Credit - Osmotic pressure

"We want a story that starts out with an earthquake and works its way up to a climax." - Samuel Goldwyn 

Looking at the continued sell-off in Emerging Markets currencies with the Indian Rupee touching a record low level of 65.56 before bouncing back by 2.1%, on Friday the biggest move since June 2012 and the Brazilian Real which continued its slide before bouncing back as well 3.7% to 2.3488 following a 60 billion US dollar central bank pledge, made us venture towards our distant memories, in similar fashion like our previous posts made us revisit our musical souvenirs from the 80's.

Emerging Currencies "tapering" in true MMA fashion since Bernanke started mentioning "tapering" its QE programme, graph source Thomson Reuters Datastream / Fathom Consulting / Macronomics:

So why "Osmotic pressure" as our chosen title you might rightly ask?

This time around, our chosen title is directly linked to capital flows we are seeing, with the outflows from Emerging Markets towards Developed Markets. 

As the Osmosis definition goes:

"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell. In fact, osmotic pressure is the main cause of support in plants. However, if a plant cell is placed in a hypertonic surrounding, the cell wall cannot prevent the cell from losing water. It results in cell shrinking (or cell becoming flaccid)." - source Biology Online.

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

So the reasoning behind our chosen title is linked to our past "biology" classes of course, given since 2009, the effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility.

We did send a warning in June in our conversation "The Daisy Cutter":

"If you think rising yields are only putting global trade at risk, think as well how it will ripple through in various sectors and countries." - source Macronomics 

This is what we envisaged in our conversation "Singin' in the Rain" as well:

"If the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

The mechanical resonance of bond volatility in the bond market started the biological process of the buildup in the "Osmotic pressure" we think and bond volatility has yet to recede. 

The volatility in the fixed income space has remained elevated as displayed by the recent evolution of the Merrill Lynch's MOVE index rising from early May from 48 bps  towards the 100 bps level again, whereas the VIX, the measure of volatility for equities is finally reacting - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Of course, what we have been tracking with interest is the ratio between the ML MOVE index and the VIX which remains elevated from an historical point of view if we look back since October 2000 - graph source Bloomberg:

With VIX picking up, no wonder the ratio between the MOVE index and VIX has fallen from last week 7.06 level towards 6.10 as the contagion in the equities space is finally picking up. Hence, last week our "Fears for Tears" concerns for our equities friend as the "tapering" noise increases as we move towards September.

As a reminder, we started pondering about the potential end of the goldilocks period of "low rates volatility / stable carry trade environment in June:

"As pointed out by Bank of America Merrill Lynch's note stable carry thrives in low rates volatility environment, the recent spike in US bonds volatility has had some devastating effect in high yielding assets:

"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past three years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving their risk premiums to abnormally low levels."

So what we are witnessing right now is indeed "reverse osmosis" in Emerging Markets, and the osmotic pressure which has been building up is no doubt leading to an "hypertonic solution" when it comes to capital outflows in Emerging Markets.

Let us explain:

In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment.

So in this week's conversation, as we moved towards the "interesting" month of September we will revisit some of our thoughts from our conversation "Singin' in the Rain" and look at the risk and opportunities lying ahead.

As a reminder from our June conversation:

"We got seriously wrong-footed by the market's reaction to the "tapering QE" scenario and we still think at some point the Fed will maybe redirect its buying towards MBS, given that rising rates could seriously dent any hope of a "housing recovery" should the move continue at a rapid pace like it has this week."

The "housing recovery is indeed at risk - graph source Thomson Reuters Datastream / Fathom Consulting:

As indicated by Prashant Gopal on the 22nd of August in Bloomberg in his article "U.S. Mortgage Rates Jump to Two-Year High With 30-Year at 4.58%": 

"The average rate for a 30-year fixed mortgage rose to 4.58 percent this week from 4.4 percent, Freddie Mac said in a statement today. The average 15-year rate climbed to 3.6 percent from 3.44 percent, the McLean, Virginia-based mortgage-finance company said. Both were the highest since July 2011.

Homebuyers are rushing to take advantage of historically low borrowing costs before they increase any more. Existing-home sales in July jumped 6.5 percent to the second-highest level in six years, the National Association of Realtors reported yesterday. Those transactions largely reflect closings of contracts signed a month or two earlier, when mortgage rates were just beginning to edge up." - source Bloomberg

From the same article:

"The Mortgage Bankers Association’s index of applications to lower monthly payments fell 7.7 percent in the week ended Aug. 16, the 10th straight decline. A measure of purchases rose 1.2 percent, the trade group said yesterday.

The 30-year fixed mortgage rate is well below its average of about 6.3 percent for the past 20 years, according to data compiled by Bloomberg. The 20-year average for a 15-year loan is about 5.83 percent." - source Bloomberg

Yes but, there is indeed a "convexity issue at play" given the US average Maturity of Fixed Rate Mortgages has been steadily increasing in the last decades - graph source Thomson Reuters Datastream / Fathom Consulting:

 And as our very wise credit friend former head of credit research said on the subject of convexity in June in our conversation "Singin' in the Rain":

"Convexity is a bigger issue in all the pensions + fixed income funds. That's one reason mortgages have been whacked. the Fed will basically have to do a ECB - stop buying USTs and start buying RMBS. But pensions (or Fannie / Freddie) do not hedge MBS with USTs - they do it with LIBOR"

At the time we argued:

"The Fed is likely to step in and actually increase QE to try and hold rates down, because mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3%, we have to agree with our friend that a "new dance" routine from the Fed might be coming." 

Central Banks Assets - graph source Thomson Reuters Datastream / Fathom Consulting:

Why the Fed might indeed increase QE? 

Point number 1:

Because the Fed is facing a raft of sellers and the economy is not as strong as it seems.

For instance, China’s holdings in May were $1.297 trillion, less than the $1.316 trillion reported by the Treasury last month. China’s stake dropped by $21.5 billion in June, or 1.7 percent according to Bloomberg as per Treasury Department data released on the 14th of August. On top of that US Commercial Banks as well have been selling as indicated by Bloomberg Chart of the Day from the 19th of August - graph source Bloomberg:

"U.S. commercial banks are dumping Treasuries at the fastest pace in a decade and boosting loans, helping make the debt securities the world’s worst performers as the economy gains momentum.

The CHART OF THE DAY shows banks’ holdings of U.S. Treasury and agency debt tumbled $34.7 billion to $1.81 trillion in July, the biggest monthly decline in 10 years, according to the Federal Reserve. The level dropped to $1.79 trillion in the first week of August, Fed data showed on Aug. 16. Also tracked are 30-year bond yields climbing to a two-year high. The lower panel records commercial and industrial loans as they surged to $1.57 trillion, the highest since 2008.

Bank sales of Treasuries accelerated after Federal Reserve Chairman Ben S. Bernanke said on June 19 policy makers may reduce the bond-buying program they use to support the economy. Concern the Fed will trim its $85 billion a month of Treasury and mortgage purchases helped send notes and bonds due in a decade or longer down 11 percent in the past 12 months. It was the biggest loss of 174 debt indexes tracked by Bloomberg and the European Federation of Financial Analysts Societies." - source Bloomberg.

