Monday, 26 June 2017

Macro and Credit - Goldilocks principle

"Harmony makes small things grow, lack of it makes great things decay." -  Sallust

Looking at the sudden violent dump in CDS protection for some issuers within the Itraxx Subordinated Financials CDS index due to HIS Markit revising index rules which will include in next roll UK and Swiss banks in the new index Series at HoldCo Level for the Senior and Subordinated Financial Indices, we reminded ourselves for our title analogy of the Goldilocks principle. 

The Goldilocks principle is the idea that there is an ideal amount of some measurable substance, an amount in the middle or mean of a continuum of amounts, and that this amount is "just right" for a life-supporting condition to exist. The analogy is based on the children's story, The Three Bears, in which a little girl named Goldilocks tastes three different bowls of porridge (ZIRP, QE, NIRP?), and she finds that she prefers porridge which is neither too hot nor too cold, but has just the right temperature. 

What we find of interest is that in cognitive science and developmental psychology, the Goldilocks effect or principle refers to an infant's preference to attend to events which are neither too simple nor too complex according to their current representation of the world, same goes with central bankers. This effect was observed in infants, who are less likely to look away from a visual sequence when the current event is moderately probable, as measured by an idealized learning model (Phillips curve). In the case of central bankers, they are less likely to look away from their idealized outdated models, hence our recent discussion surrounding the failing of their much vaunted Phillips curve they have tried to exploit. There is as well another interesting application of the Goldilocks principle in medicine where it refers to a drug that can hold both antagonist (inhibitory) and agonist (excitatory) properties. QE and NIRP come to mind when thinking about the medical application of the Goldilocks principle but we ramble again. In economics, a Goldilocks economy sustains moderate economic growth and low inflation, which allows a market-friendly monetary policy. A Goldilocks market occurs when the price of commodities sits between a bear market and a bull market. 

Funnily enough, when it comes to our title analogy and the Goldilocks principle we missed this weekend San Francisco Federal Reserve President John Williams speech in Australia which was surprisingly hawkish as indicated by our friend Kevin Muir in his latest excellent musing on The Macro Tourist:
"Today, the U.S. unemployment rate is 4.3 percent—meaning that we’ve not only reached the full employment mark, we’ve exceeded it by a fair amount. Given the strong job growth we’ve been seeing in the United States, I expect the unemployment rate to edge down a bit further and remain a little above 4 percent through next year.

Meanwhile, inflation has been running somewhat below the Fed’s goal of 2 percent for the past few years. In the past, this low rate of inflation was the product of a number of factors—the recession and the strength of the U.S. dollar being the two main ones. Recently, some special transitory factors have being pulling inflation down. But with some of these factors now waning and with the economy doing well, I expect we’ll reach our 2 percent goal sometime next year.

Now, I’d love to be able to tell you that the news is all rosy and that our work here is done. Unfortunately, they don’t call economics “the dismal science” for nothing. I’m paid to consider what potholes may be dotting the road ahead.

For starters, the very strong labor market actually carries with it the risk of the economy exceeding its safe speed limit and overheating, which could eventually undermine the sustainability of the expansion.

When you’re docking a boat in Sydney Harbour, the San Francisco Bay, or elsewhere, you don’t run it in fast towards shore and hope you can reverse the engine hard later on. That looks cool in a James Bond movie, but in the real world it relies on everything going perfectly and can easily run afoul. Instead, the cardinal rule of docking is: Never approach a dock any faster than you’re willing to hit it. Similarly, in achieving sustainable growth, it is better to close in on the target carefully and avoid substantial overshooting.

What this means is that we do not want our economy to run too hot or too cold. Like Goldilocks, we want our porridge to be just right.

During the recession and recovery, jump-starting and speeding the recovery required historically low interest rates. Today, interest rates in the United States remain low—and this is even true after the most recent Fed action, which I’ll get to in a moment.

I’m sometimes asked why we don’t just leave things as they are and not raise interest rates. After all, if things are going well, why change? The answer is that gradually raising interest rates to bring monetary policy back to normal helps us keep the economy growing at a rate that can be sustained for a longer time.

If we delay too long, the economy will eventually overheat, causing inflation or some other problem. At some point, that would put us in the position of having to quickly reverse course to slow the economy. That risks stalling the expansion and setting us back into recession.

My goal is to keep the economic expansion on a sound footing that can be sustained for as long as possible. The last thing any of us want is to undermine the hard-won gains we’ve made since the dark days of 2008 and 2009, when it seemed like the U.S. and world economies were on the verge of collapse.

Therefore, we’re in the process of normalization. At our June meeting, the FOMC undertook the second ¼ percentage point increase in our main policy interest rate this year. And we announced that we expect that economic conditions will warrant further gradual increases in the future." - San Francisco Federal Reserve President John Williams
"Re-read the paragraph about docking in a harbour. These are not the words of a Fed President willing to let growth run. He is on the same page as Dudley.
It is stunning that markets are not taking these words more seriously. I don’t know if it was too many times crying wolf, but we have hit a point where markets are ignoring extremely hawkish rhetoric from Fed officials. The Fed seems to have lost credibility, and I fear that when the market finally realizes the Fed might in fact follow words with deeds, an abrupt repricing of financial assets will be on deck." - source Kevin Muir - The Macro Tourist - The Third Mandate is Official
We do share our concerns with Kevin Muir, the Fed looks like it's getting serious about its "porridge" and the Goldilocks principle even though as of late US macro data such as the recently released May's preliminary durable goods orders tumbling 1.1% MoM has steered towards the weak side. As we pointed out last week-end, you have been warned and the Fed could mean business.

In this week's conversation, we would like to reiterate our call to start playing defense credit wise. Credit in some segments of the market has moved in earnest from expensive to very expensive

  • Macro and Credit - In the current inning of the credit cycle stealing third base in High Yield isn't worth it
  • Final chart - US Corporate Pensions? Stuck in the Middle with You

  • Macro and Credit - In the current inning of the credit cycle stealing third base in High Yield isn't worth it
As we concluded back in early June in our conversation "Voltage spike", the MDGA trade (Make Duration Great Again) has made a very good come back as indicated by the ETF ZROZ we follow, which delivered a 6% return over four weeks (not too shabby of a performance). We continue to favor style over substance, quality that is, over yield chasing from a tactical perspective. 

The relentless flattening of the US yield curve shows that in the current inning of the credit cycle, and with a Fed determined in continuing with its hiking path, from a risk-reward perspective, we believe long duration Investment Grade still offers support to the asset class and not only from a fund flows perspective with retail joining late the credit party. On another note the "Trumpflation" narrative has now truly faded to the extent that the deflation trade du jour, long US Treasuries (the long end that is) is back with a vengeance, while inflation expectations has been dwindling on the back of weaker oil prices (after all they still remain "expectations" from our central bankers perspective). 

