By Martin T. – Macronomics
September 25, 2012
“Insanity: doing the same thing over and over again and expecting different results.” – Albert Einstein
Last week, we ventured towards the diminishing returns QE in the US would have on the real economy. While you might be puzzled by our latest choice of title, we ought to give you, dear readers, some rational explanation in this week title selection. William Boyd, the novelist and screenwriter (who wrote the latest James Bond novel), used the term “zemblanity” to mean somewhat the opposite of “serendipity”: “making unhappy, unlucky and expected discoveries occurring by design”, which is exactly what central banks over the world will eventually discover with their latest merry go rounds of quantitative easing. So in our long credit conversation, we will investigate further the potential for disappointment from this latest round of “easing” from our “Generous Gamblers” which have been flooding the markets recently with even more liquidity.
Definition of Zemblanity – “The inexorable discovery of what we don’t want to know”.
While serendipity means a “happy accident” or “pleasant surprise”; specifically, the accident of finding something good or useful while not specifically searching for it, zemblanity is the opposite. Robert K. Merton in Social Theory and Social Structure (1949) referred to the “serendipity pattern” as a fairly common experience of observing an “unanticipated, anomalous and strategic datum which becomes the occasion for developing a new theory or for extending an existing theory” as indicated by Wikipedia.
What we 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%. Now at 63.5% the US is back to 1981 and velocity is still cratering (1.58), back to 1965 level – source Bloomberg:
Back to the Future? So although in the movie Dr Emmet “Doc” Brown was trying to find a way to return to 1985 from 1955, we have “Doc” Ben Bernanke expecting QE3 will be successful in increasing the labor participation rate and velocity back to 1997 and successful in reducing the unemployment burden on the US economy. It will not happen.
President Ronald Reagan, was a fan of the film “Back to the Future” and referred to the movie in his 1986 State of the Union Address when he said, “Never has there been a more exciting time to be alive, a time of rousing wonder and heroic achievement. As they said in the film Back to the Future, ‘Where we’re going, we don’t need roads.’” Unfortunately this is not 1986 in terms of economic outlook.
So what “Doc” Bernanke is telling us now is that “Where we’re going, we need jobs” basically. Nice wishful thinking.
MV=PT as per Irving Fisher’s equation. Unfortunately, it looks like the increase in M with a falling V, is not leading to a rise in T nor in a rise in the US labor participation rate for “Doc” Bernanke. Velocity and US labor participation rate from 2005 onwards – source Bloomberg:
Milton Friedman was convinced he could rebuke Keynes theory by showing that the velocity of money was relatively fixed and thus that the relationship between the money supply and national income could therefore fall apart if Friedman’s assumption was indeed correct. It wasn’t. Velocity is not constant and Friedman admitted on the 19th of August 2003 he was wrong:
“Prior to the 1980s, the Fed got into trouble because it generated wide fluctuations in monetary growth per unit of output. Far from promoting price stability, it was itself a major source of instability. Yet since the mid ’80s, it has managed to control the money supply in such a way as to offset changes not only in output but also in velocity. This sounds easy but it is not — because of the long time lag between changes in money and in prices. It takes something like two years for a change in monetary growth to affect significantly the behavior of prices. The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply — a veritable bubble in velocity. Chart 2 shows what happened. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.”
But Keynes was also wrong. For Keynes the quantity of money did not matter, what mattered were autonomous spending and the multiplier. By keeping interest low to promote investment, like the Fed is currently doing, full employment would therefore be “attainable”. For Keynes, the velocity of money would move together with the level of economic activity (and the interest rate).
We think the above charts indicating M2 and the US labor participation rate are indicative of the failure for both theories. Both theories failed in essence because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of “stocks” versus “flows”.
Our core thought process relating to credit and economic growth is solely based around the very important concept namely the accounting principles of “stocks” versus “flows”:
“We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation “The European issue of circularity“, given that while the Fed has been financing “stocks” (mortgages), while the ECB is financing “flows” (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate.”
We encountered through our weekly blog reading an essential post dealing with our core concept of “stocks versus “flows” from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled – How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: “We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).
To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth.
We have called the change in debt (or the change in credit growth) the ‘credit impulse’. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit.”
We therefore wonder in relation to the latest bout of global quantitative easings the following:
“Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?”
