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.

Negative Interest Rates. Not Much To Be Positive About. PDF Print E-mail
Written by Burnham Banks   
Monday, 09 May 2016 02:37

Global economic growth has been slow and inflation has been stubbornly low despite efforts by central banks to raise them. The first round of unconventional policy involved central banks buying bonds and other assets and increasing their balance sheets. The strategy has only been moderately successful and is probably at the point of diminishing marginal returns. Therefore, an alternative unconventional policy had to be implemented: negative interest rates.

It is hoped that negative interest rates would encourage more credit creation to spur growth and inflation. What central banks would prefer markets to focus on less is the expected impact on currencies lest they are accused of waging currency trade war. Negative rates might also encourage investors further up the risk spectrum to taking more risk and reducing borrowing costs across a wider swathe of the economy.

There are a number of problems, however, with negative interest rates. First of all, it assumes that the problem stems from weak supply of credit. Low equilibrium interest rates are indicative of poor demand for credit, not deficient supply. Lowering the cost of credit is of limited impact in raising the demand for credit which depends more on the available unlevered returns in asset markets today, which looks quite meagre, as well as the prospects of paying down debt in the future. If economic prospects are poor, increasing the supply and lowering the cost of credit is unlikely to spur lending.

Negative rates are also confounded by banking regulation. Central banks and regulators have two conflicting missions for banks, make more loans and take less risk. Banking regulation highlights the fact that banks lend not out of liquidity but out of capital, and therefore the calculus for increasing the supply of credit is not entirely the cost of the bank’s credit but the cost of its capital as well. Cutting rates into negative territory helps with one part of the equation but is nullified by the other. Negative rates pay banks to borrow from central banks and to lend cheaply to borrowers. However, the type of borrowers central banks would like banks to lend to are small, medium enterprises, businesses too small to access bond markets. Unfortunately, loans to these types of borrowers consumer more capital under Basel III regulation. Banks have to apportion more capital against these loans which makes the cost of capital more relevant to the bank than cost of liquidity, which carries the negative interest rates. Cost of capital is a more comprehensive measure of how much it costs to make a loan and this is not directly addressed by simply cutting interest rates below zero.

Meanwhile, negative interest rates have some less desirable side effects. For one, it encourages cash hoarding. While individuals might be expected to engage in cash hoarding it was instructive to see Munich Re, one of Europe’s largest reinsurance companies engaging in storing physical cash in vaults. Negative interest rates could, perversely, result in a shrinking of the money supply.

Negative interest rates are damaging to the savings industry, in particular insurance and pensions. Insurance companies have long term liabilities which have to be funded. With ultra low interest rates and low asset returns, assets maturing face a lower expected return. Most insurance liabilities, however, are not benchmarked to interest rates and many have a guaranteed floor on returns. Negative rates threaten the long term solvency of the insurance industry. The same calculus applies to pensions, especially defined benefit schemes which guarantee a certain level of payouts unrelated to the returns generated by their assets.

A more insidious way that negative interest rates undermines the economy is that interest rates represent a hurdle for investments as well as a tide for the economy to swim against. A certain level of interest rates is also useful in eroding excess capacity and euthanizing unviable businesses. Human enterprise thrives on hardship to innovate and evolve. Nothing destabilizes like a tide from the rear. It is the life support that keeps inefficient businesses alive, maintains excess capacity and ultimately weakens the economy as a whole.

Central Banks And What They Can Do For Us. PDF Print E-mail
Written by Burnham Banks   
Monday, 14 March 2016 08:40


In December, the ECB extended QE from September 2016 to March 2017. Markets did not think it was sufficient, spreads between peripheral bonds and bunds widened, the EUR strengthened and equity markets sold off.

In late January the BoJ cut rates into negative territory and was rewarded with a stronger JPY and weaker equity markets, and the equivalent of a coronary in its money markets. Fortunately, not all was lost and JGBs rallied.

