Credit - The Vortex Ring
"When a system is in turbulence, the turbulence is not just out there
in the environment, but is a part of the organization or organism that
you are looking at." - Kevin Kelly
While looking at the burst of turbulences last week in the credit and
government bond high beta space, in conjunction with the expected
results coming out of the European elections and given our fondness for
"flying" analogies which we abundantly used in our conversation "The Coffin Corner",
in this "Tapering" environment we reminded ourselves of the Vortex Ring
when it came to choosing our post title. The famous Vortex Ring also
known as the "Helicopter Stall" can happen easily under certain specific
conditions particularly when approaching landing, as illustrated more
recently in the movie Bravo Two Zero when the Special Operations 160th
SOAR helicopter came crashing down in Abbottabad during Operation
Neptune Spear after experiencing the infamous vortex ring state.
You are probably already asking yourselves where we are going with this
analogy already but, given Ben Bernanke's various QE programs have been
compared to "helicopter money", we thought a reference to a "helicopter stall" given the Fed's tapering stance would be more than appropriate for this week's chosen title.
Therefore in this week's conversation we will review various states of
central banks at play, between the Fed, Japan and the much expected ECB
move in June.
In a "helicopter stall" or vortex ring state, the helicopter descends
into its own downwash. Under such conditions, the helicopter can fall at
an extremely high rate (deflationary bust).
For such structural failure or crash to occur you need the following
three factors to be present as indicated by Helen Krasner in her article
entitled "Vortex Ring: The 'Helicopter Stall'":
"To get into vortex ring, three factors must all be present:- There must be little or no airspeed.
- There must be a rate of descent.
- There must be power applied.
- There must be little or no airspeed.
In our conversation"The Coffin Corner" we indicated the following:
"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."
With the latest reading from the US GDP
coming at 0.1% for the 1st quarter indicates for us little or no
"airspeed" for the US economy and the aforementioned "economic"
stability we mused on last year.
For Europe the latest inflation readings
indicates little or no "airspeed" on top of the very weak economic
growth reading making it paramount for the ECB to act sooner rather than
later in order to avoid the Vortex Ring state.
- There must be a rate of descent.
Tightening policies to preserve price
stability and unwind some of the trillions of dollars pumped into global
economies since 2007 via "helicopter"easing will require interest rate
hikes, and will also necessitate asset sales by central banks, according
to April's IMF Stability Report. The tapering stance of the Fed does
include indeed a rate of descent of $10 billion a month.
Of course another rate of descent which we have been following has indeed been US Velocity. What
we have found most interesting is the "relationship" between US
Velocity M2 index and US labor participation rate over the years. Back
in July 1997, velocity peaked at 2.13 and so did the US labor
participation rate at 67.3% - Graph source Bloomberg:
It has been downhill from 1997 with velocity falling linked to factor
number three of the "vortex ring" namely "There must be power applied"
(ZIRP in conjunction with the various iterations of QE).
Yet, the recent fall in unemployment has been masking the Fed's progress
in avoiding the dreaded Vortex Ring as seen in the lack of breakout in
the employment population ratio. The Fed has not been able yet to reach
"escape velocity" from this vortex ring as displayed in the Bloomberg
graph below indicative of the conundrum:
The lack of "recovery" of the US economy has indeed been reflected in
bond prices, which have had so far in 2014 in conjunction with gold
posted the biggest returns and upset therefore most strategists' views
of rising rates for 2014 (excluding us given we have been contrarian).
Those who read between our lines have done well so far in 2014 given we
hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":
"If the policy compass is spinning and
there’s no way to predict how governments will react, you don’t know
whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."
- There must be power applied.
When it comes to applying power, like many pundits, we have been baffled
by the action in US Treasury bond buying from Belgium which increased
its holdings in US debt by $201 billion in five months to $381 billion
at the end of March this year, making it the third largest holder after
China and Japan - graph source Bloomberg:
Helicopter pilot students, have a tendency to slow down, if they are
afraid of overshooting their landing point, which can put the helicopter
they are flying in a vortex ring state. In similar fashion, central
bankers have a tendency to slow down if they are afraid of
overshooting.
