Macro and Credit - Gullibility

"Mystical references to society and its programs to help may warm the hearts of the gullible but what it really means is putting more power in the hands of bureaucrats." -  Thomas Sowell

Watching with interest the 10th day of record highs for the Dow Jones and the on-going rally in other asset classes and in continuation to our previous theme of "Barnum statements" and "Woozle effects", we decided to pursue on the path of "tricks of the mind" in our title analogy by selecting "Gullibility".

"Gullibility" is a failure of social intelligence in the sense that a person or an investor gets tricked or manipulated (by central bankers) into ill-advised course of action (insatiable yield chasing). While it is closely related to credulity, many investors in the past have been vulnerable to this form of exploitation. If you would like to make a small experience on the subject you could try this popular test of "gullibility" by telling one of your friends that the word gullible isn't in "the" dictionary (earliest dictionaries did not by the way). If your friend is a gullible person he might respond "really?" and he will go and look it up. 

Some writers on gullibility have focused on the relationship between the negative trait of gullibility and positive trait of trust. The two are related, as gullibility involves an act of "trust", same goes with central banking (remember: "believe me it will be enough"). On this subject we find it amusing that a certain Stephen Greenspan (not Alan) in 2009, in his book "Annals of gullibility: why we get duped and how to avoid it" presented dozen of examples of gullibility in literature and history to name a few: The Adventures of Pinocchio, Little Red Riding Hood, The Emperor's New Clothes, The Adventures of Tom Sawyer, Romeo and Juliet, Macbeth, Othello and even in the classic The Art of War, The Prince or The Trojan Horse story. Greenspan argues that a related process of self-deception and groupthink factored into the planning of the Vietnam War and the Second Iraq War in his book. In science and academia, gullibility has been exposed in the Sokal Hoax which we referenced to in a previous post of ours "The Sokal affair" describing the acceptance of early claims of cold fusion by the media. 

In society, tulip mania and other investment bubbles (Bitcoin comes to mind) involve gullibility driven by greed, while the spread of rumors involves a gullible eagerness to believe (and retell) the worst of other people. You might be wondering where we are going with this but hearing the other Greenspan recently, Alan that is, making yet another claim that there is a bond bubble in the making, although he has done so in recent years made, it interesting to say the least.  Two years ago, when the 10-year US yield was 2.44% the other Greenspan told Bloomberg TV that "we have a pending bond market bubble." In a Bloomberg TV interview in July 2016, he again expressed concerns about stagflation and said "we're seeing the very early signs of inflation beginning to tick up." He also told us at the time with 10-year Treasury yield at 1.50% thanks to Brexit concerns, that he was "nervous" bond prices were too high. In terms of "gullibility", this is the same Greenspan that told us that no one saw the previous crisis coming. Is third time a charm for the "Maestro"? We wonder. Stephen, the other Greenspan, in 2009 wrote that exploiters of the gullible "are people who understand the reluctance of others to appear untrusting and are willing to take advantage of that reluctance." In 1980, Julian Rotter wrote that the two are not equivalent: rather, gullibility is a foolish application of trust despite warning signs that another is untrustworthy. When we see European Junk Bond yields falling to another record low of 2.33% and closing on 10-Year US Treasury Yields at 2.26%, we think that "gullibility" applies for European high yield investors as a foolish application of trust despite warning signs that our central bankers are untrustworthy hence our chosen title. To check your investor gullibility factor you could simply ask yourselves if you would rather hold US Treasuries for the next 3 years or European High Yield but we ramble again...

In this week's conversation, we would like to look again at the potential risk for a convexity event we discussed previously in our conversation "Bond ruck" from a NAIRU ((non-accelerating inflation rate of unemployment) perspective. 

Synopsis:

• Macro and Credit - Convexity - A NAIRU headache?
• Final charts - The barrel in the credit revolver is getting empty

• Macro and Credit - Convexity - A NAIRU headache?

Traditional measures of monetary policy such as the Taylor Rule that are based on growth and inflation and a nonaccelerating inflation rate of unemployment, or NAIRU, of 5 percent. NAIRU is the lowest unemployment rate an economy can sustain without spurring inflation according to the definition. The name "NAIRU" arises because with actual unemployment below it, inflation is expected to accelerate, while with unemployment above it, inflation decelerates. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve, hence the concerns of the "Maestro" and his bond bubble fears. The "NAIRU" analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed. As we posited in our June 2013 conversation "Lucas critique":

"As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion." - source Macronomics, June 2013

Also as we pointed out in our July conversation "The Rebound effect" in our final chart relating to the death of the Phillips curve, the framework is still adhered to by the Fed, meaning that they should be very slow in removing the credit punchbowl. We also pointed out that subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. The Fed's models are built on past relationships. Yet, what seems of key importance to us is that many believe the NAIRU unemployment rate to be around 4.5%, while inflation and wage pressures remain muted because as we pointed out in recent conversation demographics mismatch in the labor market is affecting wage growth. 

You might already being asking yourselves what it has to do with convexity and bond bubble fears for the "Maestro"? It all has to do with "gullibility". On the subject of the non linearity of the Fed's hiking path and therefore convexity risk, we read with interest Bank of America Merrill Lynch's take in their Liquid Insight note from the 4th of August entitled "Who doesn't love 90s rerurns?":

"Key takeaways

• The Fed is facing a similar situation to the 1990s; the unemployment rate is uncomfortably low, but so is core inflation.
• In the '90s, there were data head-fakes and confusion in the Fed's reaction function, resulting in a "fits and starts" cycle.
• This sounds familiar. We think we should prepare for the possibility of further pauses in the hiking cycle, akin to the '90s.

A not-so-distant memory

Nostalgia for the 1990s is tangible: the economy was in a prolonged expansion, the budget deficit was turned into a surplus and, importantly, the quality of television improved with Seinfeld, The Simpsons and Friends. We are now facing a feeble recovery from the Great Recession, a swelling budget deficit and reality television. Don’t fret; there are some things in common. The Phillips Curve faced similar challenges in the late 1990s as it does today (Table 1). Today’s Fed should keep in mind the lessons of the 1990s:

1. Relying on the Phillips Curve relationship can prove dangerous
2. It is essential to maintain credibility as a defender of price stability
3. Hiking cycles can have fits and starts

We think the 1990s episode puts the spotlight on a risk to our forecast. Although we have been arguing that the risks are skewed toward a slower cycle, our baseline expectation is still for the Fed to follow their dots (a hike in December and three more hikes next year). Given the lessons learned from the experience of the 1990s, we should prepare for the potential of a pause in the tightening cycle early next year.

Measured pace is the exception, not the rule

Many investors tend to look back at the 2004-6 “measured pace” episode as the norm for Fed tightening cycles. In reality, the 1990s offers a much better comparison. In the 1990s, there were many head-fakes in the data and changes in the Fed's reaction function, which led to a “fits and starts” hiking cycle. As Chart 1 shows, the Fed delayed hiking rates until three years into the recovery; did a relatively normal tightening cycle, but then did two mini-cycles of cuts followed by another hiking cycle.

On paper, this seems like a Federal Reserve that was quite confused. Why start the hiking cycle in 1994 with inflation still low? Why the abrupt reversal and then the delayed resumption of hikes? It helps to think about Fed hikes back then as a complicated interactive process rather than a pre-ordained plan.

