Macro and Credit - Ouroboros

"History is about loops and continuums." - Mike Bidlo, American artist

Reading with interest a summary of the paper co-authored by top-ranking Philadelphia Fed economist Michael Dotsey indicating "no evidence for relying on the Phillips curve", we felt indeed that our latest musing title had been more than appropriate We were amused to see a Monty Pythonesque title from Bank of America Merrill Lynch title when it comes to the Phillips curve: "The Phillips curve: it’s not dead, it’s sleeping" on this subject. Of course this relates perfectly to the Norwegian blue parrot we mentioned in our previous conversation:

- source Bloomberg

You might already ask yourselves why we choose "Ouroboros" as a title analogy. The Ouroboros is an ancient symbol depicting a serpent or dragon eating its own tail. Via medieval alchemical tradition, the symbol Orobouros entered Renaissance magic and modern symbolism, often taken to symbolize introspection, the eternal return or cyclicality especially in the sense of something constantly re-creating itself (like credit cycles). It also represents the infinite cycle of nature's endless creation and destruction, life and death (creative destruction à la Schumpeter comes to mind). The first known appearance of the ouroboros motif is in the Enigmatic Book of the Netherworld, an ancient Egyptian funerary text in KV62, the tomb of Tutankhamun, in the 14th century BC. Also, the alchemical textbook, Chrysopoeia (gold making) of Kleopatra contains a drawing of the ouroboros representing the serpent as half light and half dark, echoing symbols such as the Yin Yang, which illustrates the dual nature of all things, but more importantly, that these opposites are not in conflict. No matter how many tricks (ZIRP, QE, NIRP) used by our modern alchemists, aka central bankers, they cannot alter cyclicality of credit, that simple. Let's be very clear about that. When it comes to our assessment of the credit cycle, it's getting late in the game, and capital preservation is becoming essential. This means starting moving to higher grounds credit quality wise we think.

In this week's conversation, we would like to look at the importance of wages for signs of inflation as we discussed last week. In our previous conversation we indicated that we thought that real wage growth mattered for inflation expectations. Could we be wrong? We will also look at the unintended consequences in liquidity thanks to regulation and the Volcker rule.

Synopsis:

• Macro - Real wages growth? The "deflationistas" have won the war.
• Credit - Credit Supply is cyclical, so is liquidity...
• Final chart - Japanese support for credit - The boys are back in town

• Macro - Real wages growth? The "deflationistas" have won the war.

As we pointed out in our previous conversation, we indicated that the most important point for a rise in inflation expectations had been real wages growth. We also posited in our conversation "Perpetual Motion" in October 2014 that real wage growth would indicate the US would be reaching "escape velocity":

"In fact the Fed's conundrum can be seen in the lag in wage growth given nominal wages are only up 2% yoy whereas real wage growth remains at zero. Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, October 2014

Obviously the latest disappointing Nonfarm payroll for August, still point towards weak real wage growth and it isn't the time for clamoring victory for the Fed. 

In our previous musing we pointed out the amazing work of Jean Fourastié on the subject of real wages, real prices and productivity (which in our humble opinion should have been worthy of a Nobel prize). True capitalism is inherently "deflationist" when it comes to prices. While any aspiring economist and/or central banker should get acquainted with the work of Jean Fourastié, same goes with the work of BCG's founder Bruce Henderson seminal work on the Experience Curve.

For us, there are three main reasons why the Phillips curve is a Norwegian Blue parrot, simply resting in a Monty Pythonesque way:

1. Demographics: as population ages, there are more pressure on aggregate demand and total consumption. 
2. Globalization: real wages have come under pressure thanks to offshoring of labor in different parts of the world, leading to good solid wages jobs in the industrial sector being replaced by low qualification low paying jobs in the service and hospitality sectors.
3. Technology: As per Henderson's work and recent progress in technology, pressure on prices as been appearing thanks to the Experience curve. The fight between Amazon and the retail sector comes to mind we think about it. Technology has been holding down costs overall and facilitated rapid price competition in some sector (internet on retail).

This is why we think the Phillips curve is obsolete, for structural reasons. On the subject of the relationship between inflation and wages we read with great interest Wells Fargo's take from their note from the 31st of August entitled "Do Wages Still Matter for Inflation?":

"Executive Summary

Wage growth has garnered increasing attention in the heavily watched monthly employment reports. The scrutiny reflects the emphasis many Fed officials have placed on the critical link between slack in the labor market and inflation. With wages accounting for a significant share of costs in most industries, it makes intuitive sense that rising labor costs would soon develop into higher inflation. The reality, however, is that wage growth tells us little about future inflation. If anything, the relationship runs the other way, with inflation leading wage growth.

The limited influence of wage growth on inflation reflects the changing structure of the U.S. economy. Technology is making it easier than ever for consumers to compare prices, intensifying price competition. At the same time, globalization has diminished the role of the domestic labor market with a larger share of goods consumed imported from overseas. Finally, the inability of many firms to adjust prices frequently generates the need to set prices in anticipation of future costs, making inflation expectations a more significant driver of inflation than wages.

Watching Wages for Signs of Inflation

The PCE deflator has only briefly brushed the Fed’s 2 percent target since the start of the

expansion (Figure 1).

Nevertheless, most FOMC members remain confident that inflation will move higher from here. In the Committee’s most recent economic projections published in June, the median estimate for where inflation would end the year was 1.6 percent and 1.7 percent for headline and core inflation, respectively, while both measures were projected to end 2018 at 2.0 percent (Figure 2).

Although those estimates will likely come down a tick or two following recent months’ softness, the path remains upward and is a key factor in the Committee’s baseline outlook to further raise interest rates over the next year.

