Sunday, 21 January 2018

Macro and Credit - The Lindemann criterion

"We're just a bubble in a boiling pot." - Jack Johnson

Looking at the acceleration of inflows, with record flows piling into Investment Grade, Emerging Markets (EM) and equities, when it came to selecting this week's title analogy, we reacquainted ourselves with the "Lindemann criterion", being the first theory explaining the mechanism of melting in the bulk. An attempt to predict the bulk melting point of crystalline materials was first made in 1910 by Frederick Lindemann. The idea behind the theory was the observation that the average amplitude of thermal vibrations increases with increasing temperature. Melting initiates when the amplitude of vibration becomes large enough for adjacent atoms to partly occupy the same space. The Lindemann criterion stated that melting is expected when the vibration root mean square amplitude exceeds a threshold value. Quantitative calculations based on the model are not easy, hence Lindemann offered a simple criterion: melting might be expected when the root mean vibration amplitude exceeds a certain threshold value (namely when the amplitude reaches at least 10% of the nearest neighbor distance). In similar fashion, melting up might be expected with such strong inflows into various asset classes. As we have repeated in numerous conversations, you can expect the credit amplifier to reach 11 in true Spinal Tap fashion.  On a side note Lindemann model is based on harmonic forces, which never give way, whereas melting must involve "bond breaking". This is another serious defect of the model. Furthermore numerous experiments carried out at high pressures indicate that the Lindemann model does not estimate adequately the pressure dependence of the melting temperature, but,  the predictive success of the Lindemann melting criterion lent support to the belief that melting could be a gradual process, beginning within the solid at temperatures below the melting point. 

In this week's conversation, we would like to look at cycles in credit in conjunction with what is happening in US Consumer Credit as well as boiling markets and bubbles.

  • Macro and Credit - The credit boiling frog
  • Final charts - Fund flows have a tendency to follow total returns

  • Macro and Credit - The credit boiling frog
Whereas the heat continues to be "on" when it comes to fund inflows and in particular for Investment Grade credit, one might wonder from a "Lindemann criterion" approach, when could we reach the boiling point in this on-going "melt-up" phase. Some pundits have even called this phase "euphoria" given the strength of the start of the year performance wise in various asset classes including equities. 

As pointed out recently on Twitter by our good friend Tiho Brkan when it comes to the credit boiling frog bullet point analogy, for us there is no real value left in European High Yield to say the least:
"For the first time (possibly ever?) we have European Junk Bonds yielding less than European equities.

You have to hand it to the ECB. They really a did a terrific job bailing out the whole continent. Not a single bankruptcy was allowed!" - source Tiho Brkan - Twitter feed
No wonder flows have been very strong into equities in Europe as pointed out by Bank of America Merrill Lynch in their Follow The Flow note from the 19th of January 2018 entitled "Turbo-boosted flows":
"Inflows into IG, EM and equities continue stronger
The reach for yield continues for another week. IG, equity and EM debt funds have had a great start of the year. IG fund flows have tripled (3wks YoY); flows into equities have moved from marginally flat to $6.4bn, and flows into EM debt have more than doubled. Nonetheless, flows into HY funds have flipped to negative, on the back of rising idiosyncratic risk. With spreads continuing tighter in the IG space and rates vol remaining close to the lows we see no reason for flows to stop in the IG space.

Over the past week…
High grade funds, continued to record inflows their fourth consecutive week. The monthly December data also reflected the calm of the holiday season with the second smallest inflow of 2017 – second to January. High yield fund flows remained on negative territory recording their 10th consecutive week of outflow. Looking into the domicile breakdown for last week, as chart 13 shows, European-focused HY funds were the main source of outflows, but the US-focused and globally-focused funds also recorded withdrawals. Monthly data for December showed a 2nd month of outflows.
Government bond funds recorded an inflow erasing last week’s outflow and a strong inflow during the month of December as well. Overall, Fixed Income funds flows remained sizable – and positive – for the fourth week in a row. As for the month of December, inflows –despite being the smallest in 2017 due to seasonality - confirmed the overall inflow trend that was seen throughout the year.
European equity funds continued on their positive streak for a third week, with inflows accelerating. Last week inflow was the largest in 36 weeks. However, in December the asset class recorded a large outflow – the largest in 14 months." - source Bank of America Merrill Lynch

As long as rates volatility remains muted, there is no end in sight for the "goldilocks environment" and the Investment Grade TINA (There Is No Alternative) trade supported by the Japanese investment crowd at least when it comes to US credit markets. As we pointed out last week when it comes to US TIPS being enticing and rising risks of inflation surprises, back in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves if indeed the game was turning and if we should switch camp from the "deflationista" towards the "inflationista" camp. Flow wise, what we are seeing is large swath of investors piling into the "inflationista" camp and investors as pointed out by Reuters in their article from the 18th of January entitled "Investors scoop up U.S. inflation-protection bonds":
"Investors on Thursday pounced on $13 billion worth of U.S. bonds that offer them protection from faster wage growth and costlier goods and services as their longer-term inflation outlook rose to their highest in almost a year.
Overall bidding for these 10-year Treasury Inflation Protected Securities was the strongest at an auction in over 3-1/2 years with investors buying nearly 90 percent of the supply.
"The allocation into the (TIPS) asset class has been strong," said Michael Pond, head of global inflation-linked research at Barclays in New York. "It's all related to the pickup in global growth."
Barclays' Pond said the run-up in TIPS may be overdone in the short term. "Evaluation is getting a bit stretched," he said." - source Reuters
TIPS focused funds have reached "boiling point" to the tune of $68.01 billion of inflows in the asset class in the week ending the 10th of January according to Lipper. As the Lindemann melting criterion has shown us, melting is indeed a gradual process. Have we reached the boiling point yet? Could we be on the cusp of a vicious bear market as anticipated daily by the perma bear crowd? One thing for certain, as we pointed out again last week, you need core US CPI to tick up significantly for a bear market to materialize for our equities friends. We do not think we have reached that point yet. Financial conditions continue to remain loose which makes this credit cycle particularly long and extended.

Not all credit cycles are the same and business cycles as well tend to be different across sectors over time. On that subject we read with interest Wells Fargo Interest Rate Weekly note from the 17th of January entitled "Cycles in Credit, Economics and National Finance":
"Business cycle trends differ across major sectors; while some series are mean-reverting, others are shifting over time. Careful analysis leads to a better understanding of ‘normalcy.’
The Bank Credit Cycle: Mean-Reverting
The Federal Reserve reports a bank’s willingness to make loans on a quarterly basis as part of the Senior Loan Officer Opinion Survey. Such a qualitative measure is telling of lender expectations and is often consulted to predict the coming credit conditions in the market. A bank’s willingness to make loans is a stationary series, which contains no structural breaks. That is, the series acts in a predictable nature, allowing one to refer to it as a benchmark to assess lending practices over a business cycle (below chart).

At the beginning of an expansionary period, as banks are very willing to extend credit, the series rises. Once reaching its peak, a bank’s willingness gradually decreases until turning negative during a recessionary period. That said, it would appear that willingness has peaked in the current expansion, which is in line with our assessment of the business cycle being in the late stage.
Elevated Household Debt: Not Back to “Normal” Ratio
Debt as a percentage of GDP serves as a good measurement of indebted households relative to the size of the economy.

However, analyzing averages can be significantly misleading. As seen in the middle chart, after rising exponentially in the prior expansion, household debt as a percent of GDP never returns to its “average” trend, as portrayed in the 1991-2000 expansionary period. Despite decreasing significantly from its peak prior to the Great Recession, household debt still remains quite elevated, stabilizing around 77 percent. As this series is not mean-reverting, it does not follow a cyclical trend, and the behavior of the series in this cycle is distinct compared to prior expansions. The recent deleveraging is likely attributable to increased caution as households acquired large amounts of debt during the previous expansion, which led to a sharp increase in the debt burden.
Unusual Behavior of Profits
Corporate profits as a share of GDP appear to follow a cyclical pattern in which they gradually increase, peaking late in an expansionary period, before steadily declining during a recession. However, pre-tax corporate profits are non-stationary, and thereby are a less predictable series. Although profit growth as a percent of GDP appears to follow a traditional peak to trough trend, there have also been various structural breaks within the series leading to highly irregular and quite misleading judgements based on prior trends. Although this might not be very surprising, the larger decline being in the 2001 recessionary period seems unusual (bottom chart).

