Macro and Credit - Just Like Heaven

"The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism." -  Seth Klarman

Looking at the sudden jump in the Fed March hike probability concomitant with the "sucker punch" delivered in short order on Monday to the gold mining complex (making us reduce our exposure for the time being), while equities markets continuing their upward trajectory and credit their tightening bias, it made us wander this time around for our title analogy towards 1987 British band The Cure third single released and first American hit song "Just Like Heaven". Given the song is about hyperventilating and taking into account composer Robert Smith's childhood memories of mastering magic tricks, we are feeling impressed by the rapid move in markets from their hypomanic mood towards somewhat state of "euphoria" hence our chosen title. Whereas for the time being both flows and price action point towards a continuation of the rally, if indeed we are short term "Keynesian", we do remain, long term "Austrian" from a valuation perspective and that's just our "realistic bias".

In this week's conversation we would like to look at the sustainability of the rally particularly in credit from a flow perspective given in credit land since the beginning of the year and in particular High Yield, it feels "Just Like Heaven".

Synopsis:

• Macro and Credit - Tactically bullish, politically skittish
• Final chart - Global expansion? This time it's different

• Macro and Credit - Tactically bullish, politically skittish

When it comes to assessing credit, the ongoing rally in credit is supported by strong inflows into the asset class. What is questionable is the sustainable of the rally given its rapid advance. For instance, as displayed by Bank Of America Merrill Lynch from their most recent High Yield chart book for February, the year to date performance in credit and in particular US High Yield has been significant:

Cross-Asset Total Return Performance from 31st of December until 28th of February 2017 - Source Bank of America Merrill Lynch

What is of interest is that many sell-side pundits expect returns for US High Yield to be close to flat for the entire year. Yet, there has been a significant tightening in credit spreads on the back of strong inflows into the asset class as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of March 2017 entitled "Reaching for yields continues":

"It’s all about rates

Lower front-end rates have been pivotal to support flows into credit to the detriment of flows into equities. Investors continue to favour short-duration high-grade paper to insulate against steepening of curves, while outflows continue from high duration pockets.

Over the past week…

High grade funds continued on a positive trend for the sixth week in a row; and recorded the highest inflow in three weeks. High yield funds inflows remained strong for another week, now counting 13 weeks of positive flows. Looking into the domicile breakdown, as charts 13 &14 show, even though European-focused funds recorded inflows, the majority of the inflow is concentrated in US and globally-focused funds.

Government bond funds flows went back to negative territory after a brief week of inflows. Money market funds weekly flows were negative for the third week in a row. Overall, fixed income funds flows remained strong and positive for the tenth consecutive week; with more than $30bn over that period.

European equity funds flows on the other hand moved back to negative territory after five weeks of inflows. The outflow from the asset class was the biggest in thirteen weeks.

Global EM debt fund flows continued on the positive trend for a fifth week, however we note a weakening of that trend recently. Commodities funds flow remained positive for a seventh week.
On the duration front, strong inflows continued in short-term IG funds for the 11thweek in a row. Mid-term funds’ flows turned slightly positive after three weeks of sizable outflows, while flows into long-term funds remained negative for a second week." - source Bank of America Merrill Lynch

So all in all, the technical support for credit in particular and risky assets in general, in this "risk-on" environment has clearly sounded "Just Like Heaven". But, according to Société Générale in their Credit Market Wrap-up from the 27th of February entitled "Why inflows into credit do not mean spreads will go tighter", they indicate that there is no guarantee this rally could continue and therefore the ongoing tightening of credit spreads is unsustainable:

"Market thoughts

We have been bearish about credit markets this year, and so far (despite a slight widening in spreads last week) we have been wrong. In The big hangover Part II, we outlined the reasons for concern. In The worst is yet to come, we reiterated why we thought rising government yields would eventually put pressure on credit markets. Yet it is clear that most market participants are a lot more bullish than we are.

Chart 1 shows the percentage moves in spreads since the US elections. Euro IG spreads are wider (though the move occurred in mid-November). Spreads are tighter in all other markets, with US high yield leading gains, EM (either high yield or investment grade) in second place, and Euro high yield tied with the US IG market over the whole period. Note that Euro HY gains have mostly taken place this year, while US IG gains principally happened in 2016.

One of the drivers of the good performance has surely been capital inflows. In their latest Mutual Fund & ETF watch, SG’s asset allocation team note a surprising shift in the flow of funds into credit. Between the end of January 2016 and October 2016, there was a startling 40 weeks of successive inflows into US investment grade credit funds, with inflows totaling some $77bn. Then came an equally consistent 11 weeks of outflows totaling more than $12bn. Since mid-January, inflows have returned; the $5bn inflows in early February were the highest since summer 2016 and indeed one of the highest weekly totals since the data began.

Are we back to a lasting period of inflows – and tightening spreads? Perhaps, but be careful, for the flow of funds into credit is not necessarily a good pointer for how credit spreads are going to evolve from here.

Chart 2 shows the three month total of inflows into USD IG credit (in blue) and the subsequent three-month change in spreads (in red). The correlation between the two is slightly negative; what’s more interesting, however, is to concentrate on the periods where flows sharply accelerated (which we have picked out in blue).

We note the following:

• In two of the five periods (4Q14 to 1Q15; 1Q45) rising inflows subsequently led to higher spreads.
• In three of the five periods (late 2013-early 2014; 2Q16; 3Q16) inflows led to tighter spreads but the tightening trend decelerated.

If the inflows into credit persist, then, this is not necessarily a good sign for the market: history would, indeed, tend to suggest the reverse, with inflows met by more supply, worsening credit metrics and eventually a widening in spreads rather than a tightening. Credit investors should be careful what they wish for from here on in."  - source Société Générale.

