Adding Fiscal Policy To Monetary Policy, QE and ZIRP. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 03 August 2016 05:11

Monetary policy has likely reached the limits of usefulness, not necessarily the limits of efficacy. The efficacy of monetary policy was questionable in the first place. Multiple QE programs and low interest rates have managed to inflate assets but not to spur the economy as much as was hoped.

Monetary policy is but one class of tools available to encourage growth, fiscal policy being the other. Without fiscal stimulus, monetary policy has to work doubly hard and faces leakage in terms of risk of asset price bubbles, unequal distribution of benefits, disinflation due to increased capacity, and downward pressure on interest rates. Fiscal policy will not mitigate all of these side effects but it could reverse some of the unequal distribution of benefits and put a floor under market interest rates.

Why has fiscal policy not been engaged so far?

  • Many countries’ national debt is high in relation to GDP, many on account of financial sector bailouts in the crisis of 2008.

  • Austerity followed as economic orthodoxy. The Eurozone, for example, has strict guidelines on state budgets.

  • Operating both monetary and fiscal easing carries high inflation risk as output is boosted to potential and could overshoot. By operating monetary policy first, excess capacity is allowed to build before fiscal policy is applied to raise capacity utilization.

  • Fiscal policy is politically charged and requires strong government to obtain approvals.

  • Cost of debt is another factor. Leading with monetary policy results in lower cost of debt for governments if they subsequently raise spending and seek to finance it in the bond markets.


Are we likely to see a shift towards fiscal policy?

  • Japan has periodically engaged in fiscal stimulus which has seen its national debt climb from 0.5X GDP in the 1980s to over 2.5X today. Just days ago, the Abe government announced a 28 trillion JPY fiscal package.

  • Japan was able to do this as the Abe government, already with a super-majority in the lower house had recently won a super-majority in the upper house, was unchallenged in the Diet.

  • BoJ’s QQE and negative interest rate policy had taken 10 year JGB yields from 1.66% in 2008 to -0.29% just a week ago. Cost of debt is very low.

  • Japan needs reflationary policy to revive its economy. Recent data has shown Japan sliding back from the recovery from the first dose of Abenomics.


Does Europe need fiscal stimulus, and if it did, could it become a reality?

  • The European economy is still on track with the recovery triggered since the LTRO operations of late 2011. PMI data point to the durability of this recovery.

  • The risks to the recovery are Brexit, both directly and indirectly should it trigger more divisions, security, which could embolden nationalists and Eurosceptics seeking to close Europe and restrict freedom of movement, and a long list of local events, such as the impending Italian legislative referendum, which could escalate and spread into more, threatening the integrity of the union.

  • Even if there was cause for fiscal stimulus, Europe has strict guidelines regarding budget deficits. While these limits have often been broken, they have not been intentionally breached as part of a deliberate spending campaign. Eurozone national debt to GDP is still elevated having risen from a low 65% in 2007 to 92% in late 2014; it has receded to 90.7%, still a very high level.

  • While monetary policy is coordinated by the ECB, the lack of fiscal union would mean that fiscal plans are domestic affairs. Coordination would be difficult and depend significantly on the strength of the individual member states’ governments and their ability to approve such programs. Assuming each member state budgets towards their own situation, they would find monetary policy calibrated to the collective and not to their own circumstances.

  • That said, the ECB too has followed a similar path as the BoJ in QE and negative interest rate policy resulting in conditions conducive to debt financing fiscal deficits.

What are the consequences of adding fiscal policy to monetary policy?

  • Monetary policy has dual impact on inflation. On the one hand lower rates spur activity, or at least facilitate activity and in that respect spurs inflation. On the other hand, low interest rates encourage over investment and over capacity which have more durable deflationary pressure. Fiscal policy mitigates this by addressing directly the demand deficiency and is therefore inflationary.

  • On its own, QE and NIRP lower interest rates across the term structure. The application of fiscal stimulus increases the demand for money and bids up yields across the term structure.

  • Fiscal stimulus is likely to cause currency appreciation as interest rates rise. The impact on trade is less predictable given the number of distortionary trade pacts in force and the protectionist biases in the current environment. At this stage it is likely to be neutral.

  • Fiscal deficits are a prime example of kicking the can down the road as the expenditure will need to be financed and financed with long term debt. Given that most countries are running historically high debt to GDP ratios, the assumption of more debt could be destabilizing at some point. This could lead to sharper interest rates and weaker currencies.

  • The crowding out of the private sector is a particular risk given that monetary policy has already exposed weak private investment and demand.

  • The biggest risk is not one resulting directly from fiscal or monetary policy but the slippery slope that all analgesic solutions pose. We have witnessed how easy it is to embark on QE and rate cutting policies and how difficult it is to wean economies off such policies. The same will apply to fiscal policy. What it implies is that governments will continue to apply policies which provide short term relief but which may not treat the underlying cause of slow growth, and that the only way such policies are withdrawn is not when they are no longer needed, but when governments can no longer sustain them.

