Just do as I say, don’t do as I do

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

Think of it.

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

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

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

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

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

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

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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.

 

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.

Dude, where’s my potential?

Last week was pretty eventful in terms of central banking. Obviously, the folk from the ECB grabbed a lot of headlines with their relative optimism but they are not the only ones trying to “whisper the reality”.

Meanwhile, two important emerging markets central banks decided to cut rates last week. And dramatically so. First, the National Bank of Poland decided to reconcile the market split between a 25bp cut and a no-change decision by… slashing rates by 50bp*. Two days later, the Banxico decided to do a similar thing, also exceeding the market expectations. Now how is that possible? Two central banks, which historically have been quite hawkish and have kept rates generally high have suddenly decided to get adventurous?

Let’s start with the NBP. Today the central bank revealed the details of its latest macroeconomic projections (a neat presentation can be accessed here). I found this chart quite interesting:

pl_potential

It shows two things. Firstly, according to the NBP models, potential growth rate has declined to below 3% from close to 6% before the crisis. Secondly, the lost output is so huge that the central bank expects the output gap to remain wide open at least until the end of 2015. In theory, that means at least two more years of zero underlying inflation pressures (caveat: see the Intermission section that follows). This is bold.

Intermission: Here I need to remind you of a significant distinction between potential output and potential growth rate. Have a look at the chart again – expected growth will exceed potential growth rate already at the beginning of 2015 (which by the way is pretty far off!). Only since then will the negative green bars start becoming smaller, reflecting the catching up with the lost potential. I don’t have a definitive answer to that but it is not entirely obvious that underlying inflation can start going up with green bars in the negative territory.

Now let’s move to Banxico. In the statement following the last meeting the central bank enumerated “structural advances” which have been made in recent years (translation here). They include:

  1. the reduction in the level, volatility and inflation persistence (ok, ok, that’s just an “idem per idem” argument)
  2. the fact that the various episodes of price adjustments have not resulted in second round effects
  3. the anchoring of expectations inflation, and
  4. the significant decline in inflation risk premium.

Of course Banxico is trying to make a big success out of it by saying that it has fostered an environment with less economic uncertainty. And good for them but someone cynical could say that this simply means that the economy has lost a significant part of its potential growth rate. I am not questioning the decision itself – I actually think the Mexicans did the right thing – but wider ramifications of it could eventually lead to even lower rates than now. Same as in Poland.

As I was thinking of the whole concept of potential growth rates in emerging economies I came across this very good article from Valor via Brazilian Bubble: Brazil’s Central Bank is in search of lost credibility. I don’t necessarily agree with everything that’s been said there but have a look at this paragraph:
Now, Brazil is not in a crisis, despite the fact that GDP has been showing subpar growth over the last two years and is on its way to perhaps the third year of such a situation. Despite that, everything indicates that the Copom is preparing to raise the Selic rate, repeating the standard reaction of a past that everybody thought had been left behind.
I can see where the Copom is coming from. Inflation remains of paramount importance in Brazil, to the point that they publish data to second decimals, as if it had any macroeconomic implications. I am not sure whether hiking rates will be the correct decision but I wanted to point out what can happen to an emerging economy if potential growth rates decline. If the economy has been showing “subpar growth over the last two years” and inflation is surging then maybe it wasn’t “subpar growth” after all?
There are of course positive examples, too. Turkey is one of them (although not very recently). I have not been in agreement with their recent policies and I think they’re throwing their undisputed success in fighting inflation to the wind but if we go a bit further back, we will see at least two episodes of a durable decline in the inflation rate. Both occurred after periods of significant economic hardship – first at the beginning of the millennium and then after the 2006 crisis. Now, Turkey had a grand opportunity to durably lower inflation after the 2008/09 global crisis but the central bank instead decided to focus on micromanaging pretty much every element of the economy. The reason I mention that is all three episodes of a shock to let’s call it “normal” level of inflation were used by the central bank to slash rates dramatically. In this respect, the CBRT recognised that the economy has become less inflationary. However, it remains to be seen whether its most recent response to global events is correct. In other words, the risk the CBRT is running is that it assumes that potential growth rates is higher than it actually is. It worked in the first two instances but that may be because they were driven by local developments (rather than the global crisis like in 2008/09). If the CBRT is not lucky this time, events could necessitate a similar approach to the Copom.
How to trade this? There seem to have been two approaches to monetary policies in recent years in emerging markets. On the one hand, we have seen activist central banks such as BCB or CBRT which have actively engaged in currency wars etc. They seem to be operating under the assumption that they need to counter whatever it is that Fed/ECB/BoJ conjure. I would call that “externally driven monetary policy”. On the other side of the spectrum you have the likes of Poland or Mexico, which – while acknowledging the impact of external developments – have maintained their reaction functions roughly unchanged. The latter group is beginning to realise that their economies are developing considerably slower than they could and so chances are that last week’s rate decisions are not the last surprises they have for us. As such money market curves should steepen there. The former group is to some extent the opposite. They are either like Brazil coming to the conclusion that inflation is becoming an issue despite slow growth. Or, like Turkey, they keep playing with fire pretending that the economy is still not strong enough to push inflation higher. One should be very careful being long duration in those, in my opinion.

