The Monkey And Banana Problem

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by: Macronomics

"There are three growth industries in Japan: funerals, insolvency and securitization."

- Dominic Jones, Asset Finance International, November 1998

Looking at the evolution of markets and the convolution into which central bankers have fallen, we reminded ourselves for our chosen title analogy of the "Monkey and banana problem", which is a famous toy problem in artificial intelligence, particularly in logic programming and planning. The problem goes as follows:

"A monkey is in a room. Suspended from the ceiling is a bunch of bananas, beyond the monkey's reach. However, in the room there are also a chair and a stick. The ceiling is just the right height so that a monkey standing on a chair could knock the bananas down with the stick. The monkey knows how to move around, carry other things around, reach for the bananas, and wave a stick in the air. What is the best sequence of actions for the monkey?"

- Source: Wikipedia

While there are many applications to this problem. One is as a toy problem for computer science, and the other, we think is a "credit impulse" problem" for central bankers. The issue at hand is given financial conditions are globally tightening, as shown as well in the US in the latest publications of the Fed Senior Loan Officer Survey and the bloodbath in European bank shares. The problem is how on earth our central bankers or "monkeys" (yes, it's after all the Chinese year of the fire monkey...) are going to avoid the contraction in loan growth. As put bluntly by our friend Cyril Castelli from Rcube, the European credit channel is at risk, as banks' share of credit transmission is much higher in the EU than the US, which, of course, is bound to create a negative feedback loop and could therefore stall much-needed growth:

Click to enlarge

Source: Rcube - @CyrilRcube

Another possible tongue-in-cheek purpose of our analogy and problem is to raise the question: Are central bankers intelligent? Of course they are, and most of them have to deal with complete lack of political support (or leadership). It seems we have reached the limits of what monetary policies can do, in many instances.

Although both humans and monkeys have the ability to use mental maps to remember things like where to go to find shelter, or how to avoid danger, it seems to us that in recent years, central bankers have lost the ability to avoid danger. While monkeys can also remember where to go to gather food and water, as well as how to communicate with each other, it seems to us, as of late, that central bankers are losing their ability to communicate, not only with each other, but with the markets as well. Hence, our chosen title. Could it be that monkeys have indeed superior abilities than central bankers given their ability not only to remember how to hunt and gather, but also to learn new things, as is the case with the monkey and the bananas? Despite the facts that the monkey may never have been in an identical situation, with the same artifacts at hand (printing press), a monkey is capable of concluding that it needs to make a ladder, position it below the bananas, and climb up to reach for them. It seems to us that despite the glaring evidence that the "wealth effect" is not translating into strong positive effects into the "real economy", yet it seems central bankers have decided to all embrace the Negative Interest Rate Policy, aka NIRP, as the new "banana". One would argue that, to some extent, central bankers have gone "bananas", but we ramble again...

In this week's conversation, we will voice our concern relating to the heightened probability of a credit crunch in Europe, thanks to banking woes and the unresolved Italian nonperforming loans issue (NPLs). We will as well look at the credit markets from a historical bear market perspective and muse around the relief rally experienced so far.

Synopsis:

  • Macro and Credit - The risk of another credit crunch in Europe is real
  • Why NIRP matters on the asset side of a bank balance sheet
  • Credit spreads and FX movements - Why we are watching the Japanese yen
  • Final chart: US corporate sector leverage approaching crisis peak

Credit - The risk of another credit crunch in Europe is real

The fast deterioration in European bank stocks, in conjunction with the rising and justified concerns relating to Italian NPLs constitutes a direct threat to the "credit impulse" needed to sustain growth in Europe, we think. As we have pointed out on numerous occasions, the ECB and the Fed have taken different approaches in tackling their banking woes following the Great Financial Crisis (GFC). In various conversations, we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):

"We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation

- The LTRO Alkaloid - 12th February 2012"