Point number 2:

Our "omnipotent" magicians are desperately trying to "bend" the velocity curve and anchor higher inflation expectations. On that note we read with interest Professor Rogoff comments in Bloomberg article by Aki Ito and Michelle Jamrisko on the 12th of August - "Rogoff Saying This Time Different Calls for Reflation":

"Rogoff is espousing aggressive monetary stimulus, even at the cost of moderate price increases. At a time of weak global inflation, higher prices may even help the U.S. economy by lowering real interest rates and reducing debt burdens, he said.

“In more normal times, you’re looking for the central banker to be an anchor against high inflation expectations and to assure investors that inflation will stay low and stable to keep interest rates down,” Rogoff, co-author with Carmen Reinhart of the 2009 book “This Time Is Different: Eight Centuries of Financial Folly,” said in an interview. Now “we’re in this situation where many of the central banks of the world need to convince the public of their tolerance for inflation, not their intolerance.”

G-7 Inflation

Central banks across the developed world are struggling with inflation that’s too low. Consumer price increases in all but one of the Group of Seven economies are currently running under 2 percent, which has become the standard goal in recent years for monetary authorities. Two years ago, deflationary Japan was the only country struggling with below-target inflation."  - source Bloomberg.

The only issue is once the "Inflation Genie" is Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:

“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”

While the recent jump in interest rates, has created an "hypertonic surrounding" in the reverse osmosis plaguing Emerging Markets, it has had some positive effect somewhat for the insurance sector as well as the Auto Industry given that it has provided some relief in terms of "reserve adequacy" for insurers and a relief on "reinvestment rates" to plug the growing gap in pensions liabilities hindering the allocation of capital for the Car industry giants.

As a reminder from our conversation "Cloud Nine": 

"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

But, of course, what matters is indeed the "velocity" of the movement, and the intensity. So far we have avoided a major sell-off in credit. 

As indicated by Megan Hickey and Zachary Tracer in their Bloomberg article from the 1st of August commenting on US insurer's Metlife's results entitled "Metlife Says $10.9 billion of Bond Gain Erased, More Than Crisis", what matters is the pace of the rise in interest rates:

"MetLife Inc., the largest U.S. life insurer, saw $10.9 billion in bond gains wiped out in the three months ended June 30 as interest rates rose, exceeding the decline in any quarter of the financial crisis.

Net unrealized gains narrowed to $20.9 billion on the portfolio of available-for-sale fixed-maturity securities, from $31.8 billion three months earlier. The tumble helped cut MetLife’s bond holdings about 4.8 percent to $356.5 billion." - source Bloomberg

They also added the following comments from a Fitch Ratings analyst:

"Losses tied to deterioration in the creditworthiness of issuers are more worrisome than the more recent fluctuations related to interest rate movements, said Douglas Meyer, an analyst at Fitch Ratings. He said higher rates can help increase investment income at insurers and improve profitability on some products.

“The jump in interest rates, the way we look at it, it has a positive impact on the industry,” he said. “This will provide relief in terms of reserve adequacy, it will provide relief on reinvestment rates.”

An extreme spike in rates of more than 5 percentage points could hurt insurers, he said. Clients might redeem products that offered lower yields, forcing insurers to sell securities at a loss to meet withdrawal demands, he said." - source Bloomberg.

We quoted our fellow blogger and friend Martin Sibileau back in June in "Singin' in the Rain" on the risk ahead for credit:

"If Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau

And as we discussed above, "macro" osmosis has led to "positive correlations". When it comes for risks ahead, we share CITI's Matt King views from his European Credit Weekly, namely that after a pleasant summer for credit, it might be time indeed to continue to reduce exposure to neutral:

"Dominoes

One of my favourite games as a child was always dominoes. No, not the rather tedious business of laying tiles end to end and trying to match up their spots.

Rather, the much more thrilling challenge of creating long and winding lines before knocking them over, and being amazed at the far-reaching devastation which could be caused with a single flick of the finger.

European credit feels at present to us like the last asset in a similarly long chain – seemingly remote from the problem of higher UST yields, almost immune to date to the outflows starting to occur elsewhere, and yet nevertheless with an intricate linkage to other assets which belies its apparent distance.

Ironically, our best guess has been and remains that the domino run will not quite get started in the first place – or, at a minimum, that some benign and omnipotent central banker will reach in to remove a domino or two and stop any run before it reaches us. Our house forecasts show the UST backup abating, show credit spreads remaining tight, and the EM sell-off remaining contained to mid-2014.

Moreover, it is striking just how well spreads have generally performed in the face of the backup in UST yields to date. EM hard currency mutual funds, for example, have lost nearly one-third of the last three years’ cumulative inflows (Figure 2), against which the backup in EM spreads, while notable, is hardly cataclysmic. 

The outflows from credit funds have been tiny by comparison, and in Europe have been almost negligible. Unless outflows pick up very significantly, there is every reason to think € spreads remain resilient." 

Besides, in many respects the risks as we head into September seem rather obvious. Tapering has been extremely well flagged. The Fed minutes suggest it will happen this year, but did not seem overly attached to our view of a September start.

German elections have been talked about a great deal, but seem ever less likely to bring about a significant change in the political landscape. Conscious corporate releveraging seems largely confined to the US. Supply is likely to pick up significantly, but is likely to have been widely anticipated. Above all, we have little sense of any build-up in complacent longs during the summer in the way we earlier feared, as is vouched for by the lack of outperformance of most high-beta names.

And yet despite all this, we still recommend reducing any remaining longs in € credit to neutral." - source CITI

CITI's Matt King also added:

"When playing dominoes, it usually takes a few goes before the run really gets started (unless, of course, you didn’t mean for it to start, in which case there’s no stopping it). Our best guess is likewise that, despite the somewhat precarious lineup, not a great deal happens over the next few weeks, and that spreads trade more or less sideways.

But that’s a bit like leaving the room and hoping that when you come back later you’ll still find all the dominoes standing just as you left them. As those with younger brothers will know, you ought to be okay – but at this point we just don’t think you’re being paid for it." - source CITI

The issue for us is that from a "macro" perspective, if the reverse "osmosis" has truly started and with "positive correlations" still in place, there is indeed not only heightened risk from the continuation of the sell-off in Emerging Markets which could affect Developed Markets in the process, but, exogenous factors with political tensions and agendas could indeed roil further risky asset classes.

The $3.9 trillion of cash that flowed into emerging markets over the past four years has started to reverse, indicative of the "Osmotic Pressure" and "reverse osmosis" process taking place.

As we posited back in June for Emerging Markets:

"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?" - source Macronomics, June 2013, "Singin' in the Rain"

Moving back to our friend Martin Sibileau's June question on "precious metals":

"In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?"

At the time we argued that precious metal had further to fall and they did.

