Macro and Credit - Tantalizing takeoffs

"When everything seems to be going against you, remember that the airplane takes off against the wind, not with it." -  Henry Ford

Watching at the dizzying summits reached by US stock market indices with the Dow flirting with 20,000 on the back of the Trump rally, as we move towards the final days of 2016, with a continuation of US Treasuries getting pummeled, when it comes to selecting our title analogy, we decided to go for a vintage flying analogy this time around, "Tantalizing takeoffs" being the nickname for the 50th Beechcraft AT-11 Kansan AT-11 built in 1941 and being currently the oldest flying. The AT-11 was setup as a smaller version of the B-17 Flying Fortress or B-24 Liberator. This provided a simulated training environment similar to the full sized bombers. While in the past we have used as well a reference to aircrafts, particularly in our long 2013 post "The Coffin Corner", which is the altitude at or near which a fast fixed-wing aircraft's stall speed is equal to the critical Mach number, at a given gross weight and G-force loading. At this altitude the airplane becomes nearly impossible to keep in stable flight:

"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013.

On a side note the latest decisions from the ECB amounts to us as clear confirmation of that indeed Mario Draghi is clearly affected by "the spun-glass theory of the mind" given that he stated that “uncertainty prevails everywhere,”

The current melt-up dynamics reminds us what we indicated back in January 2012 in our conversation "Bayesian thoughts" when 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." 

Are we entering the final melt-up for asset prices, or is really the much vaunted "reflationary story" playing out in earnest? Or is it simply a case of "Information cascades playing out again as they are often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...)? We wonder.

In this week's conversation we would like to look again at some Emerging Markets vulnerabilities given the recent hike by the FED and the continued pressure stemming from "Mack the Knife" aka King Dollar + positive real US interest rates. 

Synopsis:

• Macro and Credit -  Emerging Markets, from convexity to concavity?
• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

• Macro and Credit -  Emerging Markets, from convexity to concavity?

Back in 2013 we expressed our concern regarding the impact a dollar squeeze of epic proportion would have on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

Also back in December last year we indicated a macro convex trade to think about for 2016 relating to a potential devaluation of the HKD which won the "best prediction" from Saxo Bank community in their Outrageous Predictions for 2016. We made our call for a break in the HKD currency peg as per our September conversation and made additional points made last year in our conversation "Cinderella's golden carriage". In February in our conversation "The disappearance of MS München", we also looked out the Yuan hedge fund attack through the lenses of the Nash Equilibrium Concept :

"When it comes to the risk of a currency crisis breaking and the Yuan devaluation happening, as posited by the Nash Equilibrium Concept, it all depends on the willingness of the speculators rather than the fundamentals as the Yuan attacks could indeed become a self-fulfilling prophecy in the making." - source Macronomics, February 2016

While obviously our prediction was too outrageous for 2016, we do think that the HKD peg will once again come under pressure in 2017. On that very subject we read with interest Bank of America Merrill Lynch Asia FI and FX Strategy Viewpoint note from the 15th of December entitled "HKD to be challenged in 2017":

"HKD under pressure again

The HKD is under depreciation pressure again. We believe investors’ recent positions were based more on speculative than on fundamental reasons. These positions may be supported by the increase in the US Federal Reserve’s rate hike expectations for 2017. There is a risk of a pullback in USD/HKD forward points and HKD rates if RMB depreciation expectations stabilise over the coming weeks and investors take profit.

Brace the outflows

We believe 2017 will be a year of outflows from Hong Kong. The current account surplus is expected to decrease while capital outflows accelerate. That would cause Hong Kong to draw down its foreign exchange reserves.

Weaker FX, higher rates

Outflows, a slowdown of CNH-HKD conversion, and a declining aggregate balance will shape the HKD market next year. We forecast USD/HKD to rise to 7.80 and 3M HIBOR to rise to 1.50% by end-2017. We are biased to pay USD/HKD forward points and biased to pay front-end HKD rates." - source Bank of America Merrill Lynch

As we pointed out back in November in our conversation "When Prophecy Fails", when it comes to currency attacks it is more about the resolve of the speculators than the fundamentals:

"It seems to us that speculators, so far has not been able to "hunt" together or at least one of them, did not believe enough in the success of the attack to break the HKD peg. It all depends on the willingness of the speculators rather than the fundamentals for a currency attack to succeed we think." - source Macronomics, November 2016

As pointed out by Bank of America Merrill Lynch in their note, we are seeing a repeat of last year brief attack on the HKD:

"The HKD is under depreciation pressure again. Investors have recently long USD, short HKD forward outright, which has pushed up USD/HKD forward points to its highest level since early 2016. HKD rates have consequently increased and the 3M Hong Kong Interbank Offered Rate (HIBOR) fixing jumped over 10bps (Chart 1).

Both speculative and fundamental reasons related to Mainland China supported the recent market movement (Exhibit 1):

Speculative

The correlation between the HKD and CNH broke down in 3Q: while the RMB continued to depreciate, the HKD was stable (Chart 2). 

But the strong economic links and the growing impact of China on Hong Kong’s interest rates suggest insufficient risk premium was priced into the HKD. So even if Hong Kong’s currency board is credible, which is our base case not least because it has withstood multiple tests in the past, interest in the market to hedge against tail risks persists.

The HKD is also sometimes used as a proxy for the CNH. Proxies for the CNH are attractive when the associated carry costs on shorting the CNH are high (Chart 3).

But provided Hong Kong’s currency board does not change, we believe the potential gains from shorting the HKD as a proxy for the CNH are ultimately limited. In our view, trades based on this rationale are vulnerable to being unwound in the short term.

Fundamental

Hong Kong has started to experience outflows so far this year: in 1H 2016, Hong Kong recorded outflows equivalent to -0.9% of GDP. As such, there are already signs that the HKD will be under fundamental depreciation pressure. We believe the outflow theme in Hong Kong will be much more pronounced in 2017 than in 2016, especially since the US Federal Reserve raised its policy rate for the second time after the global financial crisis in December.

We believe recent positions were based more on speculative than on fundamental reasons, based on the timing of the move.

