Wednesday, 25 March 2015

Credit - The camel's nose

"Experience - the wisdom that enables us to recognise in an undesirable old acquaintance the folly that we have already embraced." - Ambrose Bierce, American journalist.

While watching with interest the epic hunt for yield moving into overdrive courtesy of the ECB's QE, in conjunction with the continuation of the Greek tragedy facing "Zugzwang", we reminded ourselves of the metaphor of the camel's nose when it came to choosing this week's title analogy. Given the "camel's nose" is a metaphor for a situation where the permitting of a small, seemingly innocuous act will open the door for larger, clearly undesirable actions, the increasing spat between Germany and Greece in conjunction with the ECB's QE action rest assured are indeed leading to clearly "undesirable outcomes" hence our chosen title.

In this week's conversation we will focus on credit such as the "unintended" consequences of the ECB's QE on the asset class from both a spread and FX perspective as well as Emerging Markets "value" mostly in Asia rather than LATAM.

  • Credit - Back to Beta or when "bad" is "good" for the credit investor courtesy of the ECB
  • With currency war comes volatility for Investment Grade Credit
  • Will the Euro continue to go South? Watch Italian yields
  • Beware of Emerging Markets Corporate LATAM and favor Asia

  • Credit - Back to Beta or when "bad" is "good" for the credit investor courtesy of the ECB
Early 2015 in January in our conversation "Quality Street" we mentioned the significant inflows into the asset class, particularly through ETF inflows. In our long conversation we mentioned were favoring Investment Grade Credit for Financials versus equities:
"We continue to view European Investment Grade credit particularly in the financial space to be more appealing than equities (QE might change this view and boost banks equities). We expect further earning headwinds and surprises with additional goodwill writedowns particularly for European banks having significant Eastern Europe exposure. US banks earnings have erred so far on the weak side. We expect a similar picture in Europe." - source Macronomics, 16th of January 2015
No surprise that QE has indeed changed our view, but, then again, as we mentioned in our conversation the on-going trend is one of deleveraging for the European financial sector for years to come! Therefore, it was not a surprise to us to see the Eurostoxx 600 Bank sub index displaying some underperformance with a YTD performance of around 14.5% versus 17.50% for the broad Eurostoxx 600 index. But, more interestingly from our "credit" point of view, what is of interest to us is that from a "flow" perspective, Investment Grade credit "inflows" in Europe in particular have been losing steam recently as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 20th of March 2015 entitled "Can't eclipse equities":
"The equity show goes on
Last week was another week of strong asset flows. While credit and government bond funds have seen a slight moderation on their inflow pace, flows into equity funds are getting stronger and stronger. Note that equity fund flows are now averaging almost $5bn a week, over the last eight weeks. This performance eclipses fixed income inflows, which still managed to have a decent inflow of +$3.6bn over the week, down from $5.2bn last week.
High-yield saw another $1bn+ inflow last week, but this was the smallest in three weeks. It was the same for high-grade funds were inflows have been losing steam – this week saw just a $1.5bn inflow.
High-grade inflows carry interesting information when looking across currencies. Outflows from the Sterling funds suggest nervousness over the upcoming elections, while the appetite for European assets is clearly driven by ECB QE (see the chart below).

Note dollar credit was hugely popular with European investors in Jan and Feb, but the enthusiasm tailed-off pre the Fed." - source Bank of America Merrill Lynch
As we pointed out in our conversation of October 2014 "Actus Tragicus", this doesn't come as a surprise to us to see a greater enthusiasm for US dollar credit:
"We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...). - source Macronomics, October 2014
Also, the unquenchable appetite for anything having a yield, particularly with the growing support from Japanese international allocations with the GPIF and fellow pensions funds increasing their stake, it clearly points towards a stronger allocation for US Investment Grade Credit versus Europe particularly with €2170 billion of negative yields in the euro area!

As posited by Société Générale in their Multi Asset Portfolio Global Allocation note for the Second Quarter of 2015 entitled "Reducing risk in an expensive world", we agree with their US bonds stance but we disagree on their strong US growth call:
"Negative euro yields make US bonds attractive
Our central economic scenario is for strong growth in the US and tightening by the Federal Reserve, with two rate hikes this year. We expect the impact to be felt mostly at the short end of the curve, as the upside on 10-year rates is capped by very low (read: expensive) sovereign bonds in the eurozone." - source Société Générale
We continue to enjoy our long duration exposure (partially played via ETF ZROZ, up 4.32% YTD) and we disclosed that, recently we added on February's weakness on our long US Treasuries exposure.

When it comes to Investment Grade credit we agree with Société Générale's underweight European Investment Grade Credit and their overweight US Investment Grade Credit as US returns have been so far more appealing in that space:
- source Société Générale
But as far as the "camel's nose" analogy goes, the clearly undesirable actions of the ECB from their QE have indeed pushed back European investors in the "BETA" play or to put it simply, given the disappearance of the "interest rate buffer" in the Investment Grade space, "bad" namely lesser quality bonds have indeed become "good", more appealing than "quality" bonds such as Investment Grade in the European space.

This was clearly indicated in Société Générale's Credit Market Wrap-up of the 10th of March entitled "A corporate is not a custodian: how falling government yields could hurt credit":
The fall in government bond yields in Europe has helped credit spreads tighten since 2010, as investors have moved to credit to get higher yields. But if corporate bond yields cannot fall below zero, then falling bond government yields may eventually drive spreads wider. BBBs and high yield can continue to outperform AAs and As as a result.
Corporate bond yields in Europe have dropped precipitously since October 2008, falling from just over 8% to just over 1% now. 3.8% of the drop was due to a fall in underlying government bond yields; 3.16% of the drop was due to a tightening in credit spreads. So clearly falling government bond yields have been kind to the credit spread market as well.
This may be about to change, however. The lowest corporate yield in the iBoxx index is currently at just 7bp, and clients have a strong reluctance to get paid nothing – or worse, pay something – in order to lend corporates or banks money by buying their bonds. As one client told us a fortnight ago, “A corporate is not a custodian” – meaning he is not willing to pay to park his money even in AA short dated credits.
Herein lies a potential problem, which we call the “lower limit problem.” European benchmark bond yields (i.e. Bunds) are negative out to the 7yr area, and are likely to go even more negative.
This lower limit problem means two things for investors. First, lower rated bonds (with wider spreads and higher yields) are likely to continue to outperform higher rated bonds (with tighter spreads and lower yields).
Second, USD bonds (both from US and European issuers, and also quite possibly from emerging market issuers) are likely to outperform EUR issues, at least in investment grade.
When are falling yields likely to become a problem for high grade European credit? Chart 1 below shows the distribution of European corporate bond yields. Each bar shows the percentage of bonds in the index with a yield below this level. The second bar from the left, for example, shows that 4% of the bonds in the index have a yield between 10bp and 20bp, which means that a further 10bp drop in government yields could lead these issues to hit the lower limit problem.
The lower limit problem has significant implications for credit investors. To avoid it, European investors ought to move down the rating scale, while global investors should consider increasing their dollar-denominated holdings." - source Société Générale
Camel's nose or undesirable outcome for Credit investors? Yes indeed!