But, as we move towards September and what has already started is a bounce back. In similar fashion to what we confided in our January conversation "If at first you don't succeed...", we have once again put in practice the effect of our magicians ("omnipotent" central bankers practicing their "secret illusions") by starting being long gold miners via ETF GDX and some selected miners as well.

The S&P 500, the US 10 year breakeven, please note we have added Gold into our previous Chart,  graph source Bloomberg:

Once again we have broken our Magician's Oath:

"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

What is the rationale behind our call? We once again come back to our June conversation "Singin' in the Rain" where we quoted David Goldman's article about Gold and Treasuries and bonds in general which he wrote in August 2011 (the former global head of fixed income research for Bank of America):

"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?

 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.

 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

Our thermos bottle is lately behaving accordingly because the YTD movements in 5 year forward breakeven rates is falling again, which is indicative of the strength of the deflationary forces at play - source Bloomberg:

The 5 year forward breakeven was at 2.56% on the 21st of August but it has been breaking lower as per the most recent reading - graph source Thomson Reuters Datastream / Fathom Consulting:

QE and the US Dollar - graph source Thomson Reuters Datastream / Fathom Consulting:

Dollar index versus Gold - graph source Bloomberg:

So far we have bought the put leg of the put-call parity strategy and we are indeed thinking of adding the call leg shortly. That's all for magic tricks. We enjoy your company, dear readers, but we should not be breaking our Magician Oath too often as you haven't sworn to uphold the Magician's Oath in turn yet...

On a final note, in true Pareto efficient economic allocation, while some pundits wager about simultaneous developments having contributed to the weakness in Emerging Market equities, for us Emerging Markets have been simply the victims of currency wars ("Have Emerging Equities been the victims of currency wars?"), "Abenomics", and of course "reverse osmosis" courtesy of positive real interest rates in the US. It is therefore not a surprise to see that the biggest beneficiary of "reflationary"policies have indeed been the Japanese as displayed in Bloomberg's Chart of the Day from the 22nd of August displaying the Earnings Per Share for 6 regions:

"Prime Minister Shinzo Abe’s policies to lower the yen and end deflation are already paying off for corporate earnings, with Japanese companies’ profits outpacing the rest of the world.

The CHART OF THE DAY shows earnings per share in six regions tracked by Bloomberg rebased to 100 at the end of June 2011. Profits for the Topix climbed the most, rising 32 percent as companies in Japan’s equity benchmark recovered from the March 2011 earthquake that damaged large parts of the country’s north east. The lower panel of the chart shows the yen’s decline against nine other world currencies.

“Japan has been through a full earnings cycle over the past two years,” said Mert Genc, a London-based strategist at Citigroup Inc., which composed the graph. “First, largely as a result of the earthquake, earnings halved. But then they doubled again, with the latest boost coming from weakness in the yen and improving economic performance.”

Japanese exports jumped by the most since 2010 in July, showing the economy has benefited from the yen’s 22 percent slide against the dollar since the end of 2011. Earnings in the U.S. have climbed 16 percent since June 2011 as the Federal Reserve’s bond-purchasing program helped to stimulate growth. Profits in the U.K., the euro area, emerging markets and Australia have declined in the same period.

Analysts estimate earnings in the Topix will grow 11 percent in 2014, according to Bloomberg data, in line with the average for the other regions in the chart of the day." - source Bloomberg.

The MSCI Emerging Markets Index has declined 12 percent this year, compared with a 12 percent gain for the MSCI World Index of companies in advanced economies.

"Remember, the storm is a good opportunity for the pine and the cypress to show their strength and their stability." - Ho Chi Minh 

Stay tuned!

Credit - The Dunning-Kruger effect

"The truest characters of ignorance are vanity and pride and arrogance." - Samuel Butler, British poet

Watching with interest the impressive volatility in the bond space which has yet to normalize, we thought this week we would use a reference to human psychology in our reference title, given so far our "Central Bankers" mind tricks (call them jedi skills if you want) seems to differ widely, between the Fed and Bank of Japan, between the Bank of England and the Reserve Bank of Australia, and the ECB of course.

For those who have been following us, you know that like any good cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. 

So why our chosen title you might rightly ask?

"The Dunning–Kruger effect is a cognitive bias in which unskilled individuals suffer from illusory superiority, mistakenly rating their ability much higher than average. This bias is attributed to a metacognitive inability of the unskilled to recognize their mistakes" - source Wikipedia

When one look at how central bankers have been previously apt in preventing formation of asset bubbles or identifying asset bubbles, one can easily be drawn to the Dunning-Kruger effect given that ignorance of standards of performance is behind a great deal of incompetence.

Of course we are not surprised to see the Dunning-Kruger effect at play, given it is a continuation of the "Omnipotence Paradox" of our central bankers or deities:

"In similar fashion, the financial crisis and the consequent burst of the housing bubble which had taken aback the beliefs of some forefront central bankers such as Alan Greenspan; have clearly shown that Central Banks are not omniscient either (omniscient being the capacity to know everything that there is to know).

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief." - Alan Greenspan -  October 2008." - Macronomics, 18th of November 2012.

In the Dunning-Kruger effect, for a given skill, incompetent people will:
"1.tend to overestimate their own level of skill;
2.fail to recognize genuine skill in others;
3.fail to recognize the extremity of their inadequacy;
4.recognize and acknowledge their own previous lack of skill, if they are exposed to training for that skill." - source Wikipedia

In continuation to our "Omnipotence Paradox" conversation,  we believe this time around that the Dunning-Kruger effect can explain the failures of some economic school of thoughts, namely the Keynesian school of thought and the Monetarist School of thought. We have argued in our conversation "Zemblanity", when looking at the evolution of M2 and the US labor participation rate that both were indicative of the failure of both theories:

"Both theories failed in essence because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows"."

"Credit growth is a stock variable and domestic demand is a flow variable" as indicated by Michael Biggs and Thomas Mayer in voxeu.org entitled - How central banks contributed to the financial crisis.

Obviously one can posit that not only do our central bankers suffer from the Dunning-Kruger effect but they are no doubt victim of the well documented "optimism bias" which we discussed in our "Bayesian Thoughts" conversation:

"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."

Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

We have on numerous occasions discussed shipping as being not only a leading credit indicator (with the collapse in European structured finance) but as well a leading economic growth indicator (on that subject please refer to "The link between consumer spending, housing, credit and shipping"), in our "Bear Case", excess capacity and a weak global economy with a China slowdown will drive rates down even with price increases, pressuring margins - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark rose 21.8% to $2,236 in the week ended July 3, as a $400 rate increase went into effect. Rates are 11.2% lower yoy, as slack capacity pressures pricing. With four increases in 2013, rates are up 1% ytd. Carriers are expected to implement a $400 peak season surcharge ahead of back-to-school and holiday shopping on containers from Asia to all U.S. destinations, effective Aug. 1." - source Bloomberg.

