Posts Tagged ‘Switzerland’
1994 Redux? But Not In Bonds
Saturday, 15 June 2013 18:17
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In UBS’ view, 1994 is critical for guiding investing today. The key point about 1994 was not that US bond yields rose during a global recovery. But that the leverage and positioning built up in previous years, on the assumption that yields would remain low, then got stressed. The central issue, they note, is that a long period of lacklustre growth, low rates and easy money induces individual investors, funds, non-financial corporates and banks to reach for yield. In many cases, they gear up to do it. (Read more…) And as Hyman Minsky warned; in this way, stability breeds leverage, and leverage breeds instability.

 

 

Via UBS: 1994 Redux?

…

Sebastian Mallaby has written an excellent account of the 1994 bond market blowout in ‘Hurricane Greenspan’, chapter eight of his book ‘More money than God’ (Bloomsbury press, 2010). In his depiction of the legendary hedge fund trader Michael Steinhardt – he describes how hedge funds, and a range of other financial institutions, chased convergence trades from 1990-1993.

They played term carry (borrowing short term to buy long dated bonds within the US). They ran cross regional carry trades (borrowing in Germany or the US to buy Italian & Spanish bonds as these countries prepared for EU membership).

And they rushed to buy assets that were priced off convergence trades; emerging market property, peripheral banks. They even bought defensive growth stocks (with the idea that the PE on a defensive growth stock should converge to the inverse of the 10 year yield).

We argue below that the set-up today is very similar to that in early 1994.

The danger in these trades is that a cyclical recovery, especially a global cyclical recovery, will cause yields to rise and compel policy makers to withraw accommodation. And that this can induce an outsized reaction in all the convergence trades ultimately priced off treasuries, as leverage is removed.

This is why the central lesson from 1994 is that, after a long period of easy money, when a cyclical recovery kicks in and policymakers are setting to remove accommodation, at all costs avoid convergence trades and avoid assets that are priced off convergence trades.

And the popular convergence trades of the past months have been;

  • Emerging market credit
  • Emerging market property
  • Southern European sovereign debt
  • Peripheral European sovereign debt
  • US mortgage backed securities
  • US and global high yield debt
  • Global defensive growth stocks.

So what brings us to think that we can use 1994 as a guide to investing for the rest of 2013?

In the section below we highlight several key developments from 1990-1995 and the comparison with the current situation;

1990-Feb 1994

The Fed ran a very easy monetary policy from 1990-early ’94 in an attempt to reflate the US economy in aftermath of the S&L crisis. We have seen lower rates & even easier monetary policy since 2009.

US growth remained lacklustre throughout 1990-1993, going through a series of moderate ‘mini-cycles’. We have seen even more lacklustre growth over the past four years.

US 10-year treasury yields fell from 9% to 5% from 1990-early 1994, as a recession and then disinflationary pressure pushed down inflation expectations. Treasury yields fell from 4.3% in 2007 to 1.4% in the summer of 2012.

US banks hoarded treasuries.

Lending remained lacklustre.

Corporates hoarded cash & paid back debt.

From 1990-1994 Capital flowed into emerging markets. Asia boomed. The former USSR saw large inflows also. Capital flowed heavily into emerging markets from 2009-11, although it then slowed in 2H11 & 2012 as the Fed ended QE2.

Credit spreads tightened from 90-94, and from 09-13.

Commodities remained in the doldrums from 1990-1994. This was unusual, given the strong capital flows into emerging markets. But the implosion of the military/industrial complex in Russia from 1989 saw domestic demand for commodities collapse. Russia then exported nickel, aluminium, palladium, platinum, copper and oil to get hold of hard currency. Commodity prices came under intense pressure. This contrast is with the 2009-13 period – where capital flows & restocking drove commodity prices higher from 2009-11, but where capital outflows, destocking and new supply drove prices lower in 2011/12.

Headline CPI trended down, persuading many that there was no cause for rate hikes. We have seen a similar trend from mid-2001.

