Attempt to Start a Dialogue: Another Current of Thought I Really Do Not Understand: John Plender on Central Banks as “Market Riggers”
I truly do not understand how John Plender views the world, or, rather why he sees the world he does. Can anybody help me?
John Plender: Time running out for the market riggers: “Conventional wisdom has it that the long-term global decline in real interest rates…
…owes much to an increase in the demand for safe assets. Certainly it is true that the accumulation of official reserves by excess savers in the developing world has played an important role and with the eurozone breaking into current account surplus there is now a new excess saver on the block…. At the same time the increased real return required by equity investors since the dotcom boom and the great financial crisis has reinforced a portfolio shift towards bonds, resulting in further downward pressure on yields. Yet the more striking thing about today’s markets is surely the extraordinary demand for unsafe assets…. Junk bond yields are close to record lows. Securitisation is back in fashion…. There is a slide afoot in lending standards, with a reversion to such pre-2007 bad habits as payment-in-kind notes and “cov-lite” loans….
Mexico, admittedly with a good domestic economic story to tell, managed to sell a 100-year sterling bond last month on a coupon of 5.75 per cent. At the same time the yield on Spanish and Irish sovereign five-year bonds last week fell below comparable US Treasury paper. That is quite a tribute to the power of the central banks, which have rigged the market in spectacular fashion…
The Bank of Mexico? A market rigger? The Bank of Mexico does not rig the market. It takes the interest rates the market gives it, and is grateful.
And the punt-peso-dollar interest rate spread? It is the (a) differential chance that Ireland and Spain will default while the U.S. won’t, plus (b) the chance that Ireland and Spain will leave the euro times the amount they would then float downward, minus (c) the expected five-year U.S.-euro inflation rate. Given the bizarre inflation hawkery of the eurozone plus the demonstrated willingness of the German government to make whatever transfers are necessary to keep the eurozone together and eurozone sovereigns solvent in the medium term, I would buy five-year punts and pesos at the same interest rate as the dollar. Wouldn’t you?
Plender continues:
Mario Draghi at the European Central Bank has even done it on the cheap, putting up no money via the ECB’s outright monetary transactions programme to support his assertion that the ECB would do “whatever it takes” to save the euro…. In the US, the UK and Japan, meantime, the resort to quantitative easing has succeeded in stirring investors’ appetite for risk, even if its impact in the real economy has latterly failed to impress. Equity market valuations, too, reflect this prestidigitation.
Huh?! Three paragraphs above, Plender talked about: “the increased real return required by equity investors…” how does this compute? Increased required real return plus an appetite to hold risky assets at unseemly prices? Required returns and valuations move inversely John…
Plender continues:
As Richard Fisher, president of the Reserve Bank of Dallas, pointed out last week, the price/earnings ratio of stocks was among the highest decile of reported values since 1881, while the economist Robert Shiller’s inflation-adjusted PE ratio had reached 26 as the Standard & Poor’s 500 hit yet another record high. That compares with a ratio of 30 before Black Tuesday in 1929 and an all-time high of 44 before the dotcom implosion at the end of 1999.
But isn’t the enormous spread between stock-market earnings yields and long-term U.S. Treasury yields worth a mention? Stocks are at high valuations relative to patterns established when bond rates are normal, but bond rates are not normal. Should you expect outrageously high bond prices not to leak into equity valuations? That does not compute at all….
