Tuesday, December 25, 2012

A solution to Europe’s curse: United States of Europe?

A few days ago, EU chief José Manuel Barroso hinted that the ultimate solution to Eurozone’s ongoing crisis called for greater fiscal integration. Though the task apparently seems very challenging given the strong political biases in the region, it is important –in itself- that the leadership has started to discuss such sensitive issues which remain critical to the survival of Eurozone. Though European Central Bank (ECB) didn’t hesitate to bring in its bazookas (LTROs, SMP and now OMT) to reduce the fears of downside but deep down everybody knows that ECB is just kicking the can down the road. Because theoretically while ECB can buy all the troubled sovereign debt through its liquidity injections programs, those debts either have to reverse –causing liquidity constraints- or have to be effectively written off by haircuts –resulting in direct injection of hot money-  both requiring a further action and ultimately a vicious spiral like a ponzi game.
While Eurozone has offered great political and economic benefits for its members, the eurozone has always been a heterogeneous mixture with different political as well as economic structures and policies. For example,
1-      Eurozone continue to suffer from differences in economic competitiveness. At one extreme there are countries with very high economic efficiency like Germany, France and Netherlands etc and on the other hand there are economically uncompetitive economies like Greece, Portugal, Spain and so forth.  Even if Eurozone would operate closed, these differences would ultimately result in assets laden competitive countries and debt laden uncompetitive economies unless the union operated in perfect harmony (Balanced trade and budget accounts). However, this would only be possible given all the economies converged to similar competitiveness that would only be possible
a.       If Competitive economies would shed some of their competitiveness, which has not happened.
b.      Or if the uncompetitive economies would grow rapidly in competitiveness to catch up with competitive economies, which hasn’t happened either since its too unrealistic to suppose that Greece would become Germany in a decade or so.
So in either case, sooner or later, a collapse would be imminent due to structural imbalances which need to be addressed when idea of creating such union was being worked out.
2-      The eurozone economic and political dynamics can be considered as a game with peripherals holding the moral-hazard card. If Greece had piled up debt from both within and outside the Eurozone due to its uncompetitiveness, the easiest way would be to default on the debt since it naturally didn’t have the capacity to generate enough resources to  pay them back. However, if Greece defaulted on her debt, the choice of second player –say Ireland- would also be to default on her debts since she faced a similar problem. But this chain reaction would also mean the destruction of assets held by competitive economies because their asset holding would effectively be the debt issued by peripherals (A classical piece on the issue was written by Martin Wolf named “The grasshoppers and the ants – a modern fable” see notes for reference). This would also mean that if a competitive country - for example Germany - is perceived as economically strong, it is because it derived its growth and asset holdings from economically uncompetitive economies and thus could not escape the damage of chain reaction, if started. So the best interest of such countries would be to stop peripherals from defaulting by bailing them out (what has been happening so far).
3-      Thirdly Eurozone has been in a situation where one Monetary Policy has to face 16 different Fiscal policies by individual members. This not only makes Monetary Policymaking challenging for ECB but also distorts the Monetary-Fiscal coordination. Furthermore, banking regulation of monetary union has also been a challenge where around 6000 banks operate under the supervision of different national central banks with varying degrees of supervision and regulations.
However, would such proposal be a workable idea?  Answer can be yes.  For example, we can look at the economic model of US where different states operate with greater autonomy under one federal administration. For example, a state can levy taxes on her residents, can raise debt from market with municipal debt. Likewise a similar model can be adopted for Eurozone with greater political acceptability. This may include
1-      A tax contribution or tax for proposed supranational fiscal body (just like federal taxes in US)
2-      Autonomy to raise domestic taxes as well as debt as per needs of member countries.
This would be more acceptable to general residents since
1-      All residents will pay similar tax
2-      A tax contribution would be more acceptable to common German -given a Greek is also making a similar contribution- instead of footing the German funded bailout of Greece.
The economic benefits of such a superanational body would be manifold for economic stability of the region since
1-      The Collected taxation at superantional body may be used in restoring the economic competitiveness across the region. This can either be done by supernational-regional government partnership projects or directing the funding to its most efficient use. This would effectively create a development wedge which would be helpful for peripheral countries in need for infrastructure investments.
2-      Since the financial position of Superantional body would be much improved vis-à-vis member countries (due to revenue generation ability), the supernational body would be able to raise funding much more economically as compared to member countries. Thus this would also help member countries bring down the costs of their development expenditures since the high cost of debt raising would mean more cost on development activities of government as well.
  Though arguing about the feasibility- both politically and economically- of idea and appropriate structure would be farfetched at the moment. But there is, nevertheless, a growing awareness and political will amongst the policymakers that a collective effort would be required to tackle the issue on permanent basis. The only thing of concern is that whatever to be done should not be “too late to be done”. 
(This work in an intellectual property of Author, I have no issues with the material being used given accompanied by a proper acknowledgment of source)   
1-Barroso calls for EU ‘federation’ 
2-The grasshoppers and the ants – a modern fable

Sunday, December 9, 2012

Can Maradona Really help Policymakers?

