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
THoughts about Asset and Goods Price Inflation. Explaining Stock and Bond Market Performance under QE. PDF Print E-mail
Written by Burnham Banks   
Wednesday, 18 June 2014 23:46

There is more to MV=PQ than meets the eye.

Central banks can expand M but this does not mean they can expand MV. V can always fall to compensate for the increase in M, as has happened for most of the period 2008 – 2014. The maintenance or expansion of V is dependent on a number of things. Necessary conditions include a functioning fractional reserve banking system with sufficient capital and appropriate reserve ratios to transmit the increases in V. Sufficient conditions include a health demand for credit which is dependent on business sentiment.

Assuming that it is possible to increase MV, the impact on PQ and its constituents remain complicated. While PQ is a scalar, P and Q are in fact vectors. Q is a list of all the possible stuff you can spend money on, and P is the corresponding vector of prices. A couple of things to note about Q are that it includes goods, services, and assets, indeed, anything you can allocate money to, and that while the scalar PQ must rise if MV does, its not clear a) which good, service or asset market is experiencing rising nominal output or b) for a given good, service or asset market experiencing rising nominal output whether price, real output or both are rising. In other words, even if MV and therefore PQ is rising, some markets may experience falling nominal output while others may experience rising nominal output and in markets with rising nominal output it could all be due to inflation or real growth or both, but you couldn’t control which. 

Quantitative Easing and Taper in the Context of Debt Monetization. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 29 April 2014 01:28


If we stop thinking about QE as an expansionary policy but rather as a treasury refinancing operation and debt monetization, the behavior of the Fed becomes clearer. For one, the Fed surely understands that without reducing the banking system’s reserve requirements, the money multiplier and the velocity of money cannot accelerate and thus asset purchases have very little impact on real or nominal output. Indeed by increasing capital requirements, the Fed is effectively neutralizing any expansionary effects of QE. A side effect of refinancing the treasury is an expanded balance sheet which risks runaway inflation should the velocity of money pick up. Any sign of improved fiscal position must encourage a corresponding reduction in asset purchases.

The impact on pricing of the term structure due to the Fed going forward should be regarded as at best neutral.


Last Updated on Monday, 12 May 2014 01:02
Risk. Capital. Conventional Asset Allocation is Inadequate. PDF Print E-mail
Written by Burnham Banks   
Thursday, 27 March 2014 07:45

It is almost elementary to professional investors that when investment decisions are made, the appropriate sizing of the investment is based on the quantity of risk that is taken and not the quantity of capital. This has a parallel in the Sharpe Ratio measurement of investment performance. Returns are only useful in the context of the risk associated in obtaining them. Similarly, returns are obtained at a price, which is risk. To obtain returns, one should allocate risk and not capital.

Divergence Between US Equities and US Treasuries PDF Print E-mail
Written by Burnham Banks   
Tuesday, 18 March 2014 01:52

The divergence between the US treasury market and US equities can be accounted for.

  1. US treasury yields are held down because.
    1. Floating rate note issuance is expected to be circa 180 billion USD. This will substitute away some of the fixed coupon issuance. This means less supply of fixed coupons.
    2. Tax receipts are up which will also slow the issuance of treasuries.
    3. Major trading partners such as China and Japan are seeing a reduction of trade surpluses or an increase in trade deficits implying slowing supply of USD offshore and thus weaker demand for treasuries.

  1. US equity markets:
    1. Economic growth remains robust. There was a speed bump due to the harsh winter but this has passed.
    2. Trend growth is not 3% but 2%. Given this, any ‘fail’ of the 3% mark is not a risk of reception but a cyclical slowdown within a global rising trend. Since 2010 GDP YOY has oscillated around 2%, which I regard as the new trend growth rate. Why is trend growth lower today than before? This is not an easy question and there are no definitive answers. One possibility is that credit creation has become impaired. Despite efforts to inflate the monetary base, bank regulation and scarcity of bank capital are constraining credit creation. The 3% average growth rate from 1980 – 2006 was probably boosted by a full 1% due to the early 80’s boom in junk bond issuance, the securitization of debt in the late 1980’s and the surge in securitized and tranched mortgage bonds in the last 15 years. Absent this credit innovation, trend growth would have been 2% as it is now.
    3. Given the above view of a secular recovery, US equities are in a secular bull market. That said, we could be at a cyclical peak given that price levels have run ahead of earnings.
    4. The continuation of the current cyclical bull requires a recovery in corporate investment which has not yet happened. The growth of the past 5 years has been driven by consumption and housing. Corporate profitability is now at a cyclical high and household savings rates have fallen from mid 5’s to low 4’s. While US equities remain fundamentally sound, a continuation of earnings growth now stands on a single pillar, corporate investment. I believe this will happen given the average age of the capital stock…