So can someone please demonstrate to us how “this time it is going to be different” in terms of outcome for the US labor market given the “paradox of thrift” with bank reserves sitting idle at the Fed like we indicated in our previous conversation, with a broken transmission to the US economy, and questions surrounding fiscal stimulus which could potentially alleviate the situation (tax breaks for small companies anyone…)?
We came across this comment from a participant on a macro research forum from a prominent global research firm and we did find it very appropriate in relation to our title analogy, namely “Zemblanity” and thought we had to share it:
“Isn’t QE3 in one sense a blow to the essence of America’s prosperity, free markets and with that efficient capital allocation? Setting a target for unemployment rate by running the printing press sounds a lot like a planned economy. It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan? Have we become so short sighted and spoiled that we can’t face the hard facts of our previous reckless childish behavior? I can’t think of any time in history when avoiding the truth ever was a sustainable choice. Only history will tell but FED, ECB, BOJ and BOE (soon BOC?) all being in the same boat makes you worried about unintended consequences…. I’m 100% long risk for the moment but long term I think this takes us further from a sustainable world.”
“we can’t face the hard facts of our previous reckless childish behavior” – No, we clearly cannot.
Definition of Zemblanity – “The inexorable discovery of what we don’t want to know”.
“It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan?”
Of course it will! The Bank of Japan is already losing out to Yen-hoarding households! – source Bloomberg:
“The Bank of Japan’s efforts to weaken the yen are being undermined as households hoard the most currency in 14 years, according to Mizuho Corporate Bank Ltd. The CHART OF THE DAY tracks the yen’s rally versus the dollar and the deposit-assets and currency holdings of domestic savers. Also shown is the start of central bank monetary easing through the asset purchase program set up in October 2010, which has had limited impact on the currency. The yen rose the past two days even after the BOJ’s surprise Sept. 19 announcement of more asset buying, contrasting with stimulus efforts in February that helped weaken the currency for five weeks. BOJ quarterly flow of funds data yesterday showed individual investors, often referred to as “Mrs. Watanabe” because many are housewives, increased yen deposits and cash to 844.1 trillion yen ($10.8 trillion) in the three months ended June 30. That’s the most since at least December 1997 and double the annual output of Japan’s economy, the world’s third largest.” – source Bloomberg
Back in early September in our conversation “Structural Instability“, we indicated that the overall underperformance of Japanese credit spreads as illustrated from the below graph on some selected Japanese companies (source CMA) which continue to weaken in conjunction with their Sovereign CDS (Japan’s sovereign CDS wider by 20 bps in one month) is at present the only notable disconnect between credit spreads and spot equities.
The Japanese relationship between equities and credit warrants monitoring and could be played by selling CDS and buying Nikkei Put Options we indicated in early September courtesy of our good cross-asset friend. Nikkei Put Options benefit from absolute low volatility levels. Nikkei Index – 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since March 2010 until the 21st of September 2012 – source Bloomberg:
In similar fashion to the current Japanese plight, the Fed will eventually discover soon that company debt sales will counter its bond buying plan – source Bloomberg:
“Increased borrowing by companies may blunt the economic effects of the Federal Reserve’s third round of bond purchases, according to Michael Shaoul, chairman of Marketfield Asset Management LLC. As the CHART OF THE DAY shows, U.S. companies have already sold more than $1 trillion of dollar-denominated debt this year, according to data compiled by Bloomberg. The year-to-date total is 22 percent above the average for the previous five years. “Corporate debt should act to absorb the cash” generated by the Fed’s quantitative easing, Shaoul wrote yesterday in an e-mail. The central bank will buy $40 billion of mortgage-backed securities a month in an effort to stimulate economic growth and reduce unemployment. Borrowing costs for companies were unusually low before Fed policy makers reached their decision last week. Yields on Baa rated corporate bonds are less than 5 percent, according to a Moody’s Investors Service index. They fell below the threshold this year for the first time in more than a quarter century. As more companies take advantage of the relatively cheap funding, they may overwhelm any growth in bond demand that stems from the Fed’s buying and related bond investments, Shaoul wrote in the e-mail “Our greatest concern regarding QE3 was that it was not only unnecessary, but may in the end prove to be positively harmful,” he wrote yesterday in a report highlighting this year’s increase in corporate borrowing. He said the risk arises because bonds will be unable to match their gains in the past few years “unless we truly face an ‘end of the world’ type depression.”.” source Bloomberg.
