The last 30 years have been defined by falling interest rates across the USD curve. Since Volcker defeated inflation in the early 1980’s short term rates and long bond yields have tracked lower and lower. Inflation has similarly been trapped in the 3% to 5% range as Greenspan was celebrated for creating a Goldilocks economy, in reference to porridge that was neither too hot nor too cold. Since 1980, the US current account has also trended down into severe deficit until late 2006. During this time, the trade weighted USD has weakened by roughly 50%.

The ability of the US to maintain robust economic growth with low inflation and falling interest rates may be attributed to their outsourcing their manufacturing capacity abroad whether it was to China, Mexico or Japan. The policy would involve exporting US intellectual property and technology to less developed and emerging economies where labour was cheap and diminishing returns were not yet acute. US consumers then imported finished product while exporting USD. The efficacy of this approach would be evidenced by an accumulating balance of trade and current account deficit and a weak USD. The balancing of the current account took the form of a sort of vendor financing in the form of foreign central banks recycling surplus USD by buying US treasuries, keeping USD interest rates low and the US consumer accustomed or addicted to cheap credit. US household’s savings rate has steadily declined from 12% in 1981 to 1% in 2005. Inevitably the savings rate has rebounded to around 4.5% today and it appears will need to improve further due to the confluence of a dearth of easy credit, excessive debt levels and impaired collateral prices (read housing prices).

Reversing these imbalances will result in a higher rate of inflation at each level of economic growth as cheap production is less available. Inflation expectations are likely to put upward pressure on long term interest rates.

A shortage of USD internationally will also put upward pressure on rates.

This is independent of the parlous state of government finances. Taking additional account of the fact that US treasuries are effectively PIKs, that total public plus private debt levels (if one includes entitlements) are at some 7 times nominal annual GDP, and the rise of the RMB as a potential additional reserve currency, and the risk of higher interest rates suddenly becomes quite material.

How will the world cope with rising USD interest rates and falling bond prices?

• Interest rates around the world are likely to rise in sympathy since the USD is the de facto reference risk free currency.

• Leveraged trades and businesses will suffer. Banks may face some interesting balance sheet issues. Carry trades will become more viable as curves steepen, although existing positions will face mark to market impact.

• Real estate which is typically highly leveraged will see higher cap rates. In the residential sector, affordability will be affected adversely. Note that many Asian countries are significantly exposed to adjustable rate mortgages. These countries’ banks may suffer losses and rising provisions.

• Generally, rising rates are likely to encourage higher savings rates and lower marginal propensities to consume.

• On the positive side, investments will face a higher hurdle rate and there will be less frivolous investment.

• Equity market valuations which are currently highly attractive will seem less so in a higher interest rate environment. The (negative) correlation between interest rates and equity markets is remarkable and rather ominous. See the chart below. During the 1960s and 1970s the S&P 500 traded in a band as interest rates rose to combat inflation. While an acutely high inflation scenario is not as likely inflation can be expected to be more elevated and rates higher than currently prevailing.

• The search for yield. The past 3 decades has seen an insatiable thirst for yield that has depressed yields across asset classes and increased yield asset valuations. While on the one hand this has created a problem for pensions seeking to match liabilities, and driven investors into some questionable investments like AAA ABS tranche securities, the dynamics of a rising yield environment are interesting and not so easy to pin down. New investments will see higher yields but current ones, particularly longer duration assets will face markdowns through lower capitalized valuations.

The above observations are associated with high and rising interest rates. The scenarios we have looked at only consider rising interest rates. They could take some time to get sufficiently high for some of these themes to take hold.

Look for a moment at the deal struck between the US and China in the past decade. China has effectively agreed to hand over a thousand pairs of cotton underwear in exchange for an iPad 6 somewhere down the line.

 Unfortunately, somewhere along the line, those thousand pairs of cotton underwear came to be worth a paltry half an iPad 6. The USD, that generally accepted accounting currency came to be not quite so generally accepted.

A whole bunch of shopping vouchers issued by the US treasury had been debased.

In the past decade, or more, the US had managed to keep economic growth humming at low inflation rates because the US was able to outsource its manufacturing to China. China as a willing accomplice was happy to provide vendor financing via the PBOC which bought US treasuries with its surplus USDs.

