Just One More Thing... Central Banks Are Cutting Rates Like There Is No Tomorrow PDF Print E-mail
Written by Burnham Banks   
Thursday, 12 March 2015 01:47

This year we have apparently seen 23 central banks cutting rates; personally, I have lost count. The question is, why now? How dire are things? And what are these things that are apparently so dire. The US and the UK are the only two majors not cutting rates. Lets exclude the basket cases and currency manipulators from all this. Everyone else either is cutting rates, or will surprise us some Wednesday morning with a jaunty rate cut. Why? The most obvious answer is deflation. Deflation renders real interest rates higher than nominal interest rates and where an economy is struggling and a central bank is aiming for zero real rates, deflation can force a central bank into operating negative nominal rates. It’s happening as we speak at the Swiss National Bank and Sveriges Riksbank.

Real interest rates, where we consider core instead of headline inflation has been negative in the US and UK since 2008 and continue to track in negative territory. It is understandable that with the stabilization of growth in these two countries, their central banks are leaning towards raising interest rates. They want to raise interest rates, they just might have complications to deal with such as their currencies and terms of trade. The Eurozone, however, despite zero nominal rates, faces deflation and thus a rising real interest rate which has turned positive since December 2014. Riksbank, which began tightening in 2010, far too early in hindsight, has had to cut rates steadily since 2011. Real krona rates have only just turned negative in October 2014. The Swiss, operating at zero real rates since 2013, recently depressed nominal rates so that real rates are trading at 2008 levels. China’s rate cuts were not a response to real rates creeping up but rather to address flagging demand as reforms are implemented. Of the majors only the Eurozone, it appears, has suffered from real rate creep where real rates bottomed at -2% in 2012 and have crept up to +70 basis points in March 2015.

But does the world need negative rates some 7 years from the crisis of 2008? The US economy’s health is quite apparent, as is the UK’s. Only China is slowing significantly, and by the way causing a slowdown for its vendors in commodities and luxuries. Japan has sunk back into recession but not to worry, inflation is the highest in any major developed country. India is reinvigorating fast under new management. The Eurozone economy recovered in 2010 but slumped in late 2011. It has since bottomed in 2013 and growth appears to be picking up again even as the ECB has embarked on quantitative easing to address deflation.

So let me repeat the question on my mind: Why are central banks around the world cutting rates all at the same time? Do we really need real rates to be so negative 7 years on from the crisis of 2008? What am I missing?

Ten Seconds Into Darkness. 2015 02. PDF Print E-mail
Written by Burnham Banks   
Monday, 16 February 2015 02:11

Equity and bond markets have been behaving well these past few years. Despite a slowdown in returns and a few wobbles towards the year end, 2014 was a fairly good year for investors. The MSCI World Index returned 4.8% while the Barclays Global Bond Index returned 3.8%. Clever positioning would have earned the average investor more, but even fairly obvious positioning would have earned an investor circa 6% without excessive risk or sophistication. With markets this sanguine one would expect the global economy to be good health. There are areas of concern.


The strength of the US economy relative to the rest of the world is resulting in a divergence in central bank policy. In a post 2008 world where central bank credit creation lacks extension to the private sector, countries are more sensitive to trade competitiveness. It would not go too far to say that the world has been engaged in a trade war since then. Today, the gloves have come off. Central banks no longer have the luxury of considering only the state of their own economies when they formulate policy, they have to take into account the policy decisions of other central banks, the state of other economies, and soon enough, the reaction of other central banks to their own policy decisions. This complicates an already difficult task, that of balancing growth, stable prices and the solvency and funding costs of their sovereigns. Central bank activity in the first 2 months of 2015 has been remarkable. The ECB announced QE, and a rate cut, before that the Swiss National Bank cancelled the cap on the CHF against the EUR and cut rates, the Reserve Bank of Australia, the Reserve Bank of India, the Bank of Canada, the Danmarks Nationalbank, and most recently Sveriges Riksbank, cut interest rates also. China’s PBOC cut bank wide reserve requirements having cut interest rates late last year and Singapore altered the trajectory of its currency policy in an effort to address low inflation. Russia has cut rates by 2% following a rate hike of 6.5%. in December 2014. A significant number of key interest rates and bond yields are now negative. The actions of these central banks are ostensibly to address the risk of deflation, however, currency devaluation is of limited use as currencies are all quoted one in terms of the other and the low inflation phenomenon is this widespread. The US will find itself having to balance the requirements of its domestic economy with the actions of all other central banks. The USD has been strong since mid 2014 and may be driven higher if as expected the Fed hikes rates in the middle of 2015. A strong USD will impair foreign earnings and terms of trade. One consideration the Fed will be making is how important the export sector is to the US. In the past the US ran a large negative trade balance but this has receded with re-shoring and growing energy independence. A more self sufficient US might be able and willing to pivot towards a more insular trade policy. A strong USD may have unexpected consequences. It can steepen emerging market term sovereign term structures and cause interest rates to rise. Non dollar debtors borrowing in dollars could be impacted as well. Some of these are well documented phenomena but there will be other less expected ones.

A more important but apparently less pressing question is how central banks normalize policy once their economy has reached a state of normalcy. Here the US Fed is an excellent case study being the only central bank with a robust economy, and having an acutely inflated balance sheet. Rate hikes may be determined by the strength in the economy, but the side effects have to be considered and tested for, something the Fed has been doing using term deposits and reverse repos since Oct 2014, seeking feedback on the desired level of reserves by the banking system. So far the results have been inconclusive. Then there is the question of when it will begin to actually shrink its balance sheet. This is the bigger question which will likely come to the front at some point.



Following the crisis of 2008, much debt was transformed and or transferred to more stable holding vehicles such as rescue funds, central bank or state balance sheets shielding them from price discovery. At the same time, massive bail outs and central bank money printing have depressed borrowing costs. While one sector deleverages, another leverages up. As one country deleverages, another leverages up. Generally, developed world economies have increased already high levels of leverage. Developing economies are catching up, albeit from much lower levels. The charts below illustrate debt levels, which are already high, but exclude unfunded liabilities such as pensions and health insurance. In developed economies, such unfunded liabilities can add a multiple or two of GDP to the already high levels of total debt. A population does not merely borrow from others, it primarily borrows from its own future; debt is an inter-temporal transfer. It is essential that the future productivity of the population is sufficiently high to repay its obligations. As it is, government debt looks like PIK debt, paid off either with new debt or with the proceeds of new debt. Only sufficient economic growth can, with time, reduce the debt burden.






Economic growth is dependent on demographics, among other things. The rich world is generally an ageing one and the developing world, a young one. That the developed economies are the most leveraged is not encouraging. A high debt burden required economic growth, but economic growth is dependent on the steady growth of the labour force or its productivity. Japan is an example where an ageing population is resulting in slower growth and falling tax receipts. The government’s approach to spurring growth is to spend and borrow, a strategy that requires that the spending spurs more growth than it does accumulate debt. Otherwise, the stock of debt will only grow. With deflation as well, the real value of the stock of debt also grows.


Distribution Of Wealth

One of the surest and most topical trends has been the distribution of wealth. Inequality between countries has ebbed as poor countries caught up to advanced economies while inequality has risen within countries. This is in part a consequence of globalization where inter country wealth would be expected to converge while in-country inequality is boosted by capital and labour mobility. The efforts of central banks to boost economic growth by QE has created asset price inflation leading to the enrichment of asset owners, generally the more well to do. The fortunes of workers has lagged. Simultaneously, labor's share of output has fallen steadily and certainly accelerated downwards in the recent decade or so. This is not a universal phenomenon but certainly holds true for the major economies and globally in aggregate.  Income inequality dulls fiscal and monetary policy, skews labour supply, and influences politics. Acute imbalances in the distribution of wealth and the share of profits can only trend so far before they threaten the social compact and the status quo. At that point, the capitalist and democratic ideology may be challenged and fundamental regime change could occur.

In closing:

These are selected long term fundamental issues that lay in front of us. Some of these issues lie further in the future but others are more immediate. It is rational to deal with the immediate issues first, just as it is human to deal with longer term issues later, when they become immediate and have accumulated scale and intractability.

For financial markets the response is, how can one make nominal financial profit in the short to medium term. For individuals, this is a rational response since they lack the ability to individually affect policy to address longer term, collective reform.

Relevant trading and investment strategies, and more importantly, loss avoidance strategies will be covered in the coming weeks.

Last Updated on Monday, 16 February 2015 03:06
Greek Default 2015. Possibilities. PDF Print E-mail
Written by Burnham Banks   
Sunday, 01 February 2015 23:35

What is the situation in Greece?

· Government finances have been improving during the austerity measures,  the current account is now in surplus, the budget in primary surplus and economic growth has recovered, however, unemployment has risen sharply to 26%.

· Syriza has chosen a far right nationalist party, the Independent Greeks as their coalition partner. The Greek government is therefore strongly anti European Union and anti austerity.

· Syriza will likely have to stick by its election campaign promises to end austerity and seek a write-down of the national debt.


What is the troika's stand?


· The largest creditor of Greece is Germany and she will not countenance a debt write-down.

· Initial discussions between the Greek finance minister and the European Union have been adversarial.


Will Greece default?


· Nobody can foresee what will happen. The troika is clear that any debt reorganisation will be contingent on Greece continuing its austerity and reforms. Greece is clear that austerity has ended. We have a standoff.