Yet, while credit is behaving "Just Like Heaven" thanks to the supportive background of strong technicals, as we mused out recently, early 2016 was very different in the sense that the first part of the year was plagued by "bad news" from the energy sector that spilled-over to other risky asset classes and ended up "good news" performance wise during the second part of the year. We believe that 2017 could be the reverse where "good news" (technicals and fundamentals), get impacted in the second part of the year by "bad news" (additional tightening financial conditions, credit cycle turning, rise of political risk, etc.). When it comes to US High Yield and "fundamentals", the picture in 2017 is completely different from 2016 as pointed out by Bank of America Merrill Lynch in their High Yield Strategy note entitled "Let's do the limbo" from the 2nd of March 2017:

"The HY rally continues

High yield spreads tightened another 26bps for a 1.21% excess return in February, the 8th consecutive month of spread tightening. Although all 18 sectors finished in the green, performance across industries varied with Health Care (+3.40%) and Telecom (+2.97%) leading all others. The former outperformed due to alleviated concerns surrounding changes to the ACA, while the latter delivered strong returns because of M&A speculation amongst two of the largest capital structures in the index (S and INTEL). On the opposite end of the spectrum, Energy was the worst performing industry with a +0.36% gain, just the 2nd time the sector has underperformed the overall index in the last year (Note: we lowered over view on Energy from overweight to market weight back in January). Although valuations have certainly become stretched across high yield as we are now just 39bps away from the post-crisis tights, we think this trend can continue (albeit more slowly) as it has come against a backdrop of improving fundamentals and a declining default rate, which we discuss below.

 Q4 fundamentals first take: sustained improvement

With roughly 70% of our HY universe having reported Q4 earnings, so far top and bottom line growth have continued to trend higher. Notably, HY revenue continued to improve for the 4th consecutive quarter; in fact, the current +5.0% growth represents the first YoY increase since Q4 2014. The same story holds true ex-Commodities, where revenue growth increased from +3.3% in Q3 2016 to +5.7% last quarter. And because EBITDA growth outpaced modestly higher debt levels, leverage continued to decline while coverage ratios increased.

Although these figures remain better than their historical averages during ‘normal’ times, the recent trends should act as a token of optimism for investors. Within sectors, these preliminary earnings results show the strongest YoY gains in Gaming, Capital Goods, and Retail. On the other hand, Food and Health Care have experienced the largest deterioration in EBITDA on a year over year basis.

Default rate sees largest 1 month decline since 2010 

The US HY default rate fell from 7.06% last month to 6.11% today; this 95bp reduction is the largest 1 month change since August 2010, when the rate fell from 4.25% to 2.97%. There was a noticeable lack of filings last month, where for the first time in over 2 years there were 0 first time defaulted issuers1. However, also driving the default rate lower was the removal of February 2016 from the trailing 12 month rate, where we saw 10 unique issuers default. Although the reduction in Energy defaults is responsible for most of the decline, on an ex-Commodity basis the default rate still ticked lower, from 3.3% to 2.9%. These drops are consistent with our view for a lower default rate in 2017, where we expect the rate to decline to just 4.0% for US HY issuers and remain at 2.9% ex-Commodities. With just 5 defaults YTD, this would imply an additional 31 defaults in 2017 (20 ex-Commodities)." - source Bank of America Merrill Lynch

While looking at the High Yield default rate is like looking at the rear view mirror, the most noticeable change in terms of fundamentals between 2016 and 2017 has been EBITDA YoY percentage change as per the below chart from Bank of America Merrill Lynch High Yield chart book:

- source Bank of America Merrill Lynch

Some would rightly ask if this "Just Like Heaven" picture would be distorted by the Energy sector, it isn't as per the chart below:

- source Bank of America Merrill Lynch

What matters for default rate going forward is the evolution of lending conditions. As we have mentioned recently the noose is already tightening for Commercial Real Estate (CRE), but we have to see a meaningful deterioration overall, spilling over to the default rate as per the chart below from Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch

Yet, while the picture seems rosy, in fact "Just Like Heaven", given our fondness for monitoring credit conditions to assess the credit cycle, we have noticed that since the beginning of the year in the US Commercial and Industrial Loans (C&I) have turned "South". The chart below from Bank of America Merrill Lynch illustrates the latest trend:

- source Bank of America Merrill Lynch

Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth).

While markets so far seems oblivious to political uncertainties building up and remain tactically bullish, political uncertainties particularly the mess in France could throw in short order a spanner in the works, hence our cautious "optimism" or short term "Keynesian" bias. In relation to French elections and us being French we would like to give you our opinion on the matter. After all, we got Trump and Brexit right in 2016, but, when it comes to having a clear view on the outcome, we must confess we do not have one. It is probably the first time since 1958, that French elections represent such a "known unknown". One would think pundits would have learned from making inaccurate predictions after an eventful 2016 which saw BREXIT, Trump's elections and the Italian referendum. The odds of Marine Le Pen upset in the second round has to be taken into account, particularly given that the second round occurs on Sunday 7th of May and the Monday is a holiday. People might decide they have other things to do than show up at the poll stations. Bear that in mind. Whoever gets elected on the 7th of May doesn't resolve the uncertainty for France given that a month later you get the parliamentary elections for the national assembly. All in all, France is a very big mess. 

As things stand, global expansion in this particular credit cycle has seen volatility subdued, but, given the gradual pull back from accommodation from central bankers, one would think there is a heightened probability in seeing a regime change in terms of volatility regime. We think the second part of the year could mark this change. In our final chart below, we will briefly discuss the relation between global expansion and lower volatilities.

• Final chart - Global expansion? This time it's different

Though the macro data seems to be pointing towards an acceleration in global expansion, volatility continued to be subdued, yet political uncertainties keep rising on a daily basis. Our final charts comes from Nomura FX Insights note from the 3rd of March entitled Le Pen and the lessons learnt for FX Vol" and shows that global expansion has led to lower volatilities, yet this expansion, in the ongoing credit cycle has been very different from the past:

A global expansion has historically meant lower FX vols overall, but ending unconventional monetary policy could be the exception to the rule
Historically, when we have entered into a global expansion phase as we expect (see Catch-up expectations and Back to boom/bust?), we tend to see FX vols head below their long-term averages (see The Great Moderation of 2014).
While this is perhaps true for equity vols, it could be different this time for rates and therefore FX vols. The US expansion is entering its seventh year of growth, which is already the fourth-longest expansion we have seen since the late 1940s (Figure 1) and on some metrics is looking rather mature already.

Big questions remain on the outcome of the geopolitical risks, but also what impact on markets the years of unconventional monetary policy will have when it comes to an end. We studied the impact of the zero lower bound (ZLB) on fixed income and what happens at times of lift-off, where we found term premia in fixed income markets can increase in a non-linear fashion (see Lift-off, term premia and exchange rates). With the risk of a sudden non-linear increase in interest rates as the ECB and other central banks look to exit unconventional monetary policy the “post Trump” sell VIX / Buy MOVE trade still looks like it will remain at high levels (even though we already hit our target, see Top Trump Trades).
So while equity markets continue to exhibit strong optimism for global growth, in fixed income it may not be such a smooth ride, given the removal of monetary policy stimulus, which could also have a feed-through impact on FX vols on a general basis." - source Nomura

When it comes to changes in the volatility regime, for now it's "Just Like Heaven", but, maybe the road to hell is paved with European elections? Who knows...

