Markets Insight

September 9, 2013 9:15 am
Don’t bet against Bernanke’s inflation quest
It is time to start hedging against rising long-term interest rates
As the debate rages over who the next Federal Reserve chairman will be, it seems Ben Bernanke’s legacy will not just be that he saved the world from financial calamity five years ago: he is also likely to bequeath stagflation, or at least a mild form of it. It is not possible to keep real short-term interest rates negative for this long in the face of even modestly positive real economic growth without generating financial imbalances and inflationary excesses down the road.
The great secular bull market in bonds started in 1981 with inflation and bond yields at 15 per cent, and expected to head higher. With the benefit of hindsight, it is clear the consensus of forecasts at the time underestimated the resolve on the part of Paul Volcker, Fed chairman, to slay the inflation dragon.

It took him four to five years to do so, and it was not until the mid-1980s, when bond yields finally broke below double digits, that the investment community bought into what the Fed was trying to achieve, which was disinflation, followed by price stability.

No doubt it has taken Mr Bernanke far longer to dispel deflation concerns, but I believe he will ultimately be successful in his quest for higher inflation, and my call for higher long-term rates is a new secular view.
Unless you expect deflation or an economic relapse, the timeline for how long bond yields can remain negative after adjusting for the growth rate in nominal gross domestic product, is going to be put to the test. 
In fact, this process of bond yields normalising to the trend in nominal GDP began three months ago and is ongoing. Years from now it will be clear that the 1 per cent handles that inflation and 10-year Treasury yields hit at their lows as a secular turning point were the mirror image of those 15 per cent handles just over three decades ago.

While deflation continues to dominate the thought process in the market and at the worlds’ major central banks, the reality is that core inflation has bottomed.

Those who cannot see cost pressures emanating from the jobs market should take a harder look at the August employment report, specifically the private sector wage bill, which jumped 0.7 per cent and is up at a 6 per cent annual rate over the past three months.

At the same time, the US economy is likely to do better in 2014 as many headwinds subside. It is against this backdrop that the Fed is probably going to start tapering its quantitative easing programme at the September 18 meeting.
However, the Fed and other central banks are hardly going to be touching short-term interest rates, which will remain negative in real terms for years. So financial repression will remain the order of the day, until the Fed gets what it wants – which is inflation expectations heading up to 2.5 per cent.

It would be an exercise in futility to bet against that desire, just as it was for the bond bears when they bet wrong against the Fed in the opposite direction back in the early 1980s. For a monetary authority that, until several years ago, was debating whether price stability was really closer to 1 per cent than 2 per cent, this is more than just a subtle shift in policy. At a 2.5 per cent inflation rate, the price level would rise by nearly 30 per cent over the coming decade.
This surreptitious default move is one peg in the restoration of a more comfortable debt to GDP ratio. But the policy-driven move towards higher inflation will help devalue the outstanding real level of what are still huge liabilities. That is not price stability: it is more bad news for pensioners and those who live on fixed income investments, and good news for Uncle Sam and other debtors.

It will not be a straight line-up, but the big picture is that the lows in Treasury yields are behind us, and a secular bear market is now in its infancy.
So if you are an issuer, the time for refinancing is now, not later. And if you are an investor, do not spend too long debating whether you should be starting to hedge your portfolio against the prospect of a rising long-term interest rate environment, even as central banks continue to keep short-term policy yields at the floor.

From a wealth management perspective, this means embarking on strategies that over time will effectively hedge out interest rate risk and are correlated with steeper yield curves.

It also means screening in the equity market for companies that benefit in a moderate stagflationary environment, namely those with the capacity to pass on cost increases to protect profit margins. And the income equity theme shifts from dividend yield to dividend growth.