· In the coming months Greece is expected to receive loans as part of the initial bailout plan, loans that may now not be disbursed given recent developments. Greece may face a cash shortage and difficulty in refinancing it's national debt in the next two months.


What would happen if Greece were to default?


· Greek creditors would face a write-down of their assets, in this case Greek bonds. A legal process would begin to reorganize the debt.

· Greece would lose access to bond markets until it was clear if it would be allowed to remain in the currency union.

· Greece would likely be ejected from the currency union and have to introduce a new Drachma at an initial exchange rate of 1 Drachma per Euro. The Drachma would likeky devalue rapidly. There would be shortages and import inflation would surge. A deep recession would follow. Drachma borrowing costs would also soar. However,  the flexibility of having independent monetary and fiscal policy and a flexible exchange rate would place the  responsibility and fate of the Greek economy with the Greeks.

· Risk assets across the world and particularly in Europe will sell off. Portuguese bonds would suffer especially as they are not part of the ECB QE program. Greek stocks would crash.


· In terms of real economic impact, Greece is 2% of the Eurozone economy so the impact would be contained.


Would Greece defaulting be a Lehman Event? What are the contagion risks?


· The real economy impact would be small. Greece represents 2% of the Eurozone economy.

· Impact on investor sentiment will likely be serious and risk assets would sell off. The ongoing ECB QE would likely limit the downside in Eurozone sovereign bonds although Portugal might suffer as it is rated BB and thus not part of the ECB QE program.

· The Eurozone now has banking union and a bailout fund. In the past year, the ECB has required Eurozone banks to shore up their capital.

· The financial damage will not likely be as wide ranging as Lehman's insolvency because Greece is not as systemically integrated into global financial systems. Importantly, in the post Lehman world, riskier swaps are collateralized with high quality investment grade collateral so transitive counterparty default risk is mitigated.


What are the longer term implications for Europe?

· Syriza’s victory in the polls will embolden other Euro sceptic parties such as Podemos (Spain), National Front (France), the UK Independent Party and Alternative for Germany for example.

· If Syriza is successful in defying the ECB and Germany it might set a precedent for other members such as Italy, Spain and Portugal to abandon austerity.

· If Greece is forced out of the union, depending on how painful it is and to whom, it could be a template for other members to exit.

· For Greece the choice is one between the long term ache of staying in the Euro and the short term excruciating pain of leaving it. A Greece with an independent currency, central bank, monetary policy and fiscal policy would be responsible for its own fate. A Greece in the Euro might benefit from short term analgesics such as the ECB’s QE and bail out loans but be hostage to the policies and principles of Brussels and Frankfurt.






Last Updated on Tuesday, 17 February 2015 23:56
Greece under Syriza. A Compromise. A Debt Exchange Offer. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 27 January 2015 03:06

A compromise for Greece and the troika.


  • A debt exchange offer.
  • New debt at much extended maturities. Face value smaller than existing face value.
  • New debt to feature step up coupons to equalize the NPV of cash flows versus the existing debt.
  • Effectively a refinancing.


Very quickly after winning the Greek elections, Syriza has approached Independent Greeks as a coalition partner. A coalition of the radical left and nationalistic right make strange bedfellows. Syriza’s 149 seats to Independent Greeks’ 13 mean Syriza will mostly have discretion in policy. With the elections out of the way, the question is, what next? Alexis Tsipras had made conciliatory sounds during the election but victory can change things significantly. Syriza had campaigned on a decidedly anti austerity ticket which was softened slightly during at the eleventh hour. With a stronger mandate than they had expected, Syriza may return to a more intransigent position. Indeed they may be expected to by their supporters.

Tsipras is in an unenviable position. On the one hand he has promised an end to austerity and to renegotiating the national debt with the ECB, EU and IMF, specifically seeking a one third write down of face value. The Germans have signalled that debt forgiveness is out of the question and that a Greek exit from the union is a practical possibility.

The Greeks will want to end austerity, to renegotiate the national debt and to reduce the face value of the national debt, as well as to benefit from the ECB’s bond purchase program. The Germans will want the Greeks to maintain austerity, continue to service their debt, and not write down any debt. A compromise needs to be found. There is no guarantee it will be.

A practical compromise would involve the following. Austerity measures could be partially rolled back so that the government could run a budget deficit. The terms of debt would be restructured to provide the Greeks more time to achieve cash flow solvency and balance sheet stability. Specifically, the coupons on the debt would be reduced but the maturities of the debt would be extended. The debt would include a 10 year moratorium on coupon payments but step up in later years. The average duration of Greece’s liabilities are just over 16 years. The debt could be restructured to push the average out to 30 years. The coupons would start in year 10 and step up. This would satisfy the Germans that there was no bailout but rather a constructive reorganization. New debt could also be issued on a novel basis requiring an explicit senior and secured claim on a proportion of tax and other government revenues. This innovation could be adopted even for non distressed issuers.


Even then, the ECB will not be able to buy primary issue, and of the secondary issue, special arrangements are required since the ECB already owns more than 33% of the Greek national debt, beyond the limit specified in its current QE program. For Greece to benefit from QE. It would have to make some concessions on austerity and it certainly could not seek a debt writedown. What Greece could seek is an exchange offer in which the longer maturity step up coupon debt is exchanged for the existing debt. Theoretically, the face value of the new bonds could be less provided the NPV of the cash flows is equal to the NPV of the old cash flows. This would require a higher average coupon or a much extended maturity. The former is not feasible given Greece’s current cash flow but the second is certainly a possibility. These are details of course but as is so often when politics interferes with economics, a compromise solution is more cosmetic than real.

Last Updated on Tuesday, 27 January 2015 07:00
From Pawnshop to Used Car Dealer. You Want To Impress Me? Buy New Cars. ECB QE. Will It Work? PDF Print E-mail
Written by Burnham Banks   
Friday, 23 January 2015 03:36

The ECB, from pawnshop to used car dealer:

If you want to get more money out there into the economy, and get that money circulating instead of sitting in a dusty corner, you can’t just be a pawnshop. Lending cash against investment grade bonds is a pawnshop business, a.k.a. LTRO. Buying bonds in the secondary market is a used car business. You want to get the economy going, buy some new cars. Supplying money is one thing, stepping in where private demand is deficient is another. Buying used cars pushes used cars around at increasing prices making profits for other used car dealers but it does little for car manufacturers, output and employment.

And yet the ECB’s mandate excludes purchasing primary issues since this appears to be interference in fiscal policy. Purchasing secondary market issues apparently is not despite the issuers being clearly the same. Somewhere there is an argument that buying bonds from private holders does not explicitly bail out the issuers. True I guess. Bail out the holders of the debt, not the borrowers. Perverted but true.

Will QE work? The European economy is already recovering, so the timing of the announcement is fortuitous. Because trend growth globally, not just in the Eurozone, is slower than before 2008, policy will continually be miscalibrated. The European economy has slowed, but it has also very likely hit bottom and will recover. And now, the ECB and their QE will get the credit for it. On its own, QE would not have worked. QE depresses cost of debt, debt which nobody wants to incur. QE also depresses yields which are already well below US treasury yields. The analogy of pushing on a string was never more appropriate.

What is needed is more demand for goods and services, not more supply of credit. In the absence of private demand, governments need to target a budget deficit. Yet Europe is obsessed with fiscal restraint and budget discipline. What is ultimately required is a bond purchase program which is free to buy primary issue not only of sovereign debt but also of covered bonds and ABS. A To-Be-Announced mechanism of ABS and covered bond issues should be underwritten by an ECB asset purchase program. By actively encouraging demand instead of passively enabling it, policy makers might be able to awaken the moribund economy.

The current policy lifts asset prices but does little to address underlying demand deficiency and the failure of factor markets clearing. The ECB will simply have to do more later on thus fuelling a protracted asset boom while output and employment languish.

Last Updated on Tuesday, 27 January 2015 03:10
WHy The Swiss National Bank Dropped the CHF EUR Cap And What It Means for the ECB's QE Program PDF Print E-mail
Written by Burnham Banks   
Monday, 19 January 2015 23:05

Draghi; Hi Tom. I'm going shopping next Thursday.

Jordan: How nice Mario. What are you buying?

Draghi: Nothing special. Just some high grade bonds.

Jordan: Really. How interesting. How much are you buying?

Draghi: Well, that's the thing Tom. It sort of depends.

Jordan: Oh. On what Mario?

Draghi: Well, on how much YOU will be buying.

Jordan: I'm sorry? What was that?

Draghi: The exchange rate cap... Tom. Tom, are you there... Hello?


Last Updated on Tuesday, 27 January 2015 03:09
QE. That ain't working. That's the way you do it. Money For Nothing ... PDF Print E-mail
Written by Burnham Banks   
Monday, 05 January 2015 08:39

QE in the US seems to have worked whereas elsewhere it has either failed to take hold or has not been started. Yet even the US, QE has had less than stellar results requiring three rounds, with a twist and the last one was unlimited as well. Why is QE not very effective? To understand why, we need to clear what QE is. In the US context, it is specifically the purchase of US treasuries and agency mortgaged backed securities.

