Economics: A closer look

Three AAAs and an AA+

2012-02-15T01:37:00.002+01:00

AAA
Some weeks ago we had a storm in a nice cuppa as French politicians attacked the UK in frustration over Frances’s downgrade. They claimed that the British economy in all important aspects was worse off than the French economy. Rather unsurprising, the British government found the attacks unfounded. Back then I commented that there was something correct in the French criticism.

One big difference between the two countries is obviously that the UK has its own central bank and its own currency. Back then, the BoE had just announced a massive QE programme, and has later expanded the initiative further.

The problem is just that it has not worked. Moody’s is now on the prowl and has placed UK on a watch list for a downgrade. Apart from an outsized banking sector, UK has the quite dubious honour of belonging among the countries who saw the strongest growth in household debt in the past 15 years. UK consumers are busy repairing their balance sheets, curbing consumption as a necessary consequence.

This is the reason that well-intended expansionary policies from the BoE does not work. With slow growth it becomes a problem to curb the budget deficits. Again the rating companies are only pointing it out long after it became visible to the naked eye.

AAA
Another AAA country with a failing sense of reality took a couple of punches to the chin. Denmark is now on EU’s new watch list together with Bulgaria, Slovenia and 9 others. EU points to the fact that Denmark’s massive loss in competitiveness has led to significant loss of export market shares. At the same time, Danish household debt has grown strongly as consumers eagerly participated in the housing boom. Hence, the current deleveraging of household balance sheets handicaps economic growth. And that in turn creates problems in controlling the budget deficit.

Danske Bank’s outgoing CEO Straarup confirmed this situation in an exit interview. Danske sees strongly increasing losses on consumer loans as the housing bubble deflates. A shame that Straarup did not point this out earlier. But of course – once burned, twice shy. Straarup had to ask for emergency government assistance to save Danske in 2008, and he has kept a discrete profile ever since.

Nothing of all this should come as a surprise to the regular readers of this missive. I will venture into claiming that the only reason for Denmark not to be on a watch list for a downgrade is the massive improvement in public finances that happened before 2005. However, Denmark’s growth problem can end up becoming a serious problem of government balances.

AAA
Norway also holds the coveted AAA rating. It always helps a bit when you have no accumulated government debt. But all is not well in this country of oil and expensive vegetables.

Recently several voices have pointed out that the country is in the grip of a major property price bubble. Most recently the head of the Norwegian FSA, Baltzersen, pointed out that the combination of a strong Krone and a property bubble creates a very difficult policy problem. Robert Schiller, the author of the Case-Schiller housing prise index for the US, pointed to the bubble in January.

The governor of Norway’s central bank, Øystein Olsen will speak on 16 February. He will likely concentrate on his area of responsibility, which includes the NOK, but not the house prices.

The situation becomes progressively more difficult for the government. The bubble is conflated by highly distorting tax rules. It makes it easy to deflate the bubble. It also makes it very easy to become highly unpopular among property owners. It is easier if one can blame the disaster on somebody else. But in this case, the government fully owns the problem.

AA+
The goings-on in the Republican race to nominate a challenger to President Obama make people say things that could otherwise create suspicions of use of controlled substances.

Romney has recently stated that the big 3 US carmakers would have been better off today without federal help in 2008/9. Let us just remember that two of the companies were in Chapter 11 and only survived because of capital injections from Washington.

One of the elements in the rescue plan was a dramatic reduction in pension liabilities. Pension funds received a large number of shares in the recapitalised companies as a compensation. Romney also criticised that one.

If he is to continue down that road, it would only be logical that he gets critical regarding the capital injections to the banks PLUS the fact that the federal government bought some 800 bn USD worth of “troubled assets”.

The timing of that criticism is easy to get right. It will come when pigs fly.

Risk-on. Greek default. US Jobs

2012-02-06T13:02:00.001+01:00

Risk-on vs Risk Rally

Since November I have claimed that we were in a risk-onsituation in the markets and at the turn of the year I believed that it couldturn into a market rally. The distinction is crucial. A risk-on situationprevails when the markets are getting less fearful and the asset prices adjustaccordingly. A risk-on situation may turn into a rally if the price adjustmentleads to increasing volumes and that in turn leads to added asset pricemomentum. It certainly looks like we are there now. Last week’s raft of MarketStrategists turning positive is just another proof that consensus is nowfollowing the markets (and not the other way round!).

Observing a risk rally is quite obvious and does not requirea lot of rocket science. Defining the beginning of a risk-on situation is a bitmore complicated, as the signs are often weak at the beginning. Looking back,we believe that the risk-on situation began in late September and acceleratedin late November (even if the stock markets actually fell a bit) and again inDecember. The market rally only kicked in later.

At Origo we devote considerable energy to time these turningpoints. Now, in the fifth month of the risk-on situation, we are becoming a bitconcerned. The market optimism may still developing further. But there are somenot-so-healthy factors in the European economy, including credit. We still needdecisive action to recapitalise banks.

The good news is that when a risk-off situation begins, itis usually clearly visible in advance and the signs are unmistakable once ithits the markets. If you have forgotten what it feels like, think back to 2August.

A Greek default is increasingly likely

The Greek drama continues to develop, but now with a quitedifferent twist. Over the weekend, Euro-group Chairman Jean-Claude Junckerpiled the pressure on the Greek government to be serious about implementingreform as a condition for the disbursement of further help. Some days ago Isent a couple of links to documents that amply demonstrate the point: The Greekgovernment faces a serious job in reforming the public sector and that goes waybeyond just reducing costs. OECD has pointed out that the public administrationis largely dysfunctional, that there is no follow-up on policies and theireffects, that public collection and use of data is disastrous. I quote fromOECD:

“For now, it is not clear how existing and new entities ofthe Centre of Government will work together in order to secure the leadershipneeded for reform, including the necessary strategic vision, accountability,strategic planning, policy coherence and collective commitment, andcommunication. Fundamentally, there is no obvious ownership of the reformagenda either with specific entities at the Centre of Government, or shared bythese entities. The capacity toco-ordinate with key ministries is also weak.” (OECD’s emphasis)

And so on. Again it appears that the conservative NeaDemokratia party at the same time tries to present themselves as defenders ofthe country and an even stronger defender of vested interests that are deadagainst any kind of meaningful reform.

Meanwhile, the negotiations with the private bondholdersappear to have taken a back seat, at least in the newspaper headline space. Butwe certainly are on the final straight: On Wednesday the EU Council meets, andthe Greek negotiations are on the agenda. On 13 February a formal offer for the“voluntary” debt swap must be presented in order for the Greece’s large couponpayment on 20 March to actually be paid.

But at this moment, any losses ought to be fully discountedby the markets. I guess it is only the distribution of the losses that remainsto be seen.

US Jobs report

The US labour market data released on Friday gave the stockmarkets a good boost. The headline unemployment number fell from 8.3 to 8.1 percent in January. That number is one of the most suspicious numbers in theentire cycle of US monthly data releases. Since Reagan’s days, this number isan estimation, based on panel data, and not on any kind of national records. Inparticular the number of job seekers is dodgy and fluctuates significantly. Asa result the unemployment rate can fall if unemployed persons drop out of thelabour force. In the US definition you can fall out of the job-seeking categoryif a job offered is turned down, eg. because of a too low pay.

There is more substance in the data for actual jobscreation. And those data showed that job creation is getting broader and moredispersed. Anyway, it is a lagging indicator. US data have exceeded expectationssince October of last year.

Greece, Geithner, GS

2012-02-03T12:07:00.001+01:00

Time to worry about Greece?

Apparently (well, we have been wrong onthis one before), the negotiations about the Greek restructuring areinching towards a resolution and the private bond holders appear ready to accepta coupon of some 3.6% on the newly issued bonds. That corresponds to a haircutof 70%. You may call that a default or not, depending on your preferences.

But what worries me is the steady streamof reports out of Greece that the public sector is falling apart andessentially unable to implement radical policy changes. This is amplychronicled, even by such staid institutions as the OECD back inNovember. It begins to look eerily like Argentina.

In a telltale sign, Steve Hanke haspublicly stated that Greece will fall apart. Hanke was the intellectual forcebehind Argentina’s disastrous “currency board ”in the late 1990s that led tothe country’s default in 2002. He still does not see any responsibility for thefailure but blames the fiasco squarely on the implementation.

Anyway, he has seen up close whathappened, and he believes he now sees the same happen in Greece. It is notoften you will see me reference Telegraph,but in all of their euro-hostility, they have made a listing of what couldhappen to Greece if not something is done to stop the downward spiral. Not funnyat all.

Geithner

The US Secretary of the Treasury may wellbe sacrificed by Obama in order to obtain re-election. Geither is widely seenas an ambassador of Wall Street inside the US Administration (I tend to agree),and it is likely that Obama will try to tap into the public exasperation withthe financial sector excesses. Geithner’s position may stand in the way of there-election strategy.

In a statement to reporters Geithner madea comment that gives away a lot of the thinking inside the Administration. “Weare working to discourage other nations from applying softer rules to theirinstitutions in order to try to attract financial activity away from the U.S.market and U.S. institutions”, he said. One can only assume that governmentselsewhere have the same attitudes, and that explains why internationalagreements are so hard to come by.

But what about the European politicianswho want to introduce tougher rules on their banks?

It must be official by now

Goldman Sachs, one of the leadingconsensus makers in the English-speaking part of the financial sector, hasfinally given in to the positive mood. JimO’Neill, chairman of GS Asset Management offered the following gem: “just the cessation of bad news itself has sort of appeared (to be) a bitof a positive”. It must mean that GS agrees with me about the (feeble) economicrecovery and its influence on the market. I am sure he will receive a huge bonusfor this rigorous analysis. Predictably others followed in his wake.

Should we worry?

In recent days there have been somedisturbing reports about the trends in Europe’s broad money supply. Overall itcan be taken as an indicator of the amount of credit given - but not a preciseone. In the last months of 2011, the EU-zone money supply fell by a few percent (in Greece it actually collapsed). We need to see this trend reverse inthe first quarter in order for the region’s recovery to continue.

25/27 EU. Portugal. RBS.

2012-02-01T09:27:00.002+01:00

25/27 EU

So 25 of 27 EU member states decided tosign up to the new fiscal policy agreement, and the Czech Republic may sign uplater due to democratic procedure. The UK decided to remain on the sidelines –again.

I have nothing new to add. The agreement isasymmetrical and will always have a deflationary bias. Unless, that is, it iscompleted by a solidarity agreement whereby the surplus countries agree tostimulate growth when other countries are forced into budget cuts. It is not onthe agenda and the German understanding is that they have no such responsibility.

President Carter’s security advisorZbigniew Brzezinski gave this description of the UK: “Its ambivalence regardingEuropean unification and its attachment to a waning special relationship withAmerica have made Great Britain increasingly irrelevant insofar the majorchoices confronting Europe’s future are concerned. London has largely dealtitself out of the game”. It cannot be said any clearer.

There was some flowery talk about creatingmore jobs for the young unemployed and for making some initiatives to helpsmall and medium-sized companies. It will not improve the economic growth.

Auctions

I continue my focus on European bondauctions. European nations including Italy, Belgium and Spain plan to sell morethan 33 bn euros this week. Italy sold 5.5 bn euros out of a target of 6 bneuros of five- and 10-year bonds on Monday, and issued 1.9 bn euros out of amaximum goal of 2 bn euros of 4-year and 9-year bonds. Belgium sold 2.58 bneuros of bills, with Spain, Portugal, Germany and France issuing 13 differentmaturities in coming days. Italy’s auction did not go down as well as hoped andthere will be some focus on that issue in the coming weeks. But overall theresults point to continued improvement.

Portugal

The country’s 10 year yields now stand ata sky-high 16.40% after having been higher than 18% last week. Predictably, ithas led some to believe that Portugal’s refinancing costs have increased justas much, and that the country is about to be insolvent.

I am surprised some people still have notrealised that the purpose of the bail-out from May 2011 was to allow Portugalto stay out of the markets for something like three years. The country steadilymakes some auctions but they are small enough not to imply an imminentinsolvency. Contrary to the case of Greece, nobody has accused Portugal oflying about the true situation of the public finances.

It does not imply that Portugal is safeyet. The government has embarked upon a major labour market reform. About timeto clean up after the dictatorship imploded in 1974. But that kind ofinitiatives only work slowly, however well-intended they may be.

RBS

The fall-out from the RBS story continues.Sir Fred Goodwin, the ex-CEO of RBS is now ex-Sir Fred. He was stripped of hisknighthood, just because the government had to step in with a modest GBP 45bnto save the bank. He must feel that he is being treated very harshly.

As a small compensation, I guess that Fredwill keep his bonuses, contrary to the current CEO, who was brought in to cleanup. Steven Hester waived his bonus of less than 1mn GBP after a public outcrythat had nothing to do with his actual results.

We still need a serious discussion abouthow to device bonus systems for bank CEO’s. I still believe that looking at thereturns created on the balance is better than the current obsession withreturn on equity. Using the RoE creates a strong incentive for the likes ofFred Goodwin to gamble. And as we see, again a ruthless and greedy bank CEOprivatised the gains and socialised the losses.

Crisis and democracy. Downgrades.

2012-01-30T09:41:00.001+01:00

Proconsul, no thanks

Over the weekend rumours surfaced that theEU would want to put the Greek government under administration. According toapparently well-informed sources, the EU commission, supported by the German government,should be interested in making further help depending on the Greek governmentaccepting an EU representative, who would have the right to veto its economicdecisions.

It is a very dangerous route to take. Aslong as the EU is built on the principle of conservation of nationalsovereignty (as opposed to what the UK government often claims for publicconsumption), such a move would only give a new momentum to those who see EU asa fundamentally anti-democratic construction.

On the other hand, several reportsare very clear: There is no willingness or indeed understanding in Greece that fundamentalreform is necessary. There are too many votes to be had on simple populistmessages. I perfectly well understand the exasperation on the part of theEuropean leaders, who are being asked to shell out billions only to be met withobstruction from broad groupings in Greek political and administrativeinstitutions. I had mixed feelings reading Michael Lewis’ wittydescription of the mood in Greece and other crisis countries.

There is no other way forward for theeuro-zone than having Germany accept a assistance package that may becomparable to the Marshall aid after WW2. The northern countries must acceptthat helping Greece and possibly Portugal is the price to pay for rescuing theeuro-zone in the short/medium term. Putting in a pro-consul will not help.Maybe is the moment to bring in IMF as a neutral arbiter.

Downgrades

Fitch downgraded 5 euro-zone countries.Yawn! It seems already to be forgotten. Maybe it was because it was “betterthan expected” since rumours had it that 6 countries would be downgraded.Ireland kept its rating, as did France and Italy.

Sarkozy

French president Sarkozy is facing a verydifficult run-up to the presidential elections on 22 April. His main opponentFrancois Hollande of the Social-democrat PS is consistently showing asignificant lead in the opinionpolls.

To those who have accepted the Frenchclaim that the country represents a “cultural exception”, it will be disturbingto observe that electioneering in France is exactly like elsewhere. Hollandepromises to solve the economic problems by lowering the pension age (sic!).Sunday night Sarkozy went on all national TV channels to announce a tax onfinancial transactions that has neither chance of neither being implemented,nor ability to solve any problems if it ever were.

If Hollande is elected, it could at leastfor a while throw a spanner in the works for the German-French jointinitiatives. But it would only a question of time before the new (andcompletely inexperienced) French government would find out that Berlin is incharge.

Data

The somewhat weaker than expected US GDPdata from last week will focus attention on this week’s data for personal income and spending. Several EU countries will release PMI data that for surewill be scrutinised in every detail. For your investments, it is not importantwhat the economists have to say, but how the markets perceive the data.

Dollar

My colleague Frank proved to be right. Mypious hopes of a stronger dollar could do nothing against a market aggressivelypositioned against the euro. In the past two weeks, the markets have begun tounwind short EUR positions and all talk about a “collapse” just disappeared.Another element in the risk-on trend.

American banks

Yesterday we had another reminder howgrateful we really need to be to the banks. Representatives of US banks pointed outthat if the stronger capital requirements and the limitations on prop-tradingare introduced, it will lead to slower economic growth and lower liquidity forEUR denominated securities. Please!

The very banks that were saved by thetaxpayers continue to resist reforms necessary to avoid a repeat performance of2008.

However, I agree that the higher capitalrequirements need to be introduced over a longer period. The demand for a 9%Tier 1 capital on 30 june 2012 is already having a negative effect on thecredit markets. Banks prefer to bring down their balances rather than raisingnew capital.

Fed. Data. Restructuring

2012-01-27T09:59:00.000+01:00

Slow recovery in the US – and elsewhere

Federal Reserve’s decision to announcethat short term interest rates would be kept low until at least mid 2014 tookmany, including me, by surprise. But it makes sense. The current recovery wasnever going to be a strong one, since the deleveraging of the household sectorwill put a lid on private consumption. Such deleveraging historically takes 5-8years, and if we take mid-2008 to be the starting point, it makes sense thatgrowth will return to normal in 2014-15. The same goes for three othereconomies hit by similar consumer leveraging: UK, Spain, and Denmark.

But the interesting thing is of course theinvestment consequences. Since 2008 money has been earned in reflation trades.Fed’s announcement was a statement that reflation is still very much on thetable and it should feed the current risk rally further. It will weakenthe USD at least until we see the second tranche of ECB’s 3-year LTRO in March.US T-bonds were flirting with calamity, but have now pulled back. We need tostudy our indicators, but at the end of the day, I believe that this will giveinvestors one more chance to get out at very attractive prices.

No matter what Fed did, it is not anegative for the current return to risk willingness in the markets. Since themain reason T-bonds and Bunds are trading at too low yields is risk aversion, acorrection is due as the risk willingness returns.

IFO

The German IFO index of the businessclimate for January came out better than forecast. Together with the PMInumbers from earlier this week, it confirms the possibility that Germany willavoid a recession for this time. Next week we will have a raft of data for theUS but nothing really indicative of the European situation. Today we will haveUS GDP. It could come out lower than expected, given what we have seen fromFed.

Auctions – again

Italy sold 4.5bn EUR of 2 year notes at ayield of 3.7 per cent and 10 year yields fell below 6%. It did not draw anyheadlines, proving that the coverage of the Euro crisis is still biased towardsthe negative. But it does not matter. It was yet another step away from theEuro-Armageddon.

Restructuring

Discussions about the Greek restructuringhave stalled, and there is a lot of bluffing going on. The banks have madetheir “final offer” and Merkel has threatened the banks that if they do notaccept a bigger de facto haircut, there is always the possibility of justdeclaring a default. And so on.

The most entertaining statement came fromoutgoing CEO of Deutsche, Josef Ackermann. He claimed that if Greece/EU did notaccept the final offer it would mean that fears of “contagion would come backin the markets”. Hmmm. He admits that contagion fears have reduced significantly– which is good, as it rhymes with my perception of the risk-on situation inthe markets. He also indicates that the situation around Greece could lead to anew round of “contagion”.

Using my definition of contagion – a panic-likereassessment of risk in an investment – Ackermann is off the wall. The nextpossible source of contagion is Portugal, which has been priced out of themarket. But of course, Ackermann is trying to bluff us into minimising thebanks’ losses. It is his job, and his statements should be seen in that light.

Investor protection. Davos. Consensus building

2012-01-25T08:05:00.000+01:00

PMI

Yesterday’s January PMI from Germany andthe euro-zone confirmed our views – held since September, for those who care –that the European recession is likely to end within a couple of months, and Germanymay avoid recession altogether (recession defined as two consecutive quartersof negative growth). Today’s IFO indicator from Germany will show whether weare moving further in that direction.

Help!

In the UK, a new consumer protectionwatchdog wants to protect “irrational investors” from dangerousfinancial products, as such investors cannot be relied upon to find outwhat is in their own interest. Well, given the amount of brainpower thefinancial sector has poured into making their products completely impenetrable,it would be about time. At the same time the UK government is finally flexingits muscle when it comes to greedy bank chiefs. Equipped with a clearlyconservative government, UK is establishing itself as the leader in how tochange the ground rules for the financial sector.

Before you shake your head at those poorprivate investors who now have to be protected from their own ignorance, afresh study commissionedby Financial Times from Yale and Maastricht universities shows that thereis no conclusive evidence that Private Equity createsvalue for the investors. It is, however, established beyond any doubt thatsubstantial wealth is created for the owners of the Private Equity firms. Newcompulsory reading for pension fund managers, I guess.

Probably it is with Private Equity as itis with hedge funds. The early movers have earned fabulous returns, primarilybecause of their ability to fly under the radar and outside of prudentialregulation. With huge money to be made, more people and more investors move in,and after a while the average return falls towards market returns. The onlything that proves a remarkably resilience is the ability of the investmentmanagers to shroud themselves in a cloak of invincibility and keep their ownremuneration up.

FT reports that US pension funds have hadan average 4.5% return on their investments in PE over the past decade. Butmanagement fees have been on average 4%. Add all the other fees and received bythe PE firms.

Davos

For once, this year’s World Economic Forumin Davos seems to be a place where serious things are discussed. In therunning-up to the conference, Lagarde of IMF and even Zoellick of the Worldbank joined forces with 4 other leaders of international institutions issued astatement about the international economic situation.

Despite the more urbane wording, it wasanother rebuke to the German belief that austerity-based programmes can savethe world in the short term. Zoellick – a man of impeccable conservativecredentials, then went on to explain that Germanyhas to transform herself from a participant in Europe to a political leader.It means to resume responsibility for all of the area, and not, NOT, think oftheir own domestic situation first. Interesting, and very much in line withformer Chancellor Helmut Schmidts insightful comments from 2010.

Consensus

It is equally interesting to see that someof the leading consensus-makers, UBS and Citi, are now joining Origo inpointing out that a risk-on rally is ongoing. Citi even jokes that ECB hascreated “artificial life”. Whatever! It probably means that they had not seenit coming. I do not care as long as it works. Now we wait for all the othermajor banks to join.

Risk rally arrives on time

2012-01-24T02:12:00.000+01:00

Since November we have been adamant thatwe were heading into a situation where a tendency to “risk-on” could accelerateinto a real risk rally. We are there now. Financial stocks are moving up (phew,they will not go under). Spanish, Italian, Belgian government bond yields arefalling quickly (phew, they will not go under). Commodities are about to joinin (phew, the world is not going under).

Dollar is (unfortunately for Europe)weakening under a combination of a short-squeeze and a stronger belief that theeuro will not fall apart in 2012. HY bonds are doing very well, thank you, ascorporate earnings do not really reflect the apocalypse vision of earlyDecember. Will this positive sentiment ever end? Of course it will. But justlike nobody knew how far the risk-off collapse could take us down in August,nobody knows how far this rally will carry us upwards.

If anybody claims to know, we willquestion their credentials. But for now, all indications are that we cancontinue for a while. Until then, enjoy the party. You will be joined by moreand more consensus thinkers. UBS and Citi have joined us in the past two days.

Thelast shoe to drop

Just like we have been keeping tab on theEuro bond auctions, as a sign we are moving away from the pits of the risk-offdowndraft, we are now eyeing the T-bonds/Bunds. If the revaluation of riskassets continues, we will eventually see a major calamity in those two types ofassets. Once we get there, the risk-on rally will probably on its last legs.

Andon the sidelines

We have a lot of rumours going on. Germanyand France should be ready to accept a slower implementation of the 9% Tier 1capital requirement in order not to put too much pressure on the credit market.Germany should be ready to accept “solidarity” with the problem countries and“long term solutions” in order to solve the underlying problems in theeuro-zone. Germany suggests to move the ESM forward and let EFSF and ESMoperate in parallel for a while. Lagarde from IMF wants more money in order tohave bigger reserves if needed. The policy rules in the Euro-17 will be moreflexible.

Why am I not surprised about all this? Ifthere is some truth to any of the rumours it appears that a healthy dose ofpragmatism is now being brought in. But only after Germany managed to get herway in forcing a deeply destabilising set of long-term upon Europe. Quid proquo.

Finally it feels as if the ideology isbeginning to take back seat to some practical action. There is still a long wayto go before anybody can declare “mission accomplished”. But there is no doubtthat now is the right time to be pragmatic. It always works best when themarket is in a mood to believe that things are heading in the right direction.It seems to be now.

Quotes and time zones

2012-01-23T09:18:00.003+01:00

Quotes and time zones

I have been quoted a bit in the pressrecently and have now joined the club of those “quoted out of context”. Itcomes with the territory, so I am not going to complain about it. I only want tomake a couple of things clear to the readers of this column.

Most importantly, at Origo we try to workin Real Market Time (RMT). It is rather different from Economist’s HypotheticalTime (EHT) or even Newspaper Headline Time (NHT). It is also quite a risky endeavour.

Switching for a moment to EHT, I do notknow where the world economy will be in 9 or 12 months from now. There aresimply too many unknowns at play. I have an opinion about a lot of them, butthose opinions are irrelevant when it comes to today’s practical investmentdecisions. Those decisions are made in RMT.

The only thing I know is thatin RMT, we are right now putting the doom-and-gloom-and collapsescenario of the past four months behind us and that is enough to make themarkets react. Another setback may come later, but it is not visible in anyeconomic indicators right now,. We will jump off that bridge when we reach it, i.e. when it becomes relevant in RMT.