The greatest decline in corporate profits would be assumed to have occurred during the Great Recession, as we saw dramatic movements in a bank’s willingness to lend as well as households acquiring record amounts of debt. That is, one might suspect a similar case of dramatics in the decline of profits during the Great Recession; however, the drop was more significant in 2001." - source Wells Fargo
When it comes to the US economy, US consumer credit matters a lot. We continue to monitor that space given any weakness in US consumer credit could be an additional sign the US economy is reaching a turning point. Also in our October 2017 conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves what could make the credit cycle turn once we have reached boiling point:
"When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion. " - source Macronomics, October 2017
From a Lindermann criterion perspective, measuring the level of indebted households matters and in particular the use of Consumer Credit and in particular non-revolving credit we think. In regards to the results from big US banks we read with interest the Financial Times article from the 21st of January indicating a surge in credit card losses:
"US banks suffer 20% jump in credit card losses
Rising soured debts raise concerns about the financial health of middle America
The big four US retail banks sustained a near 20 per cent jump in losses from credit cards in 2017, raising doubts about the ability of consumers to fuel economic expansion.
“People are using their cards to get from pay cheque to pay cheque,” said Charles Peabody, managing director at the Washington-based investment group Compass Point. “There’s an underlying deterioration in the ability of the consumer to keep up with their debt service burden.”
Recently disclosed results showed Citigroup, JPMorgan Chase, Bank of America and Wells Fargo took a combined $12.5bn hit from soured card loans last year, about $2bn more than a year ago.
Banks have ramped up lending, wooing customers with air miles, cashback deals and other offers. The number of open credit card accounts in the US is forecast to reach 488m this year, according to Mercator Advisory Group, a rise of 108m from post-crisis lows in 2010.
Yet borrower delinquencies are outpacing rising balances. While still less than half crisis-era levels, the consultancy forecasts soured credit card loans will reach almost 4.5 per cent of receivables this year, up from 2.92 per cent in 2015."  - source Financial Times
Low inflation and loose central bank policies have indeed played a critical role in moving asset prices towards the boiling point and the ongoing "melt-up" but the narrative is slowly but surely changing as we pointed out on numerous occasions. 

Nonetheless, the most predictive variable for default rates remains credit availability. Senior officer loan survey leads default rates (SLOOs) so it is important to track them. When it comes to consumer credit, as the credit cycle matures, it is becoming essential to monitor what is happening for Credit card ABS we think.  As displayed by Wells Fargo in the below chart in their Credit Card Surveillance Report from the 19th of January, credit card ABS issuance has been increasing in 2017 but it is still relatively tame compared to the years prior to the Great Financial Crisis (GFC):
- source Wells Fargo

While securitization of US consumer credit is comparatively tame compared to what happened before the GFC, US consumer debt surged by the most in over 2 years to $3.8 trillion and jumped by 8.8% in November, the most in two years, to $3.83 trillion, according to the Federal Reserve. Clearly in the coming months US Consumer Credit should be on everyone's radar in conjunction with SLOOs we think.

As per our bullet point the credit frog is slowly but surely heating up for sure as per the Lindemann criterion but, we do not think yet we have reached the boiling point yet in credit we think.

For our final charts we have always thought tracking flows matter, particularly this year the ones coming from Japan given their support for US Credit as a whole. 

  • Final charts - Fund flows have a tendency to follow total returns
When it comes to flows the most cited linkage according to CITI is trailing returns. Our final charts come from CITI's European Credit Weekly note from the 19th of January entitled "How durable is the fund flow frenzy" and display fund inflows as a percentage of AUM (Assets Under Management) versus total returns for both US Investment Grade and US High Yield:
"Fund flows have a tendency to follow total returns, both on the way up and on the way down. The relationship holds in IG (Figure 7), in HY (Figure 8) and in equities, and while sometimes coincident, the return series quite often seem to lead at turning points.

This relationship is clearly sending a positive signal at the moment. While it left us very worried in early 2016 (after investors had lost money on almost every asset class in 2015), 2017 returns were almost universally positive. If investors simply chase trailing returns, there is very little reason for them to withdraw their money at present.
Admittedly there are a few wrinkles. In such a risk-on environment seems odd that investors are quite so keen on IG (both outright and relative to trailing returns), and quite so cautious on HY (likewise). It might just be an overhang from the losses of 2015, when investors clearly ended up regretting their enthusiasm for HY in 2010-14.
Something similar is apparent in equities: last year’s $200bn inflow to mutual funds and ETFs – a mere 1% of total holdings – seems relatively paltry when markets are returning 15+ percent. Again, it may just be that investors have been unable to regain the love of the asset class they displayed during the 1990s (Figure 9).

But we would be much more convinced of private investors’ ability to take over from central banks as the main driver of risk assets this year if we saw more elevated and sustained inflows to both HY and equities. Perhaps those are on the verge of showing up, but there is an alternative interpretation which points in the opposite direction.
Cash is king
Just as last year’s outflows from HY funds did not seem to have much negative impact on their performance – perhaps because IG or other investors were crossing over into HY – so we find we get the best understanding of fund flows when we consider the big picture, rather than looking at each asset class individually.
Specifically, we like to look at inflows to all risky (or “long-term”) assets together – IG, HY, govies, EM, equities and alternatives, in mutual funds and ETFs – relative to total inflows into money market funds and deposits. How much of people’s saving is going into risk assets relative to what they a simply trying to keep safely in cash?
This combined flow also exhibits a strong relationship with equity returns, with recent strong inflows at first sight almost exactly where they “should be” (Figure 10).

When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash.
But look more closely, and another pattern is visible. In each cycle, as the economy emerges from recession, with risk assets priced cheaply and deposit rates low, investors start by doing the vast majority of their saving in risk assets (1992-3, 2003-4, 2009-10). Then as the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off, before the cycle starts again (Figure 11).

In addition, both the red and blue lines have exhibited a long-term downward trend. The move in the blue line could just be the relative growth in deposits across cycles. But an alternative interpretation – consistent with investors’ relative reluctance to buy both HY and equities – is that as markets have become more obviously expensive, it has taken steadily lower deposit rates just to prevent them from hoarding cash.
One way or another, the past year’s shift into risk assets, so late in the cycle, is extremely unusual. Even the late 1990s sees nothing like it. It is the exact opposite of what one would normally expect as deposit rates rise. And yet this year needs to see an even bigger such shift if private investors are to absorb the $1tn global hole left as central banks reduce their purchases.
Perhaps the strong start to the year will encourage just such buying on the part of investors. And in €, at least, negative deposit rates will continue to be an incentive for a good while yet. But despite the recent drop in correlations, our instinct remains that markets remain deeply interlinked across both assets and across geographies – meaning that the Fed’s rate rises have significance even in €, and the ECB’s and BoJ’s reductions in purchases have relevance for $ investors alongside the Fed. So while the signal from recent fund flows is undeniably positive, it will take more than just a good few weeks at the start of the year to convince us that 2018 as a whole will see a continuation of this raging bull market." - source CITI
As we posited at the start of our conversation, from a Lindemann criterion perspective, melting up might be expected with such strong inflows into various asset classes, particularly in credit. That simple. Melting is indeed a gradual process, particularly for our credit frog but it seems our central banker are using a pressure cooker, which is interesting because by pressurizing the vessel, they are able to produce much more heat than the boiling point of water, and still have water (inflows) present but we ramble again...

"When the water starts boiling it is foolish to turn off the heat." - Nelson Mandela
Stay tuned ! 

Monday, 15 January 2018

Macro and Credit - Bracket creep

"Declining productivity and quality means your unit production costs stay high but you don't have as much to sell. Your workers don't want to be paid less, so to maintain profits, you increase your prices. That's inflation." - W. Edwards Deming

Watching with interest the latest US CPI posting its biggest gain in 11 months to 1.8% in a US economy plagued by "fixed income" (lack of wage growth) and "floating expenses" (healthcare and rents), when it came to selecting our title analogy we reminded ourselves of the term Bracket creep, particular following the landmark tax reform passed on Christmas Eve to replace the 30-year-old, complex U.S. tax system. 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.