David Rosenberg is chief economist and strategist at Gluskin Sheff
Copyright The Financial Times Limited 2013

The Birth of Fiscal Unions

05 September 2013

Harold James, Jennifer Siegel

Newsart for The Birth of Fiscal Unions

PRINCETON – Fiscal unification is often an effective way to enhance creditworthiness, and it may also create a new sense of solidarity among diverse peoples living within a large geographic area. For this reason, Europeans have often looked toward the model of the United States. But they have never been able to emulate it, because their motivations for union have been so varied.
Desperate countries often consider such unions to be the best way out of an emergency. In 1940, Charles de Gaulle proposed, and Winston Churchill accepted, the idea of a Franco-British union in the face of the Nazi challenge, which had already overwhelmed France.
In 1950, five years after the war, Germany’s first postwar chancellor, Konrad Adenauer, also proposed a union this time between France and Germany – as a way out of his defeated country’s existential crisis. Political unification was rejected; but economic association has had a brilliant career for more than six decades – until now.
The fundamental idea behind a fiscal union is that poorer, less creditworthy countries can gain from joint debt liability with richer countries. Indeed, one of the most fascinating proposals to this effect came at the beginning of World War I, when the Russian Empire found that its limited capacity to borrow on international capital markets and its low foreign-currency reserves left it unable to create an effective military force.
So the Russian government proposed what would have amounted to a full fiscal union with Britain and France for war-related finances. France latched onto the idea, because its borrowing capacity was also weaker than Britain’s. The British wanted to win the war – but not so much that they were prepared to accept unlimited liability for debt incurred by the French and Russian governments.
In reality, a fiscal union between such diverse political systems would have been unworkable. An autocratic or corrupt regime has a strong incentive to spend in a way that benefits the elite. That incentive increases if it can command the resources of a more democratically governed state, where citizens agree to pay taxes (and pay off future debt) because they also control the government.
The only circumstance in which democracies sign up to such a deal is when a clear security interest is at stake. It was that predicament that gave pre-1914 Russia unique access to the French financial market. Yet, in 1915, the British, even in the face of an ongoing war, were unwilling to assume Russia’s liabilities. Perhaps the sheer degree of uncertainty in pre-war Europe, or the more amorphous nature of the threat, made security concerns trump financial risk.
Russia’s World War I credit arrangements anticipated some of the political maneuvering about debt and its relation to security that occurred in late-twentieth-century Europe. Post-1945 West Germany was vulnerable for a long time, because it sat on the Cold War’s fault line. As a result, West German governments offered neighboring countries financial help in exchange for security and political solidarity, especially at moments when they were uncertain about the reliability and continuity of US support.
But there were limits. In 1979, when West Germany adopted a fixed exchange-rate regime with a support mechanism for its partners (the European Monetary System), the Bundesbank ensured that it was not committed to unlimited currency interventions and that it might stop when the stability of the Deutsche Mark was endangered.
The logic was repeated on an even larger scale at the beginning of the 1990’s, but this time without any pre-determined limits. The European Union’s commitment to monetary union enabled the eurozone’s Mediterranean countries to improve their debt dynamics and public finances dramatically. Their borrowing costs fell as they locked their currencies into a union with countriesGermany, in particular – with a stronger reputation for stability.
At that point, the problem of how to divide the eventual bill when things became costly was not addressed, and the problem of excessive debt was wished away by the establishment of convergence criteria (which were not fully implemented anyway). But, since 2009, when financial distress in the eurozone’s periphery brought such problems to the fore, Europeans have faced the same question as the WWI Allies. Are security and political interests so overwhelming that they justify assuming large and unlimited liabilities incurred by political systems over which they have no control?
Because Europe is at peace, with no singular, overriding security threat, it is likely that when the extent of the bargain becomes clear, voters and politicians in the rich creditor countries will reject it. But the more uncertain security challenges that Europe faces may just demand the kind of strong fiscal link that the French and Russians were willing to forge before 1914, and that the Germans and French embraced in 1950.
The implications for the present are important: the only palatable way in which the necessary balance between liability and security can be achieved is through a process of political reform that dissolves corrupt oligarchies and weakens incentives for fiscal imprudence. One approach might be to ask citizens in all European countries whether they are prepared to accept some sort of fiscal compact involving a hard limit on debt.
Germans refer to this solution as a Schuldenbremse (debt brake). It presupposes a profound process through which institutions and the assumptions underlying them come to be widely shared. But that takes time, as the history of the US – the world’s most successful union born of emergencyamply demonstrates.
Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. A specialist on German economic history and on globalization, he is the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Unión.
Jennifer Siegel is a professor of history at Ohio State University.