When it comes to us sticking our neck out and praising the Investment Grade long duration credit game, we were please to read that UBS in their recent Macro Keys note from the 21st of June entitled "Is the high-yield rally hitting a wall?" has joined our ranks:
"The mood from investors has certainly changed from earlier this year, when sweeping US tax reform and a significant uptick in US GDP were expected. Fast forward to today and investors are downplaying the likelihood of fiscal stimulus. Global credit impulses have fallen sharply. Consumer delinquencies are rising, raising doubts about the health of US consumer balance sheets. And further declines in oil are leading investors to question the state of global demand weakness, not only US shale oversupply.
Yet credit is holding in, admittedly better than we anticipated, given an uptick in macro data disappointments. Investors have settled on the view that growth is still good enough to keep credit spreads stable and earn carry. We still believe investors are more comfortable with credit risk than duration risk. But is this a prudent risk to hold? Remember, investments should be judged by what is priced into markets and by the distribution of outcomes around what is priced. Here, our view remains that US high-yield continues to price-in too much good news. Put simply, US high-yield spreads relative to US investment-grade spreads imply a stable mid-cycle environment, akin to 2004-2006 or 2013-2014. However, underlying credit signals we track remain moderately weaker than those in prior periods, in terms of higher credit-based recession probabilities, weak economy wide corporate earnings, and initial signs of non-bank liquidity tightening.
There are perhaps nascent signs of fatigue already building. High-yield spreads are effectively unchanged since February. This is in contrast to an equity market that continues to register new highs. HY energy spreads have widened as lower oil prices increase default risks. And US CCC spreads have started to wobble as well (Figure 1), widening 50bps over the last 3 weeks.
What should investors do? We recommend investors take advantage of underpriced credit risk to rotate further into longer-duration US investment-grade over US high-yield. Absolute returns for US IG will not be as strong going forward, as declines in Treasury yields may have moved too far, too fast. But we expect relative outperformance vs. US high-yield. We also recommend buying put options on HY ETFs, as short-dated implied volatility has collapsed to near record-lows.
How could we be wrong? An increase in US tax reform odds could be an upside surprise, given a market underwhelmed with Washington politics. A Fed that lets inflation overshoot its 2% target could spark more risk-taking, but this seems unlikely in light of the Fed's hawkish stance last Wednesday. Lastly, a new source of demand from US insurance companies due to changes in capital requirements could boost high-yield further. This latter factor is significant enough to matter and has not received enough attention in our view. Hence we address this upside risk to credit specifically in the third section of our piece. 
How expensive are current high-yield valuations?
US high-yield spreads are 392bps, a mere 280bps wider than US investment-grade spreads of 112bps (Figure 2).

This difference is near the tights of the post-crisis period, implying a lack of fear over credit risks. One can clearly see this dynamic in the relationship between BB rated US high-yield (average maturity of 7 years) and 10+yr BBB-rated US investment-grade credit (Figure 3).

Investors can now earn an extra 21bps in yield by moving up to long-duration US IG credit (BBBrated) over US HY (BB-rated). This is a rare occurrence in credit markets, and reflects still excessive fears of duration risk relative to credit risk. But we believe this pricing is misguided. As our Rates strategists wrote last week, long-duration US Treasuries have support as declines in oil price and US CPI volatility have compressed term premia. Concerns over the impact of a Fed balance sheet roll off should be mitigated by recent performance; 30-year Treasury yields have fallen 10bps since the Fed suggested a faster balance sheet contraction than expected last Wednesday. Meanwhile, shorter-duration assets could struggle as the market has effectively priced little future Fed hikes, despite easy financial conditions and booming asset prices. It appears to us that short-duration high-yield is more vulnerable than long-duration investment-grade credit.
Hence, we recommend investors take advantage of under-priced credit risk to rotate further into US investment-grade over US high-yield. Our preference for 7- 10 year US IG credit has been a decent trade for us since the beginning of the year. 7-10year US investment-grade credit has returned 4.6% YTD, in-line with HY returns of 4.6% YTD. While absolute returns will surely be less for both markets going forward, relative returns for US investment-grade will be stronger as credit risk underperforms.
Aside from moving into US investment-grade credit, investors should look to hedge risk by buying put options on high-yield ETFs. 3-month implied volatility on HYG has collapsed to near record lows (Figure 4), with 90% ATM options on Sept '17 contracts costing only 20bps.

In the past, we have recommended investors hedge downside high-yield risk through a wider cash-CDX basis (selling CDX US HY for long exposure and short-selling HY ETFs for the short-leg). But as borrow rates have climbed on high-yield ETFs to around 1-2%, put options should now be utilized tactically to protect against downside. This is yet another example of a market that has grown far too complacent with credit risk.

Credit risks are not receding
While a precise market-moving catalyst is difficult to find (and time), there is no shortage of risk factors that keep one cautious on credit. While HY spreads relative to IG spreads are priced for a mid-cycle environment, Figure 5 shows how several fundamental variables we track are much weaker today.

Our credit-based recession model implies a 20% probability of a downturn over the next year, moderately higher than in the past two mid-cycle expansions. Perhaps surprising to most investors, weaker corporate earnings are the culprit. To reiterate, we look at US aggregate non-financial corporate profits from the US GDP report, which is a broader measurer of pre-tax earnings than that from common equity or credit market indices. To put in terms of the S&P 500, unless the earnings rebound broadens beyond technology, financial, and energy firms (sectors with poor leading properties in the past two late cycle environments), downside credit risks are likely to remain elevated. The US GDP report next Thursday will be instructive in zeroing in on the specific sectors driving the weakness in Q1 GDP-based earnings. 
In addition, suppliers of trade payables from the Credit Managers Index (CMI) continue to report a worsening use of collection agencies (ticker: NACCA/RC Index); this worsening has now occurred for 12 consecutive months (i.e. readings below 50 in the index), hardly consistent with prior periods (Figure 6).

Empirically, the usage of collection agencies has tended to slightly lead overall conditions in the Credit Managers Index, which we utilize extensively to gauge non-bank lending conditions.
Lastly, sector differences make US high-yield vulnerable relative to US investment grade. US high-yield has notably more energy & mining exposure (21% vs. 13%), and consumer discretionary exposure (14% vs. 7%) than US investment-grade. US IG exposure is highly tilted to financials, a sector that can do well when our credit signals are flashing yellow, but not red (Figure 7).

HY energy spreads are still trading tight relative to the overall index, even though some initial weakness has been seen in recent weeks (Figure 8).

If 12-month forward WTI hits the $40-45 range, this could cause a more rapid re-pricing as breakeven WTI levels will be breached for HY E&P firms. By contrast, US IG energy firms are more insulated, given a greater exposure to less oil sensitive MLPs, and more room to reduce capex if oil prices remain weaker than expected." - source UBS
Of course we agree with most of the above, and indeed, the current-risk reward with on-going pressure on oil pressures validates even more our tactical negative stance on High Yield and our preference in quality (ratings that is) rather than quantity (yield chasing). When it comes to Goldilocks principle and the much talked about risk-parity strategies, the on-going low volatility regime as the one that can be inferred by looking at the MOVE index on Bloomberg (The Merrill lynch Option Volatility Estimate Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2, 5, 10, and 30 year contracts), clearly indicates a Goldilocks environment for these strategies currently. The key element for this low volatility markets, is not only understanding that complacency is very high, but also understanding that complacency can remain high for extended periods (sorry dear bond bears). After all we have been remaining "Keynesian" bullish for the entire first part of 2017, but, for the second part of the year we remain cautious hence our defensive stance while more "Austrian" bearish from a longer term perspective. 

Right now flows remain very supportive for Investment Grade credit, not only thanks to retail being late comers to the show but there has been as well a noticeable return of foreign investors into US credit as indicated by Bank of America Merrill Lynch in their Credit Market Strategist note from the 23rd of June entitled " On a slippery slope":
"Final flows data for May
On Friday our vendor released the final data on US fund and ETF flows for the month of May. The inflow to high grade rebounded to $30.3bn from $17.9bn inflow in April, approaching the record $36.3bn inflow in March. The strong reading in May brings the year-to-date total inflows to high grade funds/ETFs to $134.7bn, 207% over the same period last year. Relative to April, inflows in May improved for both short-term (to $6.9bn from $1.9bn) and outside of short-term (to $23.4bn from $16.0bn, Figure 13).

