“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.
Reinsurance premiums have collapsed, according to reports from the annual meetings of reinsurers and brokers in Monte Carlo over the weekend. Bloomberg reports that this is due to "...the absence of costly disasters and increasing competition from new entrants...", but both these reasons strike me as suspect...
For one thing, no self-respecting risk manager would reduce their expectation of a catastrophic hurricane occuring next year just because one didn't occur this year. For another thing, new entrants into the reinsurance industry are facing the same stochastic world that existing insurers face, so discounting to buy business is potentially fatal. If new entrants are buying business below actuarily fair value then they do so at their peril. Put simply, the risks facing all insurers (new and old) are pretty much unchanged so this cannot be the reason for reinsurance cost falling.
The real reason for insurance premia declining is lack of demand, and this is related to risk aversion. People buy insurance when risk aversion is high - they are prepared to pay away return in order to protect their downside. But as investors become more risk tolerant, their demand for insurance declines. Provided insurers can cover their risk expectations, insurance rates will decline in turn.
The decline in reinsurance premia is just another indication that investors are becoming more risk tolerant. The increasing appetite for risk has driven implied volatilities in option markets lower, stock market valuations higher and led to some flattening of yield curves. Investors are bidding up risk assets, which means that risk premia on offer are declining in tandem. It would seem timely to lighten up on risky assets.
"We've had 6 or 7 years of this and we still have a weak recovery. So you have to ask 'is this the answer?'" Such are the words of the Governor of the Reserve Bank of India, Mr Rajan, commenting on the effectiveness of Quantitative Easing.
Before taking the reins at the RBI last year, Mr Rajan was an economics professor at the University of Chicago. This sets him apart from just about every Central Bank Governor in the world today. Chicago economists are brutally frank when it comes to questions of interventionist economic policy. They are not against it in principle, they just need evidence that it works in order to support it. Mr Rajan, quite correctly, has decided to publicly challenge the growing chorus of QE supporters around the world without the slightest evidence of success.
So what happens next? If QE has been an ineffective policy for the last 6 or 7 years, withdrawing from QE is likely to be just as ineffective for the next 6 or 7 years. The Federal Reserve will start raising rates some time next year with no predictable consequences. Mr Rajan's point is that its time for a fundamental rethink about the conduct of monetary policy. But the real economy is unlikely to provide Central Bankers with the breathing room to extricate themselves from their policy mess.
This is because the Real Business Cycle is trundling along, as it has done for hundreds of years (recession, recovery, boom and bust). These cyclic components last for 5-8years on average - so by this metric the US expansion, weak as it has been, must soon be drawing to a close...
...which means that the Fed will be seen tightening policy into a recession. What do they do then? Its back to QE, I suppose, the New Normal in monetary policy!
Who would have thought that the success of a Central Banker would be judged by his or her ability to debase their own currency? Ben Bernanke, Mervyn King and a procession of Japanese governors have all tried and failed to undermine their own currencies' value. Can Mario Draghi succeed where his fellow policymakers have fallen?
Not likely. I have blogged many times about the tenuous link between monetary expansion and consumer spending behaviour. In modern economies, the need to hold cash for transactions purposes has rapidly diminished and with it the power of monetary policy to influence either output or the prices of goods and services. Without this link, any monetary expansion is doomed to fail. Draghi knows this, I think, but he is being pressured into "doing something" to fight the "threat of deflation".
But it's not just me who is sceptical about Mr Draghi's ability to reflate the price level. For its part, the bond markets in Europe have gone ballistic handicapping the 'race to debase' and the odds are pretty much stacked against the ECB. Long bonds are the most inflation sensitive securities (which means they should decline at the slightest whiff of inflation), yet they are up in excess of 5% in August alone. For these bonds to rally so strongly indicates that Mr Draghi has no chance of success. Instead the bond markets are predicting years, if not decades, of very low interest rates going forward. For instance, the German interest rate forward market has the cash rate remaining at 0% for the next 5 years, and less than 1% for the next 10 years.
With odds like these, its hardly worth starting...
I am not sure if the logic in this blogpost is correct as I haven't completely thought it through. But I think it is correct.
