The Signal and the Noise – why local weather forecasters get it wrong, and what it means for those big market calls

I’ve finally got round to reading Nate Silver’s The Signal and the Noise. It’s a brilliant analysis of why forecasts are often so poor, from the man who called every state correctly in the 2012 US presidential election. In short, predictions are often poor because they are too precise (asserting an absolute outcome rather than assigning probabilities to outcomes); there’s often a bias to overweight qualitative information, gut feel and anecdote over data (these shouldn’t be ignored but must have a high hurdle to overrule the statistics); and there’s also a bias to ignore out of sample data (he suggests that the rating agencies mis-rated CDOs based on MBS because they assumed no correlation between housing defaults, which was indeed the case in the 25 or so years of US data that was used in the models. Japan’s property crisis statistics would have shown that in a downturn the degree of correlation in defaults becomes extremely high). I’d like to propose a deal though – we Brits agree never to use cricket statistics in any academic paper so long as Americans shut up about baseball. What the hell is hitting .300? How many rounders is that?

I liked these charts. The first shows just how good weather forecasting is nowadays. We can’t get the outcome right every time, but we can now call the probability of a weather event occurring right with the same probability of it happening. For example, when the US National Weather Service says that there is a 70% chance of rain, it rains 70% of the time. It snows 20% of the time when they say there is a 20% chance of snow.

Slide1

But when your local TV weatherman gets hold of this same information, he or she distorted that information such that the outcomes were far worse than those of the National Weather Service’s forecasts. The chart below shows that local TV weatherpeople over-predicted weather events consistently. For example, if they say that there is a 100% chance of rain, it rains just 67% of the time, compared with the National Weather Service which if it says there is 100% chance of rain, it always rains.

Slide2

Why? “Presentation takes precedence over accuracy”. In other words local TV news and weather people believe themselves to be entertainers as much as bearers of information. A firm prediction of a biblical rainstorm is more exciting that a range of probable outcomes, and a forecast for a scorching beach day more fun than assigning a 75% chance of sunny intervals. In other studies it was shown that political analysts on panel shows performed extremely badly, systematically predicting outcomes way out of line with statistical polling. The very act of being on TV reduces one’s forecasting ability. I think there is a likelihood that this is also true of economic and market forecasting, which is why market TV channels are full of people either calling for the Dow to soar another 200%, or for the global economy to collapse into a permanent ebola fuelled zombie apocalypse. There’s a danger that when we get phoned by journalists for comment we feel the need to be significantly away from the consensus, on payrolls, on the year end 10 year Treasury yield, on the chances of the Eurozone breaking up – and I’m sure I’ve been guilty of this too in the past. What’s more I’m sure that those who forecast extreme events end up being boxed into a corner where they feel they have to implement those views within portfolios, and end up with portfolios which point only in the direction of tail events and can’t perform in normal economic circumstances. I think this is a must read book for economists and fund managers to help us understand how good forecasts are made, and that the “loudest” forecasts get disproportionate airtime – and are often wrong. Silver has bowled a wicket maiden with this one.

What is the collapse in the Baltic Dry shipping index telling us about global growth?

The Baltic Dry Index (BDI) is a daily priced indicator of the cost of shipping freight on various trade routes for dry bulk carriers, based on data submitted by shipbrokers to the Baltic Exchange in London. Since March this year the index has fallen by over 50%, and this has made economists worry that the fall reflects a generalized slowdown in global trade – dry bulk goods include cement, coal, ore as well as food stuffs like grain. A lot of it is the stuff that China imports to support its investment led growth model, so a collapse in demand for the ships that carry bulk dry goods to China might be telling us that China is slowing rapidly. And that obviously has significant impacts on those economies which are reliant on exporting to China for their own growth – for instance Australia, Chile, South Africa and South Korea all have between 21% and 36% of their exports going to China.

