The Widowmaker

There was a strange back and forth recently on Twitter after John Aziz pointed out Nassim Taleb's wrong call on treasury yields back in 2010, having said that every human should short US treasuries, and that it was a no-brainer. Taleb is a brilliant thinker, so how did he and other intelligent people get it wrong on sovereign debt? 

One of the hardest concepts to understand in finance is why seemingly insolvent governments can keep funding themselves almost for free. It doesn't seem right, or at least it doesn't fit with expectations. Taleb might have looked at the Euro debt crisis and subsequently painted all sovereigns with a broad brush, but I can't be sure of his process. I know I struggled for about 2 years to really understand why countries like Japan and the US had not collapsed from insolvency - looking at all the different angles, learning the basic operational and legal framework of the Federal Reserve. As counter-intuitive as it felt, in the end I couldn't see how the US would ever need to default, or any other country with its own currency (as the legal and operational constructs are similar).

The fact that this is so counter-intuitive is probably an essential feature of why government bond markets do not face the wrath of bond vigilantes. What I mean by this is that, if everyone understood that the government was not at risk of insolvency, there would be less accountability for wasteful spending - possibly even reckless spending would occur, which would itself put the government bond market at risk of losing credibility and an inflationary episode.

Because most people assume the government's finances resemble our own personal balance sheets, there is a genuine repulsion to high debt levels, and those in government normally try their best to reduce spending when possible, thereby retaining credibility enough that markets never seriously doubt the smooth functioning of this particular market.

This counter-intuitive nature is also probably responsible for so many senior analysts believing that when the Fed scales back its bond purchases, treasury yields will rise - which is of course backwards, because QE has never lowered yields in the first place. The implicit assumption is that the US government is spending beyond its means, and can only do this because the Fed is keeping rates low by buying debt - this is, funnily enough, also backwards even though it sounds correct. If the Fed were to remove its stimulus programs today, far from causing a flight out of treasuries, this would actually cause a flight in to the safety of treasuries, leading to drastically lower yields -  possibly even negative yields for shorter maturity instruments. We have seen this in action since the Fed tapered its bond purchases - yields have stopped rising and have even fallen since the announcement.

To get this backwards, one needs to assume that the natural path for interest rates is up, and that the Fed is keeping them down against what is 'natural'. This tends to play in to a lot of natural resentment felt towards central banks and private banks, so it is often unquestioned. Far more likely is that, because all the factors that caused falling long rates and inflation for decades are still in place, and there are powerful new factors since the GFC that have amplified this; de-leveraging; low demand for credit; high supply of savings; falling inflation or even deflation; Chinese investment in overcapacity - the natural path for interest rates is still down.

This is normal in an era that can be classified as a Balance Sheet Recession (or Great Depression/Great Recession), where the private sector is trying to repair impaired balance sheets and so demand for new loans is anemic. There have been at least 3 of these periods in recent history, and the previous 2 did not see interest rates turn around for decades. The Great Depression is particularly insightful, because even when inflation picked up during World War 2, yields still did not rise (more regarding this later on monetary policy) - again, The Widow-maker was a terrible trade, despite conditions that should have made it successful:

A long term history of interest rates and stock prices. Due to a incompelte data I've had to cobble together several data sets; 10 year UST's; Long term government bonds; High grade railway bonds; Dow Jones Industrial Index; Railway shares. Thus, this is not perfectly accurate, but the series are close enough substitutes to give a reasonable representation.

Understanding of what makes the widow-maker trade such an unrewarding trade involves, among other things:

1. Interest rate cycles.
2. Credit and savings demand.
3. Monetary policy.
4. Asset prices and bubbles.
5. Inflationary vs. dis-inflationary periods.
6. Legal framework, central bank balance sheet construction, and what separates Euro countries from other developed nations.
7. Public and private debt levels.
8. Global balance of payments imbalances (think US and China, or Germany and Greece), and the savings glut/great moderation.

I will need to break this explanation up in to parts, as it is a long one, but well worth the time as interest rates affect valuations across all asset classes. Also, yield movements make a lot more sense when you stop looking at them backwards!

China's Vast Reserves

Macroeconomics and finance suffer from huge gaps in understanding, often arising when reality is counter-intuitive, and a much simpler but incorrect interpretation exists and so is commonly accepted. Today, I'm looking at China's foreign exchange reserves and the idea that they represent accumulated wealth that can be freely spent. Most of the time (in my experience) when people consider this topic, they view China as the powerful dragon guarding vast hoards of accumulated treasure or savings, for use when the economy gets in to trouble:

Disclaimer: Not an accurate representation of China's foreign reserves. 

But this isn't really accurate. There are actually quite a few reasons why these reserves are not particularly helpful in a crisis. Today's post is sparked by a discussion over at Macrobusiness, which I identified as a misunderstanding, and I think it's one that a lot of people make, which is to consider these reserves as unburdened assets.

There is presumably an assumption that the Chinese government accumulated these savings by spending less than it receives in terms of net exports, and by generally being prudent and investing this excess cash overseas. This is an easy assumption to make given the media narrative of wealthy China and bankrupt America, but it isn't real or accurate, because China actually has been a net capital importer if we exclude the PBoC's exchange rate operations. The common understanding of the PBoC's reserve position looks like this, but this is not correct:

The best way to understand China's reserve position is to understand how the reserves got there in the first place. From there it will be easier to show that selling those reserve holdings is much less of a threat to the US than China, and that there might not actually be any accumulated wealth at all, because the heavily US dollar denominated side of the PBoC's balance sheet is offset by RMB denominated liabilities.