"Fragility is the quality of things that are vulnerable to volatility." -  Nassim Nicholas Taleb

Stay tuned!

Macro and Credit - Pareidolia

"It is discouraging how many people are shocked by honesty and how few by deceit." - Noel Coward, English playwright, composer, director, actor and singer

Watching with interest the continuation in rising asset prices and the relentless tightening in credit spreads, while monitoring our rewarding gold and silver miners exposure and itching to dive into US long bonds, we reminded ourselves for our title analogy of Pareidolia. Pareidolia is a psychological phenomenon involving a stimulus (an image or a sound) wherein the mind perceives a familiar pattern of something where none exists. Most people have never heard of "Pareidolia". But nearly everyone has experienced it. Anyone who has looked at clouds, the Moon and spotted faces or animal forms has felt the pull of "Pareidolia". Pareidolia can be extremely evocative particularly for people having "blind faith" or who are inclined in believing in "miracles" (such as the ones "pulled" by our central bankers). Put it simply, "Pareidolia is the human ability to see shapes or make pictures out of randomness. Pareidolia can be considered a subcategory of Apophenia being the human tendency to perceive meaningful patterns within random data. 

You are probably already asking yourselves where we are going with this, for us it is pretty simple. The much vaunted "Trumpflation" trade which has been put on meaningfully by many pundits, leading to some very distorted and crowded positions (short US Treasuries for instance) appear to us to be a case of "Pareidolia". The idea that the US economy can be "reflated" meaningfully at a rapid pace by the new US administration is an "optical illusion".

While last week me mused around the "Hypomanic" state of the markets and its pervasive elevated euphoric mood and the potential for equities to impact the tightening mood in credit which so far has prevailed, in this week's conversation we would like to cogitate more on the state of the credit cycle, some thoughts on Gold, and the risk of an equity drawdown. Rest assured a correction is most likely to happen in the US in the near future, regardless of the prevailing "Pareidolia" mantra.

Synopsis:

• Macro and Credit - Fooled by "Pareidolia"?
• Final charts - Credit growth? appearances can be deceiving?

• Macro and Credit - Fooled by "Pareidolia"?

In our previous conversation we wondered if in 2017 a US equities sell-off could for a change lead credit wider. We also mused around the impact a global rise in core inflation could potentially lead to, when it comes to a "sell-off". Since our last conversation we have seen some interesting developments in credit, namely that the tightening movement has been relatively impressive in the credit space as reported by DataGrapple in their blog post from the 23rd of February providing a good example of "Hypomania" in credit land:

"The credit market felt firm throughout the session. Credit indices would have closed a tad better across the board were it not for a late day wobble following a rapid increase of 4bps to 75bps of the OAT/BUND spread towards the close. The most striking feature of the session was actually the collapse tighter of a number of Crossover names. It is not often that 5 constituents of iTraxx Crossover (ITXEX) tighten in excess 30bps for completely unrelated reasons, while the index is left unchanged. SELNVX (Selecta Group BV) closed 100bps tighter at 700bps after an article published in the Italian press mentioned Argenta – an Italian vending machine operator – could be up for sale and that a merger with SELNVX followed by an IPO of the newly created entity would be on the table. DRYMIX (Dry Mix Solutions) closed 45bps tighter at 139bps, after a refinancing of the company’s debt was announced paving the way for an orphaning of the entity. WINDIM (Wind Acquisition Finance) closed 38bps tighter at 262bps after releasing good numbers and saying that they are happy with their current structure. Without many names widening significantly - New Look was the odd one out -, that was enough to send the basis of ITXEX back to its recent wides despite the absence of any sharp move of the market as a whole, which is fairly unusual." - source DataGrapple

Indeed, it is not often we do see such large movements for an index comprising 75 equally weighted single company credit default swaps. Given we have recently been fairly vocal on our contrarian stance relating to the Trumpflation trade, it seems to us that investors have been blinded by their "Pareidolia". On the subject of this phenomenon and the related "blind faith" of investors, we read with interest Morgan Stanley's recent Cross-Asset Dispatches note from the 20th of February entitled "How Likely Is a Major Equity Drawdown":

"We look at what key indicators say about the likelihood of a recession or a major equity sell-off over the next 12 months. On current readings, the likelihood averages ~20%.

We often hear "a large sell-off is unlikely, based on the levels of 'X'". We decided to test that:

A 15%+ correction for the S&P 500 within 12 months occurred around ~20% of the time when a wide variety of indicators were at the same levels they are now. That's close to average, but higher than options markets imply.

Don't forget, the probability of a 15%+ drawdown over ANY 12-month period is 18%:

We think investors underestimate the unconditional probability of a major drawdown (defined here as a 15%+ decline from current prices within a year).

What's worrying?

Year-over-year changes in oil, real yields and the level of jobless claims are all consistent with a 30%+ probability of a 15%+ drawdown over the next 12 months.

What's comforting?

The level of credit spreads and yield spreads and strong PMIs suggest that this drawdown risk is much lower than normal (in the single digits).
Investment implications – own the tails, hedges in credit: We believe that 2017 has larger-than-appreciated tails on both sides of the distribution. Calls on the S&P 500 are our preferred way of expressing underpriced animal spirits. On the downside, we think credit hedges are attractively priced, and 'lock in' one of the asset classes most relaxed about large drawdown risk.

Investment implications – own the tails, hedges in credit:

We believe that 2017 has larger-than-appreciated tails on both sides of the distribution. Calls on the S&P 500 are our preferred way of expressing underpriced animal spirits. On the downside, we think credit hedges are attractively priced, and 'lock in' one of the asset classes most relaxed about large drawdown risk.

Exhibit 1:

Oil, UST real yields and equities are flagging higher-than-average risk of a large equity sell-off over the next 12 months, while credit spreads remain relaxed

- source Morgan Stanley

Of course the worrying part is of interest to us, not because we suffer from a "pessimism bias" but, mostly because rather than going for the "optimism bias" and "Pareidolia", our contrarian stance pushes us towards "realism bias". 

