Wednesday, 16 August 2017

Macro and Credit - Experiments in the Revival of Organisms

"Life is obstinate and clings closest where it is most hated." -  Mary Shelley

Looking at the latest gyrations in risky markets including credit markets following our timely musing relating to "Gullibility", while thinking of our next post title we found it amusing the numerous attempts by various financial pundits in "reviving" the Phillips curve which we have been so critical of in recent conversations. For our title analogy we decided to steer towards the creepy given our title analogy refers to a 1940 Soviet motion picture which document Soviet research into the resuscitation of clinically dead organisms. It is available from the Prelinger Archives and is in the public domain. The creepy operations depicted are credited to Doctor Sergei Brukhonenko and Boris Levinskovsky who were demonstrating a special heart-lung apparatus called the autojektor (or autojector), also referred to as the heart-lung machine, to the Second Congress of Russian Pathologists in Moscow. Their modern "Frankenstein" experiments (involving decapitations) were related to the heart-lung machine. It was designed and constructed by Brukhonenko, whose work in the video is said to have led to the first operations on heart valves. The autojektor device demonstrated in the film is similar to modern ECMO machines, as well as the systems commonly used for renal dialysis in modern nephrology. The film depicts and discusses a series of medical experiments. It begins with British scientist J. B. S. Haldane appearing and discussing how he has personally seen the procedures carried out in the film and have saved lives during the war. The experiments start with a heart of canine, which is shown being isolated from a body; four tubes connected are then connected to the organ. 

You are probably asking yourselves already where we going with this creepy analogy of ours (after all being outright "scary" drives traffic for some blog pundits...), but in these Frankenstein markets to say the least, we found it amusing the attempts by so many including the PhDs are the Fed to cling on outdated models that were fit to purpose in their own time but not anymore. As pointed out by our friend Ilya Kislitskiy (@sayfuji on Twitter), resurrection is a complicated business, same thing goes with "Experiments in the Revival of Organisms":
"What can cause global anxiety? Maybe the fact that Phillips curve somewhere is "complicated" and "partially resurrecting" elsewhere? I definitely feel uncomfortable." - Ilya Kislitskiy (@sayfuji on Twitter)
Rest assured we do too, when it comes with macro old-school Phillips-curve-fans. Life is indeed obstinate, to paraphrase Mary Shelley, the author of Frankenstein. This is particularly the case with the Fed and the financial community when it comes to clinging to outdated models. It doesn't necessarily mean that these pundits' Phillips curve "autojektor device" will not eventually lead to a better model. In our book, for the time being, experiments in the revival of macroeconomic models such as the Phillips curve, defeat the purpose but we ramble again...

Also, when it comes to our analogy, Frankenstein markets comes to mind given Bondzilla, the NIRP monster has indeed become insatiable for anything with a yield. In similar fashion to Dr Frankenstein, our generous gamblers aka central bankers have become increasingly nervous with the "creatures" (or bubbles) they have spawned with their various resuscitation experiments and this is even without the exogenous geopolitical turmoil as of late. In recent years they have been doing various experiments in the revival of organisms, some European banks come to mind when we think about "zombies" in homage to recently departed horror film maverick director George A Romero

In this week's conversation, we would like to look at the need to continue building up your defenses in the credit space, meaning further rotation into higher quality in this overextended beta game given the accumulation of late cycle signs we are seeing.

  • Macro and Credit - Frankenstein markets thanks to our Modern Prometheus
  • Final charts - Fun in Funds

  • Macro and Credit - Frankenstein markets thanks to our Modern Prometheus
When one looks at a 70% rise in the VIX index over just three days, a 2% drop in global equities in conjunction with widening credit spreads including of course High Yield and the beta crowd, a young investor would have caught fright. But, in retrospect, this was merely a blip given our Dr Frankensteins are still busy with their central banking experiments. Obviously the big question is surrounding Bondzilla the NIRP monster, given the massive creature has been in growing in size since the start of our central bankers various iterations.

What is already starting to show credit weakness, we think is indeed coming initially from US Commercial Real Estate (CRE). Of course as we pointed out in our most recent conversation, consumer credit is another piece of the credit puzzle we watch carefully as this credit cycle unfolds and is indicative of the lateness of it.  Back in February in our conversation "Pareidolia" we pointed out the following:
"At this stage of the cycle, there is a tendency for excesses (real estate prices, subprime auto loans, etc.) to build up meaningfully. For instance, we have been monitoring the weakening demand for credit but in particular Commercial Real Estate given the latest Federal Reserve Senior Loan Officer Survey has shown that financial conditions have already started to tighten meaningfully in that space" - source Macronomics, February 2017
CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. By tracking the quarterly Senior Loan Officers Surveys (SLOOs) published by the Fed you can have a good view into credit conditions. Credit conditions for CRE have already started to tighten since a couple of quarters and from a valuation point of view, it does feel that we are close in many instances to "peak valuation". From a valuation perspective we read with interest Wells Fargo's note from the 14th of August entitled "CRE Deal Volume Shows Late-cycle behavior Q2 Chartbook" particularly the part linked to the Hotel segment of CRE:
  • "Still reflecting the previous headwind of weak corporate profits and a stronger dollar, the seasonally adjusted real revenue per available room (RevPAR), which is the product of occupancy and the real average daily rate (ADR), fell to just 0.2 percent in Q2, year-over-year. That said, corporate profits were up more than 3 percent in Q1, and the dollar is softer suggesting there are some upside risks.

  • Real RevPAR for higher-end hotels (luxury, upper upscale and upscale) posted its fifth straight year-over-year negative reading in six quarters in Q2, while the pace for lower-end hotels (mid- and economy-scale), has slowed significantly from its cycle peak of 8.0 percent in late-2014 to just 0.8 percent.
- Source: STR, U.S. Department of Labor, FRB and Wells Fargo Securities

Are we at "Peak Occupancy" in this rate cycles? It certainly looks this way to us. Also the negative trend in Real RevPAR growth is yet another sign that the credit cycle is slowly but surely turning we think.

