Just do as I say, don’t do as I do

One of the oh-so-many unintended consequences of what we’ve seen in the market for the last five years is the widespread belief that no matter what happens policy makers are in almost full control of the events. Moreover, we seem to be more willing to take their word for granted rather than analyse what they’re actually doing (which reminds me of this old Genesis song, hence also the title of the post).

Think of it.

  • If the US growth numbers turn sour, who do we think can come to save the day? Either the government with the fiscal package or, more recently, the Fed with some sort of money printing magic wand.
  • When a eurozone country gets into trouble, all the research says “if only the Troika was there to help them” or “if only Mario Draghi was not on vacation and said something about whatever it takes”.
  • Similarly, if the day of reckoning comes in India after years of screwing up the fiscal situation and very little progress on boosting competitiveness to sort out the current account (yes, that does matter), all we want is the RBI to tighten the liquidity situation to go back to normal.
  • Or when Turkey pushes the current account deficit and short term external debt to levels previously unseen in the emerging markets universe, simultaneously pumping up credit growth to very high levels and keeping negative real rates, all the JP Morgan research wishes for is for Governor Basci to sound hawkish to make it all go away. Indeed, they hiked the upper end of the interest rates corridor today and people are very happy even though it really means nothing.
  • In Egypt where the fiscal situation is completely unsustainable and people are rioting at the time when FX reserves are being depleted at a Formula I pace, many people think that the Gulf states or the IMF or some other Santa Claus can come and save the day with a simple loan. If only the government asked for it…
  • Finally, when the Governor of the National Bank of Poland categorically says that policy easing has finished at 2.5% and that he is sending a strong signal to the economy that the worst is over and therefore the economy can grow again, the market immediately takes it as a gospel even though it does sound an awful lot like my favourite Baron Munchhausen.

Trust me, I do have many more examples of when we either wish for or treat policy makers’ decisions as the ultimate solutions. Whereas if you think of it, many times it is a very twisted logic, which a friendly portfolio manager summarised as “when we turn left, a road to the left will appear”.

It didn’t use to be like this. Our faith in policy makers’ ability to reverse the course of the market has proven correct in many cases (see whatever it takes) but I think that oftentimes it’s just a reflection of the laziness of the market. After all, it’s much easier to buy bonds in Slovenia or Italy because the ECB says it will defend them rather than to look into the fundamentals. Or it’s much easier to buy the Turkish lira because the CBRT says it is hawkish rather than to think whether it’s actually true (NB it most definitely isn’t, in my opinion).

I am not denying the fact that the policy makers control developments in the very short term no matter how much you disagree with them but we need to be very careful when extrapolating that. I strongly believe that there are still things which are beyond fixing and that sometimes it really is too late. The following points are not necessarily things I am convinced about but I think you can make such counterarguments to the propositions I presented above:

  • Fed saving the day – what if the US is in the classical liquidity trap in which case without a strong fiscal stimulus you will get nowhere via QE?
  • Draghi doing whatever it takes – what if the EMU debt is actually not sustainable, in which case it’s just a matter of time before dominoes start falling? (ok, I actually don’t really agree with this one but Nouriel, Nassim and Zero would probably make that point; Also, “Zero” is the first name of Mr Hedge, right?).
  • RBI saving the rupee by squeezing front end rates to 8% – what if the awful policy mix of the recent years actually requires long term yields to increase considerably to attract any sort of interest from international investors?
  • CBRT rescuing the lira – what if we are ahead of a proper old-school funding crisis in which case the current account deficit will need to be closed in a disorderly fashion triggering a massive increase in interest rates and a huge recession?
  • Egypt bail out – what if the cost of saving Egypt is too high for anyone to bear and the country actually is unable to sustainably fund the fiscal deficit, particularly in the local market?
  • Poland recovering – what if the excessively tight monetary and fiscal policies have durably lowered the potential growth rate in Poland turning it into a country more resembling the Czech Republic (i.e. with very high savings rate and no domestic demand)?

Some of those things sound less plausible than others but I guess the message is that don’t let the policy makers whisper the reality and pull the wool over your eyes. Granted, they can and should impact your trading decisions in the short-run but if the brightest and best-paid minds working in the financial industry are having problems with forecasting what is going to happen in the marketplace then how can you assume that people who – for the most part – are politicians constantly make the best possible decisions?

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.

This time is different. No, really!

The phrase “this time is different” doesn’t usually spark very positive reactions. But I don’t care because there’s one thing about the market these days that makes me think that something is strange when compared to previous bond market sell-offs.

If you follow me on twitter you will have noticed that lately I have been talking a lot about asset swaps (ASW). This is a pretty technical concept but I will try to be as straightforward as possible.

If you are still reading this then you probably know that in the fixed income market we have two broad groups of instruments – cash bonds and swaps. In theory, their yields (prices) should be moving more or less in a parallel fashion because they are interest rates instruments. In other words, you can bet on interest rates going lower by either buying bonds or receiving interest rate swaps (IRS). The difference between those two instruments is called the asset swap and it tends to move for the following main reasons:

  • Buying bonds requires balance sheet and IRS is an off-balance sheet instrument.
  • Buying government bonds creates exposure against the issuer (sovereign) while IRS is a contract between two counterparties (e.g. banks).
  • Supply of bonds is limited while IRS can be created out of thin air.
  • Government bonds are a stream of cash flows (coupons) while IRS is an exchange of fixed against floating rate (e.g. LIBOR).

I have learnt to pay a close attention to moves in ASWs, just like I very closely monitor moves in cross currency basis because they can reveal pretty significant market developments. An ASW can tighten, i.e. bond outperforms the swap (e.g. bond yields drops by 10bp and IRS for the same maturity by 7bp) or widen. In core markets, tightening of ASW has been historically connected with higher aversion to risk. When problems arise, investors would very much rather own, say, US Treasuries than have a contract with a bank to exchange some cash flows. Chart below shows the 10y ASW (the higher the number, the more expensive the bond vs swap) in the US against the EMBIG spread. As you can see, the correlation is pretty significant.

asw_embig

Now, what happens in developed markets does not usually work the same way in emerging markets. Indeed, periods of risk aversion were generally associated with significant widening of ASW in emerging markets. The rationale is simple – let’s dump emerging bonds because the credit risk is going up. Having an interest exposure via a swap with JP Morgan becomes more valuable than buying government bonds of governments of Mexico, Hungary or Malaysia. Simple heuristic.

And this brings me to the “this time is different” proposition. As you may have noticed we are experiencing the end of days for government bond markets. Well, we’re not really but people like Bill Gross want to make you think like that. EPFR data is showing significant outflows from bond funds investing in emerging government bond markets. The last time we saw such big outflows was in September 2011. However, unlike in September 2011 when ASW totally exploded, in the recent weeks EM ASWs have actually tightened and considerably so. Just to give you an example – ASW in the 10y segment of the South African government bonds are at the tightest level they’ve ever been. South Africa – the country whose economy is in a downfall, whose currency has sold off dramatically and where the social tensions are at levels unseen in years. To be sure, the bonds have sold off too but nowhere near as much as IRS.

I can find a few explanations for that but the most important conclusion is that real money investors (so asset managers rather than hedge funds) have not been selling government bond markets to a large extent. They have sold some and shifted others to more defensive places, they probably hedged their currency exposures but they have not sold their bonds. Why? Perhaps because they don’t believe Bill Gross, thinking the scare will pass (this argument seems to be supported by Pawel Morski in one of his latest posts). Or perhaps because they know the market is not able to absorb the potential flow anyway.

At the same time, the hedge funds seem to be willing to exploit the recent change in the global mood and are pushing IRS higher. This then stops out model accounts (CTAs, aka the scum of the earth), which had been running humongous receiver positions in bellies of various curves assuming the Fed would stay put forever (or at least 3-5 years). Meanwhile, it seems like the tide has turned a bit and the convexity of the US curve is shifting. That’s why I was pointing out earlier today this tweet from Business Insider’s Matt Boesler:

All in all, I don’t want to make this post too technical but this is the first EM bond “crisis” since I have been in the industry when local bonds in emerging markets have so far been outperforming IRS and ASW have been tightening. And while I think I understand the reasons behind that this is not a sustainable situation, in my opinion. In fact, I strongly believe that something has to give – either the real money guys are in a denial or the hedge funds have jumped on the tapering bandwagon too early. Either way, the EM curves are pricing something that is almost impossible to come true, in my view.

What I make of it all

I have given a friend a task lately to come up with a consistent theory explaining recent moves in markets. I said it could be a conspiracy theory, a preposterous theory or any-other-theory as long as it provides a consistent explanation of recent moves. His reply was “people are selling what they were very long of” but then he reflected and said that it wouldn’t be consistent with the equity rally.

While I do not aspire to give you a comprehensive explanation, I think I have one that at least I feel comfortable with. But let’s start with a snapshot of what’s going on:

  • USTs are selling off.
  • Inflation keeps surprising to the downside.
  • USD is not really rallying (except against the yen).
  • US equities are generally supported.
  • Credit is wider but not spectacularly so.
  • Implied vols are creeping higher.
  • EM bonds are under tremendous pressure and currencies are weakening.
  • Commodities had come off but have sort-of stabilised lately.

Now, it may well be the case that we’re simply experiencing a risk-off period, although I’m not sure equity and commodities markets would agree with that fully. Neither is the UST sell-off the first thing that springs to mind when discussing the dreaded risk-off.

A theory, which is a bit closer to my heart is what Paul Krugman put in his blog today but again the USD is not really rallying. Alternatively, stuff like the Mexican peso shouldn’t be under so much pressure in such a scenario, I reckon.

I see two main forces driving the market at the moment. The first one is the Bank of Japan. In my post Eddie Vedder and the Japanese carry from April 13 (USD/JPY approaching 100 ) I was being skeptical about the whole concept of yen being used to fund stuff elsewhere saying that the Japanese will probably find plenty of opportunities locally if they believe in Abenomics. However, I did also say that if anything they’d go for bonds in the US, which are looking considerably better than other global bonds on a currency-hedged basis. Similarly, if a Japanese investor wants to bet on the yen decline, then they should keep it simple and do USD/JPY rather than, say, AUD/JPY. And this is a very important point because whenever USDJPY jumps 1%, it pushes the USD index higher by almost 0.15%, thus creating the impression that the risk is off because the USD strengthens. Therefore, the previous correlation of “yen lower, risk higher” does not work like a charm anymore.

But then, if it’s just a localised intervention in USD/JPY, which has very little to do with the fundamentals in the US of A then perhaps it is safe to assume that some investors have been skewing their own USD index by buying a bit more USD against the JPY and selling the greenback against the EUR? I will explain in a second why.

A global bond investor, which has a WGBI index as a benchmark (that’s representative of around 3-4trn USD in AUM) has 23 countries to choose from. These include the bond behemoths like US, Germany, Japan or Italy but also smaller markets, mostly in Europe. And the way this investor looks at the world at the moment is as follows.

  • She just heard from Ben Bernanke that the Fed might start limiting bond purchases. Granted, this will still be an expansion of the balance sheet but at a slower pace. The investor in question will be reassured that this is not a policy mistake but rather the response to recent data when, e.g. looking at the tax receipts data (chart below):
    us_taxes
    The chart shows the annual rate of receipts of the federal government. Not only have we surpassed the pre-crisis highs in terms of revenues but also corporate income taxes are looking very healthy. And no, they are below the 2007 highs not because Apple is avoiding taxes or something but because there is a lot of tax credits originating from the crisis to work through.
  • The investor then looks at emerging markets (Mexico, Poland, Malaysia and South Africa are representing EMs in the WGBI index) and thinks that there is no way these are going to withstand the UST sell-off. Anyone who thinks otherwise is in a dreamworld in my opinion. There’s also the argument of positioning, which is very heavy.
  • Then the investor looks at her global growth/inflation forecasts and sees this big black hole between the Urals and the Atlantic Ocean, which is at a brink of deflation and already in a recession. As much as such a scenario for Europe would’ve been considered a disaster 2-3 years ago, it is now a fact of life. Please see my post Systemic ain’t what it used to be for a more detailed explanation. Suffice to say that if you have reasons to believe Bernanke when he says he will “taper” then you also should believe Mario Draghi when he says that he is prepared to do whatever it takes.
  • Meanwhile, there is a significant risk of a currency war breaking out in Asia. Yesterday the Japanese told their Korean colleagues to go and… do something about the won rather than whine over the yen depreciation. Not exactly a fantastic environment for investing in bonds over there, either.
  • So if you are a fixed-income dedicated investor then there’s really pretty much one place to be – European debt markets. To be sure, trends change and it can be reversed but if you believe in the global growth/reflation trade then probably shorting BTPs or SPGBs is not the first thing to do. In fact, under such a scenario I can very much imagine peripheral spreads tightening massively, particularly in Italy, which has now officially ceased to be a fiscal troublemaker.
  • In such a scenario EUR rallies, EGBs outperform and emerging markets closely tied to the EU (Poland, Hungary etc.) perform better than those linked to the US (Mexico). All that has indeed taken place.

I would like to spend a second on the EUR here. In one of my recent discussions with long-term investors an interesting theme started taking shape – what if Europe is about to experience what Japan had experienced in the last two decades but in a very short period of time, say 1-2 years? The current account is very positive, the appetite for debt is relatively strong and domestic demand will stay very sluggish but at the same the ECB won’t go “full monty” on printing. Unless it is forced to do so, of course, like it recently happened in Japan. What if the balance of payments forces coupled by the fact that virtually every major trading partner of the Eurozone is printing money push EUR to some ridiculously high levels before the pressure on the ECB is so strong that it can’t resist it anymore? So yes, the EUR would eventually crash but there would be a lot of stop losses beforehand.

I will be very honest – I am really struggling to get a good feel on the market at the moment. There are bond markets that I still like a lot, e.g. Italy, CEE or Russia but I think one needs to have something to offset the long rates exposure (my suggestion – Turkey). I generally think emerging markets in the EU should outperform Latam and Asia due to proximity to the deflationary vortex but moves have been quite brutal there, too. On the FX, if what I wrote is correct then the theme from the beginning of the year, i.e. being long EUR/MXN, EUR/RUB or EUR/MYR should work out really nicely.

And yes, I know this post would’ve been nice to have two weeks ago but this is what I make of it all anyway.

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.

 

Forget Apple, Slovenia was the real deal

All that matters for the US media is the stock market. Just take a look at the TOP category in Bloomberg or tune into CNBC for… well… as long as you can bear it. And of course many put the “=” sign between the US equities and Apple. Therefore, last week’s premier issue of Apple bonds grabbed all the headlines. Granted, it was a bond, not a stock but it’s Apple so it can still rule the global economic reports. But honestly, in the greater scheme of things this issue had really zero relevance for anything. Yeah, probably the PIMCOs of the world decided to park some cash there expecting that high outstanding value would boost liquidity in the secondary market. Plus, there were some comments about Apple’s tax bill but that’s about it.

I think something considerably more important happened in the small European country of Slovenia.

slovenia_apple

After several days of roadshowing, the troubled Slovenia decided to open books for 5 and 10y bonds on Tuesday (30 April). Given that in the previous weeks peripheral bond markets rallied like mad, it wasn’t too heroic to assume that the book-building would be quite quick. Indeed, in the early afternoon books exceeded USD10bn (I guess Slovenia wanted to sell something around 2-3bn) and then reached a quarter of what Apple managed to get in its book building. If I were to take a cheap shot I would say that Slovenia’s GDP is almost 10 times smaller than Apple’s market capitalisation* but I won’t.

And then the lightning struck. Moody’s informed the government of an impending downgrade, which has led to a subsequent suspension of the whole issuance process. I honesty can’t recall the last time a rating agency would do such a thing after the roadshow and during book-building but that’s beside the point. That evening, Moody’s (which already was the most bearish agency on Slovenia) downgraded the country by two notches to junk AND maintained the negative outlook. This created a whopping four-notch difference between them and both Fitch and S&P (A-). The justification of the decision was appalling. Particularly the point about “uncertain funding prospects”. I actually do understand why Moody’s did what it did – they must have assumed that the Dijsselbloem Rule (a.k.a. The Template) means that Slovenia will fall down at the first stumbling point. But they weren’t brave enough to put that in writing and instead chose a set of phony arguments.

Anyway, May 1st followed and the book reopened for bids only on Thursday. In the meantime, it was interesting to see what happened in the secondary market: the existing Sloven22 USD bonds got given on Tuesday at 99.00, they were sold just below 98.00 on Wednesday and by the time the books restarted they were firmly on their way towards par. I know markets don’t care about ratings these days but this was a pretty extreme vote of no-confidence for Moody’s.

I took advantage of the fact that May 1st is a holiday across Europe and had a few meetings with fund managers here in London. All of them were telling me the same thing, i.e. that they hope that the downgrade would cheapen the deal by at least 10bp. They “hoped” but didn’t really think that would happen. This sharply contrasts with some analysts’ comments who said that the downgrade could cost Slovenia around 100bp (i.e. from 6 to 7% in yield). Imagine that – some people seriously thought Slovenia would have to pay more than Rwanda (no disrespect, of course).

Then the big day came – books reopened, bids were even stronger than during the first attempt and Slovenia sold 3.5bn worth of 5 and 10y bonds. On Friday, the new Sloven23s traded up by more than 4 points, which means yield fell by more than 50bp from the 6% the government paid. A fairy tale ending.

So why do I think this event was so important? Because it shows how different the perception of European sovereign risk is. I wrote a few times about it (see here and here) partly making fun of people who thought that Slovenia would be the next Cyprus. Now, don’t get me wrong, I don’t think that Slovenia is out of the woods yet. In fact, the 3.5bn cash injection could make the government less eager to push for necessary reforms (for details, do check an excellent summary of a great paper by @GoodRichWatts which can be found here). But the emotional reaction to the Cyprus debacle was ridiculed by the market. In other words, just because something happened in one part of the Eurozone, it doesn’t mean that there will be an impending domino effect, or an outright tsunami.

Perhaps issues from both Apple and Slovenia have only proved that investors will buy anything that yields. But I strongly believe that in the case of Slovenia we got something much more important in terms of where the crisis in the Eurozone is headed. If you want to be short Europe, feel free to do that but better check whether your story holds first and don’t count on panic spreading quickly.

* Comparing a country’s GDP with a company’s market capitalisation is ridiculous, though because one is flow and the other one is stock. But this sort of comparison is what would get me quoted on Bloomberg so I couldn’t resist. For the record, if you wanted to compare a country’s GDP to anything from the corporate finance world it should rather be sales, in which case Slovenia is a third of Apple.

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.

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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.