• Singapore property:capital immobility and slower growth is the cost of the property market shutdown

    by Stephen Fisher | Jun 30, 2014
    Markets exist primarily to efficiently allocate resources. The market mechanism has its imperfections but it is still the best way we know for ensuring that people get what they want.

    From time to time, regulators decide to shut down markets. Recently, it has become fashionable to justify closing down an asset market due to a "price bubble". The argument is that market prices do not reflect a proper market clearing equilibrium, so that closing the market protects buyers and sellers from trading at incorrect prices.

    By definition, speculative asset price bubbles burst. Successful identification and regulation should have the effect of very quickly bringing prices back to equilibrium in a matter of weeks or months. What happens, however, if there was no price bubble at all and the price does not correct? In this case, the market shutdown must lead to resource misallocations.

    The Singapore property 'market' has recently been regulated out of existence on the presumption of a price bubble.  Property prices are expensive in this land starved, cash-rich economy, but despite the regulators' best efforts, prices remain pretty much at the levels they reached when the last draconian lending restrictions were put in place 15 months ago.  15 months is a long time in the life of a bubble, so it is fair to say that while the regulators had good intentions, they basically mis-identified as a bubble what was rational market appreciation.  What is the resource cost of this policy error and what should the regulators do?

    There are many casualties.  The obvious victims are the builders and workers in the residential property industry who have had to abandon new housing initiatives and re-tool to focus on small scale renovations.  The next obvious casualties are the real estate agent's who have seen turnover in the property markets collapse due to trading taxes and liquidity constraints on borrowers.  But these front-line casualties mask a deeper, more far reaching allocation cost...

    ... these are the billions and billions of dollars that has been invested in property which is now immobilised, locked up through a combination of prohibitive taxes and lending restrictions.  Freely flowing capital is important to allow investors to respond to new opportunities, and property is a valuable form of collateral for funding investments.  Property is a form of saving that can be used to finance investments which drive economic growth. However, with the prohibitive cost of selling property (up to 18% stamp duty) together with the blanket restrictions on borrowing against property (the TDSR rules), this pool of wealth is now excluded from functioning as an engine of growth.

    What should the regulators do?  The best action is to admit the (well intentioned) error and reverse their taxes and liquidity constraints immediately.  In so doing, the regulators may well reserve the right to reinstate the measures should a bubble form in the future.  However, leaving the restrictions in place as a 'preventative' measure is entirely the wrong approach since it will lock up capital and stymie growth forever.

  • Big banks, that should be small banks, hog tie themselves with compliance

    by Stephen Fisher | Jun 18, 2014
    Q:  What is the major reason for the litany of regulatory and legal breaches committed by just about every major banking institution over the last decade?
    A: The banks have gotten too big.

    It is well known that as an enterprise grows, it becomes more difficult to monitor and control its operations. While a two-man partnership operates very effectively with each partner monitoring t actions of the other, it is inconceivable how the CEO of May 250,000 employee bank can know 99.9% of what is taking place in his institution. Needless to say, compliance breaches follow.

    The London whale at JP Morgan is an example of the loss of control that comes from  being too big. The bank needed to invest significant deposits taken as part of their day-to-day business, but in so doing the bank's positions in the credit markets were too   large.

    So if the banks are too big, so that they are prone to infringement's which may lead to  their own failure and in a wider sense systemic problems,  then the logical conclusion is to get small.  Returning to a smaller, employee owned business model would help rectify the control lapses that we have observed.  The big banks should breakup, right?

    Breakup? Not so the big banks. At the behest of regulators, they have resorted to hiring thousands of additional compliance and legal employees, who are neither financial experts nor correctly  incentivised to be able to operate a profitable business. The new compliance culture that is supposed to save the big banks very existence is effectively hog tieing  their operations. Clients are refused transactions, bankers and market professionals are restricted from making entreaties, and in the end revenues suffer and people leave to start boutiques.

    From a regulator's standpoint, it is much easier to supervise a small number of big banks than a large number of new boutique operations that service a broad range of client objectives. The next decade will see an explosion in small boutique financial companies. Regulators who thought that encouraging the big banks to hire compliance resources are about to have their work cut out for them.

  • Lower volume in the US Treasury market does not mean incorrect pricing

    by Stephen Fisher | Jun 01, 2014
    Bloomberg published a story yesterday which noted that turnover in the US Treasury market is currently 18% below its 10 year average of $502Billion per day.  Bloomberg argued that the decline in volume is one reason that interest rates have fallen so much this year. The claim is that a small group of traders have manipulated bond yields lower, as the larger market makers have reduced their commitment to Treasuries.

