Saturday, 15 October 2016

Macro and Credit - An Extraordinary Dislocation

"The only true wisdom is in knowing you know nothing." -  Socrates
Watching with interest our barbell strategy (long gold/gold miners - long US long bonds) getting trounced, in conjunction with the infamous "flash crash" of the British pound, with terrible exports data coming from Asia as of late somewhat validating our fears expressed in our most recent post made us wander towards a cinematographic analogy for our chosen title this time around. "An Extraordinary Dislocation" is a short movie dating from 1901 by French illusionist and film director Georges Méliès famous for leading many technical and narrative developments in the earliest days of cinema. Georges Méliès was a prolific innovator in the use of special effects such our central bankers of today, popularizing such techniques as substitution splices, multiple exposures, time-lapse photography, dissolves, and hand-painted color. He was also the first filmmaker to use storyboards. Georges Méliès directed over 500 films between 1896 and 1913, ranging in length from one to forty minutes. In our case our title refers to a movie lasting a mere 2 minutes as per the linked provided above to the short movie "An Extraordinary Dislocation". In subject matter, these films are often similar to the magic theatre shows that Méliès had been doing, containing "tricks" and impossible events, such as objects disappearing or changing size such as the balance sheets of central banks. While most of his early special effects films were essentially devoid of plot, the special effects were used only to show what was possible (such as QE, TWIST, NIRP and other central banks tricks), rather than enhance the overall narrative or in the case of "The Cult of the Supreme Beings" aka central bankers, the overall situation of the global economy as a whole, slowly but surely falling when it comes to assessing the true global trade situation, particularly in Asia.

While one might wonder why we chose this particular short movie, we would like to provide some explanations before we move on to the nitty-gritty of our conversation. "An Extraordinary Dislocation" is probably the funniest of all mystical pictures yet produced by Georges Méliès. In this picture several body parts of a dancing clown float away from his body and come back again. In similar fashion as we have been warning in numerous conversations and in particular our February conversation "The disappearance of MS München" about the rising risk of large standard deviations moves thanks to rising cross-asset correlations due to central banks meddling with the most important allocation signal namely interest rates. The most recent "Extraordinary Dislocation" of the British pound is yet another reminder of the risk induced by repressed volatility. When it comes to dislocations and dancing clowns such as our central bankers of today, rest assured that many more extraordinary dislocations will continue to appear from nowhere such as "rogue waves" such as the recent sell-off in the British pound. While rogue waves have long been a fascination of ours as per our February musing, what "The Cult of the Supreme Beings" aka central bankers fail to grasp in their numerous "wealth effect" experiences is the Wicksellian Differential. 

Before we start our usual Macro and Credit musing we would like as a reminder to discuss Wicksell Differential and the credit cycle (linked to the leverage cycle). Wicksell argued in his 1898 book Interest and Prices that the equilibrium of a credit economy could be ascertained by comparing the money rate of interest to the natural rate of interest.  This simply equates to comparing the cost of capital with the return on capital. In economies where the natural rate is higher than the money rate, credit growth will drive a positive disequilibrium in an economy. When the natural rate of interest is lower than the money rate which is the case today (rising Libor), the demand for credit dries up (our CCC credit canary are being shut out of credit markets) leading to a negative disequilibrium and capital destruction eventually. In a credit based global macro world like ours, the Wicksellian Differential provides a better alternative estimation of disequilibrium than the more standard Taylor Rule approach of our central bankers. At the Bank for International Settlements since 1987, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS
So when we hear Janet Yellen at the Fed saying the following:
 "Asset values aren’t out of line with historical norms." -Janet Yellen, 21st of September 2016
We reminded ourselves that Wicksell used just the housing sector to illustrate his theory. Excess lending dear Mrs Yellen, always lead to "overinvestment". Just because the Taylor Rule used by the Fed doesn't include asset prices, it doesn't mean in our book that asset values are not out of line of historical norms.

Why is the Wicksellian Differential so important when it comes to asset allocation? Either profits increase due to an increase in the return of capital and/or a fall in the cost of capital (buybacks funded by a credit binge). This is clearly reminded by Credit Capital Advisors' note from July 2012 entitled "Navigating the business cycle: A new approach to asset allocation":
"The calculation of the Wicksellian Differential is however an ex-post measure, so is unhelpful for investors to use as an investment trigger, hence an ex-ante model needs to be constructed based on the underlying drivers of growth in the Wicksellian Differential, which is of course leverage. However, an ever-increasing amount of leverage is clearly unsustainable and will cause expectations to shift at some point, resulting in a period of deleveraging and falling profits. As a result, an investment trigger can be set up based on the dynamic relationship between leverage ratios and the rate of profit, which requires constant recalibration as new data is made available.
The relationship between each leverage ratio and the rate of profit is unique and dynamic through time. For example, the slowdown and fall in the consumer leverage ratio caused the Wicksellian Differential to reverse between 1990 and 1992. Furthermore, during the tech bubble between 1996 and 1999, corporate leverage fell followed by consumer leverage, causing the rate of profit to fall. This highlights that there was no real basis for rising equity returns during the tech bubble as the rate of profit growth was falling. Thus the dotcom bubble ought to be seen as akin to John Law’s South Sea bubble, which was purely based on a rather large misconception. The extent of the credit bubble leading up to the recent financial crisis is highlighted by the substantial rise in consumer leverage, the rate of which began falling at the end of 2006, highlighting the downturn in the rate of profit growth in 2007, and thus a shift to bonds. Finally consumer leverage rose again in 2009, signaling a recovery in profits, although the recovery was short-lived. In 2011 the trend fell again, and the 2012 signal highlights a continuing slowdown in the underlying trend of profit growth. 
There are of course other factors that impact profits, such as significant changes in the general price level and in output per worker, as well as other known variables such as the tax rate; however, the most important driver with respect to the turning points is the realisation that a period of credit expansion has become unsustainable, leading to changing expectations." - source Credit Capital Advisors, July 2012
And of course dear readers, we have long been warning that the credit cycle was slowly but surely turning thanks to credit "overmedication". End of our Wicksellian Differential parenthesis.

In this week's conversation, while credit markets are still strongly technically driven thanks to central bank competing with credit investors, we would like to look at Japan's latest bending the curve experiment as well as rising inflation expectations leading to some pundits asking themselves about the potential return of the much dreaded "stagflation" word.

