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The Great Compression of peripheral to core European risk premiums

Are investors still compensated adequately for investing in peripheral rather than core European debt, or has the on-going convergence eroded debt valuation differentials altogether? In his latest blog entry, James highlighted five signs indicating that the bond markets consider the Eurozone crisis resolved. Inter alia, James pointed out that risk premiums for peripheral vs. core European high yield credit had essentially disappeared over the past two years. Here I would like to extend the periphery/core comparison by taking a look at investment grade (IG) credit and sovereign debt.

First, let’s have a look at the spread evolution of peripheral and core European non-financial (i.e., industrials and utilities) IG indices over the past 10 years. In addition to the absolute asset swap (ASW) spread levels, we plotted the relative spread differentials between peripheral and core credit. The past ten years can be divided into three distinct phases. In the first phase, peripheral and core credit were trading closely in line with each other; differentials did not exceed 50 bps. The Lehman collapse in September 2008 and subsequent market shocks lead to a steep increase in ASW spreads, but the strong correlation between peripheral and core credit remained intact. Only in the second phase, during the Eurozone crisis from late 2009 onwards, spreads decoupled with core spreads staying relatively flat while peripheral spreads increased drastically. Towards the end of this divergence period, spread differentials peaked at more than 280 bps. ECB President Draghi’s much-cited “whatever it takes” speech in July 2012 rang in the third and still on-going phase, i.e., spread convergence.

As at the end of March 2014, peripheral vs. core spread differentials for non-financial IG credit had come back down to only 18 bps, a value last seen four years ago. The potential for further spread convergence, and hence relative outperformance of peripheral vs. core IG credit going forward, appears rather limited. Within the data set covering the past 10 years, the current yield differential is in very good agreement with the median value of 17 bps. Over a 5-year time horizon, the current differential looks already very tight, falling into the first quartile (18th percentile).

Peripheral vs. core European non-financial IG credit

Moving on from IG credit to sovereign debt, we took a look at the development of peripheral and core European government bond yields over the past 10 years. As a proxy we used monthly generic 10 year yields for the largest economies in the periphery and the core (Italy and Germany, respectively). Again three phases are visible in the chart, but the transition from strong correlation to divergence occurred earlier, i.e., already in the wake of the Lehman collapse. At this point in time, due to their “safe haven” status German government bond yields declined faster than Italian yields. Both yields then trended downwards until the Eurozone crisis gained momentum, causing German yields to further decrease, whereas Italian yields peaked. Once again, Draghi’s publicly announced commitment to the Euro marked the turning point towards on-going core/periphery convergence.

Italian vs. German government bonds

Currently investors can earn an additional c. 170 bps when investing in 10 year Italian instead of 10 year German government bonds. This seems to be a decent yield pick-up, particularly when you compare it with the more than humble 18 bps of core/periphery IG spread differential mentioned above. As yield differentials have declined substantially from values beyond 450 bps over the past two years, the obvious question for bond investors at this point in time is: How low can you go? Well, the answer mainly depends on what the bond markets consider to be the appropriate reference period. If markets actually believe that the Eurozone crisis has been resolved once and for all, not much imagination is needed to expect yield differentials to disappear entirely, just like in the first phase in the chart above. When looking at the past 10 years as a reference period, there seems to be indeed some headroom left for further convergence as the current yield differential ranks high within the third quartile (69th percentile). However, if bond markets consider future flare-ups of Eurozone turbulences a realistic scenario, the past 5 years would probably provide a more suitable reference period. In this case, the current spread differential appears less generous, falling into the second quartile (39th percentile). The latter reading does not seem to reflect the prevailing market sentiment, though, as indicated by unabated yield convergence over the past months.

In summary, a large portion of peripheral to core European risk premiums have already been reaped, making current valuations of peripheral debt distinctly less attractive than two years ago. Compared to IG credit spreads, there seems to be more value in government bond yields, both in terms of current core/periphery differentials and regarding the potential for future relative outperformance of peripheral vs. core debt due to progressive convergence. But, of course, on-going convergence would require bond markets to keep believing that the Eurozone crisis is indeed ancient history.

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Jim Leaviss’ outlook for 2014. The taper debate (watch the data), inflation (where is it?), and it’s a knockout. Merry Christmas!

With many expecting a ‘great rotation’ out of fixed interest assets in 2013, bond investors will, in the main, have experienced a better year than some had predicted 12 months ago. It might not always have felt like it at the time – indeed, over the summer when markets were sent into a spin by the prospect of the US Federal Reserve (the Fed) cutting its supply of liquidity earlier than expected, it almost certainly did not. But riskier assets, notably high yield corporate bonds, have continued to perform strongly, while investment grade corporate bonds are on track to deliver another year of positive returns, in spite of the volatility.

