Sunday, 18 February 2018

Macro and Credit - Structured Criticality

"Bright light is injurious to those who see nothing." -  Prudentius

Looking at the relief rally that followed the tragedy that followed the "first to default" wipe-out of large swaths of the short volatility complex and given that we think that a large part of the continuation in the rally in equities is supported by the $171 billion in YTD stock buyback announcements, when it came to selecting our title analogy we reminded ourselves of "Structured Criticality" which is a property of complex systems such as financial markets. In complex systems such as financial markets, a small event may trigger larger events due to subtle interdependencies between elements. In our previous conversation we mentioned the pile of sand analogy with the additional grain of sand that triggers the avalanche as per the demise of the "first to default" or equity tranche short-volatility complex in the capital structure (or cone shape) of financial markets. Though the pile has retained its shape following the avalanche which has caused some number of grains to slide down the side of the cone (short volatility funds blowing up), it is nearly impossible to predict if the next grain of sand will cause an avalanche and where this avalanche will occur on the pile and how many grains of sand will be involved (risk parity, vol control products?). However, the aggregate behavior of avalanches can be modeled statistically with some accuracy. For example, some can reasonably predict the frequency of avalanche events of different sizes. The avalanches are caused when the impact of a new grain of sand is sufficient to dislodge some group of sand grains. If that group is dislodged then its motion may be sufficient to cause a cascade failure in some neighboring groups, while other groups that are nearby may be strong enough to absorb the energy of the event without being disturbed. Each group of sand grains can be thought of as a sub-system with its own state, and each sub-system can be made up of other sub-systems, and so on. In this way you can imagine the sand pile (or financial markets) as a complex system made up of sub-systems ultimately made up of individual grains of sand (yet another sub-system). Each of these sub-systems is more or less likely to suffer a cascade failure. Those that are likely to fail and reorganize can be said to be in a critical state. Put another way, the likelihood that any particular sub-system will fail (or experience a particular event) can be called its criticality. So then, the pile of sand (or financial markets) can be viewed as a network of interconnected systems, each with its own criticality. The relationships between these groups impose a structure on this network which has a profound effect on the probability and scope of a cascade failure in response to some other event. In other words - structured criticality. Given most buybacks have been funded by debt, we wonder when the next grain of sand will trigger the next avalanche. For now the complex system is benefiting from an unhealthy support coming from the flurry of buybacks announcements we think so caveat emptor ("let the buyer beware") with U.S. stocks recording the strongest weekly performance since at least 2013.

In this week's conversation, we would like to look at how volatility is the enemy of leverage and the on-going repricing of financial markets including volatility forcing markets to re-adjust to a loosening of financial repression and what it entails. There are as well many young market practitioners today that have never traded through a rising rates environment or seen what renewed inflationary pressure means for risky asset prices. 

  • Macro and Credit - Volatility is the enemy of leverage
  • Final charts - US Dollar ? Twin deficits and inflation matter

  • Macro and Credit - Volatility is the enemy of leverage

As we pointed out in our previous conversation "Harmonic tremor", the regime change in volatility and the effect of "Who's Afraid of the Big Bad Wolf?" aka "inflation expectations" thanks to rising wage inflation expectations have already claimed the small fishes such as some players in the short volatility leveraged and crowded complex. Leverage and rising positive correlations not only reduces the benefit from diversification but the jump in global risk premiums meant that the sell-off episode has shown us that this time was indeed different in the sense that what could be seen as "antifragile" havens in a true Taleb fashion such as US long bonds, gold and Swiss franc did not played their defensive purposes, only cash mattered, or having had sufficient downward protection strategies in this small avalanche that clearly put into the limelight the brewing instability in market structures. 

Whereas recently the markets have rebounded significantly thanks to the impressive support from additional buyback announcements, one should clearly be wised in  trying to understand the "Structured Criticality"  and vulnerabilities which have been highlighted by the VIX episode. The anomaly was obvious to many, namely that financial repression has led to volatility being repressed beyond anything reasonable thanks to central banking intervention. Repricing was way due for a reality check and of course as one might correctly opine, volatility is always the enemy of leverage (ask LTCM). It should not come as surprise therefore with the return of volatility to a more normal stage to see Global Macro Hedge Funds staging a comeback. As we pointed out in our November 2012 conversation "Why have Global Macro Hedge Funds underperformed", the main culprit was the lack of volatility. 

