Macro and Credit - Outflow boundary

"It was one of those March days when the sun shines hot and the wind blows cold: when it is summer in the light, and winter in the shade." -  Charles Dickens

Watching with interest the inflows pouring into short term Investment Grade credit funds, somewhat validating, the defensive posture we have been discussing as of late, we reminded ourselves for our title analogy of the concept of "Outflow boundary". An "Outflow boundary" also known as a gust front, is a storm-scale or mesoscale boundary separating thunderstorm-cooled air (outflow) from the surrounding air, similar in effect to a cold front. While outflows boundaries can persist for 24 hours or more after a thunderstorm, with passage marked by a wind shift and usually a drop in temperature and a related pressure jump, in similar fashion outflows in funds can persist for a specific amount of time. Also "Outflow boundaries" do create low-level wind shear which can be hazardous during aircraft takeoffs and landings, so if you are indeed piloting in similar "market conditions", you need to be extra cautious, and probably embrace somewhat a contrarian stance, at least from a long duration perspective we think.

In this week's conversation we would like to look at the oil fueled decompression in credit, and why we are turning more positive when it comes to going long US duration, which will be supported flow wise by a return of the Japanese crowd thanks to better cross-currency basis.

Synopsis:

• Macro and Credit - Front-running our Japanese friends?
• Final chart - Beware of "credit" repatriation

• Macro and Credit - Front-running our Japanese friends?

While we have long argued that in recent years you had to focus on what our Japanese friends such as GPIF, Lifers and Mrs Watanabe were doing in terms of allocations, given we are moving towards the end of the Japanese fiscal year, we are wondering if we are close to the "Outflow boundary" as many of them have shun foreign bonds lately. Could this time be different? 

It was only a matter of time before the weakness in oil translated into a weakness in credit, hence the fund outflows we have discussing about in our recent musing and our argument relating to High Yield being "priced to perfection" hence our recommendation to seek refuge in US Investment Grade. This outperformance of Investment Grade credit in conjunction with the weakness in oil has been clearly described by DataGrapple in their recent blog posting from the 24th of March entitled "Oil-Fueled Decompression":

"After a few months a stability, oil experienced a tumultuous month of March. Over the last four weeks, it has slid more than 10% amid supply woes. Russia’s policy makers are leaning on the cautious side. They said they were using below consensus estimates - $50/barrel on average in 2017, falling to $40/barrel at the end of 2017 and then staying near that level during the 2 following years – to establish growth forecasts in an economy still driven by oil to a large extent, adding to the market nervousness in doing so. That certainly goes a long way in explaining the underperformance of the energy heavy CDX HY compared to its investment grade benchmark equivalent, CDX IG. Since the 24th February, CDX IG series 27 – series 28 did not exist at the time – has tightened by 3bps to 60bps, while CDX HY series 27 has widened by 7bps to 327bps. Using a standard beta and thus assuming 1bp of CDX IG is equivalent to 5bps of CDX HY, it means HY has underperformed IG by almost 1 percentage point in cash price over the last 4 weeks." - source DataGrapple

In terms of oil and US High Yield with a correlation of 0.72, it makes sense from a Total Return perspective to see a relationship, particularly given the significant weight of the Energy sector in US High Yield indices:

- source MacroCharts

Of course flow wise, recent weeks saw a defensive rotation on the back of the weakness in oil prices as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 24th of March entitled "Rising risk of outflows out of short-term funds":

"Forsaking duration vs reaching for yield

Despite the significant risk-on we have seen across risky assets in the past weeks, inflows continue to pile into short-term IG funds. Total returns are turning negative over the past weeks (chart 1), and this increases the risk of outflows hitting IG funds in Europe. 2y bund yields have re-priced significantly higher since late February. The flattening of the yield curve is not supportive either. EM debt funds continue to attract interest as dollar slips lower.

Over the past week…

High grade funds flows remain on the positive side for the ninth week in a row. Even though flows are still strong, the pace is weakening lately. High yield funds flow remained negative for a second week, however the outflow was less more than halved w-o-w. Looking into the domicile breakdown, as charts 13 and 14 show, the largest part of the outflow came from euro-focused and US-focused HY funds. The globally focused funds were almost flat last week.

Government bond funds flows remained on negative territory for the fourth consecutive week, recording over $3.5bn of outflows over that period. Money market funds weekly flows remained positive for a third week, but the inflow was marginal. Overall, fixed income funds flows flipped back to positive territory after a brief week of outflows. European equity funds flows were negative for a second week, with outflows picking up w-o-w. However these outflows are significantly smaller than what we have experienced in 2016.

Global EM debt fund flows continued on a positive trend for an 8th week. The latest inflow was the highest in 34 week as dollar continued to weaken. Commodities funds recorded their second week of inflows.
On the duration front, strong inflows continued in short-term IG funds for the 14th week in a row recording the biggest inflow in this part of the curve since July ‘14. Mid-term funds posted a second outflow in a row, the largest outflow in four weeks. Flows in long-term funds remained slightly positive for a second week." - source Bank of America Merrill Lynch

When it comes to oil woes and High Yield weakness, it remains to be seen if indeed we are going through an "Outflow boundary". As pointed out by Deutsche Bank's US Credit Strategy Sector Themes from the 24th of March, High Yield's weakness apart from outflows, seems to be continuing and worth monitoring given its correlation with equities (more on this below):

"HY weakness persists, despite slower issuance, stable oil

The HY bond market has repriced noticeably this month, having seen its spread widening from the lows of 368bps reached on March 2 to 423bp today. It started with weakness in the higher-quality segments of the index, before extending itself down the quality spectrum. At the end, CCCs have lost 2.6% in excess return, compared to 1.4% in BBs in March, while maintaining about a 2pt lead for the year.