The central bankers are not the only ones to have successfully rigged the markets. Executives in the quoted corporate sector in the English-speaking world…. Does this mean, contrary to Margaret Thatcher’s famous assertion, that you can buck the market? Well, yes and no. There is an issue of timing. In effect, central bankers have been repeating the trick used repeatedly by former Fed chairman Alan Greenspan of asymmetric activism…. The coexistence of strong demand for both safe and unsafe assets is not a coincidence. As in the period before 2008 low nominal and real interest rates have driven investors into a search for yield. That is now, once again, associated with a decline in bank lending standards, as people are lulled into complacency by low default rates. It brings to mind the adage: if it’s too good to last, it will stop…
Gabriel Chodorow-Reich has looked for “reaching for yield”, and looked hard. Yet he has found very little of it…
My thoughts on this, such as they were, are below: but they very much need improvement: Brad DeLong…
Brad DeLong: May 11, 2013: MOBY BEN, OR, THE WASHINGTON SUPER-WHALE: HEDGE FUNDIES, THE FEDERAL RESERVE, AND BERNANKE-HATREDIn February 2012, a number of hedge fund traders noted one particular index–CDX IG 9–that seemed to be underpriced. It seemed to be cheaper to buy credit default protection on the 125 companies that made the index by buying the index than by buying protection on the 125 companies one by one. This was an obvious short-term moneymaking opportunity: Buy the index, sell its component short, in short order either the index will rise or the components will fall in value, and then you will be able to quickly close out your position with a large profit.
But February passed, and March passed, and April rolled in, and the gap between the price of CDX IG 9 and what the hedge fund traders thought it should be grew. And their bosses asked them questions, like: “Shouldn’t this trade have converged by now?” “Have you missed something?” “How much longer do you want to tie up our risk-bearing capacity here?” “Isn’t it time to liquidate–albeit at a loss?”
So the hedge fund traders began asking who their counterparty was. It seemed that they all had the same counterparty. And so they began calling their counterparty “the London Whale”. They kept buying. And the London Whale kept selling. And so they had no opportunity to even begin to liquidate their positions and their mark-to-market losses grew, and the risk they had exposed their firms to grew.
So they got annoyed.
And they went public, hoping that they could induce the bosses of the London Whale to force him to unwind his possession, in which case they would profit immensely not just when the value of CDX IG 9 returned to its fundamental but by price pressure as the London Whale had to find people to transact with. And so we had ‘London Whale’ Rattles Debt Market, and similar stories
The London Whale was Bruno Iksil. He had been losing, and rolling double or nothing, and losing again for months. His boss, Ina Drew, took a look at his positions. They found they had a choice: they could hold the portfolio and thus go all-in, or they could fold. They could hold CDX IG 9 until maturity–make a fortune if a fewer-than-expected number of its 125 companies went bankrupt, and lose J.P. Morgan Chase entirely to bankruptcy if more did. Or they could take their $6 billion loss and go home. They could either take their losses, or sing “Luck, Be a Lady Tonight!” and bet J.P. Morgan Chase on a single crapshoot. After all, what could they do if the bet went wrong and they had to eat losses at maturity? J.P. Morgan Chase couldn’t print money. So Drew stood Iksil down, and the hedge fund traders had their happy ending.
In late 2008, the Treasury bond went haywire. The interest rate on the Ten Year Nominal Treasury bond fell to 2.1% in the panic–clearly overpriced. In the late 1990s with the debt-to-annual-GDP ratio on the decline the Treasury bond had traded between 5% and 7%. In the 2000s with a weak economy the Treasury bond had traded between 4% and 5%. With the Federal debt exploding even faster than it had around 1990, it seemed to hedge fund traders very clear that the long-term fundamental value of the Ten-Year Treasury bond probably carried an interest rate of 7%, or more–and was at the very least more than 5%. So smart hedge fund traders shorted Treasuries, and waited for the Treasury Bond to return to its fundamental value.
And they ran into the widowmaker.
So they scrambled around, wondering: “Why did the interest rate on the Ten-Year Treasury peak at 4%? And why has it gone down since then? And why won’t it go back to its 5%-7% fundamental.” And they looked around. And they found Ben Bernanke:
The Washington Super-Whale.
He had printed-up reserve deposits, and used them to buy Treasury Bonds, and in so doing, they thought, had pushed the price of Treasuries up well beyond their fundamentals. Yet rather than easing off, taking his lumps, and letting the market “clear” he kept buying and buying and buying and buying, leaving the hedge fund traders with larger and larger and larger short positions in Treasuries that had to be carried at a loss. And every year that they carry those positions is a -2% times the size of the long leg negative entry in their cash flow.