Obviously the biggest question following the "repricing" of volatility to a more "normal" state after many years of "financial repression" led by central banks is the risk in the change in the narrative we warned about in so many conversations. This is leading to unpredictability making a return into what have been "predictable" markets for so many years. On this subject we read with interest Deutsche Bank's Special Report from the 16th of February entitled " Undoing the unstrange  - The problem of re-emancipation of the markets" which we think is a great illustration of the change in the narrative we are seeing first hand:
"After years of calm and predictable markets, suddenly there seems to be many things going on at the same time. As recently as early January, the incoming vol supply could not find a buyer as vol selling and carry trade remained the dominant themes. This changed practically overnight as rates broke through significant technical levels, which triggered a spike in gamma, which quickly spread across all market sectors. With every new installment of stimulus unwind, it seems as if things are moving in reverse, but not to where we left them, rather towards what appears to be an unknown and unfamiliar destination. This is proving to be a highly unconventional tightening cycle and recovery. After years of forced hibernation, brought about by suspension of traditional trading rules by the central banks, the markets are facing a painful process of re-emancipation. This is causing considerable confusion and anxiety. Last time we saw a recovery from a conventional recession was about 14 years ago (for many, this is longer than their entire professional career). Things are different this time. Both the 2008 financial crisis and subsequent policy response were highly unconventional, and therefore there is no reason to expect that recovery and unwind of the policy response should be conventional either. We believe that the following three observations summarize the ongoing complications associated with stimulus unwind and the conflicts they create in the context of economic recovery.
1) Unwind of stimulus is a mirror image of the QE trade. It is a de-risking mode and, as such, it goes against the grain of recovery. This is in sharp contrast with conventional unwind of the recession trade, which is the risk-on mode.
2) Risk is asymmetrically distributed between rates and risk assets. There are two distinct paths to higher rates (through higher real rates or wider breakevens). They mean two different things for bonds and stocks. For bonds, the distinction between these two paths is a matter of degree between a mild and a moderate selloff. For equities (and USD), on the other hand, the effect is binary – it means a difference between a modest rally and a substantial selloff.
3) Volatility plays an essential role in the policy unwind. It is one of the key decision variables in the process of portfolio risk rebalancing -- higher volatility causes complications. However, unlike traditional recoveries, which are collinear with the unwind of the recession trade -- and, as such, volatility-reducing – the unwind of financial repression is withdrawal of convexity supply and a vol-enhancing mode.
The main diagonal: Conventional recovery from a conventional recession
To visualize the problem, we start with a figure that illustrates how recoveries from conventional recession used to play out in terms of the interplay between yields and equities. We start at point 1: Recession typically begins with a steep decline in risk assets and allocation to bonds. Monetary policy intervenes with rate cuts, which slows the selloff in risk, with rate cuts continuing until the economy stabilizes and the market turns around (2).
The recession-recovery path in the figure moves along the main diagonal (between the 1st and 3rd quadrants) -- recovery is a mirror image of the recession. As the defensive position (long bonds/short risk) is rebalanced, it moves the market naturally into the risk-on region (3) with more aggressive allocation to risk assets and underweight in bonds continuing typically until rate hikes slow the rise in equities (4). Unwind of the recession trade (in the conventional setting) goes along the grain of the market trade – its inertia leads naturally into the recovery trade. Because of this, past recoveries have been generally accompanied with lower volatility.
The agony of the off-diagonal: Rise of the unconditional
The current policy unwind is qualitatively different from traditional recoveries. The underlying complications can be traced back to the later installments of QE, around 2011, which signaled the beginning of a new regime of market functioning, an utterly new mode rarely seen to persist beyond transient episodes. The figure illustrates a longer history of the three assets in question, USD (in terms of TWI index), S&P levels and 10Y UST yield, indexed to their Jan-200 levels.
The letters S and W stand for strong and weak. Typically, stocks, bonds and currency cannot all rally at the same time for a prolonged period of time. Generally, they support each other conditionally: For two of them to rally, one has to sell off (and the other way around). This is seen in the picture during first decade of this century. 2011 signals a structural shift to a new regime: Between 2011 and 2016, the three assets supported each other unconditionally – they rallied simultaneously. This was a result of continued QE against the background of threat of sovereign risk overseas, which created positive externalities for both USD and US stocks, and it represents the other side of the state of exception created by the extended influence of central banks.
This outlines the essence of the problem of policy unwind. While central banks actions and the market environment had clearly created optimal conditions where, for many years, every asset class made money at the same time, the natural question one had to ask is: What to expect after that? If unwind of the stimulus is its mirror image, where does one go when everything sells off?
Monetary policy pharmakon of why does it hurt when we unwind?
The figure below illustrates the recession-recovery path post-2008. It starts, as usual, with a selloff in risk assets and a rally in bonds (1 & 2), but as the crisis deepens and QE gets deployed (3), the action moves (and stays) on the off-diagonal where both bonds and equities rally. Unwind of QE now becomes essentially a de-risking move -- it goes against the grain of recovery.
Currently, we are heading towards point 4, beginning to catch sight of the bifurcation point (5) from which the market could either sink into the “stagflationary” trap (6: everything: stocks bonds and currency, sell off) or move to the 1st quadrant if the Fed and Congress manage to engineer a turnaround and we get catapulted towards what looks like a traditional recovery. This is the biggest challenge for the Fed at the moment, which is further complicated by the ongoing rise in volatility. This complication, which appears to come naturally in this context, is further amplified by the Fed’s negative convexity exposure to inflation.
Inflation is producing an Icarus effect: Although negative convexity of inflation is a far OTM risk, it is significant even at remote distances from the strike, due to its enormous size. The accumulation of relatively illiquid long-dated bonds on retail balance sheets is at toxic levels and a substantial rise in inflation, to which there is no adequate policy response, could threaten to trigger a bond unwind that the market would be unable to absorb.
Locally, the main problem for risk assets is a rise in real rates: Having UST bonds with strong dollar or high real yields will be more attractive than holding US stocks, which means accelerated de-risking and higher volatility in the stock market. Higher inflation, on the other hand, would be supportive for equities and could cause another leg of selloff in bonds. What complicates things is that the behavior of real rates at this point is also a function of expected inflation: Higher inflation warrants a more hawkish Fed and therefore pricing in higher real rates. The reaction of stocks is a non-linear function of inflation – although risk assets might “like” higher inflation, this would remain true only up to a certain point.
Unwind of financial repression: Volatility is the key variable
Traditional recoveries have not been very sensitive to volatility behavior. In fact, volatility showed a tendency to decline in those cases. This follows almost automatically because of collinearity of recession unwind with the risk-on trade. The role of volatility in the current context is a novelty. An exit from almost a decade of financial repression has another dimension defined by volatility. This is a consequence of both the nature and the duration of the stimulus and subsequent  addiction liability that central banks run at the moment. The subsequent three figures illustrate how volatility enters the play during different stages of stimulus and its withdrawal.
Step 1: The recession starts at elevated volatility levels. The solid line represents the efficient frontier of a portfolio on the risk-return plane. Changing the risk causes a repricing of the frontier. This is shown by the dashed lines which reflect the levels of the existing market volatility. The two-sided arrow represents the risk limits of a given portfolio. This is kept constant through different stages of rebalancing. For a given risk limit, one finds a place on the frontier that fits inside the dashed lines (“VaR limits”).

Step 2: Response to crisis through QE consists of constraining the rates at the long end and therefore reducing the market volatility. As volatility resets lower, investors can afford to move further out along the risk curve until their risk limits are compatible with new volatility levels. This is the asset misallocation trade (one does things that one regrets later). This persists for years after the initial decline of volatility from crisis levels in late 2009. The new position is shown with the red double-sided arrow (the initial one is shaded).

Step 3: Unwind of stimulus and Fed exit is also a withdrawal of convexity supply. This implies higher volatility, which means that the prior portfolio is now operating above the risk limits. As a consequence we have a risk rebalancing towards the left (point 3 or the green arrow).

In the subsequent months, a particular pattern of volatility, in terms of its breakdown across different assets, will determine the mode of risk rebalancing. In that context, volatility will play a decisive role in determining the success and timing of the recovery and a particular economic trajectory.
Money market repricing
Inflation or no inflation in the short run, with continued push towards easy fiscal policy, financial conditions are unlikely to tighten. In that context, inflation risk could become more acute than currently perceived. At least, this is what history  would suggest. When markets operate close to full employment, further easing of financial conditions could create an explosive response in the economy. In that environment, the Fed is likely to stay the course and continue to hike, especially in light of the realization of the actual threat of inflation getting out of hand. In the meantime, the question is more about the Fed path rather than about its stance. A possibility of frontloading some of the hikes implies a flattening between the red and green sectors of the money market curve. This mode is not yet being priced in by the curve and vol. We are buyers of conditional bear flatteners at the short end of the curve." - source Deutsche Bank

As we pointed out in our previous conversation, there lies the risk ahead for financial markets when it comes to "inflation expectations", "realized inflation" could prove to be a significant grain of sand in terms of "Structured Criticality" particularly with a potential acceleration in trade wars and geopolitical exogenous factors coming into play (both are bullish gold by the way):
"Believing that the spread between implied and realized volatility would persist has indeed been a dangerous proposal with rising positive correlations. In similar fashion believing that "implied inflation" could persist remaining below "realized inflation" could become hazardous in the coming months, particularly with growing geopolitical exogenous risks around. Whereas QE was deflationary, QT could prove to be inflationary but we ramble again..." - source Macronomics, February 2018
Also, what we re-iterated in our conversation "Who's Afraid of the Big Bad Wolf?", with inflation, the only issue is when the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:
“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”
As pointed out by Christopher R. Cole, CFA from Artemis Capital Management latest note entitled "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion. As we pointed out in our recent musings, when it comes to "Structured Criticality", for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation", being probably one of the most dangerous grain of sand around when it comes to "avalanches" in the conic structure of financial markets we think. If volatility is the enemy of leverage, then again, inflation is the enemy of volatility. 