QE appears to be useful in two ways. One, it makes cost of debt lower for sovereign issuers and by association, private issuers, thus boosting investment. Lower interest rates it is hoped also drives consumer credit and consumption. Government debt issuance has indeed accelerated and so has private debt issuance, yet proceeds have not been recycled as much as hoped. Investment has been muted, and consumption has also been slow to respond. Two, to the extent that it monetizes debt, it allows governments to finance expenditure through borrowing. From 2008 to the present, the US, UK, Germany and France expanded government expenditure even if at a decreasing rate. Notably, Italy and Spain shrank government expenditure under austerity programs. The main impact of QE appears to be in funding expansionary fiscal policy. Where countries have practiced fiscal rectitude the economic results have disappointed. Where QE is not used to finance fiscal expansion, that is where government expenditure is not expanded or maintained, the impact on output is probably negligible. The US of QE therefore appears to be solely in keeping borrowing costs down as the government borrows and spends.

A number of factors have blunted the intended impact of QE. Proceeds of asset sales (purchases by the central bank) have been one time and not recirculated, thus the velocity of money has fallen to fully compensate for the injection. The marginal propensity to consume has been low and thus the multiplier low. Weak consumer and business confidence have led households and firms to hoard capital and not consume or invest. Buying of seasoned debt issues do not encourage new lending only provide relief to stressed balance sheets. Private commercial banks having repaired their balance sheets have been slow to releverage. Buying of new debt, particularly loan securitizations on a blind pool to be announced basis would have worked much better in encouraging new loans. QE together with austerity or neutral to contractionary fiscal management is self defeating. While government balance sheets may improve the impact on consumption and output is neutralized. Austerity neutralizes QE. When we turn our eye to Europe, ECB QE will be relevant only if Europe abandons austerity and balanced budgets.

For QE to be effective, central banks cannot purchase legacy debt or bonds in issue; central banks have to underwrite new issue. The use of proceeds for such a targeted QE has to be pre-specified to directly boost output and consumption. Accepting as collateral for cheap repo blind pool, conforming, new issue, is a valid way of operating QE.

We have seen how long it has taken US QE to be effective and we have seen how blunt a tool it has been. As the ECB and BoJ and potentially the PBOC embark or continue their QE efforts, we can now build expectations about the efficacy of policy based on the above observations, namely that underwriting of new issue is fast acting and purchase of legacy assets is slow acting and ineffective. There are trading implications for this. Investment strategies are not one dimensional. Time is as important as potential returns. If policy is expected to be slow, derivative or option strategies such as calendar spreads can be used to maximize efficacy.

Put simply, if QE doesn’t involve buying new issue securities but seasoned issues, the impact will be small and late. The trade is to bet that the policy will work using long dated calls financed by selling short dated calls. If QE involves buying new issue blind pools, buy outright underlyings, futures, or short dated calls.


If governments are really serious about reviving moribund economies they might want to try more controversial (fruitcake) remedies such as:

Credit all retail bank accounts with money. Get the money down to the people who need it most. This can be quite inflationary.

Distribute to the public amortizing cash vouchers which decay when not used. This is deliberately inflationary.

All of the above will rubbish the balance sheet but desperate times call for desperate measures and you don't want to waste desperation in half measures.


Last Updated on Tuesday, 06 January 2015 07:04
Gold. Just Another Thought. PDF Print E-mail
Written by Burnham Banks   
Friday, 05 December 2014 06:59


To determine the value of an object one has to determine its usefulness. To determine the price of an object one has to understand the convolutions of the collective human mind.

Last Updated on Friday, 05 December 2014 07:41
China Outlook 2015 PDF Print E-mail
Written by Burnham Banks   
Thursday, 13 November 2014 23:59

The Chinese government has focused on a number of things some of which include:

  • An anti corruption initiative.
  • Rebalancing the economy towards domestic consumption.
  • Maintaining financial stability and a certain level of economic growth.

The anti corruption initiative is a long term structural reform to strengthen the rule of law in China. The government appears to be serious about the rule of law despite doubts from many observers who see the law as a means of control. The Fourth Plenum saw an elevation of the Constitution which may signal that China is, albeit gradually, shifting to a rule by institution than by person. The anti corruption initiative is, however, a brake on growth, as many investment decisions and projects have corrupt elements in them and these projects may either fall away or need to be reorganized in a more acceptable form. Expect delays.

The rebalancing of the economy is an important factor in assessing China’s prospects. Most countries must by now recognize that globalization has been slowed if not reversed post 2008 as countries struggle to grow. In the aftermath of the crisis, the calculus recognized the constraints on fiscal policy, consumption and investment and naturally defaulted to exports to fuel growth. This placed the world in a state of a cold trade and currency war. In such an environment, currencies would range trade. Logical tolerable bounds would be 2007 levels for JPY and 2008 levels for the European currencies. These countries must also realize that the cold trade war is nearly over and that long term solutions need to be found besides beggaring thy neighbor. Cold wars are sometimes a balance of tacit collusions and conflicts. The end of such conditions will likely drive countries to pursue greater self sufficiency. A base of domestic demand and consumption is an important resource in the face of slowing or reduced globalization.

For many reasons, China’s growth is slowing. One reason is that unless one is the generator and owner of intellectual property, one’s economy is hostage to being a low cost producer. When costs rise, business moves elsewhere. China has long had a technological disadvantage compared with the West. It clearly recognizes this. The number of patents filed by Chinese firms has accelerated recently relative to the rest of the world.


It is hoped that this push to improve its competitiveness in intellectual property will result in higher productivity and a higher long term growth rate. In the meantime, however, growth has slowed from the double digit pace in the early 2000s to 7.3% at latest count. Some observers are quoting a rate of just sub 6% actual growth this year, slowing in 2015 and the coming years. If the economy indeed slows along this path, policy must be expected to adjust to a more accommodative state.

It can be argued that the PBOC misread the impact of the US Fed led global QE and easing policy on price levels in China. Certainly inflation rose steadily from 2009 to 2011 during which food price inflation ran into double digits. Concerned about inflation through tradable goods markets, the PBOC has been too tight. The low inflation in Europe, the US and Japan, the falling domestic inflation and the end of US QE has prompted the PBOC to switch to a more accommodative state. This will likely steady tradable goods while creating inflation in services and semi-closed asset markets.

If growth should slow more than planned it is likely that China will resume growing the economy through investment in infrastructure. This could provide some respite to commodity metals and energy markets regionally as well as globally. (Miners have been acutely weak of late and could represent a buying opportunity if China growth slows much more.) Another area of potential interest would be European and US industrial equipment companies.

Generally, the outlook for China is positive. Equities are relative cheap and growth is robust. The one impediment to the Chinese stock markets has been an overly tight PBOC. With a neutral to accommodative stance, the latent investment themes can be animated.

Longer term risks:

There are of course risks associated with investing in China. The anti corruption drive will deal, if tangentially, with corporate governance. There is a risk that the campaign might be a cynical and politically motivated power consolidation exercise. Only time will tell but the focus on constitutionalism is an optimistic signal.

The growth of leverage in the corporate and local government sectors, enabled by the bond and nascent securitization markets has been an area of concern. However, most of the debt is local currency denominated and therefore within the control of the government. Central government and household balance sheets are not overly leveraged. This will allow the government to bailout any credit issues that threaten to become systemic. A strong current account is not entirely relevant to the potential imbalances in Chinese credit markets but is a help in case of contagion into the hard currency credit markets.

Perhaps one of the most intractable risks to China is its irrevocable progress and the concomitant social change. The Umbrella Movement in HK, the troubles in Western China and Tibet, threaten the status quo. Government has to address the needs and wants of a new generation facing rising wealth and at the same time greater inequality. Greater freedom of information complicates this task. China’s vagueness about whether it is a secular (prescribed by the constitution) or atheist (preferred by the party) state remains unresolved, a dangerous condition given the correlation between ethnicity and religion in a country with significant diversity.

Geopolitically, the world has become a harsher place. The years leading up to 2008 saw relatively little turbulence between the major powers as credit fuelled prosperity tempered old rivalries. The world was, is and ever shall be a contentious place, however, pre 2008, the conflicts were localized and fragmented. The deceleration of globalization, the cold trade war, the competitive devaluations and monetary debasement make the post 2008 environment more fractious and fraught. The relationship between China, the US and Russia will have important strategic implications. One country is governed by institutions and offices, another by a party apparently shifting towards governance by institutions and offices, and the third by a man. The scope for policy miscalculations and mistakes are high.


Last Updated on Friday, 14 November 2014 00:07
Proper ECB QE. PDF Print E-mail
Written by Burnham Banks   
Friday, 31 October 2014 07:52


QE is not just quantitative, it is qualitative. Until underwriting standards are dropped, credit creation in the private sector Eurozone will be moribund. How can the ECB get it going again? Purchasing sovereign bonds will do nothing more than flatten term structures and tighten sovereign CDS spreads making it cheaper for governments to borrow. This is not the idea since fiscal rectitude is still expected even of the Club Med, at least by the Germans. At best it helps debt service a bit. Buying off the run corporate and covered bonds and ABS will not help either since it does not encourage new lending. In any case the market for covered bonds and ABS is too small for the ECB to be really effective. To be really effective, the ECB needs to be bold and reckless. It needs to underwrite blind pools of ABS and agree to purchase ABS printed on a TBA (to be announced) basis, where any collateral pool conforming to predetermined criteria are eligible. There is currently only one market which operates on this basis: US agency mortgage backed securities. QE there at least has kept mortgage rates down and spurred a durable housing recovery thus improving household balance sheets and reinvigorated HELOC origination. If the ECB abandons prudence and embarks on underwriting TBAs, private commercial banks will be converted into outsourced or third party credit underwriting agents, earning fees instead of spreads and deploying less scarce capital.