The FOMC’s confidence that inflation will head higher over the next year and a half hinges critically on the assumption that as resource slack is absorbed, upward pressure on prices follows. While resources include both labor and capital, the link between slack in the labor market and inflation garners more widespread attention. As unemployment declines, firms need to pay higher wages to attract and retain workers, and those costs in turn generate the need to raise prices. Over the past couple of years, the unemployment rate has fallen to where it is now below many estimates of full employment, while inflation—headline or core—has remained stubbornly below 2 percent. The result has been to closely watch wage growth as a sign of future inflation.

Wage growth has remained frustratingly low for workers and policymakers alike. After increasing only about 2 percent a year in the early years of the expansion, average hourly earnings began to strengthen in 2015. The uptrend has fizzled by multiple wage measures this year, however, and wage growth remains weak by historic standards (Figure 3).

There are some signs that higher pay may be in the offing. Job openings are at an all-time high, underemployment is shrinking, and the share of small businesses raising compensation is hovering near cycle highs (Figure 4). But even if we see stronger wage growth, will it lead to more inflation?

Wages as a Driver of Inflation: Not What It Used to Be

The relationship between labor market slack and inflation, known as the Phillips Curve, has had its share of critics over the years as it appeared to break down completely (as in the 1970s) or at the very least weaken in recent decades. Nevertheless, Fed Chair Janet Yellen has made comments over the years indicating she is a subscriber of the Phillips Curve and that short-run fluctuations in labor market slack affect inflation. As indicated in the most recent FOMC meeting minutes, however, doubts seem to be emerging among more FOMC members about the link between labor market slack, wages and inflation. Research by Federal Reserve economists has found that the impact of labor costs on inflation has diminished in recent decades.

A simple regression of our own shows that an increase in wages is associated with a smaller rise in inflation than in previous decades. For this we look at the “nominal” component of wage growth, or average hourly earnings growth minus labor productivity since productivity drives real wages. While a one percentage point rise in the year-over-year rate of productivity-adjusted average hourly earnings was consistent with a 0.4 percentage point rise in CPI inflation from 1985 to 2000, that relationship has fallen by half since 2000. Moreover, when determining if in recent decades changes in wage growth cause changes in inflation and are not simply associated with these, we find no statistically significant support. If anything, inflation drives wage growth.

Domestic Labor Costs Only Part of the Story

For most businesses, labor represents a sizable share of costs. This is particularly true for service sector industries, where labor compensation accounts for at least 30 percent and often more than half of input costs. Why then do wages provide so little information about inflation if labor is such a big input cost? Labor conditions have increasingly taken a backseat in inflation dynamics in recent years as the U.S. economy has evolved. Technology has changed the way consumers shop and the way in which businesses offer goods and services. At the same time, globalization has opened up new sources of labor beyond the domestic workforce. And while workers may think about future inflation when negotiating wages, businesses are also thinking about future inflation when setting prices.

Technology: Holding Down Costs and Facilitating Price Competition

Technology seems to have infiltrated every corner of life so it is not a leap to believe it has affected inflation. Technological improvements have always held down inflation by improving the production processes or lowering the input costs of existing goods and services. By making it cheaper to produce products, firms can raise margins without increasing prices. It’s tough to argue, however, that technology in this way is playing a bigger role today in holding down inflation given the weak rate of productivity growth in the last decade. Instead, competitive forces unleashed by new technology have been pointed to as a recent factor holding down prices. The internet has made it easier than ever for consumers to compare prices of goods and services. Nowhere though has competition been more intense than in the retail sector as e-commerce has grown to nearly 10 percent of sales. Yet while increased competition should pressure margins, margins for retailers have held up over the past decade as the shift to online sales has limited the need for costly brick and mortar stores (Figure 5).

The upshot is prices for core consumer goods have been falling for the better part of the past 15 years (Figure 6).

The service sector has not been immune to competitive pressures either. The recent drop in the cost of cell phone services offers a relevant example. However, part of the decline since the start of the year is traceable to quality adjustments made by the Bureau of Labor Statistics (BLS). When the quality of a product improves, the BLS imputes the value of the improvement and downwardly adjusts the product “price” to account for the fact that while the listed price may be unchanged or higher, consumers are getting a better product.

Globalization: Not Just a U.S. Labor Market

Of course, the decline in core consumer goods prices has coincided with increasing global trade. The start of the North American Free Trade Agreement (NAFTA) in 1994 and China’s entrance to the World Trade Organization in 2001 both opened up significant sources of global labor. In 1992, only about one-third of U.S. consumer goods were imported from overseas, but that share has grown to about 55 percent today (Figure 7).

Although goods only account for one quarter of the core CPI, global price dynamics have had a significant, albeit small, impact on U.S. inflation. With foreign-made goods accounting for a larger share of consumption, the cyclical state of the U.S. labor market has lost importance in price setting.

Expectations: Firms Get Ahead of Cost Pressures

Inflation expectations play a more crucial role for inflation than wages. Expectations of future inflation affect firms’ decisions in price setting. As price changes can be costly in their own right, many businesses change prices infrequently. The stickiness of prices generates the need for businesses to make assumptions about future costs, including labor.7 As a result, price changes can precede wage growth, rather than wage growth leading to inflation. While a Granger- Causality test as previously noted shows wages do not drive inflation, the same test shows that inflation expectations are a significant driver of realized inflation.