The dollar trade weighted index range traded between 80 & 95 from 1990-1995. An interesting development was that the dollar weakened while the US economy recovered through 1994, and while the Fed raised rates 225bps. The DXY has been range trading in a similar manner, broadly between 75 and 90 since 2009.

The extended period of low rates and strong capital flows into emerging markets induced a huge build-up of leverage across financial & non-financial institutions on a global basis.

The strong flows of capital into emerging markets set off the procyclical growth dynamic we have described regularly.

Capital inflows induce central banks to print their own currency to buy the dollars coming in. Bank deposits rise, and banks lend to construction and engineering companies. Growth & inflation pick up. And with nominal rates sticky, real rates fall. That in turn incentivises procyclical gearing up to buy & build houses, inventory and general fixed capital formation.

The Asian tigers grew aggressively, and their stock markets boomed going into 1993. Emerging markets recovered in 2009/10, struggled into 2011/12 and then saw a patchy recovery until recently.

The problem with the reflationary process in emerging markets is that it sows the seeds for its own destruction. Because the low real rates in EM induce excessive gearing & fixed capital formation – compared to a more balanced allocation of capital, had real rates stayed steady above zero. This leaves misallocated capital, and the latent potential for bad loans to emerge when credit becomes scarce. It also causes a deterioration in the trade balance. Both make emerging markets increasingly dependent on capital flows to stay afloat.

In many cases, emerging market governments will react to rising inflation by attempting to restrict credit growth (rather than raising rates). The problem with this is that it incentivises US dollar borrowing.

Emerging market business finds it attractive to borrow in dollars when domestic inflation is rising, the domestic currency is appreciating, and domestic borrowing costs are higher than dollar funding. And it is even more attractive when the activity the loans are funding – from inventory building to FCF – sees price/cost rises.

But when the trends reverse – the domestic currency depreciates, the dollar funding becomes more dear, the inventory values fall – then emerging market corporates can find themselves squeezed. Very rapidly.

But it is not just EM. In the long history of financial crises, the ‘reach for yield’ during a slow growth and low yield environment has on multiple occasions set up the conditions for financial stress when yields eventually rose.

The book ‘More money than God’ by Sebastian Mallaby (Bloomsbury, 2010), gives an excellent description of the leverage and yield enhancing structures that built up in the 1990-1993 period, and the carnage inflicted upon that leverage in 1994. Some examples include:

  • Bank & hedge fund carry trades – borrowing at the short end to purchase long dated bonds.
  • Borrowing in USD and German marks to buy Italian and Greek long term debt
  • Borrowing to buy high yield corporate debt.
  • he use of interest rate swaps to generate yield enhancement.
  • Leverage purchases of buy-to-let properties

We have also seen a significant build up in leverage over the past four years. Buy-to-let investment has risen strongly in the US/UK/Switzerland/Scandinavia. Retail investors have become heavily exposed to credit through mutual funds and credit ETFs.

Investors became very overweight long duration defensive growth and dividend yielding equities, at the expense of cyclical exposure.

Investors have left themselves highly exposed to any kind of cyclical rally outside the US, as well as within it. Valuations (as we noted here) are extremely varied.

1994

As macro activity in the US accelerated, corporates stopped hoarding cash and started to seek to borrow to expand their businesses.

US banks, which had been hoarding treasuries, sold them to make way for increased corporate loans. Treasuries started to sell off.

The Fed then responded to the steepening curve and the improving macro conditions by raising rates by 25bps in February 1994. This came as a surprise to the market, which was not aware of the Fed’s internal deliberations. The transcript of the February meeting indicates that Fed members were wary of a 1988/89 style spike in inflation if they did not start the process of tightening.

Greenspan believed that the curve would flatten, as markets anticipated tighter policy moderated inflation expectations in the future.

But that’s not what happened.

