Posts Tagged ‘usd’
Thursday, May 2nd, 2013
by Axel Merk, Merk Investments
April 30th, 2013
Year-to-date, the U.S. dollar is up; does that mean we are in a rising dollar environment? Or is it an opportunity to diversify out of the greenback?
Last year, with all the turmoil in the Eurozone, the euro was up 1.79% versus the dollar; that appeared to be the best the U.S. dollar could do in times of turmoil. Of the major currencies only the Japanese yen was down versus the U.S. dollar:
Year-to-date, the dollar index, a trade weighted index comparing the U.S. dollar to a basket of six major currencies, is up 2.95% as of April 29, 2013. What many are not aware is that this index has not really been updated since it was first created in the early 1970s, giving the euro a 57.6% exposure. The dollar’s downward trend has been slowed in recent years in large part by the turmoil in the Eurozone. Additionally, the New Zealand dollar for example, which is not in the index, is up 3.37% year-to-date.
To ascertain what may happen to the dollar, let’s look at the greenback from a couple of different angles:
Myth: U.S. dollar’s safe haven status
In recent years, when there has been talk about a “flight to quality” benefiting the U.S. dollar, we had a couple of observations:
- Flight to quality may be a misnomer: our analysis suggests the dollar tends to be in demand in times of turmoil because of liquidity, not quality considerations;
- Since the onset of the financial crisis, each time the pendulum swings in favor of the U.S. dollar, it may be swinging there less so;
- The balance sheet of the U.S. appears to be deteriorating at a faster pace than the balance sheets of much of the rest of the world;
- Wherever there is a crisis, it is being “patched up”, suggesting that when the pendulum once again favors risky assets, more money might flow towards those assets; and when the pendulum swings once again in favor of the U.S. dollar, it may be less and less of a beneficiary.
In other words, the safe haven status of the U.S. dollar may slowly be eroding.
Myth: a rising rate environment favors the U.S. dollar
Assuming one believes interest rates are to head higher, it may be an expensive proposition to buy the U.S. dollar: as foreigners have historically had a major appetite for U.S. debt, their enthusiasm is historically trimmed back as the bond market turns into a bear market. As a result, early to mid phases of tightening by the Federal Reserve (Fed) have historically often been associated with a weaker dollar. It’s the late phases of a tightening cycle that the dollar historically tends to benefit, as the next bull market is anticipated for bonds. There may be little historic precedent for the environment we are in, but a rising rate environment, in our assessment, does not favor the U.S. dollar.
Myth: the Fed’s exit is near
It was just about a year ago that Fed Chair Ben Bernanke pronounced in a press conference: Let’s be humble. He then clarified that meant that liquidity should not be mopped up too early; that we have to be sure that the recovery is firmly entrenched before one should consider an exit from the highly accommodative monetary policy.
To understand Bernanke, consider that in his own words, he has repeatedly stated that he believes one of the biggest mistakes during the Great Depression was to raise rates too early. As a result, the Fed has promised to keep rates low, purchased longer-term bonds, and engaged in Operation Twist. All of these policies reflect an effort to keep long-term rates low. Yet, a little over a year ago, a series of good economic data points caused the bond market to sell off rather sharply on the long end. In our assessment of Bernanke’s thinking, that was undesirable as the recovery was nascent. Hence, the Fed doubled down by announcing an unemployment rate numerical threshold that would guide rate policy, moving the focus evermore away from inflation and towards employment. Not surprisingly, inflation expectations inched higher. The below chart is one of the many ways one can look at inflation expectations:
Bernanke has emphasized the Fed’s communication strategy and the importance of guiding market expectations. Without getting too technical about the chart, our assessment is that Bernanke is comfortable with inflation expectations at the upper range of this chart and may even consider more aggressive monetary easing when inflation expectations drop, as has occurred in recent weeks. A lowering of inflation expectations may suggest to the Fed that all the monetary action, all the “money printing” hasn’t been enough.Myth: economic growth will support the U.S. dollar.
Skeptics still point out that it doesn’t really matter whether the “exit” will come tomorrow or down the road: the “exit” is now coming closer and, with it, the market has to start pricing it in. Well, if it does, we might be in for another surprise. In our analysis, the biggest threat to the U.S. dollar may be economic growth. Let all the money that’s been created by the Fed “stick” (economic growth may drive excess bank reserves to work), and it may be rather difficult to mop up the liquidity that’s been made available to the system:
- Technically, the Fed has pretty much ruled out selling the securities it has acquired. That’s because the Fed might have to sell them at a loss.
- The Fed has indicated it may increase the interest it pays on reserves to mop up liquidity when the time comes. Not only may that result in no longer paying over $80 billion in “profits” to the Treasury (the more securities the Fed buys by creating money with the stroke of a keyboard, the more interest it earns, the higher the Fed’s “profits”), but it will lead to tens, if not hundreds, of billions in direct payments to large banks. While there may be an academic justification to make such payments, the political fallout could lead Congress to suspend the Fed’s ability to pay interest on reserves, botching the exit strategy.
Additionally, it’s likely that economic growth would drive interest rates higher across the yield curve. More important than the technical restrictions mentioned above may be the fact that the U.S. government cannot afford a high cost of borrowing to service the national debt. The average cost of servicing U.S. debt has come down from about 6% in 2001 to just over 2%. That cost of borrowing should continue to drift downward for a while as higher coupon Treasuries mature and are refinanced with lower coupon Treasuries. We are not predicting that the average cost of borrowing will zoom back up to 6% in the short-term, but what can come down, can also go back up. Even at 4%, discretionary spending by Congress will be crowded out by interest payments. Importantly, it may matter little what cost of borrowing the government can bear; more relevant may be the perception of the sustainability of U.S. government debt. Spain had very prudent debt management, with an average maturity of about 7 years for its debt outstanding; yet it took very little time for Spain’s government to be on the brink of a bailout.
The U.S. bond market does not currently reflect serious concern about the sustainability of U.S. debt. However, without major entitlement reform, in particular in social security and Medicare, the numbers simply don’t add up. Many have argued that, over time, Congress will come to its senses and indeed engage in reform. We are actually quite optimistic ourselves: however, we believe that the only language politicians listen to is that of the bond market. The Eurozone is proof that policy makers choose between the cost of acting versus the cost of not acting. Whenever possible, politicians kick the can down the road. But unlike the Eurozone the U.S. has a current account deficit. That is, the U.S. dollar may be far more vulnerable to a bond market that’s imposing reform on policy makers than the Euro has ever been.
The reason we put this discussion under the header of economic growth is that it may well be good economic data that help to unravel the perception that U.S. debt is sustainable as yields return to more historic levels.
For a more detailed outlook on currencies, please read the Merk Gold and Currency Outlook. For purposes of this analysis, we want to show that it’s far from clear that the U.S. dollar will benefit in the environment to come. Indeed, the downside risks to the dollar might be as high as ever. Ultimately, there may be no such thing as a safe asset anymore and investors may want to take a diversified approach to something as mundane as cash. Please make sure you sign up for our newsletter to be the first to learn as we discuss global dynamics affecting the dollar. Please also register to join an upcoming Webinar; our next Webinar is on Thursday, May 23, expanding on the discussion herein.
Axel Merk is President and Chief Investment Officer, Merk Investments, Manager of the Merk Funds.
Friday, January 25th, 2013
by David Templeton, Horan Capital Advisors
Since mid-November of last year, the S&P 500 Index has advanced nearly 11%. Due to this strong rise in the market and continued strength in the month of January, 2013, investors and strategists believe a correction or pullback is increasingly likely. A part of the market’s strength is due to cash coming off the sidelines and into equities as a result of investors’ building cash in the run up to the fiscal cliff. One “technical” factor cited for a potential correction is the high percentage of stocks trading above their 50-day moving average. As the weekly data shows in the below chart, 92.2% of S&P 500 stocks (yellow line) are trading above their 50 day M.A. which is one signal of an overbought market. The second chart displays the percentage of stocks above their 150-day M.A. The charts certainly seem to show corrections can occur at these high percentages.
For investors then, one important question is whether stocks are owned for a short term trade or owned for the long run. I wrote a post on September 21, 2009 titled, A View Of The Market, which discussed this very same issue. At that time I wrote,
“It seems the most frequent comment I receive of late is “the market is due for a pullback”…. If you are a contrarian, this is good. The more investors are skeptical of the advance, the more likely it could move higher. However, as the chart shows, this advance looks like it could or should be topping out.”
