Tuesday, 29 December 2009

Central banks are not putting the foot on the brake

The signs are multiplying that the central banks are readying themselves for mopping up excess liquidity added to the market over the past 15months. Obviously it has a tendency to make the financial markets nervous. I do not think that there is any reason to fear that the central banks will steal the punch bowl right now where the party is in full swing. They are simply preparing how to move the monetary policy from being "extremely accommodative" to just "very accommodative". Once that is achieved, there will still be several notches down to the "neutral" or even "somewhat restrictive". I do not believe that the financial markets will receive any shocks from that side for quite a while.
There has been a lot of talk about the impending hyperinflation. I just do not get it. Of course some vestiges of old monetarist theories can be used to say that if you print money, you will have inflation. This kind of thinking belies the complexity of the current situation. First, there is still a substantial output gap, i.e. difference between what the economies could produce and what they actually do produce. We are nowhere near closing this gap. And in order for the "too much money chasing too few goods" mechanism to work, one would have to assume that output cannot be increased in case demand increases. That is hardly the situation right now. Be sure that the OECD and the IMF will have ample time to warn about it happening. And those institutions are not known for being quick off the mark.

Another issue is has to do with the transmission mechanism from banks to the broader public. There is no direct connection between the liquidity being put at the disposal of the banks and the liquidity available to the broader public. It would be the case if the banks had used the facilities to increase lending. They haven't, and as a result the multiplier effect between the two kinds of money has been breaking down over the past year. This is clearly witnessed by the fact that there has been an upsurge in short term bond issues by companies. In other words, banks use the available liquidity to bolster their own capital by playing the steep government yield curve and companies are increasingly seeking funding outside the banking sector. That does not in any way indicate that the private sector is flooded in liquidity. Of course this situation will normalise over time, but there is still quite a way to go before it happens.

This could indicate that the zero interest rate policy is failing in one aspect, putting cheap liquidity at the disposal of companies in order for them to operate normally or even to resume investing. But the ZIRP is working efficiently in another way. The asset price reflation since March 2009 has made us all feel better. Our pension accounts are not bombed out, our security holdings have recovered a good deal of what they lost, property prices are stabilising, and in general we are not as scared any more. Demand is picking up and corporate managers who hit the panic button a year ago are beginning to see the light at the end of the tunnel.

I do not believe that the central banks are ready to hit the brakes anytime soon. If not for anything else, then because of the health of the banking sector. We have all heard of the high earnings and the ludicrous bonuses. One important element of this development is that the banks were given wide-ranging possibilities of hiding bad loans as when the mark-to-market principle was suspended. But hiding bad loans will not mean that they go away. As the number of corporate bankruptcies has sky-rocketed worldwide, it is safe to assume that delinquent loans are on the rise. They will have to be dealt with later, hopefully when the banks have capitalised themselves better – partly courtesy of the tax payer.

And then there is the Basel II. A lot of technical stuff published by the BIS last week, it essentially contains new and stricter requirements to the capitalisation of banks going forward. In the light of the experiences in the past year, it does not sound unreasonable. However, it means that it will take banks longer to return to "normal" health. It also makes it unlikely that central banks will be quick to revert to a restrictive monetary policy.

Tuesday, 22 December 2009

Back to normal?

2009 has truly been a remarkable year. Pitch-black pessimism in the stock markets was replaced by a powerful rally. The banks were rescued by governments without much demanded in return, and now everybody is surprised that nothing has changed in the banks' behaviour. Or rather in the behaviour of the bankers...

Among all this there have been a couple of changes in the underlying dynamics that just may give some pointers to the events in 2010. The rally that took place from early March is likely to be remembered as a relief rally, triggered by the fact that it became clear that the world economy would not collapse, that the banks would not evaporate, that the truckloads of taxpayer money thrown at avoiding a recession actually did work.

At the end of the day, the entire operation amounted to a massive move of bad assets from the banks' balances to the public sector balances without the taxpayers getting much in return. Apart from the ignominy of seeing the very same bankers walk away with huge bonuses, this time largely owing to public money.

Since October it has been clear that the stock markets moved away from the relief rally kind of thinking and back to a more "normal" focus on growth and earnings. It is no big surprise that the market participants have been rather bad at getting estimates and expectations right, a lot of economic forecasts and sales forecasts have gone out the window and have to be replaced by new ones. However, the fact that the stock markets are turning back to poring over company earnings reports represent a big step back towards the normal state of things.

