Sunday, 11 February 2018

Macro and Credit - Harmonic tremor

"Stupidity is an elemental force for which no earthquake is a match." -  Karl Kraus, Austrian Writer

Watching with interest the tragedy unfold on the short gamma crowd through the demise of the short volatility ETN and ETF complex, sending markets into some tailspin and causing additional havocs in bond yields, when it came to choosing our title analogy for our post we reminded ourselves of the meaning of "Harmonic tremor". A "Harmonic tremor is a sustained release of seismic and infrasonic energy typically associated with the underground movement of magma (rising term premiums), the venting of volcanic gases from magma, or both. It's a long-duration release of seismic energy (volatility), with distinct spectral lines, that often precedes or accompanies a volcanic eruption (the demise of some short vol ETNs). More generally, a volcanic tremor is a sustained signal that may or may not possess these harmonic spectral features. Being a long-duration continuous signal from a temporally extended source, a volcanic tremor contrasts distinctly with transient sources of seismic radiation, such as tremors that are typically associated with earthquakes and explosions. Harmonic tremor is part of the four major types of seismograms, the three others being tectonic like earthquakes, shallow volcanic earthquakes and surface events. 

In this week's conversation, we would like to look at the recent sell-off which in effect was triggered by the harmonic tremor coming from the uninterrupted rise of term premiums. This regime change in volatility and the effect of "Who's Afraid of the Big Bad Wolf?" aka "inflation expectations" thanks to rising wage inflation expectations have already claimed the small fishes such as some players in the short volatility leveraged and crowded complex. Like a new grain of sand U.S. Average Hourly Earnings triggered an avalanche as seen in complex systems such as financial markets.

  • Macro and Credit - Rising term premium have already claimed small fishes, when are the whales going to show up?
  • Final chart - Increased inflation presents a potential threat to the purchasing power of consumers.

  • Macro and Credit - Rising term premium have already claimed small fishes, when are the whales going to show up?
We had hardly pressed the "publish" button for our previous post, that the events taking place in the volatility complex led to the already well publicized demise of some short volatility ETNs. This was bound to happen given the non-linearity aspect one can find in financial markets. 

The events that took place were fascinating as it was indeed yet another confirmation of our musing from February 2016 conversation "The disappearance of MS München" when we were discussing the fascinating destructive effect of "Rogue waves" on man-made "structures". Those waves have a high amplitude and may appear from nowhere and disappear without a trace, or investors in some instances. Generally rogues waves require longer time to form (like "harmonic tremors" led explosions), as their growth rate has a power law rather than an exponential one. While a 12-meter wave in the usual "linear" model has a breaking force of 6 metric tons per square meter (MT/m2), modern ships are designed to tolerate a breaking wave of 15 MT/m2, a rogue wave can dwarf both of these figures with a breaking force of 100 MT/m2. Remember this. 

Once again we would like to come back to our February post of 2016 and quote the book "Credit Crisis" authored by Dr Jochen Felsenheimer (which we quoted on numerous occasions on this very blog for good reasons) and Philip Gisdakis and steer you towards chapter 5 entitled "The Anatomy of a Credit Crisis" page 215 entitled "LTCM: The arbitrage saga" and the issue we have discussing extensively which is our great discomfort with rising positive correlations and large standard deviations move. This amounts to us as increasing rising instability and the potential for "Rogue Waves" to show up in earnest like the one experienced last Monday:
"LTCM's trading strategies generally showed no or almost very little correlation. In normal times or even in crises that are limited to a specific segment, LTCM benefited from this high degree of diversification. Nevertheless, the general flight to liquidity in 1998 caused a jump in global risk premiums, hitting the same direction. All (in normal times less-correlated) positions moved in the same direction. Finally, it is all about correlation! Rising correlations reduces the benefit from diversification, in the end hitting the fund's equity directly. This is similar with CDO investments (ie, mezzanine pieces in CDOs), which also suffer from a high (default) correlation between the underlying assets. Consequently, a major lesson of the LTCM crisis was that the underlying Covariance matrix used in Value-at-Risk (VaR) analysis is not static but changes over time." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
You might probably understand by now from our previous sailing analogy (The Vasa ship) and wave analogy (The Ninth Wave) where it will eventually end: Another financial crisis. 

Moving back to the LTCM VaR reference, the Variance-Covariance Method assumes that returns are normally distributed. In other words, it requires that we estimate only two factors - an expected (or average) return and a standard deviation. Value-at-Risk (VaR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. This what we had to say about VaR in our May 2015 conversation "Cushing's syndrome" and ties up nicely to our world of rising positive correlations. Your VaR measure doesn't measure today your maximum loss, but could be only measuring your minimum loss on any given day.

Check the recent large standard deviation moves dear readers such as the one experienced on the VIX last Monday and ask yourself if we are anymore in a VaR assumed "normal market" conditions:
"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured." - source Macronomics, May 2015
But, last Monday's move while surprising by its velocity, has not been as significant as the move seen in the VIX back in 1987. We are yet to see a spike to 173 seen on the VIX during the October 1987 crash and that was something, really something.

This is also what we argued in February 2016:
If you think diversification is a "solid defense" in a world of "positive correlations", think again, because here what the authors of "Credit Crisis" had to say about LTCM and tail events (Rogue Waves):
"Even if there are arbitrage opportunities in the sense that two positions that trade at different prices right now will definitely converge at a point in the future, there is a risk that the anomaly will become even bigger. However typically a high leverage is used for positions that have a skewed risk-return profile, or a high likelihood of a small profit but a very low risk of a large loss. This equals the risk-and-return profile of credit investments but also the risk that selling far-out-of-the-money puts on equities. In case of a tail event occurs, all risk parameters to manage the overall portfolio are probably worthless, as correlation patterns change dramatically during a crisis. That said, arbitrage trades are not under fire because the crisis has an impact on the long-term-risk-and-return profile of the position. However, a crisis might cause a short-term distortion of capital market leading to immense mark-to-market losses. If the capital adequacy is not strong enough to offset the mark-to-market losses, forced unwinding triggers significant losses in arbitrage portfolios. The same was true for many asset classes during the summer of 2007, when high-quality structures came under pressure, causing significant mark-to-market losses. Many of these structures did not bear default risk but a huge liquidity risk, and therefore many investors were forced to sell." source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
You probably understand by now why we have raised the "red flag" so many times on our fear in the rise of "positive correlations". They do scare us, because they entail, larger and larger standard deviation moves and potentially trigger "Rogue Waves" which can wipe out even the biggest and most reputable "Investment ships" à la MS München." - source Macronomics, February 2016
Obviously, for us rising term premiums have been like a "harmonic tremor" leading to the buildup that ended with the explosion that occurred in the short volatility space. The catalyst has been rising inflation expectations coming from the latest U.S. Average Hourly Earnings rising 2.9% Y/Y, the most since 2009. This was the little grain of sand that triggered, we think Monday's avalanche. 

