Category Archives: Debt

YCC: Can’t Come Yet

28 Friday Aug 2020

Posted by in Debt, Monetary Policy, Politics

≈ Leave a comment

Tags

, ,

Yield Curve Control (YCC) or Yield Curve Targeting (YCT) – going forward, unless quoted, I will use YCC – is the latest unconventional tool in the modern central bank monetary arsenal. It was first used in 1942 by the Fed, and more recently, by BOJ in 2016, and RBA this year. YCC was first considered in the USA after the 2008 financial crisis, and again after the Covid crisis this year.

There is very little reason for the Fed to adopt YCC in the current environment given no pressure on the yield curve and government finances. On the other hand, there are other, better, tools to stimulate the economy and allow inflation to stay high. If it were eventually to adopt YCC, it is the long-end of the yield curve which will benefit the most from it.

YCC Options

In a 2010 memo, the Fed discussed “strategies for targeting intermediate- and long-term interest rates when short-term interest rates are at the zero bound”. The memo breaks down the choice of YCC into two possibilities:

  1. targeting horizon: which yields along the curve should be capped; and
  2. “hard” vs. “soft” targets: the former would require the Fed to keep yields at a specific level all the time, while under the latter, yields would be adjusted on a periodic basis.

In addition, the memo lists three different implementation methods:

  1. policy signaling approach: keep all short-term yields, in the time frame during which the Fed plans not to raise rates, at the same level as the Fed’s target rate (Fed funds, IOER, etc.);
  2. incremental approach: start with capping the very short-end rate and progressively move forward as needed; and
  3. long-term approach: cap immediately the long-end of the curve.

During the Covid crisis in 2020, there was a very extensive discussion on YCC at the June FOMC meeting, according to the minutes. In fact, there was a whole section on it, going though the other current and past experiences of YCC and listing the pros and cons. While the 2010 memo had zero effect on market sentiment, investors took this most recent development very positively. However, the market was ostensibly disappointed after the release of the July minutes, where the Fed hinted that YCC might not be happening after all, at least for now:

“…many participants judged that yield caps and targets were not warranted in the current environment but should remain an option that the Committee could reassess in the future if circumstances changed markedly.”

Reality, however, is that the July 2020 minutes did not say anything that different from the June 2020 minutes. Here is the relevant quote from the latter:

“…many participants remarked that, as long as the Committee’s forward guidance remained credible on its own, it was not clear that there would be a need for the Committee to reinforce its forward guidance with the adoption of a YCT policy.”

Compare to this quote from the July FOMC minutes:

“Of those participants who discussed this option, most judged that yield caps and targets would likely provide only modest benefits in the current environment, as the Committee’s forward guidance regarding the path of the federal funds rate already appeared highly credible and longer-term interest rates were already low.”

Despite these mentions of YCC by the Fed in its latest FOMC meetings, unlike 2010, we know very little this time about the Fed’s intentions how to structure and implement YCC, if needed. The Jackson Hole meeting revealed some of the main conclusions of the FOMC’s review of monetary policy strategy, tools, and communications practices, especially on average inflation targeting (AIT) but there was no light shed on what the Fed is thinking about YCC.

Taking the example of Japan, YCC is a natural extension of BOJ monetary policy: QE (quantitative easing: start in 1997, but officially only in 2001), QQE (quantitative and qualitative easing: stat 2013), QQE+NIRP (negative interest rate policy: start January, 2016), QQE+YCC (start September, 2016). In effect, BOJ moved from targeting the 0/N rate (QE) to targeting quantity of money (monetary base in QQE), to a mixture of quantity and O/N (QQE+NIRP) to a mixture of quantity and short and medium-term rates (QQE+YYC, in reality, even though the quantity is still there, the focus is more on the rates)

RBA took a short cut, skipped QQE+NIRP and went straight to QQE+YCC, targeting only the 3yr rate. According to the June FOMC minutes, see above, it looks like the Fed might also skip, at least, NIRP:

“…survey respondents attached very little probability to the possibility of negative policy rates.”

In addition, it seems the Fed is more inclined to look at capping short-term yields:

“A couple of participants remarked that an appropriately designed YCT policy that focused on the short-to-medium part of the yield curve could serve as a powerful commitment device for the Committee.”

While capping long-term yields could result in some negative externalities:

“Some of these participants also noted that longer-term yields are importantly influenced by factors such as longer-run inflation expectations and the longer-run neutral real interest rate and that changes in these factors or difficulties in estimating them could result in the central bank inadvertently setting yield caps or targets at inappropriate levels.”

YCC can be implemented in different formats and its goals can also differ.

The original YCC in the 1940s USA was all about helping the Treasury fund its large war budget deficit. Frankly, this ‘should’ be the main reason YCC is implemented. Indeed, it was exactly in this light that Bernanke suggested YCC is an option in our more modern times in his famous speech in 2001, “Deflation: make sure it does not happen here”:

“…a pledge by the Fed to keep the Treasury’s borrowing costs low, as would be the case under my preferred alternative of fixing portions of the Treasury yield curve, might increase the willingness of the fiscal authorities to cut taxes.”

The point is, if the goal was to stimulate the economy, push the inflation rate up and the unemployment rate down, forward guidance (which is what QQE is) and possibly NIRP (not applicable for every country though) are better options (see quotes above from the June/July FOMC minutes).

YCC is the option to use only once the economy has picked up and inflation is on the way up but years of QE has left the government debt stock elevated to the point that even a marginal rise in interest rates would be deflationary and push the economy back to where it started. In other words, YCC is giving the chance for the Treasury to work out its heavy debt load. Most likely, this would be happening at the expense of a short-term rise in inflation over and beyond what is originally considered prudent but on a long-enough time frame, average inflation would still be within those ‘normal’ limits, as long as the central bank remains credible, of course. Again, the post WW2 YCC should be a good reference point for such a scenario.

The Original YCC

The initial proposal to peg the US Treasury yield curve was first presented at the June 1941 FOMC meeting by Emanuel Goldenweiser, director of the Division of Research and Studies.

“That a definite rate be established for long term Treasury offerings, with the understanding that it is the policy of the Government not to advance this rate during the emergency. The rate suggested is 2 1/2 per cent. When the public is assured that the rate will not rise, prospective investors will realize that there is nothing to gain by waiting, and a flow into Government securities of funds that have been and will become available for investment may be confidently expected.”

