One of the fundamentals of finance is that investment markets tend to go up. This is perfectly rational, and indeed necessary to induce capital formation, but conflicts with the fashionable view amongst policymakers that higher asset prices are the product of speculative bubbles.
Singapore's government introduced a combination of credit rationing and transaction taxes over a number of years in order to arrest the increase in property prices that was experienced from 2009 to 2012. The following diagram shows the performance of Singapore's residential property market versus the US, UK, Hong Kong and Australia from January 2013 to December 2014.
The simple point of the picture is that Singapore properly has fallen nearly 5% while other markets, both globally and regionally, have appreciated between 11% and 13%. There are a number of ways to interpret this data.
1. It could be proof that cooling measures actually work to restrain the growth in property prices. On this interpretation, the assumption is that Singapore property should have risen by about 13% over two years in line with other markets. By engineering a 5% decline in property prices over the period, the Singapore government has permanently cut the price of property by 18% relative to where it would otherwise be. Rolling back the cooling measures would have no impact on prices in this scenario.
2. It could be that the 18% difference between Singapore's property and the rest of the world is a form of rationing. Once the cooling measures are lifted, prices would catch-up quickly, but in the meantime rationing leads to resource misallocation, excessive risk-taking and sub-optimal growth.
Which of these interpretations is most likely? As a property owner in Singapore, I regularly receive unsolicited enquiries from random people looking to buy my house for a 'bargain price'. This suggests to me that rationing is dominating - high taxes are keeping transactions low while at the same time there are many buyers ready to swoop on those forced to sell due to lack of access to liquidity. Recorded sale prices are artificially low since they reflect forced sales due to constraints on access to liquidity. Meanwhile, the rest of the market is locked due to taxes.
It is perfectly natural for property markets to rise, as it is for any asset market to show capital appreciation. If Singapore's property market was in a bubble 3 years ago, it certainly isn't now and the impact of the legislative measures is far greater than the -4.75% decline the government points to. Prices are 18% below those of other property markets on a relative basis. By this metric, the Government's job is done and it should be time to stop rationing liquidity...
The immediate effect of relaxing the cooling measures will see trading volume increase and prices rise from their artificially low, rationed levels. This outcome is going to be difficult to swallow since it highlights the shortcomings of the original policy. Policymakers need to go back to their Finance principles and accept the fact that property prices are supposed to rise.
“If financial-market conditions do not tighten much in response to higher short-term interest rates, we might have to move more quickly. In contrast, if financial conditions tighten unduly, then this will likely cause us to go much more slowly or even to pause for a while.” NY Federal Reserve President Dudley, April 6 2015.
At first, this sounds like a reasonable statement. Think twice, and the statement is absurd. If Dudley's comments truly reflect the US Federal Reserve's approach to policy then it is a rudderless, reactive functionary which is afraid to keep the markets informed. Let me elaborate...
First, and foremost, Dudley fails to tell us exactly what the Fed wants. One of the key underpinnings of modern finance is informational efficiency - that is, the ability for financial markets to accurately reflect the fair values of asset prices, instantly and without the necessity for any trading at all. Dudley could easily have said that the Fed's objective, for example, is to see a 1% cash rate in 1 years time and a 3% 10 year bond yield. That would have been something solid that the markets could kick around and digest. But he didn't do that. Instead, he elected to threaten the markets for under/over shooting the Fed's objectives, without telling us what those objectives are. WHAT ARE WE, MIND READERS?
Second, this sounds like experimental, reactive policy rather than a confident, rule based one. "Lets raise rates by 15bp and see what happens...". Surely, someone, somewhere in the Fed has a policy benchmark to measure what their desired effect is going to be? If so, why not tell us?
Or is the Fed just going to raise rates for the sake of it? Because it 'feels right'? If the cart isn't broken, don't fix it.
Its time for some openness and honesty on the part of our policymakers. If they don't know what they are doing, just tell us...
Monetary authorities can control the interest rate or the exchange rate, but not both. 2015 has witnessed a startling array of 'monetary stimulus' measures around the world, with varying degrees of success.
