The Fed’s Policy Mechanics Retool for a Rise in Interest Rates

It’s easy to take for granted the Federal Reserve’s ability to raise interest rates. Even among the legions who doubt that Fed officials will pick the ideal moment to start increasing rates for the first time since 2008, few question the Fed’s technical competence. The central bank has a long history. The engine is known to work.

So it may come as a surprise to learn that the old engine is broken. When the Fed decides that it’s time to “lift off” — perhaps this week, but more likely later this year — it will be relying on a new system, assembled from spare parts, to make interest rates rise.

There is a general agreement among economists and market analysts that the Fed’s plans make sense in theory. A team led by Simon Potter, a former academic who now heads the Fed’s market desk in New York, has been testing and fine-tuning the details by moving billions of dollars around the financial system.

But markets have a long history of scrambling the best-laid plans.

“If something is going to go wrong, I haven’t been able to figure out what, but there’s a lot of reason for caution,” said Stephen G. Cecchetti, the former chief economist at the Bank for International Settlements. “We’ve never done this before.”

The stakes are huge. The Fed is in charge of keeping economic growth on an even keel: minimal unemployment, moderate inflation. It tends to operate conservatively and to change very slowly because when it errs, the nation suffers.

Yet the Fed has found itself forced to experiment. The immense stimulus campaign that it started in response to the 2008 financial crisis changed its relationship with the financial markets. It has pumped so many dollars into the system that it cannot easily drain enough money to discourage lending, its traditional approach. Instead, the Fed plans to throw more money at the problem, paying lenders not to make loans.

The Fed, embedded in the banking system, has also concluded that working through the banks is no longer sufficient to influence the broader economy. It plans to strengthen its hold by working directly with an expanded range of lenders.

Fed officials have repeatedly expressed confidence that the plan will work. “The committee is confident that it has the tools it needs to raise short-term interest rates when it becomes appropriate to do so,” Janet L. Yellen, the Fed’s chairwoman, told Congress earlier this year, referring to its policy-making body, the Federal Open Market Committee.

And if the new approach does not work at first, Mr. Potter said in a recent speech, then his team of monetary mechanics “stands ready to innovate” until it does.

Freezing, Not Draining

The markets desk at the New York Fed has put monetary policy into practice since the mid-1930s. In the decades before the Great Recession, the desk exercised its remarkable influence over the American economy through its control of an odd little marketplace in which banks could come to borrow money for a single night.

The Fed requires banks to set aside reserves in proportion to the deposits the banks accept from customers. The reserves can be kept in cash or held in an account at the Fed. Banks that need reserves at the end of a given day can borrow from banks that have a surplus. Before the crisis, the Fed controlled the interest rate on those loans by modulating the supply of reserves: It lowered interest rates by buying Treasury securities from banks and crediting their accounts, increasing the supply of reserves; it raised rates by selling Treasuries to banks and debiting their accounts.

As the crisis hit in 2008, the Fed pressed this machine to its limits. It bought enough securities and pumped enough reserves into the banking system to drive interest rates on short-term loans to nearly zero. The federal government now pays about a dime to borrow $1,000 for one month. Companies with good credit pay about a dollar to borrow $1,000 from money market funds and other investors.

But the Fed didn’t stop there. It kept buying Treasuries and mortgage bonds to eliminate safe havens, forcing money into riskier investments that might generate economic activity. As a byproduct, the Fed kept expanding the supply of reserves.

One result is a banking system almost comically awash in money. In June 2008, banks had about $10.1 billion in their Fed accounts. The total is now $2.6 trillion. Picture all of the money in June 2008 as a single brick; the Fed has added 256 bricks of the same size. On top of that first brick, there is now a stack five stories tall.

Bank of America, for example, had $388 million in its Fed account at the end of June 2008. Seven years later, at the end of June 2015, it had $107 billion. The bank could double in size and double again and still have more reserves than it needs.

To switch metaphors, the old monetary-policy machine sits at the bottom of a lake of excess reserves. The Fed would need to sell most of the securities it has accumulated before short-term rates would start to rise. Selling quickly could roil markets; selling slowly could allow the economy to overheat. So the Fed decided to find another way.

Instead of draining all that excess money, the Fed decided to freeze it.

Paying Banks Not to Lend

For the last seven years, the Fed has encouraged financial risk-taking in the service of its campaign to increase employment and economic growth. By starting to raise interest rates, the Fed intends to gradually discourage risk-taking.

The straightforward part of the plan is persuading banks not to make loans.

In a serendipitous stroke, Congress passed a law shortly before the financial crisis that let the Fed pay interest on the reserves that banks kept at the Fed. Written as a sop to the banking industry, it has become the new linchpin of monetary policy.

Say the Fed wanted to raise short-term interest rates to 1 percent, meaning that it did not want banks to lend at lower rates. Because the glut of reserves is so great, the Fed could not easily raise rates by reducing the availability of money. Instead, the Fed plans to pre-empt the market, paying banks 1 percent interest on reserves in their Fed accounts, so banks have little reason to lend at lower rates. “Why would you lend to anyone else when you can lend to the Fed?” Kevin Logan, chief United States economist at HSBC, asked rhetorically.

This is not a cheap trick. Since the crisis, the Fed has paid banks a token annual rate of 0.25 percent on reserves. Last year alone, that cost $6.7 billion that the Fed would have otherwise handed over to the Treasury. Paying 1 percent interest would cost four times as much. The Fed has sent roughly $500 billion to the Treasury since 2008. As the Fed raises rates, some projections show that it may not transfer a single dollar in some years. Instead, the Fed will pay banks tens of billions of dollars not to use the trillions it paid them previously.

At first, Fed officials thought that paying interest to banks would establish a minimum rate for all short-term loans, exerting the same kind of broad influence as the old system. It soon became clear, however, that rates on most such loans remained lower than 0.25 percent. Even banks that needed overnight loans found they could borrow more cheaply. The average rate in July was 0.13 percent — about half of the Fed’s new benchmark rate.

The rest of the financial system is also awash in cash, and lenders — like money market mutual funds — put downward pressure on interest rates as they fight to attract borrowers.

And here’s where the Fed’s plans got a little less orthodox.

The Fed lacks the legal authority to pay these lenders a minimum interest rate on deposits, as it does to the banks. But two years ago, Lorie Logan, one of Mr. Potter’s top aides, suggested the Fed could achieve the same goal by borrowing from these companies at a minimum interest rate.

The resulting deals, known as overnight reverse repurchase agreements, signal a significant break from the Fed’s history of working through only the banking industry.

“We’re pushing more activity out of the regulated banking sector, and so monetary policy has to take account of the unregulated sector,” said Jon Faust, an economist at Johns Hopkins University who until recently served as an adviser to Ms. Yellen, and before that to her predecessor, Ben S. Bernanke. “The world is changing, and I think the bigger risk is not changing along with it.”

When liftoff arrives, however, the Fed plans to place this machinery inside the familiar language of the old system. It is likely to announce that it is raising the federal funds rate, the interest rate that banks pay to borrow reserves, from its current range of 0 to 0.25 percent to a new range of 0.25 to 0.5 percent. The Fed does not plan to emphasize that this rate is now a stage prop or that the real work of raising rates will be done outside the limelight by its new tools.

Mission Control

On weekdays at about 12:45 p.m., the New York Fed’s trading portal, known as FedTrade, plays three musical notes — F-E-D — signaling that Mr. Potter’s shop is open for business. So begins another day of training camp, another test of the Fed’s plans to borrow money from nonbank financial companies.

The Fed’s traders sit at terminals in a converted conference room. Along one wall are five chairs and five sets of computer monitors beneath five historical photographs of the trading desk: men answering phones, men writing bids in chalk on a long board and, in the most recent photograph, from the 1980s, a glimpse of a woman in the background. On another wall is a screen that links the room in New York by videoconference with a backup trading room at the Chicago Fed.

Potential lenders — a preapproved group of 168, including a bevy of money market funds and the housing finance companies Fannie Mae and Freddie Mac — have 30 minutes to offer the Fed up to $30 billion each. At 1:13 p.m., a warning message starts blinking red. At 1:15 p.m., the Fed closes the auction and accepts up to $300 billion in loans at an interest rate of 0.05 percent.

During two years of experiments, the Fed team has adjusted the rates it pays, the amounts it accepts and the time it enters the market, among other variables. Mr. Potter and his lieutenants have also held lunch meetings with investors on the other side of the portal to solicit advice and complaints.

The size of the program poses the most obvious risk. Fed officials limited daily borrowing to $300 billion because they didn’t want to freeze more money than necessary. They also worry about exacerbating market downturns by giving investors a new place to flee. These concerns were heightened by reports that some investment companies were interested in creating money market funds that would be advertised as the safest place to park money — because the money would be parked at the Fed.

Last year, at the end of September, shortly after the cap was imposed, lenders offered the Fed $407 billion on a single day. Demand was so high that instead of asking for interest, some lenders offered to pay the Fed to take the money. The Fed ended up borrowing at zero percent and turning away $107 billion in loans.

A cardinal rule of central banking is that you don’t starve financial markets during panics, and the Fed has been leaning in the direction of doing more. It has already announced that it is willing to borrow at least $200 billion through a parallel program at the end of September this year, for a total of $500 billion. It has also suggested that it may raise the cap during liftoff. “My sense is we’re better off making sure we can maintain control,” James Bullard, president of the St. Louis Fed, said in a recent interview.

Unpredictable Reactions

“This is where the nutty people on the bond-trading desks have control,” joked Alan Blinder, a former Fed vice chairman, when asked if the Fed’s plan would work.

Mr. Blinder’s point was that markets ultimately determined the cost of borrowing money, particularly for longer-term loans like mortgages and corporate bonds. The Fed can be precise in its planning, but the market is unpredictable in its reactions.

Fed officials have emphasized that they do not want the liftoff to surprise investors. “This has probably been the most telegraphed 25-point rate hike in history,” said Wayne Schmidt, chief investment officer at Gradient Investments in Arden Hills, Minn. “I think when they actually do something, it will be more of a nonevent.”