A record-setting streak of eight-day outflows from ETFs earlier this month claimed 7.2% of their AUM, compared to 6.7% in withdrawals in the immediate aftermath of the Third Ave fund failure in Dec 2015. Eventually the outflows extended to broader fund space, claiming a couple of $1bn+ days of heavy withdrawals, which continue to this day.
Issuance has slowed down noticeably in recent days, after breaking some records leading to the Fed meeting. This suggests it only had a limited contribution to HY weakness at that point in time. Similarly, HY temporary bounce a week ago was happening in the background of WTI trading close to its recent lows, also supporting our view that oil had only a limited impact on spread widening. We think it is mostly about repricing longer-term rates and growth expectations. IG spreads remained broadly unchanged March, oscillating around 120bp.

The global yield environment is shifting fast

The yield on Bloomberg’s Global Agg index has jumped by 20bps between late February and the Fed’s meeting, reaching 1.75% at its peak before giving back a few basis points since then. To put things into perspective, these 20bps represent 2/3rds of its increase between the US election and year-end. We think this datapoint is a key aspect of what drove HY weakness in recent weeks, as the reach for yield trade can only survive in the environment of lack of global yield opportunities, and every basis point of increase in that benchmark’s yield equals $4.6 of incremental income produced in a year. In an average month, global HY market produces $12bn of income, and in the middle of last year this number stood for a quarter of total income produced by the Global Agg. At any point in time between Brexit vote last June and US election in November, investors were willingly accepting lower yields on their EU IG holdings than they can currently get in the German 10yr bund." - source Deutsche Bank

As we pointed out recently, the performance for High Yield since the "Trumpflation"trade has been impressive to say the least. This is also pointed out by Deutsche Bank's report:

"HY vs IG

HY spreads have tightened dramatically post the US election, setting a low print of 368bp in early March, or almost 150bp below their level on Nov 8. In the meantime, IG spreads have only tightened by 20 bps to 118bps. The 1:7.5x relationship between IG and HY we experienced over the past few months breaks the historical norm of around 1:3.5x between these two asset classes.

A tight relationship that exists between these two asset classes has been pushed to the limit in early March, as Figure 2 demonstrates.

This resulted in the error term (actual vs estimated HY spread based on regression vs IG) of -75bps, matching its cyclical tights.

Going forward, we expect this tight relationship (85% r-squared) to reassert itself, resulting in relative excess return underperformance in HY. While the normal historical spread beta between IG and HY spreads is 1:3.5x, the excess return beta is only 1:1.5x (a function of shorter HY effective duration). As such, we use this 1.5x beta as the weighting for the IG leg of this positioning recommendation. One easy way to execute on this trade would by using ETFs: LQDH is a rates-hedged version of LQD, and HYGH is an equivalent in HY. We recommend shorting $1 of HYGH vs going long $1.5 of LQDH.
HY CDX is trading much closer to IG CDX based on a similar regression analysis, implying little potential value in replicating this trade there. Also, an extension of this recommendation to total returns is challenging, given our expectations for higher rates. IG is more likely to underperform HY in total return terms in that scenario." - source Deutsche Bank

We agree with the above, namely that the weakness in US High Yield is likely to persist further. and, this represents as well some headwind for our equities friends out there. Why is so, just a simple correlation close to 1:

- source MacroChart

In case you are asking, it just shows you that High Yield, isn't that much of an "alternative" asset class, as put forward by some pundits. So really please tell us where your potential for diversification is? Because,  when it comes to High Yield, we do not see it hence our "Outflow boundary"analogy.

But, the big question, as we await the allocation decision from our Japanese friends, if there will be enticed again by foreign bonds like they have in recent years. The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment. This is as well put forward by Bank of America Merrill Lynch in their Credit Market Strategist note from the 24th of March entitled "Hedging costs in the driver seat":

"Hedging costs in the driver seat

We feel increasingly confident about our bullish outlook for high grade credit spreads, as well as our 10s/30s spread curve flattener. But our 5s/10s flattener is challenged. Volatility from policy risks aside the technicals of the high grade corporate bond market are about to improve. This is because of sharp further declines in the cost of dollar funding for foreign investors (Figure 1), as US policy gridlock dampens the outlook for accelerating economic growth.

Recently this has been particularly pronounced for Japanese investors – perhaps due to liquidation of foreign assets toward the end of their fiscal year (March 31st, Figure 2).

This, along with the shift higher in US interest rates and continued decline in interest rate risk (Figure 3), come conveniently just ahead of the new Japanese fiscal year where their foreign bond buying steps up significantly.

