Masterly manipulation

“Masterly manipulation” it was called by J.M.Keynes in secret papers in the 1920’s. Today we call it QE. 

A fascinating and only recently discovered entry in old Bank of England ledgers revealed that in 1914 the Bank was forced to purchase Gilts for itself as there was insufficient demand for its new issue. The issue of the £350m “ War Loan” in 1914 was reported as being a success; press articles of 1914 talk of demand ”pouring in” for the deal. Yet, £250m of the transaction was never sold and quietly shuffled away on the to the Bank of England’s ledger – or balance sheet.

So what have we learnt from this historical discovery?

1) Just because the newspapers (social media, today) say it’s a good deal it doesn’t mean it is a good deal. Have some healthy scepticism – “Stock in trade” – for the Kames fixed team and we hope our readers.

2) QE will happen in extremis but ultimately it is about delivering confidence. In 1914 it was about financing a European war and failure to be seen to be doing so would have has huge political ramifications. Similarly, in 2009 confidence in the financial system was shot and QE helped rebuild confidence in the system. Something had to be “done” and globally central bankers responded by tripling their balance sheets over the next eight years.

3) It has taken over 100 years for the “masterly manipulation” of War Loans to come to light. Despite some disquiet, Gilt purchases in the UK or purchases by other central banks have been done in an open, transparent and formulaic fashion. With today’s QE there is no obfuscation with the purchase process but QE’s unwind is less clear and a matter for public debate. Institutional transparency is a part of the confidence we have in our system. We may not like QE but it’s a whole lot more transparent than a hundred years go.

(Thank you to the authors of the excellent bankunderground blog: https://bankunderground.co.uk/2017/08/08/your-country-needs-funds-the-extraordinary-story-of-britains-early-efforts-to-finance-the-first-world-war/#more-3230)

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Awake at the wheel

“Asleep at the wheel” has been the accusation levelled at central bankers such as the Bank of England (BoE) over the financial crisis of 2008. But eager to prove its new found vigilance, the BoE yesterday tightened its controls on bank credit by announcing changes to its counter cyclical buffer (CCB).

The CCB aims to ensure banks are considered in their lending; it requires that banks increase their capital by 0.5% by this time next year and, all other things being equal, to 1% by November 2018. That would equate to £11.4bn extra capital required to back loans in the UK. All very prudent and exactly the sort of pro-active approach that central bankers should implement in boom times.

Yet politics suggest that we are still in a fiscally restrictive environment. Witness yesterday’s British Social Attitudes survey, which has a section entitled “A backlash against austerity”. Think what you like about austerity but it isn’t the stuff of boom times. So what’s the BoE worried about?

A very low savings rate is at the heart, coupled with a material increase in consumer lending through credit cards and car loans. But in an economy growing at below 2% with declining real wages, what are the Bank’s concerns? Most recent public statements over the path of interest rates centre on whether to reverse last summer’s rate cut. But Carney’s raising of the CCB must – even if only at the margin – slow the start and path of rate rises. And 0.25% or 0.5% is the discussion; the UK is not about to replicate the US rate cycle where short rates are up 1% since 2015.

The BoE aims to take a leisurely approach to the CCB increase. Like many of Carney’s initiatives it may be that the message is more effective than the action; he sees some risks but there’s no need to rush; time may mean these risks just disappear anyway. Brexit headwinds remain a challenge for UK policymakers and that is evident in the public tussle over rates with MPC members. It is difficult to view the CCB action in isolation. There is a suspicion that the BoE may just be fighting the last war and not the next. And the orders from the generals are contradictory.

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Monetary policy: Soft or hard approach – not just a political dilemma

As the anniversary approaches of the Brexit referendum it is not just political life that has been buffeted by the referendum’s fallout. Yesterday, Bank of England MPC member Andy Haldane said he would most likely be voting for higher rates later this year. This was a day after his boss, Mark Carney, indicated that rates shouldn’t go up. This is the central banker’s equivalent of the different approaches to Brexit voiced by Philip Hammond and Theresa May.

