A turn in the credit cycle

This is interesting and worth keeping an eye on: US C&I (Commercial and Industrial) loan delinquencies have started to turn up, signalling the turn in the credit cycle. A rise in delinquencies implies a tightening in bank loan terms with about a one-year lag. We would expect lending to be weakening from here on out …

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It also has implications for Equities, of course:

VIX volatility (the volatility index for the implied volatility on the S&P500 equity index, and a generally accepted barometer of market sentiment / risk appetite) tends to follow a similar cycle: volatility tends to increase with a modest lag from delinquencies (hardly surprising that equities dislike tightening credit conditions).

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Unsurprisingly, the equity index itself moves with volatility in a lag from credit conditions:

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These are just interesting credit developments worth watching, in our opinion.

This fits together with the pressure on European banks, and impending credit contraction, that we have previously highlighted.

And with conditions outside China tightening – Singapore and Hong Kong are prime examples of the credit crunch enveloping S East Asia – it leaves China’s 25% y/y credit growth looking quite anomalous, apart from being entirely unsustainable.

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Abe’s warning

Japanese Prime Minister Shinzo Abe warned his counterparts at the G7 meeting in Japan that the world may be facing another “Lehman’s moment” (alluding to severe stresses in the financial system, indicated in his view by the weakness of commodity prices).

Once again, when we thought it would not be possible, Japanese policymakers surprise us with the paucity of their true understanding. It’s not Commodity Prices that worry us – they are simply the manifestation of an underlying process of rebalancing that the Japanese have correctly identified. It’s the perilous state of the Japanese banks and the ongoing damage being inflicted by Japanese monetary policy that is, to us, of most concern.

Mr Abe said, “We agreed on the perception that we are facing serious risks, that the world economy is facing serious risks”.

In that regard, he’s right, but the most worrying point is that Japanese Banks pose a substantial and worsening threat to Global Financial Stability. Here’s the picture:

Firstly, Yen 80 trillion of annual QE by the Bank of Japan (fully 15% of GDP each year) has left the Bank of Japan (BoJ) owning 27% of the outstanding STOCK of Japanese Government Bonds. They were purchased from banks that held them with a nice running “carry” (the difference between the cash rate they paid on their deposits liabilities used to fund them and the yield on the bonds themselves) that has now disappeared. Japanese banks, as a direct consequence of the Bank of Japan, now have approaching 20% of their entire ASSETS in cash and deposits:

Needless to say, those assets earn nothing.

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Secondly, Japanese licensed banks have 9.6% of their assets in Central Government Bonds – the yield on those bonds is now below the deposit rate paid to new deposits. That’s not good for earnings, when you pay a higher rate out than you get on your investment.

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Thirdly, the general loan rate for new loans is fast converging on the deposit rate paid to new deposits, and the margin on loans to the real economy is evaporating:

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Fourthly, banks are being “squeezed” from one side by the BoJ and “squeezed” on the other side by depositors: the level of cash in circulation in Japan relative to GDP is marching ever higher.

It stands at 18% versus 7% in 1990 and has trended higher continuously in the last 25 years:

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So, to recap:

  • Japanese banks hold extraordinary levels of non-earning cash on their balance sheets (in fact, the interest rate on the Yen 280 trillion of excess reserves held in the current account at the Bank of Japan is negative)
  • Government bonds yield less than the rate paid to depositors
  • New loan rates are barely above the rate paid to new depositors
  • The economy is becoming increasingly “cash based” – cash / GDP is way beyond international comparison
  • Non-Performing Loans, NPLs, as in China, are being concealed and understated

We’d say the likelihood of a “Lehman’s moment”, as Mr Abe notes, can’t be ignored… But we’d go further and urge Mr Abe to pay closer attention to the destruction of the Japanese Banks being propagated by the Bank of Japan’s QE policy. Any further QE, or a move to increasing negative official rates, just exacerbates the problem. Hopefully Mr Abe showed some charts like these and didn’t overplay the decline in commodity prices.

The Bank of Japan’s monetary policy is sowing the seeds for a systemic Japanese banking crisis – the TSE banks index is down 39% y/y for a reason.

Déjà vu

Last August, and again earlier this year, Chinese devaluation and the threat of a more serious decline in the Yuan (combined with USD strength) sowed the seeds of brief periods of significant drawdown in Global equity markets: the Global Index fell 12% in the month after last August’s trivial devaluation, and almost 14% in the weeks leading up to mid-February, when Yuan devaluation fears again re-surfaced.

Despite net outflows continuing apace through the first quarter – almost matching the entire outflow in the first 11 months of last year – and heavy Central Bank intervention, together with some tightening of controls at the margin, the Yuan actually strengthened in a move (vindictive, some speculators might say!) designed to head off speculative pressures and provide reassurance that all is well in the East. Another $1trillion in loans helped, but that’s neither here nor there in China these days. Move along, nothing to see here…

But we know differently. We know that you simply cannot grow credit $2.5 trillion annually with no corresponding nominal income growth; we know you cannot add capacity where there is already too much capacity; and that you cannot grow bank balance sheets at a rate annually equivalent to 40% of nominal GDP. Not if you want to keep your exchange rate fixed, you can’t.

And that’s where recent developments are interesting, the Chinese officially target the Yuan against the CFETs index – against a basket of 13 currencies (about one quarter USD weighted) and the Yuan has depreciated 1.3% since the end of March (5.9% year to date). From the mid-January low, the Yuan appreciated 2.1% against the USD through the end of March but has depreciated 1.2% versus the USD subsequently. They’ve unwound half the appreciation of the prior weeks.

Quietly, and under the radar, the Chinese have been letting the Yuan slide against the CFETs basket and, probably more importantly for the market, against USD.

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This USD strength is seen in the broad USD appreciation in recent weeks: the next chart shows the percentage of currencies in the US effective exchange rate basket that the US has appreciated against in the last 20 days: the USD has appreciated against 80% of the currencies in its own basket.

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We are seeing broad USD strength, broad Yuan weakness and, significantly, the Chinese quietly letting the Yuan slide against the USD.

This feels like déjà vu from our standpoint.

The global economy is already at low altitude, the median annual growth rate in our broad national sample is just 1.9% with over half growing less than 2% annually, and appears to be losing speed, again over half have growth slowing. Another round of Yuan/USD weakness into that mix is likely to precipitate just the same reaction as we saw last summer and earlier this year. Perhaps it’s time to seek out that tin hat again…