Last Updated on Wednesday, 03 August 2016 05:14
What is Helicopter Money, WIll It Work and What Are The Risks? PDF Print E-mail
Written by Burnham Banks   
Wednesday, 27 July 2016 01:56

What is Helicopter Money?

There is still much confusion over what exactly ‘helicopter money’ means. In 1969, Milton Friedman coined the term in an extreme example to illustrate a point.

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated." (Milton Friedman, “The Optimum Quantity of Money,” 1969)

In practical terms, helicopter money would require the central bank or some other branch of government to with the authority to create money, to fund the national debt precisely through the creation of money; debt monetization. As such a more precise name for ‘helicopter money’ is Monetized Fiscal Policy (MFP).

What is the difference between QE and MFP?

In QE, the central bank buys government bonds from private investors who had bought the bonds, ultimately from the government. In MFP, the central bank buys bonds from the government. The difference seems almost academic.

So far, QE has been undertaken in the US, UK and Eurozone without deliberately targeting a budget deficit. To the contrary, countries undertaking QE have tended to at least attempt fiscal responsibility. From a prudential management viewpoint this is sound policy but from an economic growth viewpoint this is somewhat self-defeating. When the problem is not undersupply of credit but deficient demand, monetary policy drives interest rates down with low impact on growth. This has been supported by data.

MFP involves operating a fiscal deficit, either in the form of tax cuts or investment spending which is subsequently funded by the central bank. The stimulus effect comes not from lowering interest rates and providing credit or liquidity, but in directly augmenting demand. Output rises directly as a result of the fiscal expansion. Whether or not the capital infusion circulates or gets saved is a separate matter. If the economy is facing deficient private demand it may take some time for inflationary effects to spur private demand.

What are the risks of MFP?

A distinction is often made between debt financed and money financed fiscal policy. This distinction is a very fine one and is not well defined. Proponents of MFP prefer to think of the debt purchased by the central bank as permanent, or written off. The central bank not only buys the bonds of the government but that debt is either perpetual or the central bank promises to maintain its balance sheet through refinancing these bonds in perpetuity. The accounting pedant would consider this debt outstanding and not written off, but that it had a perpetual buyer of last resort. In effect the central bank becomes the lender of last resort to the state, as much as a lender of last resort to the commercial banks. There are risks associated with this role.

We have seen how difficult it has been to wean an economy off QE. The Fed is the least accommodating of the major central banks yet its balance sheet has not shrunk since 2014 despite an end to its asset purchase program. The Fed continues to maintain a 4.5 trillion USD balance sheet by reinvesting coupons and maturing principal.

We have seen also how difficult it is to wean economies off low interest rates. The Fed had planned on a gentle path of rate hikes as early as mid 2015. It has managed one rate hike Dec 2015. The next one may come before Godot. Targeting unusually low interest rates distorts the single most important price in the economy, the price of money, leading to misallocation of resources, and encouraging overcapacity which may ultimately be disinflationary while impairing the profitability and solvency of the banking and insurance industry.

There is a tangible risk that MFP once implemented is accelerated. The experiences of QE and ZIRP have shown the economy’s propensity for chronic dependence on analgesics. Since the central bank acts as lender of last resort to the state, accelerations of MPF can damage confidence and lead to a run on the assets and currency of the country.

How should the money be spent? This is a difficult question in the best of times. Most developed world economies could do with infrastructure upgrades. Better funding of medical and social insurance programs would be welcome. However, public spending is to a great extent a political matter, less so an economic one. The risk that spending is inefficient and does not make a sufficient return on investment, not to the state alone but to society, is high. Also, fiscal spending tends to be sticky upwards, meaning that it is later difficult to cut back when MFP is no longer required. In fact it would increase the probability that MFP once begun would be perpetual.

Tax cuts are another channel for MPF. Here too, the consideration will likely be more political than economic. Given the explicitly unnatural nature of permanently financing a tax rebate by monetization, the design of MFP specific tax structure will likely be highly politicized and contentious.

Unanswered questions following MFP

Since the central bank is the lender of last resort to the state it is reasonable to ask what is the capital position of the central bank, how liquid and solvent is the central bank.

What is the balance sheet of the country? What are its assets and liabilities? Is it well defined?

What happens if the central bank’s accounts were consolidated into the country’s balance sheet?

Last Updated on Wednesday, 27 July 2016 01:59
Final Act For Falling Bond Yields and Interest Rates? QE + Fiscal Policy. Helicopter Moiney. PDF Print E-mail
Written by Burnham Banks   
Monday, 18 July 2016 01:58

We have seen how effective QE can be. Not very. Not for Main Street at least. For Wall Street, QE has depressed bond yields and helped to camouflage the overvaluation of paper assets supporting them at inefficient levels for too long. More than that, the effectiveness of QE is wearing out like an over prescribed antibiotic. Now the global economy is still growing, not fast, but still growing. The US economy is in rude health. But the progression of inequality coupled with paltry growth means that the mass of the population is actually experiencing falling standards of living, even as aggregate data show improvement.

