China. Markets and Economy. An Updated Overview. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 02 June 2015 08:27


  • China is moving from Party rule to rule of law: The constitution and anti-corruption

  • China is deregulating markets and increasing greater market discipline: Testing enterprise bankruptcy law and allowing defaults. Credit is becoming more an alpha market.

  • The credit markets are being stabilized through macro prudential policy: New formation of LGFVs banned. Muni bond market open. Systemic risk is reduced.

  • The PBOC is firmly in easing mode. MLF and PSL = LTRO = QE lite. Risk assets to rally for some time to come.

  • The PBOC will try to sterilize the side effects of its easing: Curbing excesses in equity markets. Buy the dips.

  • China intends to internationalize the RMB via the SDR: QDII2. PBOC is counting on outflows being balanced by foreign accumulation of RMB reserves.

  • China wants to deleverage local governments and corporates and leverage up consumers. Municipal bond markets supported by commercial banks, consumer sector supported by consumer credit.

  • Just a reminder, this is NOT a democracy.

Over a 12 month period the Shanghai composite index has risen by 2.5X and the Shenzen composite index by 2.7X. Equity valuations which were among the world’s cheapest are now among the world’s most expensive. China’s stock markets are reflecting an interesting period of reorganization in the underlying economy.

Political reorganization:

At November 2014’s Fourth Plenum, the Chinese government signaled the importance of rule of law drawing attention to the constitution and establishing a series of circuit courts independent of local government influence. This, together with the anti-corruption campaign that has been deeper and wider than expected can be taken as a sign of a very significant shift in policy. The drivers of this policy are likely pragmatic rather than ideological, yet even so, the reforms that we are witnessing are likely to be durable and positive in the long run. We are under no illusions that China’s party wishes to cede control to democratic rule. However, the government has seen what Western democracies are good at, and bad at, and are currently choosing positive elements of Western democracy for its own use. Conceptually, the central government remains a central planner which has chosen to outsource certain parts of the political and financial system to the market where they believe the market provides a better solution than central planning.

A growing middle class, an increasingly fluid flow of information through social media and the evolutionary demands of this growing middle class present to the government significant new challenges in governing the country. The scale of the problem has led the government to conclude that central government is not feasible and that management needs to be decentralized and localized. The government also recognizes that decentralization requires two elements, the first is that policy needs to be driven by rule of law, and that corruption needs to be minimized. The pursuit of these two objectives are evident.

Economic Restructuring and Policy:

In a global trade war a valuable asset is a large and engaged consumer base. Also, as the marginal returns to exports are eroded, it pays to focus efforts on areas of the economy that are less mature hence the desire to de-focus exports and fixed asset investment and encourage consumption and accumulation of intellectual capital (R&D). In 2005, China was 45% of global new patent filings, in 2010 it was 72%. China recognizes it lags in innovation and is investing in R&D to compensate.

The past 5 years have also seen a surge in credit in particular in local governments and corporate businesses. Local governments were previously prohibited from issuing bonds and instead financed their investments through local government funding vehicles, in effect SIVs. LGFVs are now prohibited; only refinancing of existing assets are allowed. Eligibility of LGFV liabilities as general collateral has also been shut down. Instead, local government has been directed towards the issue of municipal bonds, made available through new legislation. To accelerate this great refinancing, currently estimated at 1.7 trillion RMB, a fluid number likely to be increased serially over the coming years, the PBOC has established repo facilities analogous to the ECB’s LTRO, designating municipal bonds as HQLA for collateral purposes, and discounting risk weights to minimize bank capital consumption. On the corporate front, the government is removing implicit guarantees and seeking to slow the accumulation of corporate debt while Imposing greater market discipline into the market. China has an enterprise bankruptcy law enacted in 2007 which is largely untested. Expect it to be tested this year. There have been 4 defaults to date. The first was effectively bailed out, the second and third are entering litigation. The fourth happened last week.

Where is China expanding credit, if it seems to be trying to reign in government and corporate borrowing? Consumer credit needs to be unfettered if China is to successfully engage its consumer base. The life cycle of income generation makes consumer credit an important necessary condition as house prices grow and as consumer tastes develop and mature. SME lending is another area where credit can be extended. While the Chinese banking system serves SMEs relatively well compared with other countries on access, cost of financing is another matter. The PBOC clearly seeks to lower cost of debt for SME as the economy slows. Banks also have a disproportionate propensity to lend to SOEs which bear implicit state guarantees rather than risky private loans. Deposit caps artificially suppress interest expense boosting margins on low yielding loans. The PBOC has recently signaled it may remove deposit caps altogether exposing commercial banks to higher costs of debt and force them to move down the credit quality curve thus spurring SME lending.


The PBOC’s efforts at expansionary policy to address slowing growth, to reduce borrowing costs, to encourage SME lending and consumer credit, have side effects on inflation and asset markets. The PBOC will seek to mitigate some of the asset inflationary impact of its reflationary policies. The CSRC in January limited the pace of creation of margin accounts and most recently in May, brokerages have been tightening margin requirements evidently at the behest of the regulator.

These periodic interventions to cool possible asset bubbles will create volatility in asset markets but are unlikely to prevent a bubble from inflating. Capital finds a way. The credit restructuring efforts of the PBOC will likely lead to credit expansion and asset price inflation. It will likely lead to inflation in the services sector as well but this is a different story. Current valuations are already stretched but the potential expansion of system wide credit will likely carry to stock market further. Eventually, over valuation leads inexorably to correction but under current conditions this is some time away.


China will seek the inclusion of the RMB in the SDR. The RMB is the 7th largest reserve currency and 7th most used trade currency in the world. SDR inclusion notwithstanding, the RMB will become an international currency. China will soon launch QDII2, a scheme which will open up its capital account even further by allowing qualified investors with over 1 million RMB in financial assets to invest internationally. The calculus expects the opening of the capital account to help the RMB into the SDR and that the resulting foreign demand for RMB reserves will compensate from the domestic capital outflows for investments. This capital will seek a home by the way.

Reality Check:

I am pretty sanguine about the prospects for China. China is embarking on QE or QE lite on an ever increasing scale. This will fuel the asset inflation. The asset inflation will be punctuated by efforts to deflate any asset bubble, although it will likely be futile. The end game is a bust, but one that is far away.

The risk is political. The government appears enlightened and is pressing reform in many directions. One thing, however, has not changed and will likely not change. China is not a democracy and if it ever does, will not become one in a continuous or smooth fashion. While markets are being liberalized, personal freedoms are being limited. This may have little bearing for foreign investors who have but a commercial interest in China, however, there is a way in which the failure to reform the political system may be asynchronous with the economic reform. There is that old communist fallback of redirecting internal tensions into external tensions.

Last Updated on Tuesday, 02 June 2015 08:55
Autonomous Automobiles and Shared Mobility. The Possibilities Are Endless. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 09:22

With the coming of autonomous automobiles and with Uber’s current exploratory steps into shared mobility, the future of the automobile is becoming interesting. From a central planner’s perspective one would like encourage better productivity of capital. As it is, people who drive to work end up parking their cars for hours a day. This is inefficient use of capital.