This was further highlighted recently by Société Générale in their latest Credit Market Wrap-up on the 24th of March entitled "What European credit investors can learn from Capybaras":
"Quantitative easing is supposed to work this way: the ECB buys bonds from the banks; the banks then replace the bonds with loans to lower-rated companies, and thus reflate the economy. There are signs that bank lending is getting easier, but as our economists have highlighted, we will need to wait for the next quarterly ECB lending survey on 14 April for confirmation of this trend.
So much for the intended consequence of QE. What we are also seeing is two unintended consequences. The first is that the senior debt market in Europe is shrinking, because as banks expect to hold fewer securities, they need less financing. We warned of this back in September last year (in “Honey I shrunk the banks in the index”), but as we showed in yesterday’s credit daily (see “Poised for better days”), the amount of senior debt issued by European banks has contracted by almost a third vs the same period last year. Total senior bank issuance in euros has declined by less than a tenth, but only because senior issuance from US banks has more than doubled.
The second consequence is potentially even more serious. Because government bond yields continue to fall, and because investors are reluctant to buy corporate bonds at a yield of zero or less, highly-rated credit could actually see spreads to benchmarks rise due to QE. We call this the “lower limit problem,” and discussed it first a fortnight ago in “A corporate is not a custodian.”
There are signs that this is happening. Chart 1 shows the percentage changes in the iBoxx European investment grade and high yield indices by ratings class. The chart has been smoothed to account for monthly reweightings (like the one in March which made BB spreads jump and BBB spreads tighten). All ratings classes have generally moved in the same direction, but even in early February the AA and A ratings classes underperformed the three B ratings classes. Moreover, in the sell-off since early March, the percentage widening in AA and Single A debt has been bigger than in BBBs.
If AA and Single A issuers are squeezed out of the debt markets, it’s even possible to imagine them returning to the banks. So bank loans in Europe do grow – but to the highest-rated rather than to the lowest-rated customers.
How should investors hedge against this happening? Within Europe, we recommend buying longer-dated, lower-rated bonds, not only because of the law of unintended consequences, but also because we think beta is going to drive markets (as we argued in our Credit Strategy weekly of 6 March). Within global portfolios, we think it makes more sense to move to higher beta credit markets outside of Europe, such as the US, and even emerging markets (such as the markets highlighted in our 13 March Credit Weekly)." - source Société Générale
The "camel's nose" issue of course is, that in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger! Be careful what you wish for...

In fact since the ECB started it's QE on the 9th of March, bonds spreads have widened on an almost daily basis according to Bank of America Merrill Lynch European Credit Strategist note from the 20th of March entitled "Does credit have the FX factor?":
"A bond too far…or a bund too far?
Was the last fortnight a classic case of “buy the rumour, sell the fact” in credit?
Since QE began on the 9th, bond spreads have widened on an almost daily basis. €40bn+ of supply this month hasn’t helped, but neither have bunds. When government yields fall this quickly, the natural response is that credit spreads get pushed higher.
July 2014 levels, anyone?
Such has been the move in bunds that credit spreads in some parts of the highgrade market are now back to July 2014 levels. The big underperformers have been high-quality duration (look at 7-10yr single-As) and short-call corporate hybrids. These look interesting again, in our view. The extent of the move, combined with lower supply in April, should help limit underperformance from here, we think." - source Bank of America Merrill Lynch
Of course the ECB has been partly responsible for the "instability" in the credit space as indicated by Bank of America Merrill Lynch in their note:
"The story of spread widening lately is more than just about supply. An important catalyst, in our view, has been the speed at which government bond yields have fallen (bunds in particular). Credit spreads are simply the difference between corporate bond yields and government bond yields. Over the last fortnight, the decline in longer-dated bund yields has been drastic, and likely exacerbated by the early days of ECB buying. The ECB looks to have bought longer-duration debt so far. Accordingly, the 30yr bund yield has declined from 1% to 64bp. But credit yields haven’t been able to keep pace with the sharp fall in government bond yields, and so the result has been wider bond spreads. This is why high quality duration has been the big underperformer in credit (plus it was also a very crowded long),
The moves are far from noise as well. Investment-grade valuations have repriced 10% post the ECB, with every part of the market seeing widening (chart 1).
But the big underperformers have been high quality credit and duration. BBBs and high-yield, in contrast, have experienced relatively less pain over the last fortnight." - source Bank of America Merrill Lynch
What we find of interest from a pure "regional macro" perspective is that whereas in the last couple of years European credit has clearly outperformed equities, it seems to us that the ECB's actions have reversed the trend by pushing yields towards negative territory and very significant inflows and performances in the European equities space. At this juncture given the different paths followed by the ECB and the Fed, it seems reasonable to switch from favoring European Credit towards US Credit and, in the equities space, to favor European Equities rather than US equities as a whole.

  • With currency war comes volatility for Investment Grade Credit
The significant rise in FX volatility (which has yet to spill over into equities in true "camel's nose" fashion) is a significant factor to take into account when it comes to driving credit spreads. 

On the specific point of FX volatility on credit spreads, we read with interest the second part of Bank of America Merrill Lynch's European Credit Strategy note from the 20th of March entitled "Does credit have the FX factor?":
"When it comes to thinking about overall currency risk, three factors play a part:
  • Firstly, the size of foreign sales exposure. Do companies in high grade with exposure to a weakening currency say, have 2% sales exposure to that region, or 20%? Clearly, the latter means more currency risk.
  • Secondly, the face value of debt impacted. Do credits with a material sales exposure to a weakening currency make up a small part or a large part of the high-grade market? Again, the latter means more currency risk.
  • Finally, currency volatility. Other things being equal, the more volatile currencies, the greater the currency risk for high-grade." - source Bank of America Merrill Lynch

The rise in FX volatility has been evident since the second semester of 2014 as displayed in a Bank of America Merrill Lynch graph:
- source Bank of America Merrill Lynch

The increased in volatility in FX is an important factor to take into account going forward, from an issuance perspective as clearly indicated in Bank of America Merrill Lynch's note:
"A growing theme for credit investors to watch
Table 5 highlighted that currency volatility is an important risk for the IG nonfinancial market (weighted sales exposure to the Eurozone was below 50%).

Looking forward, we expect this theme to only grow in importance. Amid QE and negative yields in Europe, multinational companies from around the world (not just US issuers) are increasingly looking at issuing Euro corporate bonds. This points to the credit market becoming a lot more global over the next few years, and transitioning away from a market of domestic issuers." - source Bank of America Merrill Lynch
The rise in FX volatility, from a "liquidity" perspective (which has been once again the topic du jour in the BIS's most recent report) is of great importance when it comes to potentially triggering outflows in asset classes. Of course the recurring liquidity risk in credit markets has been amplified by the acceleration in disintermediation as well as the reduction in market making activities due to regulatory pressures, deleveraging and balance sheet constraints, leading of course to a growing sense of a nasty build-up in "instability" in true Minsky fashion or camel's nose but we ramble again...

 As per our quote used in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital
Furthermore, the continuing rise in the US dollar is a cause for concern. We warned about the dollar being undervalued in October 2013 in our conversation "Bread and Circuses":
"When you get both a fast improving current account for the US as well as an improving budget balance in the US, this will lead to fewer dollars available to the rest of the world in the next few years.
The two points above always lead to international liquidity crisis over a long time. Liquidity crisis always lead to financial crisis. Why? The US Current account is the primary source of liquidity for other countries given the US doesn't have a foreign trade constraint." - source Macronomics, October 2013.
Of course, the "camel's nose" impact on the US dollar is that, as ECB’s purchases bonds relentlessly, it will add more negative signs to the "shrinking" universe of European bond yields, therefore the euro should in essence continue to weaken.

