Paul McCulley on the future of loose monetary policy

Just as I posted yesterday my “US stocks in a win-win situation” and today Paul McCulley, Pimco’s Chief Economist, was reported expressing essentially the same idea, that the Fed will keep loose monetary policy for as long as it takes for the US economy to pick up enough momentum.

Mr McCulley is operating in the bond market and advises clients to buy inflation-potected government bonds (TIPS). This however should not be understood as a prediction of a runaway inflation. His advice reflects merely the fact that bonds, because of their low yields and fixed coupon payments, are more vulnerable to inflation.

Incidentally, bonds are more vulnerable to rate hikes as well. While historically there were times when stocks were rising even as interest rates were going up, the inverse relation of rate hikes and falling bond prices are practically inevitable. McCulley’s opinion should therefore not be seen as negative for stocks.

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US stocks in a win-win situation

With all the recent pessimism about the US stocks and the predictions that the S&P 500 will either severely correct or even crash, one may start wondering (or even panicking) whether not to get out of stocks. People usually cite the end of QE and the possibility of rising interest rates as the trigger for a steep market correction/crash. Alternatively, bears remind us about some bad underlying performance of the US economy: job creation not fast enough, insufficient capital expenditure, disappointing consumer confidence, etc. And sometimes the monetary and the fundamental reasons for the professed market crash are used together as if they strengthen each other.

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However, both these arguments not only fail to convince but put together they sound illogical because they are mutually exclusive. The aim of QE and the low interest rates is to boost consumer and investor confidence by keeping rates at ultra low levels and making it easier for businesses and consumers to borrow. QE was implemented precisely because confidence and therefore fundamentals in the US economy were low after the 2008 Global Financial Crisis. To the extent that confidence remains low Fed monetary support will continue. If fundamentally the economy performs well and shows signs that it is gaining “escape velocity”, i.e. sufficient privately driven consumer and investor confidence that starts a positive self-sustaining cycle, then exceptional monetary policy will indeed end. But in that scenario the US economy will be growing healthily and companies will be boosted by increased volume of sales.

Now it is true that the current monetary policy made stocks relatively more attractive by keeping interest rates ultra low. This is because stock valuation is discounted by the interest rates: rates are a proxy for the risk-free rate and a means to calculate the equity risk premium that investors will require in order to stay in stocks. Low interest rates means lower discounting and higher valuations.

It is also true that rising interest rates will make equities relatively less attractive, all other things being equal. So bears are right that rate hikes can push shares down. But not all other things will be equal because rates are going to be raised only if the economy performs well enough to assume that it has reached escape velocity. When this occurs valuations of stocks will be pushed down based on steeper discount because of higher rates but at the same time profits will be rising given the recovering economy and the positive outlook that would have warranted the rate hikes in the first place. So in practice the switching of gears from low interest rates to slightly higher rates will only cause a short-lived correction that will soon be superseded by improved fundamentals. Or else if fundamentals fail to improve the Fed will lower interest rates again.

By way of example, yesterday the Bureau of Labour Statistics reported 209,000 new jobs created in July missing estimates of 230,000. This was not particularly good news but it immediately caused market analysts to observe that it may cause the Fed to continue loose monetary policy which is good for keeping the stock market high. That is when bad news is not really bad. In fact the news coming from the jobs market, even when looked at from a purely fundamental point of view, is not at all bad: it shows a stable positive trend of job creation at an average of above 200,000 jobs per month for the last half year. And then coming in is also the unequivocally good news on fundamentals on top of that –  US manufacturing index reached a three years’ high, standing currently at 57.1 beating estimates of 56.

Add to that the planned gradual increase of interest rates. Currently the Fed projects that in 2015 rates are expected to rise to 1.13% which is still a ridiculously low level. In 2016 rates are projected to reach 2.5%, not too high either. So that means that not only rate hikes will come as a result of strong underlying economic performance but the interest rate discount on stocks will be moved up gradually by small increments which will allow for a smooth adjustment of valuations to the reality of the economic fundamentals.