Last week the ECB was given a second chance to demonstrate determination and did so by cutting rates, increasing QE by 33%, including non-financial corporate IG to the shopping basket, and another dose of TLROs. Markets were skeptical at first but seem to be warming to the measures. This is the 3rd trading day after the announcement and markets are buoyant so only time will tell.

Tomorrow, the BoJ will announce its policy decisions. It is hard to see what it can do to boost markets. Evidently it can do nothing for the economy.

On Wednesday the Fed announces its decisions and publishes an update on the dot plot. The American economy is robust despite being in a shallow, temporary and controlled slowdown. On domestic data alone, a data dependent Fed would raise rates. The Fed is, however, unwilling to unnerve investors since their behavior impacts market interest rates and credit spreads and is therefore a Fed control variable. The Fed has not signaled strongly that it will act and therefore will likely delay the rate hike into the summer. Hopefully, the USD will be sufficiently weak, equities sufficiently buoyant and spreads sufficiently tight for the Fed to play catch up.

At some stage all these central banks are going to have to start thinking about what they can do for the real economy.

Last Updated on Monday, 14 March 2016 23:11
What will the ECB do March 10, 2016 PDF Print E-mail
Written by Burnham Banks   
Tuesday, 08 March 2016 07:49

The Eurozone economy has weakened in 2016 slipping into deflation with both manufacturing and services PMIs turning south in January and February. After disappointing the market in December 2015 with a mere 6 month extension of the existing QE the ECB will be expected to do more to spur demand and head off deflation.

The market will expect the following:

  1. 20 basis point rate cut to take the deposit rate to -0.5%.

  2. Additional 10 billion EUR monthly budget for bond purchases.

  3. Program extension from Mar 2017 to Sep 2017

  4. Additional TLTRO

What might not be effective:

  1. A rate cut is not likely to be effective. The problem is not willingness to lend but willingness to borrow. Banks will not be able to pass on the lower rates while incurring costs on their reserves on deposit. They might well raise interest rates to make up for the additional costs.

  2. The bond purchases are allocated according to the capital key which means 25.6% of the budget goes to German bunds, 20.1% to OATs, 17.5% to Italian bonds and 12.6% to Spanish bonds. Deflation is worst in Italy, Spain and France. Germany has zero price growth. The money is not going to where it is needed most.

  3. TLRO take up has been disappointing.

  4. Most of what the ECB can do, the market expects the ECB to do. There is no latitude for shock and awe left.

What might the ECB do to surprise the market?

  1. Moving away from the capital key and allocating the budget to the countries which need stimulus most and trying to bring rate convergence between countries’ bond yields could be more effective and would be taken positively by the market.

  2. Currently the ECB buys 8% of the budgeted bond purchases, while the National Central Banks buy a further 12% under a risk sharing program. The other 80% is not commingled and each NCB bears the default risk of their own government’s bonds. The ECB could make all purchases risk-shared. This would pull peripheral and core spreads together bringing down interest rates in Italy, Spain and Portugal.

  3. Removing limits on buying debt yielding less than the deposit rate. If the ECB cuts rates by 20 basis points, this point would be academic.

What might get in the way?

  1. On Feb 25, 2016, Jens Weidmann, President of the Bundesbank, argued that his Eurozone counterparts are putting too much emphasis on recent weak data. The Bundesbank’s own prognosis for the Eurozone economy was less gloomy. This could be a signal that the Bundesbank, the largest capital contributor to the ECB, is unwilling to do more.

  2. Draghi himself might decide that doing more of the same is not rational given that the initial program has not been effective. As long as the ECB was strenuously fighting deflation, governments would be less inclined to pursue fundamental reform.


  1. If the ECB simply meets market expectations, it is likely the market will be disappointed.

  2. The ECB has little room to surprise the market since the market is expecting a lot.

  3. Draghi may, if he so chooses, openly speculate about going off the capital key, or commingling the NCB’s risk, to present the Bundesbank a fait accompli at the Apr 21 meeting.


  1. The EUR is fundamentally weak,  recent strength being related to the risk of a disappointing ECB announcement. The EUR remains a good short, however, the degree of uncertainty surrounding the Mar 10 ECB meeting recommends moderating this exposure.