It is not only the Fed and its central bankers which have a tendency to
overshoot, likewise, Governor Haruhiko Kuroda in Japan has failed to
convince he had done enough to spur 2% inflation and that his policies
will be enough to pull Japan out of 15 years of deflation, risking in
effect another Vortex Ring state for the Japanese markets as displayed
by the below graph plotting the performance of the Nikkei index, the
USD/JPY currency pair and the inverse Itraxx Japan indicative of credit
risk for corporate Japan:
If one looks at unemployment levels and inflation levels for a gauge of
the respective situation of various central banks it seems that, while Japan has achieved full employment,
it has failed for many years to spur inflation, while the US as well as
the United Kingdom, have achieved to reduce their unemployment levels,
Europe is still closer to the Vortex Ring State (deflationary bust)
given it boasts very low inflation levels compared to the other G4 and
record unemployment level, as displayed in this Barclays graph from
their recent Market Strategy note entitled "Japan at the end of the post
VAT hike tunnel" from the 26th of May:
"Monetary policy: Potential growth & expected inflation, quantity & quality
Opinion regarding deflation in Japan has long been divided between
those who believe the problem cannot be solved by monetary policy
alone, ie, potential growth is tied with inflation expectations, and
those arguing conversely that inflation is a pure monetary phenomenon
that can be controlled by monetary policy independently of potential
growth. For some reason, the latter group appears to overlap almost
completely with those claiming that the degree of monetary easing can be
measured unambiguously via the monetary base (monetarists). We agree
with the second group that deflation can be overcome by monetary policy
without a change in potential growth, and believe that this is in fact
occurring at present. However, we think that the driving force behind
the BoJ’s present Quantitative and Qualitative Easing (QQE) is not the
quantitative but the qualitative side.
Japanese market participants tend to subscribe to the former view.
This may reflect a general feeling based on experience rather than the
result of academic study. The nation has failed to quash deflation
despite 15 years of sundry monetary easing measures, which may have
convinced many that inflation expectations are being affected by factors
that cannot be controlled by monetary policy, such as a decline in
potential growth (including demographic trends). For those holding to
this argument, the opposing view sounds like a vacuous theory ignoring a
decade and a half of actual events. In particular, since the majority
of those supporting the second view are “reflationists”, who believe
monetary policy should give greatest weight to quantity, the two sides
basically find themselves talking at cross purposes.
Those taking the former view, which is the market consensus, feel
that events in 2001-06 proved that the size itself of the BoJ’s balance
sheet has no impact. They claim therefore that if the QQE focuses solely
on increasing this volume, it cannot achieve a change in inflation
expectations. However, we think instead that the important point is the
quality of the bank’s balance sheet; ie, the volume of risk in the
bank’s acquired assets. We believe the effectiveness of the monetary
easing by the Fed and BOE after the Lehman shock and the rapid
turnaround in the Japanese economy after the launch of the BoJ’s QQE
stemmed from their purchases of long government bonds and risk assets,
pushing supply/demand above levels (in other words, pushing yields below
levels) that the economic fundamentals would indicate as fair. The
general social principle that economic policy should not intervene in
the free market, which prior to the Lehman shock also applied tacitly to
monetary policy and financial markets, prevented the BoJ from turning
to asset purchases in JGB markets even in deflation-racked Japan. The
serious crisis brought about by the Lehman collapse led to market
intervention by countries worldwide and a shared belief that the
ideology itself needed to change. With the success of this monetary
policy approach in the US and UK, the BoJ also shifted its focus from
quantity to quality, carrying out a market intervention of unprecedented
scale with the QQE.
That is, QQE is a new monetary easing stance that had not been tried in over 15 years of deflation.
Still, the markets perceived this to be little more than an extension
of previous policy and assumed from past experience that it would have
no effect on inflation expectations. A good number of market
participants still dismiss the claim by BoJ Governor Haruhiko Kuroda and
other BoJ executives that the bank’s 2% price stability target is
achievable. Some likely hold the view that the BoJ itself is simply
maintaining the 2% target in the hope of raising inflation expectations
in the market.
In contrast, we think the bank is conducting an easing policy with
entirely different effects than its earlier efforts, and we do not
believe its past inability to beat deflation means that it will be
unsuccessful this time as well. Furthermore, we suspect that the BoJ
itself likely shares this view. Its confidence in the price stability
target may well have deepened in light of ongoing developments in the
Japanese economy. The statement from last week’s Monetary Policy Meeting
noted anew that “QQE has been exerting its intended effects”. As we
have explained, we see this not as calculated optimism designed to perk
up the Japanese public but as a straightforward reflection of the bank’s
actual belief at this time. As long as the bank maintains this stance,
we think it is unlikely to alter its monetary policy. At the same time,
we believe it will be relatively flexible in adjusting its current
policy in the event of any upward or downward risk to the economy." - source Barclays.