In this week's conversation, we would like to look at rising inflation expectations and what it entails from a US TIPs and other linkers perspective as well as what are Japanese friends are up to from an overall flow allocation.

  • Macro and Credit - The return of the inflationistas
  • Final chart - The "Bid 'Em Up Bruce" stage is now

  • Macro and Credit - The return of the inflationistas
While inflation has been the elusive piece of the puzzle for many of our dear central bankers around the world, the latest print of core US CPI is marking the return of the "inflationista". This obviously should be welcomed good news for the members of the FOMC, but be careful what they wish for. As we indicated back in June 2015 in our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation. Also remember that in the headline CPI, rental prices represent 25% in the calculations and overall housing 42%. We will eagerly watch rental prices in the coming weeks and months. Back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008 as a reminder.

Yet as posited by Wells Fargo in their Economics Group from the 12th of January in their note entitled "CPI: Beyond the Headline, Inflation is Strengthening", consumer prices are it seems indeed edging up:
"Consumer price inflation edged up 0.1 percent in December despite a fall in gasoline prices. Reversing last month’s weakness, core inflation rose 0.3 percent and is up at a 2.5 percent pace over the past three months.
Gasoline Savings Going Elsewhere
Inflation cooled in December with the Consumer Price Index (CPI) increasing 0.1 percent. That followed a 0.4 percent gain in November.

The tamer increase stemmed from a pullback in energy costs as gasoline prices fell 2.7 percent over the month. That overshadowed a modest rise in energy services (electricity and utility gas). It was not until late in the month that unusually low temperatures led to a jump in natural gas prices. Although not quite halfway through the month, spot prices for natural gas are up about 6 percent from their December average. Therefore, we suspect energy services could provide an even larger lift to headline inflation next month.
For December, food prices rose 0.2 percent. That marks the largest increase since July and suggests that more stable prices for food commodities and rising labor costs for food services workers may be reasserting some modest upward pressure on the sector.

Core Inflation Rebounds
Core inflation bounced back after a weaker-than-expected reading in November. Excluding food and energy, prices were up 0.3 percent. Core goods prices posted a rare increase and moved 0.2 percent higher.

Leaner auto inventories after last year’s natural disasters spurred demand to replace vehicles and slower production growth more generally has given some support to prices. After falling from February to September, new and used vehicle prices have risen the past three months, including the largest monthly gain in December in more than six years. A 1.0 percent jump in prescription drug prices also pushed core goods inflation higher. Stronger core inflation was also driven by services. Shelter costs advanced an above-trend 0.4 percent in December. Rent of primary residences and owned residence both rose more than in November, while lodging costs partially reversed last month’s drop. Costs for medical care services also rebounded after a sharp decline in physician services in November.
Getting Back to the Fed’s Target
Inflation has been the darkest cloud hanging over the Fed’s efforts to normalize policy. Over the past year, inflation has risen 2.1 percent, a touch lower than November’s 12-month change and noticeably below the pace set earlier in the year. Yet the recent trend looks stronger. Over the past three months headline inflation is up at a 2.6 percent annualized pace. Similarly, core inflation, which is up 1.8 percent on a year-ago basis, has risen at a 2.5 percent pace over the past three months. This should help to allay some FOMC members’ fears that inflation is stuck at undesirably low levels. We expect to see a noticeable pick up in the year-over-year change by this spring. Although that will stem in large part from base effects following weakness last year, the trend remains upward." - source Wells Fargo.
Back in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves if indeed the game was turning and if we should switch camp from the "deflationista" towards the "inflationista" camp:
"Given China's most recent uptick in its PPI to 6.9%, we are indeed wondering if this is not a sign that we should change allegiance slightly towards the "inflationista" camp and start fearing somewhat the possibility of the return of the Big Bad Wolf aka inflation. We will be monitoring closely this latest China "inflation impulse". China's rising costs via exports could boosts inflation expectations in the US. These higher inflation expectations in the US would mean a steeper yield curve with a rise in long-duration yields overall and it would lead to higher rates volatility down the line. A bear market needs a wolf and this wolf would materialize in a return of inflation we think." - source Macronomics, October 2017 
As pointed out by Christopher Cole from Artemis Capital in his must read note "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. But flow wise, as we have pointed out in numerous conversations, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" so far. It seems the bond kings such Bill Gross and Jeff Gundlach as of late have picked up their side and are steering towards the "inflationista" camp whereas Dr Lacy Hunt, from is latest  quarterly note for Hoisington continues to sit tightly in the "deflationista" camp it seems. One might therefore wonder where we stand.

Also, in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:
"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015
We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", but that was because of the following:
"If the policy compass is spinning and there’s no way to predict how central banks will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up."
Given it seems that US inflation expectations are moving upwards it seems, one could argue that the compass in the US has somewhat stopped spinning hence the move in US breakevens and TIPS, in conjunction with the continuous support for Gold Miners (yes we are still long and we have been adding...). 

We like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment? 

At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument. We highly recommend our friend Kevin Muir aka The Macro Tourist post on a refresher on how breakeven works: "BREAKEVEN REFRESHER LESSON" for those not familiar with the concept. 

We would also like to add that if indeed the rise of inflation expectations is a global phenomenon, then our UK friends have an advantage with Gilt Linkers given they do not have an embedded deflation floor so, they should outperform US TIPS on a relative basis. 

Also, as all eyes are looking at the significant surge in oil prices in recent months as per our March 2016 conversation "Unobtainium":
"A very interesting 2015 paper by the Bank of Israel (Sussman, N and O Zohar 2015, “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015.) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area. Therefore, given the recent significant surge in oil prices, we do not think it is such a surprise to see a rise in inflation expectations in that context." - source Macronomics, March 2016
Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach of the "inflationistas" for the long end of the curve. We live in a world in which the public sector has never been so indebted (The world's global debt just reached $233 trillion in 3Q 2017). Demography is as well playing its part in rendering the US Yield curve "inelastic" therefore the volatility of the US yield curve is clearly in the front-end of the curve. We continue to witness a bear-flattening of the US Yield curve with the Japanese investment crowd and in particular Lifers continuing to be dip buyers. This is confirmed by Nomura from their JPY Flow Monitor report from the 12th of January entitled "Net buying continued but at a slower pace":
"Lifers sold foreign bonds, but seemed to maintain its recovery trend
Investment by life insurers, which are prominent medium- and long-term investors, remained lackluster. They were net sellers in November at JPY234bn and in December at JPY124bn ($1.1bn). Higher FX hedging costs for US bond investment may slow their foreign bond investment, but we do not believe that the recovery trend has ended, (see “US curve flattening and Japanese lifers”, 7 December 2017). Barring another resurgence of geopolitical risks, we believe there is a good possibility that lifers will resume their net buying at a high level due to pent-up demand. The recent rises in US and European yields should encourage them to consider foreign bond buying. Lifers’ FY17 investment plans show that the structural shift away from yen bonds and toward foreign bonds continues (see “JPY: Lifers upgrade EUR/JPY forecast”, 25 October 2017). Despite this, at JPY1834bn, lifers’ cumulative foreign bond investment from April through December 2017 is below the average since FY05 (JPY1959bn; Figure 3).

When it comes to unhedged investments, If USD/JPY trades below 112, this would trigger demand to buy USD on dips (sell JPY), in our view. Major lifers forecast USD/JPY in a core range of 109-115. According to major lifers’ H1 FY17 financial statements, their hedged ratio was 58.0% at end-September 2017, down slightly from end-March (60.2%), but this level was still high (see “JPY: Modest decline in lifers’ hedge ratio”, 24 November 2017). With the Fed raising rates, higher hedging costs should push lifers into reducing their hedged ratio (thus creating pressures pushing up USD/JPY). Lifers still have substantial room to unwind FX hedges, which should keep USD/JPY steady." - source Nomura
With government bond yields ratcheting up, this means more buying at some point FX unhedged from the Japanese investment crowd and still a strong demand for US credit given it is still a TINA trade (There Is No Alternative). When it comes to the on-going "bear-flattening" of the US yield curve, yes,  one could see a rebound with some tactical steepening in the 2s10s part of the curve as pointed out by Nomura in their FX and Rates Trade Ideas note from the 11th of January:
"In the US strategy outlook for 2018 (see link), we listed several reasons why we do not expect a full flattening of the US curve, or an inversion any time soon. It is inconsistent, in our view, for curves to pancake at this time given outright levels of rates are low (versus prior periods), global QE is fading, debt issuance is rising and the economy is growing. We expect these and other factors driving the US curve to result in sharp countertrend moves at times in 2018. We envision some bull and/or bear steepening factors ahead.
1. Bullish front-end factors: The front-end has quickly discounted the 2018 hiking path. US momentum looks solid but any sort of miss in US data could prompt a front-end rally. The front-end has also built up a sizable short base as seen in Figure 1.

