Not all change is bad: coming reforms to credit default swaps

There is a lot of analysis and conjecture about how much impact the financial crisis has had on the global economy and financial markets. There has been considerably less analysis around the impact of the crisis on bond fund managers. In a small attempt to quantify these impacts, we have dug out a few old photos of members of the M&G bond team pre and post-crisis. The photos show clearly where change has been bad.

2008-08 ben

There is, though, good change. In September there are changes taking place to bank CDS contracts that represent clearly positive progression.

The CDS rules and definitions of 2003 state that there are 3 different credit events that will trigger corporate and financial CDS contracts: 1. failure to pay 2. bankruptcy, and 3. restructuring (this means that a company can’t modify the conditions of debt obligations detrimentally as far as investors are concerned). If any of these are determined to have occurred, then buyers of protection receive par from sellers of protection (and sellers of protection pay out par minus the recovery value of the defaulted bonds, so are in the same situation as if they owned the defaulted bond). In the event of one of these events being triggered, buyers of protection are ‘insured’ against the losses incurred on the bonds.
However, whilst the above works well in most cases of corporate defaults, we have seen several examples in the last few years in terms of banks in which the outcomes have left buyers of protection in effectively defaulted bonds none the better off. For purposes of succinctness and relevance, I would like to mention two of the more recent such cases so as to bring out the flaws of the existing financial CDS contracts, and to highlight the improvements we will soon see.

In early 2013, the Dutch government expropriated the subordinated debt of SNS Bank, which had got into serious difficulties. Bondholders would therefore no longer receive coupons or principal, and so the determinations committee ruled, quite simply, that a restructuring event had occurred. However, the buyers of protection had to deliver defaulted bonds to the sellers, and there being no subordinated bonds left, had to deliver senior bonds, whose value was around 85p in the pound. This meant that they ‘owned’ bonds worth zero, and were being paid out 15p as a result of the protection they had bought!

The most recent example of subordinated CDS not working is still on-going, being the case of Banco Espirito Santo. This bank has seen all the good assets, deposits and senior debt transferred to a new, good, bank, and all the bad assets, subordinated debt and equity stay with the old, bad, bank. So subordinated debt will very likely get a very low recovery (the sub bonds are today trading at around 15 cents). Subordinated bank debt is now, in practical terms, able to take losses and be written down in European banks. Senior bank debt will also become write-down-able at the start of 2016, but as yet legislators and regulators are showing the continued desire to make senior good. In BES’ case, though, with all the deposits and senior debt moving to the good bank (and with a very thin layer of subordinated debt), more than 75% of the liabilities will go to the new entity. In CDS terms, this means that the contracts move to the new entity. So, again, buyers of subordinated protection in BES are left with significant losses on their bonds, but will have to deliver senior bonds which are trading close to and in some cases above par. Not the outcome that the owners of protection wanted or expected. And, frankly, not the right outcome.

So the existing rules around financial CDS are unfit for purpose. Starting in September, new rules will come into place that will vastly improve the economics of these contracts, and in simple terms will make them behave far more like senior and subordinated bonds, which after all is what they are meant to do. The major differences can be summarised into two: a new, fourth, credit event trigger called Government Intervention will be added; and the removal of the cross default provision. The Government Intervention trigger will mean that in instances such as SNS, when governmental authorities impair debt, CDS contracts will be triggered, and in the same case, owners of subordinated protection would have delivered a claim on the Dutch government that was worth zero, through the expropriation, and would have received par from sellers of protection. In terms of the second major reform to financial CDS contracts, current contracts mean that a credit event on subordinated CDS also results in a credit event on senior. This clause will be removed, meaning that in the Banco Espirito Santo on-going case, subordinated CDS contracts would travel with the subordinated bonds, and senior with senior. Unlike the changing faces of the Bond Vigilantes, the changes soon coming in CDS are ones we think are positive.

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Deflation spreading in Europe

The ECB has already demonstrated an unusually, and perhaps worryingly, high tolerance of low inflation readings, with no additional action having been taken despite Eurozone HICP at 0.5% year-on-year as inflation continues to fall in many countries.

(Dis)inflation

Why might this be? One reason might be that while it is very concerned about deflation, at this point in time the ECB does not have a clear idea of what the right tool is to relieve disinflationary pressure, or how to implement it. Another reason might be that it is not particularly concerned about the threat of disinflation and so is happy to wait for the numbers to rise.

With regards to the latter of these possibilities, Mario Draghi discussed the low inflation numbers in January in Davos as being part of a relative price adjustment between European economies, and as being an improvement in competitiveness. One implication from this argument has to be that the lowest inflation numbers are being seen only in the periphery, and that as a result the much needed price adjustment between periphery and core is starting to take place. The other implication from this argument is that the ECB is happy to let this adjustment happen.

The chart below, however, shows inflation in Germany, France, the Netherlands, Spain and Italy (which together make up around 80% of Eurozone GDP) in terms of constant tax rates on a headline basis. This is important because fiscal reforms can have significant impacts on inflation numbers, when perhaps these should be stripped out as being temporary and artificial. The most obvious example of this would be a country implementing a hike in VAT, in which case inflation will jump upwards for a period until the base effect is removed some time later. This chart, alarmingly, shows that Spain, Italy and the Netherlands are now all experiencing deflation on a constant tax basis. It also shows that France is close to the precipice, with inflation on this basis at 0.2% year on year.