Despite all that the true bears would still remain unconvinced. The true bears are the QE haters. The people who believe that QE amounts to printing money and therefore would lead to very high inflation and who do not understand that QE only increases banks’ reserves at the Fed (see my post on that). These are the people who even think that hyper-inflation is already there only it shows in asset prices: somehow miraculously the “printed money” went into stocks without doing anything to the “real economy”. The true bears do not understand that the real effect of QE was in lowering interest rates and helping US banks and non-bank corporations clean their balance sheet and borrow cheaply on the bond market, locking in the low interest rates and preparing companies for increased capex when things improve. The true bears also do not understand that the real positive effects of QE is there to stay even after the rate hikes.

Investors should simply ignore them. True bears have been chanting the same song for five years. If one heeded their warnings one would have missed a great opportunity. If one listens to them now, further opportunities will be missed. True bears are the folk who will wait until 2016 to buys stocks. They will wait until it is absolutely clear that things are really going well. But by that time there might indeed be a market overhype and it might be “too late” to get in (whatever too late means).

In conclusion, let’s remind ourselves of the Wall Street lore: don’t fight the Fed! The Fed is intent on lifting the US economy and will stay on course until it is satisfied that the economy has gained escape velocity, there is just not other conceivable option. So putting geopolitical or other exogenous risks aside, the extraordinary monetary policy and US economic fundamentals are so correlated that it is a win-win situation for the US stock market: there will be either a strong recovery or prolonged loose monetary policy.

Disclaimer: the post should not be understood as advice to invest in US stocks. Markets are inherently risky and as the post notes there are numerous exogenous factors that may derail a recovery. 

Run on Bulgarian banks: currency peg is not a factor of stability, foreign exchange reserves and conservative balance sheets are

A CNBC video today suggested that the current run on the Bulgarian banks is a matter of pure sentiment and that this does not pose a threat to the banking system because Bulgaria is in the EU, its currency is pegged to the euro and its debt to GDP ratio is quite low compared to most developed countries (18%).

While indeed the banking system is in no danger, neither of the above arguments appear to be particularly convincing. Membership in the EU is a factor of political stability and an opportunity to tap into the huge EU market but that in itself does not guarantee banks’ stability. The fact that the Bulgarian currency is pegged to the euro is widely regarded as a factor of stability. The fixed exchange rate is a legacy of the 1996-97 hyperinflation in Bulgaria when it played the role of imposing discipline on the system which did arrest the runaway inflation. But fixing the exchange rate is a factor that also creates stress in the foreign exchange market which results from the efforts to maintain a fixed price while the market’s logic is pushing the price of foreign money constantly up and down. Finally, it is reassuring to have a low debt to GDP ratio, but again this as such does not indicate a stable banking system. By way of example, Iceland’s debt to GDP ratio just prior to its banking crisis was also low at 30%.

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Is the Fed “printing money”?

It is often said these days that quantitative easing (QE) amounts to printing money. Right after that the word ‘hyperinflation’ pops up. But is the Fed really “printing” money. Obviously the Fed is not physically printing dollar bills. Hardly anyone claims that. What exactly are the mechanics of QE then?

Under QE the Federal Reserve is buying government bonds and mortgage-backed securities from the banks (not just from any bank but from the so-called primary dealers) and is paying in return with deposits at the Fed (in fact at one of the Reserve Banks that make up the Fed). The deposits at the Fed are created out of the thin air. Their creation is a balance sheet expansion. The Fed creates these deposits by simply making an entry into the liabilities side of its balance sheet. The deposits at the Fed are a promise to pay paper dollar bills at the request of the banks. So from this point of view one may indeed say that the creation of deposits at the Fed is very close to actually physically printing bills. In practice, of course, only a fraction of the deposits at the Fed are converted into paper money. Generally this is not necessary because the Fed knows no limits of its power to expand its balance sheet and no one doubts its ability to print money on paper.