  1. Conclusion:
    1. I expect the US treasury market to be more resilient than consensus for reasons of demand and supply.
    2. I expect the US equity market to be in the early stages of a secular bull market.
    3. However, I do feel that the US equity market is currently vulnerable as fundamentals have yet to catch up to valuations.

Ten Seconds into 2014. More of the same. PDF Print E-mail
Written by Burnham Banks   
Monday, 03 February 2014 06:05

The current volatility in global markets is unremarkable. What is remarkable is the lack of volatility in the past two years. The macro conditions envisaged in mid 2012 continue to hold. For details see:

Investment Strategy In a Crazy World April 2012

To reiterate:

  1. Long term global growth rate has stabilized along a slower growth path, mainly due to moderation in credit creation.
  2. Developed Markets (DM) rebalance towards a neutral trade balance. Emerging Markets (EM) also rebalance towards neutral trade balance. Generally this is the rebalancing of economies towards better balance between investment, consumption and trade.
  3. Aiding the resurgence of exports and manufacturing in DM is an entrenched technological or knowledge advantage.
  4. Trade flows are supportive of USD.
  5. Trade flows are raising true cost of funds for hard currencies.


Last Updated on Monday, 03 February 2014 06:07
Fed Issues Floating Rate Notes. An Aside on the 30Y UST. PDF Print E-mail
Written by Burnham Banks   
Friday, 24 January 2014 08:59

For the first time in 17 years, the US treasury will issue a new security, a Floating Rate Note. This will become a program of quarterly auctions.  Why are they doing this?


  1. How does one get longer term funding at low interest rates? How does one attract investors to longer maturity assets with little or no duration?
  2. How will the US government keep debt service manageable over time despite longer dated liabilities?
    • The answer to 1 above is to issue Floating Rate Notes.
    • The answer to 2 above is to maintain short term interest rates at close to zero for longer. Given that the first issues will be 2 year maturities and coupons will be benchmarked to the 13 week T bill rate, I expect that the US Fed will not be raising interest rates till 2016 at the earliest.


On a side note, I expect the long bond (that’s the 30 year US treasury) to outperform. While I don’t like duration in general I don’t think the 10 year will fare as badly as the consensus believes. The 30 year, however, is under-issued, and demand from insurance companies and other real money investors with long term liabilities will keep it well supported. I expect the USD curve will form a hump at the 10 year. I’d be a buyer of the 30 year UST.

On another side note:Time to buy some GLD US. Time to buy some equity volatility. Some cracks are beginning to show.

The US Consensus - Equities vs Bonds and QE Taper PDF Print E-mail
Written by Burnham Banks   
Tuesday, 07 January 2014 08:13


There has emerged a clear consensus about the outlook for US asset markets. While I am with the consensus for now, it is good practice to have an eye on the alternative view. With the tapering of QE, it has become established wisdom that equities will outperform bonds. Of course, there are many types of bonds; there are government bonds, municipal bonds, investment grade corporate bonds and high yield bonds. Bank debt, or loans are another debt instrument to consider in the analysis. The consensus view is the following:

  1. The US economy is sufficiently strong that QE can be moderated.
  2. The positive prognosis for the US economy implies the same for US corporate financial performance.
  3. The Fed has announced a moderation in its large scale asset purchases from 85 billion USD a month to 75 billion USD a month, the reduction to be split equally between its agency MBS and US treasury programs.
  4. The reduction in Fed purchases of US treasuries will lift yields at the mid and long end of the USD term structure.
  5. The impact on bonds with any significant duration follows from the above. The relative preference for equities over bonds also follows.

The above consensus relies on some assumptions and interpretations that deserve closer inspection.

