Friday, 5 August 2016

Macro and Credit - Thermidor

"The seed of revolution is repression." - Woodrow Wilson, American president

Watching with interest the disappointment unfold thanks to Bank of Japan's holding pattern, pushing us to quickly take our loss and cut our small short yen exposure, while looking at the news that France was about to harvest the least wheat in 28 Years, it reminded us for our title analogy, the French Republican Calendar implemented during the French revolution and used by the French government for about 12 years from late 1793 until 1805, with Thermidor (or Fervidor) starting the 19th or 20th of July and coming from the Greek "thermon" meaning "summer heat". On many printed calendars of Year II (1793–94), the month of Thermidor was named Fervidor (from Latin fervens, "hot"). Looking at the performance of European banks stocks since the beginning of the year and following the publication of the "stress tests", we do think indeed that our title is indicative of a build up in "summer heat", at the same time it is as well indicative of the significant performance in credit which was yet given another boost thanks to the latest Bank of England raft of decisions. 

What is of interest in the Republican calendar was the tentative in the alteration of time measurement we think:
"Each day in the Republican Calendar was divided into ten hours, each hour into 100 decimal minutes, and each decimal minute into 100 decimal seconds. Thus an hour was 144 conventional minutes (more than twice as long as a conventional hour), a minute was 86.4 conventional seconds (44% longer than a conventional minute), and a second was 0.864 conventional seconds (13.6% shorter than a conventional second).
Clocks were manufactured to display this decimal time, but it did not catch on. Mandatory use of decimal time was officially suspended 7 April 1795, although some cities continued to use decimal time as late as 1801." - source Wikipedia
This was part of a larger attempt at decimalisation in France (which also included decimal time of day, decimalisation of currency, and metrication). When we look at the effects of Negative Interest Rate Policy aka NIRP, we can only think about the attempt of central bankers towards "decimation" of European bank stocks, decimation meaning to destroy a great number or proportion of. On a side note France introduced "decimilisation" of the franc in 1795 to replace the "livre tournois", abolished during the French Revolution whereas the United States introduced decimal denomination from the outset of home minted currency in 1792 with the dollar being equal to 100 cents.

Of course our use of a French revolutionary calendar term is as well a reference to our previous conversation from September 2012 "Pareto Efficiency" where we indicated the following when it comes to "wheat prices" and "revolutions":
"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?" - source Macronomics, September 2012
Now, going towards 2017 with first the Italian referendum in October, then with some important elections taking place next year in both France and Germany, we are wondering if indeed "Thermidor" will not lead to yet another summer of discontent in 2017 given the the significant rise of populism tied to the "War on Inequality" mentioned recently by Michael Hartnett's team in the latest Bank of America Merrill Lynch Thundering Word note from the 29th of July entitled "Fiscal Flip...Get Real":
"Long View
The policy baton is passing from Monetary to Fiscal stimulus in 2016/17. Central bank
rate cuts ending. New policies to address populist desire for "War on Inequality"
emerging. Policy response will be combination of:
1. Redistribution…stagflationary: winners…TIPS, munis, low-end consumption (retail,
payments, tax services); losers…brokers, luxury, growth stocks; yield curve bear
2. Protectionism…deflationary: winners…government bonds, gold, volatility, high
quality defensive stocks; losers…banks, multinational companies; yield curve bull
3. Keynesianism…reflationary (with “helicopter money): winners TIPS, commodities,
banks, value; losers…bond substitutes; yield curve bear steepens.
Fiscal flip reflects policy intent to reduce deflation, wealth inequality and wage
insecurity. Success means rotation from “deflation” to “inflation” assets; note real
assets (commodities, collectables & real estate) now at all-time lows relative to financial
assets (stocks & bonds) – Chart 1.
- source Bank of America Merrill Lynch
Could this rotation from "deflation" to "inflation" trigger indeed a surge in commodities? We wonder...

The only issue is once the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:
“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”
As we have repeatedly pointed out, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" as shown by the latest yet unsurprisingly dismal US GDP print. This of course leading to a "pre-revolutionary" mindset setting in, leading to the rise of "populism" and the deafening sound of "helicopter money" and fiscal profligacy as the "elites" and their central bankers are starting in earnest to "panic" somewhat. We will touch more on this in our conversation.