Accumulating Reserves:

China is unique, in that it runs a current account surplus, and a capital account surplus. Normally a current account surplus will be offset by a capital account deficit as excess income from abroad must invested in foreign countries - a capital account deficit means money is flowing out of the country. So why is this not the case in China if a balance of payments is meant to balance? By including the reserve account of the PBoC, which offsets both surpluses to prevent the currency from appreciating.

Source: Also Sprach Analyst

Because Chinese monetary policy involves a crawling peg, or a peg to a basket of currencies, the PBoC must stand ready to purchase any foreign dollars in order to defend its target rate or band. Both of the twin surpluses, in a normal world, would act to appreciate the RMB, as demand for Chinese exports should push up the currency, as should demand for investing in China. In both cases, foreigners must sell their own currency and buy RMB in order to deal in the domestic market.

The PBoC creates RMB when it buys USD, in the same way as the Fed does when it purchases assets during QE, creating reserves. Because this would be potentially inflationary, the central bank needs to sterilize this money expansion. It does this in two ways: By issuing RMB denominated bonds and by increasing reserve requirements for banks. Issuing interest bearing securities transforms the commercial bank's assets into longer term maturities that are less likely to cause inflation, while increased reserve requirements keep the reserve balances from supporting excess credit expansion.

In both cases, the PBoC's balance sheet is stacked towards USD denominated assets and RMB denominated liabilities. USD assets can be assumed to be US treasuries, or USD deposits but theoretically there can be purchases of private assets if the PBoC really wanted. I'll create an example and say that this reserve accumulation took place in the early 2000's, when the exchange rate was about 8 RMB = 1 USD. Such a balance sheet (simplified) would be a combination of asset-liability matches such as below at the time of the initial transaction:

Fast forward 10 years and the value of both sides of the balance sheet have changed due to asset appreciation and exchange rate movements. For the first balance sheet shown below, the US treasury bond has appreciated in value by say 20-30% due to roll-down and the long term trend of falling rates. This is great for the PBoC. The other side of the balance sheet offsets this though - the RMB has gained 20-30% and the exchange rate is now roughly 6 RMB = 1 USD - but this isn't too much of an issue, maybe in this simplified case the bank has not made a net gain or loss.

The RMB has been allowed to appreciate partially.

There would be an issue with the second transaction though, which represents a larger portion of the PBoC's balance sheet. Here the value of the RMB liability has appreciated by ~25% relative to the USD asset (I've used 30%). The asset being US dollars that don't benefit from the same asset appreciation as US bonds. 10 years later, the central bank's balance sheet might resemble this if marked to market:

This sounds bad, but it isn't all doom and gloom. The PBoC's liabilities didn't really cost it anything to create - central banks have unlimited power to create reserves. Technical insolvency (if this was marked to market) doesn't necessarily mean a central bank can't function, though in order to maintain trust and credibility it isn't the best place to be. We can't really say they are bankrupt, because this institution is the monopoly currency issuer, so they can't run out of money - but that money is the central banks liability, not an asset, which is a little confusing to think of. But given this, aren't these FX reserves essentially free wealth? 

No, for a couple of reasons listed below. But more strikingly, if it was this easy to achieve free wealth - just print money and buy up foreign assets - then every central bank would be getting rich. There are negative consequences for this, and it is a blade that cuts both ways - if accumulating reserves bestowed benefits, doing the opposite will bring costs. It cannot be beneficial both ways, or we have found the holy grail of policy prescriptions.

Take from this section that these aren't reserves that have been saved through hard work, but rather purchased by issuing domestic currency liabilities which still need to be honoured at some point - not so different from the way that commercial banks expand their balance sheets in order to make loans: Of course a commercial bank's assets have increased when it loans money to a customer (the loan is an asset), but so have their liabilities (a deposit or wholesale funding) - we wouldn't call a commercial bank $100,000 richer just because it makes a residential property loan for this amount, because it has also increased the other side of its balance sheet to fund this.

A central bank that issues reserves or longer term debt in order to buy US treasuries hasn't become rich, it has simply expanded it's balance sheet without necessarily creating positive equity. If it then gives away those assets (as people assume it will in a crisis), it's net liabilities increase by the same amount (as liabilities have not changed), taking it further into the region of technical insolvency. 

Is the Federal Reserve rich because it has bought trillions in US treasuries by issuing liabilities to the banking system? No, so the logic should be no different for the PBoC. Similarly, if the US Fed gave away it's treasury holdings to the private banks to help them, what would we think of the Fed's credibility? Not much! It would have no assets left and trillions in liabilities. If the PBoC gives away it's assets to recapitalize the banking system, then it's simplified balance sheet would look more like this:

So who pays for this? Well in the end, most likely the government borrows to recapitalize the central bank, meaning transferring the reserves didn't help, it just changed the mechanism of transfer. Now the government will be inclined to inject the central bank with assets - meaning liabilities of some other institution than the PBoC - such as Chinese government debt or similar.