The rise in rates instead dented the derivative trades predicated on no rise in yields, and it squeezed carry traders. That induced a more aggressive unwinding of treasury holdings, as leveraged carry trades unwound. And the Banks accelerated the sell off as they sold treasuries to make space for increased corporate lending. So the yield curve steepened over the year, with 10-year yields rising 306bps vs the 225bp rise in Fed funds.

An array of casualties ensued, from Orange county, California, that went bankrupt due to its exposure to a series of exotic interest rate swaps. To a number of prominent hedge funds – which saw extreme losses in February 1994.

Then there was the international fallout. The sharp increase in domestic demand for credit, combined with the increase in real rates induced powerful capital flows back to the US. This sucked liquidity out of several emerging markets, whose central banks had to retire domestic currency to repay the dollars exiting their countries. Soon, countries that had seen the most aggressive investment booms, which had done the most aggressive US dollar borrowing, and which suffered the largest current account deficits, came under intense duress. The Mexican peso crisis erupted, and the seeds were sown for a sustained deterioration in Asia, before the full collapse of the Asian crisis in 1997.

One of the conundrums of 1994 was the US dollar. It would be logical to think that, with a sharp rise in US growth, in rates & yields that the US dollar would have rallied. But it didn’t. It fell.

An important reason was that the US recovery, while stronger than expected, was not a big surprise. But what was a surprise was the European recovery – after the sustained post-unification funk in Germany, and the Scandinavian banking crisis in 1992. In our view in commodity strategy – it was the relative surprises – which made Europe’s recovery much more unexpected, that triggered the currency move.

This is particularly interesting today – with the broad consensus that the US dollar is going to rally, due to the more robust recovery in the US and the potential for tapering.

But it is always worth keeping an eye on relative macro surprises.

We see the potential for a counter trend fall in the US dollar.

Now there are clearly some stark differences between today and 1994. Back then interest rates were much higher. So 300bps on treasuries increased rates by three fifths. The same rise from the July low would treble rates. And certainly, the authorities are first talking about an extended period of QE tapering. We are still a distance away from actual rate hikes.

The Fed is also much more transparent than it was under Greenspan in the early 1990s.

Where conditions are similar is that a very large structure of leverage has built up on the back of low rates, from leveraged property & credit buying, large retail exposure to yield enhancement products (high yield ETFs etc), earlier dollar leverage driven investment booms in emerging markets.

So where are we now. It looks to us very similar to February 1994.

The Fed’s continued insistence on talking tapering despite the recent rollover in US macro surprises has started to unsettle leveraged yield enhanced positioning.

The US high yield ETF has come under severe pressure. The US mortgage spread has blown out relative to the US 30-year treasury yield. South African and Indian currencies are under pressure. India has responded by raising taxes on gold imports.

In 1994, Mexico was the first to feel the brunt. Followed by South Korea in 1997. In 2013, South Africa is feeling the pressure. Although other emerging markets, notably China, continue to benefit.

The next big question is; can the US withstand a higher cost of capital, like it did from 1994-98.

In short, no!

In the mid-late ‘90s, the US coped with a higher cost of capital in several ways. It enhanced productivity through a rapid adoption of tech. Corporates geared up, which ensured strong liquidity growth and ‘efficient’ balance sheets. Corporates went through a second round of ‘just in time’ inventory management and outsourcing. Consumers benefited from the strong dollar and falling commodity prices – seeing their disposable incomes improve. And the disinflation in EM translated to a downtrend in yields from 1994, which allowed for an acceleration in the housing market and an expansion of household debt.

But we have a number of concerns that hint at vulnerability.

The first is that the potential for sustained disinflation over multiple years is less, because yields are already low. Consequently, there is less scope for a sustained recovery in housing – beyond the initial flurry of demand from rising household formation. The sharp rise in mortgage spreads is one hint that this transition may be more difficult. The spread on mortgages may be particularly important for the leveraged buy-to-let investors, who have been heavily involved in the recent surge in housing sales.