  2. Under TARGET2, countries are essentially risk-shared and as such peripheral bonds should trade tighter to German and French government bonds. Convergence trades are still rational. Again the uncertainty around the possible outcomes leads us to defer this trade until we have more visibility.

Central Banks And The Limits Of QE. Fiscal Policy In The Wings. Leaning Left. PDF Print E-mail
Written by Burnham Banks   
Friday, 19 February 2016 06:01

Beware negative interest rates. The intention of central banks imposing negative rates upon an economy is to stimulate growth. But if 10 years of falling rates have done little to stimulate demand, 7 of those at close to zero interest rates, why would negative rates encourage more demand? Taken in the extreme, negative interest rates will encourage owners of money to change the relationship with their depository institutions from one of debtor to custodian. The result would be a withdrawal of money from the money market into a custodian network. There will of course be custody expenses but these are limited and such expenses are, at least for now, beyond the influence of central banks. Negative interest rates could therefore trigger a contraction of the money supply which would maintain the zero bound in market rates of interest while liquidity would overflow out of the money markets. The provision of liquidity to the system will have become waterboarding.

The FOMC meets March 16, the ECB March 10, the BoJ March 15. Confidence in central banks is waning resulting in more volatility surrounding signals they send whether hawkish or dovish. It certainly appears that central banks have reached the limits of policy and that efforts to boost growth will have to be even more innovative, if in fact growth needs boosting. Given the dogmatic pursuit of growth apparently beyond the natural metabolic rate of the global economy, it would not be surprising if fiscal policy were engaged.

In some ways, fiscal policy will be more effective than monetary policy. For all the magnitude of QE, it only supplies credit to the economy, it does not directly increase demand. QE policies assume that there is always demand for credit, but this is clearly not the case. If governments insist on pushing the economy towards a higher target growth rate, in the absence of private demand, it may have to spend. It cannot finance this spending out of taxes as that would sterilize the fiscal expansion. Instead, government would need to run a deficit and monetize it. When economists speak about ‘helicopter cash’, this is what they mean.

There is another way, which is to tax and spend, but to do it in a tax neutral and redistributive way. Imagine a wealth tax of 100% for all wealth over 100m USD. Put aside the practicalities and politics of such a tax for a moment and see what can be done with this. By one estimate (by Boston Consulting Group), this wealth totals 10 trillion USD, basically equal to the current nominal annual output of China. The marginal propensity to consume of these ultra-high net worth people is presumably quite low. Imagine if this, expropriation, to put it candidly, were ‘spent’ by distributing it to the bottom tenth of the global population, a group of households who could not save their income because they might be living below the poverty line, the boost to global output would be substantial. This is an absurd limiting case of course, but it illustrates the cost of inequality.

Economic orthodoxy will not easily relax the need for fiscal rectitude and austerity. Monetary policy has clearly hit a wall. Fiscal policy will eventually need to be engaged, and again, I qualify that this is if we target growth at a level beyond the natural metabolic rate of the real economy. Then countries will begin to tax and spend. Around the world, the people have already signaled their political choices, and it leans that way. Perhaps the masses know something the economists don’t.

Understanding China and How To Invest There. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 03 February 2016 02:45

China’s growth is evidently slowing and investors are concerned. China is the second largest economy in the world, and it is a manufacturing hub importing commodities and intermediate goods and exporting finished goods. More recently, China has extended its connectivity beyond trade in material goods but has sought participation in and sometimes led the establishment of significant clubs in the international arena. The establishment of the Asian Infrastructure Investment Bank, and the inclusion of the RMB in the IMF Special Drawing Rights are examples of how China seeks to engage and be part of the world. However, it is feared that its current and future position makes it a nexus for economic and financial contagion. To understand the potential for this it is useful to understand why China is slowing and if that rate of deceleration is a cause of concern or not.

