• 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.

  • What did Krish and Viss say at Jackson Hole?

    by Stephen Fisher | Aug 27, 2013

    The financial press reacted with astonishment and disbelief to Krishnamurthy and Vissing-Jorgensen's paper (Krish and Viss) at the recent Federal reserve conference at Jackson Hole. The two authors simply analysed the  "announcement effect" on Treasury, corporate and mortgage  bond yields around the announcement date for QE1 and QE2.  Exactly why the financial press is so confused by the paper is curious. The paper is written in standard  academic finance language, so this may contribute to the misunderstanding since the popular press is more accustomed to low-level economic commentary.

     Krish and Viss employed a very old technique called an "event study" to look at before and after price effects surrounding important announcements. It is a carried assumption in event studies that most of the price impact of an announcement will be impounded in asset prices within minutes, beyond which there is unlikely to be any ongoing additional impact. QE1 and QE2 displayed exactly this behaviour. The authors discovered significant announcement effects which lasted for several minutes and in some cases several hours, however little else in terms of long-term systematic price affects. Economists and journalists don't like these findings since they essentially invalidate the importance of their own ongoing analysis and commentary.

    QE1 was found to contain the most sizeable impact on prices, largely because it was announced in the midst of the 2008 to 2009 crisis months. QE2, alternatively, displayed a more muted impact. One interpretation of the paper is that the QE policies generally have had much less impact on the financial markets than the popular press has promoted.

    This is a triumph for finance over economics. Krish and Viss are no doubt perplexed by all the fuss. After all , it is well known in finance that markets react quickly and quite efficiently to new information. The lack of persistence in the ongoing policy impact on prices should be no surprise to anybody. The corollary is that once the Fed announces its exit from the same policy, then prices will quickly and effectively impound this information. This has already taken place in May this year, which is when the Fed foreshadowed its tapering at some point in the future. Much to the disbelief in the financial press, there is unlikely to be any impact on prices when the Fed finally reduces its involvement in the markets.

  • Fed tapering and risk

    by Stephen Fisher | Aug 22, 2013

    The Federal reserve released their latest minutes from the FOMC meeting last night. The consensus was that the Fed will start to reduce their asset market purchases gradually when the economic data signals it is appropriate. The Fed did not provide a timetable, nor did they indicate a magnitude for the reduced purchases. What was clear, is that they do not intend to increase their asset purchases. Tapering appears to be the next change in Federal Reserve policy.

    So how did the markets react to this new information? The diagram below shows the performance of the VIX from 1:30 PM to market close. The VIX is a measure of market volatility taken from option prices, where an increase in the VIX reflects higher demand for downside protection. The diagram shows that the initial reaction was to buy downside protection, indicating that investors expected markets to fall on the news. Eight minutes later, however, the market changed its opinion and the VIX began to fall significantly for the next hour or so. Towards the end of the trading session, the market changed its mind again and the VIX began to rise only to finish at the same level at which it started before the Federal reserve announcement. 'Risk neutrality', it would seem, is the correct characterisation of the impact of Federal Reserve tapering.

    The popular press argues that the Federal Reserve asset purchases have been fuelling demand for risky assets elsewhere, and therefore halting their purchases will lead to falling asset prices. This depends upon a critical link between the Fed's purchase of an asset being reinvested into another asset with a higher risk profile. For instance, if the Fed buys a five-year Treasury bond from a bank, then the bank must turn around and buy an equity, a corporate bond, some property or something with higher risk. This does not seem to have happened. The evidence suggests that the proceeds from Federal Reserve purchases have either made their way back to the Fed  as bank reserve deposits or been used to deleverage investment portfolios. Far from fuelling additional risk-taking, one could argue that the Federal Reserve purchases have actually lead to less risk-taking in the financial system.

    If the Fed's asset purchases have been risk neutral or risk reducing, what will be the effect of tapering? The risk neutral case is simplest. In this scenario it should be quite easy for the Fed to find investors to switch back into asset markets with equivalent risk and there should be no impact on market prices. If the Fed purchases were risk reducing, then they need to entice switching from lower risk assets back into the Fed's asset holdings. This means lower risk assets will be bid up relative to the Feds portfolio. Practically, this means that short-term interest rates might need to fall and/or credit spreads contract.

    This is a far cry from what many see as the impact of tapering. For its part, the VIX seems to favour the risk neutral argument since after a few hours of indecision, the market forecast for risk wound up exactly where it started!


  • Mr Wong responds to Australian dollar weakness

    by Stephen Fisher | Aug 12, 2013

    If you have been following the plight of the $A over the last few months, you would have thought it had no friends. Day after day, the financial press and the investment community found reasons why the $A should be falling. Fed tapering- bad for the $A. Commodity prices falling-bad for the $A. RBA rate cuts-bad for the $A. Chinese growth falling- bad for the $A.

    But in and amongst the gloom, the $A still had friends. Last week's  Chinese import data clearly showed that trade with Australia had increased 19% in value terms versus a 15% fall in the $A. Mr Wong, the invisible purchasing manager at many of China's major commodity consuming industries, had clearly responded to the cheaper import opportunities that the weak $A had created. This was big news to the market, but frankly it's exactly what the market should should have expected. The $A rose 3 1/2% last week in response to this 'startling' news.

