Monday, 20 June 2016

Macro and Credit - Ubasute

"Death by starvation is slow." - Mary Hunter Austin, American writer

Watching with interest the further "japanification" process unfolding with the mighty German 10 year government bond aka the bund, falling under the zero yield boundary and the continuation compression of the Japanese government bonds aka the "widowmaker" JGB, we reminded ourselves of the Ubasute practice for our chosen title analogy. It refers to the custom allegedly performed in Japan in the distant past, whereby an infirm or elderly relative was carried to a mountain, or some other remote, desolate place, and left there to die, either by dehydration, starvation (lack of yield), or exposure, as a form of euthanasia. Of course, "Ubasute" for us is a clear reference to the "euthanasia" of the rentier close to John Maynard Keynes which we touched on in March this year in our conversation "The Reverse Tobin tax" where we discussed the dire consequences of Negative Interest Rate Policy (NIRP):
"For us, NIRP is a "reverse Tobin tax" leading in the end to the "euthanasia of the rentier" as more and more government bonds fall into negative yield territory, hence our chosen title. If indeed James Tobin tax was supposed to lead to lower volatility in the FX markets, the reverse Tobin tax aka NIRP is leading to the reverse, that's a given but we are rambling again..." - source Macronomics, March 2016
Indeed the recent gyrations in the market comes to no surprise to us as we have indicated in recent notes the cheap levels reached by volatility and the need to rethink about hedging strategies. 

As well as a reference to the "euthanasia of the rentier", "Ubasute" is a veiled reference for movie buffs like us to 1983 Japanese masterpiece by director Shōhei Imamura "The Ballad of Narayama". The movie earned the coveted Palme d'Or at the 1983 Cannes Film Festival. Our chosen analogy "Ubasute" is as well linked to the characters of Christopher Buckley's 2007 novel Boomsday, a political satire about the rivalry between squandering Baby Boomers and younger generations of Americans who do not want to pay high taxes for their elders' retirement. In his novel, the author uses the concept of 'Ubasute' as a political ploy to stave of the insolvency of social security as more and more of the aging US population reaches retirement age, angering the Religious Right and Baby Boomers, but we ramble again...

Whereas everyone and their dog are focusing as of late on "Brexit", to paraphrase Confucius, we would rather point you towards the Moon, namely the deterioration of the credit cycle and in particular towards some areas of the credit markets such as the retail sector exposed CMBS, rather than doing like the "idiots", looking at the finger only, namely "Brexit". 

For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe... 

We apologies for the long wait for our latest musing, but we were collecting our thoughts and trying to find an appropriate analogy to reflect them.
In this once more long conversation we will focus once more our attention to Japanese woes and deteriorating credit conditions. 


  • Macro and Credit - Yen depreciation and financial repression? It's only starting
  • Macro and Credit  - Credit tightening is already starting to bite a leveraged world
  • Final chart: Bank stocks on the "Road to Nowhere"

  • Macro and Credit - Yen depreciation and financial repression? It's only starting
While we have been short yen since November 2012 when the Japanese yen was trading around 80 as described in our conversation "Cold Turkey" (partly via ETF YCS) guessing that the Bank of Japan had a lot of catch-up to do when it came to QEs and expanding its balance sheet, since the beginning of the year we have been on the "receiving end" of the strengthening of the Japanese yen as of late in our portfolio. We must confide that we do not warrant much attention to the recent gyrations in our position, given it is a long term position as we are firm believers in the long term massive depreciation of the Japanese currency. While all the recent action recently seems to be in "bondzilla" (the bond monster) getting much larger by the day with global bond yields plunging further into the void à la Swiss yield curve, when it comes to "Ubasute" and the Japanese currency, we believe it will be a slow death for sure, as "yields hogs" get slaughtered in the process. Given the multiplication of conversations surrounding the adoption of “helicopter money” policies, which could in effect lead to greater leeway for fiscal spending, we read with interest Nomura's take on the subject from their Japan macroeconomic insight from the 15th of June entitled "Fiscal policy unease and financial repression":
"Overview of postwar deposit blockade 
The postwar deposit blockade can in our view be seen as an exit from the monetary easing policies before and during the war in the shape of the BOJ's government bond underwriting. This method allowed the government to recover currency supply that had become bloated during the war while simultaneously defaulting on government debt that had become virtually unpayable with the end of the war. The deposit blockade was a scheme to write off wartime compensation at one go and eliminate financial institutions' bad debts by imposing temporary limits on some withdrawals of deposits and rescinding claim rights on some of the blockaded deposits. 
Is a deposit blockade possible today? 
It should not be overlooked that when the Japanese government allowed the policy-driven erosion of people's assets by sacrificing some deposits through the deposit blockade, it did so under the former Constitution of the Empire of Japan and before the adoption of the current Constitution of Japan, which stipulates that any deposit blockade must protect the property rights of the people. If the Japanese government were to adopt and implement such a scheme to write off debt, that could be ruled unconstitutional, making such a move very dubious from a legal perspective. We think helicopter money policies involving, for instance, the conversion by the BOJ of the JGBs it has purchased into perpetual bonds would risk similar legal problems because they would in effect institutionalize the degradation of JGB redemption terms. From this standpoint, we think helicopter money policies are unlikely to be adopted." - source Nomura
What we find is of interest to us is that Japan seems to be the central bank "laboratory" where most of the experiences have taken place and more recently with Bank of Japan implementing NIRP, replicating what others had done. As we wrote back in our January conversation "The Ninth Wave" one should therefore not have been surprised of the actions of the Bank of Japan in implementing NIRP which has already been implemented in various European countries and enforced as well by the ECB. As a reminder from last year conversation, this is the definition of "Information cascade":
"An information (or informational) cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts. A cascade develops, then, when people “abandon their own information in favor of inferences based on earlier people’s actions”." - source Wikipedia
The Bank of Japan has merely engaged in the same acts as others. "Information cascade" is a trait of behavioral economics. We behave like behavioral psychologist when analyzing market trends and central banks "behavior", we focus on the process, rather than on the content. What we tend to also focus on is what we call our "Mark Twain approach", we do, like others refer to history as it tends to "rhyme" rather than "repeat" itself, therefore we read with interest Nomura's take on what happened to Japan before WWII, during WWII and after when it comes to its "monetization" of Japanese Government Bonds (JGBs):
"Growing helicopter money debate and BOJ underwriting of JGBs before and during the Pacific War  
The helicopter money policy debate has been heating up. Although there are various definitions of helicopter money, the basic concept involves the direct financing of fiscal spending by the central bank (and its issuance of currency). Specific forms this might take include the central bank directly and without limit underwriting the increased issuance of government bonds to pay for large-scale increases in government spending and the central bank, through quantitative easing, converting the government debt it already holds into perpetual bonds or other bonds with very long maturities or else getting rid of redemption altogether.  
Recently, it has become well known that the BOJ directly underwrote government bonds before and during the Pacific War (Figure 1).

