It’s not me, it’s you

This week one of the German banks (starts with “D” and ends with “eutsche Bank”) decided to enlighten us with their insight into Fed’s communication policy and transparency. One of their “analysts” has plotted the size of the Fed’s balance sheet against the number of words in FOMC statements. This person has also decided it would be useful to do a regression and inform us that R^2 is very high. There also was an arrow to show joint direction. Reluctantly, I will paste this chart below.



And before anyone starts saying I don’t have a sense of humour, let me assure you I get the wit here. Additionally, I will not spend time explaining how absolutely retarded from the econometric point of view this is (on at least five levels).

When I moaned about it on twitter I got a few replies including one that says that the chart is “provocative”. Presumably because it points out the fact that the communication policy of the FOMC has been somewhat imperfect. In fact, this sort of criticism is often used against many other central banks, particularly after they’ve depleted traditional monetary policy tools.

I profoundly disagree with such opinions and here’s why.

The world is not exactly a carbon copy of any Macroeconomics 101 course. In fact, it is a pretty screwed up place with tons of opinions and research floating around simultaneously wrestling with burgeoning financial markets which themselves have become increasingly more random. Sure, occasionally there are chaps who make careers on calling some things right but then it quickly emerges they were one trick ponies (Roubini, Paulson, Taleb, Schiff, Whitney to name a few). And the private sector does reward being right so you can bet that many MANY people in banks, asset managers or hedge funds (including yours truly) are throwing a lot of resources at the problem of forecasting. With average results at best. So if the private sector has significant issues despite using an enormous amount of resources then why wouldn’t the public sector suffer from the same problem?

Pretty much no policy maker has never lived through anything resembling what we’re dealing with at the moment. Comparisons to the Great Depression and Japan have their significant shortcomings too. The system is extremely complicated and I am beginning to think that the whole economic analysis has hit a stumbling block similar to the Heisenberg uncertainty principle in physics. Perhaps we could calculate the trajectory of the global economy going forward but we would pretty much have to rebuild the whole world in some other place and watch it. Or, if that comparison doesn’t speak to you then maybe let’s use the Bitcoin example – the cost of mining (electricity) has now exceeded the benefits. So we end up with a combination of intuition and luck, unfortunately.

What has been the response of the central banks? Well, they’ve opened up. They started revealing all sorts of (dirty) secrets. It started even before the crisis with all sorts of fan charts. I remember very well when Poland was introducing its own Inflation Projection. The NBP spent considerable amount of time to inform people that this wasn’t a forecast but a projection. In other words, it was a work of a (pretty crappy) econometric model, which the central bank was filling with all the data it found relevant. And obviously, as the data changed, so did the outcomes of the model.

Same kind of thing happened to the forward guidance. Flawed concept as it is, it was misinterpreted from the very beginning. Yes, there were pretty silly thresholds but they were merely a reflection of what the central bank thought at the time. Plus they were always accompanied by phrases like “at least until” orunless” to demonstrate they were very soft. Anyway, the clue is in the name (“forward guidance“). Here’s a short clip to that effect:

And guess what? It turned out things have changed and central banks reacted as they saw fit. The classic example was the decision not to start tapering in September. But for some reason, people started screaming that this means the Fed has lost the credibility. Sure, the Fed has lost the credibility rather than those who came up with the cretenic #septaper hashtag in the first place. The same kind of thing happened with #dectaper and again, the Fed’s communication policy was to blame. Ok, feel free to argue that the FOMC made a series of mistakes in their assessment of the economy but for crying out loud do not say their communication policy was incorrect because that just goes against any logic.

I have this rule when analysing central bankers’ comments. When they talk about current month’s decision, I listen no matter what – after all, they are the ones pulling the trigger. When they talk about what they think they will do in the next 1-3 months, I take that into consideration when doing forecasts. And if they talk about anything beyond the next three months I just go to make myself a coffee. Sure, it might be interesting to read what they say but the disclaimer here is simple: They.Don’t.Know.

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.


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 the central bank giveth, only the central bank taketh away

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

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

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

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

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

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

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

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

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

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

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


Abolish deposit insurance, please

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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