Mispricing Risk

July 5, 2013

by Doug Noland

Bonds taken out to the woodshed, again.

U.S. bonds were crushed Friday on the back of stronger-than-expected payroll data. Long-bond yields jumped 21 bps to an almost 23-month high 3.71%. Ten-year yields rose 24 bps to 2.74% - the highest level since August 5, 2011.

Benchmark MBS yields surged 30 bps during the session to a 23-month high 3.69%. The spread between 10-year Treasury yields and benchmark MBS widened six on Friday to a one-year high 95 bps. Notably, MBS yields were up 75 bps in 14 sessions and 140 bps since May 1st.
June 29 – Financial Times (Robin Wigglesworth, Michael Mackenzie and Josh Noble): Central banks sold a record amount of US Treasury debt last week while bond funds suffered the biggest ever investor withdrawals as markets shuddered at the prospect of the US Federal Reserve ending its quantitative easing programme. Holdings of US Treasuries held at the Fed on behalf of official foreign institutions dropped a record $32.4bn to $2.93tn, eclipsing the prior mark of $24bn in August 2007. It was the third week of outflows in the past four.

Private investors are also dumping fixed income. Bond funds tracked by EPFR Global, a data provider, saw total redemptions of $23.3bn in the week to June 26. US funds were the worst hit, with withdrawals totalling $10.6bn, but emerging market debt funds also saw record redemptions of $5.6bn.”

With unprecedented outflows from the bond complex coupled with notable global central bank selling, the Bubble in U.S. fixed income would appear in serious jeopardy. And while analysts and money managers will continue talk of a “fair valuerange for Treasury securities, for the time being flow of funds analysis trumps valuation. Will foreign central banks continue reducing their enormous holdings of U.S. Treasury and Agency securities?

How much leverage has accumulated throughout U.S. fixed income – especially in corporates, MBS and municipal debt? How long until some hedge funds are in trouble? Redemptions coming? Derivative problems? Will investors continue their retreat from U.S. fixed income mutual funds and ETFs?

A few data points are in order. Since the end of 2007, Rest of World (ROW from the Fed’s Z.1) Treasury holdings have jumped $3.325 TN, or 140%, to $5.701 TN. Over this period, “Officialcentral bank Treasury holdings were up $2.233 TN, or 134%, to $4.059 TN. I have previously highlighted the extraordinary expansion of central bank International Reserve Assets (as accumulated by Bloomberg). Since the end of 2007, International Reserves have inflated $5.061 TN, or 84%, to $11.122 TN. The Fed’s $85bn monthly QE suddenly doesn’t seem as powerful.

Ongoing selling by foreign central banks could be driven by two key dynamics. First, one would think (thinly capitalized) central banks would seek to contain losses on their outsized bond holdings. Keep in mind that the higher bond yields jump, the more individual central banks will need to monitor the scope of losses and the degree of capital impairment. Second, “developingcentral banks will most likely be forced to sell Treasuries and other bond holdings to fund investor and “hot moneyflows exiting their markets and economies.

A prominent bullish view has held that emerging market (EM) central banks built up robust international reserve positions (including large quantities of Treasuries) that would be available to backstop their systems in the event of global market turbulence. Well, a surge of outflows (and currency market intervention) coupled with a spike in yields is now in the process of depleting reserves much more quickly than anyone had anticipated. There is a clear possibility that we’re early in what could be unprecedented flows seeking to exit the faltering EMs.

Recalling the 1997 SE Asian experience, it was a case of “those who panicked first panicked best.” The more reserve positions were depleted, the fasterhot moneyran to the rapidly closing exits.

As a rough guide, the pain and dislocation associated with a bursting Bubble are commensurate with the degree of excess during the preceding boom (traditional “Austrian”-type analysis). And I’ll be the first to admit this is not the first occasion I’ve believed the U.S./global bond Bubble was in trouble. Timing a Bubble’s demise is always a challenge (at best) – especially in an environment of epic central bank liquidity support. But this time has a different feel to it.