Higher inflows …

That also means continued strong inflows to high grade bond funds and ETFs, as we have argued these are presently driven by foreign investors. This is because we are seeing record inflows in a time with poor bond price performance, which contrasts with the typical historical pattern where bond fund inflows are driven by retail investors chasing performance (Figure 4).

Furthermore the acceleration in inflows began at the time dollar funding costs declined early this year, and further accelerated after the Chinese New Year.

… but in the curve

While our bullish outlook for credit spreads welcomes the decline in the cost of dollar funding, as inflows accelerate, our 5s/10s spread curve flattener does not. This is because of the high degree of yield sensitivity of foreign demand, which means that the cost of dollar funding is a prime determinant of how far out the steep maturity curve they must reach. Hence the declining cost of dollar funding this year is allowing many foreign investors to reach their yield bogeys at shorter maturities in the US corporate bond market this year compared to the last part of last year. This is why the dealer-to affiliate volumes show a large increase in 3-7 year foreign buying this year, which is the key reason for the steepening bias in 5s/10s spread curves (Figure 5).

However, as foreign inflows accelerate we expect the cost of dollar funding to rebound and again send foreign investors out the curve, generating flatter 5s/10s curves." - source Bank of America Merrill Lynch

Obviously the big question coming up is relative to Japanese foreign bond buying. Is this time different? Are we going to see them return in drove to US Investment Grade?

On this very subject we read with interest Nomura's take from their Japan Navigator note number 713 entitled "Buying lower-rated credit instruments or adding currency-market exposure?":

"On supply and demand, we believe domestic investors are unlikely to aggressively add duration in determining their FY17 portfolios, either in yen or (currency-hedged) foreign bonds, in light of substantial losses that they incurred in these markets in FY16.

For these investors, increasing purchases in foreign credit markets may be an option. Assuming this, the recent narrowing of USD/JPY basis may look positive for their flows into these markets, but this is also a result of the narrowing difference between credit spreads in the US and Japan (Figure 2), which makes their aggressive (currency-hedged) buying of US corporates unlikely, particularly as the Fed hike will likely prompt a widening of the difference between short-term rates in the US and Japan (Figure 3).

This leaves Japanese investors options of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During the previous 2004-06 Fed rate hiking cycle, life insurers lowered the ratio of currency hedged investments (Figure 4).

Currency hedging costs and Japanese foreign bond investment

More investors appear to be converting USD to JPY USD basis has been tightening, not only to JPY but also to all key currencies, meaning the tightening of USD/JPY basis is not specific to JPY (Figure 5).

We also note that USD/JPY has tightened more in short-term tenors (Figure 6), which we attribute to a reversal of the sharp widening into end-2016.

USD funding tightened on MMF reforms in the US and concerns over Fed hikes. We believe the widening trend has been reversed as the market has recognized there is greater USD supply than expected. In addition, the recovery in EM currencies likely lowered the need for USD (Figure 7).

Coupled with the recent tightening of supply and demand in short and intermediate tenors of the JGB market (Figure 8), these factors suggest to us a wider range of investors are converting USD into JPY for yen bond purchases.

Basis swaps appear to provide global investors one of the few opportunities to earn low-risk returns now that central bank tightening has reduced the range of such options. This explains why USD/JPY basis has not widened to the extent we saw in late 2016, even as the Fed continued to lay the foundation for a March hike. Investors looking to buy currency-hedged foreign bonds may well take this opportunity.

Cheaper USD may not lead to an increase in Japanese investor flows into foreign bonds

That said, Japanese investor flows into foreign bonds are unlikely to pick up just because of cheaper USD funding, as the recent tightening of USD basis – particularly in long tenors – reflects the narrowing difference between credit spreads in the US and Japan (Figure 2). Specifically, the difference between the spreads of A-rated corporates in the US and Japan has narrowed to levels that no longer cover USD-hedging costs.

In addition, we believe the recent narrowing of USD/JPY basis likely reflects a decline in Japanese investors’ appetite for foreign bond investments, as the difference between short-term rates in the US and Japan is widening while the Fed is increasingly likely to hike more aggressively than was initially expected." - source Nomura

If indeed the Fed decides to have a more aggressive tightening stance, as we posited in our last conversation when it comes to our Swiss Wall analogy and path outcomes, then indeed Nomura could be right. But, as we stated in our last conversation, the dovish tone of the Fed might be linked to the recent weakness related to Commercial and Industrial lending (C&I). This is worth monitoring from a "credit impulse" perspective.

In relation to Nomura's take on the recovery in EM currencies lowering the need for USD, we will closely be watching oil prices and its relation with Asian currencies in particular. There is a significant correlation over time. Where oil goes, Asian currencies follow:

- source MacroCharts

Now, if US long bonds yields such as 30 years continue receding, then indeed our contrarian stance of once again dipping our toes in long duration exposure (ETF ZROZ - TLT) and adding to Investment Grade credit with higher duration as well could be tactically enticing. We are watching closely the 3% level on the 30 year.

One thing that appears clear to us is that in recent years, USD corporate credit in recent years has been supported by a large contingent of foreign investors. It remains to be seen how long the ECB and the Bank of Japan (BOJ) will remain accommodative when the Fed is about to take a way the punch bowl as per our final chart below.