Conclusion: Don’t Look to Wages for Early Signs of Inflation

The payroll figures and unemployment rate have typically been the focus of the closely-watched Employment Situation report each month, but increasingly those figures have taken a backseat to average hourly earnings. Market participants have been closely watching wage growth for signs of inflation in order to anticipate future policy decisions by the FOMC. Despite the emphasis placed on labor market conditions as a as a driver of inflation, average hourly earnings contain little information about inflation. Changes in wage costs are often already anticipated by businesses, meaning there is not much new information contained in them from an inflation perspective. Moreover, the ability and need to raise prices has been altered by technology and globalization, making the state of the domestic labor market less important.

We continue to watch wage growth as a source of household income and, therefore, spending power. In conjunction with aggregate hours worked, average hourly earnings remain a useful guide of near-term income for consumers (Figure 8).

As a signal of future inflation, however, the emphasis on wage growth appears misplaced."  -source Wells Fargo

Why wage growth has remained frustratingly low for workers and policymakers alike? You have the answer, there are structural changes at play. Therefore using a Norwegian Blue parrot aka the Phillips curve in the expectation of changes in the inflation outlook is at best misplaced by the FOMC, at worse plainly wrong because of the inherently "deflationist" bias of capitalism with innovation, technology and globalization. The model might have been working in a less open world but in today's globalized world, it's just not working anymore, it's not "resting" put it simply, it's broken.

If the PhDs at the Fed had closely studied both Fourastié and Henderson, they would have stopped making wrong assumptions and discarded their obsolete models as pointed out by our friend "Polemic" recently who runs the excellent blog "Polemic pains" in relation to the Phillips curve:

"Real problem is it is used for local policy using local employment/inflation when really, with globalisation, its inputs are global not local. Take UK, falling unemployment doesn't mean labour supply diminishes.. just suck in more from Europe/RoW. So wage inflation stays low but number of employed rises. Then screw it all up again with FX rates flying around altering actual wages for migrant labour relative to their spending location and it gets really confusing. I guess it will only work if free migration of labour is stopped so we no longer have a 'spare tank' of labour that sits outside the Phillips curve measure of unemployment" - source Polemic, 24th of August 2017

Exactly. It might be fun using it locally but in a globalized world, it is just isn't working anymore dear FOMC. That's the main issue with your Norwegian Blue parrot. If indeed everyone is focusing on real wages for a change in inflation expectations, then obviously we are wrong like so many others and the US will not reach that easily escape velocity. Also, the FOMC should look more closely to the Experience curve as it refers to the ability to produce existing products more cheaply and deliver them to an ever-wider audience. Could we call this the Amazon factor? We wonder.

• Credit - Credit Supply is cyclical, so is liquidity...

When it comes to "Orobouros", as we pointed out at the beginning of our conversation, no matter how many tricks (ZIRP, QE, NIRP) used by our modern alchemists, aka central bankers, they cannot alter cyclicality of credit, that simple. If they do not believe us in similar fashion to the many points we have made when it comes to the state of their Norwegian Blue parrot, they could indeed look at the work of Bo Becker and Victoria Ivashina (link above) and their working paper from 2011 published at Harvard Business School:

"Theory predicts that there is a close link between bank credit supply and the evolution of the business cycle. Yet fluctuations in bank-loan supply have been hard to quantify in the time series. While loan issuance falls in recessions, it is not clear if this is due to demand or supply. We address this question by studying firms’ substitution between bank debt and non-bank debt (public bonds) using firm-level data. Any firm that raises new debt must have a positive demand for external funds. Conditional on issuance of new debt, we interpret firm’s switching from loans to bonds as a contraction in bank credit supply. We find strong evidence of substitution from loans to bonds at times characterized by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. The bank-to-bond substitution can only be measured for firms with access to bond markets. However, we show that this substitution behavior has strong predictive power for bank borrowing and investments by small, out-of-sample firms." - source HBS, Bo Becker and Victoria Ivashina, 2011

The provision of credit is highly pro-cyclical in the sense that not much new credit is issued during recessions. As shown in Europe with the "credit crunch" in 2012 thanks to the collapsing of loan books leading to disintermediation, from loans into new bonds issues, to paraphrase Bastiat, there is what you see, and what you don't see. In their paper Bo Becker and Victoria are showing that credit is pro-cyclical because banks have not been willing to lend (supply shift = Economics 101). In very simple terms, the contraction in bank credit supply has been offset by bond issuance on a grand scale. They conclude their paper by adding that a strong predictor of overall contraction in credit is when firms cannot tap into the bond market, hence the importance of monitoring the weaker part of the bond market namely the CCC bucket.

Obviously there have been other impacts than loan contraction in Europe when it comes to dis-intermediation and bonds issuance. At least in the US the impact of financial regulation and Volcker Rule has had an impact on liquidity. This is particularly important we think with the rise of passive investing and the growing use of ETFs in the fixed income space. This of course will have serious implications when the markets turn, particularly when one takes into account the "liquidity" factor. On this subject we read with interest Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 25th of August entitled "When the tide goes out":

"When the tide goes out… the unintended consequences of financial regulation are revealed. High grade corporate bond trading has doubled over the post-crisis years (Figure 1).

However, because the size of the market tripled that means the overall market has become less liquid - due to a number of post-crisis changes - including financial regulation and most prominently the Volcker Rule, but also less leverage in the system. For example, while annual trading volumes in the HG corporate bond market were 135% of the size of the market back in 2006, we estimate that statistic is tracking only 86% for 2017 (Figure 2).

However, counterintuitively in this environment, market-based measures of liquidity – such as off-the-run/on-the-run spread premiums are back to pre-crisis levels. This is true for bid/ask spreads as well, although we are no fan of them as measures of liquidity as we have no information on the true cost to trade more than just a small block of bonds. Moreover quality data on bids and asks naturally is concentrated in what is liquid and trades. In contrast liquidity almost by definition has to be measured where there is liquidity risk, which in many market environments is not quoted actively by traders.

