Macro and Credit - The Paradox of value

"Every positive value has its price in negative terms... the genius of Einstein leads to Hiroshima." - Pablo Picasso

Looking at the dramatic fall in the yield of Japanese 40 year government bonds (JGB) racing towards negative territory faster than a rat on roller skates thanks to NIRP, gaining 26% in price terms and yielding around 0.5%, we reminded ourselves of the Paradox of value also known as the diamond-water paradox when thinking about our new title analogy. While water is on the whole more useful than diamonds, yet diamonds do command a higher price in the market such as JGB these days. Adam Smith is often considered to be the classic presenter of this paradox while it had already appeared in Plato's Euthydemus. Many brilliant minds such as Nicolaus Copernicus, John Locke, John Law and others had previously tried to explain the disparity. The concept of value was discussed in Adam Smith seminal book "An Inquiry into the Nature and Causes of the Wealth of Nations". In his book, Adam Smith argued the concept of value in use and value in exchange and how they differ:

"What are the rules which men naturally observe in exchanging them [goods] for money or for one another, I shall now proceed to examine. These rules determine what may be called the relative or exchangeable value of goods. The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called "value in use;" the other, "value in exchange." The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it". - Adam Smith, "An Inquiry into the Nature and Causes of the Wealth of Nations"

In his book Adam Smith denied the necessary relationship between price and utility. Price for him was related to labor and not to the point of view of the consumer. Yet, saffron being the most expensive spice, most of its value is derived from the low yield growing it and the disproportionate amount of labor required to extract it.  One could argue in a NIRP world that most of the value of the 40 year Japanese Government Bonds come from its low yield:

- graph source Thomson Reuters - WSJ

Proponents of the labor theory of value argued that "saffron" was indeed a resolution of the paradox before the theory was replaced by the theory of marginal utility: 

"In explaining the diamond-water paradox, marginalists explain that it is not the total usefulness of diamonds or water that matters, but the usefulness of each unit of water or diamonds. It is true that the total utility of water to people is tremendous, because they need it to survive. However, since water is in such large supply in the world, the marginal utility of water is low. In other words, each additional unit of water that becomes available can be applied to less urgent uses as more urgent uses for water are satisfied.
Therefore, any particular unit of water becomes worth less to people as the supply of water increases. On the other hand, diamonds are in much lower supply. They are of such low supply that the usefulness of one additional diamond is greater than the usefulness of one additional glass of water, which is in abundant supply. Thus, diamonds are worth more to people. Therefore, those who want diamonds are willing to pay a higher price for one diamond than for one glass of water, and sellers of diamonds ask a price for one diamond that is higher than for one glass of water.
Conversely, a man dying of thirst in a desert would have greater marginal use for water than for diamonds so would pay more for water, perhaps up to the point at which he was no longer dying." - source Wikipedia

What we find of interest is indeed the Paradox of value in a NIRP world is that the lower the yield of the governement bond, the greater it's value in terms of price thanks to financial repression. Arguably the greatest bubble of the world is no doubt residing in the bond market hence our growing discomfort with government bonds yielding more and more into negative territory, leading to balanced funds becoming more and more "unbalanced" (a subject we discussed previously). One could argue today that indeed any particular unit of liquidity injected becomes worth less to the real economy as the supply increases. Those who want government bonds today are willing to pay a higher price for JGBs, thinking they have real value in their hand akin to some diamond. This is probably due to the fact that higher yielding government bonds are in such low supply because of central banks having vacuumed the lot (ECB, Bank of Japan, etc.). So, we are left with our Paradox of value, because it seems to us that JGBs are no diamonds, rest assured, but we are ranting again...

In this week's conversation we would like to focus once more on what Japanese investors will be doing and the attractiveness of US Investment Grade Credit in that context.

 Synopsis:

• Macro and Credit - US Investment Grade - Go with the Japanese flow?
• Macro and Credit  - NIRP finally put a nail in the coffin of Japanese Money Market Funds
• Final chart:  A strengthening Yen will weigh heavily on the future earnings of corporate Japan

• Macro and Credit - US Investment Grade - Go with the Japanese flow?

In our recent conversation "The Monkey and banana problem", we mused around the importance of the Japanese Yen and the relationship between FX and credit spreads as well as the importance of tracking "flows":

"Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings and in similar fashion in Europe previously the focused had been on the strength of the Euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward." - source Macronomics

 We also added more recently in our conversation "The Ninth Wave" the following:

"So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor." - source Macronomics, January 2016

As we pointed out, from a relative value perspective and given the better tone so far in the credit space, we continue to see more value in US Investment Grade as indicated by Bank of America Merrill Lynch in their Credit Market Strategist note from the 4th of March 2016 entitled "Morning after the dawn":

"Second phase of rally

We now enter the second phase of the rally in high grade where spreads tighten significantly due to the combination of catch up tightening in bonds, as our market has lagged the retracement in stocks and high yield (see section below), and the market finally beginning to respond to the three factors that make us bullish on spreads this year.

These are 1) Technicals: big foreign inflows of $400-500bn this year as with ultralow foreign interest rates the US investment grade market is the only game in town (Figure 9). 

2) Valuations: near recessionary spreads but no recession (Figure 10) 

and 3)
Fundamentals: we expect leverage to decline a bit in 2016, and then more in 2017 (see graph below).

What more can you ask for (apart from a favorable macro environment)? Remain overweight high grade, recommend 5s/10s spread curve flattener, overweight Autos, Energy, Life Insurance, underweight Banks" - source Bank of America Merrill Lynch

When it comes to "fundamentals", we disagree with Bank of America Merrill Lynch's take as we think that in recent years the credit clock in the US has been ticking faster than in Europe and leverage has gone up significantly, hence our more defensive, yet still constructive approach in relation to US Investment Grade. When it comes to "fundamentals" and the Paradox of value, we read with interest JP Morgan High Grade Credit Fundamentals review for the 4th quarter 2015 published on the 4th of March:

"Revenue and EBITDA growth is quite weak and interest coverage weakened as well, but leverage (ex the Commodity sectors) stabilized this quarter

4Q Revenue and EBITDA trends deteriorated vs 3Q (based on last twelve month figures) due to weakness in commodity issuers and also slowing growth from noncommodity companies, in part due to the strong dollar in 2015. Profit margins remain strong, however, and the cash going to shareholders (ex Commodity issuers) was slightly down on the year. Leverage outside of the Commodity sectors was stable compared to last quarter, which is encouraging after several quarters of rising ex-Commodity leverage. Interest coverage weakened, however, as did the earnings payout ratio (calculated as dividends plus share buybacks / EBITDA).

Revenue in 4Q15 declined 9.2% y/y (LTM basis) which was the worst y/y revenue performance since 4Q09. Excluding the Metals/Mining (-21% y/y) and Energy (- 36% y/y) sectors revenue grew 1.8%, however. This figure was also down from last quarter (+3.3%) and is the slowest growth since 3Q14. The trade weighted dollar appreciated 10% from 4Q14-4Q15 which held back the earnings of exporters and contributed to the weak revenue results.

EBITDA declined 7.2% y/y, also the weakest result since 4Q09, but excluding Metals/Mining (-27% y/y) and Energy (-34% y/y) it grew 1.5%. This is down from 2.4% growth last quarter, driven by similar trends as Revenues.

Profit Margins as measured by LTM EBITDA/Revenue have been remarkably stable in the 28-30% range since 4Q11. They ended 4Q15 at 28.9%, near the middle of this range. Perhaps surprisingly, Energy profitability is up 0.2% y/y at 27% as the sector continues to successfully achieve cost efficiencies despite the challenging revenue trends and has been able to maintain profitability in the 26%-28% range.

Total Debt increased 11% y/y, down from the trend of 12% growth y/y in the previous two quarters, so a modest change in the trend, but still a very strong increase, especially with EBITDA down 7.2% over the same period. M&A has been an important driver of issuance with $280bn of M&A related issuance in 2015 and a pipeline of $158bn for the remainder of 2016, based on publically announced
transactions.

The largest increase in debt y/y was in Technology, where debt increased by $65bn, driven by Apple (+$27bn) and Microsoft (+$16bn). The second largest increase was in Energy (+$60bn). Pharmaceuticals come next with a $48bn increase y/y driven by M&A as industry consolidation continues in the sector. Net debt is also increasing and is up 16% y/y as cash levels declined modestly y/y.

Gross leverage continues its upward trend, reaching 2.76x in 4Q15, the highest level in our analysis. Ex commodity issuers, however, leverage actually declined slightly, to 2.32x from the peak of 2.37x last quarter. In part, this was helped by issuers who are deleveraging post M&A. These names contributed to almost half of the decline from 3Q15 to 4Q15. Net leverage has increased slightly to 2.23x from 2.18x last quarter but the trend is not the same ex commodities, where leverage fell to 2.19x from 2.21x. For both Gross and Net leverage, ex commodities, these declines were the first since 3Q14 and 4Q13, respectively.

Interest coverage has been deteriorating since 2Q13 and is now 10.94x, down from 11.27x last quarter and 12.82x one year ago. It is the weakest since 2009. Ex commodities, interest coverage has also been declining. It is at 10.56x, down from 10.77x last quarter and 11.16x one year ago.