Unwinding the Reserve Holdings:

A problem we run into in assuming the reserves are wealth is that we need to ignore the exchange rate effect of selling down this USD wealth for use in China. Accumulating reserves has only one purpose, which is to manage the exchange rate below where it otherwise would be to benefit the Chinese manufacturing and export sectors. Clearly, making the opposite transaction would involve appreciating the exchange rate and severely hurting this competitive advantage.

For instance, say China sells it's US treasury holdings - now it has an equal value of US dollars, if we ignore the poor price it would receive for unloading a large amount of bonds onto the open market. This isn't very helpful, it just changes its reserve composition towards USD deposits rather than interest bearing bonds. The PBoC already has US dollars in its reserve holdings to begin with, so it's not especially helpful. But, say they went ahead and did this anyway, what would be the effect?

Initially nothing, except a spike higher in US long rates which would probably subside. Now, they still have US dollars, not Yuan. If the banks are insolvent and need recapitalizing, this may be helpful, but it only makes the banks liquid and solvent in USD. For them to address RMB outflows and maturing RMB obligations which makes up the lions share of operations, this still needs to be converted back to the domestic currency - putting upward pressure on the Chinese exchange rate. 

However, a more likely scenario  is a liquidity crisis being the problem (rather than only solvency), as China's inter-bank market freezes up again, more dramatically than it did last year when SHIBOR moved higher. This would be a similar crisis to the sub-prime credit crunch, and it is not far fetched if defaults begin rising in the realm of WMP's, trusts and real estate loans.

In the case of a liquidity crisis, the problem is that institutions won't lend to each other in RMB. Excess USD liquidity does not help the situation unless it is converted back into RMB, again putting upward pressure on the exchange rate.  The point: if foreign reserves are to help a domestic credit crisis, doing so will reverse the currency peg's benefit. This would unfortunately happen during a time when a sharply appreciating currency would be disastrous for the country's manufacturing and exports, who would likely be already suffering some effects from a freeze in lending. I can't stress enough how unhelpful this would be.

Even still, what if they try and use the USD to save the banking system as outlined further above? As Michael Pettis notes:

"In fact there have been rumors for years that the PBoC would technically be insolvent if its assets and liabilities were correctly marked, but whether or not this is true, any transfer of foreign currency reserves to bail out Chinese banks would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities. The net liabilities of the PBoC, in other words, would rise by exactly the amount of the transfer. Because the liabilities of the PBoC are presumed to be the liabilities of the central government, the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks... "

"Bailing out the banks, it turns out, is conceptually no different than transferring debt from the banks to the central government. China can handle bad debts in the banking system, in other words, by transferring the net obligations from the banks to the central government, and the large hoard of reserves held by the PBoC does not make it any easier for China can resolve any future debt problems. In fact if anything it should remind us that when we are trying to calculate the total amount of debt the central government owes, the total should include any net liabilities of the PBoC, and that these net liabilities will increase by 1% of GDP every time the RMB strengthens against the dollar by 2%. ..."

Any central bank can create reserves and buy things, and recapitalize banks in its own currency, regardless of foreign reserve holdings - central governments can borrow money to do as well this regardless of accumulated reserves. The FX reserves are a Red Herring, that only help to the extent that foreigners have lost faith in the RMB and the PBoC needs to defend the value of the currency, or to buy international commodities during a war like situation. If the PBoC unloads its reserves in this manner it has severely reduced its credibility - it is not only now completely insolvent (to the tune of trillions of RMB), but does not have any reserves with which to defend the value of its currency... And now the central government will be forced to recapitalize the central bank rather than the commercial banks.

If in doubt, come back to the question I posed earlier: Is the Federal Reserve becoming richer and more secure by purchasing treasury bonds with newly issued liabilities (excess reserves)? This is what the PBoC does when it accumulates foreign reserves. In a sense, you could say that China has been running a Quantitative Easing program for the last decade, only because it is targeting the exchange rate rather than domestic employment and the price level, it must buy foreign bonds instead of its own.

A Simple Explanation

Walter Kurtz from Sober Look points out the growing gap between loans and deposits and asks the question of what is driving this divergence. 

Some other commentators have tried to associate this change in growth rates to some nefarious practice by banks, but the reality is that it is mostly an accounting issue related to QE. The explanation is made simpler if you look at the balance sheet operations of the Fed and commercial banks under QE programs. 

From Soberlook:

"... The last one however is particularly intriguing because the $2.4 trillion gap between deposits and loans is a familiar number. The excess reserves in the banking system is now ... also around $2.4 trillion ...

The chart below adds bank reserves held with the Fed to loans and leases - and the gap "disappears" (here we use total reserves vs. just the excess reserves, but the difference is not material to this trend.)...

 

... Coincidence? Perhaps. But if there is any validity to the explanation #4 above, it would suggest that QE, which is directly responsible for the $2.4 trillion in excess reserves, was not helpful (and possibly harmful) to credit growth in the US...."

