Fed raising the stakes

On my blog, I have tended to focus on monetary policy issues. Indeed the previous post from February 2014 was ominously titled “The sum of all tightenings” (now that I just read it, it turned out not to be a completely bonkers story). Today, too, I will focus on monetary policy, albeit from a more theoretical standpoint.

A few years after the crisis, some economists were pondering the idea of raising the inflation target. Most famously, a paper by Olivier Blanchard from 2010 suggests that the CPI target should be moved from 2 to 4% (short summary here). There was also an interesting paper from Laurence Ball four years later advocating the same thing. I remember at the time that the idea was ridiculed by “street” economists and strategists with the reasoning going along the lines of “yeah right, you can’t even meet your current target so good luck with a higher one”. Even the policy heavyweights like Ben Bernanke dismissed the idea back then and we simply moved on.

Those of you who follow the markets will be aware that last week Janet Yellen somewhat surprisingly said that the question of raising the inflation target is critical (a nice FT story here). Again, the idea was quickly dismissed, eg by Martin Wolf. In fact, I chuckled to see this familiar argument from the FT View, which entirely misses the point. Again.

But the Fed should not be distracted from the theoretical benefits of changing the goal while it has consistently failed to reach the current one.

In fact, before going into the crux of my argument let’s sort out this flawed observation of missing the inflation target. Below is the chart of the core CPI and PCE in the US in the last five years:

The core PCE has fluctuated around 1.5% and core CPI, while more volatile, has been around 2% for most of the time (except 2015). If someone thinks that from the economic agents’ point of view this is sufficiently far from the target to warrant making fun of the monetary authority then they are mistaken (and that would hold even if we weren’t exiting from the biggest forced deleveraging of a generation). For the purposes of this post, I will therefore assume that the Fed has been fairly close to its inflation target and it has certainly not been a failure of the policy. If you disagree with this, you might as well stop reading. Also, please bear in mind that this argument is about the Fed and the Fed only (not the ECB or the BoJ, whose inflation credentials are considerably worse).

Back to the main story, though. Former Governor of the National Bank of Poland Marek Belka was asked several years ago during a meeting with investors in London whether he thought it made sense to lower the inflation target in order to adjust to ever-low inflation prints. He seemed shocked at the suggestion and replied asking why anyone would want a tighter monetary policy at this juncture? Most people in the room didn’t get his point so he went on explaining that lowering inflation target by 1pp is tantamount to a promise that real rates would be durably higher by this amount. In other words, the central bank would have to hike interest rates faster than otherwise. Seems simple but for many this still isn’t straightforward. For some reason, the discussion didn’t move to raising inflation target back then.

Assuming the Fed is a credible central bank (and if it isn’t then I am not sure which one is…), there is a possibility that the inflation target gets moved to 4%. In the short to medium term it would be similar to letting inflation run a little bit hot after years of low growth, which the Fed wants to allow anyway but in the long run it would be a significant change. This would mean that the Fed commits to not tightening monetary policy as aggressively as it otherwise would. Would people believe it? Sure they would!

Now, the problem these days is reflexivity of markets. For example, Fed hikes interest rates, dollar strengthens, Fed needs to refrain from hiking. All this sometimes happens at a breath-taking pace. Also, we must not forget the Fed’s dual mandate, given that we seem to be at full employment. Therefore, it is safe to assume at the moment that the Fed will continue chugging along with rate hikes for the foreseeable future. Slowly but surely.

There is a significant problem here, which the Fed seems to have identified (judging by recent comments from Dudley) – so far the slow and predictable pace of hiking interest rates has not led to any significant tightening of monetary conditions as stocks continued rallying, spreads tightened and the curve flattened. This very much resembles the pre-crisis Greenspan’s conundrum era. The Fed hikes but the market eases thus leading to significant build-up in leverage until things go really ugly. So hiking rates, while appropriate, may prove deathly in the long run given how vast the financial markets have become.

What if we raise the inflation target simultaneously then? As mentioned above, this gives the signal to people that the Fed won’t be hiking rates as fast as it otherwise would. That said, given where monetary conditions are, some additional rate hikes would still be likely. So far it sounds similar to what we have had to date. But the important distinction is that – taking Fed’s credibility for granted – markets would need to start pricing in more inflation premium to the long end of the curve. This would offset the dreaded flattening pressure, which has made people so worried lately. Note that if the curve isn’t flattening then (among others):

• the appreciating pressure on the USD is smaller than otherwise;
• investors are not pushed out of fixed income assets into riskier investments (see insurance companies);
• the banking sector stays buoyant.