This trade dynamic was happily tolerated by all as it fueled China’s growth and investment and accumulation of intellectual property. (Yes, mostly others’). The US was happy to live on credit as long as interest rates were low and collateral prices (read home prices) were rising. A key performance indicator of this policy was a rising current account and trade deficit which confirmed both hopes and fears.

This has come to an end. Negative savings rates in the US are no longer viable and therefore will rise. The trade deficit that the US runs with China and the rest of the world will shrink perhaps into the black.

A country that imports stuff, exports its currency. As the export of USD slows and contracts, the pressure will be on the USD to rise. The pressure on USD interest rates will also be to rise.

A decade of negative savings and wholesale export of USD has led to a weak USD. Yet no one has accused the US of being a currency manipulator. The weak USD has now resulted in pretty advantageous terms of trade. Also, US companies remain the strongest holders of patents, owner of trademarks and brands and holders of intellectual property.

The world has always had strong demand for US brands. For a long time these brands were made outside the US. This trend is reversing.

US exports have therefore rebounded and are likely to be the driver of growth going forward.

A country that exports stuff, imports currency. As the import of USD accelerates the pressure will be on the USD to rise. The pressure on USD interest rates will also be to rise.

The US policy of badgering the Chinese to let the CNY strengthen is not reasonable. If the Chinese float the CNY, the Americans may be in for a surprise.

Mario Draghi has been a genius. And I am sure he realizes that all he has done is bought the politicians more time to sort out the fundamental issues surrounding the Eurozone crisis. In the first 3 year LTRO 489  billion EUR was allotted. In this, the second, 529 billion EUR has been allotted, apparently to a great many banks, some 800 of them.

I have written at length about the effects of the first LTRO.  It recapitalizes the banks out of retained profits from their carry trades, it separates and realigns national debt by country thus reducing external debt, it encourages the banks to become the ECB’s proxies in monetizing sovereign debt thus it keeps rates low and allows sovereigns to refinance at reasonable rates. This we already know. The market reaction then was relief and thus a rally in risky assets, particularly the banks, the Euro, irrationally yet understandably, and just about anything you could shake a bid offer spread at.

What it doesn’t do is fix fundamentally inefficient economies. It just allows these economies to refinance themselves, essentially in the continuing issue of PIKs, in de facto voluntary exchanges. This can now go on until at some point when questions are asked of the fundamental soundness of the Eurozone’s member countries’ fiscal viability.

It is a risky strategy for the ECB. They are now accepting practically any collateral, subject to haircuts. One of the world’s largest and most important central banks has become a pawn shop; one charging a paltry 1% to its deadbeat debtors. If the politicians and bureaucrats do not keep up their end of the bargain in executing some fundamental reform, some of this collateral may default. Quite what the consequences are of such a default, I have not yet considered carefully. Presumably, the ECB will require further collateral to be posted. This would impair the balance sheets of the banks further and at a time when their assets, which are presumably similar to the collateral they have posted already with the ECB, are being further marked down, in what would effectively be an ECB enforced cram-down.

The first 3 year LTRO caught everyone by surprise and its implications for simply addressing money market liquidity and banking system stress was clear. Therefore risky assets rose.

This second 3 year discount window operation is less predictable. Why? People were expecting it and had sufficient time to confuse themselves. Markets have already recovered. If the first one worked a treat, why did 800 banks queue at the window hats in hand with their bric-a-brac? Was a big number good? Was a small number good? (The market was expecting 500 – 1000 billion EUR, they got 529 billlion.) What will these banks do with the money? This is the trillion EUR question. What could the banks possibly do with the money?