Wind back to the policy response after last year’s referendum. BoE action was fast and furious as rates were cut by 25bps and a further round of gilt and corporate quantitative easing was announced. For some this response was an outcome of the pessimistic expectations for the economy from the ‘Project Fear’ playbook and was ahead of events. However, the solid growth of the last year is starting to lose energy. Weak-currency-induced inflation and continued high debt levels are playing havoc to consumers’ real spending power. Wage inflation is failing to keep pace with inflation, keeping pressure on both consumers and politicians.

So what is the difference between Haldane and Carney? To be fair, Haldane refers to “partial withdrawal of the additional” policy measures from last summer – i.e. rates can go back to where they were prior to last year’s vote, back to 0.5%. But the current environment of decreasing consumer spending power and the uncertainty over the Brexit negotiations are not a great backdrop for rate rises – Carney’s point. Furthermore, the election has thrown a “dust cloud of uncertainty”, to borrow from Haldane. The politics of austerity are in the spotlight too, with dwindling Tory enthusiasm for it along with the fallout from the Grenfell Tower tragedy. Despite likely looser fiscal policy it also feels more likely that a soft rather than hard approach to monetary policy is on the cards.

Careful what you wish for!

Careful what you wish for! Steve Jones our CIO uses this phrase; Theresa May should have heeded these words. Not a natural gambler, May’s snap election has backfired leaving political uncertainty. There is little doubt her political authority is reduced and there will be all kinds of conclusions emerging today, most notably around the style of Brexit and her leadership. As you might imagine this morning’s meeting had the full gamut of opinion and debate.

Senior equity manager Phil Haworth summarises the state of play as “no mandate for anything stupid” – a hard Brexit is less likely and the UK is more likely to reach some economically-sound agreement, such as joining the European Economic Area (EEA). The counter is that May’s reduced political mandate leads to a worse negotiating position, with EU politicians being able to jibe May and ensure a Brexit path with less control of the process and a more material likelihood of crashing out of the EU into WTO rules. The outcome of the next few days of political discussions are crucial. As we write the Conservative Party knows May has failed to deliver her mandate but heresy would be to allow a minority Labour government for all Conservatives. Also, the UK has switched Northern Ireland for Scotland as the “king maker” of Westminster politics. But it is difficult to see the Democratic Unionist Party’s 10 seats in support of pro-Republican Jeremy Corbyn.

The market reaction to increased uncertainty so far has focused on weaker sterling, but even that looks muted as currency markets seem to interpret a hung Parliament as a softer Brexit. Equally so within the gilt market; gilts are a touch higher but there is not panic here. Further sterling weakness could see higher-than-forecast inflation. At this point Mark Carney becomes increasingly important; gilts and global bond markets are at range lows and data continues to make valuations looked stretched. Today’s electoral wobbles do not change that view. The MPC has looked through “transitory“ inflation and worries about consumer demand. With investment at only 15% of GDP and consumption nearer 70%, the consumer remains the barometer for rates policy. Given the central bank’s comments on the squeezed consumer we expect Mr Carney to remain supportive for rates markets, but he is no guarantee to gilts continuing below 1% in 10 years.

As the politics play out, opportunities should emerge; our concern is that fascinating politics may not make for the volatility we would like to see – continuing one of the themes for 2017 so far. This is no 1992 when a surprise election result saw gilts move higher by 5 points!

Somewhat dovish

The “solids, modestly and little changed” have it. Yesterday’s FOMC minutes as ever run to a dozen pages and steer the market into its thinking. The small bounce of around 25c in 10-year US Treasury prices show the text was received in a “somewhat” dovish tone. Central bank speak is always measured but May’s minutes were more measured than March’s.

Despite this, the trajectory of higher US rates was reiterated, as the FOMC “expects economic conditions to evolve in a manner that will warrant further increases”. More tellingly is that the stock of $4.5trillion odd government and mortgage-backed bonds aren’t for sale any time soon and the key reinvestment of coupon payments are set to be ongoing. What is new is the management of the amount of reinvestment of maturing bonds that will take place.

Enter into the market lexicon reinvestment “caps”. The idea here is that the nominal amount of maturing bonds increases over time and a higher cap means a smaller reinvestment into the market. Set to be discussed at the next meeting, the “caps” could well be introduced by Q4 this year. The FOMC is at pains to add that this should happen in a “gradual and predictable” manner. The market will squabble over the rate and scale of the quarterly increase of the caps, also the balance between Treasuries and ABS along with the tenor of what remains to be reinvested.