But there are at least three reasons markets are becoming less predictable.

The rise of an interconnected global financial system has weakened the Fed’s influence over interest rates. When the Fed last raised short-term rates, beginning in 2004, officials were surprised that long-term rates failed to rise because foreign money was pouring into the housing market and other domestic investments. This time, there are plenty of warnings that the weaknesses of other developed economies could once again make it harder for the Fed to raise domestic interest rates.

“Financial market conditions have come to depend increasingly not only on developments at home but also on developments abroad,” William C. Dudley, the president of the Federal Reserve Bank of New York, said in a February speech in which he cautioned the Fed’s control over those conditions had been “loosened.”

The Fed’s audience also increasingly consists of computer programs that will start buying and selling securities before people have time to read the first words of the Fed’s policy statement, creating the potential for new kinds of chaos.

On Oct. 15, for example, automated trading programs drove up the price of 10-year Treasuries in a burst of buying so intense that a government report later found the machines bought more than 10 percent of the securities from their own firms. Then, just as quickly, the computers turned around and drove prices back down.

The 12-minute spree was among the largest price movements ever seen in one of the world’s most liquid markets, yet the government report found no clear cause.

Finally, investors say regulatory changes are keeping some large traders on the sidelines, making it harder to buy and sell, even in the highly liquid market for Treasuries. That can exacerbate market movements because when people are in a hurry to buy or sell, they tend to chase the best available offers. “The depth of the market is not what it used to be,” said Tad Rivelle, chief investment officer for fixed income at TCW, a Los Angeles investment firm that manages some of the world’s largest bond funds. “You can get the same trades done, but it takes more time.”

Other observers, however, urge a broader perspective.

“People are very concerned about those 12 minutes last year,” said Mr. Cecchetti, now a professor of finance at the Brandeis International Business School. “I’m very reassured by the fact that there were only 12 minutes.”

Moreover, Mr. Cecchetti said that removing some liquidity was a good thing because much of that liquidity was a result of public subsidies for the banking system that had encouraged undue risk-taking.

“Does it mean that there’s going to be more high-frequency volatility? Sure,” he said. “It means the Simon Potters of the world are going to have to be much more careful about what they’re doing. But that seems to me to be kind of O.K.”

Volcker’s Messy Lesson

Mr. Potter has worked at the New York Fed since the late 1990s, but he spent most of his career there in the research department before taking over the markets desk in 2012. He became more involved in the practical side of the Fed’s work during the financial crisis. In a 2012 speech at New York University, Mr. Potter said the experience — particularly during a four-week period at the peak of the crisis — had impressed upon him the limits of theory, the need to understand what investors are thinking and the value of flexibility in policy making.

“For economists who did not have the opportunity to observe the panic up close as I and most of my colleagues had, the developments in this four-week period must have been bewildering, given how widely events on the ground and theory diverged,” he said.

That perspective may come in handy. The last time the Fed shifted the basic mechanics of monetary policy was in the early 1980s, when Paul Volcker was its chairman. That campaign is remembered as a triumph of central banking. Mr. Volcker succeeded in driving inflation down toward modern levels, ending a long period in which governments had floundered helplessly to prevent rising prices.

But Mr. Faust, the Johns Hopkins economist, says the messiness of Mr. Volcker’s triumph is often overlooked. The Fed’s initial plans did not work and were revised and did not work and were revised again — and still didn’t work.

He said the Volcker episode was a reminder that monetary policy is not figure skating. The Fed is likely to flail, he says, but it will be measured by its success in getting interest rates to rise, not by the grace of its performance.

“If you’re into the internal plumbing, I suspect there will be times when that looks messy because this is new,” Mr. Faust said. “But central banks can raise interest rates, and they will. And as long as that happens, from the standpoint of the broader economy, everything is fine and the rest will be forgotten or become a footnote of history.”

Source: http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.htmlhttp://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html

Fed risks using wrong tool to tighten

The Federal Reserve has been sending strong signals that it is preparing to raise interest rates for the first time since 2006. As the Fed prepares for lift-off, its operational framework and large balance sheet may pose challenges to market functioning.

The Fed’s balance sheet has increased from roughly $1tn at the end of 2007 to well over $4tn at present. This stems from about $3.4tn of purchases of US Treasuries and other bonds under the Fed’s quantitative easing programmes. This took such assets out of market ownership to reside on the Fed’s balance sheet.

This is important because market interest rates are effectively determined in the collateral market, such as the repo, or repurchase market, where banks and other financial institutions exchange collateral (such as US Treasuries, mortgage securities, corporate debt, equities) for money.

Financial agents that settle daily margins may post cash or collateral; this forms the core of the financial plumbing. Such “pledged” collateral is generally received by banks not only via repo markets but also from securities lending, prime brokerage agreements with hedge funds, and derivative positions. The largest suppliers of pledged collateral are hedge funds; other sources include insurers, pension funds, central banks and sovereign wealth funds.

The repo rate is an important market signal and should move in tandem with the fed funds rate; hence the need to have good plumbing.

In 2007, the collateral market was $10tn in size; now it is only $6tn. A further reduction lies ahead, threatening to rust the financial plumbing, as the Fed prepares to raise interest rates.

There are two ways the Fed can tighten monetary policy to control interest rates once it has raised them. The first is to use and expand its so-called reverse repo programme, which soaks up large sums of money from non-banks such as money market funds, but does not release collateral from the Fed’s balance sheet back into the market.

The second is to sell US Treasuries, which similarly mops up cash while also supplying collateral.

The reverse repo programme is currently capped at $300bn per day, but the Fed may raise this cap to ensure reverse repos mop up enough cash to maintain a floor on interest rates. Reverse repos work by persuading non-banks to remove dollars deposited with banks and place them with the Fed, in exchange for collateral such as Treasury bonds. So the Fed becomes the new counterparty to the non-bank, while the bank gets “balance sheet space” as the deposits move to the Fed.

Crucially, this process does not release collateral to the market as the operational structure of the reverse repo facility puts practical restrictions on the reuse of collateral. Thus, none of the collateral within the reverse repo programme can be used to post at central clearing houses, in the bilateral derivatives markets, in the bilateral repo market or delivered against short positions.

The consequence of a sizeable reverse repo programme would be that money becomes scarcer as it is drained from the market, thus raising the repo rate, while collateral becomes proportionately more abundant and therefore cheaper. Thus, by targeting the size of the programme, the repo rate can be made to track the fed funds rate; however, this will result in the repo rate not being a market rate.

A better option would be to keep the reverse repo programme size at its present level and sell US Treasuries . These bonds could be sliced and diced for repos and related collateral usage. While the Fed can control the amount sold, collateral gets reused, which is not under the Fed’s control, so the repo rate may not equate to the fed funds rate. However, selling of US Treasuries can be fine-tuned, to reduce a large wedge between two rates.

It is crucial to ensure that the market plumbing does not get rusty through the use of a large reverse repo programme. A deep and liquid collateral market provides price signals (like the repo rates) that would be weaker under a large programme.

For effective monetary policy transmission, all rates should move in sync with the fed funds rate and this requires good plumbing.

Manmohan Singh is the author of Collateral and Financial Plumbing and a senior economist at the International Monetary Fund; views are his own and not those of the IMF

Source: http://www.ft.com/intl/cms/s/0/0d72eaa8-885f-11e5-9f8c-a8d619fa707c.html

Economists: Don’t leave home without one

As business leaders seek to stay ahead of the curve, they should ensure that somewhere in their range of view are the ideas of economists. Not forecasts or models or the dry parade of graphs and equations found in the typical introductory textbook, but rather economists’ insights and ideas, which sometimes have an enormous impact on the evolution of industries and also have been put to use in very practical and profitable ways by real companies. I am an economist, so this assertion may seem a bit self-serving. But I wouldn’t make it if there weren’t powerful evidence in its corner.

In this article, I’ll focus on one example: the Internet economy we know today would not have been possible, in scale or in speed of adoption, without an extremely important policy development of the 1970s and 1980s—the deregulation of transportation—in which economists played an important role. Nor would the business model of two of the Internet’s well-known players have been possible without the embrace of an idea—auctions—that has its roots deep in economics. I don’t think the Internet is an isolated case. I’ll close with an example of how a big economic idea could, in the future, have major implications for another major industry: pharmaceuticals.

Transportation deregulation
Had the transportation industry not been deregulated in the 1970s and early 1980s, and had the much more efficient and flexible systems built by companies such as UPS not emerged in response to competition, it is difficult to see how Internet retailers like Amazon, which came along roughly two decades later, would have been able to get started or succeed. Amazon would have had to begin with its own fleet of trucks or even planes to escape the strictures of the pre-1980 regulatory regime, a barrier to entry that almost certainly would have been impossible for new retailers to overcome.

The deregulation of prices and of entry into the transportation industry—especially interstate cargo air traffic and trucking in the mid to late 1970s—is an exciting story in retrospect, but its importance would have been easy to miss at the time. As such, it is a useful reminder for business leaders of the value of keeping their ears to the ground when big economic ideas are playing out in policy arenas. That this particular dismantling of economic regulation happened at all is an amazing fact that contradicts one widely held notion of political economy: a policy benefiting large numbers of people and businesses in a small way is unlikely to be adopted if it imposes large harm on a small, concentrated number of other individuals and businesses.

Air cargo and trucking fit this description to a T. Economic regulation artificially suppressed competition and kept prices of freight (and passenger) traffic too high. But since freight costs represent only a small fraction of the costs of any retail operation and are not separately broken out, consumers paid only a little bit more than they otherwise might. Moreover, even if consumers knew this, they were too diffuse to oppose the concentrated lobbying efforts of the firms in the transportation industry (and its workforce), which would have been hurt greatly by additional competition. That was true even if the price for keeping it at bay had to be price regulation.

How then did things change in the United States? The starting point was congressional hearings organized by the late Senator Edward Kennedy and his chief staffer on these issues, Stephen Breyer (currently a Supreme Court Justice). The hearings featured economic research that made clear the large price cuts to be expected from dismantling price and entry controls in the airline industry. When Jimmy Carter was elected president, he joined forces with Kennedy (and senators whom Kennedy recruited to the cause) to push deregulation. Carter started with the appointment of two prominent economists, the late Alfred Kahn (as chairman) and Elizabeth Bailey, to the Civil Aeronautics Board, which oversaw the airline industry.