Not only slack capacity are pressurizing pricing in the shipping space but in general, we have long argued that overcapacity has been plaguing various economic segments such as the car industry with European car sales back at 1993 sales levels (on that subject see our 21st of April "European Clunker" conversation), but with the incoming threat of a China slowdown or even hard landing, metal prices such as Aluminum prices are indicative as well of the great deflationary forces at play and the overcapacity fuelled by "cheap credit" (the Baltic Dry reached 11,783 on May 20, 2008 and is now at 1103) - graph source Bloomberg:

"Aluminum prices, which have fallen for three straight quarters, may be poised for further declines as new production in China and the Middle East increases global output even as Alcoa Inc. trims capacity.
The CHART OF THE DAY shows production has gained 5.1 percent since the end of 2011, helping drive prices down 9.3 percent, according to data from the International Aluminium Institute. Output will reach a record near 50 million metric tons this year, up from 45 million in 2012, Harbor Intelligence forecasts.
“The market is still looking at over-capacity, over-production and an unprecedented overhang of metal,” said Jorge Vazquez, a managing director at Austin, Texas-based Harbor. “There’s a lack of credibility for the producers, and even if these cuts take place, investors expect nothing to change.” Alcoa, Aluminum Corp. of China Ltd. and United Co. Rusal, the world’s largest producer, are among companies trimming capacity amid ample supplies. The price outlook remains “depressed” as some investors are concerned that producers won’t follow through on planned cuts and amid the prospect of new and expanded plants and restarts at some older sites, Vazquez said.
Aluminum for delivery in three months on the London Metal Exchange dropped 12 percent this year to settle at $1,832.50 a ton yesterday. The metal may fall to $1,675 in the next few weeks said Vazquez, who expects supply to exceed demand by 350,000 tons in 2013 for a seventh straight year of surplus." - source Bloomberg.

Of course our "omnipotent" central bankers "fail to recognize the extremity of their inadequacy" in true Dunning-Kruger effect as far as "cheap credit" and "bubbles" implications are concerned. They have even come up with a new marketing campaign as of late "forward guidance" in Europe.

Forward Guidance:
"Forward guidance arms central banks with fresh ammunition even when they have lowered short-term interest rates close to zero. It allows them to influence not just current rates but those stretching into the future through pledges to keep them low. The forward guidance can be for a period of time or it can be linked to specific indicators, such as an unemployment-rate threshold (which is not, however, a trigger) in the case of the Fed." - source The Economist

Fresh ammunition? Yet another demonstration of the Dunning-Kruger effect at play we think. Thank god, our "central bankers" are not in the guide dog training business to lead blind and visually impaired people around obstacles...
"Forward Guidance" might be as effective as using a "Yorkshire Terrier" as a guide dog, instead of the usual Labrador retriever. The "Yorkshire Terrier" could be trained to do the job, but would they really be effective? We wonder and ramble again.

Unemployment-rate threshold? As we have argued in "Goodhart's law":
"Conducing monetary policy based on an unemployment target is, no doubt, an application of the aforementioned Goodhart law. Therefore, when unemployment becomes a target for the Fed, we could argue that it ceases to be a good measure." - Macronomics, 2nd of June 2011

In this week's conversation, we would like to focus our attention to the "Bail-in" effect and the recent clarifications made surrounding financial subordinated debt instruments which have long been a pet subject of ours ("Subordinated debt-Love me tender?") given the "Bail-in" conversations which took place on the 26th of June (BRRD) which we touched last week, will have as well  "ripple" effects in the subordinated credit space but first our market overview.

The US dollar still rising against one of the most impacted asset commodity classes since the beginning of the year namely gold - graph source Bloomberg:

The greenback is still benefiting from the surge in bond volatility which has yet to recede.

The "Daisy Cutter" effect as displayed by the evolution of the Merrill Lynch MOVE  index, which is still showing sign of high volatility in the fixed income space as witness this week and CVIX indices closely followed by the recent rise in the VIX index - graph source Bloomberg:

No wonder interest rate sensitive asset classes such as Investment Grade Credit and High Yield are as well suffering from the increased turbulences as displayed by the price evolution of the most liquid and active ETFs in the credit space namely the LQD (Investment Grade) and HYG (High Yield) ETFs, graph source Bloomberg:

In the HY Fixed Income space HYG (iShares $ High Yield Corporate Bond, Expense Ratio 0.50%) has lost $1.78 billion year to date in terms of net redemption flow.

In terms of weekly allocation trends, bond market outflows have jumped in the week of the 27th of June until the 3rd of July as reported recently by Nomura's Fundflow insight published on the 5th of July:

"Asset allocation trends: Bond market outflows jumped/money market turned to inflows
- Bond market: -USD28.1bn vs -USD8.0bn in the previous week
- Money market: +USD7.7bn vs -USD25.1bn in the previous week
For the week ending 26 June, the bond market reported outflows for the 4th week in a row — the longest streak since August 2011. Despite bond market outflows easing slightly in the week before, the latest outflows jumped more than 3x to USD28.1bn from USD8.0bn in the previous week. In contrast, the money market turned to mild"- source Nomura, Fundflow insight, 5th of July 2013.

With the recent surge in both US Treasury yields courtesy of a better than expected Nonfarm payroll number coming at 195 K and in oil prices thanks to increased tensions in Middle-East, we wonder how long equities  in general and the S&P in particular will stay immune from the growing nervousness - graph source Bloomberg:

The latest "Forward guidance" European marketing stunt is no doubt meant to prevent a dramatic repricing in the European government space and avoid the trigger of the much "hyped" OMT. The volatility jitters in the bond space, have led to a surge in European Government Bonds yields in the process as indicated in the below graph with German 10 year yields rising towards the 1.70% level and French yields now around 2.30% - source Bloomberg: - graph source Bloomberg:

Of course our "omnipotent" central bankers in Europe had to come up with another playing trick up their sleeves, given as we indicated in last week's conversation, contagion risk is now bigger than ever and the customer/investor security system is now weaker than ever because the LTROs have encouraged banks to increase even more their holdings of government debt to fund fiscal deficit, making them in the process even more "Too-Big To Fail". Yet another demonstration of the Dunning-Kruger effect.

The issue of course is "convexity", given the debt levels for both the private sector and the public sector are high in most developed countries meaning their economies are now even more sensitive to interest rate risk courtesy of global ZIRP! The more sensitive their economies get, the more solvency risk you have, the greater the risk of a sudden spike of defaults you get in a low yield environment with surging yields.

Back in November 2011, we posited the following in our conversation "Complacency":
"In a low yield environment, defaults tend to spike. Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation."

"Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - Morgan Stanley - "Understanding Credit in a Low Yield World.


Moving on to the subject of the "Bail-in" factor and the financial subordinated credit space, given it has gathered much attention in the bank credit analysts sector as of late with very diverging views on the future for legacy subordinated Tier 1 securities, a subject which warrants some attention.