To that effect, when it comes to the "barbaric relic" aka gold, when it comes to using Continuous Jobless Claims (Z-score 6months - 183 days and data non revised) as an input to generate "alpha" in relation to gold as an asset class, we find of interest that since the 22nd of January 2004 until the 17th of February, this simple input would have generated 0.76 of alpha according to the tool DecisionScreen:

- source DecisionScreen

What is as well very interesting is the sharpe generated by this simple trading rule over one year, we get a sharpe of 1.48 for a cumulated excess return of 23%:

- source DecisionScreen

Obviously as you can see from the tool above, when jobless claims rise, it is bullish for gold. The "barbaric relic" is still a buy. We also indicated dear readers our move towards a positive stance towards the asset class by the end of December 2016 if you remember our previous musings.

Also from a "realistic perspective" relative to gold, we read with interest Mish Shedlock's recent take on  the relation between gold and rate hikes in his post "Rate Hike Cycles vs. the US Dollar: Rate Hikes Bad for Gold?" from the 23rd of February:

"Gold Does Well in These Environments

1. Deflation
2. Hyperinflation
3. Stagflation
4. Decreasing faith that central banks have everything under control.
5. Rising credit stress and fear of defaults

Gold Does Poorly in These Environments

1. Disinflation (1980 to 2000 is a perfect example. There was inflation every step of the way but gold got clobbered).
2. Increasing faith in central banks’ ability to keep things under control (Mario Draghi’s “Whatever it takes” speech triggered a prime example)

Gold does worst in periods of prolonged disinflation and in periods of rising faith in central banks." - source Mish - Mishtalk.com

So while we don't have rising credit stress and fear of defaults à la 2016, the potential for stagflation should not be discarded with the increasing risks of a global trade war down the line. In that particular case, to repeat ourselves, a slowdown in global trade would evidently be bullish for gold.

But moving back to the subject of the credit cycle and being fooled by "Pareidolia", we keep telling you that we are slowly but surely moving towards the end of the cycle. From the latest Fed Senior Loan Officer Survey and in particularly Commercial Real Estate, to other segments of US consumer credit, but also other parts of the world, there are more signs that the "credit impulse" has been weakening as of late. When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. On that specific subject, we read with interest JP Morgan's special report from the 22nd of February entitled "Global credit cycle: Divided and sluggish":

• Globally, the growth of private nonfinancial credit is slowing in a major departure from the past few business cycles.
• In the DM, credit gains have firmed modestly but banks have recently stopped easing lending standards, giving some caution.
• The private sector in EM ex China has been deleveraging since mid-2015. The process is broadening and there is no sign this headwind to growth is about to dissipate.
• EM real GDP growth recently has stabilized as other factors offset the drag from credit. Our economists anticipate some pickup in 2017. Potential downside risks likely would be related to the Fed, US trade and tax policy, or China.

The growth of global private credit is slowing, maintaining a downtrend that took hold in 2014 (Figure 1).

This slowing is a major departure from the past few business cycles, when credit accelerated in the latter phase of the expansion. The dynamic underscores the significant structural forces damping credit growth. Demand for credit remains subdued in the wake of the global financial crisis. Additionally, global banks are becoming less willing to extend new credit. DM banks had been easing standards but stopped doing so in the latest quarter. EM banks have been tightening
standards since 2011 (Figure 2).

Beneath the global surface, the most striking feature of the credit landscape remains the sharp dichotomy between the DM and the EM. The DM private sector underwent a lengthy deleveraging phase from 2010 through 2014. However, DM credit growth has exceeded nominal GDP growth since 2015 and reached an estimated 3.3% in 4Q16. Taken at face value, the credit cycle has swung from being a significant headwind for DM economic growth to a modest tailwind. However, with DM banks turning more cautious, this could cap the recovery in credit growth or even reverse it.

The process is moving in the opposite direction in the EM and the dynamic is sufficiently powerful that it has dominated gains in the DM. EM private credit growth slowed to an estimated 9%oya in FX-adjusted terms in 4Q16, half the peak rate from early in the expansion (Figure 3).

Moreover, China’s double-digit gains strongly influence the EM aggregate. In the EM ex. China, credit growth has receded to just 6.0%oya. The private sector in EM ex. China has been deleveraging since mid-2015 (Figure 4).

These credit dynamics represent an ongoing headwind for EM growth, similar to what happened in the DM from 2010 to 2014. Nonetheless, it is encouraging to see that EM real GDP growth recently has stabilized due to positive offsets from EM policy support, easier financial conditions, rising commodity prices, and stronger DM growth.

Consistent with our previous analysis, this note focuses on broad private nonfinancial credit, which includes bank loans and corporate bonds, as well as other forms of financing. Up through 3Q16, our data are based on statistics provided by the BIS and the central banks (for background, see “The elephant in the room: Taking stock of the surge in EM private debt,” September 2, 2015, and “EM debt overhang is larger but its growth pace is slowing,” J. Goulden and A. Wong, September 30, 2016). We then generate estimates for 4Q16 using data on domestic bank credit, which accounts for the majority of total credit. The data for the EM cover only the subset of countries encompassed in the J.P. Morgan global economic forecast, as shown in Table 2 below.

Leverage cycle slowly turning up in DM

DM private credit contracted in the early days of the economic expansion. When credit growth resumed in 2011 the pace was slow and below that of nominal GDP as households and corporates worked to lower their indebtedness and banks struggled to shore up their balance sheets. A further acceleration in credit took hold in 2014 and beginning in 2015 credit growth moved above nominal GDP growth (Figure 5).

To be sure, any added support for consumer or corporate demand from increased leverage has been modest compared to the 1990s and 2000s cycles. The DM leverage ratio increased 1.7%-pts of GDP per annum on average from 1Q15 through 3Q16, a little more than half the pace from 2002-07.

The recovery in credit growth varies across the DM (Figure 6).

The pickup has been focused in the corporate sector (Figure 7), especially in the US, and so far has not translated into increased capex.

On the contrary, DM capex growth weakened progressively since 2014, falling below zero over the four quarters through 3Q16 (Figure 8).

It appears that many businesses, particularly in the US, used the money they borrowed for stock buybacks or M&A, or else they saved it. After having boomed in the previous cycle, household credit stagnated from 2009-12 as households in the US, the UK, 

By region, credit growth has recovered most strongly in United States, reaching about 4.6%oya in 4Q16—about 1%- pt above nominal GDP growth. By comparison, credit growth was more restrained in the Euro area, the UK, and Japan at 1.8%oya, 3.7%oya, and 1.8%oya, respectively.

We can gain insights into the bank credit cycle, and thus the broader flow of credit, through the quarterly surveys of senior loan officers conducted by the major DM central banks and the Institute of International Finance. These surveys provide information about the supply and demand for bank loans that we show in the form of net percent balances (“PB”).