  • Macro and Credit - Can the Bank of Japan bend the yield curve?
  • Macro and Credit  - Is reflation around the corner and leading to stagflation?
  • Final chart: Balance sheets are out of sync with the economy

  • Macro and Credit - Can the Bank of Japan bend the yield curve?
While following the latest market gyrations and various "sucker punches" delivered to the investing crowd, the latest "The Cult of the Supreme Beings" experiment coming from the Bank of Japan picked up our interest given the changes in policy target from quantity to interest rates, in their latest "reflationary/inflationary" attempt. On this subject we read with interest Bank of America Merrill Lynch Liquid Insight latest note from the 14th of October 2016 entitled "Will yield curve control work in Japan?":
"BoJ switches policy target from quantity to interest rates; what about prices?
At its September Monetary Policy Meeting (MPM), the BoJ carried out its comprehensive assessment and introduced QQE with yield curve control. The new policy consists of: (1) yield curve control, by which the BoJ will manipulate short- and long-term yields; and (2) an overshoot commitment, whereby the BoJ pledges to keep expanding the monetary base until CPI inflation exceeds and stays stably above 2% YoY. The sustainability of huge JGB purchase operations totaling ¥80tn annually caused some concern, and the risk that yields would decline without limit prompted the BoJ to switch its target from quantity to interest rates and thereby make purchase operations more flexible. On the price side, we see some evidence that inflation is trending downward again, such as the core CPI’s dip into year-on-year negative territory (Chart of the day).

The BoJ’s strengthened commitment to 2% inflation runs the risk of postponing the exit from monetary easing until even further in the future. In this note, we consider the BoJ’s new monetary policy, including the extent to which it can contribute to raising prices.
Yield curve control – the balancing act
The BoJ’s “yield curve control” means that a rate of -0.1% will be applied as the short-term rate to policy-rate balances in current accounts held at the BoJ. For the long-term rate, the BoJ will conduct long-term JGB purchase operations in such a way that the 10yr yield stays at about 0%. At the same time, the BoJ aims to maintain the pace of annual JGB purchase operations at the current ¥80tn while guiding interest rates, so doubts remain about the simultaneous use of yield curve control and quantity. The BoJ maintains that yield curve control is at the center of its new framework.
Indeed, as the 10yr yield approached -0.1%, the BoJ reduced purchase operations on 30 September. This reminded market participants that -0.1% was the yield’s lower limit. The purchasing cutback was small, but in light of the possibility that operations could be reduced again, the 10yr JGB will probably be seen as difficult to buy the next time its yield approaches -0.1%. Given the small size of the purchasing cutback, it might appear that tight supply-demand is likely to push the yield below -0.1% again, but the BoJ first indicated that the target yield level was 0% and then showed its intention by reducing purchase operations. If the 10yr yield approaches -0.1% again, market participants will likely start to expect another purchasing cutback. The BoJ has declared that it will control short- and long-term rates, so with the short-term rate set at -0.1%, it is difficult to envision the BoJ doing nothing if the 10yr yield sinks below that level. Therefore, the BoJ might be able to keep the 10yr yield at about 0% without reducing purchase operations very much.
The BoJ’s Summary of Opinions at the Monetary Policy Meeting (20-21 September), released on 30 September, says: “It is uncertain whether the pace of JGB purchases will slow down as intended and the sustainability of monetary easing consequently improve under yield curve control.” The goal of slowing JGB purchases is clearly mentioned, and the BoJ’s stance on “quantity” and “policy sustainability” does not appear to be settled. The BoJ is probably wary of reducing quantity only to see the yen strengthen or stocks weaken. Nevertheless, we believe it will gradually move in the direction of reducing quantity.
In any case, it would be difficult to hold the 10yr JGB yield down to 0% without purchase operations, but the BoJ itself will have to continue searching for the right amount of purchases to do the job. Even if the BoJ shifts entirely to an interest rate target, there is no guarantee that it can control the yield curve, so uncertainty would be high. The important point is how fast the BoJ can shift to an interest rate target. The BoJ for now seems to be targeting the shape of the yield curve at the time of the September MPM, so yield targets are 0% for the 10yr yield, 0.4% for the 20yr yield and 0.5% for the 30yr yield (Rates forecast: Attention on BoJ operations when yields decline).

Reflation credibility of the new framework
History shows that when prices and the economy overheat, rate hikes can be deployed to exert some control. But is it possible at normal times, in the absence of a financial or liquidity crisis, to boost prices by making monetary policy more accommodative? At this point in Japan, the effort is not going very well. In general, QE by purchasing T-Bills with 0% interest rates is not thought to be effective. Because highly liquid T-Bills with 0% interest rates have about the same value as cash, and exchanging one for the other has almost no economic effect. On the other hand, expanding the monetary base by purchasing long-term JGBs has a strong experimental aspect. Although long-term JGBs have low yields and high liquidity, they are not equivalent to cash. The BoJ introduced QQE in April 2013, and the yen’s sharp depreciation and rise of prices made the policy look effective. After three and a half years, however, inflation is heading downward again, while there was some impact from the decline in oil prices.
Since the beginning of the Abe administration at end-2012, it is true that the yen has weakened owing to a certain sense of inflation expectation. Another factor behind the yen’s depreciation is that the then Federal Reserve Board (FRB) Chairman Ben Bernanke mentioned tapering in May 2013, and tapering began in December of that year. From then until rate hikes actually began in December 2015, the US appeared to approve of some USD appreciation. In 2008 and later, amid the financial crisis that stemmed from the US subprime loan crisis and the Greek debt crisis, the FRB and the European Central Bank (ECB) implemented a variety of operations, including asset purchases. Their contribution to reducing risk premiums, raising asset prices and stabilizing the financial system helped to raise expectations of the BoJ’s QQE.
Immediately after QQE was deployed, prices steadily rose, owing in part to the weak yen effect, but the inflation trend turned downward with the decline of oil prices beginning in summer 2014. This was unfortunate for the BoJ, but even though the year-on-year decline in oil prices has shrunk considerably, inflation remains low (Chart 1).

Even the CPI inflation excluding energy prices is trending lower, suggesting that this may be the effect of the yen’s recent strength. Although the yen’s depreciation from 2013 did help to boost prices, that effect has peaked out because of the yen’s appreciation this year. The forex rate affects prices with a lag of six months to one year, so forex will be a price-lowering factor for the time being (Chart 2).

Based on the results of the September MPM, the possibility of JGB purchasing cutbacks gave rise to concern that the yen would strengthen further. Ironically, or perhaps fortunately, expectations of US rate hikes rose and this may have weakened the yen instead.
In the end, the major determinant of inflation will be the extent to which tighter labor market conditions push up wages. In 2014, when the weak yen and a consumption tax rate hike raised prices, wages did not see a commensurate rise, and as a result, consumption was sluggish. According to the Ministry of Health, Labor and Welfare’s Monthly Labor Survey, total cash earnings (nominal wages) climbed 1.2% YoY in July. However, scheduled cash earnings (basic wages, etc.) rose only 0.3%, while bonuses and other special payments boosted the overall figure. In August, total cash earnings declined 0.1%, their first downturn in three months, but scheduled cash earnings were up 0.5%. If the BoJ is aiming for 2% inflation, wage hikes are still insufficient, but the unemployment rate has declined to about 3% and companies facing labor shortages have started hiring more full-time workers, including permanent employees. Favorable changes like these are starting to be seen in the labor market (Chart 3).

The corporate sector’s retained earnings have hit a record high, while the labor share is declining, so there is plenty of room for improvement (Chart 4).