When it comes to the US and the United Kingdom, it is interesting to
note the very strong correlation between 10 year bond yields throughout
the years as displayed in the below graph from Bloomberg comparing
yields for UK gilts and US treasuries since March 1994:
And on a shorter time frame since 2011, UK 10 year yields versus US 10 year yields - graph source Bloomberg:
The question on everyone lips is of course who will blink first (raise
rates that is), the Bank of England or the US Fed? One thing we are
certain of, not anytime soon.
So in relation to the veiled question from our title and from Barclays
take, the big question is of course can the "Vortex Ring" (aka
deflationary bust) can be avoided by monetary policy alone?
We are still sitting tightly in the deflationary camp and expect further
yield compression on US Treasuries. As such, we agree with the Wall Street Rant Blog on that subject:
"Many Government Bonds Yielding Less Than United States
I can't listen to a talking head, bond manager, strategist or
seemingly anyone without hearing about how "Rates can only go higher
from here". When in reality THEY CAN go lower! In fact, when you look
around the world, on a relative basis, THEY SHOULD!" - source Wall Street Rant Blog
Indeed they should. To add ammunition to this, one should closely watch
Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion
firepower, in particular its upcoming reforms and asset shift scenarios
as reported by Nomura in their recent report from the 23rd of May:
"The yen bond market remains range-bound as market participants’ interest in Abenomics and expectations of additional BOJ action fall. The consensus view is that the USD/JPY outlook is dependent on the US economy and yields. However, it is increasingly likely that the government’s June growth strategy will exceed market expectations, which have dropped markedly. We are focused on the likely scenario that the GPIF and other public pensions will start shifting from a yen bond bias in the near future. In our upside scenario, these reforms would lead to approximately JPY20trn in foreign securities investment in the next 12-18 months, potentially weakening JPY by about 10%." - source Nomura
Here are the two potential "re-allocation" scenarios according to Nomura's paper:
"As of end-
December 2013, the GPIF had JPY128.6trn ($1.3trn) in managed assets. Of
the three associations, KKR had JPY7.8trn ($78bn), Chikyoren had JPY17.5trn ($175bn)
and Shigaku Kyosai had JPY3.6trn ($36bn, all as of end-March 2013). Total managed
assets for the four pension funds amount to almost JPY160trn ($1.6trn). The GPIF has
attracted the most attention because of the sheer scale of its assets, but the three
associations manage about JPY30trn or $300bn in assets.
The GPIF‟s weighting of Japanese bonds had fallen to 55% as of
end-December 2013. It was reported that after the Industrial
Competitiveness Council‟s follow-up section meeting on 8 April, the
GPIF‟s head office explained that this weighting had dropped to 53.4% on
the withdrawal of pension benefits. Thus the weighting of Japanese
bonds is already below 55% and could be nearing the 52% floor of the
allowable deviation. At the same time, the weighting of Japanese
equities stood at 17.2% at end-December 2013, close to the maximum
allowable deviation of 18%. Foreign bonds. weighting was 10.6%, close to
the standard median value of 11.0%. At 15.2%, foreign equity's
weighting is still some way from the maximum deviation (17.0%). Trends
in the weightings of Japanese bonds and Japanese equities suggest that,
as described in the FY14 investment plan, the GPIF has already been
investing flexibly within the permissible range of deviation, and it may
be investing such that the respective weightings do not approach the
median value. As the strong equities/weak JPY trend has continued since
end-2012 and the fund has changed its basic portfolio in June 2013, the
GPIF.s portfolio is already shifting gradually from domestic bonds to
risk assets.
Asset shift scenarios based on the new basic portfolio
We look at simulations for fund shifts following changes in the basic
portfolios of the GPIF and the three public pension funds, in line with
two scenarios, based on their current portfolios as described above. In
Scenario (1), the four funds lower the weighting of Japanese bonds to
40% and allocate 8% of the money thus freed up to Japanese equity (from
12% to 20%) and 6% each to foreign bonds (11% to 17%) and foreign equity
(12% to 18%), as Panel Chairman Takatoshi Ito recommended.