The latest surveys, which compare banking conditions in January 2017 with those in October 2016, indicate DM banks shifted to a neutral stance on credit standards following an extended easing phase (Figure 11).

This shift includes the US, the Euro area, and the UK, though not Japan. In aggregate, DM banks stopped easing business credit standards in late 2015. They shifted to neutral for consumer credit standards in the 1Q17 survey. This shift in bank behavior is typical of late-cycle expansions and needs to be watched. In these phases, excesses in household or business balance sheets  often occur, or in real estate markets. In addition, these periods normally are characterized by tight monetary policy. Against this backdrop, it is not entirely clear why the DM banks are acting this way.

The relationship generally fits this pattern looking at the available history. The DM originations proxy is positive (the demand PB is positive while standards are neutral), implying DM loan growth should be increasing. This had been the case until DM loan growth stabilized in recent quarters, when it began to undershoot the model’s projection (Figure 12).

Note that since the current-quarter originations proxy tends to lead changes in %oya loan growth, it currently points to a significant pickup in DM loan growth this year. However, since the DM proxy has been over-predicting loan growth for about a year, we would temper its projection." - source JP Morgan

From a "Pareidolia" perspective, one would assume a significant pick up in loan growth, in particular in relation to an expansion in PMIs overall, but as stated by JP Morgan, their DM proxy has been over-predicting, meaning that, in similar fashion to the much vaunted "reflation" play, it can be highly deceptive. It might be a case of us being fooled by "Pareidolia" at this stage of the credit cycle. After all us human beings have a tendency to perceive meaningful patterns within random data. 

Clearly as we pointed out last week, in a state of "Hypomania" and at this stage of the cycle, there is a tendency for excesses (real estate prices, subprime auto loans, etc.) to build up meaningfully. For instance, we have been monitoring the weakening demand for credit but in particular Commercial Real Estate given the latest Federal Reserve Senior Loan Officer Survey has shown that financial conditions have already started to tighten meaningfully in that space. This has been confirmed by Wells Fargo in their note from the 22nd of February entitled "CRE Credit: Fed Concerns, Tighter Standards and Less Demand":

"CRE Credit Availability and Demand WaneThe slowdown in transaction volumes coincides with survey measures reporting weaker demand for CRE loans. According to the Federal Reserve’s January Senior Loan Officer Opinion Survey, CRE loan demand has fallen. Lenders reported weaker demand for multifamily and construction loans on net in the fourth quarter, while nonfarm nonresidential loan demand was relatively unchanged (middle chart).

On the supply side, lending standards for CRE loans continued to tighten across the board in the fourth quarter, marking the sixth-consecutive quarter of net tightening (bottom chart). The Fed survey noted particularly “significant” tightening for loans secured by multifamily properties and construction land development loans, with a net 33.3 percent and 25.0 percent of firms, respectively, tightening standards. Meanwhile, a more moderate 13 percent of banks reported tightening standards for nonfarm nonresidential property loans. The survey data suggest that bank lenders are proving themselves more cautious/selective, consistent with indications that the sector is at a mature stage in the current cycle.

The slower pace of foreign investment in U.S. CRE, and tighter lending standards for CRE loans, should provide some relief to Fed officials that have sounded caution over credit risks associated with the elevated level of CRE pricing." - source Wells Fargo

This brings us to the relationship between credit and more importantly the credit impulse and growth. Credit growth has always been the necessary condition for economic growth. On that subject we read with interest Wells Fargo's Interest Rate Weekly note from the 22nd of February entitled "Credit and Growth: A Partnership Not Opposition":

"Growth and Debt Finance

As illustrated in the graph below, there is a close link between economic growth and domestic nonfinancial debt growth.

This pattern reflects an interaction that works both ways. Economic growth prompts creditors and debtors to accept more debt as the expectation of growth, and thereby the increased financial rewards to creditors and debtors, improves. In turn, the availability of credit opens up opportunities for entrepreneurs to pursue prospects for growth.
During the most recent economic expansion, the very modest pace of debt growth has been associated with a period of subpar real economic growth. In part, this pattern may reflect the emphasis on financial regulation to avoid risk-taking that may have put a damper on financing any idea that carried a perception of risk.

The Specific Issue of Private Credit

During the current economic expansion, the pace of private credit growth to the consumer and business sectors has been particularly weak relative to prior economic expansions (middle graph).

Since both the business and consumer sectors are major contributors to economic growth and job gains, then it is not a surprise that the overall pace of economic growth and job gains have been modest, at best, during the current cycle. This is particularly apparent by the big drag of credit during the first few years of this expansion.

This interaction of private credit and spending imparts a pro-cyclical pattern to both economic activities which, if not carefully monitored, creates an abrupt halt to both when perceptions of risk and economic growth opportunities are altered.

Household Net Worth: A Balancing Act

During the latest downturn, the hit to real estate values was very evident in the steep drop off in household net worth as illustrated in the bottom graph. Each prior recession (1981-1982, 1990-1991, 2001) was associated with a decline in the growth of net worth but not to the extent experienced in the 2007-2009 period. Each recession, including 2007-2009, was associated with a decline in the growth rate of consumer spending.

Once again the link between financial/real asset values and consumer spending emphasizes our view that credit growth and economic growth are closely linked and that this link must be considered by public policymakers.
Current economic policy proposals favor faster growth and easier financial regulation. If thoughtful actions are taken, then faster growth can be achieved within a reasonable risk-taking environment." - source Wells Fargo

Unfortunately, where we disagree with Wells Fargo is that easier financial regulation will not lead to faster growth thanks to faster credit growth (credit impulse) at this stage in the cycle. When it comes to perceiving some form of "reflation" thanks to better credit growth on the back of a stronger credit impulse, we believe our final chart and conclusion below do point out towards yet another case of "Pareidolia".

• Final charts - Credit growth? appearances can be deceiving?

When it comes to economic growth, private credit matters and matters a lot as we have been discussing to some extent in our conversation. For our final chart we would like to point out to yet another chart from the quoted JP Morgan report relating to the credit cycle. The chart displayed shows indeed that, when it comes to the growth of private credit, appearances can indeed be deceiving such as encountered through "Pareidolia" effects:

"Appearances can be deceiving. The growth of private credit exceeds nominal GDP growth and the debt/income ratio has climbed rapidly since 2012. This sounds similar to what happened in the late 1990s and the 2000s. However, this characterization belies the lopsided nature of the cycle. In the DM, credit growth remains muted and the leverage ratio barely has increased from the lows of a few years ago (Figure 18).

