Yesterday Greece sold 5 billion euros worth of 7-year bonds via syndication. The deal priced at mid-swaps plus 310 basis points to yield 6%, a level double what Germany would pay to borrow at the same tenure. The bid-to-cover ratio was only 1.4, compared to more than 3 for Greece's 5-year, 5 billion euro auction held on 4 March. Foreigners bought 57% of this deal, versus 77% in the aforementioned 5-year offering.
While the jury is out to some extent (see linked story), the perception around my office was that this syndication went quite poorly, especially considering that issue's yield widened 24 basis points in the secondary market today. Additionally, today there was an unannounced reopening of the Greek 12-year of up to 1 billion euros, which only managed to attract 390 million euros in orders. Unsurprisingly, Greek CDS spreads were wider on the day.
Many people were looking to the 7-year auction as a gauge of markets' perception of the EU plan for offering financial assistance to Greece. Some of the finer details still need some fleshing out, but broadly, there is to be a pool of 20-22 billion euros available from the EU and the IMF (providing 2/3 and 1/3 respectively) for Greece to tap in the situation that it cannot raise funds via the private market. While an effective bridge for any short-term financing issues, this does nothing to address the fact that if Greece continues refinancing in the private markets at 6%, they will end up be paying more than 7% of GDP in interest payments alone. Does anyone else see a dizzying debt spiral? See my previous post for a longer discussion of what constitutes sustainable a debt burden. Also, perhaps the ability of any euro zone country (read: Germany) to veto any potential action removes some of this bill's legitimacy?
Regardless of what aspect(s) of the bill the market did not like, this auction shows that investors are still very skeptical of Greece's ability to right the ship - arguably more so than in early March (the time of the preceding, better received syndication). Greece has a tough slog ahead of them if they are to avoid default. I am generally an optimist, but the realist in me is saying that Greece doesn't have what it takes.
Tuesday, March 30, 2010
Monday, March 29, 2010
Jeremy Grantham Weighs In on Where We Stand and What is to Come
I recognize Jeremy Grantham as a very intelligent person, and always take time to ruminate on his opinions at considerable length. Although not quite headline news any more, as it was released in January, GMO's Quarterly Letter is definitely worth a read. Mr. Grantham speaks highly of the re-emergence of Volcker in the regulation debate, and very lowly of the Supreme Court ruling to remove caps on corporate political donations (ironically, in defense of free speech - who are they kidding?). But I digress.
Given that his publication marked the turn of the decade, Mr. Grantham offered his opinions on what the coming decade had in store, as well as reviewing his firm's predictions over the last decade. Looking forward, Mr. Grantham is not particularly optimistic:
"I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s."
Broadly, I agree with this forecast, which is quite similar to that of Mr. El-Erian of PIMCO (more on Mr. El-Erian in some other post). Admittedly, the conclusions of his analysis are not particularly novel. However, I consider the following observations particularly astute.
"Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third goaround in the bubble forming and breaking business. Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which
is supremely dangerous this time because its arsenal now is almost empty." (Grantham's emphasis)
As far as I am concerned, it is this insight which should be the crux of any policy debate moving forward. There really is no room for error moving forward. In "This Time is Different", Reinhart and Rogoff calculated that government debt expands 86% in the 3 years following a domestic banking crisis. Assuming history is any guide (a classic folly, but current deficit figures are mind-numbing, lending support to Reinhart and Rogoff's findings) this implies that there won't be any more room on the government balance sheets to bear the costs of any further crises. The Fed's balance sheet stands at $2.4 trillion. How much larger can it realistically get without threatening the government's financial integrity? While there are strong arguments for extreme monetary stimulus, every meeting the Fed decides to hold off on raising rates, they increase the probability of inflating another asset bubble. This has the effect of inching the global economy (back) towards the precipice through the heightened risk of future asset bubbles, while simultaneously hauling it from the brink via extremely accommodative monetary policy. Are the benefits of loose monetary policy worth the risk of catastrophe in the form of another ugly asset bubble? I cannot claim to have this grand calculus mastered, but I sure would like to hear this question being asked a little more often.
