9/9/18: IMF and Argentina: New Old Saga

My Twitter comments on Argentina and IMF rescue package were picked up by the folks at ZeroHedge https://www.zerohedge.com/news/2018-08-30/some-observations-argentinas-imf-sponsored-collapse

9/9/18: Populism, Middle Class and Asset Bubbles

The range of total returns (unadjusted for differential FX rates) for some key assets categories since 2009 via Goldman Sachs Research:

The above highlights the pivot toward financial assets inflation under the tidal wave of Quantitative Easing programmes by the major Central Banks. The financial sector repression is taking the bite out of the consumer / household finances through widening profit margins, reflective of the economy's move toward higher financial intensity of output. Put differently, the CPI gap to corporate costs inflation is widening, and with it, the asset price inflation is drifting toward financial assets:

This is the 'beggar-thy-household' economy, folks. Not surprisingly, while the proportion of total population classifiable as middle-class might be stabilising (after a massive decline from the 1970s and 1980s levels):

 Incomes of the middle class are stagnant (and for lower earners, falling):

And post-QE squeeze (higher interest rates and higher cost of credit intermediation) is coming for the already stretched households. Any wonder that political populism/opportunism is also on the rise?

30/7/18: Annotated History of the U.S. Treasury Yield Curve

Courtesy of the forgotten source (apologies) a neat summary chart plotting the timeline of the 10 year U.S. Treasury yield:

For referencing purposes… 

7/7/18: Country Risk Survey: 1H 2018

Euromoney Country Risk quarterly survey is out, covering trends in sovereign risk for 1H 2018. With comments from myself, amongst others.

29/3/18: Credit downgrades and the sunny horizons of peak growth

The global economy is picking up steam. The U.S. economy is roaring to strength. 2018 is going to be another 'peak year'. Tax cuts are driving equity valuations up. Corporate balance sheets are getting healthier by a day... and so on.

The positivity of recent headline has been contrasted by the realities of the gargantuan bubble in corporate debt. A bubble that is not going to get any healthier any time soon. In fact, based on the latest data (through 4Q 2017) from the S&P Global Market Intelligence, H1 2017 trend toward relatively balanced (or rather relatively moderately negative skew) credit ratings has turned decisively negative in 2H 2017. Worse, 4Q 2017 dynamics were markedly worse than 3Q 2017 dynamics:

Which brings up the following question: if things are getting downgraded that fast, what's likely to happen with the Fed policy 'normalization' impact on the corporate credit markets? Answers on tears-proof napkins, please.

8/12/17: Happiness: Bounded and Unbounded

Why I love Twitter? Because you can have, within minutes of each other, in your tweeter stream this...

and this

That's right, folks. It's the Happiness Day: bounded at 0.2% annual rate of growth for the workers, and unbounded at USD11 trillion for the Governments. All good, right?

But of course all is good. We call the former - the 'great news' for the families, and the latter, 'savage austerity'.  Which is, apparently, good for the bonds markets... no kidding. At least there isn't a bubble in wages, even though there is a bubble in bonds.

29/11/17: Four Omens of an Incoming Markets Blowout

Forget Bitcoin (for a second) and look at the real markets.

Per Goldman Sachs research, current markets valuation for bonds and stocks are out of touch with historical bubbles reality: https://www.bloomberg.com/news/articles/2017-11-29/goldman-warns-highest-valuations-since-1900-mean-pain-is-coming. As it says on the tin,

“A portfolio of 60 percent S&P 500 Index stocks and 40 percent 10-year U.S. Treasuries generated a 7.1 percent inflation-adjusted return since 1985, Goldman calculated -- compared with 4.8 percent over the last century. The tech-bubble implosion and global financial crisis were the two taints to the record.”

Check point 1.

Now, Check point 2: The markets are already in a complacency stage: “The exceptionally low volatility found in the stock market -- with the VIX index near the record low it reached in September -- could continue. History has featured periods when low volatility lasted more than three years. The current one began in mid-2016.”

Next, Check point 3: Valuations are not everything. In other words, levels are not the sole driver of blowouts. In fact, per Goldman, valuations explain “less than half the [markets] variation since 1900.” But, when blowouts do happen, involving 60/40 portfolios “over the past century [these] amounted to 26 percent in real terms on average, lasting 19 months. It took two years to get back to previous peaks, on average.” And the problem with this is that there might be no firepower to fight the next blowout. “Central banks “might not be able or willing to buffer growth or inflation shocks.” They also face fewer options to ease monetary policy given low rates and big balance sheets.”

So to sum the above up: levels of market valuations are screaming bubbles in both bonds and stocks; investors are fully bought into the hype of rising valuations; and there might be a shortage of dry powder in store at the Central Banks.