Globally, the EM have accounted for most of the expansion of private credit and leverage. Yet, in the EM, credit growth has been sliding, both outright and in relation to nominal GDP.

In our interpretation, for the DM, the credit cycle gradually has shifted from being a stiff headwind to a modest tailwind. One question is whether even this modest degree of support might be fading. DM credit growth recently has leveled off near 3%. With inflation normalizing, this pace is barely above that of nominal GDP. Moreover, DM banks have unexpectedly turned more cautious. US banks are tightening lending standards while Euro area and UK banks have turned neutral. This shift in the credit supply, especially if it extends  further, could halt the recovery in credit growth or even reverse it.

For the EM, we believe the credit cycle has been damping economic growth. This belief is based on the rapid deceleration in EM credit, especially outside China, to where the majority of the EM countries encompassed in our economic forecast are now deleveraging. From the standpoint of credit supply, the weak banking sector interfered with the transmission of monetary policy. From the standpoint of credit demand, the desire of DM households and corporates to shed debt damped the recovery in consumption and business investment. We think these same dynamics are occurring in the EM. Moreover, the number of EM countries that are deleveraging continues to increase and there is no sign in credit data or in the IIF bank lending conditions surveys that the underlying supply/demand dynamics driving the deleveraging are abating.

EM credit dynamics have damped economic growth but they have not generated recessions, much less a crisis. This is consistent with recent experience in the DM, where the extended deleveraging phase from 2010 to 2014 did not prevent GDP growth but acted as a powerful headwind. In previous research, we found that deleveraging typically occurs during economic expansions, not during recessions (see “A constrained global credit cycle,” October 14, 2016). However, most episodes of significant deleveraging occur during the early phase of economic recoveries, as with the DM during this cycle. In the relatively brief history of our EM data, which extend back about 20 years to just before the Asian financial crisis, a significant number of EM countries delevered nearly all the time except during economic recessions (Figure 19).

However, the more intense phases of deleveraging followed major economic downturns (again, as happened in the DM in the 2010s). In this sense, the current shift toward deleveraging in the EM is unusual." - source JP Morgan

Could it be that the pattern of "deleveraging" in both EM and DM is simply a case of "Pareidolia"? We wonder...

"It is only hope which is real, and reality is a bitterness and a deceit." - William Makepeace Thackeray, English novelist

Stay tuned ! 

Macro and Credit - Hypomania

"Knowledge is marvelous, but wisdom is even better." -  Kay Redfield Jamison, American psychologist

Looking at the unabated records being broken in US equities markets, with the S&P 500 having had 47 consecutive trading days without a 1% move, we reminded ourselves for our chosen analogy title of the mood state of "Hypomania", well known in psychiatry. Hypomania (literally "under mania" or "less than mania") is a mood state which is characterized by persistent disinhibition and pervasive elevated (euphoric) with or without irritable mood but generally less severe than full mania (Tulip mania...). In 19th century psychiatry, when mania had a broad meaning of craziness, hypomania was equated by some to concepts of "partial insanity". Looking at financial markets today, one would ask if we have indeed reached that threshold to some extent in this long credit cycle. What we find of interest is that the state of "Hypomania" may occur as a side effect of pharmaceuticals prescribed for conditions/diseases other than psychological states or mood disorders such as the "opioids" like QE dear to our central bankers. We find interesting that as of late Fed's Harker said that opioid abuse is one cause of low labor participation by prime-age men. Maybe the Fed's opioid abuse is also the cause of stock market melting up thanks to "multiple expansion" due to record buybacks funded by cheap credit leading therefore to a "hypomanic" state of affairs? We wonder.

In those instances, as in cases of drug-induced hypomanic episodes in unipolar depressives, the hypomania can almost invariably be eliminated by lowering medication dosage (tapering), withdrawing the drug entirely (stop QE for good), or changing to a different medication if discontinuation of treatment is not possible. The funny thing with "Hypomania" is that it may also be triggered by the occurrence of a highly exciting event in the patient's situation, such as a substantial financial gain or recognition. In other words, "Hypomania" can be associated with "narcissistic personality disorder". The DSM-IV-TR defines a hypomanic episode as including, over the course of at least four days, elevated mood plus three symptoms OR irritable mood plus four symptoms, one of which being foolish business investments but we ramble again...or are we really? Because if indeed "Hypomania" can be associated with "narcissistic personality disorder", one has to wonder where we are currently located on Brean Capital Head of macro Strategy Peter Tchir's Maslow's Hierarchy Of Credit Bubble:

- source Brean Capital

If indeed, credit investors are showing traits of "narcissistic personality disorder", then it validates even more our "Hypomania" title analogy and the fact that the credit cycle is slowly but surely moving into the final inning number 9 (or 9 years?) Place your bets accordingly.

In this week's conversation we will be wondering whether or not we could be facing an inflexion point, namely that a correction in equities might start to weight on credit and in particular High Yield, currently "priced for perfection".

Synopsis:

• Macro and Credit - 2017 - Credit leads equities, but could equities lead credit in 2017?
• Final charts - US Consumers yet to feel "Hypomaniac"

• Macro and Credit - 2017 - Credit leads equities, but could equities lead credit in 2017?

While clearly the equities markets in the US have been in a state of "Hypomania" as of late, so far the environment has been pretty supportive of credit spreads, and not only thanks to the ECB's buying spree. But, while credit has always been leading equities, one could wonder if this time around a sell-off in equities could impact credit spreads this time around, contrary to what we have seen in 2016 where the widening in credit spreads in the energy sector finally had an impact on equities at the beginning of the year.

From our perspective when it comes to "Hypomania", greed and the potential for a sell-off or the start of a bear market, we reminded ourselves of our 2014 conversation "Equity bear markets tend to coincide with high global core inflation":

"High global core inflation as a risk-off signal

Individual country inflation series are noisy, but the average across G10 economies has been stable in the 1-2% range, and has exhibited clear cyclicality. Bear markets for US equities have usually coincided with high global core inflation. We believe inflation based carry will remain attractive until inflation increases globally and we would expect currencies to mean revert when this occurs.

High inflation leads to mean reversion for currencies

Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with high global inflation suggests that inflation can be used as a carry filter. More generally, we would expect currencies to mean revert during periods of risk-off, which may or may not be negative for carry strategies. Our analysis suggests that a strategy of mean reversion towards 5 year averages would have performed well during the last two periods of high inflation. Is there a fundamental link that makes this robust? 