Cash to Shareholders is down 2.2% y/y but is up 1.5% y/y excluding Metals/Mining and Energy. The Energy sector in particular is down $30bn (-29%). Energy companies have substantially cut share buybacks and some are now cutting their dividend, including significant dividend cuts from several large energy companies recently, which will show in lower cash to shareholders in future quarters. Cash to shareholders has stabilized in the past two quarters, but is still rising ex commodity issuers.

The Earnings Payout Ratio (Cash to shareholders / EBITDA) increased 2.1% y/y to 39%, which is a high since 2000. The increase is driven by declining EBITDA and lagging responses of companies to adjust shareholder friendly activities accordingly. Excluding Commodity issuers the Earnings Payout Ratio was up 1.4%." - source JP Morgan

Whereas in High Yield, EBITDA and other measures continue to point out to more caution, US Investment Grade credits apart from the usual suspects in the commodity space continue to hold their ground fairly well for now.

So what is going to be driving more yield compression apart from the fundamentals, you might rightly ask? 

As we pointed out in our conversation "The Ninth Wave" back in January you want to continue to front run Mrs Watanabe, the GPIF and their friends in their search for the Paradox of value and their unquenchable search for yield:

"Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP." - Macronomics, January 2016

When it comes to credit, don't fight the flow, run with it. And when it comes to "flows" we told you before that we do monitor closely what the Japanese are doing. On that matter we read with interest Nomura's latest Flow Monitor report from the 8th of March 2016 entitled "Negative rates accelerate foreign investment":

"Japanese investors’ foreign portfolio investment accelerated in February. Excluding the banking sector, whose foreign investment tends to be FX-neutral, Japanese investors were net buyers of foreign securities to the tune of JPY2829bn ($25.0bn), the biggest net purchases since at least 2005. As expected, pension funds re-accelerated their foreign investment, while lifers purchased foreign bonds at the highest pace since 2008. Lifers’ foreign bond investment is likely more on an FX-hedged basis at the moment though. Toshin companies also increased their foreign investment slightly. January BoP data showed strong investment in the French bond market. Japanese investors sold GBP denominated bonds in January, but only by a relatively muted amount. Japanese corporates’ repatriation from FDI profits in January slowed to the smallest since 2009." - source Nomura

In our "The Monkey and banana problem" we voiced our concern on "liquidation" and "repatriation risk" from a strengthening Japanese yen. The latest Nomura report alleviated somewhat our concerns:

"The BOJ announced the introduction of negative interest rates on 29 January, which led to a decline in JGB yields overall (see “BOJ negative rate policy to reaccelerate JPY depreciation trend”, 1 February 2016). Only 30% of JGBs still offer positive yields now, making it difficult for lifers to manage their portfolios. As a result of the lower domestic yields, lifers needed to look for investment opportunities outside Japan.
That said, we expect that most of their foreign bond investments would be hedged, ahead of the fiscal year-end. The outlook for the global economy remained uncertain in February, and life insurers became more skeptical about the prospects for JPY depreciation going forward, although major lifers expected USD/JPY to trade between 115 and 130 (see “JPY: Lifers still look for foreign bond investment opportunities”, 26 October 2015). Moreover, while hedged foreign bonds are essentially an extension of yen bonds, unhedged foreign bonds differ considerably in terms of risk weighting. We expect hedged foreign bonds to account for the majority of their investments for now.

At the same time, as hedge costs for USD assets have risen, FX-hedged UST investment has become less attractive for Japanese investors. Lifers likely need to consider investment in US corporate bonds or euro area bonds going forward, if they continue to prefer hedged investments. We will take a closer look at life insurers’ FY16 investment plans, due to be announced at end-April, to assess their preference for unhedged foreign bonds." - source Nomura

Of course this will have some implications in terms of investment hence our close monitoring on everything Yen related. What was as well of interest from the same Nomura report was the data from the Balance of Payment for January:

"January BoP data show that Japanese investors bought more EUR-denominated securities than USD-denominated securities (Figure 6).

They purchased JPY919bn ($8.1bn) of EUR-denominated securities, while their investment in USD-denominated securities was JPY405bn ($3.6bn). Although Japanese investors purchased USD denominated equities aggressively (JPY892bn or $7.9bn), they sold USD-denominated LT bonds (JPY693bn or $6.1bn). While selling USD-denominated bonds, Japanese investors purchased EUR-denominated bonds aggressively (JPY723bn or $6.4bn). A country breakdown shows Japanese investors purchased French LT bonds especially aggressively, to the tune of JPY974bn ($8.6bn). Japanese investors were net sellers of German LT bonds (JPY196bn or $1.7bn) and investment in other euro area bond markets was not strong. Higher hedge costs for USD assets likely encouraged lifers to shift into French bonds from US bonds." - source Nomura

Once more the French government with the clear deterioration of French economic fundamentals can thank the Japanese falling for the Paradox of value and embracing French government bonds (OATs) as if they were some kind of diamonds but we are ranting again...

When it comes to Bank of Japan versus the ECB and the Paradox of value, we do agree with Bank of America Merrill Lynch's take from their Liquid Insight note from the 7th of March entitled "Trading QE flows", not all easing is equal:

"BoJ easing vs ECB easing: Not all easing is equal

 BoJ easing means lower US yields

While the impact of the BoJ’s January actions on JGBs/JPY has been discussed, its impact outside the borders is only becoming apparent over the last two weeks (after its clarification/toning down of the negative rate language). Japanese private investors have purchased nearly $26bn in foreign bonds since mid-February, their largest two-week purchases since mid-2012. This is not a recent phenomenon, but a consistent trend since the launch of QQE. As we have detailed, our analysis suggests Japanese private investors purchased nearly $120bn of USTs last year (despite the TIC data showing a $100bn decline in Japanese holdings of USTs) and the US rates market consistently rallied in Japanese trading hours in 2015. Clearly the lack of higher yielding alternatives domestically (BAML Japan corporate index yielding 22bp) has meant the portfolio balance channel in Japan translates to larger purchases of foreign bonds. The flow impact of these purchases is clearly bullish for USTs, all else equal.

ECB easing more likely a risk-on trade

In contrast, the flow impact of ECB easing on USTs is not the same. The last five meetings where the ECB has positively surprised (Table 1), peripheral spreads have tightened in every episode while the belly of the US rates curve has sold-off in three of the five episodes. 

This supports the view that the European private investor is more likely to move to the periphery in “search for yield” as opposed to USTs. This preferred home bias is likely a combination of the availability of higher yielding assets and a preference for spread risk over currency risk (given onerous capital charges under Solvency II for FX unhedged positions). Irrespective of the motivation, the resulting "risk-on" trade from the tightening of peripheral spreads puts in great risk premium in the US curve, more often than not.

The differential impact of the BoJ vs the ECB is also apparent in the cross currency basis swap market. Since 2013, the yen/dollar basis swap has tightened much more significantly than the EUR/USD basis. This indicates the demand for dollars from the Japanese investor base (to fund US asset buying) has been greater than that of the European investor base.

The implications of this for the upcoming week are simple:
• If the ECB over-delivers on the rate cut, focus on trading local front end rates instead of global QE flows.
• If the ECB surprises to the upside on QE, while there may be other reasons to be bullish USTs, buying Treasuries on the sole hope of European investor diversification is probably the wrong trade." - source Bank of America Merrill Lynch

One thing for sure, regardless of "Le Chiffre" aka Mario Draghi's new tricks, when it comes to looking for "diamonds" and compressing even further government bond yields, Japan's foreign investment is indeed in the driving seat.

Also, thanks to the Paradox value, one thing fairly clear is that the Japanese NIRP will be driving even more flows from Japan into foreign securities as Money Markets Funds in Japan are clearly decimated by the policy as per our next point.

• Macro and Credit  - NIRP finally put a nail in the coffin of Japanese Money Market Funds

One thing for certain is that NIRP in Japan is forcing massive fund moves from Money Market funds towards Money Reserve Funds according to Deutsche Bank Japan Securities sector note from the 8th of March 2016:

"Temporary retreat by short-term invested funds into bank deposits

Substantial portions of funds invested in the call market (end-January: ¥6.8trn unsecured, ¥14.1trn secured) and the ¥17trn in short-term invested assets in brokerage accounts (¥1.6trn Money Market Fund, ¥10.4trn Money Reserve Fund, ¥4.6trn deposits received) are effectively shifting to bank deposits. JGB redemptions are slated to reach ¥24trn in March. 

Short-term investment market in negative territory

We expect a heavy flow of funds seeking to avoid negative interest rates, such as JGB redemption funds, into bank deposits under the current conditions. We think banks could ultimately place restrictions on large corporate deposits and money trusts. We believe the size of the call market and other at negative interest rates will depend on the scale of deposit withdrawals requested by banks to customer companies and on JGB yields.

Impact on brokerage firm earnings

We believe the redemptions of MMFs and MRFs (unless the BoJ adopts special measures) might flow into the deposits received of brokers as well. We expect brokerage firms to provide deposits received at a zero interest rate as a customer service, mainly for individual investors, and believe they (in other words, their shareholders) will cover costs related to trusts and other products. Short-term invested assets in brokerage accounts total ¥17trn, including MMF, MRF and deposits received. Daiwa Next Bank's yen-based ordinary deposits, which serve as an MRF alternative via the sweep function, separately totaled ¥2.7trn at the end of December. We estimate that the annual pretax cost is ¥20bn if a 10bp cost is applied to the combined total of ¥20trn from above.

