Tuesday, September 25, 2012

The Reintroduction of National Monetary Policies

I have previously stated that with the introduction of Outright Monetary Transactions (OMTs) the ECB has become the de-facto lender of last resort for Eurozone sovereigns. Before that it was only the lender of last resort for Eurozone banks and did everything to keep solvent banks liquid. Now it also keeps solvent sovereigns liquid and in the eyes of the ECB the solvability of the sovereigns will be assured via the conditionality of an ESM programme. Hence, solvent sovereigns cannot become illiquid anymore and a devastating bank-sovereign default spiral has become a much less likely event.
However, one can also look at the OMTs as providing the ECB with a targeted instrument to conduct a national monetary policy during a period of a renationalisation in financial markets.
Within the Eurozone, financial markets have disintegrated along national lines over the past years. Banks in the core have significantly reduced their holdings of peripheral assets and so did real money investors. On the other side, peripheral banks have increased holdings of domestic sovereign bonds.
Furthermore, the level of monetary accommodation is extremely different depending on the country one is question. The chart below shows the level of yields in Germany and in Spain. 

ECB repo rate, Spain & German yields

 Source: Bank of Spain, Bloomberg
Hence, the debt crisis has meant that the Eurozone has lost control over the level of yields in the periphery. While the monetary accommodation in Germany increased with every rate cut, the debt crisis led to an ever tighter monetary environment in the periphery. The result of very high yields coupled with a deep recession was that loan growth collapsed.

Yoy loan growth in Spain and Germany
Source: ECB
Prohibitively high yields and significantly negative loan growth mean that the monetary environment in Spain is extremely restrictive while it should have a very accommodative environment. on the other side, Germany with record low yields and moderate but positive loan growth enjoys an accommodative environment. More rate cuts would do not help Spain where monetary accommodation is needed but Germany where it is not. However, OMTs - once Spain or Italy decide to apply for help - will be helping to ease the monetary environment (to be more precise: render it less restrictive) where it is needed most without providing more accommodation where it is not needed.

Hence, the ECB has a tool provide a national monetary policy. While not exactly in the spirit of a monetary union, it will help to ease the burden of adjustment. Furthermore, given that it is a targeted form of monetary policy to be provided where it is needed most, the inflationary risks should be limited. However, it significantly reduces the likelihood that the ECB will continue to provide general monetary easing via another cut in the deposit rate into negative territory.

Friday, September 14, 2012

Lower tail-risks & more liquidity

Besides being the lender-of-last-resort for banks, the ECB will from now on also assume the lender-of-last-resort role for sovereigns. As mentioned previously, this reduces tail-risks significantly. The EFSF/ESM will keep sovereigns solvent and the ECB will keep these solvent sovereigns liquid. Hence, the risk of Spain/Italy etc. becoming illiquid has vanished. Furthermore, given that nominal yields on peripheral debts are falling, the long-term debt dynamics are improving significantly as well. The result is that it does not really matter whether the ECB is "only" active at the short end and the risk of investing into longer-term peripheral securities has been falling markedly.
Additionally, the US Fed has made significant steps as well. Not only is it starting another round of quantitative easing, it has gone even further by stating that: "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability… A highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens." Hence, the FOMC is orchestrating an open-ended liquidity glut and promises to keep it going even once the economy is on a stronger footing again. I also agree with Lars Christensen (see here for his excellent Blog: The Market Monetarist) that this constitutes very positive news and while not exactly nominal GDP targeting, it is a significant step in the right direction.
The effects of this combination of the ECB removing significant tail-risk to the Eurozone economy and the US Federal Reserve providing an open-ended USD glut should not be underestimated. I am convinced that sentiment towards the Eurozone economy can improve with the current mild recession giving way to a low growth environment (below trend amid the fiscal tightening but positive growth nonetheless) over the next few months. Additionally, seasonal adjustments still play havoc with US economic data but now as we are entering autumn the drag from this factor (which depresses seasonally adjusted data during spring and summer) reverses and we should get better economic news over the next weeks. Hence, the environment should remain very positive for risky assets. Lower tail-risks, a stabilisation in the Eurozone economy and better data out of the US coupled with more liquidity should see an ongoing buy-on-dips environment. I am not particularly concerned with respect to the timing risk of Spain (and Italy) applying for help from the EFSF/ESM. This is a much different kind of risk than the fundamental risks of a debt-deflation spiral/Eurozone break up which we were facing before and should not cause more than some temporary volatility.

For markets I expect the following:
  • Safety premia in safe-haven assets will be reduced further. Bunds/EONIA (and UST) curves can bear-steepen. 
  • The Euro can recover further as the short-squeeze carries on whereas the USD should get under broad-based pressure (hence EURUSD should move higher). Commodity, pick-up & emerging market currencies should start to be supported again by the USD glut. 
  • Credit spreads have much further to fall and credit spread curves should flatten. The trend towards record low nominal yields on carry products is not over. 
  • Hence, while during the first phase of financial easing being long duration and long credit was fine, now being short duration and long credit makes more sense.

Wednesday, September 12, 2012

Life in the negative real yield environment II

I am convinced that negative real yields are a phenomenon which will spread to an increasing number of assets and which will be with us for the rest of this decade. I have suggested earlier on (see "Life in a negative real yield environment" dated August 21) that negative real yields not only provide an easy monetary environment but that they also help to lower debt-GDP ratios over time. Contrary to popular opinion, high inflation rates are not a necessary condition to lower debt-GDP ratios. As long as deflation is averted, ultra-low nominal bond yields provide for the necessary low/negative real yields.
In the Eurozone, the ECB first pushed real yields on Germany Bunds into negative territory via cutting the repo/depo rates to record lows. Thereafter, with the help of the LTROs announced last December, it was successful in driving real yields on the so-called semi-core markets (Netherlands, Finland, France, Austria, Belgium) into negative territory. Finally, with the help of the announced Outright Monetary Transactions it aims to do the same for peripheral bond yields (and I think they will be successful).