The emergency hereby mentioned was, of course, WW2. The war started in September 1939 and by late 1940, Britain was running out of money to pay for equipment. In a speech on October 30, 1940, President Roosevelt first promised Britain every possible assistance even though Britain lacked the financial resources to pay. The Lend-Lease Act, passed by Congress in March 1941, eventually signalled that it would finance whatever Britain required. US direct involvement in WW2 after the bombing of Pearl Harbour ensured the country, itself, would have to spend heavily in the war effort.

That was the context of the YCC which followed in 1942. In addition, US economic circumstances leading to the decision to peg the US Treasury curve were actually not that different to today. The US banking system was flush with liquidity on the back of large gold inflows, inflation was around 2% and the shape of the yield curve (the very front end) was not that dissimilar: the front end was around 0%, the 5yr around 65bps, and the long bond at 2.5%. With the start of the war, inflation picked up but there were price controls put in place which limited its rise. Government debt to GDP, however, was actually much lower than today and it got to present levels only by the end of the war.

By the time the actual peg went in place, the curve had steepened, especially the 10yr had gone to 2% as inflation really accelerated. Inflation eventually reached a staggering 12.5% in 1942 at which point even more price controls were imposed.

Some FOMC members at that time regarded such a steep yield curve as inconsistent with the policy objectives (keeping inflation under control in the context of the US Treasury issuance program) and insisted on a horizontal structure of managing the curve. And that is in spite of the fact that the decision to peg interest rates was never officially announced. In fact, US Treasury Secretary, Henry Morgenthau’s preference was for a continuation of what today we regard as quantitative easing (QE), i.e. Fed using a quantity rather than rates target.

Under the peg, the Fed, instead, had to buy whatever the private sector sells as long as yields were above the stipulated levels. Naturally, investors were riding the positively sloped yield curve, selling the front end and buying the long end. The Fed was forced to accumulate a lot of T-Bills as a result.

However, its holdings of coupons were never that large.

With the end of the war, inflation started picking up again and the Fed eventually took off the yield peg in the front end in July 1947. The peg in the long end stayed until the March 1951 US Treasury Accord. By that time, US public debt to GDP had shrunk back to 73% from more than 100% at the end WW2.

The 1951 Fed-Treasury Accord did not completely end Fed’s management of the yield curve, however. Fed’s new chairman, Willian Martin, wanted to confine market operations in the front end of the curve only, insisting that this will eventually also affect the long end. This ‘bills only’ policy lasted until 1961 and it provided a turn in how the Fed views its involvement in the US Treasury market: from helping the Treasury finance the government’s debt to a more traditional approach to monetary policy focusing on price stability and employment.

Even that was not the end of Fed’s direct involvement. From 1961 till 1975, the Fed engaged in the so called, ‘even keel’ operations. Under these, the Fed supplied reserves and refrained from any policy decisions just before US Treasury auctions and even immediately after (until the time primary dealers were able to sell their inventory to the private sector).

The set-up for YCC in the 1940s has many similarities not only with present day USA but also with Japan, where public debt to GDP at 250% is even higher that US at its peak. However, as discussed below, the rationale for YCC in Japan, is nevertheless different.

YCC in Japan

With QQE starting in April 2013, BOJ indicated it would be buying 60-70Tn Yen of assets per year. On JGBs, the plan was to slowly lengthen the duration to flatten the curve until inflation surpassed 2%. This was an upgrade from the previous inflation target range of 1-2%. BOJ also added an estimated time target of when it expected that to occur (initially 2015). For all intends and purposes, this was QE plus forward guidance, plus average inflation targeting in one.

A substantial reduction in the price of oil and a consumption tax hike in April 2014 exacerbated the dis-inflationary environment and forced BOJ to increase the annual purchases to 80Tn Yen later that year, extend duration (up to 40 years, average duration moved from 3 years to 7 years) and initiate ETFs and J-REITs purchases. In the meantime, the monetary base and the balance sheet were exploding, latter reaching almost 100% GDP. In effect, through QQE, BOJ moved from targeting the uncollateralized O/N rate to targeting the monetary base.

By 2015, these efforts by BOJ seemed to have worked. Inflation rose from -0.6% in 2013 to 1.2%, unemployment went down. However, subsequent decline in inflation to 0.5% in 2016 threw some doubt over the efficacy of these monetary policy efforts. By then, BOJ holdings of JGBs were approaching 50% of the overall market, contributing to declining market liquidity. 10yr JGB had gone from 75bps to almost 0%. They eventually broke the zero-bound after the BOJ initiated QQE+NIRP by lowering the marginal rate on excess reserves to -0.1% from 0.1%.

The practical consequences of QE+NIRP was a push up of the duration and risk curve (into sub-debt, credit card loans, equities, etc.) and out of the country into international assets. As banks’ JGB holdings gradually dwindled, banks had trouble finding assets for collateral purposes, a fact which, together with the flat yield curve interfered with the monetary transmission mechanism. Eventually, BOJ was buying more and more JGBs from pension funds and insurance companies. As these financial entities don’t have an account at the BOJ, it was banks’ deposits which were increasing. MMFs funds decision to stop taking in more deposits after NIRP, moved even more money into the banking system which further lowered their profitability.

Unlike US, where a large majority of financial assets are owned by other entities, Japan has a bank-based financial system. Even though NIRP did trigger the “loss reversal rate” (loss of bank profits below a certain level of interest rates, causes tighter lending conditions), reality was that only a very small portion of the banks’ deposits, about 4%, i.e. the so-called policy rate balance, were charged the negative rate. Majority were still charged at the 0.1%, about 80%, or so-called basic balances at the BOJ. The rest were charged 0%.

But the effect on the banks was highly uneven. Regional banks suffered more as big banks could find higher yields abroad, for example. So, despite best efforts by BOJ to help the banks with the tiering system, overall bank profitability still fell.

This was the context for YCC which Japan launched in September 2016. The economy was still in need for more stimulus but the way BOJ was providing it, didn’t work, and, if anything, worsened matters as the flat yield curve hindered the monetary transmission mechanism, and the negative interest rate worsened Japanese banks’ profitability. BOJ need to slow down its purchases of JGBs, and thus lower balance sheet growth. The way it was planning to do this was to move away from a quantity target back to an interest rate target with the novelty of adding a long-end one.