    The premise that high trading volume is necessary for market efficiency is entirely wrong. One of the major insights of efficient market theory is that information driven arbitrage motivates trading decisions. If one agent knows something that another does not, then he can try to profit from that information. But the uninformed agents are not stupid - they know there are sharks in the market - and once confronted with a bid or an offer, they adjust their price expectations accordingly. The result is a 'full information revealing equilibrium' which means that prices adjust to reflect their fair value without generating arbitrage profits.  What's more, THERE IS NO TRADE IN EQUILIBRIUM! (1)

    The fact that efficient price discovery does not require any actual trading is often lost in policy discussions surrounding market structure. The popular press believes, for instance, that banks withdrawing capital from their trading desks is both reducing liquidity and increasing volatility, but neither is correct. 

    If old-style market making was prone to inefficiency then modern computer driven trading can rectify this.  Electronic trading has the advantage of responding to information driven traders as computers can rapidly react to abnormal sized trades. Prices adjust before trading takes place in the electronic markets. Therefore, a side-effect of the rise in electronic trading is likely to be declining transaction volumes. This may be what the US Treasury market is experiencing.

    (1) More precisely, there is no 'information driven' trade in equilibrium. Liquidity motivated trading will take place between agents cashing in assets to consume and those buying assets for saving.

  • US velocity of money hits a 40 year low: What determines interest rates now?

    by Stephen Fisher | May 15, 2014
    The following graph from Bloomberg shows the dramatic collapse in the demand for money in the US.

     The image shows the behaviour of the US velocity of money as measured by M1 from 1970 to the present. Velocity is a critical determinant of the price level since it measures the number of times money in circulation is spent on goods and services. Rather than spending the money that the Fed has injected into the system, the private sector has simply decided to reject the cash that has been thrown at them with QE. Velocity is now at a 40 year low - US consumers and businesses simply cannot be forced to spend cash like lemmings.

    For practical purposes, this is big news.  For one thing, low and falling demand for money renders the Federal Reserve redundant.  But the main impact is that interest rates no longer contain an inflation premium.  Accordingly, interest rates can permanently settle at lower levels, commensurate with their real sector determinants.(1)

    Could financial markets be gravitating toward a world with overall lower interest rates that fluctuate with economic activity and investor risk aversion?  If so, there would be some predictable effects.  First, and contrary to popular belief, a cyclic increase in economic activity would drive future interest rates lower in order to encourage consumption rather than saving.  Second, an increase in risk aversion would cause short term interest rates to rise and the price of risky assets to fall.

    Does a world with lower overall interest rates, which fall when economic activity accelerates and which rise when investors panic sound familiar?

    (1) How does this work? I have noted in earlier posts that it is very difficult to get money into a general equilibrium model of economic activity.  The common method is to impose a 'cash-in-advance' constraint which requires agents to hold cash (denoted M) for future purchases (PY is price times output), so that M=PY.  In this world, the interest rate is expressed as, R = Inflation x Real Stuff, where Real Stuff is made up of technological factors and investor preferences.

    What happens if agents decide they don't want to hold cash?  In this new world, the cash-in-advance constraint no longer binds so that M > PY and interest rates are simply given by R* = Real Stuff.  It can be shown analytically that R* < R which means that interest rates in the new cash-less world are LOWER than in the world where money was needed to exist.

  • Has the US Treasury market finally accepted the inflation-free growth story?

    by Stephen Fisher | May 05, 2014
    I very rarely comment on day-to-day market movements since most observed price variation can be classified as noise. However, Friday night's US Treasury market behaviour was fascinating. The main news of the day was an unexpected increase in US employment and the corresponding decrease in the unemployment rate to 6.3%. The following Bloomberg picture captures the tension between the bond market bears, who loudly call for higher interest rates, versus the largely silent bulls...

     The story is the following. At 8:30 PM Singapore time, the US employment number was released and the instant reaction was a 1 point decline in the long bond future. This is what one usually expects to see since many market participants believe that stronger growth implies higher interest rates. However, the knee-jerk reaction was reversed over the subsequent 3 to 4 hours with the long bond not only erasing the loss, but rising almost 2 points above its low and finishing with a solid gain

    My last blog cautioned against the crowded but vocal bear chorus, and it would seem that Fridays trading session vindicates this warning. Why would interest rates fall on such strong positive economic news? I can think of a number of explanations.