Market based measures are back to pre-crisis levels because of the unique post-crisis environment of extremely low global yields that has led to an unprecedented reach for yield in US HG corporate bonds. In recent years, yields have dropped so much that investors have been forced to enhance yields by reaching into normally illiquid off-the-run names and maturities, which naturally compresses the off-the-run/on-the-run liquidity measures. That means liquidity is OK because dealers are happy to use their  lean balance sheets to not only buy liquid on-the-runs that turn over quickly, but also normally illiquid off-the-runs because there is an army of investors waiting to buy them in short order.

In other words, in the post-crisis years the unprecedented reach for yield engineered by global central banks has likely mitigated the unintended consequence of financial regulation, which is diminished liquidity in the corporate bond market. This means everything is OK until it is not. Only when interest rates go up significantly, and we get large outflows, will we see just how illiquid the corporate bond market can be in the new regulatory regime. Initially liquid names and maturities would likely underperform as investors have to sell what they can. Then later when investors find they can no longer sell the vast majority of bonds they own – the off-the-runs – at meaningful prices we get a big widening in liquidity measures. This could get ugly, we think.

Rates vs. liquidity

To illustrate, Figure 3 shows our preferred measure of market liquidity - the percentage difference between credit spreads on 9-year and 10-year bonds (adjusted for the on-the- run curve).

The idea is that on-the-run 10-year bonds are issued and traded actively and are liquid. Then liquidity declines over time and they become off-the-runs. We use the 9-year maturity point for that, as the bonds have not become too illiquid for pricing to be somewhat accurate.

We plot this liquidity premium over time against interest rates to show the normal environment, which we saw for example around the US downgrade and European sovereign crisis in 2011, where there was an inverse relation. In such risk-off environment, Treasuries rally and liquidity dries up. But fast forward and starting in 2015, there has been a strong positive correlation between interest rates and the liquidity premium. The reason for this shift is very simple – as we described above – that interest rates had declined so much that further declines force investors to reach for yield in off-the-runs, while with increasing rates they are able to return to on-the-runs. Hence, the big decline in interest rates has compressed the liquidity premium to pre-crisis levels.

Why, you may ask, did investors not compress the liquidity premium back in 2H12/1H13 when interest rates were also low? Well remember that the dominant investor reaching for yield in US HG corporate bonds nowadays is the foreign investor. Back then, there was still some yield to be had in foreign fixed income (Figure 4) and foreign investors did not have to reach for yield in US corporate bonds (Figure 5).

Of course, with the collapse in foreign interest rates that has changed, and over the past few years foreign investors have had no choice but to buy US corporate bonds. To make things worse, the cost of dollar hedging has risen sharply for foreign investors, due in part to all the foreign buying of US fixed income (Figure 5).

Combined with the decline in US yields that means foreign investors are that much more pressed to reach for yield in off-the-runs." - source Bank of America Merrill Lynch

Obviously when it comes to "liquidity" and credit, when it comes to the supportive "bid", you need to pray the ECB but more importantly the Bank of Japan have your back with their NIRP and QE policies when it comes to "liquid" US credit markets that's a given as per our final chart.

• Final chart - Japanese support for credit - The boys are back in town

As we pointed out in many musings, the bid in US credit has been "Made in Japan". Back in July in our conversation "The Butterfly effect" we indicated that Japan had been heavily supporting US dollar flows but US credit as well. At the time we indicated:

"Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk." - source Macronomics, July 2017.

And even with prolonged US dollar weakness they have been wrong, no offense to their credit team. When it comes to Fixed Income flows, we keep saying this but, matters Japan and matters a lot. For instance we read with interest Bank of America Merrill Lynch Liquid Insight note from the 23rd of August 2017 entitled "Japan's outward portfolio investment resurging; diverging implications":

"Key takeaways

• Japan's outward portfolio investment is resurging led by banks' buying of US and French bonds.
• The rapid increase partly reflects a reversal of earlier unwinding, adding to structural demand for non-yen assets.
• Expect Japan investors to dip buy USD, continue buying AUD & NZD. EUR/JPY demand to remain subdued unless, until a deeper dip

Japan’s outward portfolio investment resurging

Although it may have gone unnoticed as the market has much to focus on elsewhere, the return of Japan’s outward portfolio investment since May has been notable. The purchase of foreign securities by Japanese investors hit a seven-year high on a 13-week base at ¥13.4tn in July (Chart of the day). This came after a period of net selling in the spring when we thought Japanese investors were resorting to a “wait-and-see” stance due to heightened external risks. We explore diverging implications across relevant markets." - source Bank of America Merrill Lynch

When it comes to the support provided by the Japanese investment crowd, which where there in force in 2016, particularly with Lifers, it remains to be seen how long these guys are going to stay in town. Just ensure you have a good view of the credit saloon's revolving doors, because when it comes to "liquidity", as Mark Yusko, Morgan Creek's CIO put it, it's a feeble creature:

"Liquidity is a coward, it only exists when you don't need it..." - Mark Yusko

In the current "Ouroboros" credit game, liquidity seems indeed to be plentiful particularly in the passive investment game, it remains to be seen, if it will be present when the tides goes out...

"The only relevant test of the validity of a hypothesis is comparison of prediction with experience. " -Milton Friedman

Stay tuned!