Stage 1 (1994-1995): preemptive tightening of monetary policy against the "inflation scare" in bond markets. The unemployment rate at the onset of the hiking cycle was only 6.5% while wage and price inflation was subdued. But the 30-year Treasury rate soared to 8.1% in November 1994 from 5.9% in October 1993. Fed officials became concerned about losing their inflation-fighting credibility. In the February 1994 minutes, Fed officials noted that “a relatively small move would readily accomplish the purposes of signaling the Committee’s anti-inflation resolve” and in the March 1994 minutes argued that “a stronger policy action …would serve to underscore the Committee’s commitment to its price stability.”

Even within this apparent steady tightening cycle there were plenty of head-fakes. Three times the Fed signaled that it might be done and skipped a meeting. Each time they came back with a “catch up” hike of 50bp, 50bp and 75bp, respectively. This stopand- start occurred for two reasons. First, they expected hikes to slow the economy, but the labor market continued to motor ahead. Second, most Fed officials came into the period thinking NAIRU was around 6.5% but as inflation failed to respond, they revised their estimates lower.

Stage 2: Recalibrating an overshoot: By July 1995, the Fed seemed to regret those hikes, noting in the minutes that “some modest easing was desirable now that the growth of the economy had slowed considerably more than anticipated and potential inflationary pressures seemed to be in the process of receding.” This led to 75bp of cuts over the next several months.

Stage 3: Watchful waiting: The Fed went on hold for roughly two years. While dissents were minimal (because of Greenspan’s domination of the Committee at that time), there was growing pressure from the Committee to resume hiking. Skimming through the transcripts, we find that Janet Yellen was one of the voices advocating for the Fed to hike rates. Her arguments echo those that she is making today.

In the September 1996 transcripts Yellen gave two arguments for hiking:
"First, an unemployment rate of 5.1% lies near the lower end of almost anyone's estimated NAIRU range. Second, whatever the NAIRU, the unemployment rate does have predictive power for changes in the inflation rate...for that reason, I would conclude that the risk of inflation has definitely risen, and I would characterize the economy as operating in an inflationary danger zone."

"My concern is that a failure to shift policy just modestly in response to shifting inflationary risks could undermine the assumptions on which markets' own stabilizing responses are based."

Stage 4: Crisis mode: The FOMC did eventually hike by 25bp in March 1997, but it proved to be a one-off as the economy faced a variety of exogenous shocks thereafter, including the Asian currency crisis in 1997, the Russian default and failure of LTCM. Through it all, the unemployment rate continued to glide lower, but yet the "inflationary danger zone" proved benign. As such, if the Fed actually engaged in a hiking cycle, the economy might have suffered, as would have the Fed's credibility. It turned out that Greenspan was right to hold off as he correctly saw that stronger economic growth was generated by strong productivity gains, which were disinflationary.

Stage 5: The real deal: Heading into 1999, the Fed was facing a tight labor market with the unemployment rate hovering just above 4%, wage growth of about 3%, but core PCE growth of only 1.4%. Asset prices were elevated with signs of "irrational exuberance" in the markets: by the time the Fed hiked, the cyclically adjusted P/E had climbed to historical highs. This sounds quite familiar to the situation we are in today with a tight labor market, but muted price pressures with the exception of assets.

A big theme then and now: shifting views of the Phillips curve

Janet Yellen was not the only one who believed that inflation would accelerate as the unemployment rate fell further. In fact, it was very much the consensus view. According to the Blue Chip consensus survey, economists in 1996 were looking for CPI inflation of 3.0% for 1998 while it ended up coming in at 1.6%. Core CPI similarly came in below 3%, averaging 2.3% for the year. Economists reacted to the data and within a year were bringing forecasts lower, coming in close for 1999 (Chart 2).

The challenge is that models are imperfect. If you were sitting in September 1996 with an unemployment rate just above 5%, a standard Phillips Curve would estimate 3.5% for core CPI over the next 12 months, which was about 1.3pp too high relative to the actual data. At the time, the weakness in inflation was explained by external factors such as globalization and technological improvements that could not be captured properly by the Phillips Curve. There was quite a lot of awareness at the time that the Phillips Curve was failing. In September 1999, John Williams and others at the Board authored a piece called “What’s Happened to the Phillips Curve,” which looks at various specifications of the Phillips Curve to attempt to improve the fit in the 1990s.

Finding the right re-runs

It is important to focus on the experience of the 1990s, rather than the 2000s, when considering risks to monetary policy. Fed officials struggled with the same questions two decades ago as they are today. How tight is policy? Does the Phillips Curve work? Have we maintained credibility as defenders of price stability? How should we handicap market risks?

The result in the 1990s was a hiking cycle that was not linear. It may end up being the same story today. The Fed had a 12-month pause between the first and second hikes before slowly delivering another 75bp of hikes. We could be reaching a crossroads once again as wage and price inflation remain subdued. After another hike, the Fed will be a hair away from neutral (Chart 3), which means the next hike would no longer be considered a removal of accommodation, but rather a true tightening of policy. 

We think a considerable risk to our forecast is that the Fed pauses the hiking cycle early next year, slowing the pace of rate hikes." - source Bank of America Merrill Lynch

The consensus view it seems is that inflation will accelerate as the unemployment rate falls further, in similar fashion to the 90s. We discussed convexity in our conversation "Bond ruck" recently, given that as well, some have been arguing that in a rising rates environment you would be better off with RMBS thanks to negative convexity features. We indicated there was a catch because of the significant need in "delta hedging". Maybe the Maestro's fear comes from the potential for a "Convexity event" fueled by MBS hedging, particularly in the light of the balance sheet exercise soon to be taken by the Fed. As we pointed out in the final point of this particular conversation, the unemployment rate is currently far below NAIRU. The risk again, is therefore a policy mistake in similar fashion to what was avoided by the Maestro in 1997, but, eventually burst the bubble in stage 5 as pointed in Bank of America Merrill Lynch above. If indeed Janet Yellen still believes in an acceleration of inflation as per the September 1996 transcripts, there is indeed a cause for concern from a "convexity perspective". Yet, when it comes to central banks' "Barnum statements" we are not rest assured that "gullible" and like any good behavioral psychologist we tend to focus on the process rather than on the content of their narrative.

What we think is very similar to the 90s so far is indeed the non linear hiking path chosen by the Fed. On that note we agree with HSBC's Steven Major take on disinflation sinking further Treasury Yields as reported by Bloomberg in their article from the 7th of August entitled "HSBC's Steven Major Sounds a Bearish Alarm on European Credit":

"Major, HSBC Holdings Plc’s head of fixed-income research, is a key proponent of the view that global interest rates can stay low for longer, he says investors aren’t being paid for the risks they are taking in corporate debt markets in the euro area, with yields a whisker away from post-crisis lows.

"Low volatility across asset classes may give a false sense of security and bond markets may be caught napping," HSBC strategists led by Major wrote in a note published Monday. "The risk is that with increasingly interconnected capital markets, driven by years of international spillover from quantitative easing, local triggers can have a more global impact than before.