After foreign investors drove the big acceleration in HG bond fund/ETF inflows to begin the year, retail money has returned in the usual way – chasing performance (Figure 14, see: ECB+BOJ>Fed, redux).

Data on daily flows also suggests that inflows in June so far have been steady (Figure 15).
Finally, note that flows data on the full universe of mutual funds and ETFs is released monthly with about a two week lag. A subset of funds and ETFs accounting for about half of the total AUM report flows more frequently, such as daily or weekly." - source Bank of America Merrill Lynch
Whereas inflows into Investment Grade continue to be solid, as of late there has been a weaker tone in both loans and High Yield according to Bank of America Merrill Lynch:
"The biggest change in flows was in high yield, where an outflow of $1.23bn followed a $0.94bn inflow the week before."
 - source Bank of America Merrill Lynch

As we posited above, when it comes to Goldilocks principle, you should take notice that the Fed is currently envisaging changing its "porridge" recipe, you have been warned. Also, something the Goldilocks story told us, you don't want to wait for too long for the three bears to return. While it might not be the right time to do like Goldilocks , to waking up with a fright to reality when she sees and hears the bears and jump from the bed and run away as fast as you can but it does mean that you should take notice of the change of tone of the doves turning as of late into hawks, at least that's what the US flattening of the yield curve is telling you we think.

While the Goldilocks principle has led so far to a very favourable environment for risk-parity strategies and unquenchable yield hunters, there is one segment which has fared fairly poorly in recent years and it has been US Corporate Pensions as per our final chart.

  • Final chart - US Corporate Pensions? Stuck in the Middle with You
Our reference for our bullet point is of course 1972 song by Stealers Wheel which was used in Quentin Tarantino 1992 debut film Reservoir Dogs during the scene in which the character Mr. Blonde (played by Michael Madsen) taunts and tortures bound policeman Marvin Nash (Kirk Baltz) while singing and dancing to the song. In similar fashion, despite the rally in stocks and modestly higher Treasury Yields, US Corporate Pensions have been taunted and tortured, and have not in any way managed to plug their funding gaps. No wonder General Motors will raise $3 Billion in debt to fund pensions. The final chart comes from a Wells Fargo Rates Strategy note from the 23rd of June entitled "Balancing Act". It displays the dismal fact that no matter our rosy it has been for some asset allocators, US corporate pension funds aggregate funding ratio saw no improvement in 2016:
"U.S. Corporate Pensions Are Stuck in the Mud
  • The corporate pension solvency ratio remained unchanged at a dangerously low 81% in 2016 despite a rally in risk assets and moderately higher Treasury yields.
  • The long-running shift from “risky” assets into high-quality bonds probably has contributed to pension underperformance.
  • We continue to see a pull-back from fixed income and moderate re-risking among corporate pensions. The 2016 company data appear to validate this view. 
Higher equities and Treasury yields fail to improve status-quo
Higher stock prices and bond yields are supposed to be a good thing for U.S. defined benefit corporate pensions. From this perspective, the current state of affairs among company pension funds is particularly disheartening. S&P 500 returned almost 12% in 2016, while 10y Treasury yield rose 16 bps. Yet the large universe of corporate pensions we track saw no improvement in its blended solvency ratio last year. The average figure ended the year right where it started: with a gaping 19% funding deficit (Figure 11).

Has the situation improved much thus far in 2017? Our estimates show only a negligible 1% rise in the solvency ratio (Figure 11). Worse, the 82% funding level is the mean across all companies we track, meaning that plenty of pension funds have even lower solvency ratios. Those with deficits reaching 30% or higher may not be able to remain solvent without major injections of capital from the parent companies.
Half-trillion dollar total funding gap?
Low solvency ratios translate into staggering shortfalls in dollar terms. Figure 12 shows the $420 billion funding gap for our pension universe at the end of 2016. We suspect the shortfall would worsen if we included all companies. According to our assessment, U.S. corporate pensions’ funding gap is near 2.5% of the nation’s GDP. Policymakers take notice: corporate pension deficits could grow into another major challenge to U.S. fiscal health. A significant portion of unfunded company pensions could end as the taxpayer’s responsibility via the statutory backstop provided by the Pension Benefit Guarantee Corporation (PBGC), a U.S. government agency." - source Wells Fargo
No matter how the Goldilocks principle has played out for some thanks to the "Wealth Effect", it seems that US Corporate Pensions shifted away from "risky" assets into fixed income with the blended allocation to bonds from Wells Fargo universe (which includes roughly 470 companies from the Russell 2000 index with pension liability of at least $100 million each) jumped from 29% just before the credit crisis to 41% at present while allocation to stocks plummeted from 58% to 35%. It seems they didn't get the memo and missed out on both sides, while lower for longer yields always cause the present value of pension liabilities to go up. On top of that, the rising cohorts of retiring "baby boomers" is in similar fashion to Mr Blonde's abilities in Tarantino's movie is inflicting additional acute pain to pension funds having to face rising "capital calls". US Corporate Pensions are truly stuck in the middle we think...

"Only when the tide goes out do you discover who's been swimming naked." -  Warren Buffett

Stay tuned!

Monday, 19 June 2017

Macro and Credit - Circus Maximus

"I can calculate the motion of heavenly bodies, but not the madness of people." -  Isaac Newton

Watching with interest new records being broken in equities reaching new highs, with credit "carrying on" thanks to uninterrupted inflows into funds ($6.5bn of inflow into European IG credit funds and High grade funds recorded another week of inflows; their 21st in a row according to Bank of America Merrill Lynch), we reminded ourselves for our title analogy of the Circus Maximus, the ancient Roman chariot racing stadium and mass entertainment venue located in Rome, which was the first and largest stadium in ancient Rome and its later Empire. It measured 621 meters (2,037 feet) in length and 118 meters in width and could accommodate over 150,000 spectators. In its fully developed form, it became the model for circuses throughout the Roman Empire. While we have been quite comfortable riding the uninterrupted bullish tide from our short term "Keynesian" perspective as indicated in our earlier musings of 2017, as of late, we indicated that tactically we were reducing our beta exposure credit wise and that we would rather stick to quality given that not only we feel that the credit cycle is slowly but surely turning, but, it feels like when it comes to the abundant generosity from our "Generous Gamblers" aka central bankers, when it comes to the Fed and the latest FOMC, it feels like the tide is turning. We posited in the past the following quote, which was a derivation of Verbal Kint's quote in the Usual Suspects movie:
"The greatest trick central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.
We have used in the past as a title for a post a reference to the great text from Charles Baudelaire called the "Generous Gambler". This poem appears to be the 29th poem of Charles Baudelaire masterpiece Spleen de Paris from 1869.

As one knows, the "Devil is in the details" and if indeed the Fed is serious with its hiking plan and balance sheet reduction, then it does indicates that, regardless of the slowly turning credit cycle and the flattening of the yield curve, there is an increasing possibility of the liquidity tide to turn, you have been warned. For now in all markets it's "Circus Maximus" as we move towards the euphoria stage, with additional melt-up in asset prices, in the final innings of this great credit cycle we think.

