Monetary normalization

Ten years after the last financial crisis, most of the big central banks still hold their ultra-loose monetary policies. Even though the ECB seemingly started to taper its QE programme, the money pumps will be on until the end of the year. However, due to base effects (and changing nominal pace of purchases), the ‘tapering’ started more than a year ago by now. The Bank of Japan kept his policy stance so far, although it is questionable how long can they buy assets without jeopardizing the smooth operation of private financial firms or their own solvency. The Fed also switched to a dovish tone lately. Correspondingly, the dollar index went through a mild correction following the Trump-rally in last year’s November and December. One of the reasons might be the fading of the expected policy rate difference between major central banks. Since commodity prices stabilized, inflation returned, and global trade was partly revived, expectations shifted to the upside. Europe might represent an exception, however the weighted 10-year-yield also took part in the global yield rise in the last half a year.

Nowadays the Eurozone still resembles to the international gold-standard system after WWI: fixed exchange rates with balance of payments imbalances. The main issue lies within the solution, governments have to rely solely on internal devaluation by following pro-cyclical policies. The problem with such measurement is its unpopularity, hence can not be held without political turbulences. Realizing the issue, the ECB is constantly trying to inflate the core-economies, while also trying to avoid a debt-deflation spiral in the periphery. Two birds with one stone, we could say. Lowering real debt burden, while they try to restore the balance between economies. Unfortunately, the households of the core do not cheer the measures as they feel the value of their savings eroding.

The strength in the euro and raising core government bond yields are more likely to be due to the favourable result of the French election regarding the unity of the monetary bloc. The insurance premiums (= chance of the Eurozone falling apart * appreciation in national currency) faded, however, the internal imbalances are still present in the system. Given the latter condition, I would be surprised if the ECB would rush with its policy normalization, inflation tolerance will be higher. Negative real rates are still needed and it seems they are here to stay with us.

Lagging policy

The Trump-administration pledged to cut corporate income tax rates from 35 to 15 percent in the recent days. In accordance with the previous rhetoric of Trump’s campaign and presidency, the measure is also aimed to support international competitiveness and improve external balances by lowering the tax content of American production. After the first hearing, it doesn’t seem to be a bad idea, as the US has the highest official tax rate among OECD member countries. However, if someone would take a look behind the headline numbers the picture would change significantly. On the one hand, when compared to GDP numbers the American corporate tax burden is much lower than in most OECD economies, representing a smaller burden for the overall supply chain. On the other hand, the effective corporate tax rate is 11 percentage point below what the official numbers would suggest.

The differences between official and technical measures originate from various factors. Firstly, American corporation producing for export markets may not bring the profits home, hence spare a round for the taxman, and increase the profit for themselves. Secondly, the share of profits and margins within the headline GDP numbers may differ from country to country, thus examining plain vanilla tax rates does not result an apple-to-apple comparison in the system’s competitiveness. Thirdly, and maybe most importantly, rules of taxation may once again differ between OECD member states. There are several factors, such as accounting for amortization and write-downs, or deferred payments, which can effectively change the base or the temporal flows of public funds.

American corporations already exploiting deduction policies to get a leverage against Uncle Sam. For instance, the companies of S&P 500 are eligible for future deductions around 200 billion dollars, which also appear on their books. Altering the tax rate would change the valuation of such assets, hence create an immediate loss for the firms. However, this loss might be dwarfed by the amount of lower tax obligations in the future. According to the first round calculations, the new tax regime would create a 2-billion-dollar gap on the government account in the next ten years, creating federal debt equal to roughly 12 percent of current economic output. Even though nominal numbers are set to increase, the economy does not have to effectively pay it back in order to build down its debt burden. The other way is to grow it out.