Airline deregulation passed Congress in 1978. Once the deregulation ball was rolling, it next went to the trucking industry, whose prices and routes were just as strictly controlled, even though there were thousands of firms in the industry. Trucking deregulation came in 1980, with the help of some heavy pushing along the way by the Interstate Commerce Commission, headed by another highly regarded economist whom Carter had appointed as chairman (on Kahn’s recommendation): Darius Gaskins. The bottom line is that neither deregulation success would have been possible without many years of prior economic research and, most likely, without articulate economists such as Kahn, Bailey, Gaskins, and the economists they appointed to key regulatory positions. When the stars align in this way, it’s worth paying attention.

Auctions

Economists and their ideas also have had an important impact on the evolution of the Internet directly, not mediated by policy changes, through their championing and theorizing about auctions. In the early 1900s, the whole notion of how prices are set in a market economy was analogized to an auctioneer, since frequently referred to as a “Walrasian auctioneer” in the academic literature. The auctioneer conducts continuous auctions for all kinds of commodities, not just those in scarce supply, to which it was once commonly thought that auctions would be limited.

Auctions played a role in the rise of mobile telephony, which has become deeply intertwined, through smartphones, with the Internet itself. (Economist Ronald Coase proposed auctioning off segments of the electromagnetic spectrum in the late 1950s, an idea that was not adopted until the 1990s.) And auctions also played a direct role in the growth of two well-known Internet companies.

One example is Priceline, launched by Jay Walker, who studied economics at Cornell as an undergraduate and learned his lessons well, especially the lectures and reading materials relating to demand curves, which are constructs in economic textbooks but not directly observable in the real world. Shortly after the Internet’s commercial possibilities became evident, Walker and his colleagues came up with the idea of “name your own price travel”—essentially reversing the typical process, in which firms set prices and then hope that consumers pay them. But Walker’s idea was not just to have consumers offer to pay their own prices: if it had only been that, travelers would have bid a dollar or two, and the airlines and hotels he was seeking to participate (TWA and America West became the first) would have refused. No, Walker’s clever innovation was to require consumers to pay the price they bid if the airlines and hotels on Priceline decided to accept it. That condition made travelers think hard about their bids and induced them to make serious offers.

Priceline is an example of a company founded by an innovator with a background in economics. Another company where economic principles later proved to have importance is Google. The search-engine pioneer generates most of its revenue through an auction-based system of selling ads. The system was developed by two engineers but validated by Google’s chief economist, Hal Varian, who was also the first dean of the School of Information at the University of California at Berkeley.

It’s worth mentioning as a side note that Varian has since overseen the hiring of a large corps of statisticians (mostly) and economists who developed other innovations for the company. Google Trends, for example, tracks search-term volumes, which can be helpful in predicting various real-world events, such as the progress of the flu or forthcoming official unemployment statistics. Indeed, the big data revolution ushered in by the ease of capturing, storing, and analyzing large bodies of data has generated new demand for economists and statisticians. High-tech companies like Amazon, Google, and Yahoo! now employ economists to sift through all kinds of data—retail transactions, browsing patterns, mobile-phone usage—to fine-tune their product offerings, pricing, and other business strategies. While teasing out relationships from masses of data can be helpful, correlations found in them often speak to the past and have limited forward-looking utility. Data mining is likely to be more useful if guided by underlying theories, which is what economists can do.

Looking forward

What do these stories of economic ideas have to do with business leaders today? I’d suggest that, every now and then, economic concepts are likely to make their way forward in surprising places, creating real opportunities for watchful executives and threats for unsuspecting ones. Here’s an idea, developed by economists at MIT, that I believe has promise: the securitization of research and development for pharmaceuticals or medical devices.1

The notion here is to pool the R&D expenses of many different research endeavors, most likely ones that have passed some preliminary vetting (for example, Phase 1 clinical trials mandated by the US Food and Drug Administration). I know that the mere word “securitization” has a bad name in the wake of the financial crisis. But the notion itself is not bad; it’s what’s inside the pools of securities and the completeness of disclosure for investors that matter. Structured the right way, pharma R&D bonds could be not only attractive for investors but also a potentially important way to bring more capital to support research for drug therapies and medical devices that both extend and improve the quality of life for millions of people.

When and how this kind of securitization will happen I don’t know. But I do believe that pharmaceutical researchers and leaders should keep an eye on the potential for it, and I will be surprised if, at some point, economic and financial value don’t shift in surprising ways as a result. Business leaders are unlikely to catch signals like these, though, if they limit their focus on economics to one-off situations—listening periodically to the forecasts of economists, hiring them as experts in lawsuits, or seeking their assistance in very specific projects, such as how best to bid in upcoming federal auctions for the electromagnetic spectrum.

I believe economists have a broader and more ongoing usefulness for business. John Maynard Keynes, one of the most famous economists of them all, surely was right when he observed that “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” The one qualification I would add is that the originators of the ideas need not be defunct; economics is a living field whose generation of ideas with business relevance bears watching all the time.

Source: http://www.mckinsey.com/insights/economic_studies/economists_dont_leave_home_without_one

Global savings glut suppresses bond yields

Demographics is destiny. This may be a truism for political scientists, but investors ignore the implications at their peril.

At the moment, investors are desperately trying to divine when and how quickly the Federal Reserve will begin to raise interest rates, and the impact on bond markets. The consensus is that any turbulence will be transitory, and bond yields will continue staying “lower for longer”. But don’t bet on them staying low for ever.

 

One of the most notable developments in global markets in recent decades is the inexorable march downwards in bond yields. Since Paul Volcker’s Federal Reserve broke the back of inflation in the 1980s by aggressively hiking interest rates, bond yields have fallen steadily to unforeseen, record-breaking lows — almost irrespective of where the Fed’s main policy rate has been set.

This is partly a result of dissipating inflation, the historical nemesis of fixed income. More recently, extraordinary monetary stimulus has suppressed yields further, driving investors into bonds, with pension plans and insurers major buyers of long-term debt.

But according to many economists, it is also a product of a “global savings glut” from baby boomers stashing away their earnings for their retirement, and developing countries building up their reserves. This has lifted demand for bonds and subduing borrowing costs in the process.

This hypothesis was first articulated by former Federal Reserve chairman Ben Bernanke in 2005. He recently revisited the thesis in a blog post at his new home at the Brookings Centre, arguing once again that the savings glut is a leading cause of low bond yields, not just central bank interest rates or quantitative easing.

According to recent research from Michael Gavin at Barclays, the savings bonanza could account for about 2 percentage points of the decline in the “natural” real interest rates — adjusted for inflation and the economic cycle — over the past three decades, from about 2 per cent in the 1980s to roughly zero today.

But this is unlikely to last. western baby boomers have started retiring and in the coming years will draw down their savings, as the number of working-age people declines.

The developing world is unlikely to be of much help. HSBC’s Karen Ward estimates that emerging economies will add 330m more “peak savers” by 2030, but reckons that this capital is now less likely to flow into western financial markets. “The baby boomers’ twilight years may not be so golden after all,” she warns.

Quantifying the impact is tricky. But Mr Gavin estimates that all things being equal the natural real interest rate will rise by about 1 percentage point over the next five years, 2.25 percentage points over the next decade, and 3.5 percentage points over the next two decades.

Even this may underestimate the coming rise in longer-term bond yields, given that they are currently well below the natural rate thanks to the extraordinary monetary stimulus unleashed by central banks led by the Fed in the wake of the financial crisis. Like a balloon held below water, it may snap higher when finally released.

Equity markets are also likely to be rattled. Niels Jensen of Absolute Return Partners pointed out in a recent letter to clients that middle-aged workers tended to favour stocks, but shifted sharply into bonds when retirement loomed. “What has been a tailwind for many years is likely to turn into a sizeable headwind in the foreseeable future,” he warned.

Still, nothing is set in stone. The financial crisis and the uncertain future facing many pension plans could lead to a long-lasting shift in attitudes towards thrift. How savers respond to shifts in interest rates remains unclear. Countries could also respond to the demographic challenges by lifting retirement ages or becoming more receptive to immigration.

Japan is the canary in the coal mine. Its household savings rate has declined in tandem with the average age, which is now the highest in the world. But so far there is no discernible impact on the Japanese bond market. Corporate savings have climbed as investments have dipped, and the Bank of Japan’s QE programme has pinned down yields.

But the forces of demographics move slowly, and it will take years — possibly decades — before any impact becomes apparent.

Source: http://www.ft.com/intl/cms/s/0/fda6e646-e4d1-11e4-8b61-00144feab7de.html#axzz3XmTZNo6e

Broke but never bust: The ECB and Swiss National Bank should be much more relaxed about losing money

 

CONTEMPORARY central banking is a strongbox of oddities. Deposits, which normally pay interest, can now incur a charge. Investments in government debt, which normally offer a return, give a negative yield. Faced with this weirdness central banks are trying to respect some cardinal rules of finance, with the Swiss National Bank (SNB) and the European Central Bank (ECB) taking steps to protect themselves from losses and ensure that their balance-sheets add up. The experience of several poorer places suggests they are wrong to do so.

In calm times central banking is simple and profitable. Central banks’ assets—mainly bonds issued by rich countries and blue-chip firms—pay a decent return. Their liabilities—deposits made by high-street banks and banknotes—cost them little or nothing. With this wedge between income and outgoings shareholders receive a dividend. The SNB paid dividends of SFr1 billion ($1.15 billion) to Switzerland’s federal and regional governments in 2012. The ECB’s 2013 payout—divvied up across the euro-area national central banks—was €1.4 billion ($1.9 billion).

