Saturday, March 26, 2011

Bond vigilantes call for “Day of Rates”

Flustered by the obstinate refusal of US interest rates to move up, bond vigilantes are resorting to the revolutionary tactic du jour: Twitter!

In a thread dubbed “The Day of Rates”, the vigilantes are calling on Americans to liquidate their holdings of government bonds this Monday and help spread the word by tweeting “sell”.

The appeal is in protest against what they call the government’s "exorbitant privilege” of getting away with very low borrowing rates even while the deficit keeps ballooning.

Twitter pros attested that, within hours, the thread had attracted 4.3 million followers with profile names as diverse as @JoeThePlumber, @MsWatanabe and @Broncho_Billy.

The latter is rumored to be pseudonym for legendary bond trader Bill Gross, who only last month was reported to have sold his entire stock of US government bonds held in his $237 million Total Return Fund.

Confronted with the rumor Mr. Gross gave only an indirect response: “The behavior of US interest rates has defied economic logic” he said. “Usually, I put on a trade, publicize it on CNBC and markets follow. This time round it looks like we need to broaden our audience.”

Former Federal Reserve Chairman Alan Greenspan agreed: “It’s a conundrum”, he tweeted, when asked to comment on the path of interest rates.

Meanwhile, Republican Representative Michele Bachmann offered a potentially compelling explanation.

“Every time interest rates go up, some foreign factor intervenes to push them down again,” she observed at a recent town hall meeting. “First it was the Greeks. Then the Irish. Then the Arabs. Now the Japanese!”

“It's obvious,” she continued. “This is a global conspiracy to plunge America deeper into debt. And President Obama is biting the bait. I mean, I’m not necessarily blaming him but the Kobe earthquake also happened under a Democrat President… It's an interesting coincidence…

Meanwhile, Federal Reserve Chairman Ben Bernanke played down the threat of excessive market volatility due to millions of “sell” tweets.

“The Fed stands ready to use all available tools to preserve financial stability,” he tweeted.

Fed pundits have interpreted the Chairman’s tweet as a sign he is bracing for what they called the "nuclear" option.

In response, Mr Bernanke regretted the term as "inopportune", saying the media must learn to settle with less sensational jargon, "like QE3". He added that recent experience has shown QE to be "a monetary policy tool 4 all seasons", though he did not elaborate, likely due to tweet constraints.

Fed insiders say Mr. Bernanke still struggles with Twitter and has enlisted pop star Lady Gaga to help him master the new medium. Reportedly, her top recommendations have been to reduce FOMC statements to 140 characters or less and to change the Chairman’s profile name from @Ben to @MoneyHoney.

and just in case you started selling.....
Happy Aprl Fool's!

Sunday, December 19, 2010

Blunt or blunter? Emerging markets (try to) return in kind

The one thing we can’t accuse central banks of these days is lack of creativity. The latest gem came from the Central Bank of Turkey (CBT) last week, when, on one hand, it cut its policy rate by 50bps to 6.50%, while at the same time increased the reserve requirement ratios (RRR) for short-term bank funding (deposits and repo) to help lengthen the maturity structure of banks’ liabilities.

I don’t want to dwell exclusively on the Turkish example, which, in my view, is fraught with confusion about what exactly the authorities are trying to achieve. What I do want to do is examine under what conditions, if any, a hike in reserve requirements can be effective in tightening monetary conditions. This is particularly relevant at a time when many emerging markets think they can “get away” with avoiding raising interest rates by employing alternative tools, to avoid attracting further capital flows from abroad.

Changes in the RRR are meant to influence monetary conditions through the so-called bank-lending channel of monetary transmission. Accordingly, bank funding relies in large part on demand deposits, which are subject to reserve requirements. Raising the RRR increases banks’ demand for reserve deposits at the central bank (CB). If the CB does not accommodate that demand, short-term interest rates will rise to bring demand for reserves in line with supply. Monetary conditions then tighten because banks will pass on their higher funding costs to corporates and households, in the form of higher lending rates, in order to safeguard their profitability (interest rate margins).