If Short Vol ETNs could be compared to a piece of a CDO like structure for the financial markets complex, they could be seen as the "Equity tranche", or the first loss piece of this "capital structure" (The tranche that absorbs the first loss (and thus is the most risky tranche) is often called an equity tranche). Obviously the next question one would like to have answered when looking at his portfolio, is am I "senior" enough in the capital structure and is my attachment point high enough to avoid the pain? 

In relation to the issue of rising term premiums and additional potential pain and "de-risking" coming we read with interest Nomura's Global Markets Navigator note from the 7th of February entitled "Rising term premium claims its first victim":

"According to the NY Fed, the 10yr UST term premium troughed in early December at -0.62bps. As of 5 February, the NY Fed estimates that it has risen 33bps to -0.29bps.

Over the same period, the MOVE Index of implied treasury volatility rose in sympathy from an all-time index low of 48 to today’s 66. In previous reports we have linked low term premia to low implied interest volatility and in turn low implied volatilities in risk assets, e.g., equities.

Front-end VIX started to rise from the first day of 2018 trading, lagging behind the increase in the term premium. It was toward the end of January that both measures began to move faster. The recent few days of trading needs little rehashing.
And yet other risk assets and measures of risk aversion have not gone through similarly violent changes. Equity volatility in the euro area and Japan rose in tandem with the US but didn’t reach the same intraday highs. High yield spreads widened too, but not in a disorderly manner. Investment grade spreads didn't move much. Indeed a simple model of daily VIX changes vs daily S&P changes would have implied that US equities should have been down nearer 11% on 5 February rather than 4%. In other words, implied has move significantly higher than realised.
There are two interpretations of these facts. First, the VIX is sending us a serious message about the outlook for short-term US equity returns that the market needs to pay attention too. Second, US equity volatility products are an asset class in their own right. The existence of levered short-vol carry positions in those markets makes them more exposed to relatively small changes in other asset classes, e.g., rates vol.
To the extent interpretation one is correct, we should see a large increase in long rates hedges and selling pressure in credit and EM. To the extent the second interpretation is correct we should expect, when the affected positions are removed, a return to the status quo ex ante. Feedback from discussions with market participants suggests most people are putting faith in the second interpretation; this was an isolated incident in an important derivatives market.
The evidence supports that case. But there’s a problem. And it's the term premium.
As we wrote last time, the cyclical growth outlook points to higher policy rates and flatter curves, tight spreads and strong equity performance. The secular improvement scenario calls for higher rates too but is ambiguous about the shape of the nominal and real curve. The ambiguity stems from uncertainty about the natural rate and inflation. This makes it hard to anchor long-end rates (without even taking into account net net issuance) – ergo higher realised rates volatilities. This uncertainty is unlikely to go away for some time if we remain in an above-trend positive output gap world.
Thus normalisation – whether cyclical or structural – means a higher term premium and higher rates volatility. Even while the absolute level of yields remains low the past few days tells us two important things: investment strategies habituated to low term premia are likely to struggle in this environment; and higher beta assets can rally as government yields rise so long as their risk premia fall faster than rates increase. If rates rise too quickly, all bets are off.

The speed and breadth of the recent recovery has left central banks with a communication problem – it is tough to forward guide a nervous bond market if inflation is rising and growth is well above trend. If a rising term premia has claimed its first victim, will there be others?

Given the low absolute level of yields there’s little case for a growth driven risk sell off. But it is the speed of the adjustment to normal that will now be critical. Perversely, the best thing for markets now would be more modest growth and comforting downside inflation miss. - source Nomura
There lie the crux of the situation, too much good news could lead to more bad news for risky assets such as the dreaded CPI number coming out soon in the US. This is a very important number for bond yields in particular and asset prices in general. 

As we stated in our previous conversation prior to the VIX bloodbath that ensued, positive correlations matter and matter a lot. On this subject we read with interest Deutsche Bank' Special Report from the 7th of February entitled "The bond risk premium and the equity/yield correlation":
"A few months ago, we noted that the combination of low yields and high equities raised concerns that a sudden rise in bond yields could lead to a material repricing of equities. A week ago, we had a glimpse of a potential shift in the equity/yield correlation (higher yields/lower equities) that has been mainly positive since the late 90s. The risk-off environment of the last couple of days has reasserted the positive correlation between bond yields and equities. How can we explain such shift in correlation?
Our analysis suggests that the equity/yield correlation is related to the bond risk premium. A high bond risk premium coincides with a negative correlation between yields and equities. In the post Volker period, 10Y UST ~3% above r* corresponds to a yield/equity correlation close to zero (on a 12m backward looking basis). Current estimates of r* are between 0 and 50bp, but are expected to rise to 50-75bp in the quarters ahead.
On this basis, assuming that inflation expectations remain broadly anchored, a persistent shift in correlation is likely to occur when 10Y UST is somewhere between 3 and 3.5%. Clearly, the market will notice a shift in correlation on a much shorter time frame: a few days of negative correlation between yields and equities have been enough to generate significant attention. Thus, one would expect the shift in correlation to be felt at lower level of rates.
The relative perception of the risk of high vs low inflation regimes – i.e. 70s stagflation vs. Japanese deflation – is likely to be the underlying driver of the equity/yield correlation. When higher inflation is negative for growth (e.g. the 70s), one would expect bond yields and equities to be negatively correlated. A positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, as higher inflation will coincide with lower growth, bonds will not be a good hedge for an equity portfolio. As a result, they should command a higher risk premium. We would therefore observe a higher risk premium in bond markets and a negative correlation between bond yields and equities.
Conversely, if low inflation is negative for growth (e.g. Japan), then one would expect bond yields and equities to be positively correlated. A negative shock to inflation would coincide with a negative shock to growth. It would lead to lower bond yields and lower equities. Moreover, as lower inflation will coincide with lower growth, bonds will be a good hedge for an equity portfolio, commanding a lower risk premium. We would therefore observe a lower risk premium in bond markets and a positive correlation between bond yields and equities.
From a historical perspective, higher productivity coupled with cheap supply of labour reduced the risk of high inflation since the late 1990s. Technological advances and globalization have therefore likely been instrumental in establishing the low bond risk premium regime in place since the late 1990s.
This enabled central banks to establish their inflation targeting credentials and to be more predictable, thereby reducing interest rate volatility and the bond risk premium. Moreover, the FX regime in place in key EM economies led to  a significant increase in excess savings, which in turn depressed the bond risk premium (the bond market conundrum).
Looking ahead, the focus on inequalities in DM economies coupled with the desire of China in particular to shift towards a more consumption based economy suggest the current political economy trend is conducive to some reversal of the regime in place since the 90s, pointing towards the potential for a higher bond risk premium.
Indeed, these trends should result in (a) greater risk of trade barriers, (b) greater fiscal deficits in DM and (c) reduced current account surpluses in EM. Taken together, this should reduce the savings/investment imbalance and the disinflationary pressures from globalization. The resulting rise in the bond risk premium would put downward pressure on the yield/equity correlation.
The bond risk premium and the equities/yields correlation: the evidence
The bond risk premium (defined as the 10Y yield minus long-term growth and inflation expectations) has proven to be a good indicator of the correlation between equities and yields (defined as the rolling 12m correlation of weekly changes in the S&P and weekly changes in the 10Y yield). In the early 1990s, the bond risk premium was high and the correlation between yields and equities was negative.
Since the late 1990s, the correlation has been mostly positive with temporary exceptions around the end of tightening cycles (early 2000s and 2006) and the taper tantrum (see graphs below, note that the correlation scale is inverted on the left graph).

