Friday, 28 September 2012

Japan, where credit is leading equities...

"It is better to meet danger than to wait for it. He that is on a lee shore, and foresees a hurricane, stands out to sea and encounters a storm to avoid a shipwreck." - Charles Caleb Colton 

Back in our conversation "Saint-Elmo's fire", our good cross asset friend indicated to us an interesting correlation between the Japan Nikkei index and Japan's Itraxx 5 year CDS since the beginning of March. The index had been falling whereas at the same time, Japan's Itraxx CDS had been rising. The bottom graph indicates so far a fairly muted volatility for the Nikkei index:
As one can see from the above, the Japanese Itraxx CDS has been rising steadily (inverted in the graph for comparison purposes with the Nikkei index) while volatility has remained so far muted on the Nikkei index.

Itraxx Japan CDS climbing - source Bloomberg:

As a reminder from our conversation "Ecce Creditor" from March from Cheuvreux analyst Jolyon-Charles Montague his note "Atlas shrugged" on the 7th of March:
"Japan provides two important lessons for European investors: first, a case study of the perils of failing to achieve structural reform; second, how to invest in and trade a 20-year bear market. We conclude that for the current rally to continue beyond 2012 structural reform must be implemented, deflation averted and regulatory forbearance reversed: no small feat. It is often underappreciated that in 1989 Japan's net public debt to GDP was just 14.4% and the major driver for its explosion was a lack of tax revenue not fiscal largesse. Europe arguably is in a worse position than Japan as it has little room to raise taxes. Furthermore, Japan's government spending excluding social security and interest payments is among the lowest in the world. Given an aging population, Europe is on the verge of experiencing the same surge in social security spending."

Also in our conversation "Structural Instability" we looked at correlations between credit and equities and Japan stood out in particular. Monitoring levels of correlation in the short-term is fundamental if you are looking at adding relative value positions or if you would like using historical signals to position yourself on either credit or equities.

We believe once again credit is a leading indicator particularly when looking at Japanese equities.

Chart Volatility 6 months ATM Nikkei vs CDS ITRAXX JAPAN (50 entities versus 225 names) - source Bloomberg:
The recent Itraxx Japan roll impact on the widening of the Itraxx Japan index amounted to 20 bps of the widening move.

According to our good cross-asset friend, the correlation between the Nikkei volatility and credit spreads represented by the Itraxx Japan index has not been recently materially significant but, the widening of Japanese credit spreads cannot be ignored. In a very bullish credit environment, Japan is the only region (apart from peripheral Europe) where credit spreads are closer to the higher levels reached during the crisis of 2008/2009. This on-going weakness reflects deteriorating fundamentals for Japanese corporate companies such as Utilities suffering since Fukushima, struggling exporters courtesy of a very strong currency with private households hoarding cash, and specific companies facing difficulties such as Sharp and Sony. 
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- source CMA cds data provider.

Therefore we believe this relationship warrants close monitoring. A very important point to make is that Japanese structured products (Uridashi) are totally driving the Nikkei's volatility as long as we are in a range 8,000 / 10,000 on the Nikkei index. Also please note Itraxx Japan has 50 names versus 225 names for the Nikkei index, further investigation in the components in sectorials bias would be needed in our exercise.

The Tokyo Stock Price Index commonly known as TOPIX is tracking all domestic companies of the exchanges First Section (1669 domestic companies). We find there is no opposition between Nikkei and Topix spot prices versus credit.

From the below, and following a similar exercise / analysis, we can find a similar relationship with credit, namely a high correlation in spot prices but not in volatility.

CDX Japan / TOPIX:
Correlation at -82.24%

CDX Japan / 12 months ATM TOPIX Volatility:
Correlation at 18.94%

We can therefore conclude that our Japanese "uneasiness" or discomfort courtesy of many years of "easiness" is indicative of the growing deterioration of some Japanese corporates, namely the ones being quoted in the CDS market. Globally, Japanese corporates remain "cash" rich but nevertheless the cracks are beginning to show in relation to Japan. Japanese output fell by 1.3% in July and Japan is headed for contraction this quarter.

Japanese Sovereign CDS 5 year evolution since 2004 - source Bloomberg:

The Japanese fight against deflation goes on...

On a final note in the latest spat between China and Japan, trade wise, China looks to have the upper hand:
"Japan’s increased dependence on China for export sales gives officials in Beijing the upper hand in a territorial dispute that triggered street protests and forced Chinese units of Japanese companies to close plants. The CHART OF THE DAY compares Japan’s exports to China, the European Union and the U.S. measured in billions of yen, showing sales to China more than doubling between 2002 and 2011 as the nation became the No.1 market. Exports to America dropped by almost one third and EU demand was little changed. The lower panel tracks nominal gross domestic product of the Asian countries, with China surpassing its neighbor as the world’s second-largest economy in 2010 in dollar terms, data compiled by Bloomberg show. China’s share of Japanese exports doubled over the decade to 20 percent. By contrast, the U.S. bought about 15 percent of Japan’s exports last year, half the proportion in 2002. The shift underscores China’s clout in a fracas over control of islands called Diaoyu in Chinese and Senkaku in Japanese."  - source Bloomberg

"Every government has as much of a duty to avoid war as a ship's captain has to avoid a shipwreck." - Guy de Maupassant 

Stay tuned!

Thursday, 27 September 2012

Credit - The World of Yesterday

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself."  
Stefan Zweig (1881-1942)

Our chosen title this week is a direct reference to the great writer Stefan Zweig's final masterpiece "The World of Yesterday". With the growing unrest in Europe and in particular Spain, we thought a reference to the great Stefan Zweig was appropriate given he remained all his life a pacifist and advocated the unification of Europe. It was unfortunately the growth of intolerance, authoritarianism and nazism and his feeling of hopelessness for the future that led to his suicide on the 23rd of February 1942 in the Brasilian city of Petropolis, but that's another story. 

Back in June in our conversation "Agree to Disagree", we indicated that until US Treasury Yields rose significantly in response to stronger growth and a healthier global economy, a secular bull market is not in the cards if history is any guide, although lower yields are indeed giving arguably more incentive to shift from bonds to stocks:
"When looking at the growing divergence between US stocks and US Bond yields, and softening US economic data, one can wonder our long US investors can "agree" to "disagree".

In our previous conversation we argued that the latest round of QE policy followed by the Fed would be hindered by US Corporate Borrowing given the already very low levels of funding which might overwhelm any growth in bond demand. Once again it seems to us that the latest policy enacted by the Fed looks farfetched and is that of engineering yet again another attempt in "wealth effect" in order to trigger shareholder spending as indicated by Bloomberg:
"Spending by households invested in stocks may determine whether the Federal Reserve’s efforts to bolster the economy bring more jobs, according to Jack Ablin, chief investment officer at Harris Private Bank. As the CHART OF THE DAY shows, the Conference Board’s consumer-confidence index has failed to keep pace with gains in retail sales during the past three years. Ablin cited a similar chart in a note yesterday after the board said the sentiment gauge rose to a seven-month high in September. The Fed is building confidence by holding down interest rates, which has lifted share prices along with home values, he wrote. The Standard & Poor’s 500 Index rose to its highest level since 2007 after policy makers agreed to open-ended purchases of $40 billion of mortgage-backed debt each month. “Retail spending is the next step in the Fed’s convoluted job-creation policy,” Ablin wrote. Sales growth brings higher corporate profits, which in turn lead to additional hiring, according to the Chicago-based strategist’s note." - source Bloomberg.

