disorder" with more and more large standard deviation moves in recent musings). After Humpty Dumpty's tragic fall and subsequent shattering, the inability to put him together again is representative of this principle, as it would be highly unlikely (though not impossible) to return him to his earlier state of lower entropy, as the entropy of an isolated system never decreases in similar fashion it has been incredibly difficult to return the Global Financial system to some state of "normalcy/lower entropy" but we ramble again...

In this week's conversation, we will start by looking at why the ECB is failing regardless of its QE, ZIRP and now NIRP and other tricks in spurring credit growth in Europe through the lens of European banks lack of "profitability". We will as well look at lending growth and the credit cycle.

Synopsis:

• Macro and Credit - Regardless of QE, ZIRP and now NIRP, the ECB is failing in spurring credit growth
• Macro and Credit  - Lending growth and the credit cycle and why the Fed is in a bind
• Final chart: US bond market - The warning sign from the long end

• Macro and Credit - Regardless of QE, ZIRP and now NIRP, the ECB is failing in spurring credit growth

While many pundits are highlighting "Price to book valuations" for global banking stocks. and are asking themesleves if banks cheap enough to take a risk here, we reminded ourselves our conversation from February 2015 entitled "The Pigou effect" where we clearly indicated our discomfort with European banking stocks:

"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe." - source Macronomics, February 2015

We also quoted at the time Berenberg's take on the "Japanification" of Europe "Through the Looking-Glass" of its banking sector:

"In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans." - source Berenberg as per Macronomics note from February 2015

Given our recent April conversation "Shrugging Atlas", musing around "Atlante", the Italian structure set up to tackle the sizable issue of Nonperforming loans (NPLs) plaguing the Italian banking sector, the performance of Italian banking stocks in particular and European banking stocks in general does validate our preference for financial "credit" than for financial "stocks" in Europe:

"No matter how low interest rates on corporate loans have fallen and has been much vaunted by the ECB and many pundits as a "great success", lack of "Aggregate Demand" (AD) and loans flowing to SMEs thanks to insufficient demand, this will not, rest assured, resolve the on-going woes, which have been much increased by the recent implementation of Negative Interest Rate Policy (NIRP), of the Italian banking sector. 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 exercice of dubious intellectual utility, hence our chosen title. Also as per our analogy, we wonder if, at some point, in similar fashion to Ayn Rand's book, investors will not go on "strike" when it comes to helping out the Italian banking sector as a whole." - source Macronomics, April 2016

Through the looking glass of the European banking sector, one can ascertain the futility of the ECB's policy in terms of QE, ZIRP and now NIRP in not only stabilize the "equity value" of Italian banks, but as well in resuming "credit growth". In continuation to us "Shrugging Atlas", we read with interest Bank of America Merrill Lynch's Money in the Bank note from the 20th of May entitled "Europe’s riskiest bank bonds":

"From bel canto to bank analysis 

It would be fair, we think, to typify the first trimester of this year for the Italian banks as a torrid one. It’s been tough for all global financials but Italian banks have particularly suffered. YTD Unicredit’s stock has fallen -43%, Monte dei Paschi -53%, Banco Popolare -65% and Intesa -25%. There are a number of reasons for this underperformance but at the base we see the systemic asset quality, credibility and capital problems in Italy as the drivers of investor concerns.

From bel canto to bank bond analysis: we measure the empirical riskiness of bonds by looking at the standard deviation of daily excess returns. We are not surprised that the Top 5 riskiest bonds in Europe YTD are all Italian banks, specifically Monte dei Paschi Tier 2, Veneto Banca T2 and Unicredit USD AT1. Excluding DB, Italian bank bonds occupy all 9 places of the Top 10 most volatile bonds. Following the 1Q reporting season and the recent events in the Italian banking sector, perhaps it’s a good time to reassess whether the market’s assessment is really a robust one.