In this week's conversation we would like to reiterate, like many others our concern relating to the continuation of tightening financial conditions as per the US Senior Loan Officia Survey relative to the rally seen so far in US High Yield thanks to massive inflows from the retail crowd. While we remain tactically short term bullish, or "Keynesian", we do feel fundamentally "medium term" bearish" or "Austrian" given current "credit valuations" do not reflect the deterioration in economic fundamentals. On that note we were not surprised at all by the latest US GDP print, given in January 2016 in our conversation the "Ninth Wave" we indicated:
"Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.
We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should "risk" decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy." - source Macronomics, January 2016
When it comes to our positioning relative to the US recessionary crowd, we believe that a flattening of the US yield curve is never a good sign, particularly for the financial sector which has been vaunted by some as a "compelling" buy.

Why is so?

Underperformance by the banking sector always is a bad sign for markets and the economy; it suggests that the credit mechanism is clogged, with knock-on effects for the rest of the economy, that simple.

  • Macro and Credit - Is it High Noon for US High Yield tourists?
  • Macro and Credit  - Investing Greed leaning towards Investment Grade
  • Final chart: Bank stocks under pressure? Blame central banks

  • Macro and Credit - Is it High Noon for US High Yield tourists?
For tracking credit availability, you need to use the central banks’ credit surveys. The most predictive variable for default rates remains credit availability. 

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

As we pointed out in our November conversation "Ship of Fools", credit investors are often too complacent when it comes to assessing the stage of the credit cycle and when it comes from the retail crowd aka the US High Yield tourists, they have been pouring "inflows" at a very late stage of the "game":
"Furthermore, despite their alleged high degree of sophistication, credit investors have a very weak predictive power on future default rates. This was largely discussed by our Rcube friends in their long March 2013 guest post entitled "Long-Term Corporate Credit Returns":
Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this manic-depressive behaviour (which can also be related to Minsky’s model of the credit cycle)." - source Rcube
From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.
"When default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to mal-investment, and sows the seeds of the next credit crisis." - Macronomics, November 2015
Lather, rinse, repeat. 

While it isn't yet "high noon" per se for the US High Yield tourists, the latest publication of the US Senior Loan Officer Survey confirms clearly a deteriorating trend in financial conditions which is indeed down the line (most likely in 2017) a recipe for a serious "repricing" of the asset class as a whole. To re-iterate our November call, we remain short-term "Keynesian" bullish / long term "Austrian" bearish when it comes to assessing the current stage of this credit cycle. This should provide sufficient proof for us not being labelled "perma-bears" or having a "pessimism bias" but, rather a "realistic bias" we think.

When it comes to assessing global credit conditions, we share our concerns with UBS and read with interest their latest Global Credit Strategy note from the 2nd of August entitled "Q2 Lending Conditions: Why did lenders tighten?":
"Q2 Lending Conditions: Why did lenders tighten?
A critical linchpin in our frameworks for assessing credit spreads, defaults and the read-through to macro implications is the state of lending conditions. And, to cut to the chase, recent releases could aptly characterize current conditions as increasingly uncomfortable, albeit not alarming. The improvement in our non-bank liquidity indicator since March has stalled, with the latest reading rising from 7 to 9.1 – principally due to less robust issuance of lower-quality high yield debt since April. In our view, this gauge is superior to the Fed's SLOS survey tracking bank liquidity conditions given nearly 80% of corporate funding is done via non-banks. That said, our non-bank indicators have now largely converged with the Fed's bank liquidity gauge, with net tightening of credit standards on C&I loans to SMEs increasing from 5.8 to 7.1 in the latest survey (Figure 1).

Notably, we do not believe the latest SLOS survey results were significantly affected by the UK's Leave vote (as banks received the survey on June 28, and responses were due by July 12). For C&I lending conditions, the rationales given from bank loan officers for shifts in lending standards continued to be dominated by net tightening attributed to a weaker economic outlook and industry problems versus net easing due to competition; however, in terms of shifts there were fewer officers reporting industry specific problems (e.g., energy, but prior to the latest decline in oil prices) as a reason for tightening, more respondents citing lower risk tolerance and higher regulatory concerns as rationale for tightening, and more noting increased competition as a driver of easing (Figure 2).