Sharing costs related negative interest rate

The negative interest rates applied to short-term managed assets are shared between financial institutions and cash-rich companies. We expect life insurers to shoulder the negative rate on investment for required liquidity funds and brokers to absorb the rate for managing sideline funds of individual customers. We believe declining investment yields will be transferred to policyholders through steep reductions in assumed rates of return (funding costs) starting in April 2017. We think brokerage firms will attempt to offset investment costs for sideline funds via reductions in their funding costs and buildup of sales commissions and management fees for risk products and others.

Disruption of corporate fundraising market

At this point, the adoption of the negative interest rate is adversely affecting corporate bond issuance activity through wider credit spreads. While issuance yields have been dropping closer to 0%, downward rigidity is resulting in wider credit spreads (spreads to JGBs of the same duration). Some companies with an aversion to wider issuance spreads are likely to delay corporate bond issues.
One way of avoiding wider credit spreads is to lengthen corporate bond duration (because of higher-reference JGB yields). However, the longer duration of bond holdings could result in excessive term risk (risk of declining prices when yields rise) for ordinary companies, banks, and individuals (via investment trusts and other products)

Yen-dominated MMFs: Headed for redemptions

All domestic companies have already halted new MMF purchases. While MMFs offer slightly higher yields than MRFs, combined value fell to ¥1.6trn at end-January due to yield declines. MMFs also invest funds in short-term bonds and thus might be forced to invest at negative interest rates and run the risk of slipping below principal value in the future if they continue investing. Some asset management companies have already decided to redeem MMFs. We expect other companies to follow as well. - source Deutsche Bank

So no doubt Japanese investors will be frantically searching for overseas yielding assets given NIRP in Japan has finally put a final nail in the coffin of their Money Market Fund industry and will entice further reach for duration and credit risk. When it comes to the bond bubble, it keeps inflating thanks to flows, clearly not macro fundamentals. This brings us to our final point, namely that the strengthening of the Japanese yen is indeed weighting heavily on the profitability of corporate Japan, given the "shrinking pie mentality" which is prevailing in this global currency NIRP induced war.

• Final chart:  A strengthening Yen will weigh heavily on the future earnings of corporate Japan

Whereas Japan's NIRP venture on the 29th of January has indeed put a spanner into its currency depreciation plan leading to a "sucker punch" type of risk reversal on the Japanese yen versus the US dollar, the sudden implementation of this policy has not only put a final nail in the coffin of its Money Market Funds (MMFs) industry but, is likely to affect its domestic equity market via a weakening of future earnings as displayed in our final chart from Société Générale Asia Pacific Market Arithmetic note from the 1st of March entitled "Japan sinks as Yen strengthens":

• "Despite efforts by the Bank of Japan to weaken the Yen, including a surprising move to negative interest rates announced on 29 January, the Yen strengthened to a 15 month high against the US dollar and ended the month at 112.69/$. This adversely affected the Japanese equity market making it the worst performing market in the region in February.
• A strengthening Yen will weigh heavily on the future earnings of corporate Japan with earnings forecasts for exporters likely seeing downgrades. Earnings momentum, measured as 4 week rolling upgrades vs total estimated changes, deteriorated sharply over the month. Bottom up consensus FY 16 estimate for MSCI Japan fell by 8.3% over the past 3 months while the FY 17 estimate slipped 3.4% over the same period. In contrast, FY 16 estimates for MSCI US and Europe have come down a more modest 4.8% over the past 3 months. Then again, on a 12 month horizon, Japan has seen the least amount of consensus earnings downgrades globally.
• Japan has also given up most of its gains, as measured in terms of its 12-month forecast price to earnings ratio, since the start of Abenomics in December 2012. The MSCI Japan index has fallen to 12 times forecast earnings as of the end of February, close to the lows seen during the Euro crisis of 2012 and well below its 5 year average of 13.4x and 10 year average of 15.5x. The market is currently pricing in EPS of ¥58.6 assuming a fair PER of 13.4x (based on the 5 year average), while consensus bottom-up February EPS for 2016 and 2017 are ¥58 and ¥65.6.

 - source Société Générale

It looks to us that if indeed Le Chiffre aka Mario Draghi delivers, Bank of Japan and Kuroda will most likely come back again at the QE table. For now it's the "Paradox of value" and the continuation of a rally in credit thanks partly to large inflows from Japan and a bubble that keeps growing for sure...

"To invent, you need a good imagination and a pile of junk." - Thomas A. Edison

Stay tuned!

Macro and Credit - The reverse Tobin tax

"A question that sometimes drives me hazy: am I or are the others crazy?" - Albert Einstein

Watching with interest the stabilization and even tightening in the credit markets, in conjunction with People's Bank of China (PBOC) cutting by 50 bps its Reserve Requirement Ratio (RRR), adding to the "risk-on" environment witnessed recently and given the continuous conversations relating to NIRP, we decided, for our elected title analogy to refer to the Tobin tax. The Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system which ended on August 15 of 1971. 

Why, you might rightly ask dear readers, did we elect to talk about a reverse Tobin tax in our chosen title?

Well, if you remember correctly from our previous conversation "The Monkey and banana problem", we argued that NIRP doesn't reduce the cost of capital. NIRP is simply a currency play.

And if indeed NIRP is a currency play, given James Tobin's objective was to mitigate currency volatility, no doubt to us that the latest bout of volatility witnessed on the Japanese yen is indeed some form of a "reverse Tobin tax". What we find amusing is that James Tobin was influenced by the earlier of John Maynard Keynes on general financial transaction taxes and the famous chapter XII of the General Theory on Employment Interest and Money. Keynes was an avid speculator and the recent NIRP put in place by various generous gamblers aka central bankers, is leading to a renewed frenzy of speculation in the bond market where all the fun is with more and more bonds yielding on the negative side and their prices reaching new record high levels:

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation." - John Maynard Keynes, page 104.

Indeed the situation is becoming serious when the bond market has become a whirlpool of speculation. On a side note, we find the PBOC move amusing given, as we posited with the ECB LTROs, liquidity injections doesn't resolve solvency issues, particularly when it comes to Nonperforming loans (NPLs).

John Maynard Keynes would be proud of NIRP given it will definitely lead to the "euthanasia rentier" but unfortunately also to the disappearance of "capital" as he wrote:

"I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.

Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward..." - John Maynard Keynes

We do not think in the end, capital will be "free and "abundant" with NIRP. Keynes added at the time in relation to tax on transactions the following:

"The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States." - John Maynard Keynes, page 105.

For us, NIRP is a "reverse Tobin tax" leading in the end to the "euthanasia of the rentier" as more and more government bonds fall into negative yield territory, hence our chosen title. If indeed James Tobin tax was supposed to lead to lower volatility in the FX markets, the reverse Tobin tax aka NIRP is leading to the reverse, that's a given but we are rambling again...

In this week's conversation, we will look again at the credit cycle and the issue with correlations with diversification we recently discussed. We will as well look at how NIRP will be playing out credit wise and trouble brewing in Asia. 

Synopsis:

• Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months
• Macro and Credit  - The US late stage will have nasty credit consequences on Asia
• Final chart: US Rates skew may reflect policy mistake / recession risks

• Macro and Credit - The US Global Credit cycle leads Emerging Markets by around 6 months

In our last conversation "The Monkey and banana problem" we indicated that NIRP would exacerbate the demand for yield as the saving rate goes up, which no doubt is leading the negative feedback-loop to push the frenzy for bonds into "overdrive" hence for the first time we have seen the demand for the Japanese 10 year government bond (JGB) pushing for the first time the yield into negative territory. This of course a clear manifestation of the "reverse Tobin tax" and the "euthanasia of the rentier".  The operant conditioning chamber we discussed last week, aka the Skinner box has indeed led to a "Pavlovian" response leading to even further greater compression. As we posited last week, what matters more and more to us is tracking "correlations" given the implications for "diversification" are not neutral:

"The consequence for this means that classical theories based on allocation become more and more challenged in a NIRP world because correlation patterns change in a crisis period particularly when correlations are becoming more and more positive (hence large standard deviations move)." - Macronomics, February 2016

When it comes to "correlations" we read with interest Société Générale's take from their Multi Asset Snapshot note from the 26th of February entitled "A balanced portfolio for an imperfect world":

"While we may have been too aggressive with a balanced allocation before the market downturn, we're not keen to take the revolving door and go risk averse now. We are recommending a balanced allocation. The average correlation between assets has recently pulled back, making us more convinced to keep the current allocation of 50% equities/50% bonds and others.