Goldman’s team, predictably, thinks the likeliest unwinding scenario from the above will involve, you’ve guessed it… a soft landing.

Now to Check point 4:

Source: ZeroHedge

Observe the following simple fact: the rate of the ‘balanced’ portfolio appreciation in the current cycle is sharper than in the 2002-2007 cycle. And it is sharper, in cumulative terms (both nominal and real), than any other cycle in modern (post 1970s - end of Bretton Woods and stagflationary environments) period.

So the Check point 5 adds strong bubble dynamics to bubble signals of levels of out-of-touch valuations, investors complacency and risks to the Central Banks’ commitment.

This is, put frankly, ugly. Because all four components of a major market blowout are now in place. So while the froth might still run for some weeks, months, quarters, … and may be even a year or two, the longer it runs, the worse the fallout will be. And the fallout is coming.

19/11/17: The Next Global Financial Crisis

My column for Cayman Financial Review on how the stage has been now set for the next Global Financial Crisis is available at http://www.caymanfinancialreview.com/2017/10/20/the-stage-has-been-set-for-the-next-global-financial-crisis/.

17/9/16: The Mudslide Cometh for Your Ladder

One chart that really says it all when it comes to the fortunes of the Euro area economy:

And, courtesy of these monetary acrobatics, we now have private corporates issuing debt at negative yields, nominal yields...  http://blogs.wsj.com/moneybeat/2016/09/15/negative-yielding-corporate-debt-good-for-your-wealth/.

The train wreck of monetarist absurdity is now so far out on the wobbly bridge of economic systems devoid of productivity growth, consumer demand growth and capex demand that even the vultures have taken into the skies in anticipation of some juicy carrion. With $16 trillion (at the end of August) in sovereign debt yielding negative and with corporates now being paid to borrow, the idea of the savings-investment link - the fundamental basis of the economy - makes about as much sense today as voodoo does in medicine. Even WSJ noted as much: http://www.wsj.com/articles/the-5-000-year-government-debt-bubble-1472685194.

Which brings us to the simple point of action: don't buy bonds. Don't buy stocks. Hold defensive assets in stable proportions: gold, silver, land, fishing rights... anything other than the fundamentals-free paper.

As I recently quipped to an asset manager I used to work with:

"A mudslide off this mountain of debt will have to happen in order to correct the excesses built up in recent years. There is too much liquidity mass built into the markets devoid of investment demand, and too weak of an economy holding it. Everywhere. By fundamental metrics of value-added growth and organic demand expansion potential, every economy is simply sick. There is no productivity growth. There is no EPS growth, even with declining S down to waves of buy-outs. There is debt growth, with no capex & no EPS growth to underwrite that debt. There is a global banking system running totally on fumes pumped into it at an ever increasing rate by the Central Banks through direct monetary policies and by indirect means (regulatory shenanigans of ever-shifting capital and assets quality revisions). There is no trade growth. There is no market growth for trade. Neither supply side, nor demand side can hold much more, and countries, like the U.S., have run out of ability to find new lines of credit to inflate their economies. Students - kids! - are now so deep in debt before they even start working, they can't afford rents, let alone homes. Housing shortages & rents inflation are out of control. GenZ and GenY cannot afford renting and paying for groceries, and everyone is pretending that the ‘shared economy’ is a form of salvation when it really is a sign that people can’t pay for that second bedroom and need roommates to cover basic bills. Amidst all of that: 1% is riding high and dragging with it 10% that are public sector ‘heroes’ while bribing the 15% that are the elderly and don't give a damn about the future as long as they can afford their prescriptions. Take kids out of the equation, and the outright net recipients of subsidies and supports, and you have 25-30% of the total population who are carrying all the burden for the rest and are being crushed under debt, taxes and jobs markets that provide shit-for-wages careers. Happy times! Buy S&P. Buy penny stocks. Buy bonds. Buy sovereign debt. Buy risk-free Treasuries… Buy, Buy, Buy we hear from the sell-side. Because if you do not 'buy' you will miss the 'ladder'... Sounds familiar, folks? Right on... just as 2007 battle cry 'Buy Anglo shares' or 2005 call to 'Buy Romanian apartments' because, you know... who wants to miss 'The Ladder'?.."

24/1/16: High Yield Bonds Flash Red for Growth

An interesting regularity in the markets observed by JPM research: High Yield debt as a lead indicator of recessions… and of equities…

Self-explanatory…

Some more academic links on the high yield bonds forward prediction of business cycles:

• Via credit risk channel: Wang, Pengfei and Miao, Jianjun, "Credit Risk and Business Cycles" (September 8, 2010)
• Via productivity channel: Estevão, Marcello M. and Severo, Tiago, "Financial Shocks and TFP Growth" (Janurary 2010). IMF Working Papers, Vol. , pp. 1-35, 2010
• Via yield curve shape: Peña, Juan Ignacio and Rodríguez, Rosa, "On the Economic Link Between Asset Prices and Real Activity". Journal of Business Finance & Accounting, Vol. 34, Nos. 5-6, pp. 889-916, June/July 2007. 