    The interesting aspect of this data is just how quickly Mr Wong was able to respond to the fall in the $A.  The so-called 'J-curve' was a Keynesian belief that purchasing managers were locked in to contracts that prevented them from responding quickly to currency price changes . This theory argued that it could take months, or even years, for a currency movement to generate a balance of payments response in the right direction. The theory even suggested that a fall in the currency would trigger a worsening of the trade balance in the short-term because of these rigidities. Modern China, however, seems to be very flexible when it comes to responding with higher orders for cheaper prices. The 19% increase in trade between Australia and China with prices having fallen 15%, means that the total physical volume of trade rose by about 23%.  This elasticity shows just how competitive and nimble Mr Wong intends to be when taking advantage of currency fluctuations.

    At the same time, currency traders last week were reported to have record short positions in the $A. With Mr Wong  on the other side of the transaction, $A bears should  watch their backs.

  • When does the US stop mattering?

    by Stephen Fisher | Jul 15, 2013

     It used to be the case that when the US sneezed, the rest of the world caught a cold. The US economy was so large that it dominated not only North America but the rest of the world.

    In 1990, for instance, the US accounted for 24.7% of global GDP according to the IMF. In 2000 this had fallen to 23.5% and currently stands at 19.1%. The US has not contracted over this period, instead other countries have prospered and grown at a  faster pace. China, for instance, was just 3.9% of GDP in 1990 whereas now it ranks as the 2nd largest economy in the world at 15% of GDP.  The IMF forecasts that by 2016, China will pass the US as the world's largest economy with 18% of world output versus 17.8% for the US.

    Judging by the markets over the last 2 months the US still matters enormously. Ben Bernanke mentioned the possibility that the US Federal reserve would commence to unwind its open market purchases of bonds in May, and there was an instant repricing of global assets. Not only did the US bond market fall, as it should have, but the emerging markets, the European markets, the world stock markets and even non-US dollar denominated bond markets followed. Should this have happened?

    While the US is clearly important, it is not as  important  as it used to be. In 1992 US was the world growth engine, but this has changed with the emerging markets and Asia, in particular, driving GDP growth. The massive global sell-off triggered by Bernanke's comments does not seem justified. When will the markets realise this?

    It seems that the world markets might suddenly be waking up to the realisation that the US does not matter that much any more. Take, as an example, the reaction to the strong employment numbers that were announced on July 5. The US markets reacted to the number as they should have, with the bond market falling and the stock market rising. But the rest of the world markets  were basically unaffected. In addition, the losses that were experienced in the emerging markets and the foreign bond markets following Bernanke's comments have largely been retraced.

    With the US fading out of the picture, eyes are now turning to Asia, and China in particular. The IMF's long-term forecast is for Chinese GDP to be double that of the US by 2050. At that point, the US will cease to matter.

  • Forget international pressure, China's domestic problems will float the Yuan

    by Stephen Fisher | Jul 03, 2013

     it is a well-known fact in monetary economics that the central bank can control either the exchange rate of the interest rate but not both. China has been administering a fixed exchange rate policy for many years which has encouraged significant capital inflow and the buildup of reserves. As much as they would have liked to have control over domestic interest rates, they have been content to absorb the buildup of liquidity by issuing bonds.

    In recent weeks, however, domestic liquidity pressures have forced interest rates to rise. The popular press point to deteriorating credit portfolios in the major banks as the cause. The real culprit, however, is the exchange rate. While, strictly speaking, exchange controls prohibit the export of capital from China, recent liberalisation permits capital outflow in certain circumstances. The domestic banking system, however, requires liquidity to finance these outflows. In the absence of a liquidity injection from the central bank, the system needs to find this liquidity itself which in extreme circumstances requires significantly higher interest rates domestically.

    So accustomed to capital inflow under the fixed exchange rate regime, the PBOC was caught flat-footed in response to the sudden liquidity demand domestically that they failed to respond by buying bonds. In recent days, they have learned from this error, and stand ready to smooth  liquidity conditions in the domestic market as the need arises. Nevertheless, the debate in China must now be strongly focusing on the exchange rate. For years China has resisted international pressure to free up the renminbi, but now with domestic interest rates becoming volatile the issue is having domestic  political and business ramifications.

    Faced with the potential for domestic unrest China is quick to respond. The Yuan will be floating freely very soon.

  • LIBOR fixing and stable value cash funds-two sacred cows, butchered, consumed

    by Stephen Fisher | Jun 17, 2013

    The last two weeks saw the end of two of the finance industry's most sacred cows. First, the stable value cash fund was replaced by market value daily valuation. Second, the method for fixing LIBOR, based on an average of bank estimates, was replaced by actual market referenced lending rates -  At least in Singapore.

    I could never understand why cash management fund managers defended their adherence to the holy dollar. Rather than marking to market their holdings on a daily basis, they preferred to claim that the true value of the fund was always one dollar and only in extreme cases "break the back". The original reason for this practice dates back to the 1970s when the funds were first invented. Back then, technology was not as powerful as today so that there was a physical constraint on simply being able to gather the data to calculate the fund net value. This has all changed however, but the cash fund managers refused to update their practices. Finally, in the wake of the Reserve Funds failure, and after much debate and objection between fund managers and the SEC, the correct practice of marking to market these funds finally triumphed.

    LIBOR is another case of non-market practices leading to illegal behaviour and market rigging. Last week, in Singapore, 20 banks were censured for collectively influencing the SIBOR rate at which many loans were based. In their wisdom, the MAS has put in place a world first method for measuring interest rates by actually referring to real transactions. Heaven forbid!

    Both these market-based solutions to significant problems are no-brainers. The perplexing aspect in each case is why it did not happen earlier. As a general rule, regulators should encourage market-based valuation methods for choosing benchmarks and valuing assets.