What is more interesting is to see what this increase of reserves at the Fed means for the banks which acquire them. Banks are required (in most countries by law and in some counties by the practical necessity to service their liabilities at the moment’s notice) to hold reserves at the central bank. These reserves must correspond to a minimum fraction of the deposits at the bank (these are private deposits of the bank’s clients and they are a liability of the bank). For instance if the reserve requirement is 10% and the bank has $2 million worth of reserves at the Fed it can hold private deposits worth a maximum of $20 million. Some people erroneously consider that banks collect money from the private sector and then put that money as a deposit at the Fed. The reality is exactly the opposite. The bank must have reserves at the Fed first (corresponding to the required fraction) in order to issue private deposits (this is an approximation as in reality the bank could first expand its balance sheet by adding a private deposit and obtain the Fed deposit later, but before settling with the Fed, which is not done every day, so that allows a certain gap).

To get back to the question, what exactly is the increasing of banks reserves at the Fed doing? Well, as the banks acquire additional reserves they correspondingly obtain the potential of issuing deposits or loans to the private sector. The potential is there but in a depressed economy there might not be many willing borrowers, businesses or consumers. So there is too much supply of the potential to create credit but too little demand for it. And so the price of credit, i.e. the interest rates, goes down.

The reality now is that even with the ultra low interest rates banks are accumulating record reserves at the Fed (currently US banks have $2.5 trillion dollars of excess reserves). And that is what a big chunk of the QE ‘money’ is doing – nothing. Is it then surprising that we have not seen hyperinflation?

[Added 30 May 2015] Now to be fair it has to be mentioned that the Fed bought a lot of the assets from asset managers and money market funds. This was done indirectly through the banks. Indeed the result of these purchases was that bank’s reserves at the Fed increased. But also asset managers and money market funds ended up with deposits at banks. So QE increased the money supply.

How much longer should shadow banks stay in the ‘shadows’

Shadow banking is a feature of the modern financial system that has started modestly some time in the 70s or 80s and which has grown immensely since then. It is estimated that in 2007-2008 shadow banking in the US accounted for more than 40% of financing of the ‘real economy’. Shadow banking’s importance thus grew significantly without however, being subject to much regulation and most importantly without being provided with access to a Federal Reserve backstop in case of crisis. It is not surprising then that the global financial crisis in 2008 originated in the shadow banking. Specifically, a chain of events, which otherwise could have led to a relatively benign downturn, set in motion a precipitous drop in asset prices that freezed the money markets and the financial system. Afoot was a run on the shadow banks.

First of all what are shadow banks? The term is used loosely to encompass a wide variety of non-bank financial entities but in this post we will designate as shadow banks mostly the ‘investment vehicles’ created by investment banks as a lending intermediaries between the money markets and market for packaged mortgages. Shadow banks borrowed short term from the Money Market Mutual Funds (MMMF) and lent long term on the capital market by buying residential mortgage-backed securities (RMBS), i.e. packaged mortgages. The particular variety of RMBSs used were called collateralised debt obligations (CDOs), relatively complex instruments, a feature often highlighted by commentators as the reason for the crisis. For the purposes of this narrative, though, that is not a crucial factor, except that their complexity rendered CDOs highly illiquid: they are opaque and not publicly traded.

The ‘shadow’ in the term shadow banks stands for their being off-balance sheet entities of the banks (called Structured Investment Vehicles or SIVs). In other words there is nothing inherently ‘shadowy’ or fishy about shadow banking, they are just not banks strictly speaking.

The ‘bank’ in the term shadow banks stands for short-term borrowing and long-term lending. This is what every bank is doing. Deposits in banks are liability of the banks, i.e. they borrow from their depositors. Depositors are said to be lending short-term to the banks because they can withdraw their deposits at any time. On the other side, banks are lending out to businesses or consumers for a fixed period of time, which is long-term (or at least certainly longer than deposits). In other words the maturities of banks’ borrowing and lending are not aligned in time. Banks are thus exposed to runs: depositors can claim their money back at any moment while the bank cannot claim repayment of the loans which have fixed periods (i.e. long-term by definition as compared to deposits). This business model is therefore inherently risky and can be potentially ‘deadly’ for the banks.

The shadow banks in 2008 did not have depositors. But they were financed by short-term borrowing form the MMMFs, typically three to six months loans which were rolled over (i.e. the loans are renewed/extended). However, the MMMFs had the possibility to claim their money back at maturity and refuse to roll over. The RMBSs on the other hand were 20-30 years mortgages. In other words the maturities of the borrowing and the lending of the shadow banks were not aligned in time. That is what made the ‘shadow banks’, banks.