Lately, the talk of helicopter money has been gaining volume. The practical deployment of helicopter money is fiscal deficit spending funded not by tax but by debt monetization, in other words, QE. So far QE has been less effective probably because it was an attempt to clap with one hand. At last, this failure may be addressed. This may solve some issues and get the economy growing faster, hopefully to compensate for the rising inequality so that the masses may be raised out of their financial stagnation. However, there are a few minor side effects. The national debt will gro. Fiscal policy funded by tax is neutral and ineffective. Deficits will have to be increased. QE will have to continue. Just because it had limited impact in the absence of fiscal policy doesn’t mean we can stop now. Private investors have been happy to join their central banks in funding their governments, but only because there was some semblance of fiscal responsibility. Abandoning fiscal responsibility might result in an investor revolt meaning a backstop financier has to be found. Enter, again, the central banks. Bond yields may rise. Loose money sinks interest rates but loose budgets raises them. The loss of private investment demand will likely put a floor under interest rates. Central banks will have to be careful to not allow financing costs to rise too quickly increasing debt service for the government and for corporates. Bond yields are likely to stop falling, how quickly they will rise depends on the determination for further QE and the risk of investor revolt. Given how indebted countries are to begin with, central banks will likely be very careful to cap debt service for their masters.

Helicopters are usually the sign of a last ditch attempt. Hopefully this is not the case here.

Last Updated on Monday, 18 July 2016 02:00
How To Encourage Electric Vehicle Proliferation PDF Print E-mail
Written by Burnham Banks   
Thursday, 14 July 2016 05:35

Electric vehicles need a little help. It’s no use each manufacturer pursuing their own thing. For EVs to really take off what is needed is agreement on standards.

  1. Batteries should be standardized or at least modularized.

  2. Charging takes too long. Battery swapping is better than car charging.

  3. Batteries should be modular so that more power can be added simply by adding more batteries.

  4. Replace petrol stations and charging points with battery points. Battery dispensers provide battery exchanges so depleted batteries can be swapped for fully charged batteries for a fee.

  5. Battery dispensers take up little space and can be ubiquitous and distributed.

  6. Returned depleted batteries are charged and recirculated.

  7. Cars can choose if they wish to run with one battery or two or several depending on their needs. Cars can be designed with varying maximum battery capacities.

Last Updated on Thursday, 14 July 2016 05:42
Central Banks Long Term Systemic Risk. More Harm Than Good? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 12 July 2016 05:03

Central Banks. Long Term Systemic Risk.

The history of central banks is interesting. The world’s first was Sweden’s Riksbank, the phoenix rising from the ashes of Stockholms Banco, a private concern which leveraged itself into insolvency. The second was the Bank of England, technically, an off-sovereign balance sheet funding vehicle created expressly to monetize debt which no private investor would underwrite, the national debt of the UK. The US Federal Reserve system is in fact the 3rd incarnation of central bank in the US, the first two having passed amid turbulent times, stock market and banking crises and periodic recessions. It seems that central banks were born as a fix to situations of acute economic and financial stress. Their appropriateness under non-stress conditions, and indeed their contribution to subsequent stress situations should be questioned.

Should central banks be targeting inflation and growth in the first place?

Given the natural endowments of land, labour, capital and knowledge in an economy, and given the organizational structure of that economy, there exists a natural potential growth rate. Unfortunately it is not possible to estimate with any accuracy what that growth rate is. Central banks, where they do attempt to encourage growth, work towards an implicit or explicit target growth rate, which is this unobservable potential growth rate. Given that it is unobservable and that estimates are unreliable, the probability that policy is appropriately calibrated is low.

Most central banks pursue an objective of price stability, and some have explicit inflation targets. The appropriate or desired level of inflation is not well defined. Instead, central banks seem to be advised by past traumatic experiences of inflation which tend to be the result of loss of confidence or patently ill-advised policy, rather than naturally overheating economies. Likewise, current wisdom about deflation is colored by the Japanese experience of the last quarter of a century. Inflation is an aggregate measure prone to errors in specification. Is deflation due to deficient demand or to innovation and productivity? Is inflation due to real economic constraints or to monetary and financial factors? It is impossible to resolve these questions within a single measure. Inflation targeting is complicated and confounded by these issues.

Is active monetary policy useful?

The economy is a dynamic system which is the amalgamation of multiple dynamic markets. Even if it was possible to resolve monetary policy for a single market, and I argue that we cannot, it is difficult to resolve monetary policy across this aggregation of markets. Input and output markets may lead and lag each other with significant phase differences. Which market should policy be aimed at?

Each market is dynamic and dynamic systems confound policy. The complexity of the economy is such that central banks can only guess at how they work. Without a comprehensive knowledge of the inner workings of the economy, monetary policy is vulnerable to mistakes. In a static system with stochastic parameters, policy has unpredictable results. In a dynamic system with stochastic parameters, policy is even more unpredictable. A dynamic system can be characterised as having a certain quantity of energy within it. Policy, whether in the short term it is countercyclical or not, adds energy to the system, while the longer term counter or pro cyclicality of the policy is unknown. The energy is not dissipated but is accumulated and can manifest itself pro-cyclically in the future.