Exactly. The issue with Italian NPLs is that the tepid Italian growth of the last few years is in no way alleviating the bloated balance sheets of Italian banks, which would help sustain credit growth for consumption purposes in Italy, as evidently illustrated in a recent Société Générale chart we have used in our conversation "The Vasa Ship":

"As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs"

- Source: Macronomics, February 2016

Source: Société Générale

So, all in all, the ECB is going to have to find a way to shift these impaired assets onto its balance sheet if it wants to swiftly and clearly deal with the worsening Italian situation. While some pundits would point out that the new "bail-in" resolutions in place since the 1st of January are sufficient to deal with such an issue, we do not share their optimism. This is a potential "political" problem of the first order, should the ECB decides to deal with this sizable problem à la Cyprus. Caveat emptor.

You could expect once more politicians and the ECB to somewhat twist the rule book in order to facilitate this "securitization" process and an ECB take-up of part of the capital structure (senior tranches, probably) of these new NPLs CDOs. A new LTRO at this point might once again alleviate funding issues for some, but in no way alter the debilitating course of the credit profile of the Italian banks. On a side note, we joked in our last conversation around these new NPLs CDOs being the new "Big Short":

"If you want to make it big, here is what we suggest à la "Big Short," given last week we mentioned that Italian NPLs have now been bundled up into a new variety of CDOs and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honor the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs."

- Source Macronomics, February 2016

But when it comes to the "credit impulse" and its potential "impairment" in Europe, thanks to banks' bloated balance sheets and equities bleeding, we read with interest Deutsche Bank's take in their Focus Europe note from 19th February, entitled "Moving down a gear":

"The balance between the growth drivers and detractors is being tipped towards the negative as the questioning of confidence in European banks threatens to result in a less beneficial credit impulse. In last week's Focus Europe we presented a scenario analysis to demonstrate the sensitivity of euro area GDP growth to the provision of bank credit. We did this via the credit impulse relationship. Our earlier assumption of 1.6% real GDP growth in 2016 was consistent with 2% credit growth. If, on the other hand, banks issue no net new credit this year, domestic demand would fall, confidence deteriorate and financial markets tighten. With no reaction from the ECB, 2016 GDP growth would fall to about 0.5%





The recent fall in bank equities and rise in bank debt costs combined with increasing economic risks, the balance of probabilities suggests that lending standards will tighten relative to what we expected previously. Therefore, to some degree the provision of bank credit, and hence economic growth, will suffer. The revision we are announcing is an attempt to capture this effect. There are considerable uncertainties as to the scale of the problem, but we feel a modestly weaker lending impulse is now a more appropriate baseline.

Credit (-0.2pp). Our previous baseline forecast of 1.6% GDP growth was consistent with an acceleration in bank credit growth from broadly zero in 2015 to about 2% this year. The improvement in credit conditions in the last Bank Lending Survey implied a modest upside risk relative to forecasts. The last Bank Lending Survey was conducted in December and published in January. There were no indications at that point of concern about capital, liquidity or risk. However, as we said above, the balance of probabilities implies that lending standards will now tighten. We are conservatively allowing for a scenario in which the contribution to GDP from bank credit is now 0.2pp weaker than our previous baseline.

The ECB can help minimize the damage...

The onus is on the ECB to achieve two things at the next meeting on 10 March. First, to set an appropriately accommodative policy stance given the worsen outlook for both growth and inflation. Note, since December, our headline and core HICP inflation forecasts for 2016 have fallen from 0.9% and 1.3% to 0.2% and 1.1% respectively (see page 2 for updated country inflation forecasts).

Second, to set a policy stance that does not compound the pressures on a banking system that may be perceived as being more vulnerable.

We presented a detailed discussion of the ECB's options in last week's Focus Europe (pages 8-10)2. Suffice to say, the choice of policies will be affected by conditions in the banking system. Our expectation prior to this episode of banking stress in recent weeks was a 10bp deposit rate cut and a temporary acceleration in the pace of purchases. The bank stress implies that a further deposit rate cut may be unwise without a system of exemptions. A refi cut, for example targeted at TLTROs, would be more effective.