2. Curve correlation factor: The curve versus the level of rates (Figure 2) is shifting quickly from the prior bull flattening/bear steepening regime.

Thus, those expecting the long end to outperform on any sort of risk-off (which is a common rationale we hear from investors long 10s plus) is misplaced, as 2s would now rally more in a risk-off.
3. Bearish long-end factors: As seen in Figure 3, one reason why the curve flattened in 2017 was 10-year rates were stuck in a range, while the Fed was hiking short-end rates.

This year will be unlike last year because Fed QT in ongoing, US tax reform passed (and deficits/debt loads are likely to expand) and global QE buying is slowing.
4. Curve momentum factor: We take the 3-month moving average of the curve as an indicator of momentum and take the rolling 1-week change to gauge its speed. As seen in Figure 4, the US curve momentum has hit its limit and is due for a rebound.

We recommend investors go short 10s on the curve (2s10s) and the broader butterfly in Q1 2018. For the 2s10s UST trade, our first steepening target would be half the flattening seen since November 2017 (roughly 15bp above current levels) before we re-assess." - source Nomura
While we might see indeed some rebound in the 2s10s part of the US yield curve, the continuation of the velocity in the "bear-flattening" of the US Yield curve which has started a while back is depending on renewed appetite from "Bondzilla" the NIRP monster "Made in Japan" we think.

But moving back to the attractiveness of US TIPS, we do think that, from an allocation perspective, they are of renewed interest. On that subject we read with interest another Nomura note, their Inflation Insights from the 11th of January entitled "Tip(s)-toeing into the US BEI pool":
"Avoid jumping but gradually wade into BEI waters
The macro case for adding long US inflation positions has strengthened with higher price pressure from the recovery in world trade, which has been a driver of higher commodity prices, especially for oil. These higher input costs coupled with what still remains a relatively accommodative global monetary stance (keeping real rates contained for now) is leading to wider TIPS breakevens inflation (BEI). Yet, this has been an orderly move and there are few relative value disruptions to take advantage of (i.e., cash/swap basis and curve disruption). A long US BEI position is therefore mostly a directional macro trade. 
We recommend investors stick with the macro trade, with limited risk and an oil hedge. We get long 5y breakeven rates at 1.95%, targeting 2.20% at the end of February (20bp net of negative carry) and pay for some oil price protection. We expect core inflation to strengthen in December. However, we would not hesitate to take losses if the December print meaningfully surprises to the downside. Globally we still prefer long euro BEIs.
US TIPS breakevens showed a strong performance into and out of year-end
The US 5-year breakeven inflation rate performed remarkably well into and out of yearend, increasing by about 15bp since mid-December 2017 (about 12bp net of the negative inflation carry). This is a solid performance that contrasts with the lack of movement between October and December. Inflation carry should remain negative in February, pushing forward breakeven rates higher at an increasing pace given the magnitude of the negative carry and the low number of days in the month (Figure 1).

The inflation carry profile therefore accentuates the skew to long breakeven positions into the CPI number on 12 January: a substantial positive surprise is needed for long positions to perform, while a small negative surprise would be enough to postpone long positions by a month. Note that our US economists’ forecasts for the December headline CPI are in line with both consensus and short-term inflation markets, although their forecast on core is higher (see US CPI Preview: A Potential Jump in Core).
Timing aside, the medium-term outlook for US TIPS BEIs appears favorable
As we highlighted in the TIPS section of Fixed Income Insights: 2018 Themes - US Strategy Outlook, “while valuation did not argue for a massive TIPS BEI long, the US may be the first place to benefit if the ‘reflation’ trade 2.0 is driven by Trump administration’s tax plans and fiscal stimulus”. Beyond the hurdle of short-term carry implications, various factors are forming a positive framework for US inflation valuations.
Global inflation is picking up and that should be supportive BEI wideners
The first positive technical stems from the behaviour of our Global Inflation Factor (GIF, a factor extracted from internationally-set prices such as commodity prices and manufacturing prices obtained from manufacturing surveys, which remain a large fraction of world trade). As the right chart in Figure 2 shows, global inflation picked up at the end of last year.

Furthermore the strong momentum on the price of manufacturing goods is further supported by the recent strength in energy and food commodity prices. Goods price momentum is particularly visible in Europe and is reflected in the right chart in Figure 2. The chart scaling shows this is why our favored long so far has been in euro inflation wideners. Yet, stronger momentum on commodity prices favors US TIPS breakevens, despite some discrepancy between wholesale and retail gasoline prices, probably due to margin changes after the weather-related disruptions of last year.
Valuations are balanced and not only driven by the hope of reflationary policy
The second factor supporting a long US inflation breakeven trade is a more balanced valuation framework/background. The left chart in Figure 2 shows this dynamic. In a reestimated version of a statistical model developed by Fed researchers (see IFDP notes, Dec.2016, "drivers of inflation compensation: evidence from inflation swaps in advanced economies", M.Rodriguez and E.Yoldas), the model is estimated over the 2008-2016 period, then projections are simulated since September 2016.
We find the large discrepancy that occurred between their model and actual inflation valuations that built up after the US Presidential election very informative. It validates our view at that time of some re-building of the specific inflation premium. Note that the risk premium captured by the model is generic and pertains to risk aversion, not inflation specific forces. Inflation valuations after October 2016 seem to have priced in too promptly the impact of expected reflationary policies, particularly on the fiscal side.
One year later, the US tax reform package has finally been voted on and passed. Yet, the fact that the discrepancy between the trajectory of breakevens and the fundamental factors (as implied by the model) is now small suggests there is room for upside that is motivated by expectations beyond just fiscal policy. We think the backdrop for US inflation is therefore much more balanced than was the case at end-2016 after the election.
The issue of timing and carry limits our exposure and enthusiasm
Investors should still scale into BEI wideners, as there are a few issues associated with an unconditional bullish stance on US inflation. We have already described the first issue in terms of seasonal carry not being ideal. There is also the issue of the near-term inflation profile which, according to both economists and markets, will not be very supportive.
As Figure 3 shows, year-on-year inflation is expected to fall between now and the end of Q1 2018, reaching a low of 1.8% in February 2018.

This year-on-year inflation downtrend should occur despite the robust core inflation rate forecast by our economics team at of 0.20% /month between December 2017 and December 2018, which is higher than average core inflation over the past two years. Some negative surprises on inflation are definitely not out of the question, although our economists see upside risks to the next core inflation print (see Economics Insights - US: December CPI Preview).
In February 2017, the 1-year inflation swap rate was about 2.35% and effective inflation over the period consistent with the swap rate was 2.13%, a 20bp shortfall mostly due to the unexpected fall in inflation (mostly from transitory factors but real drivers of inflation nonetheless) between February 2017 and June 2017. A quick glance back at forecasts back in February 2017 shows an underestimation of inflation by up to 60bp for some months. The reason for the underestimation is not yet fully apparent (see Special Report - Why Does the Fed Appear Insensitive to Soft Inflation Data?), and we have pointed to evidence of less-anchored inflation expectations in Inflation Insights - Reality check. The persistence of uncertainty on the inflation mechanism in the US, acknowledged by the Federal Reserve, suggests some caution is warranted on outright long US inflation stances.
Sharing between real and inflation components of yields
Keeping inflation anchored is a key condition for smooth monetary policy normalization. 
Any sort of increase in nominal interest rates that would be accompanied by falling inflation compensation would in fact entail a much tighter real stance via higher real rates pushing up overall yields. This would risk putting the economy on a very volatile path.
A key part of our analysis has been to favour inflation markets where the fostering of expectations was supported by low real yields, and this is why we have favored the euro market, where 2-year real rates are now close to their historical lows (Figure 4).

