Ten Seconds Into The Future. Investment Outlook 2017 PDF Print E-mail
Written by Burnham Banks   
Thursday, 12 January 2017 06:21

US Fiscal Policy

The impact of fiscal policy on the US economy itself has unpredictable elements. The current outlook is that the fiscal plan will create more disposable income and allow more consumption and investment and that this is inflationary and pro-growth. However, there are redistributive properties to the fiscal plan that are likely to increase inequality which suppresses the propensity to consume thus increasing saving. There are also agency issues that might change the optimal debt equity ratio for businesses. Revoking the tax deductibility of interest, for example, will skew companies toward equity financing. The consensus expectation that companies will buy back more shares might not happen. Rising interest rates may also discourage debt finance.

Therefore, the supply of corporate bonds could be constrained while demand could rise which could cause a spread compression beyond historical levels.


A strong USD is positive for European and Asian exporters, all else being equal. However, US trade policy will reduce this impact. Also, countries which cannot fund cheaply in local currency and have funded or need to fund in USD will be at a disadvantage. USD funding will rise in more ways than one, the base line curve will rise but the shortage of offshore USD will raise funding costs even further. The strong USD and rising USD rates scenario favours most countries which can fund in local currency, which means Europe, Japan and China. China, however, has local issues which may lead to tighter financial conditions this year.


If US growth picks up, the trade balance will have a natural tendency towards deficit. This is the theory. Trump’s policies appear to attempt to grow the economy while managing the trade deficit towards balance. Energy self-sufficiency, trade protectionism, and domestic job creation which discourage offshoring and encourage re-shoring will compensate for the deficit tendencies of fiscal policy.



Rising Interest Rates

2008 marked a change in the way economies function and also lifted the veil on changes which had happened before the crisis but which were possibly covered by complacency. One major development is the role of central banks in the economy. Our understanding of how the economy works has not caught up with the fervour with which we have applied new techniques for managing the economy, and indeed how we chase yield and front run central banks.

One question which is useful to ask is, were falling interest rates a good thing or will they fall too far and threaten financial stability?


Japan’s experience with NIRP was not entirely a success and had to be modified to near total control of the shape of the yield curve.


Inflation has fallen and seemed unresponsive to falling rates in recent history. Is the correlation between inflation and rates negative or has the correlation turned positive? There are arguments why this could be so.


Rising rates could be the catalyst for a return to normal levels of inflation. Falling rates could have encouraged over-investment and over-capacity leading to too much slack in the economy and weak inflation. Rising rates could be the catalyst for rightsizing the productive capacity of the economy to meet demand.


At some level, rates could get too high, but what do we mean by too high, what level is too high? Public debt in developed countries has been rising steadily since 2007. In the US, debt to GDP has risen from just over 60% in 2007 to 104% in 2016. Trump’s fiscal plans will likely increase the national debt further. Higher interest rates imply a higher debt service and in normal circumstances, the ability of nation to service its debt is a factor in the pricing of its debt. Circumstances have not been normal for some time. If market reverted to the old logic, the cost of debt could rise significantly. Central banks have tamed the bond vigilantes but could they do it again? The Bank of Japan is in a unique position in that foreign demand for JGBs is small and it is able to co-opt the purchasing power of the Japanese public to monetize the national debt. This may not be feasible in USD.


Rates are artificially low. The US 10 year had traded to 2.6% recently and a yield of 3% or 3.5% would be unremarkable. In the short term, yield hungry investors could well bid down yields to 2%. The longer term reality suggests that, looking beyond the noise and volatility, rates should trend up with the 10 year yield trading above 3.5% in the next 2 years. If the correlation with inflation has switched, this could even create an inflation loop which could drive yields higher.


As for the Fed, the task has become harder, and it will likely become more sensitive to inflation. Cutting rates is easier than raising them.



End of the Bond Bull?

From the above analysis, the answer is, the duration bull market is over. However, turning points can span 2 to 3 years. This volatility threatens to be the unfriendly kind, the kind that has no predictable triggers, the kind that confounds the hedge funds who often claim that “volatility is good for us”, and the opportunity for loss will be greater than that for gain. For that reason, the prudent strategy is to hedge duration rather than to actively trade it for profit.

The credit bull market is a separate question. The repatriation tax amnesty, the lower taxes, the loss of tax deductibility of interest expense, the rising interest rates, and tighter financial conditions will likely result in a relative undersupply of corporate bonds while yield hungry investors and a potential rise in savings from a more regressive tax code is likely to support demand. The risk for credit is on the upside, that is, spreads can be expected to tighten and to do so beyond recent historical averages.


Parting Notes

The economy and how it functions, the relationships between agents, and the behaviour of agents, has evolved over time and current models may not be adequate to explain the dynamics let alone predict the path of prices and variables.

The cold war in trade which is now becoming a hot war is a part of a more fundamental tension. When global growth rates are high, people are more likely to share and cooperate and the cooperative behaviour implied by Folk Theorem’s hold. When growth is slow, people are less willing to cooperate and prefer to play security or short term strategies. Unfortunately, less cooperative behaviour may not be limited to commercial and economic interests but to geopolitical interests as well.

Another interesting development is the rise of machines. As automation replaces human labour questions beyond economic efficiency arise, notably, the question of who should own the machines. As long as machines do not represent too large a proportion of production, and as long as growth creates new types of jobs the need for an answer can be delayed, but at some point, the question needs and answer.

Last Updated on Thursday, 12 January 2017 06:27
If Trump Had Won And Then... How Markets Might Have Reacted PDF Print E-mail
Written by Burnham Banks   
Monday, 28 November 2016 02:14

If in the immediate aftermath of Donald Trump winning the US election, equities had crashed, credit spreads had widened, bonds had sold off, the dollar was strong yet gold had surged. And held on to these trends for more than a day. What would the present look like?

The only resemblance to the above scenario to the current reality is that bonds had fallen as inflationary expectations rose, driven by Trump’s spending plans and tax cuts. What might the analysis of this alternate reality look like?

The outlook for equities is poor. US equities are already facing a profits recession if not an economic one. The economic cycle is advanced and a slowdown is probable. Add to this higher debt costs and the impact on balance sheets which have in the last 5 years been expanded to take advantage of low rates, buy back shares and pay dividends, and the prospects for business look poor as debt service rises, leverage rises organically, and the refinancing becomes more expensive and difficult.

Equities will not be the only ones to suffer, credit spreads are likely to widen as credit quality deteriorates.

USD will likely be strong. The low repatriation tax and subsequent lower tax on foreign earnings is likely to encourage inflows. Interest rate differentials across the curve support the USD. As a net importer, the retreat from trade is net positive for USD.

The market reaction to a Trump victory would prompt the Fed to delay raising rates and to generally adopt a dovish stance. While this is at odds with the President’s wishes, the Fed will want to demonstrate its independence, stave off recession, or worse, stagflation, and would be tempted to consider resuming QE. That said, reviving QE would be controversial, so the immediate action is to do nothing. The yield curve steepens as capital seeks low to no duration risk free assets.

The picture for emerging markets would be complicated. As strong USD would be good for terms of trade, which are very important for export nations. However, countries with significant USD debt would face rising debt and debt burdens as rates also rose. High risk aversion is generally bad for emerging markets and the net impact would be bad for emerging market assets.

Ceteris paribus, the situation for Europe would be less poor. A weak EUR would be reflationary. While European yields would rise in sympathy with USD yields, the fact that Europe was deleveraging and Europe can raise debt in EUR, and the ECB remains in QE mode, cushion the blow on Europe. Any sell off would be a buying opportunity.

With the long duration USD assets off the table, the attention would turn to bunds and JGBs. Non USD duration would rally. Since short term rates dispersion was low, cost of FX hedging is also low. European rates would remain low and be capped even at the long end. For Japan, the aim of maintaining a steep yield curve beyond 10 years will become more challenging leading to a selloff in banks.


In summary:

US equities fall – economic cycle peak, earnings peak, higher debt service, pressure on multiples.

US credits widen – as above.

USD curve steepens – inflation fears pressure the long end. Fed holds the short end.

USD strong – Inflation, capital flows from tax changes, interest rate differentials.

European equities outperform – Weak EUR, less levered than US, lower debt service, re-rating potential.

European credit outperforms – as above.

EUR curve flattens – demand for duration not met in USD, FX hedging costs low, low inflation.

EUR weak – dual of strong USD.

Japanese equities maintain bifurcation along JPY lines.

JGB curve flattens – demand for duration not met in USD, FX hedging costs low, low inflation.

JPY weak – dual of strong USD.

Gold strong – Risk aversion and inflation hedge.

Last Updated on Monday, 28 November 2016 02:15
Trump Wins Election. What Would You Do? PDF Print E-mail
Written by Burnham Banks   
Friday, 11 November 2016 04:57

What would you do?


· Christmas came early. Cosy up to Donald.

· Help the US out of NATO.

· Help Turkey out of NATO.

· Test the resolve of NATO by threatening Estonia, Latvia, Lithuania.

· Help the US out of trade pacts.

· Seems sympathetic to Russian strategy in Middle East.



· Christmas came early.

· Time to replace TPP with a China led trade agreement.

· Reach out to Europe to form trade alliance. Possibly reach out to Canada and Mexico to form trade alliance.

· Push the AIIB initiative, the CIPS system, RMB internationalization, One-Road-One-Belt.

· Test US resolve in South China Sea, Taiwan and Japan, dam all the rivers. But balance this with the need to subvert US hegemony. It may be beneficial to be magnanimous and conciliatory.



· Too busy with Dutch general elections in March, French presidential elections in May, German general elections in the autumn.

· Too busy with the Brexit.

· Worry about Turkey, Russia and NATO.

· What happens to TIIP, is China interested in a trade deal?

· Could the same popular revolt happen in Europe? How to appease voters? Be more populist?

· Rethink refugee and immigration policy.

· Weak EUR, no excuse for Draghi to keep expanding QE.



· Special relationship? The Foreign Secretary Johnson has called Trump unfit to lead. Perhaps he will want to reconsider that position.

· Too busy with Brexit, friendly fire from the Tory Eurosceptics and a febrile atmosphere in Brussels.

· Trying to cut deals with China and India, who may now be receptive. Thank god it’s not all bad.

· Europe may be rethinking immigration policy. Easier Brexit negotiation?



· There goes the TPP.

· If JPY goes to 90 Japan will have a problem.

· How to work with China? RCEP?


Middle East:

· Trump will go easy on Israel which will be a problem for Palestinians.

· And hard on Iran which will sooth the Saudis.

· And easy on Putin and Assad which will disappoint Syrians.

· And easy on Turkey.

· It’s complicated and requires a considered, deliberate and judicious approach lest the solutions propagate further problems. A bit like dealing with hydra.



· Re-shoring could accelerate on US tax plan. Loss of FDI.

· Trump anti-China position could be good for Indian pharma. On the other hand the ACA is a big source of demand for Indian generics. If ACA is repealed, there could be negative impact on Indian pharma. It’s a toss up.

· Cosy up to Trump in dealing with ISIS. Sideline Pakistan.



Last Updated on Friday, 11 November 2016 05:00
A Challenging Economic and Financial Landscape For Investments 2016 / 2017 PDF Print E-mail
Written by Burnham Banks   
Tuesday, 11 October 2016 00:09

10 minutes into the future…

Growth remains positive but slow, equities are expensive, credit spreads are tight, and interest rates are low. High quality assets are even more expensive leaving only lower quality, less liquid, more esoteric or clearly troubled assets with any value.

A significant contributor to the current state of affairs is central bank policy which has included suppressed interest rates and competitive demand for assets. The only hope for traditional assets such as equities and bonds to appreciate is further central bank purchases or a sudden spurt in economic growth and productivity.

On the risk side of the argument we have, in addition to expensive valuations and slow growth, monetary policy being close to or at its limits, a dip into negative growth even if cyclically and short lived, social tensions from inequality and most pressing of all, political tensions from Europe to America to the South China Sea.

Governments may mitigate some of these pressures with fiscal policy but sovereign balance sheets are already heavily indebted. China’s growth has been supported only by a significant expansion of credit. The US has had contentious debates about their debt ceiling and Europe is constrained by fiscal rules which most of its member countries have been in protracted breach of.