The bank stress also implies the ECB should offer some kind of supplementary liquidity tender. Excess liquidity is running at about EUR700bn, but if there was any sense of fragmentation re-emerging between strong and weak banks, it would be in the ECB's interest to remove all doubt about bank access to liquidity. Finally, the justification for more QE has increased given the widening of credit and sovereign spreads.
More QE would reduce the risk of a negative feedback loop between banks and sovereigns.

The ECB is conducting a technical review of the asset purchase programme (APP). This might result in some changes. In terms of broadening the eligible asset base, we suspect the ECB will remain in the sovereign/quasi-sovereign space for now. Corporate bonds are possible but not very impactful.

Purchasing unsecured bank debt might not be inconsistent with the Treaty but would be complex and politically controversial. Stresses would have to increase markedly to bring this option onto the table.

There is no relaxation of regulation, however. Both Mario Draghi, President of the ECB, and Daniele Nouy, head of the ECB Single Supervisory Mechanism (SSM), were consistent in their messages this week that (a) the new regulatory regime is resulting is a more stable and sustainable banking system - there is no sense that regulation is a net cost - and (b) "all else unchanged" there will be no significant additional capital requirements imposed on banks.

Benoit Coeure, ECB Executive Board Member, said that if bank profits are under pressure the onus would be on governments to implement structural reforms and growth-friendly fiscal policies. In short, no change in ECB message.

... but negative feedback loops cannot be ruled out either.

Last week we showed how sensitive the economic cycle can be to the bank credit cycle. This negative dynamic can become self-reinforcing. One direction is via the private sector and another is through the public sector. A tightening of lending standards weakens demand, undermining growth and asset quality, triggering a second-order tightening in credit. At the same time, weaker demand undermines sovereign sustainability which can tightening bank funding cost and additionally contribute to second-order tightening.



Fiscal dynamics have deteriorated. The primary balance gap is the difference between the debt-stabilising primary balance and the primary balance. It captures the underlying dynamic of the public debt-to-GDP ratio. A negative gap means the public debt ratio is falling. Our previous forecast was for a primary balance gap of -0.6% of GDP in 2016, the first genuine decline in the public debt ratio since the start of the crisis. Following the growth and inflation revisions, the primary balance gap is expected to be positive again. In other words, the benefits of lower funding rates thanks to ECB QE are not enough to compensate for the loss of economic momentum. Moreover, if the scenario of zero net new bank credit were to materialize, 2016 could see the primary balance gap rise back to levels not seen since 2012. That would imply a euro area public debt-to-GDP ratio of about 98%."

- Source: Deutsche Bank

Whereas indeed we are waiting to Le Chiffre, aka Mario Draghi, to come up with new tricks in March to alleviate the renewed pressure on European banks, where we disagree with Deutsche Bank is that providing new TLROs would provide much-needed support for funding in a situation where some banking players are seeing their cost of capital rise, thanks to a flattening of their credit curve (in particular, Deutsche Bank, as per our previous conversation), this intervention would in no way remove the troubled growing impaired assets from the likes of Italian banks. It is one thing to deal with the flow (funding) and another entirely to deal with the stocks (impaired assets). Whereas securitization of the lot seems to be latest avenue taken, you need to find a buyer for the various tranches of these new NPLs CDOs. Also, more QE will not deal with the stocks of impaired assets unless these assets are purchased directly by the ECB.

When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the "Association Française des Trésoriers d'Entreprise" (French Corporate Treasurers Association) surveys. In their latest survey, while it is difficult to assess for now a clear trend in the deterioration of financial conditions for French corporate treasurers, it appears to us that NIRP has already been impacting the margin paid on credit facilities, given a small minority of French corporate treasurers are indicating that since December, there is an increasing trend in margin paid on the aforementioned credit facilities:

"Does the margin paid on your credit facilities has a tendency, to rise, fall or remains stable?"