In addition to YCC, BOJ provided more clarity to its inflation targeting framework: it added an inflation overshooting commitment. This meant that inflation had to surpass 2% for some time so that average inflation rises to 2%. This brought it even closer to how AIT in the US is supposed to work.

YCC also resulted in a de facto BOJ balance sheet tapering – annual purchases went from 80Tn Yen in 2014 to eventually 16Tn Yen in 2019 – as BOJ didn’t have to interfere as much to keep interest rates within their targets. This was despite the fact that BOJ never actually changed its quantity target, which actually did create a lot of confusion – in March this year, the central bank even scrapped the upper limit on annual purchases. But there was no practical doubt that BOJ had moved on from a quantity to a rates target.

Despite the fact that YCC was initiated to steepen the yield curve, BOJ never really had to do anything in that regard. BOJ interventions were done through two tools: 1) fixed rate purchase operations and 2) fixed rate funds supply operations. The former was used only to bring 10yr JGBs below 10bps.

Benefits and Disadvantages of YCC

Historical analysis shows that a credible central bank can indeed control nominal interest rates. However, by default, it is fully in charge, strictly speaking, only of interest rates ceilings (bond vigilantes are indeed only a gold standard phenomenon; they are redundant in a free floating, irredeemable money monetary system). That is notwithstanding side effects such as higher inflation – which indeed might be one of the goals – or weaker currency.

Interest rate floors are a lot more difficult to control, as to do that, the central bank must be in possession of fixed income assets for sale. Central bank balance sheets may not have a higher bound, but they do have a lower band. When BoJ set on the steepen the yield curve, it indeed opened itself to such a risk, but it did have a very large balance sheet at the time (luckily it never had to go through selling JGBs). In theory a central bank can get around that problem by enlisting the help of the Treasury which can issue more bonds as the yield target breaks that lower bound limit. But then again, there might be negative side effects, such as deflation and a higher debt burden, which this time would be going against said goals.

When it comes to real yields, things get more complicated as inflation is added to the variables that need to be controlled. Historical experience suggests that structural shifts in inflation expectations are more likely to follow rather than lead spot inflation. Very generally speaking, it is a lot easier for a credible central bank to control an inflation ceiling than an inflation floor for somewhat similar reasons (see above). It seems that for a central bank to be able to control the floors of either real or nominal yields, it has to become ‘incredible’ (pun intended)!

Using these conclusions above, it seems to me that there is little upside to resort to YCC, if the goal was just to push inflation up. YCC is very much a complementary tool in that respect. However, YCC can be very effective in allowing inflation to go up alongside helping the Treasury fund. It is very much the main tool here.

One of the challenges of YCC is to keep the central bank balance sheet from expanding too much. Unlike limited QE, there is indeed a risk of it having to purchase large quantities of bonds to keep the interest rate ceilings. There is also the question of exit. Unlike QE which simply smoothed the yield curve, YCC provides a hard ceiling and thus the possibility of a large break higher in yields once the controls are lifted.

What Should the Fed Do?

The fact there was no specific feature on YCC at the Jackson Hole meeting this year (going by the first day of the meeting at this point), makes me think that this is not a monetary policy tool which is high on Fed’s agenda at the moment. Fed is more inclined to first try AIT and more direct forward guidance, as indeed Japan did pre-YCC. However, judging from the June 2020 FOMC minutes, if YCC were to be implemented, it would be on the short-end of the US treasury market, following the Australian model:

“Among the three episodes discussed in the staff presentation, participants generally saw the Australian experience as most relevant for current circumstances in the United States.”

The Australian model though combines YCC with a calendar-based forward guidance. It is not clear how that will work if the Fed adopts an outcome-based forward guidance first, as this is what is favored currently by most FOMC participants.

Also, the Fed must be careful as to exactly what shape yield curve it wants to eventually have. The 1940s YCC flattened the curve, while both Japan and Australia YCC steepened it. The US yield curve is currently flatter than the 1940s US curve but steeper than either Japanese or Australian one at the time YCC was announced. Going for the Australian example of pegging the front end, it will most likely steepen the curve as it did in Australia.

Prior to Jackson Hole, the OIS curve was indicating that there would be no rate hikes in the next 5 years. Post, market is not 100% sure, which means chairman Powel communication was not so clear. The 5y5y forward, which is probably the best proxy of the Fed’s terminal rate is still around 65bps: the curve is well anchored all the way to 10yr which is a great outcome given the massive supply of US Treasuries.

How much benefit would the curve get from pegging any yields up to 10 year? I don’t think a lot. It is the 30 year that the Fed might consider pegging eventually; below 1.5% today, it is still relatively low. The 30-year Treasury is where really proper market demand and supply meet and it thus becomes the focal point for the monetary – fiscal interplay.

If the Fed is planning to do YCC, it should peg the 30-year US Treasury, just like it did in the 1940s. For everything else, the Fed has better tools at its disposal.

Record liquidity leads to record net issuance of financial assets

06 Monday Jul 2020

Posted by in Asset Allocation, Debt, Equity, Monetary Policy

≈ Leave a comment

Tags

, ,

At $3.2Tn, US Treasury (UST) net issuance YTD (end of June) is running at more than 3x the whole of 2019 and is more than 2x the largest annual UST issuance ever (2010). At $1.4Tn, US corporate bond issuance YTD is double the equivalent last year, and at this pace would easily surpass the largest annual issuance in 2017. According to Renaissance Capital, US IPO proceeds YTD are running at about 25% below last year’s equivalent. But taking into consideration share buybacks, which despite a decent Q1, are expected to fall by 90% going forward, according to Bank of America, net IPOs are still going to be negative this year but much less than in previous years.

Net issuance of financial assets this year is thus likely to reach record levels but so is net liquidity creation by the Fed. The two go together, hand by hand, it is almost as if, one is not possible without the other. In addition, the above trend of positive Fixed Income (FI) issuance (both rates and credit) and negative equity issuance has been a feature since the early 1980s.

For example, cumulative US equity issuance since 1946 is a ($0.5)Tn. Compare this to total liquidity added as well as issuance in USTs and corporate bonds.*

The equity issuance above includes also financial and foreign ADRs. If you strip these two out, the cumulative non-financial US equity issuance is a staggering ($7.4)Tn!

And all of this happened after 1982. Can you guess why? SEC Rule 10b-18 providing ‘safe harbor’ for share buybacks. No net buybacks before that rule, lots of buybacks after-> share count massively down. Cumulative non-financial US equity issuance peaked in 1983 and collapsed after. Here is chart for 1946-1983.