Yes, September's reading from the Conference Board, for the sentiment index was indeed at 87.4, more than any other time since January 2008, exceeding by 17.1 points the estimate. But, consumer "fear" might derail this plan and magnify the US fiscal cliff woes as indicated by Bloomberg:
"A slump in consumer spending may exacerbate any U.S. recession stemming from the so-called fiscal cliff of automatic tax increases and government spending cuts, according to Mike Englund, chief economist of Action Economics LLC. The CHART OF THE DAY shows Englund’s baseline forecast of a slow recovery in U.S. growth if the automatic fiscal changes are avoided, and his projection for gross domestic product if lawmakers fail to avoid the cliff. “I would assume that GDP growth would drop to a zero-to-1 percent contraction rate in first quarter and second quarter,” Boulder, Colorado-based Englund said in an e-mail. “A ‘fear’ or ‘panic’ effect might add to this if households pulled back in fear of the economic consequences of the news flow, and if stock prices fell and yields rose as markets feared sovereign defaults.” The economy expanded at a 1.7 percent annual rate from April through June after a 2 percent gain in the first three months of the year, Commerce Department figures showed Aug. 29. Consumer purchases, which account for about 70 percent of the economy, also grew 1.7 percent, the weakest in a year. Spending has cooled as the labor market struggles to improve. Employers added 96,000 workers to payrolls in August, less than economists projected, after July’s 141,000 gain, Labor Department figures showed Sept. 7." - source Bloomberg.

As far as we have seen as of lately, considerable data improvement has been priced in current stock prices, leading us to feel rather "uneasy" in this sea of "easiness". "Fundamentals" wise, economic support is indeed lacking for additional US stock gains as reflected by Bloomberg so "Mind the Gap":
"As the CHART OF THE DAY shows, the Standard & Poor’s 500 Index’s ratio to projected earnings has risen in the past four months as the Institute for Supply Management’s new-orders index for manufacturing has slumped. Knapp showed the contrast with a similar chart in a Sept. 14 report. Since June, the ISM gauge has been below 50, indicating more companies reported a drop in new orders than an increase. The index was last below the threshold in April 2009, when the U.S. economy was in recession. Indicators like this need to rebound for stocks to move higher, Knapp wrote in the report, because the economic outlook is one of two forces weighing on share prices. The other is the prospects for public policy, specifically regarding the federal government’s debt and deficits." - source Bloomberg.

Not only does the projected earnings have been rising but an upcoming earnings recession may soon put some additional pressure on US stocks as we moved towards the third quarter earnings season, hence our title give projected earnings as reflected in current stock prices look to us increasingly indicating "The World of Yesterday" and not 'The World of Tomorrow", sticking with our deflationary stance.
"Lower second-quarter profit has paved the way for an “earnings recession” that will hurt stocks, according to Jonathan Golub, chief U.S. equity strategist at UBS AG. As the CHART OF THE DAY illustrates, earnings at the Standard & Poor’s 500 Index’s non-financial companies fell in the second quarter and may drop again in the third. The result would be the first back-to-back declines since 2009, according to data that Golub presented yesterday in a report. “It’s very hard for the market to move forward when earnings aren’t progressing,” the New York-based strategist wrote on the 5th of September in an e-mail." - source Bloomberg.

On top of that the large Capital Good Orders drop at the end of August which have declined in four of the past five months is as well an early warning signal about future shipment growth turning negative in the near future:
“When the level of orders falls below the level of shipments, this tends to be a warning signal that future shipment growth will turn negative,” Feroli, chief U.S. economist at JPMorgan Chase and Co. in New York, said in a research note on the 24th of August. While orders have had a spotty record in predicting sales, when the degree of divergence gets this large, the correlation is tighter, Feroli said. He cited research by economists at the Federal Reserve in Washington that showed once orders are 1 percent to 2 percent weaker than shipments, the latter will probably shrink, hurting GDP. Bookings were 5.2 percent lower than sales in July, today’s Commerce Department report showed. Minutes of the Fed’s last meeting issued this week said many policy makers thought further action would probably be needed “fairly soon” without evidence of “substantial and sustainable” improvement in the recovery." - source Bloomberg.

While orders for durable goods slumped 13%, the most since January 2009, consumer confidence in the US climbed for a fifth straight week to -39.6 from -40.8. The "somewhat" improving housing market is indeed supporting the markets but as far as Europe is concerned Europe Economic confidence is in the doldrums, and dropped from 86.1 in August to 85 in September. Record unemployment and a deepening slump with euro-area contracting 0.2% in the second quarter are putting a strain on consumer confidence.

Following up on our previous conversation dealing with "Zemblanity" and why these Central Banks operations will eventually fail, we would like at this juncture to remind ourselves of what we wrote back in May 2010 in our conversation "The inflation debate or why you can have inflation in a deflationary environment":
The initial MV = PT Fisher equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.
Fisher's equation:
MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place
"We are currently in a deflationary environment which poses no short term threat of massive inflation, but creates a risk of high inflation, if there is no debt restructuring at some point, as well as some profound structural reforms in public finances in the very near future, which will push us towards a double dip recession. It is unavoidable."

As a reminder:
"In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:
Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:
1.Debt liquidation leads to distress selling and to
2.Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3.A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4.A still greater fall in the net worths of business, precipitating bankruptcies and
5.A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6.A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7.pessimism and loss of confidence, which in turn lead to
8.Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
9.Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest
." - (Fisher 1933)

We wrote at the time:
"Therefore a perceived inflation can happen in a deflationary environment, it can co-exist."

In the post "Low rates environment and the risk of evergreening à la Japanese", we described the following:
"Companies "are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty. Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet."
We concluded our December 2010 conversation making the following important point:
"It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery."

To illustrate the above important point, we think the convergence between Iceland's  5 year CDS and Ireland is a compelling display of the impact an accelerated restructuring can have on economic recovery. We have discussed at length this important point back in our conversation in March entitled "Equities, there's life (and value) after default"): "By preventing default, creative destruction cannot happen in true Schumpeter fashion"- source Bloomberg:
Iceland and Ireland are now only around 68 bps apart when looking at their CDS spreads ("Iceland - The Great Debt Escape" - August 2011). - "He who rejects restructuring is the architect of default." - Macronomics.

We agree with the recent comments from Exane BNP Paribas from their QE3 FAQ from the 21st of September:
"The effective impact of QE3 may be less elevated than suggested by econometric models, for two reasons. First, interest rates and mortgage rates have already reached record lows, without triggering much additional business investment. In other words, investment has been much less sensitive to interest rates than in the past and it is uncertain whether a further decrease in yields can change this situation. Second, the mortgage market remains impaired, as close to 50% of households with a mortgage cannot refinance or get a loan at the record low market rates due to their lack of equity."
"In sum, while QE3 will certainly help the economy in sustaining asset prices and financial conditions, this support should remain modest in the short term due to the excessive leverage that remains in the household sector. If financial conditions stay at their current level, we would expect a positive impact of around 0.25 points over the next year. Of course, this is a static estimate. Financial conditions may continue to improve as the Fed continues to buy long-term assets, or they could deteriorate if another shock hits markets. In any event, monetary policy would not be able to offset a sizeable fiscal shock that might occur in the coming quarters. Our base scenario is that fiscal policy would wipe out 1.2% of 2013 GDP, much more than monetary policy can currently add to growth." - source Exane BNP Paribas.