September 8, 2013 7:00 pm

Unfinished business in battle to fix the Banks
A man carries a box after leaving the Lehman Brothers European Headquarters building in Canary Wharf©AFP
Workers at Lehman's European Headquarters building in Canary Wharf clear their desks
Ever since Lehman Brothers collapsed almost five years ago – the most dramatic event in an unprecedented global crisis that is still reverberating todaypolicy makers have laboured to fix the causes of that disaster and to pre-empt the next. Have they succeeded?
In an attempt to gauge the merit of the glut of global reforms, the Financial Times has looked back at the 34 main banks and brokers that failed in the crisis, judging the principal reasons for failure from a menu of fivelow capital; weak funding structures; poor lending; poor trading investments; and misguided mergers and acquisitions. Many failed for multiple reasons, though Royal Bank of Scotland is the only institution to which all five triggers applied.
(To enlarge graph click here)
The Banks at the Nucleus of the Crisis
Big acquisitions are a thing of the past, too, with regulators making it clear such dealmaking is unwelcome. And the kind of complex structured investments that spread the contagion of US subprime mortgage losses around the world are close to extinct, the victim of regulators’ higher capital charges and banks’ lower risk appetites.

Those successes have emboldened regulators on both sides of the Atlantic. Banks have been chastened and their outspoken executives slapped down, or in the case of Barclays’ Bob Diamond, run out of town.
“The colour has drained from banking,” says one top regulator who is close to Mark Carney, the new governor of the Bank of England. Regulators are the rock stars these days.”

Bankers concede that supervision, after often notoriously lax oversight before the crisis, has clearly improved. Regulation now is rightly much more intensive and intrusive and the supervisory teams are much better,” says Richard Meddings, finance director at Standard Chartered in London.
The one category of the FT’s five triggers of failure that is immune to regulation is bad lending – a perennial curse of banking since the Middle Ages and one that in the heat of the crisis, when the focus was on complex collateralised debt obligations, was often neglected. “The crisis was overspun as a markets problem,” says Robert Law, a former banks analyst and adviser to the UK’s recent parliamentary commission on banking standards. “There were major problems in traditional lending, too.”

According to the FT’s analysis, this was the single biggest factor in the crisis. Of the 34 big banks that failed, three-quarters succumbed in large part because of the poor quality of basic lendingin particular to residential and commercial mortgage customers.

There is little that the authorities can do directly in a market economy to curb foolish lending practices by private sector banks. But reformers argue that a laser focus on capital, which can absorb losses, is the essential way to protect the system from further harm.

This was the first issue tackled by regulators in the wake of crisis, with big banks today required in practice to hold equity capital equivalent to 10 per cent of their assets weighted for risk. But in recent months reformers have launched another offensive on capital, conscious that risk weightings are fallible and can in any case be massaged to reduce capital requirements.

Several countries, notably the US, the UK and Switzerland, have begun initiatives to boost the amount of equity banks hold relative to their overall unweighted assets. This leverage ratio – as low as 2 per cent at many banks in the boom yearsmeaning balance sheets were geared 50 times – will in future need to be as high as 6 per cent under US reform plans.
At the same time, however, politicians, bankers and even some regulators have expressed concern about the economic impact of an allegedregulatory overload”, especially amid nervousness about the next challenge for policy makers weaning the world off exceptional central bank liquidity.