The focus on the post 1990s period is driven by the data availability: there are no long term growth and inflation surveys prior to this date. This period has been one of relatively stable inflation (especially relative to the 1970s), and as a result a significant portion of the move in yields can be associated to changes in the bond risk premium or a decline in the neutral real rate rather than changes in inflation. Thus, over this period, using the gap between UST10Y and the neutral real rate (as estimated by Holston, Laubach and Williams) is also a good indicator of the correlation between bond yields and equities (see graphs).
By focusing on 10Y UST – r* we can extend the sample to the early 60s. The correlation observed since the 1990s, extends over the whole lower inflation era (1986-2017). During the post Bretton Woods/high inflation/Volker periods, the correlation is weaker which could be ascribe to the fact that the 10Y rates are more impacted by inflation. Also the yield/equity correlation is always negative, which is consistent with the intuition discussed above.
In the 60s, the correlation is somewhat stronger again (see graph below).
In short, the bond risk premium is a decent indicator of the correlation between equities and bond yields. When it is high, the correlation becomes negative, pointing to high bond risk premium weighing on equities.
Assuming that inflation does not vary significantly, the gap between 10Y UST and r* can be used as a reference. Looking at the most recent samples (charts below), a spread between 10Y UST and r* of 3% would be consistent with the bond equity correlation persistently changing sign.

As well as representing a gauge of bond risk premium, the equity/yields correlation can be also used to confirm the evolution of credit risk in the euro area. Indeed, the correlation between the various European bond yields and equity markets was the same pre-crisis. In 2009, Italy switched to a persistently negative correlation which increased back towards zero following the “whatever it takes” statement from Draghi. The correlation between the CAC40 and OAT briefly turned negative when French spreads where widening substantially in 2011/2012. The shift in correlation can be interpreted as the result of a tightening of credit conditions due to a widening of credit spreads." - source Deutsche Bank
If indeed the shift in correlation from positive to negative marks a regime change in the narrative, given how loose financial conditions have been, it also indicates as per Deutsche Bank a tightening of credit conditions. To illustrate further the impact changes in cross-asset volatility thanks to change in correlations we think the below chart from Bank of America Merrill Lynch Cross-Asset Hedging note from the 7th of February entitled "Few signs of X-asset contagion as equity vol bubble finally pops" illustrate even further the "harmonic tremor":
- source Bank of America Merrill Lynch

For us, the most important piece of the puzzle for additional pain would be from the "Big Bad Wolf" aka inflation. This would generate additional pressure on risk premiums and bond yields. What matters as Nomura puts it in their note, is the speed of the adjustment and also from the Fed should it fells it is behind the curve thanks to faster than expected rise in inflation expectations. The risk obviously is on the upside particularly when it comes to rising concerns with inflation expectations. Some see the current situation with the latest US fiscal profligacy as similar to what the US experienced in the 1960s. This is the case for Deutsche Bank which sees similarities as per their Global Fixed Income note from the 9th of February entitled "A structural repricing of bond markets":
"There are some striking similarities between the new policy mix discussed above and the conditions that led to a shift upward in inflation expectations in 1966. In the first half of the 1960s, unemployment was declining rapidly but core inflation remained low and the Phillips Curve was “dead” (right graph below).

In 1966, the US administration significantly increased its fiscal spending on the back of (a) the Vietnam war and (b) the introduction of Medicare and Medicaid. This denoted a turning point in core inflation, which began to rise markedly (graph above). There are competing interpretations as to what drove the pickup in inflation: (a) fiscal stimulus, (b) non-linearities in the Phillips curve as the unemployment rate dipped below 4%, (c) rising healthcare inflation and (d) a Fed that was (ex-post) behind the curve.
Irrespective of the precise drivers, there are some similarities with current conditions. As the US economy is approaching full employment, the US government is implementing a significant fiscal stimulus. The potential introduction of trade barriers creates upside risks to inflation. Finally, the Fed may not intend to be behind the curve today, but if r* rises, as the Fed and our economists expect, current market pricing of the Fed policy will be overly accommodative." - source Deutsche Bank
There are many upside risks we commented in recent conversation, one being the start of a trade war through the implementation of trade barriers (that 30s feeling) which would put indeed some pressure on prices no doubt. This set up of both US profligacy and trade war would obviously reinforce further the bullish case for gold that led, at the end of the Vietnam to the Nixon shock in August 1971 and  the direct international convertibility of the United States dollar to gold. Could the sudden rise in positive correlations be yet another sign of the buildup in "harmonic tremor" that would led to a regime shift in inflation? We wonder.