Importantly, the longer the inevitable day of reckoning is delayed the worse the consequences. Years of aggressive market intervention ensured a most protracted period of unprecedented excess excesses that encompassed virtually all markets and all risk categories. Perhaps Federal Reserve policymaking ensured that the greatest Bubble excess and market distortions materialized in perceived low-risk (fixed income and equities) strategies.

“The danger of mispricing risk is that there is no way out without investors taking losses. And the longer the process continues, the bigger those losses could be. That’s why the Fed should start tapering this summer before financial market distortions become even more damaging.” Martin Feldstein, Wall Street Journal op-ed, July 2, 2013

I appreciate Mr. Feldstein’s focus on “the danger of mispricing risk” – I only wish this would have been part of the monetary policy debate starting a few years back (before the damage had been done). I would argue that never has so much mispriced debt been issued on a global basis. Moreover, never have inflated bond pricesartificially low borrowing costs – had such a profound impact on securities and asset pricing around the world. Never have risk perceptions and market risk premiums in general been so distorted by aggressive central bank market intervention.
The Mispricing of Risk implies market re-pricing risk. And the greater the scope of mispricing – in the volume of securities issuance, price level distortions and risk misperceptions – the greater the scope of Latent Bubble Market Risks. Mispricing also implies wealth redistribution – and this has traditionally been from the less sophisticated to the more sophisticated. Actually, when enormous quantities of non-productive debt are issued at artificially high prices there is initially a perceived increase in wealth (more debt instruments at higher prices). This debt (“bull market”) expansion coupled with perceived wealth creation spurs spending, corporate profits and higher equities and asset prices. But when the Bubble begins to falter – with re-pricing, market losses, risk aversion and tightened financial conditions – the downside of the Credit cycle commences.
I believe we have commenced a “repricingprocess that will unfold over weeks, months and years – with vast ramifications and unknown consequences. With this in mind, let’s at least contemplate a few near-term issues.

Various reports claim the strong market reaction to Bernanke’s policy statement caught the Fed by surprise. Despite attempts by various officials to calm the markets, bond yields have just kept rising. As such, it’s now reasonable to suggest the Fed did not anticipate being on the wrong side of a spike in market yields.

How much higher do Treasury bond and MBS yields need to rise before the Fed is held to account - and forced to explain - the large losses suffered in its $3.4 TN (and ballooning) portfolio? At this point, the Federal Reserve is akin to a novice trader that keeps adding to a losing position.
Suddenly, with the potential bursting of the global bond Bubble, there’s a litany of important issues that come to the fore. Could mounting losses on its holdings play a role in the Fed’staperingtimeline? Keep in mind the market perception that any jump in Treasury yields would likely ensure the Fed’s ongoing QE support. Now much too complacent? What if the markets begin fretting that escalating losses on Fed holdings might become part of the debate – and provoke a less cavalier approach by our central bank – and others - in managing risk? In a way, Fed critics finally have a concrete issue to build their case around.

Market players have surely been stunned by how poorly the bond market has traded – especially with the Fed providing $85bn of monthly support. Assuming the Fed cannot keep purchasing Treasuries and MBS forever, perhaps there is now added impetus for investors, hedge funds, foreign central banks, sovereign wealth funds and others to push liquidations forward. If money managers now realize they are holding higher risk exposures than desired, it might be advantageous to make necessary portfolio adjustments prior to the Fed winding down its QE operations. If foreign central banks have begun a process of reducing bond holdings, does this accelerate hedge fund selling? Are the sophisticated players now anxious to reduce holdings before the next wave of bond fund redemptions and ETF-related selling? How does it work when the “Masters of the Universe” – having accumulated Trillions of assets under management by adeptly playing a most-protracted market Bubblefind themselves on the wrong side of rapidly moving markets?

I am intimately familiar with the bull story for U.S. equities. Corporate profits are strong and stock valuations are attractive. Bond yields are rising because of the underlying strength of the U.S. economy. The “great rotation.” The U.S. economy remains the most vibrant in the world. U.S. equities are the preferred asset class for the current environment.