  1. The US economy may be sufficiently strong that QE can be moderated. On the other hand, the Fed might be slowing LSAPs for other reasons. It could, for example, regard the size of its balance sheet as a risk to price stability. The Fed has never run a balance sheet of this size before and any pick up in demand or the velocity of money could spark of a rise in nominal output that real output might not be able to keep pace with – inflation. The Fed might have realized that interbank unsecured lending has shrunk and that lending has moved to the secured market – the repo market, and that its LSAPs are reducing the stock of available collateral for use in repo.
  2. The US economy is growing, but its long term trend rate is no longer the 4% it experienced pre 2008, and closer to 2%. The market expects growth to average 3% in 2014, but this would be above the new trend rate. Corporate earnings growth and profit margins at the same time are at a cyclical high. In the last quarter US corporate earnings saw more downward revisions and the current quarter is likely to see further moderation of earnings growth expectations. This will make current valuations, which are not cheap, harder to sustain.
  3. The Fed may have tapered its notional purchases but compared with a year ago, it is buying up an increasing proportion of new issue US treasuries. US treasury issuance is shrinking by about 18% YOY and Agency MBS issuance is shrinking by about 33% YOY. A 5 billion reduction in UST and MBS purchases amounts to a 12.5% reduction. It is not trivial nor a forgone conclusion that the 10 year UST yield is on a one way ride to 4%.
  4. One of the important determinants of UST yields is inflation expectations. US inflation numbers are low. The headline number is 1.2%, down from 1.8% a year ago. Core inflation, which excludes volatile and transitory items such as food and energy are at 1.7%, down from 1.9% a year ago. Considering that shelter is a large item in the CPI, and US housing and mortgage rates are rising, we should expect to see much slower inflation in the larger cash flow items (that is ex owner equivalent rent, which is not a cash flow item.) CPI ex shelter has fallen from 1.4% a year ago, to 1.0% today. Again, a 4% 10 year UST yield is not a foregone conclusion.

I am with the consensus on this one. However, whenever we have a strong consensus, we should be mindful of the alternative view and be particularly watchful for the signs that the consensus is wrong. One of the obvious indicators is price action itself. That’s why traders have a cut loss policy. At the same time we will be watching corporate profitability and economic numbers seeking signs of weakness, while remaining overweight in equities and underweight in duration.


Last Updated on Thursday, 09 January 2014 06:41
A slightly different style of investing: PDF Print E-mail
Written by Burnham Banks   
Monday, 30 December 2013 02:59


Traditional investing is all about asset allocation based on macro economic outlook and then drilling down to security selection. That’s a bit too fuzzy for my liking. Investing capital should be a more disciplined activity since it puts that capital at risk. The risk should always be well compensated by the prospect of returns. Thus, unless there is a very good reason to invest, capital should not be invested. There is a real cost to not being invested, but this is a relatively more certain cost, being the difference between short term cash rates and inflation. The short term cash rate will depend on the investor’s level of access and short term risk appetite. Deposit rates, LIBOR, or overnight repo rates are good proxies. This cost of not being invested can also be thought of as an option premium paid to not have exposure. It is the option to invest in the current period.

An investment would require a clear and present rationale, an event or a catalyst to justify it. Valuation itself is not sufficient. It is an important factor. Most successful value investors don’t just buy value; they buy value with a catalyst in mind. Sometimes, these investors not only have a catalyst in mind but they are active catalysts themselves. Distressed debt investors are a classic example, where the debt of a distressed business is bought with a view to reorganizing the business and the liabilities of the company in order to unlock value. Merger arbitrage is another example where the takeover code, anti trust regulation and other regulatory legislation drive investments to their fruition or deal-break.

The disciplines of event driven and distressed investing should be applied to traditional investments as well. Tighter definitions of investment rationale should be demanded by investors when they are asked to place capital in harms way.


Last Updated on Monday, 30 December 2013 03:01
Investment Strategy 2013 Recap and 2014 Outlook PDF Print E-mail
Written by Burnham Banks   
Friday, 13 December 2013 07:55

Time stamping...

Last Updated on Friday, 13 December 2013 08:20
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
Peak Corporate Profitability. Labor's Share of Profits. Intellectual Property. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 24 June 2014 00:07

It is difficult for an individual to hold, accumulate or acquire intellectual property directly. Storage capacity is one issue. At best an individual can hold or acquire the last mile of the intellectual property chain. The most practical way for an individual to own intellectual property is through ownership of a company or business. (Higher education and vocational training are examples of acquiring non exclusive access to existing technology and need separate treatment.)