Macro and Credit - The Dead Parrot sketch

"Fake is as old as the Eden tree." - Orson Welles

We read with interest the latest minutes from the FOMC and in continuation with our previous themes of revivals of defunct model, obviously once again their "beloved" Phillips curve model came to the forefront of their discussions, not only at the Fed but at the ECB as well. Therefore, when it came to selecting this week's title analogy, we could not resist but use a reference to Monty Python's flying Circus Dead Parrot Sketch which first aired on the 7th of December 1969. The sketch portrays a conflict between disgruntled customer Mr Praline (played by Cleese) and a shopkeeper (Michael Palin), who argues whether or not a "Norwegian Blue" parrot is dead. It pokes fun at the many euphemisms for death used in British culture. Obviously, one could be disgruntled at our central bankers and the lack of inflation within their inflation mandate. In the meantime some sell-side pundits and most recently central bankers have continued to discuss if the Phillips curve is "dead" or simply "resting" like a "Norwegian Blue" parrot. We rest our case. We find it amusing that a joke dated c. CE 400, recently translated from Greek, shows similarities to the Parrot sketch. It was written by Hierocles and Philagrius and was included in a compilation of 265 jokes titled Philogelos: The Laugh Addict. Probably yet another case of "barbaric relic" given the affection for gold from our central bankers but we ramble again...

In this week's conversation, we would like to look at the ongoing 2007 party like in credit that keeps going while there is indeed the need to be more discerning (beta wise that is) we think at this stage but first we will take another potshot at the Phillips curve cult members.

Synopsis:

• Macro - The Norwegian Blue parrot really DID exist but not anymore...
• Credit - Smarten your beta
• Final chart - Credit Mad Men

• Macro and Credit - The Norwegian Blue parrot really DID exist but not anymore...

The latest FOMC notes from the July minutes do indicate how puzzled our central bankers have become on the validity and efficiency of their Phillips curve framework. Back in May this year in our conversation "Wirth's law" we discussed the wage conundrum in the US, pointing out that real wage growth had so far eluded the Bank of Japan and are still eluding the United States, hence the dismal prospects for inflation expectations given high qualification jobs in many instances have been replaced by low qualification jobs (yes training matters...). Also, back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own.

Following our recent musings our friend Kevin Muir, the author of the excellent and very entertaining blog the Macro Tourist reached out and asked several questions relating to the Norwegian Blue parrot aka the Phillips curve:

"Hey Martin.  I just your latest two pieces.  I really enjoyed them.  

What is your belief about the Phillips curve?   Is it dead?  Shifted down?  

I know you discussed your views about the mismatch in skills, but the curve does indeed seem to be obsolete.

I know to some extent it doesn't matter what we think- the Fed's reaction function is what matters.  But I am curious about your personal thoughts.  

I am beginning to think that Yellen's training as a labour economist is making her more hawkish than she should be.  As you point out, they think inflation is coming.  So they are tightening.  

I realize you are probably more bearish on the economy than me, so it is easier to say the Phillips curve is not kicking in, and the economy is rolling over, so the point is moot.

But if we get a global economic upswing that drags the US along, will we see real wage growth?  

Thanks, Kev." - source Kevin Muir, author of the Macro Tourist

Of course real wages are that's the most important point for inflation expectations, real wage growth matters and matters a lot. We pointed out a few things to Kevin such as the fact that a business owner is always a "deflationista", in the sense that he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. No offense to our central planners of the world but true capitalism is inherently "deflationist" when it comes to prices. For the simplicity of our reasoning, we are not taking into account oligopolies, cartels and other shenanigans being played these days in many instances (ZIRP, NIRP, etc.). Real prices always fall and inflation is simply organized theft which is willingly pursued and supported by our central bankers, at 2% or even 4% (should they decide to try and fail in tweaking their sacrosanct target).

As well, we pointed out to Kevin the excellent work of (unfortunately little known to so many) French economist Jean Fourastié relating to real wages, real prices and productivity. One particular book comes to mind "Pourquoi les prix baissent - Why prices fall". published in 1984. We do not know if this book is available in English, but, in our humble opinion it is a must read book and should be on the required reading list of any serious central banker or aspiring economist.

For Fourastié, real prices could only be observed by dividing the prices of any product by hourly wages (link in French). The inverse of real prices calculation measures purchasing power parity. What is the most important economic fact in the last 300 years? Most probably the fall in "real" prices for wheat prices with hourly wages on the Y axis:

- source Jean Fourastié

Also in our previous conversation from September 2012 "Pareto Efficiency" we indicated the following when it comes to "wheat prices" and "revolutions":

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

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

When it comes to volatility in wheat prices and the ultimate effect of manipulating prices or when "real" prices become "fake" prices or "manipulated" prices, we reminded ourselves with our May 2016 conversation "When Doves Cry" and the fascinating account on the "assignat" which was a type of a monetary instrument used during the time of the French Revolution (money printing on a grand scale with dire consequences...), in a book written by French economist Florin Aftalion in 1987 entitled "The French Revolution - An Economic Interpretation":

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

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

The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital. With QE becoming a global phenomenon with South Korea's president indicating that the country needs to look at possible 'selective' QE and Negative Interest Rate Policy becoming rapidly the "norm", one might wonder how on earth "capital" is going to continue to be "accumulated", particularly when one looks at negative yielding assets.