If fiscal stimulus becomes widely adopted it will provide a lifeline to economies and markets for another 3 to 5 years, depending on how determined the effort. However, the world has experienced 8 years of recovery since the financial crisis of 2008, and a cyclical downturn can be expected soon.

That the monetary policy lever has not had a chance to be reset or restored is a serious concern. In the next downturn, monetary policy will have no room to act. The parachute has been deployed, there is no spare, and we haven’t packed it back in the bag.

The fate of fiscal policy will likely be the same as that of monetary policy. A slippery slope from which there is no return. Slowly, the wisdom of austerity has been pushed back, first in the fringes and then in the centre of academic orthodoxy. The biggest challenge for fiscal stimulus is not how it will be deployed but how it will eventually be rolled back.

Eventually, debt will have to be repaid or repudiated. The first step to debt forgiveness is to place the debt in friendly hands. This stage has already been done. The Bank of Japan, for example, owns over a third of Japan’s national debt. Were it to convert this debt into perpetual, zero coupon debt, the debt burden of the government would fall dramatically. If this debt was written off, it would reduce the leverage of the sovereign balance sheet to facilitate new issuance.

The mockery that such a debt restructuring would make of the concept of money and debt will have unpredictable consequences. Either interest rates go down with the leverage, or up as the internal (inflation) and external (exchange rate) purchasing power of the currency is questioned.

For the investor, this scenario is depressing. The only strategy is chicken. In the game of chicken, two cars drive towards each other at speed. The first to flinch, loses. If no one flinches, both die. The winner is the one who flinches as late as possible. For the traditional long only investor trafficking in equities and bonds, the runway is short. For less constrained investors, the runway is longer, slightly, but still finite.

Markets in asset backed securities, structured credit and leveraged finance may not be as accessible to fast money retail investors and their proxies such as mutual funds and exchange traded funds and may retain value for longer. However, it is a matter of time before the relentless pursuit of yield finds these niches and squeezes the value out of them. Regulation, complexity and tax structure may present barriers but not for long as the collective intellect of the financial industry is turned towards circumvention.

Shorting. If assets are expensive, then perhaps it makes sense to hold a short exposure to these assets. However, shorting is not a mirror image of ownership. The risks to shorting extend beyond the economics of the trade to the mechanics, regulation and legality of establishing and maintaining a short position. Shorting is an unpopular strategy particularly when it works.

What is an investor to do in this environment? If Lord Keynes’ observation that in the long run we are all dead, then chicken is a viable alternative. But do choose the longer runway, which means eschewing conventional, accessible assets and strategies.


In the long run, however, average returns have to be low, since growth is moderate and assets are expensive. The problem is most tangible in the pensions and savings industry where liabilities are chronically underfunded. The individual or individual institution may attempt to navigate the temporal distribution of returns, i.e. market timing, but for the industry as a whole, the problem is chronic.

Last Updated on Tuesday, 11 October 2016 00:13
Failure of Capitalism. Inequality, Slow Growth, Central Banks, Conflict. PDF Print E-mail
Written by Burnham Banks   
Monday, 03 October 2016 07:34



· Capitalism leads to inequality of wealth.

o Capitalism is based on competition. Capitalism incentivises competition and the maximization of inequality at the micro and macro levels.

o To maximize profits companies have to maximize revenues and minimize costs. Minimizing costs implies indirectly minimizing payments to resources, labour included.

o Labour’s share of GDP has shrunk consistently for at least the last 60 years. The relentless accumulation of intellectual capital and innovation results in greater efficiency and productivity of resources and capital. To the detriment of labour.

o Individuals supply labour. Individuals can only store a small and finite amount of knowledge in their lifetimes.

o Business entities like corporates are able to accumulate intellectual capital. As the share of returns to innovation increase, enterprises’ share of GDP will increase.

o Capital is scalable whereas labour is not. Intellectual property is an inexhaustible resource whereas labour is not. Individuals do not generally licence their intellectual property, they sell it as an integral part of their labour, rendering the intellectual property of the individual an exhaustible resource.

o Ownership of businesses allows the individual to accumulate more wealth than supplying labour.


· Inequality of wealth leads to slowing economic growth and carries political risks.

o The potential for inequality promotes greater effort, enterprise and innovation.

o Past a certain point, inequality impairs growth. The rich save a greater proportion of their income than the poor and thus greater inequality translates to more saving and a slower rate of circulation of money leading to slower growth.

o When the perceived probability of advancement from the lower strata to the higher strata becomes sufficiently small under the current economic and social system the lower strata will find it unacceptable.


· Slow economic growth has wide ranging risks.

o Humans have evolved social behaviour as an economic expedient. Sufficiently weak economic growth can threaten faith in the social compact.

o Slow growth can therefore encourage less cooperation, more competition, trade protectionism and other anti-trade practices, disintegration of economic and political unions, civil and martial conflict.


· Slow economic growth coupled with high levels of inequality imply that the majority of households experience negative growth.


· Central bank policy has limits and limitations.

o Central banks make policy while having imperfect information about and imperfect understanding of the economy. This leads to oscillations in later time periods. The probability that policy is suitable and adequate is extremely low.

o The more activity, the more potential imbalances are accumulated. The cost of policy is cumulative.

o The engagement of fiscal policy introduces the same theoretical instabilities as monetary policy but adds complexity and the political dimension.


· Low interest rates have multiple effects.

o Low interest rates make it cheaper to borrow and therefore boost consumption and investment.

o When lower interest rates stimulate growth they are inflationary.

o Low interest rates can encourage over-investment and over-capacity which in an economy suffering from weak demand can be deflationary.


· Firms versus Individuals:

o A highly knowledge based economy encourages labour specialization which can lead to loss of flexibility and diversification in the labour force.

o Firms are able to accumulate a diversified portfolio of intellectual capital and even trade in intellectual property. Individuals find it more difficult to do so.


· Globalization and open factor and goods markets increase competition in specific segments of the labour market.

o Segments facing the most immigration face unemployment and wage pressures.

o Segments which face outsourcing also face unemployment and wage pressures.

o For the other sectors, the increased efficiency and productivity is a positive development.

· Technology and Human Ingenuity

o Technology can either augment or substitute human ability. So far the ability for technology to substitute human ability has been limited.

o When labour is abundant the need for and the return on investment in human replacement is low. Efforts turn to augmentation instead of replacement. When labour is limited or inadequate, the reverse is true.

o Low unemployment, rising wages, tight labour markets and low participation rates indicate a mismatch between supply and demand for labour, namely, a labour shortage, an environment which might drive investment in human substitution.

o If human substitution increases in incidence social questions about the ownership of automatons may arise. Apart from technological and practical questions, the advent of human substitution technologies will generate many questions in the legal and ethical domain.

· Time and technology blunt the memory of the cost of war.


Last Updated on Wednesday, 05 October 2016 02:37
What Is The BoJ Up To With Its QQE? What Else Can It Do? PDF Print E-mail
Written by Burnham Banks   
Thursday, 22 September 2016 07:57

On September 21st there were two central bank meetings, the Fed and the Bank of Japan, both closely watched but both garnering very little expectations.

The Fed was expected to do nothing and to signal a December rate hike, which it did. The market reaction was positive, not because this was unexpectedly good news but because investors had taken risk off the table, despite having no big expectations for this FOMC. Some of these investors put capital back to work in the anti-climax. The buying, although relatively muted was indiscriminate as investors bought equities, credit, duration, oil and gold.

The BoJ was perhaps even more closely watched and with similarly low expectations. Investors had expected the review to justify current efforts and recommend more negative interest rates. They also expected a targeted effort to steepen the long end of the JPY yield curve. What the BoJ delivered was a promise to raise inflation expectations, perhaps beyond 2%, to be flexible about its bond buying, to maintain a cap on the 10 year JGB yield and an effort to steepen the yield curve. It was a lacklustre package, maybe even a disappointing one. The initial reaction was a rise in equities and a fall in JPY. It is too early to tell where they go from here but if the market was unimpressed by the BoJ’s negative rate debut in January it is hardly going to be impressed this time.

One view is that the BoJ’s lack of determination is a sign that the government should shoulder some of the burden. The Prime Minister has publicly welcomed the “new policy” and will “coordinate closely with the BoJ to accelerate Abenomics.” Quite how new the policy is and how Abenomics is to be accelerated remains to be seen. As long as rates and JPY do not rise too quickly or far, the economy appears to have a chance to muddle on, and there are some signs of material progress in Abenomics’ Third Arrow. Economic immigration, for example, has been growing as regulations have been relaxed and businesses begun to hire foreigners.

On current demographics and reasonable growth forecasts, Japan will not be able to repay its national debt in the foreseeable future. It has already amended its 2016 debt issuance by  3.7% or +60 billion USD, paltry, but a start.

It needs to keep issuing debt. The debt must be bought by private investors, such as the private commercial banks. The BoJ will then buy the seasoned bonds from these private investors. It could buy the bonds directly from the government but this would merely finance the fiscal deficits, which would be direct debt monetization or helicopter money, which is apparently frightening and illegal. Passing through private hands has an advantage. It is Chinook helicopter money, two rotors. First, it still monetizes the national debt, indirectly but effectively. But second, it generates a profit for the initial buyers, and thus puts money in their pockets. Now, if bond yields decline continuously, this generates a capital gain for the investor, but is not sustainable since eventually you get to negative rates at long maturities and undermine the entire savings, banking and insurance industry. A more sustainable strategy is to steepen the yield curve, particularly at long maturities. In February 2016, investors who held on to 20 year JGBs for 5 years say, would have made 1.5% p.a., on top of a 0.5% - 1% coupon just from the rolldown. This ROA is quite substantial given current interest rates. For a bank which can leverage the position, and since JGBs consumer zero capital, the impact on ROE is significant. This works best at long maturities as duration multiplies the roll down which is otherwise too small at shorter maturities. By September the yield curve has flattened so that the same trade would earn 0.95% p.a. This strategy only works with a steep yield curve.

There are a couple of loose ends to this strategy. At some point the national debt will simply get too big. One way of addressing this issue is for a selective debt forgiveness whereby the BoJ converts its holdings of JGBs to zero coupon perpetuals. Or cancels them altogether.

This just leaves the persistent strength of JPY. This is troublesome for an export economy like Japan. When the BoJ cut rates into negative space in January, JPY weakened for less than 24 hours before appreciating some 16% to September. One way would be for the government or the BoJ to buy USD and USD assets such as US treasuries.

This strategy supports the following measures:

BoJ keeps buying JGBs in secondary market. Check

BoJ keeps the yield curve steep. Check.

BoJ keeps short rates low, perhaps further into negative space. Maybe.

BoJ converts debt to perpetual zeros or cancels its JGBs. Maybe.

Japan government increases issue of JGBs. Check.


Last Updated on Thursday, 22 September 2016 08:02
Inflection: Central Banks at Crossroads PDF Print E-mail
Written by Burnham Banks   
Wednesday, 14 September 2016 04:24


From the rhetoric it is apparent that the Fed wants to raise rates, the question is not if, but when. The ECB's recent inaction and signals point to a pause and a possible rethink about QE. The BoJ is currently assessing the efficacy of current QE and has already surprised the market by its hawkish inaction in the face of weak data.

PMI data have been consistently strong globally with the exception of Japan and recently in the US. Japan is slowing but less severely and the US data is a single data point in a robust trend.

Recent musing by the financial elite have been leaning towards fiscal policy.

1. Are the world's central banks near or at the point of inflection in super low rates?

The Fed is clearly at the inflection point. The question for the Fed is not if, but how quickly rates will be raised. The options are between slow and super slow. The UST market is unlikely to be complacent.

The BoJ is likely to be at an inflection but is it between holding and handing the responsibility to fiscal policy, or is it to accelerate monetary easing towards further unconventional measures such as debt forgiveness? Economic data while indicating continued deterioration are slowing in their descent presenting the risk that the BoJ may maintain status quo or even cut back stimulus. Or, if fiscal policy is expanded, the BoJ may deem it unnecessary to increase its efforts. Interest rates can be cut further or QE expanded but current efforts have not been effective and more of the same is unlikely to be helpful. The only shock and awe policy left is to cancel some of its holdings of JGBs effectively monetizing legacy debt. Politically and culturally, this is unlikely.