Click to enlarge

Source: AFTE

Going forward, we will closely be monitoring these additional signals coming from French corporate treasurers to measure up the impact on the overall financial conditions, as well as the impact NIRP has on the margins they are getting charged on their credit facilities. For now, conditions for French corporate treasurers do not warrant caution at the microeconomic level.

While we have recently indicated our medium-to-long term discomfort with the current state of affairs akin to 2007 in terms of credit markets, the recent "relief rally" witnessed so far is for us a manifestation of the "overshoot" we discussed last week. Some welcome stabilization was warranted, yet we do feel that the credit cycle has turned, and that you should be selling into strength and move towards more defensive position - higher into the rating quality spectrum, that is - and raise your cash levels.

When it comes to enticing banks to "lend" more, as far as our analogy is concerned we wonder how the "monkey" bankers are going to react if indeed additional NIRP is going to remove more "bananas".

This brings us to our second point, namely that the flatter the yield curve, the less effective NIRP is.

Why NIRP matters on the asset side of a bank balance sheet

Whereas Europe overall has been moving more into the NIRP phenomenon, with over $7 trillion worth of global government bonds now yielding "less" than zero percent, the Fed in the US is weighting joining the NIRP club in 2016. Apparently, NIRP being vaunted as the new "banana" tool in the box to stimulate the "monkeys".

The issue, of course, at hand is that NIRP does matter, and particularly when it comes to the asset side of a bank balance sheet, as put forward by Deutsche Bank in their note from 22nd February entitled "Three things the market taught me this year":

"Negative rates - much more complicated

Negative rates look powerful at face value. Bank profits can be protected by exempting excess liquidity while market rates are pushed down. The turmoil in Japan points to three considerations that mute this view.

First, the impact of negative rates on the asset side of banks' balance sheet can matter much more than the charge on excess liquidity. Banks that own large amounts of fixed income assets relative to the size of their total balance sheet (and their excess liquidity) are hit the hardest as returns on these assets drop. Japan and the US stand out as economies where the cost to the banks is biggest, Switzerland and Sweden the least, while Europe is somewhere in between:

Second, super-flat yield curves reduce the impact of negative rates. When bonds don't offer risk premia, a perfect Keynesian liquidity trap exists: fixed income is the same as cash, and negative rates instantaneously transmit to the entire yield curve. The portfolio rebalancing into riskier assets declines as the marginal holders of zero-yielding bonds are naturally risk-averse. Japan's yield curve, the flattest in the world, failed to steepen when the BoJ cut rates earlier this month - all yields just shifted down. Sweden, the UK and Europe stand out as yield curves where there's still more risk premium to be squeezed, Japan, Canada and Norway the least:

Third, sub-zero rates can send a negative forward-looking signal. Until the technological and institutional framework is designed to pass negative rates to depositors without triggering banknote withdrawal, there will eventually be a (negative) lower bound. As this is approached the signaling cost of easing being exhausted may be bigger than the benefit of lower rates. At the extreme cash and bonds turn into "Giffen goods": the substitution effect of lower return is more than offset by expected lower future income. Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. The limitations of additional BoJ easing in addition to changing Japanese hedging behaviour, are some of the factors, that have led us to revise our USD/JPY forecasts for this year. We now think 2015 marked the peak in USD/JPY for this cycle and forecast a move down to as low as 105 this year."

