Category Archives: Financial Markets

The inverted yield curve – what does it mean?

There has been a lot in the news about the ‘inverted yield curve’ which occurs when interest rates on short-term ends are higher that the interest rates paid on long-term bonds – see video below from WSJ. Here we are talking about 2 year bonds in relation to 10 year bonds. The thinking is that people are so worried about near-term future that they are putting money into safer long-term investments.

When an economy is growing at steady rate bondholders want a higher yield (return) on longer-term bonds than for short-term bonds. The rationale behind this is that if your money is tied up for a longer period of time (10 year bond) you want to be rewarded for that risk. In contrast bonds that require shorter time commitments don’t require as much sacrifice and usually pay less.

However this week the yield on 10 year bonds fell below the yield on 2 year bonds for the first time since 2007 – remember this was followed by the GFC. The chart below shows the difference in the yield between 2 year and 10 year bonds – as stated bonds of longer duration should have a higher yield. What is significant is that the inverted yield curve has occurred before every US recession since 1955 and is viewed as a strong predictor of a recession / downturn. If people are willing to take such little money for their long-term bonds it would indicate that inflation is not a concern.

How George Soros almost broke the Bank of England and pocketed $1bn

Today I was teaching  exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM). The video below explains the drama that unfolded very well.

Background

The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in realtion to one another.

It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation

Black Wednesday

Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.

Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.

* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.

Capitalism with accountability

HT to my learned colleague David Parr for this piece from vox.com. Sen. Elizabeth Warren (D-MA) rolled out a big idea to challenge how we think about inequality and the fundamental structure of the economy. She has been concerned with the current structure of capitalism which since the 1980’s has really focused on the interests of shareholders and executives at the expense of employees further down a company’s ‘pecking order’. Reagan and Thatcher started the recent privatisation trend in the 1980’s and, with great success, a lot of the commanding heights of the economy were up for sale. This put any left wing political opposition in a quandary. Do they renationalise these industries and payout shareholders or just start to move their ideology further right on the continuum. The latter was the only real option with the expense of buying back the industries and also upsetting their maybe voters who had bought shares for saving purposes.

Warren with other Democrats is proposing the Accountable Capitalism Act in order to alter the balance of interests in corporate decision-making and giving voices to workers in corporate boardrooms. The legislation would:

  • reduce the huge financial incentives that entice CEOs to lush cash out of shareholders rather than reinvest in businesses
  • curb political activities – using lobbying funds
  • ensure workers and not just shareholders get a voice on big strategic decisions.
    bring about more meaningful career ladders for workers and higher pay
  • ensure that Corporations act like decent citizens who uphold their fair share of the social contract and not like sociopaths whose sole obligation is profitability — as is currently conventional in American business thinking.
  • limit corporate executives’ ability to sell shares of stock that they receive as pay — requiring that such shares be held for at least five years after they were received, and at least three years after a share buyback.

Business executives, like everyone else, want to have good reputations and be regarded as good people but, when pressed about topics of social concern, frequently fall back on the idea that their first obligation is to do what’s right for shareholders. A new charter would remove that crutch, and leave executives accountable as human beings for the rights and wrongs of their decisions.

More concretely, US corporations would be required to allow their workers to elect 40 percent of the membership of their board of directors. Since 80 percent of the value of the stock market is owned by about 10 percent of the population and half of Americans own no stock at all, this has been a huge triumph for the rich – see graph.

Meanwhile, CEO pay has soared as executive compensation has been redesigned to incentivize shareholder gains, and the CEOs have delivered. Gains for shareholders and greater inequality in pay has led to a generation of median compensation lagging far behind economy-wide productivity, with higher pay mostly captured by a relatively small number of people rather than being broadly shared. The graph below show the share of wealth with the top 1% owning 38% of the country’s wealth and the bottom 90% holding only 19% of wealth.

This kind of huge transfer of economic power from rich shareholders to middle- and working-class employees would provoke fierce resistance. But reform of corporate governance also has some powerful political tailwinds behind it.

I am on holiday now and out of internet range – back on the 8th January. Have a good xmas and new year.

Source: Top House Democrats join Elizabeth Warren’s push to fundamentally change American capitalism. Vox

10 years after GFC – what we’ve learnt

Thanks to colleague Paul Chapman for this article from Mercer ‘Health Wealth Career’. Its looks at the 10 lessons learnt from the GFC and 3 thoughts from what we might expect in the future.

