Snikt

As longtime Epsilon Theory readers know, I’m a big comic book fan. One of the joys of a comic done well is the effective representation of a dynamic multi-dimensional narrative within a static two-dimensional art form. As the saying goes, a picture is worth a thousand words, but occasionally so is a sound. Or rather, a picture of a sound. Whether it’s the “Thwip” of Spiderman shooting his web or the “Snikt” of Wolverine popping his claws, certain classic onomatopoeias (to use the $10 word) communicate immediately everything you need to know about what’s going on and what’s about to happen.

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© Marvel Characters, Inc.

So here’s another picture of a sound, another effective representation of a dynamic multi-dimensional narrative within a static two-dimensional form.

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This is the market price of credit default swap (CDS) protection on the senior debt of the largest European banks and insurers over the past 6 months, and the sound you are hearing is the “Snikt” of systemic risk popping out its claws once again.

A month ago I wrote the following:

There were trades available [in 2008] that, in slightly different form, are just as available today. For example, it may surprise anyone who’s read or seen (or lived) “The Big Short” that the credit default swap (CDS) market is even larger today than it was in 2008. I’d welcome a conversation with anyone who’d like to discuss these systemic risk trades.

The susceptibility of credit spreads to systemic risk(s) that I was describing last month was borne out last week. Protection on the ITRAXX senior European financial debt index widened by over 45 bps from 92 bps at the close of January to 137 bps at the close on February 8, as systemic risks emanating from the deflationary hurricane coming out of Asia wreaked havoc on a financial system already reeling from the collapse of the global commodity and industrial complex. I think there’s another 50+ bps of further spread widening to go, but it’s a tougher slog from here. The money in any major market shift is generally made during the discovery phase, and once you get the third WSJ article talking about the issue (much less the thirtieth), many market participants will start trading around the position.

Now the truth is that this outcome worked faster than I thought it would, and I attribute that to two factors. First, everyone and his brother is looking for a massive correlation like this, and once George Soros and Kyle Bass and the rest of the short-the-yuan crew started talking their book on CNBC, it doesn’t take a genius to figure out what the knock-on effects of their premise might be for global recession risks and investment grade (IG) credit. But second … the speed of this outcome means that things are even worse than I thought. We don’t need a yuan float or announced devaluation to start a 1930s-esque deflationary spiral and the insanely aggressive political response to come. It’s already here.

So Epsilon Theory is ringing the bell, with three big notes over the next month or so.

First, I’ll write about the 1930s-esque deflationary spiral and why I think it’s all happening again. This is “The Thesis”, and here’s the skinny: In 1930, the United States passed the Smoot-Hawley Tariff Act, establishing a massive system of protectionist tariffs and quotas that sparked competitive protectionist measures around the world. Within a year, the largest bank in Austria, Credit Anstalt, failed, and the Great Depression was unleashed as global trade finance collapsed. Today I believe that competitive currency devaluations will lead to the failure of another massive bank, perhaps one whose native language is also German and is in fact a direct descendant of Credit Anstalt, as global trade finance collapses once again.

Second, I’ll write about what’s next. This is “Five Easy Pieces (to Wreck the World)”, and here’s the skinny in a visual format that should be familiar to anyone who’s ever taken the SAT:

Gaussian Copula : 2008     ::     Negative Rates : 2016

If you don’t know what a Gaussian copula is, do yourself a favor and read Felix Salmon’s magisterial Wired article from 2009. The Gaussian copula was the financial innovation that broke the world in 2008, and negative rates will be the financial innovation to break the world today.

Third, I’ll write about what you can do about all this. You already know part of what I’m going to say, because I’ve said it before. Now more than ever you need convexity in your portfolio. Now more than ever you need to focus on the strategies and the assets that will do well in a deflationary hurricane AND the political response to that hurricane. Once the claws of systemic risk pop out with a Snikt, you’re in for a long and bloody fight. It’s time to prepare ourselves for that fight if we’re going to be investment survivors here in the Golden Age of the Central Banker.

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Rewardless Risk

Faramir: Then farewell! But if I should return, think better of me.
Denethor: That depends on the manner of your return.