And lower risk tolerance and greater regulatory pressures would be consistent with sentiment from the latest Shared National Credits (SNC) review, which continues to highlight concerns related to an elevated level of special mention and classified (i.e., higher risk) loans which may increase defaults this cycle and the prevalence of incremental facilities allowing greater sharing of priority claims which may lower recovery rates1 . In terms of our key forecasts, our HY spread forecast increases from 660bp to 666bp (vs 566bp current), our HY default forecast is unchanged at 5 – 5.5% by mid-2017, and our credit-based probability of recession rises to 33% from 31% (over the next 12mos).
Why the discomfort? First, the persistent albeit moderate tightening trend in C&I liquidity conditions bears watching as the relationship is not linear; i.e., further increases in net tightening from current readings will disproportionately increase spreads, defaults and recession risks in our models, respectively, when compared with commensurate decreases in net tightening (e.g., see recession gauge sensitivities on net tightening – Figure 4). 
Second, our prior concerns related to significant easing of lending standards and rising credit risks in other sectors seem to be trending in the wrong direction2. In particular, lending standards for commercial real estate (CRE) loans contracted further, with aggregate (debt-weighted) net tightening of 27% from 20% the prior quarter (CLD to 31% from 25%, nonfarm nonresi to 18% from 12%, and multifamily to 44% from 36%). While not cited, we believe the tightening reflects increased regulatory scrutiny (e.g., 2006 CRE guidance, risk retention requirements) as well as concerns around lax lending standards and lofty valuations. 
At current levels, the significant tightening observed in CRE standards, which is historically reasonably well correlated with C&I standards (as we have detailed previously), is near historical extremes (as per Figure 4).
Aside from commercial lending, the mosaic from consumer and residential sectors has been more benign in prior surveys. However, there were some signs of less easing in consumer loans – with net tightening in auto loan standards moving from -6.3 to 0 (while in credit cards net tightening was -5.6 vs -5.7 the prior quarter). Banks reported higher spreads on auto loans, and higher spreads and lower credit scores for credit card loans. For residential loans, the SLOS survey overall signaled marginally less easing – i.e., the second derivative is negative. However, like C&I loans, residential lending is primarily driven by non-bank lending (Figure 5).
In turn, the Fed's SLOS survey results should be taken with a grain of salt. One alternative, which encompasses non-bank lending, is the AEI's change in its National Mortgage Risk Indices (NMRI) 3 . This metric, updated monthly and based on actual loan origination risk metrics, suggests that while banks are reducing risk in residential originations (for FHA/VA/RHS primarily), non-banks are increasing risk in a bigger way – causing a net easing of credit conditions in resi. This point illustrates that non-bank lending standards are increasingly (if not more) important than bank lending conditions in some asset classes and, in particular, in instances when the signals can diverge. And, in this instance, continued easing in residential mortgage credit conditions is one development which is helping offset the more persistent, marginal to moderate tightening in lending standards across other asset classes. In short, for now the prognosis is increasing discomfort, but not alarm." - source UBS
Whereas the SLOS survey doesn't yet point out to "High Noon" for our US High Yield tourist friends from the retail space, we do think that the evolution of tightening financial conditions is a harbinger for things to come in 2017, namely spread widening and a rise in defaults. We do agree with UBS and share their increasing discomfort. 

As well, on the deterioration of the credit cycle, we read with interest Oaktree's insights in their special edition "Navigating cycles":
"Bruce Karsh: How does this credit cycle resemble and differ from past credit cycles?  
Rajath Shourie, Co-Portfolio Manager, Distressed Opportunities: The down-leg of the current cycle feels most like the down-leg we experienced in the early 2000s, when too much capital came into a popular industry; that industry blew up; and the dislocation spread to other industries. In the early 2000s, telecom was the darling industry that went bust. Today it is energy. In the early 2000s, a majority of the high yield bonds issued by telecom companies defaulted, and unless oil prices make a major recovery, today’s exploration and production companies are likely to face a similar fate.
Jordon Kruse, Co-Portfolio Manager, Global Principal: I’ll focus on a comparison of the current downleg to the one we experienced in 2008-09. They are similar in that both followed long periods of significant debt issuance, but different in that there is far less systemic risk today than there was in 2008-09. A major driver of that risk was the substantial amount of bad mortgage securities held by large financial institutions that played a major role in the financial system at large.
Bruce Karsh: What is your expectation for defaults this year?  
Sheldon Stone: The 2016 default rate for U.S. high yield bonds is projected to increase to between 5 and 6%. This compares to the 2015 default rate for U.S. high yield bonds of 2.8% and the 30-year average of 4%. While this 2016 estimate is higher than what we’ve seen since 2009, it is not meaningfully higher than normal observations. As you would likely guess, defaults this year already have been—and will be—heavily impacted by oil prices. I believe that easily two-thirds, or maybe even three-quarters, of the defaults this year will stem from energy-related issuers. 
Bruce Karsh: Outside of China, what factors do you think are exerting the greatest impact on the current market environment?  
Sheldon Stone: The obvious ones are low energy and commodity prices; however, those are linked to China. The other one worth highlighting is liquidity. Current trading markets are significantly less liquid, causing rapid changes from a buyer’s market to a seller’s without large trading volumes. We estimate that today, banks are carrying about 20% of their 2007 peak inventory of senior loans and high yield bonds.  As a result, banks are now looking for trades to cross, rather than putting their capital at risk.  It doesn’t take much selling these days to move bond prices a fair amount. 
Rajath Shourie: I completely agree with Sheldon. Prices have recently been declining dramatically because there’s a buyers’ strike at play, not because there is a lot of supply from forced sellers." - source Oaktree insights, July 2016
When it comes to "liquidity, to that effect we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":
Today investors face the same "optimism bias" namely that they overstate their ability to exit.
“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
Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain such as the gains seen in single A credit in the United Kingdom following's the Bank of England early "Christmas present" for the speculating crowd. Yes indeed, the fun is "uphill", in the bond market.