- Source: Deutsche Bank

Exactly, this negative feedback loop doesn't stop the frenzy for bonds and the "over-allocation" process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP, this push yields lower and bond prices even higher. This is exactly what we discussed in our conversation "Le Chiffre" in October 2015:

"The big benefactors of the Fed and Le Chiffre's gaming style, particularly since is brilliant 2012 bluff in the European Government bond poker game have been bonds. We came across this very interesting chart from Deutsche Bank (h/t Tracy Alloway from Bloomberg on Twitter) which clearly illustrates "overconfidence" and "over-allocation" to the bonds relative to the trend which are $755bn above the normal trend. This is entirely attributable to the distortions created by QEs:



Source: Deutsche Bank (h/t Tracy Alloway)

Furthermore, the significant repricing in European equities (where many pundits had been "overweight" at the beginning of the year) has led to a significant switch from equities to bonds, as indicated by Bloomberg in their article from 22nd February entitled "They'd Rather Get Nothing in Bonds Than Buy Europe Stocks":

  • "Estimates for Euro Stoxx 50 dividend yield at 4.3 percent
  • The region's government debt is yielding 0.6 percent

The cash reward for owning European stocks is about seven times larger than for bonds. Investors are ditching the equities anyway.

Even with the Euro Stoxx 50 Index posting its biggest weekly rally since October, managers pulled $4.2 billion from European stock funds in the period ended Feb. 17, the most in more than a year, according to a Bank of America Corp. note citing EPFR Global. The withdrawals are coming even as corporate dividends exceed yields on fixed-income assets by the most ever:

Click to enlargeInvestors who leaped into stocks during a similar bond-stock valuation gap just four months ago aren't eager to do it again: an autumn equity rally quickly evaporated come December. A Bank of America fund-manager survey this month showed cash allocations rose to a 14-year high and expectations for global growth are the worst since 2011.

If anything, the valuation discrepancy between stocks and bonds is likely to get wider, said Simon Wiersma of ING Groep NV.

"The gap between bond and dividend yields will continue expanding," said Wiersma, an investment manager in Amsterdam. "Investors fear economic growth figures. We're still looking for some confirmations for the economic growth outlook."

Dividend estimates for sectors like energy and utilities may still be too high for 2016, Wiersma says. Electricite de France SA and Centrica Plc lowered their payouts last week, and Germany's RWE AG suspended its for the first time in at least half a century. Traders are betting on cuts at oil producer Repsol SA, which offers Spain's highest dividend yield.

With President Mario Draghi signaling in January that more European Central Bank stimulus may be on its way, traders have been flocking to the debt market. The average yield for securities on the Bloomberg Eurozone Sovereign Bond Index fell to about 0.6 percent, and more than $2.2 trillion - or one-third of the bonds - offer negative yields. Shorter-maturity debt for nations including Germany, France, Spain and Belgium have touched record, sub-zero levels this month."

- Source: Bloomberg

In that instance, while the equity "banana" appears more enticing from a "yield" perspective, it seems that the "electric shock" inflicted to our investor "monkey" community has no doubt change their "psyche".

The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box). When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock", and hence the reach for bonds.

When it comes to our outlook and stance relating to the credit cycle, we would like to point out again towards Chapter 5 of Credit Crisis, authored by Dr Jochen Felsenheimer and Philip Gisdakis, where they highlight the work of Hyman Minsky's work on the equity-debt cycle, and particularly in the light of the Energy sector upcoming bust:

"His cyclical theory of financial crises describes the fragility of financial markets as a function of the business cycle. In the aftermath of a recession, firms finance themselves in a very safe way. As the economy grows and expected profits rise, firms take on more speculative financing, anticipating profits and that loans can be repaid easily. Increased financing translates into rising investment triggering further growth of the economy, making lenders confident that they will receive a decent return on their investments. In such a boom period, lenders tend to abstain from guarantees of success, i.e; reflected in less covenants or in rising investments in low-quality companies. Even if lenders knows that the firms are not able to repay their debt, they believe these firms will refinance elsewhere as their expected profits rise. While this is still a positive scenario for equity markets, the economy has definitely taken on too much credit risk. Consequently, the next stage of the cycle is characterized by rising defaults. This translates into tighter lending standards of banks. Here, the similarities to the subprime turmoil become obvious. Refinancing becomes impossible especially for lower-rated companies and more firms default. This is the beginning of a crisis in the real economy, while during the recession, firms start to turn to more conservative financing and the cycle closes again"

