Tuesday, May 31, 2011

Richard Koo - Fiscal Consolidation Not the Answer

Richard Koo from Nomura talks about many topics.

Is the global monetary and fiscal tightening and FX-intervention impacting the global economy? Was it Japan that caused all this damage seeing in global industrial production? Or is it a combination of all factors?
Developed economies trying to blame others for austerity-induced economic weakness

It is extremely dangerous for the government to save more at a time when the private sector is also generating surplus savings in spite of zero interest rates. Yet that is just what the Obama administration and most of the other G8 members are doing, to a greater or lesser extent.

Moreover, domestic political considerations prevent them from admitting that it is their own policies that may be causing the slowdown. Their statements focus largely on external factors, such as rising oil prices or the slowdown in China’s economy.

Inasmuch as the G8 nations are unlikely to adopt the right kinds of policies as long as their leaders are attributing recessions (or the risk thereof) to overseas factors, I think Western economies could well enter a slowdown before China. In any case, we need to closely monitor the possibility of an economic downturn in these nations.

When speaking about Japan and its 20-year low-growth path and all the people who got the higher-rates-bet on the wrong side he cites those were 'based solely on the size of the deficits involved'.

With Moody's putting the Japanese Government-Debt Ratings Under Review and Fitch also with Japaland on negative outlook how will the 'higher rates' trade play out?

I guess the missing point here is inflation. Yes, without inflation people will keep buying 10yr JGBs at 1.20%.
But how will inflation be generated in Japan? This would make savings go into another direction instead of JGB purchases.

Perhaps this is THE question to ask. How will inflation be generated in Japan?
And I have been thinking that there should be, perhaps, more deflation before inflation kicks in.

So it will be interesting to see whether this will happen.
In 2009 yields dropped to around 1.05%.
In 2010, even with the european sovereign issues, yields dropped to 0.90%.
Recently yields have peaked at around 1.40% and are now down to 1.20%.

In case there IS another leg down in economic growth and risky-assets where would the 10yr JPY Swap go to?
I'm not sure, but if it dips lower and lower I would be an eager buyer of more out-of-the-money JPY swaption payers.

Economic issues (unemployment) would cause a dip into savings and reduce demand for bonds. That would be one, but at the same time in conflict with demand, so inflation shouldn't be an issue.

But economic issues could bring a bout of federal fiscual stimulus: monetization, money printing, JPY devaluation (with a positive current account?! Not if there's another severe economic downturn), therefore inflation?

Considering this bet is against one of the largest economies in the world and that all the OTHER economies wouldn't like to see a collapse in Japan what are the odds of this happening? 1%, 2%, 5%, 10%

A 4% 3y10y JPY Swaption payer costs around 90-100bps (for 9.xx duration swap, so about 10bps against the swap strike). And the volatility is considerably lower than in OTM EUR or USD swaptions. For a 3 year play. Is the risk-reward worth it? If yields go to 2.50% volatility would sky rocket with a lot of volatility-sellers scrambling to cover.

Comparisons of fiscal deficits with personal financial assets are meaningless

Because Japan’s fiscal expenditures have been financed by corporate savings and not household savings, it is meaningless to argue over what percentage of household financial assets the national debt represents. As I have argued previously, we must persuade businesses to begin borrowing again if we want to reduce these fiscal deficits. If the government stops borrowing at a time when neither households nor businesses are taking out new loans, the Japanese economy may weaken once again, as noted above.

Fiscal deficits during a balance sheet recession caused by an emergence of unborrowed private savings are fundamentally different from those rooted in fiscal profligacy in that, in the former, there are more than sufficient domestic savings to finance the deficits. With no private-sector borrowers left, these savings have nowhere to go but the government, the last borrower standing.

That is why fiscal deficits during balance sheet recessions do not lead to high interest rates, and why the massive budget deficits seen in the US and the UK have not pushed government bond yields higher. This phenomenon of a private savings surplus at a time of zero interest rates is a salient feature of all balance sheet recessions. Yet people who do not understand this have been predicting a rise in interest rates for the last 20 years based solely on the size of the deficits involved.

JGB yields continued to fall in spite of a national debt of more than 200% of GDP because the surplus of private savings grew even faster than the national debt. This dramatic increase in the private savings surplus was observed again following the Lehman-induced financial crisis and—although the statistics are not yet available—most likely after the recent earthquake as well.

2011 05 31 - Nomura - Richard Koo - Fiscal Consolidation Not the Answer

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

No comments:

Post a Comment