Because we understand that a large part of the buying is from investors then seeking to rent out the properties, we suspect that the follow-through consumer demand may not be as aggressive as previously imagined. If a household buys a house, taking on debt, it opens the floodgates to increasing debt fuelled buying of cars, household furnishings and white goods. A very different psychology comes from paying a month up-front on a rental. You are much more likely to cut back, to be more frugal.

Government debt levels are clearly extended, and the deficit needs to be cut to prevent further deterioration

A more subtle point is that the extended expansion of government spending as a share of GDP in response to the financial crisis is crowding out the private sector, and reducing the productive potential of the US economy. This stands in stark contrast with the tight control of government debt in the early 1990s under the Clinton administration.

These suggest that it is much less likely that we see the US enter a ‘high plateau’ of growth as we saw from 1995-98, where the US saw a powerful productivity & credit fuelled boom while the emerging markets deflated. And it makes it more likely that the US stays on a lower trajectory, interspersed with periodic recessionary slowdowns in the years ahead.

The point at which the market realises this would likely herald a significant risk-off event.

    



 
In Which We Learn That The CIA Was Instrumental In Breaking The Swiss Bank Secrecy Code
Sunday, 09 June 2013 15:16
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Hidden in the Edward Snowden story is this gem exposing just how it was that the story of Swiss bank secrecy was broken. Guess who was at the bottom? None other than the US Central Intelligence Agency. We are confident any US citizens who recently have had to shut down their Zurich, Geneva, Bern, Zug or Lugano bank accounts at a sizable loss of course, not to mention countless Swiss bankers currently facing prosecution, as well as various Swiss citizens will find it all quite fascinating.

(Read more…)

By 2007, the CIA stationed him with diplomatic cover in Geneva, Switzerland. His responsibility for maintaining computer network security meant he had clearance to access a wide array of classified documents.

 

That access, along with the almost three years he spent around CIA officers, led him to begin seriously questioning the rightness of what he saw.

 

He described as formative an incident in which he claimed CIA operatives were attempting to recruit a Swiss banker to obtain secret banking information. Snowden said they achieved this by purposely getting the banker drunk and encouraging him to drive home in his car. When the banker was arrested for drunk driving, the undercover agent seeking to befriend him offered to help, and a bond was formed that led to successful recruitment.

Nasturally, that was the covert way of confiscating deposits. The less covert way was recently exposed in Cyprus. In the future, look for synergies between the two.

    



 
NSA Whistleblower Reveals Himself
Sunday, 09 June 2013 14:46
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“I realised that I was part of something that was doing far more harm than good… The NSA routinely lies in response to Congressional inquiries about scope of surveillance in America. The NSA is intent on making every conversation and every form of behaviour in the world known to them…. What they’re doing poses an existential threat to democracy.“

(Read more…)

            - Edward Snowden, 29, PRISM Whistleblower

The US government will be happy to learn it will save several million dollars on the criminal inquiry into the identity of the NSA’s PRISM whistleblower because moments ago in a lengthy profile by the Guardian’s Glenn Greenwald, said whistleblower has decided to reveal himself to the world: he is Edward Snowden, 29 years old. Originally from Elizabeth City, NC, a Maryland community college dropout and former Special Forces trainee, the 10 year “veteran” with the NSA, most recently in its Hawaii office under the employ of defense contractor Booz Allen Hamilton, has just made history and joined the pantheon of such legendary whistleblowers of the US government’ secret activities as the Pentagon Papers’ Daniel Ellsberg and Wikileaks’ Bradley Manning. Last but not least, Edward is currently residing in Hong Kong, out of harm’s (read America’s) way.

Who is Edward and how did he end up at the NSA? The Guardian has the full story.

By his own admission, he was not a stellar student. In order to get the credits necessary to obtain a high school diploma, he attended a community college in Maryland, studying computing, but never completed the coursework.