  • Will the Euro continue to go South? Watch Italian yields
While in our last conversation we recently pondered on a possible rebound of the Euro versus the US dollar, we continue to think about the extension of the rebound of the Euro given the weaker tone of both the Fed at the last FOMC meeting as well as the weaker macro picture coming from the US as displayed in the latest Durable Good Orders data. For a different perspective, we read with interest Reorient Group David Goldman's take in their note from the 23rd of March in relation to the link between Yields and the Euro currency and why Italy matters:
"Euro vs. USD: It’s the Yield That Counts
Disappearing yields in Europe’s sovereign bond universe are the drivers of the euro exchange rate. The greater the yield, the bigger the impact each of the major European economies’ bond yield exercises on the Euro. Germany, France and Italy each have about US$2 trn in outstanding central government debt. The difference is that Italy contributes most to overall yield. We observe that Italy’s 10-year bond yield shows the most linear relationship to the EUR/USD (in fact, slightly more than 95% during the past year) among the big European issuers.
Extensive econometric testing confirms the visual impression in the above chart: Italy’s 10-year yield has by far the strongest measurable effect on the Euro exchange rate. This result should not be interpreted as evidence that Italy matters much in the great scheme of things. It doesn’t. But it shows that the euro exchange rate depends on the amount of yield available in the currency. As the European Central Bank’s €60 bn per month bond buying program continues, we believe that Eurozone yields will continue to evaporate and the euro will continue to weaken.
If we regress the EUR/USD exchange rate against the German, French and Italian 10-year yields (concurrent and lagged one day), we observe that only the Italian yield shows a high degree of significance (t-statistic above 2.0) after correction for serial correlation. A trend variable is included to test for spurious correlation (the trend is significant, but does not reduce the significance of the Italian yields).
We obtain virtually identical results using Principal Component Decomposition (to eliminate collinearity among the predictors). We also observe that the Granger Causality Test strongly indicates that bond yields lead the exchange rate.
Principal Components Decomposition uses iteration to break down the variation in a universe of security returns into a set of orthogonal (uncorrelated) components. In the test below, we have used returns to the US, German, French and Italian 10-year yields.
The Eigenvalue is a measure of statistical significance; it shows that the first two components are highly significant while the second two components are of dodgy significance (Eigenvalue well below 1.0). The Variance Proportion measures the amount of variation explained by each variable; the common or systemic component of variation explains 59.2% of variation, the 2nd Component an additional 26.6%, and so forth.
The Eigenvectors measure the relative importance of each variable for the components of the universe. In the case of the first Principal Component, all four variables are exposed in the same way. The second Principal Component may be thought of as an “Italian” component, with a factor loading of 0.795 for Italy. The 3rd vector is heavily weighted to the US, and the 4th vector to Germany and France.
If we then regress the Principal Components constructed by the computer with the past 12 months’ daily returns against daily EUR/USD returns, we see that the “Italian” component (2nd Principal Component) has by far the highest t-statistic, or significance. That is a powerful result: it shows that the common (or “systemic”) component of variation of returns to the 10-year bond universe and the “Italian” component have statistical significance, but not the American, German or French components.
- source Reorient Group
Given the weaker tone of US data and the dovish stance of the Fed, we feel that the Euro pullback we discussed last week could continue for a certain period. But, in true camel's nose fashion, one should take into account European government yields and particularly Italy, when it comes to assessing the driver of the Euro going forward as per Reorient Group's note due to the significant impact QE has had on yields so far.

  • Beware of Emerging Markets Corporate LATAM and favor Asia
When it comes to the camel's nose and undesirable actions, the consequences of the negative interest rates imposed to the rest of the world by the Fed led to consequent hot money flows to the rest of the world often mentioned by the BIS and grabbed the attention with the headlines of $9 trillion in USD liabilities outside the United States. The BIS has written much about the buildup of hard currency debt in the corporate sector in emerging markets. We have also voiced our concern in our October 2014 conversation "Sympathy for the Devil" in relation to the particular vulnerability of LATAM and the large part of Brazil High Yield risk representing $30 billion of EM dollar denominated debt issued out of $116 billion with the top sector being energy with $27.7 billion of exposure:

"Given Brazilian growth is clearly stalling with Brazil's GDP shrinking 0.6% in the second quarter from the previous three months, and first-quarter data was revised to a 0.2% contraction, according to the Brazilian Institute of Geography and Statistics with a growth forecast of 0.48% this year and 1.10% next year, we would indeed watch closely the LATAM space in the coming months." - source Macronomics.
A clear illustration of the LATAM non-financial corporate debt issuance spree since QE1 can be seen in Société Générale in their Multi Asset Portfolio Global Allocation note for the Second Quarter of 2015 entitled "Reducing risk in an expensive world":
"The US dollar continues to strengthen against EM currencies.
This is a potentially destabilizing factor for EM corporates, which have borrowed heavily on international markets since the Fed’s first QE in 2009. Latam appears the most at risk from this standpoint." - source Société Générale

So does the dollar strengthening makes Emerging Markets non-financial corporates a no go zone? We would agree with Société Générale that while LATAM appears to be the most vulnerable, Asia seems to be still a good value play given they are positively impacted by the fall in oil prices by more importantly by the fall in food prices as illustrated as well by Société Générale in their report:
"Asia is the EM region where the share of food in the consumer price index is the highest on average." - source Société Générale
From a "value" proposition, it seems that indeed, Asian high yield remains the most attractive asset class based on internal rates return according to Société Générale:

"Asian high yield bonds look relatively attractive from a valuation perspective, while both euro sovereign and high yield bonds look expensive. We are taking profit on our European credit position.
In our new asset allocation, we have increased the weight of Asian high yield and reduced the weight of core eurozone bonds and of European investment grade credit. Asia is taking over on Latam as the biggest EM USD-denominated corporate credit market. This is our favourite region in terms of fundamentals ahead of Fed tightening. Asian assets should also be supported by China more aggressive monetary policy easing" - source Société Générale

While the rebalancing to the East from a longer perspective continues, but, tactically, from a credit perspective, Asia appears more appealing for the time being.

"Right discipline consists, not in external compulsion, but in the habits of mind which lead spontaneously to desirable rather than undesirable activities." - Bertrand Russell, British philosopher.

Stay tuned! 

Tuesday, 17 March 2015

Credit - Zugzwang

"I have with me two gods, Persuasion and Compulsion." - Themistocles

Watching with interest the escalating tensions between Greece and Germany while a payment was made in favor of "special creditor" IMF, we reminded ourselves, for this week's analogy in our chosen title of a situation called Zugzwang (German for "compulsion to move") found in chess and other games given Greek Finance minister Yanis Varoufakis is an expert in game theory. We found it of special interest because in German chess literature, one player is put at a disadvantage because he must make a move when he would prefer to pass and not to move. The fact that the player is compelled to move means that his position will become significantly weaker. The term is also used in combinatorial game theory, where it means that it directly changes the outcome of the game from a win to a loss. Positions with "zugzwang" occur fairly often in chess endgames, a topic we have discussed in a previous chess analogy surrounding European woes in our conversation "The Game of The Century" where we discussed at the time the great chess master abilities of German Chancellor Angela Merkel :
"By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...). Question being for us now, can Europe survive in the current form (number of countries) without making material sacrifices in true Bobby Fischer fashion? One has to wonder." - Macronomics, July 2012
As we indicated in our conversation "Eastern promises" on the 9th of June 2012, we think we are clearly approaching the end of the great European "chess" game and ultimately the only possible Nash equilibrium for Germany will be to defect:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

The ability to play these endgames well is a major factor distinguishing "masters" from "amateurs". In what was labeled "The Game of the Century" and in reference to our previous 2012 chosen title, Bobby Fischer 13 years old at the time, won the game against Donald Byrne, one of the leading American chess masters, by making material sacrifices at the time. 

On a side note and in continuation to our previous chess reference, the same Bobby Fischer used "Zugzwang" twice against Mark Taimanov in 1971 in the World Championships Candidates match. Mark Taimonov was crushed and lost 6 to zero to Bobby Fischer. The Soviet government was deeply embarrassed, and found it "unthinkable" that he could have lost the match so badly to an American without a "political explanation". In response, Soviet officials took away Taimanov's salary and no longer allowed him to travel overseas. The Soviet government later "forgave" Taimanov, and lifted the sanctions against him following Fischer's 6–0 later win the same year against Danish Bent Larsen known for his "unorthodox" style of play,  which paved the way for Bobby Fischer's achievement in reaching the first World Chess Federation (FIDE) number-one-ranked player. Bobby Fischer held the number one slot for 54 months. Maybe Greek Finance minister Yanis Varoufakis will suffer the same "orthodox" measures than Mark Taimanov, in the short term but we ramble again...

In this week's conversation we will look at France, as from our point of view, it continues to be for us as the new barometer for Euro Risk. We will also continue look at the US earnings picture, which appears to us more and more vulnerable to setbacks thanks to a rapid rising US dollar.

