The rescue efforts from 2008 – 2012 to bail out the global economy have resulted in a massive inflation of sovereign balance sheets almost everywhere from the US Fed, to the Bank of England, the Bank of Japan, the Peoples Bank of China, and even the ECB.

Central banks have become some of the largest buyers of their own countries’ debt issues. Holdings of US treasuries have surged not only at the US fed but by the US private commercial banks as well. Regulations such as Basel 3 encourage banks to purchase assets which do not consume capital (as assets risk weighted zero under Basel 3 are treated.) High grade sovereign bonds are risk weighted zero and even dodgy sovereign bonds face a lower risk weight than better quality SME loans. The result is a buying frenzy of government bonds.

There are two reasons a country would seek to buy its own bonds, whether directly through its central bank, or indirectly through its state pensions or private commercial banks. One is to increase the money supply in the hope of boosting nominal output growth, in the further hope of generating real output growth. Two is to compensate for any shortfall in demand for the country’s bonds, that is to act as lender of last resort to oneself.

Chart: Fed System Balance Sheet:

M.dV + dM.V = P.dQ+dP.Q is the relationship between money supply, velocity of money, inflation and real output.

Since 2008, the efforts of central banks to increase the right hand side of this equation, that is nominal output, has seen a drastic increase in the money base and the assets of the banking system. Central banks have levered their banking systems between 3 to 5 times over. Unfortunately for both real and nominal output, the velocity of money has simply compensated for the increase in the money base so that nominal output growth has been tepid. A proxy for the velocity of money is the money multiplier.

Chart: Money Multiplier:

For an economy not at full employment, the hope is that real output rises instead of prices. Apparently the global economy is not at full employment. The risk of inflation is thus low. This analysis does not take into account some psychology.

Given how widespread money printing is globally, and given the scale of the monetary expansion, consumers and investors would be reasonably expected to be concerned about how this policy can be retracted once full employment is restored. Further, given that money printing debases its value in real terms purely as a store of value, one may reasonably be concerned about the inflationary impact of protracted and continued debt monetization. In addition, at least thus far, quantitative easing has been seen as a part of expansionary monetary policy and not as debt monetization from an excess supply of debt perspective. Any loss of confidence may lead inflation expectations to rise. Even a real recovery might boost inflation expectations. In itself, inflation expectations can be benign but in the context of the scale of leverage in the banking and sovereign debt system, inflation expectations demand answers to difficult questions: how will financial system wide balance sheet leverage be reduced when full employment or inflation threatens?

The world’s economies and markets are all acutel
y dependent on low interest rates. If central banks were forced to withdraw liquidity, a way would have to be found which would keep rates suppressed, an almost contradictory condition. Selling bonds would be highly risky given the impact on interest rates. The borrowing requirements also suggest that the treasury will need to refinance itself well into the future.

The 30 year bull market in bonds, the agency issues with central bank ‘puts’, have brought us deep into a game of chicken played on a suspension bridge. Its not clear how long we can carry on, but neither can we flinch.

Given the fragile state of the global economy the resilience of risky assets is remarkable.

Year to date, the MSCI World index is up 8.0%, bonds are up 11.7%, high yield has gained 8.3%, emerging markets bonds 12.3% , emerging markets equities a paltry 3.2% and crude 7.9%.

Volatility and risk in developed markets has risen relative to emerging markets. A rational strategy therefore is to buy straddles on developed markets’ businesses while selling straddles on emerging markets’ businesses. Here we refer not to equities but to the underlying assets and cash flows of the businesses. Thus, buying a straddle would involve buying both a call and a put option on a company’s assets. This is equivalent to buying the equity stock and selling short its corresponding bond. Put together the whole trade broadly looks like: long (or overweight) developed market equities and short (or underweight) emerging market equity; long (or overweight) emerging market bonds and short (or underweight) developed market bonds.