Since 2008, the world has been in a Cold War in trade. As countries exhausted domestic consumption, their financial markets stopped funding business investment and their governments exhausted reserves in rescuing their banking and financial systems, trade became the only viable source of growth. A currency war was fought under the cover of financial system desperation’ it continues in fits and starts today. Weak economic data has become a relief as it justifies more monetary analgesic and currency debasement. New battlefronts have opened in the form of re-shoring in the case of Western economies previously happy to outsource manufacturing to foreign shores. The evidence lies in the stagnation of global trade since 2012. For an economy designed to export like China, a trade war is damaging. Exports as a share of GDP have fallen from 36% in 2006 to 22.6% at the end of 2014.

A related theme is the balance between manufacturing and services in the economy. Globally, services are growing whereas manufacturing is in decline. This is another consequence of the Cold War in trade. Manufacturing is more export sensitive than services so as global trade slows more than global growth, manufacturing must slow relative to services. This is a phenomenon measured from Asia to Europe to the US. As manufacturing capacity is re-shored, countries like China must experience a surge in excess capacity, even if GDP does not actually shrink. In the case of China, because manufacturing was the larger contributor to output, its relative weakness translates into weakness in aggregate growth.

It is illuminating of the culture that the shift from investment and exports to consumption and services is portrayed as an intentional strategy when fact it is a phenomenon which China cannot avoid.

Then there is the matter of simple mathematics. Economies are expected to grow exponentially even though this is not realistic. Economists expect constant growth rates or use this as the basis of their calculations even when they don’t expect constant growth rates. When growth rates are high, the path of nominal GDP levels, not growth, is exponential. When growth rates are lower, constant growth rates approximate linear growth in the level of nominal GDP. Technically, the higher powers of the polynomial can be ignored when the growth rate is small, and the linear component is sufficient to capture the growth. When China’s GDP was 3.5 trillion USD, it was easy to grow at 10% per annum. China’s GDP is some 11 trillion USD in nominal terms. If China adds 700 billion USD of nominal output every year, that is it grows linearly, growth this year, 2016, would be 6.4% and growth in 2017 would be 6.0%.

While China’s slowdown is understandable, it cannot and will not simply passively accept its fate. China recognizes that as the world evolves it too needs to keep up with it. It has to address a number of issues.

As China opens up as it evolves it has to adopt international standards and norms consistent with a free and enlightened society. The complexity of managing an economy without arbitrary control over the populace is risky both economically as well as socially. To diversify its risk, the Chinese Communist Party recognizes that rule of party poses to itself an existential risk, a risk which can be mitigated by embracing rule of law. This is already well underway as evidenced by the focus on the constitution and the anti-corruption campaign.

China is engaging the world by joining and creating economic and political coalitions such as the AIIB. It continues to engage in trade as buyer even if its export competitiveness has been eroded. China’s adventures in the South China Sea are most probably a device to appease the nationalists at home who tend to have a bit of a persecution complex and see China’s engagement in the context of weakness.

China is spending more on R&D than ever before and has overtaken the US, Japan and Germany in terms of patents filed. Not all of this frantic patent filing will be productive but China is reacting to the charge that it has a poor record of generating intellectual property and is more adept at stealing it or buying it.

Change has direct monetary as well as opportunity cost. Rebalancing an investment and industrial heavy economy to consumption and services is costs in growth. China has stated that it wishes to maintain growth near current levels, impossible without central bank largesse. The PBOC has been busy providing liquidity to the economy to compensate for the slowdown associated with restructuring costs. We have seen the debt accumulation post 2008 as China first reacted to the new reality in international trade. This will continue. The PBOC, however, knows it can only deal with one problem at a time and it has chosen to allow debt to pile up, as it must, but tackle the more immediate issue of debt service. Enter targeted open market operations and debt restructurings, particularly of local government debt, to reduce the debt burden on the more indebted corners of the economy, the local governments and SOEs. At the same time it is directing credit towards SMEs and households. Unlike developed world central banks who pull 2, maybe 3 levers, interest rates, size of balance sheet and maturity schedule of balance sheet assets, the PBOC has many more levers and behaves like a creditor committee working to maintain the going concern of its massive economy.