Equity issuance still lower than debt issuance but nothing like what happened after SEC Rule10B-18, 1984-2019.

Buybacks have had an enormous effect on US equity prices on an index basis. It’s not as if all other factors (fundamentals et all) don’t matter, but when the supply of a financial asset massively decreases while the demand (overall liquidity – first chart) massively increases, the price of an asset will go up regardless of what anyone thinks ‘fundamentals’ might be. People will create a narrative to justify that price increase ex post. The only objective data is demand/supply balance.

*Liquidity is measured as Shadow Banking + Traditional Banking Deposits. Issuance does not include other debt instruments (loans, mortgages) + miscellaneous financial assets. Source: Z1 Flow of Funds

Fed is facing a dilemma…actually a trilemma

05 Friday Jun 2020

Posted by in Asset Allocation, Debt, Equity, FX, Monetary Policy

≈ Leave a comment

Fed is now probably considering which is worse: a UST flash crash or a risky asset flash crash. Or both if they play their hand wrong.

Looking at the dynamics of the changes in the weekly Fed balance sheet, latest one released last night, a few things spring up which are concerning.

1.The rise in repos for a second week in a row – a very similar development to the March rise in repos (when UST10yr flashed crashed). The Fed’s buying of Treasuries is not enough to cope with the supply hitting the market, which means the private sector needs to pitch in more and more in the buying of USTs (which leads to repos up).

This also ties up with the extraordinarily rise in TGA (US Treasury stock-piling cash). But the build-up there to $1.4Tn is massive: US Treasury has almost double the cash it had planned to have as end of June! Bottom line is that the Fed/UST are ‘worried’ about the proper functioning of the UST market. Next week’s FOMC meeting is super important to gauge Fed’s sensitivity to this development

2.Net-net liquidity has been drained out of the system in the last two weeks despite the massive rise in the Fed balance sheet (because of the bigger rise in TGA). It is strange the Fed did not add to the CP facility this week and bought only $1Bn of corporate bonds ($33Bn the week before, the bulk of the purchases) – why?

Fed’s balance sheet has gone up by $3tn since the beginning of the Covid crisis, but only about half of that has gone in the banking system to improve liquidity. The other half has gone straight to the US Treasury, in its TGA account. That 50% liquidity drain was very similar throughout the Fed’s liquidity injection between Sept’19-Dec’19. And it was very much unlike QE 1,2,3, in which almost 90% of Fed liquidity went into the banking system. See here.  Very different dynamics.

Bottom line is that the market is ‘mis-pricing’ equity risk, just like it did at the end of 2019, because it assumes the Fed is creating more liquidity than in practice, and in fact, financial conditions may already be tightening.  This is independent of developments affecting equities on the back of the Covid crisis. But on top of that, the market is also mis-pricing UST risk because the internals of the UST market are deteriorating. This is on the back of all the supply hitting the market as a result of the Treasury programs for Covid assistance.

The US private sector is too busy buying risky assets at the expense of UST. Fed might think about addressing that ‘imbalance’ unless it wants to see another flash crash in UST. So, are we facing a flash crash in either risky assets or UST?

Ironically, but logically, the precariousness of the UST market should have a higher weight in the decision-making progress of the Fed/US Treasury than risky markets, especially as the latter are trading at ATH. The Fed can ‘afford’ a stumble/tumble in risky assets just to get through the supply in UST that is about to hit the market and before the US elections to please the Treasury. Simple game theory suggest they should actually ‘encourage’ an equity market correction, here and now. Perhaps that is why they did not buy any CP/credit this week?

The Fed is on a treadmill and the speed button has been ratcheted higher and higher, so the Fed cannot keep up. It’s a dilemma (UST supply vs risky assets) which they cannot easily resolve because now they are buying both. They could YCC but then they are risking the USD if foreigners decide to bail out of US assets. So, it becomes a trilemma. But that is another story.

The Fed needs to make a decision soon.

Who has done what in the major asset classes: real money flows since 2008*

06 Wednesday Nov 2019

Posted by in Asset Allocation, Debt, Energy

≈ 1 Comment

Tags

, , ,

Households have massively deleveraged: sold about $1Tn of US equities and bought about $2Tn of USTs. The have also marginally divested from corporate bonds.

Banks have deleveraged as well: bought about $0.5Tn of UST while selling about the same amount of equities. The have also marginally divested from corporate bonds.

Insurance companies have put on risk: bought about $1Tn of corporate bonds and small amounts of both equities and USTs.

Mix bag for pension funds with a slight deleveraging: bought $0.5Tn of corporate bonds but sold about $1Tn of equities. But also bought $1.5Tn of USTs.

Mutual funds have put on risk: bought about $1Tn of corporate bonds and small amount of equities. Also bought more than $1.5Tn USTs.

Finally, foreigners have also put on risk: bought $1Tn of corporate bonds, $0.5Tn of equities and $4Tn of USTs.  

Overall, the most (disproportionate) flows went into USTs, followed by US corporates. Demand for equities was actually negative from real money.

What about supply?

Issuance of USTs was naturally the dominant flow followed by US corporates and US equities.

On the US equities side, however, there is a very clear distinction between US non-financial corporate issuance, which is net negative (i.e. corporates bought back shares) and US financial and US corporate issuance abroad, which is net positive. In other words, the non-corporate buybacks (more than $4Tn) were offset by the financial sector (ETF) and ‘ADRs’ issuance.

The opposite is happening on the corporate supply side. Non-financial corporates have done the majority of the issuance while the financial sector has deleveraged (reduced debt liabilities).

In other words, non-financial corporates have bought back their shares at the expense of issuing debt, while the financial sector (ETFs) has issued equities and reduced their overall indebtedness.

No wonder, then that financial sector shares have underperformed the overall market since 2009.

Putting the demand and supply side together this is how the charts look.

On the equities side, the buying comes mostly from ETFs (in ‘Others’ – that is basically a ‘wash’ from the issuance) and foreigners. The biggest sellers of equities are households and pension funds. The rest of the players, more or less cancel each other out.

 So, households and pension funds, ‘sold’ to ETFs and foreigners.

On the corporate bonds side, the main buyers were foreigners, mutual funds and insurance companies. Pension funds also bought. The main seller were the banks. ‘Others’ (close end funds etc.) and households also sold a small amount.

