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

Why S&P 500 can reach the 3,000 level by 2020

We are working through a curious period in financial history during which neither capital nor labour has pricing power. Neither can generate much income. Average earnings in nominal and real terms have barely grown, while capital sits idly in cash deposits or in government bonds yielding next to nothing. Whether you are working or investing, income is hard to come by.

We know the reasons why. The power of labour to command a greater share of the economic pie has been undone around the world by policy initiatives focused on labour mobility. In most developed countries, labour’s share of GDP has been falling. Even in the US economy, which added a record 3m jobs last year, labour’s share sits at 50-year lows. Employment growth has been offset by weak wage growth. Productivity gains have passed to the owners of capital, allowing operating margins to rise.

Concurrently, the propensity of developed nations to accumulate savings faster than income growth compresses yields everywhere. Wealthy nations with excess savings and little growth, such as Japan, Germany and Italy, can only export capital, lowering yields. Central banks’ quantitative easing programmes exaggerate the yield compression. Their bond-buying further crowds these countries out of their own domestic sovereign and credit markets compounding the effects abroad.

If we are to believe economist Thomas Piketty, income will become even more prized. He argues the capital/income ratio is set to rise for the rest of this century. Private capital stands at 450 per cent of income today and is set to approach 700 per cent by 2100. Net savings (after capital appreciation) are currently rising approximately twice as fast as income. An ageing population will constrain income growth, and further exaggerate the problem, even as rates of return decline. Mr Piketty describes a world in which too much capital chases too little income.

So in this financial climate how would we value an asset class that offered a current real yield and that had consistently increased its income in double digits each year? Highly, one might think.

And yet this is precisely what the S&P 500 has offered. At the close of the third quarter of 2014, the S&P 500 notched up its 15th consecutive quarter of double-digit dividend growth. Dividend per share growth over 12 months to the third quarter of 2014 was 11.3 per cent. Over the 15-quarter period, dividends per share have averaged 14.2 per cent growth. It is little wonder the US equity market has been one of the most rewarding asset classes in recent years.

"We can find no other asset class that offers this level of income growth in dollar terms. Emerging markets offer little dividend growth in US dollar terms. Currency headwinds and falling returns on equity are the obstacles"

Is this set to continue? We think so. We can find no other asset class that offers this level of income growth in dollar terms. Emerging markets offer little dividend growth in US dollar terms. Currency headwinds and falling returns on equity are the obstacles.

In Europe we may hopefully see single-digits, but a lot will depend on the euro/dollar level. Japan, as always, is a wild card and depends largely on corporate governance reform, and the capacity of investors to convince companies to distribute excess cash.

In contrast, dividend per share growth for the S&P 500 is likely to stay at double-digit levels. This is above earnings growth but the payout ratio is 32 per cent. We need to anticipate a fall in dividends from energy companies, but this will be more than offset by dividend growth from the financial sector, which is still low.

S&P 500 dividends benefit from a high level of diversification, unlike other benchmarks where dividends are concentrated in one or two sectors, or even a handful of stocks. More than 400 stocks in the S&P 500 pay a dividend. Nine out of 10 sectors increased dividends in the past 12 months. Six of these increased dividends by 10 per cent or more. Consumer discretionary, IT and industrials were among these, emphasising that the regulatory risk to dividends is lower than elsewhere.

In the age of income investing, the income growth properties of the S&P 500 will continue to be highly valued. According to our estimates, S&P 500 dividends could exceed $48 by 2016 and $60 is not beyond reach by the end of the decade. If we assume a 2 per cent dividend yield, its 10-year median, the S&P 500 could exceed 2,400 before the next president is inaugurated. A level of 3,000 is within reach before the decade is out.

Source: http://www.ft.com/intl/cms/s/0/ff1c88f6-a588-11e4-8636-00144feab7de.html#axzz3RSBoBmRj

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

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

Sovereign bonds: Oat cuisine

FIFTEEN years ago Western government bonds were regarded as being like porridge: stodgy but easily digestible. Investors knew returns would be modest but perceived the asset class as risk-free, an important concept in both financial theory and portfolio construction. And bond markets were seen as all-powerful, capable of imposing discipline on governments by pushing up borrowing costs in the face of irresponsible policies. James Carville, an adviser to President Bill Clinton, spoke with awe of their intimidatory power.

Things are different now. The bond vigilantes seem less frightening. They were asleep at the wheel as debts mounted in the euro zone, waking up in time to provoke the latest crisis but not avoid it. Private-sector bond investors in Greek sovereign debt face losses of around 70%, making the idea that government bonds are risk-free laughable.

The most powerful investors in many government-bond markets are not profit-maximising fund managers but central and commercial banks, which are buying bonds for all sorts of reasons. Other investors need to be like Kremlinologists, guessing what central banks will do next.

The market is also much bigger than it was. According to Bank of America Merrill Lynch, there were some $11 trillion-worth of government bonds in issue at the end of 2001; by the end of 2011, that figure had risen to more than $31 trillion (see chart 1). And although some euro-zone countries have been cut off from the markets, the story is very different in other places. The British and American governments are enjoying the lowest borrowing costs they have seen for decades, despite big deficits.

The implications of all these changes are still being worked through. The risk-free rate has historically been the rock around which a financial system is built. Other borrowers, such as banks and corporations, pay a premium over their domestic government’s cost of debt. This is still true for companies that are tied to a local economy, such as utilities. But multinational firms can, in theory, move to economies where growth prospects are better and taxes lower. Some, such as Johnson & Johnson or Exxon Mobil, may thus now be seen as better bets than their governments.

Thanks to the European Central Bank’s lending activities, banks in several European countries can also now borrow more cheaply than their governments—a heavy irony given that it was the banking sector’s problems that ushered in the current sovereign-debt crisis. Indeed, investors have learned that simply studying the ratio of government debt to GDP is not enough. Both Ireland and Iceland entered the crisis with very low ratios. But the collapse of their banking sectors meant that private-sector debt was assumed by the government, causing the ratio to balloon.

Modern bond investors have to worry about other contingent liabilities, too—the pensions promised to public-sector workers, say, or the rising costs of Medicare as America’s baby-boomers retire. Governments might easily decide that such promises have a better claim on tax revenues than the rights of foreign creditors. The negotiations in Greece have shown that official creditors deem themselves to have a greater claim on a government’s revenues than private-sector creditors. The more official aid a country receives, the bigger the eventual write-off private bondholders may suffer.

The rise of official creditors is not new. It was first noticed in the 2000s when Asian central banks began to plough their massive foreign-exchange reserves into Treasury bonds. Alan Greenspan, the then chairman of the Federal Reserve, talked of the “conundrum” that bond yields were falling even as the Fed was pushing up short rates, a shift from the usual pattern.

The reason was that central banks were pretty indifferent to low yields, being content to park their reserves in the relative safety and liquidity of Treasury bonds as a way to manage their currencies’ level versus the dollar. More recently, central banks have been buying up their own government’s debt through quantitative easing (QE). It is debatable whether yields are set by economic fundamentals or by the anticipated buying patterns of central banks.

Of course, central-bank policy has always had an effect on the bond markets. One way of viewing long-term bond yields is as a forecast of future short-term rates (sometimes there is an additional premium for tying up your money). On that basis, says Eric Lonergan, a fund manager at M&G, the current level of Treasury-bond yields is quite rational. The average of American short rates over the past ten years is around 2%, almost exactly the level of the ten-year Treasury-bond yield now.