- Source: Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

The issue with NIRP and the relationship between credit spreads and safe-haven yields is that while the traditional pattern of lower government bond yields and a flatter yield curve is accompanied by wider spreads in "risk-off" scenarios, given more and more pundits (such as Hedge Funds) have been playing the total return game, they have become less and less dependent on traditional risk-return optimized approach, as they are less dependent on movements on the interest rate side. The consequence of this means that classical theories based on allocation become more and more challenged in a NIRP world, because correlation patterns change in a crisis period, particularly when correlations are becoming more and more positive (hence, large standard deviations move).

But if indeed the behavior of credit is affected in relation to safe-haven yields by changes in correlations, then you might rightly ask yourself about the relationship of credit spreads and FX movements, given the focus as of late has been around the surge in the US dollar and the fall in oil prices, in conjunction of the rise of the cost in capital since mid-2014.

In our next point we think that, from a credit perspective, you should focus your attention on the Japanese yen once more.

Credit spreads and FX movements - Why we are watching the Japanese yen

Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings, and in similar fashion in Europe previously the focus had been on the strength of the euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward. Once again, we take our cue from Chapter 5 of Credit Crisis:

"Many credit hedge funds not only implement leveraged investment strategies but also leveraged funding strategies, primarily using the JPY as a cheap funding source. A weaker JPY accompanied by tighter spreads is the best of all worlds for a yen funded credit hedge fund. However, these funds should be more linked to the JPY than the USD. One impact is obviously that the favorable growth outlook in Euroland triggers a strong EUR and tighter spreads of European companies (which benefit the most from the improving economic environment). However, the diverging fit between EUR spreads, the USD and the JPY, respectively, underpins the argument that technical factors as well as structural developments dominate fundamental trends at least in certain periods of the cycle. "

- Source: Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

However, NIRP doesn't reduce the cost of capital. NIRP is a currency play. This is clearly the case in Japan, and has been well described in Deutsche Bank's note from 22nd February, entitled "Yen hedging cycle risks rapid reverse":

"A lot of negative things have been said about negative rates, not least in Japan. Negative rates do not work by reducing financing costs materially, providing a 'price of money' stimulus. If negative rates do support activity, they primarily work through the exchange rate, adding to the portfolio substitution into risky asset.

For Japan the biggest problem is that macro policies have been directing capital toward risky assets for the last 4+ years. There are inevitably diminishing returns to this strategy, not least because 'value' matters. Value matters when it comes to the underlying domestic and foreign 'risky' asset, and the value of the exchange rate. Specifically on the latter, the yen even after the recent appreciation is still close to 20% cheap in PPP terms.

It is also cheap on a FEER and BEER basis, helped by a terms of trade shock that is seen lifting the Current Account surplus to near 5% of GDP in 2016. Figure 2 shows that in the last year, Japan has had the most favorable terms of trade shock of any major economy.

Click to enlarge

While FDI can recycle up to half of the C/A surplus, the question is whether other BoP components, notably net portfolio flows, will do the rest of the recycling, and at what exchange rate. For much of 2013 - H1 2015, vehicles like the GPIF were used to recycle (a much smaller) C/A surplus, that even briefly went into deficit in 2014. By June 2015, the GPIF's portfolio of riskier assets inclusive of domestic stocks (22.3%), international bonds (13.1%), and international stocks (22.3%) was well within the desired base/benchmark ranges (see Figure 3).

For the latest data available for Q3 2015, GPIF domestic and international equity holdings declined led by weaker equity prices and a stronger yen - price action that underscores the risky nature of these investments.

As the C/A surplus grows and the above 'structural' pension shift toward capital flows abroad diminishes, there is a danger that we have already entered the realm where yen strength becomes self-fulfilling, as many of the hedging activities that were associated with a weak yen in the first four years of Abeconomics go into reverse.