This is not a coincidence at all. While I think the explanation of #4 is a bit off, at least it gets to the understanding that this is a consequence of reserve balance growth. I don't particularly agree that QE was harmful for credit growth, but that's going off on a tangent. Back to the loan-deposit gap:

A direct consequence of banks acting as intermediaries for QE is that they accumulate excess reserves, as well as creating deposits in the process, because the end point of QE is to swap a privately held bond for a privately held deposit. This differs from another more common form of deposit creation, whereby banks make loans by expanding their balance sheet. Under the normal loan process deposits and loans grow together:

Under QE, the Fed purchases financial assets by issuing newly created reserve balances - ex nihilo.  The balance sheet operations are fairly simple, and at the end of the asset swap the bank customer ends up with a deposit at the bank. For the bank this is a liability, and the attached asset is the reserve balance at the Fed. The bank's balance sheet looks like this:

1. The bank purchases the bond from the private sector by issuing a deposit.

2. The Fed purchases the bond from the bank by creating reserves, which it swaps for the bond.

Because there is no loan attached to the creation of these deposits, there is a buildup of excess reserves, and naturally a gap will grow between the level of outstanding loans and the level of outstanding deposits. Nothing sinister or complex, just a consequence of bank inter-mediation that should exactly match the value of excess reserves.

Shifting to Neutral on US Equities, Better Value Elsewhere in 2014

While I am not prepared to become a bear just yet, I am definitely becoming neutral on US equities through 2014. At the very least a correction is about due, even if there is no catalyst for a panic. I could become a bear later in the year, perhaps Q3-Q4, as I actually see a few risks building at the same time as the Fed will be slowing down it's easing cycle. Until there is a real catalyst for a crash though, I am only prepared to say that I think the index will finish the year +/- 5% from it's current value, roughly flat. My position is that if you want to own equities, there are many other countries trading at bargain valuations because they are out of favour. US equities are now fully priced, but countries in peripheral Europe are still trading well below long term value, and Australia's slow recovery has kept it from becoming overvalued.

Sentiment became euphoric towards the end of last year, when the Fed decided not to taper in September. Analysts, rather than shifting their estimates back 2 months to the December meeting, walked the taper back to well in to 2014, some even making the call that there would be no taper at all. This might have been sound logic at the time, but it did not eventuate - the Fed announced the taper this December. What I draw from the analyst estimates is that most overestimate Bernanke's willingness to support asset prices at any cost, and most are probably already positioned as net long as possible, given the narrative heading into December was that the Fed would keep running its extraordinary easing at 85 Billion per month and equities might go into a blow off top. Now they are still positioned for this outcome, yet the reality has changed, and the market has not reacted negatively yet.

The market did not correct after the announcement to any noticeable degree for several reasons, a few being that:

1. The taper doesn't actually begin until January.
2. The Fed strengthened forward guidance and made it clear that the taper was not the same as tightening, and that rates would stay at zero for as long as needed.
3. Tapering is still easing at 75 Billion per month, not tightening.

I am unenthusiastic about US Equities now specifically because:

1. Valuations are very high, by many measures that I care to watch - US equities are now some of the most overvalued in the world. At a CAPE-10 of 25.6 it is unlikely 5-10 year returns will be decent from here.
2. Sentiment is close to euphoria - it is unfashionable to be bearish, bears are capitulating and there is a widespread belief that the Fed will not allow asset prices to fall (I think this is misguided).
3. Extraordinary stimulus is winding down over the course of this year, the market is not positioned for this.
4. Unemployment benefits are ending for many.
5. Inflation is falling, despite efforts to raise it.
6. China faces a very difficult dislocation as it attempts to "un-repress" its economy, or re-balance away from credit fueled investment growth - this will become more obvious and problematic throughout the year.
7. The recovery, though weak, is maturing after 5 years.
8. Last year was driven mostly by multiple expansion and buybacks.

Crashes Without Rate Rises:

Something I have begun discussing in this blog, and will discuss further, is the idea that in the absence of an active cash rate policy and the move towards balance sheet monetary policy, asset purchase programs have replaced the cash rate as a signalling device. In an inflationary environment, markets normally don't crash without some sort of monetary policy tightening, normally a rising policy rate is a necessary but not sufficient condition, while an inverted yield curve has been, in recent history, a near guarantee of a recession. This precondition cannot occur currently, as the Fed will not raise short term rates, so this is taken by many to conclude that a crash is unlikely. However, when the economy's natural tendency is towards de-leveraging or deflation, as it is now, policy need not be tightened to instigate asset price falls, instead reduced stimulus is enough to spark a downturn if the economy can not yet stand on its own.

The best analog for the current market conditions is the Great Depression. The market crash of 1929 was followed by a deep and painful depression, though by 1937 (as Wikipedia puts it) the recovery appeared to be under way:

"By the spring of 1937, production, profits, and wages had regained their 1929 levels. Unemployment remained high, but it was slightly lower than the 25% rate seen in 1933. The American economy took a sharp downturn in mid-1937, lasting for 13 months through most of 1938. Industrial production declined almost 30 percent and production of durable goods fell even faster."

This was also a period characterized by falling long term rates, low inflation, global recessionary conditions and a general de-leveraging of the private sector with an opposing growth of the public sector balance sheet - which sounds a lot like the current environment. Of course the monetary system is improved and unemployment lower, conversely market valuations are slightly higher and private sector leverage is also still quite high - there are definite differences, so we shouldn't expect an exact replica to occur, but since this is the closest existing experience with the current macro environment it is worth paying attention to.

Opinions vary on the exact cause of the 1937-1938 recession, depending on your political alignment and your school of economic thought. We can't really know for sure, and I don't care to open a can of worms. What we do know is that the cash rate was not raised and the yield curve did not invert - the two normal preceding conditions of recessions were not present:

After a powerful rally off the lows of the early 30's, in 1937 the DJIA corrected 50% - the Federal Reserve was not raising rates and the yield curve was far from inverting.