To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB. And when it comes to the "ultimate value" of the "assignat" (and the end result with NIRP...), a simple picture clearly display the trajectory of their final value:

  -source Macronomics, May 2016 

Hence the importance of using observable "real prices" and the impact monetary inflation can have on hourly wages and purchasing power when you want to assess the levels of inflation (Venezuela comes to mind...). We also reminded ourselves of Adam Smith's quote in relation to real "price" formation:

"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased." - Adam Smith

But moving back on the subject of the Norwegian Blue parrot, we read with interest Barclays Global Economics note from the 18th of August entitled "Questioning the reliability of the Phillips curve:

"Inflation discussion dominates July minutes

• The FOMC deliberated at length the risks to the inflation outlook, including the effectiveness of its current Philips curve framework in forecasting inflation.
• Although the minutes reveal increased concern about the inflation outlook, we did not sense that the committee is ready to pause rate hikes at this point.
• The committee sounded confident about labor market progress, but financial stability and further easing in financial conditions were a concern.

Three broad themes that stood out from the July FOMC minutes, in our view, are the increased concern among committee members about the inflation outlook; strong consensus that labor market progress has been significant; and worries about financial stability, given easy financial conditions despite monetary policy tightening. Even if the committee may have wanted to strike a balanced tone between its concerns about inflation (which would argue for a more cautious tightening path) and those about financial stability (which would argue for continuing on its path), markets seemed to read the minutes as dovish and lowered the probability of a December hike significantly, from 44% to 36%.

Also notable in these minutes was the change in tone with regards to federal government policy. Earlier in the year, committee members viewed fiscal policy as a potential upside risk to the growth and inflation outlook, but in the July minutes, those expectations were toned down or reversed. A few in the committee pointed out that “the likelihood of near-term enactment of a fiscal stimulus program had declined further or that the fiscal stimulus likely would be smaller than they previously expected,” while several others commented that policy uncertainty (including fiscal policy, trade, and health care) “was tending to weigh down firms’ spending and hiring plans.” This downgrade on the policy front was balanced to some extent by an upgrade of the external sector, as a brighter international economic outlook was seen as boosting prospects for US exports.

We maintain our call for a December hike, but see recent inflation data and the discussion in the FOMC minutes as having lowered the likelihood of its happening. In our view, continued misses on the inflation front would not make it tenable for the FOMC to hike in December. Further disappointment in this front could pause the path for the federal funds rates until the FOMC feels confident that its price stability mandate is within reach.

Some in the FOMC question the validity of its current inflation framework

The committee recognised continued misses on its inflation forecast and suggested that it would likely remain low over the second half of the year. But it also continued to assign much of the recent decline to idiosyncratic factors. While the discussion about the near-term outlook seemed broadly unanimous, there was more disagreement about the medium run. “Many” participants saw risks that inflation would remain below 2% for longer than they currently expected, and “several” saw risks to inflation as tilted to the downside. Similarly, while the committee agreed on the importance of long-term inflation expectations, not all agreed that they remained stable, and “a few argued that continuing low inflation expectations may have been a factor putting downward pressure on inflation”.

But perhaps a bigger surprise came when a number of participants challenged the way in which the Fed analyzes and forecasts inflation. They argued that “much of the analysis of inflation used in policymaking rested on a framework in which, for a given rate of expected inflation, the degree of upward pressures on prices and wages rose as […] employment of resources increased above long-run sustainable levels” – basically, a description of a Phillips Curve (PC) type of framework. A few participants argued that it was not particularly useful in forecasting inflation, while most said it remained valid despite its recent flatness. While we would agree with the latter group, we find the very opening of this discussion as evidence that concerns about the persistent misses on the inflation mandate are starting to weigh on the committee. While many have criticised the PC before, no clear candidate has emerged as a way to analyze inflation in a monetary policy setting, a fact that will, in our view, limit how far this discussion can go within the committee.

Instead, a common theme among policymakers in recent years has been to find exceptions that could have led to a temporary and transitory flattening in the PC. These minutes were no exception, as they listed a number of reasons for the coexistence of low inflation and low unemployment, including less responsiveness of prices to resource pressures (stickier prices), a lower natural rate of unemployment, more slack in the labor markets that may not be captured by the unemployment rate, nominal wage growth and inflation reacting with a lag to labor market tightening, and a loss of firm pricing power from global developments and from technology.

While we do not think the Fed reached the conclusion that its inflation framework was invalidated by the recent softness in inflation, having this discussion at all raises the risk of a shift in the reaction function away from a focus on resource utilization and the PC. But it could also drive the FOMC to look for areas where it may have mis-measured the amount of spare capacity in the economy, for instance in the recent increase in the labor force participation rate of prime age women (see Rising participation among prime age workers, August 11, 2017). As discussed in Wage growth is not as weak as it seems, August 4, 2017, we share the committee’s view that the rate of increase in nominal wages is not low in relation to the rate of productivity growth and the modest rate of inflation. Overall, this shift in emphasis could likely imply fewer rate increases over the forecast horizon, given the weakness in incoming inflation data since earlier this year. We continue to expect an announcement on balance sheet normalization at the September meeting and a third rate increase this year in December, but we have reduced our subjective probability about a rate increase later this year to about 50% (down from 60% previously)." - source Barclays

To be fair to the Phillips curve cult members and also to Monty Python, the Norwegian Blue parrot did really exist as pointed out by a Daily Mail article in may 2008:

"Adding to the absurdity was the fact that parrots - being tropical birds - don't come from Scandinavia.

Or do they? For now, in a development putting the sketch in a completely different light, it turns out that the Norwegian Blue did exist.

Dr David Waterhouse, a fossil expert and Python fan, has found that parrots not only lived in Scandinavia 55million years ago, but probably evolved there before spreading into the southern hemisphere.

His discovery was based on a preserved wing bone of a previously unknown species, given the scientific name Mopsitta Tanta - and now nicknamed the Norwegian Blue.

The dead parrot script, voted Britain's favourite alternative comedy sketch by Radio Times readers in 2004, was written by Cleese and Graham Chapman and first broadcast in 1969.

