Waking up to a new reality

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

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

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

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

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 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

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.