Notable in the chart is the fact the high percentage of stocks trading above these moving averages can run for an extended period of time. Additionally, as the below four plus year chart of the S&P 500 index shows, these corrections can be small relative to the longer term potential return in the market.
Monday, January 21st, 2013
Schwab Bond Insights: Is 2013 the year that rates rise?
January 18, 2013
by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research,
and Rob Williams, Director of Income Planning, Schwab Center for Financial Research,
and Collin Martin, Senior Research Analyst, Fixed Income and Income Planning, Schwab Center for Financial Research
The Schwab Center for Financial Research (SCFR) presents Bond Insights, a bi-weekly analysis of the top stories in today’s bond markets. This issue discusses investing in a low yield environment with the risk of rising rates on the horizon, Q4 2012 sector performance numbers, an outlook on the municipal market and a discussion on Treasury Inflation-Protected Securities (TIPS).
Is 2013 the year that rates rise?
The new year started with a jump in long-term interest rates, a trend we’ve seen many times in the past. In thirteen of the past sixteen years, ten-year Treasury yields have peaked in the first half, and subsequently declined later in the year. Recently, the yield on the ten-year Treasury hit its highest level since last May and about 50 basis points off the all-time low of 1.39% set in July 2012. Optimism about improving economic growth and the possibility that the Fed will reduce or end its bond buying program this year have been contributing factors to the rise in rates. Since yields are on the rise, talk of the bursting of the “bond bubble” has heated up – again. While we don’t anticipate a big increase in interest rates this year, there is little room for rates to move down. And we’ve seen how skittish the market can be just with a hint of a change in policy. What should investors consider doing with yields low and the risk of rising rates on the horizon?
Ten-Year Yields: 1997 to 2013
Source: Bloomberg. 10-Year Treasury Yield (USGG10Y), Percent, Daily, Not Seasonally Adjusted. Data as of January 15, 2013. Alternate shading indicates the beginning and ending of each year.
• Our interest rate outlook does not call for a significant rate increase this year or a change in Federal Reserve policy. In our view, the pace of economic growth is likely to remain sluggish due to ongoing de-leveraging and weak income growth in the consumer sector, along with headwinds from tighter fiscal policy domestically and the recession in Europe. However, with yields so low in the fixed income markets, the risks in long-term bonds are rising. Even a small increase in rates could send bond and bond fund prices lower, causing investors who sell to incur losses.
• Low coupons and long duration1 are the greatest potential risks. Even though we don’t expect an imminent rise in rates, we believe investors need to examine their bond and bond fund holdings closely—before rates rise. Prices of long duration bonds, especially those with low coupons, are likely to fall when rates move up. This leaves investors with the decision of whether to hold to maturity, ignoring the price drop, or to sell (potentially at a loss) and look to reinvest the remaining principal at higher rates.
• Compared to bond funds, an advantage to holding individual bonds is that, barring default, buy and hold investors are able to get principal returned to them at par if they hold to maturity. And if they purchased bonds several years ago, there’s a good chance that the coupon payments on the bonds are higher than what they might get in the prevailing market where rates are moving up slowly. On the downside however, an investor owning individual bonds might miss out on the potential to reinvest their principal at higher rates, and it is harder to achieve broad diversification in a portfolio of individual bonds than with a fund.
• For bond fund investors, there are many factors to weigh, in part because there are so many types of bond funds with many different strategies. Funds that use leverage, particularly closed-end funds that borrow in the short-term interest rate market, are susceptible to significant declines if rates move up quickly. Moreover, funds that are less liquid may experience outflows due to investor redemptions, forcing the fund manager to sell assets into a weak market. However, the potential advantages of bond funds, such as professional management and diversification, may mean that it makes sense for some investors to continue to hold a fund even in a rising rate environment. Some fund managers may be able to reinvest at higher rates, increasing the income the fund distributes to investors. There are even funds that can use derivatives to deliver negative duration2 in their funds, seeking to take advantage of an increase in rates.
• A warning for investors tempted to move out of bonds entirely, replacing them with other investments—we would warn that changing your asset allocation based on an expected change in interest rates could actually increase volatility and risk. Bonds continue to be an important part of overall asset allocation, providing diversification from equities and other asset classes. Also, individual bonds have a fixed maturity date and anticipated return. For those tempted to sell their bonds and sit on the sidelines in cash, there are risks as well. If interest rates don’t rise significantly, then the inability to earn higher income may alter your investment plan or lead you into riskier investments later on. Timing the market is always difficult.
• Bottom line. 2013 may be the year that the long-term downtrend in interest rates ends, but we believe investors should position their portfolios to deal with a range of possibilities. We advise investors to take this time to look at the maturities and durations of the bonds and bond funds that they hold now to prepare for the possibility of higher rates down the road.
Q4 2012 Sector Performance
Corporate and emerging market bonds paced the fixed income markets in Q4 2012, as many investors continued to search for higher yields than those available in U.S. Treasuries. Central banks, domestically and abroad, maintained easy monetary policies, keeping short-term interest rates at historically low levels. The additional yield available in riskier sectors of the market helped support bond prices, in our opinion. However, with yields low and prices high, we think that returns going forward are unlikely to be as strong as over the past few years.
• U.S. Treasuries generated mostly negative returns. U.S. Treasury yields ended the quarter higher than where they started, leading to lower prices. For the year, however, The Barclays U.S. Treasury Bond Index did generate a total return of 2%. In December, the Federal Reserve announced a continuation of their near-zero interest rate policy, and indicated that future rate hikes will be conditional on the unemployment and inflation rates rather than targeting a date range. The Fed also announced it would continue open-ended Treasury purchases to the tune of $45 billion per month. We think these two factors will keep Treasury yields from rising significantly anytime soon, but investors should be prepared for higher yields in the future. Long-term Treasury yields at or below the rate of inflation offer very little benefit beyond diversification, in our view.
• Investment grade corporate bonds outperformed the Treasury market. The investment grade corporate bond market continues to be supported by investors searching for higher yields, in our opinion. For the year, the Barclays U.S. Corporate Bond Index generated a total return of 9.8%, marking the fourth straight year of total return above 8%. For the quarter, the sectors perceived to be the riskiest outperformed their higher-quality counterparts. Triple “B” rated bonds and bonds issued by financial institutions generated the highest returns in the investment grade realm. But yields remain near their all-time lows, meaning there may be less room for yields to drop, limiting the upside price potential. We continue to favor intermediate-term investment grade corporate bonds, and we think that coupon income will be a main driver of performance going forward, not price appreciation.
4Q 2012 Sector Performance
Source: Barclays, as of December 31, 2012. Shown above are total returns for corresponding Barclays indices. Past performance is not indicative of future results.
• High yield bonds had the highest total returns in the U.S. fixed income markets. The Barclays U.S. Corporate High Yield Bond Index outperformed all domestic sectors of the fixed income markets for the quarter, with a total return of 3.29%. For the year 2012 the high yield index posted an annual total return of 15.8%. The average yield of the index dropped during the fourth quarter, pushing up the average price of the index to its all-time high. Like the investment grade market, we think that coupon income may be the main driver for performance for the coming year. With yields near all-time lows, we believe the risk/reward for sub-investment grade (high yield) bonds is becoming less attractive. We suggest short maturities for most investors considering these bonds, preferably four years or less. Investors may also want to consider exchange-traded funds (ETFs) or mutual finds that target short maturity ranges as well.
• Currency fluctuations affected the international bond markets. Lower yields in both developed and emerging markets pushed bond prices higher in the fourth quarter, but not all sectors of the international bond market experienced positive returns. The Barclays Global Aggregate ex-USD Bond Index contains an allocation to Japanese yen-denominated bonds. The yen weakened against the dollar and lowered returns for U.S. investors. The Barclays Global Emerging Markets Index, on the other hand, only contains bonds denominated in the U.S. dollar, the euro and the British pound. The euro and the pound strengthened against the dollar, helping generate stronger returns for the index. We expect developed market bond yields to remain low as central banks continue with their accommodative policies, and emerging market bonds may continue to benefit as investors look to lower-rated sectors to try and pick up additional yield.
Muni markets worked through a rough patch in late December driven by a number of factors—concerns about the debt ceiling, debate about taxes including possible reduction in deductions and exemptions, a downgrade to Puerto Rico, and limited liquidity and trading into year-end. For the year, though, it was another year of positive returns driven by price appreciation more than income. We’ve said it previously, but we’ll repeat again—we don’t count on continued price-driven returns in high-quality munis given the low level of interest rates. Prices rise as rates fall, all else being equal.