If indeed as pointed out by Christopher Cole, volatility is the brother of credit and volatility regime shifts are driven by the credit cycle, we have yet to see in earnest a significant tightening in financial conditions, yet from the buybacks frenzy to the current M&A craze, everything points towards a late credit cycle in our playbook. Yet when it comes to pressure on credit spreads, as seen during the energy crisis with the fall in oil prices leading to the blow-out in credit spreads, things can turn "south" as for the short-vol sellers faster than a rat on roller skates. What we think is of interest is that finally the much vaunted "Great Rotation" by some sell-side pundits, has finally somewhat started to materialize slowly in terms of fund outflows but this time where all the "fun" has been running thanks to low volatility and low interest rates, namely in the bond markets thanks to "goldilocks" environment enabling the "beta game" for the carry tourists. Fund outflows also point towards "Structured Criticality" in the sense that the shape of the conic structure in credit has been heavily skewed in recent years by the significant inflows into corporate bonds including the ETF complex. On the subject of fixed income outflows and the growing importance of the ETF complex we read with interest Bank of America Merrill Lynch's take from their Situation Room note from the 15th of February entitled "Position reduction":
"Following the recent equity market correction and equity and rates vol spike, investors reduced positioning in risk assets across the board this past week ending on February 14th. Outflows from equities continued for a second week at $3.55bn from $29.54bn. US-domiciled high grade bond funds and ETFs reported the first weekly outflow since December 2016 at $1.52bn, following a $5.28bn inflow the week before. HG funds had an outflow of $0.28bn after an inflow of $4.54bn, and HG ETFs had a $1.25bn outflow – highest since June 2013 – following a $0.74bn inflow one week earlier. Short-term HG held up comparatively well with an inflow of $0.12bn, down from $2.15bn the week before, while HG outside-of-short-term lost $1.65bn after gaining $3.13bn the prior week.

High yield also experienced a flows exodus of $6.33bn – the second highest weekly outflow on record – after a $2.34bn outflow the prior week, with HY funds and ETFs losing $3.58bn and $2.75bn in redemptions (-$1.37bn and -$0.97bn one week ago), respectively. Leveraged loans also had an outflow of $0.27bn from an inflow of $0.50bn the week before. Global EM reported an outflow of $2.87bn following an almost flat prior week of $0.02bn inflow. Outflow from munis accelerated to $0.66bn from $0.47bn, while inflow to money market funds slowed to $0.02bn from $27.80bn. Mortgages experienced a $0.18bn outflow following a $0.08bn inflow one week ago. On the other hand, government bonds continued to report decent inflows at $1.73bn this past week following a $1.75bn inflow the week before. The net effect on the all fixed income category was a significant $8.21bn outflow from a $4.02bn inflow a week earlier.

IG ETFs vs. bond funds
ETFs are becoming increasingly important vehicles in fixed income and inside we provide a discussion of trading volumes relative to the IG corporate bond market. Today we fielded a number of questions about yesterday’s record ~$924mn outflow from the largest IG corporate bond ETF (LQD) and whether we are concerned about it. We are not as, while the importance of ETFs in IG credit is growing, they are still relatively small. About 20% of US corporate bonds (IG+HY) are held by bond funds and ETFs (Figure 13), which applied to the size of the index eligible IG market comes out to $1.27tr.

However, we estimate that ETFs hold only $190bn of IG corporate bonds, or 2.9% of the market (Figure 16). Hence bond funds – not ETFs – are the elephant in the room as they hold more than six times as many IG corporate bond assets relative to ETFs. Even with the more recent shift to passive investment (see piece below) inflows to HG bond funds were four times ETF inflows in 2017.

The particular ETF in question (LQD) had about $34bn of assets – or 0.5% of the size of the IG market - before suffering a 2.6% outflow, which is a drop in the bucket. This ETF has suffered outflows all year totaling about $4.7bn as bond prices declined (entirely due to higher interest rates as credit spreads are flat on the year), which is normal (Figure 11).

However, we estimate that high grade bond funds and ETFs overall (a category that includes LQD) have seen inflows of $47bn this year. Hence the big story is one of very large inflows as opposed to ETF outflows. Now most IG bond funds/ETFs buy other IG assets in addition to corporate bonds - such as Treasuries, mortgages, etc. Focusing on dedicated corporate bond IG funds/ETFs (again including LQD) we estimate a $1bn inflow this year.
Recent daily outflows from HG bond funds/ETFs
However, we are starting to see small daily outflows from high grade bond funds and ETFs recently – specifically Friday-Wednesday (Figure 14).

This is to be expected given that the three main drivers of inflows to high grade bond funds/ETFs are 1) good total return performance (instead IG corporate bonds have lost 2.74% so far this year), low interest rate vol (Instead the move index has jumped to 70bps from 47bps) and equity outperformance (instead stocks corrected recently). For more details see: Inflows to taper 26 January 2018. For us to be concerned about large overall HG outflows – i.e. from bond funds as well - we need to see a much bigger increase in interest rates.
ETF liquidity injection
Fixed income ETFs are getting increasingly popular and, as a result, are adding liquidity to the mostly illiquid corporate bond market. In particular dedicated IG corporate bond ETF trading volumes are about 5.6% of cash bond trading volumes LTM – on adding the corporate bond portion of fixed income ETFs with broader mandates – such as agg-type funds - that number increases to 7.5% (Figure 15).

Trading activity in IG corporate bond ETFs is highly concentrated with the largest fund accounting for about 60% of volumes (Figure 17).