Roads are a scarce resource and need to be rationed. Road pricing is an efficient way to ration road usage. This tax should be levied specifically on the beneficiaries of using the respective road, not bus or taxi drivers, unless the meter is running. A form of this is already in force in Singapore.

Car ownership can similarly be rationed through taxation. The stock of cars on the road should be calculated based on the expected use of cars by a given population for a given set of road infrastructure. Redundant features beyond reasonable thresholds such as excessive vehicle size, engine displacement, engine power output, noise output, and the cost of the vehicle, should also be factored into the tax. Public transport vehicles should be granted preferential treatment. A form of this is also currently in force in Singapore.

Cleaner and more energy efficient cars should be encouraged again through taxation. This is done in many countries.

Cars should be encouraged to be put in use as much as possible. With autonomous cars, car owners can rent out their cars when they are not using them. Dedicated limousine services like Uber, taxi companies and private car owners would compete in a market for private car transport. Different markets and services will evolve which will defy efforts to predict them. Examples include using an autonomous car as a courier, as a surveillance drone, as a decoy or as a third party pick-up service.

Last Updated on Tuesday, 26 May 2015 09:24
Ten Seconds Into The Future. Investment Outlook 2H 2015 PDF Print E-mail
Written by Burnham Banks   
Monday, 25 May 2015 08:09

Outlook 2H 2015


Behind every forecast is a melee of competing ideas and arguments. Behind the veil of confidence is a dialectical process of self-questioning and reinforcement, and often, self-doubt. Behind every investment strategist is a risk manager acting as goalkeeper, and a trader dodging and weaving around short term volatility, avoiding the thousand cuts that often derails a sound strategy.



Table 1.1







· Stable growth

· Slower equilibrium growth rate

· Inflation likely has troughed.

· Secular intellectual capital advantage.

· Domestic demand base and credit channels to enable it.

· Less reliant on outsourcing to cheap EM producers.

· Low savings rates and flexible labor market.

· Growing energy independence.

· Slowdown of globalization affects productivity.

· Inflation has probably bottomed. Energy prices have stabilized, labor markets are tight and the housing market appears to be reaccelerating.


· Unstable growth

· Slower equilibrium growth rate

· Inflation likely has troughed.

· Intellectual capital advantage.

· Failure of EUR to clear markets leads to inter-member cyclicality.

· Inflation is likely to pick up as the weak EUR inflates input prices.

· EUR single currency is a structural self-inflicted inefficiency.

· Subordination of economic rationality to political reality.

· Preoccupation with fiscal probity.

· Greece is insolvent and needs to be bailed out or default.


· Steady slowing of growth rate

· No hard landing.

· Inflation likely has troughed.

· Political reform towards rule of law.

· Economic reform towards greater market discipline.

· Macro prudential management of credit markets.

· PBOC easing to accelerate.

· Economic slowdown is clear and present.

· Intellectual capital deficit – albeit being addressed.

· Social development lagging economic development – leads to social dislocation.

· De-globalization hurts export dependent countries.


· Unstable growth

· Loss of export sector as a driver of growth.

· Inflation likely to undershoot.

· Weak JPY improves terms of trade.

· Demographic drag.

· Debt levels too high. Even with monetization policies.



· Non Asia EM faces stagflation

· Demographic dividend.

· Second mover advantage in development.

· Major beneficiary of globalization will be impacted as globalization slows.

· Inflation risk.




Long Term:

The long term equilibrium trends for the various major economies remain intact. The US economy is growing steadily albeit at a lower rate than in in the preceding 30 years. Its drivers are a structural advantage that include such factors as strong institutions, deep markets, financial innovation, technology and intellectual capital. That the equilibrium trend growth rate is slower than before and slower than the market expects will lead to policy errors and allocative errors as cyclical growth is mis-estimated by econometric models.

Europe has much of the strengths of the US; however, it has a single currency, cultural differences, and partial and incomplete unification in important parts of legislation and regulation. These fractures will cause market failures from time to time. For example, the single currency causes market failures to manifest where local prices are inflexible, such as in labour markets where wages are sticky. Unemployment is some 23% to 25% in Spain and Greece, yet labour markets are tight in Germany.

China has been touted as the most important economy because of its size of economy and pace of growth. Despite having a smaller nominal output, China’s pace of growth will generate more incremental nominal output than the US, this while slowing to a still respectable 7%. The importance of China goes beyond its economic impact. China is in the process of an important political, social and economic restructuring. China is seeking a mechanically and logistically tractable way to govern the country which leads the Party logically to adopt rule of law over central control. It seeks to rebalance its economy by encouraging consumption over investment and exports, partly out of the reality that countries will become increasingly mercantilist, self-sufficient and insular. China also recognizes that rule of law implicitly requires that markets are subject to market discipline and not central planning.

India’s restructuring is less radical but will have no less significant impact on its economy. India seeks to unclog the plumbing of commerce, to simplify and rationalize its legislation and regulation so that a conceptually open economy can become a practically open economy.

Japan is also a reform story with new management promising change. So far the efforts on the monetary and fiscal side have been significant but structural reform has been slower to follow. One would argue that the pace was reasonable given the historical caution of the Japanese.

As countries all over restructure their economies for the new reality, globalization continues to slow and retreat. The financial crisis of 2008 is now 7 years behind us but the realization that trade was one of the few avenues left to drive growth has led countries to engage in a global cold trade war. The weapons deployed have included debasement of currency and FX manipulation to re-shoring and the development and protection of intellectual capital. This era of contentiousness will persist for some time to come. A side effect will be reduced global productive and allocative efficiency lowering the non-inflationary speed limit. The short term evidence does not support this view but inflation is a real risk.


Medium Term:

The US economy experienced a period of economic softness in the first quarter, attributed in part to the weather and to a port shutdown on the West Coast, and in part due to the natural metabolism of the economy. This period of softness is likely over. The labour market appears tight and while wages have lagged, they are likely to be dragged along. Manufacturing and services PMIs remain robust.

The European economy has been aided by a remarkable improvement in terms of trade through a much weakened Euro and disinflation. The natural metabolism of the European economy has turned in favor, however, and just when the ECB has initiated its QE program. The immediate effects are understandably optimistic but the structural inefficiencies of the single currency and a host of political challenges on the horizon may temper data and sentiment in future.

China’s stimulus efforts are evident and look set to continue. Market reforms in particular in the credit markets are positive in the long term but in the short term can lift credit default rates. The PBOC will ensure that system liquidity and solvency are unquestionable during the restructuring process. A side effect will be the risk of inflating bubbles in asset markets. To address this, the PBOC operates targeted macro prudential policies to direct the flow and cost of capital. Notwithstanding the efforts of the PBOC the basic tradeoffs between control and state variables mean that policy will continue to have unintended consequences which may present opportunities.



Table 1.2







· Fed expected to lift off Sep 2015.

· Less aggressive rate trajectory. However, expect a series of rate hikes.

· Possibility of July lift off cannot be ruled out.