• Weakness in December… a blip on the screen or sign of more to come? The broad Barclays Municipal Bond Index lost 1.24% on a total return basis in December, the worst month of the year, bouncing back in early January. All of the factors noted above were at play, most importantly (in our view) concern about the muni tax-exemption in the fiscal cliff debate and a very slow market moving into year end.
• Longer-maturity and high-yield muni bonds outperformed shorter-maturity and highly-rated munis for the year. The hunt for yield continued, as investors looking for income drove strong price driven returns. The Barclays Long Bond (22+) Muni Bond Index delivered a 11.3% total return for the year, outpaced by an 18.1% total return in the Barclays Muni High Yield (sub-investment grade) Index. States with higher credit risk, such as California (8.1% total return for the Barclays CA state-specific index) and Illinois (8.1%), generated higher total returns than the broad Barclays Municipal Bond Index at 6.8%.
Long-term Bonds Outperformed as Rates Fell
Source: Barclays Municipal Bond Indices. Yield to worst as of December 31, 2011.Total return for 2012.
• Risk rises as yields fall. The trend of outperformance of longer maturity bonds and those with higher credit risk continued, highlighting the appetite for income wherever it can be found. The conundrum is what are investors to do about it? In our view, the risk-reward balance becomes increasingly out of balance the farther yields fall, especially in longer-maturity bonds over 10-12 years as the muni yield curve has flattened (shown in the chart above). While rates may not increase significantly soon, price sensitive investors might consider looking for opportunities to take gains.
• We continue to favor credit over interest rate risk. We don’t expect a repeat of the performance in the high-yield muni sector in 2013, though a modest step down in quality from the AAA-AA range may make sense for investors looking to add yield to a muni portfolio currently biased toward quality. We continue to favor highly-rated general obligation and essential service revenue bonds (water/sewer) etc, but yield in these areas continues to be tough to come by. Although defaults and distress in bonds rated investment-grade and higher have been widely publicized, they remain a small part of the muni market. Defaults and bankruptcies also fell in 2012 relative to 2011, a trend that we expect to continue.
• Much to the relief of the market, the muni-tax exemption so far has survived the fiscal cliff unscathed. In fact, the tax increases approved as part of the fiscal cliff legislation are supportive of muni bonds. Here are the recent, relevant changes to tax law:
• Marginal income tax rate. Increases to 39.6% for singles earning $400,000 and up and $450,000 for those married filing jointly.
• Capital gains and qualified dividends. Increases to 20% for individuals in these same tax brackets.
• Medicare investment income tax. The Medicare tax was increased on net investment income to 3.8% for singles earning $200,000 and up and $250,000 for those married filing jointly. This new tax was part of the Affordable Care Act (ACA) passed earlier in 2012, not the fiscal cliff legislation. It does not include tax-exempt municipal bond interest in the definition of net investment income.
We think all of these factors could support demand for tax-advantaged income.
• The tax-exemption isn’t completely off the table. The debate about revenue isn’t going to disappear as the debate turns to spending. The Administration has continued to support a plan to place a blanket cap on all deductions and exemptions. It’s an issue investors may want to watch, as we will, though any change remains only speculation. We do not recommend a change in strategy based on the tax-exemption.
• Bottom line. For all areas of the bond market, the lower yields go, the greater the risk to price-sensitive investors if they begin to rise. In 2013, we expect to see greater rate-driven volatility at times in the muni market and continue to favor credit risk over maturities longer than 10-12 years for investors seeking income.
Tips for TIPS Investors
Over the past few years, inflation has been low but U.S. Treasury Inflation Protected Securities (TIPS) have been in demand. Yields on most TIPS have recently fallen into negative territory, even as inflation readings have been trending down. Investors appear willing to pay a high price to protect against future inflation. Given the high prices and negative yields, how should investors consider approaching the TIPS market today?
• Inflation protection is important. Current inflation trends seem benign, but over time inflation can erode the value of an investor’s principal. TIPS can provide a way to help protect principal from inflation because they are indexed to the overall consumer price index (CPI). The principal value increases with inflation and decreases with deflation. At maturity, you receive either the adjusted principal or the par value, whichever is greater. Interest is paid twice a year at a fixed rate, and the interest rate is applied to the adjusted principal. Consequently, interest payments rise and fall with inflation as well.
• But don’t overpay for it. Currently, yields on TIPS with maturities of less than 16 years are negative, reflecting elevated inflation expectations and demand for securities that provide principal protection. Buying TIPS with negative yields means an investor will need the rate of inflation to increase over time in order to break even on their investment. The break even rate for TIPS can be estimated by the difference between the yield on a TIPS and a Treasury security with a similar maturity. The breakeven represents what the inflation rate, as measured by the CPI, must average over the lifetime of the security in order to earn a higher return than a comparable Treasury security. When yields are negative, an investor needs a rise in inflation above the prevailing level up to the breakeven rate just to protect the par value of the security.
Ten-Year TIPS Have Negative Yields
Source: Bloomberg. U.S. Generic 10-Year TIPS (USGGT10Y) daily data as of January 14, 2013.
• There may be better entry points to invest in TIPS. The 10-year TIPS breakeven rate is currently above 2.5%, compared to the 20-year average of 2.0%. With current inflation running at 1.8% and the Fed targeting inflation in the 2% to 2.5% range, we believe TIPS are more reasonably priced when breakeven rates are closer to 2%.
• Recent inflation readings have been tame. Based on the CPI, the rate of inflation has been trending lower for over a year. Although there are some forces, such as higher commodity prices that could lead to rising inflation, we believe the continued weakness in the labor market should keep a lid on inflation for the time being. Over the long run, income growth and inflation are related. With unemployment still high at 7.8%, workers don’t have a lot of leverage to negotiate higher wages and consequently income growth has been weak. Until the trend in wages picks up, we expect inflation pressures to remain subdued.
• And TIPS may not give you the protection you think you’re getting. TIPS help protect against higher inflation, not higher interest rates. If interest rates rise for reasons other than higher inflation, TIPS prices will generally fall (like other Treasuries), without the benefits of inflation compensation in the form of a higher principal value. Also, with the short-term outlook for inflation fairly tame, shorter-maturity TIPS may not give investors the inflation hedge that they may be looking for.
• Bottom line. TIPS are one of the few fixed income investments that offer a promised real return that adjusts with inflation. However, in our view, TIPS appear expensive currently for those looking for a positive after-inflation return.
For other articles, please visit schwab.com/onbonds.
1. Duration indicates how price-sensitive a bond is to changes in interest rates. There are a number of ways to calculate duration; the term generally refers to effective duration, defined as the approximate percentage change in a bond’s price that will result from a 100-basis-point change in its yield. Another calculation, expressed in years, measures how long it takes for the price of a bond to be repaid by its internal cash flows.
2. Negative duration is a situation in which the price of a bond or other debt security moves in the same direction of interest rates. That is, negative duration occurs when the bond prices go up along with interest rates and vice versa.
Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Income from tax-free bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
“High-Yield” (sub-investment grade or “junk”) bonds are lower rated securities and are subject to greater credit risk, default risk, and liquidity risk than investment grade bonds.
Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.
This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
Index returns are for illustrative purposes only and do not represent actual fund performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged. One cannot invest directly in an index. Past performance does not guarantee future results.
Barclays Global Aggregate Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three majorcomponents of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices.
Global Aggregate Bond Index ex US excludes the U.S. Aggregate component.
Barclays Global Emerging Markets Index consists of the USD-denominated fixed- and floating-rate U.S. Emerging Markets Index and the fixed-rate Pan-European Emerging Markets Index, which is primarily made up of GBP- and EUR-denominated securities. The index includes emerging markets debt from the following regions: Americas, Europe, Asia, Middle East, and Africa. An emerging market is defined as any country that has a long-term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below using the middle rating of Moody’s, S&P, and Fitch.
Barclays Municipal Bond Index consists of a broad selection of investment- grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax- exempt bond market.
Barclays High Yield Municipal Bond Index consists of municipal bonds rated Ba1 or lower or non-rated bonds using the middle rating of Moody’s, S&P and Fitch.