Increasing government deficit would have the same monetary effects as credit expansions created by commercial banks. As in any kind of accounting, the economy also needs a corresponding ‘savings’, or asset side. This may come from the saved tax money, which effectively means that a unilateral social transfer would be replaced by a bilateral agreement (government bond) which would create a ‘tangible’ and marketable asset. The other way is to finance the deficit by involving foreign investors into the equation. However, this would result in deteriorating external balances, exactly the opposite what the current administration is trying to achieve. (Financial and capital accounts = current account)

The two solutions are not mutually exclusive, nor make a difference regarding following policy implications. By issuing new bonds (either financed internally or externally) the quasi-money supply increases, along with money velocity. Given that capacity constraints apply, it would be surprising if the real economy could keep up with this monetary expansion without inflationary pressures. This may help the government finances, however, the Fed would need to tolerate higher inflation.

As a result, if the Fed doesn’t raise rates the dollar would weaken due to low real rates, international investors my demand higher interest rates and sell their treasury holding off. The other way, if the Fed decides to raise the rates to fight inflation, primary fiscal deficit may prevail. Either way, the Treasury department faces a hard time in the long-term for a short-term gain on the peak of the recovery.

Currency of Mordor

More than a year ago the Fed had its first rate hike in more than a decade. The event will definitely be remembered as a milestone, however, it is yet hard to tell if it will mark the start of a firm recovery or something worse. Just remember the example of ’36; it was premature then, and given the still negative output gap, underemployment, and demographic changes this might be proved to be wrong too.

The monetary tightening started a bit before December of 2015 though. Prior to the historical hike, the Securities Exchange Commission (SEC) announced its planned reform regarding the operation of money market mutual funds, the USD 2.7 trillion sector, which is responsible for both internal and external interbank lending. According to the new regulations, money market mutual funds investing in non-government issued securities must change to floating NAV accounting (making it a bit more volatile to investors), and can use liquidity fees and redemption gates to prevent fund-runs.

The legal changes came into effect last October, however, markets always price in advance. Exactly a year before the implementation of the reform, preparing for tightening and for the reform, investors headed to the exit, and started to stockpile funds with T-bills. This raised borrowing costs on the interbank market (USD Libor), made currency swaps (Eurodollar, yen) costly, and widened the TED spread, sending small, but significant shockwaves through the markets. If you were preparing for the rate hike with floating instruments linked to Libor you could beat the market for 14 month now.

But why did Libor rates rise? If I buy the T-bill from an other investor know he will have to hold the liquidity, or buy something else, in which case his new partner will hold the money. It cannot disappear from the system this way.

Similarly to the One Ring in Tolkein’s epic tale, modern currencies can only be destroyed were they were born. In the depth of Mount Doom, in this case also known as the Fed’s vaults (or accounts, to be more precise). Given the role of dollar in international finance, I believe it is not inappropriate to say that this little change made many markets’ life harder, especially when the dollar was already increasing financing costs due to its appreciation.

One Ring to rule them all, One Ring to find them,
One Ring to bring them all and in the darkness bind them…

As this little story foreshadowed it, if you are interested in the where the money went you have to dig up the Fed’s balance sheet. In this period, when Libor started rising, and money flew from prime money funds, you will find two factors behind the tightening of liquidity. Firstly, banks entered into reverse repo agreements, obtaining government bonds from the Fed’s stock. Secondly, the government account drained bank liquidity (high powered money). Although, the latter doesn’t necessarily imply that the banks were given bonds in exchange, the effect is nonetheless the same. Interbank liquidity dries up.

Liquidity quicksand

First of all lets make something clear about zero lower bounds and costs of holding liquidity, and money in general. Money, whatever form it might take, is a nominal financial asset, just as a bond, perpetuity, or T-bill. It just happens to be a zero coupon consol.

Hence, the zero-lower-bound  allpies for nominal interest rates, where at negative rates the non-financial sector can still choose the instrument with zero coupon. Actually in today’s financial world it’s not true either, since you can not use cash for all your transactions. Also there is a risk of losing the money, or the cost of keeping it safe, the “zero-lower-bound” is rather somewhere in the negative territory, I have seen various estimates, going from -2 to -6 percent.