Europe is in a crisis, and for severalreasons. In EHT, government debt, inadequate institutions, and way too weakbanks are central ingredients. But in RMT, a crisis accelerates dramatically ifa country or a bank cannot roll over existing debt. The European inter-bankmarket is pretty much dysfunctional, but ECB has taken over the role as aclearing house. It is certainly not optimal, but it works for now.

The almost weekly auctions over Europeangovernment bonds is the space to watch (in RMT), when it comes to thegovernment debt situation. As long as the euro-zone countries can refinancethemselves at almost normal market conditions, the crisis is not spinning outof control. That is enough for now.

Everywhere the game is to play for time,time to stabilise the economies, and time to revive the economic growth. Asopposed to financial markets myths, it is really the only way to solve theproblems. There is no quick way out. The best we can hope for is that the traindoes not run off the track in the meantime.

It is a question of perceivedprobabilities. Every time the markets perceive a change in the probability thatwe remain on track, it is good or bad news. And that is exactly what we atOrigo try to monitor.

Greece

Despite some last-ditch brinkmanship, thenegotiations between the private sector bondholders and the Greek governmentcontinue, and now appear to be heading for some kind of resolution. It willmean that the official debt write down is 50% while the real haircut (once thenew, longer-dated bonds are issued) will be some 68%. Let us get it in the bagso we can move on.

Speedy solution to EU crisis?

Germany and France now wants to speed upthe resolution of the crisis and the final designs of the new EU institutions.It does not make the overall plan more correct. There has been an interestingchange in the language. Germany’s foreign minister Westerwelle now talks aboutsolidarity with the countries in trouble. He also talked about long-termsolutions. If we could please hear some more about this solidarity, please.Westerwelle also wants to speed up the creation of a European rating agency.

Auctions. Downgrade. Banks. USA. Risk

2012-01-20T09:30:00.000+01:00

Auctions

Yes I am a bit OCD about bond auctions these days.It is because that is the place where we have the clearest view from thefrontline of the euro-crisis. As long as the euro-zone countries can financethemselves at reasonable costs in the open market, there is no real crisis. Atleast for the moment.

France and Spain sold a total of eur 15bn worthof government bonds at lower yields than before the S%P downgrade. Spain hasnow sold close to 20 percent of the planned issuance for 2012. And we are only20 days into the year.

Has this started a rally in risk assets?No, that one started in late September.

Another downgrade coming

Fitch, the smallest of the three major(i.e. US-chartered, free-speech protected) rating companies is likely todowngrade 6 euro-nations in the coming days. That will be yet anothernon-event. Then we will wait for the inevitable downgrade from Moody’s, and wecan all move on.

I look forward to see if Fitch will alsomake an attack on Germany’s plan for the “fiscal compact”. In the good olddays, Moody’s was the most openly political of the three. Now they try to repositionthemselves, so maybe Moody’s will now drop the political comments.

Commerzbank, MPS

If the euro-crisis is on the backburnerfor the time being, the European banking crisis is still simmering. Commerzbankis banging the drums that they almost have found all the new capital they need.One of the tricks is that Allianz appears to be willing to convert a holding ofnon-tier 1 capital into an equity holding. From Italy we hear that the world’soldest bank, Montepaschi di Siena, is pulling off a similar stunt. It is abeginning. We need far more action on this front.

Good data from the USA

Please do remember that you read it herefirst (or in my blog back in August): The US growth pause ended in Septemberand growth improves nicely. Initial jobless claims fell in December, housingstarts increased and manufacturing output accelerated. At the same time the USbudget deficit is shrinking – as it always happens when the economyaccelerates.

We know that the fears of a “new”recession is over when the likes of CNBC and Bloomberg TV again begin tointerview people who offer “stock tips”. We are on our way. The perpetual bear,the original Mr Doom and Gloom, Marc Faber now assures us that the stock marketwill not collapse. Time to exhale!

Risk indicator

It will come as no surprise that I am aharsh critic of risk control methods based on “portfolio diversification”. Whenthe things really heat up in the markets, correlation between asset classesincrease and the diversification of portfolios lose its effect.

At Origo we have made an indicator ofthis, and guess what: it signals that we are moving back towards normal. Therisk management departments of this world are soon back where their modelsagain work. I would not be surprised if the message going out from the riskcontrollers in the banks is “risk is falling, you may take more risk on”. Stockpickers will also feel it is worth going back to work again.

Mario. Yields.Economic news. Gross.

2012-01-18T10:11:00.000+01:00

Super-Mario II

No, not Mario Monti but Mario Draghi. In atestimony to a committee of the European Parliament he is quoted to have saidthat “As regulators we should learn to do without ratings. Or at least weshould learn to assess creditworthiness in a way in which ratings or creditrating agencies are one of the many components of our information”.

I could not agree more. I have evenbeen quoted for saying so: There is no alternative to doing your homework. Evenif it implies that you will have to read up on what creditworthiness means. Or to employ staff that know.

On Monday, I quoted S&P’s musings intheir reasoning for the downgrade of France. It was an unashamed judgement ofthe shortcomings of the European initiatives to shore up the Euro. The factthat I agree with their judgement should not take the attention away from thefact that it revealed one crucial fact. The ratings agencies are as muchpolitical players as they are analysts or indeed paid marketing agents.Draghi’s words should be taken to heart and the ratings should be taken as “oneof the many components”.

I am happy to see that S&P’s downgradewas largely ignored by the markets.

Yields

French bond yields fell at the auctionMonday, a Belgian auction went well, and even Greek bond yields fell Italianand Spanish two year yields have stabilised and 10-year yields declined. Iinterpret this as a resounding proof that ECB’s 3-year loans are having thedesired effect for now. The stock market is picking up the baton.

German bonds (and other “Safe haven”assets) are worrying me. If suddenly bonds from other countries are perceivedas being not-so-risky and if even Portugal manages to sell a small amount of10-year bonds, what will happen to German yields? It does not take a genius tosee that one of the world’s most overvalued assets would be in for a rough timeif investors drop their obsession with avoiding risk.

If you are ultra-long in these assetsdespite their ridiculously low yield, take care that you will not suffer thesame fate as the (almost) proverbial frog in the water being brought to boil.

The frog story is proven to be a myth. Thelosses on your bottom line will be real.

World Bank economic forecast

The less thinking part of the financialpress will today dedicate too much space to the WorldBank’s economic forecast. WB expects global growth of 2.5% in 2012, downfrom last forecast’s 3.5%. The previous forecast is from June 2011, so most ofthe downgrade merely reflects the economic development since then. If theEuropean banks break down and the euro-zone enters a deep depression, it willlead to a global recession, according to the WB. That has no news valuewhatsoever. I notice that the World Bank does not assign a subjectiveprobability to neither the main scenario nor the doom scenario. Do read thereport, but take it as a history lesson rather than anything forward-looking.

Good news amid too much gloom

We, Origo, my business partners and I,want to have it on the record that the European recession is a fact here andnow, and we are beginning to pull out of it. Some people appear to agree withus (the stock markets, just to mention a few). ZEW’s data for German investorand analyst expectations rose for the second month running. It was the biggestmonthly increase in 20 years of data.

Greece

Market rumours now report that the negotiationson Greece’s restructuring will result in a haircut of 68% - it appears to be agood number – for Greece, at least. An anonymous source said that “a lot ofbrinkmanship is going on”. Sounds about right. Playing this one right may handa big Ka-Ching to those who blink last. Why else should hedge funds have gottenin there recently?

Gross

Sometimes I wonder what it really takes tohave one’s name mentioned in the headlines. I do my best by being mean andsarcastic. PIMCO’s Bill Gross managed to get a headlineon Bloomberg for telling the obvious truth that some institutionalinvestors have rules according to which they will be forced to sell bonds thatare rated lower than a certain threshold. That may lead to a sell-off.Toe-curling stuff. I promise myself not to quote Bill Gross again until hemakes a correct call on US Treasuries.

Downgrade. Euro.

2012-01-16T09:14:00.000+01:00

Downgrade

One should always beprepared for a hefty surprise in these markets. Suddenly I find myself agreeingwith S&P! In the explanation for the downgrade of France the following gemis hidden:

“The outcomes from theEU summit on Dec. 9, 2011, and subsequent statements from policymakers lead usto believe that the agreement reached has not produced abreakthrough of sufficient size and scope to fully address the eurozone'sfinancial problems. (...) We also believe that the agreement ispredicated on only a partial recognition of the source of the crisis: that thecurrent financial turmoil stems primarily from fiscal profligacy at theperiphery of the eurozone. In our view, however, the financial problems facingthe eurozone are as much a consequence of rising external imbalances anddivergences in competitiveness between the eurozone's core and the so-called"periphery." As such, webelieve that a reform process based on a pillar of fiscal austerity alone risksbecoming self-defeating, as domestic demand falls in line with consumers'rising concerns about job security and disposable incomes, eroding national taxrevenues.” (My emphasis).

Also very useful to read how S&P are justifyingtheir broad sweep.Somebody have beenreading up on their Kindleberger and the history of the crisis in 1929-32.

The only question is:what would S&P have done if France (and Germany) had introduced reforms andtax changes to spur domestic demand and had offered long-term loan programs toGreece and Portugal to help productivity development. Or if Italy had embarkedon a long, slow reform program to set free the country from decades of badmanagement of the laws?

Probably they wouldhave downgraded France and Italy anyway, so in that respect the above quote isjust a proof how much of a political institution SP really is. We now waitfor the next chapter: The downgrade of Germany. Ultimately it is Germany thathas forced a wrong solution upon the rest of the euro 17.

Will it mean anythingfor France and the 8 other downgraded euro-nations? Too early to tell. But forsure a lot had been priced in already.

More interesting, isthis a game-changer? My feeling is that it is not. After all, I cannot remembera rating change that was forward-looking and indicative of any changes thatwere not already visible to everybody else. But we will be able to see it in therisk appetite in the coming days.

Euro

The euro hasfortunately weakened further as a result of the ratings. Good for Europe!However, Colleague Frank points out that the number of short positions bettingagainst the euro is at a historical maximum. But I found a piece on Bloomberg that left me puzzled. Who hadunderstood that the reason for the surprising strength of the euro was that itwas propped up by the AUD. Silly me! I thought it was the belated reactions onthe part of ECB that had caused the euro to remain stronger than the other maincurrencies. Never too late to learn something new...

Reuters carry an interesting story – and theyappear very keen on telling us that it is well-researched: Hedge funds haveapparently bought sufficiently many Greek bonds to actually force a default.That would immediately release the payments of CDS according to ISDA rules.

German growth. Schizophrenia. Banks

2012-01-13T11:53:00.000+01:00

Auctions

Italy and Spain soldmore short term bonds than expected at lower yields than expected. ECB’s 3-yearloans are working their magic. The “euro-collapse” is postponed further.

German growth

Germany has announceda negative growth in Q4 of -0.25%, and newspaper stories have it that theGerman Federal government will reduce its forecast for economic growth in 2012to about 0.75%, Negative growth in Q1, zero growth in Q2 and a slow recovery insecond half of the year. It is entirely in line with the view I have statedseveral times before: We are in the middle of a European recession and sometimearound March/April we will reach the turning point.

Schizophrenia?

On 19 July last year,Origo made a call that stocks were in for a major correction. We based thisforecast on a number of factors. Most important was that on a backdrop ofsharply falling growth, stock markets had their Wile E. Coyote moment, whilethe (high quality) bond markets were right all along.

Again, we have asituation where the stock markets are on average trending upwards, while the(high quality) bond markets stubbornly cling to excessively low yields. Butthis time it happens as the growth prospects are in fact improving or about toturn the corner. Despite heroic attempts from the London-based financial pressto keep the pressure on the euro, the various initiatives to lighten thefinancing squeeze on Europe’s troubled countries appear effective. The Europeanrecession may well end up having an average length (7-9 months) and an averagedepth (a total output loss of 0.75% to 1%).

Where does that leaveus in terms of asset allocation? Well, judge for yourself. One can side withthe bond markets and remain depressed. Or decide to see the positive signs andside with the stock markets. As opposed to the turn in March 2009 or August 2011,the signs are not yet all pointing in the same direction. But it appears thatthe “perma-bears” have a harder time to make their way into the headlines.

Uh-Oh
According to FT, acertain large CSwiss bank is now offering its hedge fund clients a product thatallows them to short European banks – even if shorting bank stocks is banned inseveral countries. I will not discuss the morality of this manoeuvre. Would beakin to discussing something that does not exist. Pure metaphysics!). One thingis, however, clear. Once this particular product is offered to retailinvestors, the European banking crisis is close to being over. Yet another ofmy “hillbilly indicators” based on nothing but a long memory.

European Banks
RBS is caving in todemands from Bank of England and the British finance ministry (who owns a notinsignificant 83% of the shares in RBS). It will mainly lead to cuts in theinvestment banking activities. Deutsche Bank wants to sell its asset managementdivision. I am afraid none of it points to a solution to the banking crisis.

The banks trade atdepressed prices because nobody can figure out which banks are really rotten.They all mark their assets to fantasy instead of using mark-to-market. Theyhave not yet taken the necessary write-offs on goodwill. If we could finallyget a couple of major banks to fold, it would end up being good news for thesector – after the initial shock. As it is now, the entire sector is priced fora meltdown.

Pensions. Auctions. Banks.

2012-01-11T12:24:00.000+01:00

Pensions

Well, well, well. I have given a couple ofpresentations in Copenhagen and Stockholm about the Euro crisis. One of mypoints is that the current situation regarding government finances also has alot to do with the fact that Europe’s baby boomers are retiring in largenumbers these years. It has been pre-programmed for years (about 60 years to bespecific) but politicians have too short an attention span to focus on it. Nowthe story has been picked up by Bloomberg. Chapeau!

It goes to confirm that we have a numberof different problems occurring at the same time: Debt cycle reversal, cyclicalslowdown, badly capitalised banks, inadequate institutional design in Europe,and the pension squeeze. If anybody wants to receive the slides from mypresentation, let me know.

Auctions

Tomorrow and Friday Spain and Italy willsell up to 22bn of short and medium term bonds. The yields in that part of theyield curve have dropped sharply since the beginning of December, meaning thatthe refinancing costs will not increase as dramatically as the markets believedjust 3 months ago. In fact, the refinancing costs are far from being bad.

So I cannot understand why the headlinescontinue to focus so much on the 10-year yields?? They have been volatile buton average moving sideways for three months. Why is it that the headlines needto focus on that as a sign of impending disaster when things are getting betterin the auctions? Sensationalism!

I wrote in November that place to watch isexactly the Spanish and Italian bond auctions. As long as those two countriescan issue all the bonds they need at reasonable yields, we do not have a realeuro-crisis. We may still have a crisis, but it is not one driven by the euro.

If it were to happen that those twocountries cannot refinance their debts or that the yields they would payincreased to a point where they cannot stabilise their debt/GDP ratio, weshould all head for the hills.

Banks - again

As the pressure is easing on the euro andthe sovereigns, it mounts on the European banks. Presumably, The ECB saw the3-year loans to banks as a way of helping the banks to buy some governmentbonds from Spain/Italy. It has worked. But now it appears that the banks alsowant to use that money to refinance some of their own bond issues. It isanother sign that the region’s banks prefer to solve their lack of Tier 1capital by shrinking their balances.

They prefer to shrink their activitiesinstead of raising new capital. UniCredito’s bungled rights issue is certain toscare other banks from trying the same.

It will only undermine Europe’s growth ifthe current credit shortage continues. At some point in time politicians will haveto understand that the banks do not play along as long as it is not in theinterest of their management and/or their shareholders. With an essentiallyinsolvent bank sector, I cannot understand that European politicians do notbegin to use some muscle. The banks are already dependent on government supportin one form or another. This is the moment to seize and to force fundamentalchanges. The Swedish experience from the ‘90s still beckons as a good example.

The quote “Once You Got Them By The Balls,Their Hearts and Minds Will Follow” is ascribed to Teddy Roosevelt. BarackObama missed his moment in 2009. Europe, anyone?

Euro growth. US Data. New kind of risk. Euro down

2012-01-09T08:37:00.000+01:00

Economic data from the Euro-zone

Rather bad data from the Euro-zone werepublished on Thursday and Friday. Retail sales fell by 0.8 per cent in Novemberand economic (consumer) sentiment fell half a per cent in December whilebusiness sentiment has been picking up. Unemployment rose by 45,000 inNovember. Even if the numbers are the most recent, they are not up to date, andthat is important for understanding them. Inflation continued to fall.

I do not think that those numbers areharbingers of harder times ahead. But they are a confirmation that the Euro-zonestalled sharply in Q4, fully in line with our claim that the maximum downwardpressure is just behind us. We will still see bad numbers in Q1 but they willnot fall as sharply as in Q4 and a stabilisation will be visible around theturn of Q1-Q2.

It means that I am not in line with thosewho only now begin to forecast a European recession. They are too late. Therecession is a fact. The next game in town is to figure out when the recoverywill begin, however anaemic.

While we think of that one, it is worthwhileremembering that the financial markets react to perceived changes in trends andgrowth. For those who still remember their high school math, it is not thefirst derivative (growth rates, inflation) that are interesting, it is thesecond derivative.

Economic data from the US

The US entered the “soft patch” at the endof Q1 2010. In August, when the stock market found out, the economy was aboutto move on. It stabilised in Q4 and is now in recovery. Even that mostunreliable of American indicators, unemployment, is falling (just in time toimprove Obama’s possibilities of being re-elected?). It is in line with ourforecast from August and so far we see no signs of that recovery faltering.

A new kind of risk

What a joy to work in a profession that isso flexible as to invent new terms when the old ones are not any longeradequate. After having complied with European standards when writing theprospectus for out new fund (Origo TotalReturn Fund), I thought I knew every kind of risk relevant to thefinancial markets. But no. Now there is a new one that has established itselfover the past months. It is called “Headline Risk”.

Don’t try to find it on Wikipedia - it is not there (even if Investopedia has an entry). Itsimply covers the situation that occurs when market participants show up in theoffice and a headline carries news about a story that the said marketparticipants did not even know existed. How did we manage before we inventedHeadline Risk?

Euro is falling

Personally I am happy about the “HeadlineRisk” undermining the Euro. I see that some strategists now predict a collapseto the region of 1.25 against dollar. Wow. Let us get that euro weakened so theEuro-zone can regain some of that growth that went to other regions as the Eurostrengthened because the ECB was slower out of the starting blocks than othercentral banks. 1.00 against USD would be a huge advantage for our exports.

Boring. Economists. Hungary.

2012-01-06T12:28:00.000+01:00

Yesterday I found that the US and theEuropean markets were sort of boring. The stories of the impending collapse ofthe world as we know it are not really having a lot of traction and it tends toreduce volatility quite a bit. There was a French 10-year auction which drew“better-than-feared” demand and the 10-year yield only rose a few basispoints. Spanish and Italian bond yields had increased and they fell as theFrench auction did well. All very normal, and whilenot headline stuff, quite important. As long as we do not have hiccups weremain on course for a revaluation of risk assets. Origo’s risk indicatorscontinue to improve.

Geopolitical choking point

Do not underestimate the potential trouble brewing inthe Strait of Hormuz. 40% the world’s oil (traded) supplies pass through thisnarrow straight. The place has for years been recognised as a major “chokepoint” in case of international crisis (the other main choke point is theStrait of Malacca). We are less than one year from the completion of a majorpipeline that would dramatically reduce the importance of the Hormuz, since oiltankers would not any longer need to pass there in order to load up with oil.

So now Iran is trying to use a last chance tothreaten the Western world with closing the Hormuz. The purpose is to blackmailUSA and Europe into lifting a trade embargo on Iran, imposed because of Iran’snuclear ambitions. Major preparations for a confrontation is already on itsway. Iran will likely try to use “swarming”with small, light vessels that will hard to catch by the US Fifth Fleet, basedin Bahrain. Iran may also mine the Strait. The US, on the other hand, isapparently preparing a drone defence. This could accelerate in a very nastyfashion, particularly as both Iran and the USA have serious geopoliticalinterests at stake.

I will not guess how much oil prices couldincrease. But it would be enough to slow down growth here.

Economists and money

The American Economic Association haspublished new ethics guidelines for academic economists. AEA is the associationof research economists in the USA and has hosts of foreign members, too.

Now this venerable institution demandsthat its members disclose their economic interests when writing academicarticles. That is good news, since economists have a tendency to pass off theirpoints of view as science,even when they are highly politically charged. About time, one could say, sincefinancial analysts have had to comply with similar rules for years.

Personally, I am more worried that one ofthe best sites for jokes about economists has been closed. Where will we now goto find wise words like these?:

There are two types of economists:

- those who cannot forecast interestrates, and

- those who do not know that they cannotforecast interest rates.

Hungarian Horntails

Hungary’s conservative government hastaken some major steps in a rather worrying direction. Having won a 2/3majority in parliament, the government has fired the president of the supremecourt and announced a constitutional reform that appears to reduce theprotection of civil liberties. That kind of stuff is usually not the worry ofthe financial markets.

But the Hungarian government also wants toreduce the independence of its central bank by granting the government theright to hire and fire the bank’s councilalmost at will. That has brought the EU Commission and IMF out of their seats.Hungary received emergency loans three years ago and asked for a secondbail-out in November 2011. IMF and the EU Commission appear ready to withholdthe help unless Hungary guarantees the independence of the central bank.

If this situation ends in a stalemate we may well have a Hungariangovernment default. Since Hungary is not in the Euro, it should not affect themarkets. Unless of course, foreign (ie. EU) banks holding Hungarian debt havenot yet made provisions.

Back to Normal. Weaker Euro. Risk Rally

2012-01-04T13:40:00.000+01:00

Back to normality?

It's boring outthere. And it is perhaps the best piece of news in a long time. After reachinga crescendo in early December, the amount of headlines dealing with the eurocrisis is now in a clear decline. I choose to take it as a sign that the ECB'sthree-year money has stabilised both inter-bank market and the demand forgovernment bonds from Italy and Spain.

More bad news iscertainly still possible. As an example, I expect that a major European bank ortwo will go belly up, as no decisive action is yet taken at a European level toclean up the banking sector. But a collapse or two is probably already builtinto the soaring risk premiums in financial sector shares. It is more and moreurgent to get EFSF and ESM up and running.

A weak euro is astrong euro

I have alwayswondered a little about the media fixation on the positives of having a strongcurrency. It smells so badly of Neanderthal nationalist policies (or ofman-talk in the locker room), especially when looking at the headlines inrecent months. As if it was negative to have a weaker euro!

Since thebeginning of the crisis, several countries have profited from a weakening ofthe currency: USD, GBP, NOK, and especially the SEC. These countries all havecentral banks and finance ministries able to act quickly. The Euro-zone'sinstitutions were too slow and the result was that the euro strengthened,together with CHF and JPY. This moved growth from the Euro-zone to thecountries with weaker currencies. So I can only see it as good news if the EUR/ USD were to trade at par. It has been there before, and it was not the end ofthe world. (My colleague Frank Jensen says: “Itwill be no surprise if EUR strengthens in the short term as a result ofshort-covering”. Go figure!)

Back in 1992 wesaw the last major crisis in the European Exchange Rate Mechanism, when GBPfell out of the ERM and we had a wave of devaluations against the Deutschmark.Italy devalued by almost 30 percent. That crisis began with a dramaticweakening of the dollar, and it revealed the tensions in Europe. The currenteuro crisis is similar to the situation at the time - but now we do not havedevaluations as a means to remove those tensions. A weakening of the euro willreduce tensions significantly.

Risk Rally

New Year hasbrought the traditional amount of forecasts for this and that. Obscurity willmercifully descend upon most of them. So let me give my own anti-forecast: Ifwe are moving towards a normalisation of the conditions in Europe, and if riskpremiums have finally stabilised, there will be room for a significant shift inthe relative prices of the different classes of risk assets. Some will risedramatically (shares? Bank shares?), while some will fall with a bang (Bunds,T-bonds?). It could conceivably happen in 2012. There are just 241 things thatneed to be in place first.

Santa is finally coming to town?

2011-12-21T09:37:00.000+01:00

ECB and the stock markets

The story I told on Monday appears to begaining momentum. ECB announced new measures on 7 December and now the stockmarkets have finally picked it up. The combination of unlimited loans from theECB and a “guarantee” from EU on government bonds has caused a stampede intoshort European short-term bonds, including those issued by Spain and Italy.

This is indeed very helpful in coveringthe short term financing needs of the European countries. And it gives thebanks a healthy yield pickup, giving them a stealth, tax-payer financedcontribution towards rebuilding their capital base. Wednesday’s opening of theECB facility will give an important pointer. If the banks take upwards of EUR250bn, it will be deemed a success and the current Santa rally can continue.Downwards of EUR 100bn will be interpreted as a failure.

I have for some time held the convictionthat everything we know about pricing of risk is off the table for the moment.Except of course that bonds with a guarantee should trade at a lower yield thanthose without a “guarantee”. Go figure.

It is interesting that nobody really noticed ECB’s new initiatives when theywere introduced. Instead markets took a great interest in guessing about theimminent Euro-zone breakup.