The ECB is reviewing the effectiveness of its QE program. On recent cyclical data, the ECB may conclude it has done enough. The Eurozone does not have fiscal union and fiscal policy will be decided at the national level although Brussels will have influence though the Maastricht conditions. Politically, Europe has less scope for fiscal policy, and even less for a concerted effort.

2. Has monetary policy reached its limits?

The question is moot in the US for now, although a prudent Fed would at least academically consider its options should the economy slip back into recession.

The BOJ is likely at its limits. It already owns a third of the national debt and is struggling to find assets to buy. It's NIRP has resulted in a rise in deposits. Economic data remains weak although the pace of decline has slowed. More data are required to be certain but the current evidence is that monetary policy has had limited impact.

The ECB is likely close to limits. Negative interest rates have led to limited cash hoarding, including by corporates. The asset allocation of the QE has been politically constrained resulting in the capital flowing to where it is needed less, Germany and France, instead of the periphery. The ECB is unlike to be able to increase the scale of QE although it could make further progress by moving asset allocation away from the capital key.

3. Will fiscal policy be deployed and to what extent?

In the US this is academic. Politically also, it will depend on the future composition of Congress, the Senate  and who occupies the White House.

In Japan, fiscal policy engaged now will only be another salvo in a series which has seen the national debt swell to 2.5X of GDP. However, given the BoJ's recent demeanour and Abe's control of Upper and Lower Houses, fiscal policy cannot be ruled out.

Politics will make fiscal policy difficult to approve in Europe. Germany can afford it but doesn't need it. France might but probably can't and peripheral Europe almost certainly cannot afford it but might need it most. The political uncertainty in Europe makes this a difficult call.

4. Asset prices are very sensitive to the base curves. Equities are cheap relative to binds but otherwise expensive. IG spreads are reasonable to cheap and HY spreads are reasonable. The problem reduces to developing a view around base curves.



Short end is very sensitive to Fed funds. Long end is more sensitive to inflation. Long end will find less upward pressure from risk of fiscal policy.



Japan is already engaged in fiscal policy albeit not in a determined way. This would normally exert upward pressure on yields.  Much will depend on the BoJ's review of QE due 21 September. The results could be a) mission accomplished, b) QE didn't work, more needs to be done, and c) QE didn't work, a new approach is needed. I'd a) then JGB yields will likely rise as will JPY, if b) JGB yields will likely fall as will JPY. The last scenario is the most interesting but unpredictable. A debt cancellation is the most likely strategy left and is one which allows Japan to raise more debt and spend more. On its own, c) should drive yields lower with JPY, however, c) is also an enabler of an acceleration in fiscal policy which would drive JGB yields higher.



The system wide PMIs indicate a cyclical recovery in the Eurozone which should signal a success of policy to the ECB. The recovery, however, is not evenly distributed. The recovery in Spain is threatened by politics, the recovery in Italy by politics and specific issues in its banking system. France is in a very slow recovery with high political risk. Germany could do without any monetary or fiscal support. A tailored monetary solution is difficult given the single currency and the adherence to the capital key in QE allocation. A targeted solution would be to get off the capital key or engage national level fiscal policy.

The above would likely be neutral to positive for the EUR. Yields would react at national levels. If the ECB gets off the capital key, peripheral bonds will outperform. If national level fiscal policy is implemented, peripheral and core bonds will likely sell off. If both policies are implemented bunds suffer most.


Bank capital.

Bank capital spreads are mostly impacted by regulation and credit quality. They are, however, not immune to volatility in the base curves.

Rising rates will improve bank profitability. However, banks have significant exposure to sovereign bonds and could face losses if bonds sell off. The first order consequence is an improvement in the profit outlook for banks. Banks are generally more profitable in a higher yield and steeper yield curve environment. This is well highlighted by the relatively high short term correlation between government bond curves, yields and bank stocks

Rising rates may provide some volatility and a buying opportunity.



Loans carry very little duration, particularly as LIBOR rises above the LIBOR floor, typically 1%.  Higher rates may put pressure generally on corporate balance sheets through higher debt service and refinancing costs. The inflection point may introduce volatility to the loan market which could be a good buying opportunity.



IG spreads have compressed considerably in the short term and while in the longer term they may be cheap, in the short term the momentum from a duration sell off will likely carry IG with it. Buying opportunity if duration hedged.



Same technicals as IG. HY could be more resilient as duration element is smaller and credit fundamentals remain robust.

Last Updated on Wednesday, 14 September 2016 05:41
Japan. Will The BoJ Ease? How Big Is The Fiscal Package? What Else Can Japan Do? PDF Print E-mail
Written by Burnham Banks   
Thursday, 28 July 2016 07:39


The BoJ’s discount rate, 9% in 1980 has fallen steadily to 0.3%. The 10 year JGB yield has dropped consistently from 8% in 1990 to -0.28%.

The BoJ’s asset purchase programs have seen its balance sheet grow from 110 trillion JPY in 2010 to 436 trillion JPY expanding at 30% per annum.

BoJ ownership of JGBs rose from 9% in 2010 to 34% today. It owns 55% of Japan’s ETFs and about 1.6% of the listed market capitalization. The BoJ’s current plan involves buying 3 trillion JPY of ETFs per year. The GPIF owns about 5% of market cap.

Japan’s national debt to GDP ratio has increased steadily from 50% in 1980 to 251%. The annual rate of increase is only 4.5% but it has been increasingly almost monotonically for the last 36 years.

Inflation is still negative and not showing signs of any revival. Growth has slipped from 1.8% in Q3 2015 to 0.1% Q1 2016. Sentiment and confidence indicators are showing more weakness.

Since the imposition of negative interest rates on excess reserves JPY has strengthened from 120 to 100. It trades at circa 105 today. Also, bank deposits at the central bank have reportedly risen 20% since.


On July 29, the BoJ meets. Various analysts assign a significant probability to some kind of increase in QE in the form of increased asset purchases from the current rate of 80 trillion JPY p.a. as well as a rate cut from the current -0.10%.

On the fiscal front, the government has announced an eagerly awaited 28 trillion JPY stimulus package. The details as to how much will be spent when, how much will be direct (expenditure) and how much indirect (tax), and how much are existing and how much are is additional, are still not available. Rumours suggest that the direct spending portion will be small with the bulk of the package in the form of loans and subsidies.

So far the market has regarded the BoJ and the fiscal package with caution. JPY and JGBs have rallied while the Nikkei has come off.

The BoJ has a track record of disappointing the markets and expectations have become increasingly uncertain. The lack of details in the announcement of the fiscal package have also left the market sceptical.


While the Prime Minister’s advisers have spoken about ‘helicopter money’, technically Monetized Fiscal Policy (MFP), Mr Kuroda has said that there was “no need or possibility” of doing it. Given that ‘helicopter money’ requires close coordination between the Ministry of Finance and the BoJ, Mr Kuroda’s thoughts should be taken at face value. No ‘helicopter money.’

Monetized Fiscal Policy is likely to be ineffective in the long run and would introduce too many new and innovative problems anyway.

A sizeable fiscal package will in any case need to be financed and given the pace of the BoJ’s QQE, it will effectively be indistinguishable from MFP. The difference is a mere technicality where under QQE the bonds are passed through private sector intermediaries and under MFP the BoJ faces the state directly. Never underestimate the propensity of public servants for pedantry when they practice to obfuscate.

In the long run, the demographics of Japan will likely prove insurmountable. And in any case, the Keynesian view of the long run is probably true. In the short term Japan needs an infusion of confidence which would involve a rising equity market, stable, positive interest rates and bond yields, and a stable currency. A monotonically decreasing currency is too high a price to pay for a rising equity market. A modest recovery in inflation is also necessary.

Adding an outsized fiscal program to the currently loose monetary policy will likely stabilize interest rates and bond yields, put a floor under inflation and give a boost to demand. QQE will be needed not only to moderate any rise in yields but to finance the budget deficit and roll over the national debt. The size of the package will need to surprise the market to be effective.

The above solution is sufficiently conventional for the BoJ and the government. It provides temporary respite, but it will not address the underlying issues in the Japanese economy.

More innovative solutions:

If we are allowed to speculate, we might consider some less conventional cures for the slow growth and weak inflation. More money, debt and spending can boost demand temporarily and even give the economy sufficient momentum for the appearance of escape velocity. However, it results in chronic dependency and ultimately, policy fatigue.

In the long run, amputation could be better than analgesic. Bankruptcy law needs to be upgraded, in particular Corporation Reorganization Law, which prolongs resolution, needs to be aligned to the Civil Rehabilitation Law (equivalent to US chapter 11.) Interest rates need to be normalized and put back up to cull unprofitable enterprise and excess capacity. Negative rates cannot persist for long without detrimental impact on the banking and insurance sector. Japan also needs to encourage immigration and labour mobility to better match labour to land, capital and technology. The stock of national debt held by the BoJ could be written down.

Last Updated on Thursday, 28 July 2016 08:01
ECB LTRO. QE Lite But More Effective. Is European Demand For Credit Bottoming? PDF Print E-mail
Written by Burnham Banks   
Wednesday, 20 July 2016 00:28

In December 2011 the ECB embarked on its first 3 year LTRO, or long term refinancing operations. This is basically a secured credit line available to banks posting eligible collateral. LTRO 1 was a great success raising 489 billion EUR which the banks used to purchase sovereign bonds and unwind inter Euro area current account imbalances. LTRO 2 was 529 billion EUR. These initial LTROs were unconditional except for collateral quality. The proceeds were used in the end to buy zero risk weighted assets, sovereigns, and helped Euro area governments to refinance at a time when the bonds markets threatened to close to them. At the same time it allowed banks to borrow cheaply and buy higher yielding assets that consumed little to no capital.

The later TLTROs carried conditions, namely that the banks would be limited to borrowing up to a proportion of their loans to the private sector. The purpose of these conditions was to spur private sector lending. Take up of TLTROs has been slow because for one, the capital consumption of private sector loans is high and so the cost of lending is less impacted by the cheap financing afforded by the TLTROs, and two, private sector demand for credit has been weak.

When the ECB announced QE in early 2016, it also initiated TLTRO II, similar to TLTRO I but with cheaper financing rates, again subject to conditions. Now take up has been very strong, 399 billion at the first auction on June 24. If the high take up is a sign that bank lending is about to accelerate and that demand for credit is rebounding, this would be good news for the Eurozone economy. There are reasons for caution. The TLTRO II auction was opened June 23, the day of the UK EU Referendum. It is very possible that the large take up of LTRO II.1 was simply a risk management reaction to a highly uncertain situation and banks wanted to raise as much liquidity they could.

We are seeing an easing of lending standards and some pick-up in demand for credit from households and businesses but it remains to be seen if this can be sustained. We are a long way from a general releveraging of the economy, which might tilt the balance in favour of equity from debt.

If... PDF Print E-mail
Written by Burnham Banks   
Thursday, 14 July 2016 06:11

If I told you that it was a good idea to buy a negative yielding bond because I thought the yield would get more negative, thus paying for the potential of a future capital gain, you would probably think I was mad. Or seriously dependent on a greater fool. Or bought an option.

If I told you that I would borrow in the bond market to fund dividends which I could not afford to pay out of cash flow or profits, you would probably think me a fool or a fraud.

If I told you I would borrow in the bond market to buy back my shares because funding was cheap and I didn't know what else to do you might reasonably question my leadership qualities.

If I told you I would borrow to buy out my competitors you might question my judgment, and if you were the regulator you would certainly question the systemic competitive implications.

If I told you that stocks were cheap relative to sovereign bonds and interest rates despite slowing earnings growth and high absolute valuations you might ask how closely I monitored the bond market.

If I told you I would cut rates even into negative territory to spur lending you might reasonably ask me who wanted to borrow.

If I told you I was making banks safer by asking them to hold more capital, and apply better risk models, you might ask me how I expected them to lend.

If I told you I was going to apply more fiscal stimulus to revive our slowing economy you might ask me how I was going to pay for it.

If I told you I would buy more sovereign bonds, you might ask me where I was getting the money. Well, why do you suppose I might need to issue more sovereign bonds?