So there you have it. Business as usual. Rates are set to trickle higher at some stage – although expectations remain “modest” – and only when the economic conditions demand it; and expect only a slow and gradual unwind of QE.

Taxi Driver – the sequel

Sequels are rarely good as the first. In Robert De Niro’s original 1976 film, Taxi Driver, Vietnam veteran Travis descends into New York’s low life as sexual infatuation and delusion overtake him.

As the original is based on sex it’s no surprise that the sequel is about money. In this case the cost of being allowed to buy a New York cab licence, known as a “medallion”, and its implications.

New York cabs is a regulated market with around 13,500 medallions allowed. As New York recovered from the 2008 financial crisis, the cost or value of a medallion increased dramatically to $1.3m in 2013 being driven by a combination of this restricted market and cheap money.

And today? Medallions sell for $241,000 as Uber decimates the existing regulated taxi business. This is not without implications. Clearly the disruption caused by technology – Uber in this case – has destroyed the value of the incumbent market by 80%. No wonder taxi drivers are angry.

The figures from Capital One – the US lender – show why it’s a problem. Most cabbies don’t have the cash to buy a medallion, so borrow it. Capital One has $655m of loans to cabbies and the non-performing loan rate of that part of its lending is 52.7% – doubling over the last year. For Capital One it is a huge hit in a tiny part (0.25%) of its overall lending. Evidently chastened by large write-offs in small areas, Capital One tells us it is “building a tech brand”: reading through Capital One’s annual stockholders’ presentation and its key (basically only) theme is “disruption caused by technology”.

Lenders are starting to understand this to ensure they can effectively manage exposures to sectors under stress (e.g. cabbies) to ensure their profitability. The lesson here is that the negative effects of disruption emerge in unexpected places.

Taxi Driver the sequel has a less happy ending than the original. De Niro runs out of bullets to shoot himself but I suspect the sequel sees the cabbie succumbing to his debts. For Hollywood, the villains will clearly be bankers, but the real – and unseen – villain is surely technology.

Netflix launches Billions

OK, so “Billions” is actually produced by Netflix competitor Showtime, owned by CBS and broadcast in the UK by Sky Atlantic. However, yesterday, Netflix issued its debut bond into the Euro market with €1bn of 3.625% 10 year bonds using its B1 rating.  What is unusual with Netflix is its vast market capitalisation at $63bn is often associated with materially better rated companies.

Netflix being one of the FANGs (The new tech stock of Facebook – Amazon – Netflix – Google) is still in build-out phase as it aggressively invests overseas to capture market share.  Whilst subscription revenues are evenly divided between the US and the rest of the world, US profits subsidise overseas expansion with top line growth of up to 30% – which is a key ingredient to its huge market capitalisation.  The pricing was fairly aggressive for a B1 issuer, but the halo effect of being a FANG means the deal isn’t breaking bad as it is around ¾ point higher today. The Crown in yesterday’s European high yield market.

Step out of the shadow

We believe there is a long shadow of the 2008 Global Financial Crisis (GFC) that still prejudices investor sentiment to risk and return within corporate bond markets.

Recently we were asked about default rates in investment grade credit, and what impact this had on our positive view of the asset class.

We answered that over time investment grade spreads more than compensate for the risks of generic ownership of investment grade bonds. To support our view we borrowed some long-term evidence from the 2016 S&P ratings analysis around defaults, covering the period from 1981 to 2016.

According to the study, the Lehman default was twice the size of the next largest defaulter – Ford Motor Co., in 2009 – which in turn was almost twice the size of Energy Future Holdings at $47bn in 2010. In each year prior to 2008 (excluding WorldCom in 2002), the total default amount was less than $10bn.

Yet the lingering concern for credit markets continues to be the revisiting of the scale and size of defaults in the GFC – and the knock-on contagion that curtails access to credit. Our brighter view is that there continues to be ready access to credit for investment grade issuers and that the outlook continues to be for solid, sustainable growth – which doesn’t have the same cyclicality as we have seen over the past 40 years (the period of the S&P study).