According to classical economic theory, as real interests rates drop you hold more liquid money, as the opportunity cost is lower. Case closed.

I would disagree. The real cost of holding liquidity also depends on its return compared to alternative investments, nominal or real, inflation affects both in the same way. Liquidity traps doesn’t occur, cause real returns are near zero. They occur, cause the real return of holding money is a.) close to its alternatives b.) relatively high. By the latter I mean, that during normal times when inflation is positive you have a negative real return with this zero coupon, while at zero inflation holding money has no cost in real terms. That said lets consider the ways we can get out of such economic malaise.

Why can it be a quicksand?

In my view the best proxies as alternatives to holding cash (considering liquidity, affordability, and default risk) are safe bonds/consols. Theoretically one could consider any type of asset, but that would rule out a possibilty of negative real rates, since something (by definition) has to appreciate against everything else. It would be like saying, that you can earn double your money each year, you just have to be always at the right time and place. That would be just nonsensicle and extremly naive.

So realistically speaking safe bonds are good proxies, and even though they do not default you can earn a nice negative real return on it. That happened quite often during the last bear markets. The problem is that you have no haven option. You can stockpile into real assets (gold, REITs, stock ETFs), but that requires higher risk tolarence, and on a macro level also risks bubbles.

The problem with our current situation that IF inlfation picks up on the longer horizon, and IF central banks raise too soon they risk the offsetting of the recovery. If they are too slow noone would hold money/bonds, and an excessive amount of money would flow into commodities, raising inflation even higher. Precision will be required… for me it looks that we are in an eternal trap, where normalization is not viable in the short run.


Why has NAIRU failed us?

Recently I came across an article on Ft’s Alphaville blog, written by Matthew Klein, arguing about the uselessness of NAIRU models. I had countless similar personal arguments and discussions about the viability of economic models, which usually left unconcluded, leaving both parties disappointed. The typical critique is that one can not reduce the market to two dependent variables and expect a realistic interpretation. I personally believe that if you make this argument you haven’t quite figured out what economic modelling is about. My personal view that you are examining a causality between two variables, leaving everything else out of the correlation (using the much hated Ceteris paribus condition) is not reducing real world, but debunking it. No reasonable modelling economist would argue, that modern countries and societies are built on one or two variables.

As always I missed two parts of mathematical and logical thinking from the post. First, as in any model, here you also have a constant attached to the Phillips function, representing every other part of the system, what may affect the relationship. Mathematically speaking the partial derivative of the real world respective to one variable has to treat the rest of the system constant (ceteris paribus), but does not deny its existence, nor its importance. Logically, this means that any relationship can change, every model can shift due to an external shock, where externality stands for any change coming from the non-examined variables (but not necessarily outside of the economic system). Looking at real life data always produces the net effect of all changes, hence can mask certain relationships, but they exist nonetheless. Relying on just mechanism is just as useless, as denying their existence is ignorance.

As I promised two missing parts of the argument, let me carry on with the less econ-nerdy one. As every part of neo-classical macro modelling, PC also operates with expected inflation and inflation surprise, not merely headline numbers. If the outcome of policy changes will be expected (meaning at least the party of the transaction, who is affected adversely accounts for it) the policy may bear no fruit at all.

It’s not different this time either. Policymakers want to create larger inflation, passing purchasing power from lenders to borrowers, or cover up the losses made during the GFC. The former obviously can’t work if lenders account for higher possible inflation. The second term is more interesting though. Before GFC we, in general, regardless of social status, income, or location, lived in the illusion of wealth… and acted accordingly. I won’t blame anyone, or I could blame everyone, this happens, when group-thinking takes place. The problem is we relied on non-existing wealth, which suddenly disappeared, even faster than it built up. Someone, in real terms, has to foot the bill, and by generating higher than expected inflation the savers can easily found themselves in that undesirable position. And by savers I also mean the want-to-be pensioners.