Inflation matters when inflation is high

Central banks have historically been much more concerned with fighting inflation than deflation, so that high inflation is likely to result in greater attention being paid. Increased attention on fundamentals could drive currencies towards fair value. Behaviourally speaking, high inflation may tip the psychology of the market towards accepting the inevitability of some nominal currency depreciation. This shift in psychology might result in greater reluctance to buy expensive currencies." - source Bank of America Merrill Lynch / Macronomics, June 2014

At the time we also mused around a phenomenon we saw in 2008 in relation to core inflation in the US:

"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:

 - source TradingEconomics.com

Given January CPI rose 2.5% y-o-y, the strongest gain since early 2012 (core CPI up 2.3% y-o-y), and with Janet Yellen taking a more hawkish tone recently in the latest FOMC, one might be wondering if indeed the current "Hypomania" and global rising core CPI will not lead to some sort of "accident" in the not too distant future (like a rate hike in March...). Clearly the inflationary "build up" is putting stress on the QE infinity camp. We indicated in our recent conversations as well that the cozy relationship between central bankers and politicians was as well coming under renewed pressure (Germany). So overall, there is no doubt to us that we are seeing a dwindling support for central bankers. The QE backstop is slowly but surely fading on top of the buildup of inflationary pressures globally.

So of course, as anyone else we are watching inflationary pressure building up very closely. On this subject we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 10th of February entitled "The day of max inflation":

"The day of max inflation

WTI oil prices have more than doubled since reaching the low close of $26.21 a year ago on 2/11/2016 (Figure 1). This means that, if oil prices remain stable, headline inflation is peaking (at least locally) today. However, because economic data is reported on a delayed basis – and only monthly, not daily – we should continue to see oil prices driving up headline inflation numbers above core when reported for January (next week) and February.

- source Bank of America Merrill Lynch

As we pointed out as well in 2014, in our conversation "The Molotov Cocktail", past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years.

In this "Hypomania" environment we reminded ourselves of the wise words of Dr Jochen Felsenheimer from asset management XAIA which we quoted back in September 2011 in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!":

"in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. efficient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth." - Dr Jochen Felsenheimer

From our September 2011 conversation we also reminded ourselves this quote from Dr Jochen Felsenheimer's letter:

"In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer

Given the risk of a surge in trade wars with the new US administration, where it becomes interesting is that in our global competing systems, it seems we are moving away from "cooperation". This could of course have nasty consequences to say the least, for global trade, and would therefore continue to be bullish for gold (hence our late December positioning on gold miners as a reminder). As we pointed out on numerous occasions when discussing gold matters, has been the return of the Gibson paradox which we mused about in our October 2013 conversation:

"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics

Real interest rate is the most important macro factor for gold prices. US real rate has been the main driver for gold prices moves in recent years; while academic papers (Barsky, Summers, 1988) have given theoretical support. Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond rising fast since the US elections, gold prices went down rapidly as a consequence of the interest rate impact. You might be wondering what has led four our switch to our positive stance towards gold/gold miners at the end of December 2016, it all had to do with real rates as indicated by Bank of America Merrill Lynch in their Inflation Strategist note from the 14th of February entitled "Breakevens go overboard over border tax":

"Imports to CPI to breakevens: a perfect pass-through?

That a border tax has been interpreted as a stagflationary shock is apparent when one looks at the inflation market since the markets attention shifted to it post the Dec hike. Roughly about 11% of CPI is tied to imports using input-output tables. A 20% border tax would push 1y inflation up by 220bp immediately with a follow through impact of 40bp on 5y breakevens. It is no coincidence that since the December Fed hike, 5y breakevens went up 30bp, 5y real rates went down by 50bp and the DXY was weaker by 3% – a classic stagflationary shock priced in by the markets.

However, in our view it is too optimistic to expect the market to price in a perfect passthrough to breakevens without the any currency adjustment. Our analysis has shown that a border tax of 20% could be wiped out by a 25% likely rally in the dollar. Also, likely if a border tax were, implemented, it would be delayed and staggered over several years, making the impact on very front-end breakevens unclear. Ultimately, as highlighted in detail here and summarized in Chart 2, we see the border tax adjustment proposal largely playing out as a higher dollar and flat-lower breakeven trade.

Recent price action proves real rate a better short

To us, last week’s price action post the euphoria, proves exactly why real rates offer a better protected short than breakevens. While the upside may not all be captured in a rate selloff, any unwind of the Trump trade is far more likely to hurt breakevens than real rates. Consensus was expecting four hikes over the next two years even six months ago, when the odds were favoring a gridlocked Congress, a continued Yellen Fed and no fiscal stimulus. This suggests that the unwind of the post-election euphoria is likely to manifest as an unwind of the reflation trade as opposed to the unwind of the Fed hike trade, in our view. We maintain our short real rates recommendation across the curve."- source Bank of America Merrill Lynch

We agree with the deflating Trumpflation trade, and we also agree with Bank of America Merrill Lynch's recommendation for "shorting" real rates. There is of course an explanation around this which was very clearly put forward by David Goldman in Asia Times on the 17th of February in his article "A mistery solved: Why real yields are falling despite higher growth":

"Economists often think of real yields as the “real interest rate,” or baseline rate of return, in a macroeconomic model. From this standpoint the low level of TIPS yields is a mystery: when economic growth is rising, the real interest rate should rise. The expected short-term interest rate has been rising as the Fed sets about normalizing rates, and the rising short-term rates affect real yields. The fall in TIPS yields in the face of Fed tightening and stronger growth presents a double challenge to the conventional wisdom.

The conventional way of looking at real yields ignores the way markets treat risk. Government debt (and particularly the government debt of the United States) is not just a gauge of economic activity, but a kind of insurance. If the world comes crashing down, you want to own safe assets. Investors hold Treasuries in their portfolios not just for the income, but as an insurance against disaster. And TIPS offer a double form of insurance: If economic crisis takes the form of a big rise in the inflation rate, TIPS investors will be paid a correspondingly higher amount of principal when their bond matures. That explains why TIPS yields sometimes are negative: investors will accept a negative rate of return at the present expected inflation rate in return for a hedge against an unexpected rise in the inflation rate.

The yield on TIPS has tracked the price of gold with a remarkable degree of precision during the past 10 years, as shown in the chart below. Gold tracks the 5-year TIPS yield with 85% accuracy. That’s because both gold and TIPS function as a hedge against unexpected inflation.