  • France appears to us as the weakest link in Europe at the moment
  • Being "short" Euro is one of the most crowded trade
  • Europe continues to be a "flow" driven market
  • King Dollar even rules the Fed
  • Final note "There is an anomaly in US share prices and UST yields"

  • France appears to us as the weakest link in Europe at the moment
French politicians are benefiting from low rates on French debt issuance courtesy of on-going "japanification", but, on the economic and political front, France is showing increasing signs of growing stress as pointed out in our last conversation "China syndrome":
"Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term."
When it comes to complete credibility failure we have to agree with Louis Capital Market's Cross Asset Strategy note from the 9th of March entitled "Will China Resist America Pressure?" in relation to France's incapacity to reform:
"Last week In France we were amused to hear Pierre Moscovici of the European commission explaining to France that the economic policies implemented up to now were not of a satisfactory or adequate quality. The irony is not lost on us. Moscovici was still France’s Minister of Finance four months ago and a man in charge of deciding and implementing the country’s economic and budget policies. To see four months on telling his ex-boss that policies he most probably was involved in are inadequate is simply farcical.
Finance was promoted to head the world economic decision centre and to explain to countries what kind of reforms they should implement or what kind of macroeconomic policies they should run. In France, the nomination of Christine Lagarde as head of the IMF was seen as another farce.
It is striking to see these days the incapacity of France to adjust its economic policy, and in particular its fiscal policy. The charts below are impressive because they show that in Spain public expenditures have adjusted to the new economic reality of the country whilst in France, the public spending trajectory has not adjusted at all.
The chart below is crystal-clear: the pace of growth of public spending is intact! France and Germany are insistent upon the Greek government to maintain its previously defined fiscal consolidation objective. Yet, France has shown its incapacity to enter any fiscal consolidation. It is a shame to see the lack of effort on the expenditure side in France. However, this subject is of little importance, because confidence is so high in financial markets and because the ECB is financing states for free. The reality is that the ECB refuse to consider that they finance governments – however their actions give them away. With its government bond purchases, the ECB has ensured a low financing cost to investment grade countries, no matter what decision is taken on the budgetary front. The Germans were against QE, because they considered it to be an act similar to lending money for free without counterparties to secure risk. To put it simply their reasoning is true.
France will be the only important country in Europe to see a deterioration of its budget deficit in 2015 compared to 2013. It seems that the French government is betting on the economic recovery to get a cyclical rebound of its revenue that will prevent it from making the painful adjustment on the spending side. The opportunity for France clearly lies in its access to a very low financing cost for its public debt that – mechanically – will lower also its debt service in the budget.
Francois Hollande can send his thanks to Mr Draghi as the current context offers significant opportunities for France. French civil servants would have never accepted a decline in their remuneration as was seen in Southern Europe. These painful decisions have been avoided in France and the government is now ready to boast about the cyclical upswing France is enjoying. Such events leave us speechless." - source Louis Capital Markets
Of course the reason why French civil servants would have never accepted a decline in their remuneration is fairly simple to assess. It is the only support left to French president François Hollande! With only 25% of approval rate, there is indeed a large contingent of public servants still supporting the French president as they represent 22% of the working population versus 11% only in Germany. Please also note that 44% of the French National Assembly is made of public servants which explains the lack of "willingness" in implementing "structural reforms and only 3% of businessmen. In the UK you only find 9% of public servants in the House of Commons and 25% are businessmen. The big difference between the United Kingdom and France is that, in the United Kingdom, the particular problem of public servant eligibility was dealt with an absolute ban by the House of Commons Disqualification Act of 1975 and it was justified on the basis that civil servants should keep their political views a private matter. To do otherwise was deemed to impugn the neutrality of the British public service and its ability to serve government of whatever political persuasion. Civil servants therefore are required in the United Kingdom to resign before announcing their candidature. In France, put it simply, with their "bulletproof" status, they never lose, but, that's another matter...

On that particular point around the impossibility of major reforms, we read with interest Bank of America Merrill Lynch's note on France written by their European Economist Gilles Moec published on the 16th of March and entitled "France: doing more than it seems, but less than is needed":
"Tough fiscal and political equation
For this to be neutral for the fiscal balance, we think such a move should be offset by a reduction in public spending. Actually, Paris needs to do more than a mere offset, since the European institutions are still demanding a net fiscal tightening, in our view. This is where the political rigidities of the French centre-left kick in. Although the current administration has clearly embraced a reformist course, and is ready to confront its increasingly restive left wing minority in parliament, this imposes limits to the government’s room for manoeuvre. The administration needs to carefully choose its battles. The government can - and will - slow down spending, but changing the very structures of the public is out of reach in our view.
Cycle to help
Fortunately, a series of external factors are making the government’s job easier. The drop in oil prices will support consumer spending – which has already showed sign of recovery in the last few months. The decline in the exchange rate of the euro will be a major boost for growth, since the particular sensitivity of French exports to currency gyrations offset the low share of foreign trade in GDP. Still, while this should help keeping Paris on the right side of the European rules, we expect only peripheral progress on structural issues." source Bank of America Merrill Lynch
For the reasons stated above, we have to agree, changing the very structure in public spending is clearly out of reach. The game is not only locked but, it is rigged and the burden of taking France out of the proverbial doldrums has been put on the corporate sector. The issue of course is that the French corporate sector boasts a low and declining profitability thanks to important labor cost as indicated in Bank of America Merrill Lynch's note:
"Faced with low and declining profitability, firms have to choose between three solutions. First, run down headcounts and/or pay until the share of profits in value added is restored. Second, cut down on capital expenditure. Third, maintain headcounts/pay, and capex at the cost of higher debt. In the short run, the third solution is from a collective point of view the best one, since it is the only one which is consistent with some protection of aggregate demand (unless fiscal policy can offset the lack of private demand, at the cost of higher public debt), but obviously this is feasible only if interest rates are sufficiently low and banks have enough appetite to lend. Such option was not open in Spain for instance, where the initial level of corporate debt was high, interest rates were very high on account of the sovereign crisis and banks were not in position to lend. A “crash adjustment” of profitability was the only option (Chart 1)
Among the four largest economies of the Euro area, France is the only country where the investment rate of the non-financial corporate sector in 2008-2014 has exceeded the level of 1999-2007 (Table 2). 
Moreover, the investment effort exceeded gross saving, which is a broader measure of profitability, taking into account the impact of net interest and tax. In 2014, investment exceeded saving by 30% (from 11% in 1999-2007), while in Germany and Spain investment was lower than gross saving (in other words the corporate sector there is in a net lending position) and in Italy recourse to external funding fell (Table 3).
This reflects the resilience of the French banking sector throughout the crisis which was able to meet the demand for credit from the firms. Since Q1 2013, corporate debt as a percentage of corporate output has been is higher in France than in Spain (Chart 2). 
In Q3 2014, the ratio stands at 249% in France, very close to the peak level it had reached in Spain (251% in 2009).
This level of corporate debt is however much more sustainable in France than it ever was in Spain. While in the periphery market rates, and bank interest rates margins shot up during the crisis, imposing a major burden on firms when refinancing their debt, in France the banking sector consented to a major drop in lending rates, while the sovereign bond market was likely never seriously under attack (Chart 3). 
This means that, in spite of the significant increase in the stock of debt, net interest payments have been falling. In Q3 2014, net interests stood at only 4.2% of gross operating surplus, significantly below Spain (Chart 4).

Is there a "zombification risk"?
Still, this can’t be a sustainable growth model, for three reasons. First, even if with QE is ECB has become very credible on the “low for long” interest rates policy stance, interest rates cannot remain below equilibrium in France forever.
Second, companies cannot likely maintain a decent level of capex if their expected profitability does not recover at some point. Third, cheap credit can trigger a process of “zombification” of the corporate sector by keeping fundamentally unsound businesses alive, which down the road would damage growth potential by keeping resources skewed towards the least productive sectors.
In France the number of corporate bankruptcies never exceeded the 1993 peak. This contrasts with the explosion in corporate failures seen in Spain (Chart 5 and Chart 6). 

One could find comfort in the fact that the pace of business failure is in line with the position in the cycle, but this could be a case of reverse causality: the reason why the French output gap is not deeper could simply come from the fact that businesses are allowed to survive by an overly complacent banking sector.
However, since the French productivity performance has been decent lately - when compared with Germany - we think that the high survival rate of French companies has not yet impacted overall economic performance, but it's a risk for the future."  - source Bank of America Merrill Lynch
While the corporate sector has been clearly preserved compared to Spain from lower leverage and a lesser credit crunch, the corporate sector, in our views cannot continue to do the "heavy lifting" when public expenses continue to represent around 58% of GDP. Furthermore as it can be seen in Chart 2 from Bank of America Merrill Lynch, the French Corporate debt over corporate output has been steadily increasing and is now above Spain which has been rapidly deleveraging during the last few years.