Perceptions that this triggered the outbreak of war by supporting unlimited growth in military spending and was an underlying cause of hyperinflation following the war are seen as lying behind the provision in the current Fiscal Act (Article 5) prohibiting the BOJ from directly underwriting government bonds. 
Considering this historical background, we think there is little prospect of the government and the BOJ cooperating in the adoption of a helicopter money-type measure. However, not only is it now the mainstream view that the current quantitative and qualitative monetary easing (QQE) policy with its negative interest rate policy (NIRP) is unlikely to achieve the BOJ's inflation target (or the assumption behind its attainment of pushing up inflation expectations by giving a boost to the real economy) but also there has been growing criticism that NIRP will actually have a greater adverse impact by depressing earnings at financial institutions, impeding financial intermediary functions, raising uncertainty in the household and corporate sectors, and reducing those sectors’ willingness to spend. 
If this situation persists, the possibility that momentum may grow for the adoption a helicopter money approach as an emergency measure cannot be ruled out.
Assessment of BOJ government bond underwriting: lessons from the past  
In considering how the risk scenario of helicopter money policy might unfold after its introduction, we think it instructive to look back to when the BOJ underwrote government bonds before and during the war and how the aftermath of hyperinflation was dealt with.
First, let us look at the position with the BOJ's underwriting of JGBs. The roots of the BOJ's government bond underwriting date back to the expansionary fiscal policy (from 1931 onward) under then Finance Minister Korekiyo Takahashi aimed at escaping the deflationary recession known as the Showa Financial Crisis, triggered by the Great Depression in 1929. The general view is that the BOJ's direct underwriting of JGBs accompanying the aggressive fiscal policies was adopted as a "temporary expedient" by the bank under heavy pressure from Finance Minister Takahashi.
As noted earlier, the direct underwriting of government bonds by the BOJ acted as a trigger for the outbreak of war by allowing military spending to grow without limit and is generally viewed as having been the underlying cause of hyperinflation in the postwar period. However, we think a closer look at the causal relationship between the BOJ's government bond underwriting, inflated fiscal spending, and hyperinflation is needed in considering the current monetary easing and the impact of helicopter money. From a broad perspective, we think the relaxation of fiscal discipline and hyperinflation cannot all be blamed on the BOJ's underwriting of government bonds.  
Was underwriting JGBs the main cause of relaxation in fiscal discipline and hyperinflation?  
First, let us consider the impact of the BOJ's underwriting on JGB yields and the relaxation of fiscal discipline. Some, for example, have criticized the current large-scale JGB purchases under QQE and the adoption of NIRP as having greatly lowered government bond yields across all maturities, saying that the exceptionally low yield they have brought about have already given rise to a relaxation in fiscal discipline even without waiting for the introduction of any helicopter money measure.
However, we think it is rash to blame the BOJ's underwriting of JGBs before and during the war for the relaxation of fiscal discipline by holding down JGB yields and for supporting military expansion and triggering the outbreak of war.
From before the war to during it, JGB yields actually declined despite deterioration in the government's fiscal balance and growth in outstanding debt (Figure 2).

We think it inappropriate to blame the BOJ's JGB underwriting for the following two reasons. First, although after the underwriting of JGBs began the BOJ did underwrite a large proportion of newly issued bonds, at almost 80%, the great majority of the JGBs underwritten by the BOJ were subsequently sold in the open market. We see the BOJ's government bond underwriting as in a sense having compensated for inadequacies in the bond underwriting capacity of private-sector financial institutions. With the decline in JGB yields in the market, meanwhile, we see this as due more to the impact of the introduction of a system in 1932 whereby JGBs could be listed at book price equivalents to standard issuance prices stipulated by MOF. Exempting financial institutions from booking their JGB holdings at current value appears to have greatly eased the selling pressure on JGBs.
How about the view that the BOJ's government bond underwriting was the cause of hyperinflation in the postwar period? Although most of the bonds underwritten by the BOJ were subsequently absorbed by the market, the large increase in fiscal spending in parallel with the BOJ underwriting did lead to a large expansion in the money supply. It is possible to see hyperinflation as the result of this not being absorbed even after the war. 
From the perspective of the real economy, however, we think there was a greater impact in opening the way for hyperinflation from the extreme diversion of production capacity to military purposes during the war, from damage caused by wartime fires, and from a rapid narrowing in the output gap as private-sector demand quickly recovered with demobilization after the war. 
Deposit blockade as an exit strategy for JGB underwriting 
With helicopter money now being actively discussed as an option for what could be seen as a move toward a more radical form of conventional QQE, we believe it is crucial to look at how the authorities finally addressed the BOJ’s JGB underwriting during World War II and the swollen currency supply and hyperinflation caused by the massive expansion in wartime spending by the government.
A deposit blockade could be viewed as an exit strategy for monetary policy after the start of JGB underwriting by the BOJ. This method allowed the government to recover the excess currency supply that had emerged during the war while simultaneously defaulting on government debt that had become virtually unpayable with the end of the war. Below we take a look at the effects of this deposit blockade, both on the monetary side in areas such as currency supply and on the fiscal side in areas such as adjusting government debt.  
Overview of deposit blockade  
Here we examine the concept of a deposit blockade and the processing of government debt that accompanies it.
During World War II, the Japanese government attempted to manage the fiscal imbalance caused by the massive increase in military spending and the drop in tax revenues from the halt of private-sector industrial activity by increasing the issuance of government bonds, the underwriting of those bonds by the BOJ, and debt guarantees known as wartime compensation given to arms companies for accounts receivable related to military procurement.
Of course, Japan's defeat and the war's damage to its domestic production capacity deprived the government of its means to repay these wartime compensation debts. This resulted in many loans turning bad at the Japanese financial institutions that had supplied credit to these arms companies with wartime compensation as effective collateral. At the same time, the money created by this supply of credit collateralized by wartime compensation, alongside the destruction of supply capacity in the real economy, was a root cause of the excess liquidity and hyperinflation that followed the war.
As a measure to simultaneously reduce both the resultant risk of default on government debt and this excess liquidity, it was proposed that withdrawals be temporarily restricted for some sorts of market deposits, allowing the government to write off its wartime compensation debt while financial institutions disposed of their bad debt, while also effectively devaluing these market deposits via the currency redenomination (shift to the new yen) also carried out during the deposit blockade period (Figure 3). 