Against this backdrop, for a RRR hike to be effective in tightening monetary conditions, the following have to hold:

Banks should be limited in their ability to switch to other sources of short-term funding that are not subject to reserve requirements. In the case of Turkey for example, the RRRs (which are different across different liability maturities) have been applied to both deposits and repo funding from abroad and from domestic customers. However, they do not apply to repo transactions with the CBT and among domestic banks. For this reason, it’s unclear how the hike in RRRs can materially increase banks’ cost of short-term funding, if the CBT is effectively committed to supplying enough reserves to keep its target rate at (the now lower) 6.50%.

To make things more tangible, suppose a bank has 100bn liras worth of short-term liabilities and the RRR is raised from 6% to 8%. Suddenly, demand for reserves at the CBT rises by 2bn liras. Banks would then have to sell 2bn of their other assets, to meet the requirement, putting upward pressure on interest rates and, in the process, also shrinking the quantity of credit in the economy. However, by committing to maintain the target interest rate at 6.50%, the CBT effectively commits to creating enough reserves to meet any additional demand at that rate.

How will it do that? It will go to the open market, purchase TRY2bn worth of government securities and fund the purchase with the creation of bank reserves. Alternatively, it can go to the FX market and purchase TRY2bn worth of, say, US dollars, again funded with bank reserves. In that way, banks’ reserves go up without them having to shrink their loan book. On the contrary: new liquidity has come into the system (as the cash received by the sellers of the bonds or the foreign exchange has been deposited at the banks), which can be employed for further loan creation.

Note that the measure might still be desirable from a prudential perspective—e.g. to the extent that higher RRRs on foreign repo funding might encourage a shift towards lira-denominated funds, thus avoiding undesirable currency mismatches on banks’ balance sheets. But what I’m arguing here is that the RRR hike is unlikely to restrain credit growth because (a) it would not have a material impact on the price of credit; and (b) it might even contribute to increasing the quantity of credit, if the CB commits to accommodating whatever additional demand for reserves at the going 6.50% rate (via securities purchases or unsterilized FX accumulation).

Looking beyond Turkey, my bigger point is that measures that do not materially raise the cost of capital (and, indeed, that are intended to lower it, to fend off foreign capital inflows) are unlikely to tighten monetary conditions. Not only because their impact through the bank-lending channel will be diluted; but also because they ignore other important channels of monetary transmission—notably the wealth and financial accelerator channels.

For example, if short-term interest rates remain low, cash will seek riskier assets, boosting their prices and leading to positive wealth effects. This in turn triggers pro-cyclical investment and consumption and, potentially, overheating (the wealth channel). Admittedly, when capital markets are global, low foreign interest rates can also play a big role in boosting asset prices, so an increase in the local short-term rates might not be enough to generate the desired tightening.

Similarly, rising asset prices increases the value of collateral and thus, the perceived creditworthiness of borrowers, encouraging more lending (the financial accelerator channel). Higher RRRs on domestic banks, IF binding, could restrain the extent of such an increase, but even then, in an open economy, at least part of the capital “shortfall” is likely to be covered by foreigners.

Finally, “here and there” policy measures may be ineffective or counterproductive, by creating confusion about what a central bank is trying to achieve and undermining its credibility. Is it lower credit growth to curb domestic demand and a widening of the current account deficit? Is it the promotion of financial stability through the change in the maturity structure and currency composition of banks’ liabilities? Is it the discouragement of capital inflows and the prevention of “excessive” exchange-rate appreciation? What about that price stability?

Clearly, there are no easy answers to the policy dilemmas of our times. My suspicion is that we should be bracing for blunter measures in the year ahead.

Sunday, December 12, 2010

Why the tax “compromise” is a very dumb idea

First of all, my apologies for the bluntness of the title. As regular M&A readers know, I tend to be a tad more subtle in my characterization of things--only this time I had a hard time finding a better substitute for “dumb” other than “stupid”.

So, where to begin?

Let me start with a simple statistic: Real personal consumption expenditure (PCE). Since this past September, real personal consumption has exceeded the pre-crisis peak it reached in December 2007. In other words, Americans on aggregate are buying as much stuff (in volume terms) as before the official onset of the recession.

Now, this is not necessarily something to celebrate: On an annualized basis, real personal consumption has only grown 0.1% since December 2007, compared to the 3.5% during the decade leading up to the crisis. But there is still something impressive going on: Real consumption is back to its 2007 levels despite the fact that the number of people employed (in non-agricultural sectors) is some seven million less than it was back in end-2007.