Barclays US Aggregate Bond Index represents securities that are SEC-registered, taxable and dollar denominated. The index covers the US investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset backed securities.
Barclays U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch.
Barclays U.S. Corporate High-Yield Index the covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
Barclays U.S. Treasury Bond Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have USD250 million minimum par amount outstanding and at least one year until final maturity. Subindices based on maturity are inclusive of lower bounds. Intermediate maturity bands include bonds with maturities of 1 to 9.9999 years. Long maturity bands include maturities 10 years and greater.
Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Tuesday, January 15th, 2013
by Martin Sibileau, A View From the Trenches
In one sentence, during 2013, I expect imbalances to grow…
Click here to read this article in pdf format: January 15 2013
In the same fashion that I proposed an analytic framework for 2012, I want to lay out today what I think will be the big themes of 2013. Their drivers were established in September 2012, and I sought to give a thorough description of them here, here and here.
An analytic framework for 2013
In one sentence, during 2013, I expect imbalances to grow. These imbalances are theUS fiscal and trade deficits, the fiscal deficits of the members of the European Monetary Union (EMU) and the unemployment rate of the EMU thanks to a stronger Euro. A stronger Euro is the consequence of capital inflows driven by the elimination of jump-to-default risk in EMU sovereign debt. Below is a drawing I made to help visualize these concepts:
The drawing shows a circular dynamic playing out: The threat of the European Central Bank to purchase the debt of sovereigns (that submit to a fiscal adjustment program) eliminates the jump-to-default risk of this asset class. As explained and forecasted in September, this threat also forces a convergence in sovereign yields within the EMU, to lower levels. As long as the market perceives that the solvency of Germany is not affected, the Bund yields will not rise to that convergence level. So far, the market seems not to see that (Possunt quia posse uidentur). But the resulting appreciation of the Euro will eventually address that illusion.
This convergence, in my view, is behind the recent weakness in Treasuries. I proposed this thesis last September. However, the ongoing weakness in Treasuries does not mean I was right. In fact, I fear I may have been right for the wrong reasons. The negotiations on the US fiscal deficit and the latest announcement of the Fed with regards to debt monetization quantitative easing to infinity may also be behind this move. But until proven wrong, I will cautiously hold to my thesis.
The above factors drove capital inflows back to the European Monetary Union and strengthened the Euro. I believe this strength will last longer than many can endure. The circularity of this all resides in that the strength of the Euro will make unemployment and fiscal deficits a structural feature of the EMU, forcing the ECB to keep the threat of and eventually implementing the Open Monetary Transactions. The alternative is a social uprising and that will not be tolerated by the Euro kleptocracy.
All this -and particularly the strength of the Euro- is not sustainable. Ad infinitum, it would create a Euro so strong that the periphery would drag coreEuropein its bankruptcy. But while it lasts, the compression in sovereign yield will mask the increasing default risks in Euro corporate debt, specially the one denominated in US dollars. Both have been fuelling the rise in the value of equities globally.
The unsustainable framework rests upon the shoulders of the Federal Reserve, which thanks to the established USD swaps and unlimited Quantitative Easing, has completely coupled its balance sheet to that of the European Central Bank. In the end, as this new set of relative prices between asset classes sets in, it will be more difficult for the European Central Bank to sterilize the Open Monetary Transactions.
History provides an example of the current growth in imbalances
By now, it should be clear that the rally in equities is not the reflection of upcoming economic growth. Paraphrasing Shakespeare, economic growth “should be made of sterner stuff”.
Under the current framework, the European Central Bank can afford to engage in the purchase of sovereign debt because the Fed is indirectly financing the European private sector. The Fed does so with the backstop of USD swaps and tangible quantitative easing, which provides cheap USD funding to European banks and thus avoids a credit contraction of the sorts we began to see at the end of 2011.
This same structure was in place between the Federal Reserve and the central banks of France and England in 1927, 1928 and 1929 and, as a witness declared, “(it) transformed the depression of 1929 into the Great Depression of 1931”. Something tells me that this time however it will be different. It will be worse. That little something is the determination of the new Japanese government to devalue its currency via purchases of European sovereign debt (ESM debt).
How fragile is this Entente?
Most analysts I have read/heard, focus on the political fragility of the framework. And they are right. The uncertainty over theUSdebt ceiling negotiations and the fact that prices today do not reflect anything else but the probability of a bid or lack thereof by a central bank makes politics relevant. Should the European Central Bank finally engage in Open Monetary Transactions, the importance of politics would be fully visible.
However, unemployment is “the” fundamental underlying factor in this story and I do not think it will fall. In the long term, financial repression, including zero-interest rate policies, simply hurt investment demand and productivity. I do not see unemployment dictating the rhythm in 2013, indirectly through defaults. Furthermore, in the meantime, the picture may look different, because “…we should not be surprised if, under zero-interest-rate policies in the developed world, we witness a growing trend in corporate leverage, with vertical integration, share buybacks and private equity funds taking public companies private…”. This is obviously supportive of risk.
No systemic meltdown in 2013?
From earlier letters, you know that I believe quasi-fiscal deficits (i.e. deficits from a central bank) are a necessary condition for a meltdown to occur, and that these usually appear when deposits begin to seriously evaporate. So far, capital is leaving main street (via leveraged share buybacks and dividends), but at the same time, it is being parked at banks in the form of deposits. The case of Wells Fargo and the temporary pause in the flight of deposits from the periphery of the European Union suggest that the process towards a meltdown, if any (and I believe there will be one) will be a long agony. Furthermore, in the short term, at the end of January, European banks, have the option to repay the money lent by the European Central Bank in the Long-Term Refinancing Operations from a year ago, on a weekly basis. I expect them to repay enough to cause more pain to those still long of gold (including me, of course).
Copyright © A View From the Trenches
Friday, January 4th, 2013
FX markets and precious metals are continuing to trade weaker after hours along with Treasury yields (in some very gappy and unhappy ways) – but the S&P 500 futures are flatlining for now (as NKY futures push higher – merely playing catch up to ES since New Year’s Eve). Odder and odderer…
and for those wondering just how much further this slide in EURUSD can go (following the huge year-end repatriation dislocation) – we offer a somewhat startling suggestion…
and Japanese markets are continuing their convergence (with bear steepening in JGBs and JPY weakness)…
as Nikkei catches up to ES after being closed since New Year’s Eve…
Thursday, January 3rd, 2013
One of the Fed Chairman’s most memorable lines in recent history is that “gold is not money… it is tradition.” Perhaps he was merely listening to the Fed’s computers, Ferbus, Edo and Sigma, which we now know form the backbone of US central planning and whose DSGE model output is usually spot on until it happens to be catastrophically wrong, on the issue. Or perhaps that is merely what one is taught (and teaches) in the Princeton economics department. Whatever the reason for Bernanke’s belief, don’t show him this chart from a just released “Report of the Working Group to Study the Issues Related to Gold Imports and Gold Loans by NBFCs” in India, part of a coordinated campaign to minimize Indian gold demand and imports whose direct substitution to “(un)sound money” in the country is one of the reason being attributed for the nation’s high current account deficit (as reported earlier) and why the finance minister said “demand for gold must be moderated.” The chart shows the staggering eightfold increase in India’s gold loans “which monetize the idle gold in the country“, in just four short years. In short it proves that in India, gold is the only real money, and is the only fallback option in a country where inflation is still rampant, and where even simple peasants prefer to keep their wealth not in the local paper currency, which has been losing its value aggressively in recent years, but in the shiny metal. Must be “tradition.”
[note (on Indian numbering language) : one crore = 10,000,000 | 160,000 crore = 1,600,000,000,000 ~ 1.6 trillion Rupees = approx. USD$27 billion]
Here are some of the salient points from the report on the relentless surge of gold’s popularity in India where it is now effectively, a parallel currency, and is accepted as money good (and in many cases, better) collateral for those who need short-term liquidity and funding:
Possession of gold has been a symbol of prosperity in India and is considered a safest form of investment that provides hedge against inflation. Gold has always been a highly coveted product not only in the form of jewellery, gold bars or bullion, but also has the ready acceptability as collateral for the lenders because of its high liquidity character. According to an estimate of World Gold Council, about 10 per cent of world’s gold is in India’s possession. Accumulated Gold stock in India is around 18,000 to 19,000 tonnes as per independent estimates. During 2002-2012, annual gold demand has remained relatively stable at around between 700 to 900 tonnes despite the rise in prices from Rs. 13,333 to Rs. 86,958 per troy ounce (as on May 25, 2012). In India, the demand for gold has not been adversely impacted by rising prices.