Trading volumes for the most active bonds in the corporate bond market are comparable, although slightly lower (Figure 18). In terms of AUM ETFs rose from 0.9% of the high grade index market value in January 2010 to 2.9% currently (for both corporate and high grade bond ETFs, adjusting for the share of corp. bonds, Figure 16)." - source Bank of America Merrill Lynch
While the slow movement in outflows has not reached the "Structured Criticality" level that would mean another "avalanche, these grains of sand do start to add up. Whereas foreign investors were responsible for the big acceleration in HG bond fund/ETF inflows in recent years thanks to a big decline in the cost of dollar hedging, retail in many instances have taken over from these foreigners particularly in the High Yield ETF space, rendering them more prone to volatility thanks to the feeble nature of these investors. While tracking bonds ETFs is of interest, it is of course not the best great gauge of real health in credit markets we must confess, though from a short term perspective, it might indicate some weakness in the near term. The correlation between oil prices and High Yield is much more interesting from a "monitoring" perspective. What you should be concerned about is that the switch from a negative real yield regime to a more normal, positive real yield regime might spark a big non-financial credit crisis because this time around leverage is higher now compared to history. If you believe in a "stagflationary" scenario unfolding à la 70s, the major difference is that leverage was falling during the rapid credit cycles of the 70s, with the biggest spikes in yields taking place at the end of the period.  There also a phenomenon that needs to be taken into account and it is that the current Boomers are more leveraged than previous generations were ahead of retirement as per the final points we have shown in our March 2017 conversation entitled "The Endless Summer". We concluded our missive at the time asking ourselves how many hikes it would take before the Fed finally breaks something.

But before your worries get ahead of you, in terms of credit matters, from an allocation perspective, if indeed slowly but surely rising outflows pressure from the Fixed Income space, we got interest by the suggestion made by Deutsche Bank in their Credit Bites note from the 16th of February entitled "The Resilience of Loans":
"In the aftermath of the recent inflation induced spike in volatility we analyse the impact it has had on the relative performance of HY bonds and leveraged loans. One of our key relative value views in our 2018 outlook is that loans would fare better than bonds if we did indeed see an inflation/rising yields led move higher in volatility that puts pressure on credit spreads.
When we published our outlook back in November one of our key relative value views was that loans would fare better than bonds if we did indeed see an inflation/rising yields led move higher in volatility that puts pressure on credit spreads. Given recent events we thought it would be worthwhile taking stock of where we stand and how the recent bout of volatility has impacted the relative returns between loans and bonds.
In Figure 1 we look at the cumulative YTD returns for the HY bond and leveraged loan indices.

We can see that in the early weeks of the year with spreads generally trending sideways to tighter bonds had fared fairly well. However with Bund yields generally moving higher from the second week of January loan returns started to bridge the performance gap. Then the inflation induced spike in volatility pushed credit spreads wider and helped to accelerate this trend. At the time of publication loans have outperformed bonds by 1-1.5% across the rating bands as we can see in the right hand chart of Figure 1.
In Figure 2 we run the same analysis for the USD market. We can see the relative performance dynamics are very similar to what we have already shown for the EUR market.

After the initial spread tightening and associated outperformance of bonds, the combination of higher bond yields and the spike higher in volatility has seen loans notably outperform. In fact the level of outperformance is slightly more impressive in the USD market. At the time of publishing loans had outperformed bonds (at an index level) in the 1.5-2% range across the rating bands (right hand chart of Figure 2).

We would additionally argue that it is not just the obvious outperformance of loans that has been impressive but also the general stability of loan returns. This highlights a key factor in why we think loans will outperform this year as they are generally less susceptible to day to day market volatility as well as having negligible exposure to rates duration.
If spread weakness in 2018 is driven by macro factors such as higher inflation and rising bond yields leading to higher volatility and wider spreads then the recent trend in performance makes us more comfortable with the view that loans will outperform bonds this year. We would be more concerned about this view if spread widening were to be driven by fundamental credit factors that pushed us towards the next default cycle.
Near-term we might see some reversal of this loan outperformance if volatility continues to settle down, equities continue to rebound from the recent correction and credit spreads continue to reverse some of the recent widening. However over the medium term we expect higher inflation and yields to keep volatility elevated above the lows of 2017 and therefore credit spreads to maintain a widening bias which should benefit loans over bonds." - source Deutsche Bank
What we don't like right now in the Leveraged Loans market is that Lower-rated deals (and covenant-lite transactions) are driving it at the moment. As indicated by S&P Leveraged Loans:
"There's $970B of outstanding US Leveraged Loans and more than 75% of that is covenant-lite" - source S&P LCD News
It might be more appropriate from a defensive perspective to play the Leveraged Loans game through large "Senior Tranches" in CLOs, ensuring you have a high attachment point, should defaults make a return at some point. Yet no doubt the low volatility of the asset class is compelling. Also in the US, managers of open-market CLOs have received a waiver from retention risk from the part of the US Court of Appeals for the DC circuit recently. This decision opens the door to other markets such as RMBS, CMBS and ABS to issue with the new rule in place. With a slower pace of issuance taking place over the next few months following the ruling, the asset class could benefit from a "technical bid". 

While many continue to be puzzled by the weakness in the US Dollar as per our final charts, we do think that when it comes to the long term direction of the currency, the twin deficits matter, and matter a lot.

  • Final charts - US Dollar ? Twin deficits and inflation matter
Economies that have both a fiscal deficit and a current account deficit are often referred to as having "twin deficits." The United States has fallen firmly into this category for years. According to Nomura FX Insights report from the 16th of February entitled "Twin deficits + inflation = weak dollar, current account balances are good explainers for FX performance. Both the Twin deficits in the US in conjunction with rising inflation expectations are good reasons to put forward for the weakness in the US dollar according to their report:
"USD/JPY’s plunge to levels last seen in late 2016 has caught many by surprise, but it fits neatly into a dollar downtrend narrative. Indeed, EUR/JPY has broadly been in a range since September last year, suggesting that we are not seeing a yen- or euro-specific move, but rather a dollar move. Remember, the euro is also seeing new highs – it has recently touched its highest level since late 2014.
We wrote recently that growing twin deficits in the US typically see the correlation between yields and the dollar breakdown and also that the dollar fares poorly during actual hiking phases. Another way of looking at this is correlations of G10 FX performance against current accounts or shifts in interest rates. Here we find that current account balances have asserted themselves as the best explainer of relative FX performance just as monetary policy has lost its grip on markets (Figure 1).

As for inflation, we also have written that the current combination of higher US inflation and loss of momentum in US growth surprises should weigh on the dollar. This has panned out. Again looking at correlations across a range of indicators, we find that FX is now negatively correlated with inflation levels.
In a world where twin deficits and inflation matter, the yen stands out. Japan has the lowest expected inflation in the G10 world. Core inflation is currently an anemic 0.1% compared with the recent 1.8% in the US. Japan is running a sizeable current account surplus and its fiscal balance is improving. Meanwhile, the US’s trade deficit is widening fast and the US is set to see its worst deterioration in its fiscal balance outside of a recession in modern history. All this suggests that dollar weakness could continue. We need to monitor the pace of the move, and Fed actions (more tightening to slow the economy) or even BoJ/ECB actions, but for now we’d look for USD/JPY to breach 100 and the euro to breach 1.30 in coming months." - source Nomura
In addition to the above interesting points made by Nomura, if the US dollar tends to weaken when inflation worsen, it also tends to strengthen when oil prices fall. When it comes to "Structured Criticality", the rapid fall in oil prices in 2015 was the grain of sand that led to the "avalanche" in risk-off and the significant widening in credit spreads that led to the weakness seen in equities in early 2016. Right now, the market has regained some posture thanks to financial engineering in the form of renewed buybacks and a strong M&A pipeline, until we get another unforeseen grain of sand, but that's a story for another day it seems.