· Inflation turns out to be stronger than expected.

· Oil prices stabilize to rise.

· Labor markets tight, lead to rising wages and costs.

· Reduced trade deficits provide less USD to be recycled into treasuries.

· US treasury debt service costs

· Weaker than expected long term growth trajectory leads to policy error.

· Erring on the side of loosening – 1930’s experience of being too tight.

· Global economic weakness.

· Strong USD hurts terms of trade.


· ECB QE just underway.

· Rate hikes are not expected soon. This could change if inflation expectations recover.

· Tight fiscal policy and loose monetary policy will cap inflation and output.

· Inflation is stabilizing and could pick up.

· ECB may consider tapering QE ahead of Sep 2016, although this is highly unlikely at this point.

· Fiscal policy will be a persistent drag on output.

· ECB QE is recent and is scheduled to run to Sep 2016.

· Credit transmission is only just recovering. Bond issuance has recovered but loan and structured credit issuance still slow.


· PBOC likely to continue to loosen and may accelerate stimulus to compensate for slowing economy and reforms.

· Current liquidity operations may be extended to QE at a later stage.

· Macro prudential policies to direct credit away from overleveraged industries.

· PBOC is vigilant over equity market and real estate inflation.

· PBOC to continue to suppress cost of debt.

· Current policy includes a host of open market operations.


· BoJ may have to loosen policy further to compensate for fiscal constraints.

· Japan is in a liquidity trap.

· Fiscal policy is tight.

· Sales tax hike delayed till 2017.

· BoJ remains loose but is running out of options as output and prices sensitivity to policy is reduced.

· BoJ may have to compensate for tight fiscal policy.




Portfolios should be positioned for the long term and traded and adjusted for the medium term while being aware of the risks.


In the US stable growth will support corporate earnings and cash flows. With the Federal Reserve no longer expanding its balance sheet, the correlation between duration and equities, distorted to the positive for the duration of QE will revert to the historically negative. While we remain exposed to US equity risk we prefer to express this in US high yield corporate credit. We obtain these risks in two ways, in traditional high yield bonds, which we are underweight and in senior, secured, floating rate bank debt which bears little duration. At the same time we obtain domestic US economic growth exposure via the housing market through credit sensitive non-agency residential mortgage backed securities.



We are in the early stages of implementation of the ECB’s QE program. We do not see significant probability for an early taper despite the current cyclical uptick in activity. While QE is in force, correlations between equity and duration will likely be positive. We are therefore long hard duration in the peripheral countries while being underweight duration in the core of Germany and France. A related trade expression is available in the sovereign CDS where we would be long protection France and Germany and writing protection on the periphery.

We find an efficient trade expression in banks’ capital securities such as contingent convertible bonds and perpetuals where improving balance sheets and capital positions encourage spread compression. While it seems reasonable that high yield corporates should tighten in this environment increased volume of issuance and lighter covenant standards increase the risk in these securities. The demand and supply environment for high yield corporates may cap the returns potential for European high yield.

In European loans we find better underwriting standards, tighter covenants and wider spreads, however, the duration protection is not something we require at the moment and the liquidity of the European market is much poorer than in the US. We do not feel compelled to invest in this area yet.


In China the conditions are positive for risk assets and the most accessible and liquid trade expression is through listed equities. In the medium term, Hong Kong listed H-shares have a valuation advantage which can be exploited. A-shares on the other hand are more directly impacted by improving local liquidity conditions, but valuations are significantly higher than their HK listed counterparts. RMB bonds are another area where the prognosis is positive but here, the government’s reform efforts are likely to drive up default rates as they test insolvency law.


Less Liquid Strategies:


For investors with a tolerance of less liquid investments the prognosis is good. The common thread running through all these strategies is the increased regulation of banks and the vacuum they leave behind.

Hedge funds:

Public data about hedge fund performance is incomplete and misleading. The hedge fund industry has evolved into one where talent is global but source of capital is predominantly US based. Europe had beaten the UCITS path and Asia had almost eschewed hedge funds altogether. In the meantime, talented managers have tightened liquidity provisions to stabilize their capital base and businesses. Illiquid strategies which may either have illiquid assets or liquid assets but long gestation strategies have done well. Examples are complex agency RMBS arbitrage involving arbitraging the relative valuations between mortgage derivatives and the underlying pools. Event driven managers have profited from the surge in M&A activity. Some hedge funds have coupled risk arbitrage with activism to operate highly successful strategies. Generally, with greater regulation and higher capital requirements for principal activities, banks have reduced their principal activities in exchange for agency businesses. The lack of cross market, cross capital structure trading by banks removes an important source of capital policing the no-arbitrage pricing of markets and securities resulting in greater price dislocation that hedge funds can take advantage of. The strategies we favor include cross capital structure arbitrage, merger arbitrage and agency MBS arbitrage. We are less confident that quant driven strategies like statistical arbitrage or trend following price data driven strategies will be able to generate consistent, repeatable performance.

Private Equity and Private Debt:

Private equity and debt strategies are the natural beneficiaries of the dearth of bank capital. However, the weight of capital flowing into private equity in the past 3 years has led to a surfeit of capital seeking deals. Certainly PE secondaries are trading at high valuations and there is a shortage of quality secondaries on the market. The shortage of deals is also leading to deals circulating between funds at increasing valuations.

The private debt market is more interesting in particular mezzanine lending to mid market companies. Restricted access to debt capital markets and a shortage of bank capital coupled with disadvantageous Basel III risk weighted capital treatment make lending to SMEs attractive. One area of low volatility returns is trade finance. Properly structured, trade finance provides very stable returns with low default rates and high recoveries. Private trade finance funds profit from the dearth of credit from bank consolidation and shrinking credit limits.


What are we not positive about? Is there anything we are not buying?


The face of capitalism was unmasked in the aftermath of 2008. Moral hazard reigns supreme. Central banks will not allow any systemically important entities to fail, and will generally err on the side of easy conditions. Fundamental health of the economy notwithstanding, central banks will be supportive of risk assets and indeed any assets with a positive wealth effect. Be that as it may, we are cognizant of the risks in the world economy today.

Broad picture:

The most important risk investors should consider is how central banks will reduce their large scale asset purchases and eventually return their balance sheets to a more manageable size, the implications will be for the real economy and for markets.


Central bank balance sheets cannot be maintained or indeed expanded for too long. A pick-up in the velocity of money can quickly multiply through the money base to result in high inflation. With interest rates at such low levels, central banks may struggle to contain an unexpected increase in inflation. At some point central banks will need to shrink their balance sheets. Not even the US Fed has entered that stage and no one is quite certain what the repercussions will be. The Fed will understandably want to be gradual, probably allowing the assets to pay down and avoid selling assets in open market transactions. When the European economy achieves a durable state of recovery, the Fed will hopefully provide a template for exit.

A by-product of low interest rates is that they impair the functioning of the savings and pensions system. There is a limit to how long interest rates can be artificially suppressed. Liabilities are inflated as much as assets by low discount rates and unfunded liabilities with time become a sizeable current problem.