    1st, the brief but significant decline in Treasury prices afforded some of the nervous shorts an opportunity to close out. 2nd, and less likely, the decline in Treasury prices triggered purchases from foreign investors such as central banks and sovereign wealth funds, and maybe even the US Treasury itself. 3rd, it may well be that the smart money is betting that the US economic recovery will be supply led which in turn places downward pressure on prices and inflation.

    On reflection, the  final explanation seems most likely since the 30 year interest rate should not be so heavily influenced by short-term traders, and the foreign investment community goes to great lengths to not impact the market.

    Put simply, "inflation-free growth" would mean that the Federal reserve does not need to raise interest rates long after tapering has finished.

    Being long the bond market seems a comfortable place to be.

  • Reversing the 'no brainer' trade of 2014 could precipitate a scramble to buy bonds

    by Stephen Fisher | Apr 28, 2014
    The 'no brainer' trade was for Interest rates in developed markets to rise this year.  The rationale cited Fed tapering, economic recovery, rotation out of bonds and into stocks amongst many reasons for higher interest rates. Instead, interest rates have fallen in 2014 and the bond markets are outperforming stocks. The 'no brainer' trade is a very crowded trade, so how long can they hold out and what is likely to happen if nerves set in?

    The key to understanding why interest rates are falling is to analyse security pricing in its component parts.  All risky assets are priced off the cash rate plus a risk premium. Cash rates are zero or at historical lows in most developed markets. Risk premia, for their part, have been trading at well above their long-run averages. For instance, the long run yield premium of US 10yr bonds over cash is about 1.37% compared with 2.65% today and 3.15% at the beginning of 2014.  One reason risk premia have been so high is the perception that cash rates were artificially low - that is, the risk of higher cash rates had already been impounded into asset prices in  order to induce investors to hold them.

    So why are interest rates falling?  The simple answer is that cash rates look like being low for a long time. In Europe and Japan, the policy view is that more QE rather than less is needed. In the US, there is no compelling reason to raise the cash rate unless and until inflation spikes up - which is a long shot especially with the breakdown in the monetary transmission mechanism into goods prices.  So with cash rates low for good reason, the risk premium on offer in the risky asset markets looks quite attractive.  Credit, country and maturity assets have all been bid up strongly over the last 4-6 months.

    Who has been buying these securities?  Judging by the participation in country bond auctions, the Asian and Middle Eastern sovereign funds have been soaking up fixed income assets across the curve, while corporate bonds have attracted retail  investors taking profits on their equity positions. 

    Who is short and caught? Judging by their performance, the 'no brainer' investors seem to be the traditional institutional investors and the Macro Hedge Fund community. Both focus on the short-term. If the lower-for-longer cash rate view takes hold with these investors then they may quickly reverse and the markets could witness another mini 2009-like scramble to get neutral. 

    Being long fixed income assets feels a pretty comfortable place to be.

  • Why the broker-dealers woes are good for you

    by Stephen Fisher | Apr 22, 2014
    Making markets in US Treasuries, and other bonds as well, is no longer a profitable business. The Federal Reserve has purchased so many of the securities that "two-way flow" has all but dried up. Broker dealers make their money out of flow, buying low from one seller and selling high to another buyer. While bad news for the broking community, this is good for the average investor.

    It is well-known that transactions costs must be recouped in order to justify an investment. The expected return on any transaction is composed of 2 parts: the return for taking risks and the return as compensation for transactions costs. One unexpected benefit from the Federal Reserve's bond buying spree has been to drive down transactions costs in the bond markets. Over-the-counter bond market trading used to be a cushy business, dominated by primary dealers who were mandated and protected by the Central Bank. However, once the Federal Reserve became a major player it has demanded cheaper spreads and electronic trading platforms with lower transactions costs. In 2013, electronic trading accounted for 49% of US Treasury transactions versus 31% the year before.

    While the big banks shed labour from dealing desks in favour of computers, the big beneficiaries are investors who no longer have to pay inflated transactions costs that required compensation. This benefit is ultimately reflected in permanently lower interest rates across the yield curves.
  • QE or not QE, that is Mario's question...

    by Stephen Fisher | Apr 04, 2014
    Mario Draghi at the ECB is being pressured to adopt a Quantitative Easing policy similar to that implemented by the Federal reserve and the Bank of England. The argument most fervently pushed by Christine Lagarde, head of the IMF,  warns of the "dangers" of disinflation/deflation, which apparently (?) leads to low growth and higher unemployment. What is poor old Mario going to do?(see footnote 1)

    Christine Lagarde's comments are irresponsible since they are based on Keynesian hope rather than economic fact. How can the IMF promote a policy such as QE, particularly given the Federal Reserve's difficulty in extricating themselves from the mess created by 3 such attempts, each of which has failed?