Speculative depreciation pressure on the HKD picked up after concerns over the RMB increased due to:

• China’s low FX reserve numbers in November
• Reports of curbs on capital outflows from China
• Growing uncertainty over the US-China trade relationship

These speculative pressures may persist in the near-term after the US Federal Reserve raised its Federal Funds rate projections from two hikes to three hikes in 2017. A broad USD rally could raise concerns over capital outflows from China and, ultimately, raise RMB depreciation expectations: we showed that broad USD strength and an increase in policy uncertainty raise capital outflows from China by Chinese investors.

But we also point out that Hong Kong’s 2Q balance of payments (BoP) data have been available since September 2016 and so we think the outflow theme was not the main driver behind the recent move.

As such, there is a risk of long USD, short HKD forward outright positions based on speculative reasons being unwound if the RMB depreciation expectations stabilise over the coming weeks and investors take profit." - source Bank of America Merrill Lynch

While clearly the current pressure on the HKD is based on rising speculations, obviously, the amount of currency reserves is a crucial parameter. The accumulation of reserves by the Hong Kong Monetary Authority (HKMA), make the current speculative move difficult to sustain.

One thing for certain, when it comes to Hong Kong and its vulnerability with their currency board matching the path of the Fed with rate hikes is clearly its real estate market. On that matter we read with interest Deutsche Bank's Hong Kong Property note from the 16th of December entitled "Risk of falling off the edge":

"Every 25bps rate hike would push up mortgage payments by about 2.4%

By looking at the sensitivity of residential affordability in Hong Kong to mortgage rate hikes, every 25bps increase in mortgage rates would translate into an approximate 2.4% increase in monthly mortgage payments or to push down residential affordability (i.e. increasing the debt-servicing ratio) by about two percentage points. Conversely, residential property prices would need to fall by about 2.4% in order to maintain the debt-servicing ratio at the current 68%. By assuming Hong Kong will follow the 75bps rate hike expectation in the US in 2017, residential prices would need to fall by 7.2%. Alongside our expectation of a 3% decline in median household income, we anticipate an 11% decline in Hong Kong residential prices in 2017. If mortgage rates are to normalize to the level of 2005/06 at about 5.75%, residential prices would need to fall by 28% from current levels.

Liquidity conditions look ample for now, although downside risks are rising

Liquidity conditions remain ample in Hong Kong so far, with a stable monetary base, currency lying in strong side convertibility and composite interest rates remaining low. However, the recent surge in interbank rates in HK has led to some concerns about the need to lift the Prime rate in HK. We believe that the near-term spike in interbank rates could be a reflection of expectations of higher rates, potential liquidity outflow and HIBOR finally catching up with USD LIBOR.

Although the large banks have signaled that the Prime rate will remain unchanged, we believe there is a risk that HK banks may need to move the Prime lending rate upward if: 1) HIBOR continues the upward shift that led to increasing the proportion of mortgage loans moving to capped rate Prime loans, 2) a strong liquidity outflow leads to higher deposit funding costs for large banks, and 3) there is much weaker/reversal of system deposit growth, with more signs of a tightening of loan-to-deposit ratios.

- source Deutsche Bank

So overall while our outrageous predictions seems difficult to materialize, the pressure on HKMA to intervene again in 2017 will rise again and if indeed there is vulnerability somewhere, then it might be smarter to "short" some Hong Kong real estate players rather than betting for now the demise of the currency peg.

When it comes to Asia and vulnerabilities, clearly China comes to mind particularly given its rapid credit expansion and the potential for a trade war to flare up with the new US administration. In relation to China being concerning, we read with interest Deutsche Bank take in their Asia Local Markets Weekly note from the 16th of December entitled "Jamais vu":

"Fed & AsiaFor all of the Draghi like nuances, Yellen (& the Fed) sounded and acted hawkish this week. And for once, it looks like the market has no choice but to chase the dots, which are moving away (and up).

For Asia, that should mean,

• Policy divergence will get more acutely in focus in 2017. The market is pricing in slightly over 60bp of tightening by the Fed next year - and still below the dots - but at best one rate hike anywhere in Asia. Indeed, DB Economics, and most of consensus forecasts, do not think even this modest amount of tightening will be realized. FX is then the natural outlet for this divergence in policy outlooks. And like we have been arguing, not just in the high yielders which run the risk of capital reversal - or more likely, no fresh inflows - but also in the low yielders, and ones which also map to the trade/geopolitical policy narrative of the incoming US administration (think Korea, think Taiwan)
• China in particular has some tough policy choices to make here. The Fed tailwind to the dollar will only make these choices harder for the Chinese. Either allow a significant re-pricing of the RMB complex (and take the risk of an unstable cobweb pattern), or burn down reserves (and take the 'credit' hit on the sovereign), or shut the capital gates down even tighter. Likely that they will opt for a mix of the lot. Importantly, though, none of these options look supportive of the liquidity or rates complex - offshore and (increasingly) onshore. Overnight CNH rates are trading at 12%; trading in key bond futures has been halted for the first time; and local press (Caixin) is reporting of big banks suspending lending to non-financial institutions. The move up in inflation only makes the rates re-set story in China that much more compelling to own.
• The local stories will likely define the axis of differentiation in 2017. The dollar move will probably take most of the Asia currency and rates complex with it, to begin with. But the local stories will likely define where on the dollar smile each market ends up next year - be it the policy choices the central banks make (rates, FX, regulatory), or the headwind from political noise (Korea, Malaysia, India)." - source Deutsche Bank

Obviously until "Mack the Knife" aka King Dollar + positive real US interest rates ongoing rampage stops, there is more pain to come for some Emerging Markets players in 2017. Yet, we think that the movement has been too rapid on both the US dollar and interest rates and have yet to be meaningfully confirmed by US fundamentals. While the EM fund flows hemorrhage has stabilized, at least for equities, it remains to be seen how long the resiliency will remain with a continuation of rising yields and we agree with Deutsche Bank's comments from their note:

"US equity bullishness has likely helped arrest outflows from Asia

The buoyancy in US equities – despite the large repricing in US yields – and the softness in vol indicators like VIX has helped contribute to a general resilience in risk. After close to $10bn of outflows from Asian equities in November, the outflows have stopped, although money has not really returned. Again we remain skeptical on the durability of this calm. The correlation of Asian equities to US stocks has been falling since the election and indeed with the US less likely to share the spoils of growth with the world, a decorrelation in returns should widen. Moreover, January has been seasonally weak for US equities for the last three years, which suggests a correction could lie ahead. Chinese equities have also been under strain given the rates market developments, with Asia straddling the divergence.

