In Bernanke we Trust

Do you feel it too … The air of complacency that has engulfed financial markets and policy makers in the last month. With inflation falling and even the spectre of deflation now returning as a market meme as well as stubbornly weak growth, more stimulus and less concern about debt and deficits might of course seem warranted.

Still, two points have caught my attention in recent weeks. The first is the decisive push against austerity with the IMF, EU commission and Germany all seemingly content to allow the periphery more time. The second is the combination of two extraordinary headlines on Bloomberg in the past couple of weeks.

The first article refers to comments by GS’ CEO Lloyd C. Blankfein that he is getting a little worried about a back-up in interest rates. Specifically, he invoked 1994 as a comparison which, I am sure, gave many food for thought. Coupled with a research note from GS noting a “zero percent upside” for Spoos into year-end many investors and analysts were asking themselves whether the Illuminati knew something was coming.

Of course, before we put on our tin-foil hats, we should consider that the comments by Blankie were simply poor form. How dare he! In a world where investors are buying Australian banks as safe “dividend yield” havens, where Wal-Mart, Apple etc are financing themselves below the rate of inflation and where defensive stocks are going parabolic due to their assumed safe income stream,  invoking 1994 is just unfair.

Fear not however; contrary to 1994 and the beginning of the Greenspan era, investors have complete faith in Bernanke.

Bond investors are gaining confidence that Federal Reserve Chairman Ben S. Bernanke will unwind the central bank’s unprecedented $3.3 trillion balance sheet without sparking a crash similar to 1994, when Alan Greenspan surprised the market by doubling benchmark lending rates in 12 months.

Mis-communications, policy error and lack of transparency were all ailments of the old Fed, but not the new. Now, I am not out to get central bankers here but I think it is important to understand why investors are so happy to trust Bernanke. More specifically … so far, they have made and are still making a lot of money on the back of Bernanke et al’s ZIRP induced global hunt for yield. I find it hard to believe that bond investors (and indeed any investor) would even contemplate that Bernanke suddenly turning off the faucet of free money. I mean, that after all would mean bankruptcy for them.

However, with equities continuing to defy a lacklustre economy and headlines about retail investors betting it all on Tesla next week’s FOMC minutes may cast some light on how worried the Fed is, if at all, about the dash for yield and other un-intended consequences of ZIRP and QE.

So, starting where I began with another Bloomberg headline extolling the rising confidence of the average American we should be positive that things are improving. However, the real test for asset prices and the economy comes with monetary policy normalisation. And despite what your mate with the Tesla stocks might tell you, I think investors are more than a little worried about the Fed taking its foot off the gas; and with good reason. 

The Dash for (negative) Yield at Wal-Mart

The idea of going for yield makes perfect sense; it is being encouraged by the wardens of our monetary system, it has continued to make a lot of money even as economic uncertainty has increased and despite trolls calling for a bubble in fixed income markets for years, prices have continued to soar.

Calling a top in the global dash for yield has so far been futile. Indeed, with ZIRP now a structural characteristic of the global financial system, one has to countenance the fact that the race to the bottom in global yields have only just begun. Consider for example the latest uptake for Wal-Marts bumper refinancing issuance schedule in 2013. Recent results on the earnings side and forward guidance have been less than impressive, but investors have still provided a healthy bid for the 2016 issuance. More spectacularly however, is this from Bloomberg; 

The company’s weighted average coupon of 2.09 percent on yesterday’s transaction is about half the 4.02 percent paid on its $3.69 billion of dollar-denominated debt maturing this year, Bloomberg data show.

I have no specific agenda on Wal-Mart here (no positions etc) and I have no real insight into whether Wal-Mart will do well or not so well in the coming 12 months, let alone looking as far ahead as 2016.

Crucially however, I don't need to in order to point to the conundrum of the numbers above. 

Let me try to analyse this then from the point of view of the macroeconomist whose luxury it is to look at the big picture. We don't need fancy charts, regressions or other advanced statistical methods. We only need two numbers. Inflation in the US is currently running at about 2% YoY and 5y to to 10y inflation expectations measured by the University of Michigan recently printed 3.3%. These two numbers are difficult to reconcile with the average coupon payed by Wal-Mart. 

Buyers of Wal Marts bonds at current prices are consequently, based on current inflation readings and long term inflation expectations locking in a negative real return.  This would be odd, but not unheard of in the context of sovereign bonds. Sovereigns have a printing press and especially in the context of elevated systemic financial risks, even negative nominal yields may make sense (mainly on the short end of the curve of course). In such situations, investors and in particular financial institutions merely seek certainty that the principal will be paid back and may even pay for the "privilege" to see such principal being paid out in freshly printed central bank reserves. 

But Wal-Mart is not a sovereign and does not, as far as your humble scribe is aware, have a printing press tucked away in their Bentonville basement. Indeed, Wal-Mart is a highly complex business with inherent risks and uncertainties. But it seems that the market is willing to dispense completely with this risk at the present moment. 