The deposit blockade was put into effect with the emergency financial measures ordinance of 17 February 1946. In accordance with the simultaneously announced special asset audit ordinance, the government began the process of assessing the total amount of wartime compensation debt and the amount of citizens' assets subject to writeoffs. Following this, on 24 July of the same year, the cabinet officially decided to cancel all wartime compensation and the blockaded assets were categorized into type 1 blockaded assets and type 2 blockaded assets to reflect the amount of compensation to be written off. Figure 4 shows the extent of the blockaded deposits subject to withdrawal restrictions and the debt with which they were matched.

Unregulated deposits with no withdrawal restrictions accounted for 15.4% of total deposits at Japanese banks (as of August 1946, when blockaded deposits were categorized), while type 1 blockaded deposits accounted for 37.5% and type 2 blockaded deposits accounted for 21.9% (Figure 5). For individuals, withdrawals from these blockaded deposits (in new yen) were limited to ¥300 per household per month and ¥100 per household member.  
On 18 October 1946 the government enacted the Wartime Compensation Special Measures Law, which imposed a special tax for wartime compensation equal to the amount of wartime compensation debt. With this special tax, the government effectively defaulted on its wartime compensation debt. To address losses on the financial institution debt that consequently became unrecoverable, the type 2 blockaded deposits were allocated to fund debt writeoffs at private-sector financial institutions under the Financial Institution Reconstruction Law and Business Reconstruction and Adjustment Law implemented on the same date. Roughly 57.5% of the total balance of type 2 blockaded deposits as of directly after their categorization in August 1946 was eventually used for these writeoffs (Figure 6). 
Is a modern deposit blockade possible?  
Under QQE, the BOJ has come to hold an increasing percentage of the overall JGB balance, while JGBs have come to account for an increasing percentage of the BOJ's assets. With large-scale monetization of government spending via helicopter money policies now also being debated, some now express concern that such policies could lead to conditions similar to the postwar deposit blockade.
As described above, the postwar deposit blockade was implemented under the assumption that some of depositors' deposits would be written off in order to prevent a chair reaction of bankruptcies among Japanese businesses and financial institutions caused by the government's inability to follow through on its wartime compensationIt should not be overlooked that when the Japanese government allowed the policy-driven erosion of people's assets, it did so under the former Constitution of the Empire of Japan and before the adoption of the current Constitution of Japan, which stipulates that the property rights of the people must be protected if deposits are blockaded. 
If the Japanese government were to adopt and implement such a scheme to write off government debt, it could be judged unconstitutional, making such a move very dubious from a legal perspective.
Helicopter money policies that in effect institutionalize the degradation in redemption conditions for the JGBs purchased by the BOJ could risk raising similar legal issues." - source Nomura
Where we disagree slightly with the above is that, as we have seen it before, when it comes to "legal issues", on numerous occasions we have seen that, indeed, the rule book can be rewritten and politicians and central bankers alike have shown throughout history their capacity in changing the outcome, even when it comes to voting against the Lisbon treaty for example. Where we agree with Nomura is with their take on the Japanese yen, namely that it is most likely to weaken further in the long run as per the conclusion of their note:
"The consequences of financial repression 
The consequences of financial repression policies could show most strongly in forex rates as a result of the contradiction that would arise from maintaining policies to artificially suppress JGB yields even when the rise in the inflation rate would suggest that monetary easing should be ended.
Offsetting in part or in full the negative impact of inflation on the real prices of financial assets is one of the basic effects of a rise in interest rates. However, under a policy of artificially ultra low interest rates aimed at preventing government debt defaults, we would expect a decline in domestic financial assets that could not increase in real value without a rise in interest rates and we would expect an outflow of funds into overseas assets. The resultant drop in yen forex rates could further accelerate inflation and without a rise in interest rates to counter this, we would expect further acceleration in both the outflow of assets and the devaluation of the yenIt should therefore be kept in mind that the price of avoiding government debt defaults with the minimum of political and legal friction may well be quite a rough decline in forex rates." - Source Nomura
Whereas the "widowmaker" aka the mighty JGB has proven as of late it could thrive even further thanks to the implementation of NIRP, and effectively rendering "bondzilla" even more menacing, when it comes to the recent appreciation of the Japanese yen as a "safe haven" in current uncertain markets, we firmly believe that the yen will continue to depreciate over the long term hence our core "short" position.

In a world plagued by rising debt levels and in particularly in the private sector where the corporate sector has been leveraging significantly, regardless of the rally we might see should the United Kingdom decides to remain, credit tightening is already starting to bite.

  • Macro and Credit  - Credit tightening is already starting to bite a leveraged world
In our February conversation "The disappearance of MS München", we discussed about risk in general and CMBX in particular as another clear indicator of a deterioration in credit fundamentals apart from our much quoted "CCC credit issuance canary". We find of interest as of late that finally Bloomberg has been picking up on the deterioration in the Commercial Real Estate (CRE) space as of late in their article "America’s Dying Shopping Malls Have Billions in Debt Coming Due" from the 16th of June:
"Suburban Detroit’s Lakeside Mall, with mid-range stores such as Sears, Bath & Body Works and Kay Jewelers, is one of the hundreds of retail centers across the U.S. being buffeted by the rise of e-commerce. After a $144 million loan on the property came due this month, owner General Growth Properties Inc. didn’t make the payment. 
The default by the second-biggest U.S. mall owner may be a harbinger of trouble nationwide as a wave of debt from the last decade’s borrowing binge comes due for shopping centers. About $47.5 billion of loans backed by retail properties are set to mature over the next 18 months, data from Bank of America Merrill Lynch show. That’s coinciding with a tighter market for commercial-mortgage backed securities, where many such properties are financed." - source Bloomberg
If we remember correctly our February conversation, here it what we indicated at the time:
"We have told you recently we have been tracking the price action in the Credit Markets and particularly in the CMBS space. What we are seeing is not good news to say the least and is a stark reminder of what we saw unfold back in 2007.Among the more recently issued CMBX series (6-9), CMBX.6 has the highest percentage of retail exposure.Sorry to be a credit "party spoiler" but if U.S. Retail Sales are really showing a reassuring rebound in January according to some pundits with Core sales were 0.6% higher after declining 0.3% in December and the best rise since last May, according to official data from the Commerce Department, then, we wonder what's all our fuss about CMBS price action and SEARS dwindling earnings? Have we lost the plot?" -source Macronomics, February 2016
Also, in our May conversation "Through the Looking-Glass" we reiterated the importance of tracking the "price action" in the CRE space has a further indication of the deterioration in credit financial conditions and deterioration in economic fundamentals:
"As indicated in our conversation "The disappearance of MS München", we have been tracking the price action in the Credit Markets and particularly in the CMBS space. The reason behind us starting to track à la 2007 is that the CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. 
As a reminder from our February conversation, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so in the future." - source Macronomics, May 2016
We also told you that by tracking the quarterly Senior Loan Officers survey published by the Fed we did notice that overall financial conditions were continuing to tighten in the United States, which will eventually lead default rates higher and high yield lower, whereas in the meantime our "CCC credit issuance canary" has stop singing as confirmed by Deutsche Bank in their US Credit Strategy note from the 16th of June 2016 entitled "Illusory Benefits of Cheap Money":

