Debtful future with ‘silver’ lining

During monetary tightening short term debt is one of the best instruments you can bet on. Turning to the short end of the yield curve limits your risk, your portfolio can trace policy rates, and gives you the freedom of liquidity. The strategy won’t turn you into a self-made millionaire – unless you are already one – but provides a prudent way to hedge against rising interest rates. If you were following the markets in recent weeks, you might have noticed something irregular. The difference between 6-month and 3-month T-bills turned negative, which means that quarterly paying bills yield higher returns. (see graph)

If you are familiar with the importance of yield curves you know what it means. If you are new to the topic let me sum it up for you. The longer the duration, the higher the interest rate is supposed to be. The reasons include liquidity, interest rate, and default risks. Furthermore, the shape of the curve follows the expected policy rate between maturities, making it one of the most reliable indicators when it comes to forecasting recessions. If you want to know more about its predictive qualities click here. Since we are in the middle of a tightening cycle and interest rates don’t tend to go back and forth within a couple of months, we can conclude that policy rate expectations play little role here; it must be something from a risk perspective.

As the end of September is approaching, the U.S. Congress is supposed to create the budget for next year, however, there is a bump on the road. The debt ceiling is in the way.

A little background about the debt ceiling: the measure was introduced in 1917. As a part of its involvement in World War I, the U.S. acquired debt from the private sector in order to finance its operations and its allies in the Old World. Since its establishment Congress had to approve new debt issuance, but the wartime required a more time efficient measure. The Second Liberty Bond Act made this time efficient solution feasible by only limiting the amount of new bonds issued. To reach its current shape, a second World War was needed. The debt ceiling reached its current form in the early years of World War II, accounting for gross federal debt in nominal terms.

I have a couple of problems with the measure. Firstly, it measures gross debt. Given that the government acquires assets, and not just fills the gap in the budget, the gross number might give you a false impression about the indebtedness of the system. For a real life example look up the difference between Japan’s gross and net national debt figures. Almost a 100 percent difference. Secondly, it is in nominal terms. Inflation and increasing economic activity (ceteris paribus regarding taxation) makes it easier to service nominal debt mountains. Fixing nominal levels result in a volatile real burden, often in the way of supportive – or at least not restrictive – economic policy, assuming a growing business activity.

The new budget, proposed by the Trump administration, is about to hit the ceiling. If it can not be raised, the Congress has to find alternative financing solution to borrowing, or risk a shut down. Before we get back to those sweet, inverse short-term yield curves, let me write a couple of words about public financing.

Most entities in the economy- let it be a household, firm, or municipality – rarely aim to deleverage by paying back nominal amount of debt. The most common way is to raise capital either from the market, or gradually by improving revenue streams. The Federal Government is not an exception. Paying back one bond means issuing new ones and rolling the debt, keeping the size of the balance sheet up. Hence, if they can’t refinance, the default risk is increased. Now get back to the bonds.

The ones which are going to mature 3 months from now are just after the predicted hit of the ceiling. Without a solution, repayment might come short. Before you get the wrong idea, I don’t say that the US will default. It just got itself into an interesting situation which is enough to create some turbulence on the T-bill market. Personally, I think it is a good opportunity with limited risk to get ahead of the Fed tightening curve and get a couple of basis points for ‘free’.

Bad solution, worse solution – the old stock and flow argument

One of my favourite point is when they confuse stocks and flows in the economy. I admit, it’s not straightforward, as most of the stocks have been flows at some time, and some assets – such as capital instruments – can be both at the same time for different parties. If you are interested in the topic, I can recommend reading Minsky’s ‘Stabilizing and unstable economy’.

Once again in monetary history, precious metals can offer a way out from the malaise. I have read two interesting alternative solutions to raising the ceiling. Firstly, we have the Trillion Dollar Coin. The monopoly of minting coins is still in the hands of the Treasury. With minting a coin and selling it to the Fed the Treasury would effectively engage in debt monetization, as the coin has no intrinsic value. This would either inflate the Fed balance sheet even further, opposite to the monetary policy aim, or would create a theoretically insolvent Federal Reserve system by writing off the value of the coin from the books just as it were a zero-coupon perpetual asset – what it effectively would be. Regarding the consequences of the first case let us see the second solution.