The market has not been as focused on the potential negative Trump dynamics for Asia from trade, geopolitics, and widening policy divergence 

The market has primarily focused in this first-round on the fiscal implications of a Trump administration, and the re-pricing of growth and inflation expectations. The other side of the coin – of potential protectionist and geopolitical disruption – has been harder to price given large outstanding uncertainties about Trump’s approach off the campaign trail. Once Trump actually assumes office in January, this uncertainty should fade, with a need to take a formal stance on issues like labeling China a currency manipulator, imposition of tariffs and the bargaining chips in play from the One China Policy to North Korea. There has also been outsized focus on the divergence theme between US versus Europe and Japan, but this is equally pertinent for Asia where markets have been in a multi-year easing mindset driven by disinflation, poorer demographics, sensitive credit cycles, and little external lift. If, as DB Economics believes, there is little appetite and ability in Asia to follow the Fed, rate differentials are going to impose pressure on Asian FX. On the other hand, if markets begin to price rate hikes, then unwind of duration stories and debt outflows from the region could be equally painful.

The market has been fighting the “major” battles

With dramatic moves in major G10 currency pairs like USD/JPY, EUR/USD, and in US rates, it is quite likely that macro positioning has been concentrated on trading these bigger themes and breaks. Indeed, even as JPY shorts were being added last week (on the IMM), investors were believed to be squaring back on KRW shorts. However as price action in the majors gets more stretched, the market should begin to look for catch-up trades and mis-pricings elsewhere.

End of year and idiosyncratic effects may have helped slowed moves

While market illiquidity into year-end could have exaggerated negative price action, there are other yearend forces which could have helped. There has been little fresh supply of debt in local markets which should have helped with bond technicals. Similarly, on the debt side, major asset allocation decisions are likely to be taken only in the New Year. Issuance calendars will start up afresh in January, when demand-supply mismatches would be more acutely felt. Central banks  may have also been more active in supplying dollars to manage FX weakness, given greater sensitivity to year-end closing levels. In individual markets like  Indonesia, inflows related to tax amnesty repatriation are likely helping contain the moves. In Malaysia, the wind down of the NDF market, and the immediate provision of greater exporter supply may have helped, but we estimate that significant hedges from real money, equity, and banks could be transitioning onshore in the coming months as offshore hedges roll off. Current account surpluses in much of North Asia are seasonally stronger around year-end, but dip significantly in Q1, with Chinese New Year inactivity, and with holiday export orders behind them

In sum, we are unconvinced that regional FX resilience can last, and would be positioning for a catch-up move higher in USD/Asia into the New Year. We continue to concentrate our USD longs against North Asian pairs that would be most exposed to any worsening in Chinese stress, fallout from a US equity market correction, a negative shift in the regional trade/geopolitical order, and where currencies have relatively poorer seasonality at the start of the year." - source Deutsche Bank

As we posited in our recent musing, the biggest "known unknown" remains the political stance of the US administration relating to trade with China. From our perspective, 2017, will continue, as per 2016 to offer renewed volatility on the back of political uncertainties given the new year will have plenty of political events, ensuring therefore an increase in volatility and large standard deviation moves like we have been used so far this year. Overall "Mack the Knife" will continue to weight on global financial conditions, particularly in EM where there has been a significant amount of US dollar denominated debt issued in recent years. As pointed out as well by Deutsche Bank, the pressure of the US dollar and rising rates will put further pressure on Chinese financial conditions:

"Risk of further capital measures remains high.

In response to the ongoing RMB weakness, driven in part by the divergence in US-China monetary policy, China has again introduced a series of capital measures particularly on RMB cross-border flows (see Trying Times for RMB, 7 December 2016). However, with outflows not abating and as RMB depreciation pressure continues to build, the risk of more such controls remains high, which are likely to drive further tightening in offshore RMB liquidity.

Reversal of RMB internationalisation should tighten

RMB liquidity further. The latest regulations introduced are likely to have accelerated the decline in RMB deposits in the offshore market again, shrinking the overall RMB liquidity pool in the offshore market.

Possible maturing of USD/CNH forwards. 

China earlier this year accumulated a large chuck of short USD forward positions, which are likely to mature in the coming months. If a part of these are allowed to mature, like in August/September, it could well be sufficient to create CNH tightness." - source Deutsche Bank

Whereas for now, convexity rules, be aware that concavity could once again come back to the forefront in early 2017 with markets at the moment continuing the probe again the willingness of the HKMA to defend the peg with additional weakness coming from the RMB and a potential slowing growth outlook for China.

If indeed there is a potential in 2017 for an early "risk-reversal" à la 2016, then again, it looks to us that, from a contrarian perspective the level reach by long US treasuries is starting to become enticing.

• Final chart - In recent years rising yields have been followed by declining breakevens and real rates.

Whereas gold and gold miners in conjunction with bonds have been on the receiving end of "tantalizing takeoffs" for equities on the back of the US election, our final chart comes from Bank of America Merrill Lynch Securitized Products Strategy Weekly report from the 16th of December shows that in recent years, rising yields have been followed by declining breakevens, which have been therefore followed by declining real rates:

• The 60 basis point rise in the breakeven rate since late June 2016 is the largest rise of the past 4 years. The unusually large move would seem to have some room to give back some of the recent gains.
• The past month’s rise in the real rate is the second largest of the past 4 years. Over the 4-year period, sharply rising real rates have been followed by declines in the breakeven rate, which in turn have been followed by declines in the real rate.

"Given the persistence of the patterns in recent years, we think that over the next 4-8 weeks, the odds favor a decline first in the breakeven rate and then in the real rate. Overall, nominal yields are therefore likely to move lower. Given that the nominal rate has risen by 80 basis points over the past month, we would not be surprised to see a 50% retracement over the next 4-8 weeks, which would bring the 10yr yield back to the 2.20% area. Time will tell." - source Bank of America Merrill Lynch

If indeed, this scenario plays out, then we could see some reversal of Gibson's paradox given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. End of the day the most important factor for gold prices is real interest rates. One thing for sure 2017 will have sufficient political events to offer yet again plenty of risk-reversal opportunities rest assured.

"The political graveyards are full of people who don't respond."- John Glenn, Astronaut

Stay tuned!

