This week's guest post from Macronomics continues his recent deflation theme with a look at asset prices and the yield-chasing. The party is still going on, even though everyone knows it will end at some point.
Previously on MoreLiver’s:
Credit - The Coffin corner
"There are old wise central bankers
(Paul Volcker) and bold bankers (Ben Bernanke now joined by Haruhiko
Kuroda ); we have no old central bankers, just bold central bankers". - Macronomics.
Consequences:
When it comes to Japan, the decade-high volatility in Japanese government bond debt induced by Bank of Japan Governor Haruhiko Kuroda, similar to Chuck Yeager's flying antics in the NF-104 Starfighter may have the unwelcomed effect of weakening bond prices and therefore undermine economic-growth goals, that famous Q, in MV=PQ. Excess volatility, or "pull-up" for a Japanese plane can be seen, we think in the rise in JGBs volatility - source Bloomberg:
"The CHART OF THE DAY shows that the pace of swings in 10- year
Japanese government bonds, known as JGBs, surged to levels not seen in
more than 10 years, according to a gauge known as historic volatility.
The measure, which represents the annualized standard deviation of price
changes for a specific time period, surged amid swings in yields that
came after the central bank increased monthly bond buying to 7.5
trillion yen ($76 billion) to reach a 2 percent inflation goal." - source Bloomberg.
In the case of Japan in general and JGBs in particular, another indicator we have been closely following has been the 30 year Swiss bond yields versus the Japan 30 year bond yields throughout 2012 until the recent "Big in Japan" bang moment following the Bank of Japan "all in" move - source Bloomberg:
As one can see for the above chart, it hasn't been really "plain flying"
to say the least recently with the absolute spread widening from near
zero to -54 bps again.
As far as the Nikkei is concerned versus Emerging Markets (MSCI EM), our Japanese Chuck Yeagers have really been pushing the envelope - source Bloomberg:
Push the envelope meaning:
"To attempt to extend the current limits of performance. To innovate, or go beyond commonly accepted boundaries."
This phrase came into general use following the publication Tom Wolfe's book about the space programme - The Right Stuff, 1979:
"One of the phrases that kept running through the conversation was ‘pushing the outside of the envelope’... [That] seemed to be the great challenge and satisfaction of flight test."
In aviation and aeronautics the term 'flight envelope' had been in use since WWII, as here from the Journal of the Royal Aeronautical Society, 1944:
"The best known of the envelope cases is the 'flight envelope', which is in general use in this country and in the United States... The ‘flight envelope’ covers all probable conditions of symmetrical maneuvering flight."
So good luck to our Japanese pilot Kuroda. We wonder if this latest surge in QE wars does not amount to a "Kamikaze" approach in dealing with deflation.
Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think.
As we posited on a number of conversation, the difference in the United States PMI and Europe's PMI and the growth outlook is purely a question of credit conditions - PMI US vs Europe (top graph) and US Leverage Loans versus European Leverage Loans (bottom graph) - source Bloomberg:
Any similarities are purely fortuitous? We think not...The S&P/LSTA
U.S. Leveraged Loan 100 Index was little changed at 98.49 cents on the
dollar. The measure, which tracks the 100 largest dollar-denominated
first-lien leveraged loans, has gained 2.6% this year. What's the latest
US GDP growth figure? 2.5%.
We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (our case for Europe...).
And, when we look at credit growth for non financial corporates in Europe, the picture cannot be clearer than this:
The absolute level of core European government yields has been falling even more with the anticipation of a 25 bps rate cut next week in conjunction with the expectations of unconventional measures which should be taken by the ECB to restore, somewhat the credit transmission mechanism to the real economy, which has been so absent as of late - source Bloomberg:
Both Italian and Spanish government yields are closed to the level they had back in 2010.
But, the new record set up by the Spanish unemployment rate moving at 27.2% in conjunction with Spanish minister Mariano Rajoy seeking a two year extension to tackle its soaring budget deficit to cut its current 10.6% shortfall towards the European limit of 3% by 2016 instead of 2014 is interesting for us for a very simple reason which ties up nicely with this week analogy, namely the non-linearity of public deficits when growth is either absent or very weak. A violent reaction of budget deficits to a loss of economic growth, in similar fashion to a high altitude stall can be very simply explained by a sudden and continuous rise in unemployment levels.