J.R.R. Tolkien “The Lord of the Rings” (1954)

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I’m going full-nerd with the “Lord of the Rings” introduction to today’s Epsilon Theory note, but I think this scene — where Denethor, the mad Steward of Gondor, orders his son Faramir to take on a suicide mission against Sauron’s overwhelming forces — is the perfect way to describe what the Bank of Japan did last Thursday with their announcement of negative interest rates. The BOJ (and the ECB, and … trust me … the Fed soon enough) is the insane Denethor. The banks are Faramir. The suicide mission is making loans into a corporate sector levered to global trade as the forces of global deflation rage uncontrollably.
Negative rates are an intentional effort to weaken your own country’s banks. Negative rates are a punitive command: go out there and make more bad loans where risk is entirely uncompensated, or we will, in effect, fine you. The more bad loans you don’t make, the bigger the fine. Negative rates are only a bit worrying in today’s sputtering economies of Europe, Japan, and the US because the credit cycle has yet to completely roll over. But it is rolling over (read anything by Jeff Gundlach if you don’t believe me), it is rolling over everywhere, and when it really starts rolling over, any country with negative rates will find it to be significantly destabilizing for their banking sector.

There’s a reason that the Fed kept paying interest on bank reserves even in the darkest, most deflationary days of the Great Recession. Yes, it’s the Fed’s job to support full employment. Yes it’s the Fed’s job to maintain price stability. But the Fed’s job #1 — the reason the Federal Reserve was created in the first place — is to maintain the stability of the banking system. Go ask a US moneycenter bank how things would have turned out in 2008 if the positive interest coming in on their reserves had been flipped to negative interest going out on their reserves. Go ask a US regional bank how things would have turned out if they had made even more rewardless risk loans in 2006 and 2007 under the pressure of negative rates.

Look, I get the “theory”. I understand that weakening the yen is an existential domestic political issue for Kuroda and Abe, just as weakening the euro is an existential domestic political issue for Draghi and Merkel, just as weakening the yuan is an existential domestic political issue for Zhou and Xi. And I understand that policy-addicted markets will respond exuberantly to anything that can be described as central bank support for financial asset price inflation. Hey, I’m an addict, too.

But what I’m concerned about is not the theory but the practice. What I’m concerned about is the intentional destabilization of the global financial system for domestic political purposes. What I’m concerned about is the Fed’s inevitable adoption of negative rates, something Alan Blinder pushed for in 2008 and Ben Bernanke is pushing for now.

When the ECB instituted negative rates, that was just a point. The BOJ’s move last Thursday makes a line. Now we have a pattern. Now we have a market that expects MOAR! Now we have a Fed that will undoubtedly implement negative rates when things get squirrely again, even if there are some in the Fed who I’m sure are shaking their heads at all this.

I’ve come to expect every elected politician or politician wannabe to rail against “the bankers” and the terrible mess they’ve made of the world with their “predatory lending” and “easy credit”, even though this is exactly what every politician in the world desires. But I didn’t expect central bankers to betray their own charges. I didn’t expect central bankers to throw their own domestic banks into a battle they can’t win.

You know what negative rates are? They are the final stripping away of the illusion that central bankers somehow exist above and separately from domestic politics, that they are wise and able stewards of financial stability. Nope. They’re Denethors.

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You Can Either Surf, or You Can Fight

Kilgore: Smell that? You smell that?
Lance: What?
Kilgore: Napalm, son.  Nothing else in the world smells like that.

– Apocalypse Now (1979)

Hello, hello, hello, how low? [x3]
– Nirvana, Smells Like Teen Spirit (1991)

Outside the bus the smell of sulfur hit Bond with sickening force.  It was a horrible smell, from somewhere down in the stomach of the world.
– Ian Fleming, Diamonds Are Forever (1956)

There’s more than a whiff of 2008 in the air. The sources of systemic financial sector risk are different this time (they always are), but China and the global industrial/commodity complex are even larger tectonic plates than the US housing market, and their shifts are no less destructive. There’s also more than a whiff of 1938 in the air (hat tip to Ray Dalio), as we have a Fed that is apparently hell-bent on raising rates even as a Category 5 deflationary hurricane heads our way, even as the yield curve continues to flatten.

What really stinks of 2008 to me is the dismissive, condescending manner of our market Missionaries (to use the game theory lingo), who insist that the US energy and manufacturing sectors are somehow a separate animal from the US economy, who proclaim that China and its monetary policy are “well contained” and pose little risk to US markets. Unfortunately, the role and influence of Missionaries is even greater today in this policy-driven market, and profoundly misleading media Narratives reverberate everywhere.

For example, we all know that it’s the overwhelming oil “glut” that’s driving oil prices down and wreaking havoc in capital markets, right? It’s all about OPEC versus US frackers, right?