We think Dr Bernanke is indeed going "all in", expecting the "bluff" will be enough to raise expectations and therefore boost the economy and changing expectations.

There would be an easier way to boost the prospect for a return of economic growth and it would mean improving service for struggling homeowners given US banks have been failing to adhere to at least two sets of servicing guidelines since 2010. The Home Affordable Modification Program, that required speedy response from banks has repeatedly been ignored. As indicated by Bloomberg in their article - "Banks That Flunked Servicing Tests Face Watchdog" by Hugh Son from the 25th of September:
"One in five U.S. residential units are underwater, or tied to loans that are bigger than the value of the home, according to CoreLogic Inc., a Santa Ana, California-based mortgage data firm. Of those 10.8 million properties, 15 percent have fallen behind on payments."

We believe accelerating the restructuring process and the deleveraging of US households would be far greatly effective in helping out the US economy in the on-going deleveraging process otherwise the US risk facing "evergreening" à la Japanese as indicated above and might never move back towards "The World of Yesterday".

From the same Bloomberg article:
"The five biggest servicers have given about $10.6 billion in relief through June, mostly in the form of short sales in which a delinquent borrower’s home is sold for less than the amount owed, Smith said last month in a report. That results in fewer credits because servicers get less than 50 cents on the dollar for short sales. They are expected to ramp up loan modifications in the coming months."

Moving on to credit, we believe credit is becoming incredibly expensive and crowded akin to a potential  "Bull Trap" as indicated by CreditSights in their latest Euro Issuance Performance review from the 26th of September:
"With two days left before the end of September, fixed rate-euro denominated issuance has already easily exceeded all previous September issuance volumes with 52 billion Euro of investment grade and high yield deals brought to market. 
Those deals have broadly performed well, especially those from the stressed-eurozone countries. 
But outperformance remains reliant on improvement in the sovereign situation. And so while stressed-country new issues offers attractive yields and compelling new issue premiums, they could prove a trap for investors when volatility returns and liquidity disappears."

We already discussed at length the risks of dwindling liquidity in credit markets. Back in our July conversation "Hooke's law" we argued:
"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."

In our last conversation we also indicated the following worrying trend:
"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance. Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz..."."
Our concerns have been duly validated by the following information relating to the covenant quality of new deals from the following Bloomberg article - "Bond Sales Approach $1 Trillion in Third Quarter: Credit Markets" - 27th of September:
"Bond investors are also accepting looser terms from speculative-grade companies. A Moody’s measure of weakness in bondholder protections included in U.S. junk-rated debt increased to 3.94 in September, the worst since November. The gauge, known as a covenant-quality score, compares with 3.71 in August and a 2012 average of 3.72 through last week, according to Moody’s. “In environments where there is a lot of demand, investors will have less say in the covenant package,” said Matthew Musicaro, an associate analyst at Moody’s. “Either you invest in the deal or you don’t.” Moody’s reviewed covenants on 41 bonds sold through Sept. 21 and focused on covenants including those that restrict the use of cash, investments in risky assets and leverage. The deals are rated on a scale of one to five, with five representing the weakest covenants."

Mouse trap, or Bull Trap, it is indeed definitely loaded...

"We can't forever be spending our lives paying for political follies that never gave us anything but always took from us, and I am content with the narrowest metes and bounds provided I have peace and quiet for work." - Stefan Zweig

 Stay tuned!

Saturday, 22 September 2012

Credit - Zemblanity

"Insanity: doing the same thing over and over again and expecting different results." - Albert Einstein

Last week, we ventured towards the diminishing returns QE in the US would have on the real economy. While you might be puzzled by our latest choice of title, we ought to give you, dear readers, some rational explanation in this week title selection. William Boyd, the novelist and screenwriter (who wrote the latest James Bond novel), used the term "zemblanity" to mean somewhat the opposite of "serendipity": "making unhappy, unlucky and expected discoveries occurring by design", which is exactly what central banks over the world will eventually discover with their latest merry go rounds of quantitative easing. So in our long credit conversation, we will investigate further the potential for disappointment from this latest round of "easing" from our "Generous Gamblers" which have been flooding the markets recently with even more liquidity.

Definition of Zemblanity - "The inexorable discovery of what we don't want to know".

While serendipity means a "happy accident" or "pleasant surprise"; specifically, the accident of finding something good or useful while not specifically searching for it, zemblanity is the opposite. Robert K. Merton  in Social Theory and Social Structure (1949) referred to the "serendipity pattern" as a fairly common experience of observing an "unanticipated, anomalous and strategic datum which becomes the occasion for developing a new theory or for extending an existing theory" as indicated by Wikipedia.

What we found most interesting is the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3%. Now at 63.5% the US is back to 1981 and velocity is still cratering (1.58), back to 1965 level - source Bloomberg:

Back to the Future? So although in the movie Dr Emmet "Doc" Brown was trying to find a way to return to 1985 from 1955, we have "Doc" Ben Bernanke expecting QE3 will be successful in increasing the labor participation rate and velocity back to 1997 and successful in reducing the unemployment burden on the US economy. It will not happen.
President Ronald Reagan, was a fan of the film "Back to the Future" and referred to the movie in his 1986 State of the Union Address when he said, "Never has there been a more exciting time to be alive, a time of rousing wonder and heroic achievement. As they said in the film Back to the Future, 'Where we're going, we don't need roads.'" Unfortunately this is not 1986 in terms of economic outlook.

So what "Doc" Bernanke is telling us now is that "Where we're going, we need jobs" basically. Nice wishful thinking.
MV=PT as per Irving Fisher's equation. Unfortunately, it looks like the increase in M with a falling V, is not leading to a rise in T nor in a rise in the US labor participation rate for "Doc" Bernanke. Velocity and US labor participation rate from 2005 onwards - source Bloomberg:
Milton Friedman was convinced he could rebuke Keynes theory by showing that the velocity of money was relatively fixed and thus that the relationship between the money supply and national income could therefore fall apart if Friedman's assumption was indeed correct. It wasn't. Velocity is not constant and Friedman admitted on the 19th of August 2003 he was wrong:
"Prior to the 1980s, the Fed got into trouble because it generated wide fluctuations in monetary growth per unit of output. Far from promoting price stability, it was itself a major source of instability. Yet since the mid '80s, it has managed to control the money supply in such a way as to offset changes not only in output but also in velocity. This sounds easy but it is not -- because of the long time lag between changes in money and in prices. It takes something like two years for a change in monetary growth to affect significantly the behavior of prices. The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply -- a veritable bubble in velocity. Chart 2 shows what happened. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003."

But Keynes was also wrong. For Keynes the quantity of money did not matter, what mattered were autonomous spending and the multiplier. By keeping interest low to promote investment, like the Fed is currently doing, full employment would therefore be "attainable". For Keynes, the velocity of money would move together with the level of economic activity (and the interest rate).

We think the above charts indicating M2 and the US labor participation rate are indicative of the failure for both theories. Both theories failed in essence because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows".

Our core thought process relating to credit and economic growth is solely based around the very important concept namely the accounting principles of "stocks" versus "flows":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

We encountered through our weekly blog reading an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: "We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b). 
 To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit."

We therefore wonder in relation to the latest bout of global quantitative easings the following:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

So can someone please demonstrate to us how "this time it is going to be different" in terms of outcome for the US labor market given the "paradox of thrift" with bank reserves sitting idle at the Fed like we indicated in our previous conversation, with a broken transmission to the US economy, and questions surrounding fiscal stimulus which could potentially alleviate the situation (tax breaks for small companies anyone...)?