Genesis of Gold Loan Market in India
In India, it is believed that most of the gold is held by people in rural areas and in many cases this is the only asset they have in their possession though in small quantity. All the while, rural Indians know that if his crop fails or his family is sick, he can raise cash in a moment from the goldsmith or may be pawnbrokers and moneylenders, because the rural India lags in availing banking facilities. Therefore, even the pattern of saving in India differs for various income groups. While richer sections diversify their portfolio according to risk-return equation, the poor rely more on commodities like gold as well as silver. The jewellery bought in times of prosperity has been pawned or sold for cash in periods of distress or need. Over the years, some portion of this is being used as collateral for borrowing in the informal market, though estimates is not available. It is a common practice in India that gold is pawned, bought back and re-pawned to manage day-to-day needs of the poor and middle class. The pledging of gold ornaments and other gold assets to local pawnbrokers and money lenders to avail loans has been prevalent in the Indian society over ages. Due to the increased holding of gold as an asset among large section of people as also the borrowing practices against gold in the informal sector have encouraged some loan companies to provide loans against the collateral of used gold jewelleries for years and over a period to emerge as ‘specialised gold loan companies’.
Some independent estimates indicate that rural India accounts for about 65 per cent of total gold stock in the country. At times of emergency, gold ensures a loan almost instantaneously for the poor and without any documentation process. Most of the loans are for meeting unforeseen contingencies and may be categorized as personal. Further, growth in middle income classes and increase in the earning capacity of women, a core customer group for gold is expected to further boost the demand of gold. The demand for gold has a regional bias with southern Indian states accounting for around 40 per cent of the annual demand, followed by the west (25 per cent), north (20-25 per cent) and east (10-15 per cent). Accordingly, even the gold loan market has also developed on the same lines where a large portion of market is concentrated in southern India. India continues to be one of the largest gold markets in the world. The attraction towards gold in India stems from varied historical and cultural factors and its perceived safety in times of economic stress.
Since 1990, with the repeal of Gold Control Act, Indians have been allowed to hold gold bars. In the year 1993, the provisions of Foreign Exchange Regulation Act (FERA) relating to gold were repealed and imports were allowed by NRIs and since 1997 gold imports were brought under Open General License. All these gave fillip for the development of not only the gold market but also the gold loans market. With a view to bring the gold holdings to the core financial market, several gold based financial products have been made available to retail consumers in the Indian market from time to time. Recently, Exchange Traded Gold Funds (ETF) has also been allowed in the Indian markets, which have received a positive response from investors.
Structure of the Players in Gold Loan Market
Borrowing against gold is one of the popular instruments based on physical pledge of gold and it has been working well with Indian rural household’s mindset, which typically views gold as an important saving instrument that is liquid and can be converted into cash instantly to meet any urgent needs. The market is very well established in the Southern states of India, which accounts for the highest accumulated gold stock. Further, traditionally gold holders in Southern India are more open to accept and exercise the option of pledging gold as compared to other regions in the country which are reluctant to pledge jewellery or ornaments for borrowing money.
All of the above is purely on the regulated side of things. It is in the gold “black market” in India where things get really exciting:
In addition to a growing organised gold loans market, there is a large long-operated, un-organised gold loans market which is believed to be several times the size of organised gold loans market. There are no official estimates available on the size of this market, which is marked with the presence of numerous pawnbrokers, moneylenders and land lords operating at a local level. These players are quite active in rural areas of India and provide loans against jewellery to families in need at interest rates in excess of 30 percent. These operators have a strong understanding of the local customer base and offer an advantage of immediate liquidity to customers in need, with extreme flexible hours of accessibility, without requirements of any elaborate formalities and documentation. However, these players are completely unregulated leaving the customers vulnerable to exploitation at the hands of these moneylenders and pawn-brokers.
So in other words, in India gold is the most fungible asset, and the most rapidly converted into other forms of liquidity, to the point where it is not only the currency but also the true store of value. Sure enough:
Gold as an asset is liquid and can be readily exchanged for cash even in the informal market. With the gold market getting more organized within a formal setup, in recent years there has been rapid growth in the gold loans market particularly in gold loans disbursed by Banks and NBFCs (Table 6.1). Both demand and supply side factors have played important roles in bringing about this growth. From the demand side, holders of gold were able to get cash in lieu of their gold in a formal setup and at higher loan to value ratios at relatively less rate of interest with better terms when compared with the informal segment. From the supply side, banks and NBFCs were able to disburse loans against collateral whose value was stable even in times of financial turmoil.
As gold loans are issued solely on the basis of gold jewellery as collateral, the high growth rates observed for gold loans in recent years could be reflecting the emergence of a liquidity motive apart from the conventional saving motive to acquire gold. The strengthening of liquidity motive over time could result in increased demand for gold loans. The rapid growth in gold loans in recent years indicates unleashing the latent demand for liquidity from significant proportion of the population who faced severe borrowing constraints in the past. This could also be viewed as an offshoot of the huge rise in gold price along with liberal loan to value ratios that existed till the recent past. The prospects of gold value appreciation together with easy and flexible availability of gold loans increase the demand for gold and thereby to gold imports.
It is known that the gold demand in India is influenced strongly by the feature of gold as an attractive investment option. The recent gold loan growth phase coincided with the rise in growth of imports of gold, which grew, despite the rise in gold prices. A quiet swing in savings from financial products to assets, showing propensity for further growth, is visible in the Indian economy. There were apprehensions that liberal loan to value ratio and consistent rise in gold prices could result in an incentive for individuals, to consider investment in gold jewellery as an arbitrage opportunity, by pledging the purchased jewellery and use the proceeds to buy gold jewellery to take advantage of future appreciation. Thus, gold loans and demand for gold (jewellery) can theoretically become mutually reinforcing in the long term.
But don’t worry, it is not money. It is only “tradition.”
Needless to say, the overarching theme of this report, whose purpose is to isolate the attractiveness of gold to the general population, and most importantly, prevent it, is that gold demand must be limited as the only control a collapsing central-bank based statist system has is in controlling “money” that is infinitely dilutable and can inflate away debt, not the type that actually has value, and that a central bank can’t create out of thin binary air. Hence the report’s conclusion:
There is a need to moderate the demand for gold imports, as ensuring external sector’s stability is critical. But, it is necessary to recognise that demand for gold is not strictly amenable to policy changes and also is price inelastic due to varied reasons. What is critical is to ensure provision of real returns to investors through various financial savings products. What is also relevant is the need for banks to introduce new gold-backed financial products that may reduce or postpone the demand for gold imports. The Working Group believes that providing real rate of return to investors through alternative instruments holds the key to reducing the excessive demand for gold. Meanwhile, there is also a need to increase monetisation of idle gold stocks in the economy for productive purposes. As of now, there appears to be no close substitute to wean away investors’ attention from gold. Investors’ awareness and education is important, in this context, to channel the investment to gold-backed financial products. Banks and NBFCs may continue to deliver gold jewellery loans, which monetises the idle gold in the country. The gold loan market has grown well in recent years. It is time for consolidation of the operations of the gold loan NBFCs. The gold loans NBFCs need to transform themselves into institutions free of complaints, have proper documentation and auction procedures, with rationalised interest rate structure and have a branch network that is fully safe and secure. Gold loans NBFCs’ linkage with formal financial institutions may be reduced gradually. Such transformation ensures the gold loans NBFCs’ future growth more robust, besides making them a contributing segment to the financial inclusion process.
One can almost feel the panic.
And yet the real message here is between the lines: just like the US government’s veiled threat to curb gun sales, and/or to adjust the second amendment altogether resulted in precisely the opposite reaction to that intended, i.e., a record surge in purchases of all gun related products, so India’s ever more aggressive attempts to curb gold as a monetary equivalent will simply force the population to hoard ever more gold, result in even greater gold imports, both using legal and less than legal means, but most importantly, lead to a surge in the gold black market as the government’s more explicit intervention in the definition of what is and isn’t money forces more and more Indians to seek the safety of the yellow metal in ever greater numbers.
What this means for the supply and demand dynamics of not paper, but real physical gold, we leave to our readers to decipher. Failing that, they can always just sunmit an inquiry into the Princeton economics department.
