Posts Tagged ‘Meltdown’
Guest Post: Is Present Monetary Policy Rational?
Saturday, 11 May 2013 12:33
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Submitted by Detlev Schlichter of DetlevSchlichter.com,

While the stance of monetary policy around the world has, on any conceivable measure, been extreme, by which I mean unprecedentedly accommodative, the question of whether such a policy is indeed sensible and rationale has not been asked much of late. By rational I simply mean the following: Is this policy likely to deliver what it is supposed to deliver? And if it does fall short of its official aim, then can we at least state with some certainty that whatever it delivers in benefits is not outweighed by its costs? (Read more…) I think that these are straightforward questions and that any policy that is advertised as being in ‘the interest of the general public’ should pass this test. As I will argue in the following, the present stance of monetary policy only has a negligible chance, at best, of ever fulfilling its stated aim. Furthermore, its benefits are almost certainly outweighed by its costs if we list all negative effects of this policy and do not confine ourselves, as the present mainstream does, to just one obvious cost: official consumer price inflation, which thus far remains contained. Thus, in my view, there is no escaping the fact that this policy is not rational. It should be abandoned as soon as possible.

The policy and its aims

The key planks of this policy are super low interest rates and targeted purchases (or collateralized funding) of financial assets by central banks. While various regional differences exist in respect of the extent of these programs and the assets chosen, all major central banks – the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan – have been engaged and continue to be committed to versions of this policy. Its purpose is to facilitate exceptionally cheap funding for banks and to affect the pricing of a wide range of financial assets, in particular and most directly government bonds but also mortgage bonds in the US and real-estate investment trusts and corporate securities in Japan. There is an ongoing debate in the UK and in the Euro Zone, too, about directly boosting prices of other, ‘private’ securities, that is, to have their prices manipulated upwards by direct purchases from the central banks.

To the wider public this policy is described as ‘stimulating’ growth, ‘unlocking’ the flow of credit and ‘jump-starting’ the economy. If that is indeed the aim, this policy has already failed.

We have now had almost five years of near-zero interest rates around the world. If such low interest rates were indeed the required kick-starter for the economy, we should have seen the results by now. ‘Stimulus’ is something that incites or arouses to action, a kind of ‘ignition’ that sets off processes, in this case, one assumes, a self-sustained economic recovery. But if the world economy was really fundamentally healthy and only in need of a dose of caffeine to stir it back into action, then dropping rates from around 4 to 5 percent to zero, as happened already 4 or 5 years ago, should have done the trick by now.

Defenders of the policy will argue that we would all be in much more of a bind without it but this is not the point here. This is something we can discuss when comparing costs and benefits. There is no escaping the conclusion that this policy has failed if its aim is to provide a required ignition – the stimulus – to ‘jump start’ the economy.

In support of my conclusion that this policy has failed as a ‘kick-starter’ of self-sustained growth I can quote as witnesses the very officials and experts who advocated this policy in the first place and who are still implementing it. Not a single one of the major central banks is even close to announcing the successful conclusion of these policies or is even beginning to contemplate an exit. 5 years into ‘quantitative easing’ and zero interest rates, the Fed last week began to openly consider increasing its monthly debt monetization program. Although the week ended on a bright note, at least for the professional optimists out there, as the unemployment rate came in a tad lower than expected, manufacturing data during the week was disappointing and the US economy is evidently entering another growth dip.

Still, many argue that the roughly 2 percent growth that the US economy may achieve this year is nothing to be sniffed at. Yet, for a $15 trillion dollar economy that is just $300 billion in new goods and services. In the first quarter of 2013, the Fed expanded the monetary base by $300 billion alone, and the central bank is on course for $1 trillion in new money by Christmas, while the federal government will run a close to $1 trillion deficit despite the ‘sequester’. That is very little growth ‘bang’ for a lot of stimulus ‘buck’. Self-sustained looks different.

Last week in the Euro-Zone, the ECB cut its repo rate to 0.5%, a record low. If suppressing interest rates from 3.75% in 2007 to 0.75% by 2012, has not lead to a meaningful, let alone self-sustaining recovery, or at a minimum the type of underachieving recovery that would at least allow the ECB to sit tight and wait a bit, what will another drop to 0.5% achieve?

