Getting on with life after the "policy vol crunch" Taken together, the policy vol crunch and regret factor must be putting the remaining bears in a paroxysm of remorseful fear. He's very quotable, Nomura's Kevin Gaynor. What does Gaynor's colleague Bob "the "Bear" Janjuah think, we wonder. Actually, we thought that this whole bit (and pair of charts) from Nomura's latest Macro Navigator note was quotable. Gaynor's talking about how 2013 might end up favouring the kind of steady carry trades in credit which 2012 became known for, because (if you hadn't noticed) 2013 has been interestingly boring so far. Then he starts weaving in familiar themes about zombies and stuff: Part of the reason for the continued success of this carry trade has been the ongoing moderation in spot cross asset volatility measures. Figure 5 shows normalised spot implied volatility for the Move index, the VDAX and VIX and 3m USD/JPY and EUR/USD. This is an important chart for us. First, volatility is at levels last seen in late 2006 and levels normally associated with a boom scenario. Ordinarily contrarians like us would want to buy vol and get out of carry trades, yet here we are recommending the opposite. What is interesting is that loan delinquency rates (and many other measures of corporate and household risk) have continued to decline to levels consistent with economic boom conditions, therefore validating the implied vol measure. So should we be leaning against this - is the economy secretly booming just no one told us? Clearly not. If that were the case, government deficits would not be at the current level. Instead we think the other line shown on the chart has played a key role in both the decline of delinquencies and market-implied vol - real forward yields after Operation Twist. This factor has been crucial. First, it explains the collapse in required returns on fixed income carry products seen in Figure 4 since Twist started - largely because the required return on government paper has gone into negative territory. It also helps explain the fall in default and delinquencies despite large output gaps - interest expense is low. This is the so-called "zombie" company and household effect, whereby many with questionable finances have sufficient income to service their debt but insufficient income or capacity to either pay it off or invest to grow. Historically, it is fascinating to see how periods of high corporate churn and healthy rates of default have tended to lead to high productivity growth. If this is the opposite then it seems to us that firms with poor business models (capital destroyers) are being allowed to remain in business in order to avoid the unpleasant side-effects of the system clearing. However, policy has worked if we define success as extremely low vol returns in fixed income products. But the problem is that we now see the impact of this policy fading... The interesting part of "policy fading" being whether the market breaks out and prices in higher rates from this point onward (it sees a boom around the corner) - and what that might mean for "zombie" refinancing. And if you want to know what the "regret factor" is - note in the usual place.