We came across this comment from a participant on a macro research forum from a prominent global research firm and we did find it very appropriate in relation to our title analogy, namely "Zemblanity" and thought we had to share it:
"Isn't QE3 in one sense a blow to the essence of America's prosperity, free markets and with that efficient capital allocation? Setting a target for unemployment rate by running the printing press sounds a lot like a planned economy. It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan? Have we become so short sighted and spoiled that we can't face the hard facts of our previous reckless childish behavior? I can't think of any time in history when avoiding the truth ever was a sustainable choice. Only history will tell but FED, ECB, BOJ and BOE (soon BOC?) all being in the same boat makes you worried about unintended consequences.... I'm 100% long risk for the moment but long term I think this takes us further from a sustainable world."

"we can't face the hard facts of our previous reckless childish behavior" - No, we clearly cannot.
Definition of Zemblanity - "The inexorable discovery of what we don't want to know".

"It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan?"
Of course it will! The Bank of Japan is already losing out to Yen-hoarding households! - source Bloomberg:
"The Bank of Japan’s efforts to weaken the yen are being undermined as households hoard the most currency in 14 years, according to Mizuho Corporate Bank Ltd. The CHART OF THE DAY tracks the yen’s rally versus the dollar and the deposit-assets and currency holdings of domestic savers. Also shown is the start of central bank monetary easing through the asset purchase program set up in October 2010, which has had limited impact on the currency. The yen rose the past two days even after the BOJ’s surprise Sept. 19 announcement of more asset buying, contrasting with stimulus efforts in February that helped weaken the currency for five weeks. BOJ quarterly flow of funds data yesterday showed individual investors, often referred to as “Mrs. Watanabe” because many are housewives, increased yen deposits and cash to 844.1 trillion yen ($10.8 trillion) in the three months ended June 30. That’s the most since at least December 1997 and double the annual output of Japan’s economy, the world’s third largest." - source Bloomberg

Back in early September in our conversation "Structural Instability", we indicated that the overall underperformance of Japanese credit spreads as illustrated from the below graph on some selected Japanese companies (source CMA) which continue to weaken in conjunction with their Sovereign CDS (Japan's sovereign CDS wider by  20 bps in one month) is at present the only notable disconnect between credit spreads and spot equities.
[Graph Name]

The Japanese relationship between equities and credit warrants monitoring and could be played by selling CDS and buying Nikkei Put Options we indicated in early September courtesy of our good cross-asset friend. Nikkei Put Options benefit from absolute low volatility levels. Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since March 2010 until the 21st of September 2012 - source Bloomberg:

In similar fashion to the current Japanese plight, the Fed will eventually discover soon that company debt sales will counter its bond buying plan - source Bloomberg:
"Increased borrowing by companies may blunt the economic effects of the Federal Reserve’s third round of bond purchases, according to Michael Shaoul, chairman of Marketfield Asset Management LLC. As the CHART OF THE DAY shows, U.S. companies have already sold more than $1 trillion of dollar-denominated debt this year, according to data compiled by Bloomberg. The year-to-date total is 22 percent above the average for the previous five years. “Corporate debt should act to absorb the cash” generated by the Fed’s quantitative easing, Shaoul wrote yesterday in an e-mail. The central bank will buy $40 billion of mortgage-backed securities a month in an effort to stimulate economic growth and reduce unemployment. Borrowing costs for companies were unusually low before Fed policy makers reached their decision last week. Yields on Baa rated corporate bonds are less than 5 percent, according to a Moody’s Investors Service index. They fell below the threshold this year for the first time in more than a quarter century. As more companies take advantage of the relatively cheap funding, they may overwhelm any growth in bond demand that stems from the Fed’s buying and related bond investments, Shaoul wrote in the e-mail “Our greatest concern regarding QE3 was that it was not only unnecessary, but may in the end prove to be positively harmful,” he wrote yesterday in a report highlighting this year’s increase in corporate borrowing. He said the risk arises because bonds will be unable to match their gains in the past few years “unless we truly face an ‘end of the world’ type depression.”." source Bloomberg.

We ended up last week's conversation by indicating:
"The fight against deflation goes on..."

Bank of America Merrill Lynch report from the 11th September entitled "Bernanke and Draghi's deflationary bubbles wrote the following in relation to the on-going deflationary forces at play we mentioned on a regular basis: "Bubbles forming in the Three Wise Themes Some of the assets tied to the Three Wise Themes of Yield, Growth and Quality are exhibiting bubble-like characteristics (see chart below). But these deflationary bubbles are just beginning to form. The ECB has now joined the Fed in using liquidity injections in the war against deflation. Consequently, the prices of assets tied to the Three Wise Themes are likely to inflate further until central banks can normalize monetary policy. The RIC therefore remains overweight large-cap US Growth, preferred stocks, EM stocks, investment grade and high yield bonds and significantly overweight international bonds. We remain underweight US Treasuries, small-cap stocks and Value stocks."

Indeed it is going on. Richard Koo, the chief economist at Nomura Research Institute wrote in his 19th of September note entitled - Excitement over new policies that may have only limited impact:
"Borrowers, not lenders, are in short supply during balance sheet recessions I used the term “unnecessary” to describe recent central bank actions because balance sheet recessions are characterized by a massive surplus of private savings. In noneurozone countries, these funds have nowhere to go but the government bond market, since the government is the last borrower standing. That is why government bond yields fall steadily, as they did in Japan even prior to 2001. In other words, it is borrowers that are in short supply when the private sector is saving money and paying down debt in spite of zero interest rates. Under such circumstances it is difficult to see what economic benefit could arise from adding the central bank as a lender when the bottleneck of the economy is elsewhere."

Exactly! This even more the case when you factor in the demographic impact the "Baby Boomers Generation" has had and will have on US treasury markets (74 million to retire in the next 20 years) as we posited in our last conversation "Pareto Efficiency" and so was the impact on yields from Japan's aging population on JGB's yields.  In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, it is that simple, and the losers today being unfortunately the younger generation in "developed" countries. Therefore, we believe that, from an allocation point of view, investing in Fixed Income Emerging Markets countries, having both favorable demographic trends (young population) and decent current account balances, makes a lot of sense from a long term investment perspective, but we ramble a lot. Time for a credit overview!

The Itraxx CDS indices picture is displaying a different picture from last week given the 20th of September saw a change in the composition of the Itraxx family of credit indices - source Bloomberg:
While overall the Itraxx credit indices reflecting credit risk in various components of the credit markets ended up Friday flat following the week, we think it is interesting to note the following changes in terms of risk structure in relation to the composition of the new series of Itraxx Credit indices (series 18). While credit risk, has overall decreased in the last six months mostly for non-financial investment grade credit (Itraxx Main Europe 5 year index back to March level of around 120 bps) by courtesy of the various central banks interventions, the latest iteration of the Itraxx Main Europe investment grade index has seen various peripheral names dropping out such as Spanish Repsol (negative outlook by Moody's and Fitch), Italian bank Banca Monte Paschi dei Siena (550 bps cost for 5 year Senior CDS) and Spanish Bank BBVA (325 bps cost for 5 year Senior CDS). Both peripheral banks in the Investment grade index have been replaced by Dutch bank ING (172 bps on 5 year Senior CDS) and UK bank Standard Chartered (120 bps on 5 year Senior CDS). Therefore the new names being added to the Investment Grade index have lower default risk and lower volatility than the ones removed. Only 11 names of the new 125 entities making the new Itraxx Main Europe index come from Italy and Spain (none from Portugal, Ireland or Greece).
But more importantly the changes in the Itraxx Crossover series 18 (which references the 50 most liquid European High Yield and low triple B rated credits) have seen the arrival of Spanish giant Repsol as a result of the rating actions in conjunction with the negative outlook. 14 members of the 50 names of the Itraxx Crossover index now come from peripheral strained countries.