Macro and Credit - The disappearance of MS München

"Hope, the best comfort of our imperfect condition." - Edward Gibbon, English historian

While thinking about correlations in particular and risk in general, we reminded ourselves of one of our pet subject we have touched in different musings, namely the fascinating destructive effect of "Rogue waves". It is a subject we discussed in details, particularly in our post "Spain surpasses 90's perfect storm":

"We already touched on the subject of "Rogue Waves" in our conversation "the Italian Peregrine soliton", being an analytical solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), and being as well "an attractive hypothesis" to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace, the latest surge in Spanish Nonperforming loans to a record 10.51% and the unfortunate Sandy Hurricane have drawn us towards the analogy of the 1991 "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.", source Macronomics, October 2012

You might already asking yourselves why our title and where we are going with all this?

The MS München was a massive 261.4 m German LASH carrier of the Hapag-Lloyd line that sank with all hands for unknown reasons in a severe storm in December 1978. The most accepted theory is that one or more rogue waves hit the München and damaged her, so that she drifted for 33 hours with a list of 50 degrees without electricity or propulsion.  The München departed the port of Bremerhaven on December 7, 1978, bound for Savannah, Georgia. This was her usual route, and she carried a cargo of steel products stored in 83 lighters and a crew of 28. She also carried a replacement nuclear reactor-vessel head for Combustion Engineering, Inc. This was her 62nd voyage, and took her across the North Atlantic, where a fierce storm had been raging since November. The München had been designed to cope with such conditions, and carried on with her voyage. The exceptional flotation capabilities of the LASH carriers meant that she was widely regarded as being practically unsinkable (like the Titanic...). That was of course until she encountered "non-linear phenomena such as solitons.

While a 12-meter wave in the usual "linear" model would have a breaking force of 6 metric tons per square metre (MT/m2), although modern ships are designed to tolerate a breaking wave of 15 MT/m2, a rogue wave can dwarf both of these figures with a breaking force of 100 MT/m2. Of course for such "freak" phenomenon to occur, you need no doubt special conditions, such as the conjunction of fast rising CDS spreads (high winds), global tightening financial conditions and NIRP (falling pressure towards 940 MB), as well as rising nonperforming loans and defaults (swell). So if you think having a 99% interval of confidence in the calibration of you VaR model will protect you againtst multiple "Rogue Waves", think again...

Of course the astute readers would have already fathomed between the lines that our reference to the giant ship MS München could be somewhat a veiled analogy to banking giant Deutsche Bank. It could well be...

But given our recent commentaries on the state of affairs in the credit space, we thought it would be the right time to reach again for a book collecting dust since 2008 entitled Credit Crisis authored by Dr Jochen Felsenheimer (which we quoted on numerous occasions on this very blog for good reasons) and Philip Gisdakis.

Before we go into the nitty gritty of our usual ramblings, it is important we think at this juncture to steer you towards chapter 5 entitled "The Anatomy of a Credit Crisis" and take a little detour worth our title analogy to "Rogue Waves" which sealed the fate of MS München. What is of particular interest to us, in similar fashion to the demise of the MS München is page 215 entitled "LTCM: The arbitrage saga" and the issue we have discussing extensively which is our great discomfort with rising positive correlations and large standard deviations move. This amounts to us as increasing rising instability and the potential for "Rogue Waves" to show up in earnest:

"LTCM's trading strategies generally showed no or almost very little correlation. In normal times or even in crises that are limited to a specific segment, LTCM benefited from this high degree of diversification. Nevertheless, the general flight to liquidity in 1998 caused a jump in global risk premiums, hitting the same direction. All (in normal times less-correlated) positions moved in the same direction. Finally, it is all about correlation! Rising correlations reduces the benefit from diversification, in the end hitting the fund's equity directly. This is similar with CDO investments (ie, mezzanine pieces in CDOs), which also suffer from a high (default) correlation between the underlying assets. Consequently, a major lesson of the LTCM crisis was that the underlying Covariance matrix used in Value-at-Risk (VaR) analysis is not static but changes over time." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

You might probably understand by now from our recent sailing analogy (The Vasa ship) and wave analogy (The Ninth Wave) where we are heading: A financial crisis is more than brewing. 

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

Moving back to the LTCM VaR reference, the Variance-Covariance Method assumes that returns are normally distributed. In other words, it requires that we estimate only two factors - an expected (or average) return and a standard deviation. Value-at-Risk (VaR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. 

LTCM and the VaR issue reminds us of a regular quote we have used, particularly in May 2015 in our conversation "Cushing's syndrome":

"The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.
The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking".
To that effect and in continuation to Martin Hutchinson's LTCM reference, we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":
Today investors face the same "optimism bias" namely that they overstate their ability to exit.

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

So what is VaR really measuring these days?

This what we had to say about VaR in our May 2015 conversation "Cushing's syndrome" and ties up nicely to our world of rising positive correlations. Your VaR measure doesn't measure today your maximum loss, but could be only measuring your minimum loss on any given day. Check the recent large standard deviation moves dear readers such as the one on the Japanese yen and ask yourself if we are anymore in a VaR assumed "normal market" conditions:

"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured." - source Macronomics, May 2015

Therefore this week's conversation we will look at what positive correlations entails for risk and diversification and also we will look at the difference cause of financial crisis and additional signs we are seriously heading into one like the MS München did back in 1978, like we did in 2008 and like we are most likely heading in 2016 with plenty of menacing "Rogue Waves" on the horizon. So fasten your seat belt for this long conversation, this one is to be left for posterity.

Synopsis:

• Credit - The different types of credit crises and where do we stand
• A couple of illustrations of on-going nonlinear "Rogue Waves" in the financial world of today
• The overshooting phenomenon
• The Yuan Hedge Fund attack through the lense of the Nash Equilibrium Concept

• Credit - The different types of credit crises and where do we stand

Rising positive correlations, are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by this sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016

When it comes to the classification of credit crises and their potential area of origins both the authors  for the book "Credit Crisis" shed a light on the subject:

• "Currency crisis: A speculative attack on the exchange rate of a currency which results in a sharp devaluation of the currency; or it forces monetary authorities to intervene in currency markets to defend the currency (eg. by sharply hiking interest rates).
• Foreign Debt Crisis: a situation where a country is not able to service its foreign debt.
• Banking crisis: Actual or potential bank runs. Banks start to suspend the internal convertibility of their liabilities or the government has to bail out the banks.
• Systemic Financial crisis: Severe disruptions of the financial system, including a malfunctioning of financial markets, with large adverse effect on the real economy. It may involves a currency crisis and also a banking crisis, although this is not necessarily true the other way around.