(Dis)inflation at constant tax rates even worse

A further concern from the above two charts ties in to the ECB’s argument that the low inflation numbers in the periphery are a temporary phenomenon on a path to important and desirable internal adjustments to competitiveness. This argument might hold if the periphery is seeing low inflation, while the core is seeing stable, on-target or slightly above-target inflation that brings Eurozone inflation as a whole, to close to but below 2%. However, both the above charts show that the trend of disinflation is affecting more than just the periphery in isolation, and this calls Draghi’s competitiveness argument into serious question. The ECB might be well advised to get ahead of this worrying trend and act soon.

Disinfloyment – the state of strengthening labour markets and falling inflation

Whilst I was listening to Ben Bernanke last night, who announced his decision to reduce the monthly rate of purchases of treasuries and mortgage backed securities by $10 billion per month, it became clear that the time has come to coin a new phrase. With the employment picture improving substantially in the last few months from a very weak point, and with GDP growth moving in a similarly positive direction from a similarly weak point, it is entirely justifiable in my opinion that the Fed continues to provide historically vast quantities of liquidity, albeit at an ever so slightly slower pace. The Fed sees growth returning to between 2.8% and 3.2% for the next couple of years, and it sees unemployment falling to between 5.5 and 5.8% within that horizon. Take a step back, briefly, and you would look at these predictions for the economy and expect the policy rate to be substantially higher than zero. So why did Ben Bernanke spend so long anchoring the market’s expectations for the future path of interest rates, and why is he still creating $75 billion of cash each month?

In the 1970s the more economically developed nations were experiencing an unexpected new phenomenon: low employment and high inflation. This, as we all now know, came to be known as stagflation. Today, the US, and just very recently the UK, is experiencing the opposite: rapidly improving employment and falling inflation. I am going to call this disinfloyment.

Chairman Bernanke said that low inflation is “more than a little concern”. One has to think that it was the improving economic and political picture, as well as perhaps some concern over early bubble formations, that brought about the decision to taper, on the one hand, and the inflation picture that brought about the strengthening forward guidance and lowering and weakening of the unemployment rate ‘knockout’ on the other. Otherwise, given a better broader economic outlook, you would expect a truer normalisation of policy, with the provision of liquidity being stopped and rates being hiked. The concern I think Bernanke has, and the question I would have asked him, would have been “what if zero interest rates, massive liquidity provision, and forward guidance do not manage to generate inflation at or above target? What then Ben?”

If the Fed were to find itself in a position of full employment, acceptable growth, and disinflation, with policy rates and long term interest rates near their extreme floors, and the efficacy of increased liquidity provision being increasingly marginal of benefit, or perhaps worse, then the Fed is alarmingly close to the limits of its powers. Perhaps only helicopter drops would remain a viable tool at this point. It is the awareness of this that I think is framing current Fed action. At 1.5% 10 year treasury yields earlier this year, rapid liquidity provision, and zero interest rates, there was almost nothing the Fed could do to counteract falling inflation; it simply couldn’t add much more stimulus. The utterance of the ‘t’ word in May, and now the first minor reduction in the pace of stimulus last night has seen 10 year yields rise to 3%, and from this point there is scope for data to disappoint to such an extent that yields fall, forward guidance is pushed out further, and QE can be increased so as to stimulate the economy.

So disinfloyment is a state of the economy that policymakers are rightly very scared of, as, depending on the economy’s starting point, it is a state in which economic policy is getting ineffective. But do I actually think that this is a term that we will hear more of in the next couple of years? Probably not.

For disinfloyment to become a problem, the employment picture must continue to improve, and inflation must continue to fall or fail to rise. Whilst I believe the former to be highly likely at this point, I find that latter harder to believe, and the Fed’s projection yesterday was for inflation to return to 1.4% to 1.6% in 2014. Whilst this is clearly still below target, it is less worryingly so than it is today. Bernanke told us yesterday that he presently sees the glide-path for tapering to continue at $10 billion at each meeting, until liquidity provision stops at the end of 2014. I believe that there is a very difficult line for the Fed to tread over the next 12 months. As tapering continues and the markets come to expect the end of the stimulus, long-term yields will rise (as we saw in the Summer) and the economic data risks going in the wrong direction for the tapering to continue. For a gradual rise in rates not to detrimentally affect the recovery, the economy must be growing with such underlying momentum as to shrug off these higher rates: and in this environment, surely inflation would be returning? So: either the Fed finds the recovery to be too fragile to continue tapering, in which case it continues to increase the supply of money each month, thereby risking higher inflation further into the future when the economy improves; or the recovery is sufficiently strong, and inflation (excluding commodities, which the Fed cannot control) is rebounding.