The ECB has acted to aggressively lower interest rates in Europe by buying bonds across the curve. Lower interest rates arguably lead to more real investment. Meanwhile, the Euro exchange rate has depreciated significantly making exports more attractive to foreigners. It would appear that the interest rate and the exchange rate are being nice to the ECB.
Singapore's MAS, conversely, engineered an emergency mid-meeting currency depreciation in January but this has triggered higher domestic interest rates. Fear of further depreciation has caused a capital flight, drying up liquidity. The benefits to Singapore's exporters from a more competitive exchange rate may well be offset by higher investment costs. The Bloomberg grab shows 3mth Tbill yields in Singapore rising while German Tbill yields have fallen.
These two cases stand in stark contrast: both the ECB and the MAS tried to achieve the same outcome, but one failed while the other succeeded. While we can argue the pros and cons of active monetary policy, it must be disconcerting to our policymakers that no matter which lever they pull (interest rates or exchange rates), the other lever is basically unpredictable, and can inflict all sorts of damage...
"First, do no harm" - so starts the hippocratic oath for medical practitioners. What wonderful advice for monetary policymakers this is! As Janet Yellen contemplates raising interest rates in the US for the first time in 7 years, imposing a hypocratic oath on monetary policymakers might be worth considering...
In theory, nominal interest rates are not suppose to be negative. This is because simply stashing cash in the mattress earning nothing dominates the negative rate of return associated with a bank deposit carrying a negative interest rate. Arbitrage, the 2nd strongest force known to man next to gravity, should operate to keep nominal interest rates above zero. While this logic is compelling, strange things can happen…
The European Central bank has successfully driven short-term European interest rates into negative territory and, moreover, have been able to keep them there despite what must be very strong arbitrage forces. Their reason is to encourage spending rather than saving.
Big institutions don't have big mattresses apparently. They need to park their electronic balances with electronic custody platforms administered by the ECB paying negative electronic interest. The man in the street, on the other hand, does not have this restriction. Can "the little man" benefit from the arbitrage opportunity?
The currency futures market might well deliver this opportunity. Euro USD futures are pricing in a 40 basis point per annum interest rate differential between US and Europe. US T-bills are paying 4 basis points per annum which means the implied European interest rate is -36 basis points. Therefore, anyone with US dollar cash can buy euro, stash it in the matress, sell the future forward and deliver the euro in 3 months time for a 36 basis points per annum gain. Furthermore, those investors who can borrow USD at less than 36bp can simply do this over and over again - a sort of money machine.
While few of us can borrow at the Tbill rate, in practical terms anyone with USD balances are better off holding Euro and selling futures against it since that generates a synthetic USD 'riskless' deposit earning 0.36% versus the alternative of Tbills at 0.04%. While not earth shattering, this is something for nothing.
Ironically, the arbitrage opportunity that the ECB has created encourages investors to stash away cash rather than spend it. This runs directly counter to the aim of negative interest rates which are supposed to encourage spending!
To any student of economics, Singapore is a refreshing example of good policy triumphing over political opportunism. Mr Lee Kuan Yew, Singapore's founding father, passed away today and this is his legacy. The economic train wrecks that have become a hallmark of "modern democracy" is what he managed to avoid.
Implementation is always more difficult than theory. To be honest, Mr Lee was not an original thinker - and very few of us can claim such a tag - but he was a politician with a vision who chose the measured long term route over the easier short term one. Singapore's success is that it now commands the highest per capita income of any non-natural resource endowed economy in the world. This is truly a great contribution to Singaporean's individually, and as an example to other legislatures globally.
Being remembered for advancing good policy over potitical expediency should be a common moniker for our political leaders. How hard can this be? Mr Lee is the only leader in recent times who comes to mind who fits this description. Apparently, in politics, this is very hard to achieve.
I have been fascinated by the deluge of commentary linking Quantitative Easing in Europe with declining interest rates in other parts of the world, particularly the United States. The basic argument is that investors are buying US Treasuries to replace European bonds because they have a higher yield. This argument is obviously flawed: the higher yield in US dollars brings with it currency risk and additional volatility, so they are not substitutes. In theory, due to the absence of arbitrage, an investment in US Treasuries, when fully hedged back to Euro, should deliver the same return as a German Bund.