The financial crisis changed the business. For one thing central banks are far bigger (see left-hand chart). Between 2006 and 2014 central-bank balance-sheets in the G7 jumped from $3.4 trillion to $10.5 trillion, or from 10% to 25% of GDP. And the assets they hold have changed. The SNB, aiming to protect Swiss exporters from an appreciating currency, has built up a huge stock of euros, bought with newly created francs. The ECB, mindful of tight credit, has lent money to banks and bought corporate bonds. And on January 22nd, as The Economist went to press, it was expected to announce that it would start buying government debt.

The expansion would be greater but for worries about cashflow and capital. Bonds that paid 5% or more ten years ago now yield nothing, and other investments have performed badly (the SNB was stung by a drop in the value of gold in 2013 and cut its dividend to zero). Concerned that its euro holdings might lose value the SNB shocked markets on January 15th by abruptly ending its euro-buying spree. Worries that QE will lead to losses if struggling governments default on their debt have caused weeks of wrangling at the ECB, and may prevent it from buying Greek bonds.

From a narrow accounting perspective this caution seems prudent. With capital of €95 billion supporting a €2.2 trillion balance-sheet, the Eurosystem (the ECB and the national banks that stand behind it) is 23 times levered; a loss of 4% would wipe out its equity. Since two central banks have suffered devastating crunches recently (Tajikistan in 2007, Zimbabwe in 2009) the standard logic seems to apply: capital-eroding losses must be avoided.

But the worries are overdone. For one thing central banks are healthier than they appear. On top of its equity, the Eurosystem holds €330 billion in additional reserves. These funds are designed to absorb losses as assets change in value. Even if the ECB were to buy all available Greek debt—around €50 billion—and Greece were to default, the system would lose just 15% of these reserves; its capital would not be touched.

And even if a central bank’s equity were wiped out it would not go bust in the way high-street lenders do. With liabilities outweighing its assets it might seem unable to pay all its creditors. But even bust central banks retain a priceless asset: the power to print money. Customers’ deposits are a claim on domestic currency, something the bank can create at will. Only central banks that borrow heavily in foreign currencies they cannot mint (as in Tajikistan) or in failing states (Zimbabwe) get into deep trouble.

A helpful bias

The survival of threadbare central banks proves the theory. In the 1980s many emerging-market central banks faced sharply appreciating exchange rates and bought up dollars with newly created cash to cheapen their currencies. Since inflation was a worry they “sterilised” the purchases, mopping up the money by selling bonds to investors. With low-yielding assets (dollars) and high-cost liabilities (domestic-currency bonds) they locked in losses, as a 2008 paper* by Peter Stella and Ake Lonnberg of the IMF shows. By the late 1980s the central banks of Jamaica and Nicaragua were regularly losing 5% of GDP or more per year. After 20 years of losses Chile’s is in negative equity (see right-hand chart).

While none of these banks toppled, hawks have other fears. Like any firm, central banks face running costs. The urge to pay the bills could tempt them to print money rather than focus on inflation. Another worry, set out in a 2005 paper by John Dalton and Claudia Dziobek of the IMF, is that low capital could lead to a loss of independence. While negative capital doesn’t matter much it doesn’t look great; a central bank embarrassed by its capital deficiency might seek a capital injection from its finance ministry and be captured by boom-hungry politicians. In either case, capital erosion might mean a bias towards higher inflation.

There is some evidence for this. In a 2012 paper Gustavo Adler and Camilo Tovar of the IMF and Pedro Castro of the University of California, Berkeley, test the relationship between bank capital and interest-rate policy. Collecting data for 41 advanced and emerging economies between 2002 and 2011, they work out what a hypothetical central bank, behaving optimally, would do. They contrast this with the central bank’s choices and seek to explain why the two might diverge. They find that large deviations can be explained by a weak capital position. Flaky-looking central banks might lower interest rates by up to 72 basis points.

Doves should cheer this. Falling returns on government bonds mean central banks’ income will dwindle. Given their pumped-up balance-sheets, some losses are likely. None will fail, but a few might chase their losses by printing money and pushing rates down. In a world on the brink of deflation, bias towards a little more inflation would be no bad thing.

Source: http://www.economist.com/news/finance-and-economics/21640363-ecb-and-swiss-national-bank-should-be-much-more-relaxed-about-losing

Out of favour Reits offer contrarian rate bet

This is a tough time for contrarians looking for bargains in the US equity market. Everyone is still enjoying the dance. Bad news does little or nothing to dent enthusiasm.

There is, however, at least one sector that has conspicuously failed to join in the party. Real estate investment trusts started to drop sharply back in May, and have not recovered. Virtually the entire sector suddenly went out of favour.

Using the FTSE-Nareit indices, US Reits are down 10.1 per cent since the beginning of May, even when yield is included, while the iShares Mortgage Real Estate exchange-traded fund, which tracks the Nareit index of mortgage Reits, has fallen 19.8 per cent. Meanwhile, the S&P 500 has gained 15.4 per cent.

There is an obvious reason for this. Reits are an interest rate play. Reits rely on debt markets to finance their attempts at growth, making them rate-sensitive.

They are required to pay out at least 90 per cent of their taxable income in dividends each year to maintain their status. With short-term interest rates held close to zero by the Federal Reserve, this made Reits very attractive – especially as they can now easily be bought through exchange traded funds.

Once the Fed started talking about “tapering” its monthly bond purchases, it was no surprise that bond yields rose and Reit shares fell.

The response to the Fed’s decision not to taper in September, however, has been surprising. Stocks have set new highs, but 10-year bond yields are still a full percentage point above where they were when taper talk started in May. Other instruments popular for their high income, such as utility stocks, high-yield bonds and master limited partnerships holding oil pipelines, have recovered significantly. Yet Reits are bumping along, barely above their lows for the year.

Reit opportunity?

Could this have created a Reit buying opportunity? There are two ways this might happen. First, the market may be wrong about interest rates. The consensus expectation is that tapering will happen fairly early next year, probably in March. While not great for Reits, the sell-off so far should have taken much of this risk into account.

If this does not happen, or if incoming Fed chair Janet Yellen succeeds in jawboning bond yields downward with strong forward guidance, then securities that offer an income will be popular again. That points particularly to Reits which hold mortgage-backed bonds – which have recently fallen far out of favour. A recent brutal sell-off hit Reits such as Annaly (now at its lowest level in more than a decade) and American Capital (at a four-year low), which hold bonds issued by the federal mortgage agencies and fund themselves largely through the repo market. When rates are rising, leveraged plays on mortgage-backed bonds are naturally unpopular, so these could be value traps.

What are the chances the market is wrong about rates? Under Mr Bernanke, the Fed tried to persuade traders that tapering was not the same as tightening monetary policy, and failed. Ms Yellen is geared to make another attempt; staff at the central bank have had an extra year to make their case, and this time they may succeed.

Also, the US economy might fail to continue its recovery, causing rates to fall.

Look for value

A second way for Reits to offer value lies in the way investors bought them during the upturn. The average Reit buyer would have been unlikely to have taken notice of any statistic other than yield, and buying through ETFs – almost by definition indiscriminate – has dominated the sector.

So, anyone with a grasp of how to value a Reit should be able to find bargains. Look for value, and for Reits whose line of business gives them a chance of strengthening in line with the market – even if rates rise and the economy recovers.

As a whole, US equity Reits trade at a discount of 6.8 per cent to net asset value, according to SNL Financial. But some are at a far deeper discount, with multifamily rental Reits selling for 18 per cent less than their net asset value.

Is this as tasty as it looks? Jason Lail, manager of property research for SNL Financial, suggests this sector could offer protection if rates rise as expected. Demand to rent apartments might rise if mortgage rates rise, putting ownership out of reach for many. And if the economy is strengthening, the army of twentysomethings now living with their parents might have enough money to rent.

Another sector that should benefit from an economic rebound is hotels (whose “leases” are renewed every night, and which trade at slightly below their net asset value).

Any move into Reits is a bet that the market is wrong about rates. But for anyone who thinks US rates will fall or stagnate next year, Reits repay close study. After an almost uniform rise in the US market, they appear to be the most attractively priced way to make that bet.

Source: http://www.ft.com/intl/cms/s/0/9520ba6a-56b7-11e3-8cca-00144feabdc0.html#axzz3PTZUNDox

Don’t fight the US Treasury bond rally

The consensus among market watchers last September was that, with US interest rates so low and the US Federal Reserve about to withdraw stimulus, interest rates would trend higher. I took a different view, writing in a commentary that “10-year rates may be heading back to 2.25 per cent or lower”.

When 10-year Treasury yields ended 2013 at 3.02 per cent, some may have thought I had taken the wrong end of the bet. But in early August, 10-year Treasury yields went as low as 2.35 per cent and I believe the path of least resistance on interest rates is still lower.

A number of factors have helped push Treasury yields lower. With yields on German 10-year bonds at historic lows of about 1 per cent and Japanese government bonds yielding around 50 basis points, Treasuries look comparatively attractive. Add to that the perception that both the yen and euro are a one-way bet towards depreciation and it is reasonable to expect that international capital will continue flowing towards the US, pressuring Treasury yields down as quantitative easing draws to an end.

Tensions from Ukraine to Iraq have added to a flight-to-quality trade, boosting demand for Treasuries. With the size of incremental US government borrowing also expected to decline because of shrinking federal budget deficits, Treasury yields could move lower.

Reduce rate risk

My original forecast of 2.0-2.25 per cent still seems reasonable. Nevertheless, markets do not move in straight lines, so yields could retrace to 2.5 per cent in the near term. Ultimately, as rates head back towards 2 per cent portfolio managers should use the rally to reduce interest rate risk.

As anyone experienced in investing in the US mortgage market knows there is a phenomenon that traders call the “refi bid”. When interest rates fall, a larger percentage of mortgages becomes economically attractive to refinance at a lower interest rate.

Whenever a threshold is breached where a large amount of mortgages make attractive refinancing candidates, prepayments spike up dramatically and portfolios that own mortgages have a sudden surge in cash. This causes portfolio duration to shorten and leads to a need to buy longer duration assets in order to maintain the target portfolio duration. This demand surge can result in a sudden and dramatic decline in rates.

Currently, I estimate that the next “refi level” will hit when the 10-year Treasury yield drops to about 2.25 per cent.