Scenario (2) assumes more moderate changes, with the Japanese bond
weighting lowered 10% to 50%, the Japanese equity weighting raised 4%
(12% to 16%) and the foreign bond and foreign equity weightings raised
3% each (from 11% to 14% and from 12% to 15%). As we expect a compromise
between the stance of President Mitani, who is cautious about portfolio
changes, and Mr. Ito, who is more aggressive, a reduction in the
Japanese bond weighting to about 50% is close to our main scenario for
now. If the aggressive scenario (1) advocated by Mr Ito is realized, the
GPIF.s balance of Japanese bond holdings would drop by about JPY19.6trn
($196bn), from JPY71.0trn ($710bn) at end-2013 to JPY51.4trn ($514bn).
This JPY19.6trn decrease would translate into a JPY3.6trn ($36bn)
increase in Japanese equity, a JPY8.3trn ($83bn) rise in foreign bonds
and a JPY3.6trn ($36bn) increase in foreign equity. This scenario
assumes that the weighting of short-term assets would recover to 5% of
the basic portfolio, with short-term assets rising by JPY4.1trn ($41bn).
Assuming that the ratio of short-term assets is fixed at the 1.8% level
of end-2013 and that money is allocated to risk assets, the increase in
respective assets would expand accordingly. When including the three
public pension funds, the decrease in the Japanese bond balance would
balloon to JPY26.8trn ($268bn), and the funds could allocate JPY5.8trn
($58bn) to Japanese equity, JPY10.8trn ($108bn) to foreign bonds and
JPY6.0trn ($60bn) to foreign equity.
In Scenario (2), the GPIF.s and three
public pension funds. balance of Japanese bond holdings would decrease
about JPY11.1trn ($111bn). The GPIF.s Japanese equity weighting has
already increased to 17.2%, so if we assume that it returns to the
median after the basic portfolio change (16%), the balance of Japanese
equity would fall about JPY0.5trn ($5bn). At the same time, the balance
of foreign bonds would rise by JPY6.1trn ($61bn) and the balance of
foreign equity would increase about JPY1.2trn ($12bn).
The above figures are rough estimates that do not take valuation
gains or losses into account. Amounts may also differ considerably
depending on fluctuations in short-term assets and investments within
the permissible range of deviation. As noted above, our main scenario at
this point expects changes in the basic portfolio to be around the
scale of Scenario (2) in the near term. However, in what we can Scenario
(2)-2, we assume that Japanese bonds account for 50% of the basic
portfolio, the permissible range of deviation expands to }10“, the
ratio of risk assets is kept higher than the median value to avoid a
sharp drop in Japanese bonds as a result of a sharp acceleration in the
inflation rate, and the weighting of short-term assets is kept at about
2% (permissible range of deviation from median value set at -10% for
Japanese bonds, +5% for Japanese equity, +4% for foreign bonds, 4% for
foreign equity and -3% for short-term assets). In this case, similar to
Scenario (1) the balance of Japanese bonds held by the GPIF and the
three public pension funds would decrease by JPY26.8trn ($268bn), the
balance of Japanese equity would increase JPY7.4trn ($74bn), the balance of foreign bonds would rise JPY12.4trn ($124bn) and the balance of foreign equity would increase JPY7.5trn ($75bn).
At first glance, Scenario (2) looks like a conservative change, but
depending on the actual stance on investments after the basic portfolio
is changed, the asset mix could be significantly changed as envisioned
by Mr. Ito." - source Nomura
No wonder peripheral bonds in Europe have been benefiting from Japan's
appetite as displayed by Bloomberg's recent Chart of the Day entitled
"Euro-Area Periphery Hooked on BOJ stimulus":
"The CHART OF THE DAY shows Europe’s peripheral bond rally stalled this month as the yen strengthened versus the euro. Last
week the Bank of Japan refrained from adding to the 60 trillion yen
($589 billion) to 70 trillion yen poured into the monetary base each
year that has encouraged Japanese investors to put money into
higher-yielding European assets.
“Peripheral yield spreads appear vulnerable to a correction following
the strong rally and the yen tends to often strengthen on credit risk,”
said Anezka Christovova, a foreign- exchange strategist at Credit
Suisse Group AG in London.
“Japanese portfolio flows usually have an impact. Those flows could
now divert elsewhere. We don’t expect any substantial action from the
Bank of Japan in coming months and that could also lead the yen to
strengthen.”
Japanese investors bought a net 1.41
trillion yen of long-term foreign debt in the week ended May 16, the
most since Aug. 9, data from the finance ministry in Tokyo showed on May
22.