Shamelessly, some economists and financial commentators cite high youth unemployment in countries such as Spain as a good reason to cut rates further. The image that is projected here is evidently one of countless Spanish entrepreneurs standing at the ready with their investment projects, willing and eager to employ numerous Spanish young people if only rates were 0.25% lower. Then all their ambitious investment plans would become potentially profitable, and the long promised recovery could finally commence.

The number of young Spanish people who will find employment thanks to the ECB cutting rates close to zero cannot be known but I suggest a number equally close to zero is a reasonably good guess.

The ‘benefits’ – or are they costs?

This is not to say that this policy has no effects. It even had benefits, for some.

By suppressing market yields and boosting the prices of financial assets this policy has delivered substantial windfall profits for owners of stocks, bonds, and real estate. Those who did, for example, speculate heavily on rising property prices in the run-up to the recent crisis, then were put through the wringer by the financial meltdown, now find themselves happily resurrected and restored to their previous wealth, if not more wealth, courtesy of central bank charity.

The 0.25% rate cut from the ECB may not lift many young Spaniards into employment but it surely makes ‘owning’ financial assets on credit cheaper. For every €1 billion of assets the rate cut means a €2.5 million saving per year in cost of carry, as duly noted by the big banks, ‘investment’ banks and hedge funds. After the ECB rate cut, German Bunds reached new all-time highs as did, a few days later, Germany’s main stock index.

That we are witnessing strange and dangerous deformations of the capitalist system, if we can still even call it capitalist, and that new bubbles are being blown everywhere, is not only evident by the increasingly grotesque dichotomy between a woefully underperforming real economy perennially teetering on the brink of renewed recession and a financial system, in which almost every sector is trading at record levels, but also by the fact that the high correlation among asset classes on the way up to new records is beginning to strain the minds of the economists to come up with at least marginally plausible fundamental justifications for such uniform asset inflation. ‘Safe haven’ government bonds that would usually prosper at times of economic pain are equally ‘bid only’ as are risky equities and the grottiest of high yield bonds. The common denominator is, of course, cheap money. And if cheap money for the foreseeable future is not enough, then how about cheaper money – forever?

A conflicted conscience or outright embarrassment are now stirring some financial economists to suggest that the joys of bubble finance should be brought straight to the economic war zones in the European periphery, and that in order to have a bigger impact on the ‘real’ economy, the ECB should buy private loans and other local assets in these regions and thus more directly interfere in their pricing. The manipulations of the monetary central planners are too blunt, they need to be more fine-tuned. These suggestions are dangerously wrongheaded. Extending the addiction to the monetary crack cocaine of cheap credit beyond the financial dealing rooms of London, New York and Frankfurt and to the economy’s productive heartland is not going to solve anything, at least not in the long run, and that is a timescale that may still matter to some people, at least outside of the financial industry. Spain needs nothing less than a new artificially propped up real estate boom. The aforementioned Spanish youth would only swap today’s dependency on state hand-outs for dependency on never-ending cheap-credit policies from the ECB and ongoing asset-boosting price manipulations. This has nothing whatsoever to do with sustainable growth, lasting and productive employment and real wealth creation.

The fact that trained economists today seriously contemplate these policies and are willing to dress them up as ‘solutions’ only goes to show how far the new ’entitlement culture’ on Wall Street and in the City of London, where everybody now feels entitled to cheap credit and ongoing asset-boosting policy programs as the universal cure-all, has affected economic thinking. The speculating classes are beginning to feel generous: “Hey, this free cash is great. Let’s extend it to everybody.”

Would a deflationary correction be better?

Back to our cost-benefit analysis. The defenders of the present policy will argue that without it GDP in the major economies would have dropped more, that asset prices and lending would be more depressed, and that we might even be in the middle of some dreadful debt deflation. Maybe so. But to the extent that the present GDP readings are the result of central bank pump priming and not the result of renewed growth momentum, they are simply artificial and thus ultimately unsustainable. In fact, the mere suspicion that this might be so must undoubtedly depress optimism and thus the willingness to engage in the economy and put capital at risk. Nobody knows any longer what the real state of the economy is.