The expected wind-down of bond-buying under QE has already hurt banks by pushing down the value of bonds on their balance sheets. A secondary threat comes from the prospective end of cheap central bank funding in the eurozone in a little more than a year.

“The challenge will be to balance various regulatory initiatives with the realities of unwinding quantitative easing and fostering economic growth,” says Jim Cowles, head of Citigroup’s operations in Europe.
In private, unreconstructed bankers go much further in their complaints, arguing that the extent of reforms goes far beyond dealing with causes of the crisis.

Many are furious about onerous pay reforms, particularly the incoming EU ban on bonuses that are more than double annual salary. They resent the US Volcker rule and its constraints on using the bank’s own money for trading purposes. 
And there is growing irritation about what many see as a series of witch-hunts against banks over past misdemeanours, from insurance mis-selling in the UK to mortgage product mis-selling in the US. Regulators now appear to be on a mission of retribution,” says Bill Michael, head of financial services at KPMG UK.
All the same, there is still plenty of unfinished business for policy makers to tackleless in dealing with the direct causes of the last crisis and more in terms of preparing to tackle the repercussions of the next disaster, whatever form it takes.
In particular, worries persist about the complexity and size of banks nowadays, a problem that has, if anything, intensified. “The banks that were deemed too big to fail five years ago are now even bigger,” says Richard Portes, professor of economics at the London Business School.

JPMorgan Chase, for example has ballooned, boasting assets of $2.4tn following organic growth and crisis-triggered acquisitions of Bear Stearns and Washington Mutual, compared with only $1.6tn in 2007. The UK’s Lloyds Banking Group, after its government-sanctioned takeover of HBOS, is more than twice the size it was before the crisis, with a balance sheet of nearly £880bn. In 2007, there were only six banks in the world with assets of more than $2tn. Today there are 13.
Plans are afoot to deal with this. The central recommendation of the UK’s Vickers commission – that big British banks hive off high-street banking activities into saferringfencedentities – should make a wind-down of a large universal bank easier. But the legislation, designed to mitigate the risk of future bank collapses in the vein of RBS and Lloyds, has yet to be passed.

In the US, there has been deadlock on many elements of the Dodd-Frank reforms, much to the irritation of President Barack Obama. A campaign to restore Glass-Steagall, the repealed 1930s legislation that barred banks and brokerage houses from combining, has made little headway.
In tandem, policy makers in Europe and the US are working on the concept of predefined bail-ins” of bondholders in times of crisis. Optimists cite examples of recent failures, such as the Netherlands’ SNS Reaal, which included a bail-in of bondholders alongside nationalisation.
Overall, though, progress on the topic is laborious and few believe that banks will shrink much any time soon, whatever reformists might like to think. Size is too simple a metric [anyway],” says Douglas Flint, chairman of HSBC. “It really doesn’t matter from a systemic point of view whether you have four banks or forty banks in a market. It’s the system’s asset concentrationprincipally in government debt and in mortgage debt – that can be dangerous.”
And this, financiers say, is the eternal rub. Few elected politicians are prepared to shift the focus of debate away from banks’ size and structure and on to the underlying issue: lenders’ crucial role in propping up the often excessive debt burdens of governments and households.

Copyright The Financial Times Limited 2013.

Up and Down Wall Street


Unease About QE


Federal Reserve tapering draws nearer, like it or not.

 "Lord, make me chaste -- but not yet," St. Augustine famously prayed.

Federal Reserve Chairman Ben Bernanke and some of his colleagues on the Federal Open Market Committee may be invoking analogous words when they gather next week to consider what to do about its $85 billion-a-month bond-buying program after the "disappointing" August employment numbers reported Friday.