Price-lowering pressure from the strong yen will continue for a time, but we expect to see modest price rises over the medium to long term. However, is it possible for monetary easing to cause sustained inflation? We cannot give a definite answer, but let us consider this matter by looking back on the BoJ’s monetary policy and its ripple effect.
Effect of quantitative expansion
Under the BoJ’s QQE, asset prices rose strongly starting in 2013. Normally stock and JGB prices have a negative correlation with one another, but at that time they had a positive correlation and rose together (Chart 5).

That relation seems to have broken down since the start of this year, but for at least three years asset prices rose in a way not normally seen. The problem is that rising asset prices were not reflected in general prices. This was likely resulting from the fact that the BoJ expanded the monetary base at a rapid rate, but the expansion of money stock was limited (Chart 6).

To put it another way, even though the monetary base expanded, bank lending increased only slightly. Since 2000, Japan’s monetary environment has been accommodative, and bank deposits have continually increased, but bank lending has not. To cover the deposit-loan gap, domestic banks increased investment in JGBs (Chart 7). 

Therefore, even when the banks’ JGB holdings were exchanged for cash under QQE, the lending situation of banks did not greatly change. The asset composition of domestic banks shows that in the three years after QQE started, the share of bank assets in JGBs declined, while the share in cash increased by a similar percentage. Other asset classes did not change much (Chart 8).

Although the absolute amount of lending did increase, it mainly went into real estate-related projects. Lending growth to manufacturers for capital goods was limited. Even though the monetary base expanded, the amount of funds circulating in the real economy (money stock) did not change much, so the kinds of price increases seen in assets were not seen in general prices.
Effect of negative interest rates
At the January 2016 MPM, the BoJ applied a negative interest rate of -0.1% to a portion of current accounts held at the BoJ. It introduced a three-tiered structure for current accounts and other measures to avoid negative impact on banks, which until then had cooperated with QQE. In the JGB market, however, about three years of JGB purchase operations had tightened the supply-demand relationship, causing yields to decline sharply, the yield curve to flatten, and arousing concern about pressure on the earnings of financial institutions (Super long JGB supply-demand balance). In Europe, which introduced negative interest rates before Japan, the side effect of reduced bank margins was conspicuous, but it did not lead to much of an increase in lending to corporations, the intended benefit. With interest rates on deposits remaining positive, loan rates could only be lowered to a certain extent without eating up the margins. In particular, Japan has already experienced a long period of low interest rate policy, and interest rates on loans are already low, so further downside room is limited (Chart 9).

In Japan, with its high ratio of indirect financing, the effect on the real economy is only slight. Moreover Danish banks responded to the decline of bank margins by raising service charges on mortgages and other products. According to a 7 October Nikkei Shimbun article, Japanese banks are also considering higher service charges on mortgages. This will have a de facto monetary tightening effect. However, a low-interest rate environment is generally positive for corporate funding. Amid the limited decline of interest rates on loans, corporate bond issuance is picking up in Europe. In Japan, the corporate bond market did not expand, partly because Japanese companies have large reserves, but issuance did swell this summer (Japan Credit Monthly, September 2016). As the yield curve flattened, issuance increased at maturities over 10yr (Chart 10).

The wider variety of corporate funding alternatives can be described as a benefit, but the BoJ’s monetary policy change might also bring about a change in this trend. As the BoJ points out, the costs and benefits of policies must be watched.
With the April 2013 introduction of QQE, called a monetary “bazooka” at the time, the BoJ tried to work on people’s expectations and raise CPI inflation to 2% within two years, but the attempt failed (Looking back at three years of QQE). In the absence of any clear reason why expansion of the monetary base should lead to a higher inflation rate, the BoJ’s action was even called a social experiment. Monetary policy is a crucial means of stabilizing prices and the financial system. When the economy overheats, for example, it can be treated with a rate hike, and when liquidity dries up in a financial crisis, the central bank can supply liquidity. Although there were a number of different factors that make it difficult to blame the failure solely on the BoJ, it has proven very difficult to raise prices by monetary policy alone in normal times.
Liquidity is already adequate owing to Japan’s extended monetary easing. It is so adequate, in fact, that banks have trouble finding worthwhile investments for their funds. With the supply of even more funds beyond this point, the costs of this policy are starting to become more pronounced than the benefits. In early July, the 20yr JGB yield dipped into negative territory, a sign of low yields overall and a very flat curve. As the cost of funding foreign currency rose, the possibility arose that domestic investors would have nowhere to invest. “The lower the better” is not a phrase that applies to interest rates. Excessive monetary easing by the central bank can inadvertently rob the market of low-risk assets and heighten financial system risk. The G20 finance ministers and central bank governors have also expressed concern about the side effects of prolonged monetary easing and extremely low interest rates environment.
The increasingly easy monetary policy favored by nearly everyone until recently might now gradually change direction on a global basis. In future, a monetary policy that more closely matches the pace of real economy’s growth might be sought, as well as a policy that is more sustainable. On that point, we believe the BoJ’s switch from quantity to an interest rate target is effective, but it will raise new questions, what the appropriate shape of the yield curve is and whether that will lead to inflation." - source Bank of America Merrill Lynch
The same pattern in Europe and Japan is happening, namely that the new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hands even in Japan.

From our perspective, there are a couple of points we would like to make relative to Bank of America Merrill Lynch's comments. First of all we believe that the bending of the curve will be ineffective in triggering the much desired inflation the Bank of Japan is seeking given as we indicated before when commenting on the "Japanification of Europe, both Europe and Japan's deflationary headwinds are stemming from poor demographics. In terms of Wicksellian Differential and real estate and Japan, we note with interest that the prognosis for Japanese real estate is some more pain ahead as NIRP is translating into banks trying to recoup some profitability through higher mortgage rates as indicated by Bloomberg in their article from the 13th of October entitled "Tokyo Condo Prices May Fall 20%, Deutsche says":
"The Bank of Japan’s shift to controlling bond yields is driving up mortgage rates, prompting Deutsche Bank AG to predict Tokyo apartment prices may fall 20 percent or more by 2018.
The BOJ’s negative-rate policy was already hurting buyer sentiment, and its move to boost longer-term yields is a double-blow to the industry, according to Yoji Otani, a real estate analyst at Deutsche Bank in Tokyo. The 35-year fixed mortgage rate has climbed for two straight months after touching a record low of 0.9 percent in August, and sales of new condominiums in Tokyo this year have fallen to the lowest since the nation’s property bubble collapse in the early 1990s." - source Bloomberg
Second point, the impact on real estate prices and rising mortgages thanks to very aggressive monetary policies can be as well ascertained in Switzerland. Of course when it comes to "capital destruction" and Wicksellian Differential, you can rest assured that once prices go down in "bubbly" real estate markets, it leaves people in negative equity territory for an extended period of time. The most interesting comment from the Bloomberg article relative to Bank of America Merrill Lynch's conclusion where they think the Bank of Japan will be successful in "bending the yield curve" (which we don't think they will!) is as follows from Yoji Otani, a real estate analyst at Deutsche Bank in Tokyo:
"The one positive thing about negative rates was that it lowered borrowing costs, and now that is going to end," said Otani, who expects prices to fall 20 percent to 30 percent by the end of 2018. "The collapse of this silent bubble has begun."
"The BOJ is operating a negative-rate policy but it is trying to push up long-term yields, which totally lacks sense,” he said. “There’s a contradiction." - source Bloomberg
You can rest assured that this new NIRP trick is going to blow in the face of "The Cult of the Supreme Beings" aka central bankers members from the Bank of Japan and lead to some additional "Extraordinary Dislocation". As a reminder from our previous conversation where we quoted our April article "Shrugging Atlas" in which we discussed Japan and the kite string theory:
"That is the very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016
If indeed real estate turns "South" in Japan then banks will have to increase credit provisions which de facto will reduce credit availability and therefore credit impulse and economic growth. On top of that if indeed Japanese households fall into negative equity thanks to their real estate exposure then again, as a textbook Richard Koo explanation, these households will have no other choice but to reduce their spending and borrowing as they try to repair their balance sheet. Yet another potential for Richard Koo's Balance Sheet Recession theory playing out again in Japan we think.