1. Well lets see. If they deposit it with the ECB this is a clear sign of problems in the banking system beyond the current expectations of man and regulator. This would be a negative carry position since they would pay 1% and collect 25 basis points. This is a clear danger sign.
2. They could lend it out to the private sector. Yeah right. Any economist expecting this should be given an umbrella, a colorful tie and made to predict the weather on national TV. They would have better luck. Basel 3 pretty much ensures that no self-serving, error-fearing, creatively challenged bank CFO or CEO would ever do that.
3. Lend it to your sovereign. That’s what they did before and look where it got them. Yet this is capital efficient, most sovereigns, even downgraded ones still issue securities that attract no capital encumbrances under Basel 3. Which really is an indictment of Basel 3 and not the hapless banks. It’s the carry trade all over again. And its doubling down. If the sovereign folds, its all over anyway. But there is an advantage as well. If the Euro breaks, at least assets and liabilities will be denominated in the same sea-shells and lollipops.
4. You could give it to the prop desk to try their luck at the tables, but wait, the Volcker Rule says this is a very very naughty thing to do and by the way the traders have all fled and joined or set up their own hedge funds. 
5.  Or, you could invest it in hedge funds and private equity. But Basel 3 says that that too is very very naughty and as a result you’d have to provide a lump of capital equal to 4 times the investmen
   t in said hedge funds. You might make some money but there is that hefty capital charge. But wait, there is one hedge fund you could invest with which bears a zero capital charge. And which one is that? Why the ECB of course, but that trade will earn you, let see, 0.25% – 1.00% = -0.75%. Its cheaper than paying XYZ Capital Partners 2 and 20 in fees, and it does guarantee you a return. A guaranteed loss of 0.75%.

The 22 Feb MRO allocation came in at 166 billion EUR, 23 billion EUR more than the 15 Feb MRO of 143 billion EUR. All is not lost for those expecting another outsized allocation for the upcoming 3 year LTRO on 29 Feb. But interpreting a small or large number is not straightforward.

The size of the 3 year LTRO will not be known or estimable until the eleventh our, literally the day before. In the 22 Dec 3 year LTRO, 292 billion of MRO stood ready to rollover into the LTRO, then, a day before, a further 142 billion was allocated for the overnight repo. The next day, a full 489 billion EUR was allocated.

We will have to wait till a day or two before the settlement date to gauge the size of the 29 Feb LTRO. The implications will be interesting to say the least.

The first 3 year repo took away the stress in the banking industry and the LIBOR market, leading to a sharp relief rally in European bank stocks and risk assets in general. It was a relief rally in the true sense of the word since there was no direct link between the money thus created and the risk assets that rallied. What can we expect of the upcoming LTRO.

The market expects a big number, several surveys indicate an allocation circa 600 billion EUR. Anecdotal and ad hoc guesstimates offered by soothsayers and witchdoctors have ranged as far as 1 to 2 trillion EUR. We may yet get a large number, but we are certainly not seeing the momentum in the MRO rollovers to expect a particularly big number. The proceeds of the previous loans stew in ECB cash deposits earning 0.25% while the loans themselves cost 1%. Its not very good business. So far this warchest has only been deployed in peripheral Europe’s sovereign bond auctions, surely a case of doubling down into a precarious carry trade. The German banks have eschewed borrowing at the LTRO arguing that they do not need to (although some of them actually do) and that the stigma of doing so might actually hurt their karma.

A big allocation at the next 3 year repo may actually be a bad thing. But I would still expect the reaction to be positive for stocks as traders routinely misinterpret the facts. More morphine does not a healthy patient indicate. Besides, how would the loans be deployed. Demand for credit is slow, Basel 3 is unfriendly, buying more sovereign bonds only ties the banks more closely to their sovereigns, and leaving it at the ECB for pure liquidity reason is uneconomic. Yet one can safely bet that a big number will likely lift bank stocks and indeed the Euro, a clear loser in this stratagem of debt monetization by stealth.

What about a small number? This would be a sign of strength, that the first LTRO was successful and that no further large scale money printing was necessary. Unfortunately, it is necessary. Yet we may not get the large number we seek. If the banks believe that the 3 year repo has become recurrent and routine, it may not need to hoard liquidity. As always, it pays to bet on a behavioral basis. Myriad recreational traders will likely sell the market if the LTRO is small. And the Euro is likely to fall.

I may not get my predictions about the markets right, but I would always bet on my understanding of human behaviour. This is how we are.

The US economy consolidates its economic recovery while Europe slips into recession. China eases as its economy cools and the rest of the BRICs begin to loosen policy to bolster slowing growth. Amid this landscape, equity markets and other risky assets have rallied. The surge has been concentrated in the BRICs and in the cyclical and previously distressed corners of the global economy such as banking and consumer discretionary companies, especially luxuries. Defensive companies with stable and predictable cash flows have lagged.