China is full of opportunity but it has never rewarded the macro investor who buys equity index exposure, not for long anyway. Investing in China requires an understanding of businesses, their prospects, the behavior of management and of the government who continues to direct capital where it is needed and siphon it away from where it isn’t. China is a stock pickers market but fundamentals are but one small part of the analysis. Policy, frustratingly opaque and seemingly arbitrary, play an important part also, in determining price discovery in this fascinating market.

Well That's A Good Start. Regime Change In A Central Bank Driven Market. Why Markets Are So Volatile. PDF Print E-mail
Written by Burnham Banks   
Friday, 22 January 2016 00:22

The Euro Stoxx is down 12% year to date as I write this, Nikkei down 15.85% and China down 16-20% depending on the exchange and S&P500 down 9%. A barrel of oil (-20% YTD) is now cheaper than a barrel of fried chicken at a fast food restaurant.

I read in the newspapers that the collapsing oil price, WTI now trading below 29, is one of the factors for the rout in global equity markets, and I find this a bit strange. I understand that weak oil prices are not so good if you are in the middle or the periphery of the oil industry but for consumers, this is not such a bad thing. One argument goes that weak oil demand is an indication of a weak global economy yet we are increasingly seeing data favoring services over manufacturing almost across the globe, which could weaken that particular argument.

I also read that the slowing economy in China is responsible for the weakness in global equity markets. Yet China and the US have simultaneously turned away from one another, the US reshoring manufacturing and China turning to domestic consumption. I understand that this bodes ill for economies and industries supplying old economy China, heavy industry and somnambulistic state owned enterprises. But China world trade stagnated in 2011 and has not recovered. The world is less global from a trade perspective than it used to be. China’s ability to export deflation is contained.

Emerging markets have been cited as a source of risk. Capital flows on the back of QE(N) supported unsustainable business models and propped up currencies and assets which are now retreating as capital flows reverse. Some emerging markets have again funded themselves in USD, but where credit creation has been greatest, China, debt has been raised mostly in local currency, and the Chinese government still has sufficient capacity to support its markets and economy, if it is smart about it. Even the biggest cache of ammunition is quickly depleted by a loss of confidence.

If there is a real problem that threatens to plunge us into the next crisis, it’s unlikely to be one of these. The oil price has been declining for 18 months and China has been slowing since 2012. Emerging markets do not suffer from a balance sheet problem but a business model and cash flow problem, not insignificant, but known and therefore unlikely to be a blindsiding impact. For that we have to look elsewhere.

But since the markets are looking a bit seasick, perhaps we should try to find some positives to sooth ourselves.

One, regulators have not been complacent. The banking sector is safer now than it was before. Banks have been forced to raise more capital, to deleverage and to be more prudent in lending practices. Not all regulators have been as successful and not all banks as cooperative, but by and large the system has been fortified.

Two, central banks have not been complacent, but they may have been one dimensional. Efforts to boost output through QE have been widespread and determined. The US has ended its QE activities but they have not reversed them. Plans to reverse them have, in fact, been placed on the back burner. Whether this is a good thing is another matter. The ECB has been slower to act and then less robust, but circumstances will likely pressure them to do more. The BoJ is already at the limits of credulity in its efforts and is attempting more subtle adjustments instead of outright increasing the expansion. The PBOC has the most complex problem and the most complex policies, but is supplying liquidity wherever and whenever it is required.

In the absence of cataclysmic risks it would seem rational to seek investments which offered good value. Chinese equities listed in Hong Kong are pretty cheap, so is Korea, Taiwan, Vietnam, the US auto, transportation and tech sectors, Brazil, Argentina, Russia, Turkey and just about any MENA stock market. Some of those markets are cheap for overwhelmingly compelling reasons, recession, stagflation, sovereign insolvency, broken business models, but not all of them are and value can be found. The same variation of valuations can be found in credit markets, with the same variation of credit and legal jurisdiction quality and economic strength. Generally, credit is cheap compared with benchmark sovereign and swap curves.

So, should we all go out and buy emerging, frontier and submerging market equities, leveraged loans, junk bonds, and structured credit junior tranches? It depends on your time frame. Too short, and you have volatility, too long and an unpalatable truth might emerge.