But this for another time, lets get back to NAIRU for now. As savers are clearly the losers of the inflation surprise, and they tend to be economically more literate, the surprise factor may not materialize. Just think about it, anytime a new QE is announced markets account for the possibility of higher nominal yields, muting the intended long-term effects of the policy. NAIRU is in fact in place, only the smart money is resisting it with every tool it has.

It’s the interest rate, dummy!

Since the US elections the dollar bull carried on its way towards its historical highs. Seeing this several columnists and analysts expressed their concern regarding the effect of strong US dollar on the emerging markets. At first glance it could be confusing why people are fearing a strong greenback. For years everyone wanted weaker domestic currency (stronger foreign ones) to boost export margins or domestic inflation, what could have changed?

First of all, as weaker domestic currency indeed boosts margins (expressed in local currency terms) one should not forget, that not all companies are exporters. During the recent years more and more emerging economies grew to a size, where simply relying on external demand to generate growth is not sufficient. With a struggling internal supply chain and eroding purchasing power it would be hard for policymakers to recourse their economy onto a more domestic reliant way. This is especially true, if the given economy is less diversified, and pricey exports would crowd domestic goods out.

Secondly, it’s not just about running costs. As it has been nearly a decade of cheap money lots of emerging economies relied on foreign funding. If foreign investors start to pull out of the economy, being afraid, that their investment would lose money as emerging currencies depreciate it would be even harder to pay the principle back, resulting in a self-fulfilling expectation and fire sales.

Thirdly, its more about the interest rates, than the currency itself. The most powerful tool, which sets the course for currency trend is the interest rate differential (in my experience you ought to look at the two-year differentials for a more precise correlation). In their current state, most emerging economies are between a rock and a hard place.

Due to the maturity of the US cycle and future policy expectations US rates started to rise. If emerging central banks hike rates to protect their currency they have to increase debt servicing costs for the already indebted private sectors. If they let their currency depreciate they have to risk the fire sales.

If this wouldn’t be bad enough, there is an additional factor to the equation: the emerging countries running a biggest ever interest-rate swap with the us, and they are on the wrong side. On the one hand, many of them have reverse assets in US dollars, however, these are mostly in fixed yielding government bonds. On the other hand, as emerging banks acquired funding through the interbank market they offered loans with floating rates in order to hedge against fluctuating rates. Many private companies feel the pain of rising rates right away, while others only take the bitter pill at refinancing.

Globalization critques – don’t get too excited

After recent election and referendum outcomes (I believe I don’t have to name them) people often made conclusions as the ‘losers’ of globalization are revolting against the old world order, or that globalization and neoclassical economics are failing us. I believe there were instances where these motives are in place. However, one can not make this simple conclusion as a one-size-fits-all reason.

Economists often make the mistake to confuse homo sapiens with homo economicus. Eventhough financial numbers often capture well-being and satisfaction (I always found ‘utility’ a wierd, extremely rational term), they don’t and in fact can not account for all factors. For example, why did the majority of Northern Irish farmers, the main beneficiaries, vote against open borders, when the urban population in Belfast, the main benefactors, favoured it? Why did Brexiters had ‘elite’ leaders when they revolted against this ‘elite’? Why does millions of republicans expect change when they elect a government led by bank executives and millionaires? Several contradictions sorround this simple argument about mere financial interests; no wonder they do not fit into social sciences.

For further thoughts regarding the topic please read these really insightful articles here and here.

As a person of numbers and figures I would rather focus on the quantitative side now on. In order to support the argument, that there are losers of globalization several good-looking graphs were produced too. My problem is that if you think about the methodology they doesn’t make sense, and  I believe most of you have heard/seen the globalization elephant graph, what is often used to justify why Western middle-classes are upset. In categorizes income brackets into percentiles, and shows the change of real income in each group.