"Past-due loans in Spain have fallen to 161 billion euros ($210 billion) from a high of more than 191 billion euros in November 2012, according to the Bank of Spain, helped by transfers to a `bad bank,' reforms, increased provisions and write-offs. March's estimate-busting surge in unemployment will likely endanger this trend by further pressuring asset quality at both a corporate and retail level." - source Bloomberg
While the unconventional policies and the artificial inflation of asset prices has had few discernible negative side effects to date, the exit risk is clearly extremely large.
Part and parcel of the argument that we have made above is the fact that enormous volumes of non-dedicated money has been encouraged into risk assets, not least across fixed income markets.
Sharp adjustments like the one we have recently seen in gold are likely to become more commonplace in our view. More broadly, the reaction to the mini-backups in US yields early this year also illustrates how prone markets are to withdrawal symptoms.
Credit, in particular, has benefited from being a half-way house, offering less sensitivity to the global downturn than equities and retaining the upside benefit from falling yields. Our US credit strategists calculate that two-thirds of the inflows into US IG credit since 2009 has been through mutual funds and ETFs. A large portion of that will be retail money, more sensitive to total return prospects." - source Citi
Mutual funds and ETFs have seen significant inflows and at the same time inventories in the dealer space are nowhere near the 2007 levels, hence us still "credit dancing" but close to the exit door or ready to pull the handle on the ejection seat. As Matt King from Citi recently put it in his note from April 2013 - Mind the Gap:
- source Citi
And if you think liquidity in the credit space has improved, the unintended consequences of ZIRP from our "Top Guns" means that the turnover in IG corporate bonds is still falling, in similar fashion as velocity is as we move towards the "Coffin corner":
- source Citi
As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
Flying a "Central Bank" or a NF-104 Starfighter requires strict and delicate airplane/monetary control:
"Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via quantitative easing will require interest rate hikes, and may also necessitate asset sales by central banks, according to April's IMF Stability Report. Increased credit and securities losses would be the major negative impacts for banks as rates rise. Bank funding may also be disrupted if asset sales do take place." - source Bloomberg.
So buckle up, because our Central bankers Yeagers are indeed pushing on a string we think as indicated by the "altitude records", or spread tightening levels which are being broken as indicated by the level reached by corporate bonds worldwide as described by John Glover in his Bloomberg article entitled - Record Risk Discounted as Bonds Pass 110 Cents from the 25th of April:
"Corporate bond prices worldwide are poised to set a record as easy money policies by central banks
push investors into riskier investments even with the potential for losses at about an all-time high. Bondholders are paying an average of 110.22 cents on the dollar for the right to receive 100 cents back at maturity plus the interest from coupon payments, according to Bank of America Merrill Lynch’s Global Corporate & High Yield Index. At the same time, the so-called effective duration that measures how sensitive bond prices are to changes in yield has jumped, making the securities about the riskiest to hold ever.
Central bank purchases of government bonds to contain borrowing costs and stimulate economic growth have led investors to pour money into the $10 trillion global market for corporate bonds as they search for yield. Besides betting that interest rates won’t rise anytime soon, investors also face increased risk from restructurings." - source Bloomberg
And as indicated by the same article:
"For every 50-basis-point jump in yields, prices would drop an average 2.85 percent, compared with a low of 2.36 percent in September 2008, according to the average effective duration of the Bank of America Merrill Lynch index. Bond prices rose to a record 110.28 cents on the dollar in November. In 2009, the securities were trading below par." - source Bloomberg.
On a final note, we leave you with a Bloomberg chart indicative of the limited room which stock investors could benefit from a falling US savings rate:
"As the CHART OF THE DAY shows, household savings equaled 2.2 percent
of disposable income in January and 2.6 percent in February, according
to data compiled by the Commerce Department. The rate for March will be
released on April 29. This year’s readings are the lowest since 2007, when the rate dropped as low as 2 percent.
The chart shows the trend in savings since a peak of 8.3 percent was
recorded in May 2008, when the economy was in a recession. “The
potential for a further drop in the savings rate is obviously
more limited,” Lapointe and two colleagues wrote in a report yesterday.