"Figure 6 shows how lending volumes in CCCs, while having thawed a bit from a completely frozen state in Jan-Feb, remain at some of the lowest levels seen in the past 15 years. Investors are not exactly going after all the 13% yield opportunities in the ex-commodity HY CCC segment, and there could only be one explanation for such a behavior in a yield-starving world.
Such a behavior also naturally translated into higher realized credit losses in the ex-commodity sectors, with our default rate calculations showing an annualized 3mo issuer-weighted rate reaching 4.6% in May. Overall HY defaults, including energy and other commodities, were trending at a 9.8% issuer-weighted rate over the past three months! Trailing 12mo rates for both market segments currently stand at 2.7% and 5.8% respectively.
So, if investors are skittish about credit risk, do extreme steps taken by central banks help in reopening the credit channel? The evidence we see provides little support to that claim. Figure 7 shows overall corporate bond issuance volumes (IG+HY) in the US and EU over the past five years, presented here as a percent of respective market sizes. 
Of a particular interest is the reaction function in EU credit, where new issue volumes have peaked in Apr 2015, or a month after that ECB engaged in the original QE last year. Since then volumes have dropped precipitously, currently sitting near their lows over the past four years.
You can lead a horse to water, but you can’t make it drink." - source Deutsche Bank
While we will note delve again into the "lack of understanding" of our "Generous gamblers" aka central bankers in our credit transmission operate (hint: not through the "wealth effect"), when it comes to CRE and credit conditions, if you think "refinancing" has been tough as of late in the energy sector and in particular the CCC rating bucket, then we would like you to take a look at the CMBS space because it will not be pretty either as indicated by Bank of America Merrill Lynch in their weekly Securitization note from the 10th of June:

"While many borrowers will be able to successfully refinance their loans, it is inevitable that some will not. To the extent that borrowers with higher quality properties have already refinanced, we think that many of the outstanding 2006 vintage loans are adversely selected. If they can’t refinance we anticipate that the 60+ day delinquency rate (Chart 46) and special servicing rate (Chart 47) for legacy loans could increase sharply over the next six months. 

The inability for some legacy borrowers to refinance will likely be exacerbated by the recent slowdown of CRE price appreciation.  
To this point, April 2016 Moody’s/RCA CPPI data were released this week and offered mixed results. Although the data indicate that the index increased 16bp month/month at the national level, the index that represents assets in major markets fell (Chart 48).

Furthermore, price change by property type was mixed as well. At the property level, prices for retail, apartment and industrial properties increased, while office prices fell. 
When we analyzed the long term commercial real estate price trends by property type, the slowdown in commercial real estate price appreciation for assets located in major markets was especially noticeable. This held true for each of the core property types." - source Bank of America Merrill Lynch
On top of this surging overall weakness trend in CRE, you will probably understand our "interest" in tracking the "Ubasute" fate of CMBX series 6 and why, we continue to think it should be "shorted" from Bank of America Merrill Lynch additional comments from their note:
"Within the mall space, quarter-to-date returns don’t look particularly attractive as only one of the eight companies our equity mall REIT analysts cover posted positive returns (Chart 53). 
Along this line, Ralph Lauren announced this week that it plans to cut 8% of its workforce and close more than 50 stores. 
Despite feeling like we read these types of announcements several times a week, store closings so far this year are not only lower than they were last year at this time, but are at levels last seen in 2013 (Chart 54). 
Bringing this back to what retail sector weakness means for the CMBS market, we think that the weakness, coupled with slowing CRE price growth, imply that loss expectations for cuspy legacy bonds may be too low. This could be particularly painful for bonds in this category that are priced at levels that don’t incorporate unexpected downside. For example, many legacy deals only have a small handful of loans left, many of which are, and have been, current. Despite this, if a tenant has (or plans to) vacate the building but is still paying rent, this might result in a loss that has been neither considered nor accounted for. When we plotted 2006 vintage AJ current subordination levels against our credit model’s expected deal losses, we found that a number of AJs were very close to taking an expected loss (Chart 55) – even without taking into the account unknown unknowns that could cause performance to deteriorate relative to one’s current expectations.

The way to interpret Chart 55 is that any “dot” above the diagonal red line indicates that expected deal losses exceed the amount of subordination for the AJ represented by the dot. While it is likely that many of these AJs already trade at discounted dollar prices given the expectation that they will incur some loss, what about bonds trading at mid-to-high $90s (or higher) that are not expected to take a loss? These bonds are represented by dots below the diagonal line. Obviously, dots closer to the line indicate that less cushion exists to absorb any unanticipated negative surprises.
Although greater market stability may lead to better refinance success, it appears that fewer loans are being recycled back into the CMBS market. To the extent that the alternate lender has tighter underwriting standards, it is possible that losses could increase relative to many investors’ current expectations. In fact, despite recent comments from regulators noting the increase in CRE exposure on bank balance sheets, many local, regional and national banks continue to increase their CRE loan
origination activity and market share. This holds true both for all commercial real estate lending (both acquisition and refinance) as well as for only loans that are refinancing. While we aren’t suggesting that losses may increase significantly from current levels, we think that it makes sense to price “cuspier” bonds to a slightly more negative scenario in order to buffer against unanticipated negative events." - source Bank of America Merrill Lynch
Of course we do not think the level of provisions on banks balance sheet is adequately set for this type of "sudden" deterioration which we think is more likely to happen given the trajectory we are seeing in the US economy hence our lower for longer stance when it comes to our long duration exposure...

This leads us to our final chart given than some pundits continue to believe in the attractiveness of bank stocks, in particular in Europe from a "valuation" perspective.