Obviously though demand for space on ships is only half of the equation. As expectations grew that the Great Financial Crisis was behind us, and as China kept publishing high single digit growth rates, there was a significant expansion in shipbuilding. Since 2010 annual growth in Dry Bulk supply has been anywhere from 5% to over 15% year on year – in most periods outstripping demand growth, and certainly depressing prices. It’s not just dry bulk, there’s also big excess supply in container ships. Shipping companies are trying to manage these supply problems – the average age of ships when scrapped has fallen from 28 years in 2011 to 21 years in Q1 2014, 4% of the fleet is “idle”, ships are “slow steaming” (going slowly to save fuel and costs of being idle at port) and shipping companies are cancelling future orders for new ships (in 2013 32% of orders were not delivered as planned and were either postponed or cancelled). But for 2014 and 2015 at least the excess supply problem gets worse, not better.

So is the Baltic Dry Index telling us anything about global trade and growth? We started off from a position of scepticism – there used to be a good relationship (we wrote about it here in 2011), but since the massive shipping supply boom maybe it had lost its power as in indicator? But it turns out that the correlation between world trade and the BDI is EXTREMELY good. The CPB Netherlands Bureau for Economic Policy Analysis produces the monthly CPB World Trade Monitor. It’s clear from these global trade data that the volume of trade has been weakening since the end months of 2013. Trade actually fell in May, by 0.6% month on month, although due to volatility and seasonals, a rolling 3 month versus previous 3 month measure is preferred. The chart below shows that after some strong momentum in global trade in 2010 it’s fallen to a much more stagnant growth level in the past couple of years, and a brief recovery in mid 2013 has tailed away. In Q1 this year, world trade momentum turned negative. We have shown the Baltic Dry Index against this measure of world trade – it doesn’t just look like a strong relationship optically, but it has a correlation coefficient of 0.74 (strong) with a t value of 7.83 (statistically significant at an extremely high level).

Baltic Dry vs World Trade - Chart - v01 - CHART 1

When we last wrote about the Baltic Dry Index we pointed out that it appeared to be a good lead indicator for 10 year US Treasury yields, the theory being that a fall in the BDI presaged falling GDP and therefore justified lower rates. And indeed the fall in the BDI in early 2011 did nicely predict the big Treasury rally 3 months later. There is still a relationship today, but sadly for us bond fund managers the better relationship is with UST yields predicting movements in the BDI (so ship-owners please feel free to make money on the back of this). Nevertheless, over the same time period as the earlier chart there is still a decent correlation if you use the BDI as a leading indicator and push it forward by 3 months, so it does appear to have some predictive powers.

Baltic Dry as Leading Indicator for 10Y Treasury Yield - Chart - v01 - CHART 2

So we’ll keep looking at the Baltic Dry Index for the same reason that we like the Billion Prices Project for inflation. When you can find a daily priced, publically available measure or statistic that comes out a month or more ahead of official data and is a strong proxy for that data it’s very valuable.

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Bondfire of the Maturities: how to improve credit market liquidity

Liquidity in credit markets has been a hot topic in recent months. The Bank of England has warned about low volatility in financial markets leading to excessive reaching for yield, the FT suggested that the US authorities are considering exit fees for bond funds in case of a run on the asset class, and you’ve all seen the charts showing how assets in corporate bond funds have risen sharply just as Wall Street’s appetite for assigning capital to trade bonds has fallen. But why the worry about corporate bond market liquidity rather than that of equity markets? There are a couple of reasons. Firstly the corporate bond markets are incredibly fragmented, with companies issuing in multiple maturities, currencies and structures, unlike the stock markets where there are generally just one or two lines of shares per company. Secondly, stocks are traded on exchanges, and market makers have a commitment to buy and sell shares in all market conditions. No such commitment exists in the credit markets – after the new issue process you might see further offers or bids, but you might not – future liquidity can never be taken for granted.