But heed this warning: If – and it isstill a big IF – this re-evaluation of the risk situation continues to gainmomentum, we are likely to see a major setback in the two kinds of assets thatare the most overvalued or overbought or whatever: US T-bonds and German Bunds.

While gains in the stock market may be funto look at, the sheer volume of the bond holdings of this world means that youshould not take the eye off that ball.

Stocks are for show, but bonds are fordough – as we say on the golf course.

Positive data

Stock markets were helped by positiveeconomic data. German business sentiment data came in strong and a report confirmedthat the US construction sector is improving. Last week a rather dubious labourmarket report also told that the US economy is beginning to add jobs.

That the US economy continues to surpriseto the upside is fully in line with Origo’s view that a rebound was due in Q4.The German data are not entirely in line with our rather gloomy view on theEuropean situation. However, in all fairness, we are beginning to seeindications that the downturn in Europe may be losing momentum.

US Banks

Somebody stole the punch bowl right underthe nose of the US banks, just as a rally in bank stocks was about to take offyesterday. Rumours had it that even the US regulators are serious aboutdemanding higher capital ratios.

Did this really come as a surprise to themarkets?? Did market participants really believe that the influence of thebanking sector on the politicians is so strong that the US banking sector couldavoid completely sensible regulation when the rest of the world is moving thatdirection.

After 25 years in this business I canstill get surprised at the sheer ignorance and credulity of many marketparticipants.

Oil glut. WTF?

Yesterday’sFinancial Times carried astory that began with the words “The boom in North American oil production hastriggered a race to expand the US’s main oil storage centre, raising concernsamong some industry executives of potential glut in capacity”.

Please read it again. It tells that thereis a boom in oil production in North America. A couple of years ago anestimated 8bn barrels were found deep under the Mexican Gulf. Shale oil reserves inColorado and other US states may match the reserves in OPEC. Is this the end ofthe story of the earth running out of oil.

Maybe oil does not come from dead algae, ferns,and dinosaurs. Maybe oil is formed deep in the mantle of the earth and slowlyseeping towards the surface. At least that is a story worth following.

Crisis solved. Didn't you get the memo?

2011-12-19T14:48:00.000+01:00

On 8 December ECB announced a new 3-year financing facility.It is UNLIMITED, and with a suitable weakening of the quality of the collateralfor the loans, it could end up being a major game changer.

The LTRO will make possible a simple idea to recapitaliseEuropean banks: take 3-year loans from the ECB at 1% and place the money insouthern European government bonds. EU has promised that banks no longer haveto take losses if a European government goes bankrupt. Banks have again beengiven a "free lunch".

Apparently I am not alone in being able to see this simpleidea. Spanish and Italian 2-year yields fell like a stone yesterday. Theattached chart could be interpreted as indicating that:

• The market believes that Italy, Spain and Ireland nolonger represent a bankruptcy risk.

• Portugal is on the verge but may hold on to dear life

• The conditions of the Greek debt restructuring is stillnot in place (personally I think that the haircut will end at 80% and not 50%)

ECB begins the new LTRO 3-year loan facility on 21 December. Itwill be very interesting to see how much this credit facility will be used.Rumours in the market say that banks in each country are buying domestic debtin the two-year segment in some volume, a sign that demand could exceed expectations. If that happens, the newfacility is as close to a Euro-QE as we can come without changing the charterof the ECB.

If we now try to put a positive spin on this development soit could read as follows: the ECB has with its new facilities taken big steptowards disarming the liquidity crisis. The EU has with his "paradigmshift" given a guarantee for bonds issued by 16/17th of the euro zone. ESMand EFSF will operate at full volume in about two to three months.

The lower yields at the short end of the curve mean that itbecomes easier for the troubled countries to achieve the goals of a budgetsurplus now that their refunding costs are falling.

Hey presto - euro crisis is solved! Well, maybe we still have asmall growth problem here and there ...

This is of course the ultimate positive interpretation ofthings. However, amid all the end-of-the world headlines, we must also rememberto keep an eye on the positive developments. ECB’s initiative is one of them.

Banks

Before we let ourselves be engulfed by a warm and fuzzyChristmas feeling over the Euro-zone’s step in the right direction, let usremember that the crisis is not completely gone. It will just move to where itwas always going to end. At the banks.

We have heard more than enough lack of ethics andaccountability in certain countries. The next theme will be that the privatesector has contributed dramatically to the increase in debt / GDP in the OECDarea and the banks have been the willing / necessary instrument in this wave offinancial leverage. With Europe’s abysmal growth prospects, the ongoing deleveragingeverywhere will continue to mean losses for banks.

Fast track union changes will not help

2011-11-29T14:42:00.001+01:00

France and Germany are pushing on with fast-track treatychanges, trying to find the loopholes that will allow the Euro-zone to impose German-style budget discipline on the other member countries without beingbogged down by democratic procedure.

Presumably it means that the ECBsubsequently will be allowed to act like a central bank. Or at least one hopes.

I have come tobelieve that Germany still does not get it. The German policy is consistent,but wrong. The method for budget discipline now being pushed is just anüber-version of the tragically mis-named “Growth and Stability Pact” (PSG),Germany’s contribution to the euro from 1997.

Already back then, economists pointed out, that the PSGwould be procyclical. It means that a country typically runs a (bigger) budget deficitin a period of slow or negative growth. The PSG was then intended to impose cut-backs oncountries already having economic problems. It would deepen the problems, hencecausing even bigger cyclical swings on the country in question.

We all know that the PSG was largely ignored – even byGermany, when it found it necessary.

It is correct that budget discipline and a manageablegovernment debt are necessary for long term stability. But it will not work toimpose deflationary policies on the other Euro-zone countries, when growth isdesperately needed to in order to grow out of the deficit situation.

In order to balance the European economy, Germany needs tosupport the weaker Euro members with long term loans to the most needy and byadding to domestic German demand.

I agree with the German vision that it is better to have aneconomy based on producing things people actually need. But structural changescannot be introduced quickly. Greece and Portugal will probably never beefficient producers of reliable hairdryers, much less advanced tool machinesand industrial robots. Such changes take years, and in the meantime economicgrowth will be depressed.

So here is a yardstick by which you can measure the variousideas being touted in the press. It is good news if it brings us closer towardsone of following:

Long-termloans to the countries in problems
Stimulationof demand in the countries that can afford it
Co-ordination of economic policies to stimulate demand
Help tostructural development where needed
ECB toassume the role of a real central bank.

If a new policy idea or international agreement does not bring us closer to any of those elements, itis either bad news or quite simply irrelevant.

Whether this will end in a deep depression (as the OECD warned yesterday) or a long periodof slow growth, nobody knows yet. But if the scale tips towards the depressionoutcome, Germany will suffer more than believed today. Ouch!

2011-11-25T09:02:00.000+01:00

12 reasons for the markets to be paranoid

I cannot really find anything interestingin today's news. So let me instead use some space to summarise my views on whyit is so difficult to operate in today's markets.

I have on earlier occasions expressed thatat no other point in my career have I had to dig that deep in remote corners ofmy memory to find tools that can help me to understand. Yesterday one had todig into the conditions for European government bond auctions (French primarydealers must bid at the OAT auctions, German primary dealers can abstain fromBund auctions if they like).

The day before yesterday one had tounderstand the unique American tradition of planning government expenditureprograms over 10 years - which means that one cannot really count on anything.Last week we had to go over the ECB's charter to understand whether amodification of the charter also requires changes to the Lisbon treaty. And soon.

But we take a deep breath and list thefactors that currently have conspired to ruin our night's sleep:

A secular reversal of a 15-year trendwhere households in many countries have increased their financial leveragesignificantly
A normal cyclical slowdown in the cyclicalupturn that began in 2009
Government austerity programs acrossEurope, beginning in 2010
Additional public sector cut-backs in 2011
A dramatic reassessment of the price ofrisk - and perhaps even a new understanding of risk
Europe's central bank does not have thenecessary authority to conduct a monetary policy that can effectively help usout of the pinch
European banks have opposed arecapitalisation and are now zombies, are forced to reduce their balance sheetsdramatically now (remember Japan!). The U.S. banks are still struggling withthe aftermath of the Sub-Prime crisis
Strong ideological determination inGermany to use the opportunity to shape important aspects of European politicalcooperation after the German model
Southern European countries, which foryears have opposed productivity-enhancing reforms and general budgetarydiscipline
Maximum increase in the number of retirees(born 1945-50) putting pressure on state finances independently of thefinancial markets
Large institutional investors are stillforced to abide by the rating firms' views, even if these views are deeplycompromised
China's growing influence on world economyand the derived effects when even China has "slow" growth

I could probably find a few more. It isnot necessary. There is already plenty.

My biggest problem is not really that thesituation is complex. It is that the vast majority of communications in thefinancial sector has been shortened to a point that it can also be read bypeople with profound attention deficits.

Contagion defined

2011-10-26T00:03:00.000+02:00

While we wait for the all-encompassing, gold-plated solution to EU's institutional problems, one could reflect on the term "contagion”. The concept has been used so often in recent months that we have almost become immune to its possible meaning.

Progressive distrust
I suppose it means that distrust of one kind of assets (Greek government bonds, for example) leads the financial markets to lose confidence in other assets - such as Italian government bonds. In the financial markets it means that the price of the suspected asset drops to reflect the new perceived risk of owning the asset. Completely logical, this.

So "contagion" means that investors reassess risk on assets one by one, and it implies that prices adjust - mostly downward. Contagion is therefore a sign that the markets have begun to think. This should create some concern, since the markets not exactly known for composure when they find out that they have been wrong.

Risk reassessed
Since 1998 it has been Standard Operating Procedure that when something went wrong in the world economy, interest rates were lowered and ample liquidity was supplied to the market. Since Asia during the same period took over the production of industrial goods, this policy did not stoke inflation.

Yields on government bonds fell, and in an attempt to achieve higher returns, institutional investors around the world dramatically increased holdings of low-quality bonds and equities. As a result risk premiums fell dramatically.

A clear example is that the Italian government bond yield was less than 20bp higher than German government bonds back in 2005. A clear sign that the risk was severely underestimated and the risk premiums had fallen too far.

We think and we re-think
The banking crisis in 2008 meant that market participants again are thinking about the correct price of risk. With usual decorum and restraint, the financial markets have entered into a permanent state of catatonic shock.

In other words, the "contagion" translates into a progressive understanding that risk should be reassessed. It seems that politicians everywhere find that such knowledge must be stopped by all means before it goes too far.

A potential victim of risk re-pricing : U.S. overconsumption
Now think what could happen if the markets began to ask critical questions about the World’s largest debtor by far, the US of A.

It would mean sharply higher U.S. bond yields. The burden of debt service would force a reform of public spending and taxation. Consumers would be forced to save instead of borrowing. Businesses would have to rely more on labour instead of cheap capital.

The road to get us there would certainly not be smooth and without obstacles. But "contagion" might ultimately not be the worst outcome.

Risk willingness increases

2011-10-17T10:30:00.000+02:00

Despite the continued uncertainty over what will actually bedone in order to stabilise Greece and the European banks, G20 meeting in theweekend 15/16 October delivered enough details and pointers that the financialmarkets will begin taking the risk premium out of the market. Later on, it could develop into somekind of euphoria that will turn upside down everything that has happened in thepast few months. It started two weeks ago as the first rumours of acomprehensive solution began to circulate and it can continue for a while, atleast.

Bank crisis solution

Our often repeated take on the situation is that at least two crises overlay each other: Greece, and a general debt crisis, which inturn reflects itself in a very unhealthy banking sector. As I have statedearlier, Greece must have a debt restructuring in order to get out of the mess,and that will lead to some serious cash injections to the banks. The US banksalready got their no-strings-attached social help three years ago, and theEuropean banks will probably receive their gift vouchers over the coming sixmonths.

A classic “risk-on” reaction

In concrete talk, “taking the risk premium out” means:

Stockswill gain, possibly lead by the bank stocks, and primarily in Europe.
Bondyields on higher-rated sovereigns will increase, the yield curve will steepen.
Yieldspreads of lower rated sovereigns over higher-rated sovereigns will narrow, insome cases sharply.
Highyield bonds will see the their yield spreads over government bonds narrow butat a slower pace than what happens in the spread between high and low ratedsovereigns.
Dollarwill weaken against the Euro and so will other “safe” currencies.
Commoditycurrencies will increase against the USD.
Commodities(primarily industrial commodities) will rise moderately, and oil will receive aboost.
Gold mayfall further, as the “safe haven effect” vanishes.

It may look like an asset rotation, but we not yet seenmarket volumes corresponding to a major move of capital between asset classes.

A new divergence is building

A bit further out another theme is building. The markets hadnot seen the sharp slowing of the global economy as late as one week before thestock markets fell out of bed in early August. “The End of the World” is still verymuch on everybody’s mind.

At some point the markets will realise that apocalypse isnot now! Nor indeed anytime soon. Therisk-on scenario will then be followed by a proper risk-rally. It will probablylast for some months before the underlying longer-term problems again are takenseriously. The debt crisis has not gone away, and it will continue to subduegrowth for the coming years. It will be uncomfortable (particularly if you workin a bank), but not disastrous.

Inching closer?

2011-10-11T16:38:00.000+02:00

It could very well be that we are in the last weeks before the Greek debt restructuring. At least we hear more and more noise from the Euro-group about the terms of the haircut private sector bond holders will have to take.

On 21 July the Euro-group members presented an agreement whereby the Greek debt would be written down by 21 per cent. It did not take long time to calculate that even with the economic reforms agreed by Greek government at that time, it would not be enough. Greece needs a combination of spending reductions and debt reduction in order to get back from the dead.

With the 21% debt write-off, it would take very optimistic assumptions about future Greek economic growth in order believe that the “primary” surplus (government revenue minus expenditure ex debt service) could be sufficient to cover the servicing of debts to the tune of 170 per cent of GDP.

Several sober estimates have consistently pointed to a haircut between 50% and 70% in order for Greece to get a fresh start. That matches exactly what we now hear from the Euro-zone, namely that “more than 50%” of the debt will have to be written off. It is a great step forward that the truth is finally being tabled.

But, it is not over yet. ECB apparently is against the idea of a Greek haircut of 66%. Instead ECB insists that the 21% “voluntary” haircut must be implemented. One could wonder why, given that a haircut of 50-70% is the only thing that makes sense. Probably it has a lot to do with politics (I will not be so mean as to suggest it could have something to do with the Greek bonds held by ECB itself!).

Let us assume that the banks take the 21% haircut. In that case they would probably need only a minor capital increase, and it would possibly be possible to find that money in the market. Shareholders would be happy and the interbank market would unfreeze rapidly. No wonder the banks endorse this strongly. It would be a carbon copy of the US “money-for-nothing” program, called TARP.

The problem is that in order to arrive at a debt reduction of 66%, EFSF and the Euro-zone countries somehow would have to finance the difference between the bank’s losses and the necessary debt reduction. One could imagine that EFSF simply would underwrite difference or take over the Greek government bonds at artificially inflated prices. This would amount to a de facto gift to Greece and/or the banks.

That would be just about the worst thing that could happen for Chancellor Merkel and the other European leaders. Their electorates could rightly claim that their governments had just rewarded Greece and the banks for their recklessness.

Let us instead assume that the haircut is fixed at 66%. The banks for sure would need capital injections from their governments. In that case the governments will be able to present the expenses as a help to domestic banks and not as a rescue of the reckless Greek. The governments would for an extended period of time take control of the banks. That would be far more palatable for the electorate.

Either way, Europe’s governments will end up having to foot the bill. The difference is in the resulting relationship to the banks and the electorate. It is easy to see why politicians prefer the larger haircut. It is equally easy to see why the banks prefer the 21% haircut.

Could the markets have got it wrong?

2011-09-27T00:17:00.000+02:00

It is a dangerous game to say that the markets are wrong. As JM Keynes noted: The market can stay irrational longer than you can stay solvent.

Nevertheless, there are some elements of the developments in the last week that are worth a comment.

We have heard US Secretary of the Treasury Geithner tell us that Europe is acting too slowly and that we have to act in order to avoid a disaster. We have read tons of analyses of the Eurozone debt problem, built on dubious assumptions. And we have seen economists who 3 short months ago trumpeted a return to strong growth re-brand themselves as doomsday prophets.

The underlying economic situation is serious, but not because of the issues that are now driving the crescendo. The Western World has over the past years built a mountain of debt which is clearly unsustainable. The main culprits are the private households who in line with falling interest rates have leveraged themselves harder and harder, mainly in the property market.

Public sectors have “taken over” some of the debt during the first phase of the Great Contraction in 2009 and 2010. Countries with a weak budget discipline have been pushed in the direction of something quite unsustainable. This affects primarily the US and in second line, the UK.

The historically high Debt/GDP ratio will slowly be reduced in the coming decade. As the banks are the pivot in the debt explosion – no banks, no loans – a deleveraging will automatic lead to a shrinking of the banks’ balances. This process is progressing, but is slipping under the radar of the financial markets.

Instead, the markets are busy with something as relatively unimportant as Greece. Government after government has been lying about the real economic situation, and Greece now faces a default. It appears that the Eurozone is about to arrive at a solution that will allow an orderly default, assuming a 50-66% haircut.

This would imply a loss for (European) banks up to €130bn. A large amount, but not impossible to handle. The data released in relation to the European “stress” test showed that a default of this magnitude is possible to control.

Then we have Portugal and Ireland, which at this moment in time do not finance themselves in the open markets. They work to reduce their government deficits. Ireland has progressed nicely and is ready to try a fresh bond issue some time in 2012. There are no reason to expect that these two countries should default on their loans.

Spain is frequently mentioned, even if the country has a relatively low government debt, and a government deficit lower than those of the USA and the UK.

Italy has a government debt of some 120% of GDP, the same as 10 years ago. Reforms have been introduced that will reduce the government deficit to acceptable levels over the coming two years. There will be a significant surplus on the primary budget balance, ie. before interest payments on the existing debt.

There is hardly any reason to believe that Spain or Italy should default on their debt. However, the panic in the financial markets has reached levels that probably requires that EU provides sufficient credit facilities that both countries for a while could cover their financing needs without tapping the markets. This is not a situation based on facts, but on panic.

Then there is the interbank market. The diffuse fears of losses in the European banks have led to a freeze in the interbank market. Central banks have reacted correctly and provide liquidity in order to avoid a replay of the Lehman collapse. A further deterioration of the situation will not come from this source.

All in all it is a complicated situation where several stories are playing out on different levels. Stock and commodities markets have reacted with a huge increase in risk averseness. A quite understandable reaction, but not particularly logical, given the facts.

But what will happen once Greece has defaulted and the European credit facilities have been increased X-fold?

Then we can return to the really ugly story, namely that OECD needs to bring the debt situation under control. As I have written before, this will imply an extended period of sub-par growth and shrinking bank balances. This problem is not isolated to Europe.

The good news is that even in such a situation, it will be possible to have well functioning markets. The bank sector, however, will see no solution to its problems with the capital base as well as with bad loans.

Fed Almighty? Erh, no...

2011-09-22T11:20:00.000+02:00

Interestingly enough, at yesterday’s meeting, US Federal Reserve at the same time declared that significant risks threaten the economic situation AND decided not to introduce a new programme for monetising the Federal deficit. If things are bad, then why not try to do something about it?

The only logical explanation is that Fed does not find that there is a lot that a further QE-programme could really do about the economic situation in the short term. We are still in a Keynesian liquidity trap, where zero interest rates have no effect on the demand for credit, and hence does not contribute to increase the economic activity. Fed Chairman Bernanke was clear about such issues at the Jackson Hole conference in late August: “economic policies that support robust economic growth in the long run are outside the province of the central bank”.

Instead he, and with him a number of other high profiled officials have lately been very clear that cleaning up the mess is a responsibility of the elected governments. IMF Chief Lagarde, World Bank Chief Zoellick, and several other central bankers from across the globe have issued statements that closely match Bernanke’s explanation at the same meeting:

“To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies (...) Although the issue of fiscal sustainability must urgently be addressed, fiscal policymakers should not, as a consequence, disregard the fragility of the current economic recovery. Fortunately, the two goals of achieving fiscal sustainability--which is the result of responsible policies set in place for the longer term--and avoiding the creation of fiscal headwinds for the current recovery are not incompatible. Acting now to put in place a credible plan for reducing future deficits over the longer term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives”.

And there is more: “Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions”.

There you have it: Fed does not feel that it can do an awful lot more. It is up to US lawmakers to pull up their socks and act in order to bring the economy back on an even keel.

However, the European sovereign crisis, the increase in the price of credit risk and the fear of having government debt downgraded have led to a resurgence in fiscal conservatism at the wrong moment. Simple recklessness on the part of US Republican lawmakers does not make it better. Just a few months ago, governments in the entire OECD area seemed bent on making things worse by introducing austerity programs. Since then, the sharp deceleration in economic growth and renewed market turmoil has led policy makers to ease the foot away from the brake, sort of.

It is perhaps symptomatic that the markets have lost confidence in politicians to a degree that central bankers’ statements are studied more closely than anything else. But Fed’s lack of action clearly indicates that there is not an awful lot more central bankers can do.

What next, then? With politicians constantly on the verge of committing major policy errors and central banks with only little dry powder left, what will create the growth the world so badly needs? It has been said before and I repeat: A period of sub-par growth while fiscal balances are redressed.

A word of reason

2011-09-13T09:45:00.000+02:00

Beginning in 2008, I have several times pointed out that banks would come out of this recession downsized and with dramatically lower profitability than has been the case in the past two decades.

For a while it appeared that panic-stricken politicians had given banks yet another opportunity to consolidate and get even bigger – and even more unlikely to be allowed to fail.

Now, it appears that the UK is leading the way in how to get out of the mess. The Independent Banking Commission delivered its proposal for a bank reform yesterday, and it makes a lot of sense.

Instead of breaking up the banks, the Commission suggests to consider banks as two different businesses.

One, the sexy one, is investment banking, securities trading, and all that. The other is the boring part of banking: savings, lending, payments services. We could call it a utility.

The utility part of banking is the services that are absolutely indispensable to a society, and the banking commission suggests that this part of the banking sector is “ring fenced” by higher capital requirements and in essence kept separate from the investment banking activities.

That would turn the utility banking into a dull, but safe economic activity. It would prevent the banks from using the capital base from utility banking for funding of investment banking activities. It makes a lot of sense – and it harks back to the US Glass-Steagall act from the ‘30s, which even legally separated the two kinds of activities. The introduction of that act marked the beginning of the longest period of the US without banking failures.

The recommendations from the UK banking commission make an awful lot of sense. It recognises that the society needs banks, but not all activities currently categorised as banking. It makes it clear that the profitability of the utility banking will be (much) lower – just like that of water supplies, telephone services, electricity etc. It makes it clear that the banking industry finally will have to pay the price for two decades of foolish greed.

For a second – in 2009 – I had started to have my doubts as bonuses in the banking sector again took off into the stratosphere.

Predictably, the UK banking sector is already lobbying heavily to avoid the “disaster”. But I am afraid that the lobbying will not work any longer. One of the members of the Commission, Martin Wolf, Economics editor of Financial Times is quoted for saying: If you live in a world in which the real rate of interest on safe government bonds, bonds that the world regards as safe, is about half a percent or less, you might wonder whether you can reasonably expect a reasonably safe return of 15 percent on equity in a bank.

An equally simple word of reason from a man who cannot in any way be accused of left-leaning tendencies, UK Chancellor George Osborne: We should not confuse the interest of bank shareholders with those of British taxpayers.

So right. In America, Jamie Dimon, CEO of JP Morgan Chase, made a rant against the proposed Basel III capital requirements, qualifying them as “anti-American”. His concern is that the Basel rules will force the banks towards deleveraging and lower profitability. Obviously, US banking lobbyists are not as successful in Basel as they are in Washington DC, so Dimon suggests that the USA withdraws from Basel-based BIS altogether to avoid such disasters.

In Europe, the banks are in no position to tell the politicians what to do. With an impending bankruptcy in Greece and still carrying huge losses forward, many European banks are or will be de facto insolvent. They will depend on government support going forward. It might be that the Eurozone governments let themselves be inspired by the UK thinking.

Utility banking may be the right solution, as well as a healthy way of thinking. Contrary to what the banks have tried to make us believe, it will not be the end of the world as we see it if the banks are forced to downsize. Unfortunately, the banking lobby is still strong enough that it can persuade politicians to wait and postpone, which only delays the necessary.

Will it ever get better?

2011-09-02T17:26:00.000+02:00

So the economic slowdown is upon us. Everybody is busy revising estimates for economic growth and company earnings downwards. And the talk of the town is: will we end in a recession? That question is probably misleading. There is not a huge difference between a growth rate of 0.1% and one of -0.1%. Neither will feel good and neither will generate jobs or an investment boom.

The financial markets have (finally) adjusted. As far back as in mid-July, the stock markets were still humming along, convinced that company earnings could only continue to grow linearly. Bond markets were as usual negative and yields had reached new low levels that were only compatible with – recession. Corporate bonds were firmly in the camp of the stock markets.

Now, six weeks later, the bond market again proved right. Stocks and corporate bonds have fallen off a cliff, and nobody can apparently find any good news that will turn the market mood around. It will probably take some weeks before this can happen, and weeks are an eternity in market time.