• Final chart - Beware of "credit" repatriation

While we do think renewed signs of volatility could impact High Yield, we agree with most sell-side pundits that a move towards "quality" could be warranted and therefore US Investment Grade could provide some buffer. Our final chart comes from Wells Fargo Global Corporate Credit Outlook for Q2 2017 published on the 24th of March and entitled "Hope is not a strategy". This final chart displays Non-US Demand for US Credit and clearly highlights the risk of "repatriation", if there is a trend reversal for US credit demand from foreign investors:

"If the ECB and others start to follow the Fed's lead and move away from their extraordinarily easy monetary policies and front-end yields start to move toward a positive rate, then global flows could shift dramatically. We estimate that about 40% of the $8.5 trillion USD corporate credit market is held by non-U.S. investors with about 30% held in Europe and 10% held in Asia. For these investors, price sensitivity is determined by creditworthiness, interest rate movements and foreign exchange movements. If interest rates start to rise and the USD weakens, then non-U.S. investors would experience material mark-to-market losses and may start to repatriate their funds. Admittedly, this is more likely a risk for the second half of this year, but given the dramatic inflows into USD credit from overseas investors over the past several years, a reversal of the trend could be quite jarring to the market." - source Wells Fargo

For now the "Outflow boundary" seems to hold (low level wind), for the second part of the year, we do remain relatively cautious, yet, tactically we think adding duration is starting to become enticing on a risk of renewed turbulences and volatility in the short term.

"Political language... is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind." - George Orwell

Stay tuned!

Credit - The Fabian Strategy

"Who looks outside, dreams; who looks inside, awakes." - Carl Jung

"The Fabian strategy is a military strategy where pitched battles and frontal assaults are avoided in favor of wearing down an opponent through a war of attrition and indirection. While avoiding decisive battles, the side employing this strategy harasses its enemy through skirmishes to cause attrition, disrupt supply and affect morale. Employment of this strategy implies that the side adopting this strategy believes time is on its side, but it may also be adopted when no feasible alternative strategy can be devised." - source Wikipedia

While enjoying our break, catching up on some reading in the sun, but keeping abreast of the news surrounding the "fiscal cliff" and the evolution leading to the resolution of the "Mexican standoff" in the US Congress, as well as a lack of positive growth outlooks for Europe in general and France in particular for 2013, we could not resist using yet another military historical reference to the on-going situation. Hence, the choice of our title, which appeared to us, once more, appropriate, given the market context.

In similar fashion to the strategy named after the dictator of the Roman Republic Quintus Fabius Maximus Verrucosus employed against the mighty Hannibal during the Second Punic War (218-202 BC), Fabius strategy though a military success, was a political failure. We found it rather entertaining that in respect to the "Fiscal Cliff" saga, the great George Washington was sometimes called the "American Fabius" for his use of the Fabian Strategy during the first year of the American Revolutionary War, leading to John Adams declaring about the continuous use of the strategy at the time to declare:  "I am sick of Fabian systems in all quarters!" We too, are sick of the use of Fabian systems in the United States in general and in Europe in particular.

When it comes to Europe, will not change our stance in 2013, as we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October 2011 when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

- source JP Morgan Asset Management - Guide to the Markets - 1Q 2013 slide 48.

As far as Europe is concerned when it comes to using the Fabian Strategy, baby steps are being taken in Europe to evolve towards a full European Banking Union and more in trying to break the link between sovereigns and financial institutions, the recent one being the approval on the 13th of December of yet another acronym, the SSM (Single Supervisory Mechanism), which is assigning the supervision of European Banks by the ECB. The SSM will only be fully operational in March 2014. A SRM (Single Resolution Mechanism) dealing with ailing financial institutions is yet to be approved. 

In "A Tale of Two Central Banks" in December 2011, we correctly argued:
"You cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline."

In relation to Europe, we will even push our reference further to Fabius Maximus Verrucosus (Mario Draghi) strategy against the mighty Hannibal (Bond vigilantes). Hannibal had two particular weaknesses. First, he was commander of an invading army on Italian soil and as long as the Italians remained loyal to Rome (Brussels), then there was no hope that Hannibal (Bond vigilantes) could win. But should the Romans (European politicians) keep on losing battles, in similar fashion, the faith of the European populations in Brussels could weaken or wane. Fabius (Mario Draghi) calculated that the way to defeat Hannibal (Bond vigilantes) was to avoid engaging with him in pitched battles, so as to deprive him of victories. He determined that Hannibal's extended supply lines, and the cost of maintaining the Carthaginian army made of mercenaries (Hedge Funds) in the field, meant that Rome (Brussels) had time on its side (source Wikipedia).