Rates are likely to remain low for some time. The Fed recently indicated that it expected rates to stay near zero until late 2014. Add in the effect of QE and the Fed may be the dominant influence on yields all the way out to bonds with maturities of five years. There is talk of a third round of QE from the Fed, and the Bank of England was set to add to its £275 billion ($437 billion) pile of gilts at a February 9th meeting, held after The Economist went to press.

Rates low, bond mountains high

Analysts argue about the precise impact of QE on yields but the presence of an ever-willing buyer must have some effect. In particular, it must make private-sector investors cautious about betting on higher yields. “Bond crashes become very unlikely, unless they are accepted by central banks,” says Patrick Artus of Natixis, a French bank. “Long-term interest rates could remain very low for a long time.”

Less clear is how central banks will ever dispose of these bond mountains. In practice, it makes no difference whether central banks try to sell their holdings or simply let the bonds mature (since maturing bonds have to be refinanced). Either way the private sector will have to absorb the extra supply on top of the new bonds being issued that year. If central banks are correct in arguing that QE has driven bond yields down, then logically a reversal of QE might drive yields up, in effect tightening monetary policy. It may be a long while before the economy is sufficiently robust to absorb the impact. Large central-bank holdings of government bonds may be a semi-permanent feature of the landscape.

Central banks are not the only distorting presence in the market. In Britain pension funds have been eager buyers of long-dated securities as a way of matching their liabilities (a promise to make pension payments for 25-30 years is equivalent to a debt). Since many pension benefits are linked to inflation, this has sparked a particular enthusiasm for inflation-linked debt. Insurance companies are also heavy buyers of government debt, in large part because of solvency requirements that push them into owning “safe” assets.

And then there are the banks. One feature of the early days of the euro was convergence. Short-term interest rates are the same across the zone. Since government-bond yields are related to expectations for future levels of short rates, bond yields equalised across the region. This was immensely beneficial for countries like Italy and Greece, which saw their borrowing costs fall. It also meant that banks happily owned regional, rather than merely national, government-bond portfolios.

Now that trend is reversing. Banks are suddenly conscious of the credit risk involved in holding another country’s bonds. When the crisis broke French banks were “encouraged” to hold on to their Greek bonds by their government and suffered losses as a result. Now it seems they are willing to buy only their own government’s bonds, and those of Germany; they are far less keen on holding Italian or Spanish debt. “It is almost if the euro zone has already broken up,” says Andrew Balls of PIMCO, a fund-management group.

Domestic banks, however, may well figure that holding the debt of their own sovereign is a “double or quits” bet. If their government defaults the banking system will collapse anyway, so they might as well own its bonds. That incentive has been reinforced by the ECB’s provision of virtually unlimited three-year loans. As President Nicolas Sarkozy of France has hinted, banks can borrow cheaply from the ECB and invest the proceeds in government debt, earning a higher yield in the process.

This is an approach to boosting bank profitability that has been tried before. In the early 1990s the Federal Reserve held rates very low (by prevailing standards) to help the banks recover from the savings-and-loan crisis. Banks were able to earn a “carry” by borrowing at 3% and buying ten-year Treasuries yielding almost 7%.

The carry trade is not the only reason why banks might buy government bonds. In the wake of the 2007-08 crisis, when banks were suddenly cut off from the wholesale markets, regulators have been urging banks to own a “liquidity cushion” of safe assets. Banks can use government bonds as collateral for loans with each other, and with central banks.

The result has been a big expansion in banks’ sovereign-bond purchases, very handy when governments have lots of bonds to sell. In Britain, data from the Debt Management Office show that banks and building societies owned just £26 billion-worth of gilts in the last quarter of 2008; by the end of 2011 they owned £131 billion, or around 10% of the total (see chart 2).

How would you like your loss?

The role that credit risk is now playing in the euro area highlights another great change in the government-bond markets: the influence of exchange-rate regimes. For decades countries struggled to cope with the constraints of fixed exchange-rate systems, whether the gold standard or Bretton Woods, in part because this approach would reassure foreign creditors. “Who would be prepared to lend with the fear of being paid in depreciated currencies always before his eyes?” asked Georges Bonnet, a French finance minister of the 1920s.

But the euro crisis has shown the perils for international investors of a fixed-rate regime. Denied the option of devaluation, Greece is being forced, in effect, to default on its debts. In contrast America and Britain, with their floating exchange rates, have the freedom to expand their money supplies and depreciate their currencies. Although this may still result in losses for foreign investors, they are likely to be far smaller than the Greek write-offs. As Mr Balls puts it, countries with floating rates are the “least dirty shirt” in the markets.

Emerging markets have also changed their role. Historically, developing countries defaulted often and had high inflation. They had to borrow in dollars and to pay high yields. But now the finances of many developing countries are better than those of the rich world (see chart 3). Brazil and Mexico pay yields of less than 2% on five-year dollar-denominated debt.

It all adds up to a completely changed investment landscape. For the 25 years from 1982 to 2007, owning rich-world government bonds was almost a no-brainer. Yields fell steadily in line with inflation and there was no question of default. Now the market is much more complex. The players are more diverse and their motives more varied. The balance between risk and reward has also shifted against investors. In the past bondholders have not made money buying Treasury bonds on yields as low as 2%. At current levels of inflation, bond investors are getting negative real yields.

That may be the idea. Carmen Reinhart, Jacob Kirkegaard and Belen Sbrancia, three academics, have suggested that governments may use “financial repression”—forcing debts down the throats of captive buyers and keeping real rates negative so that inflation eliminates their debts. This trick worked after the second world war. The presence of “forced buyers” in the market such as central banks and commercial banks may enable it to be repeated.

But could governments really pull it off? Or are rich-world bond markets signalling that Japan is the more likely template? Ten-year yields there have been around 1% for much of the past decade, thanks to persistent deflation and slow growth.

This is a vital issue since a sudden surge in bond yields might wreck government finances, economic prospects and the outlook for other asset markets. “The unknown question is how much inflation central banks are willing to tolerate. Until that is settled, one cannot be sure about the outlook for bonds or other asset markets like equities,” says Manoj Pradhan at Morgan Stanley. For a supposedly risk-free asset it all adds up to a lot of risks.

Source: http://www.economist.com/node/21547245

Low rates: the drug we can all do without

Low interest rates and novel forms of monetary accommodation, such as quantitative easing, have become seen as a panacea for economic ills. The US Federal Reserve has committed to holding rates around zero for the foreseeable future. Faced with deep-seated economic problems, other central banks are likely to follow.

Financial markets have generally reacted positively to low rates, pushing up asset prices. However, low rates point to a worrying lack of economic growth and the increasing risk of deflation. Indeed, the relationship between rates and economic activity is tenuous. The cost of funds is only one factor among several complex drivers of demand.

In the housing market, demand depends on many things – the level of deposit required, existing home equity (the price of a house less outstanding debt), the ability to sell a current property, income levels and employment security.

And businesses, in the absence of growing demand for their products, are unlikely to borrow to invest in new capacity based purely on the low cost of debt.

In reality, low interest rates create economic distortions, especially where real interest rates (nominal rates adjusted for inflation) are low or negative.

Low cost of debt encourages substitution of labour with capital in the production process. Given that 60-70 per cent of activity in developed economies is driven by consumption, this shift reduces aggregate demand as employment and income levels decrease.

Low rates favour borrowing, encouraging substitution of debt for equity in financing structures and increasing financial risk. Where companies and nations are overextended, incentives to reduce debt decrease. In fact, low rates, which lower coupon payments, are economically identical to a disguised reduction of the principal amount of the loan.