In many cases, a crisis is characterized by more than one type, meaning we often see a combination of at least two crises. These involve strong declines in asset values, accompanied by defaults, in the non-financials but also in the financials universe. The effectiveness of government support or even bailout measures combined with the robustness of the economy are the most important determinants of the economy's vulneability, and they therefore have a significant impact on the severity of the crisis. In addition, a crucial factor is obviously the amplitude of asset price inflation that preceded the crisis.

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.

A so-called credit crunch scenario is the ugliest outcome of a credit crisis. It is characterized by a sharp reduction of lending activities by the banking sector. A credit crunch has a severe impact on the real economy, as the basic transmission mechanism of liquidity (from central banks over the banking sector to non-financial corporations) is distorted by the fact that banks do a liquidity squeeze, finally resulting in rising default rates. A credit crunch is a full-fledged credit crisis, which includes all major ingredients for a banking and a systemic crisis spilling over onto several parts of the financial market and onto the real economy. A credit crunch is probably the most costly type of financial crisis, also depending on the efficiency of regulatory bodies, the shape of the economy as a whole, and the health of the banking sector itself." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

The exogenous shock started in earnest in mid-2014 which saw a conjunction of factors, a significant rise in the US dollar that triggered the fall in oil prices, the unabated rise in the cost of capital.

If we were to build another schematic of the current market environment, here what we think it should look like to name a few of the issues worth looking at:

- source Macronomics

So if you think diversification is a "solid defense" in a world of "positive correlations", think again, because here what the authors of "Credit Crisis" had to say about LTCM and tail events (Rogue Waves):

"Even if there are arbitrage opportunities in the sense that two positions that trade at different prices right now will definitely converge at a point in the future, there is a risk that the anomaly will become even bigger. However typically a high leverage is used for positions that have a skewed risk-return profile, or a high likelihood of a small profit but a very low risk of a large loss. This equals the risk-and-return profile of credit investments but also the risk that selling far-out-of-the-money puts on equities. In case of a tail event occurs, all risk parameters to manage the overall portfolio are probably worthless, as correlation patterns change dramatically during a crisis. That said, arbitrage trades are not under fire because the crisis has an impact on the long-term-risk-and-return profile of the position. However, a crisis might cause a short-term distortion of capital market leading to immense mark-to-market losses. If the capital adequacy is not strong enough to offset the mark-to-market losses, forced unwinding triggers significant losses in arbitrage portfolios. The same was true for many asset classes during the summer of 2007, when high-quality structures came under pressure, causing significant mark-to-market losses. Many of these structures did not bear default risk but a huge liquidity risk, and therefore many investors were forced to sell." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

You probably understand by now why we have raised the "red flag" so many times on our fear in the rise of "positive correlations". They do scare us, because they entail, larger and larger standard deviation moves and potentially trigger "Rogue Waves" which can wipe out even the biggest and most reputable "Investment ships" à la MS München. 

The big question is not if we are in a bubble again but if this "time it's different". It is not. It's worse, because you have all the four types of crisis evolving at the same time.
Here is what Chapter 5 of "Credit Crisis" is telling us about the causes of the bubble:

"A mainstream argument is that the cause of the bubbles is excessive monetary liquidity in the financial system. Central banks flood the market with liquidity to support economic growth, also triggering rising demand for risky assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentally fair valuation. In the long run, this level is not sustainable, while the trigger of the burst of the bubble is again policy shifts of central banks. The bubble will burst when central banks enter a more restrictive monetary policy, removing excess liquidity and consequently causing investors to get rid of risky assets given the rise in borrowing costs on the back of higher interest rates.

This is the theory, but what about the practice? The resurfacing discussion about rate cuts in the United States and in the Euroland in mid-2005 was accompanied by expectations that inflation will remain subdued. Following this discussion, the impact of inflation on credit spreads returned to the spotlight. An additional topic regarding inflation worth mentioning is that if excess liquidity flows into assets rather than into consumer goods, this argues for low consumer price inflation but rising asset price inflation. In late 2000, the Fed and the European Central Banks (ECB) started down a monetary easing path, which was boosted by external shocks (9/11 and the Enron scandal), when central banks flooded the market with additional liquidity to avoid a credit crunch. Financial markets benefited in general from this excess liquidity, as reflected in the positive performance of almost all asset classes in 2004, 2005, and 2006, which argued for overall liquidity inflows but not for allocation shifts. It is not only excess liquidity held by investors and companies that underpins strong performing assets in general, but also the pro-cyclical nature of banking. In a low default rate environment, lending activities accelerate, which might contribute to an overheating of the economy accompanied by rising inflation. From a purely macroeconomic viewpoint, private households have two alternatives to allocate liquidity: consuming or saving. The former leads to rising price inflation, whereas the latter leads to asset price inflation." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

 Where we slightly differ from the author's take in terms of liquidity allocation is in the definition of "saving".  The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "The financial cycle and macroeconomics: What have we learnt?". 

"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012

Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research. 

Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before.

But, guess what: We have the same problem today and suprise, it's worse.

Look at the issuance levels reached in recent years and the amount of cov-lite loans issued (again...). Look at mis-allocation of capital in the Energy sector and its CAPEX bubble.

Look at the $9 trillion debt issued by Emerging Markets Corporates.

We could go on and on.

Now the credit Fed induced credit bubble is bursting again. One only has to look at what is happening in credit markets (à la 2007). By the way Financial Conditions are tightening globally and the process has started in mid 2014. CCC companies are now shut out of primary markets and default rates will spike. Credit always lead equities...The "savings glut" theory of Ben Bernanke and the FED is hogwash:

"Asset price inflation in general, is not a phenomenon which is limited to one specific market but rather has a global impact. However, there are some specific developments in certain segments of the market, as specific segments are more vulnerable against overshooting than others. Therefore, a strong decline in asset prices effects on all risky asset classes due to the reduction of liquidity.
This is a very important finding, as it explains the mechanism behind a global crisis. Spillover effects are liquidity-driven and liquidity is a global phenomenon. Against the background of the ongoing integration of the financial markets, spillover effects are inescapable, even in the case there is no fundamental link between specific market segments. How can we explain decoupling between asset classes during financial crises? During the subprime turmoil in 2007, equity markets held up pretty well, although credit markets go hit hard." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

As a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately.