One topical example of how a dynamic system confounds policy is the concept of moral hazard. Each time a financial crisis occurs, the threat of contagion and recession prompts central banks to cut interest rates, or more recently, to ease counter-cyclical prudential regulation. The asymmetrical reaction to losses and falling asset prices increases the risk taking culture in the economy, not diminishes it.

Is current regulation effective?

In an effort to prevent a repeat performance of 2008/2009 where taxpayers had to rescue an overleveraged, overly risked banking system, central banks and regulators have required banks to hold more capital and to restructure their capital structures to be more robust for the protection of taxpayers and depositors. In many ways, bankruptcy codes in the developed world are sufficiently defined to deal with bank insolvencies. However, the political implications of bailing in deposits necessitated a different approach. In some way, shape or form, it was necessary to subordinate senior unsecured claims to deposits. To further protect depositors and taxpayers, banks have been required to raise more capital in the form of equity and contingent capital. There has been less pressure to realize losses and correctly classify non-performing assets. The speed of rehabilitation has varied from country to country.

Regulation of a fractional reserve banking system has always been a balance between efficiency and stability. Following a crisis, it is fully expected that regulation should lean towards stability. More capital and a clarification of the capital structure of banks is a sensible route to greater stability. The price of this stability, however, is efficiency. At a time when central banks are trying to spur growth and credit creation, this leads to contradictory signals to banks. On the one hand they are required to be more conservative, and on the other they are encouraged to lend.

One example of this dilemma is the 2011 ECB LTROs which were used by the commercial banks not to make new loans to the private sector but which encouraged banks to buy low capital consuming national sovereign debt. Subsequent LTROs were aimed at spurring private sector lending and carried conditions encouraging this. These LTROs have tended to be much less enthusiastically received given the capital requirements.

One side effect of the new Basel III capital rules has been a significant reduction in bond market liquidity as banks reduced inventory now deemed too expensive to hold. At the same time, central bank policy depressed interest rates encouraged businesses with access to bond markets to greatly increase issuance, and thus balance sheet leverage. By depressing short term interest rates, central banks have been successful in encouraging investors to assume more risk and lower yields to meet the supply of debt issuance. Retail mutual funds and ETFs have been an important channel for matching demand and supply of bonds.

As is often the case, regulation in one area forces capital elsewhere. In this case, the shadow banking system, the debt capital markets, have replaced the banks as a repository of wealth. Risk has been redistributed and not diminished.

Are current debt levels a significant risk?

Debt financing for non-investment purposes, such as for consumption and purchase of primary residence is not productive. This is not to say that it is not a good thing. Non investment debt allows consumers to temporally redistribute their consumption. A successful consumption strategy requires that the consumer is able to fund the debt, and to repay it when it comes due, at which time current consumption must fall. Since the financial crisis of 2008, households have reduced debt levels and debt service has fallen as interest rates have fallen. Households may one day increase leverage once again, however, they may be more circumspect in the next cycle while lenders will also face tighter capital constraints.

Assumption of debt for investment purposes is a legitimate use. In this case it is important that the investment generates sufficient return to repay the interest and the principal. The interest rate is not only a cost but an important hurdle rate to investment. The higher the interest rate, the higher the hurdle rate, and the more selective the capital allocation decision needs to be. Artificially low interest rates therefore encourage overinvestment, overcapacity, disinflation, and misallocation of capital.

Government debt has grown substantially since the global financial crisis of 2008. As interest rates and bond yields fell over a three decade period, governments have found increasing debt levels easier to service and thus issued more debt. In the wake of the 2008 crisis, bailouts of the banking sector by governments led to a surge in public debt levels. In the US the federal public debt as a percentage of GDP has risen from 30% in the early 1980s to 65% in 2007 and then to 105% in 2016. External demand from international reserves of USD funded by trade deficits, low capital requirements for financial institutions, a savings glut, asymmetrical interest rate policy responses to recessions and market volatility, benign inflation and most latterly, QE, have kept debt service declining and allowed governments to continually roll over, refinance, and increase their borrowing over these three decades.

As long as governments and corporates can continue to refinance cheaply, current debt levels are a risk unlikely to materialize. Threats to this dynamic include loss of foreign demand in the case of deficit countries, inability of current holders to maintain positions, rising inflation, or a loss of confidence for whatever reason. Slower moving phenomena may get us to any of these points such as slow growth leading to political or social instability, slow growth leading to poorer cash flow and inability to pay down debt, and ill-advised policy leading to runs on currencies.

Given the current balance of risks it is unlikely that any central bank would intentionally raise interest rates significantly under the best of circumstances. Under the current uncertainty, the prospect of raising interest rates is low barring a currency crisis (and hence defense), or runaway inflation, (usually a case of loss of confidence.) The most significant realistic risk is therefore a crisis of confidence leading to currency stress and a loss of internal and external purchasing power.