Low rates discourage savings, creating a disincentive for the capital accumulation that would reduce overall debt levels. Lower earnings on savings should encourage spending, stimulating economic activity, but may perversely encourage greater saving to provide for future needs, reducing consumption and demand. For an individual saving for retirement, a drop in interest rates from 5 per cent to 4 per cent requires an 18 per cent increase in savings each year to reach the same target sum over 30 years.

Low rates also increase the funding gap for defined benefit pension funds. In the US, for every 1 per cent fall in rates, pension fund liabilities increase by about $180bn.

Low rates also feed asset price inflation. Low costs of borrowing encourage investors to seek investments with income, feeding demand for shares that pay high dividends and for low-grade debt. A resurgence of structured products, where investors take on additional risk, which they have not fully understood, to generate higher income, is driven by low rates. In previous cycles, this has led to large losses and costly disputes between investors and dealers. In this way, low rates encourage mispricing of risk, creating asset bubbles.

Minimal opportunity costs allow investors to hold assets that pay no income in the hope of price increases, evidenced in demand for commodities and alternative investments such as art works. Money tied up in non-productive investments reduces the flow of capital and economic activity.

Low interest rates also provide an artificial subsidy to financial institutions, allowing them to borrow cheaply and then invest in higher yielding safe assets such as government bonds. Assuming bank deposits of $6tn and a difference between borrowing costs and government bond rates of 2 percentage points, this equates to a transfer to the US banking sector of about $120bn.

Low rates do not necessarily increase the supply of credit. Risk aversion and higher returns on capital encourage banks to invest in government securities, eschewing loans. In the US, bank holdings of cash and government securities currently exceed the outstanding volume of commercial and industrial loans.

Internationally, low interest rates distort currency values, and encourage volatile and destabilising short-term capital flows as investors search for higher yields.

A sustained period of low rates, such as the one the world is experiencing, makes it difficult to increase the cost of borrowing. Levels of debt encouraged by low rates rapidly become unsustainable when they increase, as is evident in Europe. This reinforces the financial distortions implicit in the policy.

For the moment, policymakers are relying on the advice of actress Tallulah Bankhead: “Cocaine isn’t habit forming. I should know – I’ve been using it for years.” But reliance on low interest rates, like all addictions, is dangerous. It is also ineffective in addressing the real economic issues.

Source: http://www.ft.com/intl/cms/s/0/372a405c-480e-11e1-b1b4-00144feabdc0.html#axzz1l0bJLxBP

Australian Dollar on Sturdier Ground

Don't bet that a slowdown in the global economy will drag the Australian dollar down like it did in 2008.

Back then, Australia's currency fell off a cliff as the resources boom that fueled it sputtered.

But Australia's commodity sector is more firmly dug-in these days. In liquefied-natural-gas alone, more than $140 billion worth of projects are already under construction, compared with $15 billion in 2008. Significant committed investment in infrastructure to support massive coal and iron ore operations can't be quickly reversed either.



Record inbound merger-and-acquisition deals last year—worth $65.7 billion—also support the Australian currency as acquirers buy Aussie dollars to fund their investments. This year might not hit another record, but strong interest in resources should support continued dealmaking.

There are risks, especially slowing growth in China and India. But a hard-landing for Asia seems less likely than it did a few months ago. A more muted downturn won't pull the ground from underneath Australia's currency.

Further interest rate cuts from Australia's central bank are possible—dark clouds persist over retail and manufacturing. That could see yield-starved investors look elsewhere. Still, the Reserve Bank of Australia cut the cash rate twice late last year, with more or less no lasting impact on the exchange rate.

A seize-up in global credit markets would also weigh on the Aussie. When the markets shut in 2008, Australian banks were forced to sell local currency and buy greenbacks to meet short-term funding needs in U.S. dollars, Royal Bank of Canada strategist Michael Turner says. But the Australian banks, which have some of the highest credit ratings in the world, are less reliant on short-term funding than they were four years ago.

The Australian dollar has traded in a fairly tight range around parity with its U.S. counterpart for most of the past 12 months, compared with an average of around 75 cents for the past three decades. A deep shock to the global economy that decimates commodity prices could see a return to historical norms. A strong recovery in the U.S. that leads to higher interest rates there could be a game-changer too.

Absent such dramatic events though, the dollar's more likely to stay closer to parity this year than it is to fall back into its old ways.

Source: http://online.wsj.com/article/SB10001424052970204555904577164080084233546.html?mod=WSJ_Heard_LEFTTopNews

For Europe, Few Options in a Vicious Cycle of Debt

Europe has a $1 trillion problem.

As difficult as the last two years have been for Europe, 2012 could be even tougher. Each week, countries will need to sell billions of dollars’ worth of bonds — a staggering $1 trillion in total — to replace existing debt and cover their current budget deficits.

At any point, should banks, pensions and other big investors balk, anxiety could course through the markets, making government officials feel like they are stuck in a scary financial remake of “Groundhog Day.”

Even if governments attract investors at reasonable interest rates one month, they will have to repeat the process again the next month — and signs of skittish buyers could make each sale harder to manage than the previous one.

“The headline risk is enormous,” said Nick Firoozye, chief European rates strategist at Nomura International in London.

Given this vicious cycle, policy makers and investors are closely watching the debt auctions for potential weakness. On Thursday, Spain is set to sell as much as 5 billion euros ($6.3 billion) of government bonds. Italy follows on Friday with an auction of more than $9 billion.

The current challenge for Europe is to keep Italy and Spain from ending up like Greece and Portugal, whose borrowing costs rose so high last year that it signaled real likelihood of default, making it impossible for the governments to find buyers for their debt. Since then, Greece and Portugal have been reliant on the financial backing of the European Union and the International Monetary Fund.

The intense focus on the sovereign debt auctions — and their importance to the broader economy — starkly underscores the difference between European and American responses to their crises.

Since 2008, there has been almost no private sector interest to buy new United States residential mortgage loans, the financial asset at the root of the country’s crisis. To make up for that lack of investor demand, the federal government has bought and guaranteed hundreds of billions of dollars of new mortgages.

In Europe, policy makers are still expecting private sector buyers to acquire the majority of government debt. Last month, in perhaps the boldest move of the crisis, the European Central Bank lent $620 billion to banks for up to three years at a rate of 1 percent.

Some officials had hoped that these cheap loans would spur demand for government debt. The idea is that financial institutions would be able to make a tidy profit by borrowing from the central bank at 1 percent and using the money to buy government bonds that have a higher yield, like Spain’s 10-year bond at 5.5 percent.

But the sovereign debt markets continue to show signs of stress. Italy’s 10-year government bond has fallen in price, lifting its yield to more than 7 percent, a level that shows investors remain worried about the financial strength of Italy’s government.

And European banks appear to be hoarding much of the money they borrowed from the central bank, rather than lending it to governments. Money deposited by banks at the European Central Bank, where it remains idle, stands at $617 billion, up from $425 billion just a month ago.

“It’s hard to see why a banker would want to tie up money in a European sovereign for, say, three years,” said Phillip L. Swagel at the University of Maryland’s School of Public Policy, who served as assistant secretary for economic policy under Treasury Secretary Henry M. Paulson Jr.

Italy’s troubles highlight how hard it is to generate demand for a deluge of new debt from a dwindling pool of investors. The country needs to issue as much as $305 billion of debt this year, the highest in the euro zone. By comparison, France, with the second highest total, needs to auction $243 billion of new debt, according to estimates by Nomura.

Governments like Italy’s are at the mercy of markets because they simply don’t have the cash to pay off even some of their bonds that come due. They must issue new bonds to cover their old debts, as well as their budget deficits, at a time when investors are growing scarce.