Given as we pointed out again recently in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this the biggest near term concern of markets right now we think. When it comes to the relation between inflation and stock markets we read with interest Nomura's take from their Inflation Insights note from the 6th of February:
"A lesson for the near future
We think the correction in stock prices is connected to the likelihood of a return of wage inflation. We look at the traditional Gordon growth model to find that a scenario of higher wage inflation, higher inflation, higher inflation valuations, higher nominal rates and higher equity prices are very unlikely unless expectations of trend real growth substantially increase from current levels. We note that the US corporate tax cut did not manage to lift these expectations. We also note that the correction in stock prices may be a signal that US monetary policy is maybe being tightened in real terms more rapidly than what profit growth can actually sustain.
A simple framework and a reminder
According to James Bullard, President of the Federal Reserve Bank of Saint Louis, “inflation scare triggered some of the (equity) market sell-off”. There is indeed a very strong theoretical linkage between inflation and equity markets, which is best illustrated in the simple framework provided by the Gordon growth model, also referred to as the Dividend Discount Model. In this very simple model of stock prices, stock prices are discounted dividend expectations so that:

Where P is the stock price, D is future dividends and y is the nominal discount factor. Assuming a constant rate of growth for dividend g, this equation can be re-written so

Yet beyond this simple formula there are various assumptions that connect stock prices to the inflation market. First, y is the discount factor for stock prices, so it is the nominal risk-free rate plus the equity premium (y=r+ep). G is the growth rate for dividends, so it is in fact the nominal growth rate of the economy multiplied by the share of economic growth that goes to profits rather than wages (g=k*gdp, with gdp the growth rate of nominal GDP). Economists call it the sharing of national income.

A key factor affecting the sharing of national income is wage inflation. Average hourly earnings increased to 2.9% year-on-year in the US nonfarm payrolls report for January – their highest growth rate since 2009. This high number was perceived as heralding the return of wage inflation in the US and therefore altering the sharing of national income towards a larger share for wages and a lower share for profits.
Clearly, this framework from 1962 does not capture some other key financial aspects of the determination of stock prices. For example, it is likely that there is some linkage between the sharing of national income and the level of the risk-free rate (k and r). If wage inflation returns, the path of nominal interest rates is likely to be higher: that was also the case recently, resulting in a higher discount factor for dividends negatively affecting stock prices. With the equity premium term already minimal (implied volatility is low), there were few reasons for investors to expect higher risk-free rates to be offset by a lower equity premium.
We view this framework as a good reminder that a scenario of higher wage inflation, higher inflation, higher inflation valuations, higher nominal rates and higher equity prices are very unlikely unless expectations of trend real growth substantially increase from current levels. It is also intriguing that the US corporate tax cut was so promptly followed by the stock price correction – which suggests at least some skepticism about its effectiveness.
A minor caveat
And there is of course a minor caveat to this framework: the risk of an inflation overshoot remains noticeably absent from inflation valuations despite the increase in wages in January. Figure 1 shows that despite an increase in the 5yr inflation swap rate, the price of a hedge against inflation much higher than 2% is not historically high. We are only cautiously long 5yr breakeven rates in the US, it is worth recalling.
Too high, too fast?
Maybe the correction in stock prices – despite the tax cut – is a sign that real rates are getting close to “neutral” levels, for example the level of the natural real rate estimated by Williams and all, is likely to exert a negative effect on growth that may go beyond what inflation conditions currently imply. In other words, absent the risk of an inflation overshoot, real rates may normalise too fast, too soon – which would have an adverse impact on the real risk-free rate, but also on real dividend growth.
- source Nomura

When it comes to inflation "expectations", the above reminds us it is all about "implied" and "realized". In similar fashion implied volatility is more simply what the market is expecting (VIX) whereas realized volatility is sometimes deemed more tangible because it reflects the actual daily movement of the S&P 500 Index. The true outlying year in history was 2008 (before 2018's sucker punch), when realized volatility was actually higher than implied volatility - the only such instance over recent years. Even in 2017 the relationship between implied volatility and realized volatility was pretty much "normal". The issue of course is that when central banks are meddling with interest rates and financial repression leads to volatility being subdued for too long, then like a coiled spring, profiting, primarily, from the "volatility premium" (the difference between implied volatility (investors’ forecast of market volatility reflected in options pricing) and realized (actual) market volatility) seems like a "sure bet" for the likes of LJM Fund Management that got beaten up big time with the VIX blowing out à la 2008 (that infamous rogue waves we talk about with a breaking force of 100 MT/m2) . Believing that the spread between implied and realized volatility would persist has indeed been a dangerous proposal with rising positive correlations. In similar fashion believing that "implied inflation" could persist remaining below "realized inflation" could become hazardous in the coming months, particularly with growing geopolitical exogenous risks around. Whereas QE was deflationary, QT could prove to be inflationary but we ramble again...

Make no mistake, inflation is the "Boogeyman" for financial markets.  A sharp pickup in inflation is likely to entail a significant re-pricing and as per our final chart below it represents a serious headwind for the US consumers (Bracket creep aside).

  • Final chart - Increased inflation presents a potential threat to the purchasing power of consumers.
 The "Big Bad Wolf" aka inflation would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant additional repricing on the way. Inflation is our concern numero uno. Our final chart comes from Wells Fargo Economics Group note from the 8th of February entitled "Is the US Consumer Running on Fumes?" and highlights the relationship between PCE Deflator and Disposable Income:
"The Threat of Higher Inflation and Higher Interest Rates
In general, higher inflation reduces the growth rate of real disposable personal income and vice versa, which is clearly demonstrated in Figure 8.

As income and wealth are affected by fluctuations in inflation, one of the biggest threats over the next several years has to do with the rate of inflation. Markets recently seem to have been spooked by the relatively, and surprisingly, strong report on average hourly earnings, which could be indicating some pressure on prices for the U.S. economy. Higher inflation means higher interest rates, and both factors are clearly negative for the U.S. consumer. Higher inflation reduces the purchasing power of income, while higher interest rates makes purchases of durable goods, which are typically financed, more expensive over time. While for those that have fixed-rate mortgages, it is music to their ears, it is bad news for those that have adjustable rate mortgages.

Although inflation has remained low in this cycle compared to its historical trend, if prices were to accelerate, Americans’ real DPI growth will, once again, slow down and could also lead to a slowing of growth in real PCE, all else equal. Therefore, if we were to see an uptick in inflation, real DPI growth will slow and consumers’ purchasing power, or the amount they could consume based on their current income, would be negatively affected. Although this effect is clearly demonstrated in Figure 8, it is also evident that DPI experiences fluctuations with rather lackluster inflation growth. That is, although higher inflation can directly decrease disposable income growth, it is not the only factor that causes reductions in the rate of growth of income.
Furthermore, increases in interest rates could contribute to a slowdown in real PCE, as consumer purchases might diminish based on increased expense, such as what we have previously mentioned associated with durable goods financing. Another sector of risk for the consumer as well as for the credit market is the tax reform’s change in second mortgages or equity lines of credit. Americans, in some circumstances, can no longer take a credit on their taxes for interest on equity lines of credit and this together with the still-high, relative to the past, delinquency rate for these lines of credit could be signaling problems ahead for the U.S. consumer, as well as for the overall credit market." - source Wells Fargo
One could argue that the only "easing" day was yesterday. Have we seen "peak consumer confidence" in the US? It certainly looks like it so beware of the Big Bad Wolf aka "inflation" because he has already blown apart the "short vol" pig's house made of straw...