While rolling from the old Series 17 to the new series 18 (selling series 17 and buying series 18) cost you around 5 bps for the Itraxx Main Europe (investment grade risk gauge), a similar roll for the Itraxx Crossover cost you around 65 bps on Thursday. Whereas the roll for the Itraxx Financial Senior index and Itraxx Financial Subordinated index was around -11 bps for Senior and -20 bps for Subordinated, reflecting the improvement in quality of the index with the addition of ING and Standard Chartered and the removal of BBVA and Monte Paschi dei Siena (MPS).

One can expect that going forward, the series 18 should be more volatile for the Itraxx Crossover whereas the Itraxx Main Europe, Itraxx Financial Senior and Subordinated index should be less volatile given the substitutions of the entities making up these various indices.

Looking at the below graph, one could argue that severing of the link between Sovereign risk / Financial risk is somewhat happening given the significant drop of the spread between the Itraxx Financial 5 year Senior index reflecting financial risk and the SOVx 5 year index representing Sovereign CDS risk in Western Europe. It is deceptive given that the new series 18 for the Itraxx SOVx index which comprised previously 15 entities, has seen Cyprus falling out of the index because of lack of trading in CDS linked to Cyprus's debt - source Bloomberg:
We expected Cyprus to drop as we indicated on the 24th of March 2012 in our post "The Spread Also Rises": "Replacing Greece by Cyprus is the SOVx series 17 index might not be enough to preserve the 15 member's number status. On the 13th of March, Moody's rating agency joined its peer Standard and Poor's in slashing Cyprus to junk status on heightened concerns over its banking sector’s exposure to Greece. Only Fitch rating agency has maintained its rating for Cyprus one notch above junk."

The main concern of European authorities has been trying to break the close relationship between sovereign risk from financial risk. Many European politicians are expecting that the European Banking Union will finally break this relationship. But in fact, the ECB's two LTRO operations so far have not only increased the link but made it in effect more acute as indicated by a graph realized by global macro research house Gavekal:

In relation to the European bond picture, this week Spanish 10 year yields closed around 5.80% but flirted again with the 6% as the pressure is building for Spanish Prime Minister Rajoy in seeking official support whereas Italian 10 year yields still well below 6% around 5.00% whereas German government yields receding towards the 1.60% levels with other core European bonds yields rising as well in the process - source Bloomberg:

Clearly our "Generous Gambler" Mario Draghi's effect is fading as indicated by Bloomberg:
"European Central Bank President Mario Draghi’s pledge to buy short-dated government bonds may not be enough to end investor concern that Spain’s debt is unsustainable and the country will need a sovereign bailout. The CHART OF THE DAY shows that Spanish 10-year bond yields climbed past 6 percent today for the first time since Sept. 7, the day after Draghi gave details of the central bank’s asset-purchase plan. Since falling to a five-month low of 5.55 percent on Sept. 10, the yield jumped as much as 46 basis points to a high of 6.01 percent today. The yield reached a euro-era record 7.75 percent on July 25, before Draghi pledged the next day to do “whatever it takes” to safeguard the monetary union." - source Bloomberg.

On a side note we were quite amused to read Bundesbank President Jens Weidmann's reference to Faust, in reference to Mario Draghi's bond-buying programme "OMT" in similar fashion to our  "Generous Gambler"  analogy: "If a central bank can potentially create unlimited money from nothing, how can it ensure that money is sufficiently scarce to retain its value?" and added: "Yes, this temptation certainly exists, and many in monetary history have succumbed to it".

"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

Weidmann intended his speech and his reference to "Mephistopheles" and the money printing to point towards the risk of creating rampant inflation.

But as far as credit is concerned, spread wise, the process is more akin to "Japanification" rather than rampant inflation for the time being. In Societe Generale's Market Wrap-Up from the 17th of September they made the following interesting points:
"The light we see at the end of the tunnel isn't that of sustained economic recovery, nor is it that of the eurozone's issue being resolved or the US fiscal cliff issues ameliorated. It's that we are switching overnight to a pragmatic view of the world. We have decided that with all the liquidity sloshing around and the additional recent central bank actions, peripheral sovereign downgrades to junk (Spain to come?) should be no barrier to buying peripheral corporate risk. The freed up money needs to go somewhere and blue chip, national champions from the periphery are deemed as being unlikely medium-term defaulters - should the euro remain intact. In the past couple of sessions alone, Spanish and Italian corporate risk has rallied by between 50-75bp (and by some 150-200bp since the beginning of August). So all that liquidity finds itself pressing on corporate bond yields and the ‘herd’ is in thunderous form, heading in the same direction - hopefully it's not towards the precipice. 
Which means that corporate credit spreads are going into Japanification mode. The unlikely triumvirate of low growth, low rates and low yields have become the corporate bond market’s friend. And we're now ratcheting tighter, led by higher yielding financials where T1 and LT2 prices lead, although most high beta risk is in vogue. The iBoxx cash corporate is now at B+196bp and has tightened 164bp this year. We now target B+165bp for year-end. Returns for IG are close to 19%, HY at 17% and, even if we hold here at worst, this will still finish as the second best year ever for corporate credit. We might still - likely will - get some jitters along the way. Spain's expected downgrade might see some (temporary) weakness; a Greek flare up might too; and, political event risk elsewhere is quite possible. Otherwise, the ECB taking govvies out of the market is keeping liquidity plentiful and it needs a home. Some of it keeps rolling into credit, helping the supply to get mopped up, keeping confidence at elevated levels. 
Non-financial issuance YTD is now close to €130bn which is the long-term annual average; and we are now looking at somewhere well over €150bn for the full year. That's more than double what we had forecast at the beginning of the year. The €22bn for September alone is massive and we still have two weeks to go. And nearly half of the issuance has come from the periphery. Furthermore, if we can get past €26bn by the end of the month, we'll be looking at September in the context of it being the fifth best month for non-financial supply - ever. We can't get enough financial risk either. Senior paper is tightening fairly consistently amid poor secondary market liquidity. Almost €95bn has been printed YTD which is close to our €100bn forecast for the year. And the way the technicals of the market are playing out, we're in the mood to absorb much more issuance and see banks raise funds at ever decreasing costs. €125bn looks like the next stop."

As far as credit is concern, it still "Risk-On" for now, but we are definitely moving more and more in expensive territory which is not supported by a favorable economic outlook based on the latest economic releases (European PMIs). Both the Itraxx Main Europe 5 year index and Itraxx Financial Senior 5 year index are converging, indicative of falling risk aversion - source Bloomberg:

But as we posited before when quoting Bastiat around our liquidity concerns, there is what you see and what you don't see (from our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen").
As a reminder, back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

In a recent article by Mary Childs in Bloomberg entitled "Swap Traders Scrape Bottom in Fed's New World from the 21st of September we read the following that made us chuckle in a 2007ish way:

"With the global speculative-grade default rate holding at 3% in August, below the average of 4.8 percent as measured by Moody’s Investors Service in data since 1983, investors see less of a need to hedge against losses, according to Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP that oversees $45 billion of assets. “CDS is so yesterday,” she said in a telephone interview. “The will to buy default protection is diminished because you figure you don’t need it.”
We disagree with the above.