Global Macro: Deglobalization, Inequality and Country Risk Premia PDF Print E-mail
Written by Burnham Banks   
Monday, 22 September 2014 00:25

Globalization and the opening of trade and capital between countries led to a reduction in income and wealth inequality between countries. The mobility of financial and intellectual capital also led to a widening of inequality within each country. Since the global financial crisis of 2008, countries have had to reexamine their economic and commercial models. Domestic inflexibility has led many countries to pursue mercantilist policies aimed at gaining a competitive advantage over trading partners. Re-shoring is an example of a large scale, secular theme associated with mercantilism. From 2008, the world has witnessed a slowing of globalization. Countries have incentives to deglobalize. Large, developed countries with sufficient domestic demand will pursue this strategy while traditional exporters who have weaker intellectual property generation capabilities are likely to recognize the balance of power and pursue their own domestically focused policies. Deglobalization is likely to lead to a divergence in income and wealth between countries, reversing the trend of the period of globalization. There is no evident impact on income and wealth inequality within countries. That is left to a separate analysis. Country risk premia have diverged since 2008, most notably within the Eurozone, albeit for reasons surrounding the robustness of its currency union, and appear to be driven by deglobalization. This is a long term trend with implications for security valuation across equities and credit globally.

Scottish Independence PDF Print E-mail
Written by Burnham Banks   
Monday, 08 September 2014 01:43


Whether Scotland gains its independence will not only be a question of logic and rationality but of nationalism and emotion as well. Why do the Scots want independence? Why not? Some 300 years ago Scotland was an independent country. Lately, every 18 years, the Scots have brought up the issue of independence.

Scotland wants to decide what’s best for Scotland. It clearly believes that the decisions in Westminster have not been optimal for Scotland. This is the single most compelling argument for independence. It believes that the revenues from North Sea Oil have been squandered or misdirected and that an independent Scotland could follow in the footsteps of Norway with the creation of an oil financed Sovereign Wealth Fund. It feels that Westminster has neglected Scotland generally, but particularly in investment and infrastructure. Be that as it may, the calculus around North Sea Oil is equivocal. At current production, reserves are expected to last 30 years. Independence is expected to last longer than that.

Lately, indications are that the pro independents will win the referendum. There are issues to be addressed in the event of a separation.

The currency is an important consideration. An independent Scotland will need a currency. It currently uses the sterling pound. Scottish bank notes are not in fact legal tender anywhere, not even in Scotland, and are therefore legally a form of promissory note. Scotland will have to establish a currency and decide on the basis o that currency, whether it will continue to use sterling as part of a currency union, use sterling without a currency union, join the Euro or have an independent currency and central bank. Options 1 and 3 require the concurrence of the BoE and ECB respectively. Either will impose conditions which will likely severely limit monetary policy independence.

In any divorce, the balance sheet needs to be divided. This includes assets and liabilities. Each side wants the assets but not the liabilities. The Scots will understandably claim the North Sea oil reserves as their assets. How exactly the national debt will be distributed will be interesting to see. The question goes beyond the proportion of the national debt that gets allocated to an independent Scotland but to defining the new conditions of default for English and Scottish debt.




Last Updated on Tuesday, 09 September 2014 04:46
The Human Condition. PDF Print E-mail
Written by Burnham Banks   
Thursday, 04 September 2014 08:55

There is no such thing as an omnipotent central planner, even if the central planner has complete and perfect information and has unlimited resources and ultimate technology. Even an almost omnipotent central planner would not be able to satisfy everybody’s wants and needs. Sci Fi has explored such Utopian scenarios before but while they have examined the technological and social aspects of such societies, the economic aspects can confound. For one, if you give everyone all that they need, they will go crazy comparing their endowments with one another. Envy will animate avarice and before long contention and conflict will ensue. This is the human way. One mitigating strategy might be to endow each agent equally. However, different agents have different utility functions and the equal endowments will be valued differently. Envy will animate avarice and before long contention and conflict will ensue. Assuming that the central planner had access to all private information as well, it might allocate so as to equalize utility. However, utility is variable over time. Before long the equality of utility is broken and everything again descends into hostility.

Perhaps a central planner might sell the concept that each agent has the opportunity to exceed the utility of their competitors if they were good and worked hard. This is selling hope and hope is the most powerful thing ever. What precisely is that hope? It is the hope that an agent who considers themselves as inadequately endowed can achieve an equal or higher utility than their peers. That is, that they have a chance of being above average. Clearly not more than 50% of the population can be above average. It is therefore the hope that one can be above average, or equivalently, that one is not one of the 50% who will be below average.

Coincidentally, the efforts to achieve above average utility drive the population towards progress and growth. Efforts to remain above average are as strong as efforts to become above average. If all are equally successful and achieve the same incremental success, then the status quo ordinality is maintained and the efforts are ultimately futile. If the below average are more driven, under conditions of equal opportunity, they may gain an advantage over the better endowed and thus equalize the distribution of wealth. The newly below average will then strive to excel and the perpetual cycle continues.

If for whatever reason the above average excel relative to the below average then the distribution of wealth becomes more unequal. The probability of being able to move from below average to above average shrinks. In other words, hope is eroded. How might the better endowed excel relative to the less well endowed? There are all kinds of possibilities. The wherewithal to lobby government, ownership of capital, investment in knowledge and intellectual capital, networks, nepotism, the ability to cope with volatility and the unexpected are some examples. Inequality cannot increase without a point at which hope is lost, that is the probability of the below average catching up to the average or above average becomes improbably low. At this point the status quo is likely to be challenged.

What if the central planner has real time perfect information and can redistribute wealth in real time? Such a redistribution while it may bring agents into a position of equal utility on a pre-redistribution basis, will likely lead to agents valuing each redistribution payment or debit differentially. The perceived arbitrary nature of the redistribution will impair the perception of hope and is thus self defeating. Is it possible to take into account the differential valuation of the incremental transfers? Yes, but this creates a feedback loop which renders the solution hard to obtain and highly unstable. This difficulty and instability of the solution necessitates frequent adjustments to the basis of the redistribution which will render it indistinguishable from arbitrary redistribution, which again impairs the perception of fairness and hope, and is self defeating.

Absolute acceleration in aggregate wealth increases hope and stability. Absolute deceleration or negative growth in wealth decreases hope and stability. Extreme equality slows growth. Moderate to high inequality promotes growth. Acute inequality violates the social contract and leads to disruption.


Last Updated on Thursday, 04 September 2014 23:18
Ten Seconds Into The Darkness PDF Print E-mail
Written by Burnham Banks   
Thursday, 21 August 2014 06:57

Central banks have been printing money aggressively since 2008. The US Fed is now slowing its money printing with a view to a static stance in the near future. What are the consequences for markets and the economy?

When money is printed it has to go somewhere. So far it has gone into asset markets to a far greater extent than it has to the real economy. The transmission mechanism from large scale asset purchases and suppressed interest rates has directed liquidity to stabilizing the mortgage market, and keeping interest rates low across the USD term structure. This has stabilized the housing market and restored household balance sheets to stronger equity positions, strengthened bank balance sheets through their mortgage loan portfolios, and driven yield seeking investors to supporting the corporate bond market which in turn finances share buybacks buoying the equity markets. The impact of QE on financial markets and capital values has been significant yet the impact on the real economy, on employment and wages and on cash flows has been less ebullient.

After 3 rounds and 5 years of QE we are only beginning to see some impact on employment, investment and output. Yet the Fed began, in 2013, to slow its Large Scale Asset Purchases and is expected to end it altogether by October 2014. It is unclear when the Fed will actually either raise rates or shrink its balance sheet; it is currently expected to continue to reinvest coupon and maturing bond principal. The implications of an expanding Fed balance sheet are now known but what about the effects of a static or shrinking balance sheet?

The transmission of QE has thus far directed liquidity to asset markets, notably the agency mortgage backed securities market and the US treasury market. Liquidity, however, has struggled to spur bank lending to financing growth as banks lend out of capital and not just liquidity, and the SMEs which rely on bank lending have faced tight credit underwriting standards. The treatment of riskier, smaller loans under bank regulatory capital rules also hampers such lending. Larger businesses, usually with listed equities, have access to the corporate bond market and have taken advantage of lower rates to raise debt capital. Companies with listed equities have aggressively raised debt to buy back shares thus increasing earnings per share growth without the challenge of having to actually grow their businesses organically. Smaller companies without listed equities do not have this luxury.

That business investment has been slow is concerning. Corporates have raised significant levels of debt in the bond markets, yet hold substantial cash on balance sheet, or engage in share buybacks and M&A. Surveys of business sentiment notwithstanding, the actions of business leaders is not encouraging.

Equity valuations in the developed markets are no longer cheap. Even in Europe, the market has been selective and quality is expensive. Asia is the only region showing any significant value. Yet for equities to push higher, assuming fundamentals are in place, liquidity needs to flow into the asset class. The US Fed is close to neutral, the BoJ, ECB and BoE are all expansionary and the PBoC is probably at an inflection point ready to run loose again. As long as the world's central banks are in aggregate accommodative, markets will find some support. Under neutral liquidity, such as in the US, for equity and other risky assets to rise, liquidity must be diverted from the real economy. The equity market is therefore highly vulnerable to inflation since such would signal a substation to current consumption. Low inflation has been a sign that liquidity was being directed to investment. The other example is Europe, where inflation has been significantly below expectations and targets. Absent direct asset purchases, a pick up in inflation is in fact a bear signal.