What precipitated the crisis was initially a small drop in the value of the RMBSs, a drop of around 2%. That was sufficient to make the MMMFs nervous and decide to not roll over the financing of the shadow banks/SIVs. The losses were initially absorbed by the SIVs’ sponsors, the investment banks who created them, but the chain of events that was triggered by the initial drop proved to be unstoppable. As the shadow banks were in difficulty they started selling their RMBSs.

As already said, RMBSs were not very liquid, it was hard to find buyers. So SIVs started selling RMBSs at fire sale prices, i.e. at a steep discount. That in turn made the MMMFs even more nervous and they withdrew further their financing which in its turn prompted further selling of assets. This is a classic situation of a run on the banks that triggers a death spiral.

In the past runs on the banks were ordinary events. As is known, even if the trigger of the run is trivial and based on rumours or downright false information, once the run is afoot the only rational way to behave for depositors is to run as fast as possible and try to get their funds back before other depositors do so and deplete the bank’s reserves.

Nowadays runs on the banks are a rarity. This is partly due to the deposit insurance schemes but more importantly due to the central banks’ function of lenders of last resort. In times of crisis central banks ‘lend freely at a high interest rate against good collateral’. Central banks thus have the power to backstop a run, by simply expanding their balance sheets (this creates money out of the thin air). That is why nowadays runs rarely start and do not lead to bank bankruptcies if the troubled banks have sufficient assets to use as collateral.

It took centuries to figure out that banks need a central bank backstop. How much time will it take us to extend that to sound shadow banks and thus make them mainstream and safe feature of our financial system?

(to be continued)

Beginners’ mistakes in investing: finding the next big thing

One of the most prevalent mistakes among people who have limited knowledge about the stock market and companies is that they think the (only reasonable) way of making money is to find the next Google or Apple before anybody else. Without doubt this is an alluring proposition. If one bought a 50% stake in Apple before its IPO, by now that investment would amount to probably tens, if not hundreds of billions. Sounds so very easy!

But why is then the world not full of ordinary folk who bought such stakes and became filthy rich?

First, because there are tens of thousands of start ups and identifying the winners is devilishly hard. Warren Buffett likes to give the following example: Imagine that you lived in the early 20th century and you predicted that the car industry was going to grow astonishingly (as it indeed did) in the US and the also worldwide. Which company would you pick, given that there were around 2,000 car makers in the United Sates? Not easy to pick up a winner from the list. You might have had a much greater chance playing the casino than betting on the right car maker. Similarly, today the future of the biotech industry looks bright but there are scores of small biotech companies. Some of them are probably going to do extremely well but trying to predict which ones is more of a speculation than true investing.

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The S&P 500 closes at record 1900: is it just a bunch of overeager bulls that drive up the market

This Friday, 23 May 2014, the S&P 500 closed above 1900 for the first time ever. Yet this is a bull market that almost nobody loves. So, what is driving the US stock market up given that so many investors remain pessimistic and that valuations aren’t exactly cheap? This was in essence the question Julie Hyman of Bloomberg TV put to John Manley, funds chief equity strategists at Wells Fargo. He answered something like: it’s those investors that are most eager to buy stocks that push prices up.

This answer implies that the valuations are wrong. It’s just a small portion of the investors that are really ready to buy so expensively. The majority are not. Now that is undoubtedly true. However, this situation is not unique to 2014. This is how it has always been. At all times it is the investors most eager to buy stocks that drive the quotes that we see on stock exchanges. These prices obviously do not reflect the price that would prevail should all (or at least a significant part of the) investors decide to sell at once.

This view misses also another important point: the price goes up or down not only because of the most eager buyers but also because of the most eager sellers. The fact that stock prices move up goes to show that there aren’t enough eager sellers at the current price. Why? Is it not because the holders of the assets are fundamentally optimistic and consider that current valuations are not totally out of touch with reality and indeed worth holding still. That would seem to be the case. Which implies that the overall market is sufficiently optimistic, not just a fringe of over-eager bulls.