Now think about this. I choose 20 people and rank them according to their real income. 30 years later I do the same and find that the 3rd richest guys income did not change in real terms. Then I draw the conclusion that the 3rd guy must be upset about it… I hope you see the problem. It not Bob, or Steve, or Kate; no, it’s the 3rd richest guy, whoever he/she is. The chart is pretty much the same, it doesn’t account for composition changes, labour mobility, demographics or any other influencing factors.

My other personal favourite is wealth distribution, when they take the whole as 100 percent, and make time series of a group’s share. It easily could be the case that there income rose too, but now it’s just X percent of the whole pie? How terrible. Aggregate income is not fixed, never been, comparing shares on a standalone basis doesn’t bear much fruit.

On the contrary, the ones who favour gloablization could easily make statements that it is unquestionably beneficial, since the number of people living in extreme poverty fell both in absolute and relative numbers. However, this is a fine achievement of globalization, the phenomenon is about much more than just combating one problematic aspect.

If there is any takeaway points you will have after reading this, then please let that be this: don’t fall for good looking pictures or rely on a simple figure.

What will make loans pricey

As I established in my previous post a loan is basically the present value of your future income. From the bank’s perspective they are buying an annuity, where the price is depending on interest rates, risk premia, maturity; ordinary debt market metrics.

After the recent Fed interest rate hikes some articles surfaced which predicted a new credit crisis, similar to the one we had in 2007-08. Sometimes I couldn’t decide whether the authors actually meant what they claimed, or just wanted to create a good clickbait by using people’s fear. Either way, here are two points why I find it unlikely that such collapse could happen anytime soon.

Firstly, after the last crisis there has been a serious deleveraging among the households. Secondly, household debt servicing-to-income ratio is at historical lows (however the series are only going back a couple of decades), and expected to stay low, partly because of our first point.

At this side of the yield spectrum (and will decrease as yields rise) each quarter percentage point of increase in borrowing costs increases debt servicing between 0.7 and 3.8 percent (calculated on a 5 and 30 year loan respectively). However, the other side of the equition, namely household (median) income is increasing 4 percent annualy too, meaning that the difference between the cost of maintaining your household balance sheet, your own personal enterprise, and what it yields for you (given that you are working) do not rise until the Fed hikes only once or twice a year.

Please do not be decieved by the numbers; again, this does NOT mean that all your additional income goes to debt repayments, only that your debt servicing / income ratio will stay constant with having more disposable income in nominal terms.

What will eventually do the tightening is the expected rate of hikes. As banks account for future financing costs too, more hikes will translate into higher current loan yields.

Lastly, higher yield might actually mean lower savings, giving an extra impulse for the economy. The rationality behind this is the big comeback of compunded interest. As rates got lower in the last couple of years savers were only able to get back what they put into their accounts, meaning that you had to save more to reach your future target (e.g. pension).

Rethinking wealth

Wealth and income distribution have been in the social scientists’ focus since the dawn of modern economics. However, discussions on such topic often fail right at the definition of the invisible reference point of equal distribution. On the one hand, it is often interpreted as the equal distribution of goods between individuals; on the other hand, it can be also meant as equal number of people within certain income brackets. Even though these arguments would be worth a book, if not a small library, I would like to take the argument one step back to measuring wealth.

As easy as it is to observe capital-related wealth by using share or bond price indices, labour-related wealth remains hidden when we account for wealth distributions using classical models. No wonder that wealth numbers indicate a more unequal, highly dispersed scale compared to plain vanilla income figures.

In the case of a financial claim the market simply calculates a net-present value of it, and right away we know the immediate wealth of the individual(s). But what does this really mean? According to Benjamin Graham’s famous metaphor Mr. Market tells us a price where he is willing to buy our future cash-flow. There is no difference in the case of labour-related income either. The market or bank gives us a quote on which we can exchange our future earnings for a certain amount of money. Yet this kind of wealth is not accounted for, a missing element of household balance sheets which distorts overall numbers when compared to capital instruments.