31/12/15: 2016 Bonds Market Outlook

My take on 2016 outlook for bond markets for Manning Financial is available here: http://issuu.com/publicationire/docs/mf_newsletter_22122015_web?e=16572344/32155392 (see page 5)

Or you can click on the following images to enlarge

13/4/15: Bonds Traders: Give Us a Shake, Cause We So Sleepy...

Recently, I have been highlighting some of the problems relating to the Central Bank's driving up the valuations of government bonds across the advanced economies. In the negative-yield environment, the victims of Central Banks' activism are numerous - from banks to long-hold investors, to corporates, to capex, to savers, to... well... the fabled bonds trades(wo)men... the poor chaps (and chapettes) aren't even showing up for work nowadays: http://www.bloomberg.com/news/articles/2015-04-10/take-off-friday-and-monday-because-most-bond-traders-already-are because Sig. Mario is making their lives sheer misery with his euro bonds acrobatics.

Apparently, there is just not that big of a demand out there for the idea of giving money to the Governments on top of paying taxes and trading volumes are now where the rates are - in the zero corner. So the 'industry' solution is, predictably, for the Fed to raise rates. When was the last time you heard the car manufacturers begging regulators for a safety recall of their vehicles 'to jolt the complacent consumers a bit'?

23/6/2014: Euro Area Investment Funds Stats: April 2014

ECB has released April 2014 data on Investment Funds flows in the Euro Area. The release is available here: http://www.ecb.europa.eu/press/pdf/if/ofi_201404.pdf.

From the top-line:

1. In April, the amount outstanding of shares/units issued by euro area investment funds (ex-money market funds) was €68 billion higher than in March 2014.
2. In terms of the breakdown by investment policy, the annual growth rate of shares/units issued by bond funds was 4.0% in April 2014. Transactions in shares/units issued by bond funds amounted to €15 billion in April 2014. The annual growth rate and monthly transactions of equity funds were 7.3% and €21 billion respectively in April 2014. For mixed funds, the corresponding figures were 9.1% and €13 billion.
3. The kicker is in comparing growth rates in April 2013 against growth rates in April 2014. These are shown in the chart below:

The basic point is that growth is slower (transactions on buy side are smaller) and this is true for all funds, except Equity Funds. This change comes on foot of February-March 2014 when transactions were larger than in the same period of 2013.

So we have alleged economic recovery associated with slower growth in investment funds activity. Not a reason to worry, yet, but certainly a reason to ask if the recovery has been already priced in by the markets?..

25/6/2013: What the hell is going on in the markets?

Two charts from Pictet neatly illustrate the ongoing bonds markets correction:

My two cents on what's going on in the markets today:


Wednesday opening last week at the cusp of FOMC statements, US 10 years were  yielding ca 2.15%. and 4 trading days later, these were at 2.61% or 41 bps up. 30 years are up from the nadir of 2.83% on may 2 to 3.56% currently.

And what about the other QE-infused or enthused market? In just over 3 weeks, FTSE 100 is down 846 points, from 6,875 on 22 May.

Equities and bonds are moving same way? Why?

Because of three factors:
1) When bonds go down, with them goes down capital. Mandated investment vehicles and banks take a bit of a shower.
2) When US or other advanced economies bonds take a shower, Emerging Markets take a bath because of liquidity pull out to cover leveraged losses elsewhere.
3) When EMs and bonds tank, capital-backed leverage falls, so liquidity falls in the advanced markets too, dragging down all risk assets.

These are the tripartite consequences of a liquidity trap, whereby intermediated short-term funding underpins investment activities. Put differently, when humans have less cash (real economy slow recovery, coupled with tax and financial repression), while banks and other institutions have more cash (including, for the latter, via access to banks leverage against Central Banks funding), markets become correlated, even where hedges existed before, correlations turn positive. Where there is contrasting access to the same asset via both financial paper and physical or real assets (e.g. gold vs gold coins), the two diverge, with financialised asset moving in synch with other financial assets, while real/physical asset moving in the opposite direction.

Thus, Brazil's 30-year bonds (dollar-denominated) are down now more than 25% in recent weeks, and instead of flowing into safe havens or rather 'safer hells', the cash is being tucked away into reduced leverage, leading to the US bonds compression down and UK gilts erasing all gains made since October 2011 (when QE2 kicked in).

The only thing that behaves predictably so far is VIX, which has gone from low-flat around 13.6-14.0 between March 24th and May 24th to over 20 average since June 20th through today. Short term VXX index is up from 18.03 on May 17th to 22.81 today.