Here’s a 5-year chart of the broad-weighted US dollar index (this is the index the Fed publishes, which – unlike the DXY index and its >50% Euro weighting – weights all US trading partners on a pro rata basis) versus the price of WTI crude oil. The red line marks Yellen’s announcement of the Fed’s current tightening bias in the summer of 2014.

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Source: Bloomberg, January 2016.

Ummm … this nearly perfect inverse relationship is not an accident. I’m not saying that supply and demand don’t matter. Of course they do. What I’m saying is that divergent monetary policy and its reflection in currency exchange rates matter even more. Where is the greatest monetary policy divergence in the world today? Between the US and China. What currency is the largest contributor to the Fed’s broad-weighted dollar index? The yuan (21.5%). THIS is what you need to pay attention to in order to understand what’s going on with oil. THIS is why the game of Chicken between the Fed and the PBOC is so much more relevant to markets than the game of Chicken between Saudi Arabia and Texas.

But wait, there’s more.

>My belief is that a garden variety, inventory-led recession emanating from the energy and manufacturing sectors is already here. Maybe I’m wrong about that. Maybe I spend too much time in Houston. Maybe low wage, easily fired service sector jobs are the new engine for US GDP growth, replacing the prior two engines – housing/construction 2004-2008 and energy/manufacturing 2010-2014. But I don’t see how you can look at the high yield credit market today or projections of Q4 GDP or any number of credit cycle indicators and not conclude that we are rolling into some sort of “mild” recession.

My fear is that in addition to this inventory-led recession or near-recession, we are about to be walloped by a new financial sector crisis coming out of Asia.

What do I mean? I mean that Chinese banks are not healthy. At all. I mean that China’s attempt to recapitalize heavily indebted state-owned enterprises through the equity market was an utter failure. I mean that China is going to need every penny of its $3 trillion reserves to recapitalize its banks when the day of reckoning comes. I mean that China’s dollar reserves were $4 trillion a year ago, and they’ve spent a trillion dollars already trying to manage a slow devaluation of the yuan. I mean that the flight of capital out of China (and emerging markets in general) is an overwhelming force. I mean that we could wake up any morning to read that China has devalued the yuan by 10-15%.

Look … the people running Asian banks aren’t idiots. They can see where things are clearly headed, and they are going to do what smart bankers always do in these circumstances: TRUST NO ONE. I believe that there is going to be a polar vortex of a credit freeze coming out of Asia that will look a lot like 1997. Put this on top of the deflationary impact of China’s devaluation. Put this on top of an inventory-led recession or near recession in the US, together with high yield credit stress. Put this on top of massive market complacency driven by an ill-placed faith in central banks to save the day. Put this on top of a potentially realigning election in the US this November. Put this on top of a Fed that is tighteningStorm warning, indeed.

So what’s to be done? As Col. Kilgore said in “Apocalypse Now”, you can either surf or you can fight. You can adopt strategies that can make money in this sort of environment (historically speaking, longer-term US Treasuries and trend-following strategies that can go short), or you can slog it out with a traditional equity-heavy portfolio.

Also, as some Epsilon Theory readers may know, I co-managed a long/short hedge fund that weathered the 2008 systemic storm successfully. There were trades available then that, in slightly different form, are just as available today. For example, it may surprise anyone who’s read or seen (or lived) “The Big Short” that the credit default swap (CDS) market is even larger today than it was in 2008. I’d welcome a conversation with anyone who’d like to discuss these systemic risk trades and how they might be implemented today.

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Storm Warning

Unfortunately for mariners, the total amount of wave energy in a storm does not rise linearly with wind speed, but to its fourth power. The seas generated by a forty-knot wind aren’t twice as violent as those from a twenty-knot wind, they are seventeen times as violent. A ship’s crew watching the anemometer climb even ten-knots could well be watching their death sentence.

Sebastian Junger, “The Perfect Storm: A True Story of Men Against the Sea” (2009)

[the crew watch emergency surgery performed on the ship’s deck]

Able Seaman: Is them ‘is brains, doctor?
Dr. Stephen Maturin: No, that’s just dried blood. THOSE are his brains.

“Master and Commander: The Far Side of the World” (2003)

[the Konovalov’s own torpedo is about to strike the Konovalov]

Andrei Bonovia: You arrogant ass. You’ve killed *us*!
“The Hunt for Red October” (1990)

Can everyone saying “a 25 bps rate hike doesn’t change anything” or “manufacturing is a small part of the US economy today, so the ISM number doesn’t mean much” or “trade with China is only a few percent of US GDP, so their currency devaluation isn’t important” just stop? Seriously. Can you just stop? Maybe if you were making these statements back in the ‘80s – and by that I mean the 1880s, back when the US was effectively a huge island in the global economy – it would make some sense, but today it’s just embarrassing.