Well, the U.S. stock market is an integral facet of the greater Credit Bubble. Massive federal deficits, ultra-loose financial conditions and artificially low borrowing costs have been instrumental in inflating profits.

Mispriced debt and meager risk premiums have been instrumental in myriad financial engineering mechanisms that have inflated corporate earnings and stock prices. Abundant cheap finance has fueled a powerful global mergers and acquisition boom. If the bond Bubble is indeed bursting, the markets are only in the earliest phase of re-pricing risks and asset prices.

In recent CBBs I have stated that, at least in terms of systemic stability, it would be preferable for some air to begin coming out of U.S. stock prices. Fine, but this would be rather UnBubble-like. With fixed income in some serious trouble, the equity market game becomes all the more critical for all the players. And perhaps this is an importantMispricing Riskassociated with the Fed’s ongoing QE: investors that have been hit with unexpected bond losses now increase their bets on inflated stock prices. After leading unsuspecting savers into the wild world of mispriced fixed income instruments, the Fed will apparently ensure the public becomes overly exposed to unappreciated risks in the U.S. equity market.

As noted in my “Issues 2013CBB from early January: A market Bubble implies bipolar outcome possibilities. Either the entrenched Bubble bursts or it becomes an issue of “how crazy do things get?” If the U.S. stock market has evolved into the speculative Bubble of choice, there are a couple things the Fed might want to contemplate. First, QE may now work to spur similar late-cycle speculative excesses that are now coming home to roost throughout the fixed income universe. Second, inflating stock prices may work to pull additional liquidity away from an already liquidity-challenged bond market. It is, after all, the nature of liquidity to seek the inflating asset market.

lunes, julio 08, 2013



The Politics of a Slowing China

Minxin Pei

06 July 2013
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SINGAPOREThe recent financial turmoil in China, with interbank loan rates spiking to double digits within days, provides further confirmation that the world’s second-largest economy is headed for a hard landing. Fueled by massive credit growth (equivalent to 30% of GDP from 2008 to 2012), the Chinese economy has taken on a level of financial leverage that is the highest among emerging markets. This will not end well.
Indeed, a recent study by Nomura Securities finds that China’s financial-risk profile today uncannily resembles those of Thailand, Japan, Spain, and the United States on the eve of their financial crises. Each crisis-hit economy had increased its financial leverage – the ratio of domestic credit to GDP – by 30 percentage points over five years shortly before their credit bubbles popped.
Economists who insist that China’s financial leverage is not too high are a dwindling minority. Certainly the People’s Bank of China, which engineered a credit squeeze in June in an attempt to discourage loan growth, seems to believe that financial leverage has risen to dangerous levels. The only questions to be answered now concern when and how deleveraging will occur.
At the moment, China watchers are focusing on two scenarios. Under the first, a soft economic landing occurs after China’s new leadership adopts ingenious policies to curb credit growth (especially through the shadow banking system), forces over-leveraged borrowers into bankruptcy, and injects fiscal resources into the banking system to shore up its capital base.
China’s GDP growth, which relies heavily on credit, will take a hit. But the deleveraging process will be gradual and orderly.
Under the second scenario, China’s leaders fail to rein in credit growth, mainly because highly leveraged local governments, well-connected real-estate developers, and state-owned enterprises (SOEs) successfully resist policies that would cut off their access to financing and force them into insolvency. Consequently, credit growth remains unchecked until an unforeseen event triggers China’sLehmanmoment. Should this happen, growth will collapse, many borrowers will default, and financial chaos could ensue.
Two intriguing observations emerge from these two scenarios. First, drastic financial deleveraging is unavoidable. Second, Chinese growth will fall under either scenario.
So, what impact will the coming era of financial deleveraging and decelerating growth have on Chinese politics?
Most would suggest that a period of financial retrenchment and slow GDP growth poses a serious threat to the legitimacy of the Chinese Communist Party (CCP), which is based on economic performance. Rising unemployment could spur social unrest. The middle class might turn against the party. Because economic distress harms different social groups simultaneously, it could facilitate the emergence of a broad anti-CCP coalition.
Moreover, massive economic dislocation could destroy the cohesion of the ruling elites and make them more vulnerable politically. Indeed, members of the ruling elite will be the most immediately affected by financial deleveraging. Those who borrowed recklessly during China’s credit boom are not small private firms or average consumers (household indebtedness in China is very low), but local governments, SOEs, and well-connected real estate developers (many of them family members of government officials). Technically, successful financial deleveraging means restructuring their debts and forcing some of them into bankruptcy.
By definition, such people have the political wherewithal to mount a fierce fight to preserve their wealth. But, given the huge size of China’s credit bubble and the enormous amounts of money needed to recapitalize the banking system, only some of them will be bailed out. Those who are not will naturally harbor resentment toward those who are.
Slower GDP growth undermines elite unity according to a different political dynamic. The current Chinese system is a gigantic rent-distributing mechanism. The ruling elites have learned to live with each other not through shared beliefs, values, or rules, but by carving up the spoils of economic development. In a high-growth environment, each group or individual could count on getting a lucrative contract or project. When growth falters, the food fight among party members will become vicious.
The people who should be most concerned with financial deleveraging and slower growth are President and CCP General Secretary Xi Jinping and Prime Minister Li Keqiang. If the deleveraging process is quick and orderly, they will emerge stronger in time for their reappointment in 2017 (the Chinese political calendar thus dictates that they turn the economy around by the first half of that year).
Xi and Li are inseparably linked with the CCP’s promise of economic prosperity and national greatness, embodied in the official catchphrase, “China dream.” What, then, will they do when faced with a political nightmare?
Minxin Pei is Professor of Government at Claremont McKenna College and a non-resident senior fellow at the German Marshall Fund of the United States.