Not quite panic, but pressure… and pressure is a trigger. And FOMC, and the rest of the Impossible Monetary Dilemma, are triggers too. The point is, given the recent drama in bond markets and equities and EMs, triggers are dangerous in trigger-happy times. When you have lots of capital tied up in 'safe assets' and lots of leverage tied up on top of that capital, pulling the rug from underneath capital quality leads to accelerating cascades across the board.

This is bad news for strategies over the short-term, as traditional allocations based on previously stable relations between asset classes are broken down. Gold co-moves with equities and bonds and currencies. The good news: once financialisation of the long positions is unwound, leverage is reduced and repricing of 'bubble'-like assets (aka financialised assets as opposed to real assets) is finished, the stable relations will return. In the long run, we all are… well, in the long run.

12/6/2013: Bond Markets: Is Canary Kicking the Bucket?

I have written before about the prospect of the Fed starting unwinding of the QE operations. Here's my summary forward view.

Stage 1: the Fed will reduce the rate of QE print ('taper on'). This is inevitable and it is already driving 10-year Treasury yields up - in last 40 days, by some 50bps. The same is also inevitable for the Euro area, albeit via a different mechanism (unwinding of excess liquidity supply to the banks, plus scaling down of any expectations for OMT to kick in), driving the Bund up some 35bps.

In both cases, macro news-flows and inflationary pressures pointed to the opposite direction for yields. This is confirmed by the differences in risk pricing indices in the bond markets (MOVE index: Merrill Lynch Option Volatility Estimate (MOVE) Index on US Treasuries) as opposed to the equity market volatility index (VIX). MOVE has gone almost double from around 47-48 in early May to over 80 recently. Levels around 80 are consistent with the height of the peripheral euro area crisis back in 2012. Over the same period of time, VIX is up from around 13.0 to 16.0 and during the height of the euro area crisis it was averaging closer to 40.

Stage 2: In the follow up stage, the Fed will have to engage in more than simply scaling back new purchases. Here, the unwinding will begin in earnest and the Fed will have to sell longer-dated bonds into the market.

For now, we are just embarking on Stage 1. Emerging markets and corporate bonds, as well as euro periphery bonds are all signalling the same story: yields are pressured up. During May, US investment corporate bonds fell 2.7%, while junk bonds were down 2.3%.

Now, in the longer term,  when US gross interest rate rises relative to the euro area, forward exchange rate must rise relative to the spot and dollar will weaken forward. This covered parity relationship tends to hold over the longer periods of time under normal market conditions. In May-June so far, Dollar is 5% weaker than EUR, and over 2% weaker than CHF (linked to EUR). However, Dollar is stronger 22% than JPY and virtually unchanged on GBP, dollar strengthened with respect to the emerging currencies.

However, in the short run we are not in a normal economy. As US economy continues to improve, few things will happen:
1) The Fed will continue tapering on the QE in the short-term
2) Expected unwinding of QE (rising rates, instead of lower speed of purchasing of Treasuries as in (1)) will enter expectations in the market but in a longer term, rather than any time soon
3) Bond yields will continue rising and volatility will remain amplified. Long-term US equilibrium is for 10 years at 3.0-3.2% and short-term overshooting that range, for Bund - at current rates, around 2.5-2.8%.
4) Fed will be watching the speed of increases and manage unwinding process accordingly to keep yields from overshooting 3%-or-so target by a significant margin.

All of this means that news-flow will be crucial in months to come as it will be signalling both short-term and long-term changes to the Fed position (usual stuff about the rates), but also strategy (severity of (1) above, or switch to (2) from (1)).

In the short term, dollar will see pressures to appreciate as interest rates will remain intact at policy level and it will take time for higher Treasury yields to transmit into higher real interest rates in the US, inducing slowdown in the economy. Until that happens, economic recovery will be pushing up equities and USD.

In the longer run, however, this pattern will be altered: improved economic news will signal forward switch from (1) taper off to (2) unwinding. Yields will put pressure on real interest rates (3) and policy rates will move up. This will lead to subsequent devaluation of the USD toward equilibrium and a slamming of the breaks on the recovery.

The emerging markets and corporate bonds squeeze are not simple reallocations of liquidity. Truth be told, there is nowhere for liquidity to 'reallocate', given yields. Instead, these are early warning systems at work. Now, to see the underlying iceberg we are heading for, recall this http://trueeconomics.blogspot.ie/2013/04/2242013-who-funds-growth-in-europe.html


Updated: series of very interesting interviews on the issue of monetary exit: http://www.voxeu.org/article/exit-strategies-time-think-ahead

and an interesting post on term premia due to QE:
http://www.econbrowser.com/archives/2013/06/update_on_the_y.html

26/5/2013: FTT v Sovereigns' Addiction to Debt

FT.com reports (http://www.ft.com/intl/cms/s/0/c3121802-c480-11e2-9ac0-00144feab7de.html?ftcamp=published_links%2Frss%2Fhome_us%2Ffeed%2F%2Fproduct#axzz2UQE68h14) that 

"The European Central Bank has offered to help the EU redesign its financial transactions tax to avoid any ‘negative impact’ on market stability, highlighting official fears about the implementation of the levy."