Markets are being staggeringly complacent about inflation at the moment, aided by presently low inflation in the developed world. We would do well to remember that monetary policy since the start of the Great Financial Crash has been designed with one major purpose: to avoid the spiral of deflation witnessed in the 1930s. Deflation, clearly the greater evil of the dichotomy, has been avoided so far. But now developed economies are recovering, liquidity-driven positions are coming back out of commodities and emerging markets, which are pushing down inflation numbers around the world. 2014 will be treading a fine line between these disinflationary forces prevailing, and so monetary policy having to re-start the liquidity machines, and recoveries managing their ways through this transition and finding underlying momentum. Respectively, we either continue to risk higher inflation further in the future through increasing the supply of money, or we start to see it come through sooner than we all presently think: either way, we get inflation. Lest we forget: the Fed will have increased the supply of money by $4.25 trillion at the end of the tapering cycle. When the velocity of money starts rising on top of the increases in money supply, nominal output will start to rise unless the money supply is taken out to an offsetting extent. It is this that I find so unlikely, and it is this that would increase the probability of disinfloyment. In my opinion, we are more likely to get nominal output surprises, and so returning inflation, than anything else in the UK and US. We won’t hear too much, at that stage, about disinlfoyment.

The UK’s inflation outlook – the opportunity in inflation-linked assets

With inflation numbers in the UK moving back towards target and deflationary concerns prevalent in Europe, it is worth asking ourselves whether stubbornly high prices in the UK are a thing of the past. Whilst the possibilities of sterling’s strength continuing into 2014 and of political involvement in the on-going cost of living debate could both put meaningful downside pressure on UK inflation in the short term, I continue to see a greater risk of higher inflation in the longer run.

5 years of sticky cost-push inflation

The UK has been somewhat unique amongst developed economies, in that it has experienced a period of remarkably ‘sticky’ inflation despite being embroiled in the deepest recession in living memory. Against an economic backdrop that one might expect to be more often associated with deflation, the Consumer Prices Index (CPI) has remained stubbornly above the Bank of England’s 2% target.

Slide1

One of the factors behind this apparent inconsistency has been the steady increase in the costs of several key items of household expenditure, together with the recent spike in energy prices which I believe is a trend that is set to continue for many years.

Rising food prices have been another source of inflationary pressure. Although price rises have eased in recent months following this summer’s better crops, I think they will inevitably remain on an upward trend as the global population continues to expand and as global food demands change.

Sterling weakness has also contributed to higher consumer prices. Although sterling has performed strongly in recent months, it should be remembered that the currency has actually lost around 20% against both the euro and the US dollar since 2007. This has meant that the prices of many imported goods, to which the UK consumer remains heavily addicted, have risen quite significantly.

Time for demand-pull inflation?

Despite being persistently above target, weak consumer demand has at least helped to keep UK inflation relatively contained in recent years. However, given the surprising strength of the UK’s recovery, I believe we could be about to face a demand shock, to add to the existing pressures coming from higher energy and food costs.

The UK’s economic revival has been more robust than many had anticipated earlier in the year. Third-quarter gross domestic product (GDP) grew at the fastest rate for three years, while October’s purchasing managers’ indices (PMIs) signalled record rates of growth and job creation. Importantly, the all-sector PMI indicated solid growth not just in services – an area where the UK tends to perform well – but also in manufacturing and construction. At the same time, the recent surge in UK house prices is likely to have a further positive impact on consumer confidence, turning this into what I believe will be a sustainable recovery.

Slide2

Central bank policy…

Central banks around the world have printed cash to the tune of US$10 trillion since 2007 in a bid to stimulate their ailing economies. This is an unprecedented monetary experiment of which no-one truly understands the long-term consequences. There has been little inflationary impact so far because the money has essentially been hoarded by the banks instead of being lent out to businesses. However, I believe there could be a significant inflationary impact when banks do begin to increase their lending activities. At this point, the transmission mechanism will be on the road to repair, and a rising money velocity will be added to the increased money supply we have borne witness to over the last 5 years. Unless the supply of money is reduced at this point, nominal output will inevitably rise.

Furthermore, I am of the view that new Bank of England governor Mark Carney is more focused than his predecessor was on getting banks to lend. His enthusiasm for schemes such as Funding for Lending (FFL), which provides cheap government loans for banks to lend to businesses, is specifically designed and targeted to fix the transmission mechanism, by encouraging banks to lend and businesses to borrow. The same is true of ‘forward guidance’, whereby the Bank commits to keep interest rates low until certain economic conditions are met.

Perhaps most importantly, I continue to believe the Bank is now primarily motivated by securing growth in the real economy and that policymakers might be prepared to tolerate a period of higher inflation: this is the key tenet to our writings on Central Bank Regime Change in the UK.

…and the difficulty of removing stimulus.

With real GDP growth of close to 3% and with inflation above 2% at the moment in the UK, a simple Taylor Rule is going to tell you that rates at 0.5% are too accommodative. But it appears that policymakers are, as we suggest above, happy to risk some temporary overheating to guarantee or sustain this recovery. We believe that this is a factor we are going to have to watch in the coming years, as the market comes to realise that it is much harder to remove easy money policies and tighten interest rates than it was to implement them and cut them.