That said, as the Bloomberg grab shows, there does seem to be some relation between QE in Europe and the declining yields in the US. It is still difficult to believe that intelligent investors treat a 2% yield for a 10 year Treasury as a substitute for a 0.2% yield for a 10 year Bund. So what rational explanation can there be for 'QE spillover' effects?
For monetary actions to have real economic effects, they must influence either technology, fiscal arrangements or investors attitude to risk. It is hard to argue that the ECB can influence US production technology by it's actions. Equally, it is unlikely that the US Congress would alter its path for taxes and expenditures in response to Mario Draghi's shopping spree in Frankfurt. Could it be that US bond investors feel slightly more comfortable watching the ECB aggressively buying bonds and assigning a lower risk premium to US bond investments than previously? A cyclical reduction in investor risk aversion may well be what we are witnessing in the US bond markets.
A lower risk premium implies a flatter yield curve in the US. The yield curve there has been unusually steep for many years as the markets have been sceptical of the Fed's commitment to lower interest rates. Observing the ECB's aggressive action may well have convinced the sceptics in the US to step out into longer maturities. This would seem the only rational explanation.
In 2010, when the Greek debt crisis first came to a head, the politicians searched frantically for a scapegoat. "Private sector involvement", or PSI as it became known, was the eventual means by which Greek debt was reduced by restructuring bonds in the hands of the private sector. Publicly held debt in the hands of European governments and official institutions was exempt from the restructuring. European politicians found it easy to extinguish the claims of the private sector since it did not affect their own balance sheets. A clear triumph for the politicians over the bankers.
2015 is different. The great majority of Greek debt is now held by the public sector, so that an easy scapegoat no longer exists. Whereas in 2010 politicians were facing off against bankers, in 2015 we have politicians facing off against politicians. This makes the negotiation much easier, since politicians share the same objectives. Both sides know that electoral backlash needs to be contained - Greek Socialists must be seen to be valiantly fighting the establishment while the creditor nations must be seen to be resisting wealth transfers. Electoral attention spans are short, so both sides know that delay is the key to defusing the issue. Money, in fact, doesn't come into it.
The current crisis will end with a whimper, not a bang. There will be fiery speeches, emergency meetings, 5 AM "landmark" agreements to extend deadlines and eventually a long delay, after which the electorate moves on. No debt reduction for the European creditors and a pyrrhic victory for the Socialists.
And that's it!
"Oh yeah, how long is that going to last?" was my instant reaction on hearing of Kim Kardashian's marriage to Kanya West. KK's shameless self promotion and hunger for media attention virtually sentences to death any attempt at a stable relationship.
"Oh yeah, how long is that going to last?" has also been my instant reaction to the slew of policy statements, reversals, competitive devaluation's, rate cuts, projected rate hikes, official releases and unofficial media leaks, that seem to flood out from the Central Banking community with increasing regularity.
Central Banking at one time was a very disciplined pursuit, where policy rules were implemented with a high degree predictability. Under Greenspan, for instance, the Federal Reserve could be fairly counted upon to gradually raise or lower rates with the business cycle. Almost invariably, the Federal Reserve was "behind the curve", which was a very good place to be, in that the market was accurately anticipating policy.
Not today. The GFC has changed all this to a point where the key to policy is judged by its shock value. The Swiss National bank's abandonment of its Euro peg, during mid-trading session no less, wins the prize for "shock value". Monetary policy has become ineffective for a number of reasons, but this does not argue for actively courting policy uncertainty.
Central bankers would do well to revisit the debate over rules versus discretion in the conduct of monetary policy.
An adherence to free-market principles and a light touch to regulation have been the reasons behind Singapore's phenomenal success. The high taxing redistributive policies of the ailing developed nations were rejected in favour of low taxes. Infrastructure spending rather than welfare spending is the guiding logic behind fiscal policy. Monetary policy has been conducted through the exchange rate supported by a mighty foreign reserves position.
Embracing the invisible hand, however, can bring some unwelcome consequences. Property prices have boomed, as one would expect with high incomes, low taxes and limited land supply. Rising property prices are politically sensitive and so the new breed of Singapore's policy makers (post Lee Kwan Yew) introduced a series of 'cooling measures' from 2009 to 2013 in an attempt to fight the market. Not surprisingly, these measures have done little to make property more affordable - instead the effects have been to stifle capital mobility and drive market liquidity to zero.