Finally, imagine that these two forces, ie rate hikes and an increased inflation target get supplemented by offloading of the balance sheet. What the Fed would then achieve would be bearish steepening of the curve, which in my opinion is the necessary condition for us to finally move on from the aftermath of the 2008 Global Financial Crisis. And if that happens, discussions about the US fiscal stimulus and tax cuts would probably be met by questions like “Donald who?!?” or “Who cares?”. This is because the economic impact of gradual bear steepening of the curve driven by a higher inflation target would trump (sic!) everything else.

*It’s been more than three years since I last posted. I don’t suppose it will take me another three years to write the next one but one should not assume that hereby the regular service resumes.

**I do realise that I made some short-cuts in reasoning above but this is a blog post from an anonymous bloke who sits in Warsaw and comments on the Fed policy, rather than a peer-reviewed paper in Journal of Applied Economics 🙂

I am back and so is the balance of payments

As we get a breather in the indiscriminate sell-off, I think it is a good time to consider what it is that actually drives the faith of various emerging markets.

Naturally, the easiest explanation currently is “tapering”, which is something I’ve been trying to fight for the last several weeks among the investors that I speak to. Alas, the power of the front page of FT or WSJ saying “EM is doomed as Fed tightens (sic!) the policy” is difficult to overcome. What is particularly worrying is that this sort of über-lazy argumentation is very often used by fairly young traders. The reason why it worries me is that those guys will at some stage be responsible for the way the market behaves and that spells all sorts of issues, especially when it comes to concentration of views and positions.

The “reasoning” is as follows.

A financial tsunami is coming because the Fed will taper. Therefore let’s try to look for another crisis of similar sort. Oh, we don’t need to look too far back as we’ve got 2008. Brilliant! So which position would’ve made me a billionaire back then? Shorting the EUR, receiving the xccy basis in anything-USD, selling all emerging markets, particularly CEE and a few more. So why don’t I do it again as “this time is different” never works. – Risk meeting at a macro fund

I honestly can’t tell you how much I hate such an approach. Probably as much as popular it has become. Meanwhile, people are forgetting the simple, transparent approach to looking at various countries, ie the balance of payments. Everything you need to know is there, particularly in emerging markets.

You want examples? Ok, a few recent things:

– Turkey. It is selling off not because of some protests or handling thereof by the government. It is selling off because the market has realised that the current account and it’s funding is not sustainable at the current level of rates. And this process started before the infamous Bernanke speech. The only way to tackle that is by adjusting the main culprit, ie the monetary policy. Not the currency. It is very common to confuse currency depreciation with the balance of payments adjustment. Therefore the correct trade in my opinion is ratesa/bonds rather than FX. With or without the taper.

– Egypt. Again, the balance of payments will tell you that the country was going to go bust even before the whole Morsi debacle started. Why is the current account so bad? Because the fiscal policy is too lax (subsidies etc). Will FX depreciation help? Nope, it might actually worsen things. Either way, what’s going on in Egypt has very little to do with Ben or protests.

– Hungary. It’s not selling off. How come? Debt stock is huge, after all. That’s irrelevant. The balance of payments is looking ironclad and that’s why the HUF is strong like a bison. Bernanke or not.

– Eurozone. How many people have lost their shirt on shorting the euro in the last couple of years. “The euro needs to crash to help the periphery” has been such a lovely slogan. But look at eurozone’s balance of payments. It is looking spectacular both on the current account side and on the funding component. Even the intra-EMU BoP is not bad (as represented by, pardon Lorcan, shrinking Target2 balances). And this is why the euro is not crashing. Sure, Bernanke’s testimonies could create some volatility but the “macro investors” should take a step back and see how poorly shorting the euro has worked and maybe rethink their approach.

– China. Here the situation is trickier because at face value the current account and financial account don’t seem to be problematic. But there’s a third component to the balance of payments, ie fx reserves. Equally important as the other two as it determines the level of liquidity in the local banking system (the central bank by accumulating reserves pumps in more local currency), which can then create all sorts of issues, including the unprecedented growth in credit/GDP. And this is why the Shibor market has become so unstable.