July 6, 2013

A New Anti-American Axis?




THE flight of the leaker Edward J. Snowden from Hong Kong to Moscow last month would not have been possible without the cooperation of Russia and China. The two countries’ behavior in the Snowden affair demonstrates their growing assertiveness and their willingness to take action at America’s expense.

Beyond their protection of Mr. Snowden, Chinese-Russian policies toward Syria have paralyzed the United Nations Security Council for two years, preventing joint international action. Chinese hacking of American companies and Russia’s cyberattacks against its neighbors have also caused concern in Washington. While Moscow and Beijing have generally supported international efforts to end Iran’s nuclear weapons program, they clearly were not prepared to go as far as Washington was, and any coordinated shift in their approach could instantly gut America’s policy on the issue and endanger its security and energy interests. To punctuate the new potential for cooperation, China is now carrying out its largest ever joint naval exercises — with Russia.

Russia and China appear to have decided that, to better advance their own interests, they need to knock Washington down a peg or two. Neither probably wants to kick off a new cold war, let alone hot conflicts, and their actions in the case of Mr. Snowden show it. China allowed him into Hong Kong, but gently nudged his departure, while Russia, after some provocative rhetoric, seems to have now softened its tone.

Still, both countries are seeking greater diplomatic clout that they apparently reckon they can acquire only by constraining the United States. And in world affairs, there’s no better way to flex one’s muscles than to visibly diminish the strongest power.

This new approach appears based in part on a sense of their growing strength relative to America and their increasing emphasis on differences over issues like Syria. Both Moscow and Beijing oppose the principle of international action to interfere in a country’s sovereign affairs, much less overthrow a government, as happened in Libya in 2011. After all, that principle could always backfire on them.

They also don’t like watching the West take action against leaders friendly to them, like President Bashar al-Assad of Syria. As this sense of common interests becomes entrenched, increasing Russian-Chinese cooperation could pose grave risks for America and the world.

Their conduct suggests that they see less cost in challenging the United States and fewer rewards for acting as a partner. These calculations stem from two dangerous perceptions.