 

In 2003, he enlisted in the US army and began a training program to join the Special Forces. Invoking the same principles that he now cites to justify his leaks, he said: “I wanted to fight in the Iraq war because I felt like I had an obligation as a human being to help free people from oppression”.

 

He recounted how his beliefs about the war’s purpose were quickly dispelled. “Most of the people training us seemed pumped up about killing Arabs, not helping anyone,” he said. After he broke both his legs in a training accident, he was discharged.

 

After that, he got his first job in an NSA facility, working as a security guard for one of the agency’s covert facilities at the University of Maryland. From there, he went to the CIA, where he worked on IT security. His understanding of the internet and his talent for computer programming enabled him to rise fairly quickly for someone who lacked even a high school diploma.

 

By 2007, the CIA stationed him with diplomatic cover in Geneva, Switzerland. His responsibility for maintaining computer network security meant he had clearance to access a wide array of classified documents.

 

That access, along with the almost three years he spent around CIA officers, led him to begin seriously questioning the rightness of what he saw. 

 

He described as formative an incident in which he claimed CIA operatives were attempting to recruit a Swiss banker to obtain secret banking information. Snowden said they achieved this by purposely getting the banker drunk and encouraging him to drive home in his car. When the banker was arrested for drunk driving, the undercover agent seeking to befriend him offered to help, and a bond was formed that led to successful recruitment.

 

“Much of what I saw in Geneva really disillusioned me about how my government functions and what its impact is in the world,” he says. “I realised that I was part of something that was doing far more harm than good.”

 

He left the CIA in 2009 in order to take his first job working for a private contractor that assigned him to a functioning NSA facility, stationed on a military base in Japan. It was then, he said, that he “watched as Obama advanced the very policies that I thought would be reined in”, and as a result, “I got hardened.”

Why did he wait so long?

He said it was during his CIA stint in Geneva that he thought for the first time about exposing government secrets. But, at the time, he chose not to for two reasons.

 

First, he said: “Most of the secrets the CIA has are about people, not machines and systems, so I didn’t feel comfortable with disclosures that I thought could endanger anyone”. Secondly, the election of Barack Obama in 2008 gave him hope that there would be real reforms, rendering disclosures unnecessary.

That did not happen. So he proceed to reveal what he knows about the NSA to a newspaper which the NYT pejoratively referred to as a “British News Site.” Well, he certainly did not go with any of the news sites on favorable terms with the current administration. Instead, “He purposely chose, he said, to give the documents to journalists whose judgment he trusted about what should be public and what should remain concealed.”

Which of course brings up the question: now what, and why risk what was otherwise a “comfortable life” in a Hawaiian paradise?

In a note accompanying the first set of documents he provided, he wrote: “I understand that I will be made to suffer for my actions,” but “I will be satisfied if the federation of secret law, unequal pardon and irresistible executive powers that rule the world that I love are revealed even for an instant.”

 

Despite his determination to be publicly unveiled, he repeatedly insisted that he wants to avoid the media spotlight. “I don’t want public attention because I don’t want the story to be about me. I want it to be about what the US government is doing.”

 

He does not fear the consequences of going public, he said, only that doing so will distract attention from the issues raised by his disclosures. “I know the media likes to personalise political debates, and I know the government will demonise me.”

 

Despite these fears, he remained hopeful his outing will not divert attention from the substance of his disclosures. “I really want the focus to be on these documents and the debate which I hope this will trigger among citizens around the globe about what kind of world we want to live in.” He added: “My sole motive is to inform the public as to that which is done in their name and that which is done against them.”

 

He has had “a very comfortable life” that included a salary of roughly $200,000, a girlfriend with whom he shared a home in Hawaii, a stable career, and a family he loves. “I’m willing to sacrifice all of that because I can’t in good conscience allow the US government to destroy privacy, internet freedom and basic liberties for people around the world with this massive surveillance machine they’re secretly building.”

That said, he has left the US and is now in Hong Kong, which in the New Normal is a safer venue for those exposing what until recently was considered a massive conspiracy theory.