Short-term real rates in the US have increased much more rapidly which, by contrast, makes the increase in inflation valuations very dependent on economic optimism, not on policy accommodation. The stabilization in real yields suggests this element of vulnerability of the long US inflation trade is less acute now than a few weeks ago.
Still, it remains the case that the increase in inflation compensation is highly dependent upon a modest path in the recovery of real yields (see Inflation Insights - A tale of two modes).
Trade Idea: Scaling into long US 5-year TIPS breakevens
Oil prices are rising, valuations are balanced, the next CPI print is likely to surprise markets to the upside: there are many reasons to go long US inflation despite the negative seasonals.
The focus in the rally has been on cash instruments rather than derivatives, which is consistent with EPFR data showing strong inflows into TIPS ETF based funds. Also, in the latest BEI rally, the 5-year point has outperformed the 10-year point probably due to higher oil prices. Yet as during previous rallies, the 5-year breakeven rate relative to 3- year and 7-year has not outperformed, see Figure 5.

As a result, the case for relative value on the US inflation curve is limited, in our view.
The case for long US breakeven inflation exposure is therefore mostly a macro trade, with few elements of relative value selection that could “enhance” the trade. Longs need to fight less than ideal carry profiles, prospects of volatile oil prices and the Fed’s hiking path ahead. We cautiously go with the macro arguments by scaling into a long 5y TIPS breakeven trade with limited risk exposure (limited notional and some oil price hedges)." - source Nomura
Indeed it is a "macro" trade. We like these. We would also like to repeat what we have pointed out in our conversation "Hypomania" in February 2017 relative to rising oil prices given the relationship with recessionary pressure in the US. 
"As we pointed out as well in 2014, in our conversation "The Molotov Cocktail", past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years." - source Macronomics, February 2017.
As well there is a very important relationship between "gold" and "Tips" when it comes to their reaction to the velocity in rising inflation expectations as we indicated in last year's conversation:

"There is of course an explanation around this which was very clearly put forward by David Goldman in Asia Times on the 17th of February in his article "A mistery solved: Why real yields are falling despite higher growth":
"Economists often think of real yields as the “real interest rate,” or baseline rate of return, in a macroeconomic model. From this standpoint the low level of TIPS yields is a mystery: when economic growth is rising, the real interest rate should rise. The expected short-term interest rate has been rising as the Fed sets about normalizing rates, and the rising short-term rates affect real yields. The fall in TIPS yields in the face of Fed tightening and stronger growth presents a double challenge to the conventional wisdom.
The conventional way of looking at real yields ignores the way markets treat risk. Government debt (and particularly the government debt of the United States) is not just a gauge of economic activity, but a kind of insurance. If the world comes crashing down, you want to own safe assets. Investors hold Treasuries in their portfolios not just for the income, but as an insurance against disaster. And TIPS offer a double form of insurance: If economic crisis takes the form of a big rise in the inflation rate, TIPS investors will be paid a correspondingly higher amount of principal when their bond matures. That explains why TIPS yields sometimes are negative: investors will accept a negative rate of return at the present expected inflation rate in return for a hedge against an unexpected rise in the inflation rate.
The yield on TIPS has tracked the price of gold with a remarkable degree of precision during the past 10 years, as shown in the chart below. Gold tracks the 5-year TIPS yield with 85% accuracy. That’s because both gold and TIPS function as a hedge against unexpected inflation.

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

The rest of his article, is a must read we think. but if indeed there are rising inflation expectations, then it makes sense for real yields to continue to fall, which can be assimilated to the cost of the insurance for "unexpected outcomes" is rising. In the case for TIPS and Gold, the cost of insurance for the velocity in the change in inflation expectations is going up." - source Macronomics, February 2017
The recent surge in both US Tips, gold and gold miners are a consequence of the rapid surge in "inflation expectations" hence the interesting case for going both long gold/gold miners and US TIPS in that particular context we think, while there might also be a seasonal factor too it given we witnessed a similar situation in December 2016. There is a well continued weakness in the US dollar which is positive for Emerging Markets equities relative to US equities from an overweight allocation perspective. Right now risk assets continue to push higher, this in conjunction with rising inflation expectations should trigger a more hawkish change of narrative from central banks. As we pointed out in our final post of 2017, "Rician fading", once the tax deal was a done deal, US corporates with more clarity ahead could resume/start some M&A typical in the late stage of the credit cycle game in the first part of 2018.

  • Final chart - The "Bid 'Em Up Bruce" stage is now
 As a tongue in cheek reference to the mighty Bruce Wasserstein aka "Bid 'Em Up Bruce",  the M&A legend, our final point of this conversation highlights another sign of late cycle behavior, namely corporate M&A. This final chart displays M&A in the corporate sector since 1999 relative to the credit cycle seen since 1999. It comes from Nomura Japan Navigator note from the 9th of January entitled "Equities move on factors other than yields and exchange rates":
Unlike the pattern over the past three years, 2018 began with substantial risk-on momentum. China’s short-term money rates stopped climbing, allaying market concerns, and commodities and EM equities gained upward momentum. The closing of positions out of concern that the year would start with the anomaly of a risk-off flow and the winding down of selling for a loss ahead of the implementation of US tax cuts also played a role, in our view. In addition, the passage of the US tax cut legislation provided an opportunity for investors and companies to resume investments once uncertainty had been dispelled. We view corporate mergers and acquisitions as a key engine of growth during the latter part of an economic recovery, and had been concerned about their lackluster pace despite the strong credit market in 2017 (Figure 2). This should pick up now.
At the start of the year, many economists and analysts set out the major themes for the year, regardless of their probability, and we expect corporate M&As to become a market theme, at least temporarily. This year, in our view, while the stock market will place more weight on the corporate sector’s capital investment and M&As, we think the rates and FX markets will focus on policy changes by central banks, with the start of monetary tightening by the BOJ and ECB clashing with the end of Fed rate hikes. We think this explains the disjointed movements across markets." - source Nomura
Is this cycle different when it comes to late cycle behavior such as heightened M&A activity? We do not think so, and it is a consequence as well of the "Bracket creep". Get your LBO screener ready folks...

"The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation." -  Vladimir Lenin

Stay tuned! 

Monday, 8 January 2018

Macro and Credit - Iconic Memory

"There are things known and there are things unknown, and in between are the doors of perception." - Aldous Huxley

Looking at the significant acceleration in the melt-up in the equities space in early 2018 on the back of decent macro data and earnings, with credit spreads going towards the 11 level on the credit amplifier in true Spinal Tap fashion, when it comes to selecting our first title analogy for the new year we decided to go for "Iconic memory". The development of iconic memory begins at birth and continues as development of the primary and secondary visual system occurs.  A small decrease in visual persistence occurs with age. Iconic memory is the visual sensory memory (SM) register pertaining to the visual domain and a fast-decaying store of visual information. It is a component of visual memory and is described as a very brief:
  1. The duration of visible persistence is inversely related to stimulus duration. This means that the longer the physical stimulus is presented for, (QE 1, 2 and 3) the faster the visual image decays in memory.
  2. The duration of visible persistence is inversely related to stimulus luminance. When the luminance, or brightness of a stimulus is increased, the duration of visible persistence decreases. Due to the involvement of the neural system, visible persistence is highly dependent on the physiology of the photoreceptors and activation of different cell types in the visual cortex. This visible representation is subject to masking effects whereby the presentation of interfering stimulus during, or immediately after stimulus offset interferes with one's ability to remember the stimulus
Information persistence represents the information about a stimulus that persists after its physical offset (Tapering). It is visual in nature, but not visible. The brief representation in iconic memory is thought to play a key role in the ability to detect change in a visual scene such as the continuation of the Fed's reduction of its balance sheet and its impact which has yet to be fully assimilated by many investors due to their "Iconic memory" we think. In similar fashion the "Iconic memory" of the Great Financial Crisis (GFC) has led many retail investors including the US middle-class to continue to be scared out of the stock market and leading the top 10% of American households to now own 84% of all stocks. 