Bank Regulation Investment Theme. PDF Print E-mail
Written by Burnham Banks   
Monday, 12 May 2014 01:01

One of the most interesting and rewarding investment opportunities currently available trades on the reform of the banking sector. We live in a world where, unfortunately, pragmatism has for too long trumped ideology. This lack of a guiding philosophy had led banks to myopia and to overreach themselves resulting in over-levered balance sheets and inappropriate operating practices, culminating in the financial crisis of 6 years ago. Regulators are still trying to reform the banking system and this has produced a host of investment opportunities. 

Population Distribution. Labour Mobility. Storage and Transport of Labour PDF Print E-mail
Written by Burnham Banks   
Wednesday, 16 April 2014 23:41

Current economic wisdom is that geographical labour mobility is an almost unqualified positive and an inalienable right. This should not go unquestioned.

Last Updated on Wednesday, 16 April 2014 23:47
Inequality and Injustice. Bad Moon Rising PDF Print E-mail
Written by Burnham Banks   
Wednesday, 19 March 2014 05:11

Inequality has decreased globally, yet this aggregate phenomenon hides a more disturbing picture. As countries have become less unequal, the distribution of wealth and income within countries has become more unequal. If the material and commercial motivation for conflict between nations has receded between nations, it has certainly risen within each country.

Last Updated on Monday, 24 March 2014 03:00
Singapore Economic Growth and Population. PDF Print E-mail
Written by Burnham Banks   
Monday, 03 March 2014 00:25


One of the commonly accepted models of economic growth is one where economic growth is determined by capital accumulation, innovation and growth of the labour force. The growth of the labour force quickly translates into growth of the population and particular age groups which are regarded as particularly productive. This is all fine, if you can grow the population without bound. The weakness of this assumption is most apparent in the case of small islands. Singapore is a good example. Progressive immigration policy has helped growth not just in population growth but also in capital accumulation and innovation. Lately, however, the limits of immigration have been tested. The storage and transport of labour has become difficult. Incumbents have come to regard further increases in population very negatively. The government, on account of the last election’s poor result, has begun to listen to the people, to an extent. They have tightened immigration policy in sympathy to the people’s preferences. These measures are not sufficient. If the government is serious about avoiding and reversing the momentum of overpopulation, it must cut back on the creation of storage of labour. This it has not done. One can only speculate that a longer term strategy still pursues rising immigration but that an interim solution has been formulated to manage the people’s expectations. Here is how one such plan could work:

  1. The people regard the country as over populated and register their objections.
  2. The authorities tighten immigration rules to slow population growth.
  3. The authorities continue to increase population storage by land sales and the approval of building permits, etc.
  4. The stock of housing increases.
  5. The authorities can then at a later stage present a housing oversupply to the people.
  6. They authorities can present also a strategy for preventing a crash in housing prices by allowing more immigration thus increasing the demand for housing.

Thus, it would have been possible to achieve the desired population growth to sustain economic growth with the acquiescence of the people. It is a clever gambit but it fails to address the limitations faced by the island state. Population cannot be grown without bound anywhere let alone on a small island. New goals and new strategies need to be established towards a more viable society. We can only hope that the authorities have the vision to see this.


Last Updated on Tuesday, 04 March 2014 02:02
EM Bonds and USD. PDF Print E-mail
Written by Burnham Banks   
Monday, 27 January 2014 02:07

Barely are we into the end of January 2014 and the emerging market debt markets are once again showing signs if weakness.

  1. Emerging markets are suffering from a slow down in exports relative to imports relative to the US and other developed markets. This is a long term trend stemming from a technology deficit.

  1. The supply of hard currencies, USD and EUR will be constrained. This will raise the effective short term interest rates for these currencies, LIBOR and other benchmarks notwithstanding. This is likely to also drive currency appreciation.

  1. The demand for emerging market debt cannot be taken in isolation. The real money investor will want to minimize or at least manage FX risk. The high yield of an Indonesian government bond or a Brazilian government bond needs to be taken in the context of either FX volatility or the cost of hedging such FX volatility.

  1. The cost of hedging the FX volatility is the short term interest rate of the currency of the respective bond. An important metric for assessing the economics of an emerging market sovereign bond is therefore the spread between the yield of the bond and the  short term interest rate. Ceteris paribus, in particular ignoring inflation expectations, the flatter the yield curve, the worse the economics of owning the bond. For example, a 10 yr Brazilian government bond yields 11% but costs 10.75% to finance. A 10 year US treasury yields 2.8% but costs 30 basis points to finance. In addition, given that US treasuries are good collateral in the repo market, a 10 yr can in practice be financed at circa 6 basis points.