The point here is to acknowledge that it is not a sufficient argument to say that, because the Fed will not tighten any time soon, this implies asset prices can not crash. These are not ordinary times, so it doesn't pay to look for ordinary analogs and it is possible for a recession/crash to occur without tightening.

More on QE/real interest rates as the New Cash Rate (Just Brainstorming)

Regardless of whether a taper begins this year or next, I'll continue to discuss my reasoning as to why the Fed's tapering will be equivalent to a rising OCR and a full exit should have roughly the same effect as an inverted yield curve for financial markets. There are several reasons for this, some of which may occur whether the Fed tapers or not - these I will discuss here.

Early in the recovery, when most people did not understand the potential effects of excess reserves and demand for bank credit, it was in vogue to panic about inflation, and inflation was fairly strong during QE1 and QE2. Whether asset purchases had a large direct effect on inflation or not when QE was running - while possible - probably doesn't matter too much. What matters now is that even if it was QE that was driving reflation in consumer prices, this effect is dwindling. The latest round of QE, despite being prolonged and open ended, has seen a gradual trend downwards in inflation (Source: St. Louis Fed):

While interesting in itself, when combined with the fact that long rates have unambiguously risen under balance sheet expansionary QE programs (despite the question of whether or not QE is the direct cause), this has lead to some notable effects; a rising real cash rate; positive real yields on long term US bonds. In effect, the Fed is not finding it easy to maintain inflation or financial repression, and the longer QE runs, the more attractive treasuries become relative to equities and other risk assets due to multiple expansion and falling yield spreads. (Source: St. Louis Fed):

Again - whether or not QE is inflationary - at the moment it is not stimulating strong inflation and the cash rate cannot go lower - hence real rates are rising. A negative real interest rate is associated with strong asset price performance, as it rewards various forms of speculative behaviour and leverage, of course, the opposite is also true of a sharp rise in the real rate.

The problem for a continued rally is that the real rate is becoming less negative, long yields more positive and yields on equity indices are lower than yields on risk free US long bonds (which is normal, but strong capital gains are not usually associated with valuations as high as right now). I know where I would allocate more of my money when the Fed has stopped expanding its balance sheet, but I am probably more cautious (not momentum chasing) and see a lot of relative value in treasuries vs equities as we head further into this dis-inflationary environment. (Source: St. Louis Fed):

If QE does end I am of the belief that inflation will move at least slightly lower (surely not higher), leading to real interest rates that are only marginally negative. Since the cash rate will not rise soon, positive real rates might only come about via deflation, something I'm not going to suggest is about to happen, but I suppose it is possible. Real rates moving less negative is a form of tightening in my opinion, given that this bull market has been a beneficiary of strongly negative real rates. Can marginally negative real rates sustain this rally? I really have my doubts that the repression effects are strong enough.

But, thinking more speculatively, if the Fed does not exit, eventually rising risk free yields must attract investors back, not to mention associated variables like rising mortgage rates will hobble the housing recovery, so there is a lifespan on QE leading to risk assets rallying over risk free counterparts. Perhaps the reason many people don't agree with this is that they believe that QE lowers interest rates on treasuries and raises equity valuations. If this was true, as I showed previously, yields and the index could not be positively correlated when QE is running - but they are, so it's a source of confusion for me that this is still the conventional wisdom.

What I am hinting at here, is that the narrative that the Fed will not allow risk asset prices to fall does not hold water. The Fed evidently has less control over inflation than it would like, and it's asset purchase programs have the effect of making risk free assets more attractive over time - thus a risk asset rally should be self limiting in theory. Every bull market has a narrative for why valuations are justified, and this gets overdone, leading to high valuations. Previously accurate forecasters such as GMO are estimating roughly a zero real annual return on US equities for the next 7 years, due to current high valuations

What is the catalyst for these valuations to begin to correct? For me, a tapering would be the start, but more importantly a Fed exit will see investors demand treasuries strongly in a portfolio. This is one point I'm fairly sure on - when the Fed exits completely, yields will plummet precipitously.

Name the Country

Here is a good test of your economic history, which country and what period am I describing?

1. Huge real estate bubble - perhaps one of the largest the world has ever seen, following on from a huge stock market bubble just a few years earlier.
2. Securitized residential mortgages and short term loans, packaged and on-sold to investors with the promise of high returns.
3. Widespread and systemic fraud to enrich business leaders.
4. A huge demographic shift about to take place as the workforce ages and shrinks.
5. Interest rates kept too low for too long, often negative in real terms rewarding speculative behaviour.
6. Rapidly rising debt levels, over 200% of GDP and rising at twice the rate of income growth.

If you said the US in 2005, you would be correct.


If you said China in 2013, you would also be correct.

Here is the problem: while many are watching the US and Europe and expecting them to fall apart at any moment, the real risk lies in the country that most are very complacent about. Developed Western country problems are known issues -  It is not typically the known economic problems that hurt investors, but the ones that consensus says do not exist.

This is hardly surprising given that risk management tends to go out the window in these cases and in periods of low volatility. Known issues often lead to intense scrutiny over exposure and possible outcomes, and this prevents them becoming more dramatic.