"The epitaph on the grave of our democracy would be: They sacrificed the long-term for the short-term, and the long-term arrived" - Sir James Goldsmith

Stay tuned !  

Sunday, 11 February 2018

Macro and Credit - Harmonic tremor

"Stupidity is an elemental force for which no earthquake is a match." -  Karl Kraus, Austrian Writer

Watching with interest the tragedy unfold on the short gamma crowd through the demise of the short volatility ETN and ETF complex, sending markets into some tailspin and causing additional havocs in bond yields, when it came to choosing our title analogy for our post we reminded ourselves of the meaning of "Harmonic tremor". A "Harmonic tremor is a sustained release of seismic and infrasonic energy typically associated with the underground movement of magma (rising term premiums), the venting of volcanic gases from magma, or both. It's a long-duration release of seismic energy (volatility), with distinct spectral lines, that often precedes or accompanies a volcanic eruption (the demise of some short vol ETNs). More generally, a volcanic tremor is a sustained signal that may or may not possess these harmonic spectral features. Being a long-duration continuous signal from a temporally extended source, a volcanic tremor contrasts distinctly with transient sources of seismic radiation, such as tremors that are typically associated with earthquakes and explosions. Harmonic tremor is part of the four major types of seismograms, the three others being tectonic like earthquakes, shallow volcanic earthquakes and surface events. 

In this week's conversation, we would like to look at the recent sell-off which in effect was triggered by the harmonic tremor coming from the uninterrupted rise of term premiums. This regime change in volatility and the effect of "Who's Afraid of the Big Bad Wolf?" aka "inflation expectations" thanks to rising wage inflation expectations have already claimed the small fishes such as some players in the short volatility leveraged and crowded complex. Like a new grain of sand U.S. Average Hourly Earnings triggered an avalanche as seen in complex systems such as financial markets.

  • Macro and Credit - Rising term premium have already claimed small fishes, when are the whales going to show up?
  • Final chart - Increased inflation presents a potential threat to the purchasing power of consumers.

  • Macro and Credit - Rising term premium have already claimed small fishes, when are the whales going to show up?
We had hardly pressed the "publish" button for our previous post, that the events taking place in the volatility complex led to the already well publicized demise of some short volatility ETNs. This was bound to happen given the non-linearity aspect one can find in financial markets. 

The events that took place were fascinating as it was indeed yet another confirmation of our musing from February 2016 conversation "The disappearance of MS München" when we were discussing the fascinating destructive effect of "Rogue waves" on man-made "structures". Those waves have a high amplitude and may appear from nowhere and disappear without a trace, or investors in some instances. Generally rogues waves require longer time to form (like "harmonic tremors" led explosions), as their growth rate has a power law rather than an exponential one. While a 12-meter wave in the usual "linear" model has a breaking force of 6 metric tons per square meter (MT/m2), modern ships are designed to tolerate a breaking wave of 15 MT/m2, a rogue wave can dwarf both of these figures with a breaking force of 100 MT/m2. Remember this. 

Once again we would like to come back to our February post of 2016 and quote the book "Credit Crisis" authored by Dr Jochen Felsenheimer (which we quoted on numerous occasions on this very blog for good reasons) and Philip Gisdakis and steer you towards chapter 5 entitled "The Anatomy of a Credit Crisis" page 215 entitled "LTCM: The arbitrage saga" and the issue we have discussing extensively which is our great discomfort with rising positive correlations and large standard deviations move. This amounts to us as increasing rising instability and the potential for "Rogue Waves" to show up in earnest like the one experienced last Monday:
"LTCM's trading strategies generally showed no or almost very little correlation. In normal times or even in crises that are limited to a specific segment, LTCM benefited from this high degree of diversification. Nevertheless, the general flight to liquidity in 1998 caused a jump in global risk premiums, hitting the same direction. All (in normal times less-correlated) positions moved in the same direction. Finally, it is all about correlation! Rising correlations reduces the benefit from diversification, in the end hitting the fund's equity directly. This is similar with CDO investments (ie, mezzanine pieces in CDOs), which also suffer from a high (default) correlation between the underlying assets. Consequently, a major lesson of the LTCM crisis was that the underlying Covariance matrix used in Value-at-Risk (VaR) analysis is not static but changes over time." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
You might probably understand by now from our previous sailing analogy (The Vasa ship) and wave analogy (The Ninth Wave) where it will eventually end: Another financial crisis. 

Moving back to the LTCM VaR reference, the Variance-Covariance Method assumes that returns are normally distributed. In other words, it requires that we estimate only two factors - an expected (or average) return and a standard deviation. Value-at-Risk (VaR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. This what we had to say about VaR in our May 2015 conversation "Cushing's syndrome" and ties up nicely to our world of rising positive correlations. Your VaR measure doesn't measure today your maximum loss, but could be only measuring your minimum loss on any given day.

Check the recent large standard deviation moves dear readers such as the one experienced on the VIX last Monday and ask yourself if we are anymore in a VaR assumed "normal market" conditions:
"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured." - source Macronomics, May 2015
But, last Monday's move while surprising by its velocity, has not been as significant as the move seen in the VIX back in 1987. We are yet to see a spike to 173 seen on the VIX during the October 1987 crash and that was something, really something.

This is also what we argued in February 2016:
If you think diversification is a "solid defense" in a world of "positive correlations", think again, because here what the authors of "Credit Crisis" had to say about LTCM and tail events (Rogue Waves):
"Even if there are arbitrage opportunities in the sense that two positions that trade at different prices right now will definitely converge at a point in the future, there is a risk that the anomaly will become even bigger. However typically a high leverage is used for positions that have a skewed risk-return profile, or a high likelihood of a small profit but a very low risk of a large loss. This equals the risk-and-return profile of credit investments but also the risk that selling far-out-of-the-money puts on equities. In case of a tail event occurs, all risk parameters to manage the overall portfolio are probably worthless, as correlation patterns change dramatically during a crisis. That said, arbitrage trades are not under fire because the crisis has an impact on the long-term-risk-and-return profile of the position. However, a crisis might cause a short-term distortion of capital market leading to immense mark-to-market losses. If the capital adequacy is not strong enough to offset the mark-to-market losses, forced unwinding triggers significant losses in arbitrage portfolios. The same was true for many asset classes during the summer of 2007, when high-quality structures came under pressure, causing significant mark-to-market losses. Many of these structures did not bear default risk but a huge liquidity risk, and therefore many investors were forced to sell." source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
You probably understand by now why we have raised the "red flag" so many times on our fear in the rise of "positive correlations". They do scare us, because they entail, larger and larger standard deviation moves and potentially trigger "Rogue Waves" which can wipe out even the biggest and most reputable "Investment ships" à la MS München." - source Macronomics, February 2016
Obviously, for us rising term premiums have been like a "harmonic tremor" leading to the buildup that ended with the explosion that occurred in the short volatility space. The catalyst has been rising inflation expectations coming from the latest U.S. Average Hourly Earnings rising 2.9% Y/Y, the most since 2009. This was the little grain of sand that triggered, we think Monday's avalanche. 

