My 2cents on a piece by Jefferies' David Zervos I received today.
Maybe I understood his words wrongly. Maybe I am biased.
*** PIECE AT END ***
Zervos has been spot-on regarding risk-on and playing the
Bernanke-Put. No doubt about that.
And I accept/agree with most topics touched below.
One thing that gets me to scratch-head is that markets
are indeed pricing in "higher real risk-free rates of return", but
not because the animal spirits are going to get people into investing, or into
believing in growth-escape-velocity and subsequent decrease in debt/GDP (in US
it's been +45% debt for +11% GDP growth I think, speaking of
'debt-deleveraging...) producing, then, higher nominal cash flows. We're
currently borrowing from future growth as proven by the decreasing marginal
utility of debt (transformed into growth).
So...
A/ As market-prices rise for financial and hard assets
with a
1/// stable stream of Cash
Flow (equities, bonds [sovvies or corporate]) and
2/// a discount factor (time
+ real-yields), you're actually reducing the scope for higher REAL returns.
That's simple arithmetic.
B/ risk-free Bond Yields can't move higher... and here is
where I think Zervos is wrong.
Ask around what everyone
would do, at least temporarily before proven otherwise, if a Bloomberg HOT headline
printed "the Fed, the ECB, the BoJ and the BOE decide to end their
monetary stimuli".
I am pretty confident that
everyone would get the hell out of pretty much most assets they've been holding
onto.
And that could make
financial asset prices to go lower, likely much lower, and cause...
debt-deflation.
With inflation expectations becoming increasingly
negative you can, then, be long "risk-free government bonds", and
actually have a "higher risk-free real return". Welcome to deflation
(like in 2009).
So the conclusion could be that, financial repression
pushed people into risky-assets because they have no alternatives. Herd
behavior, scarcity of good assets.
While QEs remain in place and until nominal growth
disappears, keeping nominal cash flows positive and stable, people will remain
long carry, chasing yields.
Here are 2 charts I keep in a drawer nearby to remind me
that whatever doesn't have positive carry (read commodities, Ibovespa x CDI are
examples) shouldn't be bought, but sold on rallies.
Then you drill down to what are the best risk-adjusted
carries in the world.. and the answer is "what has stable, preferably
rising, carry and denominated in the currencies that have ongoing powerful QE
programs, but with a currency hedge, if hedging has very low carry against it
to your desirable currency.
That gets you to:
// USD: US Equities, Treasuries, Corp bonds
// EUR: German is the risk-free here, so German equities
and Bonds
// GBP: same…
// JPY: now, after finally reverting the
currency-appreciation due to the enormous stock of assets in foreign currency
(said to be 55% of GDP) flooding Japan after each shock, so that pension and
insurance companies could cover their deficits without selling JGBs, the Nikkei
and JGBs are making new highs…
// CHF: the Swiss Market Index and swiss sovvies.
These all posted new near-term and close to all-time or
multiple-year highs in local currency.
While the rest of EM/Commodities start taking a tumble starting
in 2010/2011/2012, saturated by foreign capital that made real estate prices
higher, inflation higher, but now with much higher currencies in real effective
terms (terms of trade…) and unable to keep expanding at the rate it did in the
past 10-15-20 years now, so multiples used for equities for example, can't be as high either. The SuperCycle, in my opinion, has ended. Time to get some of that BoP surplus back to where it came from.
Charts:
The first chart is from Bridgewater. Basically the
component break-down of Global Equity Returns into a/ growth in cash flows and
b/ the reduction in the discount factor of these cash flows. Basically real-yields dropped, causing the net-present-value of these
no-growth-cash-flows to soar.
The second chart is from Kyle Bass’s Hayman letter. It
shows the marginal utility of debt through time, since the end of WWI.
I might be wrong. But for now this is how I view things.
Thoughts are welcome.
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David Zervos - Risky real rates vs risk free real rates
Ok, I am going to be a bit of a geek today. So no
Breaking Bad, Colonel Jessup or Charlie Sheen references. Sorry to disappoint
but there are some serious changes under way in market correlation patterns.
And these need to be addressed.
Specifically, the USD is strengthening sharply as seen in
the near 4 big figure move in DXY over the last 6 weeks. The last time we saw a
dollar move like this was in late spring/early summer of 2012. Back then, spoos
dropped 10 percent and the entire global risk asset complex was rinsed. As was
typical in post crisis markets, European problems were to blame for this flight
to the dollar and away from risk. It was the Greek election and Spanish banks
that had everyone corybantic at that time. But just like in all other
"flare-ups", Ben and Janet rode to the rescue dragging the ECB along
for the ride.
I remember writing some fun commentaries at that
time - "Black Swan Down - Viva La Espana", "Germany Loses,
Spoos Win", "The Committee to Save the World - Part Deux",
"A New Euro/Spoo Correlation Coming"....etc etc. Those surely were
good times - there is really nothing more enjoyable for me than writing a solid
BTD commentary as markets swoon. Anyway, as the central bank policy measures
kicked in and the pressure from Europe dissipated, the DXY dropped and risk
assets gained traction. That was the boiler plate post 2008/2009 crisis
market correlation pattern!
But as we fast forward to the current situation, EURUSD
is dropping towards 1.30, USDJPY is pushing through 96 and the dollar is even
beating up on CAD and AUD. At the same time we are printing record highs in the
Dow, while Gold is weak and many of the once venerable developing markets (ie
BRICs) are struggling. What explains this NEW pattern in global markets? Strong
dollar/ strong risk-assets/weak gold/weak EM is not something that associates
well with our post-crisis world - in good times or in bad times. Its a pattern
from the old days of "new paradigms" and "goldilocks". Has
Ben reawakened the ghost of goldilocks or the productivity miracle?