It is fairly clear to us that when it comes to credit availability and lending, the CRE space indicates things are indeed slowing as per Wells Fargo's remarks from their report:
  • "Senior loan officers reported that CRE lending standards tightened across the three categories while demand cooled during Q2. A net share of around 17 percent of banks, which is classified as “moderate,” reported tightening standards for construction and land development loans and multifamily.

  • According to the Mortgage Bankers Association (MBA), total commercial/multifamily debt outstanding broke the $3 trillion mark in Q1. At 41 percent, commercial banks and thrifts still comprise the largest share of debt outstanding.
  • Consistent with lending standards, loan growth in multifamily and construction and land development has slowed from its cycle high. Growth in income properties is also moderating.
- Source: STR, U.S. Department of Labor, FRB and Wells Fargo Securities

There are more signs from the CRE market alone that the credit cycle is slowly but surely turning and it is of course showing up in this market first.

When it comes to "Experiments in the Revival of Organisms", clearly the CRE market has reached record valuation levels as pointed out by Wells Fargo. Our Dr Frankensteins at the Fed should clearly be nervous about these lofty valuations levels we think:
"Elevated pricing (Figure 2) has also been a concern for investors, and we suspect the disconnect in pricing and transaction volume is also due to still-elevated levels of cross-border transactions.

Indeed, the low global rate environment and reach for yield, and in some cases, safe-haven plays made U.S. CRE a preferred asset class in many markets by foreign investors. With global economic conditions stabilizing, the risk of global deflation less of a concern, and hence, some major central banks expected to begin tightening monetary policy next year; investors are bracing for higher cap rates in the U.S. and abroad, and in turn, lower valuations. That said, the short and long-end of the curve are largely driven by different determinants. Moreover, cap rates don’t necessarily move in lock-step with the 10-year U.S. Treasury yield. On a global scale, the average cap rate in the U.S. in Q2 was the highest among the 11 countries tracked by RCA (e.g. France, Australia, etc.), with the risk premium still favorable at more than 400 basis points.
- Source: FDIC, Mortgage Bankers Association and Wells Fargo Securities

Sure valuation wise, as we pointed out in our most recent conversation "The Barnum effect", in these Frankenstein markets thanks to the modern Prometheus, already expensive asset classes such as European High Yield can become even more expensive thanks to central banking "Barnum effect". No doubt their Marshall amplifier can reach "11", as in the famous movie Spinal Tap. After all, as long as the Dr Frankensteins are in the game, you got to keep dancing right?

You are probably asking when the tide will be turning when it comes to the "Macro and Credit" picture. On this very subject we read with interest Barclays note from the 11th of August entitled "Macro Credit Framework: Let's be reasonable" where they update their framework for credit returns:
"With credit valuations near post-recession tights, we believe this is a good time to update our macroeconomic framework for credit returns. The core of our framework is that:
  • For the purposes of forecasting credit performance, we can reduce the business cycle into two regimes: a steady state in which the economy is growing consistently and a transitional state that includes recessions plus de 12 months before and after. Macroeconomic indicators can signal which state the economy is in.
  • Spreads evolve differently in the transitional state than in the steady state.
  • Valuations are the key driver of returns for both steady and transitional states, but the distributions shape of those returns varies across regimes. 
- In the steady state, returns are more normal for a given valuation, and treating returns as normal should be adequate for rough estimates of returns and loss probabilities.
- Transitional state distributions are more skewed, making the distribution of expected returns rely more heavily on starting valuations.
Applying the framework to the current environment suggests a 70% chance of positive excess returns for BBB credits, with an expected return near carry (Figure 1 ). 
The macro framework suggests that we should expect 60-70bp of Six-Month Excess Returns for Corporate BBBs

Defining Business Cycle Regimes
For the purposes of making return forecasts, we believe that only two regimes really matter:
  • Steady state is the default, covering periods of consistently positive economic growth that are the “expansion phase” of traditional business cycles. These phases have periods of both slower and faster growth, but without the sustained deterioration that marks a recession.
  • Transitional states have been less frequent (especially in the past 30 years) and consist of recessions plus the 12 months preceding and following them.
There are number of reasons to condense the macro environment to only two regimes:
  • There are clear differences in how credit returns behave in the two regimes with credit more likely to widen, and more likely to linger at wider spreads during transitional states (Figure 2).
    But further subdivision do not seem to add much information - for example, for a given valuation, there is not much difference in returns from "early" in a recession to "late" - so it is sensible to use fewer states.
  • It makes it easier to define the conditions of being in each state, which makes it more likely that we will make the correct call. In general, we think it is relatively straightforward to understand when we are in a recession or its aftermath that means the only difficult call is whether we have moved from a steady to a transitional state.
Economic Indicators - Clue for Transitional Periods
The most challenging part of our framework is determining whether we have entered the transitional state, but we think there are useful indicators for when that happens. There are a number of layers to the process. First, the preconditions need to be in place. Then the timely indicators give us information about whether we are within the 12 months of a recession. Finally, a qualitative evaluation informs us whether our preferred signals are likely to have their usual reliability.
Preconditions for a Recession
Fed hiking cycles and tighter bank lending standards have historically been preconditions for recessions. The past six recessions have been preceded by Fed hiking cycles and leading up to the past two recessions, bank lending standards have tightened (Figures 3 and 4).

Intuitively, this makes sense - the economic benefits of looser Fed policy and accelerating lending conditions lean against the possibility of a recession.
While these indicators are necessary for a recession, they do not by themselves signal that a recession is imminent - both can be in place for multiple years before a recession begins. While these preconditions are currently being met, we must look at more timely measures that signal the economy is entering a transitional state.
Near-Term Indicators 
Jobless Claims
We believe that jobless claims are one of the best indicators of a regime shift, because they generally start to rise about a year before the economy enters a recession. This makes them particularly well timed for the move to a transitional state. Their usefulness as an indicator for credit is supported by the tendency of rising jobless claims to predict negative future returns for credit (Figure 5), consistent with our analysis that spreads generally widen from tights during the transitional state.

The decline in jobless claims has been impressive since 2009, and the measure is at all-time lows after adjusting for total jobs in the economy. With less slack in the series, the decline in claims has lost momentum, suggesting that further improvements could be limited (Figure 6).

