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):
    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.

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.




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


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



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



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.


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.