Banks, traditionally big holders of government bonds, have been selling Italian debt. “We’ve seen a lot of liquidation by non-European investors,” said Laurent Fransolet, head of European interest rate strategy at Barclays Capital in London. For instance, Nomura Holdings in Japan slashed its Italian debt holdings, mostly government bonds, to $467 million on Nov. 24, from $2.8 billion at the end of Sept.

European banks have also been dumping the debt. BNP Paribas, a French bank, cut its exposure to Italian government bonds to $15.5 billion at the end of October, from $26 billion at the end of June.

Italian banks, though large owners of their government’s obligations, may not want to take on too much more, to keep their investors happy. Shares in UniCredit have fallen more than 40 percent since last week as the Italian firm has tried to raise capital to comply with new regulations.

There are ways to avoid spectacularly bad debt auctions, at least in the short term.

The central bank can help by buying a country’s bonds in the market ahead of a new debt sale. That would help bolster prices at the auction, or at least keep them stable.

There is also some evidence that banks’ government-bond selling may have abated at the end of last year, according to Mr. Fransolet. Central bank figures show European financial firms acquired $2.4 billion of Spanish government bonds in November, after selling a monthly average of $4.8 billion in the preceding three months.

Governments may also be able to attract new buyers to their bond markets. Belgium sold $7.2 billion of government bonds to local retail investors last month, in part appealing to their patriotism.

Opportunistic hedge funds, betting the market is too pessimistic about certain European countries, may also bite. Saba Capital Management, a New York-based hedge fund headed by the former Deutsche Bank trader Boaz Weinstein, owns Italian government bonds, though it does so as part of a wider trading strategy that includes bets that could pay off if Europe’s problems worsen.

But it is doubtful that Italy and Spain can find enough new buyers this year to bring their bond yields down to sustainable levels. Instead, if their economies slow — and if their governments become unpopular — debt auctions could fail and their cost of borrowing could rise even more.

All eyes would then turn to the central bank for drastic action. It could lend more cheap money to banks, in the hope that some of it might find its way into government bonds. Or it could become a big buyer of government bonds itself, printing euros to finance the purchases.

But that may not be a lasting solution, since the central bank’s actions could scare off private investors. Typically, when government-backed organizations like the central bank hold a country’s debt, their claims on the debtor rank higher than those of other creditors. For that reason, private investors might think their holdings would fall in value if the central bank became a big owner of Italian debt — and they might retreat.

At the same time, the crisis response in the United States did not depend solely on government-backed entities like the Federal Reserve to buy housing loans. Professor Swagel of the University of Maryland points out that banks and investors also took large losses on existing housing debt. While painful, the mortgage debt proved less of a drag on the financial system.

So far, Europe has been averse to taking permanent losses on government bonds. Except in the case of Greek debt, European policy makers have shied away from any plan that could mean private holders of government debt get hurt.

However, Nouriel Roubini, a professor of economics at the Stern School of Business at New York University, recently argued in a Financial Times editorial that Italy’s debt should be reduced to 90 percent of the gross domestic product from 120 percent. In such a situation, investors might suffer a 25 percent hit on the value of their Italian bonds, he said.

Such haircuts might seem like the recipe for more instability right now. But if Europe struggles to find buyers for its debt, more radical options are likely to be considered. Europe’s debt problem is huge, and the experience in the United States suggests dealing with it may take several, more drastic approaches.

“If you go halfway, you’ll never get to the end,” Professor Swagel said. “And that describes European policy-making.”

Source: http://dealbook.nytimes.com/2012/01/11/for-europe-few-options-in-a-vicious-cycle-of-debt/

Bond Bulls May Yet Have Reason for Cheer

The bond-market limbo act goes on. At the start of 2011, bond-fund giant Pimco bet against U.S. Treasurys when the 10-year note was yielding about 3.3%. But Treasury yields ended the year under 2%, along with yields on German and U.K. government bonds, extending further a 30-year bull market for bonds. There might be further to go yet.

Central-bank bond purchases, known as quantitative easing, will play a part. While earlier rounds of QE pushed up yields on hopes that this would support recovery, repeat operations may have diminishing effects. In the U.K., yields have continued to fall despite a new £75 billion purchase operation. The Bank of England is widely expected to increase that program early this year, and many speculate that the U.S. Federal Reserve may engage in a third round of QE. Former European Central Bank board member Lorenzo Bini Smaghi has suggested that even the ECB could make use of the policy if monetary conditions demand it.

Such central-bank purchases may coincide with a reduction in the stock of securities still regarded as "safe" due to potential ratings downgrades in the euro zone. That could have a dual effect. Yields could be kept down as investors question the effectiveness of QE in generating economic growth. But buyers who have little choice about investing in bonds due to regulation may be forced to compete with central banks for paper.

Banks are being required to hold greater liquidity buffers. Central-bank reserve managers, particularly from Asia, are likely to remain core buyers of government debt. And despite deep concerns about the euro, many investors within the currency bloc have no choice but to invest in euro-denominated bonds. Even those struggling with the effects of low yields, such as pension funds, need to match assets with liabilities. Rather than shunning low-yielding bonds in countries like the U.K and Germany, funds that expected yields to rise may be forced to accelerate purchases to reduce the mismatch in their portfolios.

Many advanced economies are entering a multiyear period of paying down debt. That will likely weigh on growth and on domestic inflation, as it has in Japan, boosting the allure of government bonds over risk assets. This process may cause periodic outbreaks of panic about banking systems, as in 2011, driving yields lower. As the panic fades, yields may rise—but so far, they have risen to a lower peak each time.

This environment also creates a challenge for governments. Germany in November saw investors balk at buying new 10-year bonds at yields below 2%. But with two-year bond yields anchored at 0.3% or below by zero interest-rate policies, investors will have to buy longer-dated bonds to generate any return.

That means long-dated yields could go lower and for longer than many thought possible. Just look at Japan, where 10-year yields ended 2011 at 1%.

Source: http://online.wsj.com/article/SB10001424052970203550304577138101578099224.html?mod=WSJ_Heard_LEFTTopNews

Don’t expect economic boost from cash-rich companies

Growth in the developed world will continue in 2012 to be hostage to the deleveraging process that is required to address the huge debts that piled up during the credit bubble. Yet the pattern is distributed unevenly across economies. In the US non-financial corporate sector, to take a striking case in point, the balance sheet recession has long been over. Profit margins are at record levels thanks to savage labour shedding and companies are awash with cash.

A similar accumulation of cash has occurred in Europe, though without comparable shrinkage in the workforce. Bin Jiang and Tim Koller of McKinsey estimate that European and US companies hold about $2tn of surplus cash, defined as the amount outstanding over and above operating cash, which is deemed to be two per cent of revenue. The question is how these cash balances will be deployed.

Ideally, companies should be investing, which would have the benign effect in current account deficit countries such as the UK and US of helping to rebalance the economy away from domestic consumption and public spending, and to jog them out of the habit of underinvesting relative to Germany, France and Japan. Yet this seems unlikely to happen. The effect of the recent credit bubble has been to bring forward many corporate spending decisions. This bunching of investment has been further exacerbated by the Obama administration’s investment tax breaks, now coming to an end. So it is a racing certainty that investment will fall sharply in the first half of the year in the US.

In Europe, meantime, the troubles of the eurozone banking system mean that a strong precautionary motive is at work. Many industrialists are hanging on to cash that earns very little interest because they fear that banks may be unable to finance their working capital requirements. The likelihood of recession in the eurozone likewise damps animal spirits.