In fact, (the admittedly crude measure of) real PCE per employed person has grown 1.9% annualized throughout this crisis, which is pretty close to the 2.1% we saw over the previous decade, especially considering the kind of crisis to that we’ve had to the economy and to consumer confidence.

What’s my point here? That the problem with the economy is not that (employed) Americans don’t consume enough; it is that we have too many unemployed people who can’t consume, not even the basics. And this is my first reason why giving a tax gift to employed Americans is a completely dumb policy: Not only is it unfair to the unemployed; it is questionable whether those Americans with jobs and with comfortable cash positions are going to spend this tax gift, if they are already close to reaching their long-term consumption growth. So much for a “targeted”, “efficient” fiscal “stimulus”.

Second. Let’s imagine for the moment that the American government was in a fiscally strong position, sustainable deficits and all, and hence with lots of extra cash to spend to boost the ailing labor market. Is a cut on payroll taxes really the best idea they’ve got?

No. Think of labor supply and demand. Right now, at the going wage, the supply of labor exceeds by far demand for labor (for which reason we have high unemployment).

What does the cut in the payroll tax do? If anything, it reduces labor supply. This is because employed workers could work fewer hours and still end up with the same amount of disposable dollars as before the tax cut. So, at the margin, they would reduce the hours they offer to work. (To throw a bit of jargon, the labor supply curve shifts to the left: i.e. less labor is offered for a given wage).

Now, this might (temporarily) close part of the labor supply-demand gap—i.e. reduce unemployment. But that’s a reduction for the wrong reason! What we really need is for unemployment to get reduced due to an increase in labor demand (ie policies to shift the labor demand curve to the right!). So, in theory, *if* the government had cash to spare, and *if* companies’ reluctance to hire were driven by a liquidity constraint, the appropriate policy response to raise employment (and thus, consumption, GDP growth and so on) would be to give a temporary cut in the employers’ portion of the payroll tax, not the employees’.

However, neither of these two “if’s” holds: Neither is the government in good shape, fiscally; nor is companies’ hesitation to hire the result of a liquidity constraint—at least on aggregate. As the Fed’s flow of funds data show, since end-2009, non-farm non-financial corporates’ liquidity position (proxied, very roughly, by the ratio of cash-like financial assets over credit-market liabilities) has returned to its pre-crisis level. Meanwhile, corporates are already getting a huge “stimulus” from the very low interest rates, which are reducing significantly the costs of servicing their debt. So no, companies don’t need a payroll-tax gift to raise labor demand.

Then... I mentioned interest rates. In case you missed it, the 10-year Treasury yield moved up 32 basis points (0.32%) last week, which has already caused quite a bit of bleeding in the financial community. But bankers aside, the key question here is... whither long-term borrowing rates for corporates and households? And to what extent might the Administration’s tax “compromise” undermine the recovery by raising financing costs due to perceptions of fiscal profligacy?

Let’s see. Clearly, the rise in 10-year yields was not just due to fiscal concerns. According to a survey (of traders and buy-side participants) that I saw, a bit more than a third of those surveyed thought it was due to a higher growth outlook and between a quarter and a third thought it was because of the fiscal implications.

It is my personal view that the market is overestimating the growth impact of the “stimulus.” As I explained above, the economy has heterogeneous agents: But those who are unemployed, over-indebted and cash-constrained (and who would be more likely to spend any extra cash) are getting very little help; while those with jobs and comfortable cash positions are getting most of the help. In this sense, a downward revision in the market’s perception of the growth impact might actually lower long-term borrowing rates.

On the other hand, the fiscal risks are underestimated in my view, which doesn’t bode well for borrowing costs going forward. It’s not that I have in my possession the perfect fiscal-sustainability model of the US economy. It’s because it is now clear that the American government (and I include both parties under “government”) has once again shown to be incapable of introducing targeted measures that tackle the root of the problem and that have the biggest bang for the taxpayer’s buck.

Such policies would include measures (e.g. cash transfers) to facilitate the deleveraging of underwater households; measures to support the retraining of the unemployed, and thus avoid skills-erosion due to prolonged unemployment; and a bipartisan commitment to a more predictable regulatory environment and a sustainable fiscal outlook, so that businesses can plan for the long-term, including in their hiring.