So how can we make liquidity in corporate bond and credit markets as good as that in equity markets? First of all let’s consider fragmentation. If I type RBS corp <Go> into Bloomberg there are 1011 results. That’s 1011 different RBS bonds still outstanding. It’s 19 pages of individual bonds, in currencies ranging from the Australian dollar to the South African rand. There are floating rate notes, fixed rate bonds with coupons ranging from below 1% to above 10%, maturities from now to infinity (perpetuals), inflation-linked bonds, bonds with callability (embedded options), and there are various seniorities in the capital structure (senior, lower tier 2, upper tier 2, tier 1, prefs). Some of these issues have virtually no bonds left outstanding and others are over a billion dollars in size. Each has a prospectus of hundreds of pages detailing the exact features, protections and risks of the instrument. Pity the poor RBS capital markets interns on 3am photocopying duty. The first way we can improve liquidity in bond markets is to have a bonfire of the bond issues. One corporate issuer, one equity, one bond.

Jim blog

How would this work? Well the only way that you could have a fully fungible, endlessly repeatable bond issue is to make it perpetual. The benchmark liquid bond for each corporate would have no redemption date. If a company wanted to increase its debt burden it would issue more of the same bond, and if it wanted to retire debt it would do exactly the same as it might do with its equity capital base – make an announcement to the market that it is doing a buyback and acquire and cancel those bonds that it purchases in the open market.

What about the coupon? Well you could decide that all bonds would have, say, a 5% coupon, although that would lead to long periods where bonds are priced significantly away from par (100) if the prevailing yields were in a high or low interest rate environment. But you see the problems that this causes in the bond futures market where there is a sporadic need to change the notional coupon on the future to reflect the changing rate environment. So, for this reason – and for a purpose I’ll come on to in a while – all of these new perpetual bonds will pay a floating rate of interest. They’ll be perpetual Floating Rate Notes (FRNs). And unlike the current FRN market where each bond pays, say Libor or Euribor plus a margin (occasionally minus a margin for extremely strong issuers), all bonds would pay Libor or Euribor flat. With all corporate bonds having exactly the same (non) maturity and paying exactly the same coupon, ranking perceived creditworthiness becomes a piece of cake – the price tells you everything. Weak high yield issues would trade well below par, AAA supranationals like the World Bank, above it.

So your immediate objection is likely to be this – what if I, the end investor, don’t want perpetual floating rate cashflows? Well you can add duration (interest rate risk) in the deeply liquid government bond markets or similarly liquid bond futures market, and with corporate bonds now themselves highly liquid, a sale of the instrument would create “redemption proceeds” for an investor to fund a liability. And the real beauty of the new instruments all paying floating rates is that they can be combined with the most liquid financial derivative markets in the world, the swaps market. An investor would be able to swap floating rate cashflows for fixed rate cashflows. This happens already on a significant scale at most asset managers. Creating bigger and deeper corporate bond markets would make this even more commonplace – the swaps markets would become even more important and liquid as the one perpetual FRN for each company is transformed into the currency and duration of the end investor’s requirement (or indeed the company itself can transform its funding requirements in the same way as many do already). Investors could even create inflation linked cashflows as that CPI swaps market deepened too.

So what are the problems and objections to all of this? Well loads I’m guessing, not least from paper mills, prospectus and tombstone manufacturers (the Perspex vanity bricks handed out to everyone who helped issue a new bond). But the huge increase in swapping activity will increase the need for collateral (cash, government bonds) in the system, as well as potentially increasing systemic risks as market complexity increases. Collateralisation and the move to exchanges should reduce those systemic risks. Another issue regards taxation – junky issuers will be selling their bonds at potentially big discounts to par. Tax authorities don’t like this very much (they see it as a way of avoiding income tax) and it means that investors would have to be able to account for that pull to par to be treated as income rather than capital gain. Finally I reluctantly concede there might have to be 2 separate bond issues for banks and financials. One reflecting senior risk, and one reflecting subordinated contingent capital risk (CoCos). But if we must do this, the authorities should create a standard structure here too, with a common capital trigger and conversion. Presently there are various levels for the capital triggers, and some bonds convert into equity whilst others wipe you out entirely. There is so much complexity that it is no wonder that a recent RBS survey of bond investors showed that 90% of them rate themselves as having a higher understanding of CoCos than the market.