* Despite huge temptation, I will not dwell on how ridiculous the communications policy of the Poles is. After two months of becoming increasingly more hawkish and suggesting a pause, they decided to cut more than expected to show that they’re done. I did not lose money on that so it’s not my grief speaking but I really believe this is the worst Monetary Policy Council among the mainstream emerging countries.

Inflation volatility or which bond markets to avoid

As promised, a quick word about inflation linkers in emerging markets.

While in most cases, the path of inflation in the coming 3-6 months is pretty much given; many economies are a completely different level of their respective inflation rates. Importantly, volatility of inflation rates also differs wildly. Take the following chart as and example. It shows the relationship between average inflation since the beginning of 2005 (so around 100 observations) and the standard deviation of CPI in the same time-frame.

cpi_vol

As you can see, there is a group of emerging economies which have achieved a relatively low level of inflation (the circled part of the chart) but they have had mixed success in terms of staying close to the average. Arguably, Israel, Malaysia and Poland are the best in this field.

As you move to countries with higher average inflation rates, standard deviation tends to rise. However, note that we are talking here in percentage points, as opposed to normalised values. In other words, we say that Poland is “better” than Turkey just because it has had a lower average and a lower standard deviation. However, if you normalised standard deviation by dividing it by the average you will see that Turkey has been much closer to its average than Poland. We will use that in a minute.

The chart below combines the approach of the volatility in inflation rates (i.e. standard deviation divided by the average) with the distance of the latest CPI print from respective central banks’ targets (note that for some countries I had to make assumptions as their central banks are not inflation targeters).

cpi_vol2

In this chart we see, for example, that South Africa is 1.2pp above the 4.5% target (mid-point of the 3-6% SARB range) and  that standard deviation of CPI prints since 2005 has been around 40% of the average (which was 6.1%).

How to trade this? Someone could ask what the point of looking at such a chart is. Well, as worries about inflation resurface along with some acceleration in growth rates, investors will be willing to bet that some emerging economies could have their inflation rates moving up fast. At the same time, the central banks would have to respond. Therefore, I think that what we’re looking for is countries, which

  1. currently have inflation below (or close to) the central bank’s target
  2. have experienced significant volatility of inflation prints in the past.

In those economies you should consider looking at inflation linkers or shorting nominal bonds.

When using such a comparison, Chile stands out as a good candidate with low current inflation and high inflation volatility. Similarly, Israel has a history of quite rapid moves in inflation rates and we also can be reasonably sure that the output gap there is insignificant. Finally, Poland is looking at rapid declines in inflation rates at the moment, mathematically increasing odds of a rebound in the second half of the year and indeed in 2014.

There are also many caveats to this approach but I have found it to be a useful starting point when trying to play a global inflation / disinflation theme.