"Worry is the interest paid by those who borrow trouble." -  George Washington

Stay tuned ! 

Monday, 5 February 2018

Macro and Credit - A shot across the bows

"History is a vast early warning system." - Norman Cousins, American author

Looking at the markets wobbles on Friday, with the ructions taking place in various asset classes with continued pressure on bonds, there were nowhere to hide except maybe cash in US dollar, so we reminded ourselves for our title analogy of the phrase "A shot across the bows" given our fondness for maritime analogies. Admiral William Smyth, the author of the 1865 book "The sailor's word-book: an alphabetical digest of nautical terms, defines the bows as follows:
"The fore-end of a ship or boat; being the rounding part of a vessel forward, beginning on both sides where the planks arch inwards, and terminating where they close, at the rabbet of the stem or prow, being larboard or starboard from that division". 
"A shot across the bows" derives from the naval practice of firing a cannon shot across the bows of an opponent's ship to show them that you are prepared to do battle. But, the more general figurative use of the expression, just to mean warning. During the 18th century, a warning shot (in nautical terms, called "a shot across the bow") could be fired towards any ship whose "colours" (nationality) had to be ascertained. According to the law of the sea, a ship thus hailed had to fly her flag and confirm it with a gunshot. The latest nonfarm payroll number with U.S. Average Hourly Earnings rising 2.9% Y/Y, the most since 2009 against expectations could be perceived as the shot across the market bows we think as the markets are starting to feel the threat of inflation expectations building up which would mean a more aggressive hiking stance from the Fed. After all the last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan. On this very blog we warned in numerous conversations about the risk for "balanced funds" getting "unbalanced" due to rising positive correlations thanks to central banks meddling with volatility and interest rates. At the end of August 2016, we were reminded how stocks and treasuries could move together. We had the same pattern following the surprise Chinese Yuan devaluation in August 2015 as well. The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield, that simple. In this repeated scenario we saw on Friday, the diversification benefits of a traditional 60/40 (stocks/bonds) portfolio disappears, yet another shot across the bows, as in 2015 and 2016. 

In this week's conversation, we would like to look at the recent sell-off thanks to rising positive correlations rendering once again balanced funds unbalanced. Instability thanks to rising positive correlations have been brewing in recent years. We have discussed this problem in numerous conversations (as pointed out in our short August 2016 conversation "Positive correlations and large Standard Deviation moves").

  • Macro and Credit - Is the luck of "balanced fund managers" about to run out?
  • Final charts - The "Wealth" defect

  • Macro and Credit - Is the luck of "balanced fund managers" about to run out?
Back in February 2016 in our conversation "The disappearance of MS München" in which at the time we said we were writing for posterity and tackling in depth various aspects of risk including the inadequacy of VaR (Value at Risk) as a risk measurement tool, we argued the following:
"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:
"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing. The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016
Once again, the correlation between macro variables in recent months have gone in concert significantly in recent months as highlighted by Deutsche Bank in their Asset Allocation note from the 31st of January entitled "Stretched Consensus Positioning":
"Has the fever broken?
Whatever the fundamental case for each of these trades, extended positioning argues at a minimum for a breather and more likely a pullback soon. Moreover, the tight correlation in the moves across the major asset classes (oil up, dollar down, equities and bond yields up) suggests a pullback in one for idiosyncratic reasons would likely spill over to the others. There are several potential fundamental catalysts for a positioning unwind although cases of extended positioning do not always require one:
■ Oil looks most vulnerable from the vantage point of positioning. While it has been supported by a series of positive factors, a turn in any, especially a lagged increase in supply as is typical after periods of rising oil prices, risks a sharp positioning unwind.
■ A rise in the dollar has potentially the widest fundamental impact across asset classes. Arguably its depreciation has been an important driver of the run up in oil prices to which breakeven inflation and bond yields have been well correlated. The decline in the dollar and higher oil prices have been a significant positive for equities but in our view not the most important as the drivers of the rebound in earnings have been very broad based (Very Strong Earnings Growth Before Tax Reform, Jan 2017).
■ Equities while vulnerable to a positioning unwind have seen very little in terms of inflows. Recent inflows look largely to be a catch up for prior outflows. In particular US equities have seen almost no inflows cumulatively since the start of the 15-month rally.
■ Short positioning in rates is at an extreme and vulnerable to a pullback but bond valuations remain in our view completely out of line with growth, reflecting weak inflation which we expect to turn up. If inflation fails to pick up, the large short positions are likely to be unwound and rates turn lower in turn, as happened last year. Our house view remains a gradual rise in inflation which supports the large short positions and would allow for a continued orderly rise in rates. This will have implications in our view mainly for the bond market which has enjoyed the bulk of inflows through the cycle and to which end investors remain massively over allocated. However the risk is that with all 4 fundamental drivers of inflation pointing up, a move in concert has the potential to create a sharp pickup in inflation which is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle, resulting in broad based risk aversion." - source Deutsche Bank

Positive cross-asset correlation  and balanced funds getting "unbalanced" is a subject we discussed in our May 2015 conversation "Cushing's syndrome". We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:
In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out. We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 
"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets
Arguably rising positive correlations and repressed volatility are we think, recipe for large trouble ahead. In similar fashion to CPPI strategies, Vol Control funds (representing close to $200 billion) must decrease leverage to protect principal hence the dangerous feed-back loop for these strategies increasingly at risk from rising cross-asset correlations with reduced buffer from the bond allocations in some case such as the much vaunted stars of the last decade aka "balanced funds". Vol control products sell equities when volatility is rising and buy equities when volatility is falling, creating a market feedback loop.