In this context, describing the measures proposed last week as a “compromise” would be laughable, if one actually had the luxury to laugh with the US fiscal outlook. But in the current situation, they are dumb at best, if not potentially damaging.

Sunday, December 5, 2010

Global Imbalances and the War of Attrition

Back in 2005, Ben Bernanke, then (“just”) Governor at the Federal Reserve Board, coined the term “global savings glut” to describe the “significant increase in the global supply of saving” that, as he argued, helped explain the increase in the US current account deficit and the low level of global real interest rates.

In short, a deliberate rise in emerging market (EM) savings from c. 2000 onward flooded the world with cheap money, helping finance an ever-widening US trade deficit and contributing to the perverse lending incentives that eventually led to the 2008 financial collapse.

Five years later, Ben has a chance to restore the global savings-investment landscape; i.e. help force a “correction”, in the form of an exchange rate adjustment and/or a decline in EM net savings. The key here is to recognize that a repeat of the EM savings glut story is less feasible because of important differences between then and now. And the Fed has the capacity to make it, if not impossible, at least extremely costly.

The first difference is that, back then, crisis-ridden EMs in Asia, Latin America and Eastern Europe saw a need to raise their savings in order to pay down foreign debts acquired during their crises. Today, with the EM deleveraging more or less done (or not as urgent), this channel for absorbing any accumulation of dollar (or euro) reserves is no longer there.

Secondly, in the aftermath of the 1990s EM crises, many EMs saw a need to increase their resilience to foreign “hot money” with a commensurate increase in their foreign exchange reserves. This may have been possible then, but it’s considerably less so now, partly "thanks" to Ben's QE.

The reason is that this “asset swapping” from the US to the EMs and back can come at a cost: An EM central bank effectively borrows at the local short-term interest rate (the cost of sterilizing the inflows) to purchase medium/long-term US Treasuries.

For countries with historically high interest rates (e.g. Brazil, South Africa or Turkey), sterilization costs have always been high, so the "insurance" benefits of any additional FX reserve accumulation have had to be juxtaposed against such costs. However, for low-interest rate countries (incl. China, Malaysia, Singapore, Taiwan or even Korea) the “cost” of sterilization during the boom years was actually not a cost but a profit! Yields on, say, 5-year US Treasuries rose from around 3.2% at end-2003 to about 5% in 2007, which was above these countries’ short-term interest rates (i.e. they enjoyed a positive “carry”).

Today, the “carry” has turned negative even for coutnries like Malaysia and China, due to the extremely low nominal US rates across the US yield curve. This makes EM FX accumulation financially costly and politically unpalatable.

On top of that there is a third important difference: Back in the “2000s”, many EMs were operating at below-full capacity, either because of the crises of the late 1990s or because of a structural excess in the supply of unskilled labor (e.g. China). In that context, they saw it fit to promote export-led growth through an “undervalued” exchange rate, while domestic demand remained weak, and in the process maintain relatively loose monetary conditions at home.

Today, domestic demand in some major EMs is rising fast, putting pressure on inflation. Under normal circumstances, this would point to either an increase in imports to meet excess demand (--> a gradual closing of the imbalances) or a rise in interest rates to curtail demand—although the latter would come at the “expense” of a more costly sterilization of any FX interventions due to a more negative carry.

An alternative route of course is to respond by trying to cutrail foreign inflows through the imposition of taxes (or other controls) on foreign capital. But these can only be at best a temporary solution, not least because the EMs themselves do not want to stop all capital from entering. This creates an assortment of loopholes for willing, yield-seeking investors to find their way in. And in case one needed further evidence of the long-term ineffectiveness of capital controls, I'd say, "ask China!"

In that case, the Fed arguably holds the key for the reshaping of the global savings-investment landscape: If it could credibly commit to keep nominal US yields at ultra-low levels for a sufficiently long time, it could force EM action by turning current policies financially costly (through an increasingly negative carry) and politically difficult to sustain.

Of course, that's a big if. First because, unless low rates reflect (very weak) US economic fundamentals, the Fed will have to devote an increasing amount of resources to hold rates down. And the more Treasuries it buys, the larger the negative-carry costs on its own balance sheet, when the time comes to raise its own policy rate beyond 2.5-3%.