- source Société Générale

What effectively Société Générale is showing is confirming somewhat we have posited as of late in our conversation "The disappearance of MS München". Namely that in a world of growing "positive correlations" diversification reduces the benefit of diversification:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by this sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world." - source Macronomics, February 2016

This also a subject we discussed in our May 2015 conversation "Cushing's syndrome":

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

What we are currently seeing is a repricing of bond volatility which had been "anesthetized" by central bankers leading to Cushing's syndrome. Central bankers meddling with interest rates levels have led investors to get out of their comfort zone and extend both their risk exposure and duration, taking the repressed volatility regime as an empirical factor in their VaR related allocation risk process. Now they are rediscovering in the ongoing turmoil that, yes indeed long duration exposure is more volatile than shorter ones. They are also rediscovering "convexity" with artificially repressed yields. They are being significantly punished the more exposed to "credit" duration they are." - Macronomics, May 2015

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment. Where is the value left in your bond holding when the German 10 year government bond (Bund) yield is about to turn negative? Yes, it will go negative and so will probably be the rest of the Japanese curve to mimic what has been happening on the Swiss yield curve. The most dangerous negative side effect of the "reverse Tobin tax" is already pushing the Swiss real estate bubbly market into overdrive as indicated by Bloomberg on the 29th of February in their article "Mom-Pop Investors Rush Into Swiss Property at Riskiest Time":

"Mom-and-pop investors are rushing into Swiss properties just as the market faces its greatest threat of a bubble in a quarter century.
“I see two protracting trends,” Patrik Gisel, chief executive officer of Swiss Raffeisen, the country’s third-largest bank, said in an interview in Zurich. One involves big money -- institutional investors such as pension funds and insurance companies who have invaded the market, driven by negative yields on Swiss government bonds. More recently, a new group of investors has entered the fray, buying properties to rent or develop rather than for a primary residence.
“What’s really new is that private investors are piling in to buy real-estate assets for yield due to limited options,” he said. These aren’t ultra-rich speculators, rather well-to-do people looking to build nest eggs at a time of record-low interest rates and market turmoil. Although they are still just a small part of the market, “this is reducing the professionalism,” he said.

Soft Landing

Raiffeisen, a cooperative encompassing about 300 regional banks, is one of Switzerland’s five systemically relevant banks, along with UBS Group AG and Credit Suisse Group AG. It holds about 17 percent of the Swiss mortgage market, with home loans representing about 95 percent of the total volume of 166 billion francs ($166 billion) at the end of the 2015.
The Swiss property market is facing the greatest threat of a real estate bubble since 1991, UBS said in a report this month on the subject. Loan applications for properties not occupied by owners dipped in the fourth quarter, yet remain historically elevated at about 18 percent of the overall demand. House prices rose 0.5 percent from the third quarter and around 2 percent yearly.
While the risk of default on mortgages remains low in Switzerland, vacancy rates are rising, with prices “driven by investments, not by the need for living space,” Gisel said. Unlike in countries including the U.K. and U.S., Swiss buyers traditionally are looking to make a lifetime investment as capital gains taxes make it costly to speculate.
Gisel, formerly the deputy CEO who succeeded Pierin Vincenz at the head of Raiffeisen last year, said he sees a “soft landing” in the property market. The bank said during its earnings report Friday that prices are stabilizing at a high level or declining slightly.

Swiss apartment prices and mortgage lending climbed by about a third between 2007 and 2014. A price increase of 2 percent would have been unappealing just four years ago, Gisel said.
The Swiss National Bank introduced charges on bank deposits in an effort to weaken the franc, which soared after it lifted its three-year-old cap on the currency in January 2015. Some big banks such as UBS and Credit Suisse have passed on the pain of negative interest rates to their larger institutional clients. Retail clients have been spared, for now.
“Equities are too risky for many private investors, bonds don’t yield anything,
so people go for real estate but often have a poor understanding of this market,” says Fredy Hasenmaile, head of real estate research at Credit Suisse. Inexperienced investors tend to underestimate the costs associated to maintain a property." - source Bloomberg

We have argued in a 2011 conversation that the policy of achieving a high home ownership rate is the biggest threat to an economy:

"The issue with enticing a high home ownership rate is the level of household debt it generates. It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.

For us, a housing bubble is a Weapon of Economic Destruction (WED) and pushing real estate prices into overdrive is certainly akin to a "reverse Tobin tax" and the most efficient way in destroying "mis-allocation" of capital on a grand scale and "euthanizing the rentier" for good.

But moving back to the subject of the credit cycle, we still believe we are in 2007, although subprime is not the "prime" suspect this time around as the Energy sector woes have clearly spilled over into over sectors as well. The rising of distress securities is creeping up and it is not only in the Energy sector as displayed in the below S&P Global Market Intelligence chart:

"A host of U.S. energy companies joined LCD’s distressed debt Restructuring Watchlist last week, adding to an already hefty group of issuers from that still-struggling market segment.
The Watchlist tracks companies with recent credit defaults or downgrades into junk territory, issuers with debt trading at deeply distressed levels, as well as those that have recently hired restructuring advisors or entered into credit negotiations.

- source S&P Capital IQ LCD

This is entirely due to ZIRP and now NIRP as shown in the below Société Générale from their Credit Weekly note from the 26th of February 2016 entitled "Will the G20 disappoint credit investors":

"In a low real interest rate environment, however, such as the 1970s or the present, the four year period of stability disappears and the credit cycle becomes much shorter. Chart 3 illustrates this:

Table 2 above implies that the global credit cycle is, as always, relatively synchronous, with the US leading EM by around six months. Assuming two-year widening and two-year tightening cycles, with a peak of the cycle in early 2016 and a trough in late 2017 or early 2018, this implies the following:

- source Société Générale.

The United States are leading once more the credit cycle and the rapid pace at which spreads have widened since the cost of capital has been moving up since the summer of 2014 is indicative of how late the cycle is and the potential spillover to Emerging Markets thanks to Global Financial Conditions tightening in conjunction with the relentless rise of the US dollar.

When it comes to credit and the "Japanification" process, the hunt for yield is still running strongly although some might have already moved higher the quality spectrum in the light of the deterioration seen recently in credit spreads. European investors in a "reverse Tobin tax" environment will be eager to go for even more duration and credit risk as posited in Société Générale's note:

"European investors will still be hungry for yield. European ten-year yields have fallen almost 50 basis points this year, with the Bund yielding just over 10bp. It’s hardly surprising that European insurance companies are steering their clients away from guaranteed life products, as our insurance analyst Rotger Franz has noted, but they are still left with legacy products that need to be funded. Our SG shortfall model estimates the current gap between what insurers need and what the government markets are offering at almost 140bp.

Given this gap, we think the demand for credit will remain strong. It’s worth noting, however, that this demand will be much stronger in the BBB area than in the AA and A area, since spreads have compressed too much in those areas to offer the returns that investors need." - source Société Générale.

Insurers have are indeed struggling with NIRP and are slowly getting "euthanized". While we have long been highlighting the dangers with Emerging Market corporate debt denominated in US dollars, it is worth highlighting Société Générale's comment before we move on to our next point:

• "Emerging market sovereigns will not be able to bail out their corporates: The ratio between EM sovereign spreads and corporate spreads has narrowed this year, when the mismatches in the indices are accounted for. Yet EM corporate debt – either domestic debt as a percentage of GDP, or external debt as a percentage of reserves – is often much bigger than government debt, as we noted in "Can EM sovereigns really bail out their corporates?" We think this year, investors will realise that many EM corporates will not be bailed out by their sovereigns.
• EM defaults will be higher and recovery rates lower than the market expects. Given the weakness of commodity prices and the weakness of EM currencies, we are more bearish about these issuers than we are about US high yield issuers." - source Société Générale

The latest sign of the strain facing EM corporate issuers is clearly illustrated by Mexican giant PEMEX losing $32 billion in 2015. Mexico's largest company and big contributor to the government's budget has more than $87 billion in debt and hasn't recorded a profit since 2012 according to Bloomberg. The government of Mexico has pledged financial support for its ailing giant. 

This leads us to our second point and once again the unintended consequences of our Macro theory of reverse osmosis playing out as we have argued in our conversation "Osmotic pressure" back in August 2013:

"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." - Macronomics, 24th of August 2013

Now the "flows" are turning into "outflows" leading to the following points we discussed at the time:

"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." - Macronomics, August 2013.

We also added at the time:

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike.

Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates)." - source Macronomics August 2013

While the PBOC might have indeed bought some time in adding more liquidity, the worrying trend of capital outflows have yet to meaningfully slow down, meaning for us that, indeed Asia should as well be the focus of more attention, but not only China...

  

• Macro and Credit  - The US late stage will have nasty credit consequences on Asia

Back in July 2015 in our conversation "Mack the Knife" we indicated that EM credit spreads and oil prices were highly correlated. 

The correlation of oil and credit spreads mean that indeed the unintended consequences of the surge of the US dollar and the fall in oil prices have not translated much as before into Asia's energy-importing economies as illustrated by Nomura in their Asia in Charts note from February 2016 entitled "Asia's coming credit crunch":

"• Cheap oil has not benefited Asia’s energy-importing economies as much as it had in the past. In early 2008, if you responded “sub-6%” to the question of how fast Asia ex-Japan’s economies would grow if oil prices halved and most Asian central banks slashed rates to new, or near, record lows, you would have been scoffed at. More of the oil windfall appears to have been saved or offset by the China slowdown, weak EM demand, high domestic leverage and low productivity growth.