In our "investing book", these strategies are indeed directly impacted by the rise of "positive correlations". On the subject of "Risk Parity Strategies" we would like to redirect you dear readers to the guest post from our Rcube friends which we published on the 14 August 2013 entitled "Is Risk Parity a Scam":
"Because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a big rotation that would bring 10-year yields back to a theoretical long-term equilibrium value.
According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…
From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself."
Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance based arguments that are often put forward by the proponents of risk parity.
From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:
1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategy's performance under different scenarios.
2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.
3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.
4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.
5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.
For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).
There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's numerous flaws.
However, we have little doubt that when the next "black swan" terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage one's life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.-"Is Risk Parity a Scam", August 2013
We still could not agree more with our friends. This risk is still valid today and it got even more "crowded" in recent years.  One should always pay great attention to rising positive correlations as they portend some pull-back eventually with no one truly spared. 

When it comes to market jitters and flows, the High Yield ETF crowd, mostly made up of retail players continue to be feeble when it comes to exiting the party when the heat is on. Bank of America Merrill Lynch in their High Yield Flow report from the 1st of February 2018 entitled "HY outflows accelerate" continues to point towards the nervousness of the retail crowd:

"US HY sees large outflow, EM debt and high grade gain
Outflows from US HY funds totaled $1.39bn (-0.6%) last week, accelerating from $838mn and $938mn during the previous two sessions, respectively. Most of the outflows continue to be concentrated in ETFs which experienced a $1.02bn (-2.1%) redemption last week, whereas open-ended funds recognized a $375mn (-0.2%) withdrawal. These most recent outflows completely wiped out the $3bn in gains during the first two weeks of the year, sending the YTD total to -$188mn. HY funds domiciled outside the US continued to see moderate outflows as well with a $1.3bn (-0.4%) redemption last week. Because the majority of these funds still invest in USD debt, these outflows amplify the selling pressure in the secondary USD HY market. January’s 34bps spread tightening and +0.64% total return is even more impressive when viewed in this context.
 - source Bank of America Merrill Lynch

Could the current trend in continuous outflows start in earnest biting credit spreads in the High Yield space? This is an important question from an allocation perspective for the yield hungry crowd. On that subject we read with interest Barclays take in their US High Yield note from the 2nd of February entitled "Stumble and a Trip over Treasuries":

"High yield spreads have continued to rally through their 2014 tights even in the face of a pickup in supply and persistent outflows, with the 24 bp spread tightening year-to-date through Wednesday almost offsetting the 31 bp increase in 5y rates in January. As discussed in Fuller Cushions In Lower Quality, the ability of spreads to absorb rates is diminished when spreads have been at similar levels. And while markets have largely shrugged off weakening technicals, we take a more cautious near-term and tactical view considering tight valuations and the potential for further outflows driven by large adverse rate moves.
As noted in Temporary Relief from Rate Fears, outflows alone are typically not a catalyst for prolonged spread widening and particular pressure on returns. The recent experience has followed that playbook, and cumulative outflows of $23 bn over the past 12 months have done little to derail cumulative total return of 6.6% over the same period of generally stable or improving macro trends. But looking further back, episodes such as the "taper tantrum" suggest that the opposite can occur. Over the one-month period following the 34bp flare-up in 5y rates in May 2013, high yield mutual funds endured outflows of more than $8.5 bn and the High Yield Index widened by more than 50bp. We do not anticipate a similar response, but believe that this could be indicative of the direction of fund flows, if not the magnitude.
To examine the relationship between rate moves and flows in and out of high yield mutual funds more closely, we rank monthly moves in 5y rates by decile in rate rising environments and look at the average mutual fund flow as a percent of total AUM the following month. When considering all spread environments. Figure 1 shows that outflows tend not to materialize even when rates increase by more than 30bp, as they have recently.

But restricting our analysis to months when the high yield market has started tighter than 450bp (approximately the long-term average, excluding the financial crisis), shows a clearer relationship: the sharper the rate move, the larger the outflow (Figure 2).

The last two deciles, in particular, seem relevant today given a similar-sized increase in Treasury yields over the past several weeks.
The recent divergence between flows and returns, particularly stark in 2017 (Figure 3), warrants further analysis of whether rate moves and associated outflows can be a drag on total returns.

We thus tweak the analysis above to examine how High Yield Index returns vary with changes in rate movements in both normal and tight spreads environments. Two things stand out:
  • When considering the full history of spread environments, increases in Treasury yields typically do not weigh on returns. Figure 4 shows no clear relationship between changes in 5y Treasury yields and one-month-forward total returns, largely in keeping with the results of Figure 1, which shows the ensuing fund flows.

  • But in tight spread environments, adverse rate movements can affect the near-term performance of the High Yield Index. The inflection point beyond which returns are dragged down by rate movements appears to be around 23bp. Past that threshold, rate moves have, on average tended to produce negative returns for high yield credit in the next month (Figure 5).

The findings in Figure 5, particularly the negative high yield total returns after month of large moves in Treasury yields in tight spread environments, are logical and intuitive. Carry in tighter spread environments is not able to offset the drag on total returns produced by large increases in base yields. But we think this is amplified by our findings that escalation in Treasury yields similar to those seen year-to-date have historically preceded larger-than-average outflows from high yield mutual funds the following month. Finally last week, in Vol Hunting Heading into Earnings, we noted that there is historical evidence to support a pause or outright reversal in spreads during earnings seasons in similar tight spread environments. All of these data suggest near-term caution toward the high yield asset class" - source Barclays.
As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. Pretty simple. Therefore we are not surprised by Barclays take on the feedback loop we can have between higher rates and outflows for US High Yields in a very tight spread environment. Things can indeed turn "South" rapidly, regardless of how feeble the retail investment crowd is in the ETF sector.

