Terminal Velocity (13) – “Real Headwinds”

Written by , KeySignals.com

In Terminal Velocity “Getting Real Interesting”, the thesis that rising U.S. real interest rates were becoming a black hole for global capital was developed. Recent experience in the capital markets suggests that this singularity event has occurred. The cognitive dissonance observed in the Fed’s communications, about the “Taper” and/or the “Exit”, has created the rise in yields as a result of the binary decision-making process of Treasury Bond Traders. They were confused, so they sold. Yields have risen to one-year highs[i]. The rise in the Ten Year yield through 2% has flushed out the convexity sellers[ii]. This has had the knock on effect of raising mortgage rates, which will then knock on to weaker home prices.

In the global markets this has attracted capital into the U.S. Dollar, thus forcing up global interest rates[iii]. The net effect is a double whammy. In America, rising interest rates are a domestic headwind. As they attract global capital they become a global headwind[iv]. The global headwind then feeds back to America via a higher US Dollar and less export demand from global trading partners. This double whammy is also known as Deflation. QE has not shaken off Deflation, so it is now time for something new to be applied. It can be argued that QE has made the situation worse, by creating bubbles in asset prices that are only sustained by the QE itself and not real economic activity. The new policy tool therefore needs to address deflation. This is easier said than done, based on Japan’s recent bond market travails from announcing a 2% inflation target.

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The backup in US mortgage interest rates looks ominously like the backup in JGB yields. Both portend something unpleasant for risk assets and economic growth.

It is clear that a period of market volatility is coming either way. More QE risks a bigger Risk Asset Bubble; and inflation targeting risks the collapse of the Bond Bubble. The only way to get away with inflation targeting, is after a Deflation inspired collapse in Risk Asset prices that keeps bond yields low. Low yields not only provide scope for aggressive inflation targeting; but they also reduce the capital losses on the Fed’s balance sheet portfolio. The Fed can thus embark on its next course of action from a position of solvency, rather than insolvency. It is this course of action that we think the Fed is about to follow next.

The Fed must also have its eyes on the bubble developing in equities, which was about to go viral if the front page of USA Today on May 29th was any indication. Retail investors seemed just about to step back in at the top; so the Fed may wish to prevent them and the “Wealth Effect” taking the kind of beating that causes recessions. The appearance of Margin Loans, through which equity investors use their unrealized gains as collateral must have spooked the Fed; especially as these loans are being used to buy houses and expand business operations[v]. A well-engineered deflation of the asset bubble, which hits the professionals and provides scope to reward individuals with “Helicopter Money”, is an experiment that is now worth trying. Rewarding the banks created a bubble and weak growth, so it is time to reward those who will spend rather than save it.

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Further evidence of the risk to US Equities came from the publication of the latest Corporate Profit Data for Q1/2013. Corporate profit momentum has decelerated sharply from Q4/2012.

Boston Fed’s Rosengren has added to the dissonance from the Fed in his latest speech. He appears to support the “Taper” in the short-term[vi], followed by more purchases in the medium to long-term[vii]. He wishes to engineer the sort bubble deflation that then demands more QE. The Fed is clearly worried about the threat from a risk asset bubble in the short term; and is willing to correct it. He also shed more light on the thesis developed in Terminal Velocity “Pyramid Scheme”[viii], in which the Fed’s balance sheet will be expanded indefinitely. He opined that in his view, small amounts of asset purchases over a longer period of time are better than the “Shock and Awe” of large purchases over a shorter period. Rosengren implies that the bubble risk from a “Shock and Awe” execution is far greater than from an incremental approach. It also seems that he has taken a page out of Michael Woodford’s book; and concluded that the threat of exit from a large balance sheet undermines all the benefits of QE[ix]. His solution is therefore to demonstrate commitment to keep building the balance the sheet over time.

Bill Dudley provides a unique form of dissonance, because of the fact that he is both head of the New York Fed where the QE is done and Chairman of the Committee on Global Financial System (CGFS) of the BIS. He is thus poacher at the New York Fed and gamekeeper at the BIS. This conflict of interest made for interesting reading in the May issue of CGFS report number 49[x]. The paper is clearly a manual for central bankers who are going down the indefinite expanded balance sheet route. This is done by placing greater policy emphasis on the collateral markets to guide interest rates and monetary policy. Collateral market funding has emerged as the driver in the interbank capital markets since the crisis, because there is more confidence in collateral price discovery than there is in the transparency of balance sheets reported by banks.

Central banks accrue a portfolio of assets, through asset purchase; which are then used to influence liquidity conditions in specific asset markets. There is however a systemic problem based on the fact that High Quality Assets (HQAS) are now in short supply (as shown by “Graph 4” below).