I could multiply those examples but the point is that it is my profound conviction that in most cases the analysis of the balance of payments will help you both ask the right questions and get you the right answers. This is also the place where policy mistakes are laid bare.

Therefore, stop trying to guess whether the market misinterprets Ben Bernanke in one or another way because – as the last few weeks have shown – this will stop you out of positions unless you are the luckiest trader alive (in which case sit back, relax, you’re all set). But go back to the basics. Have a look at the balance of payments and this will help you get above the monkeys who trade Bloomberg headlines and are proud when they’ve guessed whether it was a risk on or a risk off day.

What the central bank giveth, only the central bank taketh away

When I first started working at a bank they told me to do liquidity forecasts for the money market desk. It was a relatively simple, yet educational exercise. I would look at a given month and put together a table of cash inflows to and outflows from the system. For example, when there would be a bond redemption or a coupon payment, it would mean an increase in liquidity. Conversely, if the finance ministry were to issue bonds, it would drain some money from the system. These were just daily moves in liquidity but they were absolutely key for the money market rates. Believe me, you don’t want to make a mistake when doing that…

But the thing is that this was just forecasting of changes in maturity of money in the system. After all, the mere fact that the finance ministry pays out a coupon doesn’t mean that there is more money in the system. The finance ministry cannot print money so they would simply move it from their account to the accounts of bond holders. On that day overnight rates would normally drop but the system would balance itself quite quickly.

Fast forward to more interesting (aka post-Lehman) times. The central banks around the world have been printing money at a spectacular pace and many agree (myself included) that quite a few of developed economies are in the liquidity trap. Naturally, the increase in central banks’ balance sheets has led to a significant build up in excess liquidity, which – as we know all too well – usually ends up back at the central bank’s deposit facility. This is beginning to raise concerns in both developed and emerging economies. Let me give you three examples from recent weeks in the European Union (in order of appearance):

• Hungary’s central bank is planning to limit banks’ access to the two-week NBH bills (open market operations). More details can be found here. NBH Governor Matolcsy is quite angry that the central bank needs to pay banks for the liquidity they park in this facility. He is pointing in the direction of foreign banks (I explained the mechanism in the post entitled The Invisible Carry), but we can assume this will eventually be extended.
• Last week, Mario Draghi said the central bank was open to negative rates on the deposit facility.
• This week, Nationa Bank of Poland’s Governor Marek Belka said that banks had too easy lives because they were parking PLN140bn using weekly open market operations and earning the repo rate without any problems.

Many commentators and indeed the central bankers themselves have been mentioning that the idea behind those measures is to make the banks lend more. It is often claimed that the liquidity in the banking system should be helping the economy recover, instead of making banks money. But this is a very simplistic approach to how banks operate.

Let’s say that a banking system has excess liquidity of 1,000bn (never mind how it got to that state). This money is kept at the central bank in weekly open market operations and earns 0.05%. Let’s then assume that the central bank slashes this rate to -1%. What happens?

Some banks may conclude that using the central bank is not a very smart thing to do anymore and will go and buy, say, 3-month TBills. But who will they buy them from? Finance ministry? Ok, but then what will the finance ministry do with the money it gets from the bank? It will pay teachers’ salaries (among others, of course). What will the teachers do? They will keep it on their bank accounts, which means the money will have returned to the system and we’re back at square one, but with one happy finance minister who just sold some TBills.

Other banks will conclude that maybe they will take the money they’d normally put at the central bank, swap it into another currency, eg the USD and buy some USD-denominated assets with it. The price of USD in the swap market will increase (and the price of the local currency will decline) but ultimately the money won’t disappear and will return to the central bank. The process will, however, lower fx swap rates.

Perhaps there will be one bank whose CEO will feel patriotic and will want to lend money to “hard-working entrepreneurs up and down the country”. Why the decline of deposit rate by 105bp would persuade her to do that is beyond me, but we can make such an assumption. So if this bank lends some money for the new investment project, then the company in question will spend the money and the money will… come back to the system! At the end of the day, there will still be 1,000bn sitting with the central bank. Just at a different price.

I don’t question the fact that such a move will persuade banks to search for higher-yielding assets, ie loans but what I’m trying to explain is that the liquidity in the banking system is like a hot potato. The central bank controls how much money there is in the system (using various ways, eg printing money, changing the reserve requirement etc) and the market only needs to decide the price of this money. The only way that lowering rates to the negative territory impacts the amount of cash in the system is because the central bank will be returning 99% of the money placed in it back to banks. But then which of the major central banks could even contemplate shrinking its balance sheet at the time when the global economy remains exceptionally fragile?

What I think discussions like the ones taking place in Europe will lead to is significant re-pricing of interbank rates (BOR-OIS spreads could decline massively as banks start passing on the potato) and an increased demand for government or quasi-government bonds by banks’ assets and liabilities management desks (ALMs). Perhaps this is the point of the whole exercise. Then again, isn’t it yet another version of crowding out and actually forcing banks to play the carry in government bond markets? Hard to see how that should please politicians but perhaps this is the only path to rejuvenate the credit action. I really don’t like growth implications of such a process. Unless of course the ultimate beneficiaries, ie the governments, use the extra demand for their papers to increase public spending… But I will spare you, Dear Reader, yet another discussion about consequences of austerity. There’s this chap in the US who does that several times a day.

 

Abolish deposit insurance, please

This crises has taken its toll on livelihoods of many people. But it’s also making otherwise reasonable and balanced investors lose the plot and move from investing to preaching.

I have found myself in a surprising situation lately – I inadvertently became the only person on my twitter feed who does not condemn Jeroen Dijsselbloem. Now, I like being controversial like the next man (anyone who ever tried to talk to me about Hungary can testify that) but this time around I have had to endure more abuses than normally.

I am sure many of you still have in mind “the Cyprus debacle”. If not, please start with an excellent piece from Joseph Cotterill entitled “A stupid idea whose time had to come” and work your way through links. The title of Joe’s piece has stuck in my mind ever since and I finally have a few moments to explain why.

To be sure, I do not contest the fact that the EU outdid itself and managed to make their communication even muddier than usual. But this is now behind us and we should focus on the essence rather than on the way the package was announced. I may have mentioned that in the old days I was quite involved in Iceland’s banking crisis of 2008. And I have always claimed that – despite a few minor hiccups on the way – letting the big banks default and closing the capital account was the right thing to do. I think there are many similarities between Iceland and Cyprus and that’s why I believe that bailing-in the (foreign to a large extent) depositors was the correct course of action. I mean of course the final solution, not the initial idea of not sparing smaller deposits, which was plain ridiculous. Yet, ever since the announcement I had to argue with people who were throwing all sort of populist arguments and who went into great length in finding ways to insult Jeroen Dijsselbloem. Jeroen Dijsselbloem who is a politician trying – like all of them – to get reelected and who understands that top priority in a support package for any country must include ways to prevent citizens of core European nations from revolting.

But instead of spending time explaining why I think the Cyprus solution was a correct one*, I thought I would touch on a somewhat more medium term issue, which is deposit insurance. This is because I think the debate in Europe whether to centralise the deposit insurance scheme or keep it on the national level is a wrong kind of discussion. I think that we should begin to discuss whether one of the lessons from the crisis shouldn’t be to cancel deposit insurance altogether.

Please bear with me before you click the unsubscribe/unfollow button.

Deposit insurance was introduced in the US in 1933 (earlier it was created in Czechoslovakia). The idea was to restore faith in the financial system and get banks to lend more. This was the idea whose time had to come. And it wasn’t stupid at the time but rather necessary. Since then a lot of things have changed, though. For starters, the world has seen a remarkable ascent of investment banks, which have benefited quite a bit from deposit insurance. This was at times coupled by quite a bit of recklessness in the way banks’ balance sheets were used and this is now widely recognised. Perhaps all-too widely.

Think about it – we just witnessed a full-blown bank holiday in a country which is relatively small but which was in the spotlight for at least a fortnight. During that time I even recall one of the macro tourists hedge fund guys who said that the best thing to do at the moment was to put live cameras in front of banks in Milan and Madrid because “the end is nigh”. Of course none of that happened and we probably need to entertain the idea that people in the street are not completely dumb, as difficult as it may sound…

But why didn’t we have a run on other European banks? I think most of the Europeans understood that the bail-in in Cyprus was due to the fact that there was a lot of foreign and most probably dirty money there. Heck, even the average person in Cyprus seems to have comprehended that problems at Laiki were pretty specific to Laiki. True, the capital account remains shut and it will probably stay like that for a while but it’s really not a big deal in the greater scheme of things.

When I first tweeted about the idea of abolishing deposit insurance, the replies I received pointed out that it could topple the whole financial system. There is some truth in it. After all, if the deposit insurance was to be abolished as of tomorrow, many people would probably go to ATMs “just in case”. But let’s try and work out the logistics of the issue. First of all, most European countries guarantee deposits up to €100k in full. This seems to be working even though there are quite a few governments who could not possibly meet this obligation if required, just like Cyprus. So it’s one of those barrier-type option hedging products that stops working precisely when you need it. Another question is why 100k? It’s a round number and nothing else, because the average deposit is way below that level. And if that’s the case then would it change much if we reduced the limit to 99,999.99€? With the exception of the holier-than-thou folk in the media who would immolate over the concept, probably not much.

Let’s take it a step further. What if Europe announced the following:

1. As of January 1, 2014, all the countries within the Eurozone will be jointly responsible for insuring any deposit up to 100,000€.
2. Starting from January 1, 2015 the limit will go down by 10,000€ every year until it goes down to zero on January 1, 2024, after which no deposit will be guaranteed by any Member State.
3. (repetition) Governments and national central banks of Member States will irrevocably guarantee the insurance with their full faith and credit until January 1, 2024.

I would argue that the average person in the street would probably be interested to browse through front pages of various newspapers which would be “shocked and dismayed” but since they don’t have anything close to 100,000€, they would probably only calculate when their savings could potentially become vulnerable. What would be far more interesting is the reaction of banks. After all, even in core countries like Germany, the Netherlands or France “some banks are better than others”. There’s no need to point them out – they are perfectly aware of their own situation. After such a change in the system they would know they have several years to build up the sufficient capital buffer and to improve their books or else… In other words, Europe wouldn’t place those institutions under an imminent threat of a rapid deposit withdrawal but would send a strong signal that the clock is (slowly) ticking. Sure, there would probably be some turbulence in the cost of bank funding but I don’t believe that would be fatal. Simultaneously, the banks would have to voluntarily cut their riskiest and most balance sheet consuming operations in trading. No need for financial transaction tax, bonus caps or short-sale bans.

I know that what I described may sound a bit like science fiction but we have just gone through something that was seemingly unthinkable only a few months ago, i.e. haircutting desposits and shutting the capital account within the Eurozone. And guess what – not much has happened. So instead of throwing calumnies at Jeroen Dijsselbloem consider that if we stop here then it will mean that we (Europe) have just sent a signal to people that they can keep money in however crappy bank they want as long as it’s less than 100,000€. Alternatively, we could give the banks’ customers and the banks themselves a friendly nudge with a not-too-close deadline and let the market forces work their magic. Remember, systemic ain’t what it used to be. Let’s take advantage of that.

* By the way, don’t even try to assume that I think every single country in trouble should be dealt with in the same way as Cyprus.

Central banks, exit strategies and space travels

Sometimes the best analysis of current conditions can be found in research written at a time when such conditions seemed only theoretical. This is because people writing about them have no hidden agenda and usually do it out of sheer intellectual curiosity. I have recently come across one such example when I was trying to figure out what the nature of the Fed/BoE/BoJ/ECB exit strategy will be. Whenever it may come, that is.

Here’s the link to the research entitled “The role of central bank capital revisited” published in September 2004 by the ECB. Interestingly, the paper was written by gentlemen with very German-sounding names (Ulrich Bindseil, Andres Manzanares and Benedict Weller). It reminds me of another ECB paper which in 2009 discussed “Withdrawal and expulsion from the EU and EMU” written by a Greek (Phoebus Athanassiou), but I digress.

I encourage you to take a minute and read at least the non-technical summary of this paper. Below are a few interesting quotes:

• It is shown that a temporary shock creating negative capital and a loss-making situation is always reversed in the long run with the central bank returning to profitability and a positive level of capital.
• However, a central bank with a loss-making balance sheet structure would in this context still able to conduct its monetary policy in a responsible way, even with a negative long-term profitability outlook.
• Positive capital seems to remain a key tool to ensure that independent central bankers always concentrate on price stability in their monetary policy decisions.

The last one is a widely accepted notion but the former two can make you go “hmmmm”. Additionally, further in the paper the authors mention a key feature: “If there were no separation between the central bank and the government, the capital of the central bank is obviously irrelevant since one then has to consider only the aggregate capital of the State (including the central bank and the government).”

The authors also mention that if a central bank has a negative capital then “The markets will have reasons to anticipate less stability-oriented behaviour of the central bank, which drives up inflationary expectations.” This catapults us straight to the current situation.

It would be remarkably difficult to argue that the BoE, BoJ or even the Fed are fully independent. Sure, they are not parts of their respective governments nor do they report to politicians (directly) but independence is illusion. This is particularly the case considering that they own the lion’s share of their local government bond markets, which many commentators perceive as a situation without an obvious exit. But let’s try and assume the unthinkable…

Imagine that efforts of the Federal Reserve eventually lead to some sort of stabilisation of growth, albeit at a low level. Assuming a fast growth rate is a bit too audacious even for me… Now surely this will raise the question of the Fed’s exit strategy. We can reasonably assume that the minute the market gets a sniff of selling of the Fed’s UST portfolio, things can get nasty. Granted, the Fed is wary of those risks and will try to minimise the impact but at the end of the day it will be a classical “more sellers than buyers” situation. As a side comment, it is entirely possible that the Fed starts with what one of my friends called Operation Untwist, i.e. selling the back end to buy short-maturity papers. This is bound to hit the central bank’s profitability. And so what?

Let’s say that the Fed adheres to the mark-to-market principles. Every bond that it sells makes the unsold portfolio look more and more under-water (all other things equal). Depending on how big the move in yields is, we can assume that the capital would be wiped out relatively quickly. The authors of the aforementioned article indicate that such a situation would “drive up inflationary expectations”. Now, hang on a minute – isn’t it what many central bankers are dreaming about? Wouldn’t that in the end increase velocity of money giving an additional boost to the economy?

The IMF analysed central banks’ losses too and concluded that if the central bank “goes bankrupt”, the risk of dollarisation of the economy increases sharply. I would agree with that when we talk about countries like Nicaragua or Egypt. But surely not in the US. It is remarkably difficult to imagine why would the Americans start preferring any other currency than the USD just because the Fed made some losses on its UST portfolio (and please don’t say “gold”). I admit that this is a slippery slope but a very important consideration at the moment is the liquidity trap and there are no easy ways out of it as many countries have painfully discovered lately (see my previous post “Has Britain finally cornered itself?“).

One of the models that the ECB study introduces spews out a nice chart:

This shows that a central bank’s capital does not have to turn negative to drive inflation a bit higher. Perhaps then we should not be too worried about what happens to the Fed when yields finally rise? Let me make an analogy to the momentum principle and space travels. When a rocket reaches outer space, a good way to boost velocity is to detach a part of the rocket which will essentially push the main chamber further and faster into space. This is pretty well explained here and can be summarised in the following diagram I have nicked:

Sometimes it is good to take a step back to achieve the required effect. Perhaps a central bank incurring some losses while selling its government bond portfolios is a way to go after all…

Has Britain finally cornered itself?

After a week of travelling I came back to see that Moody’s has finally pulled the trigger on the country where I currently reside. This is such a non-story that it feels stupid to even mention but I suppose it will be making headlines for a little while longer. And this is a very good thing.

Before I start, however, I would like to thank the British government for conducting a massive social experiment, which will be used in decades to come as a proof that a tight fiscal/loose monetary policy mix does not work in an environment of a liquidity trap. We sort of knew that from the theory anyway but now we have plenty of data to base that on.

Secondly, I will be referring to my favourite IS/LM model. If you want to read more about it, a very good tutorial can be found here.

So… Let’s assume for a second that the Osborne/Cameron duo is capable of taking a stop-loss on their policy. I know it is a heroic assumption when discussing any politicians but why not…

When looking at record low cost of borrowing, a severely depressed economy and a central bank that does not even pretend anymore to be independent or targeting inflation the recipe should probably be to spend more. In the standard IS/LM model an increase in government spending over taxes (i.e. boosting the deficit) pushes the IS curve to the right. Thus, both the output level and the level of interest rate will increase. Consequently, the exchange rate should appreciate as capital flows to the country in question. This in turn leads to widening of the trade deficit. Ideally, the government would want the Bank of England to step in and limit the increase in interest rates (a.k.a. QE) so that the currency does not appreciate. And, as I mentioned before, the BoE is more than willing to do so.

Let’s now have a look at the situation from another angle. I have been going through he Bank of England’s quarterly reports in reference to trade (which can be found here) and I have found two interesting charts. The first one looks at episodes of rapid moves in the British pound and the impact on the trade balance:

The relationship is pretty strong, which is why many people are calling for debasing of the sterling, particularly after G20 gave a pale-green light to such activities for countries, which are effectively in a liquidity trap.

The second chart shows why debasing of the sterling makes an awful lot of sense. It shows two measures of the International Investment Position – the standard one (i.e. with FDIs at book value) and what I would call a “market” one (i.e. with FDIs at market value).

You can see that the UK is looking quite a bit better if you take into account the actual values of FDIs. I would suggest that the recent rally in global equity prices has at least kept the blue line in the positive territory. This essentially means that GBP devaluation not only boosts the terms of trade but also makes the UK richer. Not very many countries are in such a pleasant situation (think of many emerging economies with significant external debt).

Again, weakening of the sterling does seem to be a very appealing strategy for the authorities. There is, however, one important problem – GBP devaluation is unlikely to bring extra revenues to the government and could actually make the fiscal position a bit worse. Here’s why – devaluing one’s currency and narrowing of a current account deficit means that the country’s savings are increasing in relative terms to investments. Granted, this may well have to happen considering a huge stock of private debt but this is not desirable from the growth point of view. On top of that, the J-curve effect dictates that the initial impact of currency devaluation will be actually adverse.

What I am trying to say is that while GBP devaluation has a lot of positive sides, it will probably not work on its own because it will further depress domestic demand thus putting a strain of public finances.

Therefore, I do believe that Britain has finally cornered itself into a situation where there is overwhelming evidence that Mr Osborne should really start spending. He should also assume that Mr Carney will not let that spending lead to appreciation of Real Effective Exchange Rate (a bit more on that mechanism in one of my previous posts entitled “Be careful what you target or am I in the right church?“). That is to say that the Bank of England will keep nominal and real rates very low. In my opinion this is the only rational way of the situation that we’re currently in. Then again, I am assuming the impossible here, i.e. that the politicians know what the stop-loss is.

How to trade this? I don’t normally trade anything related to the UK (except GBP/PLN) but I would assume that any sell-offs in Gilts should be used as an opportunity to buy. As far as the sterling is concerned, the fact that exports outside of the eurozone are now bigger than to the eurozone, EUR/GBP is a cross that doesn’t make that much sense. I would very much prefer the cable, or better yet selling the sterling against EM currencies as this is where the adjustment in trade balances will have to come from.

Be careful what you target or am I in the right church?

So the G20 damp squib is behind us and while many commentators will say that it has given a “pale green” light for the likes of the BoJ to keep devaluing their currencies, I think the whole discussion is somewhat flawed.
Here’s why.
Devaluing one’s way out of trouble seems to be a very convenient solution to most crises. It’s as if producing and selling stuff to other nations was the ultimate reason to live. But devaluation can have many different forms, which some people find confusing.
To explain that let’s actually look at something that hasn’t been discussed for a while, i.e. revaluations and real convergence. It is quite common sense that small, open economies tend to converge to income levels of their richer trade partners. The mechanism usually works through significant inflow of know-how followed by a boost in productivity, particularly in the tradable goods segment. Subsequently, the Balassa-Samuelson effect kicks in and we have a generalised increase in the price level. Usually this is accompanied by appreciation of the currency. Both those factors – higher inflation and a stronger currency – lead to appreciation of the Real Effective Exchange Rate. We have seen such a mechanism in a lot of emerging economies, e.g. in Central and Eastern Europe after the EU entry in 2004.
Note that the two factors at play (nominal exchange rate and inflation) are interchangeable and work together to balance the system. In other words, if for some reason inflation in the country in question is artificially depressed, the nominal exchange rate will move more.
Now let’s go back to devaluations. There are two broad reasons why a country would like to weaken its currency:
1) to boost exports,
2) to increase the money supply.
This distinction matters because without that how could we explain behaviour of such countries as Japan, Switzerland, Czech Republic or Israel? These economies have traditionally excelled at exports due to superior growth rates in productivity in the tradable goods sector. Yet, those countries have engaged in significant operations in the foreign exchange market in recent years (or threatened to do so). Note, however, that in each and every case it was preceded by bringing interest rates close to zero. Therefore, we should conclude that FX operations were just an extension of monetary policy after traditional ways (i.e. interest rate cuts) have been depleted. As a result, saying that these central bank have engaged in currency wars is pretty daft, in my opinion.
Now, there is a group of countries, which probably would like to see their currencies weaken to improve the competitiveness. However, if this is an objective then we must discuss the real exchange rate. And the standard economic theory dictates that it can only be done via increase in government savings.
Let’s take the most recent example of a country, which seems to be trying to pursue such a goal. The Central Bank of the Republic of Turkey has been stressing the importance of the REER lately. They even outright threatened that they would intervene in the FX market should the 120 level be broken. There is a fundamental flaw in this logic, though.
To start with, Turkey is a country with a very high current account deficit, which basically means that its domestic savings are relatively low. By extension, consumption is fairly high thus keeping inflation rather elevated. In such an environment, selling the lira (TRY) makes very little sense as it will most likely boost inflation even further, offsetting the paper (aka nominal) gains. This brings us to a paradox that higher inflation leads to higher REER thus necessitating monetary policy easing. In my home country of Poland we have a saying that “they can hear a bell toll, they just don’t know at which church”. Similarly here – the CBRT has correctly identified the problem of having to boost competitiveness but they have chosen a dangerous approach.
Instead, the government should increase its savings even more than it already has to bring total domestic savings higher, thus increasing competitiveness. This way, it can avoid persistently high inflation and current account deficits.
This is not to say that such a recipe is great for everyone. It would’ve been good for, say, Spain before the crisis but now the focus should be more on the nominal side of the equation. Such examples could be multiplied.
But what I’m trying to say is beware of people talking about currency wars any time they see a central bank intervening in the FX market because you will miss the important distinction between the nominal and the real sides of things.
And policymakers, be careful what you target because you can end up at a wrong church.

PS. I wrote this post on “yet another on time Ryanair flight” so there are no links or anything. I will try to update those tomorrow with a few interesting articles on the subject.

Very efficient markets

As I was browsing through my bookmarks, I found this very old article from The Economist: Dismal science, dismal sentence. This, surreal at first glance, court case still comes back to me when anyone mentions the Efficient Markets Hypothesis.

In recent days two blogs that I like to read posted about the subject (The Money Illusion and Noahpinion). Both posts are well worth a read as they provide a few nice examples, which at face value are actually quite compelling.

But the problem with this theory is not so much its assumptions or implications but the way it has been tested. The most common tests include plotting performance of a large sample of portfolio managers against the performance of the stock index and concluding that – after accounting for management fees – the community does not beat the index. This obviously is very convenient for the guys at Vanguard etc but at the same time it is very illogical.

Let’s take an example of a market where we have only ten investors. All of them will be trading between themselves and if you think of it – there will be equal amount of longs and shorts in the market. Therefore, it is not difficult to conclude that these investors will on average have the same return as the market itself. When I think of it like that, it reminds me (in some aspects) of the Heisenberg’s Uncertainty principle. In physics, by measuring properties you change them. In finance, the measurement and the property in question are exactly the same thing. To cut the long story short, people trying to prove the Efficient Markets Hypothesis invariably arrive at the conclusion that the market cannot beat itself. Big deal!

This is not to say that the market is inefficient. I find it to be efficient most of the time (even if it stops me out). That said there are a lot of people who really take the EMH to the extreme, just like the judge in the article from the Economist. They conclude that there is no point giving anyone money to manage as the cost will definitely make it suboptimal to buying an index.

I don’t directly manage money but I know a lot of people who do. And the most impressive individuals, who happen to have pretty high Sharpe ratios and limited drawdowns  all have similar characteristics. Firstly, they don’t start the day with “it’s going to be a risk-on day, let’s buy 200m AUD”. This Coffey-esque approach to investing is both ridiculous and pathetic. Instead, they usually have a whole bunch of uncorrelated trades and quite rigorous risk management. Directional, Hail-Mary trades are very seldom and fully controlled. These guys tend to beat the market.

Actually, scratch that last sentence. They don’t beat the market. They generate returns which are not depending on the market direction. Therefore, comparing them to returns achieved by the broad market is pointless.

So while the EMH is quite compelling and serves as a good baseline for analysis, testing it and drawing conclusions about performance of the aggregate industry is very much self-contradicting.