Wednesday, January 2nd, 2013
And so after much pomp and posturing over the past 48 hours, much of which will likely reshape the layout of the GOP in both chambers, both the Senate and the House passed the first concurrent tax hike and permanent tax cuts in about two decades. The net result of this will be a roughly 1% drag on GDP, even as the US budget deficit increases relative to the CBO’s old baseline, and the beneficial impact from the tax hikes offsets roughly two weeks of spending. In other words, while addressing the tax part of the equation, politicians delayed the spending part of the problem for exactly 60 days by punting on the expiration of the sequester, or the government spending cuts. They also delayed addressing the debt ceiling, perhaps the most integral part of the Fiscal Cliff, which has now been breached and which as of this moment means the US can’t incur one additional dollar in additional debt.
So looking forward it means the US now has about 4 separate cliffs: the debt ceiling cliff in February/March, the sequester cliff in March, the farm bill cliff in September and the expiration of jobless benefits on December.But that’s all in the future, and it will all be a function of just how quickly the GOP rolls over to once again confirm that when it comes to the stock market, America has just one political party. The party of up at all costs, which in turn is manifested right now in the first futures print of the New Year, with both the S&P and the DJIA futures up nearly 2%, and with the E-Mini up some 50 points, or half a turn of S&P multiple expansion in two trading sessions: a nice rally to show just who Washington truly works for.
From a big picture perspective it means one thing: the Fiscal Cliff discussions aren’t going anywhere, and will continue to dominate the airwaves over the next two months, only this time far more attention will be paid to the debt ceiling part of the cliff, an issue Obama said last night he will not yield to republicans, and on which republicans said they will demand far more concessions.
In peripheral news flow, corporate revenues and earnings continue to grow below trend, and economic growth will certainly be impacted adversely as none of the uncertainty has been removed, but merely delayed. European final manufacturing PMI declined from 46.3 to 46.1, even as the UK soared ahead of Mark Carney taking the helm of the BOE. Peripheral European bonds continued their declining, with Spain and Italy reaching nearly 2 and 3 year yield lows, respectively.
That said the main mission has been accomplished: all relevant newsflow has once again been pushed back from the main news stream and relegated to the backburner, where anything not meeting expectations can be “explained away” using the Cliff as a scapegoat for both Q4 2012 and Q1 2013.
In terms of actual expected US data today, we have the Manufacturing PMI at 8:58 am, Construction spending at 10 am (expected to drop from 1.4% to 0.4%) when the latest Manufacturing ISM is also released and is expected to rise from 49.5 to 51.5, and finally the December FOMC minutes at 2:00 pm.
Some more on what to expect today from SocGen:
A last minute deal saved the US from going over the fiscal cliff means that the start of the new year is being greeted by a ‘risk on’ boost to cross assets. JPY funded risk positions have been bid up causing USD/JPY to vault 87.00 and EUR/JPY to set sights on 116.00. Long-term core bond yields and swaps have backed up in the process and a round of decent US ISM data today and payrolls on Friday could cause the correction to deepen in 10y and 30y sectors in particular with yield curves steepening in the process. A break of 1,450 for the S&P-500 could presage a move back up to the September’12 high of 1,474. However, critics were quick to pour cold water on the US fiscal Bill, and the lopsided nature of the deal that focuses on tax increases and is devoid of any commitment to cut public spending will cause tense negotiations to resume over the weeks ahead as the focus now shifts on how to raise the $16.4trn debt ceiling by March. The CBO calculates that the latest agreement will add $4trn to the US deficit. Nevertheless, the negative short-term impact on the economy (and sentiment) appears to have been contained as we now wait for the Bill to be signed into law. In the meantime, we suspect that shorting JPY will continue to be popular as PM Abe takes the reins. Data today includes EU and UK manufacturing PMIs and the US ISM. Germany sells 5bn in 2y notes.
Friday, December 21st, 2012
Despite EURUSD trading in a 10pip range all afternoon (flat), a significant divergence in VIX (bearish), and a roundtrip to unchanged in Treasuries (flat), equity markets did what they do best – levitate. Volume slipped but was not terrible (as did average trade size) suggesting this strength is hardly the stuff of professional rotation (no matter what we are told to believe). For most of the day session stocks trod water in a small range but into the close (ahead of the vote tonight), S&P 500 futures went vertical amid absolutely and utterly no news whatsoever, blowing through yesterday’s closing VWAP and beyond led by financials (now +4.375% on the week). Futures kept going after the close completely wiping out yesterday’s losses. Silver came off the lows of the week marginally in the afternoon but ends today down 7.2% for the week as Copper and Gold follow it lower (and WTI +3% on the week). We suspect the liftathon is a remnant of the lack of size sellers (knowing there is no liquidity to move into) who are aggressively protecting via options. Most-Shorted names are the best performers once again.
HYG ramped in the last few seconds on decent volume as S&P 500 futures had already left the gate, interest rates and vol were not amused…
HYG’s last minute move (which blew it to recent richest levels from intrinsics) looks like a combination of arb against SPY but could potentially be an effort to hedge across the CDS roll which took place today – either way, remarkable really…
But S&P 500 futures closed at Tuesday’s closing level (as if by magic)…
Everyone talking about the great rotation… not seeing that in Treasuries, sorry…
Commodities are having a hell of a week – Copper (no recovery), Gold (no moar QE?), and especially Silver (no moar QE or recovery) are being monkey-hammered lower as Oil shrugs it off and joins the global recovery trade…
Across broad risk-assets, correlation with equities plunged as they were in a world of their own this afternoon. ETFs were dragged up by SPY at the very close…
Charts: Bloomberg and Capital Context
What Causes Hyperinflations and Why we Have not Seen One Yet: A Forensic Examination of Dead Currencies
Thursday, December 20th, 2012
What causes hyperinflations? The answer is: Quasi-fiscal deficits! Why have we not seen hyperinflation yet? Because we have not had quasi-fiscal deficits!
Please, click here to read this article in pdf format: December 18 2012
As anticipated in my previous letter, today I want to discuss the topic of high or hyperinflation: What triggers it? Is there a common feature in hyperinflations that would allow us to see one when it’s coming? If so, can we make an educated guess as to when to expect it? The analysis will be inductive (breaking with the Austrian method) and in the process, I will seek to help Peter Schiff find an easy answer to give the media whenever he’s questioned about hyperinflation. If my thesis is correct, three additional conclusions should hold: a) High inflation and high nominal interest rates are not incompatible but go together: There cannot be hyperinflation without high nominal interest rates, b) The folks at the Gold Anti-Trust Action Committee will eventually be out of a job, and c) Jim Rogers will have been proved wrong on his recommendation to buy farmland.
(Before we deal with these questions, a quick note related to my last letter: A friend pointed me to this article in Zerohedge.com, where the problem on liquidity being diverted back to shareholders in the form of share buybacks and dividends was exposed, before I would bring it up, on my letter of March 4th. )
A forensic analysis on dead currencies
When I think of hyperinflation, I think of dead currencies. They are the best evidence. There is a common pattern to be found in every one of them and no, I am not talking of six-to-eight-figure denomination bills or shortages of goods. These are just symptoms. Behind the death of every currency in modern times, there has been a quasi-fiscal deficit causing it. Thus, briefly, when someone asks: What causes hyperinflations? The answer is: Quasi-fiscal deficits! Why have we not seen hyperinflation yet? Because we have not had quasi-fiscal deficits!
What is a quasi-fiscal deficit?
A quasi-fiscal deficit is the deficit of a central bank. From Germany to Argentina to Zimbabwe, the hyper or high inflationary processes have always been fueled by such deficits. Monetized fiscal deficits produce inflation. Quasi-fiscal deficits (by definition, they are monetized) produce hyperinflation. Remember that capital losses due to the mark down of assets do not affect central banks: They simply don’t need to mark to market. They mark to model.
The only losses that can meaningfully affect central banks stem from flows (i.e. deficits), like net interest losses. These losses result from paying a higher interest on their (i.e. central banks’) liabilities than what they receive from their assets. These losses leave central banks no alternative but to monetize them, in a deadly feedback loop. They are like black holes: Once trapped into them, there is no way out, because (fiscal) spending cuts are no longer relevant, unless they produce a surplus material enough to offset the quasi-fiscal deficits. And that, by definition, is impossible.
This raises questions like: Why would a central bank need to pay interest on its liabilities? Why would the monetization of the losses necessarily lead to a spiralling process?
Why would a central bank need to pay interest on its liabilities?