Prior to Abeconomics, hedging on Japan equity flows was limited. Since 2011 when BOJ policy encouraged yen weakness, foreign inflows into Japan equities typically included much higher currency hedge ratios, while fully hedged instruments became popular. Precise numbers are not available, but it is estimated that as much as a quarter of the stock of foreign holdings of Japan equities of Y183tr has a currency hedge - a hedge that quickly becomes much less attractive with a stronger yen.

In contrast, for Japan investments abroad, FX hedge ratios declined. This particularly relates to USD investments, where expectations of USD gains increased rapidly in the Abeconomics years, and FX hedges on USD investments dropped. At the end of Q3 2015, Japan had a total of Y770trillion non-Central Banks assets abroad, inclusive of Y418tr portfolio assets, of which Y153tr are equity and investment fund shares, and Y266tr are debt securities. Even if much of the investment abroad has only limited hedges, one observation is that a very small adjustment in hedge ratios can have a huge flow impact. A shift in the hedge ratio on foreign fixed income assets by 10% is roughly equivalent to a year's C/A surplus. Secondly, to the extent that hedge ratios are very low, as is the case for, say, the GPIF, there are sizable potential losses for funds recently adding to foreign exposure, and an emerging disincentive to invest in the most risky assets abroad.

Of the large players that actively hedge FX exposure, the life insurance companies' activities can most closely be tracked through quarterly statements, and the time series can provide a useful standard to benchmark recent activity. Life insurance companies as of Q3 2015 had some Y65tr in foreign securities. As per Figure 4, their currency hedge ratios on dollar-based investments are estimated to have dropped to ~46% by the end of Q3 2015, the lowest levels recorded since the Great Financial Crisis in 2008. The hedge ratio is down from a peak of 79% in September 2009.

Life insurance company hedge ratios have likely reached a cycle nadir at the end of 2015, as concerns about JPY appreciation start to rise.

Among the other largest participants that have foreign portfolios of comparable size to the Lifers, both Toshins (foreign securities of ~77tr) and particularly public pension funds ( ~ Y57tr foreign securities) have very low currency hedge ratios and are heavily exposed to currency risk. Japan investments abroad, so actively encouraged by policymakers, are slowly being shown to have a familiar 'catch' - interest parity! Nominal yields may be more attractive abroad, but the long-term currency risks are enormous, at least when placed in the context of a yen that is still significantly undervalued.

A crucial element of hedging activity is the expected exchange rate. Here three bigger macro forces are at play for the remainder of 2016: i) Japan/BOJ policy; ii) the Fed; and iii) China FX policy. Firstly on BOJ intervention, the market should not expect any official BOJ intervention barring extreme FX volatility. It would run counter to G20 rules and risk a serious rift with the US. On rates policy, adding significantly to NIRP looks increasingly unpalatable, with our Tokyo Economics team expecting only one more 10bp cut in Q3. The next set of actions will likely need to revolve around 'qualitative QE' and the buying of more risky assets, notably securitized products.

On the Fed, we expect USD/JPY to remain sensitive to Fed expectations, but not to the point where more Fed tightening is likely to lead to new USD/JPY highs. The yen has a history of doing well in 5 of the last 7 Fed tightening cycles, although it did weaken in the two big USD upswings."

- Source: Deutsche Bank

As we posited in our conversation "Information cascade" back in March 2015, you should very carefully look at what the GPIF and their friends are doing:

"Go with the flow:

One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets."

- Source: Macronomics, March 2015

We also added more recently in our conversation "The Ninth Wave" the following:

"So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor.

When it comes to Mrs Watanabe, Toshin funds are significant players and you want to track what they are doing, particularly in regards to the so-called "Uridashi" funds. The Japanese levered "Uridashi" funds (also called "Double-Deckers") used to have the Brazilian Real as their preferred speculative currency. Created in 2009, these levered Japanese products now account for more than 15 percent of the world's eighth-largest mutual-fund market and funds tied to the real accounted previously for 46 percent of double-decker funds in 2009 with close to a record 80% in 2010 and now down to only 22.8%.