We’re mindful that Italian financials are a significant part of the HY Index. There is €27.5bn of Italian paper in the HY Fins Index which is 45% of the total. It’s one thing to be negatively positioned in these when they are in decline but what if there is a turnaround in the assessment of the fortunes of these banks?" - source Bank of America Merrill Lynch

We do not think there will be a turnaround through the looking glass of their "better earnings" thanks to "lower provisioning levels". On this subject we read with interest Bank of America Merrill Lynch's take from the same note:

In 2014, some banks briefly circulated the idea that they were more conservative in their classification of NPLs than other European peers as the reason for the high quantum – this got quashed when the AQR clearly demonstrated the opposite. There have also variously been tax reasons and legacy lending issues, amongst others. We think the reasons may encompass many of these, but at root the answer is probably simpler: Italian banks did not seem to be very good at underwriting, in our view. We think high levels of NPLs are, in some respects, a management choice. To be fair, up to 2016, no one seemed to care and we could get little traction with investors when we talked of asset risks in Italy. This indifference possibly explains the relatively high level of complacency on the part of the banks on the NPL front. Remember this is a jurisdiction where a bank with a 16% NPA ratio is considered best in class.
In contrast to what we might describe as the pusillanimity of the banks in face of this significant challenge, we think the Italian Government has moved relatively proactively to try and address systemic concerns. It orchestrated a fund to help recapitalize some of the banks and avoid failed IPOs which would likely have caused further systemic issues, we think. Importantly, there have also been a series of measures which have been designed to reform insolvency practice in Italy and address tax issues around provisioning. There has even been an attempt to create a kind of bad bank, or more precisely to kick start a more liquid market for NPLs, through the provision of a Government-guarantee to NPL securitisations. We consider the efficacy of these operations in turn. 

Atlante 

Initially, we assessed the Atlante fund as a positive development for the Italian banks as we saw it as an attempt to break the cycle of bad news around the banks. We were slightly disappointed that the fund raised only €4.25bn compared to the €5-6bn that was originally mooted. Originally designed to ensure the success of the BP Vicenza IPO, and in our view, also help rescue Unicredit from its ill-fated decision to be sole underwriter for said transaction, the IPO of BP Vicenza has now passed, with Atlante having to take up the entirety of the €1.5bn in stock that was offered, because outside investors did not take up any allocation in sufficient quantity. According to Borsa Italiana, 10 insitutions offered to buy 5.1% of the shares which was insufficient free float. Atlante now has €2.75bn in resources left. The IPO of Veneto Banca is upcoming (pre-marketing was to start at the end of this week) and has been widely considered e.g. in the Italian press to have a greater chance of success when compared with Vicenza, not least because the bank is trying to place a smaller amount (€1bn). Market conditions remains hazardous though, we think, as recent comments by CONSOB underline. We have seen some discussion in the Italian press that the fund could be scaled up but we haven’t seen anything concrete on this – Bloomberg reported on Wednesday that the Italian Finance Minister was suggesting in an interview that it could be enlarged. Atlante is in any case a closed fund now but 66% of holders could vote to expand it, so we can’t exclude that the fund will grow, especially if it needs to.

In spite of being ostensibly private to avoid the state aid rules in Europe, Atlante seems to us to be serving a specifically public policy role, on our reading of its presentation, ‘by eliminating excessive supply with respect to the demand for shares’ though it is supposed to have the ‘interest of investors as its sole objective’. It seems to be an unusual set-up even by European standards.
Atlante has already served one of its primary purposes, we think, in subscribing to the Vicenza increase and sub-underwriting the IPO thereby reducing the risk to Unicredit ofbeing left with a significant overhang of shares. 70% of the funds resources are designed to be available for the support of capital raises, with the balance, or just under €1.3bn currently, for the purchase of NPLs. On NPLs, the idea is not that Atlante replaces the NPL market, but that it promotes ‘the creation and development of an efficient market of distressed assets in Italy’. In other words, Atlante may facilitate the sales of NPLs e.g. by buying mezzanine or equity tranches of NPL securitisations – especially those that take advantage of the Government guarantee (the so-called GACS) for the senior/investment grade tranche of the structure. The first bad loan securitization, with a GACS guarantee, is already happening in Italy with a €500m 3 year transaction for BP Bari. However, as the chart shows, loan sales in Italy have been relatively few. The expectation is that Atlante, plus GACS (plus the legal reforms, below) might provide the conditions to accelerate the creation of a more active market for bank bad loans.