Historically, profit margins have tended to revert to the mean, so excess cash may anyway dwindle. I suspect, too, that the English-speaking countries may be moving to a new, low-investment paradigm and not merely because, as in the case of the UK, they have a service sector bias. The practice of rewarding executives increasingly with equity is imposing a far greater focus on short-term measures of performance. Academic evidence in the US has, for example, shown that a high proportion of chief financial officers admits to a willingness to sacrifice economic value to meet short-term earnings targets. The current record profit margins and exceptionally high unemployment reflect that ruthless focus.

The capital market culture of these countries also has a strong emphasis on merger and acquisition activity which, from a managerial perspective, substitutes the thrill of the chase for the hard slog of managing operating businesses and investing in fixed capital. Business becomes transactional at the expense of relationships and performance is seen in narrowly financial terms. Far too many of the deals fail in economic terms, partly because stock options and rewards for failure give managers a huge incentive to bet the ranch.

That brings us to the most likely outlet for all that corporate cash. Much of it will go into share buy-backs, which are relatively painless for managers since, unlike dividends, they entail no continuing commitment to pay. Part of this activity will be arbitrage because corporate bond yields for many companies are now below the yields on equity.

This carries an interesting echo of the Japanese experience in the bubble of the 1980s. As the stock market soared, big corporations turned increasingly to financial engineering, using leverage to boost short-term earnings through speculation. That all ended in tears and a painful deleveraging process.

Charles Kindleberger, the economic historian, speculated that a shift in emphasis from production to consumption and a preoccupation with financial manipulation might be symptoms of national decline. That is hard to prove. Financial sophistication is arguably a natural accompaniment of advanced forms of capitalism.

Moreover, it is a mistake to consider investment as inherently virtuous. Japanese corporations have over-invested for decades and consequently shown poor returns on capital. Much the same is now happening in China, where investment is running at close to half gross domestic product. This is hugely wasteful and causes big distortions in global as well as domestic markets.

Yet it remains the case that the increasingly financial focus of anglophone business is not doing much for the ultimate shareholders, who are chiefly pension beneficiaries. The supposed alignment between the interests of managers and beneficiaries on the basis of stock options and other equity incentives is a fiction. Perhaps the poor equity returns of the past decade partly reflect that fact.

Source: http://www.ft.com/intl/cms/s/0/d7ff64c2-361f-11e1-9f98-00144feabdc0.html#axzz1iUVbDoKd

Backlash from Netflix Buybacks

It is not Netflix's fault that investors priced its shares for perfection. But the Internet video company is to blame for managing its own balance sheet for the same flawless performance.

The former high-flier announced Monday night it had sold $200 million in new shares at $70 each and another $200 million in bonds convertible to stock at $85.80. Just months ago, the stock traded above $300. It is now at $72.



Netflix could easily have avoided this. The company has spent over $1 billion on share repurchases since 2007, leaving it with just $366 million in cash and $200 million in debt at the end of the third quarter. During that time, executives including chief executive Reed Hastings have been selling shares.

In buying back shares, Netflix failed to build a cash cushion against any slowdown in its heady growth rate. With expectations for healthy subscriber additions stretching into the future, the company locked into big contracts for streaming content. Since the start of 2011, the company has more than tripled such commitments to a whopping $3.5 billion, of which $2.9 billion is due in the next three years.

But everything changed this summer after the company raised prices and began bleeding subscribers. The company has not indicated subscriber losses have stopped and said it expects to lose money next year. Netflix has also said it expects free cash flow to lag net income over the next several quarters. In the year through September, the company's free cash flow was a modest $204 million, while buybacks totaled $200 million.

Unfortunately, dilutive stock and convertible issues have become Netflix's best option for raising cash to cover the potential outflows. The company sold $200 million in eight-year bonds in 2009, but those have a yield of about 7.3%, according to MarketAxess. So issuing more debt would mean large coupon payments. The newly-issued convertible doesn't include regular interest payments and won't mature until 2018.

What Netflix desperately needs is for streaming subscriber growth to resume. That should boost margins and cash flow, even though a portion of the content costs rise with viewership, because much of it was purchased for a fixed price. And if subscriptions improve, content owners could yet ask for higher fees in future deals, making a cash cushion crucial.

The lesson for growth companies is that buybacks can be risky—not just in large amounts, but at high prices. Netflix paid an average price of $45 a share for stock repurchased since 2007, below the current level of $72. But many of the recent purchases were at multiples of that price. If Netflix had refrained from aggressive buybacks until the business model was relatively steady, inevitable bumps in the road would have been much easier to ride out.

Source: http://online.wsj.com/article/SB10001424052970203710704577054431537105996.html?mod=WSJ_Heard_LEFTSecondNews

The euro: Beware of falling masonry

FIRST Greece; then Ireland and Portugal; then Italy and Spain. Month by month, the crisis in the euro area has crept from the vulnerable periphery of the currency zone towards its core, helped by denial, misdiagnosis and procrastination by the euro-zone’s policymakers. Recently Belgian and French government bonds have been in the financial markets’ bad books. Investors are even sniffy about German bonds: an auction of ten-year Bunds on November 23rd shifted only €3.6 billion-worth ($4.8 billion) of the €6 billion-worth on offer.

Worse, there are signs that the euro zone’s economy is heading for recession, if it is not there already. Industrial orders in the euro zone fell by 6.4% in September, the steepest decline since the dark days of December 2008. A closely watched index of euro-zone sentiment, based on surveys of purchasing managers in manufacturing and services, is also signalling contraction, with a reading of 47.2: anything below 50 suggests activity is shrinking. The European Commission’s index of consumer confidence fell in November for the fifth month in a row.

Now an even bigger calamity is looking likelier. The intensifying financial pressure raises the chances of a disorderly default by a government, a run of retail deposits on banks short of cash, or a revolt against austerity that would mark the start of the break-up of the euro zone.

The German government can probably shrug off a failed auction: it likes to price its bonds as richly as it can, and occasionally cannot sell all it would like, even in untroubled times. Still, the timing is awful, and other governments are not so lucky: the contrast between Germany’s borrowing costs and those of other euro-zone sovereigns is stark (see chart 1). European banks are dumping the bonds of the least creditworthy, and other assets, in an attempt to conserve capital and improve cashflow as a full-blown funding crisis looms. Governments are promising ever more severe budget cuts in the hope of pacifying bond markets. The direct result of these scrambles is a credit crunch and a squeeze on aggregate demand that is forcing Europe into recession. Add the indirect effects on the confidence of consumers and businesses, and the downturn will be deep.

A recipe for recession

Consider the three ingredients for recession: a credit crunch, tighter fiscal policy and a dearth of confidence. In aggregate, European banks’ loans exceed their deposits, so they rely on wholesale funds—short-term bills, longer-term bonds or loans from other banks—to bridge the gap. But investors are becoming warier of lending to banks that have euro-zone bonds on their books and that can no longer rely on the backing of governments with borrowing troubles of their own. Long-term bond issues have become scarce and American money-market funds, hitherto buyers of short-term bank bills, are running scared.

Banks are frantically shedding assets both to raise cash and to ration their capital in order to meet European Union minimum capital-adequacy targets by next June. The early victims of this deleveraging are borrowers in emerging markets. The euro zone’s eastern neighbours may be hit particularly hard: the Turkish lira, for instance, has come under pressure in the past week, a hint that money is flowing out. The repatriation of funds by euro-zone banks might explain why the euro has been remarkably stable against the dollar in recent weeks, despite the zone’s internal convulsions. But businesses and householders at home will also soon be hurt by scarcer credit and rising interest rates, as the banks’ higher funding costs are passed on.