So far so good, as FTT indeed is likely to cut liquidity in the markets, reducing markets efficiency, and potentially increasing volatility, rather thane educing it.

Of course, the original idea the EU came up involved levying tax on trading in bonds, equities and derivatives. So one would expect the following prioritisation from the ECB concerned with markets impacts:
1) Not to distinguish between bonds and equities in tax application and rates, as the two instruments are de facto long-only instruments in either corporate (real) economy, banks (financial economy) and sovereigns (for bonds - which somewhat qualifies as a real economy as well).
2) Levy tax primarily on derivative instruments (although here, tax can be avoided much easier)
3) Recognise that in the restricted competition environment and with legacy subsidies from the crisis period still in place for incumbent financial institutions, any FTT will be at least in part passed onto retail investors and savers, and in more extreme cases - e.g. duopoly model of banking in Ireland - onto all retail users of banking services)
4) Real economy - incomes, investment, entrepreneurship, unemployment, etc - will be most impacted by the FTT levied on real assets - equities and some (not all) bonds and this effect will be stronger the stronger is the banking and investment banking sector concentration in the economy.

Alas, as is clear from the FT.com article, the ECB is not concerned with (3) and (4) whatsoever, and it is unconcerned with (1) either. It also seems to be aware of (2) pitfalls. Aside from that, ECB is concerned with the perennial task faced by all European Government - the obsession of raising as much tax revenue as possible while incentivising more debt pumped into sovereign bond markets.


Per FT.com: "The ECB believes markets should efficiently “transmit” changes in interest rates to the real economy." You might think that this means transmitting higher (lower) ECB rates into higher (lower) (a) Government bond yields and (b) higher/lower cost of private credit. Err… you would be wrong.

Per FT.com there are rumours that "…the ECB would prefer to have a limited UK-style stamp duty on equities". What can possibly go wrong, then?

ECB concern is clearly to grease the wheels of sovereign bond markets. The fact that FTT will reduce markets liquidity in real instruments & will cost retail investors in the end - well, that is hardly ECB's concern at all. ECB like the EU Governments is only worried about own coffers & give no attention to the economy.  

Equity markets volatility (FTT original raison d'être is to reduce volatility) had NOTHING to do with the current crises. The ECB focus on 'UK-styled stamp duty on equities', if confirmed, thus exposes FTT as a pure scam to raise more tax revenues, not a measure to deal with 'markets instability'. 

As FT.com quotes one of the market participants: "bond markets were a “phenomenally attractive” way of channelling savings into investment." Alas, it is not - corporate bonds are debt. Shoving more debt while disincentivising equity investment is not a great idea for long term sustainable funding.

In Europe, lending money to Governments, including to fund dodgy unfunded pensions and white elephant projects, is tax-wise deemed to be more laudable than to invest in equity of real enterprises. By corollary, lending to companies is also deemed to be more preferential than funding them via equity. One of the outcomes of this decades-long preferential treatment of debt is the current crisis: over-bloated and under-funded public spending coupled with too much private debt (including banking debt) against too little equity (the latter imbalance drove the bailouts of banks in euro area periphery).

With this in mind, talking about 'Robin Hood' taxes on Financial Services in EU is equivalent to believing in Santa's Magic raindeer as a viable alternative for public transport.

16/5/2013: On That Impossible Monetary Policy Dilemma

At last, the IMF has published something beefy on the extraordinary (or so-called 'unconventional') monetary policy instruments unrolled by the ECB, BOJ, BOE and the Fed since the start of the crisis in the context of the question I been asking for some time now: What happens when these measures are unwound?

See http://liswires.com/archives/2102 and http://trueeconomics.blogspot.ie/2012/10/28102012-ecb-and-technocratic-decay.html

The papers: UNCONVENTIONAL MONETARY POLICIES—RECENT EXPERIENCE AND PROSPECTS and UNCONVENTIONAL MONETARY POLICIES—RECENT EXPERIENCE AND PROSPECTS—BACKGROUND PAPER should be available on the IMF website shortly.

Box 2 in the main paper is worth a special consideration as it covers Potential Costs of Exit to Central Banks. Italics are mine.

