How does one put an economy in order? An economy is like a business, but it is a lot more complex, with more stakeholders. Still, a business in distress is a good starting point to try to find a way out.  

Let’s look at a generic economy with

• Large quantity of public debt
• Slow economic growth
• A global recession and thus a sluggish external sector
• Persistent unemployment
• Shrinking private debt
• Stagnant housing market
• Independent central bank
• A non partisan government (for simplicity)
• Strong intellectual property capabilities.
• The country’s currency is the de facto global reserve currency.

What are the problems we seek to solve?

• Lower unemployment
• Raise economic growth
• Pay down public debt

Let us clarify the problem somewhat.

• Government deficits are rising as the government attempts fiscal reflation, for example through tax cuts and the limited provision of such public goods as healthcare.
• The central bank has so far been able to monetize government debt so as to keep interest rates low. The private sector has sterilized most of the monetary expansion. That said, the size of the monetary base presents a precarious position for the central bank in terms of price stability. The internal and external purchasing power of the currency may be questioned.

An initial solution:

• The government should raise as much long term debt as it can and quickly. It needs to remove all refinancing risk for the next 5 to 7 years. Once it has fixed its borrowing costs for a sufficiently long period into the future, it will no longer face the discipline of the bond market. It does not face this discipline today, but it may in future. It needs to lock in financing while it pursues unconventional fiscal policy (as opposed to unconventional monetary policy, which was required to bootstrap the unconventionally fiscal policy in the first place.)
• Operate an open door policy for business and capital. This may be unpopular and expensive at first. Expensive: It involves cutting marginal income tax rates and corporate tax. This may create a larger deficit in the short term but the tax elasticity of domicile will reverse the deficit given more time. This strategy is proven but it takes resolve as the initial finances deteriorate. Unpopular: Tax reform has to be designed to attract foreign capital and talent. This is a beggar-thy-neighbor policy which will be unpopular with trading partners and other countries as well as with incumbent residents who may see a deterioration of wealth and income equality. The current situation sees major economies competitively pushing capital and human resources away, counter to the more rational strategy of attracting capital and human resources.

A longer term solution:

• A government should only provide goods and services which the free market is unable or unwilling to provide. This defines the scope and scale of government, not political ideology. Shrink the government to fit. Ideally, taxes will be kept low. This is a mathematically sound approach but it does leave open the question about the use of taxation as a redistributive policy. We have noted before that the free market tends to increase the level of inequality in the system. This is outside the scope of this discussion.
• Address the major areas of moral hazard in the economy. Central banks and regulators should be responsible for the long term stability and sustainability of the financial system, to promote efficient allocation of resources, to promote full employment and most of all, to ensure a level playing field for all participants. Long term stability sometimes requires short term volatility to condition participants to the risks of participation. Efficient resource allocation requires minimum price distortion which will also require central banks to reexamine their role in the determination of interest rates, arguably the most important price of all.
• Economic reform in labour markets, particular industries, professions, banking and finance, public goods, etc etc are all well and good, but lets not be too ambitious. It is far from clear that we will even get to the initial solution let alone the longer term solution.
• A reexamination of the capitalist system of economics. Since the death of communism, capitalism has spiraled out of control without a nemesis or counterbalance. This economic soul searching can be pre-emptive or it can wait until a sufficient proportion of the global population is sufficiently disenfranchised by the particular distributive nature and inequality of wealth, income and opportunity of the current capitalist system.

Looking at how we have progressed thus far, some countries still have the means to refinance themselves sufficiently far into the future to employ the above strategy. Others do not. For these, the future is grim. Where countries have been given time and the benefit of the doubt by the capital markets, the time to act is decaying quickly.

The past decade has seen the emergence of the yield junkie. You recognize them from their propensity to pay and subsequently overpay for anything with the tiniest shred of yield from investment grade corporate bonds to sovereign bonds to AAA rated junk. In the past couple of years, the yield junkie has trampled on spreads and thinned out yields across investment grade and high yield bonds. The more hardened ones even buy equities for an at risk dividend payout.