This brings us to lead you towards some illustration of rising instability and worrying price action and the formation of "Rogue Waves" we have been witnessing as of late in many segments of the credit markets.

• A couple of illustrations of on-going nonlinear "Rogue Waves" in the financial world of today

Rogue waves present considerable danger for several reasons: they are rare, unpredictable, may appear suddenly or without warning, and can impact with tremendous force. Looking at the meteoric rise in US High yield spreads in the Energy sector is an illustration we think about the destructive power of a High Yield "Rogue Wave":

- source Thomson Reuters Datastream (H/T Eric Burroughs on Twitter)

When it comes to the "short gamma" investor crowd and with Contingent Convertibles aka "CoCos" making the headlines, the velocity in the explosion of spreads has been staggering:

- graph source Barclays (H/T TraderStef on Twitter)

When it comes to the unfortunate truth about wider spreads, what the flattening of German banking giant Deutsche bank is telling you is that it's cost of capital is going up, this is what a flattening of credit curve is telling you:

- source Thomson Reuters Datastream (H/T Eric Burroughs on Twitter)

Also the percentage of High Yield bonds trading at Distressed levels is at the highest level since 2009 according to S&P data:

2015: 20.1%*
2013: 11.2%
2011: 16.8%
2009: 23.2%
- source H/T - Lawrence McDonald - Twitter feed

In our book a flattening of the High Yield curve is a cause for concern as illustrated by the one year point move on the US CDS index CDX HY (High Yield) series 25:

- source CMA part of S&P Capital IQ

This is a sign that cost of capital is steadily going up. Also the basis being the difference between the index and the single names continues to be as wide as it was during the GFC. A basis going deeper into negative territory is a main sign of stress.

We have told you recently we have been tracking the price action in the Credit Markets and particularly in the CMBS space. What we are seeing is not good news to say the least and is a stark reminder of what we saw unfold back in 2007. On that subject we would like to highlight Bank of America Merrill Lynch's CMBS weekly note from the 12th of February entitled "The unfortunate truth about wider spreads":

"Key takeaways
• We anticipate that spread volatility, liquidity stress and credit tightening will persist. Look for wider conduit spreads.
• While CMBX.BBB- tranche prices fell sharply this week we think further downside exists, particularly in series 6&7.

As investors ponder the likelihood that economic growth may slow and that CRE prices may have risen too quickly (Chart 3), recent 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 is considered to be a good proxy for the state of the economy.

In the past, this type of activity began by investors shorting tranches that were most highly levered to a deteriorating economy and could fall the most if fundamentals eroded. This includes the lower rated tranches of CMBX.6-8, which, as of last night’s close, have seen the prices for their respective BBB-minus and BB tranches fall by 13-17 points for CMBX.6 (Chart 4), 14-20 points for CMBX.7 (Chart 5) and 17-19 points for CMBX.8 (Chart 6) since the beginning of the year.

We agree that underwriting standards loosened over the past few years, which, all else equal, could imply loans in CMBX.8 have worse credit metrics compared to either the CMBX.6 or CMBX.7 series. Despite this, and although prices have already fallen considerably, for several reasons we think it makes sense to short the BBBminus tranche from either CMBX.6 or CMBX.7 instead of the CMBX.8. First, the dollar price of the BBB-minus tranche from CMBX.6 and CMBX.7 is materially higher that of CMBX.8 (Chart 7). 

Additionally, although the CMBX.8 does have more loans with IO exposure than series 6 or 7 do, we think this becomes more meaningful when considering maturity defaults. By contrast, the earlier series not only have lower subordination attachment points at the BBB-minus tranche, but they also have more exposure to the retail sector, which could realize faster fundamental deterioration if the economy does contract." - source Bank of America Merrill Lynch

Now having read seen the movie "The Big Short" and also read the book and also recently read in Bloomberg about Hedge Fund pundits thinking about shorting Subprime Auto-Loans, as the next new "big kahuna" trade, we would like to make another suggestion.  If you want to make it big, here is what we suggest à la "Big Short", given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honour the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs". In essence, like in the "Big Short", if the whole of the capital structure falls apart, your wager might make a bigger return because of the assumed low probability of such a "tail risk" to ever materialize. and will be cheaper to implement in terms of negative carry than, placing a bet on the lower part of the capital structure. This is just a thought of course...

Moving back to the disintegration of the CMBS space, Bank of America Merrill Lynch made some additional interesting points on the fate of SEARS and CMBS:

"To this point, Sears’s management announced this week that revenues for the year ending January 31, 2016, decreased to about $25.1 billion (Chart 8) and that the company would accelerate the pace of store closings, sell assets and cut costs.

Why could CMBX.6 be more negatively impacted by the negative Sears news than some of the other CMBX series? Among the more recently issued CMBX series (6-9), CMBX.6 has the highest percentage of retail exposure. When we focus solely on CMBX.6 and CMBX.7, which have the highest percentage exposure to retail among the postcrisis series, we see that although the headline exposure to retail properties is similar, CMBX.6 has considerably more exposure to B/C quality malls than CMBX.7 does" - source Bank of America Merrill Lynch

Sorry to be a credit "party spoiler" but if U.S. Retail Sales are really showing a reassuring rebound in January according to some pundits with Core sales were 0.6% higher after declining 0.3% in December and the best rise since last May, according to official data from the Commerce Department, then, we wonder what's all our fuss about CMBS price action and SEARS dwindling earnings? Have we lost the plot?

Not really this is all part of what is known as the overshooting phenomenon.

• The overshooting phenomenon

The overshooting phenomenon is closely related to the bubble theory we have discussed earlier on through the comments of both authors of the book "Credit Crisis. The overshooting paper  mentioned below in the book is of great interest as it was written by Rudi Dornbusch, a German economist who worked for most of his career in the United States, who also happened to have had Paul Krugman and Kenneth Rogoff as students:

"Closely linked to the bubble theory, Rudiger Dornbusch's famous overshooting paper set a milestone for explaining "irrational" exchange rate swings and shed some light on the mechanism behind currency crises. This paper is one of the most influential papers writtten in the field of international economics, while it marks the birth of modern international macroeconomics. Can we apply some of the ideas to credit markets? The major input from the Dornbusch model is not only to better understand exchange rate moves; it also provides a framework for policymakers. This allow us to review the policy actions we have seen during the subprime turmoil of 2007.