The political issue of course is that in the incoming elections, the French socialist party is facing serious bashing and as we mentioned before, it's only support comes from the public sector employees as also underlined by Bank of America Merrill Lynch's note:
"This gradualist approach – which generates a pervasive sense in the foreign commentariat that “France is not doing anything” – reflects in our view the fact that i) the current administration campaigned in 2012 on a rejection of Sarkozy’s stance, seen as “too brutal” and ii) an increasingly restive traditionalist left wing of the socialist party imposes limits to the reforms.
Indeed, a peculiarity of the socialist party is that the core of its support does not come from the working class employed in the private sector (which has been increasingly deserting the left for the National Front) but public sector employees.
This puts a limit to how far the government can go in any structural overhaul of how the state operates, while the reformist turnaround of Hollande has created a wedge in the socialist party's parliamentary group.
The fairly limited deregulation offered by the “loi Macron” was forced through parliament thanks to the 49.3 procedure, which explicitly links the passing of a bill to the survival of the government. The left wing of the socialist party had no choice but to support the government on this, to avoid early elections in which they would probably have been wiped out.
The 49.3 procedure can be used only once in each parliamentary session (although the budget bill is excluded from this limit, which means that the government can almost certainly get a budget through). This means that the government must now choose its battles carefully" - source Bank of America Merrill Lynch
While the international scene is watching with caution the rise of the French National Front, the political story, we think is the slow dislocation of the unity of the left. Statistically speaking, what has been rising is more the number of non-voters (around 60%), rather than the "absolute" number of people voting for the National Front.

But, let's move back to France and its "micro-economic" picture. In our conversation "The European crisis: The Greatest Show on Earth", we indicated:
"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."
One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 13th of March points to a deterioration in the Terms of Payments, which indicates that the improving trend since mid 2012 has turned decisively negative:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their March survey have reported an increase by corporate treasurers. Overall +17.9% of corporate treasurers reported an increase compared to the previous month (+13.9%), bringing it back to the level reached in October 2014 (17.9%). The record in 2008 was 40%.

Overall, according to the same monthly survey from the AFTE, large French corporate treasurers indicated that they are still facing an increase in delays in getting paid by their clients. It is therefore not a surprise to see that the overall cash position of French Corporate Treasurers which had been on an improving trend since 2011 has now turned more negative overall according to the survey:
The monthly question asked to French Corporate Treasurers is as follows:
"Is your overall cash position compared to last month falling, remains stable or rising?"
Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's provisional figure came at -8.5%. 

This warrants significant monitoring in the coming months we think from a "corporate monitoring health" perspective.

  • Being "short" Euro is one of the most crowded trade
According to Nomura's FX Positioning Index from the 13th of March, short Euro positioning is still close to record high of November but, looks like it close to stabilising: 
"EUR positioning was little changed the week ended Tuesday, falling just $0.1bn. Since then, specs have sold a further $1.7bn. Positioning is estimated currently at -$25.9bn which is still shy of the lows from November (-$28.1bn) and February (-$28.2bn)."
 - source Nomura
The very significant rapid depreciation of the Euro in conjunction with record low yields are for us clearly signs of the on-going "japanification" process at play in Europe and validates our deflationary bias. But, in terms of risk reversal for the Euro, there could be a pause depending on the FOMC outcome we think.   

In terms of bond yields as well we are getting closer to some floor in Europe (except for Greece...). On that specific "bond" matter we agree with Louis Capital Markets take:
"We have been OW bonds for a while, but would be back to a neutral position because the upside/downside likelihood appears more balanced now. As Mr Weidmann from the ECB said, if the implementation of QE by the ECB is a success, nominal bond yields will increase in the end. This is indeed our conviction and the charts below explain the reasons why.
The green line above should creep higher as inflation expectations normalise. Indeed, the above chart on the right shows that current real yields (extracted from long term inflation linked bonds) are extremely low in Europe (well below the level reached by US inflation linked bonds during QE3). There should, therefore, be a limit to the downside of real rates in Europe which in the end implies a limit to the downside of nominal bond yields in Europe.
We would also like to add to what Mr Weidmann said that if QE is successful, bonds yields should rise AND the euro should stabilise or rise.
This is the contradiction that is emerging these days among investors: if investors continue to be short on the euro, they cannot continue buying European equities, because if the euro continues to decline it will reflect the failure of QE and will validate a deflationary scenario for Europe.
Therefore, the next phase is to see the stabilisation of the euro to validate the recovery of the growth expectations in Europe." - source Louis Capital Markets
When it comes to the success of QE in Europe, as we have stated before, QE without additional policies is bound to fail. 
While from a flow perspective we believe in short term stabilization of the Euro, we agree that the continuation of the decline of the Euro will indeed ultimately reflect the failure of QE and the deflationary scenario playing out in Europe à la Japan.

  • Europe continues to be a "flow" driven market
As far as European equities are concerned, it is indeed a flow driven market which has seen strong foreign investments, particularly by Japanese investors as indicated by Nomura in their JPY Intraday Comment from the 12th of March entitled "Strong foreign equity buying continues":
"Strong foreign equity buying continues
Japanese investors continued to purchase foreign assets at a high pace last week.
They bought JPY356bn ($3.0bn) of foreign equities, for the sixteenth week in a row, while purchasing JPY270bn ($2.3bn) of foreign bonds, for the seventh consecutive week
(Figure 1).

Foreign equity investment flows remain strong, with net purchases of over
JPY1trn per month
(Figure 2). 
Japanese investors purchased JPY1384bn ($11.5bn) of foreign equities in February, more than JPY1trn for the third consecutive month . The record pace of Japanese investment in foreign equities continues so far in March. Pension funds and retail investors were two major net buyers of foreign equities recently, and we expect them to remain strong net buyers of foreign equities as public pension funds shift their portfolios from JGBs and better economic conditions support risk sentiment among retail investors. Strong foreign equity investment by Japanese investors should support USD/JPY this year.
Foreign bond investment has also been relatively strong, while February’s MOFdata showed that banks were major buyers of foreign bonds. Their foreign bond investment likely involved smaller FX transactions than other investor types. Pension funds and toshin companies were also likely small net buyers of foreign bonds, while life insurance companies may still be quiet ahead of fiscal year-end. Life insurance companies sold foreign bonds in February for the first time in two months, albeit a small amount." - source Nomura
The Ides of March...or when Japanese investors are "Zugzwang" (compelled to invest) before the end of the fiscal year (31st of March).

According to Nomura's report,  there was net buying of JPY31bn (USD255mn) in foreign currency denominated toshins on 10 March, according to NRI, the 56th consecutive business day of net purchases. We continue to closely look at Japanese flows when it comes to their European appetite.

  • King Dollar even rules the Fed
Meanwhile the USD crowd remains near record high according to Nomura's FX Positioning Index from the 13th of March:
"According to the IMM data for the week ended March 10, non-commercial accounts increased their USD longs by $3.9bn. Our real time indicator suggests net longs increased by a further $1.2bn since. Net longs stood at $52.8bn by Tuesday and had increased to $54.0bn by Friday’s close, just shy of the all-time high of $55.6bn set the second week of January." 
- source Nomura
We do not believe in a June hike by the Fed and are adamant the Fed will remain rather dovish in the light of recent data disappointments regardless of the strong NFP data recently released. We are therefore content with our current long duration exposure which we added on recently.

On that point we agree with Nomura's latest take from their 13th of March note entitled "Fed - behind the curve or just right?":
"Cross Rates View
The start of the ECB bond-buying spree this week resulted in a further push to historical low yields in Germany, with Bunds breaking through the 20 bps barrier. Almost like clockwork, the UST auctions went over well as the overall EU curve flattening helped reverse the NFP-led selloff. Heading into FOMC next week, it will be another meeting in which they guide the market’s expectations that hiking will happen only when all factors give them enough confidence to do so later this year. The market has had a tendency recently to go into FOMC/Minutes expecting a hawkish event only to be let down. We think the recent reaction to such Fed events will be repeated next week, with the market adding to hedges ahead of time and unwinding them during the presser." - source Nomura
King Dollar: One currency to rule them all, even the Fed!
"Pace: Faster hikes should be self-restrained by an increasingly stronger USD
So far the pricing for a June hike has been a lot more uncertain compared with the 2004 cycle (Fig. 5),  and the Fed’s hiking pace is even more difficult to pinpoint—it should be anything but the well-telegraphed 25bp per meeting schedule we saw back in 2004. 

