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

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

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

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

Investment Strategy In a Crazy World April 2012

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

1. DM growth to accelerate. EM growth to decelerate.
2. DM currencies to strengthen relative to EM.
3. EM curves to flatten relative to DM curves.
4. Bearish for commodities as DM are more efficient users of commodities relative to EM.
5. Much depends on EM response to current volatility in FX and rates. Raising short rates may not work in defending currencies. Side effects include depressing local currency bond markets as cost of FX hedging rise. Hard currency bond financing faces obvious problems. Selling hard currency for local is an analgesic with poor long term prospects as foreign reserves are exhausted.
6. EM risk is likely to be continuous rather than catastrophic. Crises are unlikely. Steady underperformance is likely.
7. credit crisis risk has been postponed by the opaque bailout of the Credit Equals Gold product but refi risk is significant.

1. Avoid macro trades. Allocate to well hedged, idiosyncratic risk strategies.
2. But if you have to invest in macro fashion, invest in DM.
3. Overweight US risk assets.
4. Neutral, not underweight, USD duration.
5. Overweight European duration.
6. EM is weak, but there is a price at which EM can be bought.

1. ’s shadow banking system remains opaque and leverage is high once you include corporate credit to the infrastructure finance.
2. is in a feel good mode at the moment but much of the structural issues remain. The ECB will soon be banking regulator which is a positive, however, Glass – Steagall type legislation needs to be enacted. In the meantime, bank balance sheets remain opaque.
3. The Euro fails to clear labour markets. Employment is stabilizing but structural employment is likely to persist. Witness the recovery of labour markets in countries with a sovereign currency such as UK and US.
4. Man made risks such as risk pooling. Risk can be pooled in vehicles such as mutual funds, structured credit vehicles like CLOs, or more insidiously, through conventions and systems. Common risk metrics and common risk systems are a significant risk to financial stability.
5. Non commercial risks. In a slower growth environment, human beings are less inclined to share, the propensity for unhealthy competition is raised. Risk of martial conflict is raised.

1. For every asset there is a price too high, and a price too low.
2. If there
   is no reason to invest, don’t. Every extension of risk requires a sound thesis. Where ends the thesis, where ends the trade.
3. Fundamentals are necessary but not sufficient. Psychologically susceptible investors are an important element to market pricing.

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

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

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

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

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

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

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

1. How does one get longer term funding at low interest rates? How does one attract investors to longer maturity assets with little or no duration?
2. How will the US government keep debt service manageable over time despite longer dated liabilities?

1. • The answer to 1 above is to issue Floating Rate Notes.

1. • The answer to 2 above is to maintain short term interest rates at close to zero for longer. Given that the first issues will be 2 year maturities and coupons will be benchmarked to the 13 week T bill rate, I expect that the US Fed will not be raising interest rates till 2016 at the earliest.

http://www.bloomberg.com/news/2014-01-23/u-s-treasury-to-offer-15-billion-in-first-floating-rate-notes.html

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

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

QE Taper, for real?

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

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

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

What about long rates?

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

Food for thought…