Major’s bearish case: The European Central Bank’s asset-purchase program won’t be as large over the next year as the 12 months prior, while there’s a natural cap on credit demand as yields sit "materially below" typical expense ratios for retail funds, and to a lesser-extent insurance funds. "Gross yields leave very little left for income-seeking savers," he adds. "Spreads could widen with a volatility shock."

The strategist also takes exception with the argument that the euro-area economy is ensnared by Japanese-style stagnation, which would keep spreads in check for decades to come, amid low interest rates and a lifeless corporate sector." - source Bloomberg

We also agree with his forecast for 10 year UST yield of 1.9%, that still make us part of the bond bulls after all. As we pointed out at the beginning of the conversation, at this stage we would rather hold US Treasury notes than European High Yield no offense to the gullible investing crowd busy picking the remaining basis points in front of the credit steam roller. We also agree that the US treasury market and the US dollar are reflecting a weaker economy. If there is a market which is less gullible to the "Barnum statements" from the Fed, it is the US bond market.

The big "Gullibility" question is one of returning duration risk through a sudden rise in bond volatility and we are not even taking into account exogenous geopolitical risk at this stage (which would be bond and gold bullish and oil bullish). On this subject we read with interest Nomura's take in their Inflation Insights note from the 7th of August entitled "Returning real duration risk to the market":

"A central banker’s headache

There are still many scenarios in which the gradual normalisation in the real monetary stance pursued by central banks might not have a gradual impact on financial markets. Uncertainty still looms large on key variables conditioning a balanced path to “normal.” Separately and/or collectively, the lack of term premium in inflation valuations, the level of the natural real rate of interest, the anchoring of inflation expectations, and flow dynamics from the unwinding of large-scale asset purchases can often have outsized impacts on global bond markets. Of course, central banks might find a perfectly balanced path, yet risks remain that real rates could overshoot. We suggest short real rate trades as a hedge against an environment of fast-rising nominal rates and slow-rising inflation.

“Taper tantrum” vs. “gradualism”

In Inflation Insights - Mini “taper tantrum” vs. “dear Prudence”, we argued that risk of a large, unexpected upswing in real yields remained. Despite normalisation in the real stance of policies being widely expected and advertised by central bankers, some mechanisms might facilitate unusually large yield changes.

Several factors potentially generating unexpectedly large yield moves

These mechanisms originate in both cyclical and structural features of economies. At a conceptual level, they stem from the possibility of a sharp rebuilding in term premia accompanying higher interest rates. The inflation premium – the price of a risk of inflation overshooting – remains low on most metrics. The term premium on the inflation component of yield remains also very subdued, as we have shown in Inflation Insights - A short trip to the long end . Therefore it is from the real component of yields that the risk of fast-rising rates comes from.

At a practical level, factors potentially resulting in an unexpected and uncontrolled rise in real yields are:

• The non-linear dynamics between the level of real rates and the real term premium, as short-term nominal rates retrieve some margin away from the effective lower bound.
• The re-pricing of the natural real rate of interest (NRRI) until recently, financial markets have rather followed central banks in their downside revision of the natural real rate and accepted the consequences on fixed income valuations. Even though there is an active debate among Fed members about NRRI, most still believe it will be heading higher as they continue with their normalization. A repricing could happen if surprises on activity remain to the upside, e.g., as they have been in the euro area.
• The complex interplay between segmentation across market participants and largescale asset purchase programmes conducted by central banks. For example, the transfer back to private investors of MBS paper would probably be accompanied by reintroduction of interest rate hedges. Another example is the behaviour of insurance companies and pension funds in the euro area increasing their purchases of fixed income assets with the ECB purchase programme – against the intuition of the balance portfolio channel pushing such investors to invest more in riskier securities.
• The discontinuity of asset purchases and the “signalling channel” – an abrupt stop to bond buying or re-investment would result in the pricing in of a much denser sequence of “taper” and then rate hikes. In our opinion, the long lead time of preparing markets for the Fed’s eventual balance-sheet unwind could mean that it is rather unlikely in the US (that said, there is a risk to some US rate vol if the Fed gets new leadership). However, it is made possible in the euro area by the perception of technical constraints on the PSPP.

Low inflation duration risk, high real duration risk

All these factors would allow for potentially large and sudden nominal yield changes, translating into large and sudden real yield changes through the elasticity (“beta”) of real yields to nominal yields. However, we think there are reasons to expect real yield changes to be larger than nominal yield changes.

One feature of the environment of low inflation has been that inflation valuations are unusually highly sensitive to current realized inflation trends (both markets and consumer prices). It is not only the expectation component of inflation valuations that has remained subdued, it is also the inflation premium embedded in valuations that has only marginally corrected from its negative levels. The lack of any increase in inflation premia and also inflation term premia would push real yields upwards, even faster than nominal yields.

As Figure 1 shows, it was the case in the early stages of the “taper tantrum” in 2013. The 5y5y real rate increased by about 150bp initially - the 5y5y inflation rate lost about 40bp over the same period. With markets remaining sceptical about the sustainability of higher inflation, it is very possible that the next big bond market sell-off will be a real-rate story.

 Away from the Effective Lower Bound (ELB): a distributional change

The risk of non-linear dynamics on rates stems above all from the proximity of the ELB. The effectiveness of monetary policy is conditional on the ability of the central bank to change the real rate – in other words, to increase the nominal rate faster or slower than the expected change in inflation. At the ELB, the short-term real rate is fully determined by the (negative of the) level of expected inflation. Central banks must resort to other instruments to lower real yields further on the curve – a methodology much advertised in Japan for instance for QQE.

Credible alternatives to the use of the nominal short-term rate might lower real rates further along the yield curve. Their credibility rests to a large extent on the notion that long-term inflation expectations do not fall too much – otherwise the objective of lower long-dated real yields is difficult to achieve. This is why the focus on inflation valuations by central bankers increases – and not only the focus on realised inflation and inflation scenarios.

Figure 2 shows that 5y5y inflation rates remain above half a standard deviation below their 2014-17 average. 

The 1-year inflation rate in 9 years is 30bp below the 2% target in the euro area. In the US, it is 2.60% - which is only just consistent with the Fed’s long-term PCE target and the CPI/PCE basis. In the UK, the 1y in 9 years is 3.45% - the only inflation rate above the central bank’s target of about 3% in RPI-equivalent terms ( the target is set in terms of CPI inflation, UK markets quote RPI inflation). Yet the spread to the target has been contracting since the beginning of the year. In our view, inflation markets have not priced in risk of inflation overshoots that these numbers suggest, consequently as a result the right-side of the inflation distribution remains thin.

A particular risk arises in case of a “spurious” surge in inflation expectations – for example acceleration in prices stemming from rising energy prices. In this case, central banks could increase the pace of nominal rate normalisation on the back of a temporary increase in inflation and despite a low probability of protracted and self-sustained inflation backdrop. Although central banks in general try to “look through” temporary factors, the distinction between “temporary” and “persistent” is not always easy to make in the heat of the moment. In addition, one consequence of the effective lower bound is to skew the distribution of inflation expectations – the normalisation of the distribution to the right can easily be triggered by a temporary factor such as large oil price increases.