“The best-case scenario” for stocks would be for savings to stabilize at
less than 2 percent of disposable income or to rise gradually, they
wrote. Quarterly increases of more than 1 percentage point since 1950
preceded declines in the Dow Jones Industrial Average for the next
three, six and 12 months, according to data cited in the report. The Dow
industrials moved higher on average when rates rose less than 1 point
or declined. “The risk is that the savings
rate rapidly bounces back to a more ‘normal’ level of 5 percent,” the
report by the Montreal-based strategist and his colleagues said. “This
would put additional pressure on equities.” The rate was 6.5
percent in December, when President Barack Obama and Congress were
struggling to avert automatic tax increases and spending cuts." - source Bloomberg.
We still think deflation is the name of the game, the rest is poetry, and maybe the 1600 level for the S&P is the "Coffin corner" altitude for stalling where oxygen is rare and lift is low - triple top? - source Bloomberg:
Chuck Yeager made the mistake, not once but on each of his four zooms in
the NF-104 Starfighter, and exaggerated on each until his accident was
inevitable long before he departed his familiar flying region....just a
thought...
While watching with bemusement, or disbelief the "Yield famine"
central banks induced rally turning to a credit feeding frenzy, and
looking at a dealer's bond run on our Bloomberg on Ford company with no
offer, but bid only, we could not resist but use again an aeronautical
analogy in our title in similar fashion to our previous post "Bold Banking" where we stated:
"When it comes to "reckless banking" and "reckless piloting", we
found it amusing that current leaders have repeatedly failed to correct
central bankers' policies, like the ones pursued by former Fed president
Alan Greenspan and current Fed president Ben Bernanke, or, the ones
pursued by Japan. These policies are instigating, bubbles after bubbles
at an inspiring rate. When one looks at the fragile state of the "House of cards"
and the "boldness" of credit investors dipping their toes, once again
in very risky credit structures such as CLOs made up more and more with
Cov-lite loans, we think our title, and our analogy to the crash of
"Czar 52" is this time around very appropriate, but once again our
thoughts keep wandering."
As we indicated at the time, the demise of "Czar 52" on the 24th of June 1994 also
called the BUFF (the nickname among pilots for the B-52 meaning Big
Ugly Fat Fellow) which saw the tragic crash of a Boeing B-52H
"Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force
Base during practice maneuvers was due to Colonel Bud Holland's decision
to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick" like our bold bankers.
This week's analogy refer to what is called by pilots the "Coffin corner" also called the "Q Corner", which was responsible for the
accident of Air France Flight 447 in 2009 over the Atlantic Ocean when
the three experienced Airbus A330 pilots were unable to recognize they
were operating at a too high angle of attack to sustain flight:
"The coffin corner (or Q corner) is the altitude at or near which a
fast fixed-wing aircraft's stall speed is equal to the critical Mach
number, at a given gross weight and G-force loading. At this altitude the airplane becomes nearly impossible to keep in stable flight.
Since the stall speed is the minimum speed required to maintain level
flight, any reduction in speed will cause the airplane to stall and lose
altitude." - source Wikipedia
Consequences:
"When an aircraft slows to below its
stall speed, it is unable to generate enough lift in order to cancel out
the forces that act on the aircraft (such as weight and centripetal
force). This will cause the aircraft to drop in altitude. The
drop in altitude may cause the pilot to increase the angle of attack
(the pilot pulls on the stick), because normally increasing the angle of
attack (pulling up) puts the aircraft in a climb. When the
wing however exceeds its critical angle of attack, an increase in angle
of attack (pulling up) will lead to a loss of lift and a further loss of
airspeed (the wing "stalls"). The reason why the wing "stalls" when it
exceeds its critical angle of attack is that the airflow over the top of
the wing separates.
When the airplane exceeds its critical Mach number (such as during
stall prevention or recovery), then drag increases or Mach tuck occurs,
which can cause the aircraft to upset, lose control, and lose altitude.
In either case, as the airplane falls, it could gain speed and then
structural failure could occur, typically due to excessive g forces
during the pullout phase of the recovery.