There is a Category 5 deflationary hurricane forming off the Chinese coast as Beijing accelerates the devaluation of the yuan against the dollar under the guise of “reform”. I say forming … the truth is that this deflationary storm has already laid waste to the global commodity complex, doing trillions of dollars in damage. I say forming … the truth is that this deflationary storm has driven inflation expectations down to levels last seen when the world was coming to an end in the Lehman aftermath. And now the Fed is going to tighten? Are you kidding me?

Look, I’m personally no fan of ZIRP and QE and “communication policy”, certainly not the insatiable market devourers they’ve become over the past few years. But you can’t just wish away the Brave New World of globally interlocked, policy-driven, machine-dominated capital markets in some wave of nostalgia and regret for “normalized” days. In an existential financial crisis, emergency government action always becomes permanent government policy, reshaping markets in similarly permanent ways. This was true in the 1930s and it’s true today. It’s neither good nor bad. It just IS. Did QE1 save the market? Yes. Did QE2 and QE3 and all the misbegotten QE children in Europe and Asia break the market? Yes. And in the immortal words of shopkeepers everywhere: you break it, you bought it. The Fed owns capital markets today, like it or not, and raising rates now, as opposed to a year ago when there was a glimmer of a chance to walk back the Narrative of central bank omnipotence, isn’t “brave” or “prudent” or “necessary” or any of the other laudatory adjectives you’ll hear from Fed media apologists after they raise. It’s simply buyer’s remorse. The Fed is sick and tired of owning the market, sick and tired of giving interviews to CNBC every time some jobs report hits the wires, sick and tired of this Frankenstein’s monster called communication policy. So they’re going to raise rates, declare victory, and hope that things go their way.

Am I annoyed by China’s currency actions and their adept use of communication policy to shape the Narrative around devaluation? Not at all. This is exactly what China must do to bolster economic growth while maintaining the pleasant diplomatic fiction that they’re not a command economy. What annoys me is the Fed’s apparent hell-bent intention to force a low-level currency war with China AND whack our own manufacturing and industrial base on the kneecaps with a crowbar, just so they can get out of the communication policy corner they’ve painted themselves into.

Three or four years ago, one of THE dominant market narratives, particularly in the value investment crowd, was the “renaissance of American manufacturing”. Not only was the manufacturing sector going to be the engine of job growth in this country (remember “good jobs with good wages”? me, neither), but this was going to be the engine of economic growth, period (remember the National Export Initiative and “doubling exports in five years”? me, neither). Now we are told that we’re just old fogies to worry about a contracting US manufacturing sector. Now we are told that a global recession in the industrial and commodity complex is well contained here in our vibrant services-led economy. Right. You want some fries with that?

So what’s to be done? You do what you always do in a deflationary, risk-off world – you buy long-dated US Treasuries. Stocks down, USTs up. Of course, if you think that the yield curve is going to steepen after the Fed does whatever it’s going to do this week … you know, because the Fed rate hike is obviously an all-clear sign that we have a robust self-sustaining economic recovery and we’re off to the races … then you want to do the exact opposite, which is to buy stocks and sell the 10-year UST. Yep, time to load up on some bank stocks if that’s your view.

What else can you do? You can read the Epsilon Theory note “I Know It Was You, Fredo” and consider ways to make your portfolio more convex, i.e., more resilient and responsive to both upside and downside surprises in these policy-driven markets. The big institutional allocators use derivative portfolio overlays to inject convexity into their portfolio, and that’s all well and good. But there are steps the rest of us can take, whether that’s adopting strategies that can short markets and asset classes (like some tactical strategies and most trend-following strategies) or whether that’s investing in niche companies and niche strategies that are designed to outperform in either a surprisingly deflationary or a surprisingly inflationary world. The trick really isn’t to choose this fund or that fund. The trick is to broaden your perception of portfolio outcomes so that you don’t have a misplaced faith in either the Fed or econometric models.

I suppose there’s one more thing we should all do. We should all prepare ourselves to perform some emergency surgery on the deck of whatever portfolio ship we’re sailing in 2016. Because with a Fed hike the currency wars will begin in earnest, magnifying the deflationary storm already wreaking havoc in industrials, energy, and materials. No sector or strategy is going to be immune, and we’re all going to suffer some casualties.

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