Re-pricing the natural real rate of interest

The consequences of a lower natural real rate of interest for monetary policy are very far-reaching, in our opinion, and the uncertainty around the potential evolution of these rates would suggest in and of itself, an increased cautionary outlook for central banks in the pursuit of “normalisation”. An important aspect of this issue is that financial markets have priced in much lower levels of the “equilibrium” real rate. We focus on a simple statistical result – the mean-reversion level of the 5-year real rate, 5 years forward.

Figure 3 shows the contraction in this market’s estimate of the natural real rate. The magnitude is 150bp between our two samples across markets – the common magnitude of the contraction suggests a global issue rather than a country-specific problem.

The 5y5y real rate using swaps is currently about 0.40% in the US, 0% in the euro area and -1.40% in the UK. These levels are very close to the “mean-reverting” level that has prevailed since 2012 – but still very far from the levels before 2008. They are also not too far in the US and the euro area from estimates of the natural real rate provided by Laubach and Williams – respectively 0.45% for the US, -0.30% for the euro area and 1.50% for the UK. A very large discrepancy remains for the UK. In addition, these numbers suggest that “real normalisation” towards the natural real rate has already occurred for some version of the natural real rate – especially in the US.

When looking at the real rate curve in the US, given where 30-year TIPS have been trading, it seems as if the markets have taken to heart the idea that the long-run real rate is somewhere around 1% (2% inflation minus 3% median long-run dots). Down the curve is where the debate over how high the natural real rate could go, in our view. Further increase in real yields would therefore potentially put policy at or above the neutral level – a result that currency markets have not missed in the case of the euro area, with the consequence of a sharp euro appreciation. A sudden and sharp revision in the neutral level advertised by central banks could result in much higher real rates, with the risk to push policy into restrictive levels, which in turn would add to the negative pressure on inflation and activity. This would happen at a time when short-term rates are only some basis points away from the ELB, with limited restored potential for accommodation.

Rushing to the exit: the segmentation of investors

Another factor creating potential non-linear dynamics in real rates stems at a technical level from the segmentation of investors – a feature that accounted for the unusually large changes in US real yields in 2013 referred to as “taper tantrum.” We have explained this consequence of segmentation in Inflation Insights - Mini “taper tantrum” vs. “dear Prudence”.

In the US, a structural and potential destabilising feature for rates market dynamics is the process of MBS holdings of the Federal Reserve System slowly returning to private investors. For years, the Fed has basically warehoused US rate vol (see link) by holding so many MBS securities out of the private sector. MBS hedging in the past was an issue for global markets during quick rises in US rates (where MBS hedgers can push nominal US rates up even faster – known as “convexity hedging”). However, rates/spreads can also rise over time as private investors begin to hedge their MBS for interest rate risk.

In the euro area, the ECB provided evidence that the implementation of the PSPP resulted mostly in the selling of euro fixed income assets by non-residents to the eurosystem, while insurance companies and pension funds did not change their investment pattern. Such investors given their high fixed-income exposure would typically react to a change in the direction of monetary policy towards faster normalisation and create “rush-to-the exit” dynamics." - source Nomura

As we pointed out, a "Convexity event" would be possible depending solely on the "velocity" in the rise in US rates. Given the Fed's recent "Barnum statements" and dovish tone, we think that the Fed's first priority will be to go ahead with the initiation of its balance sheet reduction in September, before following up on additional rate hikes we think. There is a possibility though that, given the current NAIRU discrepancy, Janet Yellen travels "back to the future" so to speak, to the 90s and this, would of course generate significant instability and the aforementioned "bond" volatility which is so feared by the beta crowd and carry players alike. "Velocity" will induce "volatility" and therefore weigh on fund bond flows. Obviously, the risk is a significant rise in real rates, which would be simultaneously bond and gold bearish. We might have been gullible in some instances, but it isn't our core scenario for the time being. Not until we see the facts change, namely less muted wages growth, that we will change our mind to paraphrase Keynes.

For our final charts, back in our conversation "Orchidelirium" we asked ourselves if the US consumer was "maxed out". We noticed at the time that consumer loan demand, a finding consistent with the weaker spending in Q1 had been cooling. We mentioned it was a significant indicator to monitor in the coming months.

• Final charts - The barrel in the credit revolver is getting empty

In our book, consumer credit year-over-year change needs to be monitored very closely. Our final charts comes from Wells Fargo Economics Group note from the 7th of August and shows that Consumer Credit Growth has been slowing to end Q2. We are getting worried as well that total consumer credit momentum is decelerating:

"Consumer Credit Growth Slows to End Q2

Consumer credit rose $12.4 billion in June. Nonrevolving credit growth has been slowing for the past couple years, and with the recent halt in revolving credit’s momentum, total consumer credit is decelerating.

 Nonrevolving, Revolving Credit Both Slowing

• Steady growth in nonrevolving credit earlier in the economic expansion helped spur total consumer credit higher despite anemic growth in the revolving space.
• More recently, however, revolving credit growth has stalled. Net-charge offs have risen and delinquencies are up slightly, although both of these series have risen from historically low levels.

- source Wells Fargo

In June this year we mentioned our concern relating to the US consumer getting close to being maxed out in our conversation "Potemkin village":

"While it might be premature to pull the curtain on the Potemkin village, if indeed we break the 5% level for nonrevolving credit and continue to see a deteriorating trend in the coming months, then it will be a cause for concern. For credit markets at the moment, it's pretty much "carry on", though we are clearly tactically more cautious with High Yield and high beta in general." - source Macronomics, June 2017

If "Gullibility" is a failure of social intelligence in the sense that an investor gets tricked or manipulated by central bankers in buying European High Yield for example, then again, the US yield curve has been immune to the old tricks played by the Jedis at the Fed. As the economic cycle matures, so do credit standards and credit demand that simple. Most recent evidence indicates us that both consumer credit and business lending demand is slowing regardless of low unemployment and NAIRU readings. On top of that nonfinancial domestic corporate profit margins peaked in early 2014 and have declined in the last two years. This means, dear credit friends, that you need to have a more cautious stance going forward. Some investors might still be gullible enough to believe in "Barnum statements" and "Woozle effect", to paraphrase Jabba the Hutt in the Return of the Jedi, dear central banker your old Jedi mind tricks don't work on us.

"Most people are sceptical about the wrong things and gullible about the wrong things." - Nassim Nicholas Taleb

Stay tuned!

Macro and Credit - The Barnum effect

"If you look and act as if you believe in what you are doing, you will be able to sell even a bad reading to most of your subjects" - Ray Hyman, 1977 about the Forer effect.

Looking at the on-going rally in risky assets, making it a "Goldilocks" period for credit in particular thanks to very low rates volatility (when the MOVE index is stuck that is...), we reminded ourselves for our title analogy of the "Barnum effect". The Barnum effect also called the Forer effect is a common psychological phenomenon whereby individuals will give high accuracy ratings to descriptions of their personality that supposedly are tailored to them but that are in fact, vague and general enough to apply to a wide range of people. The Forer effect is also known as the "Barnum effect". This term was coined in 1956 by American psychologist Paul Meehl in his essay "Wanted — A Good Cookbook". He relates the vague personality descriptions used in certain "pseudo-successful" psychological tests to those given by showman P. T. Barnum who is (albeit erroneously) said to have stated that "there's a sucker born every minute". 