An unusual feature of this potential wave of mortgage refinancing is that the vast majority of US mortgages are on the cusp of being candidates for refinancing, given the relative stability of mortgage rates over the past year or so.

Additionally, there is one dominant holder of these mortgage securities that has vowed to reinvest in new mortgages as prepayments come in – the Fed.

Traditionally, in a refinancing rally, spreads on mortgage-backed securities widen due to increased prepayment risk and expected increases in supply. Spreads will not widen on this occasion to the same extent as during previous refi rallies for a number of technical reasons.

Among those reasons is that the Fed, the biggest mortgage investor on the block, has made clear it will reinvest principal repayments dollar for dollar. Normally, the widening in mortgage spreads mutes the impact of the rate decline on mortgage rates, slowing the pace of refinancing.

This time, advertised mortgage rates are likely to fall more rapidly than in prior refi experiences.

Selling opportunity

Given the likely rapidity of the interest rate decline, the potential for shortening in the duration of fixed income investment portfolios could further intensify the current rally and lead to a more extreme decline in rates than would normally be anticipated.

Declining mortgage rates will also give a lift to housing affordability, which could help clear unsold inventories of homes and support new construction activity. This would further support the US economy.

Ultimately, this expected run-up in bond prices and the associated decline in interest rates should prove unsustainable once the refinancing bid is past. For the near term, risks favour lower interest rates – perhaps sharply lower. In the medium term, as the economy strengthens further, this rally will reverse itself and will have proven to be a selling opportunity.

It is premature to sell now, but as 10-year Treasury yields approach 2 per cent it should provide an opportunity to rebalance portfolios. In other words, don’t chase the rally, but don’t fight it either. The opportunity to sell bonds is coming – but not just yet.

Source: http://www.ft.com/intl/cms/s/0/ece5bb60-22e0-11e4-9dc4-00144feabdc0.html#axzz3AkAuS7S0

End of QE will test diversification faith

Diversification, the great free lunch of investing, is often taken for granted by investors. Bonds and equities have acted as effective portfolio diversifiers for much of the new millennium because of their different return and volatility patterns. Two of the three main assets in a typical portfolio, cash being the third, moved in opposite directions during financial crises such as 2001 and 2008.

Indeed, portfolio management has become accustomed to this trend and now treats it as an article of faith. But does this faith represent a dangerous cocktail of overconfidence and extrapolation?

The mantra that monetary policy is driving market returns is well rehearsed. Less obvious is the idea that policy is driving the relationship between bond and equity returns.

This year gave a flavour of things to come: a period of high turbulence in May and June as markets took on board the possibility the global liquidity flood was about to abate. Bonds fell sharply and equities stumbled as investors fretted about an end to the Federal Reserve’s emergency asset-buying. Price volatility rose in both mainstream asset classes. Using US equities and 10-year bonds as proxies, the correlation was negative from 2009 to the middle of this year and positive thereafter.

Shock absorbers

Next year could mark a turning point as policy makers exiting the triage phase of recovery from the Great Financial Crisis move away from a material reliance on monetary activism into the potentially more volatile territory of forward guidance.

What does this mean for fixed income? Suppose there is one dominant, price-insensitive buyer (the Fed). Now suppose this buyer has a progressively smaller wallet. All other things being equal, the volatility of prices rises as buyer and seller strive to match each other. Add in another group of (reasonably) price-insensitive buyers (China and the like) downsizing their spending due to slowing growth in foreign exchange reserves, and this risk expands.

Of course, there are shock absorbers. First, the developed world’s ageing populations and their agents (think insurers) have a structural bid for yield. Second, the Bank of Japan is expanding its monetary easing . Some of governor Haruhiko Kuroda’s largesse eventually will pass through Narita Airport as growing shortages of domestic bonds force local institutions to shake off some of their home bias. The conclusion? Do not expect a fixed income bloodbath in 2014 – but brace for more volatile returns.

How about equities? 2013 will probably be known as the Year of Equity. The problem: the numerator of the price to earnings ratio (price) has been driving returns in most markets this year, rather than the denominator (earnings). Higher pricing of the final claim on corporate cash flows – equity – has been aided by the tightest debt spreads on record, insatiable demand from yield-hungry investors, and the ability to refinance and extend fixed obligations at low cost. This works well for a while, but at some point earnings need to come through.

Theory has it the discount rate partially connects bonds (fixed coupons discounted by an interest rate) and equities (fluctuating cash flows discounted by this interest rate plus some variable risk premia). Here is the rub: arithmetically, the lower the real interest rate, the greater the volatility triggered by small changes. If the major driver of returns (policy) becomes more volatile, so do the assets that have benefited from that support.

QE tide turns

Clearly the unprecedented monetary stimulus tide will not last forever. When it dwindles, what will become an effective diversifier of portfolio risk? Bonds or equities? Not entirely; see the drawbacks described above. Cash? Perhaps, but if rates rise for longer-dated bonds and remain anchored by policy for short-dated issues, the diversification benefit of a near zero return is limited.

Challenging the assumptions of the past at a time of regime change is vital in financial markets. This means rethinking fixed income to seek out relative value between bonds, capitalising on rises in volatility and harvesting risk premia. In other words, taking an unconstrained approach. It means a focus on alternative strategies that do not start with the discount rate. Examples are infrastructure and real estate debt, opportunistic acquisition of long duration assets chased off bank balance sheets by regulation and market neutral long-short strategies.

Any reversal in the policy tide involves uncharted territory. A reversal in the 30-year downward trend of rates must, however, involve some different results. 2014 may very well become known as the year in which unwary investors ask: “Who stole my diversifier?”

Source: http://www.ft.com/intl/cms/s/0/0687562c-5e7f-11e3-8621-00144feabdc0.html#axzz2nwa2gnpW

France in Fed taper line of fire

When France’s weak economy and public finances are panned by international critics, its politicians have an easy riposte: just look at our bond yields.

Paris can borrow at lower costs than London, and the spread between French over German 10-year bonds has remained remarkably stable over the past year. Standard & Poor’s early morning announcement two weeks ago of another downgrade – this time to double A – failed to cause markets to choke on their croissants. Investing in French assets cannot be so awful.

Could that change as the US Federal Reserve starts to wind back its exceptional stimulus measures? Among investors I have spoken to recently, a school of thought is developing that it might.

During the global “taper turmoil” earlier this year – the weeks after May 22, when Ben Bernanke, Fed chairman, first hinted at his plans to taper, or scale back Fed asset purchases – eurozone bond markets remained surprisingly tranquil, even as emerging markets sold off sharply.

But while global policy makers and economists still struggle to understand the interlinkages between Fed actions and global markets, it seems implausible that Europe can escape unscathed when tapering becomes real, perhaps as early as December. After all, “global QE” – quantitative easing by the Bank of Japan as well as the Fed – drove European bond prices higher and yields lower; taper turmoil showed the potential for disruption when it goes into reverse.

Stabilising factors

If there will be European fallout, where will the effects be worst? Intuitively, the weaker eurozone “periphery” economies seem most at risk of a market correction as global QE ebbs, especially if fresh taper turmoil increases investors’ risk aversion.

In fact, countries such as Spain, Italy and Ireland have benefited from four stabilising factors this year.

First has been their transition – thanks to the European Central Bank acting as a backstop – from existential crises to something nearer normal economic conditions. Growth is low and unemployment alarmingly high, but the danger of imminent ejection from the euro has gone.
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Second, at least Irish and Spanish bonds have benefited as turnround stories, with tangible evidence of structural reforms improving competitiveness and growth prospects.

Third has been the “re-domestication” of Spanish and Italian bond markets – fickle foreign investors have fled.

Fourth, eurozone periphery countries have moved decisively from current account deficits to surpluses; they no longer rely on capital from overseas.

All four supporting factors will remain in place even as the Fed tapers. None, however, apply to France. Instead other reasons explain the impressive performance of France’s bond market this year – and why it might now be vulnerable.

Higher bond yields

When the Fed was ramping up its asset purchases and US Treasury yields were falling, global investors looking for higher returns were attracted by France’s large and liquid bond markets. Until June this year, French 10-year yields were higher than US equivalents.

France was considered part of the eurozone’s safe, northern core, which made it attractive to investors for whom German Bund yields were simply too low. The Swiss central bank was an avid buyer of French bonds, as were Japanese banks.

"Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell off"

The case against France is that if the Fed slows its asset purchases and US Treasury yields rise, those inflows could start to reverse and French bonds would sell off – perhaps sharply.

Eric Chaney, chief economist at Axa, points out the very different debt profile between France and Germany. As a share of GDP, French public sector debt will soon be 20 percentage points higher than Germany’s. Without action to alter France’s debt dynamics, the spread between French and German bonds could widen by 50 or 100 basis points, warns Mr Chaney.

French politicians probably need not worry just yet. Investors shorting French bonds have often lost their berets.

When French yields have hit instability in the past, it has been because of obvious systemic risks – the exposure of its banks to the eurozone “periphery” economies in 2011, for example. Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell off. As the eurozone crisis has lost intensity, eurozone bonds have performed more like “rates” markets, with yields linked to growth and inflation prospects, rather than default risks. France’s economy is contracting, which will curb any uptick in yields.

Still, as Fed tapering draws near, markets may make life less comfortable for French politicians – and limit their bond yield bragging possibilities.

Source: http://www.ft.com/intl/cms/s/0/d1742d9e-5149-11e3-b499-00144feabdc0.html#axzz2lIoVJMpj

Thấp thỏm trái phiếu quốc tế

(TBKTSG Online) - Không có vốn ngoại tệ giá rẻ trên thị trường quốc tế dành cho các tổ chức tín dụng Việt Nam lúc này và cả trong ngắn hạn, sau khi Ngân hàng TMCP Công Thương Việt Nam (Vietinbank) bán hết 250 triệu đô la Mỹ trái phiếu quốc tế kỳ hạn 5 năm với lãi suất cuống phiếu 8%/năm và lợi suất 8,25%. Giới chuyên môn cho rằng các tín hiệu xấu từ tình hình kinh tế vĩ mô của Việt Nam và sự thay đổi liên tục của thị trường thế giới đang là thách thức với các ngân hàng đi sau Vietinbank.