In this week's conversation, we would like to look at why credit is "carrying on" and why we prefer for the moment playing it safe via Investment Grade in case volatility heats up in the near future.

  • Macro and Credit - If you love low volatility, stick to investment grade credit
  • Final charts - Italy? It's getting complicated

  • Macro and Credit - If you love low volatility, stick to investment grade credit
Reminiscences of a flow credit operator comes to mind in true 2007 fashion these days given the continuous inflows into Investment Grade funds, in conjunction of continuous tightening in credit spreads. Discussing recently with another credit pundit on a macro chat platform, we reminded ourselves of the 2007 spread compression with the current situation:
Him - "I've had banks pretty much telling me I can name my price in itraxx tranches, off the back of structured stuff they've issued to retail."
Me - "Not surprising, this is playing out like 2007, structured products issuance leads to relentless selling in CDS which is compressing even more spreads and market makers can't recycle in the market because the only takers would be loan books buying protection. Lather, rinse, repeat..."
Of course both of us like many others, have seen this movie before. As we pointed out in our recent musing, when it comes to High Yield and in particular European High Yield, given the tightness of the spreads relative to Investment Grade, we have switched to being tactically negative, underweight that is. Sure, some would argue that, it's all about the carry and that given the ECB's supportive stance, it's all about "carrying on" through the summer lull. We have a hard time seeing the relative attractiveness in Europe of € High Yield versus € Investment Grade credit as pointed out by Deutsche Bank in their European Credit Update note from the 13th of June entitled "Carry is King...For Now":
"Credit Valuations and Spread Forecasts
Despite the change in view we still think it will be difficult to see much spread tightening. More specifically, we would argue that valuations appear to be more stretched for EUR HY relative to EUR IG credit. Looking at our often used analysis in Figure 2, showing where spreads currently trade relative to their own histories, we can see that EUR HY spreads are generally at the top of the list.

More specifically BB and B spreads are well into their tightest quartile, in fact for Bs current spread levels are now close to the tightest decile through history. In addition looking at Figure 3 we can see that the HY/IG spread ratio remains around the all time lows having seen HY outperform on a relative basis since September last year.
We should stress here that we think the outperformance would be on a risk-adjusted basis. Given that we think carry will be driving returns from here, the extra yield available (although low in absolute terms) could see absolute outperformance. One other thing to potentially consider is the stark difference in duration of EUR IG vs. HY. The duration to maturity on the IG index is 5.4 years while for the HY index it is 4.1 years. This also does not take into account the fact that many HY bonds are trading to their call date rather than to maturity and therefore the duration of the HY index is likely to be even lower in practice. This could create some further benefit for IG if we do see more spread compression.
The recent trends in ECB QE could also benefit this view. The ECB appears to have trimmed corporate purchases less than government bond purchases as shown in Figure 4.

(For more details, see our report “CSPP Trimmed Less Than PSPP, with a Record Share of Primary Purchases” available at In addition, the latest ECB communication has implied that the overall withdrawal of QE could be even slower. Combined with the Italian election risk seemingly pushed back into Q1 2018, these latest developments are conducive to low volatility and tight spreads. In fact, as the market repriced QE for longer with a relatively increased emphasis on corporate purchases so far, CSPP-eligible bonds have again started to mildly outperform ineligible ones (Figure 5).
With the change in view we have also updated our year-end spread targets and what they translate to in terms of excess returns (Figure 6).

We have also trimmed our view on defaults given the combination of the positive macro data and continued low yield environment. The change in view is focused on the next few months and we will likely review this again as we move towards Q4. We have effectively pushed out our moderate widening view given the events of the last few days. And while we now expect the carry environment to last longer than we originally thought, the moderate widening stage might set in before the year end. Our end-2017 forecasts should therefore be seen with that caveat in mind.
Note that the forecast performance is risk-unadjusted. While higher-beta HY may outperform lower-beta IG in absolute terms, we expect the latter to outperform in risk-adjusted terms as mentioned earlier. On the margin, we expect the following relative performance adjusted for risk, which is in line with our previous published views:
  • IG outperforms HY
  • Financials to outperform non-financials
  • Senior financials outperform subordinated financials
  • EUR credit outperforms GBP credit
The UK elections have only reinforced our view that more macro uncertainty currently hangs over the UK economic outlook than over the eurozone, which makes us relatively more cautious on GBP credit.
The above cash bond excess returns are over government benchmarks. The total returns will additionally depend on the performance of government bonds." - source Deutsche Bank
This ties up nicely with our recent call in favoring style over substance, quality that is, over yield chasing from a tactical perspective. While the Italian elections probability has been postponed and has therefore moved from a "known unknown" towards a "known known", there is still a potential from a geopolitical exogenous factor to reignite in very short order some volatility, which would therefore put a spanner in the summer lull and "carry on" mantra. But as the Circus Maximus goes on, with very supportive inflows into the asset class, the carry trade continues to be the trade du jour for fixed income asset allocators. On this subject we read with interest Société Générale Credit Wrap-up from the 14th of June entitled "Why fixed income allocators are loving credit":
"Market thoughts
Risk-adjusted returns have become an important tool for fixed income allocation in recent years. Volatility and correlations tend to follow regimes, meaning that the past can be a decent approximation of the future under most conditions. Yields give a reasonable sense of what returns could be, unless the market moves sharply in one direction or another. Thus, dividing current yields by historical volatility is a useful tool for knowing which fixed income classes look most attractive at the moment.
Such calculations flatter the credit markets. Chart 1 uses the risk adjusted yield from our quant team (which they define as current yield divided by the standard deviation of yield over the past year) across a range of fixed income asset classes.

The horizontal axis shows the current level, and the vertical axis shows the change in the level since the end of 2016. Credit has suddenly jumped to the top of the pack, ahead of emerging markets, thanks largely to the very low level of volatility in returns since the start of the year.
But past performance is no guarantee of future returns, as every careful reader of financial boilerplates knows. Will corporate bond volatility remain low?
In the short term, yes, quite possibly, and this is one of the reasons we are bullish on the asset class into 4Q (as explained in Why credit markets could test the summer of 2014 tights). In the longer term, however, two factors worry us. First, the level of equity implied volatility is near 30-year trough levels. It could stay there for a while (as we explained in How this period of low volatility will end), but volatility always eventually gets driven higher by credit problems, and rising leverage – mostly notably in China – could be the trigger once again by early next year.
Second, the low level of credit volatility has been driven by a very high negative correlation between government bond yields and credit spreads. In Why government yield/credit spread correlations will likely reverse next year, we noted that there are fundamental reasons for thinking that this correlation could change in 2018. If it does, then the volatility of corporate bonds will necessarily rise because yields will not be a shock-absorber for spreads and vice versa.
Therefore, a word of warning. 2H may bring further inflows into credit from other parts of the fixed income world as asset allocators look at indicators like this one and draw optimistic conclusions. This may however spell the final phase of the credit market rally, for lower spreads and changing correlations could make the risk-adjusted yields look much less enticing come 2018." - source Société Générale.
We agree with the above, namely that from a risk/reward perspective, we have moved at least in European High Yield space from expensive levels to very expensive. While we had some confidence in the rally so far in the first part of the year, no doubt we could see additional melt-up in asset prices, credit included but it remains to be seen how enticing the risk-adjusted yields will look in 2018 in the Circus Maximus. The pain from rising yields and the continuation of the flattening of the yield curve will probably come to bite at a later stage.