    Fortunately for Europe, the IMF has no power when it comes to framing ECB policy. Nevertheless, Mario Draghi is in a difficult position. He cannot argue with Lagarde's assessment that Europe is experiencing low growth and low inflation, since this is fact. But if he takes the line that these economic problems are beyond the scope of the ECB then he is committing "Central Banker Hara Kiri" since his institution's very existence is predicated on "doing something".  Similarly, if he uses the Federal Reserve as an example and takes the line that QE has not delivered any of the outcomes that it was meant to achieve, he would be perfectly correct, but this would be a direct insult to the Federal reserve, potentially damaging the unity that has been forged across the monetary authorities globally.  As much as he may want to, he cannot publicly criticise QE as an ineffective policy.

    Mario's best course of action is probably to do nothing, say nothing derogatory about QE and hope the immediate pressure to adopt the policy fades away. That seemed to be the path he took in his press conference yesterday following the ECB's rate decision. However, if the chorus in favour of a European QE gains strength, he will have no option other than to respond with a useless, senseless, baseless QE policy of his own, no doubt  hoping that his successor will shoulder the burden of undoing the mess in the future.

    (1) Frequent readers of this blog will already know that I am not a fan of Quantitative Easing nor active monetary policy generally for that matter. This is for the simple reason that these policies do not work. One only has to look at the recent or long-term track records of the numerous central banks around the world who try to "manage" their real economies to realise that these institutions cannot simply order an additional serve of GDP from a menu. Were it that simple, everyone would have a job and we would all be driving Rolls-Royces.

    (2) apologies to my avid fans for not having posted a blog entry for the last 6 weeks. I have been immersed in rebalancing the fund.
  • The greatest lesson from Bernanke's Fed presidency will be swept under the carpet

    by Stephen Fisher | Feb 12, 2014

    Academic economists long for proof that their theories and beliefs actually work. In the absence of policy power, researchers are left to pick through historical databases in search of correlations that may support their economic views. Can you imagine, therefore, the gleeful anticipation that salt water economists experienced when one of their heroes, Ben Bernanke, was given the US economy as his private laboratory to experiment with!

    Ben set about his business slowly at first. He inherited a healthy US economy that was not in need of any major surgery. This was abruptly altered when the global financial crisis reared its head in 2007, triggered by falling housing prices and rising mortgage defaults. What did Ben do?

    The textbook response to a financial crisis is to keep the system liquid. The Federal reserve is in a unique position in that it can create almost unlimited credit and price their loans as low as they want. The Fed did this and was arguably successful.

    The subsequent recession in the United States was more challenging for Bernanke. There is no textbook response to a weakening economy. In fact, there are 2 very opposite points of view in academia. The less popular view is that active monetary policy cannot systematically influence real variables such as  GDP and unemployment. The more popular view is that it can. Bernanke belongs to this  more popular  camp, and so he set about proving the effectiveness of active monetary policy using QE1.

    QE1 flooded the money supply but there was no increase in GDP. One would have thought that this was sufficient evidence against the active policy camp. But no, they argued that the US economy would have been worse had QE1 not been implemented. Further stimulus was needed, they argued, and hence we got QE2.  Alas, still no surge in GDP. One would have thought that this 2nd experimental failure would have been heeded as proof that active policy does not work. But no, can you imagine what catastrophe would otherwise have occurred! 2 Experiments with 2 negative outcomes was not enough.

    And so we were treated to QE 3. This entailed an hitherto unimaginable expansion of the money supply through asset purchases.  For reasons unknown to most of us, banks, businesses and consumers simply did not pick up this money and spend it in the way that the active monetary economists had expected.

    Now, Bernanke has had his turn at bat. 3 swings and 3 misses. Surely the message must be clear?  Active monetary policy does not work, right? Not so if you are a Central Banker...

    The great majority of central banks continue to actively target short-term interest rates in the belief that they can systematically influence banks, businesses and consumers spending habits.  Janet Yellen, Bernanke's successor, confirmed that the Fed will continue in this endeavour last night. The Global monetary policy community have simply ignored the outcomes from Bernanke's experiments and swept it under the carpet.