Per IMF: "Losses to central bank balance sheets upon exit are likely to stem from a maturity mismatch between assets and liabilities. In normal circumstances, higher interest rates—and thus lower bond prices—would lead to an immediate valuation loss to the central bank. These losses, though, would be fully recouped if assets were held to maturity. [In other words, normally, when CBs exit QE operations, they sell the Government bonds accumulated during the QE. This leads to a rise in supply of Government bonds in the market, raising yields and lowering prices of these bonds, with CBs taking a 'loss' on lower prices basis. In normal cases, CBs tend to accumulate shorter-term Government bonds in greater numbers, so sales and thus price decreases would normally be associated with the front end of maturity profile - meaning with shorter-dated bonds. Lastly, in normal cases of QE, some of the shorter-dated bonds would have matured by the time the CBs begin dumping them in the market, naturally reducing some of the supply glut on exits.]

But current times are not normal. "Two things have changed with the current policy environment: (i) balance sheets have grown enormously, and (ii) assets purchased are much longer-dated on average and will likely not roll-off central bank balance sheets before exit begins."

This means that in current environment, as contrasted by normal unwinding of the QE operations. "…valuation losses will be amplified and become realized losses if central banks sell assets in an attempt to permanently diminish excess reserves. But central banks will not be able to shrink their balance sheets overnight. In the interim, similar losses would arise from paying higher interest rates on reserves (and other liquidity absorbing instruments) than earning on assets held (mostly fixed coupon payments). This would not have been the case in normal times, when there was no need to sell significant amounts of longer-dated bonds and when most central bank liabilities were non-interest bearing (currency in circulation)."

The IMF notes that "the ECB is less exposed to losses from higher interest rates as its assets— primarily loans to banks rather than bond purchases—are of relatively short maturity and yields of its loans to banks are indexed on the policy rate; the ECB is thus not included in the estimates of losses that follow." [Note: this does not mean that the ECB unwinding of extraordinary measures will be painless, but that the current IMF paper is not covering these. In many ways, ECB will face an even bigger problem: withdrawing liquidity supply to the banks that are sick (if not permanently, at least for a long period of time) will risk destabilising the financial system. This cost to ECB will likely be compounded by the fact that unwinding loans to banks will require banks to claw liquidity out of the existent assets in the environment where there is already a drastic shortage of credit supply to the real economy. Lastly, the ECB will also face indirect costs of unwinding its measures that will work through the mechanism similar to the above because European banks used much of ECB's emergency liquidity supply to buy Government bonds. Thus unlike say the BOE, ECB unwinding will lead to banks, not the ECB, selling some of the Government bonds and this will have an adverse impact on the Sovereign yields, despite the fact that the IMF does not estimate such effect in the present paper.]

The chart below "shows the net present value (NPV) estimate of losses in three different scenarios." Here's how to read that chart:

• "Losses are estimated given today’s balance sheet (no expansion) and the balance sheet that would result from expected purchases to end 2013 (end 2014 for the BOJ, accounting for QQME). 
• "Losses are estimated while assuming everything else remains unchanged (notably absent capital gains or income from asset holdings)… [so that] no stance is taken as to the precise path and timing of exit. ...These losses—which may be significant even if spread over several years—would impact fiscal balances through reduced profit transfers to government. 
• "Scenario 1 foresees a limited parallel shift in the yield curve by 100 bps from today’s levels. 
• "Scenario 2, a more likely case corresponding to a stronger growth scenario requiring a steady normalization of rates, suggests a flatter yield curve, 400 bps higher at the short end and 225 bps at the long. The scenario is similar to the Fed’s tightening from November 1993 to February 1995, which saw one year rates increase by around 400bps. Losses in this case would amount to between 2 percent and 4.3 percent of GDP,  depending on the central bank. 
• "Scenario 3 is a tail risk scenario, in which policy has to react to a loss of confidence in the currency or in the central bank’s commitment to price stability, or to a severe commodity price shock with second round effects. The short and long ends of the yield curve increase by 600 bps and 375 bps respectively, and losses rise to between 2 percent and 7.5 percent of GDP. 
• "Scenarios 2 and 3 foresee somewhat smaller hikes for the BOJ, given the persistence of the ZLB.

And now on transmission of the shocks: "The appropriate sequence of policy actions in an eventual exit is relatively clear.