Back to Grantham's piece. From this discussion, he ruminates on where investors may find value in the coming decade, as well as reviewing his calls from the end of 1999, which are amazingly accurate. For those who don't have time to read it, he considers the S&P 500 to be worth something around 850 (keep in mind that this was published in January and therefore this figure may have changed). Definitely worth the half hour it will take to read the report in its entirety.
Given that his publication marked the turn of the decade, Mr. Grantham offered his opinions on what the coming decade had in store, as well as reviewing his firm's predictions over the last decade. Looking forward, Mr. Grantham is not particularly optimistic:
"I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s."
Broadly, I agree with this forecast, which is quite similar to that of Mr. El-Erian of PIMCO (more on Mr. El-Erian in some other post). Admittedly, the conclusions of his analysis are not particularly novel. However, I consider the following observations particularly astute.
"Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third goaround in the bubble forming and breaking business. Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which
is supremely dangerous this time because its arsenal now is almost empty." (Grantham's emphasis)
As far as I am concerned, it is this insight which should be the crux of any policy debate moving forward. There really is no room for error moving forward. In "This Time is Different", Reinhart and Rogoff calculated that government debt expands 86% in the 3 years following a domestic banking crisis. Assuming history is any guide (a classic folly, but current deficit figures are mind-numbing, lending support to Reinhart and Rogoff's findings) this implies that there won't be any more room on the government balance sheets to bear the costs of any further crises. The Fed's balance sheet stands at $2.4 trillion. How much larger can it realistically get without threatening the government's financial integrity? While there are strong arguments for extreme monetary stimulus, every meeting the Fed decides to hold off on raising rates, they increase the probability of inflating another asset bubble. This has the effect of inching the global economy (back) towards the precipice through the heightened risk of future asset bubbles, while simultaneously hauling it from the brink via extremely accommodative monetary policy. Are the benefits of loose monetary policy worth the risk of catastrophe in the form of another ugly asset bubble? I cannot claim to have this grand calculus mastered, but I sure would like to hear this question being asked a little more often.
Back to Grantham's piece. From this discussion, he ruminates on where investors may find value in the coming decade, as well as reviewing his calls from the end of 1999, which are amazingly accurate. For those who don't have time to read it, he considers the S&P 500 to be worth something around 850 (keep in mind that this was published in January and therefore this figure may have changed). Definitely worth the half hour it will take to read the report in its entirety.
Sunday, March 28, 2010
About Time Somebody Stood up to China
I have long been quite critical of Western nations' unwillingness to stand up to China. Whether it's currency manipulation, domestic human rights abuses, providing diplomatic and financial support for brutal regimes, environmental degradation, domestic political repression, or an unwillingess to back tougher sanctions on Iran at the UN Security Council, no one seems willing to make any meaningful statements backed up by any action. To be honest, I am not sure what exactly I looking for, but the lack of backbone that Western countries have displayed in their dealings with China has been cause for shame.
Well finally somebody has had enough of China's shenanigans. In January, Google reported that they had been the target of a cyber-attack which targeted primarily the Gmail accounts of Chinese human rights activists. Unsurprisingly, China flatly denied the claims. After negotiations failed (what exactly were they negotiating?), Google decided enough was enough and announced that, with the intention of providing Chinese users with uncensored search results (something they could not provide at Google.cn), they were redirecting visitors to Google.cn to the uncensored Google.com.hk (Google's Hong Kong based site). This strikes me as a major loss of face for China and I am sure that they Chinese government will be doing everything they can from this point forward to make Google's operations a nightmare. I however, applaud Google for standing up to China, and it appears that Google is not alone. GoDaddy has also recently announced that, in response to cyber-attacks launched from China, they will no longer be registering new domain names in China. Anyone arguing that the timing of this announcement is merely coincidental has a tough sell. It seems quite likely that this is a statement of solidarity with Google. Here's to hoping that other firms follow suit, perhaps forcing China to think twice before applying their usual bull tactics.