For instance Morgan Stanley on the 25th of June, in their European Banks note entitled "Get Ready: Regulatory Rating Par Calls Soon" argued the following:
"We have long been cautious on high cash price regulatory and rating par calls (see Reg Par Calls:
Closer, October 12, 2012, and The End of RAC Tier 2, April 2, 2013). The finalisation of CRD IV and S&P’s decision on RAC methodology mean possible calls are weeks away.
About 60 Tier 1 bonds have reg par call language (RPC) in our space, which means that if regulations change and bonds lose their Tier 1 regulatory status, they can be called at par. More than half of these RPC bonds are currently trading above par, leaving scope for significant downside from here.
Deutsche could be the first RPC next month… As we believe it will be able to trigger the reg par call of its €9.5% and €8% retail prefs as soon as CRD IV/CRR is published in the Official Journal of the EU, on June 27, which marks the end of the legislative decision-making process. At current levels, the yield to call in, say, a month is -26% for the €9.5% and -37% for the €8%. Bondholders risk losing up to 8 points in a day if the RPC is exercised.
… affecting all RPC bond pricing negatively, in our view. The language of nearly all other RPC bonds is far less clear than Deutsche’s, and such ambiguity could bring legal challenges many of these issuers (if not all) would not want to risk. However, particularly in today’s kind of market, we believe that many holders will simply take fright and it’s hard to say how much above par any bid might be, following a potential par call by Deutsche." - source Morgan Stanley

We were quite baffled by Morgan Stanley's note given we have been watching liability management exercise for a while in the European banking space and we completely disagree with their take on Tier 1 securities trading way above par that could be rapidly called by their issuers. For us, it doesn't make sense as we indicated in our conversation "The Doubt in the Shadow" on the 23rd of March 2013:
"Banks may have an incentive to buy back non-compliant Basel 2.5 hybrids that do not qualify as regulatory capital under Basel 3. To the extent that such "liability management exercises" can result in debt being repurchased at a discount to par (well below a cash price of 100), banks are able to generate common equity Tier 1 (CET1) gains. On that subject see our October 2011 conversation "Subordinated debt-love me tender?"."

Our views have been comforted by Bank of America Merrill Lynch note entitled "Bail-in: the ripples" from the 1st of July:
"Reg par calls – still a no-no?
The new need to have a bail-in buffer if anything supports the idea that the banks need to hold onto their existing subordinated debt and would be ill-advised to rush to redeem it, even if it optically appears to be expensive. The work we have presented on the need for bail-in buffers only underlines that European banks need to retain and rebuild capital, not redeem it, in our view. Why would a regulator permit the calling of an old Tier 1 bond just because it was ‘expensive’ to the bank? We think the emphasis on retaining capital until the banks are more comfortably positioned will remain for the foreseeable future so our base case remains: No reg par calls." - source Bank of America Merrill Lynch.

Morgan Stanley is putting the cart before the horse and we also agree with the below extract from Bank of America Merrill Lynch note:
"European banks’ need to retain and rebuild capital not redeem it. Why would a regulator permit the calling of an old Tier 1 bond just because it was ‘expensive’ to the bank? They would wish to see such a bond being replaced. If we were regulating the banks, we’d also like to see the banks issued the replacement capital prior to our allowing them to call the old." - source Bank of America Merrill Lynch

On top of that it seems to us Morgan Stanley's is not taking into account earnings boosting technique of FAS 159 which allows banks to book profits when the value of their bonds falls from par, meaning for us, that banks will be encouraged to issue more loss absorbing subordinated debt rather than reduce their buffer to avoid having senior unsecured bondholders or unsecured depositors paying the piper like it happened in the Dutch SNS case in the first instance due to lack of deliverables for the CDS trigger, and in the second case like it happened in Cyprus due to lack of sufficient subordinated and senior unsecured bonds buffers.

So what is the "ripple" effect of the latest "Bail-in" discussions for senior debt and legacy subordinated debt?
"But this brings us to the ripple effect: if banks need to focus on building this buffer, we believe it will prima facie entail potentially some new sub or bail-in bond issuance.
What about retaining the existing subordinated stock though where it is evidently cheaper than issuing new stuff? We are thinking particularly of low-back end Tier 1 bonds but there are also fixed-to-float UT2s and arguably even the dated LT2s too. It makes sense to keep these outstanding forever, arguably, or at least until such a time that the spreads on e.g. bail-in bonds are comparable to those low back-ends (which may, equally, be never of course). 
This is a totally separate discussion to whether the bonds in question are included in regulatory capital. Eventually, very little of the old stock of Tier 1s, Upper Tier 2s and Lower Tier 2s should there be any long-dated enough will ‘count’ as regulatory capital. But there is a role now for all these instruments in the liability buffer above own funds that perhaps they didn’t have before last Thursday. What sense for Credit Agricole to call the €4.13% Tier 1 bond with a back-end of +165bp? Or for BNP to call the US$5.186% bond with a back-end of +168bp? How to justify retiring these bonds which are subordinated and – indeed – loss absorbing – to expose senior bondholders to potential losses? A call of these bonds would look like negligence to us, if it increased the risk that senior bondholders would be bailed-in." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch's take on the subject. From a regulatory perspective and in relation to increasing capital buffers, previous bond tenders have shown that there is a greater call risk with low back-end bonds (convexity issue) and those trading below par:
"In most cases, that CRD 4 is now European Law. It must be domestic law too. It will take several countries some time to put CRD 4 into their own law. So in most cases, there is no immediate threat of a reg par call because there isn’t even the legal basis yet for one." - source Bank of America Merrill Lynch

What is the risk for senior unsecured bondholders and the implication of having low subordinated bond levels buffers for some European banks?
Here is Bank of America Merrill Lynch take on the subject:
"If banks don’t build up their buffers and appear to have no intention to either, then their senior will widen towards their sub and the sub-senior curve (in cash) will flatten at wider levels, mutatis mutandis, we think. Current CDS contracts may not be a reliable indicator of this of course, since they are locked in their own technical until the new contracts come into being in September" - source Bank of America Merrill Lynch

We could not agree more. Of course current CDS contracts are not yet reliable indicators of this risk until the much anticipated need to revamp CDS contracts in September. For more on the importance of this issue please refer to our conversation "The Week That Changed The CDS World" from the 26th of May.