It is my conviction that markets react stronger to surprises than to anything else. Most market participants feel good about being part of the great big market consensus, and it is only when this consensus is disturbed that something has to change.

Forecasts are coming down, and in all experience it will mean that we will soon have a situation where market consensus undershoots the economic development. My guess is that by mid-September this process will have run its course. The markets will by then be ready to be taken by positive surprises.

In the current gloomy mood, nobody can see what would create growth. However, there are several elements that could turn positive. First, we have negative real interest rates. Former chairman of the US Council of Economic Advisors, Christina Romer, in academic works showed how low interest rates eventually end up by supporting the housing market. Negative real interest rates also push capital out of cash and short-term bonds, lowering the price of capital for companies. Consumers who have postponed purchases of cars and other durable goods will have a pent-up demand. Similarly, companies will have a greater need for investment after a long period of no investments. Inventories will have been brought down or written off.

And finally, austerity measures will be if not postponed, then at least delayed. Reality is finally about to win over ideological arguments that deficits will have to be cut dramatically here and now. It is slowly becoming clear that austerity will hamper growth.

So if – and that is still a BIG if – nothing goes wrong in the European banking sector, we are setting the scene for the stock markets to be positively surprised, even if economic growth will remain weak for a while.

At Origo, our work with market risk indicators has led us to precisely track the gap between economic downturn and unfounded optimism in the stock markets. We will report back here when the opposite scenario begins to unfold.

Ben did not deliver, but Wolfgang did

2011-08-28T17:25:00.000+02:00

US Fed Chief Ben Bernanke’s speech at the annual meeting of central bankers in Jackson Hole ended up by being an anticlimax. Before the speech we were told that the markets would collapse if he did not announce a large-scale bond purchase program. He did not, but he did repeat that in case the (US) economic situation did deteriorate, Federal Reserve will do something. So at the end of the day, the stock markets chose to interpret the lack of announcement as a positive statement that the economy is not that bad, after all. Confused? You are not alone. But you have just witnessed one of those episodes that demonstrate why central bankers rarely speak plainly.

At a much lower-profile economic conference at the St Gallen university in Switzerland, Germany’s Finance Minister Schäuble made some statements that were far clearer. He bluntly stated that the global programs of fiscal consolidation create a risk that the global economy faces a period of seven lean years in terms of economic growth. He also said that structural economic reform is necessary in four EU member countries and that governments should take a greater responsibility in fighting the global economic crisis.

Note that Schäuble is a politician who is not facing an election anytime soon, he is not trying to become Germany’s next Chancellor, and he has a reputation for speaking his mind – he did after all state that the previous US Quantitative Easing Programme was “clueless” and that it was a proof of how the US did not know how to solve its crisis.

Readers of this blog will not be surprised that I share Schäuble’s point of view. It is just rare to hear it stated so clearly from a senior politician in one of the large global economies. I believe that there is a risk of a period of slow growth because of the ongoing unwinding of the debt global debt bubble.

Quietly, consumers in many OECD countries have increased their savings rate significantly. It means that traditional measures to stimulate demand – lower taxes – will not work as it will only increase the savings. In itself it is enough to warrant a period of slow growth. Now this is being compounded by fiscal austerity measures that will only extend the period of slow growth further.

At the beginning of 2009, I used the same biblical metaphor of the seven lean years. That is soon three years ago. With another four years to go, I still may be right. That economic growth will be back on track by 2016 instead 2018 as implied by Schäuble.

However, there are still some structural problems where I do not see any signs of improvement. They may still derail any well-meant attempt at letting short-term pain be a mean to achieve long-term gains.

I am talking about the fact that there are countries, where the access to consumer loan finance is easy and considered almost a human right, and the biggest of them is the US. In Europe, UK is the main representative of this attitude. It could happen that there is a political backlash waiting from consumers (voters), who get fed up with having to save.

There is no political gain to be had for anybody to try and fix this by introducing legislation or regulation that puts a limit on the access to loans. No, I do not mean quantitative restrictions, but something as simple as requesting that consumers are able to make a reasonable down payment on house or car before financing the rest. Banks should be forced to make a minimum verification of borrower’s credit worthiness before extending a loan. And so on.

I know, it is not very likely. Politicians have a tendency to think in terms of elections, and that is bad news for structural reform. But then we can hope for something else – the continuation of the current trend towards forcing the banks to have a far more significant capital base. It will cut the banking sector down to size, it will reduce the profitability of the sector, it will reduce its political influence. And at the end of the day, this deleveraging will contribute to extending the period of below-trend growth. Meaning that Schäuble may end up being right that 2018 is a likely time for return to trend growth.

There are many aspects of the cleaning up after a debt bubble that burst. Schäuble did not touch upon them all. But at least he has the political courage to speak up.

Look out for more surprises

2011-08-22T15:02:00.000+02:00

In March I argued in a blog post that the stock markets were setting themselves up for a fall. I used the opportunity to explain how to use the Economic Surprise Indicators as some kind of composite indicator that has at least some value in predicting the future market mood.

An Economic Surprise Indicator measures if data releases are on average better than, in line with, or worse than consensus estimates. The indicator reached a peak in March this year and has been falling in a straight line ever since. This is pretty much in line with my explanations of 5 months ago, and certainly, the markets have heeded the call:

“Markets do not really react to good or bad news. Markets react to surprisingly good or bad news. Markets react to change rather than predictability.

Despite decades of economic research on the formation of economic expectations, most economists and stock market analysts display “adaptive expectations”: if they are surprised positively, they revise forecast upwards. If they are surprised negatively, they revise downwards.

So now that we have all been surprised positively for some months, you can be absolutely sure that forecasts are now being adjusted upwards. At some point in time they will have caught up with reality. From that point on, we will begin to have negative surprises. A new revision cycle will begin and the market mood will again turn.”

The question is where we are now, 5-6 months later? The Economic Surprise Indicator nosedived as the economy began to slow. Somewhat belated, stock markets found out on 1 August and we have had quite some market mayhem since then.

Economists and Analysts are beavering away on their forecasts of economic growth and company earnings. We are seeing a wave of downgrades. The term “Recession” is back in fashion. At the same time the Economic Surprise Indicator has stabilised at a very low level, indicating that economic surprises are still negative.

The indicator is not the answer to everything. But once the wave of forecast downgrades are over – and believe me, the downgrades will be aggressive – the market will suddenly begin to receive positive surprises. The most likely result is that the current negative sentiment will change. Market participants will convince themselves that it is not quite as bad as they thought. The “hidden factor” in the equation is to understand that the underlying consensus estimates are moving as a result of positive or negative surprises.

The important thing here is that in order to stabilise the market sentiment, it does not matter that we are looking at 5 years of below trend growth. It matters that the market somehow adopts it as a consensus. At that point in time, risk willingness will increase again.

When it will happen? I don’t know for sure. But it is typical that a cycle from exuberance to despair and stabilisation takes some six months. So sometime in September, maybe. Or it could be that downgrades are dramatic enough to stabilise sentiment earlier.

It is tough to be a stock market dealer

2011-08-16T23:19:00.000+02:00

Among bond dealers, it is a well-known fact that the stock markets cannot concentrate on more than one thing at a time. So it must be tough to be a stock dealer or advisor these days. There are so many things to worry about.

Maybe one should not be too tough on the market participants when they are being interviewed for TV or press. With a significant slowdown looming, downgrades falling hard and fast and something wrong in the Euro-zone, it really is possible to be quite confused.

Stock markets tell us that the S&P downgrade of the US Treasuries ushered in a period of grave turmoil in the stock markets and that further debt trouble in Europe makes it worse. One more downgrade would bring more chaos. So how come that those incompetent politicians are just sitting on their hands instead of doing something??

Please! Let us try and go as far back as to 1 August. Europe had just announced a clever Greek restructuring plan that avoided what everybody feared, a default event. Italy had approved a significant program to cut its government deficit. In the US, the debt ceiling had just been lifted after weeks of undignified brinkmanship. That should be what every stock market would need to create a solid rally.

In the event, the opposite happened. The bond markets had already given clear indications months in advance: Economic growth had shifted down a gear or two. Suddenly the stock markets began to fall on fears of a recession that would for sure hit company earnings. Pure logic, except one could speculate why the stock markets’ Wile E Coyote moment had lasted that long.

And then S&P announced its downgrade. Since that moment stock markets have traded sideways under high volatility. Bond yields have fallen as more evidence of the economic slowdown came in. In other words, there has been NO effect of the S&P downgrade.

But since the economic slowdown was now sort of old news, the stock markets had to find something to rationalise the palpable fear. Maybe France will lose her AAA-rating (quickly denied in unison by the tree big ratings agencies)? Maybe Italy will collapse (with a government debt at the same level as 8 years ago)? Maybe Spain may not be able to cut it (with a budget deficit and a government debt lower than that of the USA)? The Euro, then? Will it collapse (it has traded in a narrow range over the past weeks)?

Everywhere we look, things look pretty much the same as they did 4 months ago. Some uncertainties have been removed (the Greek restructuring) and some new uncertainties have appeared (the slower growth worldwide). For investors with a longer memory than 2 market days, it is obvious that the moment where the stock market discovered the slower growth, something was bound to happen.

It is particularly interesting to hear market participants now quickly turning into experts on German domestic politics. They are now looking for shards of evidence that Chancellor Merkel may throw overboard well-established (and healthy) policy principles in order to calm the nerves of stock market participants who have already forgotten everything that has happened over the past month.

I am not trying to say that everything is OK. Even if I disagree with the sometimes brutal austerity programmes and believe they will cost economic growth in the future, a lot of things are being done in Europe to fix the situation.

Unfortunately, structural problems in the Eurozone cannot be fixed within a 24-hour news cycle. Germany will eventually cave in to Eurozone bonds. But only after a revision of the EU Treaty that gives real teeth to a European fiscal authority and only after several countries have had the time to amend their constitutions in order to implement the new treaty in local legislation. That will not happen anytime soon.

We will hear more nonsense from the stock markets. The best antidote is to try and keep the focus on what is the real driver of events: it’s the economy, stupid.

Why Germany will not accept Eurozone bonds

2011-08-15T15:22:00.000+02:00

There is a lot of guesswork going on in the financial press about Germany’s apparent refusal to condone the issue of Eurozone bonds. Such bonds are bonds, issued by a relevant institution of the EU, underwritten by every member state, and the proceeds of the sale of such bonds could then go to member countries that have problems borrowing money in the financial markets.

Financial journalists have a tendency to dismiss politicians as bumbling idiots because they do not do everything the markets demand. In this case, we hear that the market wants bonds issued with complete, gold-plated German guarantees. Germany is not likely to accept that.

It is not because European politicians are incompetent. It is because the “battle to save the Euro” is played out on many levels. The upper level is where the panic has been: Something was needed to “rescue” Greece.

At a deeper level, it is about sovereignty. And about moral hazard – again. A look at history gives some important clues

Since Germany accepted the principle of a monetary union in connection with the German reunification, nothing has been more constant than the German unwillingness to underwrite moral hazard. Early on, Germany had spotted that the Monetary Union would give countries such as Italy the possibility of profiting from lower interest rates while maintaining the right to flood the market with government bonds denominated in EUR. As a result, Germany pressed hard to have a “stability pact” that would put at least some limitations on the more irresponsible governments in the Euro-zone.

As we all know now, nobody took the Stability Pact seriously, and it was never enforced. Germany’s nightmare came true.

The Stability Pact was only a second best. Germany, already familiar with a federal structure, would have preferred a Euro-zone fiscal authority. In the ‘90s this was unthinkable, as the governments jealously guarded their prerogative to collect taxes and decide government spending. It is after all one of the key elements in politicking.

Now, almost two decades later, Germany’s attitude is fundamentally the same. Germany will not underwrite Eurozone government bonds unless moral hazard is taken off the table. Germany will not bail out government after government because they have behave recklessly with their own public finances.

Under the impression of the market turmoil several countries are increasingly understanding that it is impossible to have a monetary union without adequate institutions. As a result, ECB has been permitted to expand its activities way beyond what its charted allows it to do. Some governments are ready to consider some kind of federalism in fiscal matters.

France resists any such idea. President Sarkozy has repeated what every president before him has stated. The prerogative to decide on taxes and spending lies with the French government.

In my view, France is playing with high stakes here. The French economy has not been “liberated” from the government influence and is increasingly lagging behind the German export locomotive. Nevertheless, France insists on being treated on a par with Germany. In Berlin this is accepted because membership of the Eurozone is a geopolitical imperative, and a Eurozone without France AND Germany is irrelevant. So France is playing on Germany being willing to go further in saving the Eurozone than has already been the case.

I would not bet on that happening. After all, the basic tenet of German policy towards the economic policy in the Eurozone has remained unchanged for a very long time. It makes complete sense that one country should not write blank cheques to everybody else. The financial markets may rail against German inflexibility as much as they like.

But there is no reason to expect that Germany should listen. Money talks. It is Germany holding the purse strings, and that gives a guarantee that Europe will listen.

In case anybody wants to have a short summary of Germany’s position, Finance Minister Schäuble laid it out clearly last year in Financial Times. It is worthwhile reading again.

Thrift's Paradox or how economics can be made simple

2011-08-11T14:53:00.000+02:00

We are all slaves to dead economists, the (late) British economist JM Keynes famously stated. A lot of politicians on both sides of the Atlantic have committed mistakes that indicate that they could need a hefty dose of pre-Keynes thinking. I am talking of the Thrift’s Paradox, first formulated by Mandeville in 1714. Put briefly, it states that if we all save to become richer, we all end up poorer.

It is a brief statement, and to most people without understanding of economics, it seems like simple nonsense. If something works for me (saving to improve my financial situation) it must also work for the government.

It sounds obvious. But it does not make it any more correct. If I save, it means that somebody else’s business will suffer a lack of demand. And if a lot of consumers decide to hold back on consumption, it will mean that a lot of demand disappears. In the end it is felt all the way down to the producers and they will respond by reducing output and laying off staff.

This simple mechanism is one of the most misunderstood issues in economics. It is also one of the most misused. It is easy to make political soundbites by comparing the public sector to a household. It is difficult to catch voters’ attention while trying to explain why it is wrong.

In the current situation, households on both sides of the Atlantic are saving in order to improve their balance sheets. That leads to lower demand. It would only be normal if the government sectors would do the opposite, spend in excess of the revenue, in order to keep the economy going during the transition. The public sectors can then – later – concentrate on improving its balance sheet. Usually, the governments are then also helped by a sprinkling of inflation reducing the real value of the debt.

Because of the suddenness and the depth of the economic setback in 2008/2009, many governments are running sizeable deficits – induced by lower tax revenue and increased spending related to unemployment. Since late 2010 significant efforts have been made to reduce government deficits. That austerity hits us now.

In the US, a weak president has left the field open to voodoo economics espoused by an uncompromising Tea Party. In Europe, the strongest economy, Germany, is also the one least inclined to add stimulus. And Germany will not “save Europe” until Europe’s institutions have been reformed – which is being blocked by France.

Central banks are the only ones left holding the rope. They do not have an awful lot of rope to give. Economic growth estimates will be adjusted downwards in the near future. A period of slow growth seemingly lies ahead. A lot of it caused by a wrong policy reaction, caused by the wrong political philosophy at the wrong time.

For once I will quote from the Economist's Free Exchange Blog. (Article from 28 July 2011). It reads:

“The challenges facing Europe and America are big, but they're not mysterious. In Europe, the issues are sovereign debt, vulnerable banks, and a poorly designed currency area. It's not tricky to see what must be done. Peripheral debts should be addressed through austerity, sure. But unsustainable debt loads need to be written down. Banks should be recapitalised to prevent trouble in financial markets. Emergency funds should be bolstered to fight sovereign and banking contagion. And substantial fiscal integration must take place, including fiscal transfers to support peripheral economies while they get their budgets in order. The central bank should also stop fighting the phantom of accelerating inflation.(...) “Again, it's not like the correct policy path is incredibly complicated. Here, I'll sum it up in three quick steps:

Don't cause a major crisis.
Do spend more and tax less for the next year or so.
Do spend less and tax more after that.”

Wonder how far stock markets will have to fall and unemployment will have to increase before politicians get it. If they don’t, well...

It's the debt, stupid

2011-08-09T09:01:00.000+02:00

Stock markets are plunging on an unappealing cocktail of worries about economic growth, the handling of sovereign debt problems, the apparent inability of politicians to bail out the markets when the markets really want it, and a handful of other assorted ailments.

Given that analysts now realise that growth in 2H of 2011 is going to be slower, they are working overtime to adjust earnings estimates. Those estimates will invariably be lower than the pie-in-the-sky estimates of just two weeks ago, and the assumed valuations of the stock markets may take a serious blow.

How come that the adjustment to slower growth has come so quickly? At my company, Origo, we have warned about the “soft patch” ahead since late March, when early indicators showed that the US economy was in for a slowdown. European indicators have been unequivocal since April. That was also the month when commodities took notice.

On the other hand, bond markets have been right on the ball this time. Bond yields of high quality sovereign debt have fallen in the past months, giving another clear indication that something was afoot.

However, indicators of (stock) market euphoria have shown the increasing divergence between the optimism in the stock markets and the increasingly gloomy economic background. The speed of adjustment indicates what has been obvious for some time: stock markets have been living in their own little bubble for a while, and that bubble has now burst.

Summing up all these indicators, we arrive at a picture of the best announced stock market correction for a decade. The stock markets have yet again failed to predict important economic trends. Now they are rapidly adjusting and “Double-dip Recession” is now a favourite buzzword.

Which brings me to my point. For those who believe that the decline in the stock market reliably predicts a new recession, remember the famous dictum of the late economist Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

I do not think we are heading into a global recession, i.e. a new period of negative growth. But I do believe that we are heading into a period of growth below trend. Remember that this economic crisis is not your standard run-of-the-mill recession. We are cleaning up after a major debt-fuelled party. It means that households, particularly in the US and the UK have to redress their balance sheets. It takes time to bring down debt, and in that period consumption has to be lower. Obviously it also hurts the banks that have financed the party.

It would not have taken more than a few years if the public sectors were in a position to let their balance sheets deteriorate for a period. That has historically been the role of the public sector in smoothing out economic cycles. But many countries were not in that position when the downturn started in 2008. Public sector finances in USA, UK, and some smaller European countries were hit full force.

At the same time the countries that could have afforded to expand their balance sheets were gripped by fiscal conservatism. The results have not been encouraging. We now have a situation where both private and public sectors are working to consolidate their balance sheets. That leaves the monetary policy to do the job of getting the economy moving.

It can’t. Monetary policy can only create the conditions for growth, and central banks have certainly done so. But when the consumers and business leaders are more focused on reducing debt than increasing loans, adaptive monetary policy won’t work. In such a liquidity trap, the money created by central banks in all likelihood fuels speculation in financial assets instead.

Oh, and in the longer term, it may be inflationary. Some voices are already afraid of an impending hyperinflation. In the big picture, however, such fears are pushed aside as asset reflation is supposed to make consumers feel better and hence more prone to consumption.

Central banks can reliably be counted upon to support the stock market this time around, too. It does not change the fact that we probably are heading into that period of below-par growth that may last for quite a while. It may not be a recession, but growth will be slow enough that it feels like one. I don’t know who came up with the expression “the new normal”. But I do think that it is what we are looking at now.

Will China speed up a floating of the CNY?

2011-08-08T01:20:00.000+02:00

It is interesting to observe China’s government join the chorus in demanding that the US government clean house and get back to a situation where economic policy is based on facts rather than woodoo and political blackmailing.

I could not agree more, but it is fascinating to hear China indicate that unless something happens, the country will have to reconsider its position as the world’s largest holder of US treasury bonds. Either it is complete nonsense, or else the Chinese authorities are telling us something. The timing is impeccable.

With everybody being busy panicking it is a good time to make important political statements that will not be seized upon by protectionist US politicians.

To repeat the obvious: as long as the Chinese current account is in surplus AND as long as the Chinese government opts for a (very) slow appreciation of the CNY against USD, China has no choice. The Central Bank is forced to purchase USD denominated assets in order to avoid an appreciation of the CNY. As long as the currency peg is maintained, Chinese worries about the value of the dollar are just theatrics.

China has no effective mechanism for absorbing the boost to domestic liquidity that comes when Chinese exporters exchange their dollars for CNY. This huge boost to the domestic liquidity is easily the most difficult issue for Chinese policy makers to control as it drives domestic inflation upwards. It forces the central bank to increase interest rates, when in fact the correct thing to do would be to sell CNY-denominated government bonds to the public.

As long as China does not change her currency policy, the harsh words about the US government and the need to replace to dollar with another reserve currency are simply noise, aimed at positioning China favourably towards their own constituency, a large number of developing countries. But the words will not be followed by actions.

However, something else may be brewing. In a series of articles, Yu Yongding, currently President of the China Society of World Economics, and a former member of the monetary policy committee of the Peoples' Bank of China as well as Director of the Chinese Academy of Sciences Institute of World Economics and Politics has indicated that the Chinese government is ready to move a bit faster towards letting the CNY free itself from the peg to the USD.

There is no doubt that the Chinese leadership finds itself in a dilemma. The USD peg has been instrumental in building up Chinese exports and has created a huge flow of investments into China. But now that policy creates other, insidious domestic problems. Yu Yongding’s articles indicate that a serious discussion is going on inside the corridors of power in China.

Yu Yongding is adamant that a currency reform must happen on “market terms”. Translated to plain talk it means: We will not do it if it can be seen as a result of American pressure.

While this kind of exegesis may seem irrelevant as the stock markets are taking a pounding, it is worth noticing that the symbiosis between US deficits, Chinese surplus and a CNY-USD peg has allowed us all to have lower interest rates than we have really needed. It has been one of the important elements in creating the debt-fuelled boom that burst in 2008 (of course, bad regulation and plain greed were other important drivers).

So if China is now signalling a further, more significant step away from the need to buy USD treasury bonds, the world better sit up and listen. The impact would be far bigger than further downgrades of US debt. The ensuing increase in bond yields would be sufficient to actually force the savings balance of the USA towards an improvement. Not a bad idea. But it would help to keep US growth below trend growth for a decade or so. And the rest of us certainly would not like that.

S&P downgrades the US and their own importance

2011-08-07T15:48:00.000+02:00

So Standard and Poor’s has stripped the USA of the AAA rating for its federal debt. A lot of media attention is paid to this fact and legions of experts are being asked by serious-looking news presenters: Is this really the end of the world?

Fortunately it is not.

My initial reaction was that if Standard and Poor’s put the same good analysis into the US government debt as they put into the analysis of Sub-Prime Mortgages, we are probably fine. Readers are reminded that Standard and Poor’s together with Moody’s and Fitch were caught pants down having essentially eschewed even a minimal research effort in order to maximise revenue when CDO’s were all the rage at 5 years ago.

Since then, the three US government chartered ratings institutions have done quite some work to re-establish their tarnished image and - one presumes – their revenue. They have not really succeeded.

It is a fact that the ratings institutions are home to a series of conflicts of interest that would have clients run away screaming. Their business model is that they are paid by the issuers of the bonds to be rated. They cannot be sued for damages in case they are mistaken, since they simply get away with invoking the First Amendment to the US Constitution: Their expensive analyses are simply expressions of the right to free speech. They have a government-approved monopoly on the rating of nearly anything. Like auditing companies it is considered suspicious if an issuer terminates the contract with them. They do not shy away from rating a whole “production chain” of derivative products, including the insurance companies.

Despite an appalling track record, these institutions still hold considerable power. It is because pension funds and other institutional investors across the globe have given themselves internal guidelines that essentially dictate the portfolio composition on the basis of the ratings of the bonds.

Doing so of course frees the institutions of the responsibility for having an informed opinion about the assets they hold. That reduces the cost of running an investment department considerably.

It is not because of the quality of their analysis that ratings matter. They matter because they have become a convenient replacement for independent thinking. And because of the way huge amounts of money may move as a result.

The US government and congress of course now protest: S&P are wrong. So did the Greek government and parliament as the ratings downgrades fell thick and fast over Greece the past 15 months. They know very well that money may move out of their assets as a result, pushing up interest rates in the process.

Fortunately there are signs that the financial markets have learnt to take the ratings with a pinch of salt. After some noise, investors probably will conclude that there are no compelling reasons to reshape portfolios on the basis of the downgrade alone.

The only alternative is of course to modernise the ratings institutions. They should be made liable for their own mistakes (well, not exactly in fashion in the financial sector these days). More ratings agencies should be established. Government licensing should be withdrawn and new entrants should be given easier access. Government or supranational institutions should get involved. That would be the only way of putting an end to the political meddling and abuse of monopoly powers so blatantly displayed by the ratings institutions.

Greece vs. Lehman? Look for the next AIG instead

2011-06-22T10:00:00.001+02:00

Much of the discussion about how to restructure Greece’s debt has focused on the banks and other institutions that will take a hit when the unavoidable happens. It is in fact pretty simple. As a sovereign issuer, Greece of course knows precisely how much debt is outstanding. Regulators in other countries have a pretty good idea who own the debt, since they can force the banks to disclose their holdings. So when politicians are negotiating, they know who will lose. It is just not good style to tell.