We would note that the 2008 GFC was the first systemic crisis within the S&P study period, while the next crisis is likely to take a very different format to that of 2008, not least due to the regulatory and macro prudential steps taken by authorities since 2009.

In the last five years, 99.7% of BBB issuers have not defaulted. In terms of the triple digit basis point spreads available in investment grade markets over that period (and today), the defaults have been almost de minimis. So we continue to believe that the ongoing benign economic outlook combined with active management can ensure good levels of capital preservation in well-constructed corporate bond funds.

2016 Annual U.S. Corporate Default Study And Rating Transitions – click here to view

UK election – Bypassing the bond market, again

Election announcements make good theatre. A rushed press conference, lectern in the middle of Downing Street, searing Prime Ministerial looks and boom – a snap election for June 8.

In years gone by, such uncertainty was a source of material volatility to all markets, especially bond markets, and certainly worthy of more than the 5bps of volatility that we saw in gilts yesterday. But this gives us a clue to what is going on.

The volatility we saw at the end of June and July 2016 was obviously Brexit driven. What calmed markets was the swift resolution to the power vacuum, the UK proved resilient and institutional stability prevailed.

The action was all in the currency market with the c15% fall in sterling against the dollar on a trade-weighted basis. And so it was yesterday too: the action was in currency with a push to $1.28 and a cent on the euro exchange rate. There is no institutional uncertainty in Theresa May’s announcement – quite the opposite. It is a grab for power via a larger majority in Parliament with the desire to deliver the Brexit she sees fit and not one she has to discuss and share with Remainers nor hard Brexit Tory backbenchers. All very calming for the bond market.

There are clearly risks, though. Jeremy Corbyn is elected? Low. UKIP? Now Article 50 is triggered their raison d’etre has been removed. A resurgent Liberal Democratic party retaking Tory seats? More likely but the old Lib-Dem heartlands were in the “Leave” voting South-West. Scotland? Here we have the fourth general election or referendum in four years but despite the SNP’s push for IndyRef2, they are likely to face the Unionist challenge and lose Westminster seats. In short, the gilt market is comforted by the 20 point lead for the Tories in the opinion polls and expect June 9 to be business as usual but emphatically so.

As it stands today, politics are not a driver of material gilt market volatility. The action is in the currency markets and the currency-sensitive FTSE. An increase in gilt market volatility is most likely driven by non-domestic factors.

The coupon’s round trip

A few days ago we wrote about the possibility of the US Federal Reserve not reinvesting maturing bonds in its QE programme. Over time this would see the Fed’s portfolio of bonds reduce to zero (a very long time). This debate is about the reinvestment of maturities, but of course ignores those tricky little coupon things.

There are a whole load of technicalities around the administration of this, but it is in governments’ interests that the QE unwind happens slowly.

Why?

Let’s look at the UK. With the Bank of England (BoE) owning £435bn of gilts, Her Majesty’s Treasury (HMT) pays £15bn to the BoE.

If the BoE kept those coupons, the amount of bonds would compound by about £15bn a year, which, over time, would exponentially increase the nominal amount of bonds held by the BoE. This would lead to the BoE in essence being dominated by that relationship – which is not ideal for a central bank tasked with delivering independent advice.

Thus, the £15bn of coupons are sent back to HMT; a “round trip” that in essence means HMT has more money in its pot – and all of the political implications around that large dollop of money.

It is odd that this receives such little attention. It should be a charged and political issue given its enormity, but it gets lost in the vastness of QE.

To reinvest or not to reinvest

Last night the US Federal Reserve debated its $4.5 trillion balance sheet. This discussion has started to gain momentum with the change of politics on Capitol Hill at the end of 2016, and with one of the Fed governors William Dudley already indicating that 2018 may start to see a reduction of the Fed’s balance sheet.

Despite the end of Quantitative Easing being in sight QE “continues” here in the UK as well as in the US through the reinvestment of maturing bonds which has the effect of maintaining a static nominal balance sheet. That doesn’t hit the headlines as this is regarded as the small print and quietly forgotten – but it is material and going forward is up for grabs.

So for example, in 2018 the Bank of England will continue QE to the tune of £18bn as it reinvests maturing bonds. Policymakers to date have chosen to reinvest redeeming bonds in order to keep their nominal balance sheets constant – in the UK’s case £435bn of Gilts and in the US a total of $4.5 trillion.  For the UK there is no plan or policy to reduce the amount of bonds held by the Bank Of England, but the Federal Reserve has pushed it up its agenda.