So all in all, Morgan Stanley as put the horse before the cart, and in the case of financial subordinated bonds has even jumped the gun as indicated by a JP Morgan's note from the 5th of July entitled "Tier 1: Upgrade to Overweight":
"The clarification that legacy Tier I instruments will not be eligible as Tier II capital under transitional arrangements will be an undoubted positive for valuations as this will increase the certainty of call being exercised. Whereas previously our assumption was that the Tier I instruments would be eligible as Tier II capital, making the decision to call such instruments dependent on the relative cost of issuing Tier II capital instruments, the fact that the legacy Tier I instruments will not have any regulatory capital value will imply that it will merely be a question of comparing the post-call spread on the instrument versus the cost of senior funding. Under these circumstances, we assume that the issuers will have much lower incentives to maintain these instruments outstanding and as such, the certainty with regard to call has to increase. This would also be applicable for issuers such as DB which in the past have used economic rationale to justify the calling or not of Tier I instruments." - source JP Morgan

On a final note, we have always lacked conviction in the great rotation story from bonds to equities which has been put forward since the beginning of the year. As displayed in the below graph from Bloomberg, the rotation to stocks from bonds has been indeed less than great, so has been QE to the "real economy" courtesy of the Dunning-Kruger effect:

"Anyone who expects U.S. individual investors to push stocks higher by moving away from bonds may end up disappointed, according to Vadim Zlotnikov, Sanford C. Bernstein & Co.’s chief market strategist.
The CHART OF THE DAY illustrates how Zlotnikov drew his conclusion, presented in a report yesterday. He tracked the value of equities, owned directly or through funds, as a percentage of household financial assets. Stocks were 39 percent of assets at the end of March, according to data that the Federal Reserve compiles quarterly. The figure was the highest since 2007 and surpassed an average of 29.2 percent since 1950, as shown in the chart. “U.S. households’ exposure to equities is already above historical levels,” the New York-based strategist wrote. “With rates likely to rise over the next 12 months, the case for a rotation from bonds into equities may become less compelling.” Average inflation-adjusted returns on U.S. stocks are negative 2.3 percent a year when bond yields increase at an annual rate of more than 1.3 percentage points, he wrote. The calculation is based on performance from 1871 through April of this year.
Betting against stocks with relatively high dividend yields may pay off as rates increase, Zlotnikov wrote. These shares are 20 percent more expensive than their industry peers on average when judged by ratios of price to book value, or the value of assets after subtracting liabilities, the report said." - source Bloomberg

"Real knowledge is to know the extent of one's ignorance." - Confucius

Stay tuned!

Credit - The Daisy Cutter

"A credit rating is no substitute for thought" - Jens Weidmann - President of Bundesbank

Looking at the on-going volatility in the credit and fixed income space, courtesy of the tapering / non-tapering discussions, we thought this time around we would venture towards military ordnance analogies for our chosen title, namely the BLU-82B, a 15,000 pounds (6,800 kg) conventional bomb nicknamed "Daisy Cutter" in Vietnam for its ability to flatten a forest into a helicopter landing zone. One just need to look at the devastating effect of the "QE Tapering Bomb" aka the Daisy Cutter (to prepare for an eventual QE "helicopter  Ben" landing zone), has had on financial markets which flattened in a single month the YTD fixed income gains in many different asset classes, to see the appropriatness of our chosen title. While originally the "Daisy Cutter" was used during the Vietnam war to clear helicopter landing zones, later, bombs were dropped as much for their psychological effect as for their anti-personnel effects, but we digress slightly. On another note China did as well drop its own "Daisy Cutter" which had similar devastating effect on "feral hogs"...

The "Daisy Cutter" effect as displayed by the evolution of the Merrill Lynch MOVE  index, which has been  slightly receding and CVIX indices closely followed by a rise in the VIX index albeit more muted - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

In this week's conversation, we would like once again to point out the deflationary forces at play, given the "Daisy Cutter" explosion has indeed created a worrying trend, namely rising yields and a rising dollar, which could have some greater implication down the line and also the evolution towards a European Banking Union  following the discussions which took place this week in Brussels. But first our usual market overview.

We have long argued that France should be seen as the new barometer of Euro Risk, looking at the data that keeps coming out of France, it is increasingly becoming evident to us that things will get much worse than anticipated by the current French government when one looks at the level reached by consumer confidence in France, at the lowest level since 1974 - graph source Bloomberg:

This lack of confidence no matter how "improved" the recent PMI Manufacturing and for Services look like, doesn't bode well for rising consumption levels, in particular with a continued surge in unemployment levels.

France unemployment rate at 11% versus Germany at 6.90% - graph source Bloomberg:

Not only France's economic growth prospects face serious headwinds with rising unemployment and lack of consumer confidence, the "Daisy Cutter" has also led to some serious repricing of government bonds in Europe leading to some higher yields going forward for government issuance.

The volatility jitters in the bond space, have led to a surge in European Government Bonds yields in the process as indicated in the below graph with German 10 year yields rising towards the 1.70% level and French yields now around 2.30% - source Bloomberg: - graph source Bloomberg:

What we found of interest as of late has been the repricing in the fixed income space which has left no bonds or bucket immune as witnessed by the significant rise of the Swiss 30 year bond yields which had remained fairly muted throughout 2012 versus the 30 year Japanese bond yields - graph source Bloomberg:

As far as global deflation is concerned, and in relation to Japan, another indicator we have been closely following has been the 30 year Swiss bond yields which had been nearly 100 bps lower than Japan 30 year bond yields throughout 2012 until the recent "Big in Japan" bang moment following the Bank of Japan "all in" move.

The "Daisy Cutter" explosion has also created a worrying trend, namely rising yields and rising credit spreads, indicative of a repricing of credit risk. For instance, the Itraxx Senior Financial 5 year CDS index has been rising in conjunction with the German 10 year yield, leading to a significant weakness in the Investment Grade space, with high beta financials (subordinated financial bonds and peripherals) taking the brunt of the widening move - graph source Bloomberg:

While the big beneficiary of the latest sell-off courtesy of the "Daisy Cutter" has been the US dollar, one of the most impacted asset commodity classes since the beginning of the year has been gold as of late - graph source Bloomberg:

As we discussed last week in our conversation "Singin' in the Rain" on why gold prices had further to fall (and they did) was as follows:

"To answer our friends Martin Sibileau's questions commodities have further to fall including gold.

Why? 

Gold is not an inflation hedge; it is a hedge against the end of the dollar’s status as a reserve currency, a deep out-of-the-money put against the US currency as a whole, ("The Night of the Yield Hunter" - Macronomics)."

What the falling gold prices are indicative of is that, like we posited in "The Night of the Yield Hunter", is that no matter how much liquidity has been injected (remember Fisher's equation - MV = PQ. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.), the Fed has failed in igniting inflation to offset the decline in velocity. The Fed's expanding balance sheet has failed in stoking inflation expectations as displayed in the below Bloomberg graph:

"The CHART OF THE DAY shows gold prices surged 90 percent in the four years through 2012, moving in tandem with increased debt purchases by Fed policy makers. Bullion in New York has dropped 20 percent this quarter, heading for a record loss, even as the central bank’s balance sheet reached an all-time high. Consumer prices climbed 1.1 percent in the 12 months through April, according to a measure watched by the Fed that excludes food and fuel -- matching the smallest increase since records began in 1960. The speed at which money changes hands, measured by the U.S. economy’s supply of cash and equivalents known as M2, is the least in records going back to 1959, according to data compiled by Bloomberg." - source Bloomberg.

As far as Gold is concerned, we agree with the recent note from Nomura from the 26th of June entitled "Golden sell-off":

"On a longer-term basis, we think that gold is in the later stages of a fall and indeed, it is edging towards the mining cost of gold. We think that Asian buyers are likely to come into the market at some point as well, when the dip in gold prices becomes sufficiently large. This should eventually offer support as well. However, because of the change in market dynamics following the FOMC meeting, longer term we think that the size of any recovery in gold prices once flows turn is likely to be comparatively small." 