While the unemployed Spanish youth may not benefit – or only very marginally so – from record high German stock prices and their own government’s renewed ability to borrow yet more and yet more cheaply – they may in fact ultimately benefit from a deflationary clear-out that would cause prices on many everyday items to drop. Deflation is not such a bad thing if you have to live on your savings or a modest, nominally fixed payment stream. Additionally, reshuffling the economy’s deck of cards could also offer opportunities. Tearing down the old structures and allowing the market to price things honestly again, according to real risks and truly available savings, may at first cause some shock but ultimately bring new possibilities. The present monetary policy is inherently conservative. It bails out those who got it wrong in the recent crisis at the expense of those who didn’t even participate in the last boom. Some Schumpeterian creative destruction is urgently needed.

I am not advocating deflation or economic cleansing for the sake of deflation and contraction, or out of some sense of economic sadism, or even out of moral considerations of any kind. However, it strikes me that what ails the economy is not a lack of money or lack of a powerful ‘kick-starting’ stimulant, and it may not suffer from unduly high borrowing costs either. Wherever borrowing costs are still high in this environment of ‘all-in’ central bank accommodation they may be high for a reason, maybe even a good one. What ails the economy are the structural impediments that are well established and that had been long in the making, such as inflexible labor markets with their permanently enshrined high unit labor costs and excessive regulation that have always protected current job-holders at the expense of those out of work or entering the labor market. Overbearing welfare systems, high tax rates and outsized public sectors have long held back major economies. Easy money that, for some time, enabled high public sector borrowing and spending, and facilitated local property booms, helped cover up these structural rigidities. Now these issues simply come to the fore again. New rounds of easy money will not make these problems disappear but only create a new illusion of sustainability.

I haven’t even touched upon the growing risk that never-ending monetary accommodation will end in inflation and monetary chaos but it is apparent already that this policy has no convincing claim on rationality. Nevertheless, it is almost certain that it will be continued.

This will end badly.

    



 
The BTFD Strategy Has Never Worked Better (But Beware)
Friday, 10 May 2013 14:01
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There is a mathematical term used to describe a time series’ propensity to mean-revert or not. Autocorrelation measures the tendency for today’s price direction to be in the same direction as yesterday’s. In a period of negative autocorrelation (such as today) when the market sells off one day it is much more likely to rebound the next. As Artemis Capital’s Chris Cole notes, the current level of negative auto-correlation (often associated with positive for ‘buy-the-dip’ strategies in an upward trending market) has never been higher. Mean reversion and negative autocorrelations are one reason why many pure ‘portfolio insurance’ strategies are struggling with losses. (Read more…) If you are constantly shorting volatility this trend toward powerful mean reversion is your best friend. However, empirically, this high mean reversion is unsustainable.

Via Artemis Capital,

Today, mean reversion of daily volatility returns is at the highest average levels in the history of modern derivatives markets. Autocorrelations of daily returns measure the propensity for today’s price direction to be in the same direction as tomorrows. For example in a period of negative autocorrelation (such as today) when the market sells off one day it is much more likely to rebound the next. An environment of negative autocorrelation is often associated with positive performance for “buy the dip” strategies in an upwardly trending market (correlations measure direction but not trend).

 

 

 

 

In April we experienced some of the highest levels of daily mean reversion for volatility in history. The chart at the top shows the negative autocorrelations of 3-month rolling VIX index returns (please note y-axis has been reversed to show rising levels of mean reversion or negative autocorrelation). The second chart tracks mean reversion regimes measured over a longer 12-month lagged period demonstrating the most extreme autocorrelations since just prior to the crash in 2008 (but not the highest ever). Mean reversion and negative autocorrelations are one reason why many pure ‘portfolio insurance’ strategies are struggling with losses. If you are constantly shorting volatility this trend toward powerful mean reversion is your best friend.

 

High Mean Reversion is Unsustainable. Historically when autocorrelations in daily volatility drop below -0.30 the VIX index has closed higher over the next month 76% of the time with an average gain of 19.11% (still putting us at a mild 16 level on the VIX from today). The last peak in mean reversion occurred in early 2008 just prior to the onset of the financial crisis. This is not meant to imply that I expect a great crash but I do think it gives a powerful technical signal that we are long overdue for some kind of meaningful pullback in equities (even if that is just 5-10%).