As an airplane approaches its coffin corner, the margin between stall
speed and critical Mach number becomes smaller and smaller. Small
changes could put one wing or the other above or below the limits. For
instance, a turn causes the inner wing to have a lower airspeed, and the
outer wing, a higher airspeed. The aircraft could exceed both limits at
once. Or, turbulence could cause the airspeed to change suddenly, to
beyond the limits. Some aircraft, such as the Lockheed U-2, routinely
operate in the "coffin corner", which demands great skill from their
pilots." - source Wikipedia
Looking at the desperate attempts by the Bank of Japan to cancel out the
deflationary forces at play by increasing the "angle of monetary
attack" with the "bold" central pilot banker Kuroda pulling very
strongly on the stick, we wonder if Japan will indeed endure structural
failure in the end. Maybe Kuroda is a gifted pilot such as pilots from
the famed Lockheed U-2 spy plane, but, maybe he isn't. On another note,
movie buffs like us will remember the 1983 epic movie "The Right Stuff"
depicting at one point Colonel Chuck Yeager crashing his NF-104 Lockheed
Starfighter on the 4th of December 1963 (also known as the Widow maker,
interestingly the same nickname as the famous short Japanese JGB
trade).
So how did Chuck Yeager encountered the "Coffin Corner" in his "Widow maker"? Why did this legendary test pilot crash?
"The flight data from Chuck’s last two flights, including the
accident proved there was not a single system failure on either his
first flight that day or during the entire accident flight. The data
was undamaged in the accident, due to the low impact falling in a flat
spin, with virtually no fuel on board and no resulting fire in the
airplane. The aircraft had performed flawlessly!
The facts are clear. Chuck Yeager proved incapable of doing the job. He was totally outside his element. He
was a natural pilot who had learned by experience and feel, but never
really understood stability, just ‘sensed’ how airplanes would act, but
aerodynamics and space dynamics are night and day. If he was to fail, I expected it to be outside the aerodynamics region.
But not even that can excuse his accident, which was his fault, alone
and was an error of bad pilot technique during normal, aerodynamic
flight. His shortcoming was inability to gain and maintain the 70
degree climb angle. That required strict and delicate airplane control.
No more and no less.
His failure to do that made the space flight moot. He
made the mistake, not once but on each of his four zooms, exaggerated
on each until his accident was inevitable long before he departed his
familiar flying region. His failing started at the moment he
began a 3½ g pull up to the required 70 degree climb. He never once
made his immediate angle close to 70 degrees thus losing so much energy
that he could not fly high enough to stay out of trouble. Worse yet, he
repeatedly started climb at a lower angle, then pulled the nose up
later losing energy even faster and making the situation far more
critical. He needed time outside the atmosphere to use the reaction
controls to nose over and he denied himself that time with poor piloting
in his element of expertise, aerial flight.
In effect, what he did was climb far too
shallow and then pulled up very steep in aerodynamic flight to a
hammerhead stall, which in any F-104 meant an irrecoverable pitch-up and
likely spin." - source NF104.com
We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ.
Velocity is the real sign that your real economy is alive and well.
While "Q" is the designation for dynamic pressure in our aeronautic
analogy, Q in the equation is
real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if
the central banks current angle of "attack" is not leading to a
significant reduction in "economic" stability, as well as a decrease in
control effectiveness as indicated by the lack of output from the credit
transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan
Greenspan made mistakes after mistakes, and central bankers do not
understand that negative real rates always lead to a collapse in
velocity and a structural decline in Q, namely economic growth rate!
Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies
act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was,
leading to his December 1963 crash. Central Bankers do not understand
stability and aerodynamics...
In relation to Quantitative Easing program, our "bold" pilots/central
bankers should really check the "structural" soundness of their
"confident" policies given that in similar fashion to QEs the F-104
"Widow maker" series all had a very high wing loading (made even higher
when carrying external stores), which demanded that sufficient airspeed
be maintained at all times...Even Erich Hartmann, the world's
top-scoring fighter ace, who commanded one of Germany's first jet
fighter-equipped squadrons deemed the F-104 to be an unsafe aircraft
with poor handling characteristics for aerial combat. To the dismay of
his superiors, Hartmann judged the fighter unfit for Luftwaffe use even
before its introduction.
Maybe it is the reason why the German ace bankers from the Bundesbank
are reluctant to retaliate with more QE in Europe, to the dismay of
Mario Draghi at the ECB.
The Class A mishap rate (write off) of the F-104 in USAF service was
26.7 accidents per 100,000 flight hours as of June 1977, (30.63 through
the end of 2007), the highest accident rate of any USAF Century Series fighter. Some
international operators lost a large proportion of their aircraft
through accidents, although the accident rate varied widely depending on
the user and operating conditions; the German Air Force lost about 30%
of aircraft in accidents over its operating career, and Canada lost over
50% of its F-104s.