Addressing the second difference between bonds and equities, the other requirement would be for the investment banks to move fully to exchange trading of credit, and to assume a market making requirement for those brokers who lead manage bond transactions. This doesn’t of course mean that bonds won’t fall in price if investors decide to sell en masse – but it does mean that there will always be a price. This greater liquidity should mean lower borrowing costs for companies, and less concern about a systemic credit crisis in the future.

Why aren’t bund yields negative again?

Whether or not you believe that the ECB moves to full government bond purchase quantitative easing this week (and the market overwhelmingly says that it’s only a remote possibility) the fact that German bund yields at the 2 year maturity remain positive is a bit surprising. The 2 year bund currently yields 0.05%, lower than the 0.2% it started the year at, but higher than you might have expected given that a) they have traded at negative yields in 2012 and 2013 and b) that the market’s most likely expected outcome for Thursday’s meeting is for a cut in the ECB’s deposit rate to a negative level.

The chart below shows that in the second half of 2012, and again in the middle of 2013, the 2 year bund yield was negative (i.e. you would expect a negative nominal total return if you bought the bond at the prevailing market price and held it to maturity), hitting a low of -0.1% in July 2012.

2y bund yields chart

Obviously in 2012 in particular, the threat of a Eurozone breakup was at its height. Peripheral bond spreads had hit their widest levels (5 year Spanish CDS traded at over 600 bps in July 2012), and Target2 balances showed that in August 2012 German banks had taken Euro 750 billion of “safe haven” deposits from the rest of the euro area countries (mostly from Spain and Italy). So although the ECB refinancing rate was at 0.75% in July 2012 compared with 0.25% today, the demand for German government assets rather than peripheral government assets drove the prices of short dated bunds to levels which produced negative yields.

This time though, whilst the threat of a euro area breakup is much lower – Spanish CDS now trades at 80 bps versus the 600 bps in 2012 – the prospect of negative deposit rates from the ECB might produce different dynamics which might have implications for short dated government bonds. The market expects that the ECB will set a negative deposit rate, charging banks 0.1% to deposit money with it. Denmark successfully tried this in 2012 in an attempt to discourage speculators as money flowed into Denmark out of the euro area. Whilst the ECB refinancing rate is likely to remain positive, the cut in deposit rates might have significant implications for money market funds. David Owen of Jefferies says that there is Euro 843 billion sitting in money market funds in the euro area, equivalent to 8.5% of GDP. But what happens to this money if rates turn negative? In 2012, when the ECB cut its deposit rate to zero, several money market fund managers closed or restricted access to their money market funds (including JPM, BlackRock, Goldman Sachs – see FT article here). Many money market funds around the world guarantee, or at least imply, a constant or positive net asset value (NAV) – this is obviously not possible in a negative rate environment, so funds close, at least to new money. And if you are an investor why would you put cash into a money market fund, taking credit risk from the assets held by the vehicle, when you could own a “risk free” bund with a positive yield?

So whilst full blown QE may well be months off, if it ever happens, and whilst Draghi’s “whatever it takes” statement means that euro area breakup risk is normalising credit risk and banking system imbalances, the huge amount of money held in money market funds that either wants to find positive yields, or is forced to find positive yields by fund closures, makes it a puzzle as to why the 2 year bund yield is still above zero.

The M&G Central Bank Credibility Survey – the Carney impact?

Whilst YouGov is surveying consumers around the UK, Europe and Asia for the M&G YouGov Inflation Expectations Survey, we thought it would be useful for them also ask some questions about how people perceive both their central bank’s ability to hit the inflation target, and the likely effectiveness of government fiscal policy.  You probably won’t be surprised to hear that Europeans generally don’t think highly of the ECB or their politicians (although France is striking in its low levels of confidence in both, reflecting a degree of economic stagnation there, even as other areas of the Eurozone see signs of recovery).  But it’s the UK that’s seen the biggest improvement in sentiment towards its central bank, the Bank of England.