When it comes to Deutsche Bank's recommendation in playing Senior financials versus subordinated financials, it makes sense, given the latest Banco Popular bloodbath. On this subject we read with interest Euromoney's article from the 13th of June entitled "Spain’s bank rescue could make tier 2 less Popular":
"Both AT1 and tier-2 investors lost everything when Banco Santander rescued Banco Popular, while senior bondholders were untouched. The rescue has shown that when banks in Europe get into trouble it is liquidity, not capital, that matters and that the fate of subordinated bondholders is anything but predictable.
There is no doubt that the AT1 market took the surprise bail-in of Banco Popular’s subordinated debt and equity in its stride. Despite its tier-1 and tier-2 debt trading at around 50c and above 70c, respectively, the day before, both became worthless when Spain’s Fondo de Reestructuración Ordenada Bancaria placed the bank into resolution on Wednesday, imposing losses of around €3.3 billion on debt and equity investors. The market has been patting itself on the back ever since, calling the sale of Banco Popular to Banco Santander for €1 a textbook outcome. Peripheral bank AT1s barely stirred. According to CreditSights, these bonds traded down over the course of the following week, but many by less than a point. 
Overall, the AT1 market has been trading close to 12-month highs, the memory of the market disruption caused by questions over Deutsche Bank’s ability to meet coupon payments on its AT1 paper in the first quarter of last year seemingly a faint one. Even peripheral names only fell to around 85% to 90% of those 12-month highs after Popular’s wipeout. Sorely needed This was a sorely needed win for the EU’s Bank Recovery and Resolution Directive (BRRD) after its shaky start with Novo Banco at the beginning of 2016 and the protracted horse trading over state support to Italy’s troubled MPS ever since.
The overnight move by the Single Resolution Board (SRB) saw Popular’s AT1s pushed past their CET1 triggers by the extra provisioning that Santander has demanded to take on Popular’s €36.8 billion of non-performing assets – just 45% of which were covered by provisions. So far, so good. However, there are a few things about this bail-in that are not exactly text book as well. The whole point of contingent convertible tier-1 debt is that it has triggers: Popular’s were set at 5.125% and 7%. It has two AT1 deals outstanding – a €500 million 11.5% low trigger deal and a €750 million 8.25% high trigger deal.
In the bank’s Q1 2017 presentation, its CET1 was 10.02% ­– still a long way from both of those, although its fully loaded CET1 ratio was closer to 7.33%. However, Popular had never missed a coupon payment on any of these notes: if this situation had really been played by the book that is what should have happened first. This is what the hoo-ha over Deutsche Bank’s available distributable items was all about last year. Banco Popular's situation has shown that the fate of subordinated bondholders actually has very little to do with the precise structure of the instruments that they are holding. Neither of Popular’s tier-1 notes had breached their triggers before the SRB decided that the bank had become non-viable late on Wednesday. Indeed, European Central Bank (ECB) vice-president Vitor Constâncio has clearly stated that the bank’s solvency was not the issue.
“The reasons that triggered that decision [to deem the bank non-viable] were related to the liquidity problems,” he explains. “There was a bank run. It was not a matter of assessing the developments of solvency as such, but the liquidity issue.”
There certainly was a bank run. €20 billion left Banco Popular’s coffers between the end of March and June 5 – the same day that its chairman Emilio Saracho declared that he did not plan to request emergency assistance from ECB because it was not necessary. The sale to Santander is understood to have been put together in less than 24 hours.
It was thus depositor withdrawals that caused the SRB to deem the bank to be failing or likely to fail under Article 18 (1) of the Single Resolution Mechanism Regulation. This meant that it had hit the point of non-viability (PONV). 
Investors in AT1 instruments should, therefore, be paying much closer attention to the PONV language in their documentation than to trigger language. When a takeover deal that blows through the latter is hammered out overnight there is not a lot that you can do.
The market has long muttered about the death spiral effects in the CoCo market – whereby debt investors that are converted into equity on breach of a trigger are forced to immediately sell that equity and accelerate the demise of the institution. This is the first time that there has been any principal or coupon loss in the AT1 market and there was no sign of a death spiral. 
However, that was only because the bondholders didn’t have time to be converted into anything that could be sold: Popular’s AT1s and tier 2s were converted into shares that were immediately written down to zero. The market has spent too much time fretting over the impact of CET1 triggers that – if Popular is a textbook case – will never get to be hit.
The wipeout of Popular’s equity and AT1 investors is unquestionably the BRRD doing what it was designed to do and investors will not have been surprised by their treatment.
Pimco is understood to have been holding €279 million of the AT1s at the end of March – the giant US money manager also held more than €100 million of Novo Banco senior bonds that were bailed in under its disputed resolution.
However, the fallout from Popular’s demise might be more keenly felt by its tier-2 investors.
The deal with Santander means that Popular’s tier-2 investors were dealt with in exactly the same way as its AT1 investors – they were written down to zero – although the tier-2 investors got the €1. This in effect removes any distinction between the two asset classes in resolution.
The temptation to wipe out anything that you can in resolution is understandable as it makes the bank more attractive to a potential buyer, but if this will always happen then why buy tier 2? You are getting paid more for the same risk with AT1.
All eyes are now on the tier-2 bonds of two other Spanish lenders: Liberbank, whose 6.875% €300 million tier-2 bonds traded below 81c on Friday – while a short selling ban was placed on its shares on Monday.
Another lender, Cajamar, also has a €300 million 7.75% tier-2 bond outstanding that is now trading below 90c. Popular’s tier 2s were trading at between 70c and 80c immediately before they became worthless.
What is key here is that Popular had yet to issue any new style bail-inable senior debt. If banks want investors to buy their tier-2 debt then in future, a resolution such as this might need to involve – very different – haircuts for both tier 2 and senior debt rather than oblivion for one and protection for the other; Popular’s senior bonds were up from 90c to 104c after the deal.
Although this takeover is a neat and straightforward demonstration of what investors can expect under BRRD, there needs to be a closer examination of the loss-absorbing hierarchy of tier 1 and tier 2 in the process. If they are the same then you don’t have a repayment waterfall – you have a lake." - source Euromoney
Of course, we would argue that no matter how much liquidity via LTROs the ECB has injected, liquidity doesn't amount to solvency hence the importance lessons in dealing swiftly with nonperforming loans as done by the Fed, while the ECB has been following a path more akin to Japan (here comes our "japanification" analogy). But, from a technical perspective on the subject discussed in details by Euromoney, there is a technical aspect that needs to be discussed namely protection offered only to some subordinated bondholders via the CDS market:
"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."
A typical LT2 Structure is as follows:
10 years, non-callable for 5 years (10-NC5)
-Final maturity is hard, meaning no get out clauses.
-No coupon deferral. A coupon deferral would constitute a credit event and therefore trigger a credit event and the relating CDS.
-Ratings: 1 notch below senior debt (Moody's / S&P).
-More standardised structure than Tier 1 or UT2. Given regulatory capital treatment decreases as it moves towards maturity (as it gets closer to 5 years to maturity) so many deals structured have had callable features, meaning the issuer can decide to call the bond.

As a reminder the Dutch bank SNS resolution in 2013 meant that Tier 1 bonds and LT2 losses equated to 100%. At the time the SNS intervention clearly pushed the envelope on how national authorities and now the ECB being the European regulator are willing (and able) to go in the resolution of a failing financial institution. The downside recovery for LT2 (using Irish precedents) was generally assumed to be 20%. This should have been understood to be 0% back in 2013, but yet again investors have been blind. Why the change in recovery rate from 20% to 0% matters in the CDS space?