The background of the model is the transition from fix to flexible exchange rates, while changes in exchange rates did not simply follow the inflation differentials as previous theories suggest. On the contrary, they proved more volatile than most experts expected they would be. Dornsbusch explained this behavior of exchange rates with sticky prices and an instable monetary policy, showing that overshooting of exchange rates is not necessarily linked to irrational behavior of investors ("herding"). Volatility in FX markets is a necessary adjustment path towards a new equilibrium in the market as a response to exogenous shocks, as the price of adjustment in the domestic markets is too slow.

The basic idea behind the overshooting model is based on two major assumptions. First, the "uncovered interest parity" holds. Assuming that domestic and foreign bonds are perfect substitutes, while international capital is fully mobile (and capital markets are fully integrated), two bonds (a domestic and a foreign one) can only pay different interest rates if investors expect compensating movement in exchange rates. Moreover, the home country is small in world capital markets, which means that the foreign interest rate can be taken as exogenous. The model assumes "perfect foresight", which argues against traditional bubble theory. The second major equation in the model is the domestic demand for money. Higher interest rates trigger rising opportunity costs of holding money, and hence lower demand for money. In the contrary, an increase in output raises  demand for money while demand for money is proportional to the price level. 

In order to explain what overshooting means in this context, we have to introduce additional assumptions. First of all, domestic prices do not immediately follow any impulses from the monetary side, while they adjust only slower over time, which is a very realistic assumption. Moreover, output is assumed to be exogenous, while in the long run, a permanent rise in money supply causes a proportional rise in prices and in exchange rates. The exogenous shock to the system is now defined as unexpected permanent increase in money supply, while prices are sticky in the short term. And as also output is fixed, interest rates (on domestic bonds) have to fall to equilibrate the system. As interest-rate parity holds, interest rates can only fall if the domestic currency is expected to appreciate. As the assumption of the model is that in the long run rising money supply must be accompanied by a proportional depreciation in the exchange rate must be larger than the long term depreciation! That said the exchange rate must overshoot the long-term equilibrium level. The idea of sticky prices is in the current macroeconomic discussion fully accepted, as it is a necessary assumption to explain many real-world data.

This is exactly what we need to explain the link to the credit market. The basic assumption of the majority of buy-and-hold investors is that credit spreads are mean reverting. Ignoring default risk, spreads are moving around their fair value through the cycle. Overshooting is only a short-term phenomenon and it can be seen as a buying opportunity rather than the establishment of a lasting trend. This is true, but one should not forget that this is only true if we ignore default risk. This might be a calamitous assumption. Transferring this logic to the first subprime shock in 2007, it is exactly what happened as an initial reaction regarding structured credit investments. For example, investment banks booked structured credit investments in marked-to-model buckets (Level 3 accounting) to avoid mark-to-market losses.  

... 

A credit crisis can be the trigger point of overshooting in other markets. This is exactly what we have observed during the subprime turmoil of 2007.
This is a crucial point, especially from the perspective of monetary policy makers. Providing additional liquidity would mean that there will be further distortions. Healing a credit crunch at the cost of overshooting in other markets. Consequently liquidity injections can be understood as a final hope rather than the "silver bullet" in combating crises. In the context of the overshooting approach, liquidity injections could help to limit some direct effects from credit crises, but they will definitely trigger spillover effects onto other markets. In the end, the efficiency of liquidity injections by central banks depends on the benefit on the credit side compared to the cost in other markets. In any case, it proved not to be the appropriate instrument as a reaction to the subprime crisis in 2007" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

On that subject we would like to highlight again Bank of America Merrill Lynch's CMBS weekly note from the 12th of February entitled "The unfortunate truth about wider spreads":

"As spreads widened over the past few weeks, a significant number of conversations we’ve had with investors have revolved around the concern that the recent spread widening may not represent a transient opportunity to add risk at wider levels, but instead could represent a new reality earmarked by tighter credit standards, lower liquidity and higher required returns for a given level of risk. While it may be easy to look at CRE fundamentals and dismiss the recent spread widening as being due to market technicals, it is important to realize that while that may be true today, if investors are pricing in what they expect could occur in the future, there may be some validity to the recent spread moves. As a case in point, given the recent new issue CMBS spread widening, breakeven whole loan spreads have widened substantially over the past two months (Chart 16).

Not only do wider whole loan breakeven spreads result in higher coupons to CMBS borrowers, which, effectively tightens credit standards, but it also can reduce the profitability of CMBS originators, which may cause some of them to exit the business. As a case in point, this week Redwood Trust, Inc. announced it is repositioning its commercial business to focus solely on investing activities and will discontinue commercial loan originations for CMBS distribution. Marty Hughes, the CEO of Redwood said:

"We have concluded that the challenging market conditions our CMBS conduit has faced over the past few quarters are worsening and are not likely to improve for the foreseeable future. The escalation in the risks to both source and distribute loans through CMBS, as well as the diminished economic opportunity for this activity, no longer make our commercial conduit activities an accretive use of capital." 

If, as we wrote last week, 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. The upshot is that it appears that we have entered into a phase where it becomes increasingly possible that negative market technicals and less credit availability form a feedback loop that negatively affects CRE fundamentals.
To this point, although a continued influx of foreign capital into trophy assets in gateway markets can support CRE prices in certain locations, it won’t help CRE prices for properties located in many secondary or tertiary markets. If borrowers with “average” quality properties located away from gateway markets are faced with higher borrowing costs and more stringent underwriting standards, the result may be fewer available proceeds and wider cap rates." - source Bank of America Merrill Lynch

This is another sign that credit will no doubt overshoot to the wide side and that you will, rest assured see more spillover in other asset classes. Given credit leads equities, you can expect equities to trade "lower" for "longer" we think.

Furthermore, Janet Yellen's recent performance is confirming indeed the significant weakening of the Fed "put" as described in Bank of America Merrill Lynch's note:

"With Fed Chair Yellen’s Humphry Hawkins testimony, in which she stressed the notion that the Fed’s decision to raise rates is not on a predetermined course, the probability that the Fed would raise interest rates at its March 2016 plummeted as did the probability of rate hikes over the next year. During her testimony, however, the Fed Chair mentioned that the current global turmoil could cause the Fed to alter the timing of upcoming rate hikes, not abandon them. 