Mark Carney was announced as the 120th Governor of the Bank of England at the end of November 2012, at the start of our first survey quarter.  At the time, only 28% of the 2000+ people surveyed who had a view (stripping out “don’t knows”) were confident that the “central bank is currently pursuing the correct policies in order to meet its target of price stability (i.e. inflation around 2%) over the medium term (i.e. the next 3-5 years)”.  Our latest survey shows that in every quarter since then – and Mark Carney arrived at his desk on 1 July 2013 – this percentage has increased.  The latest quarter shows the biggest increase yet, with 55% of respondents confident that the Bank is following the right policies to achieve medium term price stability.

The M&G Central Bank Credibility Survey

And this is against a backdrop of a fair few raspberries about the Bank’s forward guidance regime (gilt yields tended to rise, and the pound strengthened every time Carney did some more communicating).  So why the almost doubling in the confidence in the Bank of England amongst the UK population?  Well, it’s the economy.  The UK has been one of the developed world’s fastest growing economies over the past year, with GDP growth at 2.7% year on year, after a couple of years where it felt as if it would be stuck at or below 1% forever.  Crucially when it comes to thinking about credibility, for the very first time since the depths of the financial crisis in 2009, CPI inflation is back below the Bank of England’s 2% inflation target.  At one point in 2011 CPI was running at over 5% year on year. And whilst real wages are still falling, nominal wages have started to perk up in the past few months, so the hit to workers’ pay is lessening.

Goldilocks? CPI falling, wages rising in the UK

Our survey isn’t the only measure that shows that the Bank of England’s credibility is strong and improving.  Central banks like to use index linked bonds to derive a market participant view of whether inflation expectations are anchored.  Remembering that UK index linked gilts are priced from RPI rather than CPI, and that estimates are that the long term “wedge” between the two measures is somewhere around 1.1% over the medium term (it could be higher in a rate rising environment as RPI contains a big chunk of mortgage interest payments).  The current 5 year 5 year forward breakeven inflation rate – the market’s price for average inflation over the five years from 2019 to 2024, i.e. taking out the current cycle and looking at a medium term expectation for inflation – stands at 3.35%, down from 3.65% at the end of November last year.  If you subtract the wedge you end up with a market CPI inflation forecast of 2.25% over the medium term.  This is a little above target, but given the Bank’s history in recent years of large upside misses, could reflect improving credibility.  It should be said however that this measure has generally been pretty stable (5 year average of 3.5%) so it doesn’t feel as if there is a significant signal on King Bank versus Carney Bank credibility here.

UK 5 year 5 year forward breakeven inflation rate

You can see the full M&G YouGov Inflation Expectations Survey here, and the M&G Central Bank Credibility Survey is within that report on page 6.

Win a place in the Prudential RideLondon-Surrey 100 bike ride!

We have two exclusive places available for the Prudential RideLondon-Surrey 100 on Sunday 10 August 2014! Those of you who rode it in 2013 will know what an incredible day out it was. Starting in the Queen Elizabeth Olympic Park, this is a tough 100 mile cycle on closed roads through London and out to the famous climbs of the Surrey Alps before returning to the capital and finishing on the Mall. Later in the day you’ll be able to watch the 150 professional riders sprint in after they have ridden the same route in the Prudential RideLondon-Surrey Classic.

You can read all about the Prudential RideLondon-Surrey 100 here.

Over 80,000 people registered for places so many cyclists were unlucky in the ballot. The good news is that our parent company Prudential has kindly given us the chance for readers of the Bond Vigilantes blog to win a place. We have two packages available which include:

  • Entry to the Prudential RideLondon-Surrey 100
  • Team Prudential cycling jersey and goodie bag
  • Access to the VIP start area

Whilst it’s a fun day out, don’t underestimate the challenge of riding 100 miles. You should ideally commit to at least 10 weeks of training leading up to the event, and be confident of finishing within 8 ½ hours (by which time the pro peleton will be hammering along the course at an average of 40 kph!). But it’s only March now, so you’ve plenty of time to train. A few of us from the M&G bond team will be taking part – I’ll be heading out to the Surrey Hills this weekend. Unless it rains.