One key driver this time around is the total dichotomy of global monetary policy, wherein the Fed is about to embark on a hiking path, while the second-largest economic bloc, i.e., the Eurozone, has just started its easing program, while the BoJ is still in QQE. As a result, the FX adjustment is going to have a much more pronounced impact (Fig. 6) on both the financial markets and the U.S. economy. 

We are already seeing equity markets under a bit of pressure as the stronger dollar eats into corporate profits, especially given the heavy weighting of multinationals in the broader indices. As the effects of a stronger dollar trickle down to worsening trade and softer inflation prints, we expect the Fed to be very gentle, as a faster hike pace will have a compounded effect via FX tightening."
Terminal Rate – Higher debt loads call for a terminal rate much lower than before
The business cycle/equity rally is long in the tooth; and with other central banks easing while taper and the dollar act as tightening forces, the terminal rate will end up lower than in the past. The Fed has been ratcheting down terminal expectations (from 4.25% to 3.75%), but we believe that in the upcoming meetings it will avoid lowering this as much as the other dots. Instead we see it focusing more on lowering the dots in 2015 and 2016, because it doesn’t want to admit defeat just yet. Meanwhile, our Economics Team believes the terminal level will be closer to 3% when the Fed finishes tightening in this cycle, largely due to the dollar, as noted above (see link). We stated that the Fed will be lucky to get to 2-2.5% when all is said and done, largely because ratcheting up aggregate demand while performing debt deleveraging requires years of low real rates." - source Nomura
The large global debt overhang requires much smoother maneuvering from the Fed thanks to King Dollar although the Fed feels it needs "Zugzwang" due to latest employment data.

On the dichotomy between Economists' perception and consumers' reality we completely agree with Reorient Group David Goldman's take in their note from the 15th of March entitled "It's all about the dollar...even for the Fed":
"The fact is that consumer behavior with respect to gasoline purchases is not much different than with respect to other items in the consumption basket. The chart below shows year-on-year change in nominal purchases of all goods (excluding food services) and gasoline. The two lines have the identical shape; the only difference is that the absolute change in gasoline sales is much greater, reflecting the volatility of the gasoline price. Evidently American consumers do not feel as confident about the employment outlook as the economists. We observed last week that most of the new jobs created during the employment bounce of the past three months were in low-wage, labor-intensive industries (health care, hospitality, and retail), which explains why wage growth has been absent.

We have never been enthusiastic about quantitative easing: the drag on the US economy is regulatory and fiscal rather than monetary, and the Federal Reserve has had the unenviable task of promoting growth against these headwinds. But the prevailing view at the Fed that an economic rebound justifies higher rates—seemingly among the whole Board of Governors except for Chair Janet Yellen—is inconsistent with the data. The bond market has remained skeptical. The present 10-year Treasury yield of just over 2% reflects lower inflation expectations, consistent with falling commodities prices, and a modestly higher “real” rate (the yield on inflation-indexed securities)." - source Reorient Group, David Goldman
While the Board of Governors of the Fed might feel the "Zugzwang" urge, we remind ourselves that the fact that these players feel compelled to move means that their position will ultimately become significantly weaker. If their head prevails, at the FOMC, they will remain on hold and delay hiking interest rates in June until further data validates the "Zugzwang" we think.

  • Final note "There is an anomaly in US share prices and UST yields"
Like many pundits, we believe the velocity of the rise in King Dollar represents a significant headwind for US corporate earnings and yet another important factor for the eager to trigger "Zugzwang" Fed. In that instance we read with interest Nomura's Japan Navigator comments from the 16th of March. US corporate earnings in April will be essential to watch!
"Concerns over US corporate earnings reports in April
Since last summer, we have been pointing out the anomaly in US share prices and UST yields that appeared at the start of the quarter, which remains in place (Figure 3). 
 This anomaly is: 1) overvalued stock prices correct before earnings season starts, which has been typical in recent quarters; and, 2) The Fed conducts policy based on its communications with the market, and adjusts its hawkishness depending on stock market conditions, which also drives movements in rates markets. Currently, the impact from strong USD on corporate earnings is a key theme, which should increase investor concerns over earnings announcements.
We believe the Fed will remove the “patient” wording in its next statement, but this alone is unlikely to change rate hike expectations. However, as this would means the Fed is maintaining its hawkish stance, investor risk sentiment should then deteriorate into next month’s corporate earnings reports.
Given this, it is worth considering a risk scenario in which the Fed sends an unexpectedly dovish message at its next meeting. While this would likely prompt bond yields to fall, risk sentiment could improve, laying the groundwork for higher share prices and bond yields in April-June.
In either case, this would not trigger the next upturn in yields, unless US economic indicators surprise on the upside." - source Nomura

So "bad news" (rate hike) could end up being good news for US Long bond holders like ourselves (holding pattern). After all that's exactly what we pointed out in the first bullet point of our conversation "Information cascade":
"Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently." - source Macronomics, 8th of March 2015

"What makes zugzwang such a painful death is that the deceased is executed not by a threat but by his own suicide" - Andrew Eden Soltis, American chess grandmaster.

Stay tuned!

Wednesday, 11 March 2015

Currency war - The China Syndrome

"Battle is an orgy of disorder." - General George S. Patton
Looking at the first effects of the QE launch of our "Generous Gambler" aka Mario Draghi and following up on our "Information cascade" prognosis where we stated that central bankers around the world have done the same "marketing" exercise, namely inducing other central bankers to adopt QE, we reminded ourselves in the current "Currency war" of 1979 American Thriller "The China Syndrome" for our title analogy:
"China Syndrome" is a fanciful term—not intended to be taken literally—that describes a fictional worst-case result of a nuclear meltdown, where reactor components melt through their containment structures and into the underlying earth, "all the way to China." - source Wikipedia
Of course our dual reference is linked to our deflationary bias and the rising tail risk of a Chinese currency devaluation which has been impacted as of late not only by the rising US dollar but as well by the global slowdown in demand. China has been trying to offset its credit bubble in a "controlled fashion" and avoiding a "credit meltdown". 

Back in November 2011 we discussed a particular type of rogue wave called the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011
Wave number 3 - Currency crisis:

We voiced again our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":
"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013
At the time we stated that we were in an early stage of a dollar surge.

Back in December 2014 in our conversation "The QE MacGuffin" we added:
"The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil."
Our friends at Rcube Global Asset Management  also voiced their concerns in a guest post entitled "A Chinese Déjà-vu?" published on the 17th of December:
"The Chinese capacity of utilization rate has dropped to 70%. The investment bubble, just like for the Tigers, has been financed with cheap - and until recently plentiful - credit. China now has the largest corporate debt pile in the world, having surpassed the US last year ($14.5 Trillion vs $13.1 for the US)." - source Rcube
As pointed out by our friends in their long contribution, the current situation in China is eerily familiar with the Asian economies in 1997 particularly when you look at domestic demand which is at its weakest since 1997!

In this conversation, we would like to discuss further this clear 2015 global deflationary "tail risk" as it seems it is becoming more and more a "topic du jour" in the financial blogosphere which we are part of. After all, China might as well embrace "QE" at some point in true "Information cascade" fashion which would trigger a global deflationary "wave" of significant proportion...

  • Headwinds of deleveraging and the property markets are too powerful to offset by conventional rate cut measures
  • Lower EUR = higher deflation risk, be careful what you wish for!
  • Central bankers are falling for "Information cascade"!
  • Time to put your contrarian hat on again and go long US Treasuries
  • Final note « Optimism bias » or  how to underestimate Homeownership rates in the US

  • Headwinds of deleveraging and the property markets are too powerful to offset by conventional rate cut measures
China just had its second rate cut in three months to offset the effects of disinflationary pressures sent by its economic powerhouse neighbor Japan and now increasing with the ECB's QE. China is trying to work a balancing act of avoiding an explosion of the credit bubble while maintaining sufficient steam in their economic growth.