This effect can provide a partial explanation for the widespread acceptance of paranormal beliefs and practice such as astrology, fortune telling, graphology, aura reading and of course, central banking. Given it was recently the anniversary of Le Chiffre aka Mario Draghi "Whatever it takes" bumblebee moment, we thought our chosen title and even our above quote where appropriate choosing of ours. Obviously the latest dovish "Barnum statements" from our "Generous gamblers" aka central bankers, have had the desired effect in leading to a continuation of "Goldilocks" particularly in credit where the "trade du jour" remains "carry on". Clearly central bankers have become masters at "Barnum statements" also called the Forer effect in which the interlocutor finds valid the statements they make given the statements are generalization that could apply to almost any kind of economic situation. Such statements are used by fortune tellers, astrologers, and other practitioners of chicanery to convince customers that they, the practitioners, are in fact endowed with a paranormal gift like our wizards in central banking: 

"The moral of the Barnum Demonstration," according to Professor of Psychology at California State University, Fullerton Michael Birnbaum is that "Self-validation is no validation. Do not be fooled by a psychic, quack psychotherapist, or a phony faith healer who uses this trick on you! Be skeptical and ask for proof. Keep your money in your wallet, your wallet in your pocket, and your hand on your wallet."

Same applies with powerful narratives stated in financial markets, be skeptical and contrarian when needed. For instances, in January in our conversation "The Woozle effect", we indicated that we were ready to take a contrarian stance against the "Barnum effect" affecting the long US dollar crowd":

"If indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar. It appears that from a "Mack the Knife" perspective (aka King Dollar + positive real US interest rates), it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier." - Macronomics, January 2017

And of course willing to play on the outlier has been the correct path so far from a contrarian perspective, countering therefore the "Barnum effect" played so effectively by the wizards at the Fed. 

In our most recent musing we also hinted that we had become more positive on gold and gold miners and increased our allocation. We do practice magic, but in our own terms...

In this week's conversation, we would like to look at the continuation of the final melt up in risky assets in particular credit thanks to the "Barnum effect".

Synopsis:

• Macro and Credit - European High Yield and credit spreads overall - These go to 11
• Final charts - Credit Quality ? Lower for longer...

• Macro and Credit - European High Yield and credit spreads overall - These go to 11

The Barnum statements from our wizards at the helm of central banks have had the desired effect in neutering bond volatility as seen in the repressed bond volatility gauge MOVE index. This has indeed has had the desired effect in prolonging the "Goldilocks" environment for the better crowd. Carry players alike leveraged investors are in love and in particular with one thing, namely low rates volatility. 

As we pointed out in our June conversation "Goldilocks principle", as we indicated recently, it seems to us that in terms of risk-reward, High Yield has moved from expensive or rich to very expensive and in particular Euro High Yield. While our bullet point is a veiled reference to Spinal Tap movie when it comes to central banking "Barnum effect" and their Marshall amplifier, in this movie Spinal Tap lead guitarist, Nigel Tufnel could explain you the importance of going to 11. In our recent musings, we pointed out that in the on-going credit "Goldilocks" scenario, already expensive asset classes would become even more expensive, going to 11 that is.  The continued yield compression à la 2007 is not a surprise given we think we are indeed in the last inning of the current credit cycle. As indicated by Deutsche Bank European High Yield note from the 2nd of August entitled "Justifying tighter spreads", going to 11 is we think akin to the infamously famous "this time it's different" "Barnum effect" mantra:

"Justifying tighter spreads

July provided a return to positive performance for EUR HY credit as the index returned +0.83% including financials and +0.74% for non-financials. YTD nonfinancial returns now sit at +4.4% having been at +3.3% as recently as the second week of July. Looking at Figure 1 we can see that spreads have tightened to fresh post-GFC tights for both BBs and Bs following more than 10bps of tightening for both rating bands during July.

In terms of where current spreads sit relative to their own histories BBs have only been tighter 13% of the time since 2003 while Bs have only been tighter 9% of the time. In fact as we can see in Figure 2 where we show where current spreads trade relative to their own histories across ratings and currencies, 11 of the 21 analysed indices are currently trading in their tightest quartile.

There is no doubting that valuations are looking increasingly stretched and we would certainly argue that the risks are very much weighted to the downside. However with market volatility measures remaining at such low levels we can make an argument that spreads could actually be even tighter. Specifically it's worth noting that the VIX index closed below 10 for 10 consecutive days during July, this is the longest such run for the series. Previously the longest run below  10 lasted 4 days back in 1993. That said we have moved off of these lows in the last few days.

In Figure 3 we update our simple model looking at where rates, equity and FX implied volatility suggest credit spreads should be. The main takeaway here is that despite seeing spreads tighten and a slight shift higher in volatility in the past few days our volatility implied spread series suggests that HY credit spreads could be even tighter.

Looking at the recent history of the difference between the implied spreads and the actual spreads more closely (Figure 4) we can see that if volatility remains at current levels then it could be argued that BB and B spreads could be 20bps and 10bps tighter respectively to be in line with volatility.

Admittedly the volatility implied spread series is a lot more volatile than actual spread levels. As recently as mid-July it was suggesting spreads should be as much as 60-80bps tighter. Therefore we are mindful of over interpreting the results but this analysis does at least provide us with evidence that credit spreads are merely reflecting the very benign environment that we are currently operating in.

In a world where investors are increasingly looking for the drivers of a sell-off the very near-term direction of travel could still be tighter. As September approaches and we get more news flow around potential central bank actions in both Europe and the US we could see higher volatility that may eventually weigh on credit spreads. For now however we continue to believe that the carry trade will prevail." - source Deutsche Bank

With the current "Barnum effect" at play, of course for the "beta investors crowd" it's carry on and the near term direction for European High Yield is indeed 11, Marshall amplifier wise. So while carry trade remains the "trade du jour" thanks to low volatility in rates, we do think that from a "Great Rotation" perspective, credit wise you would be better off increasing credit quality and reducing your beta exposure as we move towards September. 

You might rightly ask yourselves, how tight can we go, in fear of missing out on the last stage of this epic rally, yet you would be wise to take notice that some astute players have already started to "cash in" and taking a few chips from the casino table as indicated by DataGrapple in their post from the 1st of August entitled "When Is Far Far Enough?":

"Credit experienced another positive session today, with all indices trading near the tightest levels of the year – which are effectively the tightest levels of the last 3 years – reached a few sessions ago. The market is benefitting from the light volumes, low volatility environment that investors foresee in August. If such scenario materialises, why would they want to give away some carry and pay for protection. The performance of credit overall was underpinned by the tightening of the miners and basic material sector. BHP Billiton, Mittal, Glencore and Anglo American all saw their 5-year risk premia reach multiyear low after commodity prices continue their surge on optimism the global economy is keeping its momentum. But down at these tighter levels, after what looked like one way traffic over the last 3 months – since early May, Mittal is 120bps tighter at 166bps, Glencore 70bps tighter at 121bps and Anglo 80bps tighter at 119bps - some 2-way flow is developing. While some investors who were holding short risk positions are throwing the towels, others who were riding the tightening wave are taking chips off the table." - source DataGrapple