I believe that "returning to normal" will be a highly important factor in 2010. It does not in any way guarantee a return to stability, though. The next big "normalisation" will be that of the monetary policy and bond markets. While the monetary policy provides explosive levels of liquidity, the excesses are slowly being reined in. Through 2010 or early 2011 we will return to a neutral monetary policy. Central banks may then move on to actually putting the foot on the brake, however lightly. Somewhere along the line the bond markets will have to deal with the fact that massive amounts of new government issues are flooding into the market in order to finance the budget deficits.

Whether that will lead to a major readjustment of bond yields (upwards, that is) will depend on whether the global private sector has increased it savings rate sufficiently to absorb the many new issues. That depends on a lot of factors ranging from the Chinese private sector savings to the spending habits of the American home owners. Having been sidelined by the stock market since the heyday of the dotcom bubble, bond markets are likely to return to take centre stage sometime in 2010. Back to normal, maybe, but without any guarantee of less volatile markets.

Wednesday, 16 December 2009

On dollar, risk models, and market stability

Buy dollar and sell stocks. This piece of advice has been handed out by investment advisers recently. They refer to the correlation between dollar and the stock markets, according to which a stronger dollar automatically should lead to weaker stock markets. I don't think so. The dollar strengthening is likely to be the result of a decreased willingness to carry leverage in a currency already cheap on almost any indicator. The stock markets have not dropped correspondingly because investors increasingly believe that the economic recovery eventually will lead to improved top line growth in most companies. Two entirely different stories.

This belief in a stable connection between dollar and the stock market touches upon one of my main criticisms against the financial institutions, the use of risk models.

Even if this is a subject for an academic discussion rather than a blog post I will try and explain. Virtually every model used to control risk or "optimise return" builds on a number of assumptions regarding the statistical properties of the markets. Unfortunately, two central assumptions have repeatedly been proved wrong. One is that the daily investment returns are log-normally distributed. The other is that correlations between asset classes are stable over time.

If we leave aside the issue of the distribution of investment returns and concentrate on the stability of the correlations, we can take as a point of departure the USD/EUR exchange rate and the stock markets. This observed correlation has been rather stable over the past two years. Episodes of dollar weakening have coincided nicely with periods of increasing stock markets.

In other words, if there are reasons to buy dollar then investors should also sell stocks. Interestingly enough, the causality is not explained. No explanations are given WHY a stronger dollar should lead to weaker stock markets. There is certainly no economic theory supporting this story, because if the a stronger USD were to drive stock markets down, it should only be the markets in the USD based economies as they lose competitiveness. European stock markets should by the same logic fact strengthen.

Lacking a theoretical foundation, one could argue that the carry trades, borrowing dollars to buy stocks has been driving the correlation. That could work for the past 9 months, but certainly not for the time between September 08 and March 09. During this period the explanation should have been that investors were shorting the stock markets in order to buy dollars??? Surely not.

Most likely, the observed correlation between dollar and the stock markets is just spurious – as it has happened many times before. There is no single explanation, just a series of events that have led to this observed connection between the two asset classes.

Risk models are always backward looking, since they are based on historical data – what else? They are constantly recalibrated in order to have the most recent developments integrated. Since the connection between dollar and stocks has been visible for two years, the models will now have picked it up and use it as an element in calculating portfolio risk.

But what happens if for some reason the correlation changes? For the users of the risk models, it means that the risk calculation is wrong for the time it takes for the models to detect the changes. Unfortunately, risk models are complicated and require a lot of daily observations in order to pick up a new trend. In this period the portfolio risk is likely to be much higher than stated by the models. Because a stable correlation between two asset classes can be used to hedge risk.

For the financial institutions that build their advice on the same connection between dollar and stocks something much simpler happens: they simply give their clients wrong advice for the period it takes to realise that something has changed.

The conclusion of all this not only that risk models are inherently misleading, and that they probably underestimate risk. It is also that the financial sector has a tendency to present ill-founded short term observations as undisputable long-term facts. Either way, the investors lose because the habits and the techniques in the financial markets are not tuned towards the detection of changes.