Lesson 1 – Credit cycles are inevitable. As long banks are driven by growth and profit margins their decision-making inevitably leads to greater risk and poorer quality. The growth from 2005-2008 was generated by leverage.

Lesson 2 – The financial system is based on confidence, not numbers. Once confidence in the banking system takes a hit investors start to pull their money out – Northern Rock in the UK.

Lesson 3 – Managing and controlling risk is a nearly impossible task. Managing risk was very difficult with the complexity of the financial instruments – alphabet soup of CDO, CDS, MBS etc. A lot of decisions here were driven by algorithms which even banks couldn’t control at the time. Models include ‘unkown unkowns’

Lesson 4 – Don’t Panic. Politicians learnt from previous crashes not to panic and provided emergency funding for banks, extraordinary cuts in interest rates and the injection of massive amounts of liquidity into the system. The “person on the street” may well not have been aware how close the financial system came to widespread collapse

Lesson 5 – Some banks are too big to be allowed to fail. This principle was established explicitly as a reaction to the crisis. The pure capitalist system rewards risk but failure can lead to bankruptcy and liquidation. The banks had the best of both worlds – reward was privatised with profits but failure was socialised with bailouts from the government. Therefore risk was encouraged.

Lesson 6 – Emergency and extraordinary policies work! The rapid move to record low policy interest rates, the injection into the banking system of huge amounts of liquidity and the start of the massive program of asset purchases (quantitative easing or “QE”) were effective at avoiding a deep recession — so, on that basis, the policymakers got it right.

Lesson 7: If massive amounts of liquidity are pumped into the financial system, asset prices will surely rise (even when the action is in the essentially good cause of staving off systemic collapse). They must rise, because the liquidity has to go somewhere, and that somewhere inevitably means some sort of asset.

Lesson 8: If short-term rates are kept at extraordinarily low levels for a long period of time, yields on other assets will eventually fall in sympathy — Yields across asset classes have fallen generally, particularly bond yields. Negative real rates (that is, short-term rates below the rate of inflation) are one of the mechanisms by which the mountain of debt resulting from the GFC is eroded, as the interest accumulated is more than offset by inflation reducing the real value of the debt.

Lesson 9: Extraordinary and untried policies have unexpected outcomes. Against almost all expectations, these extraordinary monetary policies have not proved to be inflationary, or at least not inflationary in terms of consumer prices. But they have been inflationary in terms of asset prices.

Lesson 10: The behavior of securities markets does not conform to expectations. Excess liquidity and persistent low rates have boosted market levels but have also generally suppressed market volatility in a way that was not widely expected.

The Future

Are we entering a period similar to the pre-crash period of 2007/2008? There are undoubtedly some likenesses. Debt levels in the private sector are increasing, and the quality of debt is falling; public-sector debt levels remain very high. Thus, there is arguably a material risk in terms of debt levels.

Thought 1: The next crisis will undoubtedly be different from the last – they always are. The world is changing rapidly in many ways (look at climate change, technology and the “#MeToo” movement as just three examples). You only have to read “This Time is Different” by Ken Rogoff and Carmen Rheinhart to appreciate this.

Thought 2: Don’t depend on regulators preventing future crises. Regulators and other decision makers are like generals, very good at fighting the last war (or crisis) — in this case, forcing bank balance sheets to be materially strengthened or building more-diverse credit portfolios — but they are usually much less effective at anticipating and mitigating the efforts of the next.

Thought 3: The outlook for monetary policy is unknown. The monetary policy tools used during the financial crisis worked to stave off a deep recession. But we don’t really know how they might work in the future. Record low interest rates with little or no inflation has rendered monetary policy ineffective – a classic liquidity trap.

Source: Mercer – September 2018 – 10 Years after the GFC – 10 lessons

New Zealand keep triple A rating but what does it mean?

Moody’s credit rating agency continued with a Aaa rating of New Zealand’s economy. They expect the coalition government will remain committed to fiscal discipline, with the Budget staying in surplus. The high strength of New Zealand’s institutions was a key factor in underpinning the credit rating. There are three main rating agencies in the global economy – Standard & Poor’s, Moody’s and Fitch – below are the ratings that each company uses.