Back in August in our conversation "The Unbearable Lightness of Credit" we argued:
"Yes, in this "unbearable lightness of credit / low yield" environment default will indeed spike at some point even for banks, consequence of the gradual disappearance of IGs (Implicit Guarantees). One can also argue that the advantage of explicit guarantees is that markets tend to "function" better under them. To quote again Dr Jochen Felsenheimer from his recent monthly letter:
"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"

We also indicated at the time:

"The unintended consequences of banks deleveraging and increased regulations means banks are in risk reduction mode leading to lower inventories provided to the market place which are at the lowest levels since 2002. Traders are as well jumping ship towards Hedge Funds. We already touched in liquidity issues in our conversation "Yield Famine".

In credit markets, liquidity can fast become a problem. Should the credit market experience a consequent sell-off, losses will be fast and furious. One should polish its "Bayesian learning" once in a while or take the great risk of becoming a victim of some "irrational exuberance" or "euphoria".

From the same Bloomberg article: "Investors have funneled $55.9 billion into high-yield bond funds globally this year through Sept. 12, breaking the previous record set in 2009 by $24.1 billion, according to data compiled by Cambridge, Massachusets-based EPFR Global."

This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance. Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...". Covenant-lite financing amounts to corporate credit on lax terms, where most covenants such as maintaining a certain level of profits are waived by deal-hungry lenders and were previously used to finance before the 2008 crisis big leveraged buyouts. Corporate loans typically include provisions, or what we call covenants. They can trigger a "default" if finances deteriorate, even if the borrower is still paying interest. This forces the company to negotiate with the bank lenders, often allowing to force a restructuring. Covenants also act as early warning system when the credit metrics of a company start to deteriorate.

In true Zemblanity fashion and credit market insanity as we posited at the time:
"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky".

In 2008-2010, less than 10 billion USD worth of covenant lite loans were issued. This anemic issuance period combined less than the 535 billion issuance of 2007. In 2011, 40 billion of covenant lite loans were issued and the leveraged loan volume was 373 billion USD. Refinancing was the purpose of 2011 borrowings for 54% while LBOs only represented 14%. There was a low default rate in 2011, less than 0.5%. Loans have been much "juicier in terms of yield than 10 year treasuries with B rated loans offering Libor +520 bps and BB- offering L+411 bps. Back in May 2012, 31 billion USD of leveraged loans were issued in the first two weeks hence our previous post. While European borrowers cannot easily get covenant lite in Europe, they come to the US. The default rate is higher in Europe in 2011 was higher than in the US at 4.1%.
- source Covenant-Lite Loans - Emerging Trend in the Syndicated Loan Market.

We do agree with some of the conclusions from the presentation quoted above:
"-He who has the gold, does not always make the rules.
-The market does not learn for long.
-Human nature does not change."

It looks to us we are indeed on the path towards "Zemblanity", with a difference discovery outcome as one could expect from "Serendipity".

On a final note we give you Bloomberg Chart of the day indicating that the Yen may climb to a record as the Bank of Japan lags the behind the Fed in all this Zemblanity experience:
"Yen printing by the Bank of Japan is trailing money creation by the Federal Reserve and European Central Bank, boosting risks the Asian nation’s currency will rise to record levels, according to Mizuho Securities Co. The CHART OF THE DAY shows that Japan’s monetary base, a measure of money in circulation, has grown more slowly than those of the U.S. and the euro area since September 2008 when the collapse of Lehman Brothers Holdings Inc. prompted central banks to buy bonds in a bid to stem a global crisis. The lower panel shows the yen has risen 27 percent over the same period, as measured by Bloomberg Correlation-Weighted Indexes, while both the dollar and the euro slid. The yen strengthened to a seven-month high of 77.13 per dollar on Sept. 13, nearing the post-World War II record of 75.35, when the Fed announced its plan to buy $40 billion a month of mortgage debt in a third round of so-called quantitative easing. The ECB unveiled its own unlimited bond-purchase program a week earlier." - source Bloomberg.

"Insanity in individuals is something rare - but in groups, parties, nations and epochs, it is the rule."
Friedrich Nietzsche

Stay tuned!

Saturday, 15 September 2012

Credit - Pareto Efficiency

"This is no time for ease and comfort. It is time to dare and endure." - Winston Churchill

While in last week conversation we mused around our "uneasiness" in the current "easiness", the latest round of Quantitative Easing iteration number 3 courtesy of Dr Ben Bernanke at the Fed, made us wander towards an important economic as well as engineering concept for our title, namely the Pareto Efficiency:
"In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off. Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made." - source Wikipedia

The impact QE2 has had on commodity prices has been clearly analyzed in a very interesting paper from the Bank of Japan - Recent Surge in Global Commodity Prices back in March 2011.
Given that in a Pareto efficient economic allocation, "no one can be made better off without at least one individual worse off", looking at the causality between the Arab Spring and the rise in commodity prices, one has to wonder what will be this time around the impact worldwide of this latest round of "easing" from the Fed, hence our title.

Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops. 

Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.

The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788), of course any similarities with this year's meteorological events are purely fortuitous given we are rambling again...Are we?

In similar fashion to QE2, QE3 has already triggered a significant rise in Inflation Expectations - source Bloomberg:
"The CHART OF THE DAY shows the gap between yields on 10- year Treasuries and same-maturity inflation-protected notes, a gauge of consumer-price expectations, jumped to the widest since May 2011 after Bernanke said the central bank will buy $40 billion of mortgage debt a month. It also charts five-year U.S. inflation swaps that let holders exchange fixed interest rates for returns equal to price gains. The figures suggest inflation will climb after dropping to the lowest since 2010. “We will see higher inflation pressure in the next few years,” said Hiroki Shimazu, an economist in Tokyo at SMBC Nikko Securities Inc., a unit of Japan’s third-largest publicly traded bank by assets. “It will be difficult to control.”
The breakeven rate -- the difference between yields on 10- year notes and Treasury Inflation Protected Securities -- widened to as much as 2.54 percentage points today, the most in 16 months. The swaps climbed 12 basis points to 2.50 percent yesterday, the biggest one-day jump since February 2011, data compiled by Bloomberg show. Annual inflation was 1.4 percent in July, about half the 3 percent pace at the end of 2011." - source Bloomberg

Those who follow us know that we have been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 was announced - source Bloomberg:
QE2 saw a surge of the SPX (Standard and Poor's 500) as well as a surge in oil prices as well as significant surge in US Treasuries yield, which surge by 100 bps from 2.50% to 3.50%. 2011 saw a significant correlation with SPX, Oil and US treasury yields falling significantly during the "risk-off" period triggered by liquidity. This time around, one can expect during the on-going "risk-on" period to see as well rising US Treasury yields in conjunction with surging SPX and oil prices.

We discussed asset correlation back in May in our conversation "Risk-Off Correlations - When Opposites attract". Whereas in "Risk-Off" periods the dollar acts as a powerful magnet for investors seeking safe haven, whenever there is a Fed meeting week, it ultimately weighs on the Dollar index as indicated by Bloomberg:
"The CHART OF THE DAY shows the gauge, which measures the dollar against the currencies of six major trading partners, has fallen the week of FOMC meetings four out of five times this year. The Dollar Index fell 1.7 percent in the week of Jan. 25 when the central bank extended its pledge to keep interest rates near zero until 2014. The measure declined 0.3 percent in the week of the March 13 gathering even as the Fed raised its assessment of the economy." - source Bloomberg.