Apart from the real options theory basis for the trade there is a more intuitive justification. Emerging markets growth rates continue to outpace develop markets (despite the current synchronized slowdown). Yet corporate governance and rule of law remain underdeveloped in emerging markets, at a protectionist and mercantilist time in global economics. It is safer to access emerging market growth through developed market companies deriving revenues from emerging markets, or through foreign listings. As Europe slumps and the US remains under very muted growth, the export heavy listed markets of the developing world are more likely to suffer. If one feels compelled to buy emerging market companies for whatever reason, the seniority of claim of bonds is a safer trade expression.

The co opting of banks in debt monetization, the fear of investors, the shackles of Basel 3, place significant constraints on the banking industry. 

Fractional reserve banking has always carried liquidity mismatches, but has managed to mitigate this by relying on some degree of inertia and asymmetrical information. Bank’s historically high ROEs were a function of leverage and the carry trade.

Today, government bond yields are low on a historical basis (even in Italy and Spain), and term structures are still flattening.

For the investor, the actions of central banks and regulators have created an acutely high liquidity risk premium. Normally, this would imply a steep term structure. Today it manifests in a flat term structure. How can this be? The liquidity in sovereign bond markets is responsible for their flat structures and low yields. Because the longer maturity bonds are tradable, they are liquid; and because they are liquid, they are sought after, hence their yield compression. Mark to market volatility remains a risk, however.

Investors seeking liquidity are now forced to take much higher risk than before since liquid assets either produce a low yield, or exhibit high volatility, or both.

Dogged demand for both liquidity and yield will drive some investors to seek equity dividends (discounting capital gains or losses), high yield bonds (discounting mark to market volatility and default), selling options (sometimes unknowingly in structured products), and whatever new products the financial industry will almost surely invent to meet this demand.

Spread between 2 and 10 year US treasuries:

What’s all this talk of QE3? The private commercial banks have been big buyers of US treasuries to the extent that they are operating QE3 on behalf of the Fed. Buying has accelerated from 63 billion usd in 2011 to 136 billion usd YTD 2012. The Fed is already the largest lender to the US treasury, ahead of the PBOC.

The BoE and BoJ are explicitly monetizing sovereign debt hand over fist. The only mega scale central bank to not engage in direct debt monetization is the only central bank without a country, the ECB. Constitutional issues impede the ECB from direct debt monetization, however, Mario Draghi has already found proxies in the private commercial banks using the LRTO. The current negotiations will likely lead to capitulation and a direct flow of capital from the ECB to sovereigns.

So every single central bank will be in easing mode with most of them monetizing local domestic debt.

The question of local or external funding of sovereign debt is only relevant at the micro level. At the global level, all debt is internally funded. Economists who point out that Japan need not worry since its debt is internally funded should not worry any further.

One question that arises is whether with excess liquidity at an extreme, inflation might become a problem. Debt monetization increases the money in circulation per unit output potentially leading to inflation. Depending on sentiment and confidence, inflation can occur even before the economy achieves full potential.

My wife just showed me her mutual fund statements and reports which she received from the manager. After 15 years, this much vaunted fund manager had generated a nominal return of… zero.

After inflation, living in Singapore, her investment wouldn’t be able to buy a bicycle let alone pay the downpayment on a retirement home in Southern Malaysia.

I also noticed that there had been a forced redemption. The manager had shut down one of their funds. Well, thanks. So after a decade of managing her money, the manager finally decided that they were not very good at it after all, and decided to hand the money back to her. “Here, you manage it,” is not really acceptable after you’ve taken a decade of fees off the investor.

Why did my wife invest in the fund? Well, she didn’t. In my earlier days, and in my folly, I decided to give her a birthday present which was not something she could carry, wear, eat or ride around in. So I bought her units in a mutual fund. Romantically, this is equivalent to shooting oneself in the temple. Twice.