If the recovery rate for LT2 subordinated bonds is zero (again for Banco Popular and in similar fashion to the SNS case), the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. Subordinated debt should in essence trade much wider to Senior! Particularly if liquidity, not capital, matters and if the fate of subordinated bondholders is anything but predictable.

Here is your "known unknown". Yet in Banco Popular's case the short end of the CDS curve was already inverted before the takeover for €1 was announced so while in the above article we read that there was no sign of a death spiral, this is not entirely correct. If indeed AT1 are known unknowns, and are American options like short gamma trades, who really cares about the capital threshold trigger aka the strike price seriously? We don't and continue to dislike these bonds but hey, some might enjoy nonlinearity, we are not big fans.

For those who have been following us, we have been pretty vocal on the evident lack of resolution of the nonperforming loan issues (NPLs) plaguing the Italian banking sector. On a side note we did at the end of last month a podcast on the Futures Radio Show in which we discussed Italy, being for us the biggest risk in Europe.
The on-going issues plaguing the oldest bank in the world namely BMPS aka Banca Monte dei Paschi di Siena can be seen in the CDS market and the NPLs have yet to be meaningfully tackled as indicated in the recent blog post from DataGrapple from the 19th of June entitled "A Tricky Task Just Got More Difficult":
"On Friday, it emerged that Fortress Investment Group and Elliott Capital Management had dropped out of talks to buy bad loans from MONTE ( Banca Monte dei Paschi ) complicating the rescue plan for the lender backed by the Italian government. They were the only international bidders for the riskier tranches of MONTE’s bad loan securitization. That leaves Atlante, the fund set up to help the struggling Italian banking sector, as the only potential buyer and jeopardizes the asset sale, which is a key part of the plan to restructure the bank with a capital injection from the state, after MONTE failed to shore up capital privately. Ultimately, it could also make similar rescue plans for two other northern Italian lenders, Veneto Banca Spa and Popolare Vicenza Spa, much more difficult to pull off. Surprisingly, if MONTE’s 5-year risk premium was marked aggressively wider - insuring senior debt now costs 330bps per year, while insuring subordinated costs 73.5% upfront -, it did not feed through the whole Italian banking sector and most names were actually unchanged to a tad tighter." -source DataGrapple

And guess what 73.5% upfront Subordinated CDS still seems pretty cheap if you ascertain the fact that your recovery value on the subordinated bonds will probably be a big fat zero...Just a thought. So while you might want to continue playing the Circus Maximus credit show, when it comes to favoring Senior Financials over Subordinated bonds, use your credit skills wisely.

If you indeed love low volatility, stick to investment grade credit because as the party continues flow wise in that space, the feeble crowd aka retail is now joining the party with both hands according to Bank of America Merrill Lynch Credit Market Strategist note from the 16th of June entitled "ECB+BOJ&Fed, redux":
"Retail taking over from foreigners
US high grade corporate bonds have returned 4.2% this year driven by 7.3% in the backend. With the timing of the decline in interest rates, not surprisingly about two-thirds of this performance has accrued in 2Q. These stellar returns are now attracting retail money to HG bond funds and ETFs in the usual way (chasing performance). As we have often highlighted, in the first part of the year we had record inflows without supporting preceding performance necessary to attract retail inflows – in fact HG lost almost 3% in 4Q 2016 (Figure 2).

Our view remains that foreign investors were responsible for the big acceleration in HG bond fund/ETF inflows to begin the year, as the timing coincided with a big decline in the cost of dollar hedging (Figure 3).

Furthermore these inflows accelerated more at the end of the Chinese New Year." - source Bank of America Merrill Lynch
It looks to us that indeed Circus Maximus is getting crowded, but for now everyone in the credit "karaoke" is singing "carry on" so you probably got to keep dancing...

In our final charts below and given our take in the podcast, we continue to view Italy as the biggest European risk even though elections have so far been postponed. Growth is not meaningful enough, we think to alleviate the slowing but still growing very large nonperforming loans problem on Italian banks' balance sheets.

  • Final charts - Italy? It's getting complicated
While we won't go through the debt trajectory of Italy and the dismal growth experienced in recent years, for our final charts we would like to point to charts from a recent presentation done by French broker Exane on the 12th of June. They point out to IMF work showing that the NPL ratio drops significantly when GDP growth reaches 1.2% (and particularly when this trend is sustained for a few years). Their charts below also display the relationship with the 2-10 Italian yield curve. This indicates that Italian banks are very sensitive to a surge in yields in the short-end which makes very interesting in the light of the willingness in tapering as of late from the ECB:
Italy: GDP Growth versus NPL ratio

Italy: NPL ratio versus 2-10 yield curve
- source Exane
According to them, YoY growth for Italy is likely to enable a significant decline in NPLs. Yet they indicate that while there is hope for a relaunch of the European project, the situation of the banking sector remains a concern and is still plaguing credit conditions for the corporate sector. They conclude their slide in their French presentation by saying that for the sustainability of the Italian debt, it's getting complicated. We could not agree more: "Troppo complicato!"

"Too much sanity may be madness and the maddest of all, to see life as it is and not as it should be." - Miguel de Cervantes

Stay tuned!

Monday, 12 June 2017

Macro and Credit - Potemkin village

"Now I believe I can hear the philosophers protesting that it can only be misery to live in folly, illusion, deception and ignorance, but it isn't -it's human." - Desiderius Erasmus

Looking at the CoCo Bond slaughter surrounding the €1 takeover of ailing Spanish banking giant Banco Popular by another giant Santander, while thinking about the much vaunted narrative surrounding a Spanish "recovery", we reminded for our title analogy of Potemkin village. While markets are still racing ahead, on renewed optimism and reduced wall of worries, with credit still in tightening mode, thanks to significant fund inflows, we are already seeing some cracks in the narrative, particular in consumer credit in the US decelerating, which we think warrant close monitoring. On the subject of our title analogy, a Potemkin village is any construction (literal or figurative) built solely to deceive others into thinking that a situation is better than reality (Spain and other subjects come to mind). The term comes from stories of a fake portable village built to impress Empress Catherine II during her journey to Crimea in 1787. In similar fashion the story surrounding the appeal of AT1 bonds aka CoCo bonds and the recovery of some part of the European banking sector is akin to a Potemkin village, with a narrative solely built to deceive others into thinking that the situation is better than reality. On numerous occasions we have voiced our distaste for European banks equities. In this on-going "Japanification" process, we would rather continue to play the credit part, but, we continue to have a profound aversion for CoCo bonds, being short gamma that is and its poor risk/reward "beta" proposal.

In this week's conversation, we would like to look what we think of the second part of 2017 and why we are switching, probably early to "defense" and asking ourselves how long before the cycle turns.

  • Macro and Credit - Credit cycle turning, dude are we there yet?
  • Final chart - US Consumer Credit taking a break.

  • Macro and Credit - Credit cycle turning, dude are we there yet?
While we have been wise in early 2017 to fade the US long dollar crowd while remaining short term Keynesian and bullish equities and all things credit in the first part of the year, supported by strong fund flows thanks to NIRP still plaguing a significant part of the Fixed Income world, the deflation of the "Trumpflation" narrative could indeed put a spanner into the most recent performances of the various beta trades, one being High Yield. For the much vaunted "reflation" trade to continue to play out we think, you would need higher inflation expectations and higher and steeper yield curve. In both last two instances, no matter how the Potemkin narrative is playing out for some pundits, appearences, unfortunately can be deceptive, particularly when you cannot hide a flattening yield curve. 