If Short Vol ETNs could be compared to a piece of a CDO like structure for the financial markets complex, they could be seen as the "Equity tranche", or the first loss piece of this "capital structure" (The tranche that absorbs the first loss (and thus is the most risky tranche) is often called an equity tranche). Obviously the next question one would like to have answered when looking at his portfolio, is am I "senior" enough in the capital structure and is my attachment point high enough to avoid the pain? 

In relation to the issue of rising term premiums and additional potential pain and "de-risking" coming we read with interest Nomura's Global Markets Navigator note from the 7th of February entitled "Rising term premium claims its first victim":

"According to the NY Fed, the 10yr UST term premium troughed in early December at -0.62bps. As of 5 February, the NY Fed estimates that it has risen 33bps to -0.29bps.

Over the same period, the MOVE Index of implied treasury volatility rose in sympathy from an all-time index low of 48 to today’s 66. In previous reports we have linked low term premia to low implied interest volatility and in turn low implied volatilities in risk assets, e.g., equities.

Front-end VIX started to rise from the first day of 2018 trading, lagging behind the increase in the term premium. It was toward the end of January that both measures began to move faster. The recent few days of trading needs little rehashing.
And yet other risk assets and measures of risk aversion have not gone through similarly violent changes. Equity volatility in the euro area and Japan rose in tandem with the US but didn’t reach the same intraday highs. High yield spreads widened too, but not in a disorderly manner. Investment grade spreads didn't move much. Indeed a simple model of daily VIX changes vs daily S&P changes would have implied that US equities should have been down nearer 11% on 5 February rather than 4%. In other words, implied has move significantly higher than realised.
There are two interpretations of these facts. First, the VIX is sending us a serious message about the outlook for short-term US equity returns that the market needs to pay attention too. Second, US equity volatility products are an asset class in their own right. The existence of levered short-vol carry positions in those markets makes them more exposed to relatively small changes in other asset classes, e.g., rates vol.
To the extent interpretation one is correct, we should see a large increase in long rates hedges and selling pressure in credit and EM. To the extent the second interpretation is correct we should expect, when the affected positions are removed, a return to the status quo ex ante. Feedback from discussions with market participants suggests most people are putting faith in the second interpretation; this was an isolated incident in an important derivatives market.
The evidence supports that case. But there’s a problem. And it's the term premium.
As we wrote last time, the cyclical growth outlook points to higher policy rates and flatter curves, tight spreads and strong equity performance. The secular improvement scenario calls for higher rates too but is ambiguous about the shape of the nominal and real curve. The ambiguity stems from uncertainty about the natural rate and inflation. This makes it hard to anchor long-end rates (without even taking into account net net issuance) – ergo higher realised rates volatilities. This uncertainty is unlikely to go away for some time if we remain in an above-trend positive output gap world.
Thus normalisation – whether cyclical or structural – means a higher term premium and higher rates volatility. Even while the absolute level of yields remains low the past few days tells us two important things: investment strategies habituated to low term premia are likely to struggle in this environment; and higher beta assets can rally as government yields rise so long as their risk premia fall faster than rates increase. If rates rise too quickly, all bets are off.

The speed and breadth of the recent recovery has left central banks with a communication problem – it is tough to forward guide a nervous bond market if inflation is rising and growth is well above trend. If a rising term premia has claimed its first victim, will there be others?

Given the low absolute level of yields there’s little case for a growth driven risk sell off. But it is the speed of the adjustment to normal that will now be critical. Perversely, the best thing for markets now would be more modest growth and comforting downside inflation miss. - source Nomura
There lie the crux of the situation, too much good news could lead to more bad news for risky assets such as the dreaded CPI number coming out soon in the US. This is a very important number for bond yields in particular and asset prices in general. 

As we stated in our previous conversation prior to the VIX bloodbath that ensued, positive correlations matter and matter a lot. On this subject we read with interest Deutsche Bank' Special Report from the 7th of February entitled "The bond risk premium and the equity/yield correlation":
"A few months ago, we noted that the combination of low yields and high equities raised concerns that a sudden rise in bond yields could lead to a material repricing of equities. A week ago, we had a glimpse of a potential shift in the equity/yield correlation (higher yields/lower equities) that has been mainly positive since the late 90s. The risk-off environment of the last couple of days has reasserted the positive correlation between bond yields and equities. How can we explain such shift in correlation?
Our analysis suggests that the equity/yield correlation is related to the bond risk premium. A high bond risk premium coincides with a negative correlation between yields and equities. In the post Volker period, 10Y UST ~3% above r* corresponds to a yield/equity correlation close to zero (on a 12m backward looking basis). Current estimates of r* are between 0 and 50bp, but are expected to rise to 50-75bp in the quarters ahead.
On this basis, assuming that inflation expectations remain broadly anchored, a persistent shift in correlation is likely to occur when 10Y UST is somewhere between 3 and 3.5%. Clearly, the market will notice a shift in correlation on a much shorter time frame: a few days of negative correlation between yields and equities have been enough to generate significant attention. Thus, one would expect the shift in correlation to be felt at lower level of rates.
The relative perception of the risk of high vs low inflation regimes – i.e. 70s stagflation vs. Japanese deflation – is likely to be the underlying driver of the equity/yield correlation. When higher inflation is negative for growth (e.g. the 70s), one would expect bond yields and equities to be negatively correlated. A positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, as higher inflation will coincide with lower growth, bonds will not be a good hedge for an equity portfolio. As a result, they should command a higher risk premium. We would therefore observe a higher risk premium in bond markets and a negative correlation between bond yields and equities.
Conversely, if low inflation is negative for growth (e.g. Japan), then one would expect bond yields and equities to be positively correlated. A negative shock to inflation would coincide with a negative shock to growth. It would lead to lower bond yields and lower equities. Moreover, as lower inflation will coincide with lower growth, bonds will be a good hedge for an equity portfolio, commanding a lower risk premium. We would therefore observe a lower risk premium in bond markets and a positive correlation between bond yields and equities.
From a historical perspective, higher productivity coupled with cheap supply of labour reduced the risk of high inflation since the late 1990s. Technological advances and globalization have therefore likely been instrumental in establishing the low bond risk premium regime in place since the late 1990s.
This enabled central banks to establish their inflation targeting credentials and to be more predictable, thereby reducing interest rate volatility and the bond risk premium. Moreover, the FX regime in place in key EM economies led to  a significant increase in excess savings, which in turn depressed the bond risk premium (the bond market conundrum).
Looking ahead, the focus on inequalities in DM economies coupled with the desire of China in particular to shift towards a more consumption based economy suggest the current political economy trend is conducive to some reversal of the regime in place since the 90s, pointing towards the potential for a higher bond risk premium.
Indeed, these trends should result in (a) greater risk of trade barriers, (b) greater fiscal deficits in DM and (c) reduced current account surpluses in EM. Taken together, this should reduce the savings/investment imbalance and the disinflationary pressures from globalization. The resulting rise in the bond risk premium would put downward pressure on the yield/equity correlation.
The bond risk premium and the equities/yields correlation: the evidence
The bond risk premium (defined as the 10Y yield minus long-term growth and inflation expectations) has proven to be a good indicator of the correlation between equities and yields (defined as the rolling 12m correlation of weekly changes in the S&P and weekly changes in the 10Y yield). In the early 1990s, the bond risk premium was high and the correlation between yields and equities was negative.
Since the late 1990s, the correlation has been mostly positive with temporary exceptions around the end of tightening cycles (early 2000s and 2006) and the taper tantrum (see graphs below, note that the correlation scale is inverted on the left graph).