I do invest in funds. I think its the smart thing to do, if you do it in a smart way. I don’t just invest in brand names. When it comes to fund managers, brand names are often asset gatherers who are better at getting your money than they are at managing it. I avoid brand names unless I can meet and interview the specific managers managing the relevant funds. Meeting and interviewing the managers is a necessary condition for me to invest with any fund. I need to assess for myself if the track record they have achieved is the product of skill or luck. I will only pay management (and or performance fees) for skill.

I invest in funds for a number of reasons.

– I can’t get the diversification I need for the amount I’d like to invest. Funds pool investors’ money into a bigger pot which can be deployed in assets which the hapless retail investor may not have the scale to access.

– I don’t have the time to dedicate to a particular strategy. I only have 24 hrs a day. I cannot engage in arbing interest rates, hedging converts, investing in mergers, trading credit correlation and structuring reg cap relief solutions all by myself.

– I may not have sufficient skill. This will most often be the case. Understanding an investment strategy and being able to execute it with the requisite skill are two different matters. If one doesn’t understand a strategy, the best advice is to not invest. It is irrational to invest in any scheme or strategy that one doesn’t understand. On the other hand, just because you understand a strategy doesn’t mean you can do it. It just means you know how its done. That’s all.

– I don’t have the scale for certain strategies. Not every day trader in his basement can obtain the necessary terms to trade the instruments that a strategy may require.

What I never do is invest in funds for silly reasons such as:

– A good track record. A good track record is never enough. One needs to understand how the track record was achieved, and if it can be repeated. One also has to know if the track record is real. Bernie Madoff had an excellent but fake track record. Yet so many clever investors invested with him.

– A clever trade. A clever trade does not a fund make. There are specialized closed ended private equity funds that take advantage of very specific opportunities but open ended mutual funds need to be based on more than a single opportunity. And I’m fine with those, in fact I think they are very interesting vehicles that are often launched to capture phenomenal opportunities. It worries me when managers launch funds to take advantage of the recovery post 2008. What happens when the trade is done? The manager is typically unwilling to return capital and will likely try their luck in another trade, one that you didn’t sign up for, one that the manager may not be experienced at. I want strategies that can last at least 7-8 yrs, because that’s how long, at least, I expect to leave my money in their hands.

– The market is running and I want exposure. If you want market returns, use an ETF, or buy the underlying instruments yourself. Funds are not cheap. You shouldn’t be using them as trading vehicles but as long term investments. If you want exposure to a particular segment of the market and no ETFs are available, using funds is a legitimate way of buying exposure. Luxury goods companies for example are not represented by an ETF and can be accessed through a fund.

– A brand name. A brand name is not a bad thing but it shouldn’t be the only thing, and the brand should add no additional comfort. Each fund must be assessed on its merits and this means due diligence. I have never given my trust freely, and I certainly don’t give it to brand names per se. Trust has to be earned, and it takes time. Brands are often good from a due diligence perspective, however, since they provide the basis for the question: how did they build a successful brand? Usually, a high quality product or service is the answer. Due diligence seeks to confirm and verify the answer. There are no assumptions in due diligence, or at least there are very few. I have very strong views about due diligence and how it is to be conducted. You have to identify the manager, meet the manager, his team, his ops, his service providers, speak to them about what they do. Cutting and pasting an AIMA DDQ into the file is a gross dereliction of duty, and something I’ve seen done even by institutional investors. It is for these types of investors that funds like Madoff were designed.

– I don’t know the strategy well and I want to outsource it to a professional. This is an excellent way to lose money. If you don’t know the strategy well, how do you know whom to outsource it to? If one doesn’t know a strategy well, the first and best course of action is to learn all about it. The second best and quite frankly lazy course of inaction is to stay away.

Investing is not easy. Whether one invests in funds or directly in securities, one is responsible for one’s own decisions. Using consultants is one way of delegating the research and due diligence but it means one has to research and perform due diligence on the consultant or intermediary.