As he returns the ex-parrot to Palin's pet shop, Cleese is assured it is just resting or stunned, being "tired following a prolonged squawk" and "pining for the fjords".

Cleese bangs it on the counter, trying to wake it up, screaming: "Hello, Mister Polly Parrot! I've got a lovely fresh cuttlefish for you!" But it is definitely expired.

Dr Waterhouse, 29, said of Mopsitta Tanta: "Obviously, we were dealing with a bird that is bereft of life, but the tricky bit was establishing it was a parrot."

He was studying for a PhD at the University of Dublin in 2005 when he visited a museum in Jutland and spotted a fossilised 2in-long humerus - appropriately enough, the funny bone - among bird remains which had been found near an open-cast mine.

Research has now confirmed the bone was part of an upper wing from a bird in the parrot family. Although the mine was in Denmark, the birds would also have lived in what is now Norway."

[ ...]

"However, the Pythons were wrong about one thing...the Blue could hardly have pined for the fjords.

"This parrot shuffled off its mortal coil around 55million years ago, but the fjords in Norway were formed during the last Ice Age and are less than a million years old," said Dr Waterhouse." - source Daily Mail

So dear Kevin, to answer your question we think that the Phillips curve, in similar fashion to the Norwegian Blue parrot did exist but is now simply "resting" in a Monty Python way. Same goes for the ECB's view on the Phillips curve as per Barclays recent note:

"The ECB’s accounts focused on a flat Phillips Curve and financial stability

The ECB’s accounts of the August meeting explored the Phillips Curve relationship in detail. Given the latest data, the accounts “acknowledged the strengthening of the economic expansion and confirmed that the risks to the growth outlook were broadly balanced”. At the same time, the accounts contain a very detailed discussion of the flattening Phillips Curve relationship, including due to labour market reform, hysteresis effects from prolonged high unemployment, the backward looking nature of wages, as well as the deleveraging process in the euro area. Nevertheless, the GC argued that the Phillips Curve relationship likely remained intact, but that “patience, persistence and prudence” were needed as this process would likely take time and be contingent on “very substantial degree of monetary accommodation”. While the statement explicitly mentions firm survey evidence of emerging labour shortages, a decomposition of the euro area wide European Commission survey (Figure 1) suggests that this is mainly driven by Germany (Figure 2), where, despite a 3.8% unemployment rate, wage pressures remain to be seen. Overall, the discussion is in line with underlying inflation on a moderate recovery trend and is unlikely to accelerate in the near term (Euro area inflation: Core improves but doesn't shift gear, 31 July 2017)."

All in all, with "patience, persistence and prudence" like the shopkeeper in Monty Python's sketch, we might see the Phillips Curve come back to life, but for the moment it is pretty much as the Norwegian Blue parrots, they really DID exist - but now they are all 'stiff, bereft of life and ex-parrots'.

This ends our numerous potshots we have taken in 2017 relative to the Dead Parrot aka the Phillips curve. In our credit point below, we have in recent months suggesting rotation towards higher quality credit and also recommended playing more defensively at this stage of the credit cycle while we continue monitoring the trend in credit conditions in particular consumer credit.

• Macro and Credit - Smarten your beta

Back in June in our conversation "Potemkin village", we posited that as the Trumpflation narrative was fading, so was the beta narrative. In fact our tool DecisionScreen told us the same at the time when it came to its signal switching to slightly negative for US High Yield. The aggregated rule we use is made up of the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score) and US GOV 10 year yield (1Y Z-Score). The beta trade is also a function of investors’ perception about the pace of QE. Our central planners might be using a dead parrot for guidance, but, anyone is trying to guess the change of the rhetoric, should the doves finally become hawks in the near term given financial stability matters and matters a lot for this crowd. We continue to remain slightly negative on US High Yield and we monitor closely the shape of the CDX High Yield curve, particularly the front-end, to see whether the curve is starting to flatten or not.

On the subject of smartening your beta we read with interest Barclays US High Yield note from the 18th of August entitled "Choose your Beta Wisely":

"Some of the fear that gripped risk markets due to geopolitical events just a week ago looks to have subsided. But the pick-up in volatility during that episode, has many investors more closely considering the tie between credit and equity markets. On the surface, there appears to be a dislocation between SPX and high yield valuations, but we expect the relationship to revert to its historical beta once the earnings-related volatility subsides.

US HY Still Looks Dislocated Versus S&P 500; Less So Versus Russell 2000

To start in Figures 1 and 2, we simply plot US HY Index spreads versus the S&P 500 ("S&P") and Russell 2000 ("RTY").

While not perfect comparisons, we believe asset allocators and specialists alike often look to the two broader indices to help formulate a first cut opinion on cross-asset performance and relative value. In terms of a short-term signal worth further dissection, we find that US HY spreads look modestly dislocated (wide) relative to its relationship with the S&P since the beginning of 2016. The relationship looks more in line when comparing US HY to the RTY. These findings are consistent with the broader narrative of small-cap equities and other higher-beta risk assets underperforming in August.

What could further explain the divide? Constituents differences and relative sector weightings provide a clue. Among the set of issuers in the High Yield Index, 62 are also in the S&P and 224 are also in RTY, with each group accounting for roughly 18% of par outstanding in the High Yield Index. Not surprisingly, the quality breakdown shown in Figure 3 suggests that the S&P cohort is higher in quality relative to the RTY constituents.