We witnessed a clear demonstration of this with the infamous non-taper event in September: as the data improved, Bernanke had to consider reducing the rate of monthly bond purchases. However, the combination of improved data and a potential reduction in the rate of purchases saw yields rise; ultimately higher rates saw policymakers state their concerns about what these were doing to the housing market recovery, and so we got the ‘non-taper’. I believe that there are important lessons to be learned from this example, and that policymakers are going to continue to lag the economic recovery to a significant extent.

Inflation protection remains cheap

Despite these risks, index-linked gilts continue to price in only modest levels of UK inflation. UK breakeven rates indicate that the market expects the Retail Prices Index (RPI) – the measure referenced by linkers – to average just 2.7% over the next five years. However, RPI has averaged around 3.7% over the past three years and tends to be somewhat higher than the Consumer Prices Index (CPI). At these levels, I continue to think index-linked gilts appear relatively cheap to conventionals.

Furthermore, this wedge between RPI and CPI could well increase in the coming months due to the inclusion of various housing costs, such as mortgage interest payments, within the calculation of RPI. The Bank of England estimates the long-run wedge to be around 1.3 percentage points, while the Office for Budget Responsibility’s estimates between 1.3 to 1.5 percentage points . If we subtract either of these estimates from the 5-year breakeven rate (2.7%), then index-linked gilts appear to be pricing in very low levels of CPI.

Current inflation levels may seem benign. However, potential demand-side shocks coupled with a build-up in growth momentum and the difficulty of removing the huge wall of money created by QE will pose material risks to inflation in the medium term. Markets have become short-sightedly focused on the near term picture as commodity prices have weakened and inflation expectations have been tamed by the lack of growth. This has created an attractive opportunity for investors willing to take a slightly longer-term view.

A reminder to our readers that the Q4 M&G YouGov Inflation Expectations Survey for the UK, European and Asian economies is due out later this week . The report will be available on the bond vigilantes blog and @inflationsurvey on twitter.

The M&G YouGov Inflation Expectations Survey – Q3 2013

Despite high unemployment rates, excess capacity and a sanguine inflation outlook from the major central banks, it is important to keep an eye on any potential inflation surprises that may be coming down the line. For instance, we only need to look at ultra easy monetary policy; low interest rates and improving economic growth to see that the risk of an unwelcome inflation shock is higher than perhaps at any time over the past five years. The development of forward guidance measures is a clear sign that central banking has evolved substantially from 2008 in the form of Central Bank Regime Change. It appears that there is a growing consensus that inflation targeting is not the magical goal of monetary policy that many had once believed it to be and that full employment and financial stability are equally as important.  Given that monetary policy appears firmly focused on securing growth in the real economy – at perhaps the expense of inflation targets – we thought that it would be useful to gauge the short and long-term inflation expectations of consumers across the UK, Europe and Asia. The findings from our August survey, which polled over 8,000 consumers internationally, is available in our latest report here.

The results suggest consumers continue to lack confidence that inflation will decline below current levels in either the short or medium term. Despite evidence that short-term inflation expectations may be moderating in some countries, most respondents expect inflation to be higher in five years than in one year. Confidence that the European Central Bank will achieve its inflation target over the medium term remains weak, while confidence in the Bank of England has risen.

The survey found that consumers in most countries continue to expect inflation to be elevated in both one and five years’ time. In the UK, inflation is expected to be above the Bank of England’s CPI target of 2.0% on a one- and five-year ahead basis. All EMU countries surveyed expect inflation to be equal to or higher than the European Central Bank’s HICP target of 2.0% on a one- and five-year ahead basis. Long-term expectations for inflation have changed little in the three months since the last survey, with the majority of regions expecting inflation to be higher than current levels in five years. Five countries expect inflation to be 3.0% or higher in one year: Austria, Hong Kong, Italy, Singapore and the UK.

Consumers in Austria, Germany and the UK have reported an increase in one year inflation expectations compared with those of the last survey three months ago. This is of particular relevance for the UK, where the Bank of England has stated three scenarios under which the Bank would re-assess its policy of forward guidance. The first of these “knockouts” refers to a scenario where CPI inflation is, in the Bank’s view, likely to be 2.5% or higher over an 18-month to two-year horizon. Short-term inflation expectations in Singapore and Spain continued their downward trend in the latest survey results, registering their third straight quarter of lower expectations.

Inflation expectations - 12 months ahead

Over a five-year horizon, the inflation expectations of consumers in Austria, Germany, Italy, Spain and Switzerland have risen. Whilst inflation expectations in Switzerland remain at the lowest level in our survey at 2.8%, consumers have raised their expectations from 2.5% in February. Long-term inflation expectations in France and the UK remained stable at 3.0%. Meanwhile, consumers in Hong Kong and Singapore have the highest expectations, at 5.0%, although the Hong Kong number shows a decline from 5.8% three months ago.

Inflation expectations - 12 months ahead

In search of satisfaction – our analysis of the BoE press conference

Listening to the Bank of England Quarterly Inflation Report press conference – the first with Mark Carney steering the ship – a song immediately sprung to mind. The song was written by a former student of the London School of Economics, Sir Michael “Mick” Jagger with his colleague Keith Richards in 1965. There is no better way to analyse the current thinking of the Bank of England than through one of The Rolling Stones best songs, (I Can’t Get No) Satisfaction.