Of course some "permabears" have thrown in the proverbial towel and as of late we have seen swath of retail investors on the fear of missing out the grand tricks of the sorcerer's apprentices aka our central bankers and their "Barnum effect" have in earnest decided to jump in. But, credit wise, when European Junk Bond yields hit an all-time low of 2.45%, you need to ask yourself if the risk is still worth the reward in terms of forward returns. We don't think it's enticing anymore and are happy rotating even more into Investment Grade, sacrificing style (rating) over substance (carry). It means starting building up "defense" we think:

"Be fearful when others are greedy, and greedy when others are fearful" - Warren Buffett 

It doesn't mean, it's bunker time with food and ammo stacked up, but it means starting to think seriously about reducing your beta exposure in terms of allocation and probably adding some long dated US long bonds to the mix. Yes, everything might be great macro wise in Europe with the latest raft of releases, but it's when everybody is cheerful then one should be skeptical in the tricks being played in this on-going "Barnum effect". Yes, risk assets continued to rally, with the investment grade credit index breaching 100bp for the first time since 2014, but clouds are lining up for September not to mention potential exogenous geopolitical risks that are known unknowns such as North Korea. When it comes to "Barnum" and circuses, US political gridlocks with the upcoming debt ceiling debate is yet another cause for concern we think. 

When it comes to reaching for 11, and the "Barnum effect" you would probably point out as well to the overall tightness in the credit space particularly in investment grade credit. On that subject we read with interest Barclays US Credit Alpha note from the 21st of July entitled "Breaching the Century Mark":

"Tight and Tighter

The Bloomberg Barclays Credit Index dropped below 100bp for the first time in nearly three years. Aside from a brief period in the summer of 2014, the index has not maintained a spread below its current level since the pre-crisis years of 2005-06. Over that period, the index composition has changed dramatically, with notable increases in the market value of lower-rated and longer-dated debt. The index market value weight of AAA/AA credit decreased over 10%, and debt with more than eight years to maturity increased over 6% (Figure 1).

After we adjust for these differences at an index level, we find that spreads are less than 5bp off their average level for 2005-06, although they remain roughly 15bp off the tights (Figure 2).

Dissecting the index into financials and non-financials, the majority of rating deterioration has occurred in the former. While the term structure for financials remains consistent with pre-crisis levels, lower-rated debt nearly doubled its market value weight over the past decade (Figure 3).

In particular, BBB rated debt comprised only 11% of financials’ market value in 2005-06, while today BBBs are close to 40%, even though subordinated bank debt’s share of financial market value has declined by 50% over the period. This rating migration partly explains the cheapness of financials currently relative to pre-crisis levels: from 2005 to 2006, the corporate index traded roughly 20bp wide of financial credit; that difference is about 4bp now.
However, even after adjusting for subordination and compositional differences, financials trade meaningfully wide of pre-crisis levels (Figure 4 compares senior financial spreads across different rating/maturity buckets between 2005-06 and now).

This is driven partly by concerns about TLAC supply and the increase in USD-denominated European bank debt, which generally trades wider than US bank paper (see Banking on Yankees Going into Summer). That said, we see room for further compression in US bank spreads, especially as the TLAC technical abates (see US Banks: 2Q17 Supply Update: Favorable Conditions Keep the Spigot Open).

Industrials have largely seen a more balanced change in composition (Figure 5).

While there has been an increase in BBB rated and 20-30y debt (the sector’s market value share increased roughly 4% for each from 2005 to 2006), we also see added market value share in AA rated credit and bonds in the 1-3y maturity bucket (each increased more than 3% in the same period). Comparing valuations across the ratings/maturity buckets, A rated paper consistently trades through pre-crisis averages, while BBBs appear more in line or slightly wide, particularly for longer-dated paper. One part of the market that still offers substantial pickup versus 2005-06 spreads is BBB rated 20y debt (Figure 6).

Although we do not see an identifiable near-term catalyst for spread widening, we believe that investors should focus on pockets of the index where relative value looks somewhat attractive. Within the industrials sector, 7-20y BBBs stand out as attractive, trading materially wider than pre-crisis levels, unlike the rest of the industrials sector." - source Barclays

While CDS wise with the CDX IG is within 2 bps of its post-crisis tight of 56 bps in 2014, we are still far from the all-time tight of 28 bps in February 2007. It doesn't mean we can't get to 11, even in Investment Grade, but, we still ponder how long this "Goldilocks" period can last before the return of the three bears. Some may argue that this time it's different, when it comes to credit relative to 2007 and as highlighted by Barclays in their note they would be right:

"In 2007, the biggest factor driving spreads to very tight levels was the presence of synthetic CDOs, which were sizable sellers of protection. During that period, there was significant leverage available, which made it attractive to sell protection even at low absolute spread levels. At the time the index reached its all-time tight, more than half of index constituents were trading inside of 20bp (Figure 8).

In contrast, today there is less leverage available for these trades, and structured credit is not a significant part of the market. Currently, only 10% of IG28 constituents trade inside of 20bp, and unless structured products (or similarly prolific sellers of protection) are meaningfully reintroduced to the market, we do not expect a large number of index constituents to trade at very tight levels. Another difference between the index today and the index in 2007 is quality. IG28 is of lower average quality than IG7 was back in 2007: Baa1 versus Baa1/A3." - source Barclays

Sure the CDO printing press has been fairly muted, yet synthetic activity continues as well to be helping spreads grinding tighter in similar fashion to 2007 albeit not at the same rapid pace we witnessed firsthand back in the days. We do agree though with Barclays premises from their note that a low-beta strategy can be a sound long-term approach to capital preservation, just saying, no matter how mesmerizing the "Barnum effect". Some pundits do think that August will be quiet until we reach September or at least after Jackson Hole in late August, but, rising volumes in CDS options suggest that at least some players are actively hedging their risks. As we indicated recently, gamma credit wise is still relatively cheap to own compared to other asset classes rather than going the negative carry way through CDS index purchasing outright.

Nonetheless, lower rates volatility has always been good for credit as pointed out by Bank of America Merrill Lynch in their Euro Excess Returns note from the 1st of August entitled "Lower rates vol = good news for credit":

"Lower rates vol is good news for credit. In July the European credit market posted another month of positive excess returns. Note that IG euro-denominated corporate bonds recorded 62bp of excess returns performance in July, the strongest performance
over the past year.

• Duration outperforms. In July the back-end of the curve has outperformed significantly the front-end. 1-3yr credit posted 18bp of excess returns last month, while the 10yr+ bucket posted a gain of 128bp.
• Beta underperforms. Euro-denominated high-yield credit posted not much more than the excess return of its high-grade counterpart (83bp vs 62bp, respectively). Same story within the IG space with AAAs doing better than BBBs, while double-As beat single-As.
• Sectors: The vast majority of sectors posted positive excess returns last month. Only Autos were slightly on negative territory. Insurers, telcos and tech names feature at the top of the performance table. On the other side autos and transport were at the bottom of the performance table.
• Issuers: a number of French credits like Credit Agricole, BNP and EDF were among the best performers. Seven French names are featuring in the top 15 spots of the performance table." - source Bank of America Merrill Lynch

Of course during the Barnum effect, low volatility means outperformance of the beta space including High Yield and its CCC rating bucket.  While the party is still going strong during this summer lull, we do remind ourselves that not only there has been an extension in both credit and duration risk during this long in the tooth credit cycle, but, quality wise, there has been a decay. With interest rate buffer close to zero, as we keep repeating this, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. Also in the next downturn we indicated previously we anticipated lower recovery rates this time around. We are not there yet, but the credit cycle continues to gently turn. For our final charts below, while rates might stay lower for longer than expected, for credit, quality wise, it has been trending lower for longer as well.