As well as having a contradictory approach, the Bank of Japan has played the NIRP game given it's mostly has we have explained before a currency play, but then again, anchoring the 10 year Japanese Government Bond around the 0% threshold is conditional of USD/JPY evolution. Furthermore, the Bank of Japan is playing a very difficult balancing act. This is clearly indicated by Nomura in their Japan Navigator note number 691 from the 10th of October entitled "Diminishing room for JGB rates to fall further":
"Conditions for 10yr rates to become positive
We believe 10yr yields are unlikely to reach positive levels unless, as mentioned above, the BOJ allows the pace of its JGB purchases to fall further below its target of “about JPY80trn” in annual absorption, in which case the market would determine that the Bank is unlikely to ease further.
Once expectations of further BOJ easing fade, we believe negative 10yr JGB yields would no longer attract short-term long traders, but only purchases from investors looking to buy for holding until maturity. In this case, we believe 10yr rates would trade above levels that are determined by bank deposit rates and deposit insurance premiums. This is not included in our base case for FY16, but we believe this scenario may materialize in H1 FY17, as the BOJ’s JGB purchases would fall more substantially below its target.
If the BOJ continues buying JGBs at the current pace, it would absorb a net JPY75trn in FY16. However, if the current pace continues beyond end-FY16, it would absorb only a net JPY72trn in FY17, in which case the BOJ would have to either abandon its quantitative target or allow greater flexibility (adopting a proviso) from next spring, in our view.
At that point, if the Fed is discussing another hike (following a hike in December), we would expect the risk of a strong JPY to have declined, but otherwise the BOJ could cut rates further to alleviate investor concerns over QQE tapering." - source Nomura
It appears therefore that further reaction from the Bank of Japan is conditional on the Fed's action in December. What is a cause for concern in the footsteps of our previous conversation relating to our US dollar strengthening fears is that if indeed USD funding tightens further, then USD/JPY basis widens even more which means in effect that strong buyers such as lifers will continue their purchase of US bonds without any FX hedging due to the rising cost. This particular point is worth noting and was highlighted by UBS in their recent Global Credit Comment from the 12th of October entitled "What is the consensus view? And where could it be wrong?":
Hedging FX exposure was brought up in a majority of client meetings, as widening basis swaps reduce the relative yield advantage of US credit. We found that clients are largely hedging FX exposure via short-dated swaps (3 months). But interestingly, a rising fraction noted they are no longer hedging as the costs become less economical. In continental Europe, where negative rate pressures are particularly severe, the rotation into anything with yield is driven largely by institutional pressures (rather than fundamental credit assessments). There are simply few other investment alternatives in a market structure where managers must invest incoming flows and coupon/maturity proceeds. A number of investors reported more recent interest in longer-dated US IG – and a majority of investors continue to report holding a long position in EU financials.
Among the bigger themes, UK and European clients were focused on the outlook for central bank policy, political fragmentation in Europe, the foreign demand for global credit, the state of the US credit cycle3 and US election outcomes. On risks ahead clients were quick to cite many of the known unknowns ahead: Brexit, the Italian Referendum, the December FOMC meeting and other core European elections next year. Based on our discussions, we believe the larger and more underpriced risk scenarios for European credit investors would include: 1) timing and pace of ECB tapering of CSPP, 2) rising systemic risks stemming from idiosyncratic stress among European banks, and 3) significant spread widening in US credit spreads. Note that none of these outcomes are our base case." - source UBS
Whereas there is indeed some clear sign of global US dollar shortage increasingly indicated by widening basis swaps, the yield differential still favor having US credit exposure, even long dated to Investment Grade as we feel more and more incline to look for quality rather than chasing yield in US High Yield given the late stage of the current credit cycle and significant build up in leverage with week CAPEX, poor EBITDA and rising defaults. The next US Senior Loan Office Surveys (SLOs) will be paramount for the technical bid in credit and in particular US High Yield to continue we think.

For our second point, we would like to steer towards reflationary expectations and the much commented fears of a return of "stagflation".

  • Macro and Credit  - Is reflation around the corner and leading to stagflation?

Back in March 2016 in our conversation "Unobtainium" we pointed out that the time that US TIPS were more compelling than UK linkers thanks to their deflation floor, but given the very significant performance of UK linkers thanks to Brexit and the British pound de facto devaluation, we should have noted what the UK linkers market was telling us at the time, namely that further depreciation of the British pound was coming hence the rise of inflationary expectations and the significant performance of this asset class in particular during the month of August.

Our renewed interest in rising expectations can be tracked down from our comments from our March 2016 conversation:
"A very interesting 2015 paper by the Bank of Israel ( (Sussman, N and O Zohar 2015, “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015.) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area. Therefore, given the recent significant surge in oil prices towards the $40 mark, we do not think it is such a surprise to see a rise in inflation expectations in that context. This latest rise in inflation expectations could after all be transitory as well as the sudden rise in oil prices, particularly in the light of the tight relationship between the US dollar and oil prices. We think that the latest dovish stance of the Fed all has to do with their concerns relating to the "velocity" of the US dollar and the "unintended consequences" a too rapid rise of the "Greenback" could have on Emerging Markets (EM)." - source Macronomics, March 2016
Many pundits have noticed the current reflationary trend particularly in the 10 year breakeven rate in the US over the past couple of weeks. This trend is as well highlighted in Bank of America Merrill Lynch's Securitization Weekly Overview entitled "Reflation takes flight" from the 7th of October:
"This week, we take note of the steady rise in the 10yr breakeven rate over the past few weeks, moving from 1.50% on September 20 to 1.66% as of Friday (October 6) morning, post-September payrolls. Using our breakeven inflation rate valuation framework, we consider what a 2% breakeven rate might mean for securitized products and competing sectors. We choose 2% since we think it is a reasonable target level to assume: in other words, although the Fed downplays the importance of market-based inflation expectations, we think it is likely an implicit target anyway.