Phong trào “bán mình”

Không riêng Vietinbank, xu hướng tìm vốn ngoại tệ dài hạn trên thị trường quốc tế đã manh nha hình thành từ cuối năm 2010. BIDV (Ngân hàng TMCP Đầu tư và Phát triển Việt Nam), Vietcombank (Ngân hàng TMCP Ngoại thương Việt Nam), ACB (Ngân hàng TMCP Á Châu) và STB (Ngân hàng TMCP Sài Gòn Thương tín) đều có kế hoạch phát hành trái phiếu quốc tế trong năm nay với lý do muốn thay đổi cơ cấu nguồn vốn ngoại tệ dài hạn trước nhu cầu trong nước đang tăng cao.

Vietcombank đặt mục tiêu huy động một tỉ đô la Mỹ từ năm năm 2012, ACB dự kiến đợt đầu tiên sẽ bán 100 triệu đô la Mỹ, BIDV muốn ít nhất 500 triệu đô la Mỹ. Sacombank tại Đại hội đồng cổ đông ngày 26-5 cũng đã trình phương án phát hành 200 triệu đôla Mỹ trái phiếu quốc tế, kỳ hạn 5 năm, dự kiến phát hành vào quí 2 hoặc quí 3 tới.

Các ngân hàng trên là những ngân hàng có thế mạnh về ngoại tệ nhưng vẫn phải tính đường tăng thêm nguồn vốn ngoại tệ dài hạn. Bởi họ đã nhìn thấy nguy cơ cạn kiệt dòng vốn dài hạn ngoại tệ trong nước, khi mà nền kinh tế có nhu cầu đầu tư cho các dự án quy mô lớn mà sự có mặt của ngân hàng đôi khi mang tính sống còn. Nếu các ngân hàng trong nước không đủ sức, thị phần tài trợ vốn ngoại tệ dài hạn sẽ vào tay khối ngân hàng ngoại.

Xu hướng phát hành trái phiếu quốc tế của các ngân hàng thương mại được giới ngân hàng coi là xu hướng tất yếu. “Nguồn vốn đô la Mỹ giá rẻ trong nước đang khan hiếm, nhất là sau khi Ngân hàng Nhà nước áp trần lãi suất huy động 2% đối với đô la Mỹ, những nguồn vốn lớn và dài hạn khó huy động trong nước nhưng nhu cầu tín dụng ngoại tệ của nền kinh tế không suy giảm. Vì thế, việc huy động vốn ngoại tệ dài hạn và ổn định là cần thiết với ngân hàng. Chúng tôi cho rằng vấn đề lớn nhất với các ngân hàng Việt Nam hiện nay khi phát hành trái phiếu quốc tế là đưa ra được mức lãi suất vừa hấp dẫn các nhà đầu tư quốc tế nhưng lại đảm bảo chi phí không quá đắt để có thể kinh doanh có lãi khi dùng nguồn vốn này cho vay tại thị trường trong nước”, đại diện Vietinbank nói với TBKTSG Online.


Một trong đại diện các ngân hàng đang chuẩn bị phát hành trái phiếu quốc tế cho biết, cơ cấu vốn ngoại tệ trong các ngân hàng Việt Nam không khác nhiều cơ cấu nguồn vốn nội tệ, trung bình 85-90% ngắn hạn và còn lại là vốn dài hạn. Trong khi nhu cầu vay của thị trường tối thiểu nửa tổng nguồn vốn là dài hạn. Ví dụ với Vietinbank, họ cần bù đắp thiếu hụt về nguồn vốn đô la Mỹ hiện tại của ngân hàng và đáp ứng nhu cầu vay đô la Mỹ còn cao ở thị trường trong nước. Theo Báo cáo trái phiếu của Công ty cổ phần Chứng khoán Bản Việt, các khoản cho vay bằng đô la Mỹ của ngân hàng trị giá 2,5 tỉ đô la Mỹ, trong khi tổng lượng tiền gửi bằng đô la Mỹ chỉ có 1,3 tỉ. Vì vậy, ngân hàng phải vay thêm 1,2 tỉ từ các tổ chức tín dụng khác.

Không chỉ các ngân hàng, các doanh nghiệp lớn cũng khát ngoại tệ từ lâu. Tập đoàn Than và Khoáng sản (Vinacomin), Tập đoàn Điện lực (EVN), Tập đoàn Dầu khí (PVN) và nhiều doanh nghiệp lớn trong nước đều có kế hoạch huy động vốn trái phiếu quốc tế từ hai năm qua.

Vinacomin đã ra nước ngoài thực hiện một số chương trình giới thiệu (roadshows) năm 2010 song phải từ bỏ việc “bán mình” vì tín hiệu thị trường quá yếu. PVN cũng phải dừng lại kế hoạch gọi vốn trái phiếu quốc tế vì vụ việc Vinashin “bùng lên”, sự quan tâm của thị trường gần như không còn. Sang năm 2011, tình hình thị trường tài chính ngày càng khó khăn và lãi suất đi vay đô la Mỹ của Việt Nam trên thị trường quốc tế trong nhiều tháng đã lên mức rất cao, 11%/năm. Một số doanh nghiệp đành quay sang thực hiện những khoản vay thông thường bằng ngoại tệ nhưng giá vốn và các điều kiện đi kèm cũng không hề rẻ.

"Khẩu vị" thị trường luôn thay đổi

Không phải ngẫu nhiên mà tại các roadshow với nhà đầu tư quốc tế về đợt phát hành theo benchmark size (khối lượng chuẩn, theo thông lệ thị trường benchmarke size vào cỡ là 200-500 triệu đô la Mỹ) của Vietinbank cuối tháng 3 vừa qua ở Singapore, Hongkong, London, Boston, New York và Los Angeles, một phần ba các câu hỏi được giới đầu tư quan tâm đều liên quan đến chiến lược phát triển kinh tế vĩ mô của Việt Nam, tình hình các tổng công ty và các doanh nghiệp nhà nước, tình hình trả nợ của Vinashin, các vấn đề của hệ thống ngân hàng Việt Nam, sự khác biệt giữa chuẩn mực kế toán Việt Nam và thế giới...

“Khi họ đầu tư bất kỳ khoản nào, rủi ro phải được minh bạch hóa để sau đó, nếu họ quyết chấp nhận thì sẽ mua. Cái mà họ sợ là nói thì không rủi ro mấy nhưng thực tế xảy ra sau đó lại rất rủi ro”, ông Phạm Hồng Hải, Phó tổng giám đốc Ngân hàng HSBC Việt Nam nói. “Điều mà giới tài chính quốc tế băn khoăn là liệu rằng việc ứng xử với các khoản nợ quốc tế của Vinashin thời gian qua có phải là thói quen và tiền lệ của Việt Nam hay không? Với các doanh nghiệp nhà nước của Việt Nam, khi doanh nghiệp không trả được nợ thì sự hỗ trợ của nhà nước là gì?”, ông Hải nói tiếp.

Vì sao Vietinbank bán trái phiếu có vẻ suôn sẻ hơn các tổng công ty nhà nước trước đó? Ông Hải giải thích: “Cùng là doanh nghiệp quốc doanh nhưng giới đầu tư quốc tế nhìn thấy ngân hàng là một đặc thù so với công ty nhà nước khác ở Việt Nam. Vinashin sụp đổ, ảnh hưởng nặng nhất với lĩnh vực đóng tàu nhưng ngân hàng thì khác. Ngân hàng mất tiền không chỉ mất vốn của chủ sở hữu mà mất tiền của người dân đang gửi ở đó. Vietinbank có thị phần tín dụng và tiền gửi khoảng 14% toàn hệ thống, lớn thứ hai trong nước về giá trị vốn hóa và họ tin Chính phủ không để ngân hàng sụp đổ”.

Song, nhìn về dài hạn, ba vấn đề nhà đầu tư quốc tế luôn đặt dấu hỏi và coi như nút thắt cổ chai với nền kinh tế Việt Nam là: sự ảnh hưởng ngày càng rộng của khu vực nhà nước, đầu tư công và tái cấu trúc nền kinh tế và các ngân hàng. Kinh tế vĩ mô là cái bóng bao phủ mà các tổ chức phát hành không thể không đối mặt khi muốn vay nợ tại bất cứ đâu. “Kể cả khi doanh nghiệp có tốt đến mấy mà môi trường kinh doanh bất ổn thì nhà đầu tư vẫn lo ngại. Cái đó sẽ hơi khó cho các doanh nghiệp Việt Nam hiện nay”, ông Hải nói. So với các quốc gia như Sri Lanka, Philippines, Thái Lan, Indonesia thì Việt Nam vẫn bị coi là thị trường nhiều rủi ro hơn, bởi các quốc gia này sau khi giải quyết những bất ổn chính trị đã bật lên rất nhanh trên thị trường vốn quốc tế.

Theo báo cáo mới đây của Nomura về đợt phát hành của Vietinbank, các ngân hàng Việt Nam cần đặc biệt quan ngại hơn về 2 yếu tố: Tính minh bạch về chất lượng tài sản của các ngân hàng Việt Nam là khá yếu do sự dễ dãi trong việc phân hạng nợ xấu theo chuẩn mực; Sự hỗ trợ của chính phủ Việt Nam cho các doanh nghiệp quốc doanh có thể không mạnh mẽ như thị trường kỳ vọng, sau sự việc Vinashin vỡ nợ vào cuối năm 2010. Với mức nợ nần cao của các doanh nghiệp tại Việt Nam (sau một thập kỷ tăng trưởng tín dụng quá nóng), tình hình lạm phát, lãi suất cao, và tính thanh khoản yếu trong một số lĩnh vực, Nomura vẫn đang rất để phòng khả năng còn nhiều doanh nghiệp nhà nước sẽ vỡ nợ, khi mà Chính phủ có thể không cung cấp sự hỗ trợ tới toàn bộ các doanh nghiệp này.