However, claims have remained low or flat for multiple years in the past, so flattening alone is not sufficient to indicate a rise in claims. Consequently, we do not believe that jobless claims are currently signaling that we are entering a transitional period (although that assessment could change quickly).
Output Gap
The second timely indicator that we use for our macro credit framework is the output gap - a measure that Barclays Economics uses as a framework for the US business cycle (Figure 7).

The output gap uses a multivariable approach - with inputs such as working hours, output, employment, unemployment, and the labor force - to measure the actual output of the US economy versus the potential output.
We find that the output gap tends to follow the business cycle closely. The indicator typically peaks about three quarters prior to a recession, on average, and starts to roll over during the transitional state (Figure 8).

Coincidentally, spreads also tend to widen when the output gap is declining (Figure 9).

Currently, the output gap has closed and is near the 2005-2006 peak, meaning that the current business cycle is mature. However, the indicator does not seem to be rolling over and is not indicating that we are entering a transitional state yet.
Qualitative factors
In relation to position within the business cycle and whether the economy is entering a transitional period, it also makes sense to monitor qualitative factors that could pose risks to the current steady state of the economy.
Consumer Credit
Trends in consumer credit have become a cause for concern. Consumer debt outstanding has risen for credit cards, auto loans, and student loans, giving consumers less room to use debt to support spending. Delinquency rates have also begun to rise in all three cohorts (Figure 10), with the auto loan sector particularly worrisome.

Along with the significant growth in auto credits outstanding, auto loan quality has worsened, and auto sales have lost momentum. While these trends are somewhat troublesome, the size of the auto loan market pales in comparison with the mortgage market, a major issue in the last recession. And despite some deterioration in the quality of the ABS market, losses so far have been modest. Therefore, we do not believe that concerns in the auto sector will push the economy into a transitional state at the moment, but any further development should be closely monitored.
Retail sector
Weakness in retail has been a theme in 2017, with the sector facing revenue losses to e-commerce competitors and lower returns on assets because of overcapacity. Because the retail sector is such a large employer - up to 10% of American workers are in the sector in some capacity - there is a reasonable question about whether a sector restructuring could spill into the broader economy. We examined this question in greater depth in US Economics and Credit Strategy: Technology-based change leaves retail looking overextended, and our conclusion is that so far jobs are not being lost at a fast enough pace to create exogenous recession risk. For example, the number of retail workers affected by bankruptcies has increased quickly, rising above 200k over the past 18 months (Figure 11), but given that the US sees about 250k new jobless filings a week (a record low), that is not yet enough to cause broader problems.

Returns are more volatile during transitional states 
The next component of our framework is to understand what the most reasonable distribution of returns is likely to be within each state. The first thing we observe is that returns are related to starting valuations in both regimes (Figure 12).

We also note that for a given valuation, they are more volatile, and more likely to be negative, in the transitional state.
We base this analysis on Moody's data on spreads for industrial BBB long bonds. The series starts in 1919, which allows us to calibrate spread performance around 17 recessions. This is a significant advantage over using the Bloomberg Barclays Indices, which cover only three recession cycles. The disadvantage is that the Moody's data do not provide carefully structured return calculations, so we need to estimate returns using carry, spread changes (assuming the same duration as the BBB long index), and historical default rates to account for losses.

Digging a little deeper into the steady state, both returns and volatility rise consistently with starting spreads, in a very orderly relationship (Figure 14).

We also note that they look fairly normally distributed, although with some extra downside tail risk (Figure 15).

By contrast, in the transitional state, returns are less clearly related to valuation (Figure 16).

This seems to be related to more pronounced skew during these periods. But the degree and direction of skew also appear to be a function of valuation.
  • When spreads have been in middle third (between 215 and 285bp), they have widened on average, but usually not enough to offset all returns from carry. As a result, the average estimated six-month return has been about 90bp. At the same time, the occurrences of large gains have been balanced fairly even against the number of large losses.
  • When spreads have been the widest third (widest than 285bp), they have usually tightened, generating an average estimated six-month return of more than 200bp. They have also had higher-than-normal probabilities of large gains or tightening events." - source Barclays.
This analysis in our opinion is very interesting from a Macro and Credit perspective, as posited by our Friend Paul Buigues in his 2013 post "Long-Term Corporate Credit Returns":
"Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns." - Paul Buigues, 2013
Returns are related to starting valuations in both regimes, this is a very important point for credit investors we think. Also, according to Barclays, in the transitional state, returns are less clearly related to valuation. As concluded as well in this previous 2013 by our friend Paul:
"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.
As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors."  - Paul Buigues, 2013
Do not focus solely on the current low default rates when assessing forward credit risk. Trying to estimate realistic future default rates matter particularly when there are more and more signs showing that the cycle is slowly but surely turning in both CRE and consumer credit. Peak jobless claims and peak hotel occupancy might after all show us that we are indeed moving towards a transitional state in these Frankenstein markets. One thing for certain, the energy sector credit woes in 2016 and outperformance in the second part of 2016 was a sign that returns can be clearly related to valuation or when credit spreads reached do not make economic sense that is when average high-yield spreads above 1000bp can be irrational.

Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on 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." - Mr Michael Biggs and Mr Thomas Mayer on
 We have always wondered in relation to the global rounds of quantitative easings the following:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

As a reminder, in our part 2 conversation "Availability heuristic" from September 2015, the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade. With a rising US dollar, what has been playing out is a reverse of these imbalances hence our "macro reverse osmosis" discussed in past conversations to explain violent rotations in flows from Emerging Markets. 

As we have seen on numerous occasions, and as we have remarked in our conversation  "Critical threshold", higher yields can lead to material fund outflows. As a reminder, more liquidity = greater economic instability once QE ends. As we move towards the transitional state described by Barclays in their note, one way of "mitigating" dwindling policy support would be to "embrace" a barbell strategy. 

For our final chart, no doubt to us than in these Frankenstein markets and experiments in the revival of organisms, it has been a "Goldilocks environment" for US credit.