 

The phenomenon of increasing autocorrelations is often seen in stock market crashes whereby one bad day is likely to be followed by another bad day. We saw rising autocorrelations during periods of financial contagion including 1987 Black Monday, the 1998 Russian Default and LTCM crash, and the 2008 meltdown.

 

The potential for mean reversion regimes to ‘shift’ is driven by increasing leverage and interconnectedness in the system. It’s hard to predict when these shifts occur!  When they do periods of high autocorrelations can be very damaging for equity portfolios but good for the Artemis Vega Fund LP.

 

In this environment fading fear and buying equity on every dip has made money. This cannot continue forever and presents a powerful asymmetric opportunity. At the same time it is dangerous for any long volatility player to underestimate the extent to which these cycles will persist. Eventually the rebuild of leverage in the system will provide an opportunity when the mean reversion dynamic breaks.

 

 

 

The fact that NYSE Margin Debt has been moving in lock-step with negative autocorrelations and volatility is not a coincidence.

    



 
Bill Gross: “There Will Be Haircuts”
Wednesday, 01 May 2013 06:46
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The highlights from Bill Gross’ monthly outlook letter: “The past decade has proved that houses were merely homes and not ATM machines. They were not “good as money.” Likewise, the Fed’s modern day liquid wealth creations such as bonds and stocks may suffer a similar fate at a future bubbled price whether it be 1.50% for a 10-year Treasury or Dow 16,000…. if there are no spending cuts or asset price write-offs, then it’s hard to see how deficits and outstanding debt as a percentage of GDP can ever be reduced…. (Read more…)  Current policies come with a cost even as they act to magically float asset prices higher, making many of them to appear “good as money”.

And the take away: “PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not “good money,” they are better than the alternative (cash) as long as central banks and dollar reserve countries (China, Japan) continue to participate….a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing.”

Said otherwise: continue to frontrun the Fed, but one finger on the sell button. The problem with at strategy is that everyone is doing it. And for a glaring example of what happens when everyone hits the sell button at the same time, see what happened to stocks last week following the hacked AP twitter account – that’s what a bidless market, if only for a few seconds, looks like. Now extend those “few seconds” indefinitely.

From PIMCO:

There Will Be Haircuts

 

“Good as Money,” proclaimed the ad for Twenty Grand Cognac. Being a beer drinker, and never having cashed in a Budweiser to pay for a fill-up at the local gas station, I said to myself “Man, that must be really good stuff!” Even in a financial meltdown I thought, you could use it in place of cash, diamonds, gold or Bitcoins! And if the Mongol hordes descend upon us during a future revolution, who wouldn’t prefer a few belts of Twenty Grand on the way out, instead of some shiny rocks and a slingshot?

Well, not being inebriated at that moment I immediately shifted focus to a more serious topic. What IS money? A medium of exchange and a store of value is a rather succinct definition, but we generally think of it as cash or perhaps checks that reflect some balance of “ready” cash at a friendly bank. Yet as technology and financial innovation have progressed over the past few decades, and as central banks have tenuously validated the liquidity and price of various forms of credit, it seems that the definition of money has been extended; not perhaps to a bottle of Twenty Grand Cognac, but at least to some other rather liquid forms of near currency such as money market funds, institutional “repo” and short-term Treasuries “guaranteed” by the Fed to trade at par over the next few years.

All of the above are close to serving as a “medium of exchange” because they presumably can be converted overnight at the holder’s whim without loss and then transferred to a savings or checking account. It has been the objective of the Fed over the past few years to make even more innovative forms of money by supporting stock and bond prices at cost on an ever ascending scale, thereby assuring holders via a “Bernanke put” that they might just as well own stocks as the cash in their purses. Gosh, a decade or so ago a house almost became a money substitute. MEW – or mortgage equity withdrawal – could be liquefied instantaneously based on a “never go down” housing market. You could equitize your home and go sailing off into the sunset on a new 28-foot skiff on any day but Sunday.