• That said, the commodity price drop has been a big differentiator in favour of Asia, as fundamentals and growth have fared better in Asia vis-à-vis LatAm and EEMEA. Asia is the least ugly in EM, at least for now. If risk sentiment turns, Asia may experience a short-run relief rally, buoyed by: 1) still ample global liquidity; 2) any signs of China growth stabilising, albeit it would be temporarily, in our view; and 3) more discriminating investors in global emerging markets in Asia’s favour.

• However, more fundamentally the seeds are being sown for a credit crunch and financial stress in Asia:
1) high and still-rising private debt, combined with still elevated property prices; 2) slowing potential growth rates; 3) increasing foreign-currency debt exposure; 4) large herding-like investments by global asset management companies in Asia (‘original sin II’); 5) the Fed surprising with more/faster rate hikes; and 6) China’s economy facing a secular slowdown in growth in 2016 and 2017." - source Nomura

As our reverse "macro" osmosis has been playing out and given the credit binge witnessed in some parts of Asia, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring.

There is a heightened possibility of a credit crunch looming in Asia as posited by Nomura in their very interesting report:

"Asia is setting itself up for a credit crunch 

• The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can cause financial decelerator effects.

• Cheap credit has weakened productivity by misallocating capital (eg. property speculation), dis-incentivising supply-side reforms and keeping zombie companies alive. Potential growth is slowing across most of Asia.

• Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.
• Triggers of a credit crunch could be the market caught off-guard by Fed rate hikes, USD sharp appreciation, a China setback, or a high profile Asian corporate default prompting global asset managers to pull out from the region en masse and causing market liquidity to evaporate.

 Asia’s credit and property price gaps are sending warning signals

• Pioneering work at the BIS by Claudio Borio and Philip Lowe in the early 2000s found that over a 4-year horizon a credit gap of >4% predicted 88% of crises in industrial countries with a noise to signal ratio (NSR) of 0.21, while an equity gap >60% predicted 67% of crises with an NSR of 0.15. Jointly they predicted 73% of crises with an NSR of 0.02 (i.e., issued wrong signals only 2% of the time).
• Since then more studies, including of EM crises, have reaffirmed that credit is the single best predictor of crises and, with better data, property prices are generally found to be more important than equity prices.
• In a more recent 2011 BIS study (working paper No. 355) of 36 advanced and EM countries it was found that over a 3-year horizon, a credit gap >10% predicted 67% of crises with an NSR of 0.16, and a property gap >10% predicted 77% of crises with an NSR of 0.33. This is an ominous sign for Asia, as highlighted in the table below.

The best indicator of financial crises is the credit gap; the property price gap is also a strong indicator, and jointly they send a strong signal

 (click to enlarge picture)

- source Nomura

From the table above, and as a follow up on our HKD take from our  December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. On this specific case, Nomura's report has added more on our justified concerns in their note:

"Hong Kong could be Asia's flashpoint

 HK stuck between a rock (Fed hikes) and a hard place (ebbing China)

• Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 112% (they have corrected 11%), and the ratio of private non-financial credit to GDP has surged to 293%.

• The real effective exchange rate has risen 26% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015.

 • Foreign assets and liabilities have surged since 2008. this leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.

• Economic hardship could ignite further political and social unrest, or vice versa, ahead of the 2016 Legco elections (around Sep) and 2017 chief exec elections. We would not rule out a change to the HKD peg regime." - source Nomura

And, as per us winning the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our December "Cinderella's golden carriage", we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. Maybe it will be for 2017 after all...For now the Hong Kong dollar has recorded the biggest monthly gain since 2011 in February on optimism that the city will be able to maintain its peg to the US dollar as reported by Bloomberg in their article from the 29th of February entitled "Hong Kong Dollar in Biggest Monthly Gain Since 2011 as Peg Holds":

"The Hong Kong dollar advanced 0.18 percent this month to HK$7.7724 against its U.S. counterpart, the biggest increase since October 2011, data compiled by Bloomberg show. The currency rose 0.06 percent on Monday to trade near the strong end of its HK$7.75-HK$7.85 trading range.
“The Hong Kong dollar was one of the biggest speculative targets in January, especially amid fears of the yuan being devalued,” said Irene Cheung, a foreign-exchange strategist at Australia & New Zealand Banking Group Ltd. in Singapore. “We need to watch the yuan, given how it’s affecting sentiment across markets. If the dollar-yuan rate continues to remain broadly stable, there’s no reason to focus on the Hong Kong-dollar peg for now.”

Yuan Deposits

The Hong Kong dollar was linked to the greenback in 1983, when negotiations between the U.K. and Beijing over the city’s return to Chinese rule spurred an exodus of capital, and policy makers in 2005 committed to limiting declines to the current range.
Hong Kong’s yuan deposits rose by 0.1 percent to 852 billion yuan in January, the Hong Kong Monetary Authority said on Monday. The pool posted its first annual decline last year, while issuance of Dim Sum bonds fell for the first time since the market’s inception in 2007." - source Bloomberg

As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far has not been able to  gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals.

When it comes to the fate of the HKD peg, Nomura has been solacing our concerns in their note:

"HKD re-pegged to the RMB? 

The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported
US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed accelerates hiking and China’s growth keeps slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura

Given our keen interest on this eventuality, we will be not only monitoring that space but also tracking financial conditions in Asia rest assured.

Finally for our final point and chart, we would like to point out that it's not only Hong Kong which is stuck between a rock (Fed hikes) and a hard place (ebbing China). The Fed is as well in a bind.

• Final chart: US Rates skew may reflect policy mistake / recession risks

Our final chart comes from Bank of America Merrill Lynch's Liquid Insight note from the 1st of March entitled "Rates skew may be pricing a policy mistake":

"• US rates skew is now inverted in both short- and long-dated expiries, despite more dovish Fed expectations
• We believe this, at least in part, reflects higher perceived odds of a policy mistake and/or growth shock ahead
• From a historical standpoint, inverted long-dated skew is consistent with late stages of the hiking cycle

Inverted skew: Not a good sign for the Fed

A notable recent development in the US rates vol market is the inversion of the skew surface, with low strikes trading at a premium to high strikes. Short-dated skews were first to invert earlier this year. Today skews are inverted across the board, including very long expiries (Chart above). Importantly, the skew inversion occurred against expectations of a more dovish Fed. The market now sees the next Fed hike only by 4Q17, a much less hawkish outlook than FOMC projections. Lower rates coupled with expectations of a more accommodative Fed normally imply upward risks to rates. Yet, the volatility market sees risks to rates skewed on the downside even at very long horizons.
We believe this is a worrisome signal to policy makers. The inversion of the skew all the way into longer horizons suggests perceived risks go beyond the recent financial stress and may reflect greater perceived odds of a policy mistake/recession risks. Inverted long-dated skew is consistent with late stages of hiking cycles." - source Bank of America Merrill Lynch

To hike in March, or not to hike, that is the question...

"Insanity - a perfectly rational adjustment to an insane world." - R. D. Laing, Scottish psychologist

Stay tuned!

Macro and Credit - The Monkey and banana problem

"There are three growth industries in Japan: funerals, insolvency and securitization." - Dominic Jones, Asset Finance International Nov., 1998

Looking at the evolution of markets and convolution in which central bankers have fallen, we reminded ourselves for our chosen title analogy of the "Monkey and banana problem", which is a famous toy problem in artificial intelligence, particularly in logic programming and planning. The problem goes as follows:

"A monkey is in a room. Suspended from the ceiling is a bunch of bananas, beyond the monkey's reach. However, in the room there are also a chair and a stick. The ceiling is just the right height so that a monkey standing on a chair could knock the bananas down with the stick. The monkey knows how to move around, carry other things around, reach for the bananas, and wave a stick in the air. What is the best sequence of actions for the monkey?" - source Wikipedia

While there are many applications to this problem. One is as a toy problem for computer science, the other, we think is a "credit impulse" problem" for central bankers. The issue at hand is given financial conditions are globally tightening, as shown as well in the US in the latest publications of the Fed Senior Loan Officer Survey and the bloodbath in European bank shares, the problem is how on earth our central bankers or "monkeys" (yes it's after all the Chinese year of the fire monkey...) are going to avoid the contraction in loan growth? As put it bluntly by our friend Cyril Castelli from Rcube, the European credit channel is at risk as banks' share of credit transmission is much higher in EU than US, which of course is bound to create a negative feedback loop and could therefore stall much needed growth:

- source Rcube - @CyrilRcube

Another possible tongue in cheek purpose of our analogy and problem is to raise the question: Are central bankers intelligent? Of course they are, and most of them have to deal with complete lack of political support (or leadership). It seems we have reached the limits of what monetary policies can do in many instances.

Although both humans and monkeys have the ability to use mental maps to remember things like where to go to find shelter, or how to avoid danger, it seems to us that in recent years central bankers have lost the ability to avoid danger. While monkeys can also remember where to go to gather food and water, as well as how to communicate with each other, it seems to us as of late, that central bankers are losing their ability to communicate, not only with each other but, as well with markets, hence our chosen title. Could it be that monkeys have indeed superior abilities than central bankers given their ability not only to remember how to hunt and gather but to learn new things, as is the case with the monkey and the bananas? Despite the facts that the monkey may never have been in an identical situation, with the same artifacts at hand (printing press), a monkey is capable of concluding that it needs to make a ladder, position it below the bananas, and climb up to reach for them. It seems to us that despite the glaring evidence that the "wealth effect" is not translating into strong positive effects into the "real economy", yet it seems central bankers have decided to all embrace the Negative Interest Rate Policy aka NIRP as the new "banana". One would argue that, to some extent, central bankers have gone "bananas" but we ramble again...