The second solution, even though involving precious metal (re)valuation as well, is less unorthodox. However, it would require the Fed to play the role of an investment bank or hedge fund, which it is not. The solution concerns the gold reserves of the government. Long story made short: during the 1930s everyone in the US had to sell their gold to the Fed, which amount was later sold to the Treasury in exchange of gold certificates at $20.67 per ounce. The certificates were reevaluated during the subsequent decades, all the way up to $42.22 per ounce. Today’s market price of ~$1250-1260 dwarfs the official value of the stock. By reevaluating the certificates the Fed could book an eye-watering $315 billion, which could be matched by government deposits on the liability side. Again, pretty much smells like QE.

The problem is that it would be hard to reverse the revaluation as it would cause respective accounting losses. So what happens if the Fed keeps the Trillion Dollar Coin or the reevaluated gold certificates on its balance sheet?  Here comes the problem of stocks and flows. In both cases the asset the Fed would hold is a stock, generating no income. On the other side of the balance sheet they would hold deposits – possibly converted into bank deposits sooner or later – which are cash flows, costing interest (currently costing 1.25 percent annually).

This gold trick probably won’t be implemented, as the Fed is not willing to engage in sneaky QEs. Fortunately, these are not the only, but certainly among the most unusual solutions, worth playing around and asking ‘what if’ questions.


Source: Bloomberg Marketsshort yield spreads US


The death of cash

The global economy is flushed with cash and liquidity, yet we do not see Weimar levels of inflation. After the Great Financial Crisis, when one central bank after another announced their low interest rate and quantitative easing policies, thousands of economists, business, and financial expert cried out that the era of hyperinflation is upon us. From low to high, gold prices soared 147 percent in dollar terms within three years.

Playing around with the numbers: gold appreciated 2 percent annually since the last World War. Accounting for that ‘natural appreciation’, the market priced 33 percent annual dollar inflation into the gold prices in three years on a compounded basis.

Despite low interest rates and the sea of ‘cash’, the expectations turned out to be wrong. Central bankers are still struggling to reach their inflation targets in the West – except the Bank of England due to special circumstances. Even though easy monetary policy affects the real economy through more than one channel, let me focus on my personal favourite: the wealth effect.

According to the general economic narrative, as household and companies become more affluent their willingness to spend increases too. Despite soaring net worth of the US households, personal consumption expenditure did not catch up, in fact a record low amount of their wealth is consumed in the US.

What went wrong? Well, probably you could partly blame the uneven distribution of the wealth effect, or the increased propensity to save since low interests also inflated future obligations, such as pension liabilities. But there is yet an additional, but crucial factor here: there is no income from inflating asset prices. In fact, it erodes income, creating a lack of cash.

A couple of year ago when the ECB started to cut its policy rate into negative territory, fixed-income investors – including myself – were desperately looking for meaningful yields. I managed to find a promising German real estate managing company. They were on a brink of becoming one of the industry leaders in the EU’s biggest economy, their financial metrics showed resilience, had a growth strategy, the macro background looked supporting, and they offered 4 to 6 percent yield on their bonds to finance their expansion. Perfect value target.

The bonds are about to roll over, and the company already issued new ones to refinance their debt from the market. The new bonds offer 0.5 percent coupon on over 5-6 years. Let that sink in, you technically won’t get paid until the end, there is no cash flow to be discounted, except the terminal one. There are two implications. Firstly, because of low interest rates the company can afford to issue debt on such terms. This means that the new instruments will be extremely sensitive to policy normalisation, since the final cash flow must ‘foot the bill’ of a yield increase. Secondly, you have no income to spend in the meantime.

Unluckily, the shopkeeper doesn’t accept one eights of German corporate bonds when I want to do my weekly grocery shopping. Hence, if I want to invest today it won’t add anything to consumption. I have one question to central bankers around the globe: I want to know where my money is, and I want it right now… I mean real, spendable money. Unfortunately, I know their answer

missing wealth effect

Cultural clash, banking, and economics

Recently global trade balances and free trade enjoyed the undivided attention of policymakers, economists, businessmen, and voters all around the globe. With the G20 summit just ended in Hamburg, leaving the city in devastation, it seems that global trade just got new champions. While in the second half of the twentieth century Washington was the main advocator of open trade borders, it seems that the EU with Germany in the lead and China take the role. As the baton is getting passed, even free trade advocators made an outcry about imbalances in international trade.