Meanwhile, the macroeconomic backdrop has generally improved over the past year, with the economic recovery gaining significant momentum in the US and, more recently, the UK. However, the picture in Europe remains mixed, while our concerns over the emerging markets are mounting. However, despite their disparate prospects, all countries – and all bond markets – are united by at least one common dependency: the Fed.

So what does 2014 have in store for global bond markets? In our latest Panoramic outlook, Jim outlines his macroeconomic and market forecasts for the year ahead. And for those of you who have been wondering, the annual M&G Bond Vigilantes Christmas quiz will be posted later this week.

Enjoy!

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Why the US Dollar now looks cheap against, well, basically everything

Back in January I wrote about why we loved the US dollar and worry about EM currencies, and did an update on EM in June (see EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’?).  Another EM piece will follow soon (the short version is that while it was ‘just’ a tremor,  I’m increasingly worried that ‘The Big One’ is coming).

The US Dollar was strong through Q1 and Q2, but an interesting development in Q3 was that while the US Dollar held up OK against most EM currencies, it performed abysmally against other developed currencies.  Below is a chart of the US Dollar Index, a gauge of US Dollar performance against a basket of major world currencies, where the basket contains EUR (57.6%) JPY( 13.6%) GBP (11.9%) CAD (9.1%) SEK (4.2%) CHF (3.6%). The Dollar Index is back to where it was at the beginning of the year, and despite the relative strength of the US economy versus other developed countries, the Dollar Index has now returned to the average level of the last five years.

US Dollar Index has cheapened all the way back to 5yr average

The reasons that led us (and an increasing number of others) to be so excited about the US dollar over the past 18 months were namely compelling USD valuations following a decade long slump, an improving current account balance, the rapid move towards energy independence, and a strengthening US economic recovery where a surging housing market and a steadily falling unemployment rate made it likely that the US would lead most of the world in the monetary policy tightening cycle.

The long term positives for the US dollar are still there, but have recently been overshadowed by negative ones.  So what has changed?  Recent US Dollar weakness is probably to do with the Fed’s non-tapering in September, the ongoing budget nonsense, and a very big unwind in a whole heap of long USD positions.

It makes sense to be more bullish on the US dollar because these negative forces appear to be dissipating.

Firstly the non-tapering event.  Treasury yields and the US dollar had already started to drop ahead of the non-tapering decision thanks to a slight weakening in US data, with US 10 year yields dropping from 3% on September 5th to 2.9% on September 18th and the Dollar Index falling 2%.  Nevertheless markets were still taken by surprise, and Treasury yields and the US Dollar had another leg lower with US 10 year yields briefly dropping below 2.6% at the end of September, and the Dollar Index falling almost another 2%.

But then on Wednesday we had September’s FOMC minutes, which were surprisingly hawkish.  The decision not to taper was a close call, where most members still viewed it as appropriate for tapering to start this year and for asset purchases to be finished by the middle of next year.  Yes, the US government shutdown that has occurred since the meeting took place appears to be already starting to hit US economic data (estimates vary enormously for the total hit to Q4 US GDP), and the weaker data is therefore likely to push the start date for tapering back a little.  But if you assume that the US government shutdown is a one off event (admittedly not a particularly safe assumption), then the shutdown should merely slightly delay the tapering decision and the normalisation of US monetary policy, it should not result in a permanent postponement.

That said, something that was a little disconcerting from the minutes of the September FOMC meeting was that the jump in mortgage rates played a key role in the decision not to start tapering, with some members worrying that a reduction in asset purchases “might trigger an additional unwarranted tightening of financial conditions”.  HSBC’s Kevin Logan makes the good point that higher mortgage rates present Fed policy makers with a dilemma; if rates rise because the markets expect a tapering of QE, and that in turn stops the Fed from tapering, then it makes any QE exit pretty tricky and it appears that the Fed now has an additional criterion for reducing QE – not only must the economy and labour market be doing better, but long-term interest rates cannot rise too much in advance, or even during, the tapering process.  If the Fed’s decision not to taper was heavily influenced  by higher mortgage rates, though, then their fears should now be allayed given the chart below.  This chart, together with the effect that mortgage rates have on the US housing market, has clearly taken on added importance.