First, they see American decline and decadence. In their view, the United States is on the wrong side of history, holding on to ties with Europe and parts of Asia, while losing economic leverage and moral authority in the rest of the world. American disengagement from Iraq and Afghanistan without victory contributes to a related impression that America’s unquestioned military superiority isn’t worth much in terms of achieving policy objectives on the ground.

Second, many Russian and Chinese elites consider American foreign policy objectives fundamentally hostile to their vital interests. Neither group views American democracy promotion as reflecting any genuine commitment to freedom; instead, both perceive it as a selective crusade to undermine governments that are hostile to the United States or too powerful for its comfort.

Meanwhile, Russian and Chinese leaders make clear that Washington’s support for their neighbors in practically every dispute involving Beijing or Moscow is less a matter of respect for international law than a form of dual containment that seeks to curtail the regional and global influence of these two major powers.

American backing for Georgia and the former Soviet republics of Central Asia bothers Russia. Likewise, China views American support for Vietnam and the Philippines in their maritime disputes with Beijing as a menace.

No wonder Xi Jinping of China made his first international trip as China’s president to Moscow, where he told his counterpart, Vladimir V. Putin, that Beijing and Moscow should “resolutely support each other in efforts to protect national sovereignty, security and development interests” and promised to “closely coordinate” on regional and international issues. Mr. Putin reciprocated by saying that “the strategic partnership between us is of great importance on both a bilateral and global scale.” While the two leaders’ words may have generated more of an impression of collusion than was necessary, it’s safe to assume they knew exactly the message they were sending.

POLICY makers in Washington must carefully assess the growing chumminess between China and Russia and what it means for America. To ignore it would be foolish.

Yes, China and Russia continue to be divided by a history of mutual distrust as well as by conflicting economic interests and Chinese territorial ambitions. China’s concerns about North Korea exceed Russia’s, and Moscow’s stake in Syria is greater than Beijing’s.

And in Central Asia, the two nations are outright competitors. Moreover, China is a rising superpower and Russia is fighting to stay in the big leagues, which gives them different perspectives on world affairs.

That said, both countries share a strong interest in maintaining partnerships with the United States and the European Union, their main trading partners and the custodians of the international financial system, in which each has a major stake. These are powerful reasons for staying on good working terms with Washington, but the United States should not assume that they will halt the new anti-American tack in Beijing and Moscow. That would be a dangerous misreading of history.

Before World War I, many assumed that mutual economic entanglement and the huge costs of war would prevent conflict among key European powers. On the eve of World War II, Communist Russia and Nazi Germany seemed the unlikeliest of allies, until the two-year-long nonaggression treaty known as the Molotov-Ribbentrop pact left Europe in ruins and many millions dead.

President Obama should see China and Russia as neither enemies nor friends, but as significant powers with their own interests, as the Snowden affair showed. Initially, Mr. Obama railed publicly and ineffectually at both, urging them to extradite Mr. Snowden. Only when he softened his public stance and hardened his private line did Beijing and Moscow begin to see the advantages of avoiding further confrontation.

Washington needs to understand that most security threats around the world — from Syria to Iran to North Koreacan’t be managed safely and successfully without Russia’s and China’s cooperation. With respect to Syria, this approach would mean appreciating Moscow’s historical connection to the country’s Alawite leaders as well as Russia’s concern over the fate of Syria’s Christians, especially Orthodox Christians. In dealing with Beijing, it would mean strongly protecting American trade interests while understanding that Chinese leaders face real obstacles in tackling their own domestic economic problems.

To gain the respect of Russia and China, the White House must first demonstrate that American leadership is essential to solving key world problems, including those vital to China and Russia. America can’t be seen as passive.

Relations with Russia and China deserve to be given priority, but the United States mustn’t be afraid to stand firm in some cases or, in others, to partner with these two authoritarian but ultimately pragmatic powers. To do otherwise would be a folly of historic proportions.

Leslie H. Gelb, a former columnist, editor and correspondent for The New York Times, is president emeritus of the Council on Foreign Relations. Dimitri K. Simes is president of the Center for the National Interest and publisher of its magazine, The National Interest.