In this week's conversation we will voice our concern relating to the heightened probability of a credit crunch in Europe thanks to banking woes and the unresolved Italian Nonperforming loans issue (NPLs). We will as well look at the credit markets from a historical bear market perspective and muse around the relief rally experienced so far.

Synopsis:

• Macro and Credit - The risk of another credit crunch in Europe is real
• Why NIRP matters on the asset side of a bank balance sheet
• Credit spreads and FX movements - Why we are watching the Japanese yen
• Final chart: US corporate sector leverage approaching crisis peak

• Credit - The risk of another credit crunch in Europe is real

The fast deterioration in European bank stocks in conjunction with the rising and justified concerns relating to Italian NPLs, constitute a direct threat to the "credit impulse" needed to sustain growth in Europe we think. As we pointed out on numerous occasions, the ECB and the FED have taken different approaches in tackling their banking woes following the Great Financial Crisis (GFC). In various conversations we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):

"We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation -The LTRO Alkaloid - 12th of February 2012."

Exactly. The issue with Italian NPLs is that the tepid Italian growth of the last few years is in no way alleviating the bloated balance sheets of Italian banks which would help sustain credit growth for consumption purposes in Italy as evidently illustrated in a recent Société Générale chart we have used in our conversation the "Vasa ship": 

"As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs" - source Macronomics, February 2016

- source Société Générale.

So, all in all, the ECB is going to have to find a way to shift these impaired assets onto its balance sheet, if it wants to swiftly and clearly deal with the worsening Italian situation. While some pundits would point out that the new "bail-in" resolutions in place since the 1st of January are sufficient to deal with such an issue, we do not share their optimism. This is a potential "political" problem of the first order, should the ECB decides to deal with this sizable problem à la Cyprus. Caveat emptor.

You could expect once more politicians and the ECB to somewhat twist the rule book in order to facilitate through this "securitization" process and an ECB take up of part of the capital structure (Senior tranches probably) of these new NPLs CDOs. A new LTRO at this point might once again alleviate funding issues for some but in no way alter the debilitating course of the credit profile of the Italian banks. On a side note we joked in our last conversation around these new NPLs CDOs being the new "Big Short":

"If you want to make it big, here is what we suggest à la "Big Short," given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honor the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs." - source Macronomics, February 2016

But, when it comes to the "credit impulse" and its potential "impairment" in Europe thanks to bloated banks balance sheets, and equities bleeding, we read with interest Deutsche Bank's take in their note Focus Europe note from the 19th of February entitled "Moving down a gear":

"The balance between the growth drivers and detractors is being tipped towards the negative as the questioning of confidence in European banks threatens to result in a less beneficial credit impulse. In last week’s Focus Europe we presented a scenario analysis to demonstrate the sensitivity of euro area GDP growth to the provision of bank credit. We did this via the credit impulse relationship. Our earlier assumption of 1.6% real GDP growth in 2016 was consistent with 2% credit growth. If, on the other hand, banks issue no net new credit this year, domestic demand would fall, confidence deteriorate and financial markets tighten. With no reaction from the ECB, 2016 GDP growth would fall to about 0.5%

The recent fall in bank equities and rise in bank debt costs combined with increasing economic risks, the balance of probabilities suggests that lending standards will tighten relative to what we expected previously. Therefore, to some degree the provision of bank credit, and hence economic growth, will suffer. The revision we are announcing is an attempt to capture this effect. There are considerable uncertainties as to the scale of the problem, but we feel a modestly weaker lending impulse is now a more appropriate baseline.

Credit (-0.2pp). Our previous baseline forecast of 1.6% GDP growth was consistent with an acceleration in bank credit growth from broadly zero in 2015 to about 2% this year. The improvement in credit conditions in the last Bank Lending Survey implied a modest upside risk relative to forecasts. The last Bank Lending Survey was conducted in December and published in January. There were no indications at that point of concern about capital, liquidity or risk. However, as we said above, the balance of probabilities implies that lending standards will now tighten. We are conservatively allowing for a scenario in which the contribution to GDP from bank credit is now 0.2pp weaker than our previous baseline.

The ECB can help minimize the damage… 

The onus is on the ECB to achieve two things at the next meeting on 10 March. First, to set an appropriately accommodative policy stance given the worsen outlook for both growth and inflation. Note, since December, our headline and core HICP inflation forecasts for 2016 have fallen from 0.9% and 1.3% to 0.2% and 1.1% respectively (see page 2 for updated country inflation forecasts).
Second, to set a policy stance that does not compound the pressures on a banking system that may be perceived as being more vulnerable.
We presented a detailed discussion of the ECB’s options in last week’s Focus Europe (pages 8-10)2. Suffice to say, the choice of policies will be affected by conditions in the banking system. Our expectation prior to this episode of banking stress in recent weeks was a 10bp deposit rate cut and a temporary acceleration in the pace of purchases. The bank stress implies that a further deposit rate cut may be unwise without a system of exemptions. A refi cut, for example targeted at TLTROs, would be more effective.

The bank stress also implies the ECB should offer some kind of supplementary liquidity tender. Excess liquidity is running at about EUR700bn, but if there was any sense of fragmentation re-emerging between strong and weak banks, it would be in the ECB’s interest to remove all doubt about bank access to liquidity. Finally, the justification for more QE has increased given the widening of credit and sovereign spreads. More QE would reduce the risk of a negative feedback loop between banks and sovereigns.

The ECB is conducting a technical review of the asset purchase programme (APP). This might result in some changes. In terms of broadening the eligible asset base, we suspect the ECB will remain in the sovereign/quasi-sovereign space for now. Corporate bonds are possible but not very impactful.

Purchasing unsecured bank debt might not be inconsistent with the Treaty but would be complex and politically controversial. Stresses would have to increase markedly to bring this option onto the table. 

There is no relaxation of regulation, however. Both Mario Draghi, President of the ECB, and Daniele Nouy, head of the ECB Single Supervisory Mechanism (SSM), were consistent in their messages this week that (a) the new regulatory regime is resulting is a more stable and sustainable banking system - there is no sense that regulation is a net cost - and (b) “all else unchanged” there will be no significant additional capital requirements imposed on banks.
Benoit Coeure, ECB Executive Board Member, said that if bank profits are under pressure the onus would be on governments to implement structural reforms and growth-friendly fiscal policies. In short, no change in ECB message.

…but negative feedback loops cannot be ruled out either 

Last week we showed how sensitive the economic cycle can be to the bank credit cycle. This negative dynamic can become self-reinforcing. One direction is via the private sector and another is through the public sector. A tightening of lending standards weakens demand, undermining growth and asset quality, triggering a second-order tightening in credit. At the same time, weaker demand undermines sovereign sustainability which can tightening bank funding cost and additionally contribute to second-order tightening. 

Fiscal dynamics have deteriorated. The primary balance gap is the difference between the debt-stabilising primary balance and the primary balance. It captures the underlying dynamic of the public debt-to-GDP ratio. A negative gap means the public debt ratio is falling. Our previous forecast was for a primary balance gap of -0.6% of GDP in 2016, the first genuine decline in the public debt ratio since the start of the crisis. Following the growth and inflation revisions, the primary balance gap is expected to be positive again. In other words, the benefits of lower funding rates thanks to ECB QE are not enough to compensate for the loss of economic momentum. Moreover, if the scenario of zero net new bank credit were to materialize, 2016 could see the primary balance gap rise back to levels not seen since 2012. That would imply a euro area public debt-to-GDP ratio of about 98%." - source Deutsche Bank

Whereas indeed we are waiting to Le Chiffre aka Mario Draghi to come up with new tricks in March to alleviate the renewed pressure on European banks, where we disagree with Deutsche Bank is that providing a new TLROs would provide much needed support for funding in a situation where some banking players are seeing their cost of capital rise thanks to a flattening of their credit curve (in particular Deutsche Bank as per our previous conversation), this intervention would in no way remove the troubled growing impaired assets from the likes of Italian banks. It is one thing to deal with the flow (funding) and another entirely to deal with the stocks (impaired assets). Whereas securitization of the lot seems to be latest avenue taken, you need to find a buyer for the various tranches of these new NPLs CDOs. Also more QE. will not deal with the stocks of impaired assets unless these assets are purchased directly by the ECB. 

When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys. In their latest survey, while it is difficult to assess for now a clear trend in the deterioration of financial conditions for French corporate treasurers, it appears to us that NIRP has already been impacting the margin paid on credit facilities given a small minority of French corporate treasurers are indicating that, since December, there is an increasing trend in margin paid on the aforementioned credit facilities:

"Does the margin paid on your credit facilities has a tendency, to rise, fall or remains stable?"

- source AFTE

Going forward we will closely be monitoring these additional signals coming from French corporate treasurers to measure up the impact on the overall financial conditions as well as the impact NIRP has on the margins they are getting charged on their credit facilities. For now conditions for French corporate treasurers do not warrant caution on the microeconomic level.

