Overconfident pilots? Or poor structural design? You decide, but we ramble again.
When it comes to Japan, the decade-high volatility in Japanese government bond debt induced by Bank of Japan Governor Haruhiko Kuroda, similar to Chuck Yeager's flying antics in the NF-104 Starfighter may have the unwelcomed effect of weakening bond prices and therefore undermine economic-growth goals, that famous Q, in MV=PQ. Excess volatility, or "pull-up" for a Japanese plane can be seen, we think in the rise in JGBs volatility - source Bloomberg:
In the case of Japan in general and JGBs in particular, another indicator we have been closely following has been the 30 year Swiss bond yields versus the Japan 30 year bond yields throughout 2012 until the recent "Big in Japan" bang moment following the Bank of Japan "all in" move - source Bloomberg:
As far as the Nikkei is concerned versus Emerging Markets (MSCI EM), our Japanese Chuck Yeagers have really been pushing the envelope - source Bloomberg:
Push the envelope meaning:
"To attempt to extend the current limits of performance. To innovate, or go beyond commonly accepted boundaries."
This phrase came into general use following the publication Tom Wolfe's book about the space programme - The Right Stuff, 1979:
"One of the phrases that kept running through the conversation was ‘pushing the outside of the envelope’... [That] seemed to be the great challenge and satisfaction of flight test."
In aviation and aeronautics the term 'flight envelope' had been in use since WWII, as here from the Journal of the Royal Aeronautical Society, 1944:
"The best known of the envelope cases is the 'flight envelope', which is in general use in this country and in the United States... The ‘flight envelope’ covers all probable conditions of symmetrical maneuvering flight."
So good luck to our Japanese pilot Kuroda. We wonder if this latest surge in QE wars does not amount to a "Kamikaze" approach in dealing with deflation.
Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think.
As we posited on a number of conversation, the difference in the United States PMI and Europe's PMI and the growth outlook is purely a question of credit conditions - PMI US vs Europe (top graph) and US Leverage Loans versus European Leverage Loans (bottom graph) - source Bloomberg:
We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (our case for Europe...).
And, when we look at credit growth for non financial corporates in Europe, the picture cannot be clearer than this:
The absolute level of core European government yields has been falling even more with the anticipation of a 25 bps rate cut next week in conjunction with the expectations of unconventional measures which should be taken by the ECB to restore, somewhat the credit transmission mechanism to the real economy, which has been so absent as of late - source Bloomberg:
But, the new record set up by the Spanish unemployment rate moving at 27.2% in conjunction with Spanish minister Mariano Rajoy seeking a two year extension to tackle its soaring budget deficit to cut its current 10.6% shortfall towards the European limit of 3% by 2016 instead of 2014 is interesting for us for a very simple reason which ties up nicely with this week analogy, namely the non-linearity of public deficits when growth is either absent or very weak. A violent reaction of budget deficits to a loss of economic growth, in similar fashion to a high altitude stall can be very simply explained by a sudden and continuous rise in unemployment levels.
"Past-due loans in Spain have fallen to 161 billion euros ($210 billion) from a high of more than 191 billion euros in November 2012, according to the Bank of Spain, helped by transfers to a `bad bank,' reforms, increased provisions and write-offs. March's estimate-busting surge in unemployment will likely endanger this trend by further pressuring asset quality at both a corporate and retail level." - source Bloomberg
While the unconventional policies and the artificial inflation of asset prices has had few discernible negative side effects to date, the exit risk is clearly extremely large.
Part and parcel of the argument that we have made above is the fact that enormous volumes of non-dedicated money has been encouraged into risk assets, not least across fixed income markets.
Sharp adjustments like the one we have recently seen in gold are likely to become more commonplace in our view. More broadly, the reaction to the mini-backups in US yields early this year also illustrates how prone markets are to withdrawal symptoms.