Last Updated on Thursday, 14 July 2016 06:22
Is Immigration Good For An Economy? How Is This Good For The Global Economy? PDF Print E-mail
Written by Burnham Banks   
Thursday, 14 July 2016 01:52

Immigration is topical in the wake of the UK EU Referendum. In fact, slowing growth has led to increasing unhappiness over immigration the world over. Yet economists insist that immigration is a good thing for an economy. Is this true? According to a 2014 OECD report, migrants account for 47% of the increase in the work force in the US, and 70% in Europe over the past 10 years, fill important niches in fast growing as well as declining sectors of the economy, are better educated than retiring cohorts, and contribute to labour market flexibility. They also contribute more in taxes and social security than they receive in benefits. Because they contribute to the growth of the labour force, immigrants contribute to the growth potential as well as the realized growth of an economy.

The fortunes of donor countries is less clear. Remittances are a substantial part of developing countries’ GDP. Remittances reduce poverty and fund investment, counts as a credit in the balance of payments and increases the standard of living and reduce inequality between countries. On the other hand, emigration leads to a brain drain from developing countries. Over time, migrants accumulate skills which they can repatriate to their home countries increasing the knowledge base of these donor countries.

For the global economy, net immigration is of course absurd. When economists talk about immigration being good what they hopefully means is that a redistribution or relocation of labour is beneficial. Beneficial for whom is another matter. Let us take an optimistic view and assume that it is good for both destination and source countries for the above reasons. Immigration is good because it moves the global economy towards a better geographical alignment between resources, capital and labour. The distribution of the benefits might not be equitable and it is reasonable to expect that in the short term, the macroeconomic benefits accrue to the destination countries. It is hoped that a reverse osmosis occurs at some stage which compensates for the initial asymmetry of benefits.

The state of the world is never static but hypothetically, if labour was optimally distributed geographically, then immigration could no longer improve growth or productivity. What is important for the immigration argument is not net immigration for any single country or region, but the minimization of friction in labour mobility. And then again the question of for whom this is beneficial emerges. It is remarkable that in most economic commentary and literature immigration is referred to instead of two way labour mobility.

Last Updated on Thursday, 14 July 2016 01:54
Why the UK Cannot Leave the EU. Say No To Brexit. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 22 June 2016 03:27

We can't leave the EU, not yet. The EU remains a flawed union but not a broken one, and quite clearly, the rationale for joining it in the first place was to ensure it was a failed union. As the Cabinet Secretary has said before, we've fought with the French against the Germans, the Germans against the French, the French and the Germans against the Russians and with the Germans, French and Spanish against everybody else... It might have been a roaring success. Well, not quite. The union still stands and the job is not yet done.

To really undermine the union would involve joining the currency union but the costs would be too high, so the next best is to remain in the EU and prise it apart with British exceptionalism. In this respect, the task is yet unfinished. But, we are getting closer. There is certainly more fighting today, unfortunately it’s the Germans against the Germans, the French against the French and the Spanish against the Spanish. And most unfortunately we've got Britons fighting Britons, specifically the Tories against the Tories, Labour against Labour and the UKIP against any form of sense. The only country which isn't fighting itself is Russia. They've got their hands full fighting anti-money laundering authorities everywhere just to find a suitable custodian for their assets.

So job not done, please Remain where you are and resume fighting for what you believe in.

Last Updated on Wednesday, 22 June 2016 05:28
Investment Outlook June 2016. Ahead ot Brexit. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 15 June 2016 08:03

China growth is also stabilizing but this has a cost in credit creation. The natural growth rate is slower in the new regime but the government cannot allow the economy to function there. As a result it is overstimulating the economy with side effects in commodities and real estate. These sectors will be very sensitive to Chinese policy and timing these markets will be quite difficult.

Japan is back in a difficult position. The sales tax has been postponed but this will not be sufficient. An outsized fiscal package is likely but this will only worsen the balance sheet. The BoJ will be drafted into more debt monetization. If the inflation target is to be achieved, another round of concerted fiscal and monetary policy will be needed.

The US economy is fundamentally on sound footing and we expect a pick-up in growth as spreads have stabilized. We also note that the manufacturing sector appears to have completed its pivot to a domestic audience. The poor employment number in May was an indication of a skills mismatch and not weakness in the economy. Wages are holding up, quits rates have recovered, initial claims have been subdued. Manufacturing PMI has been over 50 for 3 months now.

Oil prices have done very well this year. Oversupply peaked in January and has receded a little. At these levels we are seeing now a 3rd week of increasing rig counts. Oil prices should not rise any more from here. At these levels, however, HY defaults will still rise although the headline correlation will be reduced.

FOMC: Fed could not have moved even if it wanted to. The Fed’s control is the Fed funds rate but the real economy funds itself at market rates. Sell offs lead to spread widening and de facto tightening. Is a rate hike on July 27? It all depends on the market price of credit. If markets are well behaved, the Fed can act, if they are not, then the Fed cannot act.

The EU referendum is on the agenda. The polls have Leave in the lead by 43 to 42. The bookmakers have Remain in the lead by 65 to 35. We believe the bookmakers. Polls pick up what people want to do but bookmakers pick up what people intend to do. Negative voting has been prevalent in recent elections which have led to inaccurate polls.

Europe also looks to have been stabilized by the ECB but growth is fragile. A Brexit is going to hurt the EU. The UK is 17% of EU exports but the force of sentiment will have more immediate impact and could derail the recovery. We expect the impact on Europe could be greater than the impact on the UK. The UK economy is relatively strong compared with the EU and better able to absorb the shock of disengagement. If sterling weakens more, it could improve the UK’s competitiveness. If the euro is also weak, and there are reasons to expect this, Europe may benefit also. This might achieve what QE could not, which was to weaken the euro.

Peripheral spreads will widen on Brexit but France and Germany and the ECB will most definitely move to strengthen the union. This would see peripheral spreads snap back quickly.

Liquidity is low in the summer and we have a number of events including EU referendum, Spanish elections, Republican and Democratic conventions, Japan upper house election, and the run up to the US presidential election.

Equity valuations are high. Apart from the US, fundamentals are still fragile. Credit spreads are tight. Sovereign yields are too low. The margin for error is very small. There will be some who hope the financial press can keep the Brexit flame alive, and even hope for Brexit, to bring markets lower. At current prices there are few opportunities and one almost needs to shake the tree.

Is Brexit a globally systemic event?

  • How immediate is the problem? 2 year holiday.
  • Contagion risk? European problem. Could escalate. EU exports to UK 17%. UK exports to EU, 45%. Exports to ROTW should not be affected. UK is 2.36% of world GDP. EU ex UK is 13% of world GDP. UK is not part of Eurozone. Not part of TARGET2.
  • Sentiment risk? High in the short term.

For those with a high cash holding it is time to add some risk, pre EU referendum.

Last Updated on Wednesday, 15 June 2016 08:07
Market Outlook 2016. Where To Invest in 2016/2017. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 08 June 2016 00:50

It is now difficult to see more than 10 seconds into the future. What was chosen for a laugh as a blog title has become a reality. Central banks have led the markets if not the economy for the last 8 years out of crisis and are now losing some credibility and control. A quick survey finds weak but positive growth across most countries with the exception of Brazil and Russia in 2016, and positive growth across all countries in 2017. It also finds inflation mercifully low, and positive, even in Japan and the Eurozone. This does not appear to be a dire environment. However, aggregate data hide less tractable problems. If the averages are poor and the inequality is acutely high, it means that the majority of the population are experiencing declining wealth. Mercifully, inflation has been low.

It is always a difficult time to invest. In the 90s we fretted about inflation which in the end failed to materialize. We inflated a tech boom bubble which burst. We inflated a housing bubble which burst. And since then we’ve been led by the nose by central banks cleaning up the debris of the last bust while trying to strengthen the financial system which proved not so robust and simultaneously trying to spur economic growth which sputtered in no small part because of those very efforts at financial market reform.

The US economy is out of the woods and on a stable path of positive if rather tepid growth. The European economy is not far behind. The inefficiencies of the Euro are something they will live with regardless but so much liquidity is bound to spur some growth. China was actually first to lead with unconventional policy. It saw external demand shut down in 2008 and continue to fade as countries engaged in trade war. China is arguably ahead of the cycle in terms of policy, priming the pump quickly, smoothing the downturn, then tightening prematurely, hopefully not a lesson for the Fed, and finding itself needing to turn on the taps again. Japan is perhaps way ahead of everyone else. Demographically, Japan is the future. We can only hope that it is not also the future in terms of economics and policy.

Policy has targeted an arbitrary rate of growth and in doing so introduced more imbalances which drive delayed oscillations in market prices. At the micro level we already observe that asset prices can deviate from fundamental value for longer and gyrate more substantially as they converge to intrinsic value. Long duration assets are all the more risky in that there is no deadline for convergence. Finite and shorter maturity assets are not immune to volatility. Policy, sentiment and capital flows are the prime determinants of price discovery. Markets fail to bring convergence to intrinsic value quickly and efficiently.

There are several reasons for this. In the past, relative prices were brought into equilibrium or no-arbitrage pricing by traders or groups of traders who traded across capital structures. Most of this capital took the form of bank proprietary trading desks. With Basel III, Dodd-Frank and the Volcker Rule, the capital dedicated to these activities has shriveled. Some of these traders have sought new homes in hedge funds. However, the scale of capital in hedge funds pale in comparison with the practically bottomless pits of capital commanded by prop desks in the past.

In the search for yield, retail investors, through their regulated and sanitized vehicles like mutual funds and ETFs have ventured into markets normally traded by professional investors. The herd mentality and the artificial liquidity created by retail capital has led to more momentum driven markets where undervaluation soon becomes overvaluation and overvaluation becomes undervaluation in a cyclical and volatile fashion. Prop traders accustomed to leveraging small, predictable deviations now face large, unpredictable deviations, and in their hedge fund formats, face prime brokers who cannot extend the scale of leverage they are accustomed too, or the valuation forbearance of the investment banks of old. Therefore, they struggle. This is the new market, at least for now.

One could play the long game, identify good businesses and invest for the long term. To do this, one needs not only to be right, but one needs stability of capital and the faith of investors. With the current uncertainty, investor loyalty is understandably in short supply. Uncertainty is high. When economic growth is low, small deviations can lead to negative readings. The acute inequality of wealth is slowly translating into the feeling of injustice, and society seems heavy with social tension. Between political factions there is more civil war than inter party conflict. Policy has been deployed bearing such low marginal fruit that it has taken extreme efforts to have any effect. The risks of unforeseen side effects proportionate to the scale of the effort, not the effect, are high.

The inescapable reality is that markets have become more volatile and fickle. The patient investor can take advantage of this volatility but this can often be a test of stoic patience. Markets like this also require the investor to be more informed, even if they are outsourcing their investing decisions lest they make mistakes in their capital allocation plans. For investors who need to be invested many opportunities remain, and some very good ones at that. Investors should be careful not to overreach in their thirst for yield. However, there are areas of the market which remain beyond the reach of retail capital and other hot money and where price discovery remains linked to fundamentals. Some of these markets are the way they are because of legacy issues from the 2008 financial crisis, some even performed well through those periods but through guilt by association will not be revisited even by some institutional investors. Under-owned, under-researched, misunderstood assets represent good opportunities. But even here, markets may not be sufficient to bring price discovery; patience, and duration matching of capital, is necessary.

Last Updated on Wednesday, 08 June 2016 00:52
Singapore 2.0. Singapore Economy In A Rut. Policy Has Run Out Of Ideas. PDF Print E-mail
Written by Burnham Banks   
Monday, 30 May 2016 01:39

The Singapore economy is in a bit of a rut. A space constrained, population constrained economy like Singapore needs to look to unconventional economic models for growth. It cannot target population growth, capital accumulation and technological innovation without bound. Population growth meets space constraints and population density issues sooner or later. By all accounts, it already has. Capital accumulation faces fewer limitations but by far it is technological innovation that will liberate Singapore’s economic growth from conventional constraints.

Population constraints imply domestic demand and output constraints. Singapore has to supply the world in a scalable and dematerialized fashion. This is even more so given that the world is evidently engaged in a trade war which is impacting material goods far more so than services.

Beyond using or being associated with innovation, Singapore needs to be generating innovation. Whether Singaporean’s or immigrants or indeed transients generate the innovation is immaterial as long as the innovation is retained as Singaporean intellectual property.