We ended up last week’s conversation by indicating:
“Borrowers, not lenders, are in short supply during balance sheet recessions I used the term “unnecessary” to describe recent central bank actions because balance sheet recessions are characterized by a massive surplus of private savings. In noneurozone countries, these funds have nowhere to go but the government bond market, since the government is the last borrower standing. That is why government bond yields fall steadily, as they did in Japan even prior to 2001. In other words, it is borrowers that are in short supply when the private sector is saving money and paying down debt in spite of zero interest rates. Under such circumstances it is difficult to see what economic benefit could arise from adding the central bank as a lender when the bottleneck of the economy is elsewhere.”
Exactly! This even more the case when you factor in the demographic impact the “Baby Boomers Generation” has had and will have on US treasury markets (74 million to retire in the next 20 years) as we posited in our last conversation “Pareto Efficiency” and so was the impact on yields from Japan’s aging population on JGB’s yields. In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, it is that simple, and the losers today being unfortunately the younger generation in “developed” countries. Therefore, we believe that, from an allocation point of view, investing in Fixed Income Emerging Markets countries, having both favorable demographic trends (young population) and decent current account balances, makes a lot of sense from a long term investment perspective, but we ramble a lot. Time for a credit overview!
But more importantly the changes in the Itraxx Crossover series 18 (which references the 50 most liquid European High Yield and low triple B rated credits) have seen the arrival of Spanish giant Repsol as a result of the rating actions in conjunction with the negative outlook. 14 members of the 50 names of the Itraxx Crossover index now come from peripheral strained countries.While rolling from the old Series 17 to the new series 18 (selling series 17 and buying series 18) cost you around 5 bps for the Itraxx Main Europe (investment grade risk gauge), a similar roll for the Itraxx Crossover cost you around 65 bps on Thursday. Whereas the roll for the Itraxx Financial Senior index and Itraxx Financial Subordinated index was around -11 bps for Senior and -20 bps for Subordinated, reflecting the improvement in quality of the index with the addition of ING and Standard Chartered and the removal of BBVA and Monte Paschi dei Siena (MPS).
One can expect that going forward, the series 18 should be more volatile for the Itraxx Crossover whereas the Itraxx Main Europe, Itraxx Financial Senior and Subordinated index should be less volatile given the substitutions of the entities making up these various indices.
Looking at the below graph, one could argue that severing of the link between Sovereign risk / Financial risk is somewhat happening given the significant drop of the spread between the Itraxx Financial 5 year Senior index reflecting financial risk and the SOVx 5 year index representing Sovereign CDS risk in Western Europe. It is deceptive given that the new series 18 for the Itraxx SOVx index which comprised previously 15 entities, has seen Cyprus falling out of the index because of lack of trading in CDS linked to Cyprus’s debt – source Bloomberg:
In relation to the European bond picture, this week Spanish 10 year yields closed around 5.80% but flirted again with the 6% as the pressure is building for Spanish Prime Minister Rajoy in seeking official support whereas Italian 10 year yields still well below 6% around 5.00% whereas German government yields receding towards the 1.60% levels with other core European bonds yields rising as well in the process – source Bloomberg:
Clearly our “Generous Gambler” Mario Draghi’s effect is fading as indicated by Bloomberg:
“European Central Bank President Mario Draghi’s pledge to buy short-dated government bonds may not be enough to end investor concern that Spain’s debt is unsustainable and the country will need a sovereign bailout. The CHART OF THE DAY shows that Spanish 10-year bond yields climbed past 6 percent today for the first time since Sept. 7, the day after Draghi gave details of the central bank’s asset-purchase plan. Since falling to a five-month low of 5.55 percent on Sept. 10, the yield jumped as much as 46 basis points to a high of 6.01 percent today. The yield reached a euro-era record 7.75 percent on July 25, before Draghi pledged the next day to do “whatever it takes” to safeguard the monetary union.” – source Bloomberg.
On a side note we were quite amused to read Bundesbank President Jens Weidmann’s reference to Faust, in reference to Mario Draghi’s bond-buying programme “OMT” in similar fashion to our “Generous Gambler“ analogy: “If a central bank can potentially create unlimited money from nothing, how can it ensure that money is sufficiently scarce to retain its value?” and added: “Yes, this temptation certainly exists, and many in monetary history have succumbed to it”.