  • Final charts - Fun in Funds
Bondzilla the NIRP monster has been created by our Dr Frankensteins in various central banks. Clearly the instigation of NIRP has put the demand for US credit from foreign investors into overdrive and it has been as we pointed out recently "Made in Japan". Our final charts come from Wells Fargo Credit Connections report entitled "Correction mode" from the 11th of August and displays fund flows relative to net share buyback:  

"Follow the Money
"Nearly $1.2 trillion of new money has flowed into U.S. Taxable Fixed Income mutual funds and ETFs since 2009. Much of that money came from Money Markets as central banks slashed cash rates and investors rotated from cash to bonds to enhance their yield. International investors jumped on the bandwagon in 2014 following the Fed’s taper tantrum, and accelerated their buying last year after European and Asian central banks cut cash rates to negative. Throughout the entire period, the lion’s share of money poured into U.S. IG credit funds. An upsurge in demand for corporate bonds allowed corporations to ramp up gross bond issuance to record levels of nearly $1.5 trillion per annum over the past six years. Much of that bond issuance was used to fund share buybacks, which helped buoy stock prices. All of this is shown in the charts above and below.

So, the $1.2 trillion question is, when does this virtuous cycle end? The short answer is, not yet as the world remains awash in excess savings and global central banks continue to pump about $200 billion of new cash into the system each month via their existing QE programs. But, we suspect the slow march back towards cash has begun. In the U.S., the Fed has raised the Fed Funds rate by 100 bps over the past 20 months to 1.25% (upper bound) and remains in tightening mode. The Wells Fargo Securities’ economists expect another hike this year, and three more next year. However, cash rates in Europe, Switzerland and Japan remain deeply negative. Until these rates are greater than zero, global excess cash will likely continue to hunt for yield enhanced investment opportunities around the world, a portion of which should flow into U.S. credit and serve as a backstop against spikes in volatility." - source Wells Fargo
As long as our Dr Frankensteins keep pumping into the system and NIRP stays firmly into play, there is no reason why asset prices cannot go even further towards the 11th mark on the Marshall amplifier of our central banks. The only creepy and scary thing with experiments in the revival of organisms is when our mad scientists will lose control of their Bondzilla, but we guess that's a story for another day while we keep monitoring the credit impulse globally and weakening signs from the US.

"Invention, it must be humbly admitted, does not consist in creating out of void, but out of chaos. " - Mary Shelley

Stay tuned ! 

Wednesday, 9 August 2017

Macro and Credit - Gullibility

"Mystical references to society and its programs to help may warm the hearts of the gullible but what it really means is putting more power in the hands of bureaucrats." -  Thomas Sowell

Watching with interest the 10th day of record highs for the Dow Jones and the on-going rally in other asset classes and in continuation to our previous theme of "Barnum statements" and "Woozle effects", we decided to pursue on the path of "tricks of the mind" in our title analogy by selecting "Gullibility".

"Gullibility" is a failure of social intelligence in the sense that a person or an investor gets tricked or manipulated (by central bankers) into ill-advised course of action (insatiable yield chasing). While it is closely related to credulity, many investors in the past have been vulnerable to this form of exploitation. If you would like to make a small experience on the subject you could try this popular test of "gullibility" by telling one of your friends that the word gullible isn't in "the" dictionary (earliest dictionaries did not by the way). If your friend is a gullible person he might respond "really?" and he will go and look it up. 

Some writers on gullibility have focused on the relationship between the negative trait of gullibility and positive trait of trust. The two are related, as gullibility involves an act of "trust", same goes with central banking (remember: "believe me it will be enough"). On this subject we find it amusing that a certain Stephen Greenspan (not Alan) in 2009, in his book "Annals of gullibility: why we get duped and how to avoid it" presented dozen of examples of gullibility in literature and history to name a few: The Adventures of Pinocchio, Little Red Riding Hood, The Emperor's New Clothes, The Adventures of Tom Sawyer, Romeo and Juliet, Macbeth, Othello and even in the classic The Art of War, The Prince or The Trojan Horse story. Greenspan argues that a related process of self-deception and groupthink factored into the planning of the Vietnam War and the Second Iraq War in his book. In science and academia, gullibility has been exposed in the Sokal Hoax which we referenced to in a previous post of ours "The Sokal affair" describing the acceptance of early claims of cold fusion by the media. 

In society, tulip mania and other investment bubbles (Bitcoin comes to mind) involve gullibility driven by greed, while the spread of rumors involves a gullible eagerness to believe (and retell) the worst of other people. You might be wondering where we are going with this but hearing the other Greenspan recently, Alan that is, making yet another claim that there is a bond bubble in the making, although he has done so in recent years made, it interesting to say the least.  Two years ago, when the 10-year US yield was 2.44% the other Greenspan told Bloomberg TV that "we have a pending bond market bubble." In a Bloomberg TV interview in July 2016, he again expressed concerns about stagflation and said "we're seeing the very early signs of inflation beginning to tick up." He also told us at the time with 10-year Treasury yield at 1.50% thanks to Brexit concerns, that he was "nervous" bond prices were too high. In terms of "gullibility", this is the same Greenspan that told us that no one saw the previous crisis coming. Is third time a charm for the "Maestro"? We wonder. Stephen, the other Greenspan, in 2009 wrote that exploiters of the gullible "are people who understand the reluctance of others to appear untrusting and are willing to take advantage of that reluctance." In 1980, Julian Rotter wrote that the two are not equivalent: rather, gullibility is a foolish application of trust despite warning signs that another is untrustworthy. When we see European Junk Bond yields falling to another record low of 2.33% and closing on 10-Year US Treasury Yields at 2.26%, we think that "gullibility" applies for European high yield investors as a foolish application of trust despite warning signs that our central bankers are untrustworthy hence our chosen title. To check your investor gullibility factor you could simply ask yourselves if you would rather hold US Treasuries for the next 3 years or European High Yield but we ramble again...

In this week's conversation, we would like to look again at the potential risk for a convexity event we discussed previously in our conversation "Bond ruck" from a NAIRU ((non-accelerating inflation rate of unemployment) perspective. 