The fact that 100’s of banks would take a hit has led to comparisons with Lehman. That is a wrong comparison. When Lehman blew up as a direct result of their own incompetence, the real surprise was that AIG blew up as well. The culprits were of course CDS’s.

Buyers of CDS’s buy insurance against a credit default – lyrically referred to as “protection”. One does not need to have given credit, i.e. to hold bonds in order to buy CDS’s. Buying or selling CDS’s has become a simple speculation in a default with volumes of "protection" traded often massively exceeding the volume of underlying bonds. As the Lehman/AIG debacle showed, if too many have speculated in a default happening and on the other side we find only one major seller of CDS’s, the situation can become unmanageable.

A combination of gaping holes in the accounting rules, a complete lack of transparency, and plain incompetence and greed created a situation where the US government chose to simply pour billions of dollars into AIG. The purpose was to make sure that the buyers of CDS’s on Lehman debt did not end up in a situation where the “protection” they had bought did not vanish. It is by now a well-known story that a bank like Goldman Sachs received cash compensation to the tune of USD 14bn directly from the US government via AIG’s accounts.

Back to Greece. It is obvious that a debt restructuring is necessary, and Germany has suggested a voluntary maturity extension. It had to be “voluntary”, i.e. the holders of Greek debt would have to accept swapping short term debt for long term debt without saying: “hey, you are forcing me to do this, it means Greece has defaulted on the short term debt. That is a credit event”.

The important term here is “credit event”. What constitutes a credit event is not defined by politicians but by ISDA, the International Swaps and Derivatives Association. It is a private organisation which serves as the financial market’s own watchdog over OTC transactions. In other words, even if European politicians were hoping to construe a maturity extension as voluntary, ISDA could simply say that they were having none of it and define it as a credit event.

In that case, all the CDS’s bought and sold on Greek government debt would have to be settled, the credit default protection would be activated. And here lies the rub.

Despite several well-meaning political efforts to force open the CDS market, it is still largely unknown how many CDS’s have been established on Greek debt. Nor do we know for certain who are the holders and who are the issuers.

Whereas holders of Greek government debt are relatively simple to identify, it is close enough to impossible to find out who is sitting with the CDS risk. It may be banks. It may be commercial companies. In other words, there is a sizeable risk that the holders of Greek debt will not be alone in taking a loss. Issuers of default protection will also take a hit, and they may or may not have enough capital to survive a credit event. This uncertainty could indeed create a new freeze in the money markets. We know what that leads to.

If that were to happen, it would be the second time in three years that the CDS market proved dysfunctional. Which leads me to my real point.

Since 2001 corporate bonds and particularly junk bonds (conveniently renamed “High yield bonds”) have been very strong performers across the world. This is partly due to the existence of CDS’s , which have allowed the treasurers of the corporate world to have the illusion of being able to manage the default risk on the issuer of the corporate bonds.

If Greece fails (as I believe it will), it could lead to a major blowout of CDS’s, where nobody would know who would be hit. And in the after math, it could lead to a major loss of confidence in a system which has blown itself up twice. The effect could very well be a visible widening of credit spreads worldwide.

I have earlier written that I believe risk is priced way too cheaply. It has become cheaper since back then. A “credit event” on Greece could be one step in the direction of normalising the price of risk. But it would not be pretty.

The value of implicit bank guarantees

2011-06-06T13:49:00.000+02:00

In an event little noticed outside of Denmark, the Danish FSA and the finance ministry let the country’s former fifth largest bank, Amagerbanken, go bust . This happened after a couple of attempts at recapitalising the bank. Remarkably, the holders of Amagerbankens’s bond debt were told that they could line up with other creditors to get their money back.

It has created quite uproar in Denmark’s financial sector, where previous bank collapses had been handled with “due respect” for the interest of bond holders.

As a direct consequence, the international (read: the US) rating agencies have downgraded Danish banks several times since then, most recently at the end of May.

Predictably, Danish banks are lamenting the fact that the government has shown its willingness NOT to compensate bond holders.

Their spin is that the lower ratings mean higher funding costs and thereby a competitive disadvantage for Danish banks. So we are to believe that the FSA and the finance ministry willingly have weakened the position of the country’s own banks?

One could look at it differently. I have several times wondered why simple capitalist principles were not applied when it came to the banking sector. The answer is that a) the banks were much weaker than anybody outside the sector had expected and b) the banks have been very good at making politicians believe that it would be the end of civilisation as we know it if banks and their owners/creditors were to shoulder the burden of their own greed and recklessness.

If we look at it this way, Denmark is the first country that has shown the way forward (well, Iceland sort of did, too). If banks cannot survive with the capital they have, they go under. Those who had lent them money should take the losses, since money lending inherently is a risky business. That seems a very healthy principle for “bank resolution”, i.e. dealing with dead banks. And by the way, it was exactly what Sweden did during its systemic banking crisis in the early ‘90s.

But what about the increased funding costs, stemming from the absence of a government guarantee to the lenders??

The right way to look at this is not to bemoan the situation of the Danish banks, but instead look at the difference in funding costs as the market value of the implicit government guarantees. We are in a situation where banks in other European countries have higher ratings than Danish banks, simply because the governments are expected to pick up the pieces if another bank blows up. It could hardly be unhealthier.

I quote former US Secretary of the Treasury and Chief Economic Advisor to President Obama, Larry Summers, who in 2000 said:

“While conditioned, precautionary financial support is constructive in some cases, the risk inherent in systematic availability of unconditional credit to countries can be summarized in two words: moral hazard. ... It is certain that a healthy financial system cannot be built on the expectation of bailouts.”

Summers later minced his words in a quite spectacular way and helped engineering the biggest giveaway of taxpayer money in modern history. But that does not make his statement of 11 years ago wrong.

Banks’ funding costs should not be based on implicit guarantees. They should be based on the availability of a capital base sufficient for their activities. Incredible that it is so difficult to get this simple message across to the banks.

Well, an implicit guarantee does not weigh on the balance. It allows a higher financial leverage. And it creates the possibility of higher return to the shareholders and fatter bonuses to the bank management. Go figure.

Post-restructuring, which future for Greece?

2011-05-24T12:25:00.001+02:00

The events around Greece and its government debt are taking new turns every day. It understandably has the financial markets on tenterhooks. A good deal of the commotion comes from the fact that more and more economists and market participants are trying to do the math, and they end up with more or less the same conclusion: No austerity policy will make it possible for Greece to repay its debt. In particular not when the austerity measures are meeting increasing resistance from the voters.

Some of the more sanguine observers have begun to make – not entirely unfounded – comparisons between Greece and Argentina. Two decades ago Argentina introduced a “currency board” whereby the currency was pegged to the USD in an attempt to control inflation. After an initial period where exports picked up strongly, the domestic economy floundered, unemployment increased, government deficits exploded, and the current account worsened. The government debt was largely sold abroad, where investors believed in the strength of the currency board.

However, in absence of serious reform, the government deficit continued growing, and servicing the debt meant a serious further strain on public finances, and even a wave of privatisations was insufficient. In 2001 the currency board evaporated, the currency depreciated by a whopping 70%, and in 2002 Argentina defaulted on the debt. It has taken nearly a decade of economic hardship to rebuild the economy and in 2010 Argentina offered to resume paying back the debt.

There are some eerie similarities between Greece and Argentina. Most significantly, both entered into a very rigid currency regime with an economy that was clearly not ready for such a move. The ensuing drop in interest rates mainly led to an increase in property prices and consumption. The economy did not in any way undergo a development whereby investments were made in sectors that would increase the export competitiveness.

That is the main problem with Greece. No matter what happens to the Greek government debt (my guess: debt rescheduling, followed by a small haircut, eventually default), or Euro membership (my guess: will be maintained for now), in order for Greece to move forward, some serious structural reform is necessary.

The problem here is that “serious structural reform” has a meaning that not everybody likes. I may mean that established power concentrations will have to be dissolved, labour market conditions may have to be liberalised, public sector reformed, a serious privatisation programme will have to be introduced.

All of that will upset the existing status quo and that is usually not wanted. But since Greece’s exit from the
Euro is far away, such reforms will have to be more profound, since no currency devaluation will help the adjustment. I am afraid that the full weight of the necessary changes in the aftermath of a restructuring has not yet dawned on all parties.

It is interesting to see that the European consensus of “extending and pretending” is beginning to unravel. Whereas Germany is beginning to see the advantage in restructuring Greece’s debt while Spain and Italy have strongly denied that such a thing could happen. They are obviously afraid that they will stay out of the limelight as long as EU covers up for Greece. That position becomes increasingly untenable as time passes.

A Japanese reactor meltdown will not undermine the euro

2011-03-28T11:06:00.001+02:00

Regional elections in Germany gave negative results for Chancellor Merkel’s Christian Democrat Union. The disaster at the Fukushima nuclear power plant has apparently given the Green party a boost, and so much so that all other parties also lost ground. In the financial press, Merkel’s weakening domestic stance is likely to be used in attempts to discredit the new European Stability Mechanism.

The arguments will be something like: Merkel is losing support. Younger generations of Germans are unlikely to accept the sacrifices imposed by the German financing of the bail-out of Southern Europe. Merkel will be less firm in her support and will try to impose further draconian measures on the countries in need of a bailout. If she does not have her will, Germany may simply withdraw from the euro.

Given the German-bashing that in particular the London-based financial press thrives on, there is nothing new in that view. However, there are two things that need to be said in return. On 12 March 2010, German Finance Minister Schäuble published an article in Financial Times laying out the principles that Germany wanted to form the basis for any new agreements.

German policy towards the Euro crisis has been in line with Schäuble's statements. Nonetheless, there has been a lot of talk that Germany has in fact only saved her own banks and that Southern Europe/Ireland are “sacrificed” in order to avert significant losses in German banks.

Yes, German banks have certainly been exactly as greedy and silly as any other banks. And yes, there may well be an important element of self-help in the German bankrolling of the ESM.

But let us not forget that Greece had falsified public accounts to fool the world while the government tax collection was in shambles. Ireland let herself go in an orgy of cheap credit while using corporate tax rates as a means of stealing jobs from other EU-countries. Portugal studiously avoided economic reform and it it shows now, as the rest of the world is on the mend.

Still, the German policy is built on the rather healthy observation that you cannot have a monetary union unless there is some kind of cohesion in the economic policy.

As Germany is again pressured into taking out the check book, of course concessions are being forced upon the most profligate EU members in order to secure the long-term viability of the Euro project.

The far more important point is that Germany will not leave the Euro, irrespective of local election results. Membership of the Euro is one of the geopolitical imperatives Germany must live with, as it is the guarantee against ever again having to fight a two-front war. Following the defeat in 1945, clear-headed thinkers across Europe understood that in order to make Germany change her ways, it was necessary to change the strategic position, whereby Germany was facing Russia on one side and France/UK on the other side.

By tying Germany into the EU, the most important military enemy, France, was turned into an ally. When the Berlin wall fell, French President Mitterrand managed to convince (maybe even bluff) then-Chancellor Kohl that a currency union was the best way of anchoring Germany in Western Europe, now that the big enemy in the east was retreating.

Germany has not at any point – irrespective of whether the foreign minister came from CDU, SPD, FDP, or indeed the Green Party – questioned Germany’s Euro membership. No matter whether this week-end’s skirmishes will eventually undermine Chancellor Merkel, whoever succeeds her as German Chancellor must accept the geopolitical situation and embrace the EU solution of having a single currency.

However expensive it is to support the Euro’s continued existence, the alternative to doing so would be a major transformation in Germany’s geostrategic situation. It would require a complete political about-face and would mean that Germany again had to ready herself for a two-front war, as the demise of the EU would follow. Given the price of this alternative, Germany will remain a firm supporter of the Euro. But will of course not be willing to be taken for granted to pay for the foibles of everybody else.

Three weeks into the market correction, dynamics may be changing

2011-03-18T11:11:00.000+01:00

The guessing game has been on for some days now: Will the Japanese disaster be positive or negative for the world economy. Personally, I believe that initially it will be negative and then turn positive as the efforts to rebuild gathers steam. But it really is anybody’s guess, and to be cynical about it, it does not really matter. At least not for the financial markets. So while my thoughts go to all those who have lost lives and property in the disaster, the markets are more interested in the global policy reactions.

In that respect it looks fine. Japan finally joined the club of countries embarking on “Quantitative Easing”, also known as monetising public sector deficits. G7 and others are intervening in order to drive down the JPY, which adds strength to the monetary initiatives already taken. It all looks good and the markets have taken their cue from the developments. Stock markets will profit in the short term.

Over the past five-six months the stock markets have been supported by the fact that global economic data have surprised on the upside, indicating that the world economy is doing a good deal better than expected around the middle of last year.

This will not continue. Markets do not really react to good or bad news. Markets react to surprisingly good or bad news. Markets react to change rather than predictability.

So now that we have all been surprised positively for some months, you can be absolutely sure that forecasts are now being adjusted upwards. At some point in time they will have caught up with reality. From that point on, they will begin to have negative surprises. A new revision cycle will begin and the market mood will again turn.

On 22 February I wrote that the market had a set up for a correction. Not because of overvaluation or what not, but simply too many had become complacent about risk. I thought the unrest in North Africa and the Middle East would be the trigger. In the end it was a combination of that and the Japanese disaster that caused the markets to run for cover. The policy reaction around Japan has already taken some of the uncertainty way. I am not sure that it is enough to put an end to the current market correction.

More on the New Inflation

2011-03-02T11:52:00.000+01:00

In a recent article in New York Times, Christina Rohmer, former chairwoman of the Council of Economic Advisors to President Obama, describes a debate that limits Fed’s ability to act decisively to support economic growth. It is between “empiricists”, i.e. those who want to see solid evidence of inflationary pressures before they begin to rein in the monetary policy, and the “theorists”, who claim that one has to step on the brake in rational expectation of future inflationary pressures.

It is Rohmer’s claim that the schism between these two approaches effectively paralyses Fed at a point in time when it needed to do more to stimulate the US economy. She lays out the most important channels through which low interest rates stimulate the economy. Courteously, she remains silent on the theories that would be used to explain to explain the emergence of inflation when a large excess capacity is available.

Rohmer should know what she is talking about. A scholar renowned for her studies of the Great Depression in the 30’s, her contention is that by keeping the interest rates low, the interest sensitive sectors of the economy will eventually pick up. Manufacturing (cars!), construction etc. will all be strengthened as a result of lower interest rates. Just like it happened in the 30’es.

By making it clear that deflation will be fought at almost any cost, real interest rates are reduced. Since the difference between present nominal interest rates and expected inflation is reduced. That reduces the perceived financing cost and stimulates investment.

Given the recent data from the US housing market, there is no doubt that Christina Rohmer has a strong point. House prices are still falling, and sales of repossessed property are a significant part of the overall turnover in the market.

At the same time, there are no signs of inflationary pressures. And yet we see that across the world, central bankers are now beginning to worry about inflation creeping upwards. As I wrote in my blog earlier, it has to do with your definition of inflation. As long as one only considers “core inflation”, I share Christian Rohmer’s view.

But there is a little snag. In the 30’s the financial markets were not as developed and integrated as now. Financial institutions could not freely invest abroad. Commodities markets were largely reserved for those who needed the physical product. I need not describe how that has all changed. Just note that banks and other financial institutions are now major players in the commodities markets.

We know that the QE programs have given the banks access to tons of liquidity that they have not passed on the consumers. It seems fair to assume that the money instead has remained within the financial sector, invested in stocks, bonds, and commodities worldwide. Given that the commodities markets are the smallest by volume there is every reason to assume that the combination of monetary policies and the freeze in the normal credit markets has led to significant asset reflation. Even Ben Bernanke has stated this publicly. And of course it has also been a contributing factor that the Asian economies have recovered nicely from the downturn.

US monetary policy has contributed in a significant way to the headline inflation through the price increases in food and energy, the two “volatile elements” of inflation.

It has already given Rohmer’s “theorists” more reasons to be aggressive about reining in the monetary policy prematurely. Same situation in Europe where Axel Weber’s withdrawal from the race to become ECB’s next chairman has left the situation wide open. Prospective candidates are now jockeying for position by improving their hawkish profile, well knowing how tough talking on inflation could garner support from Germany.

So the situation is that the spill-over into the commodities markets from the US monetary policy is now leading central bankers everywhere to indicate that monetary tightening should be just around the corner. That would not be the right thing to do just yet.

A textbook example of increasing risk

2011-02-22T15:22:00.001+01:00

One can only have sympathy for the protesters in the Arab countries, demanding democracy and the most basic of personal freedoms. The stories continue to dominate the headlines and the TV screens.

But when it comes to the effect on the financial markets, there has been a strange silence. It is as if the events have no real impact on the rest of the world and we can treat it with the same indifference as if it was a Soccer World Cup final. It makes us feel good, but Monday everything is back to normal.

I shall not try to guess where the Middle East is going. But if we look at the influence on the financial markets, a few remarks are necessary.

The risk is not skewed in the direction of a positive outcome for the stock markets. If we see a quick return to orderly conditions, possibly with democratic governments, civil rights, and rule of law, it will make us all feel better. Best of all, it will give us the same stability in terms of oil deliveries as we had before the whole thing started in January.

In terms of impacts on the stock market it is not good news that things remain unchanged. In fact, It is no news at all.

On the other hand the situation can also escalate in ways that could seriously impact us all. Trouble in Saudi Arabia, supply disruptions, new regimes with limited democratic credentials but with a serious grudge against the Western world. Now that is a situation that would make itself felt in the stock markets.

Facing a choice between several outcomes, where the best is a return to status quo ante, and all other events are worse, it simply translates into an increasing risk for trouble in the financial markets in the short term.

If we add that risk willingness has clearly been increasing in the past months, we have a convincing case for limiting exposure to the stock markets. It is interesting to see that this message obviously has not yet made it to the stock markets. The reason for this appears to be clear.

The whole chain of events has unfolded quickly. The financial markets were in a sweet spot and economists and analysts have been busy improving on their outlooks for growth and earnings, and now reality suddenly shows its ugly face. Right when we were busy doing other things.

For investors interested in timing their exposure to the stock markets, it may still be too early to exit (unless you are a high-risk, high-leverage, high-everything hedge fund manager in which case you probably already have left). The rest of us are just waiting for the stock markets to wake up. And panic.

On markets and monetary policy

2011-02-18T12:04:00.000+01:00

Seen as an asset class, equities continue to rally on the familiar background of ample central bank liquidity and a surprisingly late rotation into equities by institutional and private investors alike. A major reason for this rotation appears to be that the return on bonds is unattractive – to say the least.

However, in the background several trends are quietly working to change the dynamics of the financial markets. We have already described the fact that monetary policies are being tightened at different speeds in different countries. The relative performance of the stock markets shows this clearly. The countries that have already started tightening experience underperforming stock markets.

Apart from Japan – who increasingly looks like a total basketcase – USA is the laggard among the large economies and the main culprit in flooding the markets with central bank liquidity. Recent data from the US Loan Officers Survey indicate that things are changing. Banks are resuming lending activity, albeit on a small scale.

This is important news for the financial markets. It is an early indication that event the US will at some point in time begin to tighten. The discussions whether Federal Reserve will be “behind the curve” are interesting, but irrelevant in this context.

The conclusion is that the dynamics in the financial markets increasingly will be determined by the timing of monetary tightening, and this movement will reach a crescendo once the US Fed decides to rein in liquidity.

For investors it means that we cannot any longer rely on just buying stocks and commodities when the market mood is for increased risk. Or buying bonds when the market mood is for decreasing risk.

The markets/asset classes will have to be bought and sold on their individual merits. And exactly the same goes for currencies.

As an example, take Sweden. The SEK plunged in 2008 as the Riksbanken lowered interest rates aggressively. Sweden – like Germany – is a strong manufacturer and exporter of industrial goods. Sweden therefore profited nicely when the European demand began to pick up.

Now the SEK has appreciated and seems set to continue. Exports are strong. Unemployment is falling and predictably, Riksbanken is tightening as it should be. Having been one of the strongest performers in 2010, Swedish stocks are now underperforming, as the market is discounting the combined effect of higher interest rates and a stronger currency.

Take this story and compare with recent developments in China, Norway, Australia, Canada, and several other countries. The stories may differ in their details, but the main tenet is the same.

Does all of this sound way too simple? Maybe it is. But it is a clear sign that after nearly 3 years of turmoil in the markets, we are returning to some kind of normalcy.

There is, however, one European aspect that should not be overlooked. Germany is the leader inside the Euro zone. Guess who are the laggards. Just look south.

It can be argued that for a long period, Europe had too low interest rates because of sluggish German growth. Maybe we will now have a period of too high rates because of strong German growth. Creating a one-size-fits-all monetary policy is not as easy as it seems. We will hear more about this.

The New Inflation

2011-02-14T14:05:00.000+01:00

Long time ago, back at university, I tried to make sense of the concept of “core inflation”. Consumer price inflation minus what was known as the volatile components, food and energy. I sort of understood it, but never really came to terms with it.

It is correct that by keeping the notoriously volatile elements out of the equation, one arrives at a notion of inflation that can be used in analysis of such important questions as the deflationary effects of the output gap. We have all been conditioned to believe that this is the most important way to think of inflation.

But still we have a slight problem. We, the consumers, let our economic decisions rule by the inflation as we see it in the shops or in the street. No matter how much the textbooks tell that the core inflation is the most important to watch, shop owners who increase their prices would be unwilling to let me pay only part of the increase just because the “core inflation” was lower than the headline inflation. The supermarket bill goes up and it will have to be paid, no matter where the increases come from.

So while core inflation is an element that makes sense to economists, headline inflation makes sense to the rest of the population. Including possibly even some of those working in the financial sector.

Right now we are at a point where this distinction between core inflation and non-core inflation is as important as ever. Looking at core inflation in most of the OECD area tells us that inflation is not a problem. Looking at the output gaps gives the same conclusion.

But inflation is on the rise. Food and energy prices are pulling up the headline inflation to a point where it is getting uncomfortable. A combination of financial market speculation and adverse production circumstances are working their magic.

Add a point we have made several times in 2010. Federal Reserve’s re-acceleration of the QE programme in September was bound to create asset inflation and nowhere more clearly in the comparatively small markets for commodities and energy.

The increase in the volatile inflation components have been one of the elements in destabilising regimes everywhere from Venezuela to North Africa. Following a very bad harvest, the Chinese Government is seriously concerned about food inflation – to the point where initiatives have been implemented locally to curb the inflation.

It all adds to an uneasy feeling: are we heading towards a period of inflation, pulled by exactly the elements that according to economists are irrelevant for understanding the “real” inflation? Can policymakers be forced to step on the brakes early in order to avoid inflation expectations taking hold, even if core inflation remains benign? Or, will the financial markets – in particular the bond markets – begin to take discount this inflation, no matter if bank economists tell that it is irrelevant.

The answer to this question is more important than the financial press seems to have understood. If the markets begin to fear inflation, bond yields will push upwards and threaten to put the brakes on the recovery at a time when policymakers consider using the increasingly self-sustained recovery to begin cutting the budget deficits. The combination could prove very negative for the economic growth in a global economy where consumers in the western world still need to consolidate their balance sheets.

Year Two of the big cleanup

2010-12-22T15:37:00.000+01:00

About this time last year I wrote that 2010 would be a year of normalisation. In particular that risk premiums should adjust to a new normal. I have for quite some years had the perception that risk had become way to cheap as the US Federal Reserve for more than two decades had chosen to add liquidity every time some problem showed up. Every time the result was to push down interest rates.

Well, I was only partly wrong in my predictions. Apparently, returning to a normal situation in the credit markets will take several years and could not be done in just one year. The Peripheral Euro zone members are far from being saved yet. The overall banking sector in Europe could suffer badly and end up zombie-like in the years to come.

The European debt crisis is far from over. The financial press has with great success obfuscated the fact that there are two problems. The sovereign crisis in Southern Europe is well covered. Much less so the European banking crisis and the two are intertwined, as the European banks hold loads of debt issued by the Southern Europe. Letting one of the southern countries default would immediately hit e.g. German banks badly.

I have great respect for the German design to strengthen the Eurozone institutions, saving the banking sector AND to make sure that Moral Hazard cannot be an element in business risk taking going forward. The problem is that unless radical action is taken, it cannot all happen at the same time. Without the will to actually solve the problems, Europe will simply postpone, play for time, while the bill keeps climbing.

The only radical action would be to nationalise the banks, fire the management, let bondholders take a haircut, keep the banks on the balance sheet while they reorganise and eventually sell them off in the stock market. The bad debt could be sold off in the market too with a partial government guarantee.

This Swedish solution appears more and more appealing by the day. Except of course that the banking lobby is now so strong that politicians cannot any more ignore it.

But elsewhere things are looking equally bad. The US has a well-known Federal budget problem. And a much less publicised problem with states and cities that also have deep financial problems. According to recent data releases, US states may together have a $1tn deficit that has to be financed somehow. Those working to find out how bad the situation is, are complaining that the transparency in the accounts is worse than anything seen in the banking sector (sic!).