    The danger of conducting policy without a reasonably predictable outcome is that this uncertainty causes volatility.  Investors hate volatilty, and during high periods of volatility they are likely to demand higher risk premia, in turn marking down asset prices.    

  • The RBA gets caught telling porkies...

    by Stephen Fisher | Jan 29, 2014

    The Reserve Bank of Australia has been "talking down" the Australian dollar for the last 12 months. They have threatened direct intervention but refrained. They have cut Interest rates to historical lows, to the point of exhaustion. It is still their opinion that the Australian dollar is too high.

    In December, the RBA Gov Stevens in an interview with the Australian Financial Review said "I thought 85 cents would be closer to the mark than 95 cents". At the time, the Aussie dollar was trading at 90.58c and immediately dropped to 89.81c on the comment. Similarly on January 24 this year, Helen Ridout, an external RBA board member, commented to the Wall Street Journal that "a dollar around 80 cents would be a fair deal for everybody… I don't think it has fallen far enough."

    Central bankers rarely put numbers on the level of the exchange rate. If they do, they should have good reason to justify their comments. Whether it is 85 cents or 80 cents that the Reserve Bank of Australia sees as the value of the currency, they need to point to evidence in support of their claim...

    Can you imagine the market's surprise therefore, when yesterday it was discovered that the RBA's own internal quantitative modelling in December had concluded that the Australian dollar was "… close to the level consistent with its medium-term determinants."? At the time, the Australian dollar was above 90 U.S. cents.

    Gov Stevens and board member Ridout comments' were made in full knowledge of this internal assessment, yet they deliberately ignored their own official view and basically lied in order manipulate the currency lower. Were it not for the Freedom of Information Act, the truth would never have surfaced.  (Exactly who tipped off the press to file a Freedom of information request is unknown, but it would seem that someone inside the RBA is particularly upset by the Board's external comments being at odds with internal research)

    Central banks are the guardians of the financial system and Central Bankers strive to maintain their reputation for the highest integrity. Gov Stevens and Board member Ridout have breached this code. If you can't trust a Central Banker, who can you trust?

  • A Singapore bubble?... Forbes' credibility bubble pops first

    by Stephen Fisher | Jan 21, 2014

    This is the diagram that Forbes magazine produced in support of their claim that Singapore is experiencing a ‘property price bubble’.  Does this look like a bubble to you?



    Bubbles should look like an ever-increasing, exponential growth in prices – explosive growth, in fact, driven solely by the expectation that prices will continue to rise tomorrow simply because they rose yesterday.  The diagram hardly fits the bill – there are periods of rising prices, then falling, then rising a bit, falling and steady and rising and falling etc etc…in fact, the picture could be of any normally functioning asset market that one could nominate.  What is clear from this picture is that Singapore property prices have not been rising incessantly, nor exponentially for that matter, so that a bubble is hard to justify.


    Moreover, the 20 year average return is just 3.5%, while the 18 year average return a paltry 1%.  10 year average returns measure 6.2%.


    Why would Forbes make a claim without the evidence to support it?  Sensationalist headlines sell magazines it seems, and gutter journalism has never based itself on facts.  Forbes credibility is the real popped bubble in this beat up story.



  • China and Australia's central banks: same, same but different

    by Stephen Fisher | Dec 31, 2013

    It is well established in monetary economics that the Central Bank can control either the interest rate or the exchange rate but not both.

    In China, the People's Bank is struggling to defend the fixed exchange rate regime that is the root cause of the extreme volatility in their domestic short-term interest rate markets. Historically, capital inflow could be relied upon to keep interest rates and domestic liquidity conditions in check. However recently, daily flows have been unpredictable which at times has caused liquidity shortfalls and spiking interest rates. The fixed exchange rate policy may well be abandoned in the coming months if the government decides that stable domestic interest rates are preferred to the evil of a volatile exchange rate.

    Meanwhile, in Australia, the Reserve Bank is struggling to defend their short-term interest rate while at the same time encouraging a weaker dollar. Even though short-term interest rates are at historical lows, they are still more than 2 percentage points higher than in the United States or Europe. Recent weakness in the Australian dollar has also made it attractive to foreign property investors as well as raw material consumers. Upward pressure on the Australian dollar is brewing, but the RBA can only  jawbone it down. Cutting interest rates is out of the question since this may well fuel a bubbling property market.

    China and Australia's central banks have different problems stemming from the same basic  fact: that is, capital flows to the point of highest return. Like it or not, policymakers cannot fight the market.