“The greatest trick European politicians ever pulled was to convince the world that default risk didn’t exist” - Macronomics.
Weidmann intended his speech and his reference to “Mephistopheles” and the money printing to point towards the risk of creating rampant inflation.
But as far as credit is concerned, spread wise, the process is more akin to “Japanification” rather than rampant inflation for the time being. In Societe Generale’s Market Wrap-Up from the 17th of September they made the following interesting points:
“The light we see at the end of the tunnel isn’t that of sustained economic recovery, nor is it that of the eurozone’s issue being resolved or the US fiscal cliff issues ameliorated. It’s that we are switching overnight to a pragmatic view of the world. We have decided that with all the liquidity sloshing around and the additional recent central bank actions, peripheral sovereign downgrades to junk (Spain to come?) should be no barrier to buying peripheral corporate risk. The freed up money needs to go somewhere and blue chip, national champions from the periphery are deemed as being unlikely medium-term defaulters – should the euro remain intact. In the past couple of sessions alone, Spanish and Italian corporate risk has rallied by between 50-75bp (and by some 150-200bp since the beginning of August). So all that liquidity finds itself pressing on corporate bond yields and the ‘herd’ is in thunderous form, heading in the same direction – hopefully it’s not towards the precipice.
Which means that corporate credit spreads are going into Japanification mode. The unlikely triumvirate of low growth, low rates and low yields have become the corporate bond market’s friend. And we’re now ratcheting tighter, led by higher yielding financials where T1 and LT2 prices lead, although most high beta risk is in vogue. The iBoxx cash corporate is now at B+196bp and has tightened 164bp this year. We now target B+165bp for year-end. Returns for IG are close to 19%, HY at 17% and, even if we hold here at worst, this will still finish as the second best year ever for corporate credit. We might still – likely will – get some jitters along the way. Spain’s expected downgrade might see some (temporary) weakness; a Greek flare up might too; and, political event risk elsewhere is quite possible. Otherwise, the ECB taking govvies out of the market is keeping liquidity plentiful and it needs a home. Some of it keeps rolling into credit, helping the supply to get mopped up, keeping confidence at elevated levels.
Non-financial issuance YTD is now close to €130bn which is the long-term annual average; and we are now looking at somewhere well over €150bn for the full year. That’s more than double what we had forecast at the beginning of the year. The €22bn for September alone is massive and we still have two weeks to go. And nearly half of the issuance has come from the periphery. Furthermore, if we can get past €26bn by the end of the month, we’ll be looking at September in the context of it being the fifth best month for non-financial supply – ever. We can’t get enough financial risk either. Senior paper is tightening fairly consistently amid poor secondary market liquidity. Almost €95bn has been printed YTD which is close to our €100bn forecast for the year. And the way the technicals of the market are playing out, we’re in the mood to absorb much more issuance and see banks raise funds at ever decreasing costs. €125bn looks like the next stop.”
As far as credit is concern, it still “Risk-On” for now, but we are definitely moving more and more in expensive territory which is not supported by a favorable economic outlook based on the latest economic releases (European PMIs). Both the Itraxx Main Europe 5 year index and Itraxx Financial Senior 5 year index are converging, indicative of falling risk aversion – source Bloomberg:
But as we posited before when quoting Bastiat around our liquidity concerns, there is what you see and what you don’t see (from our conversation “The Unbearable Lightness of Credit“: “That Which is Seen, and That Which is Not Seen”).
“when investors “infer the persistence of low volatility from empirical evidence” (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then “Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices.”
In a recent article by Mary Childs in Bloomberg entitled “Swap Traders Scrape Bottom in Fed’s New World from the 21st of September we read the following that made us chuckle in a 2007ish way:
“With the global speculative-grade default rate holding at 3% in August, below the average of 4.8 percent as measured by Moody’s Investors Service in data since 1983, investors see less of a need to hedge against losses, according to Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP that oversees $45 billion of assets. “CDS is so yesterday,” she said in a telephone interview. “The will to buy default protection is diminished because you figure you don’t need it.”
We disagree with the above.