Market pricing.

Asset prices have been artificially inflated due to central bank intervention. Assets are valued on a relative, not absolute basis. Equity and bond valuations which may look high in isolation look reasonable when compared to sovereign yields. Low discount rates also inflate discounted cash flows leading to higher valuation multiples and higher prices. The response of central banks to any market distress also encourages excessive risk taking which artificially supports markets. The corollary of this is that all types of asset prices have become highly dependent on sovereign term structures. Correlations between assets have risen due to dependence on a proxy asset, sovereign bonds.

With central bank intervention suppressing volatility, the observed market price of risk is depressed. It is unsurprising that there should be an excess demand for risk and an over accumulation of the stock of risk. The difference between the efficient market price of risk and the current market price of risk is unobservable, however, a protracted suppression of market risk is itself a risky strategy. Eventual price discovery may be turbulent and disruptive. It may also be difficult to reduce the intervention since the amount of risk has risen under the regime.

Negative interest rates have become common. France, Germany, Japan, Switzerland, Netherlands and Sweden have negative 5 year bond yields. Intended to spur credit circulation negative interest rates are threatening the profitability and solvency of the banks and insurance industry not to mention pensions. Assets returns are reduced while liabilities are amplified. In extreme cases, negative interest rates can lead to a reduced money supply, some insurers have begun to hoard physical cash in vaults, and can perversely push up the cost of credit. Negative interest rates are an unnatural state and price of money. Again, if the price of money is suppressed, it will theoretically be under supplied and over demanded. The fact that it is under demanded is partly an ominous sign, and partly the result of monetary policy and banking regulation being at odds.

Practical matters:

- Central banks should not blindly target inflation and growth since they don’t know what long term potential inflation and growth rates are. They should instead target full labour employment, if they are to do anything at all.

- Central banks should arguably not even attempt monetary policy since the results are highly uncertain at best. Market solutions should be sought. Central banks should retain a regulatory role.

- Regulation is moving in the right direction but should avoid political influence. Retail money should be well protected but there is no substitute for educating the investing public and providing them the flexibility to choose.

- Regulation of the shadow banking system should be light touch and focused on transparency rather than limited access.

- There is too much debt. It is not a problem now because low interest rates have kept debt service in check but the global economy cannot tolerate higher interest rates.

- Central banks are keeping interest rates too low for too long. They will find it hard to raise rates because they do not know how markets will react or if the economy can refinance itself otherwise.

- Negative interest rates are unnatural and will denude the pension, bank and insurance industries. Rates can not only not be cut further but cannot be sustained at current negative levels for too long.




Last Updated on Tuesday, 12 July 2016 05:06
Asset Allocation To Active Managers PDF Print E-mail
Written by Burnham Banks   
Thursday, 16 June 2016 00:29

Asset Allocation to Active Managers.






Last Updated on Thursday, 16 June 2016 00:30
Brexit. Inaccurate Polls. Long Term Consequences. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 14 June 2016 00:26

The latest Yougov poll on the EU referendum has the 42% voting to Remain, 43% voting to Leave and 11% undecided. The result in any case will be unpredictable because the voting intentions are not driven by commercial interests but by political, social and emotional ones, and the material consequences of leaving the EU are to a great extent, unknown. Bookmakers odds paint a different picture with odds of exit at mid-30s percent. One explanation is that the polls reflect what people want to do, whereas the odds reflect what people realistically intend to do. Opinion polls have become more inconsistent as negative voting has become prevalent. If this thesis is true then the UK will vote to remain in the EU.

Depending on how acute the fear of Brexit becomes before June 23 and the extent of damage in the markets and sterling, the rebound could be significant. The bond markets have been fairly resilient even controlling for the compensating impact of duration. Last week, Euro investment grade outperformed euro sovereigns although investment grade did also outperform high yield. The commencement of the ECB’s corporate securities purchase program had some impact on the euro IG market. The euro leveraged loan market lagged with a flat performance. As we approach June 23, don’t expect credit markets to remain resolute. They will likely also experience volatility.

Notwithstanding the bookmakers’ odds favoring Remain, the situation is very volatile and a geopolitical or security event could easily overturn the odds in an instant. Even without an event, the words and actions of the players in the theatre could spark market volatility as well.

The consequences of Brexit are difficult to quantify. The UK is the EU’s single largest destination for exports representing 17% of the total while the EU accounts for 45% of UK exports. The UK runs a goods trade deficit (-66 billion GBP) against the EU but a trade surplus (+10 billion GBP) in services. For both sides, the rationale for a trade agreement is therefore strong, however, a liberal agreement on services may be more difficult to obtain. The impact on sovereignty will depend on the UK’s intentions regarding maintaining trade access and could involve retaining compliance with the majority of EU legislation while losing the ability to influence its formulation. Trade access would also mean continuing to contribute to the EU budget. Broadly, the UK can leave the EU for reasons of budget contributions, sovereignty, immigration and benefits arbitrage, but it would have to forego trade access. To obtain trade access it would have to reinstate contributions to the budget, compliance with EU legislation, open its borders and provide access to benefits. This would be analogous to a switch from a contractual telephony plan to a pay-as-you-go plan. Complete replication will neither be desired nor achievable. The EU will want to discourage other members of the EU from leaving and would have to impose costs upon the UK to set an example.