Second, in light of the widespread (and misinformed, I might add) outcry against QE in the US, it is questionable whether the Fed can credibly commit to mobilizing sufficient resources to keep yields low for long enough—that is, for longer than many major EMs can sustain their own distortionary policies.

Against this backdrop, global monetary policy-making has not been reduced to a global currency war, as Brazil's Finance Minister recently suggested. It is rather a war of attrition.

Sunday, November 28, 2010

Cross-border deleveraging and the shifts in Europe’s bargaining game

While high-ranking eurozone bureaucrats are ruminating on the appropriate burden-sharing mechanisms of a future Europe, something potentially more momentous has been going at the background: European banks have been cutting back their intra-European exposures… fast!

The numbers are pretty stunning: Between December 2009 and June 2010 (the latest data available from the BIS), German banks cut their eurozone claims by $180bn (more than 5% of German GDP). French banks cut their own exposure by near $280bn (10%of French GDP), of which $130bn were claims on Italy and Spain. And Dutch banks cut their eurozone claims by $170bn (about 20% of Dutch GDP), with cuts across the board, from Spain, Ireland and Greece to Italy, Germany and Belgium. One can only assume that the cutbacks have continued in full force post-June.

This “deleveraging” has important implications for the core-periphery bargaining game and the future of the euro.

First, from the perspective of the stronger, core economies, a meaningful reduction in intra-European exposures means that the threat to the core’s financial stability from an adverse outcome at the periphery is smaller. In turn, this allows the core's governments to consider a more “sober” crisis resolution framework, ie one that is more discretionary and fundamentals-driven vs. one that is indiscriminate out of fear of a disorderly outcome.

What would “discretionary” really mean? Based on the ERM experience back in 1992/93, it could mean the following:

(a) For countries with no obvious fundamental misalignment (e.g. France): an explicit, large-scale and comprehensive liquidity backstop, aimed at killing any aspiring “self-fulfilling prophets.”

(b) For countries that are small (ie not systemic on their own) and in need of a sharp fiscal adjustment (e.g. Greece, Ireland, Portugal): the provision of short-term liquidity-support mechanisms conditional on the maximum possible fiscal effort, before the inevitable correction is forced upon them. (In the same way, many countries were forced to devalue their currencies back in 1992/93 in line with their fundamental misalignments, after Germany did not provide the liquidity support that would be necessary to stem the speculative attacks).

(c) For countries that are larger and, thus, a systemic threat (Spain and Italy): A strategy that buys time to allow the core economies’ private sector to exit before things escalate. This is exactly what has been happening (intentionally or not): By tackling the eurozone crisis in a piecemeal, reactive fashion, core economies have effectively bought time for their private sectors to unwind their positions in a stable environment—i.e. a common currency and an orderly payment process.

In the process, the systemic importance of Spain and Italy is gradually being reduced, improving the core governments’ ability to provide (if and when that time comes) liquidity support under their own terms.

This brings me to the second implication of cross-border deleveraging, which has to do with burden-sharing and the perspective of the peripheral countries themselves. With cross-border exposures cut, the burden of adjustment (be it fiscal consolidation and/or debt restructuring) has been shifting away from external creditors and towards the residents of the weaker peripheral countries.

This poses a natural question: What’s the appeal of eurozone membership for Greece, Ireland or Italy for that matter, in the absence of an acceptable degree of burden-sharing between debtors and creditors? And even more so, when it implies the long-term surrender of fiscal sovereignty to the “troika” of the IMF, the ECB and the European Commission? Instead, exit from the euro (with the inevitable default) would shift part of the burden to the core through an immediate improvement in the periphery's external competitiveness. It would also shift part of the debt burden to any external creditors are left, private and official (barring the IMF, which has preferred creditor status).

For these reasons, the ongoing cross-border deleveraging, and the resulting “thinning out” of the threads that tie the eurozone countries together, can mean either of two things for the euro: Either the governments of the core will demonstrate their will to share part of the burden of adjustment, in the form of a fiscal transfer rather than just liquidity support; or peripheral countries will find the unilateral assumption of the fiscal adjustment burden unacceptable, economically and politically… in which case they’ll opt out.

Under fresh light, Iceland may no longer feel too unhappy it's not Ireland.