Mortgage rates now appear key to whether & when to taper

What about the ongoing budget nonsense?  This one takes a bit of a leap of faith, but markets are clearly starting to price in the risk of something going very badly wrong as demonstrated by the jump in T-bill yields and the surge in 1yr US CDS (i.e. the cost of insuring against a US default, see chart below).  But market stresses should make the prospect of a deal more likely, and this appears to be starting to happen.  It’s dangerous reading too much into the headline tennis, but the latest news is that Republican and Democratic leaders are open to a short term increase in the debt limit.  And don’t forget, the debt ceiling has been raised 74 times since March 1962 – past performance is no guide to the future as everyone knows, but while this episode is particularly chaotic, is this time really different?

Government shutdown is starting to cause market distress

Finally, the technicals for the US Dollar are now much more appealing.  US Dollar positioning has seen a sharp reversal from earlier this year, and Deutsche Bank estimates the US dollar is the only substantial short in the market (see charts below).  Does this matter?  To finish with a quote from John Maynard Keynes* regarding investing, “It is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority.  When you find any one agreeing with you, change your mind.  When I can persuade the Board of my Insurance Company to buy a share, that, I am learning  from experience, is the right moment for selling it”‘.

In a complete reversal from earlier this year, investors are very short USD

*Keynes is famous for amassing a fortune through investing, but in 1920 he had to be bailed out by his father together with an emergency loan from Sir Ernest Cassel, and he came very close to being wiped out in the 1929 and 1937 stock market crashes.  So clearly the consensus can occasionally be right.

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Italy: the good, the bad and the…politicians

Italian politics has been in the international news, again. Markets tend to fear instability and Italy is always a creative and boundless source of uncertainty. We Italians have a wonderful ability to put ourselves into trouble. The good news is that markets in recent weeks have held up more than in the past.

Italy risk premium

1 – Political life in the peninsula

In the last few weeks, research from many well-known investment banks has identified Italy as one of the two major global sources of near-term risk for capital markets (the other being the US shutdown). The crisis started when Mr. Berlusconi asked his ministers to resign from the government in order to push for new elections. However, against expectations, the risk dissolved almost as quickly as it appeared when Mr. Letta won the ensuing confidence vote with large support. While this was good news, what is next in store for Italian politics? While I can’t forecast the future, I can say that Italy will never change in this sense. Uncertainties around party and electoral laws, social policies, public debt, tax evasion, structural reforms, trade interests and inefficient regulations (to name just a few) will be around for a long time in a nation that is incapable of moving quickly. While political risk will remain a source of noise, investors excessively focused on it may miss the bigger picture, both on the downside and on the upside.

2 - Bad news first: above and beyond the “Res Publica”

In the land where the ancient Roman Empire began, several economic problems have lingered for decades. Public debt at EUR 2 trillion (of which around 30% is non-resident holdings, according to IMF Dec 2012 numbers) is enormous with a debt/GDP number worryingly on the rise. The key concern for investors should be the implication of carrying such a high interest expense, together with the overall amount of public spending. The Italian system – including salaries for public sector employees, general benefits, ongoing expenses to run the state and transfers to local administrations – costs over EUR 790 billion (or 51% of GDP) to taxpayers each year. Interest expenses alone cost EUR 85 billion. As an anecdote, did you know that the Italian Parliament cost taxpayers about EUR 1.65 bln in 2011, as much as the English, French and German ones together? Once accounting for sub-optimal GDP growth, the necessary resources to invest in productivity, social measures and new business initiatives remain scarce. At the same time, there is limited scope to reduce the high tax burden which affects families and impacts the ability of companies to become more competitive on international markets. In the World’s Economic Forum latest Global Competitiveness Report, Italy, the world’s 9th biggest economy, was moved down from number 42 to 49.

In parallel, doing business within the country remains problematic for companies and entrepreneurs:

  • Justice – the World Bank’s “Doing Business” report for 2013 (figures here) shows that it takes an average 1,210 days to enforce a contract in Italy, more than twice the average of other OECD high-income countries. For those who prefer to see the glass half-full, days were 1,390 in 2004. But would you call this progress? Economic literature demonstrates that an inefficient judicial system and low quality legal institutions increase the cost of credit for companies because  banks perceive, and therefore price in, more risk. It has also been shown to limit inward foreign direct investments (FDI) and dampen innovation. In the last three years of available data, FDI decreased from EUR 270 billion to EUR 247 billion (OECD 2011 figures, applying current EUR/USD exchange rates).
  • A terrible customer – In October Eurostat published figures highlighting for the first time that the Italian government’s arrears to SMEs were in excess of EUR 67 billion (or 4.3% of GDP) at the end of 2011.  More recent estimates by the Bank of Italy report EUR 91 billion (almost 6% of GDP). While EUR 40 billion have just been unblocked to finally repay some of the pending debt to Italian companies, the issue remains unresolved and will continue to affect weaker contractors, forcing defaults and increasing unemployment.
  • Taxes – Italy has one of the highest corporate and personal tax regimes in the world, impacting both companies and private consumption. At the same time, Italian tax revenues (around EUR 470 billion in 2012) are not enough to keep up with the country’s excessive spending. The problem is that this tax pressure is un-even: too high for those who pay but nothing for the many that evade. Some estimates quantify tax evasion as being in the region of EUR 300 billion (or 15% of GDP in 2012), which is a sum equivalent to the GDP of Singapore, Greece or Denmark. Imagine the possibilities offered by unearthing that pocket of money? Reforms seriously targeting tax evasion would have a “fly-wheel” effect providing both an increase in state revenues and, hopefully, a subsequent decrease in the corporate and personal tax rate.

Additional ongoing economic issues in Italy are well known, from rising unemployment (latest reading in August reports a rate of 12.2%, with youth unemployment at 40.1%) to the excessive power of trade unions. Moreover, while labour costs have decreased in other European peripheral countries helping to make them more competitive, they have not done so in the “Bel Paese”.

Unit labour cost trends Europe

As a result of all of the above, Italian citizens – not surprisingly – have limited trust in institutions. The latest M&G YouGov Q3 2013 inflation report showed that the majority of respondents have little confidence in the government’s ability to follow the right economic policies. Results show a lack of trust in the government’s actions, but also a decreasing confidence in the central bank’s ability to maintain price stability over the medium term (ie inflation around 2%). For Italians, the European Central Bank is not doing much, suggesting that forward guidance measures may have been poorly received. Italians are also expecting a shift in inflation dynamics in the future, forecasting inflation up to 3% over 1 year and up to 3.3% over 5 years. This compares with the current inflation figure of 0.9% as of August 2013, reflecting the recession and a weak labour market.

MG YouGov inflation survey Q3 2013

3 – Now the good news: improving economic trends, size of private wealth and resiliency of Italian companies doing business abroad provide a different picture worth considering.

While the IMF expects Italy to come back to modest growth by 2014 with a GDP of only 0.7%, better news is that after nearly two years of recession Italy’s economy is showing signs of stabilising. Some indicators are finally improving, from PMI indices to confidence indicators and industrial new orders for the non-domestic market. The banking sector is progressing, even if we continue to be concerned. Let’s review some key developments.

Improving indicators

While unemployment, weak growth and other factors have eroded household income in the last few years – impacting both domestic demand (consumption) and savings rate – the existing stock of private wealth in the Italian peninsula (the sum of financial and non-financial assets minus liabilities) may offer a surprise. Wealth is one of the key components of the economic system, a source of finance for future consumption, for reducing vulnerability to shocks and to other unexpected developments, and for undertaking business and other economic activities. Italy is characterised by still having one of the highest levels of private wealth (gross household wealth) in Europe with a total of EUR 9 trillion assets, or 8.5 times the nominal disposable income (OECD 2013, based on 2011 figures). In the UK and France this figure is around 8 times, and only 7.6 times in Japan, 6.3 times in Germany and 5.2 times in the US. Such a high stock of savings is not a bad resource in times of economic downturn. These accumulated savings allow families to keep consuming (even if less than before) and, in many cases, prevent the long-term unemployed from a dramatic fall into poverty, thereby preventing social unrest and disorder. Moreover, given a low household indebtedness in the nation (even if on an increasing trend), the overall gross debt mix (public and private) provides a better picture than public debt on a stand-alone basis and looks broadly in line with the Euro area average around 300% of GDP.

Household debt in OECD countries

On a different perspective, doing business outside Italy can be great for Italian companies. An IMF report issued last Friday highlights the strength of Italian exports in the face of a depressed global demand. Findings show that Italian trading firms continue to be solid, adaptable and resilient. At a macro level, with exports revamping and a depressed domestic economy keeping imports weak, the current account balance is improving. At micro-level, unlike many other European countries, Italy‘s tradeable sector continues to perform in a context of an established competition from low cost emerging markets. Agility, capacity for incremental innovation and a diversified range of high-quality, high-margin products have been highlighted as central factors allowing Italy to maintain its relative world position. The country remains the world‘s top ranked exporter in textiles, clothing and leather goods; it is ranked second in the world (behind Germany) for non-electronic machinery and manufacturing.