Previously, US Federal Reserve Chair Janet Yellen had suggested it was a secondary consideration, but with rates anticipated to be up another 0.5% by year-end, it seems like reducing the Fed’s balance sheet will become part of the policy mix. We see this as being a material part of likely policy and market debates over the coming months. Previously the bond markets had anticipated that the Federal Reserve would start reducing its balance sheet when short rates (Fed funds) were around 2%. It is likely that as short rates are pushed up we will also see the cessation of reinvestments. Being a reversal of QE is implicitly monetary tightening and may well help elongate the gentle rate cycle we currently see. It may also be part of the Fed’s desire to provide a natural counter balance to a more expansionary fiscal policy from the Trump administration. Either way this suggests the Fed continues to believe the US economy is gaining strength.

Kondratieff

On Tuesday we hosted a conference where we heard from our own team and a couple of economists. Chris Watling at Longview Economics takes a, well, long view. He is quite a proponent of Kondratieff. Who he? Starting at the end, he faced Stalin’s firing squad in 1938 at the age of 46. Prior to that he had held office in 1917 as deputy minister for supply before the second, October revolution of 1917 after which he moved to academia but ultimately falling foul of Stalin’s fanaticism and being sent to the gulag.

However, in 1922 he published his first book on the long cycle. A simplified explanation is that as capital is invested it creates monies which are reinvested in similar products that are produced more cheaply until this process leads to a loss of confidence and people hoard cash rather than invest. The long cycle is around every 35 years and the slide below suggests we are at a turning point, having seen new lows in government bond markets in 2016.

I don’t dislike this explanation of the world but it has its limitations as well as practical investment limitations. Bond yields may well be materially higher in the long term but as managers we are judged on monthly, quarterly and annual performance. As yesterday’s 10bps rally in 10 year US Treasuries AFTER the Fed rate hike proves, there are plenty of opportunities on the journey to slightly higher yields.

US 10 year bond yields – 1900 to present (showing Kondratieff cycles):
 

Why the WIRP screen is misleading for US hikes

There has been some chat in the press over the past days suggesting a 50% chance of a hike in March. We think this is a little misleading. A well-used analytical tool on Bloomberg shows a 50% probability, but this number uses the midpoint between the upper and lower bounds of the Fed Fund corridor as the most recent fixing, so this is currently 62.5bps.

However, if we look at the future market where futures trade on the average effective rate (not the midpoint of Fed Funds), this is currently 66bps and has remained very stable over the past few days.

So by our reckoning if you compare the spread between the effective rate from the futures market and the Fed Fund it looks like media observations are overstating the probability of a March rate hike. We think the actual probability is 36% (not a half). We work this out by using the April futures contract expiry price of 75bps, less the effective rate of 66bps which equates to 9bps; so if there is a 25bp rate hike the chances from the more dynamic futures market are 9/25 i.e. 36%.

Here is the effective rate vs the lower bound of 50bp:

 

 

 

 

 

 

 

 

 

 

 

Mixing your metaphors

Monday morning sees our Fixed Income team sit down and thrash what’s what for markets. We assess how our positioning has fared and should it change.

In the debate this morning one of the managers quipped “If you are going to invest in a country with a crazy dictator, you may as well get paid for it” – while discussing the relative value between the US and emerging markets.

This blog doesn’t aim to proffer views on US politics; however, there is no doubt that the Trump era is very different from the Obama regime. So I wondered how EM had faired since the start of 2017.

For the US Treasury market, yields have rallied by just over 10bps using the US 10 year note as a gauge. Overall returns would have earned you a further 2 months of its 2.25% coupon. All in all you’d be up around 1.5%. So my colleague was right – a generic investment grade Emerging Market index has done double that so far this year – just over 3%.

“You are mixing your metaphors” I hear you say – mixing your Sombreros with your Stetsons. It is an observation but it is clear that what happens in the US materially effects EM. Immediately after Donald Trump’s election, markets for all the obvious political reasons, became very bearish on EM. However, as the dust has settled there is a realisation that things aren’t changing overnight and that the Federal Reserve isn’t raising rates as aggressively as some had expected. Clearly there is more to relative value between the US and EM, but so far this year looks likely to repeat some of the key themes for 2016: any softness in the US interest rate cycle is likely to be good for EM economies.