So, here it looks like foreigners, mutual funds and insurance companies ‘bought’ mostly at new issue or from the banks.

Finally, on the USTs side, everybody was a buyer. But the biggest buyer by large were foreigners. Mutual funds, pension funds, the Fed and households came, more or less, in equal amount, second. And then banks, ‘Others’ and insurance companies.

Kind of in a similar way, everyone here ‘bought’ at new issue.

Conclusion

It’s all about demand and supply.

In equities, real money has been a net seller in general, while the biggest buyer has been non-financial corporates themselves in the process of share buybacks. The financial sector has been a net issuer of equity thus its under-performance to the non-financial corporate sector. Equity real money flow is skewed mostly on the sell side.

Real money flow in corporate bonds is more balanced, but with a net buying bias.

USTs real money flow is skewed completely on the buy side.

Overall, since 2008 real money has sold equities, bought a bit of corporate bonds and bought a lot of UST: it does not seem at all that real money embraced the bullish stance which has prevailed in the markets since March 2009.

*Data is from end of Q4’08 till Q4’18, Source for all data is Fed Z1 Flow of Funds

China issues in hard currency!?

05 Tuesday Nov 2019

Posted by in Asset Allocation, China, Debt

≈ Leave a comment

Why do smart people do obviously ‘irrational’ things? It must be the incentive structure, so for them they do not seem irrational. So, I am wrecking my brain over China’s decision to issue EUR-denominated bonds (and a few weeks ago USD-denominated ones), in light of its goal of CNY and CGBs internationalization, 40-50bps over the CGB curve (swapped in EUR).

The rationale China is putting forward is that enables it to diversify its investor base on the back of the trade tensions! Seriously? Do they really mean that or are they getting a really bad advice? Wasn’t the intention to actually go the other way as a result of the trade war? Didn’t China want to be become more self-reliant? In any case, China does not need foreign currency funding given its large, positive NIIP. China has the opposite problem. It has too much idle domestic savings and not enough domestic financial assets. This, among other things, creates a huge incentive for capital flight which, despite its closed capital account, China is desperately trying to prevent.

In that sense, China does need foreign investor but to invest in CGBs (and other local, CNY-denominated bonds) to act as a buffer to the potential domestic capital outflow as the capital accounts gates slowly open up. It is for this reason that BBGAI and JPM have started including CGBs into their indices this year.

It is for this reason SAFE decided to scrap the quota restrictions on both QFII and RQFII in September. It is for this reason that Euroclear signed a memorandum of understanding with the China Central Depository & Clearing to provide cross-border services to further support the evolution of CIBM. That opens up the path for Chinese bonds to be used as collateral in international markets (eventually to become euro-clearable), even as part of banks’ HQLA.

All these efforts are done to make access to the local fixed income market easier for foreign investors. And now, what does China do after? Ahh, you don’t need to go through all this, here is a China government bond in EUR, 50bps cheaper (than if you go through the hassle of opening a Bond Connect account and hedging your CNY back in EUR).

This not only goes against China’s own goals regarding financial market liberalization but also against the recent trend of other (EM) markets preferring to issue in domestic currency than in hard currency. And while other EMs may not have had the choice to issue in hard currency from time to time, China does. And while the investor base for other EMs between the domestic and the hard currency market is indeed different, and the markets are very distinctive, China does not have much of an international investor base. Issuing in the hard currency market may indeed ‘crowd out’ the domestic market. Especially when you come offering gifts of 50bps in a negative interest rate environment.

The type of credit creation matters

04 Monday Nov 2019

Posted by in Debt, Monetary Policy, Politics, UBI

≈ Leave a comment

Credit impacts the real economy in a different way depending on whether it is to households or to corporates (see Atif Mian’s work, also his interview here). Very generally speaking, credit to households affects the economy directly through the demand-side channel, while credit to corporates – through the supply-side channel directly, and only then, potentially, indirectly through the demand-side channel.

Household debt to GDP was flat for two decades between mid-1960s and mid-1980s; and then it doubled; corporate debt for GDP, on the hand, was flat also for two decades after the S&L crisis, and even now it is only a few per cents higher. But the demand-side reduction from the household debt channel post 2008 is rather unique.

Given that the US was running a negative output gap for most of the period post 2008 (and it might still do, even though official estimate is for a small positive), it was the demand-side that needed some catching up to. Instead, the opposite was essentially happening: credit to households was decreasing relative to credit to corporates. As far as credit was concerned, it was primarily the supply side that was getting stimulated (of course, the question is how much stimulus was really created given that a lot of the corporate debt went to share buybacks).

The other theory, one to which I subscribe, is that the modern economy is essentially always experiencing a demand gap. When real wages stopped growing in the 1990s, post the the financial liberalization of the 1980s, household credit experienced a massive run-up. The demand gap left from the stagnation in real incomes was filled with household debt. Until the sudden stop in 2008.

Household debt to GDP did not grow between 1960s-1980s but real household income did, so there was no demand gap either. Post 2008, though, neither of these two options were available which left the US economy in a demand insufficiency. The ‘stimulus’ provided was mostly through the supply side with very little follow through into the demand side which meant lackluster economic growth.

The bottom line is that the type of credit creation matters. The central bank affects directly only the supply of credit (and in some cases, even less so) thus, it has limited ability (none?) to decide on whether credit goes to firms or households. We may get a lot more from lower interest rates if policy makers start thinking more holistically about the whole process of credit creation. Banks do not care where credit goes (why should they?) as long as they get their money back.

But with overall debt in the economy climbing higher and higher, it is essential to think how we can get the most out of it. And if the market can’t do that (it can’t), someone else should step in.

All this does not mean that US households should get even more indebted! On the contrary, the decline in household debt to GDP is good news only if it were also followed by a similar rise in real household income. And it the private market can’t do that either (it seems, it can’t), then we need to rely on the official sector to take on that burden.

Are these the ‘wise owls’ of the North?

03 Sunday Nov 2019

Posted by in Debt, Monetary Policy

≈ Leave a comment

Really interesting the divergence of monetary policy in Norway and Canada, and now possibly, Sweden with the rest of the DM/EM world in the last 12 months*. While pretty much every other central bank in the world has turned dovish, Norges hiked four times since September last year, while Bank of Canada has hiked 5 times since mid 2017. And last week, against all odds and expectations, Riskbank also surprised by pretty much guaranteeing a hike at its December meeting. It’s questionable whether hikes in either country was/is warranted looking strictly at economic activity.