  • Final chart: Bank stocks on the "Road to Nowhere"
While we have repeatedly indicated our "distaste" with Banks stocks and our preference for credit in particular when it comes to Europe, looking at Japan and "Ubasute", we think the "valuation" pundits should think again given the below chart from Société Générale from their recent Asia Investment Navigator note from the 17th of June entitled "Debt is not only a China problem" displaying the performance of Japanese banks over a 25 year period:
Long Japan banks -  The banks de-rating has been an important factor behind the lower valuation of the overall market. In particular, the sector has massively underperformed due to concerns of deepening deflation caused by rising yen. The negative interest rate policy framework has exacerbated these concerns." - source Société Générale.
No disrespect to Société Générale, but even with "contrarian" stance, taking a longer view perspective prevent us from seeing the "interest" in going "long Japan banks" or long anything "banks" apart from "credit" given the on-going support from central banks:
- source Société Générale
"Ubasute" in Japan might have reached "full-employment" but, when it comes to inflation and banks stocks, it is clear that it has been an utter failure. NIRP has in fact created a dangerous situation with now CDS spreads widening and banks stocks going lower.

In a world stifled by too much debt therefore weighting on global growth we can not envisage seeing any value in this environment in owning bank stocks as illustrated by Bank of America Merrill Lynch in their Thundering Word note from the 16th of June entitled "Barbells, Banks, Fizzy Bonds & Brexit":
"Year of the Barbell, not Year of the Banks

“Deflation assets” & “inflation assets” winning in 2016: gold & bonds; resources & defensives; Brazilian real & Japanese yen all outperforming. Tail assets stretched (e.g. HY energy most overbought in 7 years) but banks have “funded” barbell (Chart 1) and reversal of long barbell-short banks trade requires EPS & GDP upgrades. Neither visible." - source Bank of America Merrill Lynch
When it comes to advising you end of last year to go long duration via long dated US Treasuries, long gold and long gold miners (2016 total returns YTD: gold 23.6%, commodities 14.5%, bonds 8.0%, stocks 0.1%, and the US dollar -4.1%), there was a simple reason to it, we expected slower GDP growth given our deflationary bias as illustrated by one final chart, the correlation between gold and slower US GDP potential from Bank of America Merrill Lynch's Global Metals Weekly note from the 17th of June entitled "Era of uncertainty, weak growth and gold":
"Walking from crisis to crisis 
Switching tack slightly, macroeconomic uncertainty in the Eurozone and US remains elevated; the high correlation between US potential GDP growth and gold (Chart 15) highlights how important this is for the precious metal. While the underlying ills are nuanced between countries, an increasing polarization of politics and a rise in populism have been common by-products; to that point, wealth generation/wealth distribution, immigration and sovereignty have caused contentious debates. Of course, this has not helped confidence and did not make it easier for governments to implement the measures necessary for putting economies on a more sustainable footing. As a result, a host of countries has moved through a series of mini-crises in recent years. This dynamic has also tied the hands of central banks and persistently loose monetary policies have, through various transmission channels, been supportive of gold. As such, even if the UK remains part of the EU and gold corrects, we believe prices below $1,200/oz would be a buying opportunity." - source Bank of America Merrill Lynch
When it comes to gold, we believe the "trend is still our friend", regardless of the "sucker punch" we will get from a "no Brexit" vote, we have to agree with Bank of America Merrill Lynch and we will be happily "buying the dip" in that instance.

Don't hesitate to comment and reach out!

"The voice of conscience is so delicate that it is easy to stifle it; but it is also so clear that it is impossible to mistake it." - Madame de Stael, French writer

Stay tuned!

Sunday, 5 June 2016

Macro and Credit - Road to Nowhere

"The person attempting to travel two roads at once will get nowhere." -  Xun Zi, Chinese Philosopher

Looking at the Japanese PMI coming at 47.7, and Japan recording its seventh straight month of falling exports in April down 10.1% on-year with Haruhiko Kuroda, Bank of Japan's governor declaring at a two-day Group of Seven (G-7) meeting in Sendai:
"I think, yes, we have enough ammunition," Kuroda said, when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the target. "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." - Haruhiko Kuroda, Bank of Japan's governor
We had Japan in mind when we selected our title analogy for this week's musing "Road to Nowhere", the 1985 rock song written by David Byrne from the Talking Heads album "Little Creatures". What is of "humoristic" interest is that David Byrne indicated the following about his song:
"I wanted to write a song that presented a resigned, even joyful look at doom," - David Byrne
Clearly when one looks at the recent raft of dismal data from the Japanese behemoth, one can relates to our chosen title and analogy we think. Haruhiko Kuroda, also added when asked about what remained in Bank of Japan's "tool box" the following:
"I think, yes, we have enough ammunition," (when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the 2% inflation target). "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." Haruhiko Kuroda, Bank of Japan's governor
As far as we are concerned, we think Japan is indeed on a "Road to Nowhere". In this week's conversation we will look at Japan's "achievements" after 3 years of "Quantitative and Qualitative Easing (QQE), and what the lackluster Nonfarm payroll number means to us as well as the growing complacency in the on-going risk-on rally which we thinks warrants not only caution, but probably "hedging" as well.

  • Macro and Credit - Looking back a the "Three arrows"
  • Macro and Credit  - Is the Fed on a "Road to Nowhere"?
  • Final chart: Now is the right time to "hedge"

  • Macro and Credit - Looking back at "The Three arrows"
As a reminder, the massive experience that started on the 4th of April 2013 by the Bank of Japan ambitioned to achieve a 2% inflation rate within 2 years by expanding drastically the monetary base.
In our April conversation "Shrugging Atlas" we already touched on the impact of three years of QQE and the impact of the deflationary mindset that has taken hold in Japan. We argued at the time:
"It seems more and more evident that, the experiment overtaken by the BOJ in the last three years has failed to move upwards inflation thanks to any significant wage increases. The Japanese government cannot afford to allow rates to rise, and yet by keeping rates so low it increases distortions in the economy through the "mispricing" of risk. This is clearly evident by the inversion in correlation between bond prices and the Nikkei index!
Furthermore, the size of the BOJ's buying spree in the Japanese market has led to the market becoming not only unstable but as well as totally broken and volatile. Basically what was supposed to be riskless in the Japanese Government Bond (JGB) has become the most risky and volatile investment of all thanks to the BOJ" - source Macronomics, April 2016
We also argued that the headwinds facing Japan and as well Europe in our April conversation stem from "demography", rendering the problems more "structurally" acute. When it comes to Japan and its central bank and credit transmission we have a case of "broken arrow". Europe seems to be as well facing very similar difficulties we think.