So we entered 2010 with a vague feeling that risks had to be re-priced. At the end of the year it is dawning that the debt problem is larger than assumed and that more radical action is needed, but the political will is sorely needed. The markets will continue to re-evaluate the price of risk.

The problem for the rest of us is that the subsequent need to curb runaway budget deficits will act as a brake on the economic growth going forwards. Add that the pension problem is now growing quickly in Europe, creating a further long term problem.

So do not expect 2011 to be any calmer than 2010. Two years ago I believed that it would take five to seven years to work our way out of the debt crisis. 2010 proved that the way out is not an easy one. And it seems likely that we have another 3 to 5 years ahead of us before the situation will approach normal.

Moral Hazard receives another boost

2010-11-29T11:42:00.000+01:00

I have a great deal of sympathy for the German Chancellor Merkel’s stated project of “maintaining the primacy of policy over the markets”. This wish has led Germany to underwrite the giant European attempt at salvaging the Euro zone from collapsing under the speculation against government debt issued by Greece, Ireland, Portugal, Spain, and soon Belgium.

I am, however, afraid that the chosen method is making things worse. By effectively guaranteeing government debt from various EU member countries, Germany effectively tells the speculators that there is no problem in holding the debt of those countries. It is possible to operate in the bond markets without having to factor in the risk that the issuer will go bankrupt. Merkel is not alone in underwriting certain kinds of market behaviour.

Since the creation of the US Federal Reserve it has been the practice that if economic trouble was brewing in the US markets, FED would simply open the monetary spigots and the crisis would go away somehow. Currently, it is known as the “Bernanke Put”, a free insurance against capital losses. When the bank sector was effectively insolvent, it was bailed out by the US government with few conditions attached. The people who through monumental greed and incompetence had created the crisis, are mostly still holding on to their handsomely paid jobs. And they pay each other silly bonuses.

Having learnt the lesson that if they behave stupidly, they will receive generous help to get themselves out of trouble, they are now back to their old ways. By underwriting fully the debt of European sovereign borrowers, Merkel and her political allies are exactly supporting the behaviour they want to stop. If there is no real risk of loss, gambling against the troubled countries become a pastime, where you just have to adapt your strategies to the short term trends. Real caution is not called for.

For every rescue package put together, moral hazard becomes more and more engrained in the working of the financial markets. More and more money can participate in the speculative runs, making such runs more and more difficult to handle.

Ms Merkel has the common sense of believing that lending money should be a risky business. If a lender does not check the quality of the borrower, there is a risk of losing money. But when she had the guts to say it out loud, she was met by a storm of protest from the financial markets and their political backers: Never should there be any risk of losing moneys lent to a sovereign. The prices of Irish debt plummeted and Ms Merkel was rapidly forced to issue a calming message that it was only something she meant from 2013, when the current rescue system is to be replaced by something more permanent.

It still baffles me that the Swedish bank rescue action from 1991-92 has inspired so few of today’s politicians. Sweden’s banking problems were in every way as serious as the problems seen now (with the exception of the global systemic risk if we do not get out of the trouble).

In brief, the Swedish package saw management and shareholders of failing banks wiped out, banks were nationalised (i.e. integrated in the government balances) for a while, essential services were continued, banks were restructured, recapitalised, and sold. Bad loans were floated in the market with a temporary guarantee. The operation was quick and efficient – not the least because the government obtained full insight into the loan books. The whole action was run in a perfectly capitalist way: If you screw up, you lose your shirt. Such straight forward action was never taken in this crisis.

Now politicians are afraid of taking on the ever-larger banks, whose lobbying activities are based on huge resources. Politicians allow banks to obfuscate and hide the real magnitude of the problems. It all ends up being more expensive to the taxpayers than necessary. And when somebody – even with Ms Merkels position of strength – has the nerve to tell a few obvious truths, they are forced to beat a hasty retreat by a howl of protest from the banking sector.

I am afraid we are in for a very, very long time of trouble. So far it is becoming increasing clear that because of the attempts to “maintain the primacy of policy” the markets are being given a golden opportunity to speculate against the governments. Obviously, the influence of the bank sector lobbyists continues to grow. The markets strengthen their primacy over politics with every timid step aiming at reducing their influence.

The Irish bail-out teaches us a lesson about EU

2010-11-22T10:26:00.000+01:00

The bail-out package for Ireland is the story of a pre-announced disaster. First the Irish allowed their economy to become a hedge fund, allowing the banks to grow their balances to levels disproportionate with the size of the economy – just like Iceland. Just like Iceland, the Celtic Tiger dreamt of having invented a new economic model of debt-fuelled hyper growth. They had not.

At the same time, they decided to attract foreign direct investments by lowering tax rates to levels that have been a thorn in the side of larger EU countries. As the crisis struck, they made a colossal mistake by guaranteeing all deposits in the Irish banks. As the scale of the losses in the banks began to become clear, it dawned upon most observers able to do simple sums that honouring that guarantee would lead to budget cuts so severe that social unrest could be the consequence.

The reaction from the corporate and financial sector was predictable. Yields on Irish government debt soared and companies withdrew billions form the Irish banks. As the cost of refinancing government debt increased, it became clear that the real cost of servicing the debt would surpass the growth rate of the Irish economy, catching the Republic in a debt trap.

The situation was compounded by German Chancellor Merkel’s untimely – but essentially correct – remark that when things go badly, it is not only the borrowers that should be punished. The lenders should also take a haircut if they had not assessed the quality of the borrower properly, which should be the responsibility of any lender. That remark gave a further push to the borrowing costs, and may seen in retrospect have been the event that finally pushed the Irish over the edge. They would have gone there anyway, but it might have taken longer time.

Now that the Irish have formally asked the EU and the IMF for a “contingent loan”, i.e. an overdraft facility, we are told that granting the facility was in order to protect the Euro zone. Maybe it would be a good idea to remember that German and French banks hold large swathes of Irish debt, and would obviously have been badly hit in case of an Irish default. They are now saved from that ignominy.

All of this is just another episode in the ongoing saga of greed, incompetence, and cynicism that is the story of the European debt crisis. At every twist in the road, Moral Hazard becomes more engrained and acceptable as a business concept.

If there is any lesson to be learned from the Greek and the Irish bailout, it is that EU is slowly waking up to the fact that the common currency was launched for political reasons essentially without the support of rules and institutions required to secure the survival of the Euro zone.

In the weeks before the bailout it became clear that some of the wrangling had more to do with the future of the EU than with Ireland. Germany (again) suggested that the EU should be given far more power to control and influence the budgets of the individual member countries. This would mean a transfer of sovereignty to the EU commission and France would have none of that.

The differing positions could well be understood on the basis of economic logic. Germany has no problems transferring economic decision power to the commission, knowing full well, that the German economic strength will continue to give the Federal Republic a strong say in Europe’s fiscal affairs.

France, on the other hand, has for ages used German economic strength to project her own global aspirations. Obviously, the new assertiveness of Germany is a threat to that position, and France will for that reason resist any transfer of economic decision power to the Commission.

For now, France won the battle. Germany backed down and accepted that the procedure for dealing with bail-outs will continue to be led by politicians instead of bureaucrats. But make no mistake. The Germans are getting sharper and more precise than we are used to. In the words of German finance minister Schäuble, pretending that things can continue like they have worked in the past decade, implies a lot of wishful thinking. When Ireland has faded from the headlines, the issue of making the Eurozone work will be the most important for the future of the EU.

Chinese food price

2010-11-17T10:08:00.000+01:00

The recent weeks have given us all a clear impression that the US is losing global influence on all fronts, and in particular on the economic scene. There is nothing strange about it. An economic textbook from my days at university put it clearly: A country running a steady current account deficit will sooner or later lose room for manoeuvring.

By running a persistent deficit, the US is now inextricably linked to its largest creditor, China. For a long time, China would be influenced by whatever the US decided. But now, China’s economic decisions will gradually have an influence on the US. Already now, China’s decisions concerning her currency reserve have the potential to influence the USD and US interest rates. By implication, it affects the rest of us.

I have written about China’s problems that derive from the peg to the dollar. So far, China has profited enormously from that peg in terms of export. The flip side of the coin is a huge inflow of liquidity that China’s immature financial system cannot really cope with.

This inflow has given rise to a strong inflation in certain types of assets in China – mainly in property – but has so far not given rise to general consumer price inflation. China’s monetary authorities have tried to limit the financing of building projects, and using selective capital controls. It has cooled the economy somewhat but has not of course not resolved the real problem, namely the growth in the money stock resulting from the export surplus.

China’s Consumer Price Inflation is estimated to be in the region of 4% and ought not to be a course for real worry. But the food subcomponent is rising at a rate of 10% per year, and that is a course for concern. So much so that China is about to introduce selective price controls. A technique that has been tried on many occasions in the West. But it has never worked anywhere. It merely postpones inflation, it does not remove it.

The main reason that the Chinese government is targeting food inflation is straightforward. Despite the economic boom in the south and the east of the country, there are still large parts of the population in the North and the West that are eking out a living not much higher than the bare subsistence minimum. Authorities in Beijing rightly fears that if the inflation in food prices continue, it could lead to social unrest. Fears of social unrest remain one of the most powerful drivers of the Chinese leadership and has been so for several decades. Back in the 1970’s it was one of the drivers of the economic reform policy introduced by Deng Hsiao-Ping. After the Tien An Minh massacre it became clear that the crackdown on protesters had been severe as the authorities feared it could spread.

My guess is that the announced selective price controls and initiatives against food price speculation will have a temporary effect, but as long as the current account surplus remains capital inflows will continue unabated.

Only a change in the exchange rate policy will mean a real difference, and it will come at some point in time.

When China decides to take steps toward floating the Yuan, it will have a dramatic impact on the financing of the US current account deficit, and that will affect us all. While not many of us bide out time studying Chinese food prices, it is more important to us than you would think.

US Elections – bad for Obama, positive for risk assets

2010-11-03T11:00:00.000+01:00

The US mid-term elections ended largely as opinion polls had predicted. Republicans took the House of Representatives, Democrats kept the Senate. Given the influence of the anarchistic right-wing movement, the “Tea Party”, there is little reason to believe that the Republicans will co-operate with President Obama and the Democrats to solve the deep economic problems besetting the US. Instead, two years of further obstruction is likely.

Just like the Republican party (correctly) gambled on the economy not having recovered by 2010, the next Republican gamble appears to be that by simply doing nothing, the economy will have recovered somewhat by 2012. The election strategy will probably then be to claim having “saved” the US economy.

As a stark reminder of the seriousness of the economic situation, IMF and ILO yesterday released a study telling that since 2007, USA has suffered 25 percent of the job losses recorded globally.

For the financial markets, the consequences are likely to be the following:

No major economic initiatives will be forthcoming from President or Congress. 48 out of 50 US states are in deep economic trouble. No economic stimulus will be forthcoming from neither federal, state, nor local governments. Instead, budget cuts are likely to happen by default as spending programs expire and are not replaced.

This leaves Federal Reserve as the only institution holding the rope. Monetary easing is the only viable economic instrument available for a foreseeable future. Hence, the QE2 should be in the bag, and my guess is that it will come in two tranches of 500bn USD each.

As we have stated earlier, it will continue the ongoing inflation in risk assets, mainly stocks, commodities, gold, silver and tradable energy. The only question is how far it will run. No end in sight so far.

USD will remain under downward pressure until the US consumer demand begins to pick up in a substantial way.

Bond yields will remain under downward pressure from a combination of continued deflationary pressures and purchasing programmes from the US Fed/Treasury.

So-called inflationary expectations – which are in reality just a relative price between small-volume inflation bonds (TIPS) and big volume T-bonds - will point upwards but will have no real economic effect.

US corporations will continue to be hugely profitable in spite of unsatisfactory top lines. There will be a river of ink telling that it translates directly into higher stock prices. Wrong argument, but right conclusion. Instead we are looking for an increase in bank lending to private equity firms, looking for financing for leveraged take-overs. It has not started yet.

US policy makers stand pat and will have to play a waiting game. They are waiting for US consumers to finish the repair of their badly stretched balance sheets. As known from previous episodes of this kind throughout history, it takes years. The US consumer is 2-2.5 years into this cycle. There may be another 4 years to go.

Growth will be slower than trend growth in the time to come, and it is unlikely that the US Output Gap will have closed by 2012. Consumer Price Inflation remains unlikely.

Fortunately, things are looking better almost everywhere else.

A new currency war?

2010-10-22T01:14:00.002+02:00

To students of the Great Depression, the current discussion about a currency war should come as no surprise. In the ‘30s, the world had a fixed exchange rate system, based on a US-centered gold standard. It made it obvious for all that a series of competitive devaluations were taking place as countries turned their attention to exports as a way of boosting domestic growth.

This time around it is a bit different. We do not have a global fixed exchange rate. We have dollar, we have the euro, and the yen. Until the outbreak of the crisis, we also had two currency blocs, the Euro and the US dollar bloc. By the latter I refer to the fact that a number of South American and in particular Asian exporters unilaterally kept their currencies largely stable against the dollar.

We are now in a situation where competitive devaluations are off the table, since there is no fixed exchange rate system. This has opened the floodgates for something far more insidious, quiet and discrete manipulation of the currencies. And there is a sneaking feeling that the US of A is actually the main culprit. The US allegedly want to weaken the dollar in order to redress the huge hole in the trade balance. Doing this is so not kosher.

It is very easy to come to that conclusion when looking at the weakening of the USD since in the past months. Several currencies have appreciated significantly against the USD. I talk about the euro, the ASEAN currencies, the yen. And even the Chinese yuan also increased a bit. For all practical purposes the implicit dollar bloc has gone and the USA appear to be exporting its economic trouble to everybody else.

It always makes good headlines to accuse somebody else of currency manipulation. US lawmakers are specialists in that discipline as they pound the Chinese in order to obtain a significant appreciation of the CHY.

I am sure that everybody in the US economic policy circles welcomes a weaker USD. It was the same in Euroland in the first half of the year. But I am equally sure that the current dollar depreciation is the result of what I described in my previous post. Namely the current situation of the USA being caught in a liquidity trap.

There is a near universal expectation that the Federal Reserve will resume its asset purchasing programme within weeks. Such a program increases reserves in the banking system, but so far it does not lead to an increase in the money stock. Banks do not lend money and consumers and businesses do not borrow. Banks have a tendency to increase deposits at the central banks in that situation. It could however also happen that they help finance investments in securities. In other words, the main consequence is to inflate the value of financial assets.

To the extent that investments are not made exclusively in dollar-denominated assets, this liquidity flow will tend to weaken the dollar and to drive up assets in the “host” countries. In other words, the side effect of the US monetary policy is to drive the dollar down and financial assets upwards, also outside the USA.

Obviously, there is nobody complaining about the asset inflation, since it is supposed to lead to consumers feeling better and increasing demand. Eventually, that is.

But the falling dollar is obviously provoking a lot of politicians in other countries, from China to Brazil. A lot of noise is now audible and it is fully understandable. The weakening dollar makes US exports more competitive. The country that triggered the financial crisis through a disastrous combination of private and public sector deficits, a debt explosion and a terminally weak regulatory regime are now trying to export their way out of the crisis. At least according to the critics. I am sure that US policy makers would prefer to be in a situation where they could indeed push a string – using the monetary policy to get the economy growing faster.

Eventually the US economy will pull out of the liquidity trap, but nobody knows the timing of this. In the meantime the trends in the financial markets will continue, no matter how contradictory they are.

And in the meantime, we can all marvel at the best manipulators in town, the Chinese. Following months of increasing pressure from the Western World, the crawling peg regime from the pre-crisis years was reinstated. Not that CNY has moved a lot against the USD. But the change came virtually at the same moment as the USD began to weaken against the EUR and the JPY. So the net effect has been a weakening of the CNY in trade-weighted terms. Not bad for presumed novices in the noble art of waging a currency war.

Helicopter Ben getting ready for take-off? He ought to

2010-10-19T12:34:00.001+02:00

Back in the ‘80s, then-US Fed Governor Paul Volcker used some serious weapons to quell inflationary expectations in the US. Interest rates were hiked to a point where the economy went into recession, excess capacity was established and a veritable press blitz focused on the need to stop inflation. At the same time, like-minded governments in the Western world gave the same message and such a thing as inflation indexing was killed in most countries. And it worked. Over a couple of years, inflation and inflationary expectations were falling rapidly and they have remained on a falling trend ever since.

Now that deflation – or at least disinflation – is a very real possibility, the game is to create some inflationary expectations, hoping it will feed through the economy. The reason is the same as fighting excessive inflation, namely that inflation as well as deflation leads to sub-optimal economic decisions.

The question is how to boost inflationary expectations, and it is not quite as easy as one would expect. Monetarists have told us that inflation is essentially a monetary phenomenon – “too much money chasing too few goods”. But that is clearly not the case now. With excess capacity nearing 10 per cent of GDP in several large countries, including the US, and monetary policy not leading to credit growth, inflationary pressures are totally absent. No matter how much money Federal Reserve and other central banks have pushed into the banking sector, most of it has remained with the banks, deposited at the central bank. It has not led to an increase in credit, and the main effect has been to salvage the banking sector and to recapitalise it by stealth.

Economic textbooks prescribe increased public spending that directly creates demand. With governments across the Western world moving to reduce public sector deficits, this solution is not exactly on the agenda. So rumours abound that now the central banks, led by Fed, are about to introduce another round of asset purchases, also known as “Quantitative Easing”. Which is again supposed to increase the money stock.

It probably won’t work this time either. The rumours have created some minor moves in the financial markets, though. The break-even inflation rate between T-bonds and US Inflation-indexed bonds, known as TIPS, has increased to 2.20 per cent. It means that if US inflation over the coming 10 years is 2.2 per cent, an investor will receive the same real return on a TIPS as on a normal government bond. 2.2 per cent is obviously higher than Fed’s assumed inflation target of 2 percent. Thus the situation receives quite some attention in the financial press.

But bond dealers do not create inflation expectations out there in the real economy. Such technicalities have nothing to do with how the average consumer perceives of the world. He/she begins to expect inflation once everyday goods and services begin to increase. We need the price of homes, groceries, haircuts, child care and so on to increase before inflation becomes tangible. At this moment in time it appears that only food prices are going up.

So I am very sceptical that Fed’s attempts at creating inflationary expectations through intervention in the financial markets will work. Fed Chief Ben Bernanke (unfairly) earned the nickname “Helicopter Ben” when in 2002 he quoted the monetary economist Milton Friedman’s recipe on how to stop deflation: Drop money from a helicopter. In the same speech Bernanke went on to describe the monetary policy as it is being implemented right now.

The problem is only that as long as Fed buys T-bonds off the private sector, including the banks, essentially it turns some private sector savings into cash. If the cash is not spent, it will not increase demand. Friedman saw clearly that the cash money had to be aimed at people who would spend it.

Maybe Ben should begin to look for his pilot helmet and get himself ready for that helicopter drop.

A sweet sport ... followed by?

2010-10-07T10:26:00.002+02:00

Renowned Fed hawks believe it is necessary to expand and extend the Quantitative Easing programs in the US. Bank of Japan is doing it already. Bank of England is being strongly recommended by business leaders to do the same. And in continental Europe it is all quiet. I must admit that some of what I hear makes me rather apprehensive. Apparently there are strong worries that the current slow growth phase will last long enough to spur deflation. And deflation is the thing we do not want. At all!

In the past months we have seen some broad trends: Stronger stock markets, strong bond markets, weaker dollar, weaker yen, Stronger EUR, stronger EM currencies and EM stock markets. Market risk indicators are coming down. Credit spreads are falling.

Plainly, some of it does not make sense. I am afraid that we are setting ourselves up for a new round of market turmoil, maybe even at the level of what we experienced in May.

Since the outset of the crisis, the central banks have worked to reflate, and the asset prices have indeed recovered much of the lost ground. The loss of paper wealth should not be a major obstacle to growth. But now we have arrived at another critical junction. It is marked by a slew of new growth forecasts for 2011 from various institutions – they all represent downward revisions of growth forecasts.

The Great Recession was triggered by a huge increase in debt, mainly by households in the Western world. Households are now involved in a gigantic cleaning up of their own balance sheets. Meanwhile, the sharp recession undermined government revenue, leading to huge government deficits. Governments are now cutting back on expenditure and increasing tax revenue to fill the coffers.

Some had hoped for business investment to step in as a driver. But in terms of volume, investments do not match neither consumption nor public spending. And we have already seen an inventory rebuilding. New business investment is being delayed as final demand appears sluggish.

It means that attention turns to the original purpose of monetary policy, namely to stimulate the economy. But we are in a “liquidity trap” where pouring more money into the economy has very little effect on economic activity, since banks to not increase lending. As Keynes would have put it, we are trying to push on a string.

Several central banks have taken the step of introducing Quantitative Easing. Instead of massaging the money market they buy securities (various bonds) directly in the market, pushing money into the pockets of banks and other corporations. But the question is whether that has any effect on the economy. If we look at traditional measures, there are no significant signs that it is actually moving the economy forward. So what happens is quite simply that the reflation of the financial assets takes another step forward.

It all looks like a replay of the events following Internet bubble. This time it is not different. It is more of the same, just on a grander scale. Stocks move up, bond yields fall, commodities prices increase. We are in a liquidity driven sweet spot. It all goes well until it becomes clear that the underlying reality does not correspond to the current market perceptions.

Given that the stock markets have not yet taken to heart that growth will be slow because of the ongoing attempts to repair public and household balance sheets, this is where things may go wrong, maybe sometime in 2011. Until then, the markets look set to have quite a good time.

Fed as a dis-inflation fighter

2010-09-22T11:27:00.001+02:00

Under normal circumstances I consider close reading of the Fed statements about as useful as Bible exegesis. Important for the believers, but an utter waste of time for everybody else. The early August statement was, however, right up my alley as Fed clearly gave the hyperinflationists a cold shower: the ballooning of Fed’s balance sheet is not leading to any kind of inflationary pressures as long as the excess capacity in the US (you could substitute that by “OECD” if you like) is at the highest in decades.

This time, Fed is back at the same issue. But in a way that the FOMC is now risking to paint itself into a corner.

Firstly, Fed does not expect dis-inflation. Instead they expect inflation to hit a bottom at roughly zero: “The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term”. We are talking price stability, not falling prices.

But the inflation is clearly too low: “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability”.

And what will Fed do about it? Nothing, at least for now: “The Committee (...) is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”

Let us recapitulate. Inflation is falling towards zero because growth is below par. As the output gap is not closing at a fast clip, deflationary forces remain strong. Over time, this gap will close, so inflation will come back to desired levels. And in the meantime, we will be ready to add liquidity to the economy in order to stave off disinflation.

But honestly, since households are still restrained by “tight credit” and businesses are investing but at a slower pace than last year, what is it exactly that the “additional accommodation” that may materialise should actually do.

We are still in a classical “liquidity trap”, the QE has saved the banking sector but has not materially contributed to the economic growth. And now Fed has promised us more in case dis-inflation continues.

I am afraid it is not enough. Deflationary pressures remain strong, and monetary policy will not contribute to closing the output gap, as long as we are in a liquidity trap. More demand is needed. Which Fed of course cannot control.

This is good news for bond holders. Not so for equity investors, but they seem to be blissfully insouciant of the underlying situation.

Price trends appear never to be able to make it to the headlines. Until it is too late, that is.

There is one investment conclusion possible: go short inflation protection.

Don't ask, don't tell

2010-09-22T10:21:00.000+02:00

During the Great Depression, the world had a fixed exchange rate system, tied to the gold standard. But then a number of smaller countries began to devalue their currencies. The purpose was obviously to obtain export advantages, since domestic demand was flatlined.

Given that domestic demand is still disappointing in many countries, we see that quite a number of (smaller) countries have provoked a depreciation of their currencies by flooding their markets with liquidity. Obviously, without a global fixed exchange rate system there is no longer talk about a round of competitive devaluations. It would be more correct to talk about competitive depreciations.

But whatever the label, the end result is that there are some countries that end up being the big losers in this game, since obviously we cannot all obtain an increase in export competitiveness at the same time.

While some smaller countries – Sweden is a good example – have had an enormous success with letting their currencies weaken dramatically in late 2008, it becomes more complicated when talk is about the major currencies, dollar, euro, and yen.

These economies are closed enough that management of the exchange rate is not a primary concern. Federal Reserve has often stated that they have no exchange rate policy for the dollar. ECB just wants a “strong and stable” EUR. USA and Europe have maintained a studied silence, even if the ECB (and the rest of the EU policy-making elite) feels that the EUR is way too strong against the USD.

Predictably, there were no objections from the ECB when the financial markets decided to sell EUR as a result of Greek trouble. With no inflationary pressures in the Euro-zone, a weaker EUR would exactly give the European economy a shot in the arm. And indeed, the Eurozone exporters have done very well as a consequence.

The story is slightly different when it comes to Japan. The country has been mired in a recession/deflation situation for nearly 2 decades. A direct consequence of a rapidly aging population and a stunning inability to make the right policy choices. JPY nevertheless started to strengthen in 2007, and has continued as everybody else introduced quantitative easing in order to revive economic growth. Since late 2007, JPY has gained some 40 per cent against a trade-weighted average of other currencies. Read that again, 40%! Not exactly doctor’s orders for an export driven country in order to pull out of a recession.