While we have recently indicated our medium to long term discomfort with the current state of affaires akin to 2007 in terms of credit markets, the recent "relief rally" witnessed so far is for us a manifestation of the "overshoot" we discussed last week. Some welcome stabilization was warranted, yet we do feel that the credit cycle has turned and that you should be selling into strength and move towards more defensive position, higher into the rating quality spectrum that is and rise your cash levels.

When it comes to enticing banks to "lend" more, as far as our analogy is concerned we wonder how the "monkey" bankers are going to react if indeed additional NIRP is going to remove more "bananas".

This brings us to our second point, namely that the flatter the yield curve, the less effective NIRP is.

• Why NIRP matters on the asset side of a bank balance sheet

Whereas, Europe overall has been moving more into the NIRP phenomenon, with over $7 trillion worth of global government bonds now yielding “less” than zero percent, the FED in the US is weighting joining the NIRP club in 2016 apparently, NIRP being vaunted as the new "banana" tool in the box to stimulate the "monkeys".

The issue of course at hand is that NIRP does matter and particularly when it comes to the asset side of a bank balance sheet as put forward by Deutsche Bank in their note from the 22nd of February entitled "Three things the market taught me this year":

"Negative rates – much more complicated

Negative rates look powerful at face value. Bank profits can be protected by exempting excess liquidity while market rates are pushed down. The turmoil in Japan points to three considerations that mute this view.
First, the impact of negative rates on the asset side of banks’ balance sheet can matter much more than the charge on excess liquidity. Banks that own large amounts of fixed income assets relative to the size of their total balance sheet (and their excess liquidity) are hit the hardest as returns on these assets drop. Japan and the US stand out as economies where the cost to the banks is biggest, Switzerland and Sweden the least, while Europe is somewhere in between:

Second, super-flat yield curves reduce the impact of negative rates. When bonds don’t offer risk premia, a perfect Keynesian liquidity trap exists: fixed income is the same as cash, and negative rates instantaneously transmit to the entire yield curve. The portfolio rebalancing into riskier assets declines as the marginal holders of zero-yielding bonds are naturally risk-averse. Japan’s yield curve, the flattest in the world, failed to steepen when the BoJ cut rates earlier this month – all yields just shifted down. Sweden, the UK and Europe stand out as yield curves where there’s still more risk premium to be squeezed, Japan, Canada and Norway the least:

Third, sub-zero rates can send a negative forward-looking signal. Until the technological and institutional framework is designed to pass negative rates to depositors without triggering banknote withdrawal, there will eventually be a (negative) lower bound. As this is approached the signaling cost of easing being exhausted may be bigger than the benefit of lower rates. At the extreme  cash and bonds turn into “Giffen goods”: the substitution effect of lower return is more than offset by expected lower future income. Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. The limitations of additional BoJ easing in addition to changing Japanese hedging behaviour, are some of the factors, that have led us to revise our USD/JPY forecasts for this year. We now think 2015 marked the peak in USD/JPY for this cycle and forecast a move down to as low as 105 this year." - source Deutsche Bank

Exactly, this negative feedback-loop, doesn't stop the frenzy for bonds and the "over-allocation process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP. This push yields lower and bond prices even higher. This is exactly what we discussed in our conversation "Le Chiffre" in October 2015:

"The big benefactors of the Fed and Le Chiffre's gaming style, particularly since is brilliant 2012 bluff in the European Government bond poker game have been bonds. We came across this very interesting chart from Deutsche Bank (h/t Tracy Alloway from Bloomberg on Twitter) which clearly illustrates "overconfidence" and "over-allocation" to the bonds relative to the trend which are $755bn above the normal trend. This is entirely attributable to the distortions created by QEs:

 - source Deutsche Bank (h/t Tracy Alloway).

Furthermore the significant repricing in European equities (where many pundits had been "overweight" at the beginning of the year) has led to a significant switch from equities to bonds as indicated by Bloomberg in their article from the 22nd of February entitled "They'd Rather Get Nothing in Bonds Than Buy Europe Stocks":

• "Estimates for Euro Stoxx 50 dividend yield at 4.3 percent
• The region's government debt is yielding 0.6 percent

The cash reward for owning European stocks is about seven times larger than for bonds. Investors are ditching the equities anyway.
Even with the Euro Stoxx 50 Index posting its biggest weekly rally since October, managers pulled $4.2 billion from European stock funds in the period ended Feb. 17, the most in more than a year, according to a Bank of America Corp. note citing EPFR Global. The withdrawals are coming even as corporate dividends exceed yields on fixed-income assets by the most ever:

Investors who leaped into stocks during a similar bond-stock valuation gap just four months ago aren’t eager to do it again: an autumn equity rally quickly evaporated come December. A Bank of America fund-manager survey this month showed cash allocations rose to a 14-year high and expectations for global growth are the worst since 2011.
If anything, the valuation discrepancy between stocks and bonds is likely to get wider, said Simon Wiersma of ING Groep NV.

 “The gap between bond and dividend yields will continue expanding,” said Wiersma, an investment manager in Amsterdam. “Investors fear economic growth figures. We’re still looking for some confirmations for the economic growth outlook.”
Dividend estimates for sectors like energy and utilities may still be too high for 2016, Wiersma says. Electricite de France SA and Centrica Plc lowered their payouts last week, and Germany’s RWE AG suspended its for the first time in at least half a century. Traders are betting on cuts at oil producer Repsol SA, which offers Spain’s highest dividend yield.
With President Mario Draghi signaling in January that more European Central Bank stimulus may be on its way, traders have been flocking to the debt market. The average yield for securities on the Bloomberg Eurozone Sovereign Bond Index fell to about 0.6 percent, and more than $2.2 trillion -- or one-third of the bonds -- offer negative yields. Shorter-maturity debt for nations including Germany, France, Spain and Belgium have touched record, sub-zero levels this month." - source Bloomberg

In that instance, while the equity "banana" appears more enticing from a "yield" perspective, it seems that the "electric shock" inflicted to our investor "monkey" community has no doubt change their "psyche".

The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box): When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock" hence the reach for bonds.

When it comes to our outlook and stance relating to the credit cycle we would like to point out again towards chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis where they highlight the work of Hyman Minsky's work on the equity-debt cycle and particularly in the light of the Energy sector upcoming bust:

"His cyclical theory of financial crises describes the fragility of financial markets as a function of the business cycle. In the aftermath of a recession, firms finance themselves in a very safe way. As the economy grows and expected profits rise, firms take on more speculative financing, anticipating profits and that loans can be repaid easily. Increased financing translates into rising investment triggering further growth of the economy, making lenders confident that they will receive a decent return on their investments. In such a boom period, lenders tend to abstain from guarantees of success, i.e; reflected in less covenants or in rising investments in low-quality companies. Even if lenders knowsthat the firms are not able to repay their debt, they believe these firms will refinance elsewhere as their expected profits rise. While this is still a positive scenario for equity markets, the economy has definitely taken on too much credit risk. Consequently the next stage of the cycle is characterized by rising defaults. This translates into tighter lending standards of banks. Here, the similarities to the subprime turmoil become obvious. Refinancing becomes impossible especially for lower-rated companies and more firms default. This is the beginning of a crisis in the real economy, while during the recession, firms start to turn to more conservative financing and the cycle closes again" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

The issue with NIRP and the relationship between credit spreads and safe-haven yields is that while the traditional pattern being lower government bond yields and a flatter yield curve is accompanied by wider spreads in "risk-off" scenarios, given more and more pundits (such as Hedge Funds)  have been playing the total return game, they have become less and less dependent on traditional risk-return optimized approach as they are less dependent on movements on the interest rate side. The consequence for this means that classical theories based on allocation become more and more challenged in a NIRP world because correlation patterns change in a crisis period particularly when correlations are becoming more and more positive (hence large standard deviations move).

But if indeed, the behavior of credit is affected in relation to safe-haven yields by changes in correlations, then you might rightly ask yourself about the relationship of credit spreads and FX movements given the focus as of late has been around the surge in the US dollar and the fall in oil prices in conjunction of the rise of the cost in capital since mid 2014.

In our next point we think that, from a credit perspective, once more you should focus your attention on the Japanese yen.

• Credit spreads and FX movements - Why we are watching the Japanese yen

Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings and in similar fashion in Europe previously the focused had been on the strength of the Euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward. Once again we take our cue from chapter 5 of Credit Crisis authored by Dr Jochen Felsenheimer and Philip Gisdakis:

"Many credit hedge funds not only implement leveraged investment strategies but also leveraged funding strategies, primarily using the JPY as a cheap funding source. A weaker JPY accompanied by tighter spreads is the best of all worlds for a yen funded credit hedge fund. However, these funds should be more linked to the JPY than the USD. One impact is obviously that the favorable growth outlook in Euroland triggers a strong EUR and tighter spreads of European companies (which benefit the most from the improving economic environment). However, the diverging fit between EUR spreads, the USD and the JPY, respectively, underpins the argument that technical factors as well as structural developments dominate fundamental trends at least in certain periods of the cycle. "  - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

However, NIRP doesn't reduce the cost of capital. NIRP is a currency play. This is clearly the case in Japan and has been well described in Deutsche Bank's note from the 22nd of February entitled "Yen hedging cycle risks rapid reverse":

"A lot of negative things have been said about negative rates, not least in Japan. Negative rates do not work by reducing financing costs materially, providing a ‘price of money’ stimulus. If negative rates do support activity, they primarily work through the exchange rate, adding to the portfolio substitution into risky asset.
For Japan the biggest problem is that macro policies have been directing capital toward risky assets for the last 4+ years. There are inevitably diminishing returns to this strategy, not least because ‘value’ matters. Value matters when it comes to the underlying domestic and foreign ‘risky’ asset, and the value of the exchange rate. Specifically on the latter, the yen even after the recent appreciation is still close to 20% cheap in PPP terms.