The US has done a lot to make it's economy more resilient following the great imbalances of its bubble years; bank recapitalization; de-leveraging; a shrinking trade deficit. Europe's banking system has not been fixed to the same extent, but the adjustment is at least under way despite some lingering structural issues. While these economies may face further hardship and recessions, their restructuring has begun. The opposite case occurred in China after the GFC. Instead of re-balancing it's economy, China doubled down on its investment growth story and fueled a credit and residential construction bubble.

China's credit fueled investment boom is not sustainable, yet there is still a lot of blind faith in a few bureaucrats to pull all these economic levers efficiently to create 7.5% real growth per year for the next decade. This is, despite all the historical precedents for investment growth models not re-balancing easily that Michael Pettis points out, and the precedent of state controlled economies being very poor resource allocators.

China will not fall apart immediately either. However, over the next few years Chinese growth will slow either voluntarily or involuntarily, and this has huge consequences for Australia. A lot of the China story probably won't be apparent until the tide goes out, and we see who is not wearing any shorts. Over the next year I will be aiming to describe Pettis' arguments for re-balancing from the perspective of Australia.

Playing Devils Advocate: I think most people have misunderstood QE's effect on yields.

One of the more common misunderstandings I come across is the idea that the Fed is keeping interest rates artificially low on government securities. This often manifests itself along the lines of:

“The Fed can’t stop QE or yields will shoot up and the government won’t be able to fund the deficit”

or…

“The Fed is funding the deficit. Who will buy the bonds when QE ends?”

and…

“Quantitative Easing increases the demand for bonds, and so yields fall”

People are more than happy to accept that QE drives up equity valuations as investors re-balance portfolios towards risky assets, yet struggle to make the connection that the flip side of this is lower speculative demand for long term bonds and that yields are determined by the market (as things stand currently), so expansionary policy must be reflected in yields. If the market does not price in expansionary policy, it is not functioning correctly, but it does and yields rise under QE. For this reason it is not easy to target yields and inflation simultaneously in free markets. In the current environment yield targeting takes a lower degree of importance to inflation and employment targeting.

This misunderstanding continues for many reasons:

1. A lot of confusion between real and nominal rates, and high yield vs. government debt yields.
2. Trying to fit data to theories rather than the other way around.
3. Because the truth, like many things in economics and finance, is actually very counter-intuitive and hard to accept without deeper thought.
4. Economists are not always traders, and there is some trouble understanding how market participants act.
5. The Fed is an easy target for venting frustrations.

I want to explain why this is misguided, because it leads to a lot of unnecessary fear regarding government funding, as well as poor decision making for unsophisticated investors. It is also leads to a trap where economists call for more QE to keep interest rates from rising, despite a strong possibility that QE is exactly what is making them rise in the first place.

Below I have highlighted the periods in which the Fed was making unsterilized purchases of longer dated Treasuries. If you showed this chart to a child, they would be able to tell you instantly that QE must raise yields, yet somehow many adults are seeing something different. I will discuss why they come to this erroneous conclusion, and why the reality is different to theory. Since I want to discuss the direct effects of long term bond purchases on those yields, I have removed Operation Twist (See discussion below) and purchases of MBS.

Analysis of Data:

Changes in the 10 year treasury yield since the onset of government bond purchases are as follows.

• Periods of balance sheet expansion:
  • QE1: +90 basis points
  • QE2: +51 basis points
  • QE3: +108 basis points
  • Cumulative effect on yields: +249 basis points or +2.49% on the 10 year.
• Periods of no balance sheet expansion:
  • Post-QE1: -82 basis points
  • Post-QE2: -156 basis points
  • Cumulative effect on yields: -238 basis points or -2.38% on the 10 year.

Notice that the 10 year yield is approximately back to its value at the start of the first treasury purchase program. All falls in yields have been associated with the Fed not expanding its balance sheet. All rises in yields have been associated with the Fed expanding its balance sheet. There is no evidence that balance sheet expansion (QE in its current form) reduces government bond yields in the US, and every indication that the opposite is true. If someone can work the data to say that yields have fallen under QE, they surely have their computer screens upside down.

The 10yr Yield and the SP500 is also becoming more positively correlated during each easing program (Yields and the index rise in tandem), with values of 0.55, 0.59 and 0.79 for QE 1, QE2 and QE3 respectively. This is what would be expected from a program that reduces speculative demand for risk free assets and increases speculative demand for riskier assets.

People should not expect to see significantly lower yields at the same time as the index moves higher – which highlights the point of this post: Many see the end of QE resulting in the stock market crashing at the same time as yields rising sharply, resulting in a government that can’t make ends meet. I don’t see the basis for this. The two variables are rising together, and will likely fall together when QE ends and deflationary threats become more pronounced.

Why QE doesn’t increase net demand for Treasuries:

At first glance, there doesn’t appear to be anything wrong with the quote at the top of the post, that QE increases the demand for bonds. To say the opposite – that QE lowers the demand for bonds – sounds insane, because obviously if the Fed purchases 45 Billion of bonds a month they must be increasing the demand for what they are buying. This is incorrect however.

For the Fed to buy 45 Billion per month, the private sector (mostly the household sector, including hedge funds) must be willing to sell 45 Billion per month. The simplest way to understand this counter-intuitive truth is to rephrase the statement:

“The private sector is selling 45 Billion worth of a bonds each month, this will increase supply and yields will rise.”