Singapore needs to become a centre for research and development. It needs to be a central node in the global knowledge economy. This means it needs world class schools and research facilities. Red tape and over-regulation are the mortal enemies of innovation. Rules and regulations have to be streamlined to encourage innovation.

One area of potential development is financial technology. At one end of the spectrum is the cutting edge technology which the industry expects to disrupt the current financial system by changing how customers, counterparties, debtors, creditors, and regulators interact in the financial market place. This is so-called Fintech, which is highly topical. The other area of financial innovation is a slightly older technology that though useful has been demonized by the 2008 financial crisis.

Singapore is privileged to have two sovereign wealth funds with considerable financial firepower. One of them, Temasek Holdings, has significant investments in banks such as DBS, a national champion with Asian regional reach and services from investment banking to retail and consumer banking as well as wealth management. As the Western world struggles to regulate their banks and insurers in the aftermath of 2008, Singapore’s relative resilience emerging from that crisis is an opportunity to go back where others failed and salvage valuable technology. It has the opportunity to work around Basel III and demonstrate its weaknesses by reviving securitization and structured finance and making a success of these technologies.

The West’s experience with Shadow Banking began well, was overdone by Wall Street and ended in disaster. Through this all Asia was such a late adopter that it had not the opportunity to overextend the technology to disastrous end. There is not the political and cultural baggage surrounding structured finance in Asia to prevent it being revived in an improved form for the good of all. Where Basel III is highly restrictive, the Shadow Banking system can be a useful conduit to direct savings to investments more efficiently than a banking system hobbled by overly reactive regulation. The world has sufficient potential economic growth left in it, and central banks the means to finance it, but the plumbing is broken.

Singapore’s SWFs have the capital to capitalize innovative credit structures to enable economic growth, not just in Singapore but in Asia. It has banking relationships which in can draw upon to provide the intellectual basis. One example would be to encourage a bank like Standard Chartered to engage its credit underwriting machinery without consuming balance sheet. Standard Chartered’s new boss is an old hand at leveraged finance and is well placed to turn Standard Chartered’s investment bank into a tranched credit manufacturer. Temasek could very well sponsor such activity and anchor the equity of such investment vehicles. DBS could be similarly engaged. Both banks could become examples of how banks can work hand in hand with shadow banks in a capital efficient, profitable and regulation-compliant fashion directing capital where it needs to go and pricing risk appropriately.

If done properly, Singapore could reap a Wimbledon Effect, at least in Asia, reintroducing a technology there that went out of fashion in the West for not entirely good reasons, and which can do a lot of good in bank capital constrained regions.

If and when Singapore decides to go down these roads the institutions leading the way will need to have appropriate leadership. CEOs and CIOs will need to be familiar with these technologies. Generalists briefed by specialists only to approve or validate the specialists’ decisions and recommendations will not do. These armies will need to be led by battle scarred fighting men and not HQ bound generals.

The SWFs will have a much wider responsibility. Not only must they generate sufficient returns for the nation to augment the budget, they must actively and aggressively drive development both of industry and nation. They must shamelessly attract expertise with capital and latitude, they must attract coinvestment both financial and strategic and they must create a brand which can extend beyond the shores of this tiny island. This brand will stand for integrity, transparency, efficiency, innovation and excellence. It must demonstrate a new model for countries constrained by size and resources, that once again a small force can achieve more than a big one. Its going to take some leverage.

What Will Corporate America Do With All That Cash? Share Buybacks? No. Bond Buybacks. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 06 December 2016 02:58

Last Tuesday, the FT asked the question "Where will corporate America's overseas cash pile go?" Excellent question.

Until Trump proposed a repatriation tax and lower overseas corporate taxes, the share buyback binge which has propelled the US equity market for the past 7 years was set to peak. Goldman Sachs estimates that the tax holiday will result in 200 billion USD of repatriations. The expectation is that most of this cash will be directed at share buybacks and dividends, although share buybacks will likely dominate as the more tax efficient shareholder reward.

Let's try to argue against this consensus scenario. There are basically three things you can do with corporate cash, you can buy back shares, you can buy other companies, you can invest in capacity, or you can retire debt. Interest rates are rising which implies that, one, indebtedness is expensive, and two, investment in capacity faces a higher hurdle rate of return. Buying back shares raises the leverage of the company making it relatively more indebted. Buying other companies raises leverage far faster than share buybacks. Investment in capacity may be justified if final demand picks up but, ceteris paribus, higher interest rates means less investment. How about retiring debt either through buy backs or simply attrition.

Net debt to EBITDA for S&P 500 companies rose from 1.1X in 2013 to 1.7X while total debt to EBITDA rose from 3.6X to 4.6X. This is a considerable increase in leverage in a short time. The scope for a deleveraging cycle is ample. If US companies embark on strengthening their balance sheets, by eschewing share buybacks and reducing indebtedness, the impact on credit spreads could be significant.

From 2002 to 2007, credit spreads tightened as leverage fell. From 2007 to 2008, leverage rose and credit spreads surged, although the catalyst to be fair was not in the corporate credit market but in the housing market. The credit rally from 2010 to 2014 coincided with balance sheet deleveraging. What is remarkable about the credit market has been the rally from February 2016 to date which has occurred while corporate leverage is still increasing. If corporates start reducing their leverage, we could be seeing a more sustained rally in credit and spreads reaching for the lows of the 2004 -2006 period.

Last Updated on Tuesday, 06 December 2016 03:01
Trump Has Won. Its Time To Unite And Get To Work PDF Print E-mail
Written by Burnham Banks   
Friday, 11 November 2016 08:35

Every so often democracy produces a result that is extreme and polarizing. The personal qualities displayed by Donald Trump were far from desirable or exemplary and his proposed policies appear vague, incomplete or ill-conceived. Yet Trump addresses some deficiencies, even if his remedies may be questionable.

While 47% of eligible voters did not vote and more people voted for Clinton than Trump, the fact remains that over a quarter of the people voted for Trump. That’s 25% of people who chose a misogynistic, avaricious, egotistical, disingenuous tax evader. Some of this may have been a protest vote against an opponent they felt they could not trust.

However, it is more probable that Trump represents the feelings and ideology of more people than we care to admit. It is an uncomfortable truth about the human race, about ourselves. We are less likely to condemn or punish another if we have been guilty of the same crimes, even if to a lesser degree.

That Trump lost the popular vote may tempt one to redesign the voting mechanism, but no voting system is perfect. What America and indeed the world needs to do is to give Donald Trump the opportunity to prove himself worthy or not. America’s democracy means that a man untrained and inexperienced in the workings of government can now lead the country. There are, however, useful checks and balances in the form of Congress. If we have to worry it is that the Republicans control the House and the Senate, albeit with an insufficient majority to force policy through.

The demonstrations against Trump should stop, as should the calls for “faithless electors” to confound the election result, or actions to impeach the President Elect as a political means to stop him from taking office. If Trump is prosecuted for one of his allegedly sham commercial practices it should not be a politically motivated action.

To unfairly deny the President Elect is to deny democracy. America has the institutions and the systems to constrain a rogue President. In the meantime, Trump has 4 years to prove himself. If he doesn’t it will be 4 years lost and some work for his successor or successors to cure. There are worse outcomes in the world, incumbents who cannot or will not be removed, despots who outstay their welcome and defy the will of their people and nepotic dynasties. Trump at least is the will of a quarter of the people. The silent 47% bear some blame and chronic non-participation should result in a permanent loss of voting rights. The nation should pull together, including the 25% who voted against Trump, to steer the country to a better future, even with all the pushing and pulling associated with a liberal democracy. It would be wrong to simply work against the man. It might give him cause to undeservingly seek a second term. If he fails despite the support of the country then there is no excuse.

Last Updated on Friday, 11 November 2016 08:37
Global Debt Levels, Central Bank Policy, Implications for Interest Rates and Bonds. Nov 2016 PDF Print E-mail
Written by Burnham Banks   
Tuesday, 01 November 2016 07:44

We have had central banks telegraph their intentions to us for years now, and mostly those signals have been dovish. Recently, however, there has been a backup in bond yields and some uncertainty around what central banks want and what they can achieve.

Is the current correction in bonds similar to the taper tantrum of 2013 when the Fed signalled an end to quantitative easing, or is it a shorter, shallower correction, or is it a more durable reversal in the one way market for bonds since the crisis of 2008?

Let’s explore a slightly cynical view of the world, that central banks are in fact not independent of their political masters and that the government uses all the apparatus at its disposal in the management of the economy.

Global debt levels have risen from 87 trillion USD (246% of GDP) in 2000 to 142 trillion USD in 2007 (269% of GDP) and to 199 trillion USD (286% of GDP) in 2014. Despite deleveraging of particular sectors in the aftermath of 2008, aggregate debt levels did not drop but instead accelerated.

A plausible strategy for dealing with excessive debt would run as follows:

1. The first order of business is to ensure that the holders of the debt are strong and do not attempt a market sale which would bring about price discovery.

2. Market rates of interest need to be contained to facilitate the refinancing of existing debt towards longer maturities. This involves suppressing two elements, the first is the underlying government bond curve, and the second, the credit spread.

3. A strong holder of debt is the government since it pursues objectives beyond economic and commercial ones.

4. The government needs to finance debt purchases with the issue of government debt. This will lead to an increase in the national debt, from in most cases already elevated levels. A strategy needs to be found to reduce the cost of government debt.

5. Central bank purchases of government bonds are an efficient means of financing the government’s debt purchases and moderating financing costs. In the case of more determined programs, central banks may buy corporate debt to suppress the credit spread as well as the base interest rates.

6. A pool of investment capital sufficient to finance and refinance the debt needs to be maintained and developed.

7. Excessive savings are to be encouraged as they are another source of cheap funding. Inequality of wealth supports excessive savings and may therefore be tolerated.

8. To channel savings to fund government debt, banks need to be encouraged to buy government bonds. Under Basel III, government bonds have a risk weight of zero, making them highly capital efficient investments despite their low yield. The zero capital consumption of government bonds makes banks demand highly inelastic. In the US, in the 12 months to Oct 2016 the holdings of US treasuries and agency MBS by banks has risen from 2.16 trillion USD to 2.43 trillion USD.  Western and Southern European banks’ holdings of government securities has more than doubled from 627 billion EUR in Sep 2008 to 1,422 billion EUR in mid-2016. This has been aided by credit lines (LTRO) for which government securities are eligible collateral.

9. The slower is economic growth and corporate profit growth, the lower must financing costs be maintained in order to prevent the excessive growth of the total debt. Ideally, the objective is to at least attain steady state if not shrink the stock of debt.

If the above conjecture is true, then interest rates will be capped over the long run. The current rise in interest rates would be a short term (3 to 6 months) phenomenon.

On this basis, while we would be tactically short the 10Y UST at 1.8, we would be long the 10Y UST between 2.0 – 2.3, and the 30Y UST between 2.84 – 3.06.


Last Updated on Tuesday, 08 November 2016 01:38
Time and technology blunt the memory of the cost of war PDF Print E-mail
Written by Burnham Banks   
Monday, 03 October 2016 07:54


As the memory of war fades and technology allows us to fight wars from long distances we become distanced by time and space. The more time passes and when wars are fought in faraway places and fought with detachment the more likely we are to engage in it.

Last Updated on Monday, 03 October 2016 23:52
Banks and Hedge Funds. A Side By Side Comparison PDF Print E-mail
Written by Burnham Banks   
Monday, 03 October 2016 02:23



Hedge Funds


· Banks have permanent equity capital and long term hybrid capital.

· Hedge funds have variable capital. Equity can be redeemed although there may be lock ups, gates and low redemption frequency to stabilize equity capital.

· Lock ups and gates have been controversial. Some investors dislike them while others appreciate the stability they bring.

Price discovery

· Bank equity and capital trade on open markets and price discovery is achieved through demand and supply.

· Equity is subscribed and redeemed at Net Asset Value.

· Secondary market remains small and specialized.

Leverage (size)

· Banks are typically leveraged anywhere from 10X to 50X.

· Banks are allowed to apply risk weights to assets for the purposes of calculating their leverage.

· Hedge funds are typically leveraged between 2X to 5X although some strategies are more leveraged than others.

· No risk weighting of assets. Everything counts.