So now its January 2015 and suddenly the world economy looks a bit wobbly, the European's have embarked on a QE program, and 'deflation' is the new buzz word. Reacting with a sense of urgency, Singapore's Central Bank decided last week to take steps to weaken the currency further - the SGD has fallen roughly 10% against the Chinese Yuan (see graph) over the last 6 months and an additional 10% decline now seems on the cards...
What does this mean for property prices in Singapore? Investors from the People's Republic of China have been prolific purchasers of Singapore property and now, it seems, property prices have just cheapened 10% in Yuan terms and looks like another 10% price cut is heading their way. On the face of it, Singapore property should be about to take-off as foreign demand responds to the lower exchange rate, in turn pushing up prices.
This is going to present a real challenge to Singapore's new breed. Every time a government tries to fight natural market forces it creates distortions, unintended consequences and ultimately policy failure. What is going to happen?
First and foremost, the primary goal of lowering property prices for Singapore citizens has been lost. Instead, foreigners are the winners since they can buy Singapore property more cheaply. Second, to maintain its international purchasing power, property prices should rise. Third, the draconian constraints on borrowing against property for real investment projects has stifled capital mobility, and this is one cause of the perceived slowdown in Singapore's economic prospects. Ironically, the very policies that were to have led to lower property prices are contributing to the upward price pressure wrought upon them from the exchange rate devaluation!
How should Singapore react to all this? The logical response is to recognise that their interventionist experiment has failed and repeal the investment restrictions. At least this will allow domestic property owners to realise their rightful gains from a weaker exchange rate. Most governments would be unable to make such a radical policy reversal, however Singapore's rulers are an impressive and intelligent group who are able to admit their mistakes and rectify errors. If they don't, then the invisible hand that has delivered 50yrs of success is going to dish out a right royal spanking.
Those of you who read yesterday's post are probably wondering 'what happened?' For those who missed the post, I had conjectured that, as part of the ECB's QE policy, the regional Central Banks in Europe would enter the market in the early hours of Monday's trading, vigorously bid up the price of their longer maturity bonds, and then come off the bid an hour or two later.
The following Bloomberg grab shows Monday's market action in the Spanish and Portuguese 30 year bond markets. Spain is the white line and Portugal is in yellow.
The result: Vindication!
While we had expected the Bank of Spain and Bank of Portugal to appear closer to 8am Europe time (15:00 in the diagram), they both eventually turned up at 9:30am (16:30 in the diagram), and almost in concert pushed their 30yr bond prices up 2% over a period of 45 minutes.
Three questions come to mind.
1. Why did the Central Banks wait until 930am when they could have really shoved the market at 8am? My guess is that the Regional Central Banks trading desks schedule a regular conference call for 8am to plan their day's activity. The Greek election result would have thrown a spanner in the works, and what should have been a 15 min discussion bled over into an hour as they assessed the market response. This is only speculation, of course.
2. Who is selling the long end of the Spanish and Portuguese bond markets? With the ECB's cheque book open these markets are going up, up and away. Bondholders need a pretty good reason to stand in the way of Superman. It just doesn't make any sense to sell.
3. Why doesn't the market just accept that 30yr yields in these markets are heading for 1% and start pricing for that now? This is the Trillion Euro question and sure beats me.
Private investors trading with valuable information go to great lengths to conceal their trades so as minimise their market impact. They try to bunch their trades during periods of high liquidity, they use stealth algorithms which drip-feed orders into the market, and they try to operate quietly under the radar.
Not so the ECB and their trusted band of merry regional Central Banks. Their mission is to maximise their market impact as they spend Euro 1 trillion + on any government securities that they can get their hands on. They don't want best execution...they want the worst price they can find! So stay tuned to the European bond market over the next few months as there is some easy money to be made.