Because, for every buyer, there is an equivalent seller in each transaction - if the Fed wants to buy, someone must want to sell. It is possible that the percieved benefits of rebalancing towards equities might actually induce greater supply than the Fed's uptake, leading to rising yields. In the case of QE programs, the data shows that speculative sellers (largely households/hedge funds) are the parties selling to the Fed during QE. If QE induces a portfolio rebalancing effect, then it must also increase supply from these parties as they seek to move in to riskier assets.

“Recall, from the analysis above, households are the largest seller to the Federal Reserve for both Treasury securities and MBS. Now we find that purchases of Treasury securities by the Federal Reserve induce households to shift these asset holdings toward corporate bonds, commercial paper, municipal debt and loans, and bank deposits; MBS purchases drive all of the same substitutions, except for bank deposits. In addition, when pension funds sell MBS to the Federal Reserve, they thenshift their portfolio toward repurchase agreements, or very short-term assets. This evidence of shifting investors out of safe assets into riskier assets points to a credible channel for the effects of asset purchases on broader financial markets..." 

"... We find that not all investor types sell to the Fed uniformly. Households (the group that includes hedge funds), broker-dealers, and insurance companies appear to be the largest sellers of Treasury securities when the Federal Reserve buys these securities. Households, investment companies, and to a lesser extent, pension funds, are the largest sellers of MBS when the Federal Reserve buys." 

(Source: From Whom Does the Fed Buy?)

It should be clear from this understanding that the quantity purchased does not matter if the private sector sells willingly, and that prices will not be driven either way by this process alone. The Fed’s purchases do reduce the total outstanding supply in the market by moving the bonds on to the Fed’s balance sheet until maturity, relative to the counter-factual where the Fed made no purchases – this does not result in lower yields because QE simultaneously reduces new private sector demand for safe assets in favour of risky assets.

Taking this portfolio effect further, it also needs to be emphasized again that these are willing sellers. The Fed is not forcing these parties to relinquish their bonds, they sell because they see better opportunities elsewhere. There is no reason that the Fed's purchases would add to existing demand, because those that sold to the Fed will not reinvest their freshly issued deposit back into those same treasuries - because for them to do so would be a meaningless transaction. There is no incentive or reason for any investor to sell a bond to the Fed and then buy an equivalent bond with the proceeds.

It might be the case that sellers of long term treasuries may sell in order to purchase shorter duration bonds - this is probably occuring now as the Fed strengthens forward guidance regarding the Fed funds rate. Short rates are expected to stay at zero for longer, even if the Fed tapers its long term bond purchases, a message Bernanke is making sure to emphasize as tapering becomes more likely. This will put pressure on long term interest rates.

A simple diagram showing hypothetical effects – the reality is more likely that private sector demand falls by more (hence the rising yields) and Treasury keeps issuing new securities, however I just want to demonstrate how the portfolio effects of QE can net out to roughly zero and should not drive yields lower.

Furthermore, the Fed is a price taker in these transactions, not a price maker. That is, the Fed conducts a series of competitive auctions with its Primary Dealers (1). In this process, dealers submit offers to the Fed’s dealing desk and the Fed accepts the lowest priced offers received to fill it’s purchase amount (2). The Fed’s purchases in no way drive yields lower, because the Fed must accept voluntary offers from the private sector and the market comes to a price based on a number of other factors.

Why might QE raise yields?

With the exception of Operation Twist, QE has unambiguously been associated with rising yields and the end of QE programs have always resulted in this process reversing – leading to plummeting yields. The same occurred in Japan when Abenomics was supposed to drive long term rates lower, but instead yields on the 10 year JGB doubled under the program. Abe and Kuroda were surprised by this, but they should not have been after seeing the same effect played out many times before.

Firstly, when the Fed creates reserves ex nihilo, the market views this as expansionary and to some degree inflationary and prices this in to yields accordingly. Fed watchers over the last couple of years understand that banks don’t lend reserves (except to each other) and they are not reserve constrained. The aggregate of market participants however has a knee-jerk reaction to balance sheet expansion – that it is inflationary. From my understanding there is no direct effect on inflation, but through various second order effects such as exchange rate depreciation and lowering yields on risky credit instruments, there is probably some minor inflationary effects (though we can never know for sure without the counter-factual of no QE at all).

Because Operation Twist a) Was sterilized, and did not involve balance sheet expansion, and b) Targeted yields directly, it was not seen as particularly expansionary and inflationary by the market. Beyond this, traders will not fight the Fed if it wants to target yields. As quantitative easing is currently constructed, it targets a quantity of purchases but has no set yield target. This means firstly that the Fed does not have any control over yields, and that traders are not fighting the Fed by selling into the Fed’s purchases.

Secondly and more simply, markets ‘buy the rumour and sell the news’. This can mean pricing the event into the market in the lead up to announcement, or pricing it out of the market – dependent on what the market expects.

In the case of QE programs, the market front runs the Fed’s purchases by buying heavily before the programs begin, then ‘takes profit’ when the Fed enters the market, leading to selling pressure on treasuries and rising yields rather than falling yields. Purely academic economists sometimes struggle with this, but event driven traders will know that if an event such as tapering is to be announced, traders will continue to push yields higher until it is actually announced, then flood back into the market on the actual announcement, perhaps in anticipation of the next program – when they will again sell to the Fed. Rinse and repeat.