Well finally somebody has had enough of China's shenanigans. In January, Google reported that they had been the target of a cyber-attack which targeted primarily the Gmail accounts of Chinese human rights activists. Unsurprisingly, China flatly denied the claims. After negotiations failed (what exactly were they negotiating?), Google decided enough was enough and announced that, with the intention of providing Chinese users with uncensored search results (something they could not provide at Google.cn), they were redirecting visitors to Google.cn to the uncensored Google.com.hk (Google's Hong Kong based site). This strikes me as a major loss of face for China and I am sure that they Chinese government will be doing everything they can from this point forward to make Google's operations a nightmare. I however, applaud Google for standing up to China, and it appears that Google is not alone. GoDaddy has also recently announced that, in response to cyber-attacks launched from China, they will no longer be registering new domain names in China. Anyone arguing that the timing of this announcement is merely coincidental has a tough sell. It seems quite likely that this is a statement of solidarity with Google. Here's to hoping that other firms follow suit, perhaps forcing China to think twice before applying their usual bull tactics.
Wednesday, March 24, 2010
Fed Paper on Asset Purchases
The Federal Reserve recently published a noteworthy paper on the Large Scale Asset Purchase (LSAP) programs. A little background: when the Federal Reserve reach the effective lower bound of traditional monetary policy in December 2008 (Fed Funds rate between 0 and 25 basis points), they had a strong conviction that the economy was in need of more stimulus than the ultra-low Fed Funds rate was providing. Specifically, Fed staffers were looking to lower long term borrowing rates, a goal which cannot be achieved by manipulating the short end of the yield curve. This forced the Fed to resort to unconventional monetary policy. The desired effects were ultimately obtained through 3 LSAPs which, combined, totaled over $1.7 trillion. The purchases were divided as follows: (1) $300 billion worth of Treasuries concentrated in the 2-10 year term (2) $175 billion in agency debt and (3) $1.25 trillion in agency mortgage backed securities. As the latter two of these facilities are scheduled to wind down at the end of the month (the Treasury purchase program ended in October) the Fed published a timely paper discussing the execution and cumulative impact of the LSAPs on long term interest rates.
The Fed figures that the impact of their purchases were twofold. Initially, most of the impact can be attributed to increased liquidity in the targeted markets, thereby reducing the enormous liquidity premiums present in these markets in early 2009. The second impact was what they termed the "portfolio effect", the mechanics of which are essentially as follows: by purchasing such an enormous volume of securities currently held on private balance sheets, the supply of said securities is meaningfully reduced, increasing their price and reducing their yields. The purchases also create more reserves in the system, and force investors to turn to other markets in the search for yield, thereby bringing down interests rates (and borrowing costs) in a wide cross-section of markets. The sheer size of these purchases is put in perspective as
"22 percent of the $7.7 trillion stock of longer-term agency debt, fixed-rate agency MBS and Treasury securities outstanding at the beginning of the LSAPs...We believe that no investor - public or private - has ever accumulated such a large amount of securities in such a short period of time"
I had not given it much consideration, but I was quite surprised by how large this proportion was. Armed with this knowledge, I am (even) more willing to accept the conclusions of the study. The qualitative discussion is brought to a close with the statement that, as a result of the portfolio effect, "the winding down of LSAPs need not cause a meaningful rise in market interest rates". In other words, the effects of these programs are seen as largely permanent (a point of much contention in the markets) by the Fed.
Also included are number of statistical analyses (primarily event studies) designed to determine the cumulative impact of the operations on long term yields. A number of classes of securities are examined. The results are as follows (for the baseline 8-event set): 2y Treasury, -34 basis points (bps); 10y Treasury, -91 bps; 10y agency debt, -156 bps; Agency MBS, -113 bps; 10y term premium, -71 bps; 10y swap, -101 bps; Baa index, -67 bps. I was not surprised by the conclusions of their study - in fact I fully agree - but proving it statistically is no enviable task. There is just too much noise. All told, the discussion preceding the statistical analysis, as well as the charts (two of which are below) are definitely worth a read. The statistical analysis, on the other hand, was a bit of a slog.