Chart 1 and Chart 2 show two different longer term views of the 10yr breakeven inflation rate. We think they both tell us that the recent rise in the breakeven rate is very important and that the chances of continuing to move higher, possibly reaching 2% over the next 3-6 months, are good. At long last, central bank reflationary policies might actually be working.

Chart 1 shows that the recent rise in the breakeven rate has pushed the level through the upper end of the downward trend channel that has persisted since taper talk in 2013. Chart 2, which looks at 30-, 40-, and 50-week moving averages along with the weekly level, suggests that, in recent weeks, the trend may finally have shifted from downward to upward. The weekly reading has crossed through all the moving averages to the upside, and for now, the 30-week moving average is moving higher.
We’re as skeptical about the inflation risk as most, but the view in these charts tells us that, finally, the tide may have shifted in recent weeks towards higher inflation expectations. We’ll consider our breakeven valuation framework in a moment but first we consider what rising inflation expectations means for Fed rate hike potential.
Chart 3 compares the 10yr breakeven rate with the probability that there is at least one rate hike by December 2016; the probability currently stands at 64%.

In recent months, they have moved in similar directions, although not always at the exact same time. Over the past month, since September 2, the 10yr breakeven rate has risen by roughly 16 basis points, from 1.48% to 1.64%. If the same increase applies over the next two  months, bringing the breakeven inflation rate to 1.96%, we are confident the Fed would have hiked at least once by the December meeting (as BofAML economists expect); moreover, based on Chart 3, it also seems possible that the market probability of such a hike would be approaching 100%. In other words, the Fed would have reached a perfect position to hike: the market is fully expecting it, and would not react adversely to the hike.
It should be recognized that there is a chicken-and-egg situation here: if the rate hike probability jumped quickly to 100%, say over a day, the breakeven inflation rate would likely quickly reverse the recent rising trend; but if both gradually move higher, in line with the Fed’s gradualist approach, reaching the end state on both the rate hike and the inflation expectation becomes more achievable. The recent breakeven trend reversal to the upside, seen in Chart 1 and Chart 2, makes us believe the latter scenario is the higher probability scenario." - source Bank of America Merrill Lynch
The trajectory for inflation expectations and rising 10 year US breakevens in our book is clearly being driven by the change in oil prices, that simple. We have yet to meaningful wage inflation which would entice us to validate the recovery mantra of some sell-side pundits. Nonetheless wages are a backward looking indicator of inflation pressure.

Whereas the rise in US inflation has put indeed some pressure relative to the US yield curve, in effect pushing the US 10 year towards 1.80 % yield level, we do not have such a sanguine approach for the long end looking at the recent downward revision by the Atlanta Fed from their GDPNow latest forecast for 1.9 % on October 14th for the Third Quarter. We therefore believe we are once again approaching compelling levels for US long dated treasury and we will be monitoring the situation closely. As a reminder, when it comes to our contrarian stance in relation to our "long duration" fondness it is fairly simple to explain:
"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."
We hope, at some point, this will become "Common knowledge" and that some sell-side pundits will stop defying this simple yet compelling "Wicksellian" logic which in terms of allocation can prevent  "Extraordinary Dislocation" when eventually equities will correct.

When it comes to the stagflationary fears out there, they seem to us relatively premature given the impact rising oil prices have had on inflation expectations. What seems to us much more worrying from a potential bear market perspective is the velocity in the surge in oil prices which in the past have always preceded significant corrections in stock markets. As 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. This, dear friends is based on facts, not conjecture.

Finally, for our final chart, and given we highlighted the importance of leverage when looking at Wicksellian Differential, we think it is important to note the growing divergence between corporate balance sheets with the economy as the credit cycle moves towards the last inning.

  • Final chart: Balance sheets are out of sync with the economy
While much of the performance of US equities has been driven to a large extent by multiple expansion thanks to buybacks funded by cheap credit, it is worth noting that eventually, what matters in a credit cycle at a late stage is the level of leverage in the system from a Wicksellian perspective. In relation to this statement we would like to point towards Bank of America Merrill Lynch's chart from their Credit Market Strategist note from the 14th of October entitled "3Q=stabilizing, 4Q=improving fundamentals" where they show that corporate balance sheets are at much later stage in the cycle:
"Balance sheets are out of sync with the economy
As we have argued (see: Monthly HG Market Review: June ’16: Brexit and the decline in yields 01 July 2016 ). due to unprecedented monetary policy easing globally, in response to the challenges emerging from and financial crisis and sovereign crises, corporate balance sheets are at a much later stage in the cycle (Figure 17). 

This disconnect between the economic cycle and corporate balance sheets is highly unusual and perhaps never seen before. But these times are indeed highly unusual. As the economy moves through the last half of its cycle we thus expect that corporate balance sheets improve a bit over the coming years - although companies are not going to undergo a traditional deleveraging cycle. Then when the economy eventually goes into recession we should see the traditional spike in corporate leverage ratios driven by declining earnings." - source Bank of America Merrill Lynch
So dear Janet Yellen, if you think that asset values aren’t out of line with historical norms, balance sheets are and you can expect down the line "Extraordinary Dislocation" and very low recovery rates in the next downturn thanks to Wicksellian Differential rest assured.

"I believe in social dislocation and creative trouble." - Bayard Rustin, American leader in social movements for civil rights, socialism
Stay tuned !

Monday, 3 October 2016

Macro and Credit - Empire Days

"No one is free who has not obtained the empire of himself." - Pythagoras

Looking at the misery inflicted to battered German banking giant Deutsche Banks, emerging art getting trounced and the collectible car markets getting frothy (as we predicted back in July in our conversation "Who's Afraid of the Noise of Art?") , with luxury watches sales continuing to be under pressure in Asia, in conjunction with sabers rattling in the unresolved Syria situation and a tense election period in the United States with nationalist pressure on the rise globally, we reminded ourselves of this week title analogy of cold wave French-British group The Opposition's 1985 best album Empire Days. More and more we are convinced than the "statu quo" is failing and as we pointed out in our November 2014 "Chekhov's gun" the 30's model could be the outcome:
"Our take on QE in Europe can be summarized as follows: 
Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014
It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "statu quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us.

On a side note, while discussing the US elections outcome with some friends and there "Optimism bias" we reminded them our take on the subject around the time of the Brexit results and our contrarian stance which was indeed prescient:
"While assisting in Paris to the "Brexit conference" set up by our friends at Saxo Bank, one of the members of the audience during the Q&A session pointed out the "accuracy" of the bookmakers for the remain to "prevail". We could not resist but intervene to rebuke that statement by using as an illustration how bookmakers got it so wrong when offering 5000/1 odds at the beginning of the season for FC Leicester to clinch the British football Premier League and still having the odds at 500/1 around October. The biggest liabilities for the bookmakers were accrued at around 100-1 to 500-1. To quote Mike Tyson: "Everyone has a plan 'till they get punched in the mouth". Since that "FC Leicester punch" the longest odds that can now be placed on any event will be 1,000-1 to ensure that the betting company Ladbrokes is less exposed in future to 'black swan' events. We reminded also the Saxo crowd the Nash equilibrium concept, us playing on this occasion the "Devil's advocate". In fact not a single time did the bookmakers anticipated a victory for "Brexit" yet another display of the "Optimism bias"" - source Macronomics, June 2016
To that effect we argued with our friends about how irrelevant the results of the first television confrontation between Hilary Clinton and Donald Trump were and how low were their predictive nature when it comes to finding out about the potential "outcome" of the upcoming US elections. Therefore, given we like to put our money where our mouth is and our  long standing contrarian stance, we decided this time around to place a "friendly" bet with our friends as we argued that Donald Trump has a much higher probability of getting elected (in similar fashion to the "Brexit" base case) as the Mainstream Media (MSM) would like to "spin it". To that effect we bet on a nice bottle of wine for the winner, two friends deciding to take us on so that it's a nice 2 versus 1 situation for the time being.