With European High Yield yielding a paltry 2.59%, we can always go tighter à la 2007, but, credit wise, the risk-reward appears to us less and less appealing with US 10 year Treasuries yielding 2.21%. The Iboxx HY Corporates cash index dropped to just 2.89%, setting a new record low in the process, which is of course supported by the hunt for yield and significant inflows. While it doesn't mean you need to rush for the bunker and don a kevlar helmet as of yet, it does seems to us that there are already cracks showing up in the narrative such as weakening loan demand and decelerating consumer credit that already warrant close monitoring in this long extended credit cycle.

What appears to us fairly clearly is that, as the Trumpflation narrative is fading, so is the beta narrative. The outperformance in beta at least in credit has been very significant in the first half of 2017 and as well during the second part of 2016. Yet as we posited above, it looks to us increasingly that the second part of 2017 could become more complicated for a continuation in all things beta and we would rather reach for quality at this stage in credit. On the subject of beta in credit, we read with interest Bank of America Merrill Lynch's take on the subject in their Credit Strategy note from the 9th of June entitled "Beta losing its shine":
"Beta is losing its shine
A year ago ECB bought its first corporate bond, as part of the CSPP program. Lots have changed since then. ECB now holds more than €90bn of corporate bonds; an eighth of the eligible bonds universe. The beta trade has been in vogue since.
There is a clear correlation between macro and the performance of different beta trades (HY vs IG, XO vs Main, subs vs seniors, fins vs non-fins). So for the beta trade to continue outperforming we need higher inflation expectations and higher and steeper rates. With inflation expectations lowering in the past months we see risks that the beta trade has less favourable risk-reward profile. The dovish ECB yesterday further supports our view that in relative terms beta will underperform from here.
A key factor that has supported the relative outperformance of high beta over low beta pockets of the market was the rates cycle. Higher inflation expectations and higher and steeper rates were pivotal to see the beta trade performing. With inflation expectations lowering in the past months we see increasing risks that the beta trade has less favourable risk-reward profile. To be clear, we are not saying that high beta parts of the market will stop tightening, just that their relative outperformance will significantly reduce.
We think that the beta trade is linked to the growth outlook and inflation expectations. The stronger the economic data and the subsequent improvement in inflation expectations, the stronger the outperformance of high-spread / high-beta assets vs low-spread/ low-beta ones. As the chart above shows, there is a clear correlation between macroeconomic metrics (5y5y inflation swaps for instance) and the performance of different beta trades (HY vs IG, XO vs Main, subs vs seniors, fins vs non-fins) on a spread ratio basis. 
Till this backdrop improves again, we will favour reducing risk on corporate hybrids, high-yield bonds and senior financials CDS (vs senior bonds, high-grade credit and iTraxx Main, respectively), beta pockets that have performed significantly in the past months." - source Bank of America Merrill Lynch
We do agree with the above and in fact our tool DecisionScreen is telling us the same when it comes to its signal switching to slightly negative for US High Yield:
The current signal is at -0.25. The aggregated rule is made up of the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score) and US GOV 10 year yield (1Y Z-Score). The trading rule statistics from 1986-09-03 to 2017-06-07 delivered a Sharpe Ratio of 2.13 with an annual volatility of 2.40%.

From a low volatility perspective, should we see in coming weeks a renewed bout of volatility, given the strong inflows in fund flows in conjunctions of the return of Bondzilla the NIRP monster made in Japan returning to play with Japanese Lifers and their friends deploying their cash, as pointed out in Bank of America Merrill Lynch, credit outperformed stocks in Europe last month and could continue to prove more resilient in case of some weaknesses in the equities space:
"The beta trade is also a function of investors’ perception about the pace of QE. As credit investors were expecting the ECB to start tapering purchases across the sovereign and the credit program proportionally (more in our Credit Investor Survey from April), they looked to add more beta, riding the reach for yield trade. However, credit investors realised, over the past month, that the ECB is more than happy to up the CSPP program when supply comes and thus provide stronger support for “eligible” assets. Additionally “eligible” assets look cheap vs “non-eligible” assets and thus we think that there is room for a catch up trade, as the ECB is on full-on mode buying “eligible” credit instruments.
We will be looking for two signals for us to become more constructive on beta-assets: (i) a pick-up on inflation expectations and (ii) a slower pace of the CSPP. Till then we expect the relative pace of tightening of high beta pockets like corporate hybrids, high yield bonds and senior financials CDS (vs seniors, high-grade and iTraxx Main, respectively) to slowdown." - source Bank of America Merrill Lynch
Whereas we remain more defensive on High Yield at the moment, tactically speaking, Investment Grade in both Europe and the US should be more resilient in the case of renewed pressure on equities and high beta credit, hence our appetite to reach for quality rather than yield currently. Wednesday will set up the tone for both inflation expectations and the Fed's hiking path as we will get the most recent reading on Core CPI in the US. Yet the deceleration in credit growth seen as of late is a cause for concern and it will be interesting to see the Fed's take on the subject. With the recent weakness seen in US breakevens pointing towards a deflation in the "Trumpflation" narrative, we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 9th of June entitled "Deflation and rate hike":
"Deflation and rate hike
Since 1957 there have been 722 overlapping two-month periods. As core CPI prices almost always go up (Figure 1), in only six of these, or less than 1%, have we seen core CPI deflation – but that includes the most recent March-April period this year (Figure 2).

On Wednesday we get the most recent (May) reading on core CPI as well as the Fed’s rate decision. With the Fed widely expected to hike, and normally not inclined to surprise investors, a rate hike is the baseline. But the inflation data has to be concerning, especially as long term inflation expectations have now completely retraced their post-election increase (Figure 3).

Moreover, as we have consistently pointed out this year, other data is week and suggest everybody is in wait-and-see-mode, including C&I and consumer lending data (see: Situation Room: In wait and see mode 07 February 2017). So the Fed has to be very careful in crafting the statement message and press conference. While the biggest near term risk for spreads remains a correction in equities we remain bullish on HG credit spreads." -source Bank of America Merrill Lynch
As well, if indeed there is a return of the "Japanification" narrative and a continuation in soft data, not only it makes sense to reach for Investment Grade credit but it makes also sense to go for MDGA (Make Duration Great Again). As we stated flow wise, Investment Grade is not losing steam as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 9th of June entitled "Buy what they (ECB) buy":
"Highest inflow into IG in 44 weeks
Tapering? What tapering? CSPP buying numbers have been moving higher in the past month, while PSPP absorbed most of the tapering pressure. IG credit emerges as the winner, as investors are piling on the same ECB trade that worked when CSPP was announced. The “buy what they buy” is hence making the IG market highly resilient. Another reason why inflows have been strong lately, especially for the mid- and long term funds, has been the slowdown and reversal of the trend seen in the previous months of higher and steeper yield curves. As our analysis has shown, the level and trajectory in the rates market is a very strong predictor of flows in credit market.
Over the past week…
High grade funds recorded another week of inflows; the 20th in a row. The latest inflow has been the highest in 44 weeks and the second-highest since EPFR data started. High yield fund flows remained in positive territory for a seventh week. Inflows to European-domiciled HY funds were coming from European and global-focused funds, while US-focused funds recorded outflows. Government bond fund flows were marginally positive last week, recording the first inflow in five weeks. Money market funds recorded their second consecutive weekly inflow. Overall, Fixed Income funds recorded their 12th consecutive weekly inflow and the highest in 45 weeks, thanks to a strong credit inflow.
European equity fund flows were positive for the 11th week in a row. The asset class has seen a positive trend despite the volatility in the size of inflows." - source Bank of America Merrill Lynch
The latest dovish comments from the ECB's supremo Mario Draghi is providing additional support for the fun uphill, the bond market that is. The carry trade in Europe is still the trade du jour thanks to the central bank and its purchases. But, behind the deceitful narrative, we remain very wary of oil prices and its deflationary weigh on "inflation expectations" and the potential for additional sell-off they could trigger in financial assets thanks to some Sovereign funds and oil producing countries under pressure from continuing lower oil receipts. 