Flows into Europe may be tempered as yields in Europe’s periphery
climb. The average yield spread of 10-year Portuguese, Greek, Spanish
and Italian bonds over German bunds has risen 20 basis points this month
to 270 basis points, after touching 239 basis points on May 8, the
lowest since May 2010, based on closing prices.
New York-based BlackRock Inc., the world’s biggest money manager,
said on May 8 it had cut its holdings of Portuguese debt, while Bluebay
Asset Management said on May 9 it had seen the majority of spread
tightening it was looking for.
Trading euro-yen based on movements in the bond-yield spreads of the
euro area’s peripheral nations would have been a successful strategy,
Credit Suisse strategists, including Christovova, wrote in a May 21
note." - source Bloomberg.
It is worth noting Japanese have bought a record $86 billion of US
treasuries in the last 12 months according to Bloomberg data. It is
important to note as well that for the Japanese investors, adjusted for
living expenses, US treasuries still yield more this year than Japanese
government debt than at any time since 1998, as per monthly data
compiled by Bloomberg showed recently. So if the GPIF starts deploying
its "allocation firepower" in June, maybe you ought to cling to your US
treasuries a little bit longer, and maybe after all the Belgian central
bank is just a very "astute" investor after all...
One thing for sure our "Generous Gambler"
aka Mario Draghi has shown he is truly a magician when it comes to
driving market expectations and given all of the above, maybe just a few
tricks such as a rate cut and negative deposit rates will do the trick
nicely to provide continued support for European government bond
markets. Eurozone-residents' demand for foreign assets could be further
extended and exacerbated if the ECB were to try introducing negative
rates on deposits rather than the proverbial QE bazooka unless of course
he goes for the €1 trillion option. The current account excesses which
so far have been supportive of a strong euro versus the dollar have been
the result of Eurozone residents wish of increasing savings as security
against an uncertain future. The willingness of Eurozone residents to
accept net receipts of foreign-currency assets has weighted on the
value of the euro in recent years and has forced the current account
into surplus. Given that surplus it seemed unlikely for us until
recently that the euro would fall much against other currencies unless
credible fears of currency break-up re-emerge. Of course the latest
European elections results could has well re-ignite fears in the coming
months and allow for Mario Draghi to enjoy a depreciation of the euro
without having to resort to the proverbial QE bazooka in conjunction
with the help from the Japanese pension funds allocation.
In recent months, thanks to the US Fed tapering, the 1 year/1 year
forwards for the US dollar and the Euro have significantly diverged as
displayed in the below Bloomberg chart:
Mario Draghi is definitely the greatest central bank magician and
probably an astute student of Sun Tzu and the Art of War we think:
"The best victory is when the opponent surrenders of its own accord
before there are any actual hostilities... It is best to win without
fighting." - Sun Tzu
It is as well probably worth taking Sun Tzu's wise quote in anticipation of the next ECB meeting:
"All warfare is based on deception. Hence, when we are able to
attack, we must seem unable; when using our forces, we must appear
inactive; when we are near, we must make the enemy believe we are far
away; when far away, we must make him believe we are near."
On a final note, when it comes to avoiding the dreaded helicopter stall
aka the Vortex Ring, as per Helen Krasner in her article entitled "Vortex Ring: The 'Helicopter Stall'"
it is supposed very easy. It wasn't for the ace helicopter pilots of
the 160th SOAR during Operation Neptune Spear, There is "no easy day",
same goes with QEs:
"It is actually very easy to get out of vortex ring… at least in the incipient stage when the juddering and yawing starts.
Some say it is impossible to get out of the fully developed state, but
when you start to perceive signs of vortex ring, all you need to do is
remove one of the three factors noted above. So, you push the cyclic
forward to increase airspeed, or lower the collective to reduce power.
It is not possible to reduce the rate of descent to stop vortex ring, as
that would involve increasing power. In practice, pilots usually
increase the airspeed, as unless the helicopter is very high, you don’t
want to lower the collective and risk hitting the ground!" - source Helen Krasner - Decoded Science - January 8, 2013.
Unfortunately, getting out of vortex QE ring won't be that easy rest
assured, particularly given we have not been in the incipient stage
given Japan, the Fed and the Bank of England have all been repeated "QE
offenders", but we ramble again...
"Well, I think we tried very hard not to be overconfident, because
when you get overconfident, that's when something snaps up and bites
you." - Neil Armstrong
Stay tuned!