But, when it comes to our analogy and this week's conversation, whereas everyone and their dog are focusing on Deutsche Bank, we would like to steer our attention to what lies beneath, namely, a dollar squeeze of epic proportion as we mused in our conversation "Singin' in the Rain" back in 2013:
"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013
It might be that indeed "Deutsche Bank is one of these "big whales" turning belly up, there are indeed increasing signs in Asia and Europe that point to caution given Euro/dollar 3-month FX basis swap widest in 4 years on Deutsche Bank's troubles (-62 basis points). There is something nasty lurking we think. In similar fashion to 2011, regardless of the liquidity provided by the ECB, a widening of Euro/dollar basis swap should always be taken seriously.

  • Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity
  • Macro and Credit  - Loan growth under NIRP - The case of Japan
  • Final chart: Market’s growing dependence on central bank stimulus means more 
    prone to “corrections”
  • Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity
Back in 2011, increasing bank stress during the summer led not only to a widening of credit spreads but as well to a significant widening of Euro/dollar FX basis swap. To that effect, dollar illiquidity was manifesting itself in the FX basis swap market as well as in the CDS space with the European financial sector credit spreads significantly widening until the launched at the end of 2011 of LTROs by the ECB which was followed by the establishment of swap lines between the Fed and the ECB. Many pundits are pointing towards the upcoming reform for Money Market funds in the US as the prime culprit for this impressive spike in the Euro/dollar FX basis swap market. We think there is more to it as per our 2013 worries. As shown by the BIS in its latest quarterly report released this month, "ultra-loose monetary policies" have increased global dollar shortage. The "crowding out" effect from lower yielding Euro denominated assets is pushing investors towards the US dollar in drove such as Japanese Life Insurers as we have shown in various musings. Also we argued in our July conversation "Eternal Sunshine of the Spotless Mind" that Bondzilla, the NIRP monster is more and more "made in Japan" as for Japanese Lifers, US assets remain preferred. Therefore there is a potential "crowding-out" effect we are seeing with rising yields in Europe with an acceleration of their allocation towards the US meaning effectively additional demand for US denominated assets and rising costs for hedging FX exposure. Remember you need to follow "Japanese flows" as they matter a lot.

So when it comes to Deutsche Banks woes and the attention it is garnering, to paraphrase our Rcube friends, when everyone is thinking alike, no one is really thinking. As a reminder, under the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity. When it comes to quantity, the surge of the significant Euro/dollar FX basis swap market is displaying in earnest, a dollar shortage. 
"When a wise man points at the moon the imbecile examines the finger." - Confucius
To that effect, rather to continue musing on European banking woes, deleveraging and "Japanification" this week given we have long been touching on these issues in numerous conversations, to paraphrase Confucius, we would rather steer you towards the moon, namely issues brewing in Asia in general and China in particular. As of late was as caught our interest is the acceleration of ebt-equity-swaps (DES) and defaults in China as reported by Nomura in their note from the 20th of September entitled "Both DES and defaults likely accelerated":
"According to local media today (Caixin, 20 September), the first debt-equity swap (DES) in this round (vs the c.RMB400bn DES in 99s) has been approved, in which half of Sino Steel’s RMB60bn debt could be converted into a six-year convertible bond (ie, c.RMB30bn), while the other half remains debt at a relatively low interest rate, likely at a discount vs the one-year benchmark loan rate of 4.35% pa. For the c.RMB30bn CB, according to the same news article, the first three years would see no conversion, and the conversion would come in the fourth year at the pace of 30/30/40% until the sixth year. 
Meanwhile, Guangxi Non-Ferrous Metals announced its bankruptcy per court release on 19 September, being the first on China’s interbank bond market. On the same day, Dongbei Special Steel also announced a potential default due 24 September, the latest warning after a series of bond defaults. 
The DES ratio reportedly is up to the cash flow coverage of relevant debt, thus it varies for different banks 
Sino Steel has faced default risks since 2014 and the regulators called a meeting to resolve the company’s debt issue, which was chaired by BOC as per the news article above. The debt restructuring plan was finalised early this year, and now reportedly the DES has been approved for implementation. 
Despite an overall c.50% DES ratio for the entire debt of RMB60bn for the Sino Steel group and its subsidiaries, this swap ratio varies according to individual banks, given that cash flow coverage over individual banks’ debt exposure differs, per the media coverage. It seems that loans well covered by collateral and/or cash flow of projects would remain as debt, and it is those loans primarily on credit or guarantee and not covered by cash flow that might be swapped into CB. Capital injections from SASAC were also expected in future, according to the media coverage. 
If the reports are accurate, DES through CB puts less pressure on banks’ capital and they could avoid material write-downs upfront; though debt burden remains in short-to-medium term 
DES triggers concerns over banks’ capital pressure, given that equity investments carry 400-1,250% risk weight vs 100% of loans (see DES: Trade-off between capital and provision, 6 April), and the swap through CB could likely alleviate banks’ capital pressure in the short to medium term, although in the long term capital pressure remains if such investments cannot be disposed of in a timely manner
Meanwhile, direct DES of potential bad debt requires either a bailout (like the DES in 1999-2003, Fig. 1) or material write-downs upfront.