Tangential to the health of the savings and pensions industry are the fortunes of banks. The future for banks is unexciting. A number of banks operated in potentially disingenuous fashion both during the 2008 crisis and after leading regulators to questions the conduct of these banks. The role of banks in transmitting and amplifying the credit crisis in 2008 added to regulators concerns about the systemic risk posed by the commercial banks. Regulation has understandably swung in the direction of excessively prescriptive policies. Banks have henceforth been regulated like essential utilities, a position they are unused to. Banks may still provide short term thematic trading opportunities, especially in respect of their continuing, albeit diminishing role as the infrastructure of finance, however, for the long term investor, better alternatives exist in the value chain between savings and investments.

Medium term:

In the US, the stability and eventual recovery of inflation recommends an underweight in duration. Curve trades may be available to trade supply and demand driven flattening but outright duration longs should be avoided.

In Europe the temptation to front run the ECB’s QE program is strong. Tactically, the ECB provides a backstop for the investor to maintain a long duration profile, especially in the peripheral member states. Greece can be excluded as the ECB backstop excludes non-investment grade sovereigns. The safer trade expression is to fund the longs with shorts in core Europe. That said, the QE backstop is compelling. We will adopt a long bias to peripheral duration with a keen eye on potential risk off selloffs as happened in the second quarter.

While we have a general preference for equities the return per unit risk of equities and the relative valuation of equities encourages us to find alternatives or proxies to equity risk which suppress volatility or realign the valuations. Where no viable alternatives are available, we will not shy from investing in equities but we will size positions based on the risk of the underlying instrument. Examples are non-investment grade corporate bonds and leveraged loans where we buy credit sensitivity as a correlated asset to equities.

Commodities are ever a volatile asset class where despite having an opinion, we do not have an edge. Oil had been exceedingly weak in 2014, surprising all including the most experienced and dedicated energy traders. Since then, the price has stabilized. Oil has significant impact on inflation expectations and can impact the direction of term structures. While we do not explicitly trade energy and energy related corporates, we monitor the market carefully. Notwithstanding the current rebound and stability in oil markets, the fundamental balance is not supportive of the oil price and we are not convinced of a durable recovery. The actions of the Saudis are illuminating. The Saudis, behaving purely as merchants, clearly regard the future value of oil in the ground inferior to the cash value of what they can sell, all the way down to circa 45 USD. This is a significant overhang.

We have in the past invested in agency mortgages where we sought additional yield over our intended long duration positioning. For one, we are no longer seeking to be long USD duration and for another, agency spreads over treasuries have tightened considerable so that the compensation for prepayment risk is no longer adequate. Tactical opportunities may arise depending on issuance and demand and supply but we are otherwise underweight agency mortgages.

Table 1.3




Fixed Income



· Earnings growth slowing.

· Valuations high.

· Long term positive.

· Short term limited upside.

· Downside risk from higher rates.

· Prefer cyclicals to defensives.

· Long duration trade is over.

· High yield to benefit from slow, positive, growth environment. However, duration will detract.

· Leverage loans provide credit exposure with floating rates and little duration.

· High conviction call on non-agency RMBS as housing recovery matures into a sustainable long term trend.

· M&A activity elevated. Allocate to event driven M&A hedge funds.

· Agency MBS relative value opportunities. Rate volatility generates dispersion and dislocation which can be harvested.

· Trends are turning and have not been established. CTA’s may suffer.


· Equity and bond correlation will be positive under QE.

· Equities cheap relative to bonds and credit.

· Convergence trade in Eurozone sovereign debt, long Spain, Italy, Portugal, short France, Germany.

· Long financials capital securities.

· European equity long short opportunities.

· M&A activity elevated. Allocate to event driven M&A hedge funds.


· Equities supported by PBOC liquidity policies.

· H shares cheap to A shares.

· High yield preferred to IG

· In real estate, prefer size and IG to HY.



· Domestic pension funds are increasing allocations to Japanese equities.

· Economic reform encouraging firms to focus on shareholder value.

· JGB market liquidity reduced to BoJ activity.

· Activist hedge funds may find more opportunities.






Table 2.0




Fixed Income



· Significant demand is coming from buybacks. Buybacks tend to be a poor indicator of timing.

· Valuations are neither cheap nor expensive. There is no advantage in equities.

· Inflation could surprise on the upside.

· Growth could slow to the extent that the Fed is unable to raise rates.

· The US Fed is first in line to taper QE and to eventually reduce its balance sheet. How will it do this and how will markets react?

· As the US becomes more insular what will become of its allies?

· How will the US react to a challenge to its hegemony by China?


· Equities are being supported by the bond market as QE remains in force. Correlation to bonds is positive and optimistic bond markets currently support the equity market. This could change when the QE program matures.

· The debate over the solvency and liquidity of Greece continues on with only tactical solutions, not long term structural solutions.

· Political risk. Syriza’s win in Greece has demonstrated the consequences of populist parties and policies. Spain’s recent local government elections are a portent of the potential risk at the Spanish parliamentary elections in December.

· The UK will have an In Out Referendum on Europe by 2017.


· Valuations are very high and downside risks are substantial.

· Event risk. The Shanghai Stock Connect had a few false starts. Fortunately it is now functioning well. The Shenzhen Stock Connect is expected later this year and could introduce more volatility.

· PBOC policy is academically sound but implementation is inexperienced. Mistakes can happen.

· The promotion of rule of law will likely increase default rates, albeit limited to systemically unimportant issuers.

· Political risk is the most significant risk. Tensions in the South China Sea are unlikely to abate absent a comprehensive solution which no one appears ready to engage in.

· The inclusion of the RMB in the SDR and the ascension of the AIIB are examples of matters which challenge the US hegemony and can become contentious.


· Equity markets are quite stretched. Much depends on BoJ stimulus efforts and a weaker currency.

· The BoJ appears to be in a corner. On the one hand it expects a slow economy and on the other it expects a rebound in inflation. If both occur it could pose a new set of challenges for the BoJ.

· Japan is a test case of extreme debt monetization and debasement of currency in the hope that growth will recover before bond markets fail. A high savings rate and a captive source of funding can delay the day of reckoning for a long time, but not forever.




In Closing:


The investment landscape is risky. The world has not yet healed from its credit binge and bust, and debt levels remain high, growth is slower than before and countries have become more protectionist thus reducing economic efficiency. And yet, central bank policy is either deliberately or unintentionally inflating or backstopping asset prices. The question is, in this environment, can the rational investor ignore markets and refuse to play the central banks’ games?

One, we are mindful of valuations as we invest. Finding cheap assets or cheap trade expressions provides us with a cushion for when markets correct. Currently asset markets are buoyed by monetary policy. Buying cheap non agency RMBS to capture growth is an example of a targeted trade to capture domestic US growth. Buying leveraged loans is a way to obtain exposure to strong corporate cash flows without exposure to duration.