Thursday and Fridays' market action is a lesson in what to expect. First, following President Draghi's announcement of the QE bond buying program, the regional Central Banks' (who are charged with the responsibility to execute the purchase program in their respective bond markets) waited 15 minutes and then placed a 'buy everything' order - no limit. 2:45pm in the European bond markets is not an especially liquid time of the day so the price impact was enormous. Spanish 30yr bonds jumped 5% in the space of 30 minutes. And then there was silence - the bid disappeared - but the bonds held their gains.
Friday morning, however, is the key to making money over the next weeks and months. The European bond market officially starts trading at 8:00am Europe time but, generally speaking, not many traders are actively investing and the main buy-side firms based in London have just fallen out of bed, since its 7am, one hour behind Europe. There couldn't be a better time for a big buyer to maximise their market impact, could there? Sure enough the Bank of Spain hit the market like a neutron bomb. The following Bloomberg grab (15:00 Asia time is 8:00 European time) shows the early morning 'carnavale' in the Spanish long bond which lasted for about two hours and saw the bond rise by over 5% at one stage. And then the bid fell silent. The market subsequently managed to hold most of its gains.
So what should we expect today, Monday January 26 2015? My prediction is another opening feeding frenzy as the Bank of Spain repeats its tactics, as they will on Tuesday, Wednesday and so on and so on. These guys mean business, and the long end of the bond market is where their ability to influence prices is greatest. Once the market wakes up, prices will vault higher.
The message: buy the long end of the European yield curve NOW, especially the peripherals, and stay long. The market's going up.
Check the box which best describes the exchange rate regime you want to operate,
¤ Fixed peg to Euro /USD/Other - Yes, I like ECB/Fed/Other monetary policy so I am going to let them do it for me
¤ Floating rate - No thanks, I will conduct monetary policy myself
In 2011, the Swiss National bank emphatically checked the first box when they decided to peg the "Swissy" to the Euro. Yesterday, however, the Swiss National bank changed its mind and decided to check the 2nd box instead. The simple choice between exchange rate regimes determines just about everything for a Central Bank - it is a decision to either outsource or insource monetary policy. It is therefore a fundamental policy decision, and flicking the switch twice in 3 years is astonishing.
In 2011, I doubted that the SNB was so enamoured with the ECB that they trusted Frankfurt with the monetary affairs of Switzerland. It seemed to me that the move was more like a capitulation trade. That is, the relentless attack on the Swiss banking system by Europe and the US was leading the Swiss authorities to abandon their independent banking system. Opting to peg to the Euro was the first step toward joining the EU and ultimately adopting the Euro. Surrendering the Swiss financial system to the hungry tax economies in Europe and the US was unfortunate but understandable.(1)
But this was apparently not the case. According to the SNB, the peg to the Euro had always been a 'temporary' decision. They liked the ECB's monetary policy at the time, but now the SNB want to run their own shop for a while...
So what are we to make of the SNB's schyzo box checking? Casually switching from floating to fixed to floating exchange rates, is at best a 'bold new approach to monetary policy' and at worst cause for alarm. Maybe pegging to the oil price will be next, or gold or the Rouble or the Zimbabwean dollar?
(1) Foreign investors had continued to pour money into Swiss bank accounts, causing reserves to swell from $250B to $500B (in itself not a bad thing). Clearly, private investors saw value in the "Swissy" that its own masters did not.
"2014 will be both the Year of the Horse and the Year of the Bond", the prediction from the
First Degree Long Horizon Absolute Return Fund's Market Commentary, February 2014
And so it was! Very few market forecasters predicted positive returns for the Global Bond Markets in 2014, let alone that they would top equities, property or even cash. While Global Equities returned around 5.3% for 2014, Global Sovereign Bonds Hedged to USD delivered over 8.3% according to the Citi WGBI. This average includes all developed Government issues of 1 yr maturity and longer and therefore masks the stunning performance of long dated Sovereign bonds. For instance, the 'super-long' bonds, into which our fund was invested, in Portugal, Spain and the US returned 53%, 36% and 22% respectively over 2014.
The simple reason for bond market superiority in 2014 was that interest rates fell across the board, and proportionately more at the long end of the maturity spectrum - a fact that most forecasters failed to predict. Forecasters tend to be economists (or graduates from the humanities), with very little finance training. Don't mention term-structure theory to this motley crew since they will dismiss it as unnecessarily quantitative and missing the 'big picture'. However, embedded within the term-structure of interest rates is the reason for 2014's bond market triumph, as well as predictions for 2015. Let me elaborate...