Since 2008 we have been playing a game of chicken with the central banks. The system broke, the central banks and governments stepped in to prop things up and reassure us that everything was alright, and we in turn knew that this was not the case but that the governments would have to keep the pretense up until everything was in fact alright. We always knew that one day, either everything was alright and our initially artificially elevated asset values were justified, or that things were not alright and the game was estimating when the wheels would come off the government QE machine and asset values would head lower in pretty short order.

When central banks are the determinants of asset prices, volatility is not a reflection of the risk in an asset but the risk of execution of central bank policy. A significant part of the volatility is likely due to the recent uncertainty in central bank policy. The Fed increased uncertainty when it failed to raise interest rates in September as it said it would resulting in speculation that the economy was in worse shape than suspected. At the same time, the BoJ failed to increase its asset purchases, as weak Japanese data suggested it would have to do, disappointing the market and leading to the unwinding of large consensus shorts in JPY. The ECB failed to increase its QE efforts enough, announcing a halfhearted extension to the asset purchase program from September 2016 to March 2017. The PBOC’s and CSRC’s multiple miscommunications and missteps led to a severe loss of confidence in the Chinese equity markets. So used have the markets become that they cannot make up their own minds about economic and commercial prospects they need central banks to show them the way. And when central banks themselves falter, investors understandably panic. This is unhealthy, but some change is coming, at least from the US.

The US Federal Reserve has a useful modus operandi. When it wants to do something, it telegraphs it well in advance, gets the market to price it in and then moves to align policy to the new market reality which it created, thus avoiding nasty surprises. This was not always the case, especially under Greenspan whose deliberate obfuscation may have hid bona fide confusion. From Bernanke onwards we are being fed information to manage us, to co-opt us into the deployment of policy. The Fed will now wean us off scrutinizing its actions as determinants of market behavior by itself becoming more data dependent in policy. With time, it is hoped, the market will try to gain an edge over the Fed by looking at the data.

We are in a period of adjustment, whether central banks still command markets or not, away from watching and front running central banks. It has been an easy 7 years, although many investors made it hard for themselves, relying on fundamentals instead of central banks in those early years after the crisis. Investors are as always slow to adjust. But the central banks are either losing their way, in part because there is no longer a clear and present danger, which is good, in part because policy has reached its limits, or recognizing that it is unhealthy to forever lead the market with a helping hand. Their messages are less clear and they seem less certain, even in Europe and Japan. The adjustment from policy focus to fundamental focus is a turbulent one with elevated volatility through the process.

The question then is, what will the fundamentals tell us? What valuations will we accept, under the assumption that central banks no longer drive asset prices. History is a guide but adjustments will need to be made to account for a loss of efficacy and certainty of central bank policy, a weaker credit transmission mechanism due to greater bank regulation, slower trend growth, slower global trade as countries seek greater self-sufficiency, the evolution of economies under innovation – the dominance of services over manufacturing, et al. Estimates for uncertainty around growth estimates will also need to be updated to take into account greater financial stability within the banking sector, the gradual withdrawal of central bank influence, income inequality and the risks of social unrest, increased geopolitical risk as countries become more insular, et al.

In the long run, growth will likely be lower, the loss of specialization by trade is an important factor as is credit creation which has run well ahead of itself and needs to be allowed or encouraged to mean revert, and asset markets will need to reflect this, likely with lower long run equilibrium valuations both in equities and credit. From the early 1980s we rerated in volatile fashion with booms and busts until we peaked in 2000. From there, valuations have fallen, again in volatile fashion. This long cycle derating is likely to continue, and again in volatile fashion.

In the medium term, an investor working with long term valuation assumptions will need patience and loss tolerance. The market will continue to adapt to the slowly changing reality of policy’s role in asset pricing, and in so doing will regularly overshoot in both directions providing good entry points and exit points to the lucky or smart investor. I’m happy to be either, I’m not fussy.