The current structure of the economy is possibly a consequence of income and wealth inequality and that policy has favored the rich. Whereas expansionary monetary policy is normally inflationary, where the benefits of such policy accrue to the rich, the tendency to save or invest the new wealth is high and the marginal propensity to consume is low. Perhaps this is one price of inequality: that monetary policy is blunted and diverted towards more investment and less consumption. Policy makers may wish to consider how the distribution of wealth impacts policy efficacy. Policy that is blind to the distribution of wealth and income can create positive feedback loops which lead to unstable paths or accumulating imbalances.

6 years after the crisis, monetary and fiscal policies have not improved the economy significantly, especially when taken in the context of the financial resources and measures deployed. Global growth has slowed, unemployment remains high and where it has recovered has done so at the expense of the participation rate, income inequality has worsened at the individual and commercial level and geopolitical turbulence has risen, in part from America’s energy boom but in no small part due to growth withdrawal symptoms. What is concerning is that central banks and governments appear to have exhausted their crisis management resources and tools. Interest rates are acutely low, negative in the Eurozone, central bank balance sheets are grossly inflated, and sovereign balance sheets while improving, remain fragile. That inflation is low is a relief for high inflation would inflict serious losses for holders of duration heavy assets such as government bonds which fill the balance sheets of many commercial banks, but low inflation is also failing to erode the value of the stock of debt.

How long can central banks and governments go on supporting asset markets in the hope that sentiment can drag along the real economy? How long can wealth and income inequality continue or worsen, aided and abetted by current economic policy? How long are central banks happy to carry on with their policy tools fully deployed while their efficacy has become blunted? What are the consequences of resetting policy tools such as asset purchases and suppressed interest rates? What if inflation picks up?

Credit Spreads in Pictures. Aug 2014 PDF Print E-mail
Written by Burnham Banks   
Tuesday, 05 August 2014 23:34


Without considering fundamentals, lets look at some pictures…


The global economy is in relatively rude health. The US continues to grow and employment is becoming broader based. The UK is one of the faster growing economies in the developed world. China is recovering nicely as the PBOC eases. The ECB is underwritten the Eurozone economy and is cleaning up the banks. LatAm and some other emerging markets are flirting with stagflation but China, India, Indonesia, are healthy. The MENA is in turmoil and but this is in part a consequence of their waning energy importance. On balance, the world economy looks alright. But there is a right price for everything. Sadly we just don’t know what it is until after the fact. So here are a few pictures for you to make up your own minds.

Last Updated on Wednesday, 06 August 2014 06:37
Why The Fed May Not Be Able To Credibly Raise Rates PDF Print E-mail
Written by Burnham Banks   
Tuesday, 24 February 2015 23:08

At the Humphrey Hawkins last night, the Fed Chair, Janet Yellen signaled flexibility on interest rates neither committing to be patient nor being more hawkish in the face of stronger labour market data.


The Fed has signaled that it is ready to raise rates this year as the US economy has shown strength and the labour market has finally caught up with output growth. However, inflation at 0.8% is far from the 2% target and recent labour market strength is unlikely to boost inflation for some time to come. The strength of the USD is another concern as it could hurt exports, yet the US is a fairly domestically focused economy with exports at 13.5% of GDP (2013 numbers but the ratio is quite stationary) according to the World Bank. One reason for raising rates is that under normal conditions, 0.25% is simply too low and the Fed has to reset its policy tool as well as signal some confidence in the US economy. Even 0.50% is not a high number and neither is 0.75%. Beyond that the Fed actually has no interest in raising rates since apart from the low inflation the debt service costs for the US treasury would rise (by roughly 30+ billion USD per 0.25% increase), as would corporate funding costs.

Let’s say for the sake of argument that the US Fed wanted to raise rates. It would need to do a couple of things. One, it would have to announce its intention and pick a number. Call it a 0.25% hike to take the Fed Funds Target Rate to 0.50%. The current effective Fed Funds rate is 0.12%, it is not 0.25%. In fact the effective rate has traded below the target rate since September 2008 when liquidity injections, bailouts and QE were applied. A positive gap between target and effective rates is a sign of the extent of excess reserves in the banking system. From 1985 to 2008 the gap averaged -3 basis points. From 2008 to the present, it has averaged +13 basis points. Incidentally this is a sign of the ineffectiveness of QE on the real economy. If the Fed wants to hike rates, it will first have to close the gap. It will need to reduce excess reserves in the banking system and has 2 instruments to do this. Term deposits and reverse repos. Term deposit take up has been slow with a take up of 188 billion USD on Feb 5, followed by a 107 billion Feb 12, and 107 billion on Feb 19.

Gone are the days when there was a Fed Funds Target Rate, today we have a target band of 0-0.25%. It might be embarrassing if the Fed announced a rate hike, and found the effective rate trading below the old target.


Last Updated on Tuesday, 24 February 2015 23:28
The Economy's Natural Growth Rate. Never Knew No Miracle Of Policy That Didn't Go From A Blessing To A Curse. Never Knew No Monetary Solution. That Didn't End Up As Something Worse. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 11 February 2015 06:34

The economy has a natural rhythm, a natural metabolism, a natural rate of growth. These growth rates are determined broadly by the endowments of natural resources and the people, how many there are, how quickly they grow, their age distribution, and their intellect and enterprise, and the tools which were made by these people to make other things. To aid the transfer and storage of resources and capital, we introduced money, and with it a great deal of complexity. Yet behind the complexity of finance, the natural rhythms continue.

With time, highly intelligent people decided that they could alter the rhythm and the rate of economic activity. They sought to dampen the cycle and to increase the rate of growth. But in every dynamic system, exogenous forces ripple through the endogenous forces. Cycles are difficult to dampen, and what looks like success can be an accumulation of latent instability. Without acknowledging the long term natural growth rates of an economy, fiscal policy and monetary policy can be likened to pushing or pulling a cripple along, soon he stumbles, his feet are dragging on the floor and policy may need to bear the full weight of an inanimate body.


There are many analogies of where extraordinary analgesic measures are applied to artificially boost performance or delay demise. The concept of a bail in is an odd one. A corporation is capitalized with equity and debt. The priority of claim is well defined. Equity is first in line to take losses and profits. Debt is second in line for losses, and earns a fixed interest. Debt itself can be sliced into different layers, junior claims and senior claims. When a business becomes insolvent, equity takes first loss, then junior debt then senior debt. In the case of banks, for a host of reasons, depositors, who are senior unsecured creditors, are often bailed out. Where they are not bailed out, they are considered bailed in. A bail in is seen as an extraordinary event when in fact, in the absence of a bail out, the appropriate extraordinary event, a bail in is the normal course of assigning residual value to claims.


Much of modern medicine is to do with interfering with the course of nature to prolong and extend life beyond its natural limits. Consider the implications if in the limit we were able to prolong life indefinitely. The planet might struggle to support the population. Genetically modified foods have their advantages and side effects. For every action there are side effects. Not all bad it should be said. Examples abound where our solutions to existing problems only transform or transfer the problem spatially or temporally.


Last Updated on Monday, 16 February 2015 03:05
Negative Bond Yields and Interest Rates. Neither A Borrower Nor A Lender Be. And Now We Are Both... PDF Print E-mail
Written by Burnham Banks   
Sunday, 01 February 2015 23:04

“Neither a borrower nor a lender be; For loan oft loses both itself and friend, and negative yields dulls the edge of policy.”

Now many countries are both.

10 year Swiss and German government bonds currently carry a negative yield. When one moves to shorter maturities, such as 2 years, we find that France, Germany, Sweden, Netherlands, Switzerland and Japan all trade at negative yields. This means that investors, if you can call them that, pay to lend to these governments. One species of large investor willing to pay to lend is the central bank.

So far the negative yields have not been a phenomenon of primary issuance, save in a few circumstances such as Japan. This example is interesting because it pays the issuer to issue. The more issued, the more solvent the issuer. All this needs is a sufficiently motivated lender, the central bank.

Imagine a more extreme example of a negative coupon bond. The only investor willing to buy such an instrument would be the issuer, or their central bank. The mathematics of such an issue would require the suspension of disbelief. The issuer would be paid to borrow and the more the borrowing, the more the payment. At last it would be possible to borrow oneself into solvency, surely the Holy Grail of public finance. The buyer would, however, guarantee themselves a loss. Any other institution than a central bank could therefore lend itself into insolvency if the size of such lending was sufficiently large. Central banks, however, are special. They can meet obligations by creating money. All this is of course a circuitous route for a government seeking to spend and fund its spending with bits of paper.

So far the money creation has not multiplied through the economy to encourage economic growth. Instead the velocity of circulation of money has slowed, nullifying the money base expansion. Why is this? It is hard to tell but one possibility is that the transactional demand for money simply isn’t there. Consumers are cautious and businesses are sceptical. Trade is complicated by competitiveness, policy and productivity. Governments could spend. If, however, despite the largess of their central banks, governments, for ideology or other reasons, decide to rein in spending then it is no wonder that output and employment languish. A practical case in point is the ECB’s bond buying program. While the scale of the program is large, by requiring Member State’s conform to the Maastricht debt criteria, the EU is neutralizing QE. So QE works if it monetizes debt incurred when the government spends on behalf of the private sector and is much less effective if the government does not.