A number of Italian, non financial companies have very valuable brands recognised at a global level. Many are well managed businesses which continue to generate value, provide a source of talent and will continue to compete in international markets in the future. On the banking side, Italian banks on average have so far managed to overcome the shocks coming from a severe and prolonged recession at home and the crisis in Europe. Quoting a recent IMF report on Italian banks, the system has stabilised. Banks expanded domestic deposits and built additional capital buffers without significant state support. In addition, the impact of the sovereign debt crisis has been softened by the ECB intervention via LTRO and OMT announcement, shielding Italian banks from wholesale funding volatility. Capital buffers have strengthened in recent years and seem sufficient to absorb most of the losses in case of an adverse shock. In the team, we continue to believe that the system is not out of danger, though. Continuing weakness in the real economy and the link between the financial sector and the sovereign remain key risks. Weak profitability and deteriorating loan quality (the average non-performing loan ratio has nearly tripled to 14 per cent since 2007)  are the most pressing vulnerabilities affecting Italian banks, while the coverage of non-performing loans by provisions and collateral remains lower than most other EU countries, a concern as the ECB is set to review banks’ asset quality in the first half of 2014. Moreover, while the decline of Italian sovereign yields from their peaks has eased these pressures, the crisis in Europe has not ended. Banks with large holdings of Italian government securities continue to be exposed to direct mark-to-market losses and higher funding costs should sovereign yields surge again.

We cannot ignore the ongoing concerns that the Italian economy and domestic companies continue to face. That said, it is important to continue to monitor progress towards a stronger and more competitive Italian growth model. Italian assets have rebounded strongly in 2013 (despite the recent political-induced  wobble) and there are some good examples in credit markets of well diversified companies that are trading cheap, not because of fundamental problems, but reflecting the stress that Italian government bonds have come under in recent years. Valuation remains key for credit investors, and fundamental analysis will be crucial to picking winners in the peripheral markets.

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Asian currency wars; is China really the ‘currency manipulator’?

Ever since the Asian financial crisis in 1997, Asian economies have generally engaged in a policy of maintaining artificially cheap currencies in order to generate export-led growth. This led to substantial political pressure being placed on Asian countries, primarily from the US, to allow their currencies to appreciate.

The problem facing export dependent Asia is that this growth model has now broken. Firstly many of Asia’s currencies no longer appear that cheap (eg Indonesia is running its largest current account deficit since Q1 1997 and its reserves hit a two year low last month), and secondly, who is going to import all the exports given that the developed world is busy deleveraging?

These export dependent countries have been left fighting over a shrinking pie, or at least a non-growing pie. When countries are dependent on exporting tradeable goods, small changes in currency valuation can make a big difference to competitiveness. (As the UK has discovered, the flip side is that devaluation doesn’t make the blindest bit of difference when selling tradeable goods forms a very minor part of your economy.)

And that’s when you get currency wars. In the note I wrote in January (see why we love the US Dollar and worry about EM currencies), I mentioned that China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade today than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way?

The chart below shows the magnitude of Japan’s so far successful devaluation versus China, its biggest trade partner and global competitor. Some Asian currencies have weakened a little in sympathy, but more from investor expectations of action rather than from action itself. Chinese exports grew at a surprisingly strong 21.8% year on year in February, but it will be very interesting to see whether this can be sustained, whether other Asian countries can bounce from their current export slump, and if not, then what the region’s central banks and governments plan to do about it.

CNYJPY spot exchange rate

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Should the people of Middle Earth have done Quantitative Easing to mitigate against Smaug’s tight monetary policy?

Any blog that begins with the words “Smaug the dragon is typically viewed as a fiscal phenomenon…” has immediately got my attention. Please read The Macroeconomics of Middle Earth by Frances Woolley. Woolley compares the size of the dragon’s hoard with a picture of the gold reserves at the Bank of England – although it is likely that Smaug is the beneficial owner of his gold, rather than a custodian of gold for richer dragons elsewhere in Middle Earth. He concludes by suggesting that the peoples of Middle Earth should have abandoned the gold specie standard and adopted paper currency to reduce the deflationary drag that Smaug’s monetary tightness produced. Unfortunately though “the lack of a central bank, or indeed any but the most rudimentary monetary institutions, was a major obstacle to currency reform”. The comments are worth reading too – was Middle Earth an Optimal Currency Area? Before Smaug arrived, were the the Dwarves running Middle Earth like a petro-state?