As a result, risky asset prices broadly fell and a flight to quality ensued due to the uncertainty of the timing of future rate hikes, the notion that the Fed put may be further out of the money than was previously anticipated and the prospect that a growing policy divergence among global central banks could contribute to a U.S. recession. While delaying the next rate hike may be viewed positively in the sense that it could help keep risk free rates low, which would allow a greater number of borrowers to either refinance or acquire new properties, we think it is likely that many investors will view it as a canary in the coalmine that presages slower economic growth, more capital market volatility, wider credit spreads and lower asset prices.
Ultimately, the framework that has been put in place by regulators over the past few years effectively severely limits banks’ collective abilities to provide liquidity during periods of stress. As global economic concerns have increased, investors and dealers alike have become increasingly aware of the extremely limited amount of liquidityavailable, which has manifested through a surge  in liquidity stress measures (Chart 21) and wider spreads across risky asset classes.

 - source Bank of America Merrill Lynch

When it comes to rising risk, it certainly looks to us through the "credit lense" that indeed it certainly feels like 2007 and that once again we are heading towards a Great Financial Crisis version 2.0. For us, it's a given.
When it comes to the much talked about Kyle Bass significant "short yuan" case, we would like to offer our views through the lens of the Nash Equilibrium Concept in our next point.

• The Yuan Hedge Fund attack through the lense of the Nash Equilibrium Concept

Hyman Capital’s Kyle Bass  has recently commented on the $34 trillion experiment and his significant currency play against the Chinese currency (a typical old school Soros type of play we think).

Indirectly, our HKD peg break idea which  we discussed back in September t2015 our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen. This Yuan trade is of interest to us as we won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our recent "Cinderella's golden carriage".

We also read with interest Saxo Bank's French economist Christopher Dembik's take on the Yuan in his post "The Chinese yuan countdown is on".

Overall, we think that if the Yuan goes, so could the Hong Dollar peg. Therefore we would like again to quote once again the two authors of the book "Credit Crisis" and their Nash Equilibrium reasoning in order to substantiate the probability of this bet paying off:

"Financial panic models are based on the idea of a principle-agent: There is a government which is willing to maintain the current exchange rate using its currency reserves. Investors or speculators are building expectations regarding the ability of the government to maintain the current exchange-rate level. An as answer to a speculative attack on the currency, the government will buy its own currency using its currency reserves. There are three possible outcomes in this situation. First, currency reserves are big enough to combat the speculative attack successfully, and the government is able to keep the current exchange rate. In this case there will be no attack as speculators are rational and able to anticipate the outcome. Second, the reserves of central banks are not large enough to successfully avert the speculative attack, even if only one speculator is starting the attack. Thus, the attack will occur and will be successful. The government has to adjust the exchange rate. Third, the attack will only be successful if speculators join forces and start to attack the currency simultaneously. In this case, there are two possible equilibriums, a "good one" and a "bad one". The good one means the government is able to defend the currency peg, while the bad one means that the speculators are able to force the government to adjust the exchange rate. In this simple approach, the amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

If indeed the amount of currency reserves is obviously the crucial parameter when it comes to assessing the pay off for the Yuan bet, we have to agree with Deutsche Bank recent House View note from the 9th of February 2016 entitled "Still deep in the woods" that problems in China remains unresolved:

"The absence of new news has helped divert attention away from China – but the underlying problem remains unresolved

• After surprise devaluation in early January, China has stopped being a source of new bad news
• Currency stable since, though authorities no longer taking cues from market close to set yuan level*
• Macro data soft as expected, pointing to a gradual deceleration not a sharp slowdown
• Underlying issue of an overvalued yuan remains unresolved, current policy unsustainable long-term

−At over 2x nominal GDP growth, credit growth remains too high
−FX intervention to counter capital outflows – at the expense of foreign reserves

- source Deutsche Bank

When it comes to the risk of a currency crisis breaking and the Yuan devaluation happening, as posited by the Nash Equilibrium Concept, it all depends on the willingness of the speculators rather than the fundamentals as the Yuan attacks could indeed become a self-fulfilling prophecy in the making.

This self-fulfilling process is as well a major feature of credit crises and a prominent feature of credit markets (CDS) as posited again in Chapter 5 of the book from Dr Jochen Felsenheimer and Philip Gisdakis:

"Self-fulfilling processes are a major characteristics of credit crises and we can learn a lot from the idea presented above. The self-fulfilling process of a credit crisis is that short-term overshooting might end up in a long-lasting credit crunch - assuming that spreads jump initially above the level that we would consider "fundamentally justified; for instance reflected in the current expected loss assumption. That said, the implied default rate is by far higher than the current one (e.g., the current forecast of the future default rate from rating agencies or from market participants in general). However the longer the spreads remains at an "overshooting level", the higher the risk that lower quality companies will encounter funding problems, as liquidity becomes more expensive for them. this can ultimately cause rising default rate at the beginning of the crisis; a majority of market participants refer to it as short-term overshooting. Self fulfilling processes are major threat in a credit crisis, as was also the case during the subprime meltdown. If investors think that higher default rates are justified, they can trigger rising default rates just by selling credit-risky assets and causing wider spreads. This is independent from what we could call the fundamentally justified level!

The other interesting point is that the assumption of concerted action is not necessary in credit markets to trigger a severe action. If we translate the role of the government (defending a currency peg) into credit markets, we can define a company facing some aggressive investors who can send the company into default. Buying protection on an issuer via Credit Default Swaps (CDS) leads to wider credit spreads of the company, which can be seen as an impulse for the self-fulfilling process described above. If some players are forced to hedge their exposure against a company by buying protection on the name, the same mechanism might be put to work." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

As we highlighted above with the flattening of MS München and/or Deutsche Bank and the flattening of the CDX HY curve, the flattening trend means that the funding costs for many companies is rising across all maturities:

"Such a technically driven concerted action of many players, consequently can also cause an impulse for a crisis scenario, as in the case for currency markets in financial panic models" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

So there you go, you probably understand by now the disappearance of MS München due to a conjunction of "Rogue Waves":

"The laws of probability, so true in general, so fallacious in particular." - Edward Gibbon, English historian

And this dear readers is the story of VaR in a world of rising "positive correlations" but we are ranting again...

Stay tuned!