Recently, the Japanese government has begun to make all the right noises, rumours of a substantial (quantitative) easing of the monetary policy have been floating around and last week the BoJ finally decided to step in and intervene directly in the forex market.

Absurdly enough, this decision drew ire from many market participants. The Chairman of the Eurozone council sharply berated Japan for the unilateral intervention. Politicians of all colours were suitably “appalled”. Most of the FX market was in shock that Japan would do it alone. Personally, I have a hard time understanding the hoopla. Intervention to stop a currency from strengthening further after it has already gained significantly somehow appears to make good sense. Except of course if your competitors had more or less secretly hoped to profit from the rise of your currency.

And China drew its own conclusions. A spokesperson stated that China would never commit the same mistake as Japan, to let herself be pressured into an appreciation of the currency.

What can we learn from all this? That manoeuvering your currency in order to gain an export advantage is still very bad style. Unless you do it discretely. The Japanese did not.

Banks to become less profitable

2010-09-13T10:01:00.001+02:00

So, there they are, the new Basel rules for solvency. Effectively, the required capital base to run a bank will have to double over the next 8 years. Despite what industry representatives will tell you, it is good news for the rest of us. Let me explain.

In the past 20 years or so, the banks' importance in the economy has grown disproportionately, and the weight of the bank's stock in the stock market indices has followed.

Most of the explanation is that banks essentially have been very imaginative in influencing what could be counted as "capital base". As a result, the bank sector has been able to inflate their balances, and thereby increasing the return on the equity. As a consequence, banks have been highly profitable in the past.

The way banks operate has also had a tendency to allow them to increase loans when the economy was doing well. Conversely, they were quick to cut back lending activities once the economy was doing badly. By having this "procyclical" element, the banks have played a role in augmenting the volatility of the economy as a whole.

The crisis that began in the banking sector was to a large extent caused by the banks effectively increasing their leverage in the pursuit of a higher profitability. They did so by pushing the possibility of using their own investment products (mortgage loans, CDO) as part of their capital reserves. When that is a possibility, of course the banks could leverage their real capital harder and earn more money.

Obviously, when the sub-prime crisis started, many banks saw that a part of their reserves simply evaporatedand the banks became insolvent overnight. Since they did not have detailed knowledge of how bad the situation was at the neighbour's, they stopped lending to each other. The rest is history.

I wrote more than a year ago that one element in the Big Cleanout would be stricter capital rules. That is exactly what we are getting now. Unless the banking industry manages to lobby significant changes to be introduced between now and 2018 when the rules are fully implemented, it will mean that the profitability of the banking sector will trend downwards over the coming years. Probably it will also mean that the finance sector will end up weighing less in the stock market indices.

In my book, it is all good news. Of course we all need an effective solid banking sector. Increasing the capital reserve will only contribute to that. Tightening the rules for what can be counted as capital will also be positive. Reducing the banks' possibilities of using the capital reserves to play the financial markets will not be a negative influence on their lending activities.

Banking industry representatives have already been out there telling that the new rules will "delay the recovery". Excuse me! For new rules that are implemented in 2018?? In the past year, at a time of record profits and government guarantees, the banks have not resumed lending but have preferred to place their liquidity reserves with the central banks and play the bond market yield curve as best they could.

The risk willingness of the sector has shrunk dramatically in the recent past, and leads to yet another bout of behaviour that holds the rest of the economy hostage. This time it delays the recovery.

The banking sector as a whole had demonstrated its greed-driven incompetence beyond any reasonable doubt in the past two years. So when regulators now tighten up the rules, it is in order to protect the rest of us from a yet another repeat performance. That implies reducing that bank balances and increasing the capital reserve requirements. Time for the banking sector to go back to work.

Judging deflation risk

2010-09-02T14:47:00.001+02:00

Are you afraid of deflation? Probably not, and for two reasons. One is that we have not had any experience with deflation for more than 70 years. The other is that because of this time distance, we have no real experience in estimating the conditions under which deflation will prevail.

For many years, the dominant way of thinking was that inflation is purely a monetary phenomenon. If the central bank for some reason "prints too many bank notes", we will end up with "too much money chasing too little goods" and that will force up prices.

However, this simplistic theory ignores another fact, that when increased demand can be met quickly by increasing output, no inflationary pressures will emerge. Only when production cannot keep up with demand, the foundation for inflation is laid. Several institutions, eg. OECD, regularly publish an estimation for how much extra capacity the economy has available. It is commonly referred to as the "Output Gap". For many years, this gap has comfortably been around 2 percent.

In 2008, the Western world saw the fastest contraction of output ever seen. My perception is that Cisco-style production and inventory management combined with a carpet bombing of media coverage of the bank crisis created an extraordinary fear in business managers. As a result, orders were cancelled, inventories were slashed, investment plans were binned, all at a pace never seen before. It is probably fair to assume that managers still have a tendency to act quickly in case of bad news.

As a result, the Western world today has the largest output gap on record. Probably, the economies could increase output by 5-7% before reaching capacity. Add that despite the downturn, the technological progress continues, adding quite a bit every year through new technologies and work routines.

And here we come to the real problem. Despite the economic recovery seen over the past 12 months, the growth speed has not been enough to significant reduce the output gap. It means that despite economic growth, the deflationary pressures remain. On top of that, the intense price competition from Asia continues as strong as ever.

Add now that economic growth is slowing. In the US and the UK, it is a structural phenomenon, as households continue to repair and reduce their balance sheets, killing the much-hoped-for recovery in private sector demand and will continue to do so for the next 4-5 years. Elsewhere, the slowdown appears to be a combination of premature austerity programs and a regular "mid-cycle" slowing of growth.

I do not (yet) subscribe to the double dip view. But the fact that the economic growth is anaemic is enough for the Output Gap to remain wide open. In other words, there is nothing out there that can counter the deflationary forces of having a huge output gap for an extensive period of time. If it continues we will enter a period of negative inflation sometime in 2011

Oddly enough, only the bond markets have reacted rationally to the situation. And they have only reacted to the ever-falling inflation, not to the expectation of a lower future inflation. The stock market has not yet eyed the risk. Caveat emptor.

Yuan back to normal

2010-06-21T10:32:00.002+02:00

In a statement crafted with traditional Chinese care, it was announced the China's monetary authorities would allow for more flexibility in the movements of the Yuan. This Newspeak caused something of a stir in the markets, which immediately began to brace themselves for a major appreciation of the Chinese currency. Markets are likely to be disappointed in this respect.

There had been rather quiet around the Yuan for a while. USA's China-bashers had for some reason backed down and that created the situation we described in an earlier post: China needs to revalue the Yuan for purely internal purposes, but cannot be seen to bow to pressure from the most populist US lawmakers.

China has an urgent need to control the capital inflows that result from running a huge current account surplus, but has not equipped herself with a modern money market and the necessary instruments. Instead, Chinese monetary policy is run on the basis of quantitative methods reminiscent of the period of central economic planning.

Needless to say, when there is a huge appetite for credit in one segment of the economy (property and construction sectors), and the government tries to cut off this sector's access to otherwise abundant liquidity, you set yourself up for major distortions that provide huge incentives for corruption.

In 2008, the Chinese government was the first to introduce a major package to cushion the impact of the international banking crisis: This package has now been proven efficient, and the Chinese leadership can rightly be proud of the timely action. However, the package did not shift as much growth over to domestic demand as hoped, and recently the Chinese trade surplus has begun to grow again.

Thus the monetary inflows have begun to increase again at a time where the Chinese economic policy authorities have clearly signalled that they want to see slower growth.

Before the outbreak of the international crisis, the Yuan had been allowed to appreciate in a clear but controlled manner against the USD. In July 2008 this policy was reversed and the currency was again locked to the USD. As a defensive initiative it was a brilliant move. Nobody knew if the Dollar would go up or down as a result of the goings-on in the banking sector. Roughly half of the world's economy is running a de facto peg to the USD.

By locking the Yuan to the dollar, China chose to protect their relative position towards the major export markets. Obviously not against Europe, but the Euro proved to be the stronger currency. This solution helped Chinese exports but created some other problems.

Now the exports are back on track, and the Chinese authorities appear poised to resume a policy of a slow and controlled revaluation of the Yuan. The probability of a sudden, major appreciation of the Yuan is close to zero.

The winners will be China's direct competitors as well as companies exporting to China. This has been clear for a while. This week-end's announcement is not revolutionary. It is just a reassurance that China's monetary policy has reverted back to the crawling peg policy from 2005-2008.

Stressful stress testing

2010-06-18T11:56:00.002+02:00

EU leaders yesterday agreed to publish the results of stress tests, performed by European banks. Spain was forcing the hand of her fellow Euro-zone members by declaring that the results of stress tests performed by Spanish banks would be published irrespective of the EU decisions. The stated goal of conducting stress test and of publishing the results is to increase transparency. Hopefully this will calm down the markets, which are now increasingly doubtful about Spain's public debt.

A stress test is a series of calculations, aimed at simulating losses incurred by a bank under a series of specific assumptions about the economic developments. The purpose is to show whether the bank has sufficient capital to survive if accident strikes. US banks were subject to a stress test in 2009 and some banks were revealed as being undercapitalised. The US government subsequently provided help to those banks under the TARP program.

The direct reason for the EU move is the increasing rumours concerning the health of the Spanish banking sector. Spain is currently undergoing its own savings bank crisis, with most of the 45 regional savings banks having ventured into lending activities that are now killing them. 16 of the savings banks are on the brink of collapse and one, CajaSur was taken over by the central bank.

Markets now fear that a) the commercial banks are in similar dire straits and b) that healthy banks will be forced to take over the unhealthy ones, given that the government finances will not allow a bail-out.

The Spanish government and central bank (who had impeccable credentials before the creation of the Euro) have attacked the issue head-on. They have pushed Spanish banks to bring losses forward instead of hiding them, as it is now allowed under European accounting rules.

This step towards transparency has already brought two consequences: Spanish banks have underperformed their European counterparts, and they are already rumoured to come out on top once the stress tests are performed and presented. Seen on this background, the Spanish government had little to lose by releasing the stress tests.

Not surprisingly, virtually every European banker has taken to the microphone in the past 18 hours. 'Stress tests are a not a bad idea, but please do not publish the results' seems to is the message they convey.
This looks like a living proof how little bankers have learned from the crisis over the past couple of years. They still believe that their businesses are best protected behind a shroud of secrecy, when it is increasingly clear that transparency is the way to create reassurance.

Of course some European banks are badly capitalised. European governments have tried to make bank rescue packages on the cheap and that will show. But the correct way of handling this is not by pretending that the problems do not exist.

Armies of financial analysts are convinced that Spanish banks are carrying tonnes on hidden bad loans on the books. This is a clear sign that the secrecy thinking is deeply entrenched in Europe. It can only be bad for business.

In a past life I worked in an investment firm where we almost never had European financials in the portfolio – for the simple reason that they were not sufficiently transparent. While stress testing for sure has its shortcomings, there are only reasons to cheer the EU for the decision to force the banks' hands. Obfuscation is no solid basis for business.

Rating agencies under heavy pressure

2010-06-16T15:47:00.001+02:00

As an element in the ongoing political battle for financial reform in the US, the newspapers report a victory for the rating agencies. Well, sort of.

First, for those who have not yet heard of rating agencies, an ultra-short primer. A rating agency is a commercial company that produces ratings of various debt instruments, paid for by the issuer. The ratings are supposed to be based on a thorough analysis of the issuers' ability to repay the debt. There are three US based rating agencies that have government authorisation, Moody's, Standard and Poor's, and Fitch. Across the world, pension funds and insurance companies have used the ratings to "control risk" in their portfolios.

Many of financial institutions have a provision that if one of the rating agencies has issued a rating below investment grade, the institution simply cannot hold the security in their portfolios. US government agencies are required to use the ratings. Further, the ratings agencies have been protected under a peculiar interpretation of the Constitution, whereby their ratings were considered an expression of "free speech", meaning that it was impossible to sue them for any kind of malpractice. Their ratings are – despite the supposedly thorough analysis – just an opinion.

In the aftermath of the dotcom bubble, the reputation of the agencies took a bad hit, as the ratings of companies such as Enron dropped from the coveted AAA to "junk" in a matter of weeks before the company went bankruptcy (and months after the stock price had fallen by more than 90%). Surely the ratings agencies should have seen it coming, if they really had checked the books.

In the wake of the Sub-Prime Crisis it became abundantly clear that the rating agencies had "adapted" to the wishes of the issuers and had bestowed their highest ratings on packages of dodgy debt based on a paper-thin assurance from badly capitalised insurers. Who had by the way also been rated by the very same rating agencies.

And most recently, the rating agencies began to meddle with the EU as they have lowered the rating of Greek debt to "junk" status, despite a massive underwriting by the EU. Yes, the rating agencies defend themselves, but the underwriting will end in three years. Apparently their experience with both Sub-Prime issues and Enron or WorldCom have taught them a lesson about being ahead of the curve. But many institutional investors decided not to sell their holdings of Greek government debt, breaking with the diktat from the agencies.

Now their previously unassailable status is under heavy attack. The EU is actively trying to promote European rating agencies. The planned US reform of the financial sector will most likely lead to a change in the constitutional protection (so they can be sued for telling fibs), US government agencies will not any longer be required to use the services of the rating agencies. There will have to be far more openness and transparency about their ratings and analysis.

Amid all this bad news for the rating agencies, it is made out to be a victory that the US Congress has dropped an idea of assigning rating assignments on a random basis. Some victory.

For the rest of us who take an interest in risk management, what is going on is highly interesting. In a recent blog post I laid out how some of the thinking members of the financial community have arrived at the conclusion that mathematical models of risk are useless when they are most needed.

Now all of those who had used ratings as an excuse for independent thinking are receiving yet another blow. If you cannot consider the ratings as the results of proper diligence, how should you then manage a portfolio of debt instruments? I am afraid that I again come back to my conviction that there is no alternative to independent thinking.

In the real world, businessmen know that there is no such thing as a free lunch. Risk exists, even if you would really, really like it to go away (or to be sold off in tasty little morsels). Faced with this categorical imperative, too many risk managers have for too long relied on mathematical models and ratings. The mathematical models are built on assumptions alien to the real world. Ratings are issued by commercial companies who have shown clearly that ratings are a product which can be moulded to the clients' needs. For sure it is not quite as independent and well-founded as rating agencies would like us to believe.

Risk managers of the world, unite. You have everything to lose if you don't start thinking.

New risk regime – or “Houston, we have a problem”

2010-06-16T09:50:00.001+02:00

We have long been adamant that risk models based on Value at Risk (VaR) or other backward-looking statistical models are close to useless. The reason is that the underlying correlations between financial variables are inherently unstable, and that this instability is most pronounced in periods of strong market movements.

In a remarkable piece, Jim Caron, Morgan Stanley's Head of International Bond Strategy admits to have found out that something is wrong. In a recent piece, he admits to having been wrong on interest rates and bond yields. It may well be so, but the more interesting is his observation of recent market movements.

"April and May were difficult months for us and others, judging by fund data on market performance. We did not properly discount the risks associated with peripheral Europe. As a result, we had a larger risk exposure than we should have. We measure the return potential for our positions on a per-unit-of-risk basis, similar to a Sharpe Ratio. That unit of risk turned out to be much higher than we anticipated. This will force us, and many others, to right-size our risks."

In other words: the models used to discount risk have understated the risk. Caron is optimistic that it is possible to "right-size". It counts in his favour that he actually tries to find a way out of the problem. He suggests the following

Liquidation of risk exposure: Portfolio positions turned out to be much more correlated than we had initially anticipated. Traders seek to reduce correlation by liquidating many positions, leaving behind perhaps only a few core positions. We saw these liquidations in May and early June

Sit, wait and re-assess: Traders will now have to evaluate the new risk relationships. Since there is great uncertainty, traders might start by making small and short-term tactical bets to get a feel for the risks. Again, only a few core positions may still be left on.

Right-size risk: As the new market environment becomes somewhat better understood – albeit still marked by great uncertainty and higher realized volatility – traders could now start to make an assessment on the proper risk they should have relative to the increased level of expected volatility of returns. For example, if the market is twice as volatile today as it was before, then one should run positions with half the size of risk.

For better or for worse – the introduction of a new tail risk: Given the losses taken and positions liquidated in the past few months, the new tail risk is for risky assets to reverse sharply higher and for yields to rise. This could cause traders to chase performance, so as not to be left behind relative to their peers. Similarly, if markets turn against them, then they will be quick to exit. This introduces two-way risk: traders may start to react equally to both good and bad news. Previously, the tail risk traders were mostly focused on a worsening of risky assets. Now they have to be concerned about both tails, for better or for worse, which will add to market volatility.

It all sounds very reasonable. But it sidesteps one important issue: the complete collapse of predictive models when multiple sigma events like the May Flash Crash and the accelerating sovereign collapse of the past several months occur.

Carons observation that "Portfolio positions turned out to be much more correlated than we had initially anticipated" hammers the point home - markets are not inherently stable. But the situation is more serious than Caron thinks: There are no models that can model the behaviour of the financial markets when disaster strikes. The solution is to introduce much simpler and much more pragmatic ways of dealing with risk, once it appears. Risk cannot be dealt with by a machine, however clever. This has been known for ages outside of the financial markets. The financial markets need to reconnect with the real world.

EU Commission is (again) told to back off

2010-05-14T11:36:00.001+02:00

The week started off in a way that looked constructive. Facing a major run on the Euro and the debt of the Club Med members, EU responded constructively. A prototype of a European Monetary Fund was launched and the ECB assumed wider responsibilities than seen before in running day-to-day monetary policy. So far, so good.

To anybody with a bit of insight it has been clear that the Eurozone was a project where everybody wanted the benefits of a common currency without being willing to sacrifice political sovereignty. Everybody wanted to maintain the fiscal policy as a purely national matter.

The "Stability Pact" was a feeble attempt at establishing some rules that would at least impose some limits on the most profligate members. The Pact envisioned a system of economic sanctions on those member states that did not adhere to some simple rules regarding government debt and budget deficits.

As it is now obvious, nobody took those rules seriously, and the sanctions were never applied. Greece's lack of budgetary discipline threw the EU into one of the deepest crises ever.

Some of the ideas flying around after last week-end's panic summit were in fact quite sensible. One idea presented yesterday was to equip the European Commission with some powers to approve budgets before they were implemented. In order to avoid the nasty idea that the EU Commission would try to exert influence on national budgets, the approval was suggested to take the form of a "peer review". This would imply that representatives of other EU countries – but not the Commission - would review a country's budget.

The idea was then to let the "review committee" suggest changes and ultimately even sanctions that could take the form of withdrawal of EU subsidies.

This seems reasonable, particularly given that German Chancellor Merkel and French President Sarkozy in the days leading up to the summit jointly vented the idea of giving EU more authority in budget matters.

But now the crisis is over (?) and we are back to reality. And the reality is that France has no intention to hand over budget authority to Brussels. A French government spokesperson briefly stated that the authority over budgets lie with the national governments and not with the Commission. The Swedish prime minister expressed that the peer review was only necessary for country with "bad finances". One can only guess about the reaction in London, but it is unlikely to be positive.

So it goes. The reality is that Europe is not yet ready for the political demands of having a monetary union. Everybody wants a free ride on Germany's tailcoats. One can only guess how many more crises are necessary to either break up the Euro Zone under the weight of huge differences in government finances and productivity or to remove the political resistance to the necessary integration.

Nationalism was invented in Europe in the aftermath of the 1848 Paris Commune as sovereigns tried to protect themselves from revolutionary ideas spreading. Among the many results were national hymns, the sudden creation of national languages, national education system, a professionalisation of the administrative systems.

And it may still lead to the collapse of the most ambitious attempt at creating a European Union.

Small but important steps in fixing the monetary union

2010-05-10T14:12:00.001+02:00

Most of us harbour bad habits and it often takes a life-threatening event to make us change our ways. It seems to work that way in many other contexts as well. EU or the Euro Zone was badly under pressure last week as the financial markets began to doubt the viability of the Euro project.

In some of my earlier posts, I have expressed my doubts about the long term prospects for the Zone, given the huge structural differences between the countries and the lack of integration. The EU summit in Brussels this weekend addressed none of that, but took clear steps in overcoming some of the most glaring deficiencies.

Right from the start it has been a problem that the Euro was launched without the creation of strong institutions to support it. In order for a currency union to work, one would expect a strong central bank, and a central budget instance with the possibility of financing deficits in the markets if needed.

Instead we got a central bank with a very limited charter (inflation fighting), and no central fiscal authority. Plus an increasingly unwieldy decision process as a steadily increasing number of members have resisted handing over authority to the EU institutions.

The Greek crisis forced some changes to all that. We now have the first steps towards establishing the Commission as a fiscal authority (managing the huge stand-by facility for countries in need of credit while dealing with fiscal problems), ECB announced that they suspend the rating limits for Repos, and will begin to make open market purchases in bonds issued by institutions and companies in Europe. ECB will also become more active in offering overdraft rights to commercial banks, something that the US Federal Reserve and Bank of England did already in 2008.

While market participants may complain that the underlying budget issues have not been resolved, the steps agreed by the EU member states have all the potential to become a game changer. EU just made a significant move in the direction of strengthening the monetary union. It may not dispel all doubts about the debt of the Club Med members immediately. However, I believe that the markets will eventually realise that this is meant very seriously.

So compared with the situation a week ago, we have now seen that the EU has moved to strengthen the community institutions, to give the ECB a good deal more muscle, and to show that fiscal solidarity is available to member states who take determined action to address their fiscal deficits. The only question that lingers is: why did it take so long until something happened?

That is an issue for the history books, but it has to do with Europe being made up of sovereign states which have a very hard time accepting to play together as it is needed in order to have a monetary union.

For now, we should see the panic sentiment seep out of the market. The market panic was based on ignorance about the fiscal and financial effects of the Greek loan package. With the new stand-by package, such worries should be addressed. ECB's new liquidity facility for the banks should remove the fears between European banks. Markets should recover. The long term problems inside the EU will, however, persist and will rear their heads again. But that is for tomorrow's markets, not today's.

Another Greek lesson

2010-05-06T16:31:00.001+02:00

The misadventures of the Hellenic Republic continue to roil the financial markets. Despite a considerable stand-by loan package from IMF and the EU, the markets continue to react as if there is an imminent danger of a Greek debt default. Stock markets fall, yield spreads continue to increase, crude oil has plummeted, other commodities are falling, and the Euro is heading south. Junior parliament members are taken as witnesses that the European governments will renege on premises, and all the Euro-sceptic analysts in the entire English-speaking world have come out of the wormholes. There is apparently only one possible reaction: SELL!

I have repeatedly stated my conviction that the initiatives taken by the IMF and the Euro Zone in concert will be sufficient to solve the current situation at least for the next 3-4 years, and it follows that my take on the market reaction is that it is blown out of proportion.

Greece is the black sheep of the Euro Zone, no doubt. 13-14 per cent budget deficit, fudged budget numbers, lax accounting standards, collusion with Goldman Sachs to "hide" debt. The list of misdemeanours is long and impressive. Worst of all, however, is the culture of tax evasion. In a country of more than 11m inhabitants, less than 5000 persons filed a tax return stating taxable revenue in excess of €100,000 in 2008. Apparently large swathes of the population do not pay income taxes at all, and predictably, it tends to be the better off who enjoy this privilege.

No wonder that it will take a while to fix.

But even when the package is in place and the financial markets have caught their breath, there are certainly issues to address. One was raised by Germany's Merkel and France's Sarkozy in concert. Their point is the simple, that in order to make the Euro work better, there has to be a much better budget discipline among the member countries. Their solution would be to strengthen the central oversight – i.e. to create some kind of Euro Zone budget watchdog.

Sounds fair enough, but the question would be what kind of powers would be invested in the new central budget authority. Already, there is a draconian system of fines put in place. But as the Greek adventure has shown, the sanctions are dropped once the going gets tough. So let me guess.

Merkel and Sarkozy want to create a central budget authority that can, could, would kick out countries with an insufficient budget discipline. Such as Greece in three years' time if a comprehensive tax reform is not in place.

Productivity is another issue. Germany built its economic success in the Post-war period on having a stronger productivity growth than all other countries. It gave Germany a huge economic advantage and room to keep inflation down by constantly revaluing the D-Mark against the trade partners.

When Germany purchased the neighbouring DDR at an inflated price it took some 15 years until the German productivity miracle was back. In the meantime Euro had replaced D-Mark and countries with higher inflation and much, much lower productivity growth had managed to gatecrash. And this is the fundamental problem of the Euro, if there ever was one. Combining national states, different languages and cultures, and low labour mobility with pronounced productivity differences and a common currency is not exactly the recipe for success, EU had expected.

Germany, which has been bankrolling EU for decades, is understandably worried about the contingent claims that may be forthcoming. Referring to Germany's success, officials have been busy promoting German budgetary virtues everywhere. But the issue really is not the budget. It is only a beginning. The issue is what it takes to maintain a currency union across huge differences. It may well be that all the political will and all the stand-by loan facilities may not be enough.