When it comes to assessing the effectiveness of the "Three arrows", we read with interest Nomura's take on the subject in their Japan Economic Weekly note from the 20th of May entitled "Taking a fresh look at the three arrows":
"Summary: 1) Reconstructing the "three arrows"
When the second Abe administration was formed in December 2012, it announced what it called "the three arrows." Since last year, the government has been talking about "three new arrows," policies aimed at achieving its goal of the "dynamic engagement of all citizens." While the label may have changed, the government is presumably still committed to what it has called "growth strategies," structural reforms aimed at supporting economic growth.
Summary: 2) Shortcomings of existing economic policies
While the government has in the past claimed that deflation would soon be overcome, it cannot be said to have achieved this or to have boosted economic growth. We see two shortcomings in its policies. First, it has failed to sufficiently counter dwindling expectations of economic growth, with the result that the first and second arrows of traditional monetary and fiscal policy have not had the expected impact. Such policies seek to bring forward demand at the expense of the future. With demographics depressing growth expectations, policies that seek to bring forward future demand can make households and companies even more reluctant to spend. Second, in terms of the third arrow of growth strategies, the government may not have properly considered whether to bias its policies in favor of either labor or capital or, how in what order to do so.
Summary: 3) Some distinctive features of the Japanese economy now
The government's focus, which during the early stages of its strategies for growth was on capital (specifically on increasing corporate earnings power by means of structural reforms such as corporate governance), has since gradually shifted to trying to boost the labor participation rate (eg, by means of the government's Plan to Realize the Dynamic Engagement of All Citizens) and improving the share of labor. As a result of implementing policies biased towards capital and, especially, improving shareholders' rights, Japanese companies have probably become more focused on efficiency, productivity, and profitability than ever. The result is a state of affairs where wage growth and the labor share have failed to increase and a virtuous cycle of rising employment, incomes, and consumption has failed to develop.
Summary: 4) Challenges
It would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. What the government needs to do next is to increase the number of companies that succeed in improving their earnings power, thereby increasing both employment and the labor share, rather than encourage such companies to use those earnings to increase the labor share." - source Nomura
When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited. This is clearly explained in Nomura's interesting note:
"To put it rather bluntly, traditional fiscal and monetary policies seek to boost the real economy and stir inflation by bringing forward demand at the expense of the future. Monetary policy basically works by artificially reducing the future value of a currency, whether by means of positive or negative policy interest rates or by means of interest rates or the quantity of money, in order to encourage companies and households to spend more. Fiscal policy, on the other hand, does not exactly bring forward future demand but achieves a similar effect by using (increased) future government revenue as collateral to fund current spending.
The Nikkei and other news media reported on 14 May that Mr Abe is probably going to announce that the planned increase in the consumption tax is going to be postponed for a second time. Bolstering current demand by postponing a tax increase is also a kind of fiscal policy as it tries to encourage current spending by using future government revenue as collateral.
However, policies that try by one means or another to bring forward future spending in order to boost current economic growth assume that people will expect the economy to grow. However, if people are convinced that the economy is going to shrink, traditional economic policies may have the unintended consequence of making people even more reluctant to spend. We cannot rule out the possibility that the demographic headwinds facing the Japanese economy in the form of a declining and aging population may have led many Japanese households and companies to assume that the Japanese economy will inevitably shrink. This may explain why traditional fiscal and monetary policies have not had the expected impact." - source Nomura

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) as displayed in Nomura's note:
"ROIC, far from declining, has been rising despite a substantial decline in interest rates in general suggests to us that companies have increasingly been focusing their capex on projects with better returns than in the past. In other words, that companies have been increasing their capex and stepping up depreciation of their existing plant and equipment without raising more capital suggests to us that they have managed to both increase their capex and improve their margins without expanding their balance sheets.
At the same time, we note a marked tendency for the profits generated by this efficient capex to accumulate as retained earnings and to be paid out as shareholder returns in the form of dividends, etc without impairing ROE." - source Nomura
If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere". The challenges facing Japan in revisiting its "three arrows" are clearly underlined in Nomura's note:
Assuming the above analysis is correct, it would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. The main challenge is how to raise growth expectations, and the solution probably lies in the existing policy mix.
Two of the existing growth strategies that have proved relatively successful are probably (1) the corporate governance reforms aimed at increasing corporate earnings power and (2) the resulting increase in capex. If that is indeed the case, the next step that needs to be taken is presumably to implement a strategy for increasing the number of companies that succeed in increasing their earnings power.
The labor and employment policies the government has begun to push strongly should focus on those aimed at further improving corporate earnings power as well as on increasing employment and the labor share by increasing the number of Japanese and foreign companies that develop their earnings power, rather than focus on policies aimed at increasing labor participation or the labor share that target existing Japanese companies.
With a widening income gap becoming a social problem on a global scale and politics heading in a direction that reflects that trend, coming up with such policies will be no easy matter. However, in view of Japan's position as the most disadvantaged country in terms of the impact of its demographics on growth expectations, the need for such policies is all the greater." - source Nomura
We could not agree more, unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable".

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street".

When it comes to the effect NIRP has had on Japanese Life insurers, we have discussed on numerous conversations the impact it has had on their foreign allocations and in particular bonds. This was as well clearly displayed in Nomura FX Insights note from the 26th of May entitled "JPY: Lifers' hedge ratio inched up":
"As monthly flow data have been showing, the nine major lifers accumulated foreign exposures aggressively during H2 FY2015 (Figure 2). 

Total foreign exposures held by the nine lifers increased to JPY42.9trn ($391bn) from JPY40.2trn six months ago. After considering the FX valuation impact, we estimate they have increased foreign exposures by JPY4.9trn ($44bn) during H2 FY2015, the highest pace at least since FY2002, which is consistent with the historically biggest foreign bond investment by lifers in February and March, after the introduction of negative rates by the BOJ (see “Temporary pause in portfolio outflows”, 12 May 2016).
Unhedged foreign exposures stood at JPY18.8trn ($171bn), largely unchanged from JPY18.7trn in September 2015. As we expected, most of the recent foreign bond investment by lifers has been on an FX-hedged basis. At the same time, they kept unhedged exposures almost constant despite JPY appreciation in Q1, which suggests lifers were likely small dip buyers of USD/JPY, to keep FX exposures.
US assets remained preferred
A large part of the foreign investment during H2 FY2015 was in USD-denominated assets as expected. The nine major lifers’ exposures in USD assets increased to JPY26.9trn ($245bn) from JPY24.6trn. The USD share in total foreign assets increased to 62.7% in March from 61.3% in September 2015, recording the highest share since September 2002. The FX hedge ratio for USD assets increased to 55.7% from 51.6% during the same period (Figure 3).

As a result, unhedged exposures in USD assets stayed at JPY11.9trn ($108bn), largely unchanged from September last year (Figure 4).