As our global macro "reverse osmosis" theory has been playing out, so has been the allocation to the US dollar in selection-type Toshin

Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP."

- Source: Macronomics, January 2016

So, from a "flow" perspective, and like any trained "monkey" looking to reach out for "bananas", at least the slippery type, whereas other "monkeys" are focusing on the US dollar and oil-related woes, we'd rather for now focus our attention on the Japanese yen and the allocation implications of a stronger yen. For us, like others, a PBOC devaluation move on the yuan would send a deflationary impulse worldwide, but in terms of risk assets, it would have serious consequences on Japanese asset allocations and would lead to an acceleration in capital repatriation (this would mean liquidation of some existing positions rest assured), as indicated in Deutsche Bank's note:

"Even modest JPY gains against the USD should translate to a strong yen against all the other G10 currencies and EMG Asia FX, not least because of global macro risks elsewhere. Nothing is capable of lifting the yen trade weighted index more than a speed up in the Rmb's depreciation rate, leading to knock-on devaluations in EM Asia. This risk alone should encourage higher Japan hedge ratios for investment abroad, inclusive of the stock of Japan FDI assets abroad. A risk-off China shock would tend to concentrate JPY gains against currencies of other G4, but initially would likely include additional yen strength against all currencies. It should also drive the Nikkei sharply lower.

Click to enlarge

The Nikkei and yen have a long and sometimes tortured history of moving in lock-step. A stronger yen has hurt the Nikkei for obvious reasons, but a weaker Nikkei also tends to lead to a repatriation of capital and a stronger yen.

Interestingly, the current Nikkei levels are already consistent with a USD/JPY below Y105."

- Source: Deutsche Bank

When it comes to the year of the Fire Monkey, the slippery banana type, no doubt, could come from Japanese investors hurt by the violent appreciation of the Japanese yen, which has indeed been a significant "sucker punch" when it comes to the large standard deviation move experienced by the Japanese yen versus the US dollar. If Mrs Watanabe goes into "liquidation" mode, things could indeed become interesting, to say the least.

When it comes to Minsky and the equity-credit cycle, whereas central banks can affect the amplitude and the duration of the cycle, in no way can they alter the character of the cycle. In our final chart, we once again indicate our 2007 feeling, thanks to the rise in leverage, tightening financial conditions with the issuance markets closing down on the weaker players, which bodes poorly from a risk-reward perspective.

Final chart: US corporate sector leverage approaching crisis peak

Like many pundits, we have voiced our concerns on the increasing leverage thanks to buybacks financed by debt issuance and the lack of the use of proceeds for investment purposes. Our final chart comes from the same Deutsche Bank note from 22nd February, entitled "Three things the market taught me this year" quoted previously and displays the US corporate sector leverage, which is approaching crisis peak:

"US deleveraging - not that great

US consumer deleveraging stands out as one of the major achievements of the Yellen Fed. Yet the corporate picture looks much less impressive. Total amount of US corporate debt has approached the highs seen in the financial crisis (chart 3).

Not only that but the bulk of the leverage has been directed towards corporate stock buybacks (chart 4), explaining how low investment but high borrowing have existed at the same time. Persistent volatility in the US credit market has highlighted vulnerabilities that weren't a concern last year.

Source: Deutsche Bank

While a respite is always welcome, when it comes to the rally seen recently, as far as the Monkey and banana problem is concerned - as everyone is hoping from additional tricks from our "Generous gamblers", aka our central bankers - this rally might have some more room ahead. But then again, it doesn't change our belief in the stage of the credit cycle and our focus on what the Japanese yen will be doing.

"Life is full of banana skins. You slip, you carry on."

- Daphne Guinness, British artist

Stay tuned!