When it comes to "Thermidor" or "investment heat", when it comes to "investment grade" credit, the summer heat is truly "on". This leads us to our second point below.

  • Macro and Credit  - Investing Greed leaning towards Investment Grade
While we have been predicating for the right reasons to stick with quality Investment Grade credit since the beginning of the year (particularly as per our last post on Senior Unsecured bank credit rather than equities...), even recommending a long duration exposure to the asset class, the ECB playing the "corporate credit game" now being followed as of late by the Bank of England points towards even more "fun" running uphill to this particular segment, or, to put it bluntly, "Investment Greed" is leading to "Investment Grade". When it comes to "flows", the "summer heat" is indeed "on" during our "Thermidor" period rest assured as pointed out by Bank of America Merrill Lynch in their latest Follow The Flow note from the 5th of August entitled "Largest inflow into IG funds ever":
"Large outflows from equities; large inflows into IG 
Inflows into high-grade have accelerated. Over the past four weeks inflows have been almost doubling on a w-o-w basis. However, while inflows into credit have been strong, equity funds have been suffering continuous outflows over the past 26 weeks. Should the recent trend continue, the inflows that came into the asset class since 2015 would be erased in the next 10 weeks or so (Chart 1).  
High grade funds recorded their 21st week of inflows and the highest ever since the start of our data set (table 1).

Flows into the asset class have doubled w-o-w, and propelled the year to date cumulative inflow to over $13bn. High yield funds however reported a substantial outflow, the first in five weeks. The outflows were a mix of global, US and European-focused funds. More in chart 13. 

Government bond funds flows switched to positive after two weeks of outflows. Money Market funds flows also turned positive after three weeks of outflows. 
Flows into equity funds remained in negative territory for the 26th consecutive week. Almost $80bn has left the asset class over that period." - source Bank of America Merrill Lynch
So much for the much lauded "Great Rotation" story from "equities" towards "bonds". When it comes to having some "fun" uphill, Fixed Income is still "the place to be" and when it comes to "greed", Investment Grade credit rules the game for now thanks to central banks joining as well the "party".

While equities are making news highs while flows are making new lows, we think that we haven't seen yet the lows of the current credit rally in investment Grade à la 2006. On this particular point we agree with JP Morgan's take in their Credit Market Outlook and Strategy from the 28th of July when it comes to US Investment Grade:
"Credit has not reached a low in spreads while equity indices are at all-time highs 
One of the interesting cross market dynamics recently is that equity markets are reaching new highs while HG bond spreads have been range bound well off of their tightest levels. This month the Dow and S&P reached new peaks and the Nasdaq came close. The JULI spread is at 171bp, 83bp above the pre-crisis low of 89bp (29th July, 2005) and 49bp above post crisis low of 122bp (24th June, 2014). There are several logical explanations for this divergence in performance, but we still believe the trend is for tighter spreads.