We keep an open mind on the Atlante structure and its benefits – the market has been skeptical hitherto. We recall Fitch’s warnings that Atlante potentially drags healthy banks down in their rescuing less healthy institutions. But we still believe perceptions can quickly change as e.g. NPL transactions materialize using GACS, whether or not Atlante participates. Currently, in our view market sentiment around the Italian banks is still overwhelmingly bearish, especially after the last reporting season which was, in summary, rather underwhelming, in our view. We think it’s rather soon to assess the potential benefit from Atlante. We will need to see successful transactions concluded, however. Positive conclusions for the upcoming IPOs of other Italian banks would also be helpful, we think." - source Bank of America Merrill Lynch

We do not think it is rather "too soon" to assess the potential benefit from "Atlante", as we reiterated earlier on, 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 exercice of dubious intellectual utility, and through the "looking glass" of Italian banking woes and credit growth, the ECB is failing we think because with its QE and NIRP, it has not enticed Italian banks to accelerate the clean up of their balance sheets on the contrary as indicated in Bank of America Merrill Lynch's note:

"Perhaps the banks are anticipating the benefits of the patto marciano and so believe there is less need to keep provisions high (we understand that many European banks are also eager to anticipate the -0.40% rate at which they may be able to borrow from the ECB, even though that rate strictly speaking can’t be calculated ex ante). Lower provisions was a driver of many of the beats to consensus expectations in Italy, though, it seems. " - source Bank of America Merrill Lynch

Exactly, why bother? On a side note, and in similar fashion, for some countries and in particular France, why bother launching structural reforms when the ECB enables you to borrow for close to nothing (0.5%) for 10 year?

But moving back to why the ECB is failing is once again its lack of basic understanding of "stocks" versus "flows". We have long argued that for Eurozone members, if credit growth does not return, economic recovery may prove to be difficult in the absence of sizable real exchange rate depreciation. Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth. 

When it comes to assessing "banking revenues", it is actually pretty straightforward as presented by Société Générale in their European Banks note from the 20th of May entitled "The revenue crisis":

"Net interest income is nothing more complicated than the revenue spread on the balance sheet. It depends on three pretty straightforward variables: the size of the balance sheet, the yield on assets and the cost of liabilities. It is the first two of these variables that have been under consistent, sustained pressure across the sector. Liabilities have not got cheap enough, quickly enough to compensate.
Across the sector, NII contributes c. 60% of the revenue base, and so is the major part of the dynamic. Non-interest income is more volatile, and spread between a multitude of different business lines. Essentially, fee income is a flow on the franchise value of the bank: the branches, the product range, the staff, etc. The outlook is less clear, and the drivers can change quickly. Strong markets would tend to be the biggest single force." - source Société Générale

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of budget deficits and NPLs.

Furthermore, the ECB's NIRP policy has aggravated the "deflationary" spiral in the deleveraging process by limiting the possibilities for banks to offset their NPLs woes with more revenues as pointed out by Société Générale in their note:

"Revenue wipe-out European banks are suffering. Every bank we cover has reported a year-on-year drop in Q1 16 revenue. A heady mix of zero rates, tough markets, weak CIB and stagnant lending volumes is taking a heavy toll. This matters for the sector. While nearterm earnings have been underpinned by better credit quality, this is not a theme that can continue forever. Sector earnings are stuck in a downgrade cycle, and pressure on the revenue line is at the heart of this." - source Société Générale

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think. Although the ECB has been trumping the convergence in Europe in interest rates charged on new corporate loans, as we stated before, the "fun" is uphill, in the bond market, not downhill, in the "real economy". If there is one chart displaying the failure of the ECB we believe it is the below chart from the same Société Générale note that illustrates the ECB's failure in spurring credit growth:

- source Société Générale

With the ECB's NIRP, there is no revenue, and there is as well no loan growth, so some pundits might be highlighting "Price to book valuations" for global banking stocks, we haven't change our views and we would rather play the "credit" side than the "equity" side from an investment perspective particularly "Through the Looking-Glass" of "consensus" EPS trend as displayed by Société Générale in their note:

"The weak revenue environment helps to explain a major anomaly with the Q1 16 results season: the sector generally ‘beat’ consensus on earnings, but consensus EPS downgrades have continued unabated." - source Société Générale

Indeed thanks to the ECB and its NIRP policy, when it comes to European banks stocks, you can no doubt, expect lower, for longer, that's a given. Whereas, the leveraging in the US has run fast and furious in the US credit markets, courtesy of the Fed, as we pointed in our last conversation we expect the impact of the ECB's much anticipated "credit binge" to materially deteriorate the credit quality of European credit markets which had been in recent years much more defensive of their balance sheets, no doubt even in High Yield than in the US. This leads us to our second point namely that, "Through the Looking-Glass", the Fed appears to us to be in a bind, with its "hawkish" stance, highlighting more and more the law of diminishing returns when it comes to its "credibility".