Two, because central banks have such strong influence in the economy and markets today we watch them closely to understand their objectives and limitations, and the propensity for policy errors. We focus not only on what central banks are doing and thinking but we study the mechanical processes by which they effect policy to gain a head start on policy and to find opportunities from operational aspects of policy. For example, when the Swiss National Bank announced an end to the currency cap, it signaled to us the near certainty of the ECB announcement to undertake QE and allowed us to buy bonds before the announcement. Another example is where we focused not on the directional aspect of the ECB’s QE but on the risk sharing by the member states’ central banks to construct a Eurozone core-peripheral convergence trade.

Third, fundamentals and asset prices are joined by an elastic couple which can result in perverse phenomena. Weak economies can spur loose monetary conditions that drive asset prices. Strong fundamentals on the other hand can signal tighter monetary conditions that might choke off an asset rally. Being too early in to a trade can be costly, just as overstaying a theme which has run its course. We keep a close eye on that elastic couple, psychology, which drives markets, even as we maintain conviction in our fundamental views.

The problems that face the global economy are many, but human ingenuity is great. We are acutely aware of the problems and we relentlessly trade the efforts of regulators and market participants to address these problems until a point when market prices are no longer as acutely distorted by regulators and policy and markets can return to pricing assets according to their intrinsic value.












Last Updated on Monday, 25 May 2015 08:29
China's QE Lite II. Jiangsu Successfully Issues 52 billion RMB of Muni Bonds PDF Print E-mail
Written by Burnham Banks   
Thursday, 21 May 2015 00:37

On Monday, 18 May, Jiangsu province successfully sold 52 billion RMB of municipal bonds.


Recently, the Chinese government has accelerated a municipal bond program that effectively is a debt swap for some 1.7 trillion RMB of existing local government debt. Cost of debt for the local governments is expected to fall by some 250-300 basis points.

There is some logic behind what is effectively a system wide restructuring. The municipal bonds yield less than the maturing or retired debt, however, they also have a lower risk weight of 20% or less and thus consume a lot less capital.

For a bank seeking to maintain profitability, it would have to extend more loans for every dollar notional of restructured debt. The municipal bonds are financed at highly advantageous rates and haircuts. Naively, if risk weights were reduced to 20%, a bank could make 5 times the loans it used to with the same capital and fund itself cheaply, not with deposits where reform is raising rates, but with medium to long term repos with the PBOC, namely the MLF and PSL. Impact on bank profitability would be neutral, balance sheets would expand, loan growth would rise, credit quality would improve, and the impact will likely be felt across the economy as a whole and drive the stock market even further.

At the same time, the Chinese regulators have relaxed funding conditions by allowing banks to refinance existing LGFVs in respect of projects started prior to the end of 2014. This is likely a stop gap measure as the PSLs are unlikely to be able to absorb the volume of refinancings of what is essentially the substantial majority of local government debt in the system.










Last Updated on Friday, 22 May 2015 01:25
Why Did German Bunds Selloff and What Opportunities Are There in European Sovereign Bonds PDF Print E-mail
Written by Burnham Banks   
Thursday, 14 May 2015 07:09

Why did German bunds selloff so violently?

When the ECB announced QE, traders attempted to front run the program. The program would buy bonds according to the capital subscription of the national central banks to the ECB. On that count, bunds would see an 18% allocation of the budget, France 14%, Italy 12% and Spain 9%. Traders reasoned that bunds would see the biggest allocation not only in absolute terms but relative to the stock of bonds available. The problem with this thesis was the investors who had over 2 years of profits ready to crystallize.

A less volatile trade expression for QE was to realize that with risk mutualisation, 20% explicitly and 100% implicitly through TARGET2, it made sense to sell protection on Italy, Spain, Portugal and to buy protection on Germany and France.

When the Maastricht treaty was signed, peripheral spreads over bunds were much wider than they are today, some 4%-5%. They spent the best part of a decade converging, in the case of Italy, to a negative spread to bunds... In 2012, spreads widened to pre Maastricht levels as country risk reasserted itself in the European sovereign bond market. Since the ECB's "all it takes" policy, spreads have converged again. We are currently still well wide of zero and convergence remains a logical trade.


Last Updated on Thursday, 14 May 2015 07:15
Greece. No Way Out But Exit? Example Solution From Corporate Workout. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 12 May 2015 00:59

A business cannot borrow itself into solvency. On the other hand there will be a cost of debt beyond which no business model can survive. What Greece needs to do is examine its business model to get a handle on its revenues and expenses (including unfunded liabilities), examine its balance sheet (including state owned assets) and find a viable business model (from a cash flow and profit perspective) and balance sheet.

A rational creditor would work with Greece to maximize the value of the loans they have already extended to Greece. This could very realistically involve extending more credit to Greece, at easier terms. A rational creditor would only agree to this if there was a formal business plan.

In order that any such business plan was sufficiently reassuring to Greece's creditors, cash flows from tax and other revenue might have to be directed to escrow accounts where a waterfall of priority of cash flows directed cash so as to satisfy basic needs of the Greek government and people, then creditors, then less high priority Greek interests.

Last Updated on Friday, 22 May 2015 01:25
EUR and Greece PDF Print E-mail
Written by Burnham Banks   
Monday, 11 May 2015 00:23

A short EUR position has been a consensus trade for most of 2014. Recent EUR volatility and the contentious negotiations about Greece's finances challenge the consensus.

If Greece manages to stay in the Eurozone it will be by postponing its problems and continually deferring default and exit. The Euro would be weak under this scenario. Volatility would remain elevated with bouts of strength at each narrow escape. This is not rational but markets are often not rational. Greece's membership of the Eurozone should cheapen the EUR not strengthen it.

If Greece is removed from the Euro it would be positive for the currency. While short term reactionary price action is difficult to predict, one would expect a Grexit to promote EUR strength with the EUR heading perhaps to 1.30 to the USD. This could hurt European exports and growth.

Herein lies a trading strategy.





Last Updated on Monday, 11 May 2015 00:39
Equity and Bond Correlations. Inflation. Commodities. Implications. PDF Print E-mail
Written by Burnham Banks   
Thursday, 07 May 2015 03:49

In 2014 we saw stronger equity markets and falling bond yields. In 2015 we see slowing equity markets, slower growth and rising bond yields. The 2014 correlation went against historical correlations but could be explained by equity valuations being supported by falling discount rates and thus rerating. Also, despite a stronger economy, bond yields fell as a result of demand and supply conditions. Corporate tax revenues were strong, defense spending was receding and the US treasury started to fund with 2 year FRNs for the first time reducing supply at longer maturities. This explains the unusual correlations in 2014.

In 2015 we have a weaker US economy, low inflation in Q1, a Fed seeking to raise rates but confounded by data, and rising bond yields.

1. Is the correlation between equities and bonds reverting to their historical levels?

Equity Bond correlations are widely accepted to be negative. In fact they are highly variable and often change sign. They are also sensitive to short term interest rates and inflation. Correlations were negative in the 1950s through 1960s, and from the late 1990s to the present. They turned positive in 2014. And, they were positive throughout the 1970s and 1980s. In 2015 correlations appear to have reverted to negative although the time frame is too short for statistically significant estimation.