It is also cheap on a FEER and BEER basis, helped by a terms of trade shock that is seen lifting the Current Account surplus to near 5% of GDP in 2016. Figure 2 shows that in the last year, Japan has had the most favorable terms of trade shock of any major economy.

While FDI can recycle up to half of the C/A surplus, the question is whether other BoP components, notably net portfolio flows, will do the rest of the recycling, and at what exchange rate. For much of 2013 – H1 2015, vehicles like the GPIF were used to recycle (a much smaller) C/A surplus, that even briefly went into deficit in 2014. By June 2015, the GPIF’s portfolio of riskier assets inclusive of domestic stocks (22.3%), international bonds (13.1%), and international stocks (22.3%) was well within the desired base/benchmark ranges (see Figure 3).

For the latest data available for Q3 2015, GPIF domestic and international equity holdings declined led by weaker equity prices and a stronger yen – price action that underscores the risky nature of these investments.

As the C/A surplus grows and the above ‘structural’ pension shift toward capital flows abroad diminishes, there is a danger that we have already entered the realm where yen strength becomes self-fulfilling, as many of the hedging activities that were associated with a weak yen in the first four years of Abeconomics go into reverse.

Prior to Abeconomics, hedging on Japan equity flows was limited. Since 2011 when BOJ policy encouraged yen weakness, foreign inflows into Japan equities typically included much higher currency hedge ratios, while fully hedged instruments became popular. Precise numbers are not available, but it is estimated that as much as a quarter of the stock of foreign holdings of Japan equities of Y183tr has a currency hedge – a hedge that quickly becomes much less attractive with a stronger yen.

In contrast, for Japan investments abroad, FX hedge ratios declined. This particularly relates to USD investments, where expectations of USD gains increased rapidly in the Abeconomics years, and FX hedges on USD investments dropped. At the end of Q3 2015, Japan had a total of Y770trillion non-Central Banks assets abroad, inclusive of Y418tr portfolio assets, of which Y153tr are equity and investment fund shares, and Y266tr are debt securities. Even if much of the investment abroad has only limited hedges, one observation is that a very small adjustment in hedge ratios can have a huge flow impact. A shift in the hedge ratio on foreign fixed income assets by 10% is roughly equivalent to a year’s C/A surplus. Secondly, to the extent that hedge ratios are very low, as is the case for, say, the GPIF, there are sizable potential losses for funds recently adding to foreign exposure, and an emerging disincentive to invest in the most risky assets abroad.

Of the large players that actively hedge FX exposure, the life insurance companies’ activities can most closely be tracked through quarterly statements, and the time series can provide a useful standard to benchmark recent activity. Life insurance companies as of Q3 2015 had some Y65tr in foreign securities. As per Figure 4, their currency hedge ratios on dollar-based investments are estimated to have dropped to ~46% by the end of Q3 2015, the lowest levels recorded since the Great Financial Crisis in 2008. The hedge ratio is down from a peak of 79% in September 2009.

Life insurance company hedge ratios have likely reached a cycle nadir at the end of 2015, as concerns about JPY appreciation start to rise.

Among the other largest participants that have foreign portfolios of comparable size to the Lifers, both Toshins (foreign securities of ~77tr) and particularly public pension funds ( ~ Y57tr foreign securities) have very low currency hedge ratios and are heavily exposed to currency risk. Japan investments abroad, so actively encouraged by policymakers, are slowly being shown to have a familiar ‘catch’ – interest parity! Nominal yields may be more attractive abroad, but the long-term currency risks are enormous, at least when placed in the context of a yen that is still significantly undervalued.

A crucial element of hedging activity is the expected exchange rate. Here three bigger macro forces are at play for the remainder of 2016: i) Japan/BOJ policy; ii) the Fed; and iii) China FX policy. Firstly on BOJ intervention, the market should not expect any official BOJ intervention barring extreme FX volatility. It would run counter to G20 rules and risk a serious rift with the US. On rates policy, adding significantly to NIRP looks increasingly unpalatable, with our Tokyo Economics team expecting only one more 10bp cut in Q3. The next set of actions will likely need to revolve around ‘qualitative QE’ and the buying of more risky assets, notably securitized products.

On the Fed, we expect USD/JPY to remain sensitive to Fed expectations, but not to the point where more Fed tightening is likely to lead to new USD/JPY highs. The yen has a history of doing well in 5 of the last 7 Fed tightening cycles, although it did weaken in the two big USD upswings." - source Deutsche Bank

As we posited in our conversation "Information cascade" back in March 2015, you should very carefully look at what the GPIF, and their friends are doing:

"Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets." - source Macronomics, March 2015

We also added more recently in our conversation "The Ninth Wave" the following:

"So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor.
When it comes to Mrs Watanabe, Toshin funds are significant players and you want to track what they are doing, particularly in regards to the so-called "Uridashi" funds. The Japanese levered "Uridashi" funds (also called "Double-Deckers") used to have the Brazilian Real as their preferred speculative currency. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted previously for 46 percent of double-decker funds in 2009 with close to a record 80% in 2010 and now down to only 22.8%.
As our global macro "reverse osmosis" theory has been playing out, so has been the allocation to the US dollar in selection-type Toshin
Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP." - source Macronomics, January 2016

So from a "flow" perspective and like any trained "monkey" looking to reach out for "bananas", at least the slippery type, whereas other "monkeys" are focusing on the US dollar and Oil related woes, we'd rather for now focus our attention onto the Japanese yen, and the allocation implications of a stronger yen. For us, like others, a PBOC devaluation move on the Yuan would send a deflationary impulse worldwide but, in terms of risk assets, it would have serious consequences on Japanese asset allocations and would lead to an acceleration in capital repatriation (this would mean liquidation of some existing positions rest assured) as indicated in Deutsche Bank's note:

"Even modest JPY gains against the USD should translate to a strong yen against all the other G10 currencies and EMG Asia FX, not least because of global macro risks elsewhere. Nothing is capable of lifting the yen trade weighted index more than a speed up in the Rmb’s depreciation rate, leading to knock-on devaluations in EM Asia. This risk alone should encourage higher Japan hedge ratios for investment abroad, inclusive of the stock of Japan FDI assets abroad. A risk-off China shock would tend to concentrate JPY gains against currencies of other G4, but initially would likely include additional yen strength against all currencies. It should also drive the Nikkei sharply lower.

The Nikkei and yen have a long and sometimes tortured history of moving in lock-step. A stronger yen has hurt the Nikkei for obvious reasons, but a weaker Nikkei also tends to lead to a repatriation of capital and a stronger yen. Interestingly, the current Nikkei levels are already consistent with a USD/JPY below Y105."  - source Deutsche Bank

When it comes to the year of the Fire Monkey, the slippery banana type, no doubt could come from Japanese investors hurt by the violent appreciation of the Japanese yen, which has indeed been a significant "sucker punch" when it comes to the large standard deviation move experienced by the Japanese yen versus the US dollar. If Mrs Watanabe goes into "liquidation" mode, things could indeed become interesting to say the least.

When it comes to Minsky and the equity-credit cycle, whereas central banks can affect the amplitude and the duration of the cycle, in no way can they alter the character of the cycle. In our final chart, we once again indicate our 2007 feeling thanks to the rise in leverage, tightening financial conditions with the issuance markets closing down on the weaker players, which bode poorly from a risk-reward perspective.

• Final chart: US corporate sector leverage approaching crisis peak

Like many pundits, we have voiced our concerns on the increasing leverage thanks to buybacks financed by debt issuance and the lack of the use of proceeds for investment purposes. Our final chart comes from the same Deutsche Bank note from the 22nd of February entitled "Three things the market taught me this year" quoted previously and displays the US corporate sector leverage which is approaching crisis peak:

"US deleveraging – not that great

US consumer deleveraging stands out as one of the major achievements of the Yellen Fed. Yet the corporate picture looks much less impressive. Total amount
of US corporate debt has approached the highs seen in the financial crisis (chart 3). 

Not only that but the bulk of the leverage has been directed towards corporate stock buybacks (chart 4), explaining how low investment but high borrowing have existed at the same time. Persistent volatility in the US credit market has highlighted vulnerabilities that weren’t a concern last year.

- source Deutsche Bank

While a respite is always welcome, when it comes to the rally seen recently, as far as the Monkey and banana problem is concerned as everyone is hoping from additional tricks from our "Generous gamblers" aka our central bankers, this rally might have some more room ahead but then again, it doesn't change our belief in the stage of the credit cycle and our focus on what's the Japanese yen will be doing.

"Life is full of banana skins. You slip, you carry on." - Daphne Guinness, British artist

Stay tuned!