If a country can borrow at negative rates of interest, expand its central bank’s balance sheet without bound and target a budget deficit to replace deficient private demand, what is the cost and what are the limits?

Private and external investors may be discouraged from buying bonds. This can impair liquidity and price discovery in the bond market. God forbid anyone should discover the true price of a bond. With negative interest rates, investors will naturally seek alternative stores of value. Central banks inducing negative interest rates may find themselves the sole buyers of their sovereign’s bonds. Captive domestic investors may not have the luxury of directing their capital elsewhere. Examples of this are state pension and social security funds. If private investors are discouraged from buying bonds it means that central banks will have difficult exits and find it painful to reduce the size of their balance sheets. Any reduction of central bank bond buying would lead to higher yields. The US experience today confounds this analysis but here, a stabilizing budget and the changing structure of treasury financing are responsible for keeping yields low. And, yields may still rise for we are still in uncharted territory. The US is in fact further along this path than their brethren. The Fed’s balance sheet has only shrunk in the last two weeks having peaked at USD 4.516 trillion on January 14.

The currency might weaken. This can improve the competitiveness of the country’s exports but can also import inflation through higher input prices. Yet not everyone can be a net exporter, try though they might. Since 2008 countries have tried to debase their currencies in an effort to improve competitiveness and export their way to recovery. Weakening a currency is a risky strategy since excessive weakness brings its own problems. Hyperinflation is seldom the consequence of bad economics. They are the consequence of a failure of confidence, a failure that is often the consequence of bad economics. A beggar-thy-neighbour strategy requires a steadily declining currency. A volatile and acutely weak currency can lead to capital flight, spiking interest rates and end in capital controls and market failure.

Confidence is one of the most important factors in finance. Loss of confidence can lead to acute acceleration of trends leading to currency crises, credit crises and hyperinflation.

Efficacy. The intent of policy is to revive private demand. Government spending can improve headline output but can also crowd out private demand with little impact on private output and employment. The poor efficacy of multiple rounds of QE in the US is illustrative. While the money base was expanded nominal output languished as the velocity of circulation fell. The private economy has a natural metabolism which cannot easily be accelerated simply by association. There was simply no multiplier effect to the government’s fiscal efforts to boost the economy as liquidity was soaked up by saving.

Artificial depression of interest rates across the term structure are intended to reduce borrowing costs, but if rates were already low, policy may be pushing on a string. Again, the private economy’s natural metabolism cannot always be accelerated by the provision of cheap credit. ‘Build it and they will come’ doesn't translate well into ‘offer to lend and they will borrow’.

Nominal output may grow but there is no guarantee that real output will grow. The growth might be entirely in prices, that is inflation. Moreover, nominal output would include all goods and services as well as assets. The growth may manifest more in asset price inflation. Asset price inflation supported mostly by liquidity and a dearth of viable alternatives can easily be deflated in disorderly fashion.

Nobody knows what market prices are. For factor inputs, assets or goods and services. As a result, certain markets will not clear. When central banks buy sovereign bonds they impact prices. In order to avoid acute price distortion bond purchase programs may have limits on how much of an issuer’s total debt or how much of a particular issue or issues in a particular maturity range may be bought. This is not effective because apart from the direct impact on pricing central banks’ intentions signal to the market future demand leading the market to react accordingly. This may be helpful at the initiation of a bond purchase program as the market aids the central bank in depressing borrowing costs but can be less helpful on the exit. For the central planner the price distortion is a difficult problem. Since the market price absent intervention is unknown, the impact of withdrawing from intervention is unknown. This uncertainty discourages central banks from exiting intervention until it is too late.


Some tidbits:

In a sense, central banks are going back to their roots. The Bank of England was established in 1694 to fund William III’s defence spending. The government issued debt of GBP 1.2 million, which was subscribed by the bank in a very modern QE type move, and carried an interest rate of 8%, which would surely have sunk modern United Kingdom. What was different was that the Bank bought a primary issue loan and the government promptly spent it building a navy. Imagine if the government was told to maintain a 3% budget deficit limit.

The world’s oldest central bank, the Riksbank, was established in 1668. Its predecessor was Stockholm Banco, whose founder Johan Palmstruch was condemned to death for bankrupting the bank through over issuing bank notes; he was later pardoned and is today unconsciously emulated by most fashionable central bankers. Riksbank was the first bank to use negative interest rates, lowering its deposit rate to -0.25% in July 2009. Its motto is Herefore Strength and Safety.

You may now stop suspending disbelief.

Suppose the US Fed Decides To Delay The Rate Hike. PDF Print E-mail
Written by Burnham Banks   
Friday, 23 January 2015 07:36

Yet another FOMC meeting has passed and the market continues to scrutinize the language of the FOMC statement for clues of what the Fed intends to do, heavily assuming that the Fed in fact knows what to do. The details will have been circulated ad nauseum by the financial press so we won’t delve into them here. Instead let us consider possibilities.

The market has been expecting the US Fed to raise interest rates, the timing is fluid but sometime this year seems to be the expectation. The Fed has to raise interest rates eventually if nothing else to reset an important policy tool. The strength of the US economy where employment is finally catching up to headline GDP growth is another factor. The current growth the US is experiencing is reminiscent of the mid 1990s Goldilocks (not too hot, not too cold, just right) economy, helped by depressed oil, energy and commodity prices. The weakness in the global economy is also helping the US grow without a pickup in inflation. China’s growth is decelerating, Japan is in recession and the Eurozone while recovering is barely clinging on to positive growth.

The consensus is therefore that the US has done with monetary accommodation and low rates while the rest of the world, stagflationary economies excepting, are in monetary loosening mode. What if the Fed was to postpone its rate hike? What would be the consequence? What is the likelihood? The USD could weaken. The consensus is for a strong USD and this is a very strong consensus. In the absence of a rate hike, the market could be quite unpleasantly surprised. The 10 year US treasury yield could move towards 1% and the 30 year to 2%. This could happen anyway while we wait for the rate hike. Fixed coupon issuance is likely to slow as tax receipts improve and debt is issued in FRN format. The demand and supply dynamics could flatten the curve.

Why might the Fed delay a rate hike? Low inflation might be one reason. 5 year 5 year forward breakeven which traded between between 2.4% to 2.6% has fallen steadily to 1.94% in Jan 2015. Deflation risk might stay the hand of the Fed. Slowing international growth is another possibility. The US is currently the main engine of growth. Of course people forget that the 7% growth rate that China puts out is a big number for a big economy, but even that number is shrinking. Latin America is flirting with stagflation. Brazil’s rising rates since March 2013 have not stopped the Real from steadily losing ground against USD. Europe has only just begun its money printing and debt monetization activities. If the European QE takes time to bite and Europe slows further, the US may not be able to raise rates for a while. In these scenarios, however, a weak USD is not likely since other currencies would be debased aggressively. Then there is the little question of the US treasury's interest expense, currently 416 billion USD a year. A 0.25% hike in rates could, depending on debt maturities, issuance and impact on the term structure, result in interest expense rising some 50 billion USD, a 12% increase. Gently does it Janet.



Last Updated on Thursday, 29 January 2015 00:52
Staying Positive on China PDF Print E-mail
Written by Burnham Banks   
Wednesday, 21 January 2015 03:10

We remain positive on the outlook for China generally across risk assets.

  1. Political reform is happening in the open and behind the scenes. At the Fourth Plenum, China elevated the constitution and announced the establishment of circuit courts free from local government influence.
  2. Part of the reform is the wide scale anti-corruption effort which has ensnared some high profile officials previously believed off limits.
  3. China is embarking on credit market reforms including eschewing blanket bailouts, encouraging more market discipline, regulating local government financing methods, prescribing collateral eligibility in swaps and repos. The recent policing of equity market margin trading is another encouraging measure.
  4. Monetary policy has turned loose and is likely to stay that way. The PBOC reacted to US QE by tightening monetary conditions for the past 5 years expecting inflation. Inflation has abated and external economies are at risk of deflation. The PBOC has moved to compensate. Expect further macro prudential as well as traditional loosening.
  5. The Chinese economy is slowing which is to be expected. That said, it is still the fasting growing large economy. The slowing economy will encourage the PBOC to be more aggressive.






The outlook is good for China risk assets. The investment strategy should be, A) avoid the obviously non viable, B) diversify among the remaining alternatives.


Grexit or Grejection PDF Print E-mail
Written by Burnham Banks   
Tuesday, 06 January 2015 08:23

Can you bail out a country by extending it more credit? Can a distressed entity borrow itself into solvency? The answer to both questions is, yes, but its hard. Greece seems to be expected to do so. In 2014 Greece has managed a primary surplus and is expected to repeat this performance in 2015.

1. 1. Greece stays in the currency union but defaults on its debt.

This Greece has done before in March 2012 when creditors exchanged existing bonds for longer dated ones with a 53.5% write-down of face value. Absent a better business model or an internal adjustment to domestic factor prices, expect more defaults.

2. 2. Greece stays in the currency union but has its debt restructured subject to austerity conditions.

This is what was the situation in 1 above was sold to creditors and the market. The restructuring above involved an exchange and a write-down. Absent a better business model or an internal adjustment to domestic factor prices, expect more debt restructurings.

3. 3. Greece leaves the currency union.