While neither cohort is exactly comparable to the High Yield Index, the quality weights of the High Yield Index align slightly better with the RTY than the S&P, which may help to explain the dislocation seen in Figure 1. That said, higher-quality credits have actually underperformed on a beta-adjusted basis recently, as noted in this week's Tuesday credit call. As a result, we find the magnitude of high yield's underperformance with respect to the S&P somewhat surprising considering that high yield is underweight higher quality.

Figure 4 shows the differences in sector exposures relative to the High Yield Index for both equity index's matched cohorts.

With the exception of energy, the S&P cohort is actually more closely aligned with respect to index weights than the RTY cohort. That said, the S&P's relative underweight with respect to energy has been a key driver of its outperformance relative to both the RTY and US HY in 2Q17, when E&P companies were faced with a litany of issues. However, adjusting for the differences in sector exposures using the weightings of the S&P cohort, we find that the High Yield Index would still have widened by the same 31bp in the aftermath of the recent sell-off despite its outsized energy exposure.

Quantifying How Sensitive Credit Returns Are To Equity Returns Now

While optically, high yield may appear modestly disconnected with respect to the S&P 500, it's worth noting that this relationship is somewhat fickle. In Figure 5, we track the trailing 6-month betas of daily total returns of the US High Yield Index versus the S&P and RTY.

As shown, both have gyrated significantly over time, suggesting that there is not a single best fit to explain the relative performance of credit and equities beyond short periods of time. At the moment, the betas are all generally towards the lower end of their two-year range, though slightly higher for the S&P than the RTY. This likely reflects the relatively more benign macro and volatility backdrop that has persisted for most of the last 12 months now that many of the stresses around weak commodity prices in 2015 and 2016 have become better understood and digested.

While it is true that the credit/equity relationship has been far from stable, it is interesting to note that the High Yield Index has consistently displayed higher sensitivity with respect to the S&P than the RTY. In other words, in order to design a "true" delta neutral portfolio, one would theoretically have to short more units of the S&P than the RTY against a long High Yield Index exposure. Of course, determining the "correct" market neutral hedge ratio is complicated by the changing face of the equity/credit relationship. Nonetheless, using the rolling 1-year historical total return beta to equities as the hedge ratio, we find that the return of the hedged portfolio is closer to zero using the SPX (Figure 6). 

A simple regression of weekly returns of the SPX and RTY against HY returns over the past five years would suggest that high yield displays a marginally better fit with respect to the S&P (R-squared of 36%) than the RTY (33%). Over the past month, however, high yield performance has more or less tracked its beta to the RTY month-to-date total returns through Wednesday's close (0.16x) has been closer to its historical beta to RTY (0.21x). Meanwhile, the ratio of high yield to SPX returns (-6x) suggests that its relationship to SPX (characterized by a total return beta of 0.32x to S&P) has recently broken down. For the reasons stated above, this divergence has less to do with its outsized commodity exposure, and has more to do with idiosyncratic stories and earnings-related volatility. But looking forward, we believe that high yield will perform more in line with its historical beta to the SPX once these concerns subside" - Barclays

Of course it should perform in line with its historical beta to the SPX. It remains to be seen how long US High Yield and the S&P 500 maintain their "elevated" valuation level. This of course, partially depending on the trajectory that will be taken by oil prices in the second part of the year.

As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remain very strong as per the below chart from MacroCharts.pro we also used in the past (data up to the end of July):

Correlation 0.966, R2 0.933, 139 months in sample - source MacroCharts.pro

In case you are asking, it shows you that High Yield, isn't that much of an "alternative" asset class, as put forward by some pundits.

When it comes to credit, defaults and leverage matters but pointing out the "low default rate" in Europe or elsewhere like some pundits do, it is we think "oversimplistic". Leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash we think should you want to play the "hedging" beta game. Just a thought. When it comes to the maddening crowd our final chart displays WPP cds prices move following their profit warning and the warning it delivered for both credit and equity players.

• Final chart - Credit Mad Men

 Our final chart comes from DataGrapple's latest blog entry entitled "Do as I say, not as I do" and displays WPP CDS 5 year price evolution. The comments they made are very interesting from the point of view of credit investors but as well in the light of  WPP's "forward guidance" and the very challenging situation for retail. One might wonder if the situation will be contained...

"WPP blames “Uncertainty and short-termism reducing investment in favor of buybacks/dividends, although market levels lowering attraction” as a reason for the lack of dynamism of the advertising market. Companies are cutting costs to keep dividends & buy-backs very close to 100% of operating profits. At the same time WPP intends “Use of our substantial cash flow to enhance EPS through acquisitions, share buy-backs and debt reduction”. This was not enough to avoid the 10% drop in WPP’s share price today. WPP credit default swap did not react as much. The CDS is only 3 bps wider at 63 bps. Looking at the attached grapple, we see that the credit market is much more cautious on WPP for some time. The CDS is 40% wider than its lows mid-June. The company intends to use cheap debt to increase its net debt to twice its EBIDTA. The uncertainty of WPP’s EBITDA is a new challenge for credit investors. However, today was more an equity story with an interesting analyst presentation with a lot of data. WPP confirmed for instance the stress on the retail sector which is cutting on ads, -3% yoy.
Meanwhile, the credit index market was quiet. The credit index index option market was busier with some investors looking at options rather than outright hedges for the months to come." - source DataGrapple

As we pointed out recently, credit options are still a cheaper way in hedging your credit bets than going outright long the CDS index from a negative carry perspective. Volatility might indeed return in September thanks to additional US political uncertainties and other exogenous factors. It remains to be seen if contrary to the Phillips curve, volatility is not a dead Norwegian Blue parrot after all, we don't think it is but we ramble again...

"What the eyes see and the ears hear, the mind believes." - Harry Houdini

Stay tuned!