Focusing on recent behavior, it is possible that with the multiple asset purchase programs of the central bank, bonds have come to be regarded as a risk asset held for return and not for safety. In that respect, bonds would have become a risky asset and correlations with equities would have turned positive. This would explain 2014 behavior. With bonds falling and equities holding as the economy slows, there is a risk that either the correlations have reverted to negative, or one of either the bond or equity market is lagging the other.

Scenario A: Let us assume that correlations have indeed reverted to negative. Let us assume that the US economy is in a phase of stable but low growth with a moderate cyclicality around it. This should be moderately supportive of equity markets. With negative correlations, bonds should weaken as investors substitute away from the safety of the reserve asset to the risky asset. The current cyclical weakness in the economy and the weakness of the USD seem to contradict this scenario. If this scenario is in fact valid, the USD would have to recover and the economy rebound. There are expectations for both so time will tell if this scenario is valid.

Scenario B: Let us assume that bonds are a risky asset and that correlations are therefore positive. Let us assume again a stable, low growth economy with moderate cyclicality. In this environment cyclical weakness might trigger a selloff in risky assets leading to weak equity and bond markets. The relative weakness would depend on the weight of capital in each asset class attempting to exit. Given the leveraged nature of bond holdings one might reasonable expect a sharper sell off in bonds than equities. The reserve asset here would no longer be bonds but cash. The bond purchases of the central bank would have led to private investors front running the central bank rendering bonds a speculative asset instead of a risk-free asset and at the same time impairing price discovery so that the efficient market price of the bond was unknown. If at the same time as the cyclical weakness the central bank was considering raising rates for other than economic reasons, such as resetting a policy tool for example, the coincident impact on bonds could be exacerbated. Even if weak data delayed central bank action bonds would remain volatile with a downside bias. In this environment, equities would be vulnerable.

Equity Bond Correlation



Strong growth

Equities positive

Bonds positive

USD positive

High yield positive

Short duration credit neutral

USD curve flattens

Agency and Non Agency RMBS positive

Equities positive

Bonds negative

USD positive

Short duration credit positive

Long duration credit negative

USD curve neutral

Prefer Non Agency to Agency RMBS

Weak growth

Equities negative

Bonds negative

USD negative

Investment grade neutral

USD curve steepens

Agency and Non Agency RMBS negative

Equities negative

Bonds positive

USD negative

Investment grade credit positive

Short duration credit negative

USD curve flattens

Prefer Agency to Non Agency RMBS


2. What are inflation expectations?

Inflation is a significant risk. Inflation expectations have been stable except for the 2008 crisis. In 2014 inflation expectations, as indicated by the breakevens, fell, mostly on the back of weak commodity prices. Commodity prices have stabilized in Q2 2015 and may well recover. This would lift bond yields.

Apart from the recovery in commodities, the monetary base remains very much inflated and any acceleration in the velocity of money could result in a strong increase in nominal growth. This risk is tempered by capacity utilization retreating from the 80 level in recent months. Also, the Fed has tools at hand to absorb liquidity should prices accelerate. The cost, however, would be higher repo and short rates.

3. If money is coming out of equity and bond markets, where is it going or how is it being absorbed?

The default reserve asset is cash. Investors will not stay long in cash if inflation accelerates and alternatives will be sought.

For yield seeking investors who are unwilling to raise cash, they may seek alternatives such as ABS, leveraged loans or commodities or gold. Most investors, especially ex US, are unfamiliar with ABS and loans. The complexity of ABS will deter some but loans could absorb significant capital. Currently retail investors are reducing exposure as institutional investors are adding to loans. Recent experience in commodities has been volatile and investors may take some time to return to the asset class. Gold is an asset class that will likely benefit from inflation but will also require that investors exhaust the set of viable liquid alternatives before large scale inflows can be expected. If correlations are in fact positive, which is a strong assumption, the set of viable alternatives could shrink very quickly. However, all that is required is that one or two alternatives are found which are more liquid with lower transaction and storage costs.


* This analysis does not consider the possibility of investing internationally to simplify the analysis. Cross border investing will be considered separately.

Last Updated on Thursday, 07 May 2015 04:05
Japan. Abenomics and the BoJ Run Out Of Options. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 05 May 2015 08:36

Japan is a cautionary tale of what happens when an export dependent economy has an inadequate domestic demand base.

The Bank of Japan appears to have run out of options. QQE on its own can exert pressure on interest rates and boost output but on the fiscal policy side, tax hikes have the ability to further depress interest rates but suppressing output. The result can be a serious liquidity trap where interest rates become irrelevant and output stagnates.

After chronic deflation and recession, inflation might finally finish off the Japanese economy.


Last Updated on Tuesday, 05 May 2015 08:44
Why The Fed May Not Be Able To Credibly Raise Rates PDF Print E-mail
Written by Burnham Banks   
Tuesday, 24 February 2015 23:08

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


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

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

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


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

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

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


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


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


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

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

Now many countries are both.

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

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

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

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

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

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

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

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

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

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

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

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


Some tidbits:

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

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

You may now stop suspending disbelief.

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

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

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

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

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



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

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

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






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


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

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

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

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

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

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

3. 3. Greece leaves the currency union.

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

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

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

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

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


Last Updated on Tuesday, 06 January 2015 08:31
Off Topic: Cancer A Sign Of Resilience Of The Species? PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 09:27

Increased incidence of cancer can be indicative of the improved resilience of the human species. The environment constantly evolves in uncertain ways. To adapt to the constantly evolving environment, a species needs to also evolve. Increased mutation is equivalent to increased evolution. Unfortunately, with increased mutation comes increased negative mutation, leading to cancers. The propensity to mutate is collectively positive for the species but individually negative for a particular member of the species. Positive mutations may go unnoticed or unreported whereas negative mutations naturally draw attention as treatments are sought.

Is it possible that some cancers are in fact an early evolutionary phenomenon which left untreated could lead to a discontinuous evolution of the species?

Private Banking Industry In Asia 2015. Identity Crisis. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 26 May 2015 08:27

With regulation like Basel III, Dodd-Frank and other local regulations it is no wonder that banks are turning to asset management and private banking to generate fee income. The wealth generation in Asia has caught the attention of the private banking industry and many banks are investing heavily in building and growing their Asian businesses. The Asian private banking scene is an interesting one. The trust between clients and banks has been tenuous and it has been difficult to scale businesses profitably.

Principal Agent Model: Brokers, not fiduciaries.

The single most important question for a private bank is one of identity. An organization behaves the way it does because of the what it is; it cannot act against its nature. Arguably, most so-called private banks in Asia are in fact brokerages. Fee paying AUM is in low single digit percentages of total AUM. Their relationship with their clients is defined by earning commissions or transaction fees, receiving retrocessions from product providers, and providing leverage. Private bank investment research is provided for free and in return clients are encouraged to transact and thus pay commissions. Where managed products such as funds are concerned, in addition to charging the client commissions, private banks are paid trailer fees or retrocessions by product providers. For example. the distributing bank typically takes half of the management fees from the mutual fund manager for distributing their products to their clients. Transaction fees encourage activity and can lead to advisors churning their clients assets. Trailer fees lead private banks to represent the interests of the fund managers above those of their clients.