Of course, the story is not that simple and not even the macroeconomist can neglect microeconomic structures. Wal-Mart is a behemoth and any large fixed income manager need to hold its bonds to some degree, if only to not veer to much away from her benchmark. In addition, Wal-Mart still holds a coveted AA rating which is of course good for capital requirements in testing times such as these. Finally, Wal-Mart's free cash flow is too good of a prize not to have a crack at and buying its bonds is of course, to some extent, a claim on this (well technically it isn't of course, but you get my drift I am sure). All in all, the Wal-Marts of the world will always be able to find buyers of their debt, but this is not strictly the issue I am adressing here. 

As such, beyond all the reasons for why the Wal-Mart transaction makes perfectly sense in a well oiled big economy such as that of the US, the basic math looks a bit ridiculous in my view. Even if the supply of capital for Wal-Mart debt issuances is structurally deep and thus lends itself to the description of a very liquid market, we must pause to reflect the inelasticity of such capital relative to the price. Would there also be readily available capital for Wal-Mart refinancing at 1% or even at 0% or perhaps at -1%?

The answer is of course that such current fixed income "mispricing" is condoned and encouraged by monetary policy through the promise to keep benchmark rates at zero. Yet, this is hardly a very useful answer in the context of Wal-Mart and similar corporate issuances. Global and US fixed income managers are highly intelligent people with access to endless streams of historical and current information that would allow them to put a price on the business risk of Wal-Mart. Yet, such risk has been completely discounted in this case and the only thing we can say is that the dash for (negative) yield continues. I find this perplexing and it is a worrying sign for the global economy and her investors in my view. Higher rates as imminently unlikely as they currently seem would not go down well in the current investment climate. 

When Safe Havens Fall

By far the most important bit of economic news this week came in well after Europeans had closed down for the weekend in the form of Moody's decision to cut the UK's credit rating. It was important because it added some colour to why GPBUSD crashed through support earlier in the week (wink, wink) as well as it crystallised just how poor economic fundamentals have now become in the UK. 

As always, Moody's are coming in after the fact. It has been pretty obvious for a while that to term the UK as a safe haven only made sense if you believed that continental Europe would sink into ground leaving an open sea between Dover and the Ural. This was always going to be one of the more unlikely outcomes, but with the famous speech by Draghi that the ECB would do whatever it takes to preserve the euro, the wheels were slowly set in motion for a re-rating of all safe haven trades (and thus the EURGBP going vertical and the GBPUSD plunging out of its recent 3y range). 

The main question we are left with is what a safe haven actually is? Should we look at traditional macro fundamentals which would certainly, from a capital flows perspective, seem to offer a usable framework or is a safe haven simply what the market terms it to be?  

This is an important question to think about when considering global capital flows and carry trade fundamentals. Take Japan for example. It used to be considered a safe haven only 6-12 months ago. A high external surplus, deflation (generating positive real returns), and low volatility in the bond market were all factors. However, recently two things have happened. The first gives me hope that macroeconomics has not completely lost its usefulness. The fundamentals of Japan have simply changed for the worse. Growth has slumped, the external surplus has disappeared and the budget deficit has ballooned. Still, the second major change is that Japan through both its monetary and fiscal policy initiatives in the past 12 months has simply sent a signal that it does not wish to be a safe haven anymore. 

Indeed, Japanese politicians (and its corporates) would probably prefer that we went back to the days of the Yen carry trade. 

Cue of course the re-emergence of currency wars as a major talking point. However, the fascinating point about this report by Bloomberg (and similar reports) is that e.g. Australia and New Zealand are lumped together with Norway and Switzerland as "victims" of carry trade flows as a result of a race to the bottom among G4 central banks. 

This is fascinating because only someone deliberately ignoring even the simplest macroeconomic analysis would group these economies together. If you don't believe I recommend a two step process; read up on simple open economy dynamics and then compare the twin deficits (budget balance + current account balance) of Australia, New Zealand, Norway and Switzerland. See the difference? 

The only reasonable explanation is of course that everything has been reduced to a hunt for positive yield. This makes sense in a world where ZIRP in all the major central banks force investors into any and every instrument that offers a positive nominal yield (never mind that the real yield which will probably be negative). I think this process is easy to rationalise, but to frame these flows in relation to safe havens makes absolutely no sense. 

What now appears to be UK's fall from grace is a pertinent reminder and this leads me to the view the notion of a safe haven is probably one of the most mis-used concepts in the economics media today. Keynesians v Austrians would be another one (but that is for another day!). 

So what is a safe haven you might ask? Well I certainly don't have the final answer, but I would suppose it should as many as the following characteristics as possible. 

1) Large, stable and structural external surpluses

2) High net savings, strong net foreign asset position 

3) Positive government balances, stable and low domestic interest rate environment 

4) Non-volatile real return on base rate linked products 

5) Open capital account (ease of getting money in and out, but because of the strong current account currency volatility would likely be relatively low)

6) Deep and liquid financial markets. 

I am sure I have forgotten something, but it obviously occurs to me that such and economy does not exist today. It is better then to recognize this than trying to lump all kinds of different economies together as safe havens just because they offer positive nominal yield; because eventually even the most solid perceived safe haven may ultimately fall. Just look at the UK.