This is a key point to understand inflation. According to mainstream economists, inflation is a process that pops once the potential output gap of a currency zone is eliminated. Inflation is the consequence of reaching full employment of resources, they say, and place the situation within the context of “hydraulics”. In the figure below, I illustrate this context, showing two glasses: One is not full, and therefore, there should not be inflationary pressures.
Please, do not laugh at the figure. It also contains a citation from a speech given by Fed’s Governor Jeremy C. Stein a few months ago, that uses this same metaphor to illustrate how the Fed thinks about their policies. If it wasn’t so sad, it would be comic. And it is sad because there is absolutely no historical evidence of a nation sustainably living under inflation that would have reached full employment. In fact, it is quite the opposite: Inflation breeds unemployment, which breeds shortages and further inflation. This is why this whole situation is so sad. Millions of lives have been and will continue to be ruined because of this error.
The truth is however that inflation and financial repression are inseparable. They are different faces of the same coin, and as inflation develops, financial repression morphs into plain confiscation. As at December 2012, we have only had increasing financial repression, mostly in the form of price manipulation. Some of this manipulation is open, as with interest rates, and some of it is covered, as with gold, the consumer price index or the unemployment rate. But as the US fiscal deficits grows, the manipulation will be increasingly open and the fear of confiscation will be very tangible. Yes, the manipulation will be so open that even the GATA (Gold Anti-Trust Action Committee) will completely lose its raison d’être. It will be worthless to expose what will be public.
With regards to the fear of confiscation, there is a good example in the drop in deposits from the banks in the periphery of the Euro zone. Any rational investor could see that his bank was being coerced into purchasing the worthless debt of its sovereign and that the likelihood of being caught in a bank run was exponentially rising. Policy makers in the Euro zone chose not to confiscate. It was too early to do so, in the presence of other alternatives. But deposits dropped nevertheless, and to restore them, the European Central Bank will have to pay higher interest rates on its sterilized purchases, when it finally engages in Open Monetary Transactions (i.e. purchase of sovereign debt with maturity under three years). I explained this in September: Since the backstop of the ECB removes jump-to-default risk from the front end (i.e. 1 to 3 years, in sovereign debt), selling the sovereign debt to the central bank for cash will be a losing proposition for banks. The Euro zone banks will demand that the purchases be sterilized, to receive central bank debt in exchange and at an acceptable interest rate. This rate will have to be higher than it currently is. This is why, in my opinion, we are seeing a stronger Euro and weaker Treasuries.
Why would a government want to maintain a certain level of deposits?
Governments need bank deposits to fund the bonds they force their banks to buy. The regulations, the pressure on the bankers, the open threats are all part of the same means to coerce bankers to fund their debts with your savings. Is this what was behind the failed moves in 2012 to destroy the US money market funds?
Essentially, hyperinflation is the ultimate and most expensive bailout of a broken banking system, which every holder of the currency is forced to pay for in a losing proposition, for it inevitably ends in its final destruction. Hyperinflation is the vomit of economic systems: Just like any other vomit, it’s a very good thing, because we can all finally feel better. We have puked the rotten stuff out of the system.
Why would depositors not want to renew deposits?
Whenever the weight of deficits passes a certain milestone, people begin to flee en masse from the system. They not only take their savings from the system, but they generate income outside it too. This has happened since times immemorial. Below is a picture of buried coins, found in Hertfordshire. They are presumed to have been hoarded in 4th century during the final years of Roman rule.
Then and now, the tax pressure ended breaking capital markets and trade. In the early stages, everyone seeks to stop investing and collect by any means whatever capital that can be recovered. Nobody should be surprised if, with these low interest rates, the wave of share buybacks and dividend payments increases. The shrinkage of the system exacerbates the fall in tax revenue and the intervention of central banks, leading to the self fulfilling outcome of quasi-fiscal deficits. Production falls and the shortage of goods, together with the increase in the circulation of money, triggers high inflation. Price controls follow. If this is correct, Jim Rogers is wrong and you should not buy farmland. Farming will not be profitable. The increase in food prices would not be a signal to encourage farming, but the reflection of the fact that farming is not profitable because it is easy to tax. Hence, the food shortages. The same applies to real estate in general, as the rule of the mob spreads and the rights of debtors and tenants are favoured over those of creditors and landlords. Hyperinflation therefore is not just a run from a currency, but from the economic system entirely. Thousands of years of Diaspora are screaming to us in the face that the advantage of gold as an easy-to-transport and store asset is not to be underestimated.
Why have we not seen a quasi-fiscal deficit yet and how close are we to see one?
I think that at this point one can easily see how high nominal interest rates (to attract deposits) and hyperinflation go together. The loss of confidence in the system pushes nominal rates higher, which causes even more pain to produce, unleashing shortages of goods and higher prices. Von Mises, for instance, remembered that in the case of the German hyperinflation, “…With a (my note: nominal) 900 per cent interest rate in September 1923 the Reichsbank was practically giving money away…” (Chapter 7, in “Money, Method, and the Market Process”).
Frankly, I do not have a definitive answer to the question of why we have not seen a quasi-fiscal deficit yet. But I can intuit that we are still far from seeing one. There are many factors at play. The existence of coercive pension plans (i.e. monies coercively taken from salaries to fund collective distributions) could be playing an important role. These funds are “other peoples’ monies” to their managers and they will not risk their careers to protect them from governments that force them to assign a zero risk weight to US Treasury holdings. It is conceivable that as funds are burdened with losses, the contributors wake up to them and decide that at a certain point, one is better off working outside the system than in it, to avoid this hidden tax. Just like Romans left the city, millions of workers in the developed world may decide to become self-employed and leave the system. This is a typical characteristic of under-developed economies.
So far, the Federal Reserve does not even need to sterilize what it prints. The European Central Bank did have to sterilize but the market does not demand an interest rate on its liabilities, higher than that of the sovereign debt it purchases. Not yet…Perhaps because the market somehow still believes that institutional structure of the European Monetary Union is fixable. Further downgrades in the risk rating of core Europe, the concurrent rise in the yields ofGermany’s sovereign debt and corporate defaults in USD denominated bonds will eventually wipe this belief. For now, the European Central Bank has been successful in not even having to pay interest on deposits.
If I have to think of a main and most likely trigger of quasi-fiscal deficits, I have to name the future bailout of the next wave in corporate defaults, particularly from the Euro zone.
Wednesday, December 19th, 2012
Exceprted from Saxo’s Steen Jakobsen’s 2013 Extreme Complacency,
Our biggest concern here on the cusp of 2013 is the current odd combination of extreme complacency about the risks presented by extend-and-pretend macro policy making and rapidly accelerating social tensions that could threaten political and eventually financial market stability.
Before everyone labels us ‘doomers’ and pessimists, let us point out that, economically, we already have wartime financial conditions: the debt burden and fiscal deficits of the western world are at levels not seen since the end of World War II. We may not be fighting in the trenches, but we may soon be fighting in the streets.
To continue with the current extend-and-pretend policies is to continue to disenfranchise wide swaths of our population – particularly the young – those who will be taking care of us as we are entering our doddering old age. We would not blame them if they felt a bit less than generous. In other words, the kind of confrontation we risk is not a military one, but rather a struggle between the mistreated young generation and the old fogies, who think they are entitled to all of a society’s wealth and to do everything to defend the status quo.
All of this leads us to believe that society will tilt increasingly towards more radicalism in Europe in 2013, where the far left and far right will both gain ground by appealing to the desperately disenfranchised voters who have very little to lose in responding to their messages.
The macro economy has no ammunition left for improving sentiment. We are all reduced to praying for a better day tomorrow, as we realise that the current macro policies are like pushing on a string because there is no true price discovery in the market anymore. We have all been reduced to a bunch of central bank watchers, only ever looking for the next liquidity fix, like some kind of horde of heroin addicts. We have a pro forma capitalism with de facto market totalitarianism. Can we have our free markets back please?
As we leave 2012, the consensus call is for the S&P 500 to rise 10 percent next year, and not a single analyst sees the market down in 2013 – I do not remember a similar level of complacency since the year 2000, when everyone I knew quit their job in the hope of making a fortune day trading. One of the things we can learn from history is that we rarely ever take its lessons to heart.