  1. With Basel 3 and Solvency 2, US treasuries capital treatment and declining issuance could make them the surprise outperformer this year.


QE Taper. For Real? Fed Interest Rate Policy. PDF Print E-mail
Written by Burnham Banks   
Thursday, 09 January 2014 06:55


QE Taper, for real?

  • The Fed is reducing UST purchases from 45 billion USD to 40 billion USD per month, a 11.1% reduction. It is reducing Agency MBS purchases from 40 billion USD to 35 billion USD, a -12.5% reduction.
  • US treasury issuance is shrinking at roughly 18% YOY due to an increase in tax receipts as the US economy recovers. Agency MBS issuance is also slowing, by about 30% YOY as banks underwriting standards have tightened and asset quality has improved to the extent that banks are willing to retain mortgages on balance sheet.
  • This implies that despite spending fewer dollars on buying bonds, the US Fed is buying up an increasing proportion of new issuance. This is hardly tapering.

Short term interest rates, low for how long? The market expects rates to be kept low till 2015. Its possible that rates may be kept low for even longer. Why?

  • Its possible that all that bond buying by the Fed was to maintain a respectable bid to cover ratio at auction, and not to reflate the economy. Why? Surely the Fed would understand that banks lend out of capital and not liquidity and all the LSAPs would do is liquefy the financial system, not provide it with capital.
  • Treasury relied on the Fed to keep yields low so that it could refinance itself cheaply.
  • The Fed balance sheet, at 4 trillion USD has reached critical limits making general prices potentially unstable. The Fed needed to find a less risky means of refinancing Treasury.
  • This month, Jan 2014, will see the inaugural issue of Treasury FRNs (floating rate notes). Treasury needs to fund itself longer than the T Bills market. It intends to issue 2 and 3 year paper. It understands that investors will only provide longer term financing if they do not have to take on duration risk. FRNs are ideal for both lender and borrower.
  • This provides the Fed with a cheaper and less risky way of suppressing Treasury’s interest expense. The Fed only needs to keep short rates floored at zero.
  • The risk to this strategy is that whereas fixed rate debt can be inflated away, floating rate debt becomes more expensive under inflation as rates react to inflation expectations.
  • Under the above thesis, interest rates will be kept low for another 3 years or more. Unless inflation perks up.

What about long rates?

  • Inflation expectations are one of the important determinants of UST yields. US inflation numbers are low. The headline number is 1.2%, down from 1.8% a year ago. Core inflation, which excludes volatile and transitory items such as food and energy are at 1.7%, down from 1.9% a year ago. Considering that shelter is a large item in the CPI, and US housing and mortgage rates are rising, we should expect to see much slower inflation in the larger cash flow items (that is ex owner equivalent rent, which is not a cash flow item.) CPI ex shelter has fallen from 1.4% a year ago, to 1.0% today. Again, a 4% 10 year UST yield is not a foregone conclusion.
  • However, given that the US Fed is a large buyer of treasuries, the eventual withdrawal of QE is likely to steepen the term structure.
  • Take note of the US trade balance which has been recovering quite steadily. US manufacturing is rebounding, an ageing population is consuming more services and less goods, more production is being re-shored and shale gas and fracking technology is reducing reliance on energy imports mean that the US will export less USD, less exported USD will mean less demand for US treasuries, implying a steepening of the term structure.

Food for thought…


Last Updated on Thursday, 09 January 2014 07:53
Wait Worry PDF Print E-mail
Written by Burnham Banks   
Monday, 30 December 2013 02:59


We began 2012 utterly dejected. Apart from the US, most regions from Europe to Asia to Latin America faced slowing growth. That said central bank pump priming managed to sustain global equity markets and 2012 turned out to be a good year for risk assets despite some mid year volatility. We began 2013 optimistic on the back of momentum in risk assets. As 2013 unfolded in became clear that the US real economy was actually improving and this helped to dampen volatility as the US equity market climbed steadily. In the latter half of 2013, the European economy began to signs of recovery driving their equity markets higher. Emerging markets fared less with slowing growth and rising inflation. Signs that the US Fed might slow down its large scale asset purchases added fuel to the fire and drove volatility there. Japan continued to confound the skeptics adding real economic progress to the improved sentiment. And even China appeared to recover from its apparent risk of a hard landing. Taken together, there is little to fear in the world of investing today. This is a thing to fear.