  • Will the "great rotation" trade succumb to the "great correlation"?

    by Stephen Fisher | Dec 12, 2013

    Investors who are betting on the "great rotation" from fixed income markets into equity markets may well be disappointed. As bond yields fell across the global markets, a consensus grew that not only would equity returns exceed bond returns over the next few years, but bond returns would actually be negative. This view encouraged investors to short the fixed income markets to buy equities, rather than using cash to buy equities. The "great rotation", it was believed, would drive bond prices even lower.

    Some evidence in favour of this view surfaced in May and June when the bond markets suffered a major correction; the problem was that equities markets also fell in tandem. Contrary to the "great rotation" hypothesis, bonds and equities moved in the same direction. Adherents to the trade took the view that the bond markets would continue to decline after June while equities would recover.  What has happened? 

    Six months later, the equity markets have recovered well but so have most sectors in the fixed income markets. High yield bonds , for instance, are now trading higher than their peak in April on a total return basis. Concerns over federal reserve "tapering" of their regular security purchases are now solely confined to the Treasury market.  Investors who sold bonds across-the-board in May and June have overreacted and subsequently missed out on the longer run attractiveness of the fixed income spread sectors. 

    The  "great correlation" is a phrase I have coined to refer to the long-run positive correlation between bond and equity returns. This correlation is about 0.4 which is both statistically significant and surprisingly stable. In 2013, the correlation is actually higher at 0.6!

    Betting against this correlation requires strong justification and a strong will. The "great rotation" hypothesis argues for a negative correlation, based on the extraordinarily low level of bond yields.  Investors who have been counting on the statistical facts represented by the "great correlation", however, seem to be winning.

  • Mining for Bitcoin: Another Japanese triumph for elegance over logic

    by Stephen Fisher | Nov 19, 2013

    Satoshi Nakamoto is credited with the creation of 'Bitcoin'.  Bitcoin is a digital currency designed to facilitate transactions while ensuring stable prices. It is modelled on the gold standard that permitted holders of paper money to convert into gold at a fixed price, thus ensuring that the supply of money was fixed in line with the supply of gold.

    Theoretically,  a successful currency requires relative certainty in supply to be generally accepted  as the medium of exchange. Under the gold standard there was a clear incentive for miners to fossick for gold discoveries which they could then sell to the central authority in exchange for paper money. This meant that the money supply would grow as the cost of mining declined with technology and with the discovery of new mines. In turn, the general price level would increase as new gold was converted into new paper money. Inflation caused by expanding the currency supply is a tax on users, and discourages its acceptance. The fact that the money supply increased, and hence inflation occurred, under the gold standard was one reason for its abandonment. Mining was actually a bad thing for the gold standard.

    Nakamoto san  could have designed his Bitcoin to be fixed in quantity, but he elected to allow his money supply to grow slowly with an electronic mining mechanism. This mechanism is similar in form to mining for gold.

    Ironically, Nakamoto-san has elegantly created a similar incentive for computerised miners to fossick and discover new Bitcoin.  Just as there is a physical limit on the supply of gold in the world, Nakamoto sans algorithm also places a physical limit on the total supply of it.  But why would a user of Bitcoin want a currency with a built-in debasement mechanism?Just as the gold standard debased its own  value with mining, Bitcoin has built-in electronic debasement!

    In the interests of elegance, Nakamoto san has sown the seeds for Bitcoin's loss of confidence and ultimate destruction!

  • With the rupee collapsing the Reserve bank of India decides to… Sell?

    by Stephen Fisher | Nov 13, 2013

    India is a fascinating place. There are so many  contrasts and contradictions in the culture that it is impossible to understand in a lifetime. Government and policy practice share these traits.

    A few weeks ago I blogged that the declines in the Indian rupee and Indonesian rupiah could have been completely avoided had the central banks in each country opened up their foreign-exchange reserve account and smoothed the capital outflow that was triggered by international events. Instead, it appeared that the central banks were sidelined during this time, electing to protect their reserves rather than purchase some local currency. Not so the Reserve Bank of India…

    … Yesterday, new data from the RBI shows that foreign reserve holdings actually increased by $6 billion, the most in almost two-years! Rather than being sidelined during the rupee decline, it turns out that the RBI was actually selling the rupee as well!

    The stated reason for official selling of the rupee, and hence the additional reserve purchases,  is that  the central bank is preparing for the potential outflows that may eventuate when the US Federal reserve begins to taper their asset purchases next year. This seems convoluted logic since it implies that the RBI is prepared to an fuel domestic currency volatility today in the hope of dampening volatility in the future which may or may not happen.