*SPOILER ALERT* So Smaug dies in the end, and the gold was released into Middle Earth’s money supply. Was there hyper-inflation as a result? Or did Nominal GDP return to trend (i.e. the “catching up” theory that has been talked about by Central Bankers like Mark Carney lately) without longer term inflation problems? If there was hyper-inflation perhaps the political instability that resulted allowed the rise of Sauron as a leader, and the subsequent world war between Men and Elves, and Orcs?

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Metroboom – Lessons from Britain’s Recovery in the 1930s by George Trefgarne. And win a copy!

In my last blog, about the many positive signals for US housing and the massive potential for that to drive US growth over the next couple of years (see here). I mentioned that I’d met recently with George Trefgarne, the author of a Centre for Policy Studies booklet called Metroboom. In it he pointed out how important housing construction had been in the UK’s recovery from the “slump” of the 1930s – I suggested that house building would be a very powerful way for the UK to get out of our current growth problem. As we’ve pointed out before, the UK’s growth performance from the credit crisis onwards is actually far worse than it had been in the 1930s in terms of lost GDP.

Metroboom is definitely worth a read. It certainly adds to the debate on the austerity vs fiscal stimulus debate, and (perhaps controversially) argues that it was a combination of spending cuts and tax cuts that helped to restore economic growth in the UK in the 1930s. The paper also argues that the view of the 1930s as universally gloomy in the UK is overstated. Areas that relied on shipbuilding and coal mining (the Special Areas) did remain depressed for much of the decade, and only re-armament ahead of the war stimulated growth again, but for much of the nation recovery came much earlier. Trefgarne claims that the UK was well ahead of most of the rest of the world in coming out of depression (only Germany grew faster), and that the period was one of industrial and technical innovation (and an obsession with world speed records!), an infrastructure and housing revolution, and improved leisure time (paid holidays, a cinema boom).

Perhaps one problem that we face today, that makes the UK’s 1930s solution difficult to implement today is that the tighter fiscal stance then could be offset with looser monetary policy – a policy tool that Trefgarne says was necessary to run alongside the austerity. As we approach the zero bound in interest rates around the western economies, and when the Bank of England hints that it finds diminishing returns from more and more Quantitative Easing, those monetary tools are unavailable. Olivier Blanchard, chief economist of the IMF, suggests that the reason for the negative fiscal multipliers being perhaps 3 times higher in this current downturn than they had expected them to be (1.5x versus 0.5x) is exactly this effect – monetary policy can no longer offset fiscal policy tightening. Additionally, when the UK came off the Gold Standard in 1931, the depreciation of sterling was very beneficial to UK exporters – I think that this currency depreciation was the most important factor in the UK’s eventually recovery. It’s also interesting to note that at the recent IMF/World Bank meetings in Tokyo (see my video here), Blanchard used the UK in the 1930s as an example of exactly why austerity failed, so the data from that period can be interpreted in very different ways!

I highly recommend you read Metroboom – it’s a short and concise economic history of the UK in that period with some great colour too (Neville Chamberlain at the time was regarded as a dynamic, media savvy “Man of the Year”, the Navy came close to mutiny following wage cuts, and 180 lidos were built in the decade). It’s interesting to have a different view to the commonly held one that the UK’s policies were disastrous whilst the New Deal Keynesian policies of the US proved to be the way to get out of Depression.

We have 20 copies of the Metroboom booklet to give away to the first names out of the hat with the correct answer to this question:

Which famous train broke the speed record between London and Edinburgh in 1938?

Terms and conditions hereEnter here or email us at bondvigilantes@mandg.co.uk

Congratulations to the 20 winners named below – we will be in touch to get your copy of Metroboom to you. My question turned out to be a little ambiguous. I was looking for The Mallard as the answer to the question, as it hit a record speed of 126 mph at one point between London and Edinburgh in 1938. However, the Flying Scotsman set the record time for the entire journey between London and Edinburgh. In light of the confusion I generated, both answers were accepted. Thanks to everybody who entered, and good luck if you are attempting the annual Bond Vigilantes Christmas Quiz!

William Blake, Quilter
Chris Summers, FAMC Ltd
John McLaughlin, Brewin Dolphin
Nigel Farmer, Charles Stanley
Rachel Revesz, Citywire
Harry Rogers, Bentley Reid & Co
Joanna McIntyre, Standard Life Investments
John Slater, Medicas
Chris Spink, Thomson Reuters
Chris Rule, Kingfisher Financial
Herman Bakker, VSB
Jacob Nelson, BIS
John Topalian, Topalian Associates
Neil McHaffie, KM Financial
Mateusz Malek, Killick & Co
Mark Jones, Brewin Dolphin
Debbie Behrens, Charles Stanley
Richard List, J O Hambro Investment Management
Ian King, The Times
Bill Crowley, Independent IFA

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What should Mervyn do with his QE gilts? Free finance.