The most important explanation is that HG bond yields rather than spreads are the key valuation metric for many now (particularly overseas investors), and they are almost at a record low. The JULI yield is 96bp lower YTD and at 3.32% as of Wednesday it’s just 6bp off its record low of 3.26% reached on July 8th of this year.
The second explanation is the much higher weighting of banks in credit (24.4%) vs in the S&P (5.2%). The banks index of the S&P is not at its post crisis peak – it is 16.4% below the peak reached on 22nd July, 2015.
JULI Financials are at 172bp, 96bp above where they were when JULI spreads were at a pre-crisis low and 54bp above the JULI post-crisis low point. Banks have lagged in both equity and credit markets, but it matters more in credit markets. The third explanation is that 30.5% of the JULI comes from issuers outside the US. Of this 29% is EM and 71% is DM. This subset of the JULI is at a spread of 183bp, which is 93bp and 38bp above where it was vs the pre and post crisis low spread points for the index. Excluding EM these figures are 81bp above and 54bp above for Yankee
issuers." - source JP Morgan.
Whereas we think equities have much more less room to rise in the US, we do think we are going to see additional melt-up in and records been broken in the US. When it comes to "valuation" and "rotation", we do think that in this "japanification" and "Thermidor" period, the trend is indeed, your friend and there is more "fun" to come given "greed" is still running high in the context of "financial repression". 
While we keep noticing the deterioration in "financial conditions" as pointed out by the US Senior Loan Officers Surveys (SLOS), we still recommend a "rotation" towards "quality". This recommendation was made again in our previous conversation when it comes to bank exposure and "senior unsecured credit" was less volatile than merely chasing "beta".

When it comes to "greed" and "Investment Grade" credit, we continue to favor US Investment Grade credit and we do think that having the ECB, the Bank of England and the Bank of Japan, competing with their local investment base when it comes to chasing assets, we do think that once more US credit will strongly benefit from investors in September after the summer lull or "Thermidor" period. 

We therefore agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 29th of July entitled "Kuroda and Draghi and Yellen":
On balance we view recent developments in global monetary policies from the major central banks as positive for the US HG corporate bond market. At this week’s FOMC meeting the Fed was not as hawkish as investors had feared – specifically they did not prepare investors for a September rate hike. Recall that last year - prior to starting the rate hiking cycle at their December meeting - the Fed had warned the market of that possibility explicitly in the statement from their previous (October) meeting.
In Europe, as our European credit strategist, Barnaby Martin, highlights (see: Resistance is futile), the ECB appears on a mission to deflate credit spreads in the European corporate bond market. This has to drive even more European investors into the US corporate bond market – probably when they come back from vacations in September (Figure 3). 
Furthermore, unlike the BOJ the ECB has plenty of ammunition left that – if deployed – would help drive US credit spreads tighter. This includes changes to its capital key (Figure 4) that would direct QE purchases away from bunds toward assets that have more credit risk (see: Brexit pushing Draghi out the curve?).
So we continue to expect accelerating foreign purchases of US corporate bonds during the last part of the year driven by Europe, while Asian buying remains steady – which means strong.
(Reverse) Yankees are coming 
In additional to accelerating European demand for US corporate bonds starting in September, we should we expect accelerating reverse Yankee issuance (i.e. US companies coming abroad in non USD currencies). Given what the ECB is doing this is certainly the case for the EUR market (Figure 5), but with global yield starvation we expect increasing reverse Yankee issuance in other currencies too (Figure 6). 

That should further support USD credit spreads just like we saw for the banking sector this month post-earnings." - source Bank of America Merrill Lynch
If indeed "greed" is "good" then obviously there is more room when it comes to spread tightening in US Investment Grade thanks to somewhat to some "crowding out" due to to central bankers competing with investors in this "unhealthy" yield chasing game. We can as well anticipate a significant return of the Japanese investor crowd to foreign bond markets while the Bank of Japan, while on hold, is preparing for some more "unconventional" bazooka in September when we will eventually revisit our short yen exposure.

When it comes to "crowding out" and the ECB, we read with interest Bank of America Merrill Lynch's European credit strategist Barnaby Martin note "Resistance is futile" from the 28th of July highlighting how central banks are pushing outside of their comfort zone "yield hogs" towards more credit risk and/or higher duration exposure:

"Honesty doesn’t pay 
Spreads took another leg tighter last Monday as CSPP ISINs were disclosed. We sense “doubters” threw in the towel. But we think disclosure rubs both ways. While the aim is to facilitate securities lending – and aid credit market liquidity – we fear the sheer size of CSPP buying has heightened investors’ nervousness over credit market liquidity.
As chart 1 shows, investors are already starting to have concerns over the growth of negative yielding corporate debt across the globe. Note the weakness in European corporate bond spreads over the last 2 days despite equities being up…

How has credit market liquidity fared through CSPP life?  
Chart 2 shows the average bid-offer spread (in bp) for investment-grade corporate bonds. We split the universe up into  CSPP eligible non-eligible (non-banks) and  CSPP purchased bonds. 