Overconfident pilots? Or poor structural design? You decide, but we ramble again.
Overconfident pilots? Or poor structural design? You decide, but we ramble again.
So this week we will look again at the "unintended consequences of our "bold pilots".
The recent meteoric rise in the Japanese Yen, the Nikkei index and the
receding pressure on Itraxx Japan credit spreads courtesy of Abenomics
is validating we think, this week's aeronautical analogy - graph source
Bloomberg:
Looking at Japan's consumer price
index falling 0.9% in March from a year earlier, we do think Japan is
indeed pushing towards the "Coffin corner":"The
relationship of stall speed to critical Mach narrows at high altitudes,
to a point where any sudden increases in angle of attack or roll rate
and disturbances, such as clear-air turbulence, can lead to a stall." - source AINonline - Understanding High-altitude Aerodynamics Is Critical
Moving back to our Lockheed Starfighter reference, at extremely high
angles of attack the F-104 was known to "pitch-up" and enter a spin,
which in most cases was impossible to recover from. We think QEs
like the F-104 are very sensitive to control input, and extremely
unforgiving of pilot error. No wonder another nickname for the plane was
the Flying Coffin.
When it comes to Japan, the decade-high volatility in Japanese government bond debt induced by Bank of Japan Governor Haruhiko Kuroda, similar to Chuck Yeager's flying antics in the NF-104 Starfighter may have the unwelcomed effect of weakening bond prices and therefore undermine economic-growth goals, that famous Q, in MV=PQ. Excess volatility, or "pull-up" for a Japanese plane can be seen, we think in the rise in JGBs volatility - source Bloomberg:
In the case of Japan in general and JGBs in particular, another indicator we have been closely following has been the 30 year Swiss bond yields versus the Japan 30 year bond yields throughout 2012 until the recent "Big in Japan" bang moment following the Bank of Japan "all in" move - source Bloomberg:
As far as the Nikkei is concerned versus Emerging Markets (MSCI EM), our Japanese Chuck Yeagers have really been pushing the envelope - source Bloomberg:
Push the envelope meaning:
"To attempt to extend the current limits of performance. To innovate, or go beyond commonly accepted boundaries."
This phrase came into general use following the publication Tom Wolfe's book about the space programme - The Right Stuff, 1979:
"One of the phrases that kept running through the conversation was ‘pushing the outside of the envelope’... [That] seemed to be the great challenge and satisfaction of flight test."
In aviation and aeronautics the term 'flight envelope' had been in use since WWII, as here from the Journal of the Royal Aeronautical Society, 1944:
"The best known of the envelope cases is the 'flight envelope', which is in general use in this country and in the United States... The ‘flight envelope’ covers all probable conditions of symmetrical maneuvering flight."
So good luck to our Japanese pilot Kuroda. We wonder if this latest surge in QE wars does not amount to a "Kamikaze" approach in dealing with deflation.
Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think.
As we posited on a number of conversation, the difference in the United States PMI and Europe's PMI and the growth outlook is purely a question of credit conditions - PMI US vs Europe (top graph) and US Leverage Loans versus European Leverage Loans (bottom graph) - source Bloomberg:
We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits (our case for Europe...).
And, when we look at credit growth for non financial corporates in Europe, the picture cannot be clearer than this:
The absolute level of core European government yields has been falling even more with the anticipation of a 25 bps rate cut next week in conjunction with the expectations of unconventional measures which should be taken by the ECB to restore, somewhat the credit transmission mechanism to the real economy, which has been so absent as of late - source Bloomberg:
But, the new record set up by the Spanish unemployment rate moving at 27.2% in conjunction with Spanish minister Mariano Rajoy seeking a two year extension to tackle its soaring budget deficit to cut its current 10.6% shortfall towards the European limit of 3% by 2016 instead of 2014 is interesting for us for a very simple reason which ties up nicely with this week analogy, namely the non-linearity of public deficits when growth is either absent or very weak. A violent reaction of budget deficits to a loss of economic growth, in similar fashion to a high altitude stall can be very simply explained by a sudden and continuous rise in unemployment levels.
The case for Spain is interesting, but looking at the alarming rise in
unemployment levels in France, at 3.2 million, the highest level since
1997 and an 11.5% annual increase , France looks increasingly close to
the "coffin corner" we can argue. In relation to France, in our
conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk".