  • Macro and Credit - Convexity - A NAIRU headache?
  • Final charts - The barrel in the credit revolver is getting empty

  • Macro and Credit - Convexity - A NAIRU headache?
Traditional measures of monetary policy such as the Taylor Rule that are based on growth and inflation and a nonaccelerating inflation rate of unemployment, or NAIRU, of 5 percent. NAIRU is the lowest unemployment rate an economy can sustain without spurring inflation according to the definition. The name "NAIRU" arises because with actual unemployment below it, inflation is expected to accelerate, while with unemployment above it, inflation decelerates. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve, hence the concerns of the "Maestro" and his bond bubble fears. The "NAIRU" analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed. As we posited in our June 2013 conversation "Lucas critique":
"As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion." - source Macronomics, June 2013
Also as we pointed out in our July conversation "The Rebound effect" in our final chart relating to the death of the Phillips curve, the framework is still adhered to by the Fed, meaning that they should be very slow in removing the credit punchbowl. We also pointed out that subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. The Fed's models are built on past relationships. Yet, what seems of key importance to us is that many believe the NAIRU unemployment rate to be around 4.5%, while inflation and wage pressures remain muted because as we pointed out in recent conversation demographics mismatch in the labor market is affecting wage growth. 

You might already being asking yourselves what it has to do with convexity and bond bubble fears for the "Maestro"? It all has to do with "gullibility". On the subject of the non linearity of the Fed's hiking path and therefore convexity risk, we read with interest Bank of America Merrill Lynch's take in their Liquid Insight note from the 4th of August entitled "Who doesn't love 90s rerurns?":
"Key takeaways
  • The Fed is facing a similar situation to the 1990s; the unemployment rate is uncomfortably low, but so is core inflation.
  • In the '90s, there were data head-fakes and confusion in the Fed's reaction function, resulting in a "fits and starts" cycle.
  • This sounds familiar. We think we should prepare for the possibility of further pauses in the hiking cycle, akin to the '90s.

A not-so-distant memory
Nostalgia for the 1990s is tangible: the economy was in a prolonged expansion, the budget deficit was turned into a surplus and, importantly, the quality of television improved with Seinfeld, The Simpsons and Friends. We are now facing a feeble recovery from the Great Recession, a swelling budget deficit and reality television. Don’t fret; there are some things in common. The Phillips Curve faced similar challenges in the late 1990s as it does today (Table 1). Today’s Fed should keep in mind the lessons of the 1990s:
  1. Relying on the Phillips Curve relationship can prove dangerous
  2. It is essential to maintain credibility as a defender of price stability
  3. Hiking cycles can have fits and starts
We think the 1990s episode puts the spotlight on a risk to our forecast. Although we have been arguing that the risks are skewed toward a slower cycle, our baseline expectation is still for the Fed to follow their dots (a hike in December and three more hikes next year). Given the lessons learned from the experience of the 1990s, we should prepare for the potential of a pause in the tightening cycle early next year.
Measured pace is the exception, not the rule
Many investors tend to look back at the 2004-6 “measured pace” episode as the norm for Fed tightening cycles. In reality, the 1990s offers a much better comparison. In the 1990s, there were many head-fakes in the data and changes in the Fed's reaction function, which led to a “fits and starts” hiking cycle. As Chart 1 shows, the Fed delayed hiking rates until three years into the recovery; did a relatively normal tightening cycle, but then did two mini-cycles of cuts followed by another hiking cycle.

On paper, this seems like a Federal Reserve that was quite confused. Why start the hiking cycle in 1994 with inflation still low? Why the abrupt reversal and then the delayed resumption of hikes? It helps to think about Fed hikes back then as a complicated interactive process rather than a pre-ordained plan.
Stage 1 (1994-1995): preemptive tightening of monetary policy against the "inflation scare" in bond markets. The unemployment rate at the onset of the hiking cycle was only 6.5% while wage and price inflation was subdued. But the 30-year Treasury rate soared to 8.1% in November 1994 from 5.9% in October 1993. Fed officials became concerned about losing their inflation-fighting credibility. In the February 1994 minutes, Fed officials noted that “a relatively small move would readily accomplish the purposes of signaling the Committee’s anti-inflation resolve” and in the March 1994 minutes argued that “a stronger policy action …would serve to underscore the Committee’s commitment to its price stability.”
Even within this apparent steady tightening cycle there were plenty of head-fakes. Three times the Fed signaled that it might be done and skipped a meeting. Each time they came back with a “catch up” hike of 50bp, 50bp and 75bp, respectively. This stopand- start occurred for two reasons. First, they expected hikes to slow the economy, but the labor market continued to motor ahead. Second, most Fed officials came into the period thinking NAIRU was around 6.5% but as inflation failed to respond, they revised their estimates lower.
Stage 2: Recalibrating an overshoot: By July 1995, the Fed seemed to regret those hikes, noting in the minutes that “some modest easing was desirable now that the growth of the economy had slowed considerably more than anticipated and potential inflationary pressures seemed to be in the process of receding.” This led to 75bp of cuts over the next several months.
Stage 3: Watchful waiting: The Fed went on hold for roughly two years. While dissents were minimal (because of Greenspan’s domination of the Committee at that time), there was growing pressure from the Committee to resume hiking. Skimming through the transcripts, we find that Janet Yellen was one of the voices advocating for the Fed to hike rates. Her arguments echo those that she is making today.
In the September 1996 transcripts Yellen gave two arguments for hiking:
"First, an unemployment rate of 5.1% lies near the lower end of almost anyone's estimated NAIRU range. Second, whatever the NAIRU, the unemployment rate does have predictive power for changes in the inflation rate...for that reason, I would conclude that the risk of inflation has definitely risen, and I would characterize the economy as operating in an inflationary danger zone."
"My concern is that a failure to shift policy just modestly in response to shifting inflationary risks could undermine the assumptions on which markets' own stabilizing responses are based."
Stage 4: Crisis mode: The FOMC did eventually hike by 25bp in March 1997, but it proved to be a one-off as the economy faced a variety of exogenous shocks thereafter, including the Asian currency crisis in 1997, the Russian default and failure of LTCM. Through it all, the unemployment rate continued to glide lower, but yet the "inflationary danger zone" proved benign. As such, if the Fed actually engaged in a hiking cycle, the economy might have suffered, as would have the Fed's credibility. It turned out that Greenspan was right to hold off as he correctly saw that stronger economic growth was generated by strong productivity gains, which were disinflationary.
Stage 5: The real deal: Heading into 1999, the Fed was facing a tight labor market with the unemployment rate hovering just above 4%, wage growth of about 3%, but core PCE growth of only 1.4%. Asset prices were elevated with signs of "irrational exuberance" in the markets: by the time the Fed hiked, the cyclically adjusted P/E had climbed to historical highs. This sounds quite familiar to the situation we are in today with a tight labor market, but muted price pressures with the exception of assets.
A big theme then and now: shifting views of the Phillips curve
Janet Yellen was not the only one who believed that inflation would accelerate as the unemployment rate fell further. In fact, it was very much the consensus view. According to the Blue Chip consensus survey, economists in 1996 were looking for CPI inflation of 3.0% for 1998 while it ended up coming in at 1.6%. Core CPI similarly came in below 3%, averaging 2.3% for the year. Economists reacted to the data and within a year were bringing forecasts lower, coming in close for 1999 (Chart 2).