I can’t get no satisfaction

The new BoE Governor began with the positive news that “a recovery appears to be taking hold”. This wasn’t news to the markets, as more recently we have seen a remarkably strong string of economic data. However, the very next word in Mr Carney’s introduction was “But…”. What followed was, in my opinion, the most dovish sounding central bank policy announcement since the darkest days of the financial crisis.

Carney firmly announced his arrival as the global independent (excluding BoJ) central banking community’s uber-dove through the acknowledgement of a broadening economic recovery in the UK, and then making explicit that the BoE remains poised to conduct more, not less, monetary stimulus. Until now, these two conditions were considered by bond markets to be pretty much incompatible.

’Cause I try and I try and I try and I try

Carney told us that the BoE will maintain extreme monetary slack (in terms of both the 0.5% base rate and the £375 billion of gilts held) until the unemployment rate has fallen to at least 7%. He went even further than this, stating the MPC is ready to increase asset purchases (QE) until this condition is met. However, there are two conditions under which the BoE would break the new, explicit link between monetary stimulus and unemployment: namely, high inflation and threats to financial stability. Did the new governor have to put these caveats in place because other members of his committee would only agree to the announcement if they were mentioned?

Supposed to fire my imagination

The new framework announcements were broadly in-line with what we were expecting. In that respect, the Governor’s major announcement was not too much of a surprise. The market agreed and there was a relatively muted response. Carney was supposed to fire our imaginations, so the question is – did we learn anything new? The “yes” and “no” arguments are outlined in the below table.

2013-08 ben blog

When I’m watchin’ my T.V. and that man comes on to tell me how [the economy should] be…

The market suspected Mr Carney would bring in some forward guidance, but I think the most interesting implication of this announcement today is that he felt the need to do something, but did not feel the need to increase asset purchases through QE. Mervyn took on the first part of Friedman’s equation, the supply of money. This was not inflationary as the transmission mechanism was broken, and the cash was hoarded and not released into the real economy. Could Carney be the governor to focus on the second part of the equation, money velocity? Forward guidance is designed to give individuals and companies the confidence to borrow in order to spend or invest. If they do, velocity will return as the transmission mechanism repairs. I believe we are considerably less likely to see an increase in QE under the new governor.

If forward guidance does not have the consequences Carney intends, and my belief that he is more focused on the transmission mechanism than his predecessor, what might Carney do next? At that point, he might increase schemes akin to Funding for Lending, and hand banks cheap funds at the point at which the banks release the loans to borrowers. This way, banks are heavily incentivised to lend at levels that are attractive to individuals and companies.

He’s tellin’ me more and more, about some useless information

Carney told us that if and when unemployment reaches 7%, policy will start to tighten. But then he stated that if inflation exceeds 2.5% on the BoE’s shocking 2 year forecast (is this a rise in the inflation target?), or if inflation expectations move beyond some unannounced bound, or if financial stability is under threat, then he might have to break the newly explicit link between unemployment and monetary policy. And then he stated that even if unemployment hits 7%, this will not trigger a policy change, but a discussion around one.

I don’t think we actually got pure forward guidance, but a pretty muddled variant thereof. Bond markets are rightly unsure as to how to react, and have struggled for a satisfying interpretation. All we can really take from the BoE is that they will need to be sufficiently satisfied that the UK economy has reached escape velocity before hiking rates or reversing policy.

I predict a CypRIOT: Three major implications for the European and UK banking systems

Stefan blogged earlier this week about the landmark sovereign bailout occurring in Cyprus, and about some of the interesting issues this raises. Sure enough, the parliament did not approve the package in the form talked about at the weekend. The reason? The taxes were felt too painful for the poor and too lenient for the more wealthy. This harks back to a blog I wrote about a couple of years ago, and goes to reiterate the issues we discussed then. However, for now I wanted to highlight some of the issues that this raises more specifically for the European banking system at large.

Firstly, depositors were presumed to be guaranteed by governments up to at least  €100,000 in Europe. Last weekend, that notion was dealt a brutal blow by the Cypriot situation. However, it feels to us as though the main reason for the parliamentary delays is that deposit guarantees could and should remain in place – or at least to a greater extent than was implied in the original bailout package. This package stated that those people with deposits of less than €100,000 would pay a 6.75% tax, whilst those with more than this amount would be taxed 9.9%. The politicians that have delayed the approval of the rescue package want to see greater amounts of the burden borne by the wealthier (those with more than €100,000, and perhaps an even higher rate borne by those with greater amounts than, say, €500,000 in deposits), and so lesser amounts of the burden borne by those with small amounts of deposits.

My guess is that this is the key issue here. If the tax rates are not changed, then I would expect to see some significant moves in Spanish, Italian and other peripheral deposit flows and movements. As a risk, this must not be underestimated by the Troika. Why not maintain the deposit guarantee and generate the amount raised by the taxes, through taxing more on those with more than €100,000, more still on those with more than €250,000, and more still on those with more than €500,000?