In this week's conversation, we would like to look at what allocations could benefit 2018 in the on-going "goldilocks" environment thanks to a very muted volatility overall but, the most important question, we think will be once again the direction of the US dollar. In terms of "allocation" we gave a small Christmas present in our last musing on the 17th of December when we hinted that we liked gold miners again because they had "cheapened" a lot. We continue to like the sector for 2018. 

  • Macro and Credit - The US Dollar New Year's hangover
  • Final charts - Credit Conditions in early 2018? Take it "easy"
  • Macro and Credit - The US Dollar New Year's hangover
While in early January last year we indicated our contrarian view to the long USD investing crowd and we also indicated that in the context of a weaker US Dollar one should rather be overweight Emerging Markets (EM) equities versus US equities. The US dollar index fell by around 10% in 2017 which does indeed validates our early contrarian stance of 2017 as per our conversation "The Woozle effect":
"It appears that from a "Mack the Knife" perspective, it will be rather binary, either we are right and the consensus is wrong thanks to the Woozle effect, or we are wrong and then there is much more acute pain coming for Emerging Markets, should the US dollar continue its stratospheric run. From a contrarian perspective we are willing to play on the outlier." - source Macronomics, January 2017
And as indicated from the table below from the blog "The Capitalist Spectator", playing the outlier namely being overweight EM versus Equities has rewarded the "contrarian crowd" handsomely in 2017:
- source The Capitalist Spectator

Could 2018 play out differently than 2017 when it comes to the US Dollar? We do not think so, yet no doubt we could see in the early stage of 2018 a technical bounce of the US dollar. But, for us, from our "Iconic memory" perspective, we still see a weakening of the US dollar from a medium term perspective. On that note we agree with Barclays take from their note from their Thought for the Week Ahead note from the 7th of January entitled "The perils of following the consensus":
"USD: Holiday hangover
The USD has lost ground versus practically all major G10 and EM currencies (except for the JPY and MXN) since mid-December. Price action suggests that FX markets had largely anticipated the announced tax bill. Our economists have taken a closer look at the final details and recently updated their forecasts (see US Economics Research: 2018-19 US Outlook: Tax cut-induced bounce in activity, 4 January 2018). The tax plan is likely to boost near-term growth prospects by about 0.5pp and push out any slowing in the economy into 2019. Above-trend growth and a tightening labor market imply an increase in inflation toward the Fed’s target, and we now look for four Fed hikes in 2018 and three in 2019, taking the target fed funds rate to 3.00-3.25%.
That said, we do not see a lasting effect of the tax plan in pushing potential growth and, hence, long-term rates higher. The expected temporary boost to growth would be driven, largely, by a one-time improvement in disposable income. With many of the changes to personal taxation expected to be phased out of the bill, we do not expect it to have a permanent effect. In addition, it is likely to have heterogeneous effects for consumers based on household situations and the type of income earned. On the investment side, business spending has tended to have low elasticity with respect to changes in the required rate of return on capital, and as such, we are skeptical that it can deliver a substantial increase, particularly given the maturity of the business cycle. Finally, the discussion of restrictive immigration and trade policies that are also on the administration’s agenda may work against delivering lasting productivity improvements.
We remain USD bears over the medium term on account of an overvalued exchange rate (13% versus BEER), compression in risk premium in the US as symbolized by a bear-flattening yield curve, and a global backdrop that remains positive both in terms of cyclical prospects (the US cycle looking more mature) and from a valuation perspective. We believe the market’s focus will shift from tax policy to other policy priorities in Washington. These include approving the budget, immigration (DACA, the border wall, etc.), healthcare (renewal of CHIP, paying for Obamacare subsidies, etc.), and trade policy (NAFTA, alongside Korea and China). The 19 January government shutdown deadline and the seventh round of NAFTA negotiations on 23-28 January should be on investors’ radar." - source Barclays
As per our final conversation for 2017, either you think we are in a bull flattening case or in a bear flattening case:
"In a Bear Flattener case thanks to the Fed's Rician fading, it is still TINA playing out for the Japanese investor crowd" - source Macronomics December 2017.
We argued in our previous conversation that Japanese investors (and global credit and overall allocation wise these guys matter a lot) tends to be dip buyers ensuring in effect a bear flattening of the US yield curve. In 2018 we will watch again very closely what "Bondzilla" the NIRP monster "Made in Japan" will do in terms of "allocation". It is a major support to US credit markets as well. We think monitoring what the Bank of Japan (BOJ) does in 2018 will be paramount. On that note we agree with Deutsche Bank's take from their Japan Fixed Income Weekly note from the 5th of January entitled "BOJ normalization could pose a tail risk to domestic and overseas rates":
"Global investors focusing on the BOJ?
We expect the BOJ to be a major focus of attention among global investors in 2018. We say this because any change in the BOJ's monetary policy stance could have significant ramifications for how Japanese investors approach foreign bonds.
For example, the January 2016 launch of BOJ NIRP and September 2016 institution of YCC each had an important impact on international bond investment flows. Japanese banks were net sellers of foreign bonds to the tune of around JPY1 trillion and life insurers were big net buyers (+JPY4.8 trillion) over the 34- month period between the April 2013 launch of QQE and the January 2016 launch of NIRP, but the subsequent eight-month period up until the September 2016 launch of YCC saw net purchases of JPY5.2 trillion by banks and JPY9.3 trillion by lifers. The obvious conclusion is that the introduction of BOJ NIRP played a major role in the decline in the 10y UST yield from above 1.9% to below 1.4% that was observed between January and July 2016.
Conversely, the eight-month period following the launch of BOJ YCC (October 2016~) saw banks sell off foreign bonds to the tune of JPY9 trillion while lifers cut back their net purchases to just JPY1.3 trillion. We attribute this to bear-steepening of the JGB curve under YCC leaving domestic players with less of  an incentive to invest in foreign bonds, with life insurers in particular probably becoming more willing to wait for overseas interest rates to move higher once they perceived that the risk of the JGB curve bull-flattening had diminished.
Banks began FY2017 by selling off foreign bonds to the tune of JPY5.6 trillion in April (the biggest monthly selloff on record), rebuilt their holdings somewhat through July, and then shifted back into selling mode, meaning that they have now sold more than they have bought since April 2013. Lifers have also remained slow to add to their positions. We attribute this to a flattening of the UST curve —with the 10y yield having ranged between 2.00% and 2.60% even as the Fed has proceeded with multiple rate hikes—reducing the relative appeal of USTs. The flipside is that we see ample potential for Japanese investors to shift into dip-buying mode in the event of overseas yield curves starting to face bear-steepening pressure.
The key question among overseas investors is whether BOJ easing will continue to serve as an anchor for global interest rates. Under the current easing framework, demand from yield-starved Japanese investors should help to prevent overseas long-term interest rates from rising more than modestly. Conversely, if domestic long-term interest rates rise as a consequence of the BOJ commencing "normalization" efforts, then overseas interest rates could rise sharply due to Japanese players seeing less of an incentive to invest abroad. The trajectory of overseas interest rates in 2018 and beyond could therefore depend in significant part on what the BOJ decides and does.
It would not be at all surprising for short- to medium-term JGB yields to move significantly higher if BOJ normalization starts to be seen as a realistic possibility given that (1) foreigners have been by far the most active traders in negative yield short- to medium-term JGBs and (2) BOJ normalization is liable to reduce the FX "hedge premium" available to foreigners (and hence the attractiveness of short- to medium-term JGBs) by causing (negative) USD/JPY basis swap spreads to tighten.
Foreigners' cumulative net purchases have totaled JPY23 trillion for Japanese long-term debt securities and JPY14 trillion for short-term debt securities since the April 2013 launch of QQE, with medium-term JGBs likely to have accounted for much of the former if purchases were indeed funded mostly via the basis swap  market. Up until 2016 net purchases tended to increase when basis swap spreads widened, with this positive correlation reflecting the ability of foreign investors to earn positive spreads over USD LIBOR. However, we would expect foreigners to start reducing their Japanese bond holdings if and when the BOJ commences normalization, in which case short- to medium-term JGB yields might face some quite strong upward pressure until the YCC framework (which will presumably remain in place at least initially) begins to exert its influence once again.
Much will ultimately depend on inflation, but we are wary of bear-steepening risk under the YCC framework
Our US economics team expects US inflation to quicken in 2018, supporting a total of four further Fed rate hikes and a rise in the 10y UST yield to around 3%. The JGB yield curve is liable to face at least some bear-steepening pressure under such a scenario. However, we do not expect Japanese inflation to establish a firm foothold at or above +1% and thus see little prospect of the BOJ actually commencing normalization this year. As such, we will be looking for Japanese investors to step up their purchases of foreign bonds if interest rates move higher, thereby acting as a counterbalance. Irrespective of how many times the Fed hikes, upside for JPY rates is likely to be limited so long as Japanese inflation remains sluggish, leaving foreign bonds as the best means of generating carry. We expect the JGB curve to face a certain amount of bear-steepening pressure in 1H 2018 if overseas interest rates do indeed rise, but bull-flattening pressure may then start to dominate if the Japanese economy loses momentum, domestic CPI inflation peaks out, and the BOJ persists with its YCC framework.
The most obvious risk scenario is that of the BOJ shifting into normalization mode, in which case interest rates could rise quite sharply both at home and abroad. Attention in the first quarter of 2018 is thus likely to be focusing largely on (1) whether domestic and overseas inflation accelerates and (2) whether the Fed hikes once again in March." - source Deutsche Bank
As we pointed out it is still TINA (There Is No Alternative) for the Japanese investing crowd therefore we believe the bear-flattening of the US yield curve will continue its "Iconic memory" movement in 2018.