What’s wrong with the bond market?

The last few months have seen some dramatic changes. Lots of attention has been paid to the Trump team line up; much political capital spent on Britain’s Brexit Bill being pushed through the UK Parliament. Given these events along with upcoming European elections, you would expect the bond market to be experiencing unprecedented volatility. But you would be wrong. Since mid-November the 10-Year US Treasury has traded in a range of 30 basis points – eerily similar to the UK’s 10-year Gilt as well as Germany and Switzerland’s benchmark issues. Likewise, the ‘term structure’ of yield curves for 30-year bonds compared to five or 10-year bonds for all these major markets are not dramatically different.

Also cross market valuations are not distinctly different over the last three months. European markets (Germany, UK and Switzerland) have become a little more expensive compared to US treasuries.

So what are the bond markets telling us? They are reminding us that they are forward looking and efficient. With 10-year US treasuries priced at 2.45% and 10-year Gilts at 1.3% all the action was in the previous three months. That action was driven by Brexit and Trump – with neither event anticipated by markets.

Thus, bond markets rapidly assessed a material change in outlook; Gilts almost trebled in yield from mid-August to November with a logical and unemotional assessment of higher inflation and further political challenges for the UK. Likewise, for the US, expectations of Trump shaking the political tree in Washington were rapidly priced in the days after his election. For Europe a similar story, Bunds were unchanged over this period but political stress signals are starting to be priced into the valuation of French and Italian bonds.

So what are the bond markets missing? Not much bar the politics – witness the underperformance in French bonds. Expect volatility if populism really does become a European phenomenon; Wilders in The Netherlands and Le Pen in France are still regarded as unlikely winners by markets but swathes of people voting for them can readily change that.

But the central case is that Europe rattles on with the European Central Bank in the driving seat. Slightly higher inflation and moderate growth across the EU, Switzerland and US are what the bond markets are currently expecting. However, a political shock from Europe has the capacity to shake the bond market from its current complacency.

A million miles apart

The scores were in today for Europe’s 2016 GDP. A mildly disappointing 0.4% growth in last quarter took the full year’s growth in 2016 to 1.7%. Not bad but short of the achievements in the US and UK where growth measured more than 2% for 2016.

Digging deeper and an odd fact occurs – at the bottom of the European growth pile for Q4 2016 – Greece and Finland. Growth contracted by 0.4% in Greece and 0.5% in Finland. Whilst both economies contracted, all eyes are on Greece, again. Deterioration in Finland’s finances are not the stuff of market volatility. Fundamentally there is trust in Finland to honour its liabilities. This is encapsulated by Finland’s 10 year bond yield of 55bps – a mere 20bps higher than Germany’s – impressive for a country with one fifteenth of the population.

Whilst Greek debt to GDP has barely increased from c. 175% over the last 5 years we are about to enter the fourth round of negotiations over Greece’s debt burden since 2010. For Finland that debt has increased by over 50% over the same time period to 63%, but ranking number 50 in the world’s most indebted countries (measured by debt/GDP) it isn’t the stuff of default nightmares. However, for the IMF, the EU and ECB (the “troika”) Greece’s position continues to be systemically problematic.

Finland is rated AA+ and Greece is CCC (technically having not defaulted in 2011). Greek 10 year debt at 7.3% yield is 6.75% more than Finland. The ECB currently supports Finland’s debt through its QE purchase programme, keeping Finnish yields low. The ECB judges it has already used its QE pro-rata firepower for Greek debt back in 2011 with previous programmes of Greek support.

There are two age-old debt market facts. Number 1) Borrowers who are committed to repaying can access funds at the cheapest terms. Finland. Those who aren’t committed, struggle. Greece. Number 2) If your debt is big enough it’s the lenders problem not yours i.e. the EU which owns around two thirds of Greek debt. 2017 represents another stab for the EU in an attempt to deal with Greece’s debt and a recalcitrant Greek government.  There may only 1,500 miles between Athens and Helsinki but they are still a million miles apart.