Governments are cutting back too. The precise impact of next year’s belt-tightening is tricky to gauge. France’s budget plans are close to being agreed on; further cuts are likely but will be delayed until after the elections in spring. Italy has yet to vote through a much-revised package of cuts. Spain’s incoming government has promised further spending cuts, especially in regional outlays, in order to meet deficit targets agreed with Brussels.

Even so, it seems plain that fiscal tightening will weaken growth. Take the plans that countries presented to the European Commission and add what has been advertised since, and the squeeze across the euro area comes to around 1.25% of GDP next year, reckons Laurence Boone, chief European economist at Bank of America. That alone is enough, says Ms Boone, to chop around a percentage point off GDP growth in 2012. Germany will be the least affected of the zone’s four biggest economies, followed by France. Spain and Italy will be hurt most.

The euro zone’s businesses and consumers will be drawn into the downward spiral of confidence. In the autumn of 2008 companies learned that credit lines could not be relied on when banks were fighting for survival. When banks are short of liquidity, firms have to watch their own cashflow closely. That implies leaner stocks and reductions in discretionary spending, such as capital projects or advertising campaigns.

September’s sharp decline in industrial orders is an early sign that companies are cutting back. Andreas Willi, head of capital-goods research at JPMorgan, notes that SKF, a Swedish firm that is the world’s largest maker of ball bearings and a bellwether of industrial demand, gave analysts a cautious assessment of its future revenues in mid-October. That guidance suggests a further softening of investment demand. Consumers are also likely to defer big purchases as long as the crisis is unresolved and credit is scarce.

A drop in demand for capital equipment, durable consumer goods and cars will strike at the euro zone’s industrial heartland, including Germany. Ms Boone reckons GDP will fall by around 0.5% in Germany next year and by the same amount in the whole zone. In September the IMF forecast that the zone’s GDP would grow by 1.1% in 2012 but estimated that if European banks were deleveraging quickly (as they are now), the economy could shrink by around 2%.

Breaking point

A downturn of such severity will hugely increase the pressures within the zone. Investors will be even less willing to finance banks, as more garden-variety loans to businesses and householders turn bad. As unemployment rises, tax receipts will go down and welfare payments up, making it harder for governments to rein in their deficits and hit the targets they have set, and causing bond markets to question their solvency more pointedly still.

In such circumstances, the chances of a policy error or broader panic increase sharply. The calculations of bond investors, bank depositors and politicians are prone to sudden change. Hopes that the fracture of the euro zone might be averted by far-sighted policymakers could give way to a belief that it is inevitable. Such beliefs, once they take hold, are likely to be self-fulfilling.

How? The drying-up of funding for sovereigns and for banks is a threat to the integrity of the euro, because of the stark divide between debtor and creditor countries within the zone. As late as March 2010, Jean-Claude Trichet, then head of the ECB, boasted that simply belonging to the euro area automatically ensured balance-of-payments financing. It doesn’t look that way now.

During the credit boom, cheap capital flowed into Greece, Ireland, Portugal and Spain to finance trade deficits and housing booms. As a result, the net foreign liabilities—what businesses, householders and government owe to foreigners, less the foreign assets they own—of all four are close to 100% of GDP. (By comparison, America’s net foreign liabilities are 17% of GDP.) Much of their debt is being financed by local bank borrowing or bonds sold to investors in creditor countries, such as Germany. Ireland is unusual in that a large chunk of what it owes is in the form of equity (all those American-owned factories and offices) and so does not need to be refinanced.

With a few exceptions, the benchmark cost of credit in each euro-zone country is related to the balance of its international debts. Germany, which is owed more than it owes, still has low bond yields; Greece, which is heavily in debt to foreigners, has a high cost of borrowing (see chart 2). Portugal, Greece and (to a lesser extent) Spain still have big current-account deficits, and so are still adding to their already high foreign liabilities. Refinancing these is becoming harder and putting strain on local banks and credit availability.

The higher the cost of funding becomes, the more money flows out to foreigners to service these debts. This is why the issue of national solvency goes beyond what governments owe. The euro zone is showing the symptoms of an internal balance-of-payments crisis, with self-fulfilling runs on countries, because at bottom that is the nature of its troubles. And such crises put extraordinary pressure on exchange-rate pegs, no matter how permanent policymakers claim them to be.

One of the initial attractions of euro membership for peripheral countries—access to cheap funds—no longer applies. If a messy default is forced upon a euro-zone country, it might be tempted to reinvent its own currency. Indeed, it may have little option. That way, at least, it could write down the value of its private and public debts, as well as cutting its wages and prices relative to those abroad, improving its competitiveness. The switch would be hugely costly for debtors and creditors alike. But the alternative is scarcely more appealing. Austerity, high unemployment, social unrest, high borrowing costs and banking chaos seem likely either way.

The prospect that one country might break its ties to the euro, voluntarily or not, would cause widespread bank runs in other weak economies. Depositors would rush to get their savings out of the country to pre-empt a forced conversion to a new, weaker currency. Governments would have to impose limits on bank withdrawals or close banks temporarily. Capital controls and even travel restrictions would be needed to stanch the bleeding of money from the economy. Such restrictions would slow the circulation of money around the economy, deepening the recession.

External sources of credit would dry up because foreign investors, banks and companies would fear that their money would be trapped. A government cut off from capital-market funding would need to find other ways of bridging the gap between tax receipts and public spending. It might meet part of its obligations, including public-sector wages, by issuing small-denomination IOUs that could in turn be used to buy goods and pay bills.

When cash is scarce, such scrip is readily accepted by tradesmen. In August 2001 the Argentine province of Buenos Aires issued $90m of small bills, known as patacones, to employees as part of their pay. The bills were soon circulating freely: McDonalds even offered a “Patacombo” menu in exchange for a $5 pata c ón. Argentina broke its supposedly irrevocable currency peg to the dollar a few months later.

Scrip of this kind becomes, in effect, a proto-currency. In a stricken euro-zone country, it would change hands at a discount to the remaining euros in circulation, foreshadowing the devaluation to come. To pre-empt further capital outflows, a government would have to pass a law swiftly to say all financial dealings would henceforth be carried out in a new currency, at a one-for-one exchange rate with the euro. The new currency would then “float” (ie, sink) to a lower level against the abandoned euro. The size of that devaluation would be the extent of the country’s effective default against its creditors.

Market gurus and other students of misaligned stock, bond or home prices often say that although it is easy to spot an asset-price bubble, it is impossible to know the event that finally pricks it. In much the same way, the likeliest trigger for a disintegration of the euro is unknowable. But there are plenty of candidates. One is a failed bond auction that forces a country into default and sends a shock wave through the European banking system. Italy has €33 billion of debt coming due in the final week of January and a further €48 billion in the last week of February (see chart 3). Since bond investors are turning their noses up even at offerings from thrifty Germany, the odds against Italy’s being able to raise the money it needs early next year are uncomfortably short.

Another danger is a disagreement between Greece and its trio of rescuers (the EU, the IMF and the ECB) over the conditions of its bail-out. The risk of a mishap will be greater after the Greek elections in February if the country’s political mood sours yet further. Perhaps the spark will come from another source: the bankruptcy of a bank; fresh trouble in Portugal; or a chain of events that starts with France losing its AAA rating and ends with runs on banks across Europe. The exposure of French banks to Italy and to other countries that have been in bond traders’ sights for longer implies that contagion would quickly spread to the euro’s core (see chart 4). Widespread defaults in the periphery would wipe out a big chunk of Germany’s wealth and begin a chain of bank failures that could turn recession into depression.