In discretionary and advisory portfolio management services, clients pay private banks to manage or advise on their assets. They pay an annual management or advisory fee regardless of the activity of the account. Private banks then buy the cheapest available versions of each particular investment instrument, or if trailer fees are collected, rebate these to the clients. Commissions and activity are transparent to clients. Private banks operating under this model are aligned with the client because the client is their paymaster and as a result the banks are contractually bound to represent the client above all other parties.

In Asia, discretionary and advisory assets are in the acute minority. Asian clients are reluctant to pay fees for discretionary management or advice preferring to retain control over their investments. Trust has been difficult to build in the aftermath of 2008 when products and funds sold by private banks either incurred substantial losses or restricted liquidity. Also, the dearth of international and cross asset / cross market expertise among private bank advisory staff does not instill confidence. Asian HNWs are also likely to be first or second generation wealth and actively managing their operating businesses. The returns on equity on their operating businesses far exceed what they can reasonably expect to earn in a private wealth portfolio. Clients do not yet understand that the route to a multiple of return on capital can only be purchased with a significant probability of catastrophic loss of principal. Operating businesses take time, effort and risk to build. When the time taken to generate the return multiple is taken into consideration, internal rates of return might not be that attractive. Additionally, when the risks are factored in, the risk reward may not be that attractive either. Private banking clients are the ex post successful sample, the ex post unsuccessful sample falling away and not being counted. The return and risk targets of a wealth preservation portfolio are far more conservative and the diligence and complexity of investment strategies are directed at risk mitigation rather than unfettered returns generation. Remarkably, few clients see the contradiction in leveraging up such portfolios with full recourse credit lines provided by the same private banks. The private banks clearly do not. The return on assets from the bank’s fees perspective make this a reasonably attractive business, especially if there is recourse to the client as well as to the assets.


Private Banks to do list:

  • Decide on their identity, if they are brokers or fiduciaries.
  • Private banks who want to be brokers are not purveyors of advice or investment management; they are purveyors of market access and transaction capability. They need scale and volume and they should recognize margin compression as a reality and an eventuality. The resources they require are very different. Brokers can survive on far fewer human resources than fiduciaries. Technology resources for brokers are also different than for fiduciaries and can and should be used to replace human resources. Brokers are more capital intensive, have lower overheads, slimmer margins, more volatility of cash flows and need scale.
  • Private banks who want to be fiduciaries seek stability and predictability of fee income and better margins. Overheads, however, will be higher as technology solutions cannot be deployed to replace costly human resources. Fiduciaries are not purveyors of transaction capabilities but of advice and investment management. Fiduciaries need to invest in experienced and expert advisors and relationship managers. Fiduciaries are less capital intensive, have higher overheads, better margins, less volatility of cash flows and do not require scale.
  • If any universal banks attempt to do both it is best that both businesses are run separately with Chinese Walls. There are no synergies to be had here, only potential for conflict and revenue cannibalization.

Clients to do list:

  • Diversify between brokers and fiduciaries. Decide on the proportion of assets they wish to allocate to active self-directed management, that is to their broker, and what proportion they wish to allocate to a discretionary manager.
  • Select a broker with the lowest all in cost, the best market access and good reporting.
  • Select a fiduciary with the best investment management talent, operational integrity, risk reporting and client service.
  • Resist the temptation to replicate the fiduciary portfolio at the brokerage. On the one hand this cheapens the fiduciary service but at the same time it concentrates the risk and dilutes the diversification benefit.

Last Updated on Monday, 15 June 2015 06:36
FX Rate Fixing. Banks Fined. A Clarification. PDF Print E-mail
Written by Burnham Banks   
Friday, 22 May 2015 01:11

The rights and obligations of principal and agent need to be properly defined, particularly in complex business like banking and finance. Five banks have recently been fined $5.5 billion over a rate manipulation scheme that has seen them not act in their clients’ best interest.

A bank should be clear about whether it trades as principal or agent when it transacts with a client. If as principal, the rules of disclosure may be relaxed. If as agent the rules of disclosure are clear: the client must be made aware of the detailed economics of the trade including the commissions, costs and expenses. The concept of markup pricing is incompatible with an agency trade. In fact, not only the quantum but the beneficial recipients of commissions, costs and expenses should be transparent, so that there is no ambiguity as to the interests of the agents and their delegates or associates. For principal trades, the client needs only know the all in cost of the transaction. Margins and markups, and their beneficial recipients are irrelevant.

This transforms the issue from one of transparency of pricing to one of the distinction and separation of principal or agent relationships. Client’s may want to choose whether the bank they trade with is trading as principal or agent. If there is no liquidity, it may be preferable to do a principal trade since the bank makes market. If there is ample liquidity, an agency trade may be preferable as pricing is transparent. What is required is a Chinese Wall between the principal desk and the agency desk. If a client chooses to call the agency desk, they receive full transparency but have to live with the liquidity available. If they choose the principal desk, they are aware that the bank is trading as principal and does not in any way guarantee best execution but the bank must guarantee execution.


Incidentally, the complaint against the banks was not that they did not act in the best interest of clients, but that they colluded to create a false market, or lack thereof, and distort prices. In a fair market, even if all transactions were principal ones, clients would have obtained price discovery by shopping around.


The current convention is one where banks trade as principal and therefore, rightly should have no obligation to provide transparency of pricing or best execution. When trading as principal the bank acts in its own best interests, not that of its so-called clients. The clients of the bank, when entering a principal trade become counterparties for the purposes and duration of the trade, and counterparties are owed a different set of obligations than clients or customers. The possible source of confusion is that clients are unaware or unaware of the implications of being in a principal trade. They may be under the impression that the bank acts in any way in their interests, a clearly mistaken assumption. The fault of the banks, if any, is to perpetuate the myth, actively or passively, that they in fact act in clients’ best interests. Where there is a fiduciary responsibility to do so, the law compels them to act in the best interests of their clients but where there is no such relationship, clients should beware.


Regulators can clear the situation by distinguishing between principal and agent transactions and setting out the standards of behavior in each relationship.


It would certainly be interesting to see, in a free market, which business, principal or agency, finds more custom and which is more vigorously supplied. Thin and thinning agency margins balance regulatory capital requirements needs to support principal businesses and only an unfettered market providing both alternatives will complete the market for these services. It is likely that with clarity and the clear distinction between business lines, new entrants and innovation will lead to more efficient markets less prone to abuse.











Last Updated on Friday, 22 May 2015 01:25
China's QE Lite. PSL, MLF, SLF a.k.a LTRO, MRO PDF Print E-mail
Written by Burnham Banks   
Friday, 15 May 2015 00:33

China is initiating QE lite mimicking the ECB's LTRO programs. The objectives are clearly to lower borrowing costs for local governments, and to establish a liquid municipal bond market as part of a reorganization of the funding mechanism for local governments which until now had used opaque, off balance sheet, so-called Local Government Funding Vehicles (LGFVs). The opacity of LGFVs lead to uncertain priority of claim and difficulty in measuring systemic risks. The side effects of QE Lite will include expanding liquidity and bank lending through the eligibility of municipal bonds as collateral in PBOC repo operations.