Since a bailout for DES has been ruled out this time (Re-rating may start as defaults accelerate, 21 July), banks conducting DES may face material write-downs upfront if the loans convert into equity directly. DES through CB could have given banks more time vs direct swap into equity, and thus could facilitate progress.
For a company involved in DES, however, debt burden likely remains before equity conversion, and when conversion starts, it seems to be selective (eg, just the credit/guaranteed loans, with no underlying cash flow for Sino Steel). 
Reiterate our estimate of limited-scale DES this round 
With a full government bailout, the last round of DES digested c.RMB400bn in NPLs (non-performing loans) from banks, equivalent to c.30% of RMB1.4trn NPLs sold to AMCs (asset management companies) at par value. This time around, we see no government bailout, which makes DES a less attractive option both for banks and for companies, in our view. DES through CB may increase the feasibility of the swap, but long-term capital pressure remains for banks and debt burden remains for companies in the short to medium-term, as analysed above. We reiterate our view that DES is one of the options for NPL digestion in this credit cycle, but it is unlikely to be a primary tool for banks, compared with measures of cash collection, write-offs and sales to AMCs. 
Bond defaults expected to accelerate 
Compared to bank loans, the bond market is seeing a normalisation of risks, with this first bankruptcy case coming through on the interbank bond market today. We still see c.RMB50bn bonds on the watch list, all of which are bonds that have announced defaults but are still trying to work out repayment plans to avoid ultimate defaults, including Dongbei Special Steel as mentioned above. We believe that defaults are positive for the risk normalisation in the bond market, which we hope could lead to better risk pricing and higher liquidity efficiency. 
We see a change in the landscape, though we are cautious, with volatilities likely coming through as well 
As banks turn risk-off in 2Q16, DES were launched to start addressing the SOE debt issue (and may be a prelude to other more marketised deleveraging measures in future), as well as risk normalising on the bond market, we see the landscape change discussed in our 2016 outlook (see Changing the playbook in 2016, 2 November 2015) happening. However, fundamental volatilities may come together in this structural change, and we recommend booking profits on vulnerable banks, like mid-caps. In comparison, ICBC (1398 HK, Buy) remains our top pick, given its tighter risk control and stronger loss-absorbing capacity with decent capital ratios (12.5% CET1 by 1H16). CCB (939 HK, Buy) is the other fundamental pick, for similar reasons (13.0% CET1 by 1H16)." - source Nomura
Whereas prompt restructuring is a welcome feature when dealing with nonperforming loans (NPLs), as posited by Nomura, long term capital pressures will remain. Furthermore, the significant surge in Chinese property prices leading to many pundits talking about a large bubble, means that China needs no doubt to rein in credit growth at the time where credit continues to outpace nominal GDP growth!

Yet in another important report published as well by Nomura, it shows that all isn't that quiet on the Eastern front for some countries. in their September special report entitled "The party is getting crazier – stay close to the door":
"China is borrowing growth from the future 

  1. China needs to adjust to the new normal of a persistent slowing in potential growth, as the working population shrinks and the low-hanging productivity gains diminish.
  2. China has reached the point where the rubber hits the road: The problems of overcapacity, over-leverage and keeping zombie companies afloat have become so large that they are bearing down on growth via falling returns on capital and rising debt-servicing costs. Leaving it so late, rebalancing away from investment is being forced upon China, and is fraught with risks.

  1. Rebalancing and restructuring is likely to hurt growth in the short run, including negative spillover effects on consumption and services. Unsurprisingly, the hardest supply-side reforms – restructuring SOEs, deleveraging and banks properly pricing credit risk – have been left to last. Monetary and fiscal stimulus can buy some time, but they are losing efficacy and can fuel bubbles.

  1. For new engines of growth, the economy must be opened up to market forces, but as China is discovering, this is hard at the best of times, let alone when economic fundamentals are weak. History in EM shows that financial liberalisation often precedes credit crunches, banking crises and capital flight.
  • We find it striking that the distribution of the latest 2017 growth forecasts display no fattening tail risk of hard landing (i.e., exactly 50% of forecasts are below the median).

  • The downside risks to our growth forecasts of 6.5% in 2016 6.1% in 2017 and 5.5% in 2018 include a mass exodus of capital by Chinese residents and snowballing corporate defaults. Upside risks are mega policy stimulus (but this risks creating bigger bubbles) or window-dressing reported GDP (ultimately undermining policy credibility and the chance of policy mistakes).
Four reasons not to overburden monetary policy
  1.  Easing monetary policy risks inciting even stronger capital outflows.
  2. Aggressive monetary easing risks creating even bigger financial imbalances, since debt and asset prices are interest-rate sensitive. The inflation-adjusted bank deposit rate is near zero.
  3. Monetary policy is a blunt instrument affecting the overall economy; it can be less useful when the economy’s performance is more uneven. In 2014, only one of China’s 31 provinces had sub-3% nominal GDP growth; in 2015, eight did, with a total population of 304mn. Also, China’s large manufacturers had a PMI reading of 51.8 in August 2016, compared with 47.4 for small manufacturers.
  4. It may be wise to save some interest rate ammo to ease the pain of eventual deleveraging." - source Nomura
One might wonder if indeed it is a case of "Big Trouble in Little China" or "Small Trouble in Big China" but we ramble again. Of course while everyone is focusing on Deutsche Bank, we would like to point out to Nomura's very valid points regarding a potential credit crunch unfolding in Asia at some point from their very interesting special report:
"There is a high risk of a credit crunch in Asia

  • The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can activate financial decelerator effects.
  • Cheap credit has weakened productivity by misallocating capital (e.g., property speculation), reducing pressure for supply-side reforms and kept zombie companies alive. Potential growth is slowing across most of Asia. 
  • Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.
  • Potential triggers: faster than expected Fed rate hikes; sharp USD appreciation; large RMB devaluation; a major EM corporate default prompting global asset managers to pull out from the region en masse, causing market liquidity to evaporate; inflation shock in Asia; politics.

- source Nomura

Of course, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring. As a follow up on our HKD take from our  December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. While we won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg back in December last year,we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. maybe it will be for 2017 after all. As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:
"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfillingIf at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
It seems to us that speculators, so far have not been able to gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals. For a short strategy to succeed, it is much better to hunt as a pack than to be a lone wolf or at least to cry wolf on a specific situation. When it comes to the fate of the HKD peg, Nomura has been solacing again our concerns in their note:
"HK stuck between a rock (Fed hikes) and a hard place (ebbing China)
  • Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 109% (the recent correction is reversing), and the ratio of private non-financial credit to GDP has surged to 278%.

  • The real effective exchange rate has risen 21% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015, and is no longer a larger buffer to net capital outflows.

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

  • Economic hardship could ignite further political and social unrest, or vice versa, ahead of the selection of a new chief executive in March 2017. We would not rule out rising pressures on the HKD peg regime.
HKD re-pegged to the RMB? The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed were to accelerate hiking and China’s growth keep slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura.
Back in September 2015 in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.

It remains to be seen, if the recent spike in Hibor rates will not once more put yet again some end of the year additional pressure on the currency peg. We might have been early but, after all, we might not be wrong eventually. We will of course continue to monitor this interesting trend rest assured. End of the day currency pegs like "empires" are not eternal as a reminder:
- source Société Générale

When it comes to Asia, while Japan has been at the forefront of Quantitative Easing for many years, they recently joined the NIRP club in early 2016 on the footsteps of the ECB, in our next point we will look at the impact the policy has had on loan growth and what it entails.

  • Macro and Credit  - Loan growth under NIRP - The case of Japan
While we have long been indicating that QEs and NIRP in no way on their own were sufficient enough to trigger a material change in "credit impulse" which would therefore entail a significant change in real economic growth, we find that Japan's recent experiment with NIRP in the footsteps of the ECB is as well a confirmation of the broken credit transmission which has plagued Southern Europe in recent years thanks to bloated banks balanced sheets and the insufficient rapidity with which these NPLs were addressed in both instance but has as well impacted the Japanese economy.