Lifers’ preference for US assets remained strong, but they still prefer FX hedged investment for now.
Fed policy and political risk to be important for lifers’ hedging stance
Major lifers’ FY2015 financial results confirmed their strong appetite for foreign bond investment, without increasing FX risks for now. The results also showed stronger preference for US assets over other foreign assets. As JGB yields remain low, UST investment could give lifers slightly higher yields than JGB investment even after FX hedging (see “Lifers’ shift into foreign bonds continues”, 20 May 2016). The major lifers’ investment plans for FY2016 showed a strong appetite for foreign bond investment this fiscal year, but their investment should be largely FX hedged for the time being (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016).
At the same time, the likelihood of a Fed rate hike by July is clearly rising now, which will increase hedging costs further. Lifers’ risk appetite could also improve after the UK referendum on Brexit. Thus, lifers may consider taking more FX risks in H2 this year." - source Nomura
Of course the latest "sucker punch" delivered to the US dollar versus the Japanese yen thanks to the clearly weak Nonfarm payroll data could somewhat tamper the hedging appetite of the Lifers and trigger some additional volatility on the currency pair.

Whereas Japan has stronger demographic headwinds, the latest miss in the United States coming from the labor market pushes us to ask ourselves on our second point if indeed the Fed is not as well on a "Road to Nowhere" when it comes to its willingness in hiking further during this summer.

  • Macro and Credit  - Is the Fed on a "Road to Nowhere"?
Looking at the miserable May employment report published on Friday, one might rightly ask itself if indeed the Fed is not on the "Road to Nowhere". With only 38,000 jobs created in nonfarm payroll growth and a -59,000 of net revisions, given employment is a lagging indicator on the state of the economy and that we have long argued that the US economy was weaker than expected, it seems to us particularly clear that our long US duration stance will continue to be rewarding. 

While our stance relating gold miners had been vindicated in recent weeks, another surge in gold was clearly expected with this type of miserable NFP. We agreed with Martin Sibileau's view when he posted in his blog A View from the Trenches, on April 4th, 2011 "Gold, the Fed, Ron Paul and Napoléon Bonaparte" at the time he made the following comment:
"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."
In our previous conversation "Through the Looking-Glass", we argued that the Fed was in a bind given the late state of the credit cycle and tightening lending standards. What is of course of interest as well from the previous comments of our friend Martin Sibileau quoted above is that contrary to the key assumption, because the US fiscal deficit has fallen, the Fed had to start "tapering as displayed in the below chart from TradingEconomics:

- source

What is of interest today is that with this kind of employment report, the job of Janet Yellen at the Fed has become even more complicated. On that note we read with interest Bank of America Merrill Lynch's take from their US Economic Watch note from the 3rd of June entitled "Payroll pain for the Fed":
"As expected, average hourly earnings grew 0.2% mom and 2.5% yoy, the latter pace holding steady from April. The modest acceleration in wage growth from last year reflects the tightening in the labor market, although there is still a debate as to whether we have reached full employment. Indeed, the broader measure of the unemployment rate, the U6 figure, held at 9.7%.

What does this mean for the Fed?
There was no saving grace in this disappointing report, and the recent sluggishness in the labor market warrants increased Fed cautiousness. We think a June hike is off the table (and the markets agree, pricing in less than a 5% chance of hike after the number this morning). While a hike in July is still a possibility, we are increasingly comfortable with our September call. There is simply not enough time leading up to those summer FOMC meetings to see the growth and labor data rebound convincingly, and inflation continue to accelerate—all necessary conditions for another increase in rates. After today’s report, Fed Chair Yellen’s speech on Monday will be even more important." - source Bank of America Merrill Lynch
As a reminder if a lower unemployment rate implies higher wages, sooner rather than later, then indeed Janet Yellen's hiking job is difficult. So far wage acceleration doesn't seem to be that material from the latest readings. A real tightening scare from the Fed would only happen if there is concrete evidence of an acceleration in wage pressure. On the other hand, deteriorating market conditions, meaning falling share prices and rising credit spreads à la Q1, would most likely lead the Fed to some renewed easing we think.

What is more and more apparently clear is that too much conflicting communication snippets from Fed members are leaving market pundits puzzled and are indeed eroding more and more the Fed's credibility. This was bound to happen and was clearly illustrated by Nomura's economist Richard Koo, quoted in our November 2014 conversation "Chekhov's gun":
"Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members."- source Richard Koo, Nomura Research Institute
This outcome of "eroding credibility" has been highlighted in our musings and has also been put forward by Bank of America Merrill Lynch in their Ethanomics note from the 3rd of June 2016 entitled  "The Fed's risk management":
"Dazed and confused
It is fair to say that many clients are a bit confused and frustrated with Fed communication. The Fed seems to be constantly changing its focus from one meeting to the next. They seem to regularly promise hikes, only to back off at the last second. Fed statements often seem stale, reflecting where the economy and markets were a couple months ago, rather than current conditions. They say their 2% inflation target is not a ceiling, and yet they only plan to bring inflation back to 2%. They argue that the risks to the outlook are very asymmetric—with rates near zero they have limited anti-recession ammunition—and yet their inflation target is symmetric. This is policy transparency?