This time was not different. The Dollar Index fell to around 79 with Gold rising in the process as indicated in the below graph displaying the Dollar Index versus Gold since June 2011:

"Pareto efficiency is an important criterion for evaluating economic systems and public policies. If economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements can be made to at least one participant's well-being without reducing any other participant's well-being." - source Wikipedia.

Therefore in this week credit conversation we would like to delve into the diminishing returns QE has on the real economy following our usual credit overview.

The Itraxx CDS indices picture displaying yet another very significant rally in the credit derivatives space below the March lows for some indices - source Bloomberg:
The High Yield risk gauge indicated by the Itraxx Crossover index (50 European entities) is tighter this week by another 40 bps courtesy of the third round of QE triggered by the Fed. The move tighter for credit derivatives indices was significant on Friday with the Itraxx Crossover index tighter on the day by 35 bps and with the Itraxx Financial 5 year subordinated index closing below its March lowest point of 313 bps at around 300 bps. It wasn't only the Itraxx Financial Subordinated 5 year index falling to the lowest levels since the series 17 was launched in March, the Itraxx SOVx index (15 Western Europe sovereign CDS including Cyprus) declined by 10 bps towards 173 bps, retreating for a 10th straight week, the longest-ever streak.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
Clearly, the HY risk gauge indicated by the Itraxx Crossover is moving towards expensive territory close to 400 bps falling in synch with volatility. The gap between the Itraxx Crossover and Eurostoxx volatility has closed.
As well as the European High Yield market, the US High Yield market continues to perform and becoming a cause for concern as a market maker put it bluntly:
Why has the market rallied and stayed bid? Here's one reason.....Massive credit issuance continues. Monday was the LARGEST day of US corporate issuance ever (14 deals, $19bn) and the largest day for European corporate issuance this year (9 deals, E7.5bn). Yield! Yield! We know that companies are using this money for one thing more than any other: Buybacks. Non directional activity in US stocks (gamma hedging, liquidity providers, quant strategies) has become over 65% of activity...."
From a credit point of view, we believe buybacks are credit negative.

Yes, the last two weeks have seen an "avalanche" of new issues coming to the market given the prevailing tone in markets leading to 19.3 billion euros worth of new issues coming to the markets with 12 billion alone last Monday. While core non-financial issues are getting more and more unattractive, there was a flurry of new issues coming from peripheral countries, such as Energias de Portugal on Friday which came to the market with 750 million euros worth of bonds which drew 7.5 billion in orders from 475 investors at a yield of 5.875% from an initial 6.25%. It was the first issue for Energias de Portugal (EDP) in the last 18 months. Effectively EDP had been shut out of the markets since February 2011.

This directly a translation of the pressure easing on Portugal sovereign CDS 5 year spread, as indicated in the below graph displaying Portugal 5 year sovereign CDS versus Ireland sovereign 5 year CDS:
Both Ireland and Portugal's respective CDS continue to Converge from -891 bps apart early 2012 towards -170 bps apart.

But, the severing of the link between Sovereign risk / Financial risk has yet to happen. The main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index has been trying to break that close relationship, expecting that the European Banking Union will finally break this relationship. We doubt it will - source Bloomberg:
The ECB is to be given new powers in the framework of the single supervisory mechanism for Eurozone banks. The EBA and national supervisory authorities will continue to carry out day-to-day tasks. While this change in profile is akin to an additional step towards a banking union, it is as well a precondition of the ESM's ability in lending directly to banks and part of the move towards fiscal, economic and political union. Given our "bipolar disorder" markets are in a positive "mania" phase, this ECB expanded role has been so far well received leading to further tightening in Itraxx Financial Spreads, sovereign CDS spreads and rising European financial stocks. The "unelected" President of the European Commission José Manuel Barroso set out this week his "vision" for Europe, namely a "federation of nation states". CreditSights recent report entitled - ECB Bank Supervision - The Road to Banking Union, indicated the following important points: "According to the commission between October 2008 and October 2011, European countries "mobilised Euro 4.5 trillion in public support and guarantees to their banks". It wants to break "the vicious circle between banks and sovereigns". However, whether this is achievable through a banking union is doubtful. The majority of most banks' assets are located in their home country and therefore intertwined with their local economy, and banks tend to hold large (and increasing) portfolios of home country government securities, which itself makes the link between the sovereigns and banks difficult to break. However the Commission is more concerned with removing the burden on national governments of bailing out their banks. It would probably be more logical to reduce sovereign risk first, but that is more difficult, practically and politically, than trying to fix the banks".

In relation to the European bond picture, the move was less dramatic for peripheral bonds this week with Spanish 10 year yields around 5.80%, slightly below 6% whereas Italian 10 year yields still well below 6% around 5.00% whereas German government yields continued rising, this time around towards 1.70% levels with other core European bonds yields rising as well in the process - source Bloomberg:

As far as "Flight to quality" picture is concerned, it is clearly pointing towards "Risk-On" with Germany's 10 year Government bond yields rising towards 1.70% and the 5 year CDS spread at 52 bps converging - source Bloomberg:

Both the Eurostoxx and German 10 year Government yields are still moving in synch in "Risk-On" mode in with rising German Bund yields towards 1.70% yield level and a stronger Eurostoxx 50 at the end of the week converging with the Itraxx Financial Senior 5 year index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:
It's definitely called capitulation in the credit (bear?) space. The flattening of CDS curves is indeed happening with forward prices collapsing especially on 2/5 CDS curves, 3/5 and 1/5. On top of that the Itraxx Crossover 5 year CDS index versus the Itraxx Main Europe 5 year index is compressing, meaning the bull is back for now.
As a market maker rightfully commented: "Pure capitulation from Macro Funds is round the corner".
Back in our previous conversation "The Uneasiness in Easines" we argued:
"The lag in European stocks given the very recent negative tone in Europe has made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead to an outperformance of European stocks versus US stocks."
We stick to our call.
We have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:

In fact Spain's falling CDS may indicates additional extension of the on-going rally as displayed by Bloomberg:
"As the CHART OF THE DAY shows, Spain’s benchmark IBEX 35 Index has moved inversely to credit-default swaps on the country’s five-year bonds since 2010. The CDS contracts have tumbled since Sept. 6, when European Central Bank policy makers agreed to implement an unlimited bond-buying plan to boost confidence in the euro. The IBEX 35 has jumped 34 percent from this year’s low on July 24 as ECB President Mario Draghi pledged to do whatever it takes to preserve the single European currency and Federal Reserve Chairman Ben S. Bernanke said he would provide further
Moving on to the subject of the diminishing returns QE has on the real economy, we recently commented in the blogosphere our discontent with Dr Bernanke's latest round of QE and for obvious reasons we think. Namely that QE3 will only prove that monetary policy alone cannot prop up the labor market because in normal times triggering inflation expectations should trigger a credit boom, but given this is not your normal recession but a Balance Sheet Recession (BSR), it will eventually fail again.