Jim recently discussed the merits of officially cancelling the gilts bought back through QE, so I thought I would discuss another option that maintains the status quo through the Bank of England (BoE) simply rolling over the QE gilts into new gilts at maturity.

In order to understand the results of this process it is useful to re-examine how QE works.

Simply, QE is the willing exchange of gilts for cash between the BoE and the private sector.

What is the difference between a gilt and cash? Both are denominated in the same common currency, the main difference to the investor is that gilts pay a coupon, usually until a specified maturity date when they funge into cash on a one for one basis. Cash on the other hand has a zero return, unlike a gilt, and exists in perpetuity. Both cash and gilts can be lent to a third party in return for a payment. But that payment is simply a transfer payment for borrowing the asset (cash or gilt) with no extra intrinsic returns being embedded in the cash or the gilt.

Therefore as an investor you have the choice of owning a gilt that pays you extra return until a set date when it turns into a cash security that pays you no return forever, or investing straight away in cash that pays you no return forever.

The holding of a gilt looks intrinsically superior. A buy to hold investor of a gilt with a positive yield will always end up with a higher cash balance than the investor holding cash. Why do investors therefore choose cash over gilts? Mainly, it is due to the fact that the price of a gilt can go up or down, while the price of cash never varies. This risk aversion means investors are willing to forego a positive return in order for certainty when they decide to hold cash.

From an issuer’s perspective this is wonderful and can be taken advantage of. If the government can exchange interest bearing securities for cash (QE) then they can swap interest bearing securities that need refinancing at maturity for non-interest bearing securities that never need refinancing.

If for example 25% of the national debt has been exchanged for zero coupon perpetual securities (cash), then an 80% debt to GDP ratio effectively gets transformed into a 60% debt to GDP ratio, as 20% costs nothing to finance, never has to be repaid, and so is therefore effectively free finance.

The more of your outstanding debt you can finance at zero cost forever, the more debt you can sustain. If this free financing is undertaken responsibly it can be used as a sensible economic tool. However, if the temptation of free finance results in a misallocation of resources via the state, then it can be very harmful to the economy. This is why many economies have introduced the concept of an independent central bank to remove some of the political process from the real economy.

So far, the BoE has convinced the market that QE is a responsible policy. The use of QE has neutered the bond vigilantes, whilst the next enemy of this policy, the currency vigilantes, remain dormant.

The BoE could officially cancel the gilts or could simply exchange its existing gilts at maturity for new gilts to maintain the windfall gain of free finance. This topsy turvy world of money printing, low bond yields and free financing is a new challenge for investors.

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Paying the locusts – what the PSI means for Greek bond investors

Early this morning it appears that at last Greece and the European authorities are at the final stages of  launching a bond swap with the private sector – known as the private sector involvement (PSI) procedure – which will aim to reduce Greece’s debt-to-GDP ratio to 120.5 percent by 2020 (currently 160 percent). The deal will receive blanket press coverage, we are going to focus on the PSI element.

The PSI ensures that the private sector will suffer a real loss while the public sector (national European central banks and the ECB) will not suffer any losses. Central banks have this privileged position as they are prepared to provide further finance to Greece (akin to a rescue rights issue diluting existing shareholders). Of course, it is not in the politicians’ interests for the central banks to bear any losses as a result of lending to Greece and of course it is the politicians that set the legal and regulatory framework. Not only can politicians change the goal posts, they can change the ball you are playing with. Politicians, and the authorities, are exercising their imbedded power.

This deal will cause the private sector to suffer a disproportionate level of losses both in absolute and relative terms to the public sector. This punishes the private sector investor in Greek debt relative to the private speculator who was short Greek debt. We noted in an earlier blog that governments perceived owners of their debt to be good investors, whilst investors holding short positions in government debt are evil speculators.

The problem with the PSI procedure is that it does not reward these economic agents accordingly. This PSI precedent means that in the future, should a government debt crisis occur, private investors will be less willing to support troubled government debt, and speculators will be rewarded for being short. Obviously this will impact the sustainability of government finances at precisely the time they would be seeking to generate confidence in their ability to service their debt obligations.

What does this PSI look like in pounds, shillings, and euro cents? Those investors that are short Greek debt will make money, the legal power of the state means the authorities suffer no damage, while the private sector will suffer losses. The locusts will feed well, the authorities will not eat less, and the private investor will waste away.