So the question. Which double Olympic cycling champion is the ambassador for Prudential RideLondon, and won the inaugural Prudential RideLondon Grand Prix in 2013?

Please click here to enter, and here for terms and conditions.

If you aren’t lucky enough to win, you can still take part by joining up with one of the charities which still have guaranteed places (see here for a list) or by entering as part of a team through your local British Cycling club. Good luck!

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Japan hikes consumption tax in April – will retail sales spike in March, only to collapse afterwards?

Next month, Japan will raise its consumption tax from 5% to 8% as a step towards reducing the nation’s 200%+ debt to GDP ratio by moving towards a budget surplus in 2020.  This may be the first of two hikes in the sales tax, with a further rise to 10% planned for October 2015.  Prime Minister Abe has said that the second hike will be dependent on an economic recovery, rightly realising that only a significant increase in Japan’s growth rate will make any impact on the national debt.  He’s said that the data from July to September 2014 will determine whether or not the second VAT hike goes ahead.

We’ve looked at the impact of pre-announced sales tax hikes before when I wondered whether the UK’s rises from 15% to 17.5% (at the start of 2010), and then again from 17.5% to 20% (at the start of 2011) would impact retail sales.  History had shown us that when Japan raised consumption tax in 1997, and when Australia did the same in 2000, retailers saw a huge boost to sales in the month before the hike (12% year on year rises in both cases) but when the higher prices came in retail sales collapsed to near, or below zero.  Rational consumers front loaded consumption ahead of the known price rises.

I thought that we would see something similar in the UK, but there is little sign of it in the data – after the 2010 VAT hike, sales did turn negative, but in neither case did we see any of the “rational frontloading” that Japan and Australia saw.  Perhaps the very weak period of GDP growth (averaging below 1.5%, and at times as low as 0.5% year on year over 2010 and 2011), and the UK’s famous squeeze on real incomes through higher inflation than wage growth meant that there was no ability to frontload consumption.  Or perhaps we are not as rational as the Japanese and Australians.

What happens when you pre-announce a consumption tax hike?

So the implications for Japan in 2014 are not clear cut.  But I was surprised to see that Japanese retail sales growth is already running much higher than in any of the historical examples at the same stage of the VAT hiking cycle, with a 4.4% year on year increase.  Cars and machinery equipment led the way – the big ticket items that you might expect to make most sense for consumers to buy in advance of higher prices.  Economists have attributed this to front loading, but it is also worth exploring alternative explanations.  Today’s release of Japanese wage data showed the first rise in base pay for nearly two years, so perhaps the recent improvement in some economic data, and the psychological impact of Abenomics are producing a real increase in consumer sentiment.  But pay is still only growing at 0.1% on an annual basis, and including bonuses and overtime it is negative.  Also the recent exit from deflation is squeezing real incomes.  The Japanese economy, and consumer, remains fragile – Abe will be hoping that this doesn’t end up being a replay of 1997.

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The Professor Michael Pettis China forecast: 3-4% real growth on average for the next decade. And that would be a good result.

Having seen one of my favourite economists, Professor Michael Pettis, present twice in the past couple of months, I thought I’d try to distil his important messages about the future of the Chinese economy. For those with more time, he also writes a blog which you can find here. The recent presentations aside, I first saw Professor Pettis at a breakout session during the World Bank-IMF meeting in Tokyo in 2012. I was in the crowd in a packed room when Pettis said that Chinese GDP growth would likely fall to an average of 4% for the next decade. Across the audience there were audible titters and even people making the “he’s crazy” thing by swirling their fingers next to their heads. Little more than a year on, and the China slowdown view is nearer to the consensus – although you’d still find it difficult to find an official sub-5% China GDP forecast over any timeframe. Pettis maintains that 3-4% average growth is China’s likely future; the IMF’s World Economic Outlook has revised down its estimate of Chinese potential growth, but only from 8.9% to 8.0%. This morning the 2013 Chinese GDP number was released, at 7.7%, the 4th year in a row now of lower annual growth rates (and even then sceptics suggest that electricity consumption data and freight analysis show that the GDP numbers are overstated in the official statistics).