Leverage (structure)

· Banks issue across the spectrum from hybrid capital to senior, secured, bonds as well as secured and covered bonds.

· An important source of banks’ funding is deposits. Bank deposits are a source of duration mismatch.

· Some banks rely on short term, wholesale funding such as interbank, commercial paper and repo markets.

· Hedge funds rely on prime brokers for their leverage. Prime brokers are usually the large investment banks.

· Hedge funds not only borrow money but also borrow securities for shorting, leading to de facto if not financial leverage.

· Cash and securities lending is usually on a short term basis and can be recalled.


· Banks lend to households, businesses, and governments. When they do so they make money by taking credit risk.

· Banks provide services to clients earning fee income.

· Banks engage in trading activities. This has been substantially reduced post 2008 as regulation has been introduced to reduce systemic risk and taxpayer bailouts.

· Most hedge funds make money from trading and investment.

· Some hedge funds provide financial services and earn fees but this is usually in conjunction with assuming some market or credit risk.

· Some large hedge funds are significant lenders providing credit not only through bond investment and underwriting but in private loans.

· Many hedge funds were spin outs of bank proprietary trading desks. As heavier capital requirements weighed on banks capacity for trading more traders left to join or establish hedge funds.

Investor base

· Equity is publicly traded and bought by institutional investors, retail investors, mutual funds, and institutional funds.

· Other claims are variously traded by investors of varying sophistication.

· The offer of hedge funds is usually restricted to sophisticated investors.

Operating costs

· Borne by shareholders.

· Investors pay management and performance fees, ostensibly 2% p.a. for management and 20% of profits. Actual management fees are lower as institutional investors obtain discounts.

· Investment manager bears the operational costs which are paid out of the management and performance fees they collect.

Asset Valuation

· Banks have some discretion on whether assets are marked to market or not depending on whether the bank deems them to be Held To Maturity, Trading, or Available for Sale.

· Almost all hedge funds mark all their assets and liabilities to market. The market convention is that long positions are market to bid and short to offer.

· Typically an independent administrator is involved in the valuation of individual assets and the calculation of NAV.


· Regulated internationally (e.g. BIS), regionally (e.g. EBA, ECB), and nationally (e.g. local central bank.)

· Largely unregulated although AIMFD in Europe is an attempt at better regulation.

· Increased regulation if they seek wider distribution such as retail investors.

History of Instability

· Bank runs have been recorded since banks were invented.

· A record of banking crises exists from 1763 with roughly one crisis per decade.

· Over-leverage and a concentration in one area of collateral appear to be factors.

· Hedge funds have not had as long a history as banks but the frequency of systemic failures has not been as frequent as in the banking industry.

· 2008 was the last time hedge funds faced forced closure en masse. Their demise was closely related to the failure of a number of investment banks which were prime brokers, notably Lehman Brothers, but also Merrill Lynch and Bear Stearns.

· The last systemic crisis in hedge funds occurred 10 years earlier when LTCM failed as a result of over leverage and over dependence on theoretical models. A number of Wall Street banks were called upon to bail out the fund. Bear Stearns and Lehman did not participate.





Last Updated on Monday, 03 October 2016 04:04
Fiction. Ten Seconds Into Our Future. The Journey Home PDF Print E-mail
Written by Burnham Banks   
Thursday, 22 September 2016 00:40

One day in the future, the world has nearly depleted its resources. Natural resources have been over-mined, agricultural land over-farmed, the seas over-fished and over-farmed. A surge of population growth in the developing world has led to over-population and overcrowding in cities, while some areas face neglect and become under-populated. Parts of the world become dumping grounds for industrial and energy (read nuclear) waste. These areas become permanently uninhabitable.

The rise of robotics and artificial intelligence is a significant factor in exacerbating inequality through mass unemployment and a rising share of output accruing to owners of capital. Inequality of wealth within countries gives way to social tensions and domestic secular terrorism and limited civil war. Countries turn inwards and escalate an existing economic and trade war. In some cases, these turn into full martial conflict.

The complete depletion of resources forces some countries to surrender to others in order to survive. Eventually there is peace, but the scarcity problem persists. A united Earth begins to search a new home, a new planet on which to settle. One is found some 200 light years away. Analysis indicates a resource rich world with an atmosphere and gravity similar to Earth’s, not only capable of supporting, but on current evidence, actually supporting life. Unfortunately, this includes intelligent, humanoid life.

An analysis of animal behaviour suggests that the optimal approach is invasion. Spacecraft are built to not only transport the human population of Earth to the new planet but provisions are made for combat and conquest. Fortunately, the evidence is that the population of the new planet, dubbed, KoHo, is relatively technologically primitive and easy prey.

50 years of preparation later, Earth is evacuated and the first transports are launched, destination KoHo. A 400 year journey begins. The period begins in peaceful cooperation but soon, civil strife ensues, on account of inequality and segregation by wealth and social status. A revolutionary, left wing faction develops commanding some 20% of the fleet and population. War erupts lasting 100 years. The war ends in the destruction of the revolutionaries and some 50% of the fleet and population.

The surviving population rebuilds and continues their journey to KoHo. Upon entering the KoHo system, there are initially difficulties in locating the planet KoHo. When the planet is finally identified, landing parties find an abandoned planet devoid of life or resources.

Archaeological studies indicate that a humanoid species lived on KoHo and, similar to humans, ruled the planet at the top of the food chain, using its intelligence and technology to dominate the planet.

One day, this world had nearly depleted its resources. Natural resources had been over-mined, agricultural land over-farmed, the seas over-fished and over-farmed. A surge of population growth had led to over-population and overcrowding in cities, while some areas faced neglect and became under-populated. Parts of the planet became dumping grounds for toxic industrial and energy waste. These areas became permanently uninhabitable…

A solution had to be found. Fortunately, a living, breathing planet was found, a blue planet some 200 light years away…

Last Updated on Thursday, 22 September 2016 00:43
Adding Fiscal Policy To Monetary Policy, QE and ZIRP. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 03 August 2016 05:11

Monetary policy has likely reached the limits of usefulness, not necessarily the limits of efficacy. The efficacy of monetary policy was questionable in the first place. Multiple QE programs and low interest rates have managed to inflate assets but not to spur the economy as much as was hoped.

Monetary policy is but one class of tools available to encourage growth, fiscal policy being the other. Without fiscal stimulus, monetary policy has to work doubly hard and faces leakage in terms of risk of asset price bubbles, unequal distribution of benefits, disinflation due to increased capacity, and downward pressure on interest rates. Fiscal policy will not mitigate all of these side effects but it could reverse some of the unequal distribution of benefits and put a floor under market interest rates.

Why has fiscal policy not been engaged so far?

  • Many countries’ national debt is high in relation to GDP, many on account of financial sector bailouts in the crisis of 2008.

  • Austerity followed as economic orthodoxy. The Eurozone, for example, has strict guidelines on state budgets.

  • Operating both monetary and fiscal easing carries high inflation risk as output is boosted to potential and could overshoot. By operating monetary policy first, excess capacity is allowed to build before fiscal policy is applied to raise capacity utilization.

  • Fiscal policy is politically charged and requires strong government to obtain approvals.

  • Cost of debt is another factor. Leading with monetary policy results in lower cost of debt for governments if they subsequently raise spending and seek to finance it in the bond markets.


Are we likely to see a shift towards fiscal policy?

  • Japan has periodically engaged in fiscal stimulus which has seen its national debt climb from 0.5X GDP in the 1980s to over 2.5X today. Just days ago, the Abe government announced a 28 trillion JPY fiscal package.

  • Japan was able to do this as the Abe government, already with a super-majority in the lower house had recently won a super-majority in the upper house, was unchallenged in the Diet.

  • BoJ’s QQE and negative interest rate policy had taken 10 year JGB yields from 1.66% in 2008 to -0.29% just a week ago. Cost of debt is very low.

  • Japan needs reflationary policy to revive its economy. Recent data has shown Japan sliding back from the recovery from the first dose of Abenomics.


Does Europe need fiscal stimulus, and if it did, could it become a reality?

  • The European economy is still on track with the recovery triggered since the LTRO operations of late 2011. PMI data point to the durability of this recovery.

  • The risks to the recovery are Brexit, both directly and indirectly should it trigger more divisions, security, which could embolden nationalists and Eurosceptics seeking to close Europe and restrict freedom of movement, and a long list of local events, such as the impending Italian legislative referendum, which could escalate and spread into more, threatening the integrity of the union.

  • Even if there was cause for fiscal stimulus, Europe has strict guidelines regarding budget deficits. While these limits have often been broken, they have not been intentionally breached as part of a deliberate spending campaign. Eurozone national debt to GDP is still elevated having risen from a low 65% in 2007 to 92% in late 2014; it has receded to 90.7%, still a very high level.

  • While monetary policy is coordinated by the ECB, the lack of fiscal union would mean that fiscal plans are domestic affairs. Coordination would be difficult and depend significantly on the strength of the individual member states’ governments and their ability to approve such programs. Assuming each member state budgets towards their own situation, they would find monetary policy calibrated to the collective and not to their own circumstances.

  • That said, the ECB too has followed a similar path as the BoJ in QE and negative interest rate policy resulting in conditions conducive to debt financing fiscal deficits.

What are the consequences of adding fiscal policy to monetary policy?

  • Monetary policy has dual impact on inflation. On the one hand lower rates spur activity, or at least facilitate activity and in that respect spurs inflation. On the other hand, low interest rates encourage over investment and over capacity which have more durable deflationary pressure. Fiscal policy mitigates this by addressing directly the demand deficiency and is therefore inflationary.

  • On its own, QE and NIRP lower interest rates across the term structure. The application of fiscal stimulus increases the demand for money and bids up yields across the term structure.

  • Fiscal stimulus is likely to cause currency appreciation as interest rates rise. The impact on trade is less predictable given the number of distortionary trade pacts in force and the protectionist biases in the current environment. At this stage it is likely to be neutral.

  • Fiscal deficits are a prime example of kicking the can down the road as the expenditure will need to be financed and financed with long term debt. Given that most countries are running historically high debt to GDP ratios, the assumption of more debt could be destabilizing at some point. This could lead to sharper interest rates and weaker currencies.

  • The crowding out of the private sector is a particular risk given that monetary policy has already exposed weak private investment and demand.

  • The biggest risk is not one resulting directly from fiscal or monetary policy but the slippery slope that all analgesic solutions pose. We have witnessed how easy it is to embark on QE and rate cutting policies and how difficult it is to wean economies off such policies. The same will apply to fiscal policy. What it implies is that governments will continue to apply policies which provide short term relief but which may not treat the underlying cause of slow growth, and that the only way such policies are withdrawn is not when they are no longer needed, but when governments can no longer sustain them.

Last Updated on Wednesday, 03 August 2016 05:14
What is Helicopter Money, WIll It Work and What Are The Risks? PDF Print E-mail
Written by Burnham Banks   
Wednesday, 27 July 2016 01:56

What is Helicopter Money?

There is still much confusion over what exactly ‘helicopter money’ means. In 1969, Milton Friedman coined the term in an extreme example to illustrate a point.

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated." (Milton Friedman, “The Optimum Quantity of Money,” 1969)

In practical terms, helicopter money would require the central bank or some other branch of government to with the authority to create money, to fund the national debt precisely through the creation of money; debt monetization. As such a more precise name for ‘helicopter money’ is Monetized Fiscal Policy (MFP).

What is the difference between QE and MFP?

In QE, the central bank buys government bonds from private investors who had bought the bonds, ultimately from the government. In MFP, the central bank buys bonds from the government. The difference seems almost academic.

So far, QE has been undertaken in the US, UK and Eurozone without deliberately targeting a budget deficit. To the contrary, countries undertaking QE have tended to at least attempt fiscal responsibility. From a prudential management viewpoint this is sound policy but from an economic growth viewpoint this is somewhat self-defeating. When the problem is not undersupply of credit but deficient demand, monetary policy drives interest rates down with low impact on growth. This has been supported by data.

MFP involves operating a fiscal deficit, either in the form of tax cuts or investment spending which is subsequently funded by the central bank. The stimulus effect comes not from lowering interest rates and providing credit or liquidity, but in directly augmenting demand. Output rises directly as a result of the fiscal expansion. Whether or not the capital infusion circulates or gets saved is a separate matter. If the economy is facing deficient private demand it may take some time for inflationary effects to spur private demand.