Despite a spike in core inflation in early 2019, something which Norges had actually expected to be temporary, inflation is back below 2%. Both Canada’s and Sweden’s inflation spiked up in mid 2018 and have recently retreated back below 2%. Growth in all three counties has actually been more elevated than in neighboring Europe or US but growth was never the reason their respective central banks cut rates before, so it does not seem to be the reason they are now hiking. In fact, looking at weakening domestic demand and rising unemployment rates in Sweden, there are probably more reasons to cut than hike now.

So why are they hawkish? One theory is that the central banks are worried about rising household leverage with private debt to GDP in each close to the highest in the world. The thing is, other countries in a similar situation have chosen to go the opposite way. Australia, New Zealand, Korea, which also have high household debt ratios, tried to be ‘hawkish’ but have been aggressively cutting over the last 12 months on the back of slowing global demand.

The problem with hiking rates when over-indebtedness is high is that you are ‘inviting’ financial instability and when that is one of your mandates, it is probably not such a wise choice. Is that why the Riskbank has said it would hike only once and stop at 0%?

Another theory is that the Riskbank is preparing to introduce the e-krona and does not want to be dealing with the arb of negative rates. I find that a poor excuse to hike as well.

And finally, some people are looking for a symbolic meaning of Sweden going back to 0% after being the first modern central bank to go below, 10 years ago. I don’t know. My guess is that it is more likely to be part of the experimentation process, but that ultimately it would turn out to be too early not to be a policy mistake.

*In Israel, the UK and the Czech Republic the last interest rate moves were a hike. However, Israel hiked only once, in November last year (from 0%) and with inflation at 0.5% and below the target range of 1-3%, the central banks has removed any prospect for a further rate increase and confirmed inflation is in a downward trend. UK is a special case of Brexit and deserves a post on its own. The Czech Republic, I have to admit, is a proper outlier here with both growth and inflation bucking all trends in Europe and, therefore, also deserves its own blog post.

The best portfolio diversifier (cont.)

01 Friday Nov 2019

Posted by in Asset Allocation, China, Debt, EM

≈ Leave a comment

…is (actually) Chinese bonds

When speaking to investors, the two most common questions I get asked, given rather extreme levels and valuations of (most) asset classes, are:

1.Should my asset allocation change dramatically going forward? and

2.What is the best risk diversifier for my portfolio?

I have previously opined on this here. Very broadly speaking, on the equity portion, one should reduce exposure to US equities and increase allocation to EM equities (unhedged). On the fixed income side, one should move completely out of the long end of UST and put everything into T-Bills to 2yr UST; exposure to EU-denominated sovereigns should also be reduced to zero at the expense of EM local (unhedged) and hard currency bonds. In the normally ‘Others’ section of the portfolio, one should include soft commodities (or alternatively, scale everything down to make space for them). Finally, in terms of FX exposure, apart from EM currencies through the unhedged portions of the bonds and equities allocations, one should hedge the USD exposure with EUR.

Here I am adding some more general thoughts on what I consider to be the best portfolio diversifier for the next 5 years, possibly even longer. To my knowledge, ‘noone’ is invested in any meaningful way in Chinese bonds (I am excluding the special situations credit funds, some of which I know to be very active in the Chinese credit space – but even they are not looking at Chinese government or bank policy bonds).

The big fixed income funds, the pension/mutual funds, the insurance companies have zero allocation to Chinese bonds. Some of the index followers started dipping their foot in the space but most of them are either ignoring China’s weight or are massively underweight the respective index. Finally, a sign of how unloved this market is, on the passive/ETF side, the biggest fund is just a bit more than $100mm.

Let me just say here that we are talking about the third (possibly even the second, by the end of this year) largest fixed income market in the world. And no one is in it?

Chinese bonds merit a rather significant place in investors’ portfolios. They offer diversification thanks to their low correlation and superior volatility-adjusted return relative to other developed and emerging markets. In addition, Chinese bonds are likely to benefit significantly from both the passive and active flows going forward: I expect up $3 trillion of foreign inflows over the next decade on the back of indexation.

Bloomberg Barclays Global Aggregate Index (BBGAI) and JP Morgan Global Diversified have already confirmed Chinese bonds inclusion in their respective indices. FTSE Russell WGBI is likely to do that next March. This inclusion is a big deal! It will have huge repercussions on the global bond industry. It is a much more important and far-reaching development than a similar inclusion of Chinese equities in global indices last year. And the market is not only not ready for this, but it is also underestimating its impact overall.

China is a highly rated sovereign with a much better risk/return profile than other high-quality alternatives.  Chinese bonds offer a significant scope for portfolio diversification because they have very low correlation to global interest rates which means lower return volatility.

Therefore, China sovereign bonds offer a much better volatility-adjusted return than Global Bonds, EM Hard Currency and Corporate Bonds, US HY and Equities, Global Equities and Real Estate.

Among the plethora of negatively yielding sovereign bonds, China sovereigns offer a good pick-up over other DM bonds while yielding not too much lower than EM bonds. In addition, they offer much more opportunity for alpha generation than both DM or EM sovereign bonds. This alpha partially comes from the fact that Chinese fixed income market is still not so well developed and partially from the fact that there are not many sophisticated foreign players in it, as access to it is still not that straightforward.

However, things are rapidly improving on the access side. Bond Connect has already started to revolutionize the onshore market. Before the setting-up of CIBM, and especially Bond Connect in 2017, access to the China bond market was extremely cumbersome through a lengthy process requiring approvals from high authority (QFII and RQFII). Bond Connect, on the other hand, does not require domestic account and custody while following international trading practices. In addition, not long ago, it started real-time settlement and block trading. As a result, Bond Connect volumes doubled.

Moreover, in September this year, SAFE decided to scrap the quota restrictions on both QFII and RQFII, while Euroclear signed a memorandum of understanding with the China Central Depository & Clearing to provide cross-border services to further support the evolution of CIBM. That opens up the path for Chinese bonds to be used as collateral in international markets (eventually to become euro-clearable), even as part of banks’ HQLA. Such developments are bound to make access to the Chinese bond market much easier for overseas investors.

September proved to be a very important month for the China bond market also because the authorities finally delivered on the interest rate reform agenda. The central bank eliminated the benchmark policy loan and deposit rates in favor of a more flexible reference rate. This should be positive for yield curve formation and the continued expansion of interbank liquidity.