Professor Pettis’s starting point is that any investment led growth model eventually comes to an end as the quick wins from early infrastructure spending and urbanisation/industrialisation fade away and profitable investment opportunities become harder to find. And this investment has to be financed somehow – and it is the household that pays. For Brazil, the first example of an “economic miracle”, the investment was financed through high income taxes. In the “East Asian” model however (and this was true in Japan’s growth phase post WW2 as well as in China today) the burden on households is less explicit than taxation. The three hidden methods of boosting investment growth at the expense of consumption growth are:

  1. An undervalued exchange rate, boosting exporting manufacturers at the expense of higher imported goods prices for consumers.
  2. Low wage growth vs productivity growth, a subsidy for employers.
  3. And most importantly, financial repression. This confiscates savings from consumers and is another subsidy for, in particular the State Owned Enterprises (SOEs). Pettis estimates that Chinese interest rates have at times been 8-10% below where they “should” have been.

When the supply of profitable investment starts to run out, debt starts to rise more quickly than the ability to service that debt. This leads to a Japan style debt crisis or stagnation. Some estimate that 30% of new loans issued are simply to rollover debt that would otherwise be in default, and that non-performing loans are seriously underestimated in the official data (under 1% according to the China Banking Regulatory Commision). But what about reform, as promised by the Third Plenum? President Xi Jinping appears to recognise the problems that the economy faces, and accepts the need for rebalancing towards consumption. But he has also publically recognised the vested interests in China. The interests of the political elite are aligned with infrastructure projects and the State Owned Enterprises, and this will make reform exceptionally difficult. Studies of “successful” economic development have suggested that nations that democratise quickly and fully or nations that centralise aggressively do well economically over the long term. Examples of those that do neither are Argentina and Russia. It remains unclear whether China will follow a “successful” path, because of its vested interests. As a result growth of 7-8% per year might continue to be the debt-fuelled norm – but the hangover will be much bigger (disorderly negative growth rather than 3-4% in an orderly rotation away from investment towards consumption).

What would real reform look like, in Professor Pettis’s view?

  1. Reduced investment into the SOEs, local government and real estate sectors. Increased investment in SMEs.
  2. Liberalisation of interest rates to reflect the real risks of lending.
  3. Reduction in overall Chinese debt to GDP ratio.

You can read FT Alphaville’s Third Plenum cheat sheet here. You would have to say that progress towards what Michael Pettis thinks is necessary looks pretty slow – although it does appear that there has been some upwards movement in Chinese money market rates more recently, with the average 3 month money market rate (SHIBOR) moving up from below 5% in Q3 2013 to over 5.5% now.

2013 Bond Vigilantes Christmas Quiz – the answers and the winners

Thanks for all the entries to the 2013 quiz. The winner is Adam Weidner who gets to choose where we send a £200 charity donation, and a copy of Morrissey’s autobiography. We’ll be in touch, and tweet the charity name on @bondvigilantes. The five runners up who win a Moz book are Jonathan Moore, Mark Nelson, Adrian Coates, Joshua Giersch and Richard Milne. Have a great 2014.

1. “The band the Beatles could have been” was Wings, according to Alan Partridge. Here’s Band on the Run.

2. French Club Olympique de Marseille, winners of the Champions League in 1993, play in blue and white and took their colours from the Greek flag in honour of the ancient founders of the city of Marseille who came from Phocaea.

3. Duran Duran had three of their members with the surname Taylor (John, Roger, Andy). They were not related.

4. Noli timere – “do not be afraid” – was the final thing said (actually texted to his wife) by poet Seamus Heaney, who died this year.