Bộ phận nghiên cứu của Citigroup nhận định trong một báo cáo phát hành ngày 11-5: “Với tình hình tài chính yếu, được xếp hạng tín nhiệm ở nhóm thấp nhất trong hệ thống ngân hàng toàn cầu, kế hoạch của chính phủ sẽ bán thêm cổ phần tại Vietinbank, và sự thực về khả năng trả nợ của các tập đoàn doanh nghiệp nhà nước ở Việt Nam vẫn đang gây quan ngại, chúng tôi tin rằng các ngân hàng Việt Nam nên giao dịch ở mức giống như là mức rủi ro của trái phiếu ngân hàng của Mông Cổ với kỳ hạn 5 năm, tức khoảng 9-10%”.

“Trái phiếu là cuộc chơi của thời điểm và ăn nhau ở chỗ ‘chớp’ đúng thời điểm, vì những gì bán được hôm nay chưa chắc bán được vào ngày mai. Thị trường biến động cực nhanh và thay đổi liên tục nên vấn đề là người bán cần xác định rõ ngưỡng chấp nhận của mình đến đâu”, Tổng thư ký Hiệp hội thị trường trái phiếu Việt Nam Đỗ Ngọc Quỳnh nói.

Trong nước, việc huy động nguồn vốn đô la Mỹ trung dài hạn là hầu như không khả thi, đặc biệt là tại các kỳ hạn ba năm trở lên trong khi các ngân hàng cần ngoại tệ dài hạn, mà đợi thì đến bao giờ? Trong khi kinh tế thế giới xì xụp cả năm qua và các tín hiệu xấu từ châu Âu chưa biết bao giờ chấm dứt? Ở trong nước, tình hình kinh tế vẫn tiếp tục khó khăn. Đó là lý do nhiều đề án phát hành trái phiếu ngoại tệ đang nhấp nhổm trên bàn các ngân hàng, doanh nghiệp lớn.

Source: http://www.thesaigontimes.vn/Home/taichinh/nganhang/77207/Thap-thom-trai-phieu-quoc-te.html

Some European Companies Try Bonds to Raise Cash

Among the midsize, family-owned companies that power the German economy, it has long been an article of faith: credit comes from the friendly local banker, not from cold and distant capital markets.

Andreas Dombret, a member of the executive board of the Bundesbank, said the sale of debt by companies was “limited in scope” but a “welcome response” to tighter lending by banks.

 

So Peter H. Leibold was breaking from the norm last year when he decided to finance the expansion of his company, which makes wood pellets for heating and energy generation, by selling corporate bonds. The company, German Pellets, raised more than 80 million euros ($102 million).

Now he is a convert. 

“The advantage of a bond is that you can raise a large amount from a completely different group of investors,” said Mr. Leibold, the founder and chief executive of the company, which is based in Wismar, on the coast in northern Germany. 

Corporate bonds — essentially, interest-bearing i.o.u.’s that companies sell to whomever is willing to buy — have long been an essential borrowing tool for companies in the United States. 

But in Europe, borrowing from banks, whether local ones or big multinationals, has traditionally been the preferred way to raise money. Just 9 percent of corporate credit in the euro zone comes from debt markets, according to the Bundesbank, Germany’s central bank, compared with 64 percent in the United States.

But as the euro zone’s financial crisis has forced many banks to hoard cash and curtail lending, more European companies are turning to bond markets. If the trend continues, it could not only begin reversing the Continent’s longstanding preference for bank credit, but also make the region less prone to banking crises.

There might be resistance, however, from European regulators, who regard such borrowing as a form of shadow banking that they cannot control. In addition, bank lobbyists might fight what they see as competition. 

“People are afraid of a financial system not based on what they know, which is financial intermediation by banks,” said Nicolas Véron, a senior fellow at Bruegel, a research group in Brussels. 

The fears are not unfounded. The propensity of banks in the United States to turn loans into securities that can be sold to investors arguably helped create the subprime mortgage crisis. 

But later on, there was an upside: the practice meant that the fates of companies in the United States were less coupled to those of banks. Not so in Europe, where the problems of credit institutions remain a grave threat to the rest of the economy. 

“Euro-area firms are particularly vulnerable to reduction in bank credit because of their greater reliance on banks for funding,” the International Monetary Fund said in a report last month. 

Companies’ tapping of euro zone bond markets has surged this year, more than doubling to $107 billion in the first quarter, according to Dealogic, a data provider. For the first time since 2009, bond issues surpassed syndicated bank loans as a source of financing for larger companies. 

When even large European banks are cutting back on risk, bond issues enable companies to raise money from investors outside the euro zone who are less affected by the crisis. 

It remains unclear, though, to what extent debt markets can fill the vacuum left by troubled European banks. Bond markets might not help the thousands of smaller companies that form the backbone of the euro zone economy but are too small to attract investors’ attention. 

“The corporate sector in Europe still comprises mostly small- and medium-sized enterprises that will continue to rely on bank loans,” Andreas Dombret, a member of the executive board of the Bundesbank, said in an e-mail. 

The countries that need credit most desperately are also the ones with the highest proportion of small firms least able to gain access to debt markets. Companies with 50 employees or fewer employ 68 percent of the work force in Italy and 62 percent in Spain, according to Goldman Sachs. Those figures compare with 40 percent in Germany. 

“For smaller firms in particular, the fixed costs can simply be too high, rendering a bond issuance uneconomical under all circumstances,” Dirk Schumacher, an economist at Goldman Sachs in Frankfurt, wrote in a report last month. 

But the experience of German Pellets, which had sales of 275 million euros ($350 million) last year and has 500 employees, suggests that bonds could be an alternative for at least some midsize companies.

Mr. Leibold said that it initially had taken some effort to explain to investors why wood pellets were an interesting business. The pellets are a source of renewable energy and are cheaper than oil or natural gas, he told them. 

Mr. Leibold, who founded the company in 2005 after he saw wood pellets being made by small operations in Sweden and realized there was an opening for a mass producer, says his sales are rising — even in Greece — as people and companies look to cut costs. 

Eventually, investors came around. The company used the money it raised to make several acquisitions and build new manufacturing plants, including one in Woodville, Tex., that is to employ 250 people when it is completed later this year. 

German Pellets also continues to draw on traditional bank financing, Mr. Leibold said. But the bond market provides a diversity of fund sources, without the drawbacks of a stock listing. Like many European entrepreneurs, Mr. Leibold expresses an aversion to going public. 

The company reflects his spirit and that of his colleagues, he said. 

“If German Pellets was listed on an exchange, it would change the company from that day on,” he said.

While there has been no broad effort to curtail debt issues, regulators at the European and national levels are now scrutinizing so-called shadow banking. That is a broad category that includes hedge funds and other activities outside the traditional banking system, as well as corporate bond issuance. 

In practice, corporate debt is typically handled within the banking system, with banks earning hefty fees for marketing the bonds. But because the business is dominated by large investment banks, the concern by some regulators is that smaller institutions have trouble competing in that market and could lose revenue as a result. 

Mr. Véron of Bruegel said central bankers might also worry that a shift from traditional banking could make it harder to control interest rates — their main policy tool. 

“The European Central Bank sees a need for more credit,” he said. “At the same time they are concerned about losing the monetary policy transmission channel.” 

For all that, though, officials do not seem to be terribly concerned. 

Mr. Dombret of the Bundesbank said that the sale of debt by companies was “limited in scope” and a “rational and welcome response” by companies to tighter lending by banks in many parts of the euro zone. 

Risks that banks will be bypassed “seem to be rather low at this stage,” he said, but he added that the Bundesbank would “continue to monitor this area.” 

Mr. Leibold of German Pellets, for his part, said he was happy with his bond experience and planned to tap debt markets again. But he was not sure bonds would work for all companies. “You need a story for investors,” he said. 

Source: http://www.nytimes.com/2012/05/19/business/global/credit-flows-through-a-new-channel-for-europe.html?_r=1&ref=global

U.S. Considers Notes That Float

s borrowers around the U.S. rush to lock in near-record-low interest rates on everything from mortgages to corporate bonds, the Treasury Department soon might embark on a program that seemingly does just the opposite.



Treasury officials will decide this week whether to start issuing floating-rate debt for the first time. Matt Phillips reports on Markets Hub. Photo: AFP/Getty Images.

After a series of meetings early this week, Treasury officials will decide whether to start issuing floating-rate debt for the first time ever. Instead of the interest rate being fixed throughout the life of the notes, the rate would move up and down as overall rates move higher and lower.

The change would be the first new addition to the Treasury's arsenal of debt products in 15 years. Analysts are widely expecting Treasury officials to sign off on the program.

While it may seem like odd timing to start issuing floating-rate debt, since most analysts predict interest rates are unlikely to get much lower, Wall Street analysts say the changes make some sense.

For one thing, the new debt products wouldn't necessarily increase Treasury's exposure to short-term fluctuations in rates. That is because the floating-rate notes mainly would be used in place of short-term debt—bills and notes that are issued with maturities of less than two years. Treasury is constantly issuing new bills, mainly to replace maturing debt.

Issuing a floating-rate note of two years in place of a series of three-month bills also would reduce the number of times Treasury would have to sell new debt, which it does via auction. That is appealing, bankers say, especially in light of the recent debt auctions of heavily indebted countries such as Spain and Italy. Those debt sales have been nail-biting events for the financial markets.

"With bills, the thing is you have to come to the market every week," said Priya Misra, head of U.S. interest-rate strategy at Bank of America BAC +2.71% Merrill Lynch in New York. "And [issuing floaters] lessens the amount that you have to come back."

Of course, Treasury has no problem finding buyers for its debt. Investors have flocked to the safety of U.S. government bonds throughout the crisis. The rush, along with bond-buying from the Federal Reserve, has pushed U.S. interest rates to some of their lowest levels since World War II.

It is not certain that the Treasury will go ahead with the plan. The government considered the possibility of issuing floating-rate Treasury securities in the 1990s and ultimately it decided not to go forward with the program.

The U.S. would follow countries such as Italy and the U.K., which are both big issuers of floating-rate government debt.