Secondly, subordinated debt bail-in is a key part of the package, and without it one senses the Troika will not part with the bailout funds needed. We have expected weaker banks in weaker regions to have to use this as a necessary tool to break the sovereign-bank link for some time now. It is now official, and being used. I would expect more of these to come.

Thirdly and finally, sovereign bailouts of banking systems where the sovereign is already in an over-levered position will no longer be tolerated. It is time to break the sovereign-bank feedback loop (as we previously wrote about here). This has to be through bail-in and burden-sharing. However, the most unpalatable part of the proposed package to us (and I guess to many riotous Cypriots) is this: up until 2007 it was believed that senior bank bondholders ranked pari passu with depositors in the event of a bank failure. And now in 2013 we learn quite vividly that in actual fact in Cyprus depositors are likely to be subordinated to a bunch of wholesale and institutional (ie banks and insurance companies) investors?

The capital stack has been turned on its head in this regard. No one used to buy senior unsecured bank debt because they thought that depositors would take losses before them. Rather, it was because the markets believed 100% in the government guarantee of depositors. The pari passu relationship of depositors and bondholders supported high valuations on senior bank bonds. Thus to be pari passu with depositors, senior bank bonds need to take the same losses as depositors are. In my opinion, this part of the proposed deal is the most disgraceful.

So, I find myself wondering how on earth a deposit tax found its way into the package. The answer to me seems to be quite simple: contagion, or the avoidance thereof. We all know that in Europe and the UK in the future (as in the US already), senior bank bonds will be bail-in-able or writedownable if a bank fails or gets into difficulty. We were originally told that the date for senior bank bond bail-in in Europe would be 2018, although there has recently been much talk about bringing this forward to the beginning of 2015. It has long struck me that this should be the favoured route out of the bank-sovereign interconnectedness problem in Europe: continue to promote and enable senior issuance in Europe by banks, and then implement a higher level piece of legislation that at some date in the future makes all debt in the Eurozone and UK writedownable.

No matter how small Cyprus is relative to the rest of the Eurozone, if the Troika had forced senior bank bondholders to accept losses before 2018 – or is it 2015? – senior bank debt spreads would have suffered significantly across Europe. Given that this is the most attractive funding market for banks at the moment, as it is still cheap to issue from a bank’s perspective, and as sovereigns do not want to have to (or cannot, in the Cyprus case) step in to take on more liabilities on behalf of their banks, the Troika has ripped up the rule book and done the insane.

I think parliamentarians in Cyprus should force a rethink on the sovereign-bank feedback loop, as well as forcing a more palatable (ie Robin Hood) sharing of the burden between smaller and larger depositors. After all, can anyone truly imagine the French, German or any core European government accepting losses for their depositors whilst a bunch of international senior bank bondholders get made whole? Our view is that depositors should be protected (at least to the guaranteed amount) over and above all wholesale creditors, whether senior or subordinated. This is the first step to break the sovereign-bank loop. The second step, only to be used in cases where there is not enough senior and subordinated debt to prevent the sovereign, and so tax-payers, from having to bail out the failed institutions, is to look at forcing losses on depositors, but with preserving the preceding guaranteed amounts of deposits. The final, most radical, and rarest, step is to have to renege on that deposit guarantee amount, so as to avoid tax-payer bailouts and increased probability of sovereign default.

Depositors across Europe are already watching Cyprus carefully. My guess is that many are starting to check the amounts they keep with any one institution or in any region. Subordinated bondholders are already aware of the risks if those banks get into difficulty, but senior bondholders in my opinion are not. These investors must ask whether the Cyprus package is likely to be copied in future cases. And they must also start to wonder if they still have until 2018 before senior bonds can be bailed in, or if it is significantly sooner.

Judgement Day – RPI Damp Squib

Today has seen the release of the decision by the National Statistician about what to do with the Retail Prices Index. We were told of the consultation in September last year, and were presented with 4 options, ranging from 1) to do nothing, to 4) to make RPI as much like CPI as possible.

Our view was always that the consultation arose as a result of the desire to correct an error made in the clothing component of RPI in January 2010 see blog. This change had seen the ‘wedge’ between RPI and CPI anomalously and erroneously increase by close to 1% following its implementation. We therefore believed that it was perfectly appropriate for the National Statistician to correct this error, and so we were expecting to see Option 2 materialise, which most closely targeted correcting this source of the wedge.

UK linkers had noticeably underperformed other markets since the announcement of the consultation. The market had initially started to price in a 30 to 50 basis point reduction in the wedge of RPI over CPI in expectation of Option 2′s intention to rectify the error.  However, as Judgement Day approached nervousness increased in the linker market as people started to worry that the more severe options could be implemented.

Were Option 4 to have been recommended today, the wedge of RPI over CPI would have been reduced by approximately 100 basis points. This would have been a severe and brutal change for the index linked bond market. All else remaining equal, this change would have seen breakevens on index-linked bonds fall by approximately 70 basis points (allowing for 30 basis points of underperformance already priced in).  To put it another way, this would have see the price of the longest index-linked gilt, the UKTi 0.375% 2062s, fall from 107.7 to about 85, a fall of 21%. Today, things really could have got nasty!