    The new RBI governor Mr Rajan was credited with calming the rupee crisis upon taking office 2 months ago. This latest revelation may well reignite the rupee's decline.

  • Is monetary policy dead?

    by Stephen Fisher | Nov 08, 2013

    Last week I presented my views on Quantitative Easing and Tapering at the Asiamoney Borrowers and Investors' conference in Singapore. Basically, I pointed out that almost all the monetary injection that had been provided by the US Federal Reserve had found its way back to the Fed because consumers and investors did not want to spend the additional liquidity. By this analysis, the Fed's QE policy had failed and future tapering is much more difficult than most markets participants can   comprehend. (The presentation can be downloaded from our website at Velocity presentation)

    I had expected that many in the audience would not understand what I was saying since it is very different to the mainstream view expressed in the popular press. To my great satisfaction, however, the feedback was that my point was "… very clear and very succinct…".  Moreover,  several delegates asked me  what role, if any, does the Fed have to play if the conditions for an effective military policy are violated?

    This is the $64,000 question. I was  impressed that at least 5 delegates asked me this question but  also astonished that hitherto they had believed that the Fed could systematically influence economic activity in the textbook fashion. (My cynicism towards active monetary policy is clearly not the common belief!) So, what is the answer?

    In short,  monetary policy is dead. The days when the central bank could independently increase the money supply and expect either output or prices to rise have gone. People simply don't need paper money to purchase goods or services any more. (A central plank in monetary theory is that all purchases are made with paper money, and this assumption provides the path for active policy). The QE experience, however, demonstrates that this is rubbish since the additional paper that the Fed has printed has been given back.

    Personally, I can live comfortably aware that central bank's monetary policy tools are very blunt. Some market participants, however, feel uneasy when they discover that monetary policy doesn't matter any more. Central Bankers seem blissfully in denial of the evidence, but this is not surprising since otherwise they would be out of a job!

  • Private equity secondaries… A rough exit

    by Stephen Fisher | Oct 30, 2013

     "Give us your money and come back in 20 years" is the simple description for private equity investments. PE funds are basically "closed-end funds" that gather cash to invest in a number of private ventures. Once the cash is raised, the investment period can be 3 to 5 years or longer, after which the investments  remain in the fund until they mature or are sold and the capital returned to investors and the fund liquidate's. The life of a PE fund can be anywhere from 8 to 10 to 20 to 30 years and beyond.

    But what if an investor needs his money back earlier? I receive a lot of junk email from brokers and fund promoters in my job, and I have recently detected a sudden emergence in the popularity of secondary private equity transactions. Secondary private equity markets enable  investors in PE funds to liquidate their holdings.  It is common for a PE fund to strike a net asset value or NAV, but from an investor's standpoint this is really a fabrication since the fund manager does not allow  exit or entry into the fund at the stated NAV. The secondary market has filled this gap.

    One interesting email I received quoted 321 PE funds seeking bids from willing sellers. Price indications on average were about 10% less than current NAV for the funds. This is a significant haircut, and compares unfavourably with the average stock exchange listed "closed-end fund" which trades  at a 3.5% discount to NAV.

    It is often argued that PE investments offer a higher return to compensate for their illiquidity. The evolution of a secondary market should arbitrage this return advantage away. That would mean that PE prices get bid up, to the point that the majority of PE funds should trade at a premium to NAV rather than a discount. This clearly has not happened, and despite the spawning of a number of hedge funds investing in secondary PE, anyone seeking to sell their holdings face a rough exit.


  • Why China and Japan are panicking over a US default

    by Stephen Fisher | Oct 08, 2013

     China and Japan are the US government's largest single creditors. As the 2 largest owners of foreign reserves in the world, they have consciously invested the majority of their assets in US Treasuries. The reason they chose the US Treasury market is because it fits their strict investment guidelines as determined by their respective ministries of finance and ultimately set down in legislation. These guidelines stipulate "safe investments" that are default free.

    While nobody really expects the US Treasury to default on its obligations, the prospect of a 'technical default' in the form of a delayed coupon unless the US Congress resolves their impasse has reserves managers shaking in their shoes around the world. While a small delay in the receipt of a coupon would be made good after the fact, it still represents a default.  Under strict interpretation of investment guidelines this could, in the worst case, require China, Japan and many other central banks to jettison their existing holdings of US Treasuries, or more likely to exclude future purchases of US Treasuries from foreign reserves portfolios. Since foreign reserves managers must operate strictly according to the law, they do not have the discretion to ignore a technical breach of a guideline-only an act of Parliament in each country can create an exception.