The challenge is that models are imperfect. If you were sitting in September 1996 with an unemployment rate just above 5%, a standard Phillips Curve would estimate 3.5% for core CPI over the next 12 months, which was about 1.3pp too high relative to the actual data. At the time, the weakness in inflation was explained by external factors such as globalization and technological improvements that could not be captured properly by the Phillips Curve. There was quite a lot of awareness at the time that the Phillips Curve was failing. In September 1999, John Williams and others at the Board authored a piece called “What’s Happened to the Phillips Curve,” which looks at various specifications of the Phillips Curve to attempt to improve the fit in the 1990s.
Finding the right re-runs
It is important to focus on the experience of the 1990s, rather than the 2000s, when considering risks to monetary policy. Fed officials struggled with the same questions two decades ago as they are today. How tight is policy? Does the Phillips Curve work? Have we maintained credibility as defenders of price stability? How should we handicap market risks?
The result in the 1990s was a hiking cycle that was not linear. It may end up being the same story today. The Fed had a 12-month pause between the first and second hikes before slowly delivering another 75bp of hikes. We could be reaching a crossroads once again as wage and price inflation remain subdued. After another hike, the Fed will be a hair away from neutral (Chart 3), which means the next hike would no longer be considered a removal of accommodation, but rather a true tightening of policy. 

We think a considerable risk to our forecast is that the Fed pauses the hiking cycle early next year, slowing the pace of rate hikes." - source Bank of America Merrill Lynch
The consensus view it seems is that inflation will accelerate as the unemployment rate falls further, in similar fashion to the 90s. We discussed convexity in our conversation "Bond ruck" recently, given that as well, some have been arguing that in a rising rates environment you would be better off with RMBS thanks to negative convexity features. We indicated there was a catch because of the significant need in "delta hedging". Maybe the Maestro's fear comes from the potential for a "Convexity event" fueled by MBS hedging, particularly in the light of the balance sheet exercise soon to be taken by the Fed. As we pointed out in the final point of this particular conversation, the unemployment rate is currently far below NAIRU. The risk again, is therefore a policy mistake in similar fashion to what was avoided by the Maestro in 1997, but, eventually burst the bubble in stage 5 as pointed in Bank of America Merrill Lynch above. If indeed Janet Yellen still believes in an acceleration of inflation as per the September 1996 transcripts, there is indeed a cause for concern from a "convexity perspective". Yet, when it comes to central banks' "Barnum statements" we are not rest assured that "gullible" and like any good behavioral psychologist we tend to focus on the process rather than on the content of their narrative.

What we think is very similar to the 90s so far is indeed the non linear hiking path chosen by the Fed. On that note we agree with HSBC's Steven Major take on disinflation sinking further Treasury Yields as reported by Bloomberg in their article from the 7th of August entitled "HSBC's Steven Major Sounds a Bearish Alarm on European Credit":
"Major, HSBC Holdings Plc’s head of fixed-income research, is a key proponent of the view that global interest rates can stay low for longer, he says investors aren’t being paid for the risks they are taking in corporate debt markets in the euro area, with yields a whisker away from post-crisis lows.
"Low volatility across asset classes may give a false sense of security and bond markets may be caught napping," HSBC strategists led by Major wrote in a note published Monday. "The risk is that with increasingly interconnected capital markets, driven by years of international spillover from quantitative easing, local triggers can have a more global impact than before.
Major’s bearish case: The European Central Bank’s asset-purchase program won’t be as large over the next year as the 12 months prior, while there’s a natural cap on credit demand as yields sit "materially below" typical expense ratios for retail funds, and to a lesser-extent insurance funds. "Gross yields leave very little left for income-seeking savers," he adds. "Spreads could widen with a volatility shock."
The strategist also takes exception with the argument that the euro-area economy is ensnared by Japanese-style stagnation, which would keep spreads in check for decades to come, amid low interest rates and a lifeless corporate sector." - source Bloomberg
We also agree with his forecast for 10 year UST yield of 1.9%, that still make us part of the bond bulls after all. As we pointed out at the beginning of the conversation, at this stage we would rather hold US Treasury notes than European High Yield no offense to the gullible investing crowd busy picking the remaining basis points in front of the credit steam roller. We also agree that the US treasury market and the US dollar are reflecting a weaker economy. If there is a market which is less gullible to the "Barnum statements" from the Fed, it is the US bond market.