July 4, 2013

E Pluribus Unum


It’s that time of year — the long weekend when we gather with friends and family to celebrate hot dogs, potato salad and, yes, the founding of our nation. And it’s also a time for some of us to wax a bit philosophical, to wonder what, exactly, we’re celebrating. Is America in 2013, in any meaningful sense, the same country that declared independence in 1776?

The answer, I’d suggest, is yes. Despite everything, there is a thread of continuity in our national identityreflected in institutions, ideas and, especially, in attitudethat remains unbroken. Above all, we are still, at root, a nation that believes in democracy, even if we don’t always act on that belief.

And that’s a remarkable thing when you bear in mind just how much the country has changed.

America in 1776 was a rural land, mainly composed of small farmers and, in the South, somewhat bigger farmers with slaves. And the free population consisted of, well, WASPs: almost all came from northwestern Europe, 65 percent came from Britain, and 98 percent were Protestants.

America today is nothing like that, even though some politicians — think Sarah Palinlike to talk as if the “real America” is still white, Protestant, and rural or small-town.

But the real America is, in fact, a nation of metropolitan areas, not small towns. Tellingly, even when Ms. Palin made her infamous remarks in 2008 she did so in Greensboro, N.C., which may not be in the Northeast Corridor but — with a metropolitan population of more than 700,000 — is hardly Mayberry. In fact, two-thirds of Americans live in metro areas with half-a-million or more residents.

Nor, by the way, are most of us living in leafy suburbs. America as a whole has only 87 people per square mile, but the average American, according to the Census Bureau, lives in a census tract with more than 5,000 people per square mile. For all the bashing of the Northeast Corridor as being somehow un-American, this means that the typical American lives in an environment that resembles greater Boston or greater Philadelphia more than it resembles Greensboro, let alone true small towns.

What do we do in these dense metropolitan áreas? Almost none of us are farmers; few of us hunt; by and large, we sit in cubicles on weekdays and visit shopping malls on our days off.

And ethnically we are, of course, very different from the founders. Only a minority of today’s Americans are descended from the WASPs and slaves of 1776. The rest are the descendants of successive waves of immigration: first from Ireland and Germany, then from Southern and Eastern Europe, now from Latin America and Asia. We’re no longer an Anglo-Saxon nation; we’re only around half-Protestant; and we’re increasingly nonwhite.

Yet I would maintain that we are still the same country that declared independence all those years ago.

It’s not just that we have maintained continuity of legal government, although that’s not a small thing. The current government of France is, strictly speaking, the Fifth Republic; we had our anti-monarchical revolution first, yet we’re still on Republic No. 1, which actually makes our government one of the oldest in the world.

More important, however, is the enduring hold on our nation of the democratic ideal, the notion that “all men are created equal” — all men, not just men from certain ethnic groups or from aristocratic families. And to this day — or so it seems to me, and I’ve done a lot of traveling in my timeAmerica remains uniquely democratic in its mannerisms, in the way people from different classes interact.

Of course, our democratic ideal has always been accompanied by enormous hypocrisy, starting with the many founding fathers who espoused the rights of man, then went back to enjoying the fruits of slave labor. Today’s America is a place where everyone claims to support equality of opportunity, yet we are, objectively, the most class-ridden nation in the Western world — the country where children of the wealthy are most likely to inherit their parents’ status. It’s also a place where everyone celebrates the right to vote, yet many politicians work hard to disenfranchise the poor and nonwhite.

But that very hypocrisy is, in a way, a good sign. The wealthy may defend their privileges, but given the temper of America, they have to pretend that they’re doing no such thing. The block-the-vote people know what they’re doing, but they also know that they mustn’t say it in so many words. In effect, both groups know that the nation will view them as un-American unless they pay at least lip service to democratic ideals — and in that fact lies the hope of redemption.

So, yes, we are still, in a deep sense, the nation that declared independence and, more important, declared that all men have rights. Let’s all raise our hot dogs in salute.