First, term structure theory tells us that low interest rates are associated with lower rate volatility. The declines in global yields during 2014 suggest lower volatility in bond markets in 2015. Expect a quiet year.
Second, the risk premium in many markets continues to remain above long term averages, despite some contraction in 2014. Indeed, 2014's bond market performance can be attributed to the growing realisation that interest rates are likely to stay low for a long time, and therefore the risk that rates will spike has diminished. This, in turn, reprices the risk premium that investors require to extend the maturity of their lending, and so the term structure has flattened. Nevertheless, the degree of flattening in the US, Spain, Portugal, Indonesia and the Philippines bond markets has not reached levels that are consistent with neutrality, so it is likely that these markets will continue to offer capital gains at longer maturities during 2015. Were we to rebalance the fund today, we would be reducing some risk ('taking profits') yet remain overweight these markets relative to cash. The obvious exception to this general view is the German bond market wherein, with 10yr rates at 0.50%, is expensive and we would be short.
Third, credit turned in a lacklustre year in 2014, which surprised us, however this should be the big performer in 2015. High Yield bonds offer yields of 7% or more relative to 1.6% for similar maturity US Treasuries. A 5.4% risk premium compares with something like 3.5% over the long run net of defaults, so there is room for a 2% spread contraction in this market, which maps into total returns of 12-16% for benchmark indices during 2015. The market negativity that was present in the Sovereign markets at the beginning of 2014, but which ultimately capitulated during the year, continues to rule in the credit markets.
So our prediction for 2015 is that volatility will be low, longer maturity Sovereign bonds will outperform, and ultimately 2015 will be remembered as the Year of the High Yield Bond. Equities, eat your heart out but again...
“Bottom line is, you pay attention to fundamentals and the fundamentals are solid, and then you look at your screen and you want to throw up.” Philip Orlando, Chief Equity Strategist Federated Investors as quoted by Bloomberg 12 Dec 2014.
Does this sound familiar? Nearly every equity analyst and economic strategist must have this nausea as they watch the oil price fall, which is fundamentally good for most companies, yet global stock markets are selling off aggressively. As always, those who focus on fundamentals have overlooked the primary force determining asset prices - the risk premium.
Fundamentalists focus on the impact on future cash flows of a major event such as a massive decline in the oil price. Collectively, this should be good for aggregate profits in output producing countries such as the US, Japan, China, India, Europe and the majority of the world. This is because lower energy costs mean higher profits. While the energy producing countries suffer, the net effect should be positive for global equity markets - energy makes up only 10% of global output. On the fundamentals, stock markets should rise.
The problem is that fundamentals don't matter that much in asset pricing. This is the insight from Robert Shiller, who demonstrated that market volatility is much higher than can be explained by cash flow volatility. Variation in the 'market risk premium', the rate of return that investors demand to induce them to bear risk, is the dominant parameter determining asset prices. The risk premium reflects investor risk aversion - and when investors get scared, the risk premium goes up which means that asset prices go down...
...and so it turns out that lower oil prices have created uncertainty in investors minds, leading them to sell risky assets in favour of safe haven assets such as cash and US Treasuries. This is perfectly rational behaviour even though the fundamentals remain solid.
Those of us who are less skittish, and with longer investment horizons, can profit from this short-term phenomenon. Assets which are cheap now offer higher expected returns going forward. This is a wonderful time to start buying risky assets!
Several weeks ago I attended a seminar where current and former Monetary Policy Committee members from the ECB and US Federal Reserve were leading speakers. The interesting part of the discussion focused on how dependent their respective European and US Government's had become on the monetary authorities for taking responsibility for macro-economic management. The speakers stressed that monetary policy cannot fix a broken fiscal model, and were therefore frustrated with the high expectations that governments and financial markets place on monetary policy to stabilise the economy. In fact, the Central Bank representatives were of the view that monetary policy plays a distant 'second fiddle' to fiscal policy.