The LTRO of the ECB, surely a sign of the weakness of the European banking system and clearly dilutive of the Euro have sent both European bank shares and the Euro surging. If one understands the psyche of the investor, more, of humans, this is to be expected and was envisaged in my article of mid December 2011 when the ECB had just cut its refinancing rate by 50 bps and announced its 3 year repo. It was as if the ECB provided a massive dose of morphine and suddenly the corpse sat bolt upright, and people thought this was a good thing.

I have never purported to be better at forecasting or predicting the future prospects of markets than the next drunk at the bar. But I always have a thesis, supported by signposts which serve as the evidence as time unfolds, and I am impatient with losses and patient with winnings. I’m probably right half of the time. That’s life. This is a bit of a warning to all who read these articles. There are times when I have stronger belief in my own expectations and times when I have less conviction.

Look at the world today. Apart from the US, the world economy is slowing, dangerously so in some areas such as Europe. Even the BRICs are slowing. The US economy’s recovery is a lagged effect from China’s voracious appetite for Keynesian fiscal railway track building. That and an out of phase inventory cycle which is likely to drive US manufacturing for another 6 months.

But the future is very much unclear. This is no way to write an investment article but it’s the truth. We often sound more confident than we are. We are so used to behaving like that, especially with other peoples’ money. But now the stakes are especially high. Investors, wrong footed by the December LTRO which they grossly underestimated in size and market impact, now expect the Feb 29 LTRO to be 2 to 3 times larger than the 489 billion EUR of the previous one. They might be disappointed and at risk of being whipsawed. I do not see the collateral accumulation in the MRO or short term 1 week repos these past weeks as I saw in the run up to the Dec 22 LTRO. The market impact if the Feb LTRO is below the expected size might be quite bad.

While the US looks to be in recovery there are always mini cycles within the longer term cycles. The colossal Federal debt is a problem for the US. At 15 trillion USD it outstrips US GDP. It is remarkable that sovereign debt has effectively become PIKs (payment in kind), a type of financing reserved for cash strapped and highly geared borrowers, which of course actually makes sense. The fiscal drag for the next decade is ominous. Somehow money has to be found to pay down existing debt and to cover medical care, pay for pensions for the aged, maintain military infrastructure, provide for unemployment insurance, fund education etc etc. All this at a time when the banking system, globally, is going through a process of restructuring existing assets as well as restructuring the standards of future credit provision.

If banks have been given a reprieve, it is not a long term solution. Now that the frailties of fractional reserve banking have been exposed, and patchwork solutions such as Basel III have been introduced, how will we get capital, money, from over here to over there? Central banks have liquefied the banking system with massive loans at artificially depressed costs in the hope that this money will find itself into the hands of enterprises and households so as to fund economic growth and consumption. Capital requirements whether under Basel or local regulations deter banks from lending to all but the highest rated borrowers, even if these borrowers turn out to be deadbeats. Healthy, cash flow generative private businesses may not find it so easy to borrow. Households may not find it so easy to refinance their mortgages, or get home equity loans or lines of credit.

If banks were meant to de-leverage their balance sheets, they certainly have a strange way of doing it. Tier One Capital Ratios are still widely seen as the metric of financial stability even as the problem assets carry a zero risk weight while healthy corporate assets carry a full 100% risk weight. With the provision of credit from the central banks, banks have chosen to shore up Tier One Capital ratios by loading up on sovereign bonds while eschewing more capital intensive corporate loans. In this way, commercial banks are co-opted into monetizing sovereign debt on behalf of their central banks. Artificially depressing interest rates and inflating asset prices are excellent strategies in debt management. The trick is in sheltering the inflationary pressures from public scrutiny. This two pronged strategy of regulation and credit extension also drives a direct substitution away from private credit provision towards quantitative easing and is a perverse example of crowding out at low interest rates.