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The hot money has flown south to Australia for the winter, but will it fly back in the summer?

On Friday we had a Dumb and Dumber moment in the office when a colleague for a few seconds thought that Australia had lost its AAA rating.   The error was quickly realised (it was Austria that was downgraded) and Australia kept its AAA rating across the board that it has had with Moody’s and S&P since 2002 and 2003 respectively (although Fitch only upgraded Australia’s foreign currency rating to AAA in November 2011).

There were however some disturbing figures that came out of Australia on Friday – foreign investors bought a record AUD$23.9bn (=US$23.9bn) of Australian government bonds in Q3 2011, resulting in foreign ownership soaring to 80.4%, which is also a record.  Judging by the price action on Aussie bonds and the Aussie Dollar in Q4, foreign ownership is likely to have jumped further in Q4.  For us, this is worrying as heavy foreign ownership of government bonds can be very dangerous, particularly when this is combined with a country running a current account deficit (i.e. the country is reliant on capital inflows from abroad).  Ireland and Portugal, which saw similar levels of foreign ownership before the crisis hit, are great (or poor?) examples of how this combination can leave a country’s exchange rate and solvency very exposed if the country hits a crisis.

Of course, Australia does have some big advantages over the Ireland of 2006. Australia has the ability to print its own currency and set its own interest rates (just ask the Irish how much they would like this power right now). Secondly, despite the massive expansion in credit and house prices that Australia has experienced over the last two decades, Ireland’s was comparatively greater. The run up in Australian house prices since 1990 is reflective of a massive increase in household debt (fuelled by the Aussie banks) and is not the product of more fundamental factors such as population changes or rental income equivalents. Additionally, there is likely to have been a change in demand, as years of rising prices that have made the Australian housing market one of the most expensive markets in the world on price-to-income and price-to-rent ratios (as The Economist pointed out last November) have probably changed household formation dynamics.

Australia’s current account deficit is currently only 1.5% of GDP which is far from alarming. However, on a cumulative basis, Australia has averaged a deficit of 4.8% since the beginning of 2003 which should have investors’ alarm bells ringing.  The credit bubble in Australia (credit bubbles usually accompany large credit account deficits) has never really popped (we wrote about Aussie housing market here). The end of a bubble is always difficult to predict and identifying the trigger for such an unwind is similarly fraught with difficulty. Given that markets are extremely sensitive to the potential for asset price bubbles bursting and with the effects of such events still in mind, the Australian housing data are key to AUD maintaining its lofty levels.  Something else that is worrisome is that the Australian banking sector dwarfs the size of Australia’s economy at 3.5 times nominal GDP (Ireland’s banking sector was 4.4 times GDP in 2008).  The key challenge facing the Australian banking sector is its exposure to the housing market, with about two thirds of assets on the banks books consisting of housing loans.

The following chart shows the AUD/USD currency rate versus foreign ownership of Australian government bonds going back to 1989.  It appears that there is a positive correlation which makes a lot of sense – obviously if foreigners are buying government bonds in large size then the currency should strengthen.  In fact, we think this is precisely why the British Pound has been surprisingly strong over the last six to nine months as the UK government is one of the few AAA sovereigns still standing and has been the beneficiary of a huge safe haven bid.  Of course, if this safe haven status gets called into question, which could easily happen in both Australia and the UK, then capital outflows would leave their respective currencies extremely vulnerable.  On this front the UK’s current account deficit of 4% of GDP recorded in Q3 2011 wasn’t exactly encouraging – since 1955, it has only been worse in Q2 1974 (which preceded sterling’s 1975-76 collapse and IMF bailout) and from Q4 1988 to Q2 1990 (which was a symptom of the UK’s housing bubble and preceded the pound’s sharp fall after it was booted out of ERM in 1992)

The obvious catalyst for the popping of the great Aussie bubble is China, as that’s essentially all that matters if you’re taking a view on Australia’s economy. Almost 70% of Western Australian and Queensland mining exports go to China.  If China has a hard landing then Australia is in serious trouble, and even if it has a soft landing then Australia may be in trouble anyway. If China wobbles or the Australian housing market starts to correct, the RBA would be forced to cut interest rates as it did late last year, reducing the Aussie Dollar’s appeal as a higher yielding currency. The Aussie Dollar is only just over 3% below its strongest ever on a trade weighted basis, and we think that leaves it looking very vulnerable. With the market pricing in a reduction in the RBA cash rate of 1% to 3.25% by August, will the hot money fly away from Australia in the summer?

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