Any analysis will be inadequate because only the instantaneous effects are the least bit predictable. The impact on sovereignty, trade, immigration and politics will vary as each agent’s behavior evolves in reaction to the actions of other agents. In the best case, one could hope that the UK economy is sufficiently flexible that the new degrees of freedom are used wisely and growth is enhanced. In a more sober scenario, the event of Brexit is a Y2K event, a non-event, where an omnibus relationship is replaced with a series of specific ones which largely replicate the pre Brexit status quo. In the worst case, the UK either cannot or will not negotiate to reinstate trade access and goes down the path of trade war to the detriment of both the UK and the EU. Given the already fragile economic condition of Europe, this is a scenario they can ill afford and the region plunges into a protracted recession. In a scenario which is hard to classify as good or bad, the UK example emboldens other members to leave the EU which ultimately threatens the Eurozone and the single currency is abandoned.

The reaction functions of players in this game are non-linear. But the range of our vision allows us only to extrapolate.

It is unlikely that the UK will vote to leave the European Union.

If it does, the consequences will be short term instability and long term gain on both sides simply based on the adaptability and resourcefulness of humans.

Last Updated on Wednesday, 15 June 2016 08:06
US Labour Market. The long and short view. What the weak May Non Farm Payroll numbers mean. PDF Print E-mail
Written by Burnham Banks   
Monday, 06 June 2016 22:35

Below are a series of pictures depicting the US labor market. We highlight a number of points.

  1. The weak payroll numbers in May are significant in that

    1. they were well below even the lower bound estimates,

    2. prior month numbers were revised down significantly,

    3. temporary non-farm payrolls were also below estimates,

    4. there were no special mitigating factors

  1. Average hourly earnings and quits rates remain in an uptrend indicating a tight labour market.

  2. Falling participation rates can be explained by factors other than economic growth such as increased school and post graduate enrolment and the better health of new cohorts in the over 55 segment. We do not see falling participation as evidence of a weak economy.

  1. While the non-manufacturing PMI has weakened recently it remains above 50 (52.9) and the manufacturing PMI has turned over 50 in the last 3 months. Recession risk is low.

  2. We conclude that the labour market is at an inflexion point and is failing to adjust quickly enough to the evolving economy and that the May number is not a sign of a weak economy.

  3. The Fed is likely to look beyond the weak May data in their assessment of the economy. We maintain our outlook for a July rate hike. Our initial thesis for not expecting June was based not on the economy but rather the UK EU referendum due Jun 23, just 1 week after the Jun 15 FOMC.

With the exception of the 1990s, whenever labor productivity fell, unemployment fell. This is consistent with a model where labor’s share of output increases to compensate from lower labor productivity when technology could not pick up the slack. The 1990s was the era of the PC and internet which led to higher productivity even as unemployment fell.

The fall in labour participation is not a post 2008 phenomenon, it is a post 2000 phenomenon. The largest falls have been in the 16-19 year segment, presumable due to higher school enrolment. Post 2008, we have also seen declines in the 20-24 year segment with smaller declines in the 25-54 year segment. The falloff in the 20-24 year segment could be due to increased enrolment in post graduate education which was particularly popular in the post dotcom bust years. The 55+ segment has seen participation increase, presumably due to healthier populations. The trend of falling participation rates can therefore be explained mainly by demographic and non-economic factors ruling out the hypothesis of a weak economy.

The latest non-farm payroll numbers were quite poor, at 38K they fell below the lowest professional estimate of 90K and far below the average 160K. Taken as a percentage of the total labor force the number does not look better.

Two areas of strength, albeit not too much of it. One is the quits rate which is steadily climbing, although it has yet to reclaim the levels pre 2008. Quits rates are consistent with a tight labour market. Second is average hourly earnings which continues to recover. It also has yet to reclaim pre 2008.


Charts data source: Bloomberg and BLS

Last Updated on Wednesday, 08 June 2016 03:44
Quantitative Easing Explained. And Anti Social Economics. PDF Print E-mail
Written by Burnham Banks   
Friday, 27 May 2016 00:40

Every so often the free market fails to sort itself out and the economy grows more slowly than it should, according to the economists, bankers and investors. Measures need to be taken to spur economic growth so that it can run at its potential again. Having lowered interest rates to zero or close to zero with less than spectacular results on economic growth, central banks turned to unconventional monetary policy, also known as quantitative easing. Purists define QE as the expansion of the central bank’s balance sheet through the purchase of assets funded by, well, funded by the creation of money, a talent and right exclusive to central banks. Basically, governments borrow by issuing bonds, which to a point private investors become leery off due to the usually parlous state of the finances of governments wont to engage in such innovative practices. At this point the country’s central bank buys these bonds thus lending to its own government. The government. Fine distinctions have been made about whether central banks are lending to their own governments, which is seen rightly as debt monetization, and buying bonds in the secondary market from private investors thus injecting money into the economy which it is hoped will circulate and stimulate demand. The reality is that the private investors holding government bonds are hardly borrowing from the central bank by selling them their bonds, and experience has shown that the money thus injected gets saved or hoarded somewhere, usually back on the said central bank’s balance sheet. The velocity of money falls almost precisely to compensate for the liquidity injection and demand and output hardly budge. There is a physical analogy in all this.