Disappointing was the characterization from our friends at the Liscio Report, Philippa Dunne and Doug Henwood, of the jobs data, which showed a 169,000 increase in non-farm payrolls, just shy of the 180,000 consensus forecast but after sizable downward revisions totaling some 74,000. And while the jobless rate ticked down to 7.3%, instead of holding steady at July's 7.4% as expected, the decline reflected further shrinkage in the labor force. The labor-force participation rate slid to 63.2% -- the lowest since August 1978, when women's entrance into the workplace was ramping up.

The percentage of the population that's employed -- an all-inclusive measure whose denominator doesn't discriminate among those seeking work or not -- also fell to 58.6%, at the low end of its recent range, they add. "As we've pointed out before, this matches 1983 levels -- but 1983 was early in a recovery from a deep recession. Today's ratio is below its 1979 level and on a par with 1977 -- an awful time, economically speaking, in the popular memory."

As with every jobs report, the data weren't all good or all bad. JPMorgan economist Michael Feroli points out that, unlike the pattern for most of the year, the household survey (the source for the unemployment rate that gets the main attention on the evening newscasts), showed that full-time jobs rose by 118,000 while part-time employment fell by 234,000. In addition, the U-6 "under-employment" measure that takes in discouraged workers and those who work part-time because they can't find full-time work, declined to 13.7% from 14%.

In addition, Feroli turned up a factoid in the establishment data that might account for some of the shortfall in payrolls -- a record 22,000 plunge in motion-picture jobs last month. "Some reports attribute this to a temporary work stoppage in the adult-film business which, if true, should contribute to a rebound in job growth in September."

How much the FOMC might be swayed by that swing is hard to say. For their Sept. 17-18 confab, they'll have to go with the August jobs report, which was not good, former Fed Vice Chairman Donald Kohn told Greg Valliere, chief political strategist at the Potomac Research Group. Kohn still expects the FOMC to begin gently tapering its asset purchases, but adds that the odds of that happening has shifted, to perhaps 60-40 from 80-20 a few days ago, according to a research note published after the jobs numbers' release.

Given that the August employment report "wasn't a disaster," the Fed is likely to go ahead with the taper because it was "pre-announced," Kohn continued. Bernanke broached the idea of trimming the securities purchases in late May and laid out a tentative timetable after the June FOMC meeting -- contingent upon economic data improving in line with its forecast. Had the Fed not pre-committed, "they might wait until they see whether the economy and labor markets are indeed strengthening as expected," Kohn added.

But the central bank has tied the end of quantitative easing to a 7% jobless rate, "and even if it's for the wrong reason, they're getting closer to that," Kohn continued. Fed officials also would prefer to shift attention away from QE and toward "forward guidance" -- the notion that they can shape the markets' expectations about policy by declaring their intent to keep short-term rates anchored near zero well into next year and beyond.

While a fair contingent of Fed officials is dubious about QE (with Kansas City Fed President Esther George, a voting member of the FOMC this year, wanting to begin tapering earlier), other members would argue for a delay, according to Kohn. Still, the FOMC probably "will go with a very gentle first step -- complete with caveats about how it could be reversed and how it doesn't imply anything about when rates will be raised."

Fed watchers guess that the central bank could begin paring its monthly purchases from the current $85 billion pace by perhaps $10 billion or $15 billion. Barry Knapp, Barclays' chief equity strategist, suggests that there may be little or no tapering in the purchases of agency mortgage-backed securities, from the current $40 billion a month, with the reduction being concentrated in the $45 billion Treasury portion.

That would continue to support housing, important because the mortgage-credit channel remains impaired and is having outsize effects on first-time home buyers, Knapp writes. Moreover, some research papers presented at last month's Jackson Hole confab suggest that the mortgage-backed securities purchases were more effective than buying Treasuries.

The impact of the anticipated tapering has been evident on housing, with mortgage applications down sharply and new-home sales beginning to buckle. As anyone who has bought a house knows, months can pass between the time someone starts shopping and the time he or she gets a mortgage commitment, goes to contract, and finally closes. The summer's deals probably reflect borrowers' behavior in the spring, when rates were at historic lows and buyers were looking to be settled before the new school year started.