The big "Gullibility" question is one of returning duration risk through a sudden rise in bond volatility and we are not even taking into account exogenous geopolitical risk at this stage (which would be bond and gold bullish and oil bullish). On this subject we read with interest Nomura's take in their Inflation Insights note from the 7th of August entitled "Returning real duration risk to the market":
"A central banker’s headache
There are still many scenarios in which the gradual normalisation in the real monetary stance pursued by central banks might not have a gradual impact on financial markets. Uncertainty still looms large on key variables conditioning a balanced path to “normal.” Separately and/or collectively, the lack of term premium in inflation valuations, the level of the natural real rate of interest, the anchoring of inflation expectations, and flow dynamics from the unwinding of large-scale asset purchases can often have outsized impacts on global bond markets. Of course, central banks might find a perfectly balanced path, yet risks remain that real rates could overshoot. We suggest short real rate trades as a hedge against an environment of fast-rising nominal rates and slow-rising inflation.
“Taper tantrum” vs. “gradualism”
In Inflation Insights - Mini “taper tantrum” vs. “dear Prudence”, we argued that risk of a large, unexpected upswing in real yields remained. Despite normalisation in the real stance of policies being widely expected and advertised by central bankers, some mechanisms might facilitate unusually large yield changes.
Several factors potentially generating unexpectedly large yield moves
These mechanisms originate in both cyclical and structural features of economies. At a conceptual level, they stem from the possibility of a sharp rebuilding in term premia accompanying higher interest rates. The inflation premium – the price of a risk of inflation overshooting – remains low on most metrics. The term premium on the inflation component of yield remains also very subdued, as we have shown in Inflation Insights - A short trip to the long end . Therefore it is from the real component of yields that the risk of fast-rising rates comes from.
At a practical level, factors potentially resulting in an unexpected and uncontrolled rise in real yields are:
  • The non-linear dynamics between the level of real rates and the real term premium, as short-term nominal rates retrieve some margin away from the effective lower bound.
  • The re-pricing of the natural real rate of interest (NRRI) until recently, financial markets have rather followed central banks in their downside revision of the natural real rate and accepted the consequences on fixed income valuations. Even though there is an active debate among Fed members about NRRI, most still believe it will be heading higher as they continue with their normalization. A repricing could happen if surprises on activity remain to the upside, e.g., as they have been in the euro area.
  • The complex interplay between segmentation across market participants and largescale asset purchase programmes conducted by central banks. For example, the transfer back to private investors of MBS paper would probably be accompanied by reintroduction of interest rate hedges. Another example is the behaviour of insurance companies and pension funds in the euro area increasing their purchases of fixed income assets with the ECB purchase programme – against the intuition of the balance portfolio channel pushing such investors to invest more in riskier securities.
  • The discontinuity of asset purchases and the “signalling channel” – an abrupt stop to bond buying or re-investment would result in the pricing in of a much denser sequence of “taper” and then rate hikes. In our opinion, the long lead time of preparing markets for the Fed’s eventual balance-sheet unwind could mean that it is rather unlikely in the US (that said, there is a risk to some US rate vol if the Fed gets new leadership). However, it is made possible in the euro area by the perception of technical constraints on the PSPP.
Low inflation duration risk, high real duration risk
All these factors would allow for potentially large and sudden nominal yield changes, translating into large and sudden real yield changes through the elasticity (“beta”) of real yields to nominal yields. However, we think there are reasons to expect real yield changes to be larger than nominal yield changes.
One feature of the environment of low inflation has been that inflation valuations are unusually highly sensitive to current realized inflation trends (both markets and consumer prices). It is not only the expectation component of inflation valuations that has remained subdued, it is also the inflation premium embedded in valuations that has only marginally corrected from its negative levels. The lack of any increase in inflation premia and also inflation term premia would push real yields upwards, even faster than nominal yields.
As Figure 1 shows, it was the case in the early stages of the “taper tantrum” in 2013. The 5y5y real rate increased by about 150bp initially - the 5y5y inflation rate lost about 40bp over the same period. With markets remaining sceptical about the sustainability of higher inflation, it is very possible that the next big bond market sell-off will be a real-rate story.
 Away from the Effective Lower Bound (ELB): a distributional change
The risk of non-linear dynamics on rates stems above all from the proximity of the ELB. The effectiveness of monetary policy is conditional on the ability of the central bank to change the real rate – in other words, to increase the nominal rate faster or slower than the expected change in inflation. At the ELB, the short-term real rate is fully determined by the (negative of the) level of expected inflation. Central banks must resort to other instruments to lower real yields further on the curve – a methodology much advertised in Japan for instance for QQE.
Credible alternatives to the use of the nominal short-term rate might lower real rates further along the yield curve. Their credibility rests to a large extent on the notion that long-term inflation expectations do not fall too much – otherwise the objective of lower long-dated real yields is difficult to achieve. This is why the focus on inflation valuations by central bankers increases – and not only the focus on realised inflation and inflation scenarios.
Figure 2 shows that 5y5y inflation rates remain above half a standard deviation below their 2014-17 average. 

The 1-year inflation rate in 9 years is 30bp below the 2% target in the euro area. In the US, it is 2.60% - which is only just consistent with the Fed’s long-term PCE target and the CPI/PCE basis. In the UK, the 1y in 9 years is 3.45% - the only inflation rate above the central bank’s target of about 3% in RPI-equivalent terms ( the target is set in terms of CPI inflation, UK markets quote RPI inflation). Yet the spread to the target has been contracting since the beginning of the year. In our view, inflation markets have not priced in risk of inflation overshoots that these numbers suggest, consequently as a result the right-side of the inflation distribution remains thin.
A particular risk arises in case of a “spurious” surge in inflation expectations – for example acceleration in prices stemming from rising energy prices. In this case, central banks could increase the pace of nominal rate normalisation on the back of a temporary increase in inflation and despite a low probability of protracted and self-sustained inflation backdrop. Although central banks in general try to “look through” temporary factors, the distinction between “temporary” and “persistent” is not always easy to make in the heat of the moment. In addition, one consequence of the effective lower bound is to skew the distribution of inflation expectations – the normalisation of the distribution to the right can easily be triggered by a temporary factor such as large oil price increases.
Re-pricing the natural real rate of interest
The consequences of a lower natural real rate of interest for monetary policy are very far-reaching, in our opinion, and the uncertainty around the potential evolution of these rates would suggest in and of itself, an increased cautionary outlook for central banks in the pursuit of “normalisation”. An important aspect of this issue is that financial markets have priced in much lower levels of the “equilibrium” real rate. We focus on a simple statistical result – the mean-reversion level of the 5-year real rate, 5 years forward.
Figure 3 shows the contraction in this market’s estimate of the natural real rate. The magnitude is 150bp between our two samples across markets – the common magnitude of the contraction suggests a global issue rather than a country-specific problem.
The 5y5y real rate using swaps is currently about 0.40% in the US, 0% in the euro area and -1.40% in the UK. These levels are very close to the “mean-reverting” level that has prevailed since 2012 – but still very far from the levels before 2008. They are also not too far in the US and the euro area from estimates of the natural real rate provided by Laubach and Williams – respectively 0.45% for the US, -0.30% for the euro area and 1.50% for the UK. A very large discrepancy remains for the UK. In addition, these numbers suggest that “real normalisation” towards the natural real rate has already occurred for some version of the natural real rate – especially in the US.