Bruno Iksil, they thought, had been pulled up short by his boss Ina Drew’s unwillingness to bet the firm and risk bankruptcy. Ben Bernanke, they thought, ought to have been pulled up short by his regard for financial stability–by his promise to keep inflation at its target, for the counterpart to J.P. Morgan Chase’s bankruptcy and liquidation would be the national bankruptcy that is another episode of inflation like the 1970s. But Ben Bernanke wasn’t pulled up short by the risk of inflation. He had no supervising CEO. And he dominated the Federal Open Market Committee.
But what Bernanke was doing, they thought, was as unprofessional as it would have been for Ina Drew to tell Bruno Iksil: “You turn out to have made a large directional bet that we can sell unhedged protection and profit? Let’s see if you are right: let it ride!”
And so they went public with the Washington Super-Whale, as they had gone public with the London Whale. Perhaps somewhere out there was an equivalent of Jamie Dimon who could tell Bernanke that it was time to unwind the Federal Reserve’s balance sheet now? Jeremy Stein, perhaps?
From my perspective, of course, the hedge fundies’ analogy between the London Whale and the Washington Super-Whale is all wrong–the hedge fundies are thinking partial-equilibrium when they should be thinking general equilibrium. CDX IG 9 has a well-defined fundamental value: the payouts should each of the 125 companies go bankrupt times the chance that they will. What Bruno Iksil does does not affect that fundamental value. He can bet, and drive the price, but he cannot change the fundamental.
But the Washington Super-Whale is different.
In a healthy economy, the Ten-Year Treasury Bond does have a well-defined fundamental. When the economy is healthy enough that pricing power reverts to workers and keeping inflation from rising is job #1 for the Federal Reserve, the level of the Federal Funds rate now and in the future is pinned down by the requirement to hit the inflation target. And the fundamental of the Ten-Year Treasury Bond is then the expected value over the bond’s lifetime of the future Federal Funds rate plus the appropriate ex ante duration risk premium.
But when the economy is depressed, like now? When market appetite for short-term cash at a zero interest rate is unlimited, like now? When workers have no pricing power, and so wage inflation is subdued, like now? The Federal Reserve is not J.P. Morgan Chase. It is not a highly-leveraged financial institution that must worry about holding too much duration risk. As Glenn Rudebusch once said:
Our business model here at the Fed is simple: (i) print reserve deposits that cost us 0 (OK. 0.25%/yer), (2) invest them in interest-paying bonds that we then hold to maturity, (3) PROFIT!!
And the more quantitative easing the Fed undertakes and the larger is its balance sheet the larger is the amount of money the Federal Reserve makes on its portfolio, without running any risks–as long as the economy remains depressed.
The Federal Reserve, you see, is unlike J.P. Morgan Chase: the Federal Reserve does print money.
But, the hedge fundies say: “What if the economy recovers and starts to boom? What if inflation shoots up? The Fed could loose $500 billion on its portfolio as it moves to control inflation! Why doesn’t that fear that?”
The Fed does not fear that. That is what it is aiming for. The Fed is charged by law with “promot[ing] effectively the goals of maximum employment, stable prices, and moderate long term interest rates”. A full-employment economy is not something to be feared but something to be welcomed. And a $500 billion mark-to-market loss on its current portfolio? The Fed has given $500 billion to the Treasury, as a present, over the past decade. It is not a profit-making private bank. It is a central bank charged with “promot[ing] effectively the goals of maximum employment, stable prices, and moderate long term interest rates”.
“But,” the hedgies say, “George Soros! The Bank of England held the pound sterling away from fundamentals in 1992, and George Soros bet against them and they could not maintain the parity and George Soros took them for $2 billion! Why aren’t we doing the same?” Ah. But George Soros took $2 billion from the Bank of England because its political masters told it to stand down: “We will not,” they said, “defend the ERM pound parity at the price of bringing on a deep recession and mass unemployment.”
Who do the hedgies imagine are the Fed’s political masters who will tell it to shift and adopt policies that will bring on even massier unemployment?
Rand Paul?
There is a reason that the trade of shorting the bonds of a sovereign issuer of a global reserve currency in a depressed economy is called “the widowmaker”.