The gold standard revisited

As my good friend pointed out, Germany’s trade surplus doesn’t primarily flow to the EU periphery. In fact, if any members should be blamed for destabilising the monetary union it should be the Dutch. However, the Netherlands runs the biggest surpluses against the German and the British. Using the logic of the Economist, the former one cannot complain, while the latter is not in the monetary bloc, hence currency movements should be able to offset imbalances.

The main issue of critics regarding the monetary bloc is that in its current form the Eurozone is technically a fixed exchange rate system, where the fixed ratio happens to be one to one. We have seen fairly similar circumstances in the 1920s, after European countries tried to return to the gold standard. Due to different implementations of the return – fixing exchange rate or returning to pre-war price levels – some countries gained a competitive advantage compared to their peers trying to curb inflation by conducting pro-cyclical policies. Such imbalances does not necessarily imply a modern way of mercantilism, as long as the nations, foreign institutions and individuals are willing to lend to each other. The problem – just as in the case of a domestic crisis – is the ebb of liquidity or lost trust in the counterparty… and when the tide goes out we discover who’s been swimming naked, as we know.

So why is Germany’s surplus a problem? Not because it might leave Southern members in debt, but because German companies and states are reluctant to lend to the periphery. What remains is either paying in cash, leading to effective mercantilist trends and deepening deflationary forces on the periphery, or selling capital (real estate, companies, etc.) to German counterparties. While to former one seems unattractive since it demonetizes the economy, the latter one rather receives resistance due to populist arguments.

The back-up plan

As exchange rates have fixed relative prices, real effective exchange rates must adjust through internal devaluation. Expressing it using human language: Germany must become more expensive compared periphery prices if we want to equate trade balances. The ECB got a plan for that, namely conducting idiosyncratic monetary policy. Supporting the periphery with cheap euro and low rates, while also overheating the German economy with the same measures.

The problem is German financial culture is anti-debt. Despite the ultra-low rates nor the government, nor the private sector rushes through the door to get new loans. However, the rest of the Eurozone has no problem with hoarding debt.

Gresham’s law with a twist

Bad money drives out good. It’s not any different when it comes to ‘Italian Euros’ and ‘German Euros’.

The ECB’s monetary policy resulted further undesirable consequences on top of the counterproductive debt trends. As part of the QE programme private investors government bonds are getting purchased by the ECB and local arms, meanwhile they receive deposits in exchange. The problem is that it is not central bank deposit, but belongs to commercial banks. As some periphery investors don’t trust these banks over solvency issues, they rather take their money and put it into a core bank. Eventually this fund will flow back to the periphery, using interbank channels involving ECB guarantee. Not even the rest of the Eurozone wants to fund itself, why would the Germans?

Balance of payments?

As a result of general rejection of taking debt of the protestant business culture, Germany was not as good at ramping up non-financial debt as the remaining of the Eurozone. High savings rate can simultaneously keep wages competitive and the trade balance in surplus. At the same time, German businesses and institutions are struggling to find an acceptable counteroffer, as they don’t really want consumer goods or periphery debt. Capital account redemptions – currency or physical capital – only offer temporary solution, just as the inter-state lending.

Who to be blamed? Nobody. You cannot blame the lender if they are not willing to lend to a client with deteriorating credit rating. Nor can you accuse the upper-middle class with being careless if they don’t want to bail out the economy using their savings during a recession, and say ‘they should consume more’.

The gold standard broke down once countries ceased to be willing to lend each other. Today is not different. The Eurosystem helps to mitigate the risk for now, but the first bank failure could undermine the trust if (among others) German taxpayers had to recapitalise the ECB. The only accusation you can make is against German ignorance towards the realisation that in one form or another Germany has to foot the bill sooner or later.

Bumpy road ahead

“Buy When There’s Blood in the Streets” – Baron Rothschild

… and sell when everything seems to be alright. The serenity of the markets might be unsettling for contrarian-investors. The VIX (implied volatility index) is reportedly cheap, hitting multiyear lows, indicating that market players – or at least those who have access to these hedging instruments – expect no correction in the short term, as the index trails only 30 days. However, the concerns are below the surface, hidden in least known indices and instruments.

First a quick catch up for those who are not entirely familiar with option trading and the importance of volatility. Among other metrics and constant, option pricing requires 3 main inputs: the timeframe the option can be called, the risk-free interest rate for discounting purposes, and the expected volatility. However, in the real world the last bit is rather an output, a side-product of trading, rather than an ingredient.