When looking at the real rate curve in the US, given where 30-year TIPS have been trading, it seems as if the markets have taken to heart the idea that the long-run real rate is somewhere around 1% (2% inflation minus 3% median long-run dots). Down the curve is where the debate over how high the natural real rate could go, in our view. Further increase in real yields would therefore potentially put policy at or above the neutral level – a result that currency markets have not missed in the case of the euro area, with the consequence of a sharp euro appreciation. A sudden and sharp revision in the neutral level advertised by central banks could result in much higher real rates, with the risk to push policy into restrictive levels, which in turn would add to the negative pressure on inflation and activity. This would happen at a time when short-term rates are only some basis points away from the ELB, with limited restored potential for accommodation.
Rushing to the exit: the segmentation of investors
Another factor creating potential non-linear dynamics in real rates stems at a technical level from the segmentation of investors – a feature that accounted for the unusually large changes in US real yields in 2013 referred to as “taper tantrum.” We have explained this consequence of segmentation in Inflation Insights - Mini “taper tantrum” vs. “dear Prudence”.
In the US, a structural and potential destabilising feature for rates market dynamics is the process of MBS holdings of the Federal Reserve System slowly returning to private investors. For years, the Fed has basically warehoused US rate vol (see link) by holding so many MBS securities out of the private sector. MBS hedging in the past was an issue for global markets during quick rises in US rates (where MBS hedgers can push nominal US rates up even faster – known as “convexity hedging”). However, rates/spreads can also rise over time as private investors begin to hedge their MBS for interest rate risk.
In the euro area, the ECB provided evidence that the implementation of the PSPP resulted mostly in the selling of euro fixed income assets by non-residents to the eurosystem, while insurance companies and pension funds did not change their investment pattern. Such investors given their high fixed-income exposure would typically react to a change in the direction of monetary policy towards faster normalisation and create “rush-to-the exit” dynamics." - source Nomura
As we pointed out, a "Convexity event" would be possible depending solely on the "velocity" in the rise in US rates. Given the Fed's recent "Barnum statements" and dovish tone, we think that the Fed's first priority will be to go ahead with the initiation of its balance sheet reduction in September, before following up on additional rate hikes we think. There is a possibility though that, given the current NAIRU discrepancy, Janet Yellen travels "back to the future" so to speak, to the 90s and this, would of course generate significant instability and the aforementioned "bond" volatility which is so feared by the beta crowd and carry players alike. "Velocity" will induce "volatility" and therefore weigh on fund bond flows. Obviously, the risk is a significant rise in real rates, which would be simultaneously bond and gold bearish. We might have been gullible in some instances, but it isn't our core scenario for the time being. Not until we see the facts change, namely less muted wages growth, that we will change our mind to paraphrase Keynes.

For our final charts, back in our conversation "Orchidelirium" we asked ourselves if the US consumer was "maxed out". We noticed at the time that consumer loan demand, a finding consistent with the weaker spending in Q1 had been cooling. We mentioned it was a significant indicator to monitor in the coming months.

  • Final charts - The barrel in the credit revolver is getting empty
In our book, consumer credit year-over-year change needs to be monitored very closely. Our final charts comes from Wells Fargo Economics Group note from the 7th of August and shows that Consumer Credit Growth has been slowing to end Q2. We are getting worried as well that total consumer credit momentum is decelerating:
"Consumer Credit Growth Slows to End Q2
Consumer credit rose $12.4 billion in June. Nonrevolving credit growth has been slowing for the past couple years, and with the recent halt in revolving credit’s momentum, total consumer credit is decelerating.
 Nonrevolving, Revolving Credit Both Slowing
  • Steady growth in nonrevolving credit earlier in the economic expansion helped spur total consumer credit higher despite anemic growth in the revolving space.
  • More recently, however, revolving credit growth has stalled. Net-charge offs have risen and delinquencies are up slightly, although both of these series have risen from historically low levels.

- source Wells Fargo

In June this year we mentioned our concern relating to the US consumer getting close to being maxed out in our conversation "Potemkin village":
"While it might be premature to pull the curtain on the Potemkin village, if indeed we break the 5% level for nonrevolving credit and continue to see a deteriorating trend in the coming months, then it will be a cause for concern. For credit markets at the moment, it's pretty much "carry on", though we are clearly tactically more cautious with High Yield and high beta in general." - source Macronomics, June 2017
If "Gullibility" is a failure of social intelligence in the sense that an investor gets tricked or manipulated by central bankers in buying European High Yield for example, then again, the US yield curve has been immune to the old tricks played by the Jedis at the Fed. As the economic cycle matures, so do credit standards and credit demand that simple. Most recent evidence indicates us that both consumer credit and business lending demand is slowing regardless of low unemployment and NAIRU readings. On top of that nonfinancial domestic corporate profit margins peaked in early 2014 and have declined in the last two years. This means, dear credit friends, that you need to have a more cautious stance going forward. Some investors might still be gullible enough to believe in "Barnum statements" and "Woozle effect", to paraphrase Jabba the Hutt in the Return of the Jedi, dear central banker your old Jedi mind tricks don't work on us.

"Most people are sceptical about the wrong things and gullible about the wrong things." - Nassim Nicholas Taleb

Stay tuned!
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