Now that 8 years of QE have failed to produce the spectacular recoveries in economic growth expected, governments are beginning to toy with the idea of fiscal easing. The problem with fiscal easing is that it involves a government spending to boost the economy, in effect replacing private demand with government demand. Monetary easing it was hoped, would spur demand by placing money in the hands of businesses and households in the hope that it would spur demand but it’s easier to lead a horse to water than to make it drink. Fiscal easing is a bit like leading your horse to water and then leading by example and taking great swigs yourself. There is no guarantee that the horse will drink. A case in point is Japan which has engaged in QE and fiscal easing and seem its national debt surge to 2.5X annual output. At the current G7 meeting in Japan you can sense the government once again tilting towards fiscal easing. In April 2017 there is a scheduled sales tax hike. The options before the government are to scrap the tax hike or to go ahead with it and sterilize it with a big fiscal package. There is a physical analogy in all this.


Experience has shown that you cannot borrow yourself into solvency try though some countries might, given that some investors have been happy to buy bonds at negative yields. It might not be long before someone voluntarily buys a bond with a negative coupon. Perhaps a central bank somewhere might want to lead by example. At some point the world will realize that you cannot move a boat by blowing into your own sail.

There are solutions which can work but the weight of the establishment and politics stand against them. And the weight of the establishment can mobilize academia, investment pundits and popular opinion against such solutions. Putting aside arguments for equitable wealth distribution aside, it doesn’t take much to observe that a dollar taken from a billionaire does not change their consumption levels much if at all, whereas this dollar transferred to a poor household will be spent almost completely, raising the velocity of money, the one variable which has confounded QE. The efficiency of this transfer, however, will be drowned out by the indignant accusations of it being blatantly socialist policy.


Last Updated on Monday, 30 May 2016 01:40
Central Bank Liquidity: Waterboarding PDF Print E-mail
Written by Burnham Banks   
Monday, 14 March 2016 23:38

Negative interest rates.


Hmmm. I've seen this kind of liquidity provision before...


Now I remember!








Last Updated on Monday, 14 March 2016 23:42
An update on the ECBs latest QE. PDF Print E-mail
Written by Burnham Banks   
Friday, 11 March 2016 07:56

The ECB’s moves were largely expected except for the inclusion of corporate debt on the shopping list. This should at least put a floor under the Euro IG market. The details, however, have not been released so we don’t know what the total or country allocations might be.

The ECB’s best policy has always been its LTRO. Its first incarnation, a 3 year unconstrained program, turned the ECB effectively into a pawnshop. It achieved a number of things:

  1. Banks bought government debt when the ECB could not. The ECB had co-opted the banks into its QE. Call it, proxy QE.

  2. National banks bought their respective national debt thus unwinding current account deficits very rapidly.

  3. Coupled with a rate cut, the ECB provided banks with a profitable business, good for 3 years, consuming no capital. The profits would recapitalize the banks to some degree.

  4. Governments’ borrowing costs fell.

The subsequent TLTROs were less effective. Why?

  1. Private enterprise is unwilling to borrow. That’s it. The TLTROs were extendable only if the banks were seen to be pivoting their loan books to SMEs and private obligors. These LTROs were not meant for government bond purchases.

  2. As one hand of the ECB provided liquidity to fund private loan growth, the other hand increased capital requirements. This placed banks in an untenable position.

What about the latest TLTROs?

The details are still patch but basically, the repo rates are zero with a discount available for compliant banks, banks with a willingness to engage in more active private lending. At a fully discounted rate of -0.4%, the ECB is basically paying the banks to lend. In effect, it is co-opting the banks to grow their loan books. Will it work? Basel III and TLAC rules still hold which will continue to constrain the banks. Assets tendered in repo are not a true sale. And for all these technicalities, demand for credit is simply weak.