In its nature this invisible wealth, or labour stock is very similar to share prices: its value is positively correlated with earnings growth, negatively with required returns. Let me express it with less econ-finance nerdy words. With increasing wages one could afford higher instalments, hence is eligible for a higher amount of principle. Given lower debt servicing costs our fixed income can finance a higher amount of debt.

Credit issuance makes this invisible element of household balance sheets observable through debt markets. However, market creation always helps optimal allocation, each coin has two sides. On the one hand, we are able to exchange these future earnings for another asset (e.g. real estate), while we are also make changes on our liability side, converting invisible equity into visible liabilities. (See picture below) On the other hand, this conversion of the invisible part of the balance sheet might create false assumptions, as physical balance sheets expend, but in reality the economy does not necessarily follow as the potential were there all along.

After all this theoretical discussion lets see how much money are we considering. If the labour force of the US would exchange their future earnings to a fixed amount of money they would receive an eye-watering 338 230 billion US dollars… plus change. The number is derived by using the Gordon growth model on wages and salaries as they were dividends, data retrieved from the Fed. So let me put it into context: this is 19 folds the GDP, or 14 times the S&P market capitalisation (all at the end of 2015). The growth rate of this stock is also remarkable. In the last half of a century the value growth of labour stock outpaced S&P 500 returns by an annualised 48 basis points.

My point here is not to support one or the other perspectives when it comes to considerations of what is just. My aim is rather to say that before we get ourselves into such discussion get the right numbers and use apples-to-apples figures, before we make false claims or assumptions. Because of this invisible part of the economy I would certainly prefer income numbers over wealth.

Hitchhikers’ guide to instant wealth

A penny saved is a penny earned. It is especially usuful when companies are struggling to generate higher earnings during recessions, when demand and market expension are scarce commodity. Fortunately, nowadays it only takes four letters to achive higher returns: WACC. (Weighted Average Cost of Capital)

Thanks to cheap credit many of the hedge funds and activist investors could buy firms (usually using some credit in the first place), replace some equity with cheaper loans, and get the money out of the company while earnings numbers have been boosted too.  However, higher leverage or gearing on the balance sheet should make the investment more risky and cheap, higher earnings and multipliers compensate for the effect. Veni, vidi, vici; too good to be true.

The eye-watering returns seen on stock markets recently are fueled by these takeovers, or as a metter of fact, why would the management wait until the takeover, they can initiate share buyback programs too. Financial engineering within and higher multipliers outside the firms.

Luckily, we can not say that the market went full nuts. The widening spread between equity and debt returns reflects the understanding of this situation, and also indicates some kind of market efficiency. But back to the original question…

Is this kind of financial engineering essentially wrong? Boosting the ‘wealth-effect’ or decreasing savings through buying back equity could be beneficial for a troubled economy. Could be…

The problems with the argument is that it is superficial. First of all, the majority of these shares are held by higher income classes, whose marginal propensity to consume is naturally lower. Secondly, the lack of interpretable interest payments demolish the effect of compounded interest.For example, since the low interest policy savings rate has actually risen in the US. Low interests not only increase the NPV of assets, but also liabilities… pensions for instance. Last but not least, the combined effect of the last two factors can easily lead to overvaluation (let’s not overuse the ‘B’ word). After the buyback it is plausible that our investor would like to buy more shares using the returned money. The real economy would not see a dime before the prices of financial instruments are over the roof.

Why is it important now? Recently the S&P 500 buyback index once again surpassed its older brother. With a US fiscal expension on the horizon monetary policy could pass the baton to the fiscal policy, and switch into tightening mode. Taking away the punch-bowl would certainly hurt today’s valuations and ratios. There are no instant riches, and there is no free lunch. The tailwind of cheap credit can easily turn into a headwind.