This is exactly what Fabius aka Mario Draghi has been doing with his OMT promises! Avoiding in effect pitched battles and frontal assaults so far with the Bond vigilantes (Hannibal). So, rather than fight, in similar fashion to Fabius, Mario Draghi has been shadowing Hannibal's army instead (aka the Bond vigilantes), sending out loud and clear messages against the Bond vigilantes to nullify Hannibal's superiority. Mario Draghi's strategy is similar to Fabius, given he has been wearing down the Bond vigilantes' endurance and so far discourage a break-up of the European Union, without having to challenge the "Carthaginians" to a decisive "monetization" battle.
"Hannibal's second weakness was that much of his army was made up of mercenaries from Gaul and Spain, who had no great loyalty to Hannibal, although they disliked Rome. Being mercenaries, they were unequipped for siege-type battles; having neither the equipment nor the patience for such a campaign. The mercenaries desired quick, overwhelming battles and raids of villages for plunder, much like land-based pirates. As such, Hannibal's army was virtually no threat to Rome, a walled city which would have required a long siege to reduce, which is why Hannibal never attempted it. Hannibal's only option was to beat Roman armies in the field quickly before plunder ran out and the Gauls and Spaniards deserted for plunder elsewhere. Fabius's strategy of delaying battle and attacking supply chains thus hit right at the heart of Hannibal's weakness; time, not energy, would cripple Hannibal's advances. The Fabian strategy, though effective in some ways, was perceived as cowardly and unbecoming of the Fabian name, established by his ancestors' victories in pitched battles." - source Wikipedia

In similar fashion to the mercenaries of Hannibal, Hedge Funds have no great loyalty, the equipment or patience (of their investors) for such a long European campaign, given they also desire quick overwhelming battles and raids for plunder hence the significant bond rally in 2012, following Mario Draghi's use of the Fabian Strategy but we ramble again...

The Fabian Strategy at play - European bond picture, the fall was dramatic for peripheral bonds in the second half of 2012 thanks to Mario Draghi's intervention with Spanish 10 year yields falling towards 5.00%, whereas Italian 10 year yields are now well below 5% around 4.25% and German government yields rising towards 1.60% levels with other core European bonds yields rising as well in the process - source Bloomberg:

So, what is our prognosis (literally fore-knowing, foreseeing the likely outcome of an illness) in relation to the European outlook for 2013 in general and credit in particular you might rightly ask? In our first conversation of the year we will share our views.

EUR/USD and Gold views for 1st quarter of 2013:

Last year, on the 25th of January 2012 we made the following forecast in relation to the European recession and the EUR/USD following the FOMC decision to maintain US rates in our conversation - The law of unintended consequences:
"Unintended Consequences according to Martin Sibileau:
"With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unaddressed. All these factors only contribute to prolong the recession and a high unemployment rate."Given today's decision of the FOMC to maintain US rates low until late 2014, it seems to us that the European recession can only be prolonged as indicated by Rcube Global Macro research in our previous conversation, increasing the likelihood of a Euro Breakup.
Again, like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content.
Does the FOMC's latest decision put a floor to the drop of the euro versus the dollar? Are the FED's swap lines and latest FOMC decision delaying a painful adjustment in Europe? We wonder."

The on-going "Risk-On" scenario is maintaining the Euro at an elevated level versus the dollar. While touching again on our recent subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, such as now, the correlation is falling to lower levels. The correlation between both the German Bund and US 10 year note is currently falling albeit at very smaller pace than in early 2012 - source Bloomberg:

Until there is another "Risk-Off" phase, the EUR/USD should remain in the region of 1.30 versus the US dollar.
Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).

The current "Risk-On" phase will continue to put as well some downward pressure in the short term on Gold prices and commodities. Dollar index versus Gold - source Bloomberg:

This short term bearish pattern on Gold has been reflected in the Gold Options market - source Bloomberg:

"The CHART OF THE DAY tracks options for the SPDR Gold Trust, the biggest exchange-traded fund backed by bullion. The ratio of puts, which grant the holder the right to sell the security at a specified price by a certain date, to calls, which confer the right to buy, advanced to 0.57 last week, the highest since Jan. 4. Open interest in puts has jumped 30 percent since October. Gold has dropped 8.5 percent since reaching this year’s high of $1,798.10 an ounce on Oct. 5 as signs of improvement for the U.S. economy reduced demand for haven assets. Prices are still on pace for a 12th straight annual gain, a streak that Goldman Sachs Group Inc. forecasts will end next year as the growth continues to accelerate." - source Bloomberg

Gold could recede towards 1550-1600 levels during this quarter before bouncing back when "Risk-Off" will materialise again.

Economic outlook in Europe in 2013 is depending on "genuine" credit growth:
As we posited in numerous conversations, "genuine credit growth" to the real economy (not LTROs which amount to "Money for Nothing") is key in order to generate sufficient economic growth to counter solvency risks. Given corporate loans supply is still falling in Europe, we do not think the deflationary forces in Europe in 2013 will be countered, far from it - source Bloomberg:

"Corporate loans outstanding to the euro zone, down 240 billion euros from January 2009's all-time high, fell for the twelfth time in fourteen months, as financing to the troubled region's businesses remains scarce. With the application of Basel III capital and liquidity rules potentially deferred, policymakers will be keen to encourage increased lending in this key segment." - source Bloomberg

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits:
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011

Spanish Real GDP growth and Loan Growth since 2006 - source Bloomberg:

As displayed by the latest Spanish misery index making new highs, the deflationary spiral is still playing out - source Bloomberg:

We expect Spanish unemployment to come close to 28% in 2013 with continued rising NPLs in the process.