But moving back to the US dollar and the New Year's hangover, we read with interest Nomura's take in their FX Insights note from the 4th of January entitled "Two factors hurting the dollar":
"As is often the case, markets move when it is least convenient. The dollar has tumbled since mid-December until now – a period when investors were more likely to be embroiled in family dramas and over-eating than to be trading FX markets. Dollar weakness has come despite the passing of US tax cuts, an associated upgrade to US growth expectations and a hawkish Fed. There are many medium-term factors that we think are weighing on the dollar, but in terms of short-term factors, two stand out:
1. The dollar typically falls after a hike. Markets are all about expectations and it was likely the expectation of the December Fed hike that was helping the dollar. The actual hike, then, would naturally reset those expectations and would lead to a “buy the rumour, sell the fact” dynamic in the dollar. Indeed, the dollar has followed a pattern of trading relatively well into Fed hikes, but selling off after (Figure 1).

This time appears to be no different.
2. Rising US inflation expectations could be hurting the dollar. Wednesday’s ISM report showed the prices paid component bouncing back from an earlier dip. Oil prices are marching higher. Importantly, US inflation expectations as priced by US rates markets have consistently risen since early December. The 10yr breakeven from the TIPS market breached 2% in recent days – the first time since early 2017, and the 5y5y inflation swap inflation breakeven has gone above 2.35%. The dollar does not always move with inflation expectations (notably during the” Trumpflation” phase), but typically it does (Figure 2).

Some of this co-movement could be the dollar influencing inflation expectations, but some could be inflation affecting the dollar (through PPP, real yields or “credibility”). Either way, inflation could be returning as a market factor.
Of course, the start of the year is a period when market liquidity is poor. Therefore, we need to be cautious in extrapolating too much from price action, but these two factors do warrant some attention." - source Nomura
It isn't a surprised to see inflation returning as a market factor. A surge in inflation expectations would indeed mark a return of volatility and would be negative for bond yields. If inflation expectations are rising, then again it would continue to be headwind we think on the US dollar. Morgan Stanley in an interesting FX Pulse note from the 4th of January 2018 entitled "New USD Lows in Store" make as well the case for a lower US dollar:
"The case for USD weakness. The USD has come back under selling pressure and the DXY is set to break its early September low. This renewed weakness has occurred despite continued positive US economic surprises (Exhibit 2).

However, we note that the strength of US performance should be taken in the context of the global economy. Global synchronized growth, which should eat into global capacity reserves, will in turn clear the way for a pick-up in investment. Investment requires funding, which augurs poorly for funding currencies.
USD is the world's dominant reserve and funding currency. In order for a currency to be considered a funding currency, it should meet two important criteria: expected funding costs should stay below anticipated returns on investment; and the availability of capital must be ample.

In other words, there needs to be a substantial supply of the currency to be lent out and institutions or individuals willing to lend it. By definition, a dominant reserve currency meets this criterion.
As the world's primary reserve currency, then, it is no surprise that the USD makes up the majority of cross-border foreign-currency lending (Exhibit 5).

Other currencies may temporarily fall into the funding currency category, such as JPY, EUR, and CHF, which have seen periods of significant outflows.
Funding qualifications. The use of QE by global central banks has altered the funding environment, with central banks absorbing outstanding sovereign bonds in exchange for base money. In the case of QE programs from the ECB and Riksbank, EUR- and SEK denominated sovereign bonds held by foreigners declined as a proportion of total bonds outstanding (Exhibit 6).

In comparison, the proportion of foreign holdings of US Treasuries held relatively stable despite the Fed conducting its QE operations.
However, the relative stability of foreign Treasury holdings masks an important underlying shift. While foreign private accounts reduced their Treasury holdings, the ownership by foreign central banks increased. Two factors explain this. First, the Fed's QE operations took place in a period when global currency reserves were rising (2009- 2013), so demand for Treasuries from reserve managers rose in tandem. Second, debt issuance by the US government during this period also increased, so as demand for Treasuries grew with the Fed entering the market, supply also expanded simultaneously.
US assets for sale. Importantly, US agency debt and higher-yielding corporate bonds did experience a significant uptick in foreign holdings. Unlike in Europe and Japan, where private fixed income assets are in relatively limited supply, the US bond market offers a high yielding alternative to sovereigns. This in part explains the increase in the US' net foreign liability position (Exhibit 7).

Private foreign investors selling their Treasury holdings to the Fed reinvested those funds into higher-yielding USD-denominated bonds.
Our key point here is that foreign holdings of USD-denominated debt have increased, while foreign holdings of European debt instruments have declined. A similar dynamic has taken place for equities, where foreign ownership of US equities has more than doubled, which contrasts with trends in the foreign ownership of European equities. An important implication is that, should US assets lose their relative attractiveness (e.g., widening credit spreads, declining equities), then there could be a substantial amount of foreign-held USD-denominated assets for sale. In comparison, the relatively smaller share of foreign-owned assets in Europe renders it more immune to a pullback in foreign sentiment. This is why an environment of rising global bond yields may see the USD lose further ground.
The increase in the US's net foreign liability position comes at a time of relative stability in the US current account, with the deficit fluctuating around 2.5% of GDP since 2009 (Exhibit 8).

However, inward US net foreign direct investment (as provided by the World Bank) has turned negative for the first time since 2006. The composition of US inflows has become narrower, which renders the USD more vulnerable to selling once US equity and credit markets turn lower.
The case for JPY strength. One could argue that foreign ownership within the JGB market has increased, too. The BoJ's QE operations resulted in a significant absorption of JGBs held by the Japanese banking system, which reached the lowest level since 2007 and is now lower than that held by foreign investors (Exhibit 9). 

Importantly, many of these foreign JGBs have been currency hedged - with the FX hedge offering additional income, as opposed to a cost. Indeed, with the widening of the USDJPY basis, the returns offered for asset swaps into Japanese fixed income have increased. These foreign purchases have helped keep JGB yields low, particularly as the majority of the currency-hedged return comes not from the yield on the JGB itself, but from the currency hedge, which renders these foreign investors fairly price-insensitive.
The cross-currency basis represents the cost difference between domestic and offshore FX. A wider basis, all else equal, suggests tight offshore liquidity conditions, while a narrower basis indicates that offshore liquidity is relatively more ample. At this point, the 1 year USDJPY cross-currency basis is trading at its tightest since the summer of 2017, reducing the relative attractiveness of foreign accounts holding FX-hedged JGB exposures (Exhibit 10).
The reduction in this exposure may have no initial FX impact given the FX-hedged nature of the investments. The second order effects, though, are important, as reduced exposures could lead to a potential steepening of the JGB curve. A steeper JGB curve raises the incentive for Japan-based investors to keep funds at home, instead of investing in higher yielding foreign securities. For more detail on our JPY framework and why we no longer view the JPY as a funding currency, see: JPY: Impact of Bank Lending.