• Macro and Credit  - Lending growth and the credit cycle and why the Fed is in a bind

As indicated in our conversation "The disappearance of MS München", we have been tracking the price action in the Credit Markets and particularly in the CMBS space. The reason behind us starting to track à la 2007 is that the CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. 

As a reminder from our February conversation, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so in the future.

For instance, the continued weakened price action noticed in some space of the CMBX market as per the below chart from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 20th of May illustrates why we are watching closely that space:

- source Bank of America Merrill Lynch

"Through the Looking-Glass" of "retail" CDS price action and the link between retail and CRE, given we told you about this relationship in February with Sears’s management announcing in February that the company would accelerate the pace of store closings, sell assets and cut costs, this is clearly a "headwind" for CMBX and CRE. This is ncreasingly a sign that all is not well in the much vaunted "economic recovery" picture painted by the Fed and Humpty Dumpty aka Janet Yellen and her 'incoming data consistent with economic growth picking up in the second quarter'. As an illustration of the tailwind facing the Fed, the CDS price action depicted by DataGrapple on the 13th of May is indicative of the risk facing CRE investors:

"The above grapple depicts the weekly change of the risk premia of the constituents of the US Corporate cluster identified by DataGrapple. Retailers are easy to spot. In an otherwise resilient market as shown by the greenish shades of most boxes, all of them are red (and some bright red). Most of them reported first quarter numbers, and all of them managed to disappoint. Today, JCP (J C Penney Company, Inc) posted revenues that trailed analysts’ estimates and joined fellow discount-oriented KSS (Kohl’s Corporation) which missed estimates yesterday. Higher end rivals did not fare any better. M (Macy’s, Inc) reported lacklustre results and lowered EPS guidance for the year by 57cts (to $3.15-$3.40 from $3.80-$3.90), while JWN (Nordstrom, Inc) also added to evidence that the department store industry is mired in a deep slump when it cut its annual earning forecast. Shoppers across the income spectrum appear to pull back on purchases of apparel and other discretionary goods." - source Datagrapple, 13th of May 2016

For those with a "short bias mentality", please note that CMBX.6 has the highest percentage of retail exposure. CMBX.6 has considerably more exposure to B/C quality malls...just saying. 

And when we say the Fed is in a bind because of this relationship between "retail" and CRE we are not the only one meaning it. For instance Bank of America Merrill Lynch make the following interesting points in their Weekly Securitization note:

"While limited issuance might otherwise provide a powerful tailwind for spreads, myriad uncertainties remain on the horizon lead us to adopt a more cautious near term view. 

First, as we mentioned above, is the increasing probability that the Fed may raise rates over the next two months. Although a rate hike in and of itself won’t be overwhelmingly negative, it is likely, if not probable, that any near-term hike will be negatively viewed by many investors and could possibly be interpreted to signify that the Fed will be overly zealous as they seek to normalize interest rates against what they believe is an improving economic environment. Second, to the extent higher rates exacerbate the recent credit tightening, it is reasonable to fear that CRE price growth, which is already showing signs of slowing, could be exacerbated to the downside. While the recent Federal Reserve Senior Loan Officers Survey showed that bank lending standards have tightened since the end of 2015, rising recent conduit debt yields (Chart 52) and stabilizing Moody’s stressed LTV (Chart 53) metrics indicate the same is true within CMBS. Risk retention, which dealers are actively planning for, is likely to tighten lending standards further.

The combination of better underwriting, subdued new issuance activity and shrinking dealer balance sheets (Chart 54), which make it difficult for investors to add bonds in size away from the new issue market, have likely contributed to the cash bond spread rally. 

Recent CMBX spread/price movements, however, tell a different story and may provide insight into the macro-related nervousness investors are feeling.

On the week, CMBX prices, especially for tranches at or near the bottom of the capital structure, fell by as much as three points (Chart 55) and have fallen by as much as five points since the beginning of the month (Chart 56).

Again, to the extent that oil prices remain rangebound or increase and no major economic disruptions occur over the next month, we anticipate that CMBX spreads will trade directionally with broader markets." - source Bank of America Merrill Lynch

And of course, "Through the Looking-Glass" of the price action of CDS in the "retail" sector and CMBX, this is indeed a cause for concern regardless of "Humpty Dumpty" aka Janet Yellen's rethoric.