• Final charts - Credit Quality ? Lower for longer...

Of course the Barnum effect from our central banks' wizards has had the desired effect in shutting down rates volatility since the "Taper Tantrum", pushing in effect the continuation of a "Goldilocks" scenario for credit markets, carry players and all leveraged investors alike. Yet, something which has been prevailing is that not only in the current cycle investors have reached out for more duration and more credit risk, overall, credit quality has been eroding as per our final charts from Morgan Stanley's Corporate Credit Research note from the 28th of July entitled "Living the HY-Life:

"To size up downgrade potential in the next cycle, we think it's important to remember two points. First, credit markets have grown considerably since the crisis, a phenomenon we have discussed frequently. Low rates and easy liquidity drove a need for yield, which led to significant demand for credit. Spreads compressed, and all-time low yields incentivized companies to issue debt. Issuers responded accordingly. As we show in Exhibit 5, US credit markets (measured by index debt) have more than doubled in size since 2008.

Second, credit quality has deteriorated in a number of ways. Most simply, the ratings quality of the IG index has weakened considerably. For example, as we have mentioned in the past, BBBs comprise 49% of the IG index today vs. 28% in 1997. The decline in credit quality, in fact, accelerated this cycle, with A-rated bonds now representing 37% of the IG market, down from 45% at the cycle tights in mid-2014. Note that 49% of the index is currently BBB, and that is after accounting for $133bn of IG to HY downgrades in 2016 (net of the upgrades into IG).

This ratings decline has been relatively broad-based, affecting over half of the subsectors for which we have data going back to 1997 (see Not Your Parents' Market, 6.2.2017). Looked at another way, the lower-quality part of the IG market (rated BBB) combined with the HY and loan indices makes up 64% of total corporate debt today , compared to 35% in 1991, 48% in 1999, 61% in 2007.

Thus, not only has the absolute volume of credit markets grown substantially, but so has the proportion of debt theoretically at risk of a downgrade into high yield. As an example, the 1999-2003 credit cycle was severe, with a 29% 5Y cumulative default rate over the full period . However, in 1999, the IG index was $1.1tn in size, with 32% or $379bn in BBB debt. Today the market is $4.8tn in size with 49% or $2.4tn BBBs in total.

This is not to suggest that all BBBs will fall into HY by any means. The default and/or downgrade rate could be lower in this cycle than in the past. Our point is to illustrate that actual downgrade (and default) volumes will still be magnitudes bigger. 

Also remember that in every cycle some factor causes valuations to deviate from fundamentals on the way down. In the last cycle, as mentioned above, it was the severe deleveraging of the financial system. In our view, the next time around, meaningful default/downgrade potential given the massive growth in credit markets, combined with post-crisis liquidity dynamics in periods of stress, will contribute to the overshoot as markets are heading lower." - source Morgan Stanley

As we recently said, what goes up often goes down to paraphrase Mark Yusko from Morgan Creek's previous quarterly gravity parabola. We would add that what goes too tight often goes too wide in relation to credit spreads. Next downturn, it won't be any different when it comes to overshooting. The only difference is that we think recovery values will be lower, blame it as well on the increase of Non-GAAP measures embedded within the Barnum effect but we ramble yet again...

"There are two kinds of magicians, the honorable kind and the unethical kind. The ethical magician admits that he or she uses tricks to create illusions. The unethical magicians use the same devices to claim to have magic powers. Magicians do not reveal how tricks performed by ethical magicians are done, in order to preserve the mystery. However magicians make an exception when unethical magicians use their methods to defraud and deceive. Harry Houdini, Amazing Randi, Penn and Teller, are examples of real magicians who reveal secrets to expose phonies, quacks and frauds who claim to have psychic powers, mind over matter, or to communicate with the dead." - Professor of Psychology, Michael Birnbaum.

Stay tuned!

Macro and Credit - The Butterfly effect

"The foolish are like ripples on water, For whatsoever they do is quickly effaced; But the righteous are like carvings upon stone, For their smallest act is durable." -  Horace

Watching with interest the retreat in government bond yields, thanks to overall dovishness from our "Generous gamblers" aka central bankers including recently ECB's Le Chiffre (Mario Draghi), leading to renewed inflows into High Yield and equities in the US making new records in the prospect, with a continuation of the bull market in complacency, we reminded ourselves for our title analogy of the much used "Butterfly effect" narrative. While the "Butterfly effect" is the concept that small causes can have large effects and was initially used in weather prediction, in chaos theory, the sensitive dependence on initial conditions in a nonlinear system such as financial markets can lead to large differences in a later state of a credit cycle. The name was coined by American mathematician, meteorologist and chaos theory pioneer Edward Lorenz.

Our chosen analogy is also a veiled reference to US Treasuries Butterfly, given we think it is showing us that the US economy to some extent is tracking Japan. The butterfly spreads formed by the gaps between short, medium and long term US Treasury yields has been narrowing with Japan as of late:

- source Bloomberg 

In this week's conversation, we would like to look at what continues to provide inflows and support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan". 

Synopsis:

• Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets
• Final charts - Financial conditions? The punch bowl is still plentiful.

• Macro and Credit - Bondzilla is back and he provides strong support for US Credit Markets

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. 

While 2016 was a record year in terms of foreign bond purchases by Japanese Lifers, 2017 was more tepid thanks to European elections risk, but according to Nomura in their JPY Flow Monitor note from the 21st of July, Insurance companies bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row:

"Insurance companies: Insurance companies kept purchasing foreign bonds in June, but momentum remained relatively weak (Figure 1). They bought JPY201bn ($1.8bn) of foreign bonds for the fourth month in a row. They tend to be net buyers of foreign bonds in June, and the amount of net purchases was not significant (see “JPY: Season of seasonality”, 2 March 2017). Their investment in JGBs slowed to JPY171bn ($1.5bn). We expect lifers to keep purchasing foreign bonds, as major lifers’ investment plans suggest JGB yields will remain unattractive (see “BOJ review: Waiting longer for tailwinds”, 21July 2017).

Banks: Banks were net buyers of domestic and foreign bonds in June for the second month in a row (Figure 2).

They were large net sellers of bonds in April, but as seasonality shows, they resumed purchasing bonds in May and June. Foreign bond investment has slowed from May, but the FX impact was limited, in our view.

Pension funds: Trust banks, which manage pension funds’ money, kept purchasing foreign securities in June for the third month in a row (Figure 3).