As indicated by a recent note from Natixis on France and the
non-linearity of deficits, when growth falls strongly (like in 1975,
1993 and 2009), the budget deficit is important, in particular when
growth has stalled for two consecutive years. They indicated that if GDP
growth falls by 2 points, the budget deficit, due to its non-linearity
feature, rises not by 0.88 points of GDP in the case of France but by
1.32 points of GDP. So when the French Minister of Economy and Finance
Mr. Moscovici targets 3.7% of budget deficit for 2013 with 0.1% of
positive growth, we think he is seriously deluded given we think GDP
growth for France will be between -0.5% to -1% in 2013.
France unemployment level versus Germany - source Bloomberg:
Meanwhile in the credit space the ""spring-loaded bar mousetrap"
continues to be coiled. For instance on the 23rd of April in the US
credit space the market has witnessed the lowest yield ever recorded
(2.21%) out of more than 3000 observations spanning 12 years of iBoxx
history.
We could not agree more with Societe General recent credit comment:
"Not quite speechless, but we're out of superlatives. The iBoxx junk
index yield is at a record low of 6.19%, IG at a record low of 2.21%;
returns YTD at 3.38% and 1.51% respectively - and it doesn't feel
overheated.
Annoyed at the poor liquidity? Frustrated at the level of the market
and the low levels of supply? Well, we're going to have to get used to
it. We're resigned to going tighter, all-in yields will likely go lower
while secondary market accommodation of a trade will remain the
exception rather than the rule. An exaggeration perhaps, but the point
is made. It's not all about throwing in the towel - well, maybe it is -
but performance will come from embracing risk. We
think it is also about recognising that policy is forcing us to take
higher risk on further massive (potential) manipulation of yields, while
new marginal buyers emerge to take assets out of the market. If it has yield attached to it, there's pretty much a bid.
The more nervous February and March months seem very far away now. Into
the weakening eurozone economy, risks of corporate bond downgrades will
be ignored for the foreseeable future; while the addition of risk
assets outside of our comfort zone will be a necessity, but hopefully a
measured investment in most cases. The recent data (PMIs, for example)
paint a bleak picture with downside risks to the eurozone's Q2 GDP
growth story. Much more of the same (as is likely) and the ECB might cut
soon enough; and while the lower interest rate might have little direct
impact on valuations, the sentiment behind it will matter more.
Additionally, the use of non-conventional tools could lead to a new
marginal buyer of credit risk - and this would heighten investor
frustrations substantially. After all, we're waiting for the Japanese to
put their buying boots on as well. If these buying cares eventually
materialise - well, scary. And the way
equities and fixed income assets are moving - higher in tandem into the
bleak economic outlook - suggests that the market is expecting its next
fix from further central bank policy response. There is some
room for immediate disappointment, but it will come, and not too far
down the road. There's no point in fighting it; instead embrace it, make
yieldier assets your friend - single name event risk permitting. There
will be a pull-back at some stage, but the feared structural unwind of
credit positions isn't likely to be coming any time soon." - source Societe Generale.
And, like our credit friends, we keep dancing, but close to the door,
knowing well enough, at some point the music will stop, and given the
poor liquidity in the secondary space, the feeding frenzy on any new
issues coming to the market, even with a miserable yield (Nestlé 7 year
bond at mid-swaps +25 bps), when it will, it will no doubt be messy,
like a NF104 Lockheed Starfighter falling from the sky.
But until then enjoy the liquidity party as indicated by Bank of America
Merrill Lynch in their recent note from the 25th of April entitled
"Great Divergences and Yogi Berra:
"The liquidity party continues: best performing asset in the past
week = Italian equities; past month = Greek government bonds; YTD =
Japanese equities.
“When you come to a fork in the road, take it.”
The financial markets are currently riddled with divergences and
contradictions. High debt, low growth; record high stocks, record low
bond yields; a bull market in US and Japanese real estate stocks; a bear
market in Chinese real estate stocks. The Great Divergences are best
explained by the war between deflationary debt fundamentals and
aggressive reflationary policies. Real estate and banks remain the best
barometer of policy success." - source Bank of America Merrill Lynch.
Could the below picture be the picture of the "Coffin Corner? Low growth and high debt:
- Source Bank of America Merrill Lynch.
Or could that be the one when one looks at the discrepancy between record low bond yields and record high equities?
- Source Bank of America Merrill Lynch.