Given the change in the narrative of the Fed and it's continuing hiking path and the fear of rising inflation expectations, one could rightly ask given recent market gyrations if the shot across the bows mark the end of financial repression and indicate trouble ahead for the Risk Parity investing crowd. On this subject we read with interest Deutsche Bank FX Special report from the 4th of February entitled "Risk Parity, FX and the end of financial repression:
"The charts below show that consecutive weeks of higher US bond yields and lower equity prices, have become progressively less common since the 1980s/1990s, and especially since the 2008 financial crisis. Three weeks, of equities down,10y yields up, has not happened for more than a decade. The bad news, is the markets may be contending with a shift in two big macro factors that point to a change in the post-2008 world: i) reduced financial repression, and, ii) some inflation creep
A look through history does show that in an environment where US 10y yields go up and equities go down, the USD tends to go up sharply versus the AUD and the JPY. The JPY loses out more from higher US yields than it gains protection from the retreat in risk appetite. In a higher 10y yield, lower equities environ, the USD has historically traded near flat versus the EUR, but in aggregate this still leaves the USD up moderately on a TWI basis. With bond and equity prices tumbling in the last week,the FX markets price action did conform remarkably closely to how the USD has traded in tough risk parity environments of the past, going back over the last 30 years.
Bond and equity prices falling sharply on the week may feel like an unusual environment, because in the last decade, it has become unusual. However, especially as we go back to the 1980s and 1990s it was a more frequent occurrence to see the following causal chain develop: Equities go up, supporting growth with a lag, pushing bond yields up, to the point where higher bond yields eventually pull equities down. In this way the equity - bond causality and correlation shifts, from a positive correlation where equities drive up yields, to a negative correlation as bond yields take the causal lead in pushing equities down.
From a macro perspective what is intriguing about this dynamic is two old school factors could be back in play: i) At least in the US there is a confluence of inflationary factors - lagged demand, tight labor markets, the tax reforms impact on wages/bonuses and growth, higher oil prices, latent protectionism, and the weak USD. All these factors are apt to have a cumulative effect, chipping away at global disinflation and inflation inertia. ii) the Fed and other Central Bank's balance sheet adjustments, may signal the end of financial repression, and this repression likely helped risk parity trades.  Risky assets are understandably worried because these are indeed important changes.
Now for the good news. Figure 1 below shows the number of weeks in each year where the S&P went up and the 10y yield went up. This was a common event in a high inflation era, but dwindled in the noughties, and especially after 2008 when the Central Banks went out of their way to support asset prices by supporting bonds. The good news that Figure 1 reveals, is it becomes very rare for the S&P and Bond yields to go up two and especially 3 or 4 consecutive weeks on the trot. Three weeks, of equities down 10y yields up has not happened for more than a decade.

Consecutive week after week of both bond and equity price declines is unusual. This is likely to prove true in current circumstances, where the US bond market is such a stand-out relative to other G10 bond markets. US 10y yields will likely not easily soar much above 3% without finding some real support, most obviously near the 3.03% January 2014 yield peak. In addition, were bond yields to keep on going higher, it would do enough damage to stocks to start hurting growth expectations, in turn supporting bonds. Bond bears would in this way create the source of their own demise, which is not an unusual self correcting mechanism.
In that sense we do not want to exaggerate the prospect of weeks like we have gone through that threaten risk parity trades consistently. At the same time, if inflation pressures and quantitative tightening are not about to change, then the weeks where both equities and bonds sell-off will become a good deal more frequent than we have seen since the Great Financial crisis.
So what does this all mean for currencies?
The Tables below shows how currencies have traded under different bond (10y yield) and equity (S&P) scenarios.
We first demarcate each week as falling into one of 4 scenarios: S&P up, 10y yield up; S&P up 10y yield down; S&P down and 10y yield down, and S&P down, 10y yields down. We then looked at how currencies traded, taking medians and averages of the weekly performances for ach scenario.
The table below shows the following:
i) The percent of time when S&P is down and 10y yields are up is roughly 1 in 6 trading weeks, so not all that unusual, but certainly less common than the other scenarios.
ii) In the environment where 10y yields go up and equities go down, the USD tends to go up sharply versus the AUD at least in the past decade. The USD also goes up substantially versus the JPY. The USD is mixed to near flat versus the EUR (or before the EUR the DEM). This leaves the USD up moderately on a Trade weighted basis. Since 1999, the USD also appreciates (somewhat less than we might expect) versus EM carry - using the Bloomberg EM-8 carry index of cumulative total returns. The USD's positive response versus EM looks much more substantial when using average weekly gains as distinct from median weekly gains. This suggests that every now and then there are some very large negative EM moves, when US bond prices and stock prices go down, which is not a huge surprise.
To summarize, past history does tend to support the thesis that when it feels like there is nowhere to hide between poor simultaneous trading conditions in the equity and fixed income markets, the USD and more recently the EUR have been the currencies to shelter in.
With bond and equity prices tumbling in the last week, the FX markets price action conformed remarkably closely to how the USD and other currencies have traded in tough risk parity environments of the past 30 years." - source Deutsche Bank
As a rule of thumb, positive correlation between growth assets is most notable when investors are most concerned about risk as we indicated in our May 2012 conversation "Risk-Off Correlations - When Opposites attract". Whereas opposite attracts during "Risk-Off" periods, it looks like the greenback is still working so far as a powerful magnet. As posited above rising positive correlation between macro variables in recent months should always be seen as instability brewing which increases the probability of a pull-back.

From a credit perspective, another shot across the bows is also coming from the Citi Economic Surprise Index (CESI) which could potentially indicate that economic fundamentals are trading ahead of themselves and could portend some credit spreads widening in the near future. On this subject we read Bank of America Merrill Lynch's take from their Securitization Products Strategy Weekly note from the 2nd of February:
"As nominal Treasury yields and breakeven inflation rates moved steadily higher over the past month (Chart 69), several market indicators we analyze suggest that the wind in the market’s sails may be fading.

As a result, the massive stock rally and price momentum experienced since the beginning of the year were thwarted this week as markets endured a spike in the VIX index and the worst weekly declines since 2016 (Chart 70).
Furthermore, the Citi Economic Surprise Index (CESI), which has previously been a decent indicator of the future direction credit spreads may take, continued to fall this week (Chart 71) while liquidity risk and financial stress, as measured by BofAML GFSI™ liquidity risk and financial stress indicators, rose (Chart 72).
Admittedly while the falling CESI could be somewhat seasonal in nature, the decline may also reflect the notion that expectations regarding economic fundamentals may have gotten ahead of actual fundamentals.
Historically, we’ve noticed a reasonably strong relationship between the inverse of Citigroup Economic Surprise Index and both the IG CDX (Chart 74) and HY CDX (Chart 75) indices: credit spreads tend to tighten as the CESI rises and vice versa.
With the CESI currently showing few, if any, indications that it may rebound over the near term, Treasury yields gapping higher and equity markets selling off, it is likely that credit spreads from other sectors will remain under pressure over the near term, which sets the stage for softer CMBS spreads as well." - source Bank of America Merrill Lynch
Is this time different when it comes to the relationship with rising yields, outflows and weakening CESI in recent weeks? We do not think so. 

At some point there is a potential strong risk reversal in US long bonds we think and that would put us back into the "deflationista" camp. For now the "inflationista" camp are having a field day but, as we pointed out be careful of what you wish for when it comes to inflation. Global rise in inflation expectations would indeed intensify the pressure on risky assets as we pointed out in our conversation "Who's Afraid of the Big Bad Wolf?". Remember what our friends say above according to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…You have been warned, again...