There are various sources of yield. There is duration risk, which tends to be isolated in the sovereign debt of a handful of countries who remain solvent enough to repay their debts or have a sufficiently strong following that they can continually issue their payment-in-kinds until, well, until they cannot. There is credit risk, which is the element of risk over and above the risk free asset of similar duration or tenure, although the concept of a risk free asset is a bit threadbare at the moment, but let’s suspend disbelief for a moment. And why not, the central banks have suspended theirs indefinitely. Another source of yield, and now we are in the realm of Class A drugs, is option premium. Side effects include a healthy dose of negative gamma and often an even healthier dose of built in leverage. Dealers of course would suggest the application of light leverage, only because the application of heavy leverage looks too much like a lit fuse. A mercury switch is much more marketable.

As so often happens, dealers become users when they sample their own wares. Its when management samples the inventory that the wheels really threaten to come off. The largest buyers of US treasuries are private commercial banks and the Fed. The continued debt monetization operations of the central banks flatten yield curves and compress yields leading to mark to market profits for current investors. But what can investors today expect in future returns? The same question is relevant not only of treasuries but also of investment grade and even high yield corporates.

Lets try to find the new drug of choice for the yield junkie before they really get deep in it. What are the prospects for high yield? Average high yield spreads in the last 20 years have been around 590 bps. In the financial crisis, they spiked to over 1800 bps. Today, high yield has recovered to a fairly tight 615 spread to worst. How about leveraged loans? Leveraged Loans have typically traded 140 bps tight of high yield. In the financial crisis, leveraged loans traded in line with high yield, a significant underperformance. Since then they have recovered with equal abandon. However, since the financial crisis, leveraged loans now trade within 50 bps of high yield. Why is this?

The reason lies not in the properties of the asset but the nature of their buyers. The main buyers of high yield are mutual funds. (If ever there was a proxy yield junkie, the long only, index hugging mutual fund is it.) Insurance companies, bank prop desks and hedge funds used to also participate but with increased regulation (read Basel 3 and Solvency 2 which are basically trying to wean the junkie off the poison by allowing them only controlled doses supported by…. Capital), demand is a lot less frantic than before. And besides, hedge funds tend to be long and short the stuff, equally imbibing and dealing at the same time. Leveraged loans, however, were the preserve of the structured credit animal called the CLO, a specific flavour of CDO. CLO issuance has ebbed since 2008, globally, but especially acutely in Europe. As a result leverage loans are relatively unloved. Also, because of the unfortunate nomenclature of credit markets, these senior secured debt instruments have been unloved by the garden variety investor (this includes institutional investors, it’s a big garden.)

Since central banks have fiddled with sovereign balance sheets, banking system balance sheets and real economy relative prices, they have created a situation where interest rates are expected to remain low for the foreseeable and indeed unforeseeable future. Until inflation perks up, or a recovery takes hold, or someone describes the Emperor’s new clothes.

Corporate bonds, investment grade:

• Fixed rate.
• Tight as a drum.
• Implying low default rates.
• Senior unsecured.

Corporate bonds, high yield:

• Non investment grade issuers
• Senior unsecured
• Elements of equity risk
• Fixed rate
• Average spread of 615 bps 

Loans:

• Non investment grade issuers
• Senior secured – senior in claim to second lien and to senior unsecured (bonds)
• Floating rate.
• Average spread of 580 bps.

Loans are no panacea in an over QE’d world, but hopefully, given that garden variety investors will take some time to react to this asset class, yields should not collapse. Also, there is a relative value argument that is pretty compelling. With average recovery rates of 40% for high yield and 80% for loans, and average spreads of 6.1% for high yield and 5.8% for senior loans, conceptually at least, one could buy a dollar of loans and 60 cents of credit protection netting a yield of 2.14% with a loss given default of 16 cents. It is highly highly highly unlikely that you will be able to perform this little trick within the same issuer, that would be too easy. However, the arithmetic highlights the relative value opportunity between high yield and senior loans.

The above analysis is a stretch for the yield junkie but here is something they might understand. When a government is as indebted as the Western governments are, interest rates cannot remain low for long. Fixed rate bad, floating rate good. Unsecured bad, secured good. Subordinated bad, senior good.

PS

What are the chances that strategies like this will be offered in a regulated, risk managed, transparent, fund format to investors? Professional gatekeepers and experts stand in the way, and unfortunately the industry contains professionals who may lack the intellectual faculties or experience to understand strategies or matters in general outside a very tightly defined remit. Fear of the unknown, superstition, insularity, and reckless extrapolation plague certain parts of the industry. These elements limit the scope of investment opportunities to the general public to the detriment of all.