Coined by Sir Mervyn King, the maradonian theory of interest rates holds that a central bank may let expectations of economic agents work to its advantage instead of acting. An avid fan of soccer himself, Sir Mervyn actually derived his theory from one of the most astonishing goal runs made by Diago Maradona where he single handedly beat five English midfielders to score one of the most celebrated goals in the history of soccer. He argued that after receiving the ball near centerline, Maradona -famous for his turns and dribbling moves- interestingly made a straight run towards the English goal. The English midfielders, who were expecting him to make usual fast turns, were taken by a complete surprise.
Likewise he argued that a central bank, after fueling expectations about interest rates, doesn’t necessarily needs to act since economic agents start making behavioral adjustments under expectations. To what extent he can be agreed with, is debatable. I will try to put forth both arguments for and against this in the later section.
A fact that has certainly worked to the advantage of Central banks has been that inflation hasn’t picked up. While Ben, Dragi and King may attribute this to central bank’s credibility, softening commodity and oil prices, household deleveraging and sluggish global growth did play their role in keeping the aggregate demand subdued especially in developed economies. Secondly and importantly, the inflation expectations didn’t pick up despite Central Banks launched rounds after rounds of their analogs Quantitative Easing program –interestingly, BoJ is now being pressed for an open ended QE by political policymakers-. Despite all odds, Central Banks did succeed in keeping the monetary policies accommodative yet at no risk of inflation –the only exception is BoE where inflation remained over inflation target for an intended period subsequently softening-  
However, one should ask himself if Maradona scored such a spectacular goal again? Or putting in literal words can a central bank can just ‘cheat’ an extended period of time by not acting? Answer is quite obvious. A simple example used in Macroeconomics is the impact of central bank’s credibility over labor supply. It says that economic agents engaged in labor initially increase their labor supply given central bank outsmarts them by allowing a higher inflation. Result is an increased labor supply and increased output at higher prices, leading to an expansion. However, as the central bank keeps outsmarting them,  the ultimate result is the demands for wage indexation or a decreased supply or labor hours since the labor’s price for labor falls relative to leisure, resulting in people preferring not to work.

To further elaborate why Maradona can’t always make a blistering run consider the market as English players and maradona as central bank. In scenario A markets are so used to central bank’s credibility that they virtually neglect the possibility that central bank would cheat them.
This given central bank a chance to ‘cheat’ them, resulting in higher economic activity at higher inflation which agents consider exogenous rather than a direct result of central bank’s actions. However, given central bank repeats the strategy and defeats the expectations of economic agents, economic agents start to price in the possibility of “cheating” and start positioning them for inflation (Scenario II).

The more central bank doesn’t act, the weaker the credibility grows and less effective central bank becomes for an economy since if the cheating behavior becomes obvious, the agents start seeking inflation protection (Scenario III). 
This is quite obvious from the subsequent rounds of QE by central banks which has fueled more inflation expectations than initial ones because markets came to realization that “Bazooka” with the central bank no longer works.
So can maradona help policymakers? Yes it surely can. However, can it always help policymakers? The answer depends upon till how long it can pull out the same stunts while keeping others dumb. In Next post I will try to post some of the empirical evidences for this phenomenon. 
(This work in an intellectual property of Author, I have no issues with the material being used given accompanied by a proper acknowledgment of source) 

Monday, November 12, 2012

Duration management and bond strategies in low interest rate environment.