Last Updated on Friday, 22 January 2016 07:45
Insanity Investing. Ramblings From The Barstool. PDF Print E-mail
Written by Burnham Banks   
Friday, 08 January 2016 03:38

Market pundits did say that 2016 would be a difficult year for investing. However, they did say the same thing in 2015, 2014, 2013, not to mention 2010, 2011 and 2012. One can only conclude that it is always a difficult year for investing. 2009 was easy. You either couldn’t or wouldn’t exit in which case you made some money in the recovery but lost all your clients, or you could exit, did, missed the recovery, and lost all your clients. All the investors who experienced 1997, 1998, 2001, and said they were waiting for a crisis to invest, all fled, and missed the boat. These same investors are awaiting a market crash sometime in the near future when they say they will pile in, but will probably flee again when push comes to shove.

The two most important things in investing are courage and luck. Fundamentals and analysis are excellent at shoring up courage and providing very general direction. Too much a focus on fundamentals and your profit and loss will be volatile. Focus on profit and loss, and you will lose faith in your analysis. Markets are moved by the average marginal buyer or seller, and therefore by the average interpretation of the facts. The average person is by definition smarter than 50% of the population and dumber than 50% of the population, and has therefore a 50% chance of being right. Markets are therefore a coin toss. A series of coin tosses is a drunken walk (random walk is a technical term and I cannot afford precision here). To successfully trade a drunken walk, one needs courage or one will never act, and luck, or one will never win. The only other thing is discipline and risk management to ensure that one is able to replicate one’s good or bad luck day in day out. As long as you can stay in the game, you are successful. Don’t be overambitious or delusional.

In markets, perception drives reality. It’s has a parallel in quantum mechanics.

Once in a while, an obvious trade comes along. If it is obvious to many, it will become crowded and volatile and risky. Before it becomes obvious to too many, you will not be able to convince your boss, the risk manager, the client, the prime broker, the investment committee, or indeed your wife. Often you will need market counterparties to trade with without alerting them to the opportunity. Hired guns or investment banks, can help to run interference. The instruments available to capture the trade will often not be available, or you won’t be set up operationally to trade it, your risk systems cannot capture it or measure it, your back office will have no idea to settle it. If you are Supreme Commander, you might be able to surmount these obstacles, by which time, half of the opportunity has been realized by price discovery and the trade is becoming crowded.

Markets are prone to changing direction when the majority agree. If a market is going up and all agree that it will continue, it is likely to reverse. If the consensus is that the market will fall, it is likely to fall. If, there is disagreement and uncertainty, markets may be volatile but are likely to hold the current trend. When there is a strong consensus, either there is no longer incremental capital to maintain the trend, or there is sufficient incremental capital to reverse it.

Last Updated on Friday, 22 January 2016 00:29
Liquid Alternative Investments. The Next Big Liquidity Mismatch? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 05 January 2016 01:42

Post 2008 there has been a significant preference for liquidity. UCITS alternatives and 40 act funds were a reaction to this and assets under management have grown. Central bank liquidity has suppressed base yields, and investors have tightened spreads across multiple asset classes, notably credit. Alternative strategies or hedge fund strategies have been deployed, with mixed success, to meet demand for returns. Liquidity preference has led to some less liquid strategies being packaged in liquid fund structures. 

The largest segments of liquid alternatives are credit and real estate linked funds. Not all of these strategies are liquid despite the liquidity provided by their investor pooling vehicles (funds). Liquidity has not been a problem as central banks mounted a concerted effort to inject liquidity and suppress yields. The divergence of the Fed towards a neutral to tightening stance changes the calculus. Financial market regulation also reduces dealer participation in market making further reducing liquidity in certain markets.

The importance of matching the liquidity of the underlying assets to the liquidity provided to investors in collective investment schemes may re-emerge with painful consequences.


2015 witnessed the closure and liquidation of Third Avenue's Focused Credit Fund, a distressed debt fund investing in the less liquid end of the credit market which was inappropriately structured as a liquid fund. Other similar distressed debt funds have closed since, the most recent being Lutetium Capital.


Alternative UCITS










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.