It would be irrational for Greece to leave the union without also defaulting on its Euro denominated debt. This would be the main perk for leaving the union. A new Drachma would re-price rapidly to adjust domestic factor prices so as to reflect productivity. It is likely that inflation would surge as the Drachma fell and Greece would be pushed into stagflation. Then it would recover. Without the crutch or shackles of the Euro, a flexible Drachma would adjust where domestic prices were sticky and factor and goods markets would clear. Absent a better business model... well, you get the idea. A country that defaults in Euros will default in Drachmas.

4. 4. Greece is ejected from the currency union.

The only reason Greece might be ejected from the currency union, apart from economic enlightenment, would be debt default. Actually, there is another reason but it is highly unlikely. The ejection of Greece would certainly encourage the rest of the union to take fiscal viability seriously. It is in Germany’s interest therefore to eject Greece before any default or bailout is negotiated. Such brinksmanship is highly improbable.

What does Greece want? Scenario 1 is most preferable for Greece. A debt write-down would be ideal for the debtor nation but this would leave Greece locked out of debt markets for some time. If the ECB had intended to buy sovereign debt in its recent plans for QE, a Greek default would certainly delay if not destroy such plans as questions would be raised as to the treatment of Greek bonds already on the ECB’s balance sheet. These bonds were not impaired in the first Greek debt exchange in 2012 and it is improbable that they would escape a write-down this time. Hold them at par and the recovery on the rest of the claims will be reduced. It would debase the entire "whatever it takes" pledge of the ECB.

What does Germany want? Fiscal rectitude and austerity on the part of Greece. Already it has leaked to the media its preparations for a Greek exit from the union, a leak which it subsequently quickly denied.


Last Updated on Tuesday, 06 January 2015 08:31
Debt Monetization, QE, Inflation, Deflation and Expropriation PDF Print E-mail
Written by Burnham Banks   
Friday, 12 December 2014 01:44

Central Bank Large Scale Asset Purchases, by which is meant the buying of government or agency debt, is intended to ensure demand for such bonds and to keep borrowing costs low for the government and any other debt issuer whose cost of debt is correlated or benchmarked to government bond yields. Large Scale Asset Purchases, or QE, as they are popularly called, are meant to be a boost to the economy. The experiment has worked in the US, to  a certain extent. Lower borrowing costs have certain allowed corporate bond issuers to liquefy their balance sheets. Lower mortgage rates have spurred a rebound in housing prices which have led to healthier household balance sheets. The follow on impact from businesses to labour and employment has been slow.

QE directly funds government whereby a central bank buys bonds issued by the government. The central bank’s assets rise by the value of the bonds it has bought, and the liabilities rise by the same amount as it issues liabilities to fund the purchases. These can take the form of cash in the government’s reserve or cash accounts. It is convenient if the bonds are sufficiently highly rated that they consume no capital. It is hoped that central banks are thus able to help governments refinance themselves and buy enough time to return to fiscal balance and thus more attractive to private lenders. A growing economy is necessary, but not sufficient, for a government to improve its fiscal position through improving tax receipts. Fiscal profligacy can confound even a growing economy and rising tax receipts. It would appear that debt monetization cannot go on indefinitely if the government’s financial position is steadily deteriorating. Note that a constant budget deficit or a constantly rising level of debt has been demonstrated to be sustainable whenever there was sufficient domestic savings to fund this debt. It helps if the savers have no option but to fund this debt. In the absence of a such private funding there is debt monetization by central banks. The result, however, is an ever inflating balance sheet as more debt is issued to central banks in return for more printed money. This type of creative accounting can be quite persistent.


If rates rise and the bond prices fall, the central bank can either not mark them to market arguing that they will be held to maturity, or, they can mark them as available for sale and mark them to market. At that stage, any loss incurred by the bank will impact its equity. If the issuer, that is the government, buys back these bonds at below par, they will have made a profit equal to the loss incurred by the bank. The government could then recapitalize the bank by precisely the loss it had incurred in the first place. The value of the bonds, therefore, once in the hands of the central bank, are immaterial. This is pure money printing.


The government’s reserves with the central bank do not count as the money base. A government that is printing money is, however, likely not to leave too much money in its reserve account but to spend it quickly. The money thus finds its way to the commercial banks and becomes part of the money base. The money base is the multiplicand to which the velocity of money is multiplier in the identity that equates to nominal output. A sufficiently large money base makes an economy vulnerable to inflation or hyperinflation. Hyperinflation is usually a consequence of loss of confidence rather than a continuous process and will require more than an over inflated money base to trigger. But, persistent inflation can lead to a loss of confidence at some point.


Inflation aggregates domestic and external purchasing power. The measure of the external purchasing power of a currency is its exchange rate. Where debt monetization results in acute currency weakness, external inflation is already underway. This can impact headline inflation through imported goods and inputs.


In many ways, inflation is a signal rather than a lever. Targeting inflation religiously can distract policy from underlying causes. Disinflation can either be a result of productivity gains or deficient demand, or both. Persistent QE and low inflation can be a sign of an acutely weak economy as efforts at supporting sagging demand only just compensate for natural weakness. If the currency is also weak at the same time, it could signal that price support from rising costs were being compensated by substitution in a flexible economy with high productive efficiency which was also operating below capacity.


Where a country has financed itself in a foreign currency and or with foreign capital, as many emerging markets do, the ability to borrow is limited. Countries can default on debt not denominated in their own currency. The risk of default limits the demand for ever increasing issuance. Countries are not compelled to, but may choose to default on debt denominated in their own currency. Venezuela (1998), Russia (1998), Ukraine (1998), Ecuador (1999), Argentina (2001) are some examples. The ability to choose not to default, come hell or high water, on local currency debt, comes at a price, being the external value of that debt, thus the currency bears the brunt, and a de facto default occurs with a recovery rate equal to 100% less the depreciation of the currency relative to the bond holders base currency. Where the bond holders are hapless domestic investors, forced to lend to the government, no default de facto or technical occurs. Such investors would behave rationally if they save more to make up for the debasement of their forced saving and invest abroad as far as possible to compensate for the de facto expropriation. This can result in lower demand and deflation. Governments of such countries have to spend more to compensate for this demand deficiency, worsening their balance sheet and necessitating further debt monetization or de facto expropriation.


Ten Seconds Into The Future. 2015 Macro and Investment Outlook PDF Print E-mail
Written by Burnham Banks   
Wednesday, 26 November 2014 02:41

Themes: Risk On and Pray Hard.


Rates and Credit:

Long US treasuries at the long end. 30 year and 10 year USTs remain attractive relative to short end. Expect further curve flattening.

Overweight / Long China equities. Despite slowing economic growth, earnings growth remains robust and the PBOC will likely be expansionary and China equities are cheap compared with most international equity markets. Longer term prospects are supported by structural reform.

Developed market credit is still attractive but investors have to be selective. Despite healthy profits and balance sheets, US corporate credit is expensive and high yield particularly so.

European corporate credit remains attractive based on fundamentals but pricing is also getting stretched. We prefer idiosyncratic situations such as regulation driven bank recapitalization trades.

European bank capital is a trade which is long in the tooth but remains attractive as ECB policy supports the recapitalization and reorganization of bank balance sheets.

The leveraged loan market is underpinned by healthy fundamentals but secondary market liquidity is becoming a concern. Fundamentals remain healthy with default rates likely to be in the 2% region with high recoveries in the coming year. The risk of a sharp correction is significant but such should be regarded as a buying opportunity.

In securitized products, US non agency RMBS remains an attractive asset class despite the trade being long in the tooth. Agency RMBS derivatives are cheap and can be used to also hedge a long duration portfolio. Australian RMBS has done well but bonds are now expensive. European ABS and covered bonds will be underpinned by the ECBs asset purchase programs.

The thirst for yield has caused the high yield market to run ahead of itself. Generally, globally, we prefer investment grade to high yield on a relative value basis as high yield is now trading tight to investment grade.

Underweight LatAm equities and corporate bonds. With the exception of Mexico, the region is in or close to stagflation on the back of over-reliance on China demand for commodities and failure to reform or a regression towards inefficient and populist policies.


US equities are not cheap but they are supported by strong fundamentals. Relative to other regions, US equities have the advantage. While a long term buy, valuations are too rich. To buy US domestic risk, look to credit. High yield is similarly expensive, however, so focus on private label mortgages and investment grade corporates.

China equities will benefit from the PBOC’s newly accommodative stance. Despite strong growth and cheap valuations, China equities have been constrained by tight monetary conditions at home. This is already changing with noticeable effect. Buy the domestic listings.

European equities were cheap but no longer. The international nature of European equities and the level of dispersion in their financial performance means that Europe is an excellent place to generate alpha. The rate and policy environment do, however, recommend corporate credit ahead of equities as the more efficient trade expression. In Europe, underweight equities in favour of credit.

Reform countries including India, Indonesia and Japan will be well supported as investment is revived. Where corporate governance lags the developed markets, side with business owners and own the equity instead of the debt.

FX and Commodities:

The long USD trade has become an alarmingly consensus trade. While the long term fundamentals are constructive for the USD, volatility is picking up and a trading strategy is recommended. The obvious candidates to short are the EUR and JPY where policy is decidedly in favour and economies are sufficiently weak that the US will tolerate the clearly mercantilist policy.

China’s slowdown may be more pronounced than reported or expected. This will likely trigger more infrastructure investment boosting basic materials and industrial metals.