During the past year, for example, we observe that the relationship between gold and the 5-year TIPS yield has remained consistent, while the relationship between the expected short-term rate (as reflected in the price of federal funds futures for delivery a year ahead) has jumped around. There are lots of local relationships between federal funds futures and the TIPS yield, but the overall relationship is highly unstable." - source Asia Times - David Goldman

The rest of his article, is a must read we think. but if indeed there are rising inflation expectations, then it makes sense for real yields to continue to fall, which can be assimilated to the cost of the insurance for "unexpected outcomes" is rising. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations is going up.

So moving back to how inflation can play out ultimately on credit spreads, it is most likely through a sell-off induced in equities which could be triggered by a "preemptive hike" by the Fed in March. On this subject we read with interest Bank of America Merrill Lynch Credit Market Strategist note from the 17th of February entitled "Equities not rates":

"Equities not rates

As highlighted by this week’s tightening of credit spreads amidst increasing rate hiking risks (Figure 1), higher interest rates and inflation are not the biggest near term risks to our bullish view on credit spreads.

With the continued rally in equities instead we are getting to the point where we are most concerned in the near term about scenarios that lead to a correction in stocks (Figure 2) – especially if interest rates decline materially in sympathy. Two leading candidate scenarios for this include US policy risk – including most prominently, but not limited to, disappointments around tax reform – and developments ahead of the French election.

Border adjustment tax

The key uncertainty in US tax reform is the border adjustment tax (BAT) from House Speaker Ryan’s blueprint. As we have argued, should the BAT – against our house view – be included, chances are that tax reform gets delayed significantly, as the scheme creates many losers that will push back (and winners – but losers tend to complain more than winners cheer), both domestically and internationally. As much of the recent rally in risk assets hinges on tax reform such delays could be troublesome. Perhaps we will know more on or before February 28th when President Trump addresses a joint session of congress.
To see this note that from an international trade perspective taxing imports, but exempting exports, is the equivalent of imposing an import tariff and giving out an export subsidy. There are three key effects of this. First it creates winners and losers domestically (see: Equity Strategy Focus Point: Death and tax reform 29) which again, as we have seen, translates into pushback against the plans. Second it creates losers and winners internationally as well. Potential losers and winners include countries that are net exporters to (Figure 3) and importers from (Figure 4) the US, respectively. Because the US is running a large trade deficit in goods and services ($490bn in 2016) of course there are more losers than winners abroad. That ensures significant pushback against the BAT abroad as well and the risk of trade war.

Third, the BAT issue is particularly sensitive as about two thirds of the US trade deficit is with just one country – China – which creates a particularly high risk of retaliation. In terms of possible responses, to mitigate the impact of a US border BAT for example China could choose to devalue the Renminbi against the dollar, which is very deflationary globally through commodities (Figure 5) and would bring back the memories of some of the biggest sell-offs in risk assets we have seen the past couple of years (Figure 6).

There are many reasons why the Trump administration might want to implement a BAT scheme, including that it creates significant revenue to help mitigate the impact of lowering the corporate tax rate. This is because the net effect of the border adjustments is effectively to tax the trade deficit by the new corporate tax rate – for example, a 20% tax on a $500bn trade deficit translates into $100bn in new tax revenue annually. Hence, taking out the BAT creates the need to find $100bn annually elsewhere, which may constrain the ability to lower tax rates." - source Bank of America Merrill Lynch

The conjunction of all these factors in an environment where "Hypomania" has reigned supreme, makes us particularly more nervous as we move towards March and a potential rate hike on the back of a stronger than expected January CPI and retail sales data. We also note that from a flow perspective, there have been some significant inflows into High Grade funds and ETFs as put forward as well in Bank of America Merrill Lynch's note:

"Flows refocus on stocksInflows to US equity funds and ETFs reached $13.13bn this past week (ending on February 15th) – the highest weekly inflow in two months – compared to a $1.95bn inflow the week before and $8.81bn inflow for the week ending on February 1. The pickup in inflows is consistent with the recent stock market rally. At the same time inflows to bonds moderated to $5.06bn from a high $8.04bn inflow in the prior week, mostly due to lower inflows to high grade." - source Bank of America Merrill Lynch

We don't think that "Hypomania" is warranted when the reliance in "opioids" is fading. On top of that, as we pointed out in our previous conversation, the latest Federal Reserve Senior Loan Officer Survey shows a weakening demand for credit overall, with Commercial Real Estate feeling the brunt.

• Final charts - US Consumers yet to feel "Hypomaniac"

Whereas in the financial sphere, "Hypomania" is clearly running high, the US consumer it seems is less "euphoric". If indeed it is "Hypomania" for Wall Street, Main Street seems much more prudent as per our final charts from Bank of America Merrill Lynch in their Inflation Strategist note from the 14th of February entitled "Breakevens go overboard over border tax" displaying a decline in December in Consumer Credit which is consistent with declining Credit and Auto loan demand reported in the Senior Loan Officer Survey (not to mention rising delinquencies in subprime auto loans as of late...):

"In wait and see mode

While most often the Federal Reserve Senior Loan Officer Survey is closely monitored for color on bank lending standards, the most striking aspect of Monday’s report was weak loan demand across the board (see: Situation Room: The French Connection 06 February 2017). Perhaps this is due partly to rising interest rates, which would make sense for mortgages. However, one would certainly expect that development to play a smaller role for consumer loans and business loans. Tuesday’s Fed Consumer Credit expansion of $14.6bn in December (Figure 9), the lowest since June, is consistent with the sizable contractions in credit card and auto loan demand reported in the Senior Loan Officer Survey (Figure 10).

For more timely data the Fed’s weekly H.8 data allows us to come up with good estimates for January 2017 bank loan growth. We estimate that in January US banks experienced only a 0.6% annualized increase in consumer lending, down from 5.3% in December and the lowest reading in two years (Figure 11).

Furthermore C&I lending remained weak in January at 0.9% (Figure 12).

While bank profitability stands to benefit from higher NIMs as interest rates go up, nothing yet suggests animal spirits – in fact US consumers and businesses appear presently stuck in wait-and-see mode." - source Bank of America Merrill Lynch

So if indeed US consumers are closed to being "maxed out", then if the Fed is ready to pull the "hike trigger" in March, things could become interesting in "Hypomania" land we think. Can you spell "Policy Mistake"? Because we can...

"Mistakes can be corrected by those who pay attention to facts but dogmatism will not be corrected by those who are wedded to a vision. " - Thomas Sowell, American economist

Stay tuned!