Unfortunately, we do not think that a "conventional" approach will be sufficient to offset the "Shrinking pie mentality" we discussed in April last year:
"When it comes to the benefits of "Quantitative Easing" program which went on in various countries (Japan, United States and the United Kingdom), the possible gains of this uphill battle against strong deflationary trends for a small share of a shrinking pie rarely justify the risks in the long run we think.
In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:
"Revaluation of Japanese Yen, a historical lesson to draw: analysis" - Macronomics, April 2014
We also commented at the time:
"In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB. As we pointed out, the Chinese have learned their "Japanese lesson" unfortunately for the US Treasury and there are no US military bases in China (like the United States have in Japan...). Given the raging "Shrinking pie mentality" in the world today, the US economy won't benefit like it did in the 90s from Chinese committing "economic seppuku" as the Japanese did, as they have learned their "Japanese economic lesson" but we ramble again..." - source Macronomics, April 2014
Of course the start of Europe's own QE program is accentuating the difficulties for China to complete its balancing act and avoid a credit meltdown. To that effect, we agree with Nomura's take from their Asia Special Report note from the 28th of January entitled "Quantifying China's monetary policy" that conventional measures will not be enough to counteract disinflationary pressures now coming from Europe as well:
"• The ECB’s QE program is adding further appreciation pressure on the CNY nominal effective exchange rate (NEER), which by constraining exports and adding to disinflationary pressures, further adds to the likelihood of policy loosening in China.
• The types of monetary policy instruments used will depend on economic and financial conditions. Should net capital inflows surge again, we would expect the probability of four RRR cuts in 2015 (our base view) to fall, but the probability of more benchmark rate cuts to rise (we currently expect one 25bp rate cut in Q2).
The risk, however, is that the monetary policy framework may have changed. Given concerns of reigniting the property and credit market booms, authorities may be reluctant to send strong signals of policy easing through interest rate or RRR cuts, leaving piecemeal, targeted instruments as the PBoC’s new, preferred tools. The authorities have expressed their intention to continue targeted piecemeal measures this year. For example, at the 2015 World Economic Forum, Premier Li stressed that China will pay more attention to policy fine-tuning and better utilising targeted policies to ensure the economy within a reasonable band.
The problem is, however, that the headwinds of deleveraging and the property market correction are so powerful – domestic demand is at its weakest since 1997 – that the economy is unlikely to be stabilised on piecemeal easing measures. Moreover, the potency of stealth-like, piecemeal targeted easing on the real economy has weakened significantly, in our view, even for the sectors (e.g. small enterprises) that the targeted measures are supposed to support.
Should this time window for more traditional wholesale monetary policy loosening be missed, the authorities may eventually be forced to ease more aggressively when the economy is slowing more sharply and edging closer to deflation, adding volatilities to the economy." - source Nomura
Further pressure on CNY nominal effective exchange rate (NEER)? this can be ascertained from Société Générale's Cross Asset note from the 9th of March entitled "Is China the major tail risk for global equity markets?":
"RMB weakness

  • The yuan appreciated strongly over the past ten years. Its recent depreciation has fuelled concerns that China could be about to join the currency war.
  • But in fact, the PBoC has been consistently selling dollars to offset capital outflows and maintain the trading band. A continuation of dollar-selling intervention, rather than persistently raising the daily fixing, widening the band, or outright devaluation, remains our base case scenario
  • Our EM strategists highlight that devaluing the RMB has little economic justification given a robust trade balance, medium-term objectives of rebalancing away from exports to the domestic economy, and could work against internationalisation efforts." - source Société Générale
The issue we have with Société Générale's EM strategists case that devaluating the RMB would have little economic justification in the current "rebalancing" act, is that increasing disinflationary pressures from outside China might indeed lead it to succumb to "Information cascade" as a 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.

When it comes to China and "Deleveraging", the country is facing yet another "Long March" as indicated by Morgan Stanley in their March 10 China strategy note entitled "China Deleveraging - the long, bumpy ride continues":
"Total leverage to official GDP has risen to 247% at Sept 2014, still rising but at a slower pace than in the 2008-2011 time frame. Our score of progress on 10 dimensions of successful deleveraging drops back to 48 from 51 out of 100, erasing the improvement made in our last review. China’s deleveraging looks set to stay a long and bumpy ride.Scores have fallen most notably in
1) Guiding down real exchange rate; 2) Generating negative real borrowing rates; and 3) Fiscal transfers to low end households and SMEs. We raised scores for 1) better recognition of bank NPLs and, 2) accelerated capital markets development."
The absolute leverage scale has continued growing but its pace has slowed down. Total system leverage amount in RMB has only been growing at 12% YoY in 20143, ~1/3 of its growth during the peak year of 2009 at 30% (Exhibit 4).However, this is in the context of nominal GDP growth slowing.

Among different segments, mid/large enterprises are the only category that has consistently been growing its leverage amount faster than the entire economy since 2011. As a comparison, small business’s total leverage growth has been consistently lagging the overall economy during the same period. We have always argued that de-levering of large enterprises while further levering up the small enterprises is essential for China to achieve a successful deleveraging. Unfortunately this is not really happening. Exhibit 5 shows how mid/large enterprises’ share in total system leverage balance grows while that of the small enterprises shrinks.
On the plus side, the consumer segment has reported meaningful positive development. Total leverage by consumer has been growing faster than total system leverage in 2013 and 2014 (Exhibit 4), and its absolute share in total social leverage has grown from 8.6% in 2012 to 9.6% by Sep 2014 (Exhibit 5).
Local government also shows a minor slowdown in leverage growth in 2014. However the pace is slower than we would have preferred. This is consistent with our view that thorough auditing/quantifying and designation of LGFV obligations would be much more time-consuming than expected." - source Morgan Stanley
The on-going anti-corruption campaign in China has been gathering momentum, yet, the clean-up in the local authority credit binge as pointed out by Morgan Stanley in their report has been slower. We have long been advocating swift and fast restructuring when dealing with bloated balance sheets, a road Europe has not decided to follow hence the "japanification" process, but that is another matter.

In the devaluation case, Morgan Stanley doesn't believe in their recent note would be the right course of action:
"We have long argued that a lower real exchange rate should be part of an overall policy setting (along with fiscal and monetary adjustment) to help China achieve a successful deleveraging. This is because the net export sectors could play a cushioning role during the adjustment process for the broader corporate sector given its leverage problems and entrenched PPI deflation (see the next section). However, a sudden nominal devaluation of the CNY is not necessarily the right course of action or indeed likely to happen. Our baseline scenario sees only a modest and gradual weakening in the fixed parity of the CNY near term, before gradually appreciating back to 6.09 at the end of the year." - source Morgan Stanley
We agree to disagree with Morgan Stanley and side with Nomura and others on the devaluation risk given the weakness in global demand but we give them for now the benefit of the doubt in the light of exports data showing recently a 15% rise in the first two months of 2015, while the value of imports fell 20 by 20%. 

In similar fashion to Europe, could the decrease in imports in China and lower GDP means consumer have indeed less money to spend as well? We wonder.

Another point which is of great interest from the same Morgan Stanley note is the evolution of China's PPI which has fallen to level not seen since the Great Financial Crisis (GFC):
"The rise in the real interest rate has been mostly caused by the recent deflationary trend itself reflecting China’s excess capacity in over-leverage sectors. PPI in China has dropped to its lowest levels since the Financial Crisis. Feb 2015 PPI declined at accelerated rate of -4.8% yoy (versus -4.3% yoy in Jan 2015) whilst CPI inflation modestly edged up to 1.4% yoy (from 0.8% yoy in Jan 2015). Among all Asia EM countries, China has been in PPI deflation for the longest time – 36 months (Exhibit 14). This PPI deflation has been further exacerbated by the recent stagnated commodity prices at a global level.
China’s actual system wide credit costs are higher than official lending rates. Moreover, China’s system wide credit costs are significantly higher than the official lending rate. Our MS China Banks team estimates the overall system wide credit costs of 7.69% at year-end 2014 has fallen to 7.45% at the time of writing after the most recent official interest rate reduction to 5.35%. On this basis we calculate the real interest rate expressed in relation to PPI inflation is approaching 12% significantly above overall real GDP growth with the real interest rate expressed in relation to CPI quite close to current overall economic growth."
 - source Morgan Stanley

The actual system wide credit costs indicated by Morgan Stanley do validate additional rate cuts in the coming months to facilitate the deleveraging and the economic slowdown.

What could arguably put a spanner in the difficult Chinese "rebalancing" act is in our mind the deflationary impulse of the latest QE player being the ECB hence our next bullet point.