Back in December in our conversation "Rician fading" we  reminded ourselves about the Laffer Curve which used to mean the following: "Too Much Tax Kills the Tax". With the upcoming Tax deals mostly benefiting the 1%, we mused that "Too Much Wealth Effects Kills the Wealth". In our final chart below we tackle again the "Wealth" defect.

  • Final charts - The "Wealth" defect
The wealth effect is the premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more. According to the Fed and other central bankers following the same policies, the wealth effect should have enabled a repair of the balance sheet of households deeply impacted by the Great Financial Crisis (GFC). On top of the Wealth Effect thanks to ZIRP, NIRP and various QE iterations, the US has just implemented at the late stage of the credit cycle some "Trickle-down economics", also referred to as trickle-down theory. This economic theory advocates reducing taxes on businesses and the wealthy in society as a means to stimulate business investment in the short term and benefit society at large in the long term. However has shown in our final charts below from Wells Fargo Economics Group note from the 2nd of February 2018 entitled "The Rich Get Richer - Ownership Drives Net Worth", only the wealthiest American families have fully recovered from the financial crisis:
"Diverging Trends in Median and Mean Net Worth
Key indicators associated with household wealth might give the impression that balance sheets should be in much better shape than they actually are. Home prices, for example, are at or near their pre-recession peak in many markets. Stock prices are more than 80 percent above their prerecession peak. Yet, in inflation-adjusted terms, median household net worth is still about 30 percent below where it was back in 2007 (Figure 1).

Only the wealthiest American families have fully recovered from the financial crisis (Figure 2).
 - source Federal Reserve Board and Wells Fargo Securities
The outsized wealth gains recorded in recent years by high-net-worth families are reflected in the disparity between median and mean net worth, which have de-coupled since 2007. This is because “mean” net worth is calculated by taking the average net worth of all families, and is pulled up by very high values at the top of the distribution. Meanwhile, “median” net worth is that of the middle family (50th percentile), and is therefore not lifted by extreme values at the top of the net worth distribution, or impacted by changes isolated at either end of the distribution.
What Figure 1 shows is that before the financial crisis, net worth for the median American family was growing on a similar trend as net worth across all families. However, after 2007, high-net-worth families experienced much larger gains (or smaller declines) in net worth than middle wealth families. As a result, the mean – pulled up by wealthy families - did not show the same precipitous decline as median net worth post-financial crisis so the data does not track net worth growth of individual families. Rather, data from the SCF reflects how the distribution debt and asset ownership changes across society over time.
Fewer and Smaller Mortgages Reduces Debt
Changes in net worth occur because of growth (or decline) in debt and asset values. In the years after the Great Recession, middle- and high-net-worth families have reduced the quantity of debt on their balance sheets, contributing positively to net worth (Figure 3).
  - source Federal Reserve Board and Wells Fargo Securities
The median family with debt owed $59,800 in 2016, which is $18,200 less than in 2007 in real dollars. Mean family debt has similarly declined, down $22,500 since 2007 to $123,400.
Residential debt is the most commonly-owned type of debt after credit card debt, and makes up the largest share of debt that families hold. Therefore, trends in mortgage debt have a large influence on trends in overall family debt. A main contributor to debt reduction since the Great Recession is fewer, smaller mortgages. For mortgage owners, median and mean mortgage debt have both declined by about $13,500 since 2007. In addition, fewer families have mortgages: 40 percent of families in 2016, compared to 46.3 percent in 2007.
Lower debt among families is not just as a result of paying down mortgage balances, but also because fewer families are participating in the real estate market. The homeownership rate has declined from 69 percent in 2007 to less than 64 percent today. Whether by choice (preference for renting) or circumstance (tighter regulatory standards), fewer Americans have a piece of the American Dream in this expansion.
It’s Not What You Owe, it’s What You Own
The source of the divergence in median and mean net worth is asset values more than quantity of debt. Whereas the median family which holds assets owned about $256,500 worth in 2007 (in 2016 dollars), this has since dropped to $189,900 (Figure 4).
  - source Federal Reserve Board and Wells Fargo Securities
In contrast, the mean family with assets now values these at about $792,000, up from $775,900 just before the financial crisis.
This story has to do with the mix of assets that families of different wealth levels own, and trends in ownership rates. When looking at homeownership by net worth percentile, we see that the decline in homeownership is concentrated at lower percentiles of wealth. From 2007-2016, the share of families in the second quartile of net worth (25th-49th percentile) owning homes declined 14.1 percentage points to 58.1 percent, compared to a 2.2 percentage point decline in homeownership to 94.6 percent for families in the top decile of wealth (Figure 5).
  - source Federal Reserve Board and Wells Fargo Securities
The share of middle-wealth families owning other types of assets has also fallen at a faster rate versus high-net-worth families. Fewer families in the second quartile of the net worth distribution are owning vehicles (-1.5 points), retirement accounts (-5.5 points) and stocks (-4.3 points). Meanwhile, families in the top decile of net worth own stocks at a slightly lower rate (-1.8 points), but more own retirement accounts (+3.8 points) and about the same percentage own vehicles.
Lower asset ownership subtracts from net worth, since the value of asset holdings declines. Even for middle-net-worth families who own assets, they have not added as much to their holdings since 2007. Families in the second quartile saw retirement account and stock median values decline 13.8 percent and 5.7 percent, respectively. For families in the top decile, retirement accounts gained 71.3 percent and stocks 38.1 percent over the same period. This has exaggerated the pre-existing disparity in the value of asset holdings between middle and high-net-worth families (Figure 6).
 - source Federal Reserve Board and Wells Fargo Securities
The CoreLogic home price index has gained about 45 percent since its trough in February 2012. Meanwhile, the S&P 500 is up about 250 percent since its 2009 recession-low. The combination of lower asset ownership rates and smaller holdings for middle-wealth families, therefore, is a major reason that explains why mean family net worth has recovered since the Great Recession while median family net worth has languished." - source Wells Fargo

Some would argue that "Capitalism" has been seeding the seeds of its own destruction. As we posited in the past, bear markets for US equities generally coincide with a significant tick up in core inflation as we indicated again in our recent conversation "Bracket creep" until recently the US economy  has been plagued by "fixed income" (lack of wage growth) and "floating expenses" (healthcare and rents):
"Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation. Given most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple" - Macronomics, January 2018
After all it seems that the "Wealth defect" could be leading in the end to trickle-down "inflation" but the wrong one, but, we digress again... 

"The best way to destroy the capitalist system is to debauch the currency." - Vladimir Lenin
Stay tuned ! 
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