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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?

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

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


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

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



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






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


Distribution Of Wealth

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

In closing:

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

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

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

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

What is the situation in Greece?

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

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

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


What is the troika's stand?


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

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


Will Greece default?


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

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


What would happen if Greece were to default?


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

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

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

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


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


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


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

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

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

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


What are the longer term implications for Europe?

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

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

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

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






Last Updated on Tuesday, 17 February 2015 23:56
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