It is refreshing to know that our Central Bankers agree that real variables such as productivity, taxes and government versus private spending shape real economic outcomes, as opposed to helicopter drops of money showered from time-to-time by the monetary authorities. This agrees with my long-held views that regular readers of this blog will find familiar. But this raises the following questions...
If Central Bankers question the power of monetary policy to influence economic activity, why do they draw attention to themselves with regular policy meetings, minute releases, official speeches and unofficial media leaks? Why does the Federal Reserve Open Market Policy Committee need to meet 10 times a year? Why does Mario Draghi face the media every six weeks to answer questions he doesn't know the answer to?
Monetary policy needs a rethink. For starters, why not reduce the number of official meetings to just once or twice per year? This would send a clear "...don't look at me to fix your problems..." message to Government's and financial markets alike.
"Deflation" is a word that we will be hearing a lot over the next year or two. This is because most of the major economies such as the US, Europe and Japan, are currently experiencing very low or negative changes in their price levels. Nearly every central banker and finance minister spits the word "deflation" out as if they have just sucked the venom out of a snakebite. This is curious, however, since deflation is the opposite of inflation, and inflation itself has been an enemy of the state for decades! Mario Draghi, the president of the ECB, has vowed to do everything possible to stave off the threat of deflation. What is everyone scared of?
If inflation is a tax, then deflation is a subsidy. People who are owners of nominal claims such as cash, bank deposits and bonds benefit from lower prices since they can buy more stuff with the same amount of money. The average man in the street is such a person. Fighting deflation, as the ECB has vowed to do, is akin to denying the average man in the street a higher standard of living.
This is the fact, but central bankers and finance ministers read a lot of fiction, specifically Keynesian economic fiction, which associates falling prices with lower GDP. This is the public justification for denying the average man a higher standard of living.
I can think of two reasons why the "fight deflation" warcry has become popular:
1.Taxation. Deflation is a subsidy that the government would rather not pay.
2. Survival. I have argued many times that monetary policy does not work. By this I mean that the monetary authorities cannot systematically influence either output or prices. Admitting this would be publicly embarrassing and also professional suicide, so taking the challenge to defeat deflation is a last ditch effort to prove their policy power. Put simply, its a desperate act of survival for the current species of Central Bankers.
My last blog entry sparked some interesting comments about the role of Sovereign investors in the US Treasury market. It is well known from Price Theory that market clearing prices are determined by the marginal demanders and suppliers for that good or security. But just who are these people? In most cases, they are faceless agents that come and go without recognition. In the US Treasury market, however, the marginal players have a discernible character. Meet Mr Lee and Mr Smith...
MR LEE is an academically high achiever who has been recruited by China's State Authority of Foreign Exchange (SAFE). He works in Beijing a team of 10 people whose job is to re-invest the coupon and maturity clip from SAFE's $2.5 trillion US Treasury portfolio. This is roughly $50billion per month. He has a standing order with every major US Treasury market maker to buy US Treasury securities at any maturity when they get offered.
MR SMITH is an Ivy League graduate working in New York for a mid-sized hedge fund with $500m under management. He has been closely following the Fed and thinks the 30-year Treasury yield is simply too low. He plans to recommend selling $10m of 30yr UST's in Friday morning's strategy meeting.
Mr Lee and Mr Smith don't know each other of course. Its Midnight on Friday in Beijing and Mr Lee hasn't filled his weekly quota of $1billion 30yr UST, and he just wants to go home. Fortunately, its 11am in NYC and Mr Smith has convinced his team to sell Treasuries, so rings his primebroker and instantly his sell is matched with Mr Lee's standing buy order. Day's work is done for Mr Smith but Mr Lee only gets $10m closer to target.
Now, Mr Smith never actually owned any 30yr UST's. He relies on his primebroker borrowing the stock. Mr Lee, on the other hand, thinks to himself "...at least I won't have to sell that $10m 30yr UST, it belongs to our buy-and-hold portfolio and will roll off in 30years."
So the result is we have hedge funds short 30yr UST's they never owned, while the Sovereign investor has just locked it away for 30 years. The marginal buyer is still unsatisfied while the hedgie has got his position on all too easily...
Sounds like a short squeeze is brewing and that is why interest rates in the US are heading lower.