Back in October we argued that Spain surpassed 90's perfect storm:
"Generally rogues waves require longer time to form, as their growth rate has a power law rather than an exponential one. They also need special conditions to be created such as powerful hurricanes or in the case of Spain, tremendous deflationary forces at play when it comes to the very significant surge in nonperforming loans."

In percentage term, it is true that the latest figure of 11.23% is significantly above the 1994 record of 8.99% but, in absolute term, Spain is not facing a perfect storm but the mother of perfect storms when it comes to the absolute size of the non-performing loans in billions of euros - source Thomson Reuters Datastream / Fathom Consulting:

We therefore share Nomura's view on the growth outlook for the Eurozone in 2013:
"The key challenge for the eurozone in 2013 is the prospect of continued weak growth. On balance, the fiscal stance for the region will continue to be a drag on growth, and monetary policy is unable to provide an offset because of ongoing deleveraging dynamics in key banking systems, and tightening credit conditions in peripheral countries. The currency channel has for now not worked either. Meanwhile, consumption and investment remain weak as the deleveraging process continues its course. In that context, the only meaningful source of growth in the region will be externally driven, in our view. Our baseline scenario for the euro area is one of contraction on average for the region (of -0.8% in 2013) with deep recessions in peripheral countries and shallow recessions in the core." - source Nomura, 14th of December, Euro Area - The 2013 Challenge.

Since 2008, European policy makers approved more than 5 trillion euros of state aid to banks with Ireland and Denmark leading recipients according to Bloomberg:

"The CHART OF THE DAY shows how much the European Commission allowed each country to use to prop up lenders from 2008 to the end of September 2012. The amount is expressed as a percentage of 2011 economic output. The payments comprise recapitalizations, funding guarantees and treatment of toxic assets. More than 1.6 trillion euros was actually used by the end of last year. Ireland needed to pump more than 60 billion euros into its banks after a housing bubble burst following the 2008 collapse of Lehman Brothers Holdings Inc. Denmark used 145 billion euros in guarantees and put 10.8 billion euros into lenders as capital. “Guaranteeing a financial system after a crisis is one thing; if banks have to actually take losses it’s another entirely,” said Christian Schulz, an economist at Berenberg Bank in London. “If bank losses migrate onto the public balance sheet, then they’ll have an impact.” The Commission approved aid of 571 billion euros, or 365 percent of 2011 output, to banks in Ireland, and agreed to 613 billion euros of state aid to Denmark, the equivalent of 256 percent of GDP. While Denmark actually used 158 billion euros of the sum approved, Ireland used 350 billion euros, according to the Commission." - source Bloomberg

We expect to see a much larger bailout figure for Spain in percentage terms of GDP in 2013.

The big beneficiaries of the "Fabian Strategy" in 2012 have been European Banks - source Bloomberg:

"Following Mario Draghi's late-July promise of ECB action to protect the euro, the Bloomberg Industries Emerging European Banks Index rallied 29% to year-end 2012. With the fiscal cliff averted for the time being, the keys to share price performance in 2013 include attaining a "grand bargain" on the U.S. budget and a lasting solution to Europe's debt crisis, including the proposed banking union." - source Bloomberg

Given the unconditional support provided by the ECB, you can expect Core European Banks to continue to rally during the 1st quarter in 2013. Senior Financial bonds from peripheral banks should as well continue to perform. The recent 5 year  Spanish bank BBVA  new 1.5 billion euro senior financial issue has been easily absorbed by investors (5 billion euros worth of orders in the book from more than 400 investors), and performed significantly at the launch last Thursday. Initial guidance was mid-swaps +310 bps and launched at +295 bps. Last September BBVA issued a similar bond offering at +380 bps.

In fact CDS wise the Itraxx Financial Senior 5 year index is at the tightest level versus the Itraxx Main Europe index representing Investment Grade credit risk since April 2011 at around 20 bps apart. - source Bloomberg:

Europe in 2013 will still be a story of broken monetary policy transmission channel to the real economy.
So we still expect the US to outperform significantly Europe when it comes to economic growth!

The divergence which we explained in our conversation "Growth divergence between the USA and Europe" should persist in 2013. US PMI versus Europe PMI - source Bloomberg

Short term, we do expect a minor reduction in the divergence as reflected in credit prices such as the US leveraged loan cash price index versus its European peer. You can clearly notice the uncanning similarity with the above graph from Bloomberg indicating the evolution of the PMI index:

The story for 2013 in Europe we think, will be France:
In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

Back in November in our credit conversation "Froth on the Daydream" we argued:

"Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far")."

France's industrial production and GDP growth since 2001 - graph, source Bloomberg:

December figure came at -3.6% and next week data print for France industrial production is expected at -3.9% confirming our recession call for 2013, yet the French government is sticking to its 0.8% growth target which the budget is based on to reach the 3% deficit target. Not only will France fail to reach the 3% target but the budget shortfall will be significant.