The Fed figures that the impact of their purchases were twofold. Initially, most of the impact can be attributed to increased liquidity in the targeted markets, thereby reducing the enormous liquidity premiums present in these markets in early 2009. The second impact was what they termed the "portfolio effect", the mechanics of which are essentially as follows: by purchasing such an enormous volume of securities currently held on private balance sheets, the supply of said securities is meaningfully reduced, increasing their price and reducing their yields. The purchases also create more reserves in the system, and force investors to turn to other markets in the search for yield, thereby bringing down interests rates (and borrowing costs) in a wide cross-section of markets. The sheer size of these purchases is put in perspective as
"22 percent of the $7.7 trillion stock of longer-term agency debt, fixed-rate agency MBS and Treasury securities outstanding at the beginning of the LSAPs...We believe that no investor - public or private - has ever accumulated such a large amount of securities in such a short period of time"
I had not given it much consideration, but I was quite surprised by how large this proportion was. Armed with this knowledge, I am (even) more willing to accept the conclusions of the study. The qualitative discussion is brought to a close with the statement that, as a result of the portfolio effect, "the winding down of LSAPs need not cause a meaningful rise in market interest rates". In other words, the effects of these programs are seen as largely permanent (a point of much contention in the markets) by the Fed.
Also included are number of statistical analyses (primarily event studies) designed to determine the cumulative impact of the operations on long term yields. A number of classes of securities are examined. The results are as follows (for the baseline 8-event set): 2y Treasury, -34 basis points (bps); 10y Treasury, -91 bps; 10y agency debt, -156 bps; Agency MBS, -113 bps; 10y term premium, -71 bps; 10y swap, -101 bps; Baa index, -67 bps. I was not surprised by the conclusions of their study - in fact I fully agree - but proving it statistically is no enviable task. There is just too much noise. All told, the discussion preceding the statistical analysis, as well as the charts (two of which are below) are definitely worth a read. The statistical analysis, on the other hand, was a bit of a slog.
Tuesday, March 23, 2010
Great SocGen Piece on Sovereign Debt
Okay, I know I am a little late to the party when it comes to discussing sovereign debt, but I read an article a while back that really struck a cord and I thought should be shared. Fear not, I am not here to rattle off a bunch of platitudes about the causes of and potential solutions to the situation in Greece. What I want to discuss is an excellent piece from SocGen's Popular Delusions series which honestly examines the bigger picture, specifically, western countries' sovereign debt situations.
The authors begin with an examination of people's (and governments') tendency to put off tough decisions and responsible action "for later", within the context of irresponsible government spending. The discussion then transitions to an examination of government off-balance sheet obligations, before moving to the arithmetic of sustainable government debt. Summarizing the (extensive) literature on the topic, the authors assert that "maintaining a stable debt to GDP ratio requires governments to run a primary balance [surplus before interest] proportionate to the difference between interest rates and GDP growth" - a rule of thumb so logical it is irrefutable. This rule is applied to various countries' debt situations based on the very conservative assumption that current costs of financing will persist in the future. Their findings are summarized in the following bar chart.
For those with a thorough knowledge of governments' recent fiscal histories, this graph is all that is necessary to differentiate the sinners from the saints. For those not as familiar with this history, the next chart summarizes it nicely for you.
Putting the two together is the real show-stopper...
This series of charts make it clear that a number of countries in the West (and Japan) have a lot of fiscal consolidation to do in the coming years - not a particularly original insightful. Now consider what will happen when this year's deficits are added to the governments' respective mountains of debt and government funding costs tick upward as monetary policy tightens - whenever that may be. If a host of countries couldn't get their finances in line over the last decade, what is there to make us believe that they will be able to do so in the "New Normal" economic environment of high unemployment and sluggish growth? Hope may spring eternal, but the latest CBO baseline forecast - and its analogues from other developed countries - aren't cause for much optimism.
The entire SocGen report is definitely worth the 20 minutes.
The authors begin with an examination of people's (and governments') tendency to put off tough decisions and responsible action "for later", within the context of irresponsible government spending. The discussion then transitions to an examination of government off-balance sheet obligations, before moving to the arithmetic of sustainable government debt. Summarizing the (extensive) literature on the topic, the authors assert that "maintaining a stable debt to GDP ratio requires governments to run a primary balance [surplus before interest] proportionate to the difference between interest rates and GDP growth" - a rule of thumb so logical it is irrefutable. This rule is applied to various countries' debt situations based on the very conservative assumption that current costs of financing will persist in the future. Their findings are summarized in the following bar chart.
The entire SocGen report is definitely worth the 20 minutes.
Friday, March 19, 2010
Bank of Canada's Next Move?
Lately there has been a slew of good economic data out of Canada. Employment, retail sales, housing starts, you name it, they have all beat expectations this month.