The few left in the euro (Germany and perhaps a few other creditor countries) would be at a competitive disadvantage to the new cheaper currencies on their doorstep. As well as imposing capital controls, countries might retreat towards autarky, by raising retaliatory tariffs. The survival of the European single market and of the EU itself would then be under threat.

Such a disaster can still be averted. The ECB might launch a programme of bond-buying on the pretext that a deep recession in the euro area threatens deflation. If done on the scale that the Bank of England has undertaken, it could restore stability to Europe’s panicky bond markets. If bond purchases were made in proportion to the size of each euro member’s economy, that might go some way to overcoming German misgivings that the central bank was being used to provide favourable financing to profligate countries.

Such action by the ECB is an essential short-term palliative. But any lasting stability for the euro must lie with governments, particularly in the degree to which they are willing to give up fiscal sovereignty in return for pooling liabilities. Germany stands firmly at one extreme of this debate. Its chancellor, Angela Merkel, wants big changes to force probity (and wants the EU summit on December 9th to focus on such rule changes), but has opposed the idea of jointly guaranteed “Eurobonds”. German officials have argued that any open-ended commitment to joint liabilities would encourage errant governments to profligacy, violate Germany’s constitution and raise its borrowing costs. Even now, the head of the Bundesbank, Jens Weidmann, appears to believe that the imposition of fiscal rigour will be enough to restore calm to Europe’s bond markets.

Hanging together

Others think that circumstances demand speedier concentration on ways to pool liabilities. On November 23rd the European Commission laid out three approaches for issuing Eurobonds, two of which imply mutual guarantees.

Another new proposal is intriguing—thanks, in part, to its provenance. Germany’s Council of Economic Experts recently proposed a “European Redemption Pact”. This scheme would place the debt, in excess of 60% of GDP, of all euro-zone governments not already in IMF rescue plans into a jointly guaranteed fund that would be paid off over 25 years. Modelled in part on the federal government’s assumption of the debt of America’s states begun by Alexander Hamilton in 1790, the fund would provide joint liability for these debts under strict conditions. These would require euro-zone countries to introduce debt brakes into their constitutions, like the one Germany and Spain already have; give priority to paying off the mutualised bonds; set aside a specific tax revenue to do so; and pledge foreign-exchange reserves as collateral.

At its peak, the redemption pact would be huge: the joint liability would amount to €2.3 trillion. But it would technically be temporary. For all these safeguards, Germany’s government has so far poured cold water on the idea. But time is running out. And the scale of the impending catastrophe demands radical answers.

Source: http://www.economist.com/node/21540259

Pulling for the home team

IT CANNOT be pleasant to start a new job with a continent’s fate resting on your shoulders. On November 1st, Mario Draghi’s first day as president of the European Central Bank (ECB), peripheral-government bond yields shot up and stockmarkets sank on fears that Greeks might reject a rescue plan agreed days earlier.

On November 3rd, as The Economist went to press, Mr Draghi was presiding over his first policy meeting. Much is riding on what the ECB decides then and in coming weeks because it alone currently has the means to stem the intensifying crisis. It has bought Greek, Portuguese and Irish debt; since early August, it has also purchased Spanish and Italian bonds. But its purchases have been intermittent and begrudging. Without a firm commitment to buy as much as needed to prevent yields on Italian and Spanish bonds rising so high that both countries become insolvent, investors have less incentive to return.

The ECB’s reluctance to make such a commitment is understandable: its legal mandate and doctrinal persuasion bar it from directly supporting governments. Yet throughout history central banks have been lenders of last resort to their governments. In 1694 the English monarchy was broke and in need of a loan so that it could wage war with France. A group of financiers agreed to lend the crown £1.2m in return for a partial monopoly on the issue of currency. Thus was born the Bank of England.

Central banks routinely serve as their government’s agent: they accept payments, disburse outlays, auction and redeem their bonds. Most buy and sell government bonds to carry out monetary policy. At times they have done so to finance government, especially in wartime. The Bank of England suspended the convertibility of its notes to gold from 1797 to 1821 to enable it to better finance Britain’s wars with France. In the 1930s the Bank of Japan was compelled to buy the government’s bonds, and from 1942 to 1951 the Federal Reserve agreed, at the Treasury’s request, to hold Treasury yields to 2.5% or below.

The risks are obvious: bond purchases expand the money supply, potentially leading to inflation. Virtually all hyperinflations begin with such monetisation of budget deficits, including Germany’s in 1920-24, which explains the Bundesbank’s, and now the ECB’s, reluctance to lend to governments.

The mere possibility of inflation can force governments with weak central banks to pay punitive interest rates. But as Chris Sims of Princeton University, who shared this year’s Nobel prize for economics, notes in a recent presentation, there is another side to the story. Bonds of a country with its own central bank are simply a promise to repay one government obligation (ie, debt) with another (ie, currency). The owner of such a bond is confident he can always sell or redeem it, and thus does not demand a higher yield to compensate for counterparty risk.

A country that gives up its monetary sovereignty by dollarising or adopting the euro may gain greater credibility on inflation but may have to pay more to compensate investors for counterparty risk. This may seem like a good idea when counterparty risk is low, but that can change abruptly and dramatically. Mr Sims, in a 2002 paper, says the option of using inflation to repay debt is a valuable fiscal-shock absorber that over time may be less expensive than the risk, or fact, of default.

This can be seen starkly by comparing Britain with Spain (see chart). Based on debts, deficits and inflation, Britain should be the riskier credit. But British bonds yield around 2.3% whereas Spain’s yield around 5.5%. One reason is that Britain can still devalue to boost growth; Spain can’t. Another is that it has a lender of last resort; Spain doesn’t. Paul De Grauwe of the University of Leuven says that if Britain couldn’t roll over its debt at acceptable interest rates, it could ultimately force the Bank of England to buy it. “This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default.”

No central bank wants to be put in that position, of course, and institutional arrangements have sprung up to prevent it. The most common is to require that bonds be purchased only at market prices. The Federal Reserve is prohibited from buying bonds directly from the government, except to roll over a maturing issue in its portfolio. It can buy bonds on the secondary market, which is how it enforced the yield ceiling during the second world war, but its accord with the Treasury in 1951 ended that obligation. The Bank of Japan can buy bonds on the secondary market, but not directly from the government unless the Japanese Parliament votes to require it. The Chilean central bank may not buy government securities while Israel, Argentina, Canada and South Korea impose limits on how much the central bank may purchase.

The European Union’s Maastricht treaty is in keeping with these arrangements: it prohibits the ECB from buying bonds directly from member governments, but not from buying them on the secondary market. The ECB claims it buys only to ensure its monetary policy is transmitted to interest rates.

How could the ECB be enticed into becoming lender of last resort? Mr Sims says the ECB needs to be reassured its own balance-sheet has sound fiscal backing. That is because it may deplete its capital by selling assets at a loss or paying interest on reserves to prevent bond purchases from fuelling inflation. He suggests empowering the European Financial Stability Facility, Europe’s bail-out fund, both to issue euro-denominated bonds (backed by a euro-zone-wide tax) which the ECB could buy during open-market operations, and to recapitalise the ECB if needed.