- source Nomura

In the previously mentioned conversation from April this year we added the following comment:

"We think there is currently an accumulation of worrying signs that the global economy is decelerating and that old left hand deflation has indeed a solid grip when one looks at China's shrinking electricity use, a bearish sign for a price index of industrial metals that, according to Bloomberg, has posted a first-quarter decline for the first time in 12 years"

Container rates, which we follow, have dropped 6.2% to the lowest level since March 2012 - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark fell 6.2% to $1,836 in the week ended June 26. Below the $2,000 mark for the fourth straight week, rates are at their lowest since March 2012 ($1,771). Even with three increases, rates are down 17.1% ytd, as slack capacity pressures pricing. Carriers are expected to raise rates by $400 on containers from Asia to the U.S. West Coast, and by $600 to all other destinations, effective July 1." - source Bloomberg.

So our "Daisy Cutter" explosion has indeed created a worrying trend, namely rising yields and a rising dollar with rising container rates and weaker global demand, a recipe that could spell for default for weaker container shipping companies already strained by weaker demand.

If you think rising yields are only putting global trade at risk, think as well how it will ripple through in various sectors and countries.

For instance, as reported by Frances Schwartzkopff in Bloomberg on the 26th of June in her article "World's Most Indebted Households Face Rate Pain":

"Danish consumers, who owe banks more than three times their disposable incomes, are about to find out how sustainable that debt load is as interest rates rise. Signals from the U.S. Federal Reserve that it’s preparing to scale back monetary stimulus have already sent mortgage costs higher as yields rise across global bond markets. The Nykredit Index of Denmark’s most traded mortgage bonds sank this week to its lowest in more than four months after investors sold assets once coveted for their haven status." - source Bloomberg.

Danish households owed 310 percent of disposable incomes in 2010, government debt is less than half the euro-zone average at only 45 percent of gross domestic product this year, the European Commission estimates.

On top of that, Student-Loan Interest Rates are set to double next week because the US Congress will act in time to prevent the rate hike as indicated by James Rowley and Caitlin Webber in Bloomberg on the 26th of June in their article "Student-Loan Interest Rates Set to Double as Fix Eludes Congress":

"About 7 million undergraduates borrow for college using the subsidized loans, for which the government pays the interest while these students are in school. Students must show financial need to qualify for these loans.

The rate for unsubsidized Stafford loans is already at 6.8 percent; those loans are available to any undergraduate, regardless of financial status, and to graduate students who are no longer considered their parents’ dependents. Students with unsubsidized loans pay monthly interest while in school; if they don’t, their interest charges during that time are added to their loan balance. Both subsidized and unsubsidized loans are taken out annually and are based on anticipated costs for the next academic year." - source Bloomberg

Finally rising mortgage rates and the recent REIT rout are likely to curtail the number of property purchases as indicated by Brian Louis in Bloomberg on the 26th of June in his article "REIT Rout Seen Curtailing Deals as Rising Rates Cut Share Sales":

"Property purchases by U.S. real estate investment trusts are likely to be curtailed after almost $36 billion of deals this year as a tumble in share prices makes a key source of capital costlier.

The Bloomberg REIT Index has dropped 11 percent from an almost six-year high in May as the yield on 10-year Treasury notes surged amid speculation the Federal Reserve would reduce bond purchases, which have kept borrowing costs low. The decline was three times the slump in the Standard & Poor’s 500 Index.

Just five U.S. property REITs have sold shares this month, down from 14 in May and eight in April, according to data compiled by Bloomberg, and Tom Barrack’s house-rental trust Colony American Homes Inc. postponed an initial public offering in early June. Because federal tax laws require REITs to distribute most of their earnings to investors through dividends, the companies rely on stock and debt sales to raise money for real estate purchases." - source Bloomberg.

From the same article:

"A decline in deals may limit a rebound in commercial-property values. A Green Street index of prices, compiled from estimates of REIT holdings, had recovered all of its losses from the real estate collapse and as of May was 4 percent higher than its previous peak in August 2007.

With bond yields low, REITs have been an attractive investment alternative with their higher, steady returns -- an advantage disappearing with rising interest rates. Since REITs rely on the equity and debt markets to raise money for acquisitions, they are vulnerable to jumps in interest rates. They have access to capital through credit agreements that they can use for short-term funding obligations, said Keven Lindemann, real estate group director at SNL Financial in Charlottesville, Virginia." - source Bloomberg.

The Bloomberg single-tenant index has dropped 19 percent since May 21, and the health-care REIT index has slumped 16 percent with Mortgage rates for 30-year surging to 4.46%, the highest in two years and the biggest one-week increase since 1987. Bonds tied to mortgages are on track to be the worst in almost two decades, such as Fannie Mae’s 3 percent, 30-year securities fell about 0.2 cent on Friday to 97.6 cents on the dollar as of 11:19 a.m. in New York, down from about 103 cents on March 28, according to data compiled by Bloomberg. A Bank of America Merrill Lynch index tracking the more than $5 trillion market lost 2 percent this quarter through yesterday, the most since the start of 1994. The shock and awe tactic of dropping a "Daisy-cutter" bond on pure beta plays. 

Oh well...

All in all the Daisy-Cutter Fed bomb has had "unintended consequences" which are yet to ripple on a global basis in the coming weeks and months, but has already been devastating in the fixed income space as reported by Bloomberg on the 27th of June in their article "U.S. Bond Funds Have Record $61.7 Billion in Redemptions":

"U.S.-listed bond mutual funds and exchange-traded funds saw record monthly redemptions of $61.7 billion through June 24 amid signs the country’s central bank may scale back its unprecedented stimulus.

The redemptions surpassed the previous monthly record of $41.8 billion, set in October 2008, according to an e-mailed statement by TrimTabs Investment Research in Sausalito, California. Investors withdrew $52.8 billion from bond mutual funds and $8.9 billion from ETFs during the period, said Richard Stern, a spokesman for TrimTabs." - source Bloomberg

This is why we pondered the following in our last conversation "Singin' in the Rain":
"If the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

Already some countries have had to take drastic measure to preserve their balance of payments, for instance Vietnam's central bank just devalued its currency for the first time since 2011 as reported by Bloomberg on the 28th of June:
"Vietnam’s central bank devalued its currency for the first time since 2011 and cut the interest-rate cap on dollar deposits to help “improve” the balance of payments and boost foreign-exchange reserves.
The State Bank of Vietnam weakened its reference rate by 1 percent to 21,036 dong per dollar, effective today, according to a statement released yesterday. The currency, which can trade up to 1 percent either side of the rate, fell 0.8 percent to 21,195 as of 12:01 p.m. at banks in Hanoi, the most since Aug. 9, 2011, according to data compiled by Bloomberg. The fixing has been kept at 20,828 since Dec. 26, 2011, and the spot rate touched a record 21,036, the lower limit of the band, on most days in June.
The change in the reference rate is the biggest since a record 8.5 percent cut in February 2011 and comes after the government announced yesterday that imports exceeded exports by $1.4 billion in the first half of this year. " - source Bloomberg.