To answer these questions let's go back to our basic
storyline from the last 3 years. In nearly every commentary I have written
since I joined Jefferies, I have argued that global central bank balance sheet
expansion would not stop until we achieved a fully fledged GLOBAL reflationary
outcome. In turn, I postulated that these actions would lead to rising long
term inflation risks, falling risk free real yields, a reduction in the real
value of fixed income assets and an increase in the value of real
(non-printable) assets. And while it took some time to get all the central
banks on board, we have basically arrived at the realization of this view.
We now have a world where ALL developed market central
banks, led by the Ben, are engaged in balance sheet expansion, reserve creation
and money printing.
Expected risk free real rates are plummeting across
developed markets and inflation expectations are rising. These economies are avoiding
a dreaded debt deflation spiral and are instead generating domestic
reflationary recoveries.
The monetary policy makers are all in essence relying on
the portfolio balance channel to force savers/investors out of financially
repressed risk free assets and into the world of risky investing. And while the
long term returns to these risky investments remains highly uncertain, the
market appears to be turning a corner on the expected gains from this risk
taking - at least in the US. It is precisely this "exuberant"
expectational shift in US that is driving our new correlation pattern between
the DXY, Equities, Gold and EM.
Let me elaborate - the variable that best explains this
NEW correlation patterns is the expected real rate of return for risky investments
in the US. A rise in what I will call the "risky" real rate
represents a turn in animal spirits, a jump in investing optimism, and the
destruction of deflationary forces. And it represents the expectational seeds
of a REAL US recovery.
Of course it is very important to make sure we do not
confuse this expected "risky" real rate with the expected risk free
real rate. The latter of course is in complete control of the Fed at least in
the short run. They can drive the short term risk free real rate at will given
that short term inflation is sticky and they control nominal short rates. In
fact, I would argue that they even have quite a lot of control over the
expected long run risk free real rate - which is just a weighted average of expected future
short term risk free real rates. With the use of forward looking language and
the balance sheet, the Fed is actually able to drive both the risk free nominal
and real yield curves wherever they like (in the limit they can always buy up
all the 10yr notes and 10yr Tips and set both rates).
In any case, having the central bank manipulate the risk
free term structure of interest rates does NOT ensure that real returns are
generated from actual investment in real economic activity. Nor does it ensure
that we get real growth. In the old days we used to debate the neutrality of
monetary policy aggressively. I was brought up reading Sargent and Wallace,
Brunner and Meltzer, and McCallum. Their basic argument was that monetary
policy had little long run impact on real variables. Of course that breaks down
as the Fed steps in to alter both short run and long run real risk free rates.
It is the movements in these variables that enables the effective transmission
of policy from the monetary side to the real side. As our central banks drive
risk free real rates lower and lower, and force financial repression into the
system, they also force risk taking. The central banks change our incentives to
invest in the private sector, but importantly, they do not themselves ever directly
generate any real investment activity.
However, to the extent that there is some market failure,
changing these incentives, and forcing us to take risk can lead to a better
outcome for real investment returns and hence growth. This is where the long term
money neutrality arguments really break down. It's actually a situation akin to
the old collective action problems that have been studied for decades by game
theorists. If our incentives to take risk are beaten down after a big crisis -
and everyone is in hoarding mode - there will be no growth and no incentive for
any one person to be entrepreneurial. But if we become incentivised/forced to
take risk via financial repression, then we could achieve a higher equilibrium
real growth outcome as everyone joins in the risk taking activity. That's the
power of collective action and that's the transmission mechanism. Monetary
policy stokes the animal spirits that revive real economic growth. Ben and his
disciples are simply trying to solve our post crisis collective action problem
and thereby get us to a better equilibrium with higher real growth. Their tool
is the term structure of risk free real rates - which is being lowered
aggressively. By taking that down, and incentivizing risk taking, they are
driving long-run expected real returns on risky investments HIGHER. Those
higher expected risky real rates then drive the dollar stronger, equities
stronger, gold lower and EM weaker. Et voila! I warned you I was going to get
geeky today so don't be shocked. And wait there's more!!
Going forward we need to be very careful about the
delineation between long run risk free real rates and long run risky real
rates. After reading Ben's speech in San Francisco from March 1st on why long
term (risk free) rates are so low, it is clear that he fails to make this
distinction. He is talking about how markets have low expectations for long run
real returns to investment. That is patently false! Decomposing a highly
manipulated risk free rate term structure into real, inflationary and term
premium components is NOT going to give you any information about market
participants view of the long run expected real returns to risky investing.
Rather, it will tell you what market participants think about the path for
expected risk free real rates - or more specifically the Fed policy reaction
function since they set them.
To repeat, because this is very controversial and very
important, the current term structure of Treasury rates tells you virtually
NOTHING about market participants view on long term returns to risky investment
activity. Why are long term nominal rates so low is Ben's question? Because of
him is the answer!
The Fed reaction function, the Bernanke Put, the
Greenspan Put, the Yellen put are all drivers of the long run outlook for risk
free real and nominal rates.
Actually, I just dug out a presentation I made in 2006 at
a MacroAdvisors conference that tried to make this point in a completely
different era. I will send it out shortly, but even 7 years later the arguments
are the same. Back then we were all talking about the conundrum and low rates.
And today, Ben is still asking why risk free rates are so low. He suggests that
market participants have low expectations for real returns on real investment.
Pulllease - the Dow is at a record high, that is just
plain wrong. The current structure of the monetary policy reaction function is
the driver of these risk free rate structures. That's what I argued back in
2006, and I stand by that view today. The consistent exercising of the Bernanke
Put is the reason why the risk free real and nominal term structures are so
low. And the only transmission of these low rates to the real economy comes
from the mechanism described above where we have a breakdown in animal spirits
and collective action problem that