This brings us further "Through the Looking)Glass" of the relationship between lending growth and the credit cycle thanks to UBS's recent take on the subject from their Global Credit Comment note from the 17th of May 2015 entitled "Bank vs nonbank lending signals: the plot thickens...":

"In corporate (non-household) lending markets we believe the proverbial plot has thickened considerably. The two key lending segments are commercial and industrial (C&I) and commercial real estate loans (CRE). For C&I lending, banks comprise less than 20% of total lending; the bond markets are the new marginal provider of liquidity (Figure 2). 

Our non-bank proxy, incorporating bond and trade finance measures of credit conditions, has been indicating more tightening than bank proxies (i.e., the Fed's SLOOS survey) for several quarters. And our proxy is still suggesting further tightening ahead, primarily given that new issuance in US high yield and leveraged loan markets remains sluggish despite recent outperformance (US HY and institutional LL issuance are down 47% and 33%, respectively, in 2016; CLO issuance is off 68% YTD). That said, the rate of tightening has slowed, as HY issuance and trade-credit standards improved in April (Figure 3). 

In short, the trend in lending conditions is still tighter – but there has been some easing in funding conditions.
Conversely, lending conditions in commercial real estate have deteriorated. Banks comprise about 55% of total lending, so the Fed's SLOS survey is more telling. And, in the last quarter, banks tightened lending conditions in CRE, specifically in multifamily and construction/land development vs nonfarm non-residential (36% and 24% net tightening versus 12%, respectively, Figure 4; CMBS issuance is also down 38% through April). 

Why are banks tightening?

The most important factor cited was not CRE fundamentals, cap rates, competition nor funding, but 'other' factors – and by a large margin. What is our interpretation? Increased regulation was the underlying cause. We have previously flagged concerns around the pervasive easing of underwriting standards for corporate lending broadly 5 . Since 2007 FDIC-insured banks have increased nonfarm, nonresidential loans (ex-owner occupied) approximately 82% to $730bn; multifamily loans rose by roughly 142% to $344bn6 . In December, the OCC released its Statement on Prudent Risk Management for CRE Lending in response to "significant growth in CRE lending, increased competitive pressures, historically low cap rates and rising property values". This guidance was originally issued back in 2006, requiring banks with higher CRE concentrations to tighten risk and managerial controls.
We estimate approximately 8% and 16% of FDIC-insured banks by count and CRE debt outstanding, respectively, were above at least one of the concentration levels at YE 2015 (i.e., >100% CLD vs total capital, or >300% CRE vs total capital and >50% growth prior 3 years). For comparison, in 2006 about 31% and 40% of banks, respectively, exceeded one of the thresholds. Last month an American Bankers Association survey suggested similar, but modestly higher, figures in terms of bank concentration levels among respondents. Further, 40% indicated they expected a measurable reduction in credit availability to certain CRE sectors, while another 25% suggested a measurable reduction in credit availability across all sectors from the guidance. 

Why is this important? First, regulation can have a significant impact on the supply of credit, with US leveraged loans a recent case in point8. Back in 2006, the CRE guidance for banks also coincided with a significant tightening in CRE lending conditions. Second, changes in lending conditions for C&I and CRE loans have been quite highly correlated in the past (see Figure 4 above ).

One study finds banks that were above CRE guidance concentrations not only slowed CRE loan growth, but also tended to reduce C&I loan growth. Simply put, macroprudential regulation can have a more broad-based and severe effect on commercial bank lending. One could argue that constraints on lending as the credit cycle matures may guard against excess losses; conversely, an exogenous shock to the supply of credit at a time of lacklustre global growth and upcoming risk events could exacerbate
funding pressures.
And the linkages between CRE and C&I lending are multi-faceted. The lenders – in particular regional and community banks – tend to have higher concentrations of commercial and C&I loans, and some smaller business loans are collateralized by commercial property. Second, borrowers can also be concentrated in certain sectors across C&I and CRE. According to the Fed's Shared National Credit Review the largest industries in the leveraged C&I portfolio included Healthcare (14%), Media/Telecom (13%), Finance/Insurance (12%), Materials/Commodities (6%) and  Retail (5%)10. In CRE portfolios, larger concentrations lie in multifamily (28%), office (18%), retail (16%), industrial (12%), hospitality (8%) and healthcare (7%) according to the ABA. Much of the CRE growth has occurred in coastal cities. This implies, while not directly comparable, C&I and CRE depend more heavily on similar industries – media/telecom, finance (non-bank), retail and healthcare.