Last Updated on Friday, 11 March 2016 08:02
How To Think About The Chinese Economy. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 08 March 2016 00:29

  • The world is engaged in a trade war which hits manufacturing and industry more than services and consumption. The composition of the Chinese economy makes it vulnerable. The Chinese are a proud people and will claim that the rebalancing is an intentional project rather than a phenomenon forced upon them.
  • China’s markets are still closed albeit becoming more open. A financial crisis in China will have less contagion effects than a financial crisis in a more open economy.
  • China’s contagion risk lies in the real economy through trade. But world trade is already stagnating and the world becoming more insular. Also, the weakness in the Chinese economy is over 5 years old and not new. Its effects have already been felt.
  • China’s nominal output is some 10 trillion USD per annum. To expect even a balanced economy to grow at 6% is very optimistic. For an economy plagued with overcapacity in heavy industry and state owned enterprises to grow at 6.5%-7.0% will require more stimulus.
  • The central bank has been stimulating the economy with Open Market Operations (repo operations), interest rate cuts and reserve ratio cuts. This will accelerate. Even so, monetary policy will be insufficient given the examples of the Bank of Japan and the European Central Bank. The Chinese government recognizes this and will engage fiscal policy, budgeting for a 3% deficit, officially, but in fact more, to boost demand. Other countries may learn from the Chinese experience, positive or negative, as their policy unfolds.
  • China’s debt stands at over 2.5X GDP. Government debt is circa 40% of GDP and is not a problem. The bulk of China’s debt is corporate debt and raised in local currency. Being mostly in local currency, China’s debt is less sensitive to exchange rate fluctuations. However, most of the debt was raised by unproductive SOEs and heavy industry and will face increasing defaults. The government has the financial ability to bail out or to absorb debt write-downs on behalf of the banking system and domestic investors without depleting its foreign reserves.
  • The government has been encouraging refinancing of USD debt in local currency, with extended maturities, and lowered debt costs by changing collateral rules and capital requirements for specific assets such as municipal bonds and LGFV debt. The total debt may rise before it falls.
  • China’s non-manufacturing economy is healthy. Despite declining, non-manufacturing PMI’s hold above 50, whereas manufacturing PMI’s have now been below 50 for close to a year. There are good sectors, industries and companies in China. Unfortunately, investing in China is a very risky endeavour. 90% of capital accounts are owned by retail investors leading to a highly sentiment and technically driven market often subordinating fundamental factors such as earnings and cash flow.
  • The macroeconomic conditions in China imply a weakening RMB. The weakness in RMB has not been entirely due to capital flight. The government’s efforts to get corporate China to refinance USD debt in RMB must result in capital outflows and a reduction in foreign reserves, which we have seen. The solution to private capital flight is a sharply weaker RMB which the PBOC is unwilling to allow.

Last Updated on Tuesday, 08 March 2016 00:33
Investing in tumultous times. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 17 February 2016 06:54

2016 began with very weak equity and credit markets. Markets reacted strangely and counterintuitively to data and central bank policy. So, how does one invest in times like this? Ideally, one invests in precisely the same way one invests in calm markets. When the herd is panicking, calm is the scarce resource and therefore valuable. A few principles are worth remembering.

Find the exit before the entry. This is true whether one is investing or indeed doing anything. It is a most general concept. It is fine if the exit is expected to be a tricky one. Recognizing it as such prepares one for the eventuality and advises the enthusiasm of the entry. Sometimes, the exit requires that the market comes to its senses, and sometimes the exit is structurally established. Relying on the rationality of other investors is a risky endeavor, judging by one’s own rationality or lack of it. Relying on a structural or contractual exit is better, but the returns are usually commensurately smaller.

There is no return without risk. If there appears to be such an opportunity, then one has failed to identify the source of risk. Risks are not limited to market risk. General conditions can change altering the fortunes of companies and countries. Laws and regulations can change or be open to interpretation. Contracts are not always honored or enforceable.

Compounding is powerful. It is difficult to compound a volatile investment. An investor should realize that losses are inevitable. The nature of compounding is such that you want your profits to compound, that is to grow exponentially, and your losses to be linear. The only way to do that is to limit your losses. The downside to this strategy is that you will leave a lot of profits on the table, which is still preferable to sustaining losses which take too much time to recoup.

Managing losses comes with experience. Investors who have never lost money are either economical with the truth, or have yet to make a loss and are therefore inexperienced in dealing with it and at risk of sustaining a bigger loss than one practiced in the art of losing. Lose often, not big. But not too often for that is when embarrassment takes over.

Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”, said the great Warren Buffet. This needs some qualification. The market isn’t always greedy or fearful, most of the time its just mildly manic depressive. In these in-between states, it pays to be with the herd. How can you tell when there is fear? It’s when you yourself are fearful and selling. You will feel awful and feel like selling everything. Until you get there, it’s not fear. You must be acutely opposed to buying when you buy.

Managing one’s own emotions is at least as important as the cold rational decisions one is supposed to make. Completely removing emotions from investment decisions is almost impossible to do unless one delegates the decisions to a trading algorithm. The patchy performance of such algorithms implies that there are elements of our emotions which are useful in investment decisions, or that algorithms are inherently incomplete. A few rules might be necessary to mitigate emotional biases, such as having stop losses, independent risk managers, diversification rules and time outs.

Don’t overdo it. When a great investment idea comes along, do it, but don’t overdo it. Wall Street is great at coming up with great ideas but overdoing them, that’s why they almost always end in tears. CDOs, CLOs, SIVs, CDS, po