In recent years the U.S. government has been focused on borrowing from investors by issuing longer-term debt, rather than short-term Treasury bills. That has pushed the weighted average maturity of the U.S. debt—a measure of when the bulk of the debt must be repaid to investors—to 62.4 months at the end of 2011, up from 49 months at the end of 2008.

Shifting the composition of the U.S. debt load to longer-term bonds from bills helps make the costs of carrying the debt load less sensitive to market sentiment.

But there are downsides to borrowing long-term. With interest rates so low, the U.S. government pays next to nothing to borrow short-term.

For example, the yield on three-month Treasury notes is just 0.09%. By comparison, the government cost of borrowing using the 10-year note is around 1.92%.

That is quite low by historical standards, but it is still a lot more expensive that 0.09%.

Analysts say the Treasury is betting that issuing floating-rate notes can help Uncle Sam pay a bill-like yield, but lock up the money it borrowed for a longer period than a few months.




"The Treasury is trying to avoid issuing more Treasury bills," said Joseph Abate, money-market strategist at Barclays. "And this would be potentially one way of doing that."

Still, the program would take some time to have a meaningful impact. Bank of America Merrill Lynch analysts estimate that the Treasury would start any floating-rate program by issuing around $10 billion in floating- rate notes each month. That compares to the roughly $400 billion in bills the Treasury issues each month.

Analysts expect demand for such short-term, high-quality floating-rate debt to be strong. New regulations that came in the wake of the financial crisis pushed financial institutions to hold more safe assets such as Treasurys, and floating-rate notes might be more attractive when interest rates eventually begin to rise.

Other potential buyers include money market mutual funds and state and local governments looking to manage their cash.

"The product should be suitable for a diverse investor base," wrote Morgan Stanley MS +1.91% interest-rate strategists in a note published last week.


Source: http://online.wsj.com/article/SB10001424052702304868004577376401074885134.html?mod=markets_newsreel

Equity markets: Shares and shibboleths

IF THERE is a sacred belief among investors, it is that equities are the best asset for the long run. Buy a diversified portfolio, be patient and rewards will come. Holding cash or government bonds may offer safety in the short term but leaves the investor at risk from inflation over longer periods.

Such beliefs sit oddly with the performance of the Tokyo stockmarket, which peaked at the end of 1989 and is still 75% below its high. Over the 30 years ending in 2010, a “long run” by any standards, American equities beat government bonds by less than a percentage point a year.

In the developed world, the period since the turn of the millennium has been a particular disappointment. Since the end of 1999 the return on American equities has been 7.6 percentage points a year lower than that on government bonds (see chart 1). That has left many corporate and public pension funds in deficit and many people with private pensions facing a delayed, or poorer, retirement. Understanding why equities have let investors down over the past decade will help them work out what to expect in the future.

The long-term faith in equities is based on the theory that investors should be rewarded for the riskiness of shares with a higher return, known as the “equity risk premium” (ERP). That risk comes in two forms. The first is that shareholders get paid only when other claimants on a company’s cashflow, such as workers, the taxman and creditors, have received their due. Profits and dividends are thus highly variable and can disappear altogether when times get tough. The second risk is that share prices are volatile, more so than bond prices. Since 1926 there have been seven calendar years when American equity investors have suffered a loss of more than 20%; investors in Treasuries have suffered no such calamitous years.

The big question, however, is how large that extra return should be. Here it is important to distinguish between the extra return investors actually achieved for holding equities (what could be called the ex post number) and the return they expected to achieve when they bought them (the ex ante figure). Academics started to focus on this problem in the mid-1980s when a paper by Rajnish Mehra and Edward Prescott indicated that the ex post return of American equity investors had been remarkably high, at around seven percentage points a year. It seems unlikely that investors expected to do so well.

Premium puzzle

There are a number of possible explanations for these very high ex post returns. One is survivorship bias in the numbers. America, which is the benchmark for ERP measurements, turned out to be the most successful economy of the 20th century, but it might not have been. Before the first world war investors doubtless had high hopes for Argentina, China or Russia—only to be disappointed.

Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS) have analysed the data for 19 countries from 1900 to 2011 and found that the ERP relative to Treasury bills (short-term government debt) ranged from just over two-and-a-half percentage points a year in Denmark to six-and-a-half points in Australia. They found a premium for America of five percentage points.

Another explanation for the high returns is a paradoxical one: that equities have become less risky. In the early part of the 20th century corporate accounts were more opaque and less reliable (though shareholders in Enron, a bust energy company, may disagree). Most stocks were owned by private investors with only a handful of individual shares. This left them more exposed to the risk of a single firm failing, which meant they put a lower value on shares—or, to put it another way, they demanded a higher premium for owning them.

Today most equities are owned by institutional investors who can assemble a diversified portfolio. Even small investors can own an index fund at low cost. The impact of one company failing is thus far smaller. This reduced risk has prompted investors to pay higher prices for shares; in other words, to accept a lower dividend yield. That may well have increased the ex post risk premium (other things being equal, a fall in the dividend yield from 4% to 2% means investors double their money).

The size and persistence of the ERP led some commentators in the late 1990s to come up with an ingenious, if flawed, argument. In their book “Dow 36,000”, for instance, James Glassman and Kevin Hassett argued that the reliable outperformance of shares over bonds meant that equities were not riskier at all. As a result, there need be no ex ante risk premium.

This time is not different

If this belief were correct, equity investors should have been willing to accept a lower earnings yield. (This is the inverse of the price-earnings ratio; if the p/e is 50, the earnings yield is 2%.) In the course of moving to the lower earnings yield, the market would have soared to the 36,000 level of the book’s title. A lower ex ante risk premium implies higher returns in the short term. The authors were proved right in one sense. Investors who bought shares in 1999 did not earn a risk premium. But that will be of scant consolation to those who believed the book, since 13 years later the Dow is at around 13,000, not 36,000.

One obvious problem with their reasoning was that, although equities might have beaten bonds over most long periods, the horizon of the average investor is much shorter. There have been many equity bear markets in history and investors are exposed to the real risk that they will have to sell in the middle of one. Most shares are owned by professional fund managers, who have to report to their clients every three months. If a big bet on equities goes wrong they cannot wait 20 years to be proved right. Clients will have deserted them long before then.

The late-1990s debate illustrated a familiar pattern at the top of bull markets. When share prices have already risen a lot, commentators scramble for reasons why they should rise even further. In the 1980s those who queried whether the Japanese stockmarket was expensive on a minimal dividend yield and a sky-high price-earnings ratio were told that “Western valuation methods” did not apply in Tokyo. At the turn of the century many assumed that, because the achieved ERP had been high in the past, it would be so in the future. But investors had their reasoning backwards. When share valuations are high, future returns are likely to be low and vice versa.

Given the history of the risk premium, what will the future reward for equity investors be? This question is discussed in a new set of papers* issued by the Chartered Financial Analysts Institute. The collection is a follow-up to a similar exercise undertaken in 2001, where the range of estimates of the premium varied from zero to seven percentage points a year.

The first step is to define the equity risk premium more exactly. Mssrs Dimson, Marsh and Staunton break it down into the following components: the dividend yield, plus the real dividend growth rate, plus or minus any change in the price/dividend ratio (the inverse of the dividend yield), minus the real risk-free interest rate.

In the period 1900-2011, the average world dividend yield was 4.1%; real dividend growth was just 0.8%; and the rerating of the market added 0.4%. That comes to a real equity return of 5.4% (the calculation is geometric, not arithmetic). Stripping out the risk-free interest rate, the ERP was 4.4% versus short-term government debt and 3.5% versus longer-term government bonds (see chart 2).

The dividend yield comprised the vast bulk of the return. This was true across all the countries studied by the authors. Had investors consistently bought the highest-yielding quintile of equity markets over the past 112 years they would have earned an average nominal annual return of 13.3% compared with a return of just 5.4% for those buying the lowest-yielding quintile. High-dividend markets have also performed best so far this century.

The importance of the dividend yield is ironic, given the lack of focus on the measure in most modern investment commentary. Many analysts argue that the dividend has been superseded by the share buy-back which (particularly in America) is a more tax-efficient way of returning cash to shareholders. But Robert Arnott of Research Affiliates points out that, although buy-backs reduce share capital, companies are also finding ways to add to it. Firms issue shares to pay for acquisitions, for example, or to reward executives through incentive schemes. Historically, net share issuance has been around 2% of total equity capital a year. This dilution of existing shareholders is part of the reason why real dividend growth has been so low, well below GDP growth.

As a starting point for estimating the future ERP, this is not encouraging. The current dividend yield on stockmarkets is lower (at 2.7% in the countries covered by the LBS data) than the historical average. Dividends tend to grow (at best) no faster than GDP, and usually slower because of the dilution effect. Nor is there much hope of a boost from a revaluation of the market. Since the yield is low, relative to history, it is more likely that any revaluation will subtract from returns. In another paper, Cliff Asness of AQR Capital, a hedge-fund group, uses his estimates of dividend yield and likely dividend growth to come up with a forecast for future real equity returns in America of around 4% a year.

Future imperfect

Although this figure is lower than the historical average, it still means that equity investors will earn a risk premium. The real yields on short- and long-term debt are zero, or negative in some cases. Nominal yields are close to historic lows. If the risk-free return is zero, then the entire return from equities will count as a risk premium. And a 4% premium would be only a little below the long-term average for America.

That still would not be high enough for many pension funds. In America, local-government pension funds base their contributions on the assumption that they will earn 8% (in nominal terms) on their investment portfolios. Treasury bonds yield 2% at the moment, so a 4% risk premium suggests a nominal return of 6% on equities. That means pension funds will fall well short of their targeted return.

Pension providers have two options: increase contributions or cut benefits. Cutting benefits will be difficult for many American states since pension rights are legally or constitutionally guaranteed. So taxes will have to go up or other services will have to be cut. Companies that have offered pensions linked to final salaries may have to divert money into their pension schemes, cash that could have been invested to boost the economy. Individuals who rely on private pensions (or on so-called defined-contribution benefits, where the company does not promise a payout) face the same problem.

Equities are not a miracle asset that will turn measly contributions into a generous pension. Those who want to retire in comfort should save more.

Source: http://www.economist.com/node/21550273