What is the option for? As a hedging instrument option can be perceived as insurance policies. I pay a premium, and if the non-desirable outcome materialized I can make a claim on the multiple of the paid price. The more likely the outcome the more encouraged option buyers will become, while suppliers (insurers) might want to re-evaluate the likeliness of claims and increase their premiums. Both trend points towards higher prices.

Risk-free rates and timespans are known, not changed by the option market`s sentiment. Prices, on the other hand, might very well be a victim of changing attitudes. In order to equilibrate the option pricing formula, the only variable which `must have changed` is perceived volatility in the lifetime of insurance policies. Thus, the implied volatility index has been born by using the above derivation.

VIX measures all the options which are currently out-of-money (the strike price has not been reached yet or the trigger event is still ahead with other words). If it were health insurance it would cover minor injuries just as life threatening ones, a whole bundle of outcomes. The SKEW index (also published by the Chicago Board Options Exchange (CBOE)) rather resembles a life insurance. The calculation merely relies on outstanding options which have a strike price 2-3 standard deviations out-of-money, meaning they are highly unlikely and would be fatal for the underlying market.

Currently the big fish trading such indices kept the general insurance cheap, while the life-insurance policies have been slowly crawling higher as the bull-market matures. Why bother to pay for papercut coverage when we are heading towards the edge of the cliff? At least the narrative of markets suggests it… my takeaway point is only that one should always examine the whole scope of sources, and don’t get deceived by a single metric. The current sentiment is far from calmness, which is also reflected in record amounts of dry gunpowder to support the market a bit longer, or for more prudent fund managers to be used to buy the dip in case of a collapse.


On the value of money

If you ask people about the meaning of money they will either give you the textbook definition of the three roles, given that they are litarate in basic economics, or give you a very confused look. In one form or another, we used it every day for several millenia, yet most of us have never concieved the true meaning of it. ‘I can buy stuff with it, and that’s more than enought to know.’

Except it is not. Approximately a century ago economic litarature and interests were sufficiently developed to examine the phenomenon of inflation, or the change in the value of a monetary unit. The aftermath of a great wars of the 20th century served with the extreme real life experiment for the next decades. Fisher argued that the source of all evil is the changing nature the ‘monetary yardstick’, gold standard must be reestablished, and prices should be fixed. A couple of years later Keynes found that the source of all evil is indeed the change in the ‘price of money’, yet the solution is the manage the change, and let prices float.

But what is this price we are arguing about? Money, whatever form it takes, is a debt. If you own it you have saved, the market (meaning the group of users of the currency) owes you one, while if it is presented the seller supposed to settle the debt. Default is an option too, though it will erode the market. Hence the price of the debt is all the goods it can be redeemed for. Fisher’s dream, that every debt should be settled in commodities, actually has been in place since the beginnings. It’s just the ratio which tends to flucuate. If one can be certain that the debt will be settled, trust is high, capacity exceeds needs the price of money (not to be confused with price of goods!) goes up. If doubts arise about future shipments, vendors quit the market, or productive capacity destructed the price of money goes down, inflation picks up.

On velocity of money and willingess to exchange

Since capacity/consumption/GDP all measured over time and money is just a plain number/stock, we have to convert it to be able to make an apples-to-apples comparision. For this reason economists created the term ‘velocity’ of money, which means the amount of occasions money changed its owner within certain period of time.

Eventually this circulation will determine the price of money. As mentioned above money can be redeemed. Holders of the money stock must be willing to redeem their previous savings, otherwise a vast amount of goods will compete for scarce amount money, increasing the price of money. This in return will make it a good investment, further decreasing willingness to exchange money for goods (increase willingess to sell goods for money), creating a deflationary spiral. In such an environment the amount of money did not change, only the willingness to give it away, indicated by lower velocity numbers.

What Keynesian policy smartly included and contemporary policy is lacking is this willingness. The owner of the newly printed money must spend it, optimally without creating new capacity. In the 30s the governments did not only create the stock, but also velocity and artificial willingness (inducing further willingess on behalf of the private sector and kickstarting economic circulation). If you ever wonder why this time is different, look for this hidden feature of monetary policy conduct, and the austerity measures of governments. The real game changer for markets won’t be the extra stock, but the increased willingness to spend.