The risk of QE and its gradual withdrawal are significant. So far investors are pretty sanguine and some even interpret QE tapering as a sign of strength in the US economy and thus a positive development for equities, albeit less positive for fixed income. Depending on why US equities were bought up, there is a risk that the taper could be more damaging than expected. If for example, equities were bought as a claim on future production to hedge against future inflation, then higher discount rates further along the term structure could reprice equities making them more expensive than previously thought.

The other risk of QE is that we really don’t know what asset prices look like without it. Short rates are artificially low, but the arbitrary nature of the setting of short rates is something we have come to live with. That QE has been extended across the term structure means that the shape of the yield curve absent QE is also unknown, and the shape of the curve is a somewhat important factor in signaling economic growth and shaping asset pricing. Quite worryingly, we have come to rely on QE and embrace it as a reality in our investment strategy.

Like the consensus, we expect the world to be less globalized and that trade growth while positive will slow in the wake of the underground trade war that has been waged invisibly these last 5 years. However, there will be an impact on the leveraged shipping finance industry which is supported primarily by European banks. This could be another source of volatility in store for markets in the near future. A lot depends not only on the asset side of balance sheets but also on the liabilities. Some investments are simply not robust against rising interest rates.

The heavy issuance of debt in 2013 is also disturbing, almost like a last hurrah. As a rule of thumb, it is always good to be a reluctant lender, and thus to prefer securities companies are less willing to issue and to not prefer securities companies are more willing to issue. Overzealous lending is leading to a resurgence of covenant-lite issuance, now some 60% versus a mere 30% in 2007. Some companies have become, to an extent, passthru’s whereby their senior unsecured issuance is being used to fund dividends and payouts to other parts of the capital structure.

Pooling vehicles generally increase systemic risk. The rise of mutual funds and the return of CDOs and CLOs in the US add to instability in markets. The state of the art in risk management is backward looking. Any risk metric that aims to provide not only amplitude but timing of risk events must fail at one, or both. We believe that the estimation of timing of risk events is futile and advocate estimating the amplitude of risk events. We advocate a Gini Coefficient methodology for dealing with liability based risk.

A related risk is the large scale adoption of a small number of standardized risk models. Blackrock’s Alladin system stands out as an example. As more small, independent, boutique investment managers and traders outsource risk measurement to more standardized risk systems such as Alladin, investor behavior becomes more correlated and less independent. This violates the necessary conditions for convergence in many central limit theorems used in the same risk systems and could lead to highly leptokurtic markets.

Bank Regulation. Another Way PDF Print E-mail
Written by Burnham Banks   
Monday, 16 December 2013 01:18


The Volcker Rule, Basel 3. Dodd-Franck and all the rules and regulations will not help banking stability until banks are allowed to fail. As long as banks are not allowed to fail, managers will continue to be engage in willful or ignorant risky behavior.

Too much regulation also sacrifices efficiency.

The way to ensure a balance between stability and efficiency is to regulate in a different way.


  • No bailouts. Period. No lenders of last resort.
  • Regulate standards of disclosure in financial reporting to ensure transparency and clarity.
  • Encourage linear and not convex alignment of managers' rewards and losses to the institution's fortunes.


If a bank is too opaque, or too complex in its conduct of business and in its financial reporting, or if managers have too convex a call on its profits, investors and savers will direct funding away from them starving them of equity and debt capital, and deposits.

It is a remarkable state of the industry that savers and investors can no longer rely on bank management to act in good faith. The need for more regulation is simply a restatement of this hypothesis. If one believes that this new level of regulation is necessary, they must also accept the hypothesis.


Last Updated on Monday, 16 December 2013 01:20
US monetary and fiscal policy 2014 - 2017 PDF Print E-mail
Written by Burnham Banks   
Monday, 18 November 2013 06:23


US monetary and fiscal policy 2014 – 2017.