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The weak economic fundamentals are one reason for this scarcity; and the other is that fiscal austerity is reducing the volume of HQAS outstanding at both the corporate and sovereign level. There is then a further wrinkle added, because central banks have now become the greatest owners of HQAS. As the volume of HQAS has declined however, capital markets have become more reliant upon collateral funding. What this therefore means is that the very nature of collateral markets has made them a pro-cyclical monetary asset. In times of crisis they become scarce and liquidity becomes constrained; and in bubbles they are readily available to finance all kinds of credit creation. It therefore makes sense to see central bankers seize this problem with both hands; in an effort to address the pro-cyclicality that creates systemic risks. Ultimately, banks will be expected to collateralize all their balance sheet assets, so that they can be used as funding instruments. Collateral reporting and price discovery are expected to be more transparent and accurate than the quarterly financial reports from the banks. This is all good in theory, but in practice the banks have to get there first. Thus far, they are still using customer collateral to fund their own positions. They are also using customer collateral to create new credit. These two actions create the process called “Re-hypothecation”. Re-hypothecation looks like another egregious privilege granted to the banks; in addition to the implied Federal Bailout guarantee that reduces their funding costs. Clearly the BIS seems to be taking a dim view of Re-hypothecation, especially in times of crisis. In times of crisis, customer collateral that is being Re-hypothecated becomes encumbered, because it is tied to the funding of the banks’ assets. Collateral markets and the underlying securities markets themselves cannot then function. The BIS would like to make the banks stand on their own feet in relation to funding, by using their own assets rather than their customers’. First they must start taking these assets back on balance sheet; and reporting their prices and degree of encumbrance. The removal of the Re-hypothecation privilege will be a massive blow to bank funding; and will see them cut back their own lending activities, as they are forced to be more transparent about the collateral they own. Banks will have to carry more equity capital as they become more reliant on their own assets as collateral for funding, rather than appropriating their customers’ assets.

Perhaps more worryingly for banks, is the fact that removing obstacles of encumbrance makes it much easier to wind them down in times of bankruptcy. As the move to collateralized funding occurs, the collateral position will signal a weak bank in advance and will also speed up its liquidation. Too Big to Fail Banks suddenly become Too Easy to Fail Banks. Going forward, banks will have to carry more equity capital and higher deposit insurance. Leverage and double digit returns-on-equity are going to vanish; so that the days when the S&P500 was driven by financials will disappear forever. The future for banks and bank bonuses looks bleak.

It may be Dudley’s intention to steer the banks’ business models towards collateral funding by application of these BIS standards. The CGFS paper however clearly overlooked a significant unintended consequence of this strategy, when it is evaluated through the lens of Quantitative Easing (QE). QE has exacerbated the lack of HQAS; so it has therefore exacerbated the pro-cyclicality of the behaviour of collateral markets. QE has therefore led to an increase in the volatility of capital markets. Liquidity in collateral markets has therefore been made worse by QE. As a consequence, banks have been forced to rely heavily on Re-hypothecation to fund their balance sheets. If this Re-hypothecation is taken away, their financial position will become even more precarious; and credit will dry up even further. A quick reference to “Graph 4” above will show that the volume of HQAS recovered in 2011, but to a much lower level than pre-Crisis. Since then, the “Sequester” in the USA and “Bail-Ins” along with continued fiscal austerity in developed economies has made the volume of HQAS even lower. This reduction in HQAS therefore exaggerates the dangerous pro-cyclicality of collateral market funding. As the Fed’s balance sheet grows and the volume of the HQAS falls, the situation has become even more extreme. The Fed may actually be revisiting the whole issue of QE via the “Taper”, because it has realised that it has a new systemic risk all of its own making. In “Fedspeak”, this means that the risks from QE are now greater than the benefits.

One thing that the CGFS paper did admit to was that the increased use of collateral markets will increase the interconnectedness of markets. Interconnectedness is a euphemism for bubbles created by Beta, when liquidity is perceived to be abundant; and contagion, when things go wrong and liquidity is perceived to be tight.

Going into Jackson Hole, we have a scenario of a pro-cyclical bubble (that is the result of the Fed’s QE activities) deflating. The pro-cyclicality means that the markets will overshoot to the downside, in an already deflationary macro-environment. The increased global inter-connectedness, which has been created by the pro-cyclical behaviour of collateral capital markets, will lead to contagion. The Fed is thus making policy for the world, by default. The externalities from QE are negative at the current size of the Fed’s balance sheet, so it is not at all certain that more QE is the solution. Time for “Plan B”, if there is one.

One option would be to boost the real economy rather than the capital markets; so that real growth supports the inflated debt infrastructure beneath it. To boost the real economy, policy makers have two choices. They can re-embark on deficit financed public sector expansion. Alternatively, they can put money into the hands of consumers and let them do the heavy lifting. Consumers may however elect to save, if they are given more money. Commitment to fiscal austerity also precludes more deficit financing. Deflation is therefore a certainty, until policy makers decide on the next major policy action. Unfortunately, American policy makers are too busy playing politics to understand any of this. “Helicopter Money” may then fly into this vacuum; as a new Fed initiative, to get the economy out of the next hole that it is currently digging itself into.

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