In sum, the impact on housing from the percentage-point-plus jump in fixed-rate mortgages is only beginning to be felt, and likely most acutely by first-time buyers, who usually are constrained by the monthly nut.

Keeping the monthly nut in check for automobiles is another sign of the Fed's success. Car and light-truck sales surged to a 16 million seasonally adjusted annual rate in August, matching the cyclical peak of 2006-07. While the average selling price of a new car is north of $30,000, cheap leases can put you behind the wheel for $200 or less for mid-size sedans and under $400 for some luxury models. Credit the revival of the asset-backed securities market by the Fed's zero-rate policy for the boom in car sales.

No matter how many times Fed officials insist that tapering doesn't equate with tightening, the credit markets nonetheless begin to anticipate the first boost in short-term rates as the eventual, inevitable next step -- even if that isn't likely until 2014 or maybe 2015. In any case, tapering wouldn't help what have been two bright spots for the U.S. economy: housing and autos. Perhaps chastity could be put off a bit longer.

SOME ARGUE THAT THE PROSPECTS of a Fed taper have been largely discounted, at least in the Treasury market where, ahead of Friday's jobs report, the benchmark 10-year note yield touched the psychologically important 3% for the first time since mid-2011. That represented a huge surge since the beginning of May, when the 10-year bottomed a hair over 1.60%, which as noted has translated to a jump in mortgage rates.

But it hasn't deterred a new generation of Internet stocks from partying like it was 1999. Facebook (ticker: FB) has more than doubled from its lows, has climbed past its May 2012 $38 initial public offering price, and Friday was closing in on its record, never-to-be repeated $45 peak trade on its first fete day.

But that pales next to the surges this year in the likes of Zillow (Z), LinkedIn (LNKD) or Yelp (YELP). And so what if Netflix (NFLX) has more than tripled and sports a triple-digit price-earnings multiple? At least it has earnings, unlike the dot-com wunderkinder of the previous generation.

Those kinds of surges don't happen without a rising tide of liquidity, to which corporations are availing themselves by the truckload. Verizon's (VZ) buyout of Vodafone's (VOD) stake in their wireless business will be funded in part by a record $50 billion debt financing, a sum impossible to contemplate in the absence of Fed QE. Elsewhere in telecoms, Sprint (S) did a $6.5 billion junk-bond offering late in the week.

But emerging markets have suffered mightily from the prospect of Fed tapering. Countries with large current-account deficits had been able to fund those gaps cheaply and painlessly as all the central-bank liquidity flowed in search of higher returns. That flow reversed in anticipation of the Fed's tightening the tap, hitting emerging equity markets such as Indonesia, Turkey, Brazil, and Thailand.

It's a trading desk cliché that the pain trade is the right one. None has been more painful tan EM equities and bonds, which have seen $60 billion of outflows from their funds in the past three months, including $6.1 billion in the latest week. To Michael Hartnett and Brian Leung, respectively chief investment strategist and global equity strategist at Bank of America Merrill Lynch, those massive outflows equal capitulation.

The pain has been especially acute in India, which has suffered a huge collapse in the rupee, doubling the hit to U.S. investors in its stocks. The heavily advertised WisdomTree India Earnings exchange-traded fund (EPI) plunged by about one-third from late May (coincidentally when Bernanke started his taper talk) to its late-August low. But a new head of India's central bank has taken steps to steady the rupee. And proving itself a perfect contrary indicator, the New York Times last week ran a page-one story on India's economic travails; the ETF jumped 7% on the week.

The Fed might well take into account the impact of tapering on emerging economies, significant markets for U.S. multinationals. Those who are willing to speculate that the worst has been seen on the subcontinent can consider two closed-ends selling at double-digit discounts to net-asset value: Morgan Stanley India Investment (IIF) and India Fund (IFN.)