Three weeks ago, Snowden made final preparations that resulted in last week’s series of blockbuster news stories. At the NSA office in Hawaii where he was working, he copied the last set of documents he intended to disclose.

 

He then advised his NSA supervisor that he needed to be away from work for “a couple of weeks” in order to receive treatment for epilepsy, a condition he learned he suffers from after a series of seizures last year.

 

As he packed his bags, he told his girlfriend that he had to be away for a few weeks, though he said he was vague about the reason. “That is not an uncommon occurrence for someone who has spent the last decade working in the intelligence world.”

 

On May 20, he boarded a flight to Hong Kong, where he has remained ever since. He chose the city because “they have a spirited commitment to free speech and the right of political dissent”, and because he believed that it was one of the few places in the world that both could and would resist the dictates of the US government.

Snowden’s future is bleak to say the least, and if Bradly Manning’s recent travails are any indication, a life in prison may be an upside option:

“All my options are bad,” he said. The US could begin extradition proceedings against him, a potentially problematic, lengthy and unpredictable course for Washington. Or the Chinese government might whisk him away for questioning, viewing him as a useful source of information. Or he might end up being grabbed and bundled into a plane bound for US territory.

 

“Yes, I could be rendered by the CIA. I could have people come after me. Or any of the third-party partners. They work closely with a number of other nations. Or they could pay off the Triads. Any of their agents or assets,” he said.

 

“We have got a CIA station just up the road – the consulate here in Hong Kong – and I am sure they are going to be busy for the next week. And that is a concern I will live with for the rest of my life, however long that happens to be.”

 

Having watched the Obama administration prosecute whistleblowers at a historically unprecedented rate, he fully expects the US government to attempt to use all its weight to punish him. “I am not afraid,” he said calmly, “because this is the choice I’ve made.”

 

He predicts the government will launch an investigation and “say I have broken the Espionage Act and helped our enemies, but that can be used against anyone who points out how massive and invasive the system has become”.

 

The only time he became emotional during the many hours of interviews was when he pondered the impact his choices would have on his family, many of whom work for the US government. “The only thing I fear is the harmful effects on my family, who I won’t be able to help any more. That’s what keeps me up at night,” he said, his eyes welling up with tears.

…

As for his future, he is vague. He hoped the publicity the leaks have generated will offer him some protection, making it “harder for them to get dirty”.

 

He views his best hope as the possibility of asylum, with Iceland – with its reputation of a champion of internet freedom – at the top of his list. He knows that may prove a wish unfulfilled.

 

But after the intense political controversy he has already created with just the first week’s haul of stories, “I feel satisfied that this was all worth it. I have no regrets.”

Now the great debate begins: is sacrificing it all in the name of ethical principles under a totalitarian regime now fully set on destroying you, worth it? And since we are dealing with one grand revealed conspiracy, another one will naturally emerge: is Snowden’s explanation of his motives honest and accurate? Why now and why him? Surely at least one other person has worked at the NSA in the past decade whose thought process has been identical and who put the value of democracy over and above that of one’s personal career development and safety.

Most importantly, the ball is now in Obama’s court, and the constitutional scholar’s every action will be studied under a microscope by civil liberty defenders (both real and paid for) everywhere while one Jon Corzine withdrawls millions of dollars from East Hampton ATM machines unhindered, and without any scruples.

Finally, we would like to thank Snowden for putting a nail into the coffin of all those who use the term “conspiracy theorist” pejoratively. Because whatever his motives, whatever the outcome of this dramatic escalation between the people’s right to know and a government intent on hijacking all civil liberties one by one, Snowden has showed that the distance from Conspiracy Theory to Conspiracy Fact is just one ethical judgment away.

For those curious, here is the full text of the US-Hong Kong Extradition treaty.

* * *

Snowden’s interview with the Guardian’s Glenn Greenwald (produced by WaPo’s Laura Poitras) can be seen after the jump.