The pace of net purchases slowed to JPY132bn ($1.2bn) though. Pension funds were also net buyers of domestic equities for the first time in five months. They bought JPY236bn ($2.1bn) of domestic equities, the biggest amount since August 2016. They were net buyers of JGBs too (JPY411bn or $3.7bn). The GPIF’s latest portfolio data up to end-March showed the fund’s portfolio is closer to its target portfolio. However, it accumulated short-term assets at a high level, and the president of the fund said the accumulation of short-term assets is to enhance available capacity for the next investment. Diversification from short-term assets into portfolio assets should continue for the time being as European political uncertainty has diminished. We expect pension funds to be dip buyers of foreign bonds and equities." - source Nomura

Not only for Japanese Lifers, but also for retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years as per Barclays JPY Monthly Flows noted from the 20th of July:

• "Japanese institutional investors continued to buy foreign bonds, but net outflow slowed down from last month. By investor type, banks and trust banks remained net buyers of foreign bonds. Meanwhile, life insurers continued to purchase foreign bonds. Foreign equity investments also decreased slightly in June, led by banks and bank trust account. Weekly data indicates that a net purchase of foreign bonds by Japanese investors turned positive again in the first week of July amid yield curve steepening globally since the end of June. Regional breakdown of foreign bond flow shows that Japanese investors turned net buyers of US, German and French bonds in May (Figure 1).

• Among retail investors, toshin funds remained popular while net issuance of foreign-currency-denominated uridashi bonds decreased somewhat in June. In bonds, INR- and RUB-denominated uridashi bonds continued to attract solid demand from investors. As for toshin funds, BRL-denominated funds increased for the first time since January this year and TRY- and INR-denominated funds continued to tick higher. Margin FX investors reduced their net long positions in USDJPY and AUDJPY notably and increased their short EURJPY and GBPJPY positions.

- source Barclays

Clearly, for Japanese retail investors, it has all been in recent years about low bond volatility and "king dollar". We continue to believe that when it comes to global flows, Japan matters and matters a lot. Japanese yen is indeed the source of the carry trade on a global basis and this has very significant implications from a tactical perspective when it comes to foreign bonds overall. Since the implementation of NIRP in 2016, Japanese Lifers went into "overdrive" in their purchases of foreign bonds. No surprise therefore that, when it comes to the "Butterfly effect", Bondzilla's appetite has been increasing at a rapid pace. 

You might be wondering where we going with the reference to the Butterfly effect and the importance of Japan but for US credit markets, Japan matters as well and matters a lot. Back in March 2017 in our conversation "Outflow boundary", we indicated the following:

"The big question, as we await the allocation decision from our Japanese friends, if there will be enticed again by foreign bonds like they have in recent years. The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment." - source Macronomics, March 2017

For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments.  

One thing that appears clear to us is that USD corporate credit in recent years has been supported by a large contingent of foreign investors in particular Japan. Reading through UBS Credit Strategy note from the 21st of July entitled "Where are we in the credit cycle?" we were pleasantly surprised that indeed, Bondzilla the NIRP monster is "made in Japan" and it is as well a critical support of US credit markets:

"Our deep dive analysis isolates Japan as the critical support for US credit"

- source UBS

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

The latest dovish retreat from our "Generous gamblers" (Fed and ECB) has created a "Rebound effect" as posited last week in the sense that is has not only prolonged the goldilocks state in credit markets with spreads tightening further for a longer period in this credit cycle, but, equities wise, it has provided additional strong support as well. Summer 2017 has led to record stock indices and all time spread tights in many instances. For now it seems it is "carry on" and we are indeed in the final melt-up of this last inning of the credit cycle risky assets wise. For many it continues to be the most hated bull-market in history. So far it seems our gamblers are reluctant in removing too early and too fast the credit punch bowl. For the moment the credit love boat is still sailing strong during this summer lull and unless we see some exogenous factors coming into play, it is difficult to see what could be a catalyst for a reversal before September where the Fed and the ECB could decide to tighten the financial conditions spigot as per our final charts.

• Final charts - Financial conditions? The punch bowl is still plentiful.

As we have seen recently, the Butterfly effect from the hawkish comments from Le Chiffre aka Mario Draghi led to a mini-tantrum in the Euro government bond space. Obviously the recent tone down in the rhetoric from both the Fed and the ECB has led to a continuation of "goldilocks" for risky assets thanks to record low volatility. Given the current financial conditions on both side of the Atlantic, it remains to be seen if our "Generous gamblers" will maintain further their dovish rhetoric in September. Our charts below come from Nomura and displays the US and Euro area financial conditions and comes from their recent Japan Navigator notes:

"Euro area and US policymakers are likely concerned about riskier asset rally;

Japanese policymakers may welcome it

This week 40yr and 2yr JGB auctions will be held. Japanese CPI data will be released.

The FOMC meets.

This week’s ECB announcement and market reaction have strengthened our conviction that the global yield upcycle that started from the euro area in late June has faded. We believe bond markets will move substantially only in September, when the Fed and ECB are likely to tighten policy, but only if riskier asset markets remain bullish despite Fed and/or ECB action. During this period, yields are likely to trade in a fairly narrow range, with risks on the downside, in our view. Riskier asset markets may strengthen and prevent yields from rising, but they tend to destabilize in the summer, particularly because US growth expectations are unlikely to rise.

UST yields have begun to fall. Although the market had become bearish owing to momentum from the euro area government bond (EGB) market, it lacked bond-negative factors (Figure 1).

There have been fairly strong concerns over US growth and inflation, and August data will likely be interpreted with scepticism – at the very least, a single month’s worth of data are unlikely to dispel these concerns, in our view.

We believe the ECB and Fed will look to tighten policy further if the output gap continues to improve and the riskier asset rally continues, even as they express concern about slow inflation growth, in our view. However, the Fed and ECB are unlikely to have an opportunity to jawbone until the Jackson Hole symposium in late August. Although the BOJ has emphasized its dovish stance, we believe it has basically the same stance as the Fed and ECB, and is unlikely to adopt an easing stance again as long as the output gap continues to improve. However, if JPY strengthens on risk aversion this summer, the market’s easing expectations may rise again, if only temporarily.

Compared with the Fed and ECB, the BOJ appears more tolerant about an increase in JPY carry trades and a riskier asset rally, and appears to be concerned about how much it can increase its JGB purchases further, rather than ETF buying, in our view. That said, if the BOJ revises its policy framework in such a way as to (erroneously) cause risk aversion, the negative impact on the appointment of the next governor should be substantial. Therefore, we do not expect policymakers to change the upper end of the target 10yr JGB yield range (0.11%) in the near term." - source Nomura

There you go, for now the ECB and the Fed have been mindful of the "Butterfly effects" in risky asset markets, hence the tone down of the rhetoric and insisting on a gradual process in removing the proverbial punch bowl, while the Bank of Japan (BOJ) has so far been in a holding pattern, ensuring in effect that investors in Japan as well continue to play out the low volatility leveraged "carry" play into overtime. No wonder the "Butterfly effect" is made in Japan, maybe it's related to the famous Opera play Madame Butterfly by Giacomo Puccini where the hero was so excited to marry an American that she had earlier secretly converted to Christianity or like Bank of Japan to central bankers' current religion we wonder. It didn't end well for Madame Butterfly in the end but we ramble again...

"See, the night doth enfold us! See, all the world lies sleeping!" - Giacomo Puccini

Stay tuned !