5. If you swap the soda water for gin in an Americano, you end up with a Negroni.

6. Once 21 million bitcoins have been made, production automatically stops. We’re about halfway towards that total now.

7. “I am not in the office at the moment. Send any work to be translated”.

8. North Korea’s Kim Jong-il, according to his official biography, hit 11 holes in one at his first attempt at golf, and then retired from the sport.

9. Graced fair wound is an anagram of FORWARD GUIDANCE.

10. The KLF burnt a million quid on the Isle of Jura in 1994.

11. The best-selling vehicle in the US in 2013, was, as usual, be the F-Series pickup.

12. Incoming Fed chief Janet Yellen said that letting inflation rise could be a “wise and humane policy”.

13. George W. Bush wrote that note asking for a bathroom break.

14. Music video number 1 was Michael Jackson’s Billie Jean.

15. Music video number 2 was Fatboy Slim’s Weapon of Choice.

16. Music video number 3 was Madonna’s Music.

17. I’m guessing there are many different estimates of the US government’s net P&L on the GM, AIG and Citibank positions that it took in the middle of the credit crisis. But by the power of Google I come up with a $10 billion loss on GM, a $22.7 billion profit on AIG, and a $15.5 billion profit on Citibank, making a net profit of $28.2 billion. But we accepted anything near that or with a sensible explanation, especially if you provided a spreadsheet and NPVed some cashflows.

18. This is the marker at the top of Mont Ventoux in Provence.  Are you bored yet with my tales about my awesome cycle up the tough route this year – ruined for me only by the news that someone else did the same climb on a Boris Bike recently?

19. Verizon issued $49 billion of corporate bonds this year, the biggest deal ever.

20. The national anthem of the Netherlands spells out the name of the founder of its royal house, Wilhemus, through the first letter of each stanza.

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US Treasuries – are we nearly there yet? Maybe we are.

Before we get all beared up about tapering, it’s worth seeing how far we’ve come already, and what the end game should be. The sell-off in US Treasury bonds has already been severe. 10 year yields have risen from a low of 1.4% in July 2012 to nearly 3% today. Most street strategists have yields rising further in 2014, with the consensus 10 year forecast at 3.37% for a year’s time.

But as well as looking at the spot yield, we should see what the yield curve implies for future yields. The chart below shows the 10 year 10 year forward rate – in other words the expected 10 year UST yield in a decade’s time backed out mathematically by looking at long dated UST yields today. You can see that the implied 10 year yield is now over 4%, at 4.13%.

The other thing I have put on the chart is a shaded band representing the range of expectations within the Federal Open Market Committee (FOMC) for the longer run Federal Funds rate. You can find this range of expectations here on the third slide of the charts from yesterday’s FOMC minutes. Four members think that that the long run Fed Funds rate is as low as 3.5%, and two think it is as high as 4.25%. The median expectation is 4%.

The bond market expects 10 year USTs to yield 4.13% in a decade’s time

Now the 10 year bond yield is effectively the compounded sum of all short rates out to 10 years, plus or minus the term premium (which we will discuss in a minute). If the FOMC members are correct that 4% is the long run interest rate, then if the term premium is zero, the 10 year forward rate at 4.13% has already overshot where it needs to be, and we should be closing out our short duration positions in the US bond markets.

The term premium is important though (this blog from Simon Taylor is good at explaining what it is, and showing some estimates). The term premium is compensation for the uncertainty about the short rate forecast. Historically it has been positive, as you might expect, reflecting future inflation or downgrade risks. In recent years though it has been negligible, even negative – perhaps due to a non-price sensitive buyer in the market (the Fed through QE), but also perhaps due to deflation rather than inflation risk? It is likely however that the term premium rises at a turning points in rates – and also that if inflation ever made a sustained comeback, with central banks refusing to fight it, like in the pre-Volker years, the risk premium would rise strongly. We also know that markets tend to overshoot in both directions. Nevertheless, whilst it’s too soon to say that we’ve seen the highest yields of this cycle, as a value investor you could say that yields are moving towards fair value.

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