The PBOC has effectively halted the creation of new LGFVs, is encouraging local governments and their creditors, mostly commercial banks, to exchange LGFV debt for municipal bonds. It is also encouraging private commercial banks to invest in municipal bonds which are eligible for repo and thus provide a nexus between the PBOC and local governments.

Initial efforts have been clumsy due to the inexperience of the parties, the banks, the local governments and the PBOC. For the strategy to work, the banks have to be de facto guaranteed a return on capital exceeding borrowing costs for buying the muni bonds.

1. The bonds have to offer sufficient yield over the repo rate and other competing investments consuming the same amount of capital. This would include treasuries.

2. The capital consumption, or the risk weight assigned to these municipal bonds has to be sufficiently low so that, returns notwithstanding, they consume little or no capital.

3. The collateral standards have to be sufficiently accommodative.

The above conditions have to be in place before any muni issuance takes place. The PBOC may need to bootstrap the process by communicating and educating the banks.

Next week, on May 18, the Jiangsu government will issue 52 billion RMB of bonds, 30.8 billion of which are refinancings. The bond issue was initially planned for Apr 23 but was postponed for lack of interest. We wish the Jiangsu government and the PBOC a healthy bid to cover.





Last Updated on Friday, 22 May 2015 01:24
A Simple China Growth Model. Implications For Hard or Soft Landing PDF Print E-mail
Written by Burnham Banks   
Tuesday, 12 May 2015 06:15

The Chinese economy generated about 10.4 trillion USD of nominal output in 2014, representing incremental nominal output of 680 billion USD, equivalent to 7.0% growth. If the Chinese economy continues to generate this same incremental nominal output of 679 billion USD this year and next, 2015 growth will be 6.54% and 2016 growth will be 6.14%. This naïve calculation provides one potential lower bound estimate for a safe landing for the Chinese economy, that is growth rates that would not trigger significant unemployment, deflation and social unrest. On this trajectory, China will have slowed to mature market rates of growth by 2030.

Incidentally, the Economist forecasts growth of 6.90% in 2015 and 6.80% in 2016.


Last Updated on Friday, 22 May 2015 01:23
China. PBOC Cuts Rates. Economy Slows. Constructive For Equity Markets and Risk Assets. PDF Print E-mail
Written by Burnham Banks   
Monday, 11 May 2015 01:32

The Chinese economy is clearly slowing down and the PBOC is reacting by providing stimulus to maintain a sustainable rate of growth. It needs to do this in a balanced way without undoing some of the credit market reforms that have been enacted in the last year. On Sunday, the PBOC announced a 0.25% cut to its benchmark 1 year lending rate (to 5.1%) and its benchmark 1year deposit rate (to 2.25%) while raising the deposit rate ceiling from 130% to 150%.

The PBOC is seeking to reduce borrowing costs and boost output while keeping asset bubbles from inflating, particularly in its real estate market, stock market and shadow banking system. The PBOC has a host of monetary policy tools at its disposal including the Standing Lend Facility, Medium-term Lending Facility and Pledged Supplementary Lending, analogous to the ECB’s MRO and LTRO open market operations. The PBOC said recently that there was no need for QE at this point and would rely on its open market operations.

The economy is slowing down but conditions are in place for stabilization and recovery.

That said, the PBOC will likely continue to operate expansionary policy while the economy rebalances towards more consumption and less exports and investment.

Conditions are supportive of equity and risk assets, however, the current volatility may persist a bit longer as the PBOC seeks to avoid a hyperbolic equity market bubble.

Credit market reforms have been enacted that will see greater market discipline. Expect increased defaults among smaller and non-systemic issuers, even among SOEs.

Last Updated on Monday, 11 May 2015 05:14
Euro Convergence Trade. Buy Spain, Italy and Portugal, Sell France and Germany PDF Print E-mail
Written by Burnham Banks   
Friday, 08 May 2015 05:00

Why would German bund yields fall to zero? Why would they not? ECB QE is a rescue operation. In a rescue operation, you don't buy the healthiest, you buy the weakest. Greece is not part of the rescue operation by the way, since it is probably to weak to save and on a battlefield you save the ones who have a realistic chance of survival. Why waste the morphine...

So with a bit of explicit risk sharing, some (12+8)%, and complete implicit risk sharing through TARGET 2, I would expect convergence of yields between peripheral Europe and core Europe. The trade to be done, and the trigger point was the SNB's decision to scrap the Euro cap, was to go long Italy, Spain and Portugal and short Germany and France. You could do it at the 10year or at the 30 years, if you were sufficiently inebriated, even 50 years in the case of Spain, but the buying protection on France and Germany would have cushioned the blow, and on the German leg, actually made some money, in the current sell off.

Anyhow it is time to double up on the convergence trade, writing protection on Italy, Spain and Portugal and buying protection on Germany and France. To do one leg without the other is not a good idea. The trade is not about the weight of QE money buying, its about the risk sharing which should tighten the spreads between the wides and the tights.


Last Updated on Friday, 08 May 2015 05:02
USD. Strength or Weakness PDF Print E-mail
Written by Burnham Banks   
Wednesday, 06 May 2015 03:29

Where will the USD go, up or down? We dealt with the possibility that the Fed would delay the rate hike and concluded that any resultant USD weakness would be temporary. As long as rate hikes were on the horizon, any USD weakness would be temporary. If a rate hike was ruled out indefinitely, then perhaps USD weakness would be more durable.

Assuming that the US economy continues on a low, stable, trend growth path, the USD would only see potential longer lasting weakness after the rate hike cycle was over. To rephrase, USD weakness is more likely to only follow after rate hikes, not before.

Last Updated on Wednesday, 06 May 2015 03:35
Just One More Thing... Central Banks Are Cutting Rates Like There Is No Tomorrow PDF Print E-mail
Written by Burnham Banks   
Thursday, 12 March 2015 01:47

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

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

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

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

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

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


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

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



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






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


Distribution Of Wealth

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

In closing:

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

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

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

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

What is the situation in Greece?

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

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

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

What is the troika's stand?

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

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

Will Greece default?

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

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

What would happen if Greece were to default?

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

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

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

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

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

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

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

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

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

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

What are the longer term implications for Europe?

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

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

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

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


Last Updated on Wednesday, 17 June 2015 23:20
Greece under Syriza. A Compromise. A Debt Exchange Offer. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 27 January 2015 03:06

A compromise for Greece and the troika.


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


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

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

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

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


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

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

The ECB, from pawnshop to used car dealer:

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

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

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

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

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

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

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

Jordan: How nice Mario. What are you buying?

Draghi: Nothing special. Just some high grade bonds.

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

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

Jordan: Oh. On what Mario?

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

Jordan: I'm sorry? What was that?

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


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

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

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

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

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

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

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


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

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

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

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


Last Updated on Tuesday, 06 January 2015 07:04
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