This trend continued today with some surprising CPI data. Core CPI came in at 2.1% versus expectations of 1.7%. For those of you not fully in touch with what's going on up North, allow me to fill you in. On 21 April 2009 the Bank of Canada (BoC) reduced the overnight rate to the effective lower bound of .25% and pledged to keep it there until the end of Q2 2010, "conditional on the outlook for inflation". The BoC also effectively put their money where their mouth was by "rolling over a portion of its existing stock of one- and three-month term Purchase and Resale Agreements (PRAs) into six- and twelve-month terms at minimum and maximum bid rates that correspond to the target rate and the Bank Rate, respectively." Since then, at each Fixed Announcement Date (FAD), the same (now tiresome) message has been repeated. To paraphrase somewhat, it is as follows: 'the outloook for inflation remains steady, therefore we aren't going to hike until the end of Q2 2009, conditional on the outlook for inflation.'
Well, now the game has changed. In their quarterly Monetary Policy Report, published in January, the BoC forecast core inflation to average 1.6% in Q1 and 1.7% in Q2. If this were to materialize, it was implicit that rates would stay on hold. With core CPI in January coming in at 2% and now a 2.1% print in February, this forecast is beginning to look sanguine. The BoC shrugged off higher than expected inflation in their press release after the FAD on 2 March, stating that it was "the result of both transitory factors and the higher level of economic activity". With inflation being more sticky than expected and the next FAD scheduled for 21 April, there should be some vigorous debate behind closed doors at the BoC over the next few weeks. Governor Mark Carney (formerly of Goldman Sachs for all you conspiracy theorists out there) holds the veto at FADs. He is highly regarded in Canada for his handling of the crisis and is surely aware that a lot of the BoC's credibility rests on the right decision on 21 April.
Addendum:
The BoC has repeatedly fingered the strengthening Canadian dollar as a downside risk to inflation. Ironically, traders have been bidding up the Canadian dollar of late in expectation of a rate hike by the BoC. If this momentum trade continues, the feedback on inflation could provide Governor Carney the inflation data necessary to eschew the very rate hike that said traders are looking for.
This trend continued today with some surprising CPI data. Core CPI came in at 2.1% versus expectations of 1.7%. For those of you not fully in touch with what's going on up North, allow me to fill you in. On 21 April 2009 the Bank of Canada (BoC) reduced the overnight rate to the effective lower bound of .25% and pledged to keep it there until the end of Q2 2010, "conditional on the outlook for inflation". The BoC also effectively put their money where their mouth was by "rolling over a portion of its existing stock of one- and three-month term Purchase and Resale Agreements (PRAs) into six- and twelve-month terms at minimum and maximum bid rates that correspond to the target rate and the Bank Rate, respectively." Since then, at each Fixed Announcement Date (FAD), the same (now tiresome) message has been repeated. To paraphrase somewhat, it is as follows: 'the outloook for inflation remains steady, therefore we aren't going to hike until the end of Q2 2009, conditional on the outlook for inflation.'
Well, now the game has changed. In their quarterly Monetary Policy Report, published in January, the BoC forecast core inflation to average 1.6% in Q1 and 1.7% in Q2. If this were to materialize, it was implicit that rates would stay on hold. With core CPI in January coming in at 2% and now a 2.1% print in February, this forecast is beginning to look sanguine. The BoC shrugged off higher than expected inflation in their press release after the FAD on 2 March, stating that it was "the result of both transitory factors and the higher level of economic activity". With inflation being more sticky than expected and the next FAD scheduled for 21 April, there should be some vigorous debate behind closed doors at the BoC over the next few weeks. Governor Mark Carney (formerly of Goldman Sachs for all you conspiracy theorists out there) holds the veto at FADs. He is highly regarded in Canada for his handling of the crisis and is surely aware that a lot of the BoC's credibility rests on the right decision on 21 April.
Addendum:
The BoC has repeatedly fingered the strengthening Canadian dollar as a downside risk to inflation. Ironically, traders have been bidding up the Canadian dollar of late in expectation of a rate hike by the BoC. If this momentum trade continues, the feedback on inflation could provide Governor Carney the inflation data necessary to eschew the very rate hike that said traders are looking for.
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