But the decision today has been Option 1. No change. Whilst highlighting that “the RPI does not meet international standards” and recommending that a new index be published, Jil Matheson “also noted that there is significant value to users in maintaining the continuity of the existing RPI’s long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations”. For the release, go to this link.

All the lobbying that we – and some others – have been doing behind the scenes has been worth it. In the Financial Times today, Chris Giles (who was on the Consumer Prices Advisory Committee) stated that the ONS rejected the committee’s advice in the face of  ‘overwhelming opposition to changes in the calculation of the RPI’.  The market has recently opened, and is removing the expected reduction of 30 basis points or so from Option 2. Breakeven inflation rates at the moment are up by 37 basis points at the 10 year part of the curve and by 22 basis points at the long end. The 2062 index-linked gilt is up by 12 points in price terms, and the whole linker market is rallying in the relief that no change is being made…

…for now! We will soon see the creation of a new RPI index, called RPIJ. This effectively makes RPI equal to CPI through making the older RPI index more modern by removing arithmetic mean and replacing it with geometric mean. This will be run in parallel with the old, untouched index. But it suggests that this debate is not over forever. We could again see recommendations to move from RPI to RPIJ, but more likely, we will soon start to debate moving the index-linked corporate bond market from RPI linkage to CPI linkage.  The creation of RPIJ does seem a little irrelevant, where a new index has been created that few people will care about given that inflation linked bonds will continue to be linked to RPI and the government is clearly dedicated to linking other forms of government compensation to CPI.

Ultimately, though, even if we had seen a brutal reduction in RPI today, I still think that the strong case could be made to want to own UK index-linked bonds over the medium and long term. And changing the calculation to option 4 could have saved the Treasury a whopping £3bn per year, so while the decision to make no change has been great for inflation linked bond holders, it’s not so great for the UK’s coffers.   Finally, the strong opposition to the RPI changes gives you a good idea of how hard it will be to implement austerity measures, and if we aren’t going to get out of this debt crisis through austerity, then the likelihood of us getting out of it with the help of inflation has just increased a bit!

Panoramic: central bank regime change – inflation targeting or inflation hunting?

Given the success that central banks have had in targeting inflation over the last decade or so, the recent increase in their powers, and the broadening of their remit to include economic growth, has been largely welcomed by the markets. But have we put too much faith in central banks abilities? And, with record levels of peacetime government deficits and the clear political incentive to tolerate higher levels of inflation, have we come to overestimate their commitment to reining in prices?

In this note, which is part of our quarterly Panoramic series, we argue that we are seeing potential upside risks to inflation as central banks continue to preside over the biggest coordinated global monetary stimulus that we’ve seen in recent history. In our view, the expansion of central banks’ balance sheets signals an unspoken shift in these institutions’ remits that could have important consequences for future inflation rates. It is a phenomenon we have coined “central bank regime change”.

The Bank of England and European Central Bank seem no longer to be primarily focused on delivering price stability. Their new mandate now covers supporting domestic banking systems, offsetting the effects of government austerity measures, bolstering trade and implementing the conditions needed to generate jobs and economic growth.

With central banks’ macroeconomic responsibilities straying ever further into what was previously the state’s domain, their independence is looking increasingly fragile. The hijacking of monetary policy by politicians cannot be ruled out, especially if it enables them to inflate their way out of their growing debt burden. If we get to this stage, inflationary pressures will rise, although central banks’ credibility will be tarnished and policy responses rendered ineffective.

In our view, there are potentially plenty of reasons to expect the current period of low inflation to come to an end. Central banks are still thinking of new ways to ignite growth and they appear to be increasingly tolerant of above-target inflation. But are they moving ever closer to a major policy error that could ruin their inflation-targeting credibility? And should we all start thinking about inflation again?

To read the latest Panoramic, please follow this link.

Office of National Statistics or Office of National Savings? The Future of the UK’s RPI-CPI wedge

There has at almost all times been a ‘wedge’ between RPI and CPI, given different calculation methodologies (arithmetic mean vs geometric mean, respectively), different items within each, and different weights of these different items. The long term difference has on average seen RPI at 0.5% to 0.8% more than CPI. Recent changes, though, saw the wedge widen in 2007 to more than 2%, and to almost 2% again in early 2010.

Differential between RPI and CPI

What are these changes? RPI is a much older index, originally conceived in the early 20th century to track the effect of price moves on workers during The Great War, using less up to date and less relevant averaging calculations and, arguably in some cases, weightings and items. CPI was not developed until much later, in 1996.

Since the coalition’s formation we know that the government has been attempting to change certain future liabilities’ (eg public sector pensions and benefits) indexing from RPI to CPI. Why? Simply, because this wedge of RPI over CPI means over the long term it is more expensive for the government to pay RPI than CPI. And given the long duration of these liabilities, the present value and so budgetary impact today of such changes are extremely powerful in terms of delivering on austerity. From a rather different perspective, that’s why there has been so much resistance to these changes on the part of public sector workers, amongst others.