The need for political correctness is the tolerated, celebrated suppression of honesty. It conflicts with the goal of transparency. Yet today’s world seems to drift toward more political correctness, rhetoric and oratorical populism.

It is as if people have lost faith in their past heroes in the boom years and cry out for new direction only to find a gaggle of game show hosts, used car salesmen and worse, politicians, chasing their dollars, votes and adoration. This is dangerous because humans are generally weak minded and seek to be led. This encourages those who wish to lead, including those who are driven by greed, glory and ambition which may be independent of the causes of the people they seek to lead.

It is in this sweltering climate of famine, inequality and oppression that this species has elected some of our worst madmen to replace our erstwhile oppressors. Those fed us lies of prosperity through the application of credit, rising housing prices, ever falling interest rates and a persistent sense of entitlement. What will the new generation sell us? It almost seems that we cannot survive without some form of oppression.

What could Washington sell Americans still drunk on the inevitability of the success of the American Way? More QE? More credit? Rising house prices? More useful jobs certainly wouldn’t hurt.

What might Beijing sell a billion witnesses to the failure of Western Capitalism, the apparent triumph of the Chinese model, unbridled greed in the coastal cities and an inequality of wealth unmatched in the Western Democracies? Affordable housing? Lower food inflation? Greater equality? Within? Without?

And what could European leaders sell their collection of people’s shoehorned into union by a broken currency union? Closer union? Fracture? Fission?

Morality and social norms are informal rules of law which humans invent to deal with conflicts which do not yet warrant formalization in law. Morality exists for pragmatic reasons, the result of a Folk Theorem.

Humans are entirely self interested. I offer this without proof because it is patently self evident. Charity or selflessness is only the product of fear, guilt, mistaken strategy and superstition. Individually, the human being is interested in one thing and one thing alone and that is to achieve whatever they wish to achieve unimpeded. How do we pass from the self interested individual to a system of social norms or morality that governs collections of individuals? Humans interactive repeatedly, thus engaging in repeated games, and hence any grim trigger strategy will punish deviation to such an extent that cooperative behavior becomes accepted as a social norm or a form of morality.

It is useful to understand behavior with these basic axioms. The analysis can be extended to policy makers, government, individuals, economic agents, crowds and markets. These axioms do not replace the basic motivations of fear and greed. They do, however, animate these motivations.

Prior to the financial crisis of 2008, the world was driven by greed, not fear. The objectives of profit, of gain, dominated the world. Under our assumptions of human behavior, the boundaries of moral and socially accepted behavior, even lawful behavior would be tested by the most ambitious examples of humankind. The types of behavior under greed were concentrated in fraud, the inflation of one’s own abilities or achievements in order to obtain acclaim or reward. Some of this fraud has been discovered but it is almost certain than some have escaped detection, at least until another day.

The current climate is characterized by a shrinking economic pie and increasing desperation, resulting in a more contentious atmosphere, protectionism and a latent state of conflict. Fear will drive behavior and test the boundaries of social norms and morality for the foreseeable future. Our analysis of human behavior should be advised by this regime.

• Protectionism and Mercantilism including for example, competitive currency debasement.
• Martial conflict, over resources and territory for example. As a species we have matured beyond conflict over ideology and other such high principles.
• Fraud to hide weaknesses rather than advertise strengths.
• Risk of expropriation by means direct or indirect, overt or covert, including financial oppression.
• Increased risk of Class Conflict arising from wide and growing disparity of wealth, income, and opportunity.

Never write off the US consumer, particularly when the Fed is providing them with financing.

There is a recovery underway in the US, beginning in housing, but through legislation and Fed policy, expected to extend to consumption through the potential monetization of home equity.

The Fed is not only no longer the safekeeper of the punchbowl, they are spiking the brew.

Given the track record of the experts, the EUR is likely to be strong, and European yields will go to zero in the long run, supporting bonds of Eurozone members, at least the ones who are less insolvent than others. Check out Euro area competitiveness and trade balances if you think I’m crazy.

Correlation is introduced between assets by vehicles which connect them in unexpected ways. For example, US treasuries being widely used as collateral in total return swaps can correlate with swap reference assets even if they are unrelated in any other way. Think of Gold ETFs done on swap.

Yield addiction beats rationality every time.

For every yield junkie, there exists a dealer.