The neutral rate matters. Despite the Fed hiking rates 5 times since 2015, the USD will remain the globe's best funding currency. Buoyant financial conditions suggest that the Fed's gradual pace of rate hikes has not yet overtaken the market's perceived neutral rate of interest. The continued easing of financial conditions and the strong growth environment, it can be argued, suggest that the Fed may be behind the curve. Moreover, with soon-to-be Chair Powell taking the reins of the Fed in February, President Dudley planning to retire in mid-2018, and the three vacancies on the Board, markets may begin to question whether the FOMC's reaction function is set to change.
Forget the textbook. Textbook analysis would suggest that the estimated $1.5 trillion deficit expansion as part of the recently-passed tax reform bill, coupled with the limited degree of economic slack, should lead to higher US rates and a stronger USD. However, real yields remain at low levels by historical standards.

One way to explain this dynamic is that markets believe that there has been a structural shift in the mix between growth and inflation. However, another explanation could be a perceived shift in the Fed's reaction function, justifying real yields staying low.
Accommodative Fedspeak. FOMC participants have generally eschewed aggressive policy tightening, remaining instead in favor of a gradual normalization which keeps financial conditions from tightening prematurely. Indeed, despite the 5 rate hikes so far this cycle, financial conditions are at their loosest level since 2014 (Exhibit 13).

The most recent FOMC minutes support this thesis. However, some have also supported a looser regulation approach, most notably soon-to-be Chair Powell, whose comments during his testimony suggested an openness to regulatory reform.

Combining easy monetary policy with financial deregulation suggests that the velocity of money is poised to rise, which bodes well for USD liquidity conditions remaining ample. Other major central banks such as the ECB and the BoJ are also likely to gradually normalize their policy stances. This speaks in favor of the EUR and JPY against the USD as these areas remain investment destinations.
Explaining real yields. What drives real yields? Traditional academic research has suggested that factors such as demand deficiency, demography and aging societies, inequality, and poor total factor productivity are important, and these may explain the current low real yield environment within the DM world.
A recent BIS study has enriched this debate by claiming that the above factors may explain the evolution of DM real yields over the past 30 years, but they fail to explain real yield behaviors in eras preceding the 1980s. Instead, they argue, changes in central bank regimes may have had a bigger impact on the broader evolution of real yields. The current low real yield environment began in the early 1980s when DM central banks began adopting inflation-targeting regimes.
The effects of inflation targeting. Inflation targeting has been successful by maintaining price stability and providing stable funding conditions in the DM and EM alike, which has been an important foundation for EMs to develop income and wealth. Another implication, though, may have been an increase in liquidity preference (increased demand for cash and cash-like instruments) within DM economies which may also explain demand deficiency and, implicity, weak DM investment. This is because low and stable inflation reduces the costs of saving - compared to higher and less stable inflation, which may incentivize consumers to invest in other financial assets or consume.
Creating higher inflation expectations may reduce this liquidity preference, pushing these funds into circulation within the economy. The combination of Fed policy accommodation and financial deregulation may be sufficient to do so. A weaker USD in the FX market would be the side effect.
Bringing China into the equation. Prices tend to fall when supply exceeds demand. DM investment-to-GDP ratios have come down within the post-Lehman environment. However, what investors often miss is that the global investment-to-GDP ratio has been rising since the early 1990s, driven in large part by China (which currently has a 40% investment-to-GDP ratio). Exhibit 17 shows the relationship between the US 10-year yield with the global investment-to-GDP ratio. Yields declined as investment rose relative to GDP.
The fact that much of the investment took place in China, which has closed and regulated capital and financial accounts, may have helped global bond yields to stay low via two key channels. First, China's investment boom had largely been funded by local savings, meaning that little foreign capital was needed (which would have drawn capital away from DM bond markets). High household savings and an accommodative PBoC provided the sufficient liquidity. Second, the emphasis on investment provided a source of latent deflationary pressure, pushing inflation risk premia lower. This, in turn, bolstered the demand for liquidity, as inflation risks were low and stable, and in turn supported subsequent demand weakness.
In general, it is fairly unusual within a historical context to see a domestic investment boom without foreign funding contributing to it. Typically, investment booms and current account deficits (where investment exceeds domestic savings) should go hand in hand. When this is not the case, then funding costs tend to decline. Another example has been Japan's investment boom in the 1980s, which turned Japan into a country of low inflation even before the 1990s and beyond.
The concentration of investment in China, where local liquidity was sufficient to finance it, meant that global demand for capital did not rise, which allowed yields to stay low. Should China's investment boom be replaced by investment in other jurisdictions with open capital accounts, prices may still face disinflationary headwinds, but funding pressures would rise. The Fed, then, has an incentive to counter these disinflationary headwinds by keeping policy accommodative.
Still bullish on EM: The bearish USD story has been seen across the emerging market spectrum too. As risk appetite remains strong, investors will likely focus on vol-adjusted carry again to capture excess return. As seen in Exhibit 18, most of the high-yielding EMFX offers such value and we are bullish on most of these currencies.

We believe that rising global growth momentum, improving EM fundamentals and reasonable valuation in EMFX will prompt new inflows into EM in 2018." - source Morgan Stanley
Whereas Morgan Stanley believes a steeper JGB curve raises the incentive for Japan-based investors to keep funds at home, instead of investing in higher yielding foreign securities, we do not think Japanese investors have much alternative at the moment so the TINA trade will still make them buyers of the dip as mentioned above in our conversation. While we do expect some short term pull-back and US dollar strength in the near term, we do think that from our Iconic memory perspective more weakness lies ahead for the US dollar and given the positive macro momentum, equities wise, we would continue chasing EM over US equities from an allocation perspective. When it comes to credit, it is still "carry on" as we move again towards that famous 11 on the credit amplifier in true Spinal Tap fashion, basically more of the same, though as we pointed out we expect debt-fueled M&A to be a big theme in 2018 which will no doubt deliver some "sucker punches" along the way to the Investment Grade investing crowd, so, as we repeated in various conversations, dust up your LBO screener in 2018.

Yes 2018 has started with a bang with relentless tightening and equities indices racing even higher, the goldilocks environment is still alive and kicking, even if there are some genuine geopolitical concerns on the background. It is still pretty much "carry on". In our final chart below, for those still rooting for US High Yield, financial conditions in early 2018 still remain plentiful. Apart from a surge in inflation expectations that would warrant a faster tightening by the Fed in 2018, we do not see at the moment the catalyst for a sell-off unless of course our Iconic memory is playing with our thought process but we ramble again...

  • Final charts - Credit Conditions in early 2018? Take it "easy"
As we pointed out, the goldilocks environment continues to be supportive thanks to low volatility in various asset classes. Credit conditions remain a key support for sensitive credit such as US High Yield, yet we do think after the significant rally of low beta in 2017 including the CCC bucket, one should start switching from quantity (yield) towards quality (up the rating spectrum). After all the US yield curve continues to bear flatten thanks as well to its Japanese support. Our final charts come from CITI Monday Morning Musings from the 5th of January entitled "Five Charts to Start 2018" and display comforting credit conditions:
"Comforting Credit Conditions
Commercial & Industrial (C&I) lending standards are the key reasons for being comfortable with the upcoming trend in business activity. Figure 9, which is key, illustrates the long-term relationship between the two and Figure 10 provides additional underlying detail. Essentially, easy money lowers the cost of capital and allows corporations to fund hiring plans, capex and working capital needs with C&I credit conditions providing a nine-month lead getting us well into 4Q18. As we have shown in the past, industrial production is very closely correlated with changes in net income.

- source CITI

While the US dollar has started 2018 with a hangover, we do expect a short term rebound in the near future though we remain bearish in the medium term. Meanwhile, no doubt to us, the central banking narrative is changing and it isn't only the Fed which has been retreating from QE, the ECB and even the BOJ are paring as well. Though your Iconic memory might be still playing tricks, you have been warned, the level of the strike on the central banking put is fading we think.
"There is no truth. There is only perception." -  Gustave Flaubert

Stay tuned !

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