• "A tightening cycle would begin with some forward guidance provided by the central bank on the timing and pace of interest rate hikes. [At which point bond markets will also start repricing forward Government paper, leading to bond markets prices drops and mounting paper losses on the assets side of CBs balance sheets]
• "It would then be followed by higher short-term interest rates, guided over a first (likely lengthy) period by central bank floor rates (which can be hiked at any time, independently of the level of reserves) until excess reserves are substantially removed. [So shorter rates will rise first, implying that shorter-term interbank funding costs will also rise, leading to a rise in lone rates disproportionately for banks reliant on short interbank loans - guess where will Irish banks be by then if the 'reforms' we have for them in mind succeed?] 
• "Term open market operations (“reverse repos” or other liquidity absorbing instruments) would be used to drain excess reserves initially; outright asset sales would likely be more difficult in the early part of the transition, until the price of longer-term assets had adjusted. Higher reserve requirements (remunerated or unremunerated) could also be employed." [All of which mean that whatever credit supply to private sector would have been before the unwinding starts, it will become even more constrained and costlier to obtain once the unwinding begins.]
• For a kicker to that last comment: "The transmission of policy, though, is likely to somewhat bumpy in the tightening cycle associated with exit. Reduced competition for funding in the presence of substantial excess reserve balances tends to weaken the transmission mechanism. Though higher rates paid on reserves and other liquidity absorbing instruments should generally increase other short-term market rates (for example, unsecured interbank rates, repo rates, commercial paper rates), there may be some slippage, with market rates lagging. This could occur because of market segmentation, with cash rich lenders not able to benefit from the central bank’s official deposit rate, or lack of arbitrage in a hardly operating money market flush with liquidity. Also, there may be limits as to how much liquidity the central bank can absorb at reasonable rates, since banks would face capital charges and leverage ratio constraints against repo lending." [But none of these effects - generally acting to reduce immediate pressure of CB unwinding of QE measures - apply to the Irish banks and will unlikely apply to the ECB case in general precisely because the banks own balance sheets will be directly impacted by the ECB unwinding.]
• "There is also a risk that even if policy rates are raised gradually, longer-term yields could increase sharply. While central banks should be able to manage expectations of the pace of bond sales and rise in future short-term rates—at least for the coming 2 to 3 years—through enhanced forward guidance and more solid communication channels, they have less control over the term premium component of long-term rates (the return required to bear interest rate risk) and over longer-term expectations. These could jump because leveraged investors could “run for the door” in the hope of locking in profits, because of expected reverse portfolio rebalancing effects from bond sales, uncertainty over inflation prospects or because of fiscal policy, financial stability or other macro risks emerging at the time of exit. To the extent a rise in long-term rates triggers cross-border flows, exchange rate volatility is bound to increase, further complicating policy decisions." [All of which means two things: (a) any and all institutions holding 'sticky' (e.g. mandated) positions in G7 bonds will be hammered by speculative and book-profit exits (guess what these institutions are? right: pension funds and insurance companies and banks who 'hold to maturity' G7-linked risky bonds - e.g peripheral euro area bonds), and (b) long-term interest rates will rise and can rise in a 'jump fashion' - abruptly and significantly (and guess what determines the cost of mortgages and existent not-fixed rate loans?).]

And so we do  it forget the ECB plight, here's what the technical note had to say about Frankfurt's dilemma:  "The ECB faces relatively little direct interest rate risk, as the bulk of its loan assets are linked to its short-term policy rate. However, it may be difficult for the ECB to shrink its balance sheet, as those commercial banks currently borrowing from the ECB may not easily be able to repay loans on maturity. The ECB could use other instruments to drain surplus liquidity, but could then face some loss of net income as the yield on liquidity-draining open market operations (OMOs) could exceed the rate earned on lending, assuming a positively-sloped yield curve, if draining operations were of a longer maturity." [I would evoke the 'No Sh*t, Sherlock" clause here: who could have thought Euro area's commercial banks "may not easily be able to repay loans on maturity". I mean they are beaming with health and are full of good loans they can call in to cover an ECB unwind call… right?]

Obviously, not the IMF as it does cover the 'geographic' divergence in unwinding risks: "But the ECB potentially faces credit risk on its lending to the banking system for financial stability purposes. In a “benign” scenario, where monetary tightening is a response to higher inflation resulting from economic growth, non-performing loans should fall and bank balance sheets should improve. But even then, some areas of the eurozone may lag in economic recovery. Banks in such areas could come under further pressure in a rising rate environment: weak banks may not be able to pass on to weak customers the rising costs of financing their balance sheets." [No prize for guessing which 'areas' the IMF has in mind for being whacked the hardest with ECB unwinding measures.]

So would you like to take the centre-case scenario at 1/2 Fed impact measure for ECB costs and apply to Ireland's case? Ok - we are guessing here, but it will be close to:

1. Euro area-wide impact of -1.0-1.5% GDP shaved off with most impact absorbed by the peripheral states; and
2. Yields rises of ca 200-220bps on longer term paper, which will automatically translate into massive losses on banks balancesheets (and all balancesheets for institutions holding Government bonds). 
3. The impact of (2) will be more severe for peripheral countries via 2 channels: normal premium channel on peripheral bonds compared to Bunds and via margins hikes on loans by the banks to compensate for losses sustained on bonds.
4. Net result? Try mortgages rates rising over time by, say 300bps? or 350bps? You say 'extreme'? Not really - per crisis historical ECB repo rate averages at 3.10% which is 260bps higher than current repo rate... 