Last week witnessed the "capitulation trade" from the myriad of short sellers in the global interest rate markets. The shorts were predominantly hedge funds and professional investors who have been betting that interest rates will rise in the US for the best part of 5 years. "Capitulation" occurs when these investors can no longer bear the pain of negative carry coupled with capital losses as interest rates continued to fall across the curve. October 15, in particular, saw the US 10 year yield fall from 2.1% to 1.84% in the space of half an hour as the shorts scrambled to cover.
While Wall Street licked its wounds publicly in the media, very little has been said about the identity of the winnersfromn this capitulation. The fact is that for every borrower in the bond market there is a lender such that the net supply of bonds is zero. Thus for every loser there is a winner. Just who are these winners?
The natural owners of government bonds are, in fact, the central banks and sovereign wealth funds from the creditor countries across Asia, the Middle East and a smattering of other countries with advantageous cost structures and endowments. These institutions have been not only quietly profiting from the losses being racked up by short-term speculators, but continuing to add to their long positions in the government bond markets.
Potential short sellers take note: These investors are long-term holders of debt which means they are not price sensitive, nor are they likely to sell their positions to "take profits". In the absence of these investors liquidating their holdings, this suggests that the low levels of interest rates on offer currently are here to stay for a very long time.
Bill Gross' departure from PIMCO rattled the bond markets for 3 or 4 days on the expectation that redemptions from his famous Total Return fund would put upward pressure on interest rates and negatively impact corporate bonds. It's a credit to Bill's stature that one man can influence an extraordinarily large and deep market. No credit, however, belongs to the trading community for thinking that PIMCO's redemptions imply lower prices.
PIMCO reported $23 billion worth of redemptions from Bill's flagship fund during September. This is a large amount of money for an investment team to liquidate, but where were the assets going? It's common for investors to withdraw their assets from an investment firm when its lead investor departs, but it's not common that these assets depart the asset class itself. In fact, investors switch managers, redeeming their investments with PIMCO while simultaneously subscribing to funds operated by competitors such as DoubleLine, Legg Mason or TCW to name a few. The overall effect on the market should be neutral, since PIMCO's total bond sales should be matched with its competitors purchases.
But wait...there is more to it than just this. Investors tend to switch to better performing managers. At the margin, there may be slightly higher demand for some fixed income sectors versus other sectors owing to the fact that PIMCO's strategy differs slightly from its competitors. These marginal differences should help predict the net relative impact on the fixed income sectors...
The winning strategies over the last year or two have been overweight US duration, overweight European bonds and overweight High Yield credit. The logical implication is that the money redeemed from PIMCO would find its way into managers who continue to hold these biases. This means that the net effect of the switch should increase duration, increase European holdings and increase high yield demand. Rather than causing interest rates to rise and credit to sell off, the net effect should be exactly the reverse!
The bottom line is that Bill Gross's departure should be marginally good for bonds.
Last Friday, Standard and Poors announced that they were removing India from negative watch, in turn affirming that country's BBB- Sovereign rating. This unexpected announcement immediately caused the Indian Rupee to jump 0.5% on the basis that India's bond market will attract capital inflows now that the country remains investment grade.
The disappointing aspect of the event is that, despite the self-inflicted debasement of their reputation over the last 2 decades, investors still pay attention to S&P's credit rating opinions. So much so, in fact, that the vast majority of Fixed Income investment mandate guidelines reference S&P, Moody's and/or Fitch ratings when framing investment limits. For instance, it is common for Sovereign Bond mandates to require a minimum rating of BBB- or better to be a candidate security.
Why would any self-respecting investor obfiscate responsibility for defining their investible universe to the same agencies that brought us the Global Financial Crisis? Moreover, the term 'investment grade' has some romantic connotation, but really, what does this mean in practice? Drawing a line between BBB- and BB+ to classify the former bonds as 'investment grade' while the latter are 'non-investment grade' is completely arbitrary.
Last Friday's Rupee price action, however, clearly says that S&P's investment grade status matters to someone. With Indian short-term yields exceeding 8% and the Rupee still 40% below its 2011 high, it would seem that these people are prepared to push both the Rupee and the Indian Bond markets higher.