Finally, portfolios re-balance. QE makes treasuries unattractive and equities and high yield instruments more attractive. People are simply not willing to hold treasuries at the same low interest rates while QE is supporting risk assets, and they adjust their pricing accordingly.

QE can lower yields in at least 4 scenarios:

1. If the purchased quantity is too low to offset deflationary fears.
2. If the purchase program targets yields directly rather than a set quantity of assets.
3. If the program is sterilized and there is no central bank balance sheet expansion.
4. If yields are rising because there is sovereign default risk (Euro Area, sub-optimal currency area), QE can lower the risk premium by guaranteeing the solvency of the country.

However the Fed only has the ability to target one variable at a time. Richard Koo has explained this a few times, however I will go over it also:

1. If the Fed sets a firm inflation target, it loses control over what quantity of assets it must purchase to achieve this and cannot control yields (as the market will price in the inflation and yields rise).
2. If the Fed sets a monthly quantity to purchase, it controls it’s purchase amount, but can never really force a set inflation rate or maintain control over interest rates (hence the Fed hasn’t been able to achieve it’s target inflation rate or keep yields down).
3. If the Fed targets yields, then it cannot control the amount of assets it purchases to achieve and defend the yield and cannot control the rate of inflation. It might actually be the case that the market respects the Fed’s target yield, and so the Fed ends up buying very little from the market to defend its target – in this case inflation would be hard to come by. The opposite could be true in a central bank that has less credibility – the central bank might be forced to buy vast quantities of assets to control yields – in such a case the country might find itself in trouble.

Why make the claim that QE lowers treasury yields?

This is really hard to figure out, since it seems so clear from the evidence and the logic that QE hasn’t done anything to bring yields down. I have some suspicions.

1. Some economists set out to prove a point, then find data to support their perspective. I haven’t read every paper and article written on QE’s effects, but from the ones I have that claim a reduction of yields through QE I notice two ways in which the methodology seems disingenuous.
   1. By selecting arbitrary dates between which to run a regression instead of simply the period in which the program was actually running – this includes dates of announcements and discussions. If they regressed only the period between which the purchases took place I cannot imagine how they could come to the conclusion that yields moved lower under QE.
   2. By examining the whole period since the onset of the crisis. This ignores the deflationary effect of a bursting credit bubble (debt deflation) over the period in which yields kept moving lower, only to be periodically raised by QE programs. It also ignores the 30 year trend of yields moving lower due to a glut of savings and low inflation.
2. People confuse real rates with nominal rates. Some discussion argues that QE lowers the real interest rate by inducing inflation. This is obviously not the same thing as the nominal interest rate and I do not dispute that QE can lower the real interest rate. The problem is that this distinction is not made clear enough in much of the financial media, and so the point gets muddied and muddled until it is assumed that QE lowers nominal rates.
3. People confuse Treasury yields and the effect on high yield and corporate debt markets. QE has helped lower funding costs here, so QE does lower yields – just not for risk-free assets like treasuries. This is another point that gets confused and blended together, leading to incorrect conclusions.

Conclusions:

Though it can never be known for sure, there is a strong case to be made that the Fed is keeping rates artificially high, rather than low. Trying to picture the counter-factual – where the Fed did not begin its QE programs, it seems like a no-brainer that a debt deflation scenario, with an oversupply of savings would lead to some very low yields. Demand for credit would be incredibly low.

It is incorrect that the US Treasury will have difficulty funding itself when QE ends. I will need to explain this further in another post, but from a purely mechanical point of view QE neither lowers the nominal rate on bonds nor is it direct funding (as the Fed purchases in the secondary market). To the extent that QE may help to lower real yields, this may help reduce the significance of the debt over a longer term. From a short term perspective however, nominal yields will be lower without a QE program running so at best the effect is ambiguous as to whether it would be easier or harder for Treasury to fund.

For short term interest rates such as the Fed Funds rate, the Fed also is forced to keep rates higher than they otherwise would be (3) – this occurs because of the large quantity of excess reserves that accumulate due to banks inter-mediating purchases from the household sector. The Fed needs to pay interest on these reserves to maintain control over the Fed Funds rate, which, in the case of large excess reserve balances and no interest paid would see the Fed Funds fall to zero as banks sought to loan their excess reserves. By putting a floor under rates the Fed maintains control over its policy rate.

A Final Thought:

Explicit in my thinking here is that while QE is running, yields and the indices are positively correlated. This poses an interesting question – if QE makes risk free yields rise, and conversely makes yields on risky assets fall, will there come a point where the psychology behind QE ‘flips’ and stops working because the yield on risk free assets has risen enough that they become attractive again?

My belief is that, yes, this is the ultimate outcome if QE continues running indefinitely. The portfolio re-balancing of QE is largely psychological and not mechanical, and it can change if valuations get too far out of line or sentiment too bullish on equities and risk assets. At what point this would happen, I am not sure, but I think the idea that multiple expansion will continue regardless of anything else until QE ends is not correct (though it may continue for a while). When relative value differentials become large enough, Treasuries will look attractive and equities repulsive – especially considering the lack of inflation achieved by QE.

1. FOMC: Statement Regarding Purchases of Treasury Securities.

2. POMO FAQ.

3. Why pay Interest on Reserves?