The focus on the post 1990s period is driven by the data availability: there are no long term growth and inflation surveys prior to this date. This period has been one of relatively stable inflation (especially relative to the 1970s), and as a result a significant portion of the move in yields can be associated to changes in the bond risk premium or a decline in the neutral real rate rather than changes in inflation. Thus, over this period, using the gap between UST10Y and the neutral real rate (as estimated by Holston, Laubach and Williams) is also a good indicator of the correlation between bond yields and equities (see graphs).
By focusing on 10Y UST – r* we can extend the sample to the early 60s. The correlation observed since the 1990s, extends over the whole lower inflation era (1986-2017). During the post Bretton Woods/high inflation/Volker periods, the correlation is weaker which could be ascribe to the fact that the 10Y rates are more impacted by inflation. Also the yield/equity correlation is always negative, which is consistent with the intuition discussed above.
In the 60s, the correlation is somewhat stronger again (see graph below).
In short, the bond risk premium is a decent indicator of the correlation between equities and bond yields. When it is high, the correlation becomes negative, pointing to high bond risk premium weighing on equities.
Assuming that inflation does not vary significantly, the gap between 10Y UST and r* can be used as a reference. Looking at the most recent samples (charts below), a spread between 10Y UST and r* of 3% would be consistent with the bond equity correlation persistently changing sign.

As well as representing a gauge of bond risk premium, the equity/yields correlation can be also used to confirm the evolution of credit risk in the euro area. Indeed, the correlation between the various European bond yields and equity markets was the same pre-crisis. In 2009, Italy switched to a persistently negative correlation which increased back towards zero following the “whatever it takes” statement from Draghi. The correlation between the CAC40 and OAT briefly turned negative when French spreads where widening substantially in 2011/2012. The shift in correlation can be interpreted as the result of a tightening of credit conditions due to a widening of credit spreads." - source Deutsche Bank
If indeed the shift in correlation from positive to negative marks a regime change in the narrative, given how loose financial conditions have been, it also indicates as per Deutsche Bank a tightening of credit conditions. To illustrate further the impact changes in cross-asset volatility thanks to change in correlations we think the below chart from Bank of America Merrill Lynch Cross-Asset Hedging note from the 7th of February entitled "Few signs of X-asset contagion as equity vol bubble finally pops" illustrate even further the "harmonic tremor":
- source Bank of America Merrill Lynch

For us, the most important piece of the puzzle for additional pain would be from the "Big Bad Wolf" aka inflation. This would generate additional pressure on risk premiums and bond yields. What matters as Nomura puts it in their note, is the speed of the adjustment and also from the Fed should it fells it is behind the curve thanks to faster than expected rise in inflation expectations. The risk obviously is on the upside particularly when it comes to rising concerns with inflation expectations. Some see the current situation with the latest US fiscal profligacy as similar to what the US experienced in the 1960s. This is the case for Deutsche Bank which sees similarities as per their Global Fixed Income note from the 9th of February entitled "A structural repricing of bond markets":
"There are some striking similarities between the new policy mix discussed above and the conditions that led to a shift upward in inflation expectations in 1966. In the first half of the 1960s, unemployment was declining rapidly but core inflation remained low and the Phillips Curve was “dead” (right graph below).

In 1966, the US administration significantly increased its fiscal spending on the back of (a) the Vietnam war and (b) the introduction of Medicare and Medicaid. This denoted a turning point in core inflation, which began to rise markedly (graph above). There are competing interpretations as to what drove the pickup in inflation: (a) fiscal stimulus, (b) non-linearities in the Phillips curve as the unemployment rate dipped below 4%, (c) rising healthcare inflation and (d) a Fed that was (ex-post) behind the curve.
Irrespective of the precise drivers, there are some similarities with current conditions. As the US economy is approaching full employment, the US government is implementing a significant fiscal stimulus. The potential introduction of trade barriers creates upside risks to inflation. Finally, the Fed may not intend to be behind the curve today, but if r* rises, as the Fed and our economists expect, current market pricing of the Fed policy will be overly accommodative." - source Deutsche Bank
There are many upside risks we commented in recent conversation, one being the start of a trade war through the implementation of trade barriers (that 30s feeling) which would put indeed some pressure on prices no doubt. This set up of both US profligacy and trade war would obviously reinforce further the bullish case for gold that led, at the end of the Vietnam to the Nixon shock in August 1971 and  the direct international convertibility of the United States dollar to gold. Could the sudden rise in positive correlations be yet another sign of the buildup in "harmonic tremor" that would led to a regime shift in inflation? We wonder.