Monday, 14 December 2009


No, it is not a new Flu strain. It is a monster of a package of laws passed by the US House of Representatives on Friday. And it is otherwise a referred to as the Wall Street Reform and Consumer Protection Act. It is a catalogue of initiatives aiming at making the financial sector more accountable, more transparent, and less leveraged. I have on earlier occasions voiced my doubt that anything significant would happen to one of the most profitable financial products namely the OTC products. Such products are also covered in the HR4173.

Among many other things the law package also deals with boring stuff such as accounting practices and what must be counted on the balance sheet of a financial institution. The package also suggests a new role for the FDIC in the dissolution of systemic important institutions and new standards for consumer protection.

Trying to make sense of it leaves the impression that there are ample possibilities of creating loopholes. Not surprising given that the banking lobby has spent more than $300m in 2009 to influence lawmakers.

Take one example, swaps, which have always been OTC products, with no marketplace, little standardisation and non-existing transparency. No more has this been the case than for the Credit Default Swaps. A CDS is a contract between two parties that a third party will not default on its debt. One of the two parties issues the CDS and the other party is said to buy protection. The outstanding volume of CDS's on a given company has nothing to do with the actual volume of debt.

One of the biggest issuers of such protection was AIG and it is still anybody's guess how much money the US Treasury had to give to AIG in order for the company actually to be able to pay to all those who had bet that e.g. Lehman would fail. It would seem highly appropriate to make sure that such products were subject to standardisation and transparency. Notionally, the HR4173 does that in the sense that swaps (if the package is passed by the US Senate) must be traded via a recognised exchange. Unless the company buying it belongs to certain sectors, which are specifically exempt (hedge funds, airlines??) or alternative settlement facilities exist. In that case, no transparency is required.

The HR 4173 will probably not survive in its existing form when it moves on to the senate. What is important is that the areas of reform are now laid out and the Europeans can get going on their own projects. Sadly I have to use this word in plural, as the only sensible solution would be to have a solution for the entire European Economic Area. What we have seen so far from the European governments has largely been pathetic (a 50% surcharge on bank bonuses) and will prove ineffectual in the medium term. While we are waiting for the Americans, probably the European initiatives will be limited to small issues primarily aimed at pandering to public opinion.

For one, I do not understand why the EU has not seized the initiative and introduced a pan-European legislation. The experiences of the futures markets in the '90s proved that standardised contracts traded on a controlled exchange could attract large volumes of trading.

For the investors, the HR4173 contains provisions likely to be passed in one form or the other, and in the longer term the most important is the requirement to carry more instruments on the balance sheets. It means one thing, namely lower gearing. It will undermine the profitability and reduce the size of the banking sector relative to the economy. While many of the provisions in HR4173 will appear pointless, this one makes sense. Investors beware.

Friday, 11 December 2009

Timing a downgrade

On the surface, it looks simple: Independent experts issue reports that a debtor's ability to repay his debt has diminished. This because of overspending and lower income (in this case tax revenue). As a consequence of this, the borrower must pay a higher interest on his loans. This is roughly what has happened to Spain and Greece in recent days. The three (US-based) global rating agencies have issued reports or warnings that these two countries represent an increased default risk.

There is, however, a lot more to this story than meets the eye. Firstly, the stories about reduced ratings are a detriment to the Euro. The main beneficiary is the dollar. Having the world's undisputed reserve currency has over the years given USA a considerable advantage, as the quickly growing world trade required an increasing number of dollars for trade purposes. This role has been increasingly questioned as the Euro has proven stable. Several large development countries have openly talked about using euro for trading and currency management purposes. A healthy dose of euro unrest could stop such initiatives dead in their track.

Secondly, the world is emerging from a deep economic crisis triggered by irresponsible banking practices. Whereas the logical (and comparatively cheap) solution would have been to temporarily nationalise the banks, fire the management, rebuild their balance sheets and, in due time, to reprivatise the banks, no governments chose this avenue. The governments did not have the stomach to take on the banks, which, despite being deadly injured, were allowed to continue roughly as before. Instead governments threw tons of (future tax payer) money at the banks.

The effect was to turn what should have been a balance sheet issue into a strongly negative cash flow for the public sector. In the medium term, the effect is worse, as the refinancing of the banks anyway have caused the public sector balance sheets to deteriorate sharply. So the end effect was anyway to replace the unhealthy bank balance sheets with an unhealthy public sector balance sheet. On top of that the banks reacted by cutting credits, which negatively influenced the economic growth. This could partly have been counteracted by a Swedish-1990's-style intervention.