What are the risks of MFP?

A distinction is often made between debt financed and money financed fiscal policy. This distinction is a very fine one and is not well defined. Proponents of MFP prefer to think of the debt purchased by the central bank as permanent, or written off. The central bank not only buys the bonds of the government but that debt is either perpetual or the central bank promises to maintain its balance sheet through refinancing these bonds in perpetuity. The accounting pedant would consider this debt outstanding and not written off, but that it had a perpetual buyer of last resort. In effect the central bank becomes the lender of last resort to the state, as much as a lender of last resort to the commercial banks. There are risks associated with this role.

We have seen how difficult it has been to wean an economy off QE. The Fed is the least accommodating of the major central banks yet its balance sheet has not shrunk since 2014 despite an end to its asset purchase program. The Fed continues to maintain a 4.5 trillion USD balance sheet by reinvesting coupons and maturing principal.

We have seen also how difficult it is to wean economies off low interest rates. The Fed had planned on a gentle path of rate hikes as early as mid 2015. It has managed one rate hike Dec 2015. The next one may come before Godot. Targeting unusually low interest rates distorts the single most important price in the economy, the price of money, leading to misallocation of resources, and encouraging overcapacity which may ultimately be disinflationary while impairing the profitability and solvency of the banking and insurance industry.

There is a tangible risk that MFP once implemented is accelerated. The experiences of QE and ZIRP have shown the economy’s propensity for chronic dependence on analgesics. Since the central bank acts as lender of last resort to the state, accelerations of MPF can damage confidence and lead to a run on the assets and currency of the country.

How should the money be spent? This is a difficult question in the best of times. Most developed world economies could do with infrastructure upgrades. Better funding of medical and social insurance programs would be welcome. However, public spending is to a great extent a political matter, less so an economic one. The risk that spending is inefficient and does not make a sufficient return on investment, not to the state alone but to society, is high. Also, fiscal spending tends to be sticky upwards, meaning that it is later difficult to cut back when MFP is no longer required. In fact it would increase the probability that MFP once begun would be perpetual.

Tax cuts are another channel for MPF. Here too, the consideration will likely be more political than economic. Given the explicitly unnatural nature of permanently financing a tax rebate by monetization, the design of MFP specific tax structure will likely be highly politicized and contentious.

Unanswered questions following MFP

Since the central bank is the lender of last resort to the state it is reasonable to ask what is the capital position of the central bank, how liquid and solvent is the central bank.

What is the balance sheet of the country? What are its assets and liabilities? Is it well defined?

What happens if the central bank’s accounts were consolidated into the country’s balance sheet?

Last Updated on Wednesday, 27 July 2016 01:59
Final Act For Falling Bond Yields and Interest Rates? QE + Fiscal Policy. Helicopter Moiney. PDF Print E-mail
Written by Burnham Banks   
Monday, 18 July 2016 01:58

We have seen how effective QE can be. Not very. Not for Main Street at least. For Wall Street, QE has depressed bond yields and helped to camouflage the overvaluation of paper assets supporting them at inefficient levels for too long. More than that, the effectiveness of QE is wearing out like an over prescribed antibiotic. Now the global economy is still growing, not fast, but still growing. The US economy is in rude health. But the progression of inequality coupled with paltry growth means that the mass of the population is actually experiencing falling standards of living, even as aggregate data show improvement.

Lately, the talk of helicopter money has been gaining volume. The practical deployment of helicopter money is fiscal deficit spending funded not by tax but by debt monetization, in other words, QE. So far QE has been less effective probably because it was an attempt to clap with one hand. At last, this failure may be addressed. This may solve some issues and get the economy growing faster, hopefully to compensate for the rising inequality so that the masses may be raised out of their financial stagnation. However, there are a few minor side effects. The national debt will gro. Fiscal policy funded by tax is neutral and ineffective. Deficits will have to be increased. QE will have to continue. Just because it had limited impact in the absence of fiscal policy doesn’t mean we can stop now. Private investors have been happy to join their central banks in funding their governments, but only because there was some semblance of fiscal responsibility. Abandoning fiscal responsibility might result in an investor revolt meaning a backstop financier has to be found. Enter, again, the central banks. Bond yields may rise. Loose money sinks interest rates but loose budgets raises them. The loss of private investment demand will likely put a floor under interest rates. Central banks will have to be careful to not allow financing costs to rise too quickly increasing debt service for the government and for corporates. Bond yields are likely to stop falling, how quickly they will rise depends on the determination for further QE and the risk of investor revolt. Given how indebted countries are to begin with, central banks will likely be very careful to cap debt service for their masters.

Helicopters are usually the sign of a last ditch attempt. Hopefully this is not the case here.

Last Updated on Monday, 18 July 2016 02:00
How To Encourage Electric Vehicle Proliferation PDF Print E-mail
Written by Burnham Banks   
Thursday, 14 July 2016 05:35

Electric vehicles need a little help. It’s no use each manufacturer pursuing their own thing. For EVs to really take off what is needed is agreement on standards.

  1. Batteries should be standardized or at least modularized.

  2. Charging takes too long. Battery swapping is better than car charging.

  3. Batteries should be modular so that more power can be added simply by adding more batteries.

  4. Replace petrol stations and charging points with battery points. Battery dispensers provide battery exchanges so depleted batteries can be swapped for fully charged batteries for a fee.

  5. Battery dispensers take up little space and can be ubiquitous and distributed.

  6. Returned depleted batteries are charged and recirculated.

  7. Cars can choose if they wish to run with one battery or two or several depending on their needs. Cars can be designed with varying maximum battery capacities.

Last Updated on Thursday, 14 July 2016 05:42
Central Banks Long Term Systemic Risk. More Harm Than Good? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 12 July 2016 05:03

Central Banks. Long Term Systemic Risk.

The history of central banks is interesting. The world’s first was Sweden’s Riksbank, the phoenix rising from the ashes of Stockholms Banco, a private concern which leveraged itself into insolvency. The second was the Bank of England, technically, an off-sovereign balance sheet funding vehicle created expressly to monetize debt which no private investor would underwrite, the national debt of the UK. The US Federal Reserve system is in fact the 3rd incarnation of central bank in the US, the first two having passed amid turbulent times, stock market and banking crises and periodic recessions. It seems that central banks were born as a fix to situations of acute economic and financial stress. Their appropriateness under non-stress conditions, and indeed their contribution to subsequent stress situations should be questioned.

Should central banks be targeting inflation and growth in the first place?

Given the natural endowments of land, labour, capital and knowledge in an economy, and given the organizational structure of that economy, there exists a natural potential growth rate. Unfortunately it is not possible to estimate with any accuracy what that growth rate is. Central banks, where they do attempt to encourage growth, work towards an implicit or explicit target growth rate, which is this unobservable potential growth rate. Given that it is unobservable and that estimates are unreliable, the probability that policy is appropriately calibrated is low.

Most central banks pursue an objective of price stability, and some have explicit inflation targets. The appropriate or desired level of inflation is not well defined. Instead, central banks seem to be advised by past traumatic experiences of inflation which tend to be the result of loss of confidence or patently ill-advised policy, rather than naturally overheating economies. Likewise, current wisdom about deflation is colored by the Japanese experience of the last quarter of a century. Inflation is an aggregate measure prone to errors in specification. Is deflation due to deficient demand or to innovation and productivity? Is inflation due to real economic constraints or to monetary and financial factors? It is impossible to resolve these questions within a single measure. Inflation targeting is complicated and confounded by these issues.

Is active monetary policy useful?

The economy is a dynamic system which is the amalgamation of multiple dynamic markets. Even if it was possible to resolve monetary policy for a single market, and I argue that we cannot, it is difficult to resolve monetary policy across this aggregation of markets. Input and output markets may lead and lag each other with significant phase differences. Which market should policy be aimed at?

Each market is dynamic and dynamic systems confound policy. The complexity of the economy is such that central banks can only guess at how they work. Without a comprehensive knowledge of the inner workings of the economy, monetary policy is vulnerable to mistakes. In a static system with stochastic parameters, policy has unpredictable results. In a dynamic system with stochastic parameters, policy is even more unpredictable. A dynamic system can be characterised as having a certain quantity of energy within it. Policy, whether in the short term it is countercyclical or not, adds energy to the system, while the longer term counter or pro cyclicality of the policy is unknown. The energy is not dissipated but is accumulated and can manifest itself pro-cyclically in the future.

One topical example of how a dynamic system confounds policy is the concept of moral hazard. Each time a financial crisis occurs, the threat of contagion and recession prompts central banks to cut interest rates, or more recently, to ease counter-cyclical prudential regulation. The asymmetrical reaction to losses and falling asset prices increases the risk taking culture in the economy, not diminishes it.

Is current regulation effective?

In an effort to prevent a repeat performance of 2008/2009 where taxpayers had to rescue an overleveraged, overly risked banking system, central banks and regulators have required banks to hold more capital and to restructure their capital structures to be more robust for the protection of taxpayers and depositors. In many ways, bankruptcy codes in the developed world are sufficiently defined to deal with bank insolvencies. However, the political implications of bailing in deposits necessitated a different approach. In some way, shape or form, it was necessary to subordinate senior unsecured claims to deposits. To further protect depositors and taxpayers, banks have been required to raise more capital in the form of equity and contingent capital. There has been less pressure to realize losses and correctly classify non-performing assets. The speed of rehabilitation has varied from country to country.

Regulation of a fractional reserve banking system has always been a balance between efficiency and stability. Following a crisis, it is fully expected that regulation should lean towards stability. More capital and a clarification of the capital structure of banks is a sensible route to greater stability. The price of this stability, however, is efficiency. At a time when central banks are trying to spur growth and credit creation, this leads to contradictory signals to banks. On the one hand they are required to be more conservative, and on the other they are encouraged to lend.

One example of this dilemma is the 2011 ECB LTROs which were used by the commercial banks not to make new loans to the private sector but which encouraged banks to buy low capital consuming national sovereign debt. Subsequent LTROs were aimed at spurring private sector lending and carried conditions encouraging this. These LTROs have tended to be much less enthusiastically received given the capital requirements.

One side effect of the new Basel III capital rules has been a significant reduction in bond market liquidity as banks reduced inventory now deemed too expensive to hold. At the same time, central bank policy depressed interest rates encouraged businesses with access to bond markets to greatly increase issuance, and thus balance sheet leverage. By depressing short term interest rates, central banks have been successful in encouraging investors to assume more risk and lower yields to meet the supply of debt issuance. Retail mutual funds and ETFs have been an important channel for matching demand and supply of bonds.

As is often the case, regulation in one area forces capital elsewhere. In this case, the shadow banking system, the debt capital markets, have replaced the banks as a repository of wealth. Risk has been redistributed and not diminished.

Are current debt levels a significant risk?

Debt financing for non-investment purposes, such as for consumption and purchase of primary residence is not productive. This is not to say that it is not a good thing. Non investment debt allows consumers to temporally redistribute their consumption. A successful consumption strategy requires that the consumer is able to fund the debt, and to repay it when it comes due, at which time current consumption must fall. Since the financial crisis of 2008, households have reduced debt levels and debt service has fallen as interest rates have fallen. Households may one day increase leverage once again, however, they may be more circumspect in the next cycle while lenders will also face tighter capital constraints.

Assumption of debt for investment purposes is a legitimate use. In this case it is important that the investment generates sufficient return to repay the interest and the principal. The interest rate is not only a cost but an important hurdle rate to investment. The higher the interest rate, the higher the hurdle rate, and the more selective the capital allocation decision needs to be. Artificially low interest rates therefore encourage overinvestment, overcapacity, disinflation, and misallocation of capital.

Government debt has grown substantially since the global financial crisis of 2008. As interest rates and bond yields fell over a three decade period, governments have found increasing debt levels easier to service and thus issued more debt. In the wake of the 2008 crisis, bailouts of the banking sector by governments led to a surge in public debt levels. In the US the federal public debt as a percentage of GDP has risen from 30% in the early 1980s to 65% in 2007 and then to 105% in 2016. External demand from international reserves of USD funded by trade deficits, low capital requirements for financial institutions, a savings glut, asymmetrical interest rate policy responses to recessions and market volatility, benign inflation and most latterly, QE, have kept debt service declining and allowed governments to continually roll over, refinance, and increase their borrowing over these three decades.