I believe it is inevitable that QE tapering will happen. This is driven by the need to control the growth, and one day shrink, the Fed’s balance sheet which is currently at 4 trillion USD and growing. The dangers of maintaining a balance sheet of this size are high. Any pick up in the velocity of money could cause nominal output to surge and capacity may not be able to expand as quickly. That said a reverse repo facility may mitigate much of this risk by being able to remove excess liquidity from the system very quickly. The other risk is that an unconventional policy tool has now been used quite some time with limited impact on the real economy and the Fed needs somehow to reset at least one of its policy tools in case another crisis should follow. Since QE had limited impact on the real economy, it has had significant impact on asset prices, the impact on the real economy of its gradual withdrawal should be orderly. Based on these considerations, I would say the risk of QE tapering is moderate and acceptable and the Fed will do it fairly soon.

The market has erroneously linked short term interest rates to QE tapering. QE is an attempt to monetize debt and to control the mid and back end of the curve, not the front where the Fed already has good control. A number of things suggest that the Fed will maintain its low interest rate policy for another 3 years at least (that is into 2017.)

Now there has been some talk of optimal control theory which is of limited use. Control theory is a methodology and tells us little about the actual path of interest rates or the intentions of policy makers. What the rhetoric and the introduction of control theory do is to widen the spectrum of potential determinants of monetary policy beyond inflation and growth. The definition of the Loss Function can include everything from traditional measures such as inflation and growth, but can also include multiple objectives such as unemployment, distribution of wealth, and even softer targets.

Forward guidance is another new policy tool which has been added to Large Scale Asset Purchases. Again there is little content in forward guidance. With interest rates at their lower bound, and the Fed’s balance sheet at acutely inflated levels, it seems that new and innovative ways of controlling the mid to back end of the term structure need to be found, and that forward guidance is a ‘cheap’ way of achieving this as the costs and risks are low. There are non-financial costs and risks, however, as it requires that the Fed is fairly accurate with its forecasts, and that the Fed’s credibility can be maintained. Choice and judgment are crucial in a complex and leveraged system as optimal control solutions are not unique, they yield a continuum of solutions, and the probability is high for boom and bust trajectories. The widespread adoption of forward guidance among the world’s central banks is somewhat troubling. On the one hand, if realized state variables deviate sufficiently from forecasts, central banks may lose credibility and the efficacy of forward guidance may be impaired, and on the other, such loss of credibility may lead to a more structural decline in central banks as influencers in the economy which is possibly a positive outcome.

For unclear and unspecified reasons, forward guidance and optimal control seem to imply to the market low interest rates for the next 3 years. I agree with this conclusion but present a simpler, cynical and causal explanation for my expectation. The clues to this expectation come not from the US Federal Reserve but from the US Treasury. The introduction of Floating Rate Note (FRN) issuance by the US Treasury supports the view of low interest rates for longer. As a borrower, the US Treasury has to provide investors or lenders with terms which are favorable to them in order to attract their capital. Investors are duration risk averse and seek low duration instruments. The US Treasury would like to finance itself over a longer term without steepening the term structure, and with the US Fed moderating its asset purchases, such funding terms may not be achievable. Funding itself with FRNs is useful in that it provides the US Treasury with longer term financing while providing investors with a low duration investment. The typical coupon for an FRN resets every quarter to some fixed level over the 3 month USD LIBOR or some other similar benchmark. For the US Treasury to maintain a manageable debt service profile, the US Federal reserve has to maintain short interest rates at close to zero. This is a cheaper funding strategy than longer maturity fixed coupon issuance that has to be monetized by the Fed via LSAPs.

What are some of the implications?

Short term interest rates will be kept low for some 3 years or so. The rest of the term structure will be determined less by LSAP but by market forces. Longer maturity volatility will rise, and yield levels are very likely to rise as well.

Conditions conducive to carry trades will arise. This will favor banks and deposit taking institutions. Hedge funds may also capitalize on this.

Implications for highly leveraged companies are complicated. Capital intensive industries will struggle with ongoing funding. In the current period, bond buybacks are accretive, however, over the longer run, this encourages consolidation over growth. Share buybacks will be more expensive as well, so expect a slowdown in volumes.

Increased yields and yield volatility will have real economy impact. Increased yields will discourage issuance and at least make it more expensive to finance with longer dated debt. Businesses may choose to issue more floating rate debt. On the demand side, increased yield volatility will cause investors to demand higher rates of compensation.

It is difficult to guess where the yield curve will settle without central bank large scale asset purchases. One of the more damaging consequences of QE has been to impair the allocative and productive signaling properties of the yield curve.


Last Updated on Tuesday, 19 November 2013 03:08
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