Here we pierce the cacophony and offer a simple guidebook to understanding the Fed. The core lesson here is simple: until the Fed is able to achieve significant separation from the zero lower bound for interest rates they will remain highly risk averse. This means they will:
• focus on the latest risk factor rather than their baseline,
• pause at relatively small signs of trouble,
• be very slow to “turn off” risk warnings,
• take a very high risk of overshooting their inflation target,
• and take very little risk of an economically meaningful hawkish “policy mistake.” 
Attention deficit disorder
A common complaint from clients is that the Fed seems to be constantly shifting its focus. One day it is the labor market, and then it is GDP, then inflation, then global developments and then financial conditions. No wonder markets are confused about just what “data” the Fed are “dependent” on.
Contrary to popular belief, the Fed is not constantly changing its mind. Instead, their shifting focus is a sign of very high risk aversion. With the Fed and many other central banks facing chronically low inflation, a weak recovery and near-zero rates they are much more sensitive to downside risks to growth than to upside risks to inflation. As a result, their focus tends to shift to whatever is causing downside risks at the moment.
The labor market has been out of the Fed spotlight for a long time because it is the healthiest part of the economy. By contrast, there have been a number of troubling dead spots for GDP growth and there have been repeated periods of elevated global economic and financial risks.
We expect the Fed to remain highly risk aversion until they have created significant separation from the zero lower bound. Get used to it: as risks rotate, so will the Fed’s focus.
Markets are fast, the Fed is slow
Despite a rebound in the markets in late February and March, Fed officials remained super dovish until after the April 26-27 FOMC meeting. Some investors wondered “what more are they looking for to become more optimistic” and “if this improvement is not enough, will they ever hike?” Recall that even in normal times, there is a good deal of inertia in Fed decision making as they have a very strong aversion to flip flopping. This is one reason why the lagged funds rate is often included in econometric models of the Fed reaction function. Moreover, in our view, each shock is making the Fed a bit more risk averse, making them a bit slower to give the “all clear sign.”. Yellen’s next major speech is on June 6th and we expect her to offer a much less stale view, given months of better markets and no sign that the risk-off trade damaged the economy. There are two lessons here: (1) what the Fed is looking for is more time to decide, and (2) their caution means slow hikes, not no hikes.
The inflation target: do the right thing
Another confusing part of the Fed’s message is the way they describe their inflation target. On the one hand, they swear 2% is “not a ceiling” and they want to average 2% over time. On the other hand, they only want to raise inflation to 2% in the next few nyears, taking an equal risk of overshooting and undershooting. As we noted here, inflation tends to be low early in business cycles and then rise late in the cycle. Hence achieving average inflation of 2% requires overshooting in the second half of economic recoveries. As we also note, this has nothing to do with making up for past low inflation, but is a requirement if the Fed is going to avoid repeatedly undershooting its target in the future.
They also have an inconsistent message on the risks around policy. On the one hand, they underscore that their targets are “symmetric”; on the other hand, they argue that with interest rates near zero the risks to the economy are asymmetric to the downside.
If the risks are asymmetric, why would they have a symmetric target? Moreover, the zero lower bound constraint is one of many things arguing for asymmetry:
• Inflation expectations have clearly slipped below their 2% target, restoring
expectations requires proving that they can achieve average inflation of 2%.
• The increased volatility of the business cycle means the Fed needs to have a higher
nominal funds rate at the end of an expansion to have sufficient ammunition to
fight the next recession.
• The drop in the equilibrium real funds rate lowers the equilibrium nominal funds
rate, giving the Fed less anti-recession ammunition, not more.
• The risks of deflation have risen relative to when the Fed first set its target.
• With other central banks stuck at zero, the Fed may be alone to fight the next
We see only two offsetting arguments. First, overshooting could trigger political backlash. The Fed can deal with this by quietly overshooting and assuring that the overshoot will be limited. Second, a slow exit adds to bubble risks. However, even with its slow exit the Fed has already taken some of the froth out of high yield bonds and commercial real estate lending.1 Ultimately, we expect the Fed to do the right thing and acquiesce to a moderate overshooting of their inflation target. Hence we expect them to act like they have a de facto target of 2.5% over the next several years.
It is hard to fall down when you are crawling
For much of the economic recovery, the bond market consistently priced in rate hikes that never materialized, but the last two years the roles have reversed with the market pricing in less hikes than the Fed is forecasting. Thus a common refrain is that the Fed is “making a policy mistake.” They are going to hike too quickly, damaging the recovery and may be forced to reverse course.
We are skeptical. A corollary of this high risk aversion is that the Fed is unlikely to make a “hawkish” policy mistake. The Fed is moving at a snail’s pace and pauses at every sign of downside risks. Indeed, they have delayed every planned tightening. Moreover, the economy has done fine despite the “taper tantrum,” the “surging dollar” and repeated stock market corrections. The Fed may be making small tactical mistakes, but their goslow-and-hesitate strategy makes an economically meaningful tightening error very unlikely.
Damned if you do; damned if you don’t
The bond market sees a relatively low probability of a rate hike in the second half of the year (Chart 2).

Presumably this is partly because of the looming Presidential election. Clearly the Fed is under political pressure: some candidates have been quite critical of the Fed, there are several bills in Congress designed to reduce Fed independence and a move near the election is likely to attract a good deal of criticism. In our view, political pressure on the Fed is the highest since Paul Volcker broke the back of inflation in the early 1980s. A risk-averse central bank may decide to go into hibernation around the election." - source Bank of America Merrill Lynch
In relation to Bank of America Merrill Lynch's point about inflation tending to be low early in business cycles and then rising late in the cycle, we reminded ourselves that equity bear market tend to coincide with high global core inflation as we wrote about in June 2014:
"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:
 - source

When it comes to "inflation" being the "Unobtainium" element we wrote about in March this year, we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "most important" piece of the puzzle the Fed has so far been struggling to "generate":
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014
And if historically, a true peak in the equity market always happens between 2 and 14 months before recessions, a sudden burst of inflation on conjunction with heightened velocity in the rise in oil prices could indeed have severe consequences on equities we think. Given the on-going complacency and significant rally seen since the bottom of the first quarter, and the low level attained by the Vix, it seems to us that the time is right to start thinking about "hedging" your US equity risk as per our final chart.

  • Final chart: Now is the right time to "hedge"
As clearly we are moving towards the final inning of this credit cycle and given the signs we pointed out recently coming from the Commercial Real Estate market (CRE) indicative of tightening financial conditions, we have to agree with Société Générale's Cross asset Quant Research note from the 26th of May entitled "The Right Hedge for You", now is the right time to hedge as per their table below:
"We’ve been here before
We also looked at buying options opportunistically, using various tactical indicators. We find that it is relatively easy to identify economic crises of a more cyclical nature by monitoring such indicators as the valuation of the stock market, high-yield spreads and the cost of hedging. Forecasting financial and geopolitical crises is a much more daunting task.
Using risk indicators can help reduce the cost of hedging in good times, and possibly buy more options in times of stress. But in the long run, such tactical choices matter less than such seemingly mundane issues as selecting the right expiry, leverage, and strike.
It is interesting to note that most of the indicators we have selected show that now is the right time to hedge equity risk. Volatility is cheap, especially for the S&P and Eurostoxx. As Andrew Lapthorne argues in ‘High aggregate PE valuations and weak profits and not wholly down to Energy’ [GS5], price/earnings valuations are high and profits weak. US high-yield spreads are wide, as they were in the late 1990’s and before the subprime crisis.
Nobody can predict exactly what will happen next, but we think it is a good time to take a serious look at hedging strategies." - source Société Générale
While nobody can predict exactly what will happen next, from our point of view, we know from the early signs of the growing stress in some segments of the credit markets, that it will happen, how it will happen, namely what will be the trigger remains a big unknown. Revisiting hedging strategies, we agree with Société Générale is essential particularly if one believes the US economy is indeed, like Japan on  a "Road to Nowhere".

"Fun without sell gets nowhere but sell without fun tends to become obnoxious." -  Leo Burnett, American businessman
Stay tuned!
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