Given as we pointed out again recently in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this the biggest near term concern of markets right now we think. When it comes to the relation between inflation and stock markets we read with interest Nomura's take from their Inflation Insights note from the 6th of February:
"A lesson for the near future
We think the correction in stock prices is connected to the likelihood of a return of wage inflation. We look at the traditional Gordon growth model to find that a scenario of higher wage inflation, higher inflation, higher inflation valuations, higher nominal rates and higher equity prices are very unlikely unless expectations of trend real growth substantially increase from current levels. We note that the US corporate tax cut did not manage to lift these expectations. We also note that the correction in stock prices may be a signal that US monetary policy is maybe being tightened in real terms more rapidly than what profit growth can actually sustain.
A simple framework and a reminder
According to James Bullard, President of the Federal Reserve Bank of Saint Louis, “inflation scare triggered some of the (equity) market sell-off”. There is indeed a very strong theoretical linkage between inflation and equity markets, which is best illustrated in the simple framework provided by the Gordon growth model, also referred to as the Dividend Discount Model. In this very simple model of stock prices, stock prices are discounted dividend expectations so that:

Where P is the stock price, D is future dividends and y is the nominal discount factor. Assuming a constant rate of growth for dividend g, this equation can be re-written so

Yet beyond this simple formula there are various assumptions that connect stock prices to the inflation market. First, y is the discount factor for stock prices, so it is the nominal risk-free rate plus the equity premium (y=r+ep). G is the growth rate for dividends, so it is in fact the nominal growth rate of the economy multiplied by the share of economic growth that goes to profits rather than wages (g=k*gdp, with gdp the growth rate of nominal GDP). Economists call it the sharing of national income.

A key factor affecting the sharing of national income is wage inflation. Average hourly earnings increased to 2.9% year-on-year in the US nonfarm payrolls report for January – their highest growth rate since 2009. This high number was perceived as heralding the return of wage inflation in the US and therefore altering the sharing of national income towards a larger share for wages and a lower share for profits.
Clearly, this framework from 1962 does not capture some other key financial aspects of the determination of stock prices. For example, it is likely that there is some linkage between the sharing of national income and the level of the risk-free rate (k and r). If wage inflation returns, the path of nominal interest rates is likely to be higher: that was also the case recently, resulting in a higher discount factor for dividends negatively affecting stock prices. With the equity premium term already minimal (implied volatility is low), there were few reasons for investors to expect higher risk-free rates to be offset by a lower equity premium.
We view this framework as a good reminder that a scenario of higher wage inflation, higher inflation, higher inflation valuations, higher nominal rates and higher equity prices are very unlikely unless expectations of trend real growth substantially increase from current levels. It is also intriguing that the US corporate tax cut was so promptly followed by the stock price correction – which suggests at least some skepticism about its effectiveness.
A minor caveat
And there is of course a minor caveat to this framework: the risk of an inflation overshoot remains noticeably absent from inflation valuations despite the increase in wages in January. Figure 1 shows that despite an increase in the 5yr inflation swap rate, the price of a hedge against inflation much higher than 2% is not historically high. We are only cautiously long 5yr breakeven rates in the US, it is worth recalling.
Too high, too fast?
Maybe the correction in stock prices – despite the tax cut – is a sign that real rates are getting close to “neutral” levels, for example the level of the natural real rate estimated by Williams and all, is likely to exert a negative effect on growth that may go beyond what inflation conditions currently imply. In other words, absent the risk of an inflation overshoot, real rates may normalise too fast, too soon – which would have an adverse impact on the real risk-free rate, but also on real dividend growth.
- source Nomura

When it comes to inflation "expectations", the above reminds us it is all about "implied" and "realized". In similar fashion implied volatility is more simply what the market is expecting (VIX) whereas realized volatility is sometimes deemed more tangible because it reflects the actual daily movement of the S&P 500 Index. The true outlying year in history was 2008 (before 2018's sucker punch), when realized volatility was actually higher than implied volatility - the only such instance over recent years. Even in 2017 the relationship between implied volatility and realized volatility was pretty much "normal". The issue of course is that when central banks are meddling with interest rates and financial repression leads to volatility being subdued for too long, then like a coiled spring, profiting, primarily, from the "volatility premium" (the difference between implied volatility (investors’ forecast of market volatility reflected in options pricing) and realized (actual) market volatility) seems like a "sure bet" for the likes of LJM Fund Management that got beaten up big time with the VIX blowing out à la 2008 (that infamous rogue waves we talk about with a breaking force of 100 MT/m2) . Believing that the spread between implied and realized volatility would persist has indeed been a dangerous proposal with rising positive correlations. In similar fashion believing that "implied inflation" could persist remaining below "realized inflation" could become hazardous in the coming months, particularly with growing geopolitical exogenous risks around. Whereas QE was deflationary, QT could prove to be inflationary but we ramble again...

Make no mistake, inflation is the "Boogeyman" for financial markets.  A sharp pickup in inflation is likely to entail a significant re-pricing and as per our final chart below it represents a serious headwind for the US consumers (Bracket creep aside).

  • Final chart - Increased inflation presents a potential threat to the purchasing power of consumers.
 The "Big Bad Wolf" aka inflation would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant additional repricing on the way. Inflation is our concern numero uno. Our final chart comes from Wells Fargo Economics Group note from the 8th of February entitled "Is the US Consumer Running on Fumes?" and highlights the relationship between PCE Deflator and Disposable Income:
"The Threat of Higher Inflation and Higher Interest Rates
In general, higher inflation reduces the growth rate of real disposable personal income and vice versa, which is clearly demonstrated in Figure 8.

As income and wealth are affected by fluctuations in inflation, one of the biggest threats over the next several years has to do with the rate of inflation. Markets recently seem to have been spooked by the relatively, and surprisingly, strong report on average hourly earnings, which could be indicating some pressure on prices for the U.S. economy. Higher inflation means higher interest rates, and both factors are clearly negative for the U.S. consumer. Higher inflation reduces the purchasing power of income, while higher interest rates makes purchases of durable goods, which are typically financed, more expensive over time. While for those that have fixed-rate mortgages, it is music to their ears, it is bad news for those that have adjustable rate mortgages.

Although inflation has remained low in this cycle compared to its historical trend, if prices were to accelerate, Americans’ real DPI growth will, once again, slow down and could also lead to a slowing of growth in real PCE, all else equal. Therefore, if we were to see an uptick in inflation, real DPI growth will slow and consumers’ purchasing power, or the amount they could consume based on their current income, would be negatively affected. Although this effect is clearly demonstrated in Figure 8, it is also evident that DPI experiences fluctuations with rather lackluster inflation growth. That is, although higher inflation can directly decrease disposable income growth, it is not the only factor that causes reductions in the rate of growth of income.
Furthermore, increases in interest rates could contribute to a slowdown in real PCE, as consumer purchases might diminish based on increased expense, such as what we have previously mentioned associated with durable goods financing. Another sector of risk for the consumer as well as for the credit market is the tax reform’s change in second mortgages or equity lines of credit. Americans, in some circumstances, can no longer take a credit on their taxes for interest on equity lines of credit and this together with the still-high, relative to the past, delinquency rate for these lines of credit could be signaling problems ahead for the U.S. consumer, as well as for the overall credit market." - source Wells Fargo
One could argue that the only "easing" day was yesterday. Have we seen "peak consumer confidence" in the US? It certainly looks like it so beware of the Big Bad Wolf aka "inflation" because he has already blown apart the "short vol" pig's house made of straw...

"Worry is the interest paid by those who borrow trouble." -  George Washington

Stay tuned ! 
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