China does not have some of the weaknesses typical of emerging markets. On the opposite, it has very little sovereign FX debt, has large FX reserves, and it is a net creditor to the world. Moreover, some of the foreign debt is most likely offset by foreign assets.

Corporate-sector leverage, however, is still high, though default rates, despite lots of recent media focus, are still relatively low. On the other hand, the recovery rates are high, while the official, banking and household sectors are in relatively strong position which, reflects degrees of freedom to deal with these challenges. China has large amounts of debt with implicit state backing and a culture averse to defaults. In effect, the government controls both the asset and the liability side of the domestic debt issue thus a debt crisis is much less likely than in a fully free-market economy. The fact that China has the ‘fiscal’ space to deal with the private debt issue is one big advantage it has over DM countries with similarly high private debt burdens but which have also already used the option of shifting that debt to the government balance sheet.

The high debt issue and the authorities’ attitude to it, the structure of the economy (export-driven) as well as the potential transition from an extremely high growth rate to a more ‘normal’ one, makes China’s situation very similar to Japan’s in the late 1980s. Yet, there are also major differences. China’s urbanization rate is much below Japan’s before the 1990 crisis, the real estate bubble is only in the top tier cities as opposed to country-wide as in Japan, the Renminbi is more likely to depreciate going forward than massively appreciate which is what happened to the Yen after the Plaza accord.  

The high debt issue is a problem China shares not only with Japan but also with most advanced countries in the world. Similar to them, China is fully sovereign (the government has full control of the overall economy balance sheet; the currency peg is a “question mark”, not a real issue given China’s large positive NIIP). Of all these advanced economies with similarly high non-financial debt to GDP, only China has not reached the zero-bound*. It is, therefore, likely for the Chinese policy rate to continue to move lower until it eventually hits 0%.

Similar to Japan, it has a high household savings rate and a rapidly ageing population. Yet, Chinese households have relatively low exposure to financial assets and especially to bonds. Given the policy agenda of financial market reform and the life-cycle savings behavior (i.e. risk-aversion increases with age), Chinese households’ allocation to bonds is bound to increase manifold. Moreover, with the looming of the property tax law (sometime next year), I expect the flow into bonds to start fairly soon.

This flow aspect makes the case for investing into China bonds much stronger. Given the size of the Chinese fixed income market, its rapid growth rate and the reforms undertaken most recently, global bond indices had ignored Chinese bonds for too long. However, last year BBGAI announced that it would include China in its index as of April 1, 2019. Purely as a result of this, China bond inflow is expected to reach $500Bn by 2021 as the weights gradually increase from 0.6% to 6%. By then China will be the 4th largest component in the index (after US, Japan and France – and bigger than Germany!)

Before BBGAI’s inclusion, there had never been a bond market that large, that was not included in an index, as the Chinese bond market. In fact, China already represents the third largest bond market in the world, growing from $1.6 trillion in 2008 to over $11 trillion now.

And there is much more money flowing into Chinese bonds, for example, than into Chinese equities for the first time in history.

Despite the setback of FTSE Russell postponing its decision to include Chinese bonds into its index to March next year, JP Morgan did follow through with the inclusion. The FTSE Russell decision to wait for the inclusion happened literally a day before Trump announced that he is considering banning all investments into China on the back of the escalating trade war. Tensions since then have been substantially reduced and I do not expect Trump’s warning to materialize regardless. I expect foreign flows into Chinese bonds, therefore, to continue to grow substantially (probably by another $150Bn combined on the back of the FTSE/JP Morgan inclusions).

And that’s just from index accounts. I expect substantial inflows also from accounts outside of the passive investment universe. In addition, CBs and SWFs (which so far have been the largest investors in Chinese bonds) are also likely to keep increasing allocations. Bottom line is, as the liquidity and transparency improve, unconstrained bond managers and sovereigns are also likely to start allocating money in this space.

And even after these inflows, China bonds are still likely to remain relatively under-owned by foreigners as they would represent just 5% of China’s total bond market (currently foreign ownership of the overall bond market is around 3%, PBOC expects it to reach 15%). Foreign ownership of China sovereign bonds (CGBs) is slightly higher, but even at around 6%, it is materially lower than in other major sovereign bond markets. This under-ownership is even more pronounced relative to the emerging market (EM) universe (the ranges there are between 10% and 50%).

Compare this potential foreign involvement in Chinese bonds with those in Japanese bonds (the second largest market currently in the world, one which, actually, China is likely to surpass very soon): 40% of the traded volumes there are by foreign entities. Foreigners own about 13% of the market there – this may indeed seem small but it is still larger than local banks ownership, plus one has to take into consideration that Bank of Japan owns majority of the issues. The Chinese bond market, on the other hand, is completely dominated by domestic institutions (more than two-thirds is owned by commercial banks).

Domestic commercial banks have very much a ‘buy-and-hold’ mentality but liquidity in Chinese bonds is expected to increase substantially as local insurance companies and asset managers start becoming more active. In the sovereign bond market, for example, there are 45 primary dealers. Auctions are regular with single issue sizes varying between $3bn and $17Bn and maturity up to 50 years. On-the-run bonds (there isn’t a well-defined yield curve which actually provides opportunity for surplus alpha – see above) have bid-offer spreads normally around 1-3bps. In terms of liquidity, bonds stay ‘on-the-run’ for at least a year, in some cases longer.

Finally, foreign investors are expected to continue to get very favorable treatment from the Chinese authorities. The government has an incentive to make things easier as they need the foreign inflows to balance the potential domestic outflows once the current account is liberalized. For example, the tax changes implemented last year allowed foreigners to waive the withholding tax and VAT on bond interest income for a period of three years.

I am still frankly shocked how little time investors have to discuss these developments above but, at the same time, how eager they are to discuss the Chinese economy and the trade tensions. From one hand, they acknowledge the importance of China for their investment portfolio, but on the other, they continue to ignore the elephant in the room being the Chinese bond market. I understand that this choice is perhaps driven by investors’ inherent negative bias towards any Chinese asset, but the situation between asset and asset is much more nuanced.

In the fixed income space, one can be bearish select corporate credit and bullish CGBs or bank policy bonds (in fact, the more bearish one is on corporate credit, the more bullish sovereign bonds one should be). Finally, I do acknowledge that the big unknown here is the currency. But even there, the market has become much more sophisticated: one can now use a much longer CNY/CNH forward curve to hedge.