10 Outrageous Predictions
1. DAX plunges 33 percent to 5,000 (Peter Garnry)
The leading German stock market index DAX was one of the world’s best performing stock markets in 2012 as Europe’s economic juggernaut continued to fare better than most Eurozone countries, despite the crisis on the continent and weaker activity in China. This will all change in 2013 as China’s economic slowdown continues, thereby putting a halt to Germany’s industrial expansion. This causes large price declines in industrial stocks due to stagnating revenue and declining profits at major industry players such as Siemens, BASF and Daimler. This market stress deflates consumer confidence and as a result domestic demand, highlighted by weak retail sales. With domestic demand failing to offset weakening exports, approval ratings for Chancellor Angela Merkel plunge ahead of the German election in the third quarter, and ultimately the deteriorated economic situation obstructs her re-election attempt. With a weak economy and uncertainty about a new government, the DAX index declines to 5,000, down 33 percent for the year.
2. Nationalisation of major Japanese electronics companies (Peter Garnry)
Japan’s electronics industry, once the glory of the ‘Land of the Rising Sun’, enters a terminal phase after being outmatched by the roaring South Korean electronics industry, with Samsung the winner. The core driver of the industry’s decline is a too domestically oriented approach which has led to a high fixed cost base due to Japan’s extreme living costs, pensions and the strong yen. With combined losses of USD 30 billion in the last twelve months ending September 30, 2012, for Sharp, Panasonic and Sony combined, creditworthiness deteriorates greatly and the Japanese government nationalises the electronics industry in déjà-vu style – similar to the government bailout of the US automobile industry. There has been no nominal growth in Japan’s gross domestic product in eight out of the last 16 years and as a consequence of the bailouts, the Bank of Japan formalises nominal GDP targeting. The BoJ expands its balance sheet to almost 50 percent of nominal GDP to spur inflation and weaken the yen. As a result, USDJPY goes to 90.
3. Soybeans to rise by 50 percent (Ole S. Hansen)
Bad weather during 2012 caused havoc to global crop production and we fear this will continue to play an unwanted role during the 2013 planting and growing season. The US soybean ending stock, which improved slightly ultimo 2012, is still precariously tight at a nine-year low. This tightness leaves the price of new crop soybeans, illustrated by the January 2014 contract on Chicago Board of Trade futures, exposed to any new weather disruptions, either in the US or South America (which is now the world’s largest producing region) or in China (the world’s largest consumer and biggest importer). Increased demand for biofuel, in this case soybean oil to cover biodiesel mandates, will also play its part in exposing the price to spikes should worries about supply resurface. Speculative investors, who reduced their soy sector exposure by two-thirds towards the end of 2012, will be ready to re-enter and this combination of technical and fundamental buying could potentially push the price higher by as much as 50 percent.
4. Gold corrects to USD 1,200 per ounce (Ole S. Hansen)
The strength of the US economic recovery in 2013 surprises the market and especially financial investors in gold, who in recent years have come to dominate the market thereby making the yellow metal extremely sensitive to expectations for the global interest rate environment. The changed outlook for the US economy combined with a lack of pick-up in physical demand for the precious metal from China and India, which both struggle with weak growth and rising unemployment, trigger a major round of gold liquidation. This is particularly a result of the US Federal Reserve’s decision to reduce or completely cease further purchases of mortgage and treasury bonds. Hedge funds move to the sell side and once the important USD 1,500 level is broken a massive round of long liquidation follows, especially by investors in Exchange Traded Funds who have been accumulating record holdings of gold. Gold slumps to USD 1,200 before central banks, especially in emerging economies, eventually step in to take advantage of lower prices.
5. WTI crude hits USD 50 (Ole S. Hansen)
US energy production continues to rise beyond expectations, primarily brought about by advanced production techniques, such as in the shale oil sector. US production of West Texas Intermediate crude oil rises strongly and with inventory levels already at a 30-year high and export options limited, WTI crude oil prices come under renewed selling pressure and slump towards USD 50 per barrel. Weaker than expected global growth compounds this process triggering a surprise drop in global consumption of oil and the price of Brent Crude, the global benchmark. The supply side, led by the Organization of the Petroleum Exporting Countries and Russia, reacts too late to this challenge as its members – desperate for revenues to pay for ever increasing public expenditure – hesitate to reduce production, so the supply glut rises even further.
6. USDJPY heads to 60.00 (John J. Hardy)
The Liberal Democratic Party comes back into power with its supposedly JPY-punishing agenda. But the reality of office, an uncooperative parliament and resistance from the Bank of Japan, mean that only half-measures are introduced. Meanwhile, the market has become over-enamoured with the potential for LDP leadership to bring about change and over-positioned for JPY weakness. As the market loses its enthusiasm for global quantitative easing and risk appetite retrenches, the yen vaults to the fore again for a time as the world’s strongest currency due to deflation and repatriation of investments, and carry trades find themselves turned on their head. USDJPY heads as low as 60.00 and other JPY crosses head even more violently lower, ironically paving the way for the LDP government and the BoJ to reach for those more radical measures aimed at weakening the yen.
7. Hong Kong unpegs HKD from USD – re-pegs to RMB (John J. Hardy)
China deepens its political commitment to turn away from its managed peg to the US dollar. A big step in this direction is taken as Hong Kong moves to unpeg the Hong Kong dollar from the US dollar and repeg it to the Chinese renminbi. Other Asian countries show signs of wanting to follow suit in recognition of Asia’s shifting trade patterns and as national policies of accumulating endless USD reserves begin to erode. China also takes steps to increase RMB convertibility to grab a larger share of global trade – part of its large ambition to hold more sway over developing and frontier economies and commodity producers. This starts a process of wresting some of the advantages of holding a major reserve currency away from the US currency. RMB volatility increases as China loosens its grip on the currency’s movements, and Hong Kong quickly grows to become a major world currency trading centre and the most important centre for trading the RMB.
8. EURCHF breaks peg, touches 0.9500 (John J. Hardy)
European Union tail risks are re-aggravated – perhaps by the Italian election – or over the nature of Greece’s exit from the European Monetary Union and the worry that Spain and Portugal will follow suit. This sends capital flows surging into Switzerland once again and the Swiss National Bank and Swiss Government decide it is better to abandon the Swiss franc’s peg to the euro for a time, rather than let reserves accumulate to more than 100 percent of gross domestic product after they more than doubled to nearly two-thirds of GDP over the course of 2011 and 2012. Punitive measures and capital controls eventually brake the franc’s appreciation, but not until EUR CHF has touched a new all-time low below parity after having neared parity in 2011.
9. Spain takes one step closer to default as interest rates rise to 10 percent (Steen Jakobsen)
The market ignores the strains on the social fabric at the European Union periphery as input to EU systemic risk. This is particularly the case for Spain, where disposable income for over 1.8 million people is now less than EUR 400 a month and only 17 million out of a population of 47 million are employed. The unemployment rate is 25 percent and youth unemployment is alarmingly over 50 percent. On top of this, Catalonia is threatening to break away from Spain. While the European Central Bank and the EU are busy ‘selling the success’ of lower interest rates, Spain has seen total debt (public and private) explode to over 400 percent of its gross domestic product. Only Japan is in a worse state. With social tensions so high, the public sector simply cannot cut its public outlays further. In 2013, Spanish sovereign debt is downgraded to junk and the social strain pushes Spain over the edge, seeing Spain reject the extend-and-pretend policies of EU officialdom. Yields rapidly increase after the downgrade and as an inevitable default is priced in.
10. 30-year US yield doubles in 2013 (Steen Jakobsen)
The 30-year US Treasury bond tells us that the expected return over the next 30 years is a real return of 0.4 percent (2.8% yield minus a break-even inflation of 2.4%). This cannot last in a world of forced inflation via infinite monetary printing and a possible downgrade of the US – if we fail to get structural fiscal reforms. The Federal Reserve is expected to keep rates low for longer but in 2013 this could be challenged by the zero interest rate policy which forces investors to leave fixed income to attain any yield. The global bond markets is USD 157 trillion versus a stock market valuation of USD 55 trillion (Source: Mapping global capital markets 2011 – McKinsey & Company). This means that for every one dollar in equity there are three in fixed income. With no return or even negative return (after costs) the substitution of bonds with stocks is appealing. For every 10 percent the mutual funds reduce their bond weightings the equity market will see 30 percent on net inflow – this could not only lead to higher US rates, but also be the beginning of decade-long outperformance by stocks over bonds, which is long overdue.
Source: Saxo Bank
Full presentation below:
Outrageous Predictions 2013