We think that the picture shows some encouraging but also some concerning developments: 
• What’s clear is that the announcement of CSPP on March 10th initially caused mass confusion in the market. Bid-offers surged and liquidity deteriorated meaningfully in non-financial bonds. Yet, bid-offers remained steady in parts of the market that were expected to be untouched by Draghi (note the calm in  non-eligible bid-offers).
• From March 10th until CSPP buying began (June 8th), credit market liquidity improved noticeably. Bid-offers tightened for all parts of the market as CSPP was deemed to be the policy that would rejuvenate the corporate bond market.
• But since June 8th, bid-offers have widened and liquidity has deteriorated again. True, Brexit took place on June 23rd, but nonetheless there has been a drift higher in bid-offers since Draghi started buying credit. And if anything, liquidity seems to have deteriorated further for  eligible and  purchased names, post the ISIN publication last week.
So while the aim of CSPP disclosure was to preserve credit market liquidity, the initial signs seem to point to something more worrying: that the ECB’s dominance in corporate bond buying is in fact becoming counterproductive for market health.
We think that this will be another reason why investors will want to accelerate their movement into non-eligible parts of the credit market post the summer break. Not only are non-eligible sectors relatively attractive spread-wise now, but they also offer an attractive combination of yield and volatility, we think, compared to CSPP purchased sectors" - source Bank of America Merrill Lynch
In similar fashion than the Bank of Japan has completely destroyed the liquidity in its Government Bond Market (JGBs), the ECB is as well in the process of wreaking havoc in the liquidity of the Corporate bond market and has now been joined in a similar process by its neighbor the Bank of England. 

When it comes to the "Thermidor" period, we do live in pre-revolutionary times we think and wonder how long markets are going to cope with this financial repression.

On a final note and in our final chart and in continuation to last week's conversation surrounding bank "valuations", we would like to point out how interest policies of our "omnipotent" central bankers and now with NIRP are destroying slowly but surely "bank capital".

  • Final chart: Bank stocks under pressure? Blame central banks
We will not re-iterate why we dislike banks stocks and in particular European banks stocks given the "japanification" process and the significant on-going deleveraging. If there is indeed some clear culprits when it comes to "capital destruction" thanks to Zero Interest Rate Policies (ZIRP) and now with Negative Interest Rate Policies (NIRP), the blame is entirely on the shoulders of our "generous gamblers" aka central bankers and their experiments. 
This is clearly illustrated in our final chart displaying the correlation between interest rate policies and bank stocks as pointed out by this chart from Bank of America Merrill Lynch from their Credit Derivatives Strategist note from the 5th of August entitled "Corporate ‘QE²’ - When CBPS met CSPP":
- source Bank of America Merrill Lynch
As a "bonus chart" we will point out to yet another chart from Bank of America Merrill Lynch's European credit strategist Barnaby Martin note "Resistance is futile" from the 28th of July chart displaying that the "fun" has been going "uphill", namely to the bond market and in particular German Bunds:
- source Bank of America Merrill Lynch

For the "real economy", downhill that is, we are not too sure they are getting their share of the "fun", which does indeed explain the rise in inequalities, populism and the rising prevailing "pre-revolutionary" mood in many parts of the world.

Back in November 2014 in our conversation "Chekhov's gun" we argued the following:
"Our take on QE in Europe can be summarized as follows: 
Current European equation:  
QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 
“Hopeful” equation:  
QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend." - source Macronomics, November 2014
Obviously our "Hopeful equation" suffered from "Optimism bias" and we argued at the time:
"Our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015) " - source Macronomics, November 2014
Increasingly it looks to us that we are moving towards the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). That's our take and our "realist bias" for now unless of course we finally get a wake-up call from the political class leading to the realization of our "Hopeful" equation but we would not bet on it for the time being.

"Those who make peaceful revolution impossible will make violent revolution inevitable." - John F. Kennedy

Stay tuned!

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