Or maybe this one, when one looks at the discrepancy between low commodity prices and higher stock prices?
- Source Bank of America Merrill Lynch.
Just a fact in relation to the defensive nature of the S&P rally, year to date, 2013 buyback authorizations are at around $275 billion, +102% from a year ago and +8% vs 2007.
So what's the risk for our bold pilots / central bankers you might
rightly ask? Well, on that very point we agree with Citi's recent note
from the 25th of April entitled "Too much money, not enough assets to
buy", which for us is reminiscent of the crazy days of 2007:
"What's the risk?
While the unconventional policies and the artificial inflation of asset prices has had few discernible negative side effects to date, the exit risk is clearly extremely large.
Part and parcel of the argument that we have made above is the fact that enormous volumes of non-dedicated money has been encouraged into risk assets, not least across fixed income markets.
Sharp adjustments like the one we have recently seen in gold are likely to become more commonplace in our view. More broadly, the reaction to the mini-backups in US yields early this year also illustrates how prone markets are to withdrawal symptoms.
Credit, in particular, has benefited from being a half-way house, offering less sensitivity to the global downturn than equities and retaining the upside benefit from falling yields. Our US credit strategists calculate that two-thirds of the inflows into US IG credit since 2009 has been through mutual funds and ETFs. A large portion of that will be retail money, more sensitive to total return prospects." - source Citi
Mutual funds and ETFs have seen significant inflows and at the same time inventories in the dealer space are nowhere near the 2007 levels, hence us still "credit dancing" but close to the exit door or ready to pull the handle on the ejection seat. As Matt King from Citi recently put it in his note from April 2013 - Mind the Gap:
And if you think liquidity in the credit space has improved, the unintended consequences of ZIRP from our "Top Guns" means that the turnover in IG corporate bonds is still falling, in similar fashion as velocity is as we move towards the "Coffin corner":
As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
Flying a "Central Bank" or a NF-104 Starfighter requires strict and delicate airplane/monetary control:
"Tightening policies to preserve price stability and unwind some of the trillions of dollars pumped into global economies since 2007 via quantitative easing will require interest rate hikes, and may also necessitate asset sales by central banks, according to April's IMF Stability Report. Increased credit and securities losses would be the major negative impacts for banks as rates rise. Bank funding may also be disrupted if asset sales do take place." - source Bloomberg.
So buckle up, because our Central bankers Yeagers are indeed pushing on a string we think as indicated by the "altitude records", or spread tightening levels which are being broken as indicated by the level reached by corporate bonds worldwide as described by John Glover in his Bloomberg article entitled - Record Risk Discounted as Bonds Pass 110 Cents from the 25th of April:
"Corporate bond prices worldwide are poised to set a record as easy money policies by central banks
push investors into riskier investments even with the potential for losses at about an all-time high. Bondholders are paying an average of 110.22 cents on the dollar for the right to receive 100 cents back at maturity plus the interest from coupon payments, according to Bank of America Merrill Lynch’s Global Corporate & High Yield Index. At the same time, the so-called effective duration that measures how sensitive bond prices are to changes in yield has jumped, making the securities about the riskiest to hold ever.
Central bank purchases of government bonds to contain borrowing costs and stimulate economic growth have led investors to pour money into the $10 trillion global market for corporate bonds as they search for yield. Besides betting that interest rates won’t rise anytime soon, investors also face increased risk from restructurings." - source Bloomberg
And as indicated by the same article:
"For every 50-basis-point jump in yields, prices would drop an average 2.85 percent, compared with a low of 2.36 percent in September 2008, according to the average effective duration of the Bank of America Merrill Lynch index. Bond prices rose to a record 110.28 cents on the dollar in November. In 2009, the securities were trading below par." - source Bloomberg.
On a final note, we leave you with a Bloomberg chart indicative of the limited room which stock investors could benefit from a falling US savings rate:
We still think deflation is the name of the game, the rest is poetry, and maybe the 1600 level for the S&P is the "Coffin corner" altitude for stalling where oxygen is rare and lift is low - triple top? - source Bloomberg:
"A kamikaze is a surprise attack, according to our ancient war
tactics. Surprise attacks will be successful the first time, maybe two
or three times. But what fool would continue the same attacks for ten
months? Emperor Hirohito must have realized it. He should have said
'Stop.'"
- Saburo Sakai, IJN flying ace