  • Lower EUR = higher deflation risk, be careful what you wish for!

In terms of China Syndrome and currency war, we have also read with interest Bank of America Merrill Lynch from the 9th of March entitled "Currency war, ECB QE and deflation risk:
"Lower EUR = deflation risk?
The decline of EUR/USD below 1.10 may be less benign than it may appear at first.
We believe it is likely to exacerbate an exit from EM, increase the risk of an RMB devaluation, place renewed downward pressure on oil prices, and heighten concerns about deflation risks.
In our view, the decline of EUR/USD this week below 1.10 may be less benign than it looks at first glance:
  • Lower EUR/USD is exacerbating the exit from emerging markets (Chart 10). 

USD/TRY hit an all-time high last week (a risky cut, and USD/MXN is within striking distance of its all-time high reached briefly after the Lehman bankruptcy. Even USD/BRL has moved above 3 for the first time since 2004.
  • Lower EUR/USD will likely put more pressure on China to devalue the CNY (Chart 11). 

As we have argued, a CNY devaluation, which would signal which would signal to us that China is joining the currency war, is the biggest tail-risk of 2015.

  • Lower EUR/USD will likely place downward pressure on commodity prices, particularly oil prices (Chart 12). 
Our commodity team continues to think that the balance of risks for oil prices points to further downside given the elevated level of inventory globally (Chart 13).
 - source Bank of America Merrill Lynch
On the deflationary impact of QE which we have discussed in numerous conversations, we read with interest CITI Matt King's 27th of February note entitled "Is QE Deflationary":
"It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?
Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”
Clearly this is not what’s supposed to happen. QE, and stimulus generally, is supposed to create new demand, improving capacity utilization, not reducing it. But as we pointed out in our liquidity wars conference call this week, it feels ever moreas though central bank easing is just shifting demand from one place to another, not augmenting it.
The same goes for the drop in oil prices. In principle, this ought to be hugely stimulative, at least for net oil consumers. And the argument that it stems solely from the surge in US supply, not from any dearth of global demand, seems persuasive as far as it goes.
But in practice, the wave of capex cuts and associated job losses in anything even vaguely energy-related feels much more immediate than the promise of future job gains following higher consumption. The drop in oil prices, while abrupt, in fact follows a three-year decline in commodity prices more broadly. It’s not just oil where we seem to have built up excess capacity: it’s the entire commodities complex." - source CITI
 What we have long posited is that while wanting to induce inflation, QE induces deflation.

In our conversation "Supervaluationism" back in May 2014 we indicated we were in complete agreement with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":
"Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete
Capital gains in the form of exorbitant bond price? You bet!

Here is a good illustration we think in the meteoric rise of a long Portuguese Government Bond 4.1% maturing on the 15th of February 2045 issued on the 13th of January at par! - graph source Bloomberg:
A nice price increase to say the trading around 134 in cash price meaning risk-free profits on a continuing basis, unconditionally offered to bond speculators thanks to Central banks and their QEs! "Irrational exuberance" à la Alan Greenspan? As we posited in our conversation "Pascal's Wager" bond investors are indeed making a "rational" decision based on the premises that central bankers are "deities".
  • Central bankers are falling for "Information cascade"!
As we posited in our last conversation, central bankers around the world have done the same "marketing" exercise. They have induced other central bankers to adopt QE. The China Syndrome is leading to another form of mimic, this time around currency war as described by Bank of America Merrill Lynch in their 3rd of February note entitled "Currency war and its consequences:
"The unspoken war
There is a growing consensus in the market that an unspoken currency war has broken out. For many countries facing zero interest rates and binding fiscal constraints, the only policy tool left at their disposal to stimulate growth is a weaker exchange rate. The reason why this is a war is that it is ultimately a zerosum game – someone gains only because someone else will lose.
Nevertheless, it would seem that policymakers are becoming more open and ready to avail themselves of this last resort. This includes even those of some large and closed economies that are generally thought not to benefit as much from weaker exchange rates as small and open ones. This is not totally surprising given currency devaluation, unlike structural reforms that can also increase competitiveness, is relatively painless and easier to do politically.
How time has changed. Central bankers who are normally reticent when it comes to talking about exchange rates in public are now openly expressing their desire for a weaker currency. Last September, the BOJ Governor Haruhiko Kuroda suggested that “it is nothing strange at all for the dollar to strengthen” and said that he did not believe that “a weakening yen is undesirable for the Japanese economy.” A month before, ECB President Mario Draghi made the case as to why “the fundamentals for a weaker exchange rate [euro] are today much better than they were two or three months ago.”
All this is helping to reduce the stigma associated with currency devaluation in the international policy circles. Of course, respectable central bankers would still insist that currency depreciation is a consequence of their monetary easing rather than a goal in itself. However, evidence suggests otherwise. The ECB’s new asset purchase program is having a much bigger impact on the euro than on Eurozone interest rates (Chart 1) 

and the clearest impact that BOJ QQE has had so far is a boost to the profit margins of Japanese exporters (Chart 2)."
 -source Bank of America Merrill Lynch

  • Time to put your contrarian hat on again and go long US Treasuries!
While it is no secret that we are sitting tightly in the deflationary camp and that our biggest 2014 has been to go long US duration (partially via ETF ZROZ), we have to confide that, as of late, we have been increasing our exposure following the decent pull-back seen during February. As we also indicated previously, our losses on our exposure have been mitigated by our long standing short exposure on JPY (via ETF YCS). With the EUR/USD touching 1.06 levels, we believe it represents an additional deflationary impulse that both China and the US cannot ignore. On that sense we fully agree with the additional comments made by Bank of America Merrill Lynch in their recent note:
"If the recent negative correlation between S&P 500 and USD/EUR (Chart 3) were to hold, a lower EUR/USD could trigger a more generalized risk-off that would benefit deflationary assets including lower long-term Treasuries. Note that the recent back up in nominal yields has been driven by increased inflation breakevens.
The obvious implication is that investors are becoming concerned about the ability of the US economy to cope with the strengthening USD. Even though on a trade-weighted basis the USD is still far from its highs in the mid-1980s or early 2000s, the pace of the USD appreciation over the past half year has been the second fastest in forty years (Chart 4).

Furthermore, even though exports are only 13% of the US economy, 40% of S&P 500’s earnings now come from outside the US. 
The fact that the weakness in manufacturing export orders appears to be spilling over to general manufacturing orders (Chart 5) and the lack of evidence that consumers are spending what they are saving on gasoline are also likely starting to concern investors.
  What is the trade?
Generally, strong US data lead to higher US bond yields and stronger USD, like on Friday after the February NFP came in stronger than expected. However, we are making the case that we are close to the point that the positive correlation between US rates and the USD begins to turn negative – stronger USD leading to higher deflationary risk leading to lower long-term bond yields." - source Bank of America Merrill Lynch
Indeed, we agree with the above. The economy in the US is much weaker than it seems as we posited in our February conversation "While My Guitar Gently Weeps":
"The recent widening in US Treasuries make a good entry point for those who missed out, we indeed, expect, the data in the US, from a contrarian perspective to be weaker than previously expected, regardless of the most recent NFP."
We will be continuing to add on our long US Treasuries exposure rest assured in true Lacy Hunt fashion.

  • Final note « Optimism bias » or  how to underestimate Homeownership rates in the US:

On a final note we leave you with Bank of America Merrill Lynch's Home Ownership rate simulations from their Morning Market Tidbits note from the 9th of March entitled "The world against deflation" showing that the decline in the US has been more dramatic than the published data:
"Homeownership rate simulations: We derive a homeownership rate assuming household weights by age group as of 1994. In other words, we only allow for the change in the homeownership rates over time to matter, holding the household age weights constant. Under this methodology, the homeownership rate would have declined to 62.1% last year. Hence, the aging of households added 2.3pp to the homeownership rate since 1994. This suggests that the decline in the homeownership rate thus far has been even more dramatic than the published data suggest." - source Bank of America Merrill Lynch
So go ahead Dr Janet Yellen, normalize this...

"Thus it is that in war the victorious strategist only seeks battle after the victory has been won, whereas he who is destined to defeat first fights and afterwards looks for victory." - Sun Tzu

Stay tuned! 
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