Behind the Potemkin village of higher equity prices and tighter credits lies the on-going fight to the death between OPEC countries in general and Saudi Arabia in particular with US shale producers. The strategy of trying to drive US shale producers towards bankruptcy has spectacularly backfired thanks to innovation in 2016. On this subject Bank of America Merrill Lynch again highlighted in their 2016 Breakeven Analysis published on the 9th of June in their report entitled "The Incredible Shrinking US Breakevens" the relentless fall in breakeven prices which spell bad news in the light of recent OPEC cuts trying to offset the stiff competition. 
"2016 Breakeven Prices declined 9%…1-yr B.E. & $43/boe
In 2016, North American investment grade oil & natural gas producers continued to sharply reduce their cost structures with the mean aggregate breakeven (B.E.) price declining 9% to $54.22 per equivalent barrel of oil (/boe). However, when we adjust our methodology to look at B.E.s using reserve replacement costs (RRC) from just 2016, we find that B.E.s are much lower than that with a mean cost of $42.64 per boe with 11 of 17 companies having B.E. cost structures under $50/boe.

In short, this clearly explains why with oil prices trading around $46 per barrel WTI, the U.S. rig count continues to rise. Companies are making attractive (in some cases VERY attractive) returns in the current price environment. With capital still relatively cheap, our analysis suggests that crude prices would need to decline back to $40/bbl to change this behavior.
2016 Breakeven Prices declined 9% over 2015
Operating costs decline but lower realizations offset some of the benefit After the sharp 16% decline in the industry breakeven price among North American investment grade (IG) issuers in 2015, the aggregate breakeven price for the industry declined to $54.22 per barrel of equivalent production, down another 9% from 2015. Total costs for the seventeen companies in our annual breakeven report declined by 11% in 2016, relatively lower than the 15% reduction in unit costs we have calculated last year. Producers continued to cut costs in the first half of the last year and consequently cut production as commodity prices softened. While these cost savings are significant, we believe that it will be difficult to continue to cut costs beyond a point. Added to that, average price realizations relative to the West Texas Intermediate and Henry Hub averages for the year modestly declined to 57% from 58% in the previous year.
As commodity prices declined further, producers adopted different strategies to optimize costs like rationalizing production expense, reducing employee counts, recontracting service terms, asset sales, etc. Our annual review of unit costs and resulting breakeven calculation showed this declining trend clearly with 14 of the 17 companies achieving breakeven cost reductions.

The decrease in revenue due to lower realizations and production cuts more than offset declining costs and as a result, average margins per boe fell 10% y-o-y to a loss of $6.25/boe. In particular, the gassy names saw margins erode or if they did rise, the improvement was at a much slower pace than oil producers." - source Bank of America Merrill Lynch
On a side note, the velocity in the surge of 5 year forward breakeven inflation is what killed Gold post the US elections. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations matters. Both gold and TIPS function as a hedge against unexpected inflation. But returning to the relationship between commodities and rising real rates we also agree with Bank of America Merrill Lynch's take from their Global Liquid Markets note from the 12th of June entitled "Oil is the Fed's canary":
"Commodities perform poorly on rising real rates...
Yet our rates strategists argue that opposite seems to be happening. For starters, as a number of Trump administration initiatives such as tax and health care have stalled, economic growth expectations have fallen. Also, gasoline prices are already down year on year as OPEC production cuts have failed to remove the oil inventory overhang, acting as a drag on inflation (Chart 5).

Moreover, a fast and furious recovery in US shale oil production YTD suggests we are witnessing yet another technology-induced deflationary episode. With expectations already stretched, a less accommodative Fed that accidentally creates a higher real rate environment could further exacerbate the recent drop in commodity prices. We have previously found that rising real rates are associated with negative commodity beta returns, and falling real rates are associated with positive commodity returns (Chart 6).

Moreover, changes in commodity prices can mechanically cause big swings in realized inflation, but can also drive expected inflation near term, exacerbating the Fed's problem. another sell-off may signal a policy mistake
Real rates have a causal impact on commodity prices due to a variety of transmission channels (Chart 7).

Demand for consumed commodities like oil and base metals tends to fall when real rates rise all else equal, as it makes consumption of energy intensive goods harder to finance. Higher real rates also tend to be associated with a stronger USD, which can hurt consumption of energy intensive goods in EM countries. True, periods of high nominal yields have been associated with higher commodity returns during the past 20 years, as economic expansions tend to be characterized by both strong commodity demand and high nominal interest rates. However, periods of ultralow nominal interest rates have been linked to very poor commodity performance since the Global Recession (Chart 8), as commodities need healthy global nominal GDP growth to move higher.

So far, the commodity markets have assumed oil prices are lower because of a supply glut. However, if the Fed hike next week triggers another leg down in commodity prices, the focus may turn on demand conditions. Should the Fed be sleepwalking into a policy mistake next week, commodities may provide some warning signs." - source Bank of America Merrill Lynch
And that's the main issue with the Potemkin village of the GDP recovery story being sold out by many pundits, namely that in reality Global nominal GDP growth is not healthy, yet the Fed is continuing in its hiking path and tells us it is data dependent. 

So to answer the question relating to the credit cycle turning, yes it is slowly but surely turning but, we are not there yet. A burst in inflation and a significant rise in inflation would force the hand of the central banks, and this we think could be the real catalyst for a nasty bear market in various asset classes as discussed recently. We are also data dependent and watching very closely the trend in consumer credit as per our final chart.

  • Final chart - US Consumer Credit taking a break.
Back in our conversation "Orchidelirium" at the end of last month we asked ourselves if the US consumer was "maxed out".  We noticed at the time that consumer loan demand, a finding consistent with the weaker spending in Q1 had been cooling. This is a significant indicator to monitor in the coming months we think and our final chart comes from Wells Fargo Economics Group note from the 7th of June and shows that consumer credit was below expectations in April and shows that year-over-year percent change in consumer credit needs to be monitored closely: 
"Consumer Credit Growth Decelerates
  • Consumer credit rose by just $8.2 billion in April, the slowest pace since mid-2011. Both nonrevolving and revolving credit growth were soft in the month.
  • Revolving and nonrevolving credit growth have continued to move in lockstep on a year-ago basis. This convergence makes sense as student and auto lending cool, while revolving credit plays catch up after an unusually slow recovery." - source Wells Fargo
While it might be premature to pull the curtain on the Potemkin village, if indeed we break the 5% level for nonrevolving credit and continue to see a deteriorating trend in the coming months, then it will be a cause for concern. For credit markets at the moment, it's pretty much "carry on", though we are clearly tactically more cautious with High Yield and high beta in general.

"Everything's fine today, that is our illusion." - Voltaire
Stay tuned!

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