So as long as liquid assets can hold par/cost with an option to increase in price, then these new forms of credit or equity might be considered “money” or something better! They might therefore represent a “store of value” in addition to serving as a convertible medium of exchange. But then, that phrase “Good as Money” on the cognac bottle kept coming back to haunt me. Is all this newfangled money actually “money good?” Technology and Fed liquidity may have allowed them to serve as modern “mediums of exchange,” but are they legitimate “stores of value?” Well, the past decade has proved that houses were merely homes and not ATM machines. They were not “good as money.” Likewise, the Fed’s modern day liquid wealth creations such as bonds and stocks may suffer a similar fate at a future bubbled price whether it be 1.50% for a 10-year Treasury or Dow 16,000.

But let’s not go there and speak of a bubble popping. Let’s perhaps more immediately speak about current and future haircuts when we question the “goodness of money.” Carmen Reinhart has said with historical observation that we are in an environment where politicians and central bankers are reluctant to allow write-offs: limited entitlement cuts fiscally, no asset price sink holes monetarily. Yet if there are no spending cuts or asset price write-offs, then it’s hard to see how deficits and outstanding debt as a percentage of GDP can ever be reduced. Granted, the ability of central banks to avoid a debt deflation in recent years has been critical to stabilizing global economies. And too, there have been write-offs, in home mortgages in the U.S., for example, and sovereign debt in Greece. But the cost of these strategies, which avoid what I simplistically call “haircuts,” has been high, and their ability to reduce overall debt/GDP ratios is questionable. Chairman Bernanke has admitted that the cost of zero-bound interest rates, for instance, extracts a toll on pension funds and individual savers. Some of his Fed colleagues have spoken out about the negative aspects of QE and future difficulties of exit strategies should they ever take place. (They won’t!) So current policies come with a cost even as they act to magically float asset prices higher, making many of them to appear “good as money” – shots of cognac notwithstanding.

But the point of this Outlook is that even IF… even IF QEs and near zero-bound yields are able to refloat global economies and generate a semblance of old normal real growth, they will do so utilizing historically tried and true “haircuts” that rather surreptitiously “trim” an asset holder’s money without them really knowing they had entered a barbershop. These haircuts are hidden forms of taxes that reduce an investor’s purchasing power as manipulated interest rates lag inflation. In the process, governments and their central banks theoretically reduce real debt levels as well as the excessive liabilities of levered corporations and households. But they represent a hidden wealth transfer that belies the vaunted phrase “good as money.”

Before drinking up, let’s examine these haircuts to see why they do not represent an authentic store of value even if their bubbly prices never pop. I will give each haircut a symbolic name – I welcome your suggestions as well via e-mail reply: outlook@pimco.com

(1) Negative Real Interest Rates – “Trimming the Bangs”

During and after World War II most countries with high debt overloads resorted to artificially capping interest rates below the rate of inflation. They forced savers to accept negative real interest rates which lowered the cost of government debt but prevented savers from keeping up with the cost of living. Long Treasuries, for instance, were capped at 2½% while inflation was soaring towards double-digits. The resulting negative real rates together with an accelerating economy allowed the U.S. economy to lower its Depression-era debt/GDP from 250% to a number almost half as much years later, but at a cost of capital market distortions.

 

Today, central banks are doing the same thing with near zero-bound yields and effective caps on higher rates via quantitative easing. The Treasury’s average cost of money is steadily grinding lower than 2%. If current policies continue to be enforced in future years it will eventually be less than 1% because of the inclusion of T-bill and short maturity financing. The government’s gain, however, is the saver’s loss. Investors are being haircutted by at least 200 basis points judged by historical standards, which in the past offered no QE and priced Fed Funds close to the level of inflation. Large holders of U.S. government bonds, including China and Japan, will be repaid, but in the interim they will be implicitly defaulted on or haircutted via negative real interest rates.

Are Treasuries money good? Yes. But are they good money? Most assuredly not, when current and future haircuts are considered. These rather innocuous seeming (-1%) and
(-2%) real rate haircuts are not a bob or a mullet in hairstyle parlance. More like a “trimming of the bangs.” But at the cut’s conclusion, there’s a lot of hair left on the floor.