Conflict of Interest and the sub-prime crisis of 2008
Rating agencies are paid by the people whose products they grade and they are competing against other rating agencies for the business. Subsequently the rating agencies were being played-off against each other by the bankers in this market and this led to a systemic decline in standards and willingness not to check the underlying information as thoroughly as possible for fear of losing the deal. Even the rating agencies themselves admit mistakes were made is assessing sub-prime debt and that there were issues to do with data quality from their sources of research. However one has to consider whether the world have been better off if credit rating agencies had not existed as pension funds, bond funds, insurance companies etc would have had to do a lot more of their own research on what they were buying.

Remember before the credit crisis AAA investments mushroomed between 2000-2006 see graph below.

But consider the following:
Bear Stearns
– rated A2 a month before it went bankrupt
Lehman Brothers – rated A2 just days before it collapsed
AIG – rated AA within days of being bailed out
Fannie Mae & Freddie Mac – AAA rating before being bailed out by the government
Citigroup – A2 before receiving a bail out package from the Government
Merrill Lynch – A2 before being sold to Bank of America

A2 is considered a good investment grade

 

A2 Economics – Liquidity Preference Curve

With mock exams this week here is something on Liquidity Preference – included is a mind map that has been modified from Susan Grant’s CIE revision book.

Demand for money

TRANSACTIONS DEMAND – T – this is money used for the purchase of goods and services. The transactions demand for money is positively related to real incomes and inflation. As an individual’s income rises or as prices in the shops increase, he will have to hold more cash to carry out his everyday transactions. The quantity of nominal money demand is therefore proportional to the price level in the economy. (note:  the real demand for money is independent of the price level)

PRECAUTIONARY BALANCES – P – this is money held to cover unexpected items of expenditure. As with the transactions demand for money, it is positively correlated with real incomes and inflation.

SPECULATIVE BALANCES – S – this is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑.

If a bond has a fixed return, e.g. $10 a year. If the price of a bond is $100 this represents a 10% return. If the price of the bond is $50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

There is an inverse relationship between the rate of interest and the speculative demand for money.

The total demand for money is obtained by the summation of the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curve and is inversely related to the rate of interest.

 

 

Has banking culture changed since GFC?

Below is an excellent video by Gillian Tett of the FT looking at banking culture. She discusses the ‘flaw’ in Alan Greenspan’s thinking and how culture has been overlooked at the cost to the global economy 10 years on from the financial crisis. By understanding the role of culture in banking, are we more resilient to another crisis now? She also talks of trust in the modern economy and in order to build it you must understand it and how human culture works. And once trust or credit is lost it is very hard to regain.

New Zealand’s Neutral Rate of Interest

A speech delivered last July by John McDermott (Assistant Governor and Head of Economics at the RBNZ) talked about the neutral rate of interest. Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.

The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.

OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy

The RBNZ’s last published estimate of the neutral OCR was in June 2017 at 3.5%, with a range of estimates around that between 2.6% to 4.6%. Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.

Since the GFC neutral rates around the world have been falling which reflects the following:

  1.  Lower expectations about growth in the economy = reduces the return to investment
  2.  Relative to pre-GFC, a wider spread between the central bank rate and the interest rates faced by households and businesses (i.e. mortgages and business lending rates).
  3. An increase in global desired savings. For instance, demographic trends offshore have led to an increase in saving among the cohort of the population going through prime earning years (as they save for retirement). Likewise, increased income inequality is thought to increase desired savings, as top income earners typically have a lower marginal propensity to consume – MPC.
  4. Higher debt ratios in some countries (including NZ) make the economy more sensitive to interest rate increases than before.

Central Banks don’t have the independence to set the neutral rate as it is very much influenced by global forces. However they do have independence as to where they set their policy rate relative to the neutral rate.

Source: BNZ – Interest Rate Research – 14th June 2018

10 years on and the financial system is still fragile

Nassim Taleb of “Black Swan” fame has a new book out entitled “Skin in the Game”. Below is an interview with John Solman of PBS ‘Making Sense’. In this he argues:

  • a financial system works only if the people who are running it have a stake in the outcome.
  • a society should be built around risk and reward – if you make good decisions you do well but if something goes wrong you are penalised.
  • Currently profit is privatised and loss is socialised, where the taxpayer only has a downside and will never have the benefit of what’s going on.
  • The financial system is at risk if people can make money transferring risk to others and aren’t penalised. Dangerous, unfair and immoral
  • The Federal Reserve tried to cure debt with debt, transferring debt from one to the other, from the private to the public.
  • The system loaded — laden with debt and with pseudo experts will collapse eventually.