Ooopsy... as some would say. Have a nice day paying that 30 year mortgage on negative equity home in Co Meath (or Dublin 4 for that matter).

15/1/2013: Risk Taking Up, Cash Down

In contrast to CFA members cautious optimism (see here), markets bullishness is hitting historical highs:

via @Pawelmorski

And understandably, cash is not the King (see second chart here).

12/2/2012: A road map to a cooperative solution for Greek crisis

Papandreou: 'this is a battle between the markets and democracy'.

Greek political discourse - mirroring the received wisdom of the crowds has been reduced to a blatant, and populist lie.

The battles in Greece today are between democracy and European/ECB dogma of preserving the status quo of existent statist system, of which patronage by the State of some markets participants is just an element. Here's why:

1. The markets did not impose ANY conditions on Greece - EU/ECB did. The markets simply refuse to be conned any longer into subsidizing the Greek state through cheap credit. This is the basic right of any participant in the markets - to refuse investing or lending to anyone, just as it is the right of any baker to refuse selling bread to someone with no money and no desire to pay on credit.
2. The markets investors are the injured party - excluding the bottom-fishing hedge funds who bought Greek bonds very recently at hefty discounts. The investors are the only ones who were first deceived by the Greek Governments cooking books and fudging numbers in official statistics. The investors should have known better, but that is not a valid defense of the case against them - they were deceived by fraudulent data reporting by the Greek State (yes, right - politicians, Governments, civil servants). The markets/investors are also the only ones who have to take any writedowns. The ECB and the European Union are taking no writedowns on Greek bonds, and are, in fact, lending Greece 'rescue funds' at a profit. 

I am pointing this not to prevent imposition of losses on Greek bonds investors. They deserve to lose and they should lose more than 70-75% of the face value of their investments in Greek bonds.

I am writing this to point that the battle we are facing in Athens today is between people pushed to a breaking point by the policies of the Governments past, and the EU/ECB.

And there is a way out, folks. Here's what should be done:

1. Impose full losses on Greek bondholders to bring debt/GDP ratio in Greece to 75%. Do same for banks bondholders in Ireland and Spain, and combine these sovereign and banking measures to achieve the same in Portugal and Belgium. Seniority under these arrangements should be as follows: private sector debt holders take the first hit, followed by the public debt holders.
2. All PIIGS bonds held by the ECB are to be transferred into a separate holding fund. This fund is to run between 2012 and 2021. Bonds are to be held in the fund not at face value, but at purchase value to instantaneously reduce debt overhang in these countries. Note: this imposes no loss on ECB until the fund is wound up.
3. The ECB Special Fund (outlined in (2) above) is to monitor the conditions of compliance with real (not the currently identified) reforms aiming to restructure PIIGS economies to put them on the path of private sector-driven growth and fiscal sustainability over 10 years horizon.
4. No coupon payments or principal repayments to be accepted by the ECB on these bonds between 2012 and 2021 to reduce debt overhang drag on the participating economies and improving their fiscal capacity to implement reforms.
5. The bonds held in the ECB fund are to be automatically written down to zero face value in 2021 as long as the participating country meets conditions of implementing the reforms.

The above proposal will eliminate or severely restrict the problem of moral hazard, as countries participating in the programme will be subject to strict reforms programme implementation. The plan will also reduce the burden of repayment of debt on the countries that do stick to the conditions of the reforms. The plan will also bring, gradually, these countries economies to more competitive institutional, fiscal and regulatory environment. In other words, the proposal contains both the sticks (under items (2), (3) and conditionality) and the carrots (items (4) and (5)).

In other words, the fund, as outlined above, would satisfy core objectives of the crisis resolution framework:

• Allow for meaningful change and reforms
• Create an incentive to participate actively in reforms for the countries engaged with the fund
• Reduce moral hazard problem
• Help to establish popular support for reforms by providing real, tangible improvement in the economies ability to sustain reforms

We can't keep fighting battles driven by noble objectives, but based on faulty logic that simply serves the very same elites that have created this crisis. We need to find a cooperative solution to the problems we face.

12/12/2011: Bonds starting position for the week

Couple of very handy charts from Dolmen Stockbrokers on week opening in bond markets:

The above clearly show risk-off condition at the start of this week when it comes to European sovereigns and risk-taking positions in the corporate debt markets.

And a handy summary of current corporate deposit rates across Irish financial institutions:

The above highlights the closely-realigned relationship between risk and deposit rates with permo leading the pack of 'sickies' and EBS following the lead.