A fixed income (FI) instrument –more commonly called a bond- is an instrument which provides a consistent/fixed stream of cash flows throughout its life. Unlike shares and other financial instruments -e.g. options etc- where returns are uncertain and unknown, fixed income instruments often provide a stable and already known stream of income for foreseeable future. With greater volatility and uncertainty surrounding the markets, fixed income instruments become lucrative since their returns are known with a greater certainty for foreseeable future. However, the return certainty doesn’t necessarily makes them “risk free” security. In fact, traditionally perceived “risk-free” FI instruments –Treasuries, Tips etc- also entail variety of risks with them. To further elaborate the concept, the bond, return /yield or coupon is a function of: 1 )Maturity 2)liquidity 3)Market returns 4)Ratings 5)Returns of alternative assets 6)Issuer profile etc. Thus what we consider a “risk free return” on a Treasury security is actually a collective compensation for various kinds of risks except credit risk.

Since now we have argued that even so called “risk free” securities are actually a bundle of various risks, there is always value in the market up for grabbing since fluctuations in risk factors keep generating opportunities to generate extra returns. That’s why we see growing active investment mandates for treasuries and other risk free securities since there are always opportunities available given appropriate strategies being used. I will discuss some of them in this article. However, consider this as a primer for active FI management, it is essential to thoroughly understand and predict the future path of interest rate and linkages of financial markets and economy with interest rates to properly position oneself for a winning bet.   

First and foremost risk that offers profit opportunity is what we call “price risk”. It means that while face value of FI security coupons and remains same and does not change, its market price does. To understand the dynamics, just consider a bond to be any commodity, say an IPhone. When there is an excessive demand, the holder of IPhone has the incentive to sell IPhone at significantly higher prices. This is exactly what happens when markets are gripped by uncertainty and volatility. Investors seek certainty of returns and thus gravitate towards Treasuries –increasing their demand and thus prices- thus if an investor expects troubled times ahead, it’s just the right time to enter FI market. However, there is a limit to the price appreciation potential since: 1) yield of FI instruments usually don’t fall into negative territory 2) This is a tactical trade –not a buy and hold trade- since price will converge to its par value as the bond matures.

Furthermore, investor can also make decent money out of duration bets. Duration is the % change in the price of security with respect to % change in price. Many analysts and portfolio managers quote duration in terms of years. However, it is incorrect to consider duration as a concept related to maturity or time. Duration is the sensitivity of security with respect to change in interest rate. This sensitivity in turn, is determined by host of factors including the coupon rate, years to maturity, credit ratings etc. To be a bit more elaborative, just consider the Time Value of Money concept. For example if a bond’s coupon and principals as cash flows while the current market rate is the discount factor. The value of bond with higher coupon and longer number of cash flows (maturity) will be more affected by movements in interest rates. This strategy is useful given the longer end of the curve (long term interest rates) remain very volatile to the developments in the market. Since the central banks have a good control over the short term rates (1-3 Years) thus duration bets for the short term rates can be successful if the central bank behavior can be anticipated.

Moreover, the sector allocation can also be used to a good effect in enhancing returns especially investment grade securities and Mortgage Backed securities. MBS securities of federal agencies like Fannie Mae, Ginnie Mae and Freddie Mac can offer a decent yet safe spread (around 20-50 bps) over the traditional treasuries. Furthermore, the maturity of these securities is usually much less than the traditional treasuries (due to prepayment option) making them more acceptable for investors with short term needs. In addition to high quality MBS, a conservative investor seeking yield may also invest in investment grade corporate bonds. This has been especially a very lucrative option since corporate continue to accumulate cash on their balance sheets in the aftermath of great depression. So while high cash on the balance sheet is not favorable for equity investor since it is not an earning asset, it is very favorable for bond investor since even at higher yield than the treasuries, a liquid balance sheet means enhanced credit worthiness. Furthermore, the bond yields also don’t respond as vigorously to bad news (e.g. credit downgrade) as the equity prices. Thus a good yield is on offer to investor if he knows which sectors to are much actually safer than presumed by market.  

(This work in an intellectual property of Author, I have no issues with the material being used given accompanied by a proper acknowledgment of source)

Wednesday, November 7, 2012

The demons of low interest rate environment: Risks and implications for markets and economy