What the governments could have done differently is uninteresting now, except that we can learn how not to do it next time. The fact is that in order to avoid a collapse of the banking sector under the weight of its own greed and incompetence, the governments HAD to accept a certain erosion of its financial situation. Since a well-functioning banking system is necessity in a modern economy, the governments simply had no choice.

Of course some countries had public sector finances already in a not-so-good shape and Greece is certainly one of them. One thing is that the current public deficit is about 12 percent of GDP. Quite another thing is that its existing debt already stood at approximately 100 per cent of GDP at the end of 2008. This combination does not call for a lot of confidence.

If I had been a conspiracy theorist I would have added a third point: The deterioration of the government finances is nothing new, nothing surprising, and nothing that the rating agencies have not known about for quite a while. So my point would have been that the timing of the downgrades or warnings has a curious coincidence with the apparent attempts from the US political establishment to talk the dollar out of the weakening trend we have seen for most of 2009. And that this timing could form the basis for next round of the battle for having the dominant reserve currency. It obviously would not be nice of me to suggest anything like that.

The loud support for Greece from Germany could indicate that this whole story is not only about what we see on the surface. There are much bigger interests involved, namely the future of the status of the euro.


Wednesday, 9 December 2009

Downgrading Greece

One of the issues not dealt with in the set of agreements that led to the creation of the Euro was a sovereign default. Probably the situation was not taken seriously at that time and it would anyway have led to some seriously uncomfortable questions.

Before the creation of the Euro, a government could issue debt in their own currency or in a foreign currency. Credit rating agencies would normally concentrate on the foreign currency debt, since debt in local currency could always be paid back by printing money. Foreign currency debt, however, has to be repaid (or rolled over) in the same currency. In order to do that one needs some foreign currency income, some government discipline and – in the case of a debt rollover -some market confidence.

With the creation of the Euro, this traditional perception was confounded by the new question: How should a default of government debt issued by a euro member country be dealt with. It is not really local currency debt, since the government has no ability to force the central bank to finance the debt. It is not really foreign currency debt either, since all government revenue and expenditure as well as a large proportion of the foreign trade is in euro.

Ratings agencies have sidestepped this issue by now referring to national debt, and presumably treating all debt as sovereign debt.

The issue remains: Would the members of the Euro-zone allow a national government to default on its debt? So far the official policy is: yes of course. In reality I believe it would be very hard to obtain an agreement to let one of the smaller nations go bankrupt, even if the default would be entirely deserved. The euro-zone members would face the hard choice: let a country default and suffer the blows to the reputation of the euro, or shoulder the bill and bail out the debtor.

My guess is that in the case of Greece or Ireland, a complex series of loan arrangements would be made. The result would effectively be a bailout, engineered to take place over 20 or 30 years. The alternative would, I guess, be too damaging to the entire idea behind a common currency as the ultimate effect might be to force out a membership country.

If this logic holds, the ratings have no relationship to the risk of default. For investors it appears to have more to do with whether Greek government debt is eligible as collateral for repo transactions with the ECB. And here it gets very interesting. Being able to use government debt as collateral is an integral part of the risk management procedures of any bank.

So far, the ECB has used ratings from the three US rating agencies, Standard & Poor's, Moody's, and Fitch. As the independence of these rating companies were shown to be fictional in the sub-prime disaster, several politicians called for the creation of a European rating agency. One could guess that in case the rating agencies were to rate Greek debt sufficiently low that it under the existing definition would not any longer be eligible, the rules would be changed, and a serious effort would be made in order to establish some kind of European rating.

Relying on the three US ratings agencies has long been a thorn in the side of both the French and German governments, since they consider the agencies as potential political instruments for the US government. If a rating would directly lead to a major rearrangement inside the EU or the ECB, my guess is that this issue would be addressed very quickly and most likely, to the detriment of the rating agencies.

So what is all the noise about? Observing that the risk premium in the bond markets had fallen to the lowest since early 2007, I believe that we are heading for a period of general reassessment of the price of risk. But that is a completely different question.



Monday, 7 December 2009

Carry trades to hit a bump in the road or?