But the ECB may not have time to await such arrangements. Brad DeLong of the University of California, Berkeley, notes that central banks have taken liberties with their mandates when financial stability was at stake. The Bank of England lent aggressively during the financial crisis of 1825-26, for example, despite lacking the legal authority. Sir Robert Peel, First Lord of the Treasury, later said: “If it be necessary to assume a grave responsibility, I dare say men will be willing to assume such a responsibility.” Whether Mr Draghi does so may determine the euro’s fate.

Source: http://www.economist.com/node/21536567

Dim-Sum Bonds Difficult to Digest

The unwritten promise embedded in the Hong Kong market for yuan-denominated bonds is that low yields will be offset by the steady upward march of the Chinese currency. Now that the promise seems broken, investors are finding the bonds—referred to as dim-sum—more difficult to swallow.



In the first half of the year, the continued rise of the yuan appeared inevitable. But a combination of China's weak export growth, diminished domestic inflation and a stronger U.S. dollar have taken the edge off expectations the currency will strengthen significantly.
[CHINAHERD]

Data on China's current account, released Tuesday, bolster Beijing's argument that the yuan is close to fair value. The surplus for the first three quarters of the year came in at 3% of gross domestic product, down from 5.1% in the same period in 2010. Importantly, the surplus is below the 4% threshold proposed by the U.S. as the baseline for assessing currency misalignment.

The nondeliverable-forward market is pricing in close to zero appreciation of the yuan against the dollar in the year ahead. NDF markets are often too pessimistic, but certainly a slowdown in yuan appreciation from around 5% in 2011 to something more like 3% in 2012 seems likely.

With less to gain from movement in the exchange rate, investors are already demanding higher yields on their dim-sum bonds. Chinese government bonds issued in Hong Kong this August with a 0.6% coupon are now trading at a yield of around 1.5%.

Another factor that might push up yields: alternative options for investing in yuan-denominated debt. The government of Hunan province in south-central China is reportedly seeking a 10 billion yuan ($1.58 billion) syndicated loan in the Hong Kong market. Patrick Law, head of trading for Greater China at Barclays Capital, says more competition for offshore yuan means there will be increased pressure for issuers in the dim sum market to offer higher yields.

Excess liquidity should put a cap on how far yields rise —there is 622 billion yuan in deposits sitting in Hong Kong's banks, compared with around 190 billion yuan in outstanding bonds.

But the evidence suggests that expectations about China's currency are still driving the market. The Bank of China Hong Kong offshore yuan bond index is down 6.5% since its June high, the same period over which hopes for yuan appreciation have faded.

Long term, the yuan's rise against the dollar still seems like a good bet. But dim sum bonds are no longer perceived as a sure-fire winner from appreciation. As more nuanced expectations on the exchange rate develop, investors will surely develop a more discerning appetite for dim sum.

Source: http://online.wsj.com/article/SB10001424052970203699404577041572665925312.html?mod=WSJASIA_hps_sections_china

Europe’s debt crisis: Rushing for the exits

THE moment when a throng of peacefully moving people turns into a panicked herd is difficult to predict. Yet, once triggered, it is almost impossible to calm the hysteria. In financial markets too, it is better to avert panic than to try to pacify it.

On Italy’s bond market, the world’s third-largest, where yields had been rising for weeks, fear turned to panic early on November 9th. Risk officers at LCH.Clearnet, which stands between banks trading in bonds, said that its members would have to post much higher margins against their holdings of Italian government bonds.

This was intended to protect the clearing house by reducing the risks posed by banks trading Italian government bonds, given the wild swings in their prices over the past few months. Yet this technical change to a part of the financial system that most people have never heard of had the same effect as shouting “Fire!” in a crowded theatre. Almost at a stroke banks trading Italian government bonds, or using them as collateral for other transactions, would have either had to come up with billions of euros in extra cash or would have quickly had to sell some of their holdings.

Within minutes of the market opening there was a fully fledged run on Italian government bonds. Buyers were hard to find, and in thin markets yields on the bonds jumped past 7% before stabilising just below 7.5% on what traders assumed was buying by the European Central Bank. “The clearing platforms have no option but to protect their members and in doing so, they will inevitably turn the screw on Italian government bond markets and push yields closer to levels which could potentially trigger a death spiral,” wrote Don Smith of ICAP, which helps dealers trade.

The margin increase was not entirely unexpected. Over the past year the clearing house asked for more margin on Portuguese and Irish bonds after their prices fell sharply. Yet the increase on Italian debt came sooner than expected, as it was triggered before Italian bonds crossed a threshold that the clearing house was thought to use (4.5 percentage points above the average interest rate of AAA-rated government bonds in the euro zone). And the margin increase is unlikely to be reversed, even if ECB buying drives yields back.

The triggering of margin calls has changed investors’ perceptions of Italian government bonds and will worsen the government’s funding position. The immediate risk is that banks which might have held Italian bonds as part of their liquidity reserves or the building blocks of other financial products are dumping them for safer bets, such as German Bunds. “There is a reason why Bund yields are approaching 200-year lows,” says Hans Lorenzen of Citigroup, a bank. “Everyone is trying to crowd into the same trade.”

Among the large European banks that are dumping Italian bonds are BNP Paribas and Commerzbank. “It is what the market is asking us to do,” says one banker. At the top of many bankers’ minds are the woes of MF Global, a mid-sized investment bank that went bust at the end of October after loading up on Italian and other peripheral European government bonds. So toxic is their taint that shares in Jefferies, another mid-sized American investment bank, were pummelled over the firm’s trades in European bonds, despite the fact that it had “shorted” them and stood to benefit if they fell in price. It too has been forced to cut back both its holdings and bets that they might fall.

Now that a run on bond markets has started, it may well keep feeding on itself. After clearing houses raised margin requirements on Portuguese and Irish bonds, their prices fell sharply (pushing yields up), prompting clearing houses to increase margins yet again (see chart 1). Euro-zone bail-outs followed shortly afterwards.

Rising bond yields can themselves stoke worries about a country’s ability to service its debt. Italy’s national debt is high, but affordable at the yields it was paying earlier this year. If its borrowing costs were to climb for a sustained period its debt would begin to look unaffordable, prompting further selling and further increases in bond yields.

Borrowing costs paid by Italian banks and companies are also likely to rise. Banks are generally unable to issue long-term bonds at interest rates lower than those paid by their governments, because they would be hardest-hit by a default. Higher borrowing costs for banks will force them to rely more on the ECB to keep credit flowing; and it will mean scarcer and costlier loans for Italian companies, which in turn may slow economic growth and hamper debt repayment. Italy’s strongest companies can sell bonds directly, but the rates they pay are also correlated to the yields on government bonds.

The very visible signs of runs in government and corporate bond markets seem to be mirrored in more opaque corners of finance. Greek banks have been bleeding deposits for months, yet panic may be setting in. Reuters reports that over the past week as much as €5 billion was withdrawn by savers. “My father sent me money as a ‘gift’, to get it out,” says one London-based but Greek-born banker. In Italy corporate deposits have also been moving out of the country to other members of the euro zone, or to the subsidiaries of foreign-owned banks in Italy, according to bankers.

Another sign of strain may be found in demand for €500 bills. These are too large for everyday transactions and are mainly used for mattress-stuffing or money laundering, say bankers. Demand for them surged after the collapse of Lehman Brothers in 2008, and it has ticked up again in recent months (see chart 2).

Worrying, too, are signs that companies across Europe are preparing for the possibility of a break-up of the euro zone. One London lawyer says he has been inundated by requests from clients asking about the validity of contracts. “There is a contractual obligation to make payment in euros,” he says. “People are asking what happens if there isn’t a euro.”

Source: http://www.economist.com/node/21538195