I have argued several times in previous posts that the Federal Reserve's QE initiatives failed because velocity collapsed. While the QE policies expanded the monetary base, the additional liquidity was not taken up and spent by the private sector as would be expected. Instead, the liquidity injections found their way back to the Fed, which consequently reflects as lower velocity of circulation. With money demand unstable and unpredictable, the Fed's primary monetary policy tool has become ineffective - operating on the monetary base has no systematic effect on liquidity.
In recent weeks, the Fed has made reference to its plans to target the 'shadow' banking system - most notably the large pools of liquidity in US Money Market Funds (MMFs) - when it comes time to tighten policy. How it plans to interact with the MMFs is not clear, but it could take the form of offering a deposit facility for MMF's with the Fed which offers an interest rate consistent with its targeted cash rate. The idea is that it can influence interest rates by trading with the MMFs directly, instead of indirectly through the banks who keep reserves with the Fed.
Now here is the rub: the Fed is less likely to control liquidity dealing with MMFs than with banks. Banks have to deal with the Fed by virtue of their priveleged position as Primary Dealers whereas MMFs do not. When the Fed 'eases liquidity', they buy bonds from the banks who then increase their lending to secondary market participants and this flows down the financial chain. MMF's, on the other hand, are constantly searching for investments and there is no compulsion to deal with the Fed, and therefore the desired liquidity effect may not eventuate. This is clear from the following two examples.
Example 1: attempts at tightening liquidity to avert inflation. Suppose the Fed wants to raise rates from 25bp to 50bp, to reduce the money supply, and so offers an MMF a deposit rate of 0.50%. A corporate issuer who had attracted MMF investors at 30bp, observes the new higher Fed deposit rate, now decides to offer 55bp to retain the MMFs funding. Interest rates ratchet up 25bp but the money supply is unaffected, so money driven inflation risk remains.
Example 2: attempts at easing liquidity in a crisis. A financial crisis develops and the Fed wants MMFs to withdraw their deposits to inject liquidity, and so lower the interest rate to Zero%. But the MMFs are feeling risk averse, and instead they increase their deposits with the Fed. The net effect is tightening of the system's liquidity position.
Clearly, Example 2 is the disaster scenario for the Fed's new policy tool and, more worryingly, exactly how MMFs are likely to behave in a financial crisis. While the Fed can instruct their Primary Dealers in a crisis to '...go out and lend, keep the system liquid and we will support you...', they are in no such position of control when it comes to dealing with the MMF community. In fact, during a crisis, MMFs could rightly argue that they have a fiduciary duty to protect their investors by keeping their assets with the Fed.
The proposed procedures do not address the core issue of why velocity has collapsed, or equivalently, why money demand has collapsed. If the Fed thinks dealing with MMFs is going to make their operations easier, they have a shock ahead. Monetary policy is desperately in need of a total re-think.
With US Treasury 10 year yields at 2.49%, the likelihood that they will close the year in line with the bearish 3% consensus view is looking more and more remote. How much longer can the bears hold out?
There are only 5 months left in 2014, and the 5 month implied volatility for 10yr Treasuries is currently 0.29%. An implied volatility of 0.29% is one standard deviation, so for rates to rise 0.51% to reach 3% means they must experience a 1.76 standard deviation leap. Statistically, the chance of this happening is just 3.9% or 1 chance in 25.
'Consensus' forecasts measure Wall Street's guru views and does not necessarily reflect the positions taken by real money investors. Real money, however, has been sympathetic to the consensus judging by the poor performance of Macro hedge funds this year. Ending 2014 with a 3% 10 year yield is simply not realistic, so expect downward revisions to start seeping through over the next few weeks. This will prompt some shorts to run for the doors...which will generate further downward momentum for bond yields.
While the consensus adheres to the positive growth-inflation correlation belief, it is hard to imagine Wall Street ever adopting a bullish bond view while yields are below 4%. The evidence in favour of this correlation is weak at best, so betting with consensus is a loss making enterprise. Wall Street's loss is being harvested by the large natural bond investors, such as the Foreign Reserve managers in Asia and the Middle East, who are having a really good year!
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.
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.
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.
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.
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.
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.
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.
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.