The conclusion is that the plot is thickening with respect to the signals of corporate lending conditions, and we believe clients should increasingly view them in a holistic framework. While there are signs of moderation in the rate of tightening for C&I loans, we are already seeing rising delinquencies and defaults weigh on corporate profits and growth (stages 3 and 4 of our rudimentary credit cycle model outlined earlier). But for CRE loans we think there is greater cause for concern as potential harbingers of greater credit constriction emerge.

Importantly, we have yet to see much rise in delinquency and default rates – although examiners noted rising concerns over CRE credit risk for 75% of banks and expected credit risk to rise in 50% of all commercial loans at year-end. The ESRB provides a simple but useful framework for the CRE cycle (Figure 5); while the CRE cycle appears less advanced than the C&I cycle, we believe investors should closely watch for evidence of potential negative effects on credit availability in CRE and potential broader spillover to C&I lending.

In particular, investors should closely watch the media/telecom, finance (non-bank), retail and healthcare industries given the linkages across both markets. In terms of investments, our view of recent trends in corporate lending conditions does not support 'reach for yield' or down-in-quality trades. In corporate credit, we continue to prefer longer duration US high grade bonds versus high yield." - source UBS

We agree with UBS's preference for US longer duration US high grade bonds exposure versus High Yield. When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2.

This leads us to our final chart, indicating as well that "Humpty Dumpty" aka Janet Yellen should pay attention to what the long end of the US bond market is telling her no matter what she thinks whether or not she can make words mean so many different things in the FOMC...

• Final chart: US bond market - The warning sign from the long end

What "Humpty Dumpty" aka Janet Yellen doesn't seem to realize is that the credibility of the Fed, is "decaying" in similar fashion as the "theta" (time value) of the "put" option of the Fed. Given the recent "hawkish" tone to somewhat "dampen" the "credibility risk", we tend to agree with Bank of America Merrill Lynch's take on the warning sign being sent by the long end of the US yield curve as per their recent US Rates Watch note from the 18th of May entitled " Fed vs. bond market: The warning sign from the long end". The final chart taken from their note plots long term real rates in five major countries vs. the miss to the respective central bank’s inflation target:

"Bond market vs. Fed speak: look at the long end, not EDs 

Recent Fed speak and a slew of important speakers lined up to talk before the June meeting (Dudley, Yellen, Fischer) has shifted attention back to the front end of the rates curve. Eurodollar bears that were forced into hibernation since March have woken up, revisiting similar arguments of dots vs. the Fed, rates vs. US data surprises etc. To us, there is one worrying sign in the reaction of the bond market to the better data and hawkish Fed speak unlike 2013: instead of the optimistic signal the yield curve sent during the taper tantrum, long end rates now suggests a re-ignition of the policy mistake trade. Raising June/July probabilities is a small victory that is coming at the cost of dealing with higher probability of inverted yield curves 2-years forward, in our view. 

This is not 2013: reigniting the policy mistake trade 

A critical difference between 2013 and today is the inability of Fed optimism to filter through into higher long end yields. Chart 1 plots OIS forwards in mid and end 2013 (pre and post taper tantrum).

The combination of better data and shift in messaging from the Fed in 2013 was viewed to be a sign of an optimistic longer term growth picture – the resulting rise in yields was a healthy combination of 1) higher terminal rates 2) higher term premiums 3) and thereby a license for the Fed to hike sooner and faster than was originally thought. Recent communication however struggled in this regard: hawkish Fed talk and better US data has only helped 1) strengthen the dollar and weaken inflation expectations 2) lower terminal rates priced in 3) increase hike probabilities for the near meetings without shifting medium term expectations. 

Lack of credibility constrains effectiveness 

The policy mistake angle assigned to the Fed is visible in more areas than the yield curve. Chart 3 plots long term real rates in five major countries vs. the miss to the respective central bank’s inflation target. The market continues to believe that the Fed will deliver real rates that are far too high and miss on its long term inflation target by at least 50bp. To us, this inability of the Fed to improve longer term expectations priced in to the market tows the line of igniting a bigger concern: getting dangerously close to the market pricing in inverted yield curves, 2 to 3 years forward." - source Bank of America Merrill Lynch

So go ahead "Humpty Dumpty", hike, because looking through the "Looking-Glass" of retail earnings, their respective CDS price action, the state of CRE versus lending standards continuing to tighten and the state of the "long end" of the US yield curve, we do think that you will not be able to return the US economy to its earlier state of lower entropy...

"If you stop being scared, that's when entropy sets in, and you may as well go home." -  Tamsin Greig, English actress

Stay tuned!