As long as governments and corporates can continue to refinance cheaply, current debt levels are a risk unlikely to materialize. Threats to this dynamic include loss of foreign demand in the case of deficit countries, inability of current holders to maintain positions, rising inflation, or a loss of confidence for whatever reason. Slower moving phenomena may get us to any of these points such as slow growth leading to political or social instability, slow growth leading to poorer cash flow and inability to pay down debt, and ill-advised policy leading to runs on currencies.

Given the current balance of risks it is unlikely that any central bank would intentionally raise interest rates significantly under the best of circumstances. Under the current uncertainty, the prospect of raising interest rates is low barring a currency crisis (and hence defense), or runaway inflation, (usually a case of loss of confidence.) The most significant realistic risk is therefore a crisis of confidence leading to currency stress and a loss of internal and external purchasing power.

Market pricing.

Asset prices have been artificially inflated due to central bank intervention. Assets are valued on a relative, not absolute basis. Equity and bond valuations which may look high in isolation look reasonable when compared to sovereign yields. Low discount rates also inflate discounted cash flows leading to higher valuation multiples and higher prices. The response of central banks to any market distress also encourages excessive risk taking which artificially supports markets. The corollary of this is that all types of asset prices have become highly dependent on sovereign term structures. Correlations between assets have risen due to dependence on a proxy asset, sovereign bonds.

With central bank intervention suppressing volatility, the observed market price of risk is depressed. It is unsurprising that there should be an excess demand for risk and an over accumulation of the stock of risk. The difference between the efficient market price of risk and the current market price of risk is unobservable, however, a protracted suppression of market risk is itself a risky strategy. Eventual price discovery may be turbulent and disruptive. It may also be difficult to reduce the intervention since the amount of risk has risen under the regime.

Negative interest rates have become common. France, Germany, Japan, Switzerland, Netherlands and Sweden have negative 5 year bond yields. Intended to spur credit circulation negative interest rates are threatening the profitability and solvency of the banks and insurance industry not to mention pensions. Assets returns are reduced while liabilities are amplified. In extreme cases, negative interest rates can lead to a reduced money supply, some insurers have begun to hoard physical cash in vaults, and can perversely push up the cost of credit. Negative interest rates are an unnatural state and price of money. Again, if the price of money is suppressed, it will theoretically be under supplied and over demanded. The fact that it is under demanded is partly an ominous sign, and partly the result of monetary policy and banking regulation being at odds.

Practical matters:

- Central banks should not blindly target inflation and growth since they don’t know what long term potential inflation and growth rates are. They should instead target full labour employment, if they are to do anything at all.

- Central banks should arguably not even attempt monetary policy since the results are highly uncertain at best. Market solutions should be sought. Central banks should retain a regulatory role.

- Regulation is moving in the right direction but should avoid political influence. Retail money should be well protected but there is no substitute for educating the investing public and providing them the flexibility to choose.

- Regulation of the shadow banking system should be light touch and focused on transparency rather than limited access.

- There is too much debt. It is not a problem now because low interest rates have kept debt service in check but the global economy cannot tolerate higher interest rates.

- Central banks are keeping interest rates too low for too long. They will find it hard to raise rates because they do not know how markets will react or if the economy can refinance itself otherwise.

- Negative interest rates are unnatural and will denude the pension, bank and insurance industries. Rates can not only not be cut further but cannot be sustained at current negative levels for too long.




Last Updated on Tuesday, 12 July 2016 05:06
Asset Allocation To Active Managers PDF Print E-mail
Written by Burnham Banks   
Thursday, 16 June 2016 00:29

Asset Allocation to Active Managers.






Last Updated on Thursday, 16 June 2016 00:30
Brexit. Inaccurate Polls. Long Term Consequences. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 14 June 2016 00:26

The latest Yougov poll on the EU referendum has the 42% voting to Remain, 43% voting to Leave and 11% undecided. The result in any case will be unpredictable because the voting intentions are not driven by commercial interests but by political, social and emotional ones, and the material consequences of leaving the EU are to a great extent, unknown. Bookmakers odds paint a different picture with odds of exit at mid-30s percent. One explanation is that the polls reflect what people want to do, whereas the odds reflect what people realistically intend to do. Opinion polls have become more inconsistent as negative voting has become prevalent. If this thesis is true then the UK will vote to remain in the EU.

Depending on how acute the fear of Brexit becomes before June 23 and the extent of damage in the markets and sterling, the rebound could be significant. The bond markets have been fairly resilient even controlling for the compensating impact of duration. Last week, Euro investment grade outperformed euro sovereigns although investment grade did also outperform high yield. The commencement of the ECB’s corporate securities purchase program had some impact on the euro IG market. The euro leveraged loan market lagged with a flat performance. As we approach June 23, don’t expect credit markets to remain resolute. They will likely also experience volatility.

Notwithstanding the bookmakers’ odds favoring Remain, the situation is very volatile and a geopolitical or security event could easily overturn the odds in an instant. Even without an event, the words and actions of the players in the theatre could spark market volatility as well.

The consequences of Brexit are difficult to quantify. The UK is the EU’s single largest destination for exports representing 17% of the total while the EU accounts for 45% of UK exports. The UK runs a goods trade deficit (-66 billion GBP) against the EU but a trade surplus (+10 billion GBP) in services. For both sides, the rationale for a trade agreement is therefore strong, however, a liberal agreement on services may be more difficult to obtain. The impact on sovereignty will depend on the UK’s intentions regarding maintaining trade access and could involve retaining compliance with the majority of EU legislation while losing the ability to influence its formulation. Trade access would also mean continuing to contribute to the EU budget. Broadly, the UK can leave the EU for reasons of budget contributions, sovereignty, immigration and benefits arbitrage, but it would have to forego trade access. To obtain trade access it would have to reinstate contributions to the budget, compliance with EU legislation, open its borders and provide access to benefits. This would be analogous to a switch from a contractual telephony plan to a pay-as-you-go plan. Complete replication will neither be desired nor achievable. The EU will want to discourage other members of the EU from leaving and would have to impose costs upon the UK to set an example.

Any analysis will be inadequate because only the instantaneous effects are the least bit predictable. The impact on sovereignty, trade, immigration and politics will vary as each agent’s behavior evolves in reaction to the actions of other agents. In the best case, one could hope that the UK economy is sufficiently flexible that the new degrees of freedom are used wisely and growth is enhanced. In a more sober scenario, the event of Brexit is a Y2K event, a non-event, where an omnibus relationship is replaced with a series of specific ones which largely replicate the pre Brexit status quo. In the worst case, the UK either cannot or will not negotiate to reinstate trade access and goes down the path of trade war to the detriment of both the UK and the EU. Given the already fragile economic condition of Europe, this is a scenario they can ill afford and the region plunges into a protracted recession. In a scenario which is hard to classify as good or bad, the UK example emboldens other members to leave the EU which ultimately threatens the Eurozone and the single currency is abandoned.

The reaction functions of players in this game are non-linear. But the range of our vision allows us only to extrapolate.

It is unlikely that the UK will vote to leave the European Union.

If it does, the consequences will be short term instability and long term gain on both sides simply based on the adaptability and resourcefulness of humans.

Last Updated on Wednesday, 15 June 2016 08:06
US Labour Market. The long and short view. What the weak May Non Farm Payroll numbers mean. PDF Print E-mail
Written by Burnham Banks   
Monday, 06 June 2016 22:35

Below are a series of pictures depicting the US labor market. We highlight a number of points.

  1. The weak payroll numbers in May are significant in that

    1. they were well below even the lower bound estimates,

    2. prior month numbers were revised down significantly,

    3. temporary non-farm payrolls were also below estimates,

    4. there were no special mitigating factors

  1. Average hourly earnings and quits rates remain in an uptrend indicating a tight labour market.

  2. Falling participation rates can be explained by factors other than economic growth such as increased school and post graduate enrolment and the better health of new cohorts in the over 55 segment. We do not see falling participation as evidence of a weak economy.

  1. While the non-manufacturing PMI has weakened recently it remains above 50 (52.9) and the manufacturing PMI has turned over 50 in the last 3 months. Recession risk is low.

  2. We conclude that the labour market is at an inflexion point and is failing to adjust quickly enough to the evolving economy and that the May number is not a sign of a weak economy.

  3. The Fed is likely to look beyond the weak May data in their assessment of the economy. We maintain our outlook for a July rate hike. Our initial thesis for not expecting June was based not on the economy but rather the UK EU referendum due Jun 23, just 1 week after the Jun 15 FOMC.

With the exception of the 1990s, whenever labor productivity fell, unemployment fell. This is consistent with a model where labor’s share of output increases to compensate from lower labor productivity when technology could not pick up the slack. The 1990s was the era of the PC and internet which led to higher productivity even as unemployment fell.

The fall in labour participation is not a post 2008 phenomenon, it is a post 2000 phenomenon. The largest falls have been in the 16-19 year segment, presumable due to higher school enrolment. Post 2008, we have also seen declines in the 20-24 year segment with smaller declines in the 25-54 year segment. The falloff in the 20-24 year segment could be due to increased enrolment in post graduate education which was particularly popular in the post dotcom bust years. The 55+ segment has seen participation increase, presumably due to healthier populations. The trend of falling participation rates can therefore be explained mainly by demographic and non-economic factors ruling out the hypothesis of a weak economy.

The latest non-farm payroll numbers were quite poor, at 38K they fell below the lowest professional estimate of 90K and far below the average 160K. Taken as a percentage of the total labor force the number does not look better.

Two areas of strength, albeit not too much of it. One is the quits rate which is steadily climbing, although it has yet to reclaim the levels pre 2008. Quits rates are consistent with a tight labour market. Second is average hourly earnings which continues to recover. It also has yet to reclaim pre 2008.


Charts data source: Bloomberg and BLS

Last Updated on Wednesday, 08 June 2016 03:44
Quantitative Easing Explained. And Anti Social Economics. PDF Print E-mail
Written by Burnham Banks   
Friday, 27 May 2016 00:40

Every so often the free market fails to sort itself out and the economy grows more slowly than it should, according to the economists, bankers and investors. Measures need to be taken to spur economic growth so that it can run at its potential again. Having lowered interest rates to zero or close to zero with less than spectacular results on economic growth, central banks turned to unconventional monetary policy, also known as quantitative easing. Purists define QE as the expansion of the central bank’s balance sheet through the purchase of assets funded by, well, funded by the creation of money, a talent and right exclusive to central banks. Basically, governments borrow by issuing bonds, which to a point private investors become leery off due to the usually parlous state of the finances of governments wont to engage in such innovative practices. At this point the country’s central bank buys these bonds thus lending to its own government. The government. Fine distinctions have been made about whether central banks are lending to their own governments, which is seen rightly as debt monetization, and buying bonds in the secondary market from private investors thus injecting money into the economy which it is hoped will circulate and stimulate demand. The reality is that the private investors holding government bonds are hardly borrowing from the central bank by selling them their bonds, and experience has shown that the money thus injected gets saved or hoarded somewhere, usually back on the said central bank’s balance sheet. The velocity of money falls almost precisely to compensate for the liquidity injection and demand and output hardly budge. There is a physical analogy in all this.

Now that 8 years of QE have failed to produce the spectacular recoveries in economic growth expected, governments are beginning to toy with the idea of fiscal easing. The problem with fiscal easing is that it involves a government spending to boost the economy, in effect replacing private demand with government demand. Monetary easing it was hoped, would spur demand by placing money in the hands of businesses and households in the hope that it would spur demand but it’s easier to lead a horse to water than to make it drink. Fiscal easing is a bit like leading your horse to water and then leading by example and taking great swigs yourself. There is no guarantee that the horse will drink. A case in point is Japan which has engaged in QE and fiscal easing and seem its national debt surge to 2.5X annual output. At the current G7 meeting in Japan you can sense the government once again tilting towards fiscal easing. In April 2017 there is a scheduled sales tax hike. The options before the government are to scrap the tax hike or to go ahead with it and sterilize it with a big fiscal package. There is a physical analogy in all this.