A central bank is one of the most important policy institutions in any economy. Generally, a typical central bank controls the economy by changing the interest rate -sometimes also called policy rate, repo rate, fund rate etc- which, in turn, sets the benchmark for determination of domestic interest rates for retail investors. In general belief, a low interest rate environment is considered conducive for economic growth since it cheapens the cost of credit. A lower cost of credit means more consumption and resultantly more production especially for credit driven advanced economies.
Notwithstanding the positive aspects of low interest rate for boosting credit and thereby general demand, there is an equal negative impact on the opposite side of the coin i.e. Savings. Savings occupy a very special place as they are not only considered as one of the key engines of economic growth but also a funding source of financial intermediation –the process of generating and lending funds-.As a rule of thumb higher the savings, higher the potential for future growth.  The preference for savings by people depends upon a host of factors including but not limited to: 1) Competitiveness of returns 2) Risk aversion and 3) Inflation etc. To elaborate the point so as to how a low risk environment adds to more risks, I will use Capital Asset Pricing Model –aka CAPM-. The traditional equation of CAPM divides the sources of returns in two broad categories i.e. a risk free return which could be earned at no credit risk and marginal risk-driven return on the market. Now suppose an investor (be it equity investor in a company or retail investor with asset divided in risk free and risk bearing assets) has a minimum target return of say Rt with risk free return being Rf and market return of Rm associated with the return of a specific benchmark (e.g. Bond, Equity, Currency or Commodity) 
 The CAPM equation of target return comes at

Rt=Rf+β (Rm-Rf) --------------------------(1)

Now one can modify equation 1 to get modified  target return - the need to earn risk-prone return- which comes:  

Now consider if Rf≥Rt , a risk averse investor with Rt≤Rf would not be willing to take excessive risk since the need Rf to earn risk-prone return is zero. This is particularly important for long term investors e.g. Pension Funds, equity investors and Endowment Funds etc since the interest rate is expected to remain volatile over the longer term so they usually set a return target for their portfolios. Availability of sufficient risk free return keeps a check on their downside risks at a given target return. Now consider that the Central bank -say Fed- starts to suppress the both long and short end of the curve –i.e. both short term as well as long term interest rates- by rate cuts, QE and Operation Twist and thereby fuels the “zero interest rate” expectations for n future periods (like recently market consensus remains that Fed would not start tightening before 2015-almost 8 years of zero risk free returns-) .

The equation for modified target return becomes
Rt=β (Rm)
This indicates that there is no safe return available in the market and the only return available is the risky return which means that an investor looking for a particular target return would have to take excessive risk for extended period of time. This also means that for same target level of returns, now investor would have to accept more risks than the previous situation. Now given the high volatility of market returns in the periods of uncertainty, the long term and retail investors are prone to serious downside risks with. Faced with such a situation, investors/corporations/investors are left with two alternatives 1) Be indifferent between cash holdings and security holdings if their target return is low and can be compensated to some extent by lower yields of risk free assets and don’t go into risky ventures. 2) Take excessive risk to keep achieving the target returns consistently over time. There are certain headwinds to the strategy even if the investor chooses to take second option. Firstly, the diversification benefits reduce significantly since it is a well established fact the correlations amongst the markets and asset classes increase while great uncertainty prevails. Secondly, the involvement of central bank in the market, to certain extent, changes the fundamental asset price behavior. For example, if Fed continues to buy Mortgage Backed Securities during it QE, the price of security keeps going up and as a general rule may not revert to its long term mean as it would have in normal times. Thus typical strategies for investment focusing on shorting the overpriced and going long in underpriced securities may not be as successful as they would be in normal environment. This further adds to the probability of downside risks.
Even for corporate entities, same rule can be applied whereby equity investors target a certain level of returns. For example, consider a financial institution- say a bank- whose business model depends upon the movements in interest rate. In zero interest rate environments, the bank would have the liberty of paying low interest rate on deposits. But at the same time bank cannot charge a higher interest on its loans as well. Now if we personify bank as a retail investor with the loans portfolio the bank would also have two ways of earning spread (profit): 1) Invest in risk free securities to earn risk free return 2) invest in commercial loans to earn a risky returns. In a zero interest rate environment, the first source of spread dries up. The lesser interest rate paid on deposits also affects the bank’s ability to generate funds for its business since at no interest paid, the depositor would be at least indifferent between keeping money in hard cash (risk less) than lending it to a bank (who has certain amount of credit risk). However, the equity investors’ demand for a considerably higher return may push the bank for excessive risk taking just like a retail investor. This may have further serious economic implications since stable banks are essential for economic stability. The recent rise of banking scandals -JPM, Barclay’s and now HSBC- may be an indication that further the risk free spread remains unavailable, further the banks would be prone to the downside risks.       
In short, while it is agreed that low interest rate environment is conducive for growth, but a prolonged zero interest rate environment may have its own implications for investors, markets and economy. It is necessary to regularly conduct a cost and benefit analysis of zero interest rate policy before extending it further. 

(This work in an intellectual property of Author, I have no issues with the material being used given accompanied by a proper acknowledgment of source)