Credit, in particular, has benefited from being a half-way house, offering less sensitivity to the global downturn than equities and retaining the upside benefit from falling yields. Our US credit strategists calculate that two-thirds of the inflows into US IG credit since 2009 has been through mutual funds and ETFs. A large portion of that will be retail money, more sensitive to total return prospects." - source Citi
Mutual funds and ETFs have seen significant inflows and at the same time inventories in the dealer space are nowhere near the 2007 levels, hence us still "credit dancing" but close to the exit door or ready to pull the handle on the ejection seat. As Matt King from Citi recently put it in his note from April 2013 - Mind the Gap:
And if you think liquidity in the credit space has improved, the unintended consequences of ZIRP from our "Top Guns" means that the turnover in IG corporate bonds is still falling, in similar fashion as velocity is as we move towards the "Coffin corner":
As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
Flying a "Central Bank" or a NF-104 Starfighter requires strict and delicate airplane/monetary control:
"Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via quantitative easing will require interest rate hikes, and may also necessitate asset sales by central banks, according to April's IMF Stability Report. Increased credit and securities losses would be the major negative impacts for banks as rates rise. Bank funding may also be disrupted if asset sales do take place." - source Bloomberg.
So buckle up, because our Central bankers Yeagers are indeed pushing on a string we think as indicated by the "altitude records", or spread tightening levels which are being broken as indicated by the level reached by corporate bonds worldwide as described by John Glover in his Bloomberg article entitled - Record Risk Discounted as Bonds Pass 110 Cents from the 25th of April:
"Corporate bond prices worldwide are poised to set a record as easy money policies by central banks
push investors into riskier investments even with the potential for losses at about an all-time high. Bondholders are paying an average of 110.22 cents on the dollar for the right to receive 100 cents back at maturity plus the interest from coupon payments, according to Bank of America Merrill Lynch’s Global Corporate & High Yield Index. At the same time, the so-called effective duration that measures how sensitive bond prices are to changes in yield has jumped, making the securities about the riskiest to hold ever.
Central bank purchases of government bonds to contain borrowing costs and stimulate economic growth have led investors to pour money into the $10 trillion global market for corporate bonds as they search for yield. Besides betting that interest rates won’t rise anytime soon, investors also face increased risk from restructurings." - source Bloomberg
And as indicated by the same article:
"For every 50-basis-point jump in yields, prices would drop an average 2.85 percent, compared with a low of 2.36 percent in September 2008, according to the average effective duration of the Bank of America Merrill Lynch index. Bond prices rose to a record 110.28 cents on the dollar in November. In 2009, the securities were trading below par." - source Bloomberg.
On a final note, we leave you with a Bloomberg chart indicative of the limited room which stock investors could benefit from a falling US savings rate:
This year’s readings are the lowest since 2007, when the rate dropped as low as 2 percent. The chart shows the trend in savings since a peak of 8.3 percent was recorded in May 2008, when the economy was in a recession. “The potential for a further drop in the savings rate is obviously more limited,” Lapointe and two colleagues wrote in a report yesterday. “The best-case scenario” for stocks would be for savings to stabilize at less than 2 percent of disposable income or to rise gradually, they wrote. Quarterly increases of more than 1 percentage point since 1950 preceded declines in the Dow Jones Industrial Average for the next three, six and 12 months, according to data cited in the report. The Dow industrials moved higher on average when rates rose less than 1 point or declined. “The risk is that the savings rate rapidly bounces back to a more ‘normal’ level of 5 percent,” the report by the Montreal-based strategist and his colleagues said. “This would put additional pressure on equities.” The rate was 6.5 percent in December, when President Barack Obama and Congress were struggling to avert automatic tax increases and spending cuts." - source Bloomberg.
We still think deflation is the name of the game, the rest is poetry, and maybe the 1600 level for the S&P is the "Coffin corner" altitude for stalling where oxygen is rare and lift is low - triple top? - source Bloomberg: