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.

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.

Eddie Vedder and the Japanese carry

Just like everyone else in the financial markets over the last week or so I have become the world-famous specialist on Japanese flows (!)*. I have heard a lot of more or less plausible stories and when I was trying to digest all the noise, I couldn’t help but think about “Nothing As It Seems” by Pearl Jam:

Occupations overthrown, a whisper through a megaphone
It’s nothing as it seems, the little that he needs, it’s home
The little that he sees, is nothing he concedes, it’s home
And all that he frees, a little bittersweet, it’s home
It’s nothing as it seems, the little that you see, it’s home…

Jeff Ament, Pearl Jam

I am not certain what is going to happen with the wall of money that is seemingly coming from Japan, but I know that there’s a remarkable amount of superficial analysis, which I would like to comment on.

1. The Japanese carry trade will continue as the BoJ prints more.

According to estimates by Daiwa net issuance of JGBs after stripping BoJ purchases will be -26trn yen. This is around 5% of GDP, which is a pretty monstrous amount. This naturally makes people’s imagination go into overdrive, particularly as we’re talking about the country with decent carry-trading history. But there is one problem with such an approach. Carry trade was Japan’s response to the lack of returns in the local market. Bond yields have been ridiculously low and the stock exchange was still suffering as zombie-banks kept dragging it (and the economy) lower. Now, do you think this situation has not changed even a bit? We may be agreeing or disagreeing with what the BoJ is doing but investors (particularly retail) could be excused for e.g. thinking that the Nikkei will double this year. This is particularly the case as what the BoJ seems to have orchestrated is a fantastic opportunity for the Japanese banks to cash in on their available-for-sale JGB portfolios. So answer yourself this question – is it so entirely obvious that Mrs Watanabe continues buying AUDJPY (annual yield of 3.2%), ZARJPY (annual yield 5.4%) or MXNJPY (annual yield 4%)? Granted, these and many other currencies will continue to constitute a very important part of the Japanese investment portfolio but pretending that the investment backdrop in Japan has not changed is naive in my opinion.

2. The big yen move has only just begun.

Currently various forecasters are trying to come up with the most bearish view for the yen. I have already seen 120/USD but admittedly I do not pay much attention to that stuff. But try to think who has so far made money on the yen debasement? If you don’t know then try to get a hold of the HSBC hedge fund report to see that the vast majority of macro funds have caught at least a part of this move. And because selling the yen is seemingly such a no-brainer**, not being in the trade is a big career-risk for many. In some sense, macro hedge funds cannot afford to miss another leg in the yen move (if there is one). But in the greater scheme of things this is just noise. Don’t forget that the Japanese economy has just become at least 30% cheaper. And we are talking about a bunch of historically deadly innovative companies who have managed to keep their place in the global market place against all odds.

Goldman has recently produced a study showing that the country with the most similar exports composition to Japan’s is… Germany. It is already very much visible it the underperformance of the DAX, in my opinion. Personally I prefer Mercedes over Toyota but at a 25% discount I know I would change my mind.

My thinking is as follows: if this yen depreciation and the crowding out of the Japanese banks from the JGB market is persistent then Japan has every chance to become the champion of the global trade again. And if so, why on earth would I be buying GBPJPY or AUDJPY?

Let me give you another example: If you have been selling the yen and buying the South African rand consistently in the last five years then only last week did you break even on your average spot level. Sure, you got some coupons in between but it cannot be ruled out that investors who have been buying the ZAR against the JPY will just take this as an opportunity to close the position after being bailed out by the BoJ.

3. Banks will invest abroad.

This bit I find preposterous. I have mentioned above that banks may have just been given a lifeline by the BoJ and they will be able to off-load their available for-sale portfolios at a significant profit. What they do with the cash next is anyone’s guess but banks are not really in the business of punting on currency markets with their balance sheets. Believe it or not but even when GS recommends buying EURUSD, it’s not like Goldman’s treasury shifts all its money to Europe. Banks operate in the “LIBOR+” world. They are happy to take exposure to foreign bonds but it is usually done on an asset swap basis. Below are a few bonds that I just looked up on Bloomberg and how they compare when swapped to JPY.

  • T 2 02/15/23                                     78bp
  • SAGB6.75 03/31/21 #R208       68bp
  • MBONO6.5 06/09/22                    68bp
  • POLGB 4 10/25/23                          10bp
  • TURKGB8.5 09/14/22                   36bp

As you can see those differences are not huge and definitely not big enough to make emerging markets irresistible. Additionally, there’s a perverse effect of what’s been going on in the JGB market lately. The chart below shows a crude calculation of VaR for 10y JGB futures since 2000.

JGBVaR

A chart of the yield volatility is looking even scarier, which – paradoxically – could bring the Japanese banks into a risk-reduction mode as no one can bear such wild swings of the profit and loss account. And adding Brazilian assets to the portfolio doesn’t help much.

4. Asset managers, insurance companies and pension funds will invest abroad.

Yes they will. The same way as they have in the past. Well, maybe with a bit bigger size but it’s far from being certain at the moment. If it’s the yen weakness they’re after then I suppose buying the USD will do (without adding an extra layer of volatility between the USD and some other currency). And if they don’t think the yen weakens much from here then why would they accelerate foreign buying in the first place?

This brings us to the last point I would like to make. As much as in previous years the Japanese investments abroad were driven by expectations of superior returns outside of the country, we are now talking about the expected yen weakness. In my opinion this changes the structure of investors taking advantage of the move and I believe that it will be the foreigners shorting the yen, rather than the locals. This, at least in the near term, makes it a tactical, rather than a structural trade.

So these were my views on the whole situation. I don’t have any concrete recommendations this time but I just don’t like how one-sided the discussion has become. And if I’m wrong then… well… listening to Eddie Vedder while writing this post definitely made it worth my while.

* not sure how to stress that I am being ironic, but I have noticed that subtitled movies on Sky have (!) at the end of sarcastic sentences.

** I have always thought that no-brainers are for people without brains but somehow this definition hasn’t become mainstream.

Baron Münchhausen and spreads in Europe

Hieronymus Carl Friedrich von Münchhausen is known for telling the story that he pulled himself (and the horse he was sitting on) out of the swamp by his own hair.

This reference was the first thing that came to my mind after seeing this and this post on Paul Krugman’s blog. After the whole bunch of swearwords, that is.

In the first one he argues that France has finally joined the club of ultra-sovereign countries, i.e. countries who can do whatever they please and yet get away with it because bond yields remain remarkably low. The second one uses “research” material from VoxEU entitled Panic-driven austerity in the Eurozone and its implications. There are five charts in it which I would like to discuss before circling back to Krugman’s thesis about French bonds.

Chart 1. Austerity measures and spreads in 2011.

 

degrauwe_fig1

 

In this chart the author argues that the higher the spread, the bigger the austerity that was subsequently applied. Well if it isn’t remarkable – so they’re telling us the higher the increase in credit spread in 2011, the bigger the adjustment had to be? Brilliant. But let’s say it’s an introductory statement just to warm us up.

Chart 2. Change in spreads vs. initial spreads

degrauwe_fig2

Now this is epic. The Baron Münchhausen argument. It basically says that the the higher the initial spread, the bigger the subsequent decline. A few things about that. Firstly, absent of a total collapse of the eurozone, how else should this chart look like? Secondly, using the same weight for the spread on tiny Portugal and Greece as Spain or Italy is just skewing the results. Thirdly, I don’t think that using the decline in percentage points as dependent variable is kosher because spreads can’t go negative and so 50bp for France is something completely different to 50bp for Portugal. Finally, I seriously wonder if the fit would be so bombastic if they removed Portugal and Greece – those dots at the beginning seem close to the best-fit line but I have a sneaky feeling that this is mostly because of the scale.

Chart 3. Change in debt-to-GDP ratio vs. spreads since 2012Q2

degrauwe_fig3

 

First of all, this is just plain wrong from the econometric point of view. What is this -0.6747 factor in the equation? It means that if there is no change in debt/GDP then spread will fall on average by 67bp. So 10 years of unchanged debt and spread falls by almost 700bp? No, friends, such results should be deemed “inconclusive” and there shouldn’t be any downward sloping line here. But if you want the line then have a look what it would imply if debt levels fell. Spreads would increase… Brilliant. Finally, assuming no lags or anything is just ridiculous.

Figure 4. Austerity and GDP growth 2011-2012  <– this one I actually have no problems with. Stating the obvious, but so be it.

Figure 5. Austerity and increases in debt-to-GDP ratios

degrauwe_fig5

 

This one says that austerity increases debt to GDP. A lot has been said on the subject and in the short run it is very difficult to argue with that. One could make an argument that without austerity debt/GDP would’ve increased even more because of super-high borrowing costs but let’s not go there here.

Wait a second though. So if austerity increases debt to GDP and we “know” from (ridiculous) Chart 3 that higher debt to GDP is associated with a decline in credit spread then isn’t austerity leading to lower spreads? Alternatively, if we interpret Chart 3 as the lack of relationship then shouldn’t we also conclude that austerity has no impact on credit spreads?

If the author’s only intention was to show that the ECB was instrumental in narrowing the spreads then fair enough. But the analysis provided is weak to say the least.

And this brings us back to Paul Krugman. Because if he believes in what De Grauwe wrote, i.e. that the reduction in spreads was the function of how high the spreads went in the first place then why has France rallied so much? Similarly, why would it rally if austerity worsens things so much?

Oh, I know why. Blame the markets (both ways).

First De Grauwe:

Since the start of the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushed the spreads to artificially high levels and forced cash-strapped nations into intense austerity that produced great suffering.

Then Krugman:

Markets have concluded that the ECB will not, cannot, let France run out of money; without France there is no euro left. So for France the ECB is unambiguously willing to play a proper lender of last resort function, providing

If one wants to make an argument that OMT has led to significant tightening of credit spreads in the eurozone, we really don’t need working papers – a tweet will do. But for crying out loud do not mix austerity with that. Especially as austerity and OMT were completely coincidental. And if you do have to mix austerity into all this then make a little bit of effort to make a consistent and mathematically correct set of arguments. And make up your mind, Mr. Krugman. Either austerity is bad and ultimately keeps debt to GDP high and thus credit risk elevated in which case you need to rethink France. Or austerity sometimes makes sense in which case… well… you need to rethink a hell of a lot of things.

Otherwise your story is not far from what Baron Münchhausen – amusing and entertaining but ultimately ridiculous.

 

Systemic ain’t what it used to be

I remember that in the first days after the bankruptcy of Lehman Brothers, many believed that the collateral damage would not be terrible. I distinctly recall asset managers who were still eager to discuss idiosyncratic factors in some emerging markets. Not that I was so much smarter back then – after all, I did not send an email entitled “SELL EVERYTHING”. Of course shortly afterwards came an avalanche and dominoes started falling. All of a sudden everything appeared systemic, even things you wouldn’t normally care about.

Just to give you a few examples from my turf:

  • Iceland was relevant because of huge assets of local banks outside of the country (aka Icesaave);
  • Hungary (and CEE in general) was key for survival of Austrian and Italian banks;
  • Latvia threatened the stability of the banking system in Sweden;
  • Ukraine was a big risk for French banks;
  • The Middle East… well, it’s always considered to be a tail risk anyway.

One could extend this list quite a bit.

Considering the fragility of the financial system back then, any of those factors could’ve spiralled out of control. Therefore we had various programmes, such as the Vienna Initiative which were aimed at ring fencing potential fallout. When that initial phase of panic ended (with the London Summit) we had a brief period of calmness followed by the mighty Eurocrisis.

This one has been very similar to the initial “Lehman” stage. First came Greece, which initially was considered to be not that relevant. That was the case until roundabout the PSI Summit of 2011, which – perhaps inadvertently – wreaked havoc in the system. There was also Ireland with its “bad bank” ideas and the Iberia with all sorts of problems. And then, again, everything became systemic and potentially fatal. The culmination of it all was in my opinion when a) the market went after Italy and b) people wanted the Bund to start trading with a credit premium (search Bloomberg headlines towards the end of 2011 if you want to see that actually was the case).

Like with the Lehman, many people missed the Eurocrisis trade and began making up for that by creating more or less far-fetched implications. I described this mechanism in one of my previous posts about Slovenia. But does anyone really care about Greece or Ireland anymore? I know there’s punting going through in GGBs and some when-in-trouble-double funds made a killing buying Irish bonds but in terms of global significance this is barely relevant. Similarly, we shouldn’t really care about Cyprus, although some people are trying to persuade us it’s yet another reason to buy gold bitcoins and hide.

In this vein, I was actually pretty impressed with recent comments from Jeroen Dijsselbloem. He is right and he knows he can take a bit of a gamble by speaking his mind: not everything is systemic. And if something is then, well, we have the Draghi Doctrine.

Granted, Europe is pretty screwed economically and this won’t change anytime soon but this is a completely different set of issues than forecasting the total annihilation of the financial system. The two most important measures of stress, i.e. the cross-currency basis between EUR and USD as well as the BOR-OIS spread are telling us that we should change the way of looking at European affairs. And maybe this is the answer to a tweet from Joe Weisenthal asking why on Earth is the euro so stable. The euro has plenty of reasons to fall and I have been suggesting short EUR/EM positions lately but systemic just ain’t what it used to be.

The truth about € in Poland, Mr. Krugman

As a big fan of IS/LM, I have always admired Paul Krugman. He obviously knows his stuff but more importantly he has held his stance throughout the crisis and has done it in a very convincing way. This will definitely be remembered.
However, I sometimes have issues with what he says and these issues are proportional to the distance between him and the subject in question. While his views on Iceland were pretty much in line with what I think, I’ve been under the impression that he oversimplified things by conveniently ignoring the fact that there is a lot of cash trapped there, which will remain a big problem for many years to come. But this is nothing compared to what in my view is a completely misguided and superficial analysis of the Baltics. The fundamental difference between what he says and what I think is that for me just because a country that used to run significant excesses before the crisis has not returned to the previous level of output is by no means a proof of a failure of local policies. I would argue that a lot of pre-crisis GDP was, in effect, phantom and should not be treated as a benchmark. Additionally, countries like Lithuania are an example that internal devaluation can work well, which you can see looking at a rapid growth in productivity in recent years. And no, I don’t care that a lot of that has happened through reductions in employment. Not because I’m a heartless liberal but because a lot of the pre-crisis employment should not have happened in the first place. The same situation could be observed in Latvia and yet prof. Krugman keeps waving the GDP chart saying how ridiculous the policies have been.
But I wasn’t going to write about the Baltics. Today I read Paul Krugman’s latest post entitled Poland Is Not Yet Lost. The mention of Latvia aside, there is nothing in this post that would be factually incorrect – Poland did have a “nice” global recession and the zloty was an efficient corrective mechanism in 2009 and after.
However, the problem with his post is that it discusses an absolutely irrelevant issue of Poland joining the EMU. Sure, the Polish authorities have been quite vocal mentioning that in recent months but in my strong opinion it has nothing to do with the actual intention.
What’s the reason then? Polish bonds. After a spectacular rally in 2012, yields on POLGBs reached record low levels and the curve flattened dramatically as the NBP stayed way behind the curve. At the same time, standard valuation metrices like eg asset swaps or carry have become extremely tight. To the point that without assuming a paradigm shift or without classifying Poland as a safe haven it was difficult to justify further strong purchases. “Expensive” was the word most commonly used at the turn of the year. The Finance Ministry, which by the way holds a Ph.D. in public relations, realised that too and was frantically looking for a way to portray POLGBs as “still attractive”. And they quickly found one, ie the spread to Bund, which is hovering above 200bp. But in order for people to start looking at this spread they had to give them a reason. Joining the EMU was one. And believe me, this has been quite successful judging by how many requests I get about this spread these days.
Talk is cheap and Poland knows about it so if saying that eventually the zloty will be converted into € can bring us some flows then why not? Especially that there hasn’t been any commitment regarding the date or no indication on how on Earth Poland will meet the Maastricht criteria. But I guess this is a much simpler strategy of communication than trying to explain how the budget will cope with the first drop in consumption in almost 20 years or what does it mean that the budget deficit is already at 60% of the full-year plan after only two months. I guess it’s good there’s Hungary (and now Slovenia) next door who will always attract eager sellers, eh?
But coming back to prof. Krugman, I realise that my credentials are nowhere near his. Heck, I’m not even writing this under my own name. Still, I think in cases like Latvia or Poland, he lets his ideology run before the analysis of what actually is going on.