Since 2008, China has been a major driver of global economic growth. The fortunes of Latin American and
Australian resource companies, of German equipment manufacturers, of US brands and intellectual property owning companies, of European luxury purveyors, can be traced ultimately to a credit induced, infrastructure investment binge driven spurt of economic growth from China. The restructuring of China into a more balanced consumption driven economy has been slow. The acute income inequality does not help. Until the distribution of wealth is more equitable China will remain an investment and government driven economy. The Keynesian policies have already driven up inflation and despite a slowing of top line CPI growth, food prices remain stubbornly high, confounding government efforts at reflating a slowing economy. With an upcoming change of management at the top of the Party, China’s policy makers are faced with addressing inflation, managing the massive credit creation in the shadow banking industry and keeping economic growth sufficient to absorb new entrants into the labour market. Short term considerations will likely force China into further infrastructure investment. Any ideas about investing in resources should be tempered by the massive stockpiles that the Chinese have accumulated directly and indirectly.

And then there is just the total debt including unfunded public liabilities globally. There is simply too much debt in the system. Focusing just on the US before turning one’s attention to Europe and Japan, is enough to discourage the most bullish investor. Total Federal debt is roughly 100% of GDP, that’s 15 trillion USD. Private debt is over double that. So all in we are looking at over 300% of GDP. The Federal debt needs further adjustments for social benefits and healthcare which add another 50 over billion USD to the bill. And soon we are staring at public liabilities alone of over 300% of GDP. The USA’s debt to GDP ratio stands at over 3.5X. The numbers in Japan are similarly poor. Public debt is circa 200% and while we are told that this is not a problem because it is domestically funded, it is a huge fiscal drag and an accident waiting to happen. Private debt in Japan is over 300% of GDP, down from almost 400% in the late 1980’s when Japan’s bubble burst. The impact of debt on Japan is clear to see; decades of slow growth and stagnation. And in the UK and the Eurozone, the situation is worse than in the US. The way in which GDP is measured results in debt financed expenditure being counted in the national income accounts as GDP. If then we expect that debt levels need to be reduced then we should also expect muted if not falling GDP in the future. High debt levels also encourage savings, at least in the private sector where unlimited credit growth is not viable.

To summarize these random and highly equivocal thoughts:

• The rally in risk assets is liquidity driven. Long run fundamentals remain in acutely poor condition.
• Each central bank will attempt debt monetization and stoking inflation to the extent that they can.
• Each country will try to debase their own currency in rounds of rotational devaluation.
• It is not a long term viable solution to solve a debt crisis with credit creation. This is analogous to attempting to extinguish a fire with gasoline.
• Long term debt reduction is the only viable solution not to create more booms and busts.
• The US recovery has another 3 months or so to run. Beyond that we have no visibility. It is likely to stall.
• Europe is likely to remain in recession for some time despite liquidity infusions.
• China will concentrate on local issues until the handover is complete. Political sensitivities such as food price inflation come first.
• Resource economies may benefit from further infrastructure investment by China but given the volatility of this single offtaker and current stockpiles, this is a risky bet.
• The current rally in risk assets is not expected to extend too much further. (Japan’s stimulus may drive Japanese equities a bit further.)

The long term is not so relevant from a trading perspective. And the forecasts and expectations need to be discounted with a higher level of uncertainty the farther we look out on the horizon. My gut feel is the following:

The risk surrounding over optimistic expectations over the ECB’s LTRO could hurt risk assets. I would not hold a large net position, in fact I would not hold a large gross position over the next 2 weeks. The market has swung from a heavily oversold position at the end of last year, and an acutely pessimistic view, to an unreasonably rosy view of economic growth in the BRICs and recovery in the US.

Over a slightly longer horizon, say 6 months, I expect the lack of diabolically game changing good or bad news to maintain the status quo of uncertainty, thus also maintaining the upward pressure on risk assets. Reality is likely to rear its head later in the year once equities have reached higher valuations. A US Presidential election looms, the changing of the guard in China has already begun, Europe’s political landscape may change as economic issues spill over to the political landscape. All these complicates matters. I expect weakness in ri
sk assets to set in only in the latter part of the year. In the meantime, the only viable strategy is NOT to buy and hold, but to actively trade, as much for profit as to manage exposure and risk.

At the end of the day, I too struggle in the fog of uncertainty as I try to cope with each piece of news and each new development. I wish my crystal ball was Baccarat and not Lalique.