Bottom line is that if you are still looking for a fixed income alternative to diversify your portfolio and you are not looking at Chinese sovereign bonds as an alternative, you are not being fiduciary responsible.

*For more details, see JP Morgan’s economics research note, “China’s debt: How will it evolve?”

Negative interest rates may not be a temporary measure

29 Tuesday Oct 2019

Posted by in Debt, Monetary Policy, Politics

≈ Leave a comment

Tags

,

In the current debt-backed system, the majority of money is still loaned into circulation at a positive interest rate. Even in Europe and Japan, where base interest rates and sovereign bond yields are negative, the majority of private debt still carries a positive interest rate. This structure inherently requires a constantly growing portion of the existing stock of money to be devoted to paying solely interest. Thus, the rate of growth of the money supply has to be equal to or greater than the rate of interest, otherwise more and more money would be devoted to paying interest than to economic activity.

The long-term average growth rate of US money supply is around 6%, which is only slightly higher than the average interest rate on US government debt but it is below both the average US corporate interest rate and US household debt. While I have used the UST 10yr yield as the average yield on US government debt (the average maturity of US debt is slightly less than that), the estimates for both US corporate debt and US household debt are very generous. For the former, I used the average yield on Aaa and Baa corporate bonds, and for the latter I used a weighted average interest rate between mortgage debt and auto loans (I have used 2/3 and 1/3 weights). I have not included the much higher yield on US corporate junk bonds which comprise a growing proportion of overall corporate debt. I have also not used credit card/consumer debt, which has a much higher interest rate than auto loans, and also student loan debt which carries approximately similar interest rate to auto loans. Just like for BBB and lower rated US corporates, credit card and student loan debt are a much higher proportion of total US household indebtedness compared to before the 2008 crisis.

I estimate the long-term average economy-wide interest rate as a weighted average of government, corporate and household debt – with the weights being their portions of the total stock of debt. That rate currently is about 7%, still higher than the average money supply growth rate since the early 1980s. Over the last four decades, US money supply has not only not grown enough, on average, to stimulate US economic growth, but has been, in fact even, below the overall interest rate in the economy. Needless to say, this is not an environment that could have persisted for a long time.

Indeed, if one calculates the above equivalent rates for the period 1980-2007, the situation would be even more extreme (see Chart below). In fact, until the late 1990s, money supply growth had been pretty much consistently below the economy-wide interest rate. Only after the dotcom crisis, but really after the 2008 crisis, money supply growth rate picked up and stayed on average above the economy-wide interest rate.

What is the situation now? The current money supply growth rate is just above the average economy-wide interest rate; respectively above the government and corporate interest rates but below the household interest rate (data is as of Q1’2019).

It is also still below the combined average private sector interest rate.

So, even at these low interest rate, US money supply is just about enough to cover interest payments on previously created money. And that is assuming equal distribution of money. Reality is that it is only enough to cover interest payment on public debt. And even in the private sector, money distribution is very skewed: corporates have record amount of cash but it is only in the treasuries of few corporates. The private sector, overall, can barely cover its interest payment, let alone invest in CAPEX, etc.

The deeper question is whether money creation should indeed be linked to debt at positive interest rate. In fact, we have already answered that question, and gone beyond, with some portion of money creation in Europe and Japan actually happening at negative interest rate. In effect, the market is trying to correct for all those decades when money creation substantially lagged interest payments: money there is starting to decay.

Demurrage money is not unusual in history. Early forms of commodity money, like grain and cattle, was indeed subject to decay. Even metallic money, later, on was subject to inherent ‘negative interest rates’. In the Middle Ages, in Europe, coins were periodically recoiled and then re-minted at a discount rate (in England, for example, this was done every 6 years, and for every four coins, only three were issued back). Money supply though, did not shrink, as the authorities (the king) would replenish the difference to find his own expenses. In 1906, Silvio Gesell proposed a system of demurrage money which he called Freigeld (free money), effectively placing a stamp on each paper note costing a fraction of the note’s value over a specific time period. During the Great Depression, Gesell’s idea was used in some parts of Europe (the wara and the Worgl) with the demurrage rate of 1% per month.

The idea behind demurrage money is to decouple two of the three attributes of money: store of value vs medium of exchange. These two cannot possibly co-exist and are in constant ‘conflict’ with each other: a medium of exchange needs to circulate to have any value, but a store of value, by default, ‘requires’ money to be kept out of circulation. Negative interest rates in effect split these two functions.

Seen from this point of view, negative interest rates may not be a temporary phenomenon just to spur lending. On the opposite, negative interest rates may be here to help reduce the overall debt stock in the economy and to escape the deflationary liquidity trap caused by the declining marginal efficiency of capital.

Pension fund crisis?*

24 Thursday Oct 2019

Posted by in Debt, Politics, Questions

≈ Leave a comment

Tags

At presentations you will see the blue line below.

How many times have you seen the red line?

Pension funds unfunded liabilities have indeed been on the rise, especially after 1999. But so have pension funds assets. So much, that the ratio between the two has been declining (which is the natural, long-term trend) since 2008.

In fact, for the whole period between WW2 and 1984, unfunded liabilities were always bigger than funded liabilities. In 1999, unfunded liabilities hit an all time low of 25% of funded liabilities and even though that ratio has risen since then to 75%, it is still much closer to the bottom of the whole period since 1945.

So, is there a pension fund crisis?

Maybe, but it is not obvious to me that it is anything bigger than at any other point in history before the 1990s.

Could there be a pension fund crisis?

Of course. But you know what is going to happen (as long as the US is fully sovereign), the Treasury will bail out the pension fund industry just as it bailed out the fund management industry in 1988 following the Asian/Russia crisis, and the banking, insurance and auto industry following the 2008 financial crisis.

This, sadly, does not prevent that future pensioners might be exposed to some misguided government attempts to respond to this supposed pension fund crisis by extending the retirement age.

Bottom line is that 1) pension funds unfunded liabilities are not even close to being in a crisis and 2) any fully sovereign government is in a position to provide all the necessary resources to secure comfortable retirement to its people.

We have advanced as a society to such an extent that the only hurdle to a normal life to all at the moment is our antiquated rules of accounting, not our lack of resources.

*Betteridge’s law of headlines: “Any headline that ends with a question mark can be answered by the word no.”