    The implications of being excluded from foreign reserve portfolios are obvious. The US Treasury would have to seek other avenues to fund their obligations, driving up interest rates and their cost of funds. It would be many years before their folly was forgiven.

    The gravity of the situation seems to be lost on the U.S. Congress. Communication channels between foreign central banks and the US Treasury are scant at the best of times so it is unlikely that the Americans are paying attention to their creditors. The US Treasury claims to have special contingencies lined up to avert default, the list of which has not been made public, but which might include the sale of their own foreign assets to generate USD cash etc.

    Notable by its silence, however, the Federal reserve holds the key to avoiding default simply  in its capacity to print the money to pay a coupon (a practice that they are very familiar with).  Technically, this would not violate the debt ceiling since no new debt would be created. It would, however, violate its independence.


  • Did Larry Summers kick the political vending machine?

    by Stephen Fisher | Sep 16, 2013

     I first met Larry Summers in a corridor at the University of Rochester. Famished and between sessions at  a conference, Mr Summers had just deposited two quarters into a vending machine. His selected snack got stuck in the machine. Angered, he pounded the machine with his fists, and when that failed to dislodge the item, he seized the machine and began kicking it forcefully. Nothing, it seemed, would stand between Mr Summers and a Twinkie!

    The US Democrat party, however, has stood between Mr Summers and the post of Chairman of the Federal Reserve. Today's news that Mr Summers has withdrawn his candidacy has fired up the markets. For some reason, Mr Summers is broadly perceived as a monetary hawk and some kind of free markets freak. This is astonishing since, far from being a right-wing free markets campaigner, Mr Summers is all about regulation, active monetary policy and market intervention.

    For instance, Summers most widely cited publication is entitled "Noise Trader risk in financial markets" (1990) Journal of political economy, which hypothesises that there is a class of 'Noise Traders' in financial markets who can systematically drive prices away from  their fair equilibrium price. Noise traders are so powerful, according to Summers, that efficient arbitrage is unable to correct these pricing errors. The natural policy implication is that markets should be regulated and taxed in order to eradicate the Noise Trader (i.e. Wall Street).

    The financial press is reporting that Summers nomination for Fed chairman was opposed by the Democrats on the basis of him being a deregulator. This is clearly rubbish. My guess is that somewhere in the corridors of the Democratic party he has more likely been caught kicking the proverbial political vending machine.

    As for the market's, the positive reaction to his withdrawal is not because he is a monetary hawk,  rather it is because he ran the risk of regulating the markets out of existence.

  • Are the 'Swing Consumers' in Emerging Market currencies the cause of crisis?

    by Stephen Fisher | Sep 11, 2013

    The most significant development in currency markets over the last 15 years has been the enormous accumulation of foreign reserves by emerging market economies. The central banks of China, India, Malaysia, Korea, Taiwan, Indonesia, the Middle East, Brazil and many more have elected to stand in the market and purchase foreign currency in the face of significant capital inflow. Central banks in the emerging markets have become the "swing consumer" of foreign exchange.

    The recent sell-off in the emerging currencies has highlighted an important weakness in this policy. While the central banks have been content to buy foreign currency in the open market, they are evidently reluctant to sell back the same foreign currency when capital flows reverse. India, currently in the midst of a vicious speculative attack on the rupee, has elected to protect their $275 billion of reserves by keeping them firmly under lock and key.

    The reluctance to adopt a "swing producer" of foreign exchange policy to support capital outflow while acting as "swing consumer" during periods of capital inflow, is creating a structural imbalance in the foreign exchange market. Historically, central banks have tried and failed to successfully  intervene in FX markets during periods of speculative attack. Intervention failed primarily because the central bank had insufficient reserves to withstand an onslaught of sellers. In the current environment, however, reserve holdings in some cases exceed the supply of local currency in circulation. This means that the balance of power rests with the central bank in the face of a speculative sell-off in the local currency.

    There is a distinction, therefore, between currency intervention on the one hand (which is likely to fail) and acting as the swing producer in the event of short-term capital repatriation on the other hand. Refusing to fund demand for foreign currency out of existing reserves runs the risk of exacerbating the decline in the value of the domestic currency and precipitating a currency crisis. This may well be the case in India and Indonesia at the present time.