As far as France's sovereign CDS is concerned, it now trades 9 bps above Belgium's sovereign CDS, Belgium being in a better fiscal position (not because of the recent arrival of Gérard Depardieu, there is more to it!) - source Bloomberg:

Is the OMT a game changer courtesy of our "Generous Gambler" and Fabius aka Mario Draghi? We do not think so:
On that subject we agree with Nomura's take from their 10th of December paper - Italian political uncertainty highlights the insufficiencies of the EU firewall:
"The insufficiency of the eurozone’s “firewall” Many investors validate long positions in peripheral debt markets based on the presumption of a "Draghi put", or that the ECB will indeed do all that is necessary to remove the risk premium from markets and preserve the EUR. However, the ECB has actually backtracked on many of the commitments made in July and August to the point where the forthcoming OMT programme appears to even less effective than the unlamented SMP it has replaced:
-Seniority. The ECB originally said it would ensure that the OMT would be pari passu to private investors, but Draghi stated in October that rules against direct monetary financing of sovereigns preclude the ECB taking a hair-cut on its bond holdings or even an NPV loss. As such, the subordination problem of the SMP seems likely to recur in the OMT.
-Predictability. One problem with the SMP was that investors were unable to embed their bond purchases in their asset allocation strategies. It would buy into weakness, but not necessarily follow through into strength, and would be out of the market for long periods. The OMT looks even less predictable than the SMP as the ECB has said it will buy for 1-2 months before pausing to see if a country passes its conditionality test. This would impose on countries such as Spain and Italy the quarterly event risk that originally helped undermine liquidity in GGBs. In this respect, while some investors may have purchased 4-5 yr SPGBs or BTPs in expectation of sliding down to the ECB‘s 1-3 year intervention zone, the current parameter actually stresses that the timeframe for investors looking to "co-invest" with the ECB might need to be 1-2 months rather than 1-2 years. 
-Market access. An additional problem of the OMT is that it can buy only as long as a country has full market access. This precludes the OMT supporting countries such as Portugal, and increases the risk of the ECB actually being able to buy SPGBs or BTPs: technically, the OMT will not be able to operate if Spain or Italy lose market access during the 3-4 week gap that will exist between a country asking for ESM support and requisite approvals allowing the ECB to buy bonds. 
Because of these factors, the OMT appears less flexible and effective than the SMP was, especially when one considers that the OMT will only be focused on the 1-3 year part of curves. Moreover, the aspect of the firewall designed to support sovereigns beyond 3yrs – the ESM – appears even weaker than the OMT. We have already noted how we are concerned that the OMT might not be able to fund itself at a pace and price sufficient to finance the degree of primary market bond buying that may be needed in Spain and eventually Italy. Moreover, the ESM‘s "Plan B" of transforming itself in part into an entity that issues first-loss certificates is fundamentally flawed as the ESM cannot legally take a first loss." - source Nomura.

In our late 2012 conversation "Synchronicity" we approached the subordination issue coming from the introduction of Collective Action Clauses in the European government bond market in 2013:

"Although the introduction of CACs reduces restructuring costs and facilitate the process, it should nevertheless increase risk premiums attached to the new issues. Welcome to subordination in the European government bond market!

But as we stated, "caveat creditor" given that even non-CACs bondholders can face the music with the introduction of retroactive CACs."

In addition to the above points made by Nomura, we also agree with the views of Protesilaos Stavrou, from his blog posted in September 2012:

"-Assuming that the governments of Spain and Italy sign a deal with the EFSF/ESM and that the ECB will then stick to its promise of buying "unlimited" amounts of bonds on the secondary markets; it seems that the sterilization process will effectively set in motion a gradual but steady diminution of available credit for other borrowers. Put simply, if the ECB bails out Spain and Italy it will effectively have to sterilize its operations by cutting off credit from more credible borrowers, meaning that Spain and Italy will crowd out the rest. Those who will suffer the most out of this, are of course small and medium sized enterprises that will be bereft of any affordable credit for years to come. 

Spain's broken transmission mechanism - source Nomura - No solidarity without conditionality:

-"With the collateral requirements being reduced into insignificance, it is clear that bankers will have an incentive to use whatever funds they have at their disposal to cling on to sovereign bonds of any kind, so that they may put them up as collateral for near-zero ECB liquidity in a circular process of speculation where cheap ECB-funding is channeled into the bonds markets and repeats the cycle leaving the banker with the profits from the margin between the primary interest rate and the yield of the bonds. If that is so, the distortion of the capital structure is exacerbated as credit will continue to flow into state coffers and the vaults of financiers to sustain the toxic debts and malpractices of the past. Once again the chilling effects will be felt by the lower and middle parts of the income distribution, while a selective elite will enjoy their speculative bonanza." - Outright Monetary Transactions: Reasons not to be cheerful - Protesilaos Stavrou, September 2012

Credit views for 2013:
We share similar views with Citi when it comes to the perspective for credit in 2013 after a stellar performance in 2012:
"In forming our views for 2013, first we'll make the case that corporate credit quality is deteriorating by more than what seems to be consensus. Leverage, measured as net debt / EBITDA, has risen notably from the low of two years ago. Moreover, we'll argue that the systemic risk has now been priced out of the market even though it could very well return under similar or different guises later in the year. 

However, it is getting harder and harder to find anyone prepared to put such fundamental arguments above all-powerful "technicals". Like Pavlov's dogs, it feels like the credit market has been conditioned by central banks to assume that any selloff is self-defeating as it will be met with yet more liquidity, with yet more inflows pushing asset prices up again. 