The ONS is the body that is responsible for the classification, collection and measurement of these compensation indices – no mean task I hasten to add (see here for a video we did with the ONS last year). We have heard much in research notes and certain press articles in recent weeks about the ONS undertaking a project to eradicate the wedge entirely! What would this mean for us as investors? It would be less attractive to own UK linkers, as inflation as defined by RPI would be structurally lower than it has been. The breakeven rate (the rate between nominal gilt yields and index-linked gilt yields) would fall, meaning that index-linked bonds would underperform nominal bonds. This would be especially so at the long end, where the price or present value impact would be felt most.

I can think of 5 strong arguments against such an assault on the wedge:

1.To eradicate the wedge altogether would be tantamount to an event of default, especially if this is specifically to eradicate the structural difference between the two indices! We bought these securities on the basis that we would be paid RPI, which we know changes in terms of items and weightings on an annual basis, but according to changes in spending habits rather than Government policy. That’s fine! But the index is based on an arithmetic mean and always has been, and so will (almost always!) be higher than an index calculated according to a geometrically calculated mean. To change this, willingly and knowingly, with the purpose of reducing future outgoings of index-linked borrowing cashflows feels very similar to the altering of the War Loan’s coupon from 5% to 3.5% in 1932, or to the Greek PSI exercise of coercive write-downs, neither of which, arguably, were ‘defaults’.

2. The Statistics and Registration Service Act that covers changes to RPI states that any changes to the index must be carried out in consultation with the Bank of England as to whether the changes are fundamental and materially detrimental to holders. If the BoE decides that both of these conditions are met, then the changes to RPI cannot go ahead without prior approval of the Chancellor. Well, given the changes Mr Osborne has been trying to make elsewhere in his search for austerity, might he simply approve the changes in the index? Well this would not be without significant risks, electorally, and it would have a fundamentally and materially detrimental impact on the ability of the DMO to borrow through the linker market, which we will touch on in a moment. But perhaps it would be open to legal challenge? Consideration of this last issue involves looking into the contractual protections embedded within the old-style 8 month index-linked gilt prospectuses. It turns out that these documents state that if both the conditions of a change to the index above are met in the opinion of the BoE, HMT will inform bond holders of this, and offer them the right to redeem their stock. So the next issue for holders is: at what price can I put my bonds? The prospectuses state that “the amount of principal due on repayment and of any interest which has accrued will be calculated on the basis of the index ratio applicable to the month in which repayment takes place”. Thus, in current markets, with substantial negative real yields, the protection provided in these old style bonds is not sufficient to compensate holders fully, as it only pays accrued inflation. As a result of this, holders are going to be very sensitive to any chatter about substantial changes to the index. And this will have pretty major consequences. For instance, looking at the 4.125% gilt linker of 2030, the current price of the bond (given by current accrued RPI relative to RPI at the date of issue, along with future assumed inflation of 3% per year, positive real coupons, and negative real yields) is 316.5. To take this bond and assume we put the bond in the event of a change to the RPI, we multiply par (100) by the index today (242.5) over the base RPI at issue (135.1) to arrive at a price of 179.5. A holder would be set to lose 137 points, or 43% of the bond’s current value!

3. It would also serve to ruin the RPI linker market, at least for a long while. The uncertainty from recent headlines cannot be helping sentiment among the linker buyer base at the moment, and this has been an extremely important source of funding for our high levels of borrowing in the UK in recent years. It would be unwise to annoy these buyers, as it will only serve to increase the costs of issuance (through demanding higher real yields), irrespective of the final outcome of the ONS’ project to lower the paid level of inflation. Indeed, this begs the question as to whether to make the change to linkers from the perspective of our financing position would be to shoot ourselves in the foot?

4. The ONS states on its website under its ‘Vision and Values‘ that: “Our mission is to improve understanding of life in the United Kingdom and enable informed decisions through trusted, relevant, and independent statistics and analysis” (my emphasis added). To target the structural and total eradication of the RPI-CPI wedge would in my opinion clearly be an impeachment of its independence, and would see huge criticism about the political motivations of such a change in the index. This could perhaps lead to legal challenge.

5. Could this not be interpreted as an attempt to specifically and deliberately conceal high levels of headline inflation, Argentina style? Or, if not, to artificially and deliberately manage UK inflation down? It is not just pensions and benefits that are linked to inflation, but wages and commercial contracts, which all have significant impacts on the economy’s overall level of inflation. To change the major index underlying all these contracts from RPI to CPI (the logical equivalent of making RPI CPI) would be to manage inflation down, at a time when so many are concerned about stubborn inflation in recent years, as well as the effects of super-accommodative monetary policy on future inflation. What would this tell us about our politicians’ and policymakers’ inflation targeting attitudes and indeed capabilities?

As a result of these arguments, I personally find it difficult to believe that this is the intention of the ONS or of its project to examine the wedge. I believe instead that the review is targeted at removing some of the anomalous sources of the wedge, which resulted, in no insignificant part, from a change in measurement that took place in 2010 that particularly impacted the wedge between RPI’s clothing price level and CPI’s clothing price level.

Year-on-Year RPI vs. CPI clothing and footwear

Indeed, the clothing and footwear components of RPI and CPI alone represented 60% of the total wedge between the two indices! This kind of change would be justifiable in my opinion. Anything else would at best be ill-advised, and at worst would be mismanagement on a major scale.

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