We could not agree more with Cheuvreux's latest Microscope publication by Nicolas Doisy namely that:
"So far, only QE-2 is actually a quantitative easing as it has elicited banks into pure cash hoarding, while QE-1 (an emergency action) was credit easing. But QE-2's ability at capping nominal yields is stumbling against the law of diminishing returns: the impact of QE-2 is just around half that of QE-1.
While unmistakably signaling a real credit crunch, the QE-2 cash-hoarding also elicited an actual but temporary pent-up in inflation expectations.
If it has thus managed to reduce real interest rates, QE-2 has proved unable to prop up wage inflation, the effective driver of trend price inflation. Likewise, a QE-3 would just prove that monetary policy alone cannot prop up the labor market, as banks would keep hoarding cash and not lend it."

Indeed QE2 was arguably a period of credit crunch due to banks hoarding cash and QE2 did trigger inflation expectations upwards (via resumption of credit) but insufficiently to sustain credit expansion according to Nicolas Doisy's recent note:
We already touched on the impact credit conditions have had to the US growth versus Europe back in our conversation with the help of our friends from Rcube Global Macro Research in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...":
But avoiding a non-deflationary growth would entail fiscal stimulus in order to avoid a Japanese style deflation.
"The CHART OF THE DAY shows the yield on the benchmark Treasury 10-year note since 2005 has closely tracked the first seven years of Japan’s slow-growth period that started in 1990. That is a correlation central bankers should keep in mind when formulating policy, said Porter, deputy chief economist at BMO Capital Markets in Toronto. “It’s a tad unnerving,” Porter said in an interview. U.S. rates have followed Japan’s even as the Federal Reserve has been more successful than the Bank of Japan in fighting deflation, or a protracted drop in prices. “This could be a long-grinding episode where yields bounce around at low levels for an extended period of time,” he said. While there are plenty of differences between the two countries -- such as their rates of inflation, the aging of the population in Japan and the relative strength of U.S. financial institutions -- there are also similarities, said Porter. These include severe financial crises and protracted periods of weak growth that are difficult to shake off, he said. If U.S. Treasuries were to continue following the trajectory of securities for the world’s third-largest economy, the yield on the 10-year note over the next 15 years would decline to about 0.75 percent -- in line with the current level of Japan’s 10-year bond." - source Bloomberg.

Because, a decline in wage inflation is indeed a clear deflationary sign (paradox of thrift). Wage inflation has kept trending down since November 2008 with the exception of a short-lived plateau in November 2010 to August 2011 according to Nicolas Doisy' s recent report. QE2 has been running out of steam since with wages driving price inflation down again:
"The continued decline in wage inflation is a sign of deflation taking root as it is translating into rising household saving rate and decelerating consumption. Both reflect the impact of paradox of thrift / paradox of toil.
-aggregate demand is insufficient to kick-start growth (paradox of thrift).
-labor productivity gains are not accurately compensated (paradox of toil).
The final lesson is that any QE3 is pretty unlikely to ever be able to turn wage inflation around with no other pro-active policy aimed at the labor market. This is yet another sign of the paradox of thrift / paradox of toil: even unconventional, monetary policy is pushing on a string as long as fiscal policy does not come to the rescue to prop up the labor market. This one of Bernanke's recurrent messages."
"The central reason behind the QE's inability at durably triggering upward inflation expectations is that the Fed's cash does not leave the banking system. In simpler terms, the Fed's cash sits idly on the commercial banks current account at the Fed. It thus never sees the light of the real economy, just as if banks were anticipating an indefinitely continued decline in wage inflation and, thus aggregate demand." - Nicolas Doisy, Cheuvreux.

Fed's new easing will do little to lift bank lending:
"As the CHART OF THE DAY illustrates, banks reduced the amount of reserves held at the Fed’s regional banks and made more money available to businesses in the past 12 months. The shifts took place even though the central bank’s total assets were little changed, as Michael Shaoul, CEO of Oscar Gruss and Son Inc's wrote on the 11th of July in a report.
“This point is sadly missed by those looking for a new round of quantitative easing,” the report said. Between 2008 and last year, the Fed bought $2.3 trillion of debt securities in two rounds of easing to support economic expansion. Bolstering reserves through a third round of purchases “will not increase the supply of or demand for credit,” the New York-based analyst wrote. Reserves for the week ended July 4 were $179.2 billion lower than their peak last July, according to data compiled by the Fed. The decline coincided with a $171.2 billion increase in commercial and industrial loans, based on central-bank data. “This is precisely how monetary policy can affect domestic activity,” wrote Shaoul, who also helps oversee more than $2 billion as Marketfield Asset Management LLC’s chairman. “What it cannot do is magically increase employment.” - source Bloomberg

In addition to cash sitting idling on the commercial banks current account at the Fed, the business bank-balances boom is as well hurting the US economy (yet another sign of the paradox of thrift at play):
"Companies may have to tap into their bank balances in order for U.S. economic growth to accelerate, according to Pierre Lapointe, Brockhouse and Cooper Inc.’s global macro strategist.
As the CHART OF THE DAY depicts, U.S. non-financial companies held a record $931 billion of checking and savings deposits as of March 31, according to figures compiled by the Federal Reserve for quarterly flow-of-funds reports. Deposits more than doubled from June 2009, when the latest recession ended, as the economy grew 6.3 percent. “Corporations are still cash rich and could provide a much-needed boost to the economy,” Lapointe wrote on the 12th of September in a report that presented a similar chart. “We need companies to come in and start spending.” Cash is rising as companies guard against the risk of another slump, the Montreal-based strategist wrote. Data on capital spending, dividends, stock repurchases and takeovers
point toward the same conclusion, according to Lapointe, who prepared the report with two colleagues. “Even though they have cash in the bank, companies do not feel as rich as they used to,” he wrote. The ratio of cash to assets for the Standard & Poor’s 500 Index has declined about half a percentage point in the current economic expansion and now stands at 8 percent, according to the report. Checking accounts held 40 percent of non-financial companies’ deposits at the end of the first quarter, and the
other 60 percent was in savings. Deposit figures at the end of the second quarter will be included in the Fed’s next flow-of-funds report, due Sept. 20." - source Bloomberg.

Nicolas Doisy concluded is recent note with the following important point which we agree with:
“All in all, the US strategy to exit the current deflation(ary) trap misses the point by focusing only on monetary policy, while a fiscal stimulus is also needed. In other words, labor is insufficiently compensated for the sole reduction in real interest rates to kick start growth. So, either labor is given a larger bargaining power or it must receive massive money transfers to start spending again.”

Given that in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, investors are facing indeed an increasingly strong dilemma, due to the growing number of US retirees and a falling yield environment:
"The Baby Boomers Generation is that huge post-war cohort born between 1946 and 1964. The first wave of baby boomers turned 65 in 2011. It is estimated that during the next 20 years, roughly 74 million "boomers" will retire in the United States. That is an average of more than 10,000 new retirees a day!
The rest of the world also had their own "baby booms". The United Kingdom, France, Denmark, The Netherlands, and Australia are just some of the other countries considered to have had Baby booms starting around 1946." - source Keenan Overseas Investors.

As far as consumers and The Wealth effect is concerned courtesy of yet another round of QE, as indicated by Keenan Overseas Investors:
"- Many US and European property markets have significant unsold inventories.
- New generation of young adults in the US weighed down by student debt.
- Consumer demand reduced when people consider themselves poorer.
If interest rates increase, all of these problems get worse!"

The fight against deflation goes on...
"Trouble springs from idleness, and grievous toil from needless ease." - Benjamin Franklin

Stay tuned!
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