Back in August in our conversation “The Unbearable Lightness of Credit” we argued:
“Yes, in this “unbearable lightness of credit / low yield” environment default will indeed spike at some point even for banks, consequence of the gradual disappearance of IGs (Implicit Guarantees). One can also argue that the advantage of explicit guarantees is that markets tend to “function” better under them. To quote again Dr Jochen Felsenheimer from his recent monthly letter:
“The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up – even in a crisis! For this reason, we can quote the “last man standing” at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:”The constitution also applies during the crisis”. That is a hard guarantee, both for politicians and for investors!”
We also indicated at the time:
“The unintended consequences of banks deleveraging and increased regulations means banks are in risk reduction mode leading to lower inventories provided to the market place which are at the lowest levels since 2002. Traders are as well jumping ship towards Hedge Funds. We already touched in liquidity issues in our conversation “Yield Famine“.
In credit markets, liquidity can fast become a problem. Should the credit market experience a consequent sell-off, losses will be fast and furious. One should polish its “Bayesian learning” once in a while or take the great risk of becoming a victim of some “irrational exuberance” or “euphoria”.
From the same Bloomberg article: “Investors have funneled $55.9 billion into high-yield bond funds globally this year through Sept. 12, breaking the previous record set in 2009 by $24.1 billion, according to data compiled by Cambridge, Massachusets-based EPFR Global.”
This latest credit market “euphoria” has been marked by the significant return of Covenant lite issuance. Back in May 2012, we specifically discussed this return in our conversation “The return of Cov-Lite loans and all that Jazz…“. Covenant-lite financing amounts to corporate credit on lax terms, where most covenants such as maintaining a certain level of profits are waived by deal-hungry lenders and were previously used to finance before the 2008 crisis big leveraged buyouts. Corporate loans typically include provisions, or what we call covenants. They can trigger a “default” if finances deteriorate, even if the borrower is still paying interest. This forces the company to negotiate with the bank lenders, often allowing to force a restructuring. Covenants also act as early warning system when the credit metrics of a company start to deteriorate.
In true Zemblanity fashion and credit market insanity as we posited at the time:
“Any statistician will tell you, a good outcome for a bad risk doesn’t mean the risk wasn’t bad; it just means you happened to get lucky”.
In 2008-2010, less than 10 billion USD worth of covenant lite loans were issued. This anemic issuance period combined less than the 535 billion issuance of 2007. In 2011, 40 billion of covenant lite loans were issued and the leveraged loan volume was 373 billion USD. Refinancing was the purpose of 2011 borrowings for 54% while LBOs only represented 14%. There was a low default rate in 2011, less than 0.5%. Loans have been much “juicier in terms of yield than 10 year treasuries with B rated loans offering Libor +520 bps and BB- offering L+411 bps. Back in May 2012, 31 billion USD of leveraged loans were issued in the first two weeks hence our previous post. While European borrowers cannot easily get covenant lite in Europe, they come to the US. The default rate is higher in Europe in 2011 was higher than in the US at 4.1%.
We do agree with some of the conclusions from the presentation quoted above:
“-He who has the gold, does not always make the rules.
-The market does not learn for long.
-Human nature does not change.”
It looks to us we are indeed on the path towards “Zemblanity”, with a difference discovery outcome as one could expect from “Serendipity”.
On a final note we give you Bloomberg Chart of the day indicating that the Yen may climb to a record as the Bank of Japan lags the behind the Fed in all this Zemblanity experience:
“Yen printing by the Bank of Japan is trailing money creation by the Federal Reserve and European Central Bank, boosting risks the Asian nation’s currency will rise to record levels, according to Mizuho Securities Co. The CHART OF THE DAY shows that Japan’s monetary base, a measure of money in circulation, has grown more slowly than those of the U.S. and the euro area since September 2008 when the collapse of Lehman Brothers Holdings Inc. prompted central banks to buy bonds in a bid to stem a global crisis. The lower panel shows the yen has risen 27 percent over the same period, as measured by Bloomberg Correlation-Weighted Indexes, while both the dollar and the euro slid. The yen strengthened to a seven-month high of 77.13 per dollar on Sept. 13, nearing the post-World War II record of 75.35, when the Fed announced its plan to buy $40 billion a month of mortgage debt in a third round of so-called quantitative easing. The ECB unveiled its own unlimited bond-purchase program a week earlier.” - source Bloomberg.
“Insanity in individuals is something rare – but in groups, parties, nations and epochs, it is the rule.”
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