A carry trade is if you borrow money to invest. And obviously the cost of borrowing should be lower than the expected return on the investment. The "dollar carry trade" has been very popular in recent months. With dollar interest rates close to zero and the dollar depreciating against most other major currencies it has been obvious to borrow in dollars. This has led to a continued depreciation of the dollar, and so on. The investments? Well, just about anything would do, so let us just assume that investors have been investing in some of the assets that have profited from the recovery. Assets - stocks and corporate bonds - that have increased as the companies moved to rebuild profitability in the wake of the sharp downturn.

This Friday's report about the sudden improvement in the US labour market was a surprise. It was published right in time to improve the mood for the holiday shoppers, and politicians will hype it to make us believe that this was the turning point in the recession. No matter that there will be significant revisions showing that the data probably were erroneous. The revisions will only come after the holiday season...

Whether this is conscious manipulation of data or not, there has been another side effect of the report. Worldwide, central bank officials have been busy over the past two months to make sure we all understand that interest rates will not be tightened until the economic recovery is robust. With the publication of the labour market report the market began to reconsider this. Forward curves show that on average, the market now expects Fed to push up policy rates in August 2010 instead of September same year. As a result the dollar rose almost two percent in trade weighted terms, a quite significant move given the long period of a sagging dollar.

While this is all rather technical, the effects may actually prove to be important, as it is the first indication that the risk appetite may be falling. To those who established their positions in time, having invested in the stock market and borrowing in USD has been a one-way street for much of the year. Friday's strong move in USD served as a timely reminder that the market does not offer any free lunches but that all investments are risky.

The point is now whether this bump in the road is enough to wean investors off the carry trades. Probably not, but the story is out now. Add to this that the USD probably by some measure is undervalued (Just think of the number of Europeans going stateside holiday shopping). Friday's reaction also gave the indication that once investors want to close these trades, the market movement can be swift and merciless. I do not want to sound alarmist, but this issue has the potential to be one that really could roil the market.

Tuesday, 1 December 2009

Regulating derivatives markets

There are signs that the extremely well-organised US banking lobby is successful in killing attempts to introduce more regulation of the derivatives markets. The US regulators have presented a project to force substantial part of the OTC (over the counter) market into becoming a transparent, regulated market.

The advantages of doing this are obvious: By creating a clearing house, the market will roughly know who is exposed as counterparts. By using standard contracts, it will be possible to create a reasonably efficient second market, where buyers of the products will be able to sell their derivatives at a narrow bid-offer spread.

Previous moves in this direction have always seen a positive effect for nearly everyone: Better liquidity, lower prices, improved regulatory oversight. All of those things would have very nice to have during the big bailouts of US banks last spring. So it is not surprising that the suggestions presented by the chairman of the US Commodities and Futures Trading Commission contain exactly these provisions.

Intense footwork from the bank lobby has been efficient. Several major US manufacturing companies have come out in favour of individual, non-standard contracts, citing that it will be cheaper and more efficient to work on the basis of individual contracts. They have even gone so far as to say that if they cannot continue having their individual contracts, it may cost jobs. And these jobs may magically disappear in the constituencies of certain senators or representatives.

Here as in many other contexts, it is about money. Contrary to what the OTC providers claim, they make more money on individualised contracts than on standard contracts, and the big players maintain a huge advantage by knowing more about the flows than other market participants.

The best guess is that the US banking lobby has already managed to kill off the attempt at regulation, thereby protecting the revenue of the big players in the OTC market. A year ago the banks needed rescue. Now they have been rescued, and promptly use some of the money they received to block relevant legislation.

In Europe there has been some hesitation on the part of the EU regulators, there has been a hearing but obviously EU regulators wanted to delay their own proposal until they had indications regarding the US initiatives. Now it will be exciting to see if the EU regulators have the guts to present new regulation in the absence of US initiatives.

Initially one would expect this NOT to happen. However, in this particular case there would be good reasons to do so. Previous experience with regulated and standardised derivatives markets have been encouraging. Loads of players have moved over to the standardised markets and have realised that they were more efficient. The experience of the European markets in bond futures are a good example. So actually here might be a way of attracting turnover by being stricter. It does not happen often, but in this case it appears so obvious that it would work.

Another example where it would be good to see European leadership.