(2) Inflation / Currency Devaluation – “the “Don Draper”

Inflation’s sort of like your everyday “Mad Men – Don Draper” type of haircut. It’s been around for a long time and we don’t really give it a second thought except when it’s on top of a handsome head like Jon Hamm’s. 2% ± a year – some say more – but what the heck, inflation’s just like breathing air … you just gotta have it for a modern-day levered economy to survive. Sometimes, though, it gets out of control, and when it is unexpected, a decent size hit to your bond and stock portfolio is a possibility. If our TV idol Don Draper lives another decade or so on the airwaves, he’ll find out in the inflationary 70s. Such was the example as well in the Weimar Republic in the 1920s and in modern day Zimbabwe with its One Hundred Trillion Dollar bill shown below. As central banks surreptitiously inflate, they also devalue their currency and purchasing power relative to other “hard money” countries. Either way – historical bouts of inflation or currency devaluation suggest that your investment portfolio may not be “good as the money” you might be banking on.

 

(3) Capital Controls – the “Uncle Sam Cut”

Uncle Sam with his rather dapper white hair and trimmed beard serves as a good example for this type of haircut, if only to show that even the U.S. can latch on to your money or capital. Back in the 1930s, FDR instituted a rather blatant form of expropriation shown above. All private ownership of gold was forbidden (and subject to a $10,000 fine and 10 years in prison!) if it wasn’t turned into the government. Today we have less obvious but similar forms of capital controls – currency pegging (China and many others), taxes on incoming capital (Brazil) and outright taxation/embargos of bank deposits (Cyprus). Governments use these methods to keep money out or to keep money in, the net result of which is a haircut on your capital or your potential return on capital. Future haircuts might even include a wealth tax. Are gold and/or AA+ sovereign bonds good as money? Usually, but capital controls can clip you if you’re not careful.

 

(4) Outright Default – the “Dobbins”

Ah, here’s my favorite haircut, and I’ve named it the “Dobbins” in honor of this 5-year bond issued in the 1920s with a beautiful gold seal and payable, in dollars or machine guns! Bond holders got neither and so it represents the historical example of the ultimate haircut – the buzz, the shaved head, the “Dobbins.” As suggested earlier, the objective of central banks is to prevent your portfolio from resembling a “Dobbins.” I have tweeted in the past that the Fed is where all bad bonds go to die. That is half figurative and half literal, because central banks are typically limited from purchasing bonds payable in machine guns or subprime mortgages (there have been exceptions and Bloomberg reported that nearly 25% of global central banks are now buying stocks believe it or not)! But by purchasing Treasuries and Agency mortgages they have rather successfully incented the private sector to do their bidding. This behavior reflects the admission that modern-day developed economies are asset-priced supported. Unless prices can continuously be floated upward, defaults and debt deflation may emerge. Don’t buy a Dobbins bond or a Dobbins-like asset or a bond from a country whose central bank is buying stocks. They probably aren’t “good as money!”

 

 

 

Investment Strategy  

So it seems as if the barber has you cornered, doesn’t it? Sort of like Sweeney Todd! Let’s acknowledge that possibility, along with the observation that all of these haircuts imply lower-than-average future returns for bonds, stocks, and other financial assets. If so, the rather mixed metaphor of “money’s goodness” and “avoiding haircuts” is still the question of our modern investment age. The easiest answer to the question of what to buy is to simply take your ball and go home. If the rules aren’t fair, don’t play. That endgame however, results in a Treasury bill rate of 10 basis points or a negative yield in Germany, France and Northern EU markets. So a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing. PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not “good money,” they are better than the alternative (cash) as long as central banks and dollar reserve countries (China, Japan) continue to participate.

The same conclusion applies to credit risk alternatives such as corporate bonds and stocks. Granted, this sounds a little like Chuck Prince and his dance floor metaphor does it not? His example proved that dancing, and full heads of hair are not forever. So give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of Sweeney Todd. There will be haircuts. Make sure your head doesn’t go with it.

Quick Read

1) Central banks and policymakers are acting like barbers. They haircut your investments.

2) Negative real interest rates, inflation, currency devaluation, capital controls and outright default are the barber’s scissors.

3) Gradually reduce duration, risk positions and “carry” as the year proceeds.