Headlines and other lines

2010-05-05T11:12:00.002+02:00

The Greek story continues to take the headlines and is being used as the explanation for the continued weakening of the Euro. I see no reason to buy the story. When you have finished listening to the news programs and reading the newspapers, all telling that the Euro is doomed, try and think objectively, you might end up reaching a different conclusion.
For starters, it is useful to watch such a thing as the USD trade-weighted index. Since December 2009, this index has increased by 13 percent. So when somebody says that the Euro has weakened by 15 per cent against dollar, 13 per cent of that change comes from a strengthening of the dollar.
Of course, part of that has to do with the fact that the Euro-zone is one of the USA's largest trade partners. But it nevertheless indicates that the talk about "the" European sovereign debt crisis as being the reason for an imploding Euro completely misses the point.
At the outset of the global economic crisis, virtually every major currency weakened against the Euro. Probably many reasons could be given for that, nevertheless the result has been that European exports have suffered and increasingly it looks as if the European economic could enter into a "double-dip". Even if it was not announce that way, the situation looks like a replay of the competitive devaluations of the '30s.
USA, UK, Japan, and Sweden have all pushed some of their economic problems over to the Euro Zone. When the Euro weakens, the member countries of the Euro Zone recover some of their lost competitiveness. Probably this is the reason that no comments at all in order to support the EUR have been forthcoming from ECB or any other quarters in order to reverse the trend. European politicians appear quite happy to see a stronger dollar.
Meanwhile, the US economy appears to have turned the corner and has repeatedly seen growth data well ahead of the expectations. The US trade deficit has shrunk visibly (even if it again trends towards a widening). US corporations are making money and more than widely expected. So buying dollars rather than Euro is not a hard case to sell.
It has also become popular to refer to the PIGS countries when talking about the southern European EU members. Apart from the obviously derogative content of the abbreviation, it also belies the fact that the 4 countries have very different situations and very different problems.
Greece has a huge debt and chaotic public finances. Portugal has a huge debt, but relatively well run public finances, Spain's debt is by comparison low, and the main problem is the soaring unemployment. Italy has a high debt, but did not see a disastrous deterioration of the budget deficit in 2008 and 2009.
Summing all of this up, it means that we should not fear a weaker Euro, as it will only create better possibilities for European exports, and we should not be led to believe that the southern European EU members have uniform problems that require uniform reactions. In particular, their current problems do not threaten the Euro.
If we should begin to look for European fault lines, we could begin to talk about the fact that the productivity differences between the various EU countries have widened markedly in the past decade, with Germany having made the most convincing progress. But this kind of talk does not easily translate into market talk, and is largely ignored.

A couple of Greek lessons

2010-04-30T11:30:00.001+02:00

Greece has taken all the headlines in the past week. Greek government bond yields have soared and so have the price on CDS's, also known as default protection. S&P downgraded Greek government bond yields to junk status. The air has been thick with rumours of an imminent default. The Greek government yield curve took the shape seen in countries just before a default: Short yields much, much higher than the yield on longer-dated issues.

All of this happened against a backdrop of an agreed standby facility offered by IMF and the European Union.

So we have now seen most of the financial markets and one of the 3 (American) rating agencies basically telling IMF and the European Union: we do not believe in your rescue plan. True, a number of European politicians have been trying to make some political mint on denouncing the Greek people/politicians profligate ways. True, the German government has not been forthcoming in terms of the soothing messages the market wanted to hear. True, the Greek government has met determined resistance to any cutbacks. All of this has of course created a fertile ground for rumours and half truths. Both are important elements in a good market run on something, be it a weak company, a currency, or the debt of a country.

There are many aspects of the Greece story. One is the potential viability of the current Eurozone. That is a subject for the longer term. In the short term, there are two lessons that market will probably have to learn. One is: don't mess with us! If the EU governments, led by Germany say that they will put a hand under Greece's debt, it means that they will actually do so. ECB and the German/French governments will with great gusto enjoy if speculators lose their shirt here.

It is my guess that Germany's Chancellor Angela Merkel will have some special consideration for S&Ps downgrading of Greece. As early as 2008, when the insidious role of the ratings agencies in creating the the Sub-Prime debacle, Ms Merkel pointed out that the ratings agencies were for-profit institutions and that the European Union ought to create an independent rating institution. S&P's description of the IMF/EU support package for Greece was described as "revocable". This choice of words is a direct challenge to the EU's resolve and is bound to reinforce the impression that S&P's downgrade was politically inspired. We will see.

The other lesson is that the financial markets may finally be waking up to the uncomfortable reality that default risk is a fact of the day. For the past decade, risk has almost been considered equal to the short term interest rates: when rates are comfortably low, we do not have to worry too much about risk, so let us add some. For the technically minded: When market volatility (or one of its derivatives, such as Value-At-Risk) is low, risk is low. I believe that the way the stock markets shook off the speculative selling of Greek bonds is a valuable signal. A general widening of the credit spreads would be another indication that a reasonable pricing of risk is on its way back.

A Chinese revaluation?

2010-03-17T14:45:00.001+01:00

American lawmakers, supported by some Europeans are clamouring for a strengthening of the Yuan or the introduction of a tariff on Chinese imports, aimed at protecting the domestic industry. China retorts out that there is no reason to listen to American claims, as the US trade deficit is structural and has not been helped by the steady decline in the value of the USD over the past decades.

The fact of the matter is that China pegged the Yuan to the USD for years until 2005. The Chinese authorities let the Yuan appreciate some 21% between 2005 and 2008, but when the crisis struck, the Yuan was again locked to the USD, and has been there ever since. My best guess is that we are about to see a slow appreciation of the CNY sometime in 2010.

Through its exchange rate policy since early 2008, China has profited from the weaker dollar, in the sense that exports have remained competitive to the USA and have gained strongly towards Europe and Japan. Together with a very quick response in terms of fiscal stimulus, China has been pulling out of the current downturn earlier than other large countries. It has also helped that the Chinese banks are government owned, removing any need for dealing seriously with bad debts.

If we for a moment ignore the political noises, there are two elements that strongly point to a coming strengthening of the Yuan. For years China has claimed that the domestic financial system was unfit for living in a world of floating exchange rates. While this may have been a valid objection 10 years ago, it is certainly not the case anymore. Hong Kong has for years been a major hub in Asian FX trading, and the transfer of knowledge from there has been significant.

The problem now seems to be the opposite. The peg to the USD is becoming a problem. Perusing official Chinese newspapers quickly reveal concerns over the domestic monetary situation. The combination of a huge export surplus and a fixed exchange rate towards the major trading partner is creating a healthy capital inflow. Without a bond market designed to soak up the extra liquidity, foreign currency (read: dollars) wind up in the currency reserve, while domestic liquidity increases quickly. This forces the government to introduce quantitative measures in order to restrict lending towards certain economic activities, such as construction. This has now reached a level, where domestic monetary policy is rapidly losing effectiveness, and despite trying to put a spin on it, it is obvious that the situation is getting untenable.

Letting go of the dollar peg would lead to a rapid increase in the Yuan, to less competitive exports, cheaper imports, and would immediately stop the inflow of capital. Given that Chinese exporters were already suffering at the beginning of 2008, it is unlikely that China would accept a sudden – and very possibly, disruptive – appreciation of the CNY.

But given the economic situation of the Chinese economy, the increasing exasperation of US congress members, and the difficult domestic monetary situation, all odds are that China will resume the "crawling peg". We are just waiting for a situation where it will not look as if the People's Bank of China is giving in to American pressure.

Bailing out Greece – to help the Euro?

2010-03-15T09:20:00.001+01:00

So Greece will really be bailed out by the EU? So it seems, even if there will be a good deal of smoke and mirrors making the support package look better than it really is. It will mainly be a series of measures, allowing Greece to finance her existing debt at better conditions than currently offered by the market, while maintaining the pressure on the Greek government to improve public finances. Personally, I do not believe that Greece will receive any support except for some loan guarantees.

But the whole Greece episode points importantly to two aspects of the current Euro cooperation. One is the cultural differences between north and south. The other is the political importance of the Euro, often overlooked by the financial markets.

When digging into the Greek public finances, it quickly becomes clear that profligate spending indeed is a problem. But that haphazard tax collection is a far bigger problem. Greece may make one ambitious budget after the other, but realistically, government finances will not improve visibly on this side of 2015 unless tax collection is improved. As opposed to Northern Europe, where taxes are collected with ruthless efficiency (and often with scant regard for the most basic principles of the rule of law), Greek tax collection is random. Just making sure that the government actually received the taxes due would make much of the current crisis go away.

Probably Greek tax collection will improve somewhat, but it will still remain a far cry from the standards of Germany, Sweden, or Denmark. Without a reliable tax collection mechanism, any Greek budget forecasts are pure fantasy. This is a cultural problem far more than just a question of overspending. Even a convergence to the European average will take quite some time.

The Euro is the posterboy of the European Union ambitions. So when the usual choir of anti-Euro campaigners from the City of London and their allies in the mostly Conservative press began to discount the demise of the Euro, they again overlooked the sheer determination to keep it afloat.

The Euro was not created in order to solve largely hypothetical problems in the Intra-European trade flows. It was created as a part of the European ambition to create an economic unit strong enough to challenge the US when it comes to domination of the world markets, including the financial markets.

The charter of the European Central Bank may well be too narrow for stepping in and taking the lead in a critical situation. And the reliance of the majority of EU countries on Germany to shoulder the economic costs may well be exaggerated. But in the end, all stops will be pulled to make sure that the Euro survives. This political will to make the Euro work will put everything else aside.

Including the fact that the Euro currently is overvalued by quite a bit. We are likely to see something of a relief rally in the EUR. Europe would need the opposite in order not to end up having a much slower recovery than other regions. Engineering a weaker Euro is probably out of the reach of the ECB. So we could do with another glorious little budget crisis inside the Euro Zone.

Carry trades

2010-03-01T09:58:00.001+01:00

Most people would think that a carry trade consists in borrowing in a currency with low interest rates (typically Swiss Franc) and investing in a currency with higher interest rates (let us say Icelandic Krona, just for illustration), the idea is to pick up the interest rate differential which is supposed to be the reward for the currency risk involved in the transaction.

As of late, the meaning of carry trade has changed a bit. It now appears that the interest rates are not important any more, which is quite evident, given that interest rates are close to zero everywhere. So carry trades now means borrowing in a currency which is expected to weaken against other currencies.

Since Dollar weakened against pretty much all other currencies from March to December 2009 (losing some 13 per cent against the Euro), the market began to talk about the "Dollar carry trade". News media have now begun to report that some investors are beginning to "worry" about the dollar carry trade, meaning that the dollar will continue to appreciate. At the same time, Wall Street Journal Friday printed an article stating that leading NY hedge fund managers have decided to gang up and try a "career trade" against Euro.

Europe should be so lucky! It would be just what we needed. Europe would truly profit from a weaker currency and the quicker the better. So if some hedge fund managers can help us, so much the better.

The English language financial press is prone to present any news about a weaker Euro as a sign of the Union's imminent demise. In this case, Greece's perennial budget problems are the reason.

Conversely, a stronger euro is rarely – if ever – presented as a sign of the strength of the European project. Usually you have to read the French, German, Belgian and possibly even the Italian financial press to get that view on things.

If we try to ignore all this political talk, the situation is that from the beginning of the European downturn, the Euro has been the currency that strengthened the most against pretty much everything: Dollar, Sterling, Yen, Swiss Franc, Swedish Krona. There has been little talk about this fact and even less talk about the fact that Europe's economic recovery would be significantly hampered by the surging Euro. But it is now visible in the European growth data.

In my mind there is no doubt that the Euro needs to weaken and by quite a bit in order to escape the worst effect of the "beggar-thy-neighbour" policy openly implemented by our friends and allies. The only question is by how much and how quickly.

Using my own indicator, the Euro can fall far. This indicator simply says that if Europeans are willing to travel to NYC to go shopping and come home laden with shopping bags, dollar is too weak. If the good burghers of my native Copenhagen are willing to sit on a bus for two hours to go shopping in Swedish Malmö on the other side of the Sound, then the Euro (and by extension the DKK) is way too strong.

Some are talking about parity between Euro and Dollar. Why not? In 2002 a Euro would buy only 85 cents. After the most recent 10% weakening, it still buys $1.35, still a whopping 60 per cent increase. Nothing in the relative productivity growth justifies that increase.

Would it not create inflation? Probably not as long as the potential output gap is as big as it is now. More expensive import goods, then? Yes, but that is the whole point of a weakening currency, that the domestic products gain in competitiveness.

And the speed of adjustment? Everybody loves to see things develop smoothly and in a straight line, not too quickly. The truth is of course that if the Euro were to weaken quickly, it would cause some disruption, once things stabilise everything settles back to normal.

So please, do not fear for the "dollar carry trade" when it can be turned into a "euro carry trade" instead. NYC hedge fund managers, please do not waste your time on too many "idea dinners". Do something, go ad sell some Euros short.

It would even make it easier for Greece to handle her economic situation.

Curious enough

2010-02-23T12:45:00.001+01:00

A month ago, I wrote that I thought we were in for a round of general re-rating of risk. It proved more right than I had expected it to be in the short run. But it happened in a quite different way than I expected it. Under normal circumstances, the bond markets would be where the clearest indications would show up and then the stock market would latch on at a later stage. That is what happened from early 2007 and onwards to August 2008. But this is not a replay of August 2008.

I find it quite obvious that fears of the looming debt crisis are playing havoc with the markets. It is equally obvious that there most market players have no idea what is really at stake and when and how it will strike. So all we have to relate to is a general feeling of uneasiness.

This time around we have seen a rather muted reaction in the bond markets and a strong reaction in the stock markets. It could be explained as follows: after the stock market collapse and a good run in 2009, probably the reactions from the risk management departments have become a good deal quicker. Faced with a mounting uncertainty about sovereign debt, probably quite a number of risk managers have strongly recommended to reduce portfolio risk, i.e. to cut exposure to the stock markets. This appears to be done broadly and not with reference to any specific countries. Probably a wise move given that once this kind of broad-based panics occur, it does not matter a lot what kind of stocks you happen to have in the portfolio.

Adjusting the bond market risk appears to be done using CDS's and not much else. The bond market appears to have the most muted response, being steeped in the tradition of evaluating individual default risks. We have simply seen a dramatic widening in spreads reflecting the apparently increased default risk in Greece.

This could be interpreted in a way, not particularly gentle on the stock markets. They reacted quickly to a rumour, to an unconfirmed story, and to facts that are not yet known.

The recent euro trend is more interesting. Since March last year Euro had gained against most other currencies, and as a result European exports have suffered. Now the markets – and the perennially Euro-critic camp in London - use the Mediterranean debt crisis as an excuse to sell Euro. We are now supposed to believe that the Euro is coming apart in the seams, as it has weakened some 10 per cent against dollar.

Most of the English language press chose to ignore the dramatic increase in Euro, but focused on the dollar's weakening instead. It was not a good story that Europe's economic recovery would be hampered by a stronger Euro.

Contrary to what one would believe reading the reports about Euro's terminal decline, its weakening is welcomed in most European quarters. A weaker Euro will support an economic recovery in the growth and reverse the beggar-thy-neighbour policy quietly supported by Washington and London. Instead of fearing a weaker Euro, we should celebrate it.

Waking up to a new reality

2010-01-29T09:30:00.001+01:00

This is beginning to look like something we have seen before. Stock markets are falling in a straight line. Yield spreads – the difference between government bonds and corporate/mortgage bonds – are widening. Sovereign spreads – the difference in yield between bonds issued by virtuous states (read: Germany) and reckless states (read: Greece, Spain, Portugal, Dubai) are moving the same way.

VIX, the index for S&P volatility, had fallen in a straight line since the panic in October 2008. With the recent setback, VIX has moved up visibly, indicating nervousness in the stock market. After months of overperforming, emerging markets are now leading the stock markets downwards.

Adding all of this together paint a picture of a market where risk aversion is increasing. Investors want to be better paid to take on risk.

We last saw this in early 2007 (and we all know how it continued), when there were good, solid reasons for the financial markets getting jittery.

This time around the situation is quite different. The economies are recovering, corporate earnings are heading north and beating expectations easily. Interest rates are low and liquidity is more than abundant. The stock markets are not by any measures expensive. Ben Bernanke has even been confirmed for his second term in office and the weather is beautiful in Davos.

So we cannot really use the economic background as an explanation. Instead I believe that the best explanation is found in the theme I addressed last week, general versus specific risk aversion.

Since 2007 risk pricing has moved in two long trends: First pricing of risk went through the roof and then, as the central banks opened the liquidity spigots, risk pricing fell dramatically. By some measures it even fell to prices lower than seen any time since 2005.

In other words, since 2007, the fears of a systemic meltdown and the attempts to stave it off have been the major drivers of risk aversion. Now that the economy is improving and the central banks are signalling that they will eventually adjust the monetary policy to a more normal situation.

The financial markets are coming off their life support and that will have a lot of practical implications. The tide will not lift all boats as it was the case through 2009 and we will be on our way back to a situation where we have to estimate the risk related to each individual investment.

The current trouble in Greece is a good example. The yield spread on Greek sovereign debt has risen in line with the market's appreciation of the risk. But as the story broke, the first reaction was to price all the other southern European countries as if they had the same problems. They may also have problems, but those problems are not the same as those of the neighbours.

This analogy is probably also true for the stock markets where even badly managed companies have gained strongly in value during the relief rally. This is unlikely to continue going forward. We will all have to go back to work and get used to the fact that risk is not only a macro factor.

Why should this mean that the markets go in reverse? For the simple reason that it represents a change in the dynamics compared to what we have seen in the past two years or so. And the markets have shown beyond any reasonable doubt that they are very bad at handling changing dynamics.

Taking on the banks

2010-01-22T10:10:00.001+01:00

President Obama yesterday laid out the main themes of his initiatives to curb the banking sector. Forget that the timing was chosen to position this issue as the main theme for the US mid-term elections. Forget that the best opportunity to have taken the fight to the banks was a year ago when the banks survival was dependent on government support.

It is good news that President Obama yesterday in a well-covered speech finally came clear about several of the issues that became clear in the aftermath of the banking crisis.

It is good news for many reasons. One is that the debate has now moved into very public spot, where it is much less likely that the banks and their lobbyists can exert discrete but powerful influence. Bank chiefs who award themselves 100's of millions of dollars in bonuses do not exactly have a lot of support in the public. It is good news as it is now clear that the Obama administration is doing something about one of the main moral hazard issues in modern capitalism: that banks have been allowed to grow to a size where letting them fail is not a political option.

It is also a stunning reversal of fortunes for former US central banker Paul A Volcker, who had been entirely marginalised by the Obama team. Volcker has been vocal in his criticism of the banks and their greedy practices and recently stated that the banks' most important contribution to the modern society in the past three decades was the ATM. Volcker has become an ardent proponent of introducing legislation effectively breaking banks into smaller specialised units, who each will have to manage their own risk.

Proposal now forwarded by the Obama administration indicate exactly that kind of thinking. Otherwise, the ideas presented were not particularly well thought out. The idea to prevent the banks from having proprietary trading appears to be a populistic element, mainly driven by Obama's attempt to tap into popular outrage over the astronomical bonuses handed out for 2009.

It does not matter that the ideas are unclear as an eventual law package will have little to do with the initial proposal anyway. What is important is that the Obama administration is now promoting the banks to the centre stage of policy making.

The financial markets still have not got it. The banking sector had grown out of proportion in the past 20 years and made up nearly 20 percent of the major indices while not bringing much to society except for a culture of greed and neglect of basic principles for handling of risk. Plus – of course – the bank rescue package that it will take a generation to pay for.

Apart from introducing regulatory reforms forcing a new and far more prudent approach to risk, there is no other way than to cut the banks down to a size where no bank is too big to fail. It will mean that the banking sector becomes less profitable, and through the iron laws of capitalism, it will mean that the sector will attract less capital.

If the Obama administration is successful in this new initiative, it will have a huge impact as it will be copied by governments elsewhere. For the markets, it means that the financial sector will shrink and that the expectation that banks should return the glory of yesterday is unrealistic.

For the markets and for asset managers across the globe, it is worthwhile following this debate very closely. If everything goes as Obama now indicates, we may well see the relative size of the banks in the various indices cut by more than half over the coming years.

Pricing of risk is about to change

2010-01-18T15:19:00.001+01:00

One of the hallmarks of the ongoing economic recovery has been the narrowing of yield spreads. In 2007, before the wave of collapses hit the banking sector, something happened in the bond and swap markets.

Yields spreads between government bonds and corporate/mortgage bonds increased and the prices of CDS's moved up significantly. Similarly, the TED spread, the difference between the USD interbank 3 month rate and the yield on 3-month US government bills, had increased. With the benefit of 20/20 hindsight, HSBC's decision to pull out of the US lending business following massive losses on Subprime loans marked the beginning of this development.

Since the rescue packages began to be implemented, the credit spreads and the CDS prices have fallen almost in a straight line. Ample liquidity in the banking sector has pushed the risk tolerance back up and some yield spreads have fallen to pre-crisis levels. In the past days, several of these key risk indicators have gone in the reverse.

So the movements over the recent days are an early warning that things may be about to change. It could be that we are on our way back to normal. The "normal" state of things is of course that yield spreads or CDS's should accurately reflect the default risk related to the individual issuer. This simple truth has not really been the case in the past couple of years.

Some events are now bringing home the truth to the markets. A high profile near-default (Dubai), some well-reported problems with an EU-member (Greece), and massive issues of corporate bonds have all contributed to an increasing nervousness.

In a broader perspective, the global economy is moved towards recovery, and the financial markets are well past the point where the dominant driver was the relief that we were not all going bust.

Instead, the financial markets are now driven by more everyday factors: Growth, profitability, valuations, monetary policy, inflation expectations, market issuance.

While these factors are standard fare, one of them, the monetary policy, is definitely not "standard" at all. It is explosively aggressive and even the most ignorant market participant knows well that it will not continue. And we all know that treasury bonds will swamp the market later in 2010. Corporate issues are already strong due to the reluctance of banks to lend money.

The question is whether there is anything to be nervous about. The answer is not quite as straight-forward as it would seem. General yield levels are not determined by supply and demand. It is determined by savings and investments in the society as a whole. If there is not enough saving to support the investments, yields will go up and vice versa.

At this moment in time we may well be facing a huge increase in government issues. But at the same time, consumers all over the world are saving or reducing their debts. As long as that is the case, there should be no reason to fear significantly higher bond yields. They may indeed fall in the short term despite market jitters.

Instead we should focus on the link between the ample liquidity and the risk premium. The risk premia have been driven down by excess liquidity. We all know that the excess liquidity will be drained out of the market at some point in time. So yields spreads should indeed increase. Does that mean that the market is getting more risk averse? Probably not, but it means that the price of risk is about to change.

Testing for the coming stress

2010-01-08T10:52:00.001+01:00

Two days ago the US Federal Reserve gave instructions to US banks to run stress tests, based on a scenario whereby short term interest rates would increase by as much as 400bp. It could easily be interpreted as if interest rates were just around the corner. It is probably not, but it is certainly a not-so-subtle hint that the banks ought to begin remodelling their balance sheets.

Over the past year, the banks have been busy recapitalising themselves by borrowing at zero cost from the central bank and investing the money in government bonds. It has given the banks a nice yield pickup of some 300bp and has helped the finance ministries to place some of the huge new issues, stemming from the effort to save the very same banks. At the same time, the banks have been more than stingy with giving out loans to companies and individuals.

Positioning the banks in this way gives a wonderfully discreet way of giving them a hefty economic support: the 300 bp in yield pickup is of course paid for by the taxpayers.

But there is a downside, and a significant one. If the short term yields increase by 200bp and the government bond yields increase by 100bp, the value of the bond holdings will drop like a stone. Since the government bond market is highly transparent, it is not possible to hide the lower value of the bond portfolio. The result is that the banks would be hit badly, not by the higher short term interest rates, but by their bond holdings.

For those of us old enough to remember the Savings and Loan Crisis in the early 1990's, this is exactly what happened when Fed increased the interest rates. Then-chairman Greenspan had otherwise issued an extraordinarily clear statement that interest rates would go up some three months before the event. The banks had just not believed it would happen.

The current situation in some respects bears comparison with the aftermath of the S&L cleanup. This time there is the added complication that many banks still have a significant exposure to collateralised mortgage securities. A significant part of those loan packages are based on variable rate mortgages, and mortgages with an initial interest-only period. Mortgage lenders with such structures will be hit badly once the short term interest rates begin to increase, and that may lead to an increase in loan delinquencies.

In other words, the banks have positioned themselves for a maximum use of the low interest rates to bolster their profits and their capital. They may not have positioned themselves optimally for what will happen within 18 months from now.

I have argued that it would be a while until short term interest rates would begin to hit the economy. But given the way many banks have positioned themselves, they will be hit by the slightest increase in the short term interest rates.

It again seems that the drive to maximising profits from a given situation implies that some obvious risks are being ignored. Sounds eerily familiar, doesn't it?

Central banks are not putting the foot on the brake

2009-12-29T12:49:00.003+01:00

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.

Back to normal?

2009-12-22T01:57:00.002+01:00

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.

On dollar, risk models, and market stability

2009-12-16T15:57:00.001+01:00

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.