Last Updated on Thursday, 27 November 2014 00:00
China. A positive outlook at last. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 04 November 2014 00:49

The China A share market surged last week. It is time to reiterate my optimistic appraisal of the China market. It is not too late.

Back in July, we noted that

  1. China equities were underowned.
  2. China equities were trading cheap.
  3. China equities had been in a 6 year bear market. This was most likely the consequence of the PBOC’s tight monetary conditions.

We postulated that the PBOC’s stance was driven by inflation concerns in the traded goods sector and the volatility in the commodities and food markets. 3 years ago food prices were rising at nearly 15% YOY and has since hovered between 2.5% to 5% since. It is likely that the PBOC views the US Fed’s expansionary balance sheet policy as a source of inflation in the traded goods sector and felt it necessary to compensate. Another concern was the growth of the Shadow Banking system in the form of off balance sheet funding vehicles. This is a more complicated topic but one which I believe has less of an impact on PBOC policy. The reason is that credit can be isolated in a semi closed economy whereas traded goods are sufficiently open to be impacted by international flows.

The trigger for the buy recommendation was the impending end to the US Fed’s expansionary balance sheet policy. With the end of QE, while the Fed’s balance sheet will not likely shrink quickly, or at all in the short term, it is at least static. The latitude that this provides the PBOC in expanding liquidity to support a slowing economy is important. China’s inflation has slowed to 1.6% with food inflation down to 2.3%. Widespread global disinflation will impact the traded goods markets in China providing further room for expansionary policy. The impact on semi closed markets, whether by nature or regulation, such as services and asset markets, is inflationary.

I previously held that China had a long term innovation deficit and that it had to buy or otherwise acquire technology. I am still of this view, but there are nuances to that view. The cutting edge of technology remains in the developed Western economies, bit China is catching up. There is a chance that this long term trajectory can be reversed.For investors and traders, a shorter time frame is more relevant.

One of the more important developments in China took place last week. The Fourth Plenum produced a number of interesting and constructive signals. The Central Committee chose to reduce the influence of local level officials over the legal system, establishing circuit courts with greater independence from local Party officials. There was some woolly announcement about accountability and transparency of government but details were scant. The most important announcement was the elevation of the constitution within the rule of law. The consensus is that the Party’s authority would not be weakened by constitutionalism but an optimist would hope that while the Party might not be compelled to work within the constitution, it might work with the constitution to more efficiently and fairly govern the country. Certainly this focus on the constitution places the anti corruption efforts in a less cynical perspective.

Bottom line: We are likely to have an expansionary PBOC and we are hopeful that concrete legislative reform is underway. At the same time we have cheap stocks and healthy growth at a time when developed markets face deflation risks and other emerging markets like LatAm face stagflationary risks, China is a good place to invest.

Last Updated on Tuesday, 04 November 2014 00:53
Fed Funding Treasury PDF Print E-mail
Written by Burnham Banks   
Tuesday, 23 September 2014 04:30

The current interest expense on public debt of the US treasury presents an interesting picture. Given the current term structure, 2 year treasury FRN’s are an extremely attractive means of financing. They trade at some 4 basis points over 3 month T bills, which trade at about a basis point.

Assuming that the 3 month T bill trades up to 230, which is where the 2 year 2 year forwards are trading, this means that the existing stock of FRNs would see an increase in interest expense from 0.01% of total debt service, to 0.6%, an almost negligible increment. The math changes if the issuance accelerates. If we cynically assumed that the Fed worked only for the Treasury, a CFO would look at the trade off of financing between 2 yr fixed and the floating rate, in 2 years time. If the 2 yr rate was 230, then what latitude would the Fed have in raising interest rates? It turns out, quite a lot.

Unfortunately, at this point, I have not the resources to conduct a thorough study of the US treasury’s funding needs and planned issuance and what a rational CFO would structure the balance sheet. Let's see if I can co-opt the research team to do some work for me...

Just as an aside and an aide memoire…

For the year 2014, UST issuance will roughly look like:

160+m of 2y FRN

168m of 30y

260m of 10y

350m of 7y

420m of 5y

340m of 3y

360m of 2y

Policy Fatigue in Europe PDF Print E-mail
Written by Burnham Banks   
Thursday, 18 September 2014 23:33


There is policy fatigue in Europe. The recent LTRO has had poor take up, a mere 83 billion eur compared to 290 billion at the first 3 year LTRO.

The first LTRO allowed banks in the euro area to do something they had not been able to before, to trade out of their foreign debt and into their local debt, and to buy more bonds. It was an outsourced QE. The current LTRO allows banks to do nothing new. In fact, the conditional nature of this LTRO makes it less attractive. Moreover, the euro area banks are in the midst of recapitalization and until this is done, LTRO’s are merely liquidity operations that require capital for animation, capital which is yet scarce.

This is positive for Europe. A ‘big gun’ solution might be a better analgesic but this current incremental policy provides a protracted and incremental support for European risk assets. It is, to be clear, a dangerous game, but it lifts the market steadily. Given the tepid response to the LTRO the ECB will be forced to do more, and do more it will.

Let me make a wild and reckless forecast. The ECB will design a TBA market for ABS underwriting not only secondary market ABS but blind pool primary issues, in effect co-opting the commercial banks to be their originators.


Last Updated on Thursday, 18 September 2014 23:35
The Putin Problem PDF Print E-mail
Written by Burnham Banks   
Friday, 05 September 2014 06:47


What does Putin want? It’s not clear. It’s likely he wants more than Ukraine. Those who believed that he would stop with South Ossetia and Abkhazia were wrong.

What drives Putin? Avenging the humiliation of the USSR is a clear motivation. Having held arbitrary power within the KGB, he longs to exercise it again. He does so within Russian territory but he longs to exercise it at least to the extent of the old Soviet boundaries.

How does Putin operate? He sows discord among his enemies. He knows when to hold and when to fold but he’s always at the table. He doesn’t need allies, only that his enemies are not completely aligned. He relies on his enemies not being committed to action, a glimmer of fear, a seam of pacifism.

He lives by obfuscation, behaves erratically, arbitrarily and disingenuously. In a word, he is capricious.

Those who engage him are bewildered by his irrationality, a gambit he employs well. They misread him. The illogic is designed to confuse and to conceal a deeper logic which is only revealed when it is too late. Putin needs to be dealt with firmly. Europe’s prevarication plays into his hands. Their measured and considered approach is based more in hope than experience and they will pay for it. This man does not mean to stop at Ukraine. Nor are his ambitions circumscribed by geography. He is a danger to Europe and to world order. Deal with him meekly and the world will pay.


Last Updated on Friday, 05 September 2014 06:50
Rates, Bonds, Inflation. PDF Print E-mail
Written by Burnham Banks   
Monday, 25 August 2014 01:05

The near term direction of rates and bonds are not dependent on whether or not the Fed actually hikes rates in Q3 2015 or Q1 2016. They are dependent on when the market thinks the Fed will hikes rates in Q3 2015 or Q1 2016. It is clear from the ruminations of central bankers that they themselves don’t know when they will hike rates; so much is dependent on data. Each piece of data exerts a pull on the Fed, some towards raising rates and some towards delaying the day.

  1. The US economy is stronger than the Fed or the market thinks. Especially relative to the new lower long term potential mean.
  2. The labour market is healthier than consensus.
  3. Economic nationalism will favor economies with a deep consumer base, intellectual property generation and manufacturing capability. NAIRU will, however, be lower.
  4. Inflation may surprise on the upside. Inflation could arrive sooner than expected as slack in the economy is underestimated.
  5. The US treasury’s funding requirements may be lower than expected on the back of stronger tax revenues.
  6. The substitution of funding type from fixed coupon to floating creates a relative shortage of fixed coupon.
  7. War may change the funding requirements for Treasury. Currently, however, military spending is expected to continue to decline.

Point 1 above allows one to trade around cyclical assets as the market misjudges the cycle by misjudging growth relative to long term mean. Cyclical slowdowns are pauses which can be misinterpreted as fails creating buy opportunities. Cyclical lows are misjudged as fails when in fact they are inflexion points. Trading should be buying and selling earlier than the consensus cycle.

Point 2, 3 and 4 may introduce volatility to the treasury market and duration assets. Point 5 and 6 could imply a relative oversupply of corporate duration relative to sovereigns translating into spread widening.

Points 5 and 6 in isolation of 2, 3 and 4 suggest buying the dips of longer dated treasuries. Unless 7 takes hold.





Credit Market Turbulence. How To Think About Credit Investing August 2014 PDF Print E-mail
Written by Burnham Banks   
Wednesday, 06 August 2014 06:38

After a year of abnormally low volatility, high yield markets are correcting across the globe. Since 2008 the high yield market has experienced 3 bouts of turbulence

  1. The European sovereign crisis in 2011.
  2. The “Taper Tantrum” of 2013.
  3. The last few weeks.

Why have high yield credit markets exhibited this volatility recently?

Ten Seconds Into The Future. July 2014 PDF Print E-mail
Written by Burnham Banks   
Tuesday, 15 July 2014 23:19

Equity, bond, FX, swaption and commodity volatility have one thing in common. They have contracted steadily from 2008/9 levels to 2006 levels, almost in lockstep. To some, this is a sign of complacency, to others, calm.

Last Updated on Wednesday, 16 July 2014 06:41
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