To summarize the deflationary forces at play in the current environment, we have read with interest Russell Napier's CLSA note from the 7th of June entitled "Great reset revisited":

"The world has been in disinflation since 2011: deflation is next. Japan has won the currency war and its cheaper exports are forcing others to cut prices. Meanwhile, slowing growth and weakening currencies in emerging markets augur a debt crisis; and commodity prices continue to fall amid a global slowdown and rising supply. Most worryingly, both real interest rates and the US dollar are rising. The great reset’s deflationary shock is at hand and investors should hold as much cash as they can.

US inflation has fallen despite QE

- QE is not delivering: the Fed's balance sheet has grown by 18% since September 2011, while inflation has fallen from 3.9% to 1.1%.

- The US 30-year bond yield has remained unchanged over this period: thus US real rates have risen by 280bps despite QE.

- US nominal rates bottomed a year ago and have risen by 83bps since then, while inflation has fallen by 33bps.

- Moreover, the Treasury inflation-protected securities (TIPS) market indicates that inflation expectations are falling, while nominal yields are rising.

EM growth is slowing and exchange rates are under pressure

- Weakening emerging-market (EM) currencies augur a balance-of-payments crisis, which means either lower domestic growth or lower exchange rates and defaults.

- As the EM growth outlook deteriorates, global inflation will fall further.

- EM foreign-currency bond prices are cracking, indicating that the large capital inflows that funded current-account deficits are ending.

Japan has won the currency war and is now exporting deflation

- On the back of yen depreciation, Japan is cutting its US-dollar selling prices.

- Japan¡¦s actions have forced competitors to follow suit: now Korea and China are also exporting deflation to the USA.

- The Bank of Japan's need to prevent JGB yields from rising will mean ever greater intervention and even more deflationary pressure from a weakening yen.

Cash is the place to be

- Cash does well as inflation turns to deflation and real interest rates rise.

- Cash can finally be utilised profitably as central bankers fail to sustain asset prices.

The S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play, graph source Bloomberg (28th of June 2013):

Moving on to the subject of the evolution towards a European Banking Union  following the discussions which took place this week in Brussels surrounding the Bank Recovery and Resolution Directive (BRRD), European Finance ministers (ECOFIN) came to an agreement on the 26th of June which will have to go through the European parliament, with the objective of adoption before year end.

No timing has been given for when the resolution authorities will have to use the bail-in tools and earlier indication were for 2018, but countries will have the flexibility to adopt it earlier it seems. National resolution authorities will be in charge of the implementation of the resolution plans which comply with some common rules, in particular bail-in measures imposing losses following order of seniority.

What will be included in the bail-in?
All bank creditors will see haircuts on the principal in line with the following order of seniority:
Shareholders > Hybrids > subordinated debts > Senior debt (including CP > 7days) + unguaranteed deposits of large corporations

What will be excluded in the bail-in?
-Guaranteed deposits of individuals and SMEs (<100 -covered="" bonds="" br="" days=""> -Payables to employees
-Some commercial claims

Debts with payment systems maturing in less than 7 days, and interbank market debts with an initial maturity of less than 7 days  before debts <30days days--="">

The entry of public capital will take place once at least 8% of liabilities have absorbed losses. Direct recapitalization from the ESM would only come into play in a second phase, once all possible haircuts have been exhausted, if the bank still needs help.

The issue of course is that the consequences of rising government bond yields could accelerate the realization of losses for senior bondholders particularly if one takes into account that in the last couple of years, rather than severing the links between banks and sovereigns, governments in Europe have increased that link with the help of banks which have been big buyers of government debt as indicated by a recent post from Dr Constantin Gurdgiev on "true economics" entitled - Bank-Sovereign Contagion - It's getting worse in Europe:
"•Italy EUR404bn (26% of 2013 GDP) up on EUR177bn at the end of 2008
•Spain EUR303bn (29% of 2013 GDP) up on EUR107bn at the end of 2008

Now, recall that over the last few years:

•European authorities and nation states have pushed for banks to 'play a greater role' in 'supporting recovery' - euphemism for forcing or incentivising (or both) banks to buy more Government debt to fund fiscal deficits (gross effect: increase holdings of Government by the banks, making banks even more too-big/important-to-fail); 
•European authorities and nation states have pushed for separating the banks-sovereign contagion links, primarily by loading more contingent liabilities in the case of insolvency on investors, lenders and depositors (gross effect: attempting to decrease potential call on sovereigns from the defaulting banks);
•European authorities and nation states have continued to treat Government bonds as zero risk-weighted 'safe' assets, while pushing for banks to hold more capital (the twin effect is the direct incentive for banks to increase, not decrease, their direct links to the states via bond holdings).

The net result: the contagion risk conduit is now bigger than ever, while the customer/investor security in the banking system is now weaker than ever. If someone wanted to purposefully design a system to destroy the European banking, they couldn't have dreamt up a better one than that..." - source "true economics", Dr Constantin Gurdgiev.

While the "Daisy Cutter" is no doubt an impressive military ordnance, it looks like the European politicians have built the ultimate bomb,  similar to the "father of all bombs", equivalent to the Russian Aviation Thermobaric Bomb of Increased Power (ATBIP),but we ramble again...

On a final note, stocks and housing may take down US confidence as indicated by Bloomberg in a recent Chart of the Day (25th of June):

"Consumer confidence in the U.S. may fall victim to the Federal Reserve’s foreshadowing of reduced
bond buying, according to Brian G. Belski, chief investment strategist at BMO Capital Markets.
As the CHART OF THE DAY depicts, consumer sentiment has typically mirrored a ratio of household net worth to disposable income during the past decade. The confidence figures come from surveys by the Conference Board. The Fed compiles data on net worth, and the Commerce Department tracks income.
Swings in stock and house prices largely explain this relationship, Belski wrote in a June 21 report with a similar chart. That’s why it has lasted through the economy’s four-year expansion even though jobs and income have risen more slowly than in past recoveries, the New York-based strategist wrote. “Consumers should not become overly reliant on these ‘paper gains’ for self-assurance,” Belski wrote. “Obstacles are beginning to develop” that may hamper further advances.
Fed policy looms over stocks and housing, the report said, because possible cutbacks in bond purchases have lessened the appeal of equity dividends and made home loans more expensive.
More houses may be put up for sale as the number of homeownerswhose debt exceeds their properties’ value falls, Belski wrote. The U.S. economy has added an average of 105,000 jobs a month in the current expansion. The pace trails an average of 178,000 in similar post-World War II periods, according to data cited in the report. The comparable growth rates for disposable income are 0.9 percent and 3.8 percent, respectively." - source Bloomberg

"There is no IQ in QE but no QE = NO IQ" - Macronomics

Stay tuned!