Examining the link between central bank interventions and asset prices, what strikes us is that although the central banks clearly have huge leverage over markets, their influence is not constant. The last three years demonstrate that. When asset prices are elevated their incentive to stimulate further wanes – and indeed central banks may want a certain amount of market pressure from time to time to keep politicians committed to painful reforms. 

The interaction between these two opposing fundamental and technical influences will probably determine much of your fund performance in 2013. Ask us about our "forecasts" and we don't end up very far from our peers: We expect € cash spreads to tighten 10-15% generically and total returns of 2.5% in IG and 5% in HY. 

However, we are not on board with the emerging consensus that systemic risk has been all but eliminated for now, and that volatility will be much lower from now on. That view feels complacent to us. Central bank technicals probably have the upper hand longer-term, but we think it is very unlikely that the year will pass without one or more of the risk-off periods as seen in recent years. But when? 

Chances are the selloff will occur exactly when the last skeptic has capitulated and lots of crowded longs have accumulated. And the trigger will be an event that is either impossible to predict or insignificant relative to the size of the market movement it causes. We didn't say it would be easy!". -source Citi - Credit Outlook 2013.

We don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks:
"So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

Citi's final thoughts from their 2013 Credit Outlook:
"In our opinion, the biggest decision investors face this year is whether the OMT really is an effective backstop against perceptions of systemic risk, allowing credit markets to trade on an idiosyncratic basis. If it is, then the next decision is whether the liquidity rush will be strong enough throughout the year for spreads to go on ignoring the deterioration in most credit metrics. 

The consensus that appears to be emerging is that the answer to both is 'yes'. On that basis, it is no wonder that markets have been performing so well. 

However, we'd answer those questions a little differently. To us, systemic risk is dormant, but not eliminated. It could crop up from any number of angles. We expect that the ECB backstop and others like it will be tested during the year in what remains an exceptionally challenging economic environment for Europe. Moreover, we struggle to see markets disregarding the weakening credit metrics and rating downgrades indefinitely. 

We do concur with the consensus position that these challenges will ultimately be circumvented, but just not without a certain amount of kicking and screaming in markets. 

Quite likely it will be from spread levels that are significantly tighter than currently – and indeed tighter than our full-year forecasts imply. But it is exactly in a significant overshoot that credit becomes vulnerable: central banks are likely to do less, money is likely to flow elsewhere, issuers will take advantage of tight spreads and investors will have extended themselves. 

The market we operate in today is just inherently more prone to volatility than previously. Consider that in 2007, a 5% reduction in exposure by US mutual funds in credit sold to the dealers would have increased their positions by just 10%. Today, a 5% outflow from mutual funds would double dealers’ exposure! 

As such, when it comes to 2013, much more than is reflected in the modal forecasts, the devil really is in how spreads are distributed through the year."

“It may feel antisocial to switch to the orange juice when the party’s still in full swing, but the last few drinks are always the ones you end up regretting later.” – Matt King - CITI

and particularly when your drink has been spiked by Central Banks' Rohypnol (Rohypnol rose to prominence as the date rape drug because it was colourless, odourless, tasteless and easily dissolved)...

We would like to use again a reference to Bastiat in relation to liquidity and Credit Markets (from our conversation "The Unbearable Lightness of Credit"): "That Which is Seen, and That Which is Not Seen"

The "Fabius Strategy" followed by Mario Draghi and the liquidity injected have effectively done "Rohypnol" wonders to Swap pressures - source Bloomberg:

"Movements in the currency derivative market over the past 12 months confirm European Central Bank President Mario Draghi’s success in vanquishing the funding pressures in the region’s banking sector. Demand by European banks for short-term dollar-based financing via swaps has dimmed after the ECB provided emergency long-term funding and cut interest rates. The CHART OF THE DAY shows the cost to covert euro-based funding into dollar loans through the currency market has collapsed after reaching almost three-year highs in November 2011, cross-currency basis swap rates indicate. The agreements to borrow in one currency and lend in another, usually last one to 30 years." - source Bloomberg.

As we argued in "The Omnipotence Paradox", the Zero Rate policies induced by our "omnipotent" Central Banks are destroying capitalism in the sense that capital because of lack of return cannot be deployed efficiently and is once again "mis-allocated. It is as well, to some extent, neutering volatility: VIX shows Economic-Policy Risk are overlooked - source Bloomberg:

"Investors are showing too little concern about the possibility that U.S. stocks will fall victim to an economic-policy debacle, according to Myles Zyblock, chief institutional strategist at RBC Capital Markets. The CHART OF THE DAY compares the Chicago Board Options Exchange Volatility Index, also known as the VIX, with a policy- uncertainty index developed by professors at Stanford University and the University of Chicago. The VIX appears to be “a coiled spring,” Zyblock wrote two days ago in a note to clients. The performance gap between the index and the policy gauge shows investors are too focused on rising home and auto sales, falling unemployment and other favorable signs, the Toronto-based strategist wrote." - source Bloomberg.

In 2013 it is still deflation in Europe:
"When it is hard to get money because banks will not lend, or for any other reason, there is less power to bid for goods. Prices then fall, because people lack money with which to pay." - Irving Fisher - The Money Illusion, 1928.

Stay tuned!