Negative real yields have frequently been used in history to lower debt-GDP ratios over a time horizon of about a decade (see "The Liquidation of Government Debt" by Reinhart and Sbrancia, NBER Working Paper 16893, March 2011 - thanks to Peter Schaffrik for directing me to this paper). To quote:
"Throughout history, debt/GDP ratios have been reduced by (i) economic growth; (ii) a substantive fiscal adjustment/austerity plans; (iii) explicit default or restructuring of private and/or public debt; (iv) a sudden surprise burst in inflation; and (v) a steady dosage of financial repression that is accompanied by an equally steady dosage of inflation."
In the current environment, higher growth is difficult to achieve amid the need to bring down budget deficits, the low rate of trend growth in Western countries and increasing headwinds from demographic developments. Austerity programmes work only in the medium-to-longer term and initially kill off growth and hence can even raise indebtedness. Default/restructuring has frequently been used in the case of foreign currency debt (because there was no other option left) which is not the issue in the Eurozone at present. I do not expect a surprise burst in inflation given the ongoing deleveraging (which limits the availability of credit in the broad economy and hence is deflationary) and the high amount of spare capacity/high level of unemployment. I have been of the opinion that we will see a slow reduction in debt-GDP ratios on the back of very low nominal yields, moderate but positive inflation and hence negative real yields. This is exactly the point Reinhart/Sbrancia make as well: "We find that financial repression in combination with inflation played an important role in reducing debts. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards). In effect, financial repression via controlled interest rates, directed credit and persistent, positive inflation rates is still an effective way of reducing domestic government debts in the world’s second largest economy-- China."

The reduction in real yields has been the key factor driving nominal yields lower
 Source: St. Louis Federal Reserve

Reinhart/Sbrancia attribute negative real yields almost exclusively to financial repression on the back of explicit or indirect caps or ceilings on interest rates as well as the creation and maintenance of a captive domestic audience that facilitates directed credit to the government. At present, however, I think we have only a mild form of financial repression at work (short-end yields are set at or close to 0% by central banks), rather I see some additional reasons why longer-term real yields have dropped so sharply since 2009 (see chart): Given that longer-term growth expectations have dropped markedly and demand for capital is weak amid the ongoing deleveraging/low level of investment, the risk-free "neutral" longer-term real yield has come down significantly compared to the time period leading up to the financial crisis. Moreover, central banks have started bond-buying programmes (quantitative easing) to directly lower bond yields and have provided a very high amount of liquidity to the banking sector (which the banks at least partially used to buy sovereign bonds) which also resulted in lower bond yields. The latter is clearly not a traditional "repression" tool which would rather see banks being forced to buy government bonds via changes in regulations rather than incentivise them to enter carry trades at free will via the provision of unlimited quantities of liquidity.
Hence, so far the "repression" element needed to bring real yields into negative territory appears softer than in the past. However, given that ultra-low/negative real yields are needed for a long time (10 years) to bring down debt-GDP ratios significantly, I think that at a later stage (i.e. in 3-5 years), stronger "repression" elements will become a distinct possibility in order to maintain the ultra-low real yield environment.

Thursday, September 6, 2012

The new ECB takes shape II

Summing up: the ECB is now also the lender of last resort for the sovereigns. As with banks (solvent banks are kept liquid), the ECB now also will keep solvent sovereigns liquid. The EFSF/ESM will take care that the sovereigns remain solvent. It does not matter whether they buy only up to 3y or longer. That is not that important in the grand scheme of things.

(This is a follow up to "The new ECB takes shape" dated August 7)

The ECB has delivered a massive step. Up until now, the mandate of the ECB was to deliver price stability for the Euro area and to be the lender of last resort for the banking sector. The latter function meant that the ECB did everything to keep solvent banks liquid. However, the same was not the case for sovereigns. Now, also solvent sovereigns will be kept liquid. The conditionality that sovereigns have to apply for help from the EFSF and ESM should ensure that he sovereigns are solvent. The result, is that the solvent sovereigns cannot become illiquid. This was a key risk for the peripheral markets amid the threat of a buyers’ strike developing. The combination of lower short end yields (which will translate into lower average interest costs for new debt) and a much reduced risk of illiquidity significantly reduces the risk of investing into long-term peripheral bonds as well. Additionally, the expectations that the ECB will be announcing a programme to buy short-term bonds has led peripheral curves to much steeper levels. However, such a steeper curve with a very high likelihood that short-term yields stay low for a protracted period of time, means that horizon returns (i.e. returns under the assumption that the yield curve stays unchanged) increase whereas investment risk falls. The result is that investing into securities which are longer than the ECB’s stated maximum maturity of 3 years has become much more attractive. While some risks remain (ESM verdict by the German constitutional court, timing of applying for help by peripheral countries etc.), I favour the 4-7y area of the Spanish and Italian curves at present given the steepness of the curve and expectations for a reduction in volatility.
Overall, as the ECB now keeps solvent banks liquid and solvent sovereigns liquid, the systemic risks of a meltdown in financial markets amid a domino bankruptcy in banks and sovereigns has been much reduced. The combination of a 0% deposit rate with a high amount of excess liquidity should increasingly force investors to search for yield via extending on the yield curve and moving out the rating spectre. Hence the longer-term trend towards lower nominal yields on carry products is far from over. The recovery in the Euro which has taken shape over the past weeks can run further as investor positions remain tilted to short side.