On this particular subject of loan growth under NIRP, we have read with interest yet another note from Nomura from the 17th of September entitled "Loan growth has not changed materially in
real terms":
"The BOJ expects its negative rates policy to boost borrowing by companies and households as loan rates fall, spurring capital investment and housing investment. In this report, we examine changes in loan balances since the negative rates policy was introduced, trends in loan rates, changes in loan demand by companies and households, and changes in financial institutions’ lending stance.We found that growth in bank lending seems to be falling. However, this was largely due to changes in currency exchange rates (stronger JPY reduces the amount of foreign currency lending in nominal terms), while actual lending growth is almost unchanged. Financial institutions appear to have become more aggressive in lending, but corporate loan demand has not changed much, and the increase in loan demand from households was largely attributable to refinancing, with few signs of accelerated loan growth.
Implications and points to watch for in comprehensive assessment 
As noted above, loan rates have fallen since the BOJ adopted negative policy rates, but loan growth has not picked up, which suggests that BOJ policy has only a limited impact on the real economy.
The BOJ cites an increase in the issuance of super-long corporate bonds and subordinated loans as a result of its adoption of negative policy rates, but we believe this has had only a limited impact on the economy overall. The BOJ should also look at the impact that a stronger stock market and weaker JPY could have on the economy.
The BOJ’s main concern has been a deterioration of the financial intermediary function, which could occur if banks tighten their lending (i.e., extending fewer loans, raising loan rates) as loan margins narrow. This has not yet been the case.
The BOJ should quantitatively assess the negative impact of its policy on financial institution earnings and their net capital, and determine how much policy rates can fall before destabilizing the financial system." - source Nomura
As loan margins will continue to narrow, there is a heightened risk that banks could decide to extend fewer loan due to lack of demand or poor profitability, in effect triggering a credit crunch in a context where there is subdued demand for credit overall. This is as well highlighted in Nomura's report:
"According to a survey on major loan trends, loan demand was unchanged for companies (5 in June from 7 in December) and rose sharply for households (9 in June from 0 in December). However, lending to households may have included substantial refinancing demand.
In fact, the key factor cited by financial institutions in explaining the increase in individuals’ demand for capital is the drop in loan rates, not growing housing investment and higher personal spending. Moreover, we believe slow growth in corporate lending likely reflects weak loan demand in the corporate sector, and not so much financial institutions’ stance on lending. " - source Nomura
Weak loan demand means that at the Zero Lower Bound (ZLB) and now NIRP, there is very little monetary policies can do. Now that we have a case of broken monetary transmission to the real economy, there is very little in that context for additional unconventional policies from the Bank of Japan to work their magic on the real economy.

We have already touched on this subject in April in our long conversation "Shrugging Atlas" where we discussed Japan and the kite string theory:
"That is the very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016
We keep hammering this but it seems to us that central banks do not understand clearly the difference between stock and flows. Aggregate Demand (AD) as well as "credit growth" are flow variables, NPLs are stock issues. That simple. Despite aggressive monetary policy easing, the ability of central banks to boost bank lending and hence economic growth is been limited at the ZLB or NIRP level. The basic problem, both with monetary expansion and NIRP, is that the primary transmission channel is via the commercial banks, and that channel has, for a variety of reasons, is broken as we have pointed out in numerous conversations.

Maybe "The Cult of the Supreme Beings" aka central bankers should Bank of America Merrill Lynch's recent primer entitled "How European Banks work" from the 26th of September to fully grasp the stupidity of NIRP in a difficult deleveraging environment akin to adding fuel to the fire they have set up:
"Bank profits leveraged to economic cycle 
Bank profits are naturally leveraged to the economic cycle. Net interest income accounts for c.50% of bank revenues. Increasing this revenue generally involves growing the loan book, which relies on a combination of economic growth and product penetration. Fee revenue also depends on economic activity. On the other hand, economic downturns cause banks to increase provisions for credit losses.
  • Credit risk has a pro-cyclical effect on profits. Credit losses are higher ineconomic downturns
  • Credit provisions cumulate on the balance sheet as a negative asset and reduceboth shareholders’ equity and regulatory capital
Banks lend money on the expectation that the full amount is paid back. However, borrowers cannot always pay back all of the money they have borrowed, nor can they always meet their monthly loan costs.
Payment difficulties typically increase during times of economic stress: Individuals may lose their jobs, see a sharp fall in incomes and not be able to cover their repayments. Companies may find reduced demand for their products, affecting revenues and their debt obligations.
Banks are exposed to potential losses, as they may not get back the full amount they initially lent. Once a borrower misses a payment they are said to be “in arrears”. Once they are 90 days behind, the outstanding portion becomes a non-performing loan, (NPL).
Banks must set aside provisions for such losses. These provisions can be large and reduce profits, equity and regulatory capital. While critical to a bank’s health, such provisions are a non-cash item. This undermines the usefulness of cash flow statements for banks.
Loan growth and revenues are linked to the economic cycle. Credit losses are also linked to the cycle. Bank profits can therefore be highly cyclical. 

  • Credit risk has a pro-cyclical effect on profits. Credit losses are higher in economic downturns
  • Credit provisions cumulate on the balance sheet as a negative asset and reduce both shareholders’ equity and regulatory capital
- source Bank of America Merrill Lynch

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings. And, to say the least, one thing for sure, NIRP marks the end of Banking Empire Days rest assured. Also like we posited before, the problems facing Europe and Japan are more acute than in the United States because they are driven by a demographic not financial cycle. So, when it comes to low loan growth under NIRP, in the case of Japan, thanks to unfavorable demography, it marks we think the end of the "Empire Days" and the sun is setting, not rising.

Finally, as we have been commenting as well on various occasion, central banks meddling with asset prices is not only pushing cross-asset correlations higher but it is as well brewing instability and triggering more significant large standard deviation movements overall.

  • Final chart: Market’s growing dependence on central bank stimulus means more prone to “corrections”
While we have shown in various conversations the instability created by "The Cult of the Supreme Beings" aka central bankers thanks to rising correlations, the impact can be seen in our final chart coming from Bank of America Merrill Lynch's The European Credit Strategist note from the 20th of September entitled "QE’s merry-go-round" from the 20th of September which displays the number of 4 plus SD (Standard Deviations) movements across markets over time:
“Corrections” par for the course 
"More broadly, because of the market’s growing dependence on central bank stimulus, we think assets are generally becoming more prone to “corrections”. Chart 1 highlights our Correction Counter: the number of 4 SD moves registered across markets over time. Brexit (June ’16) and China (August ’15) were clearly powerful events that drove market reversals. Yet, we think chart 1 also shows a general rise in the number of “corrections” since mid-2014 – interestingly, a time when the ECB first embraced negative rates." - source Bank of America Merrill Lynch
So there you go, what is indeed NIRP accelerating is the end of the statu quo and end of the low volatility regime which will of course end many "Empires" including banking Empires we think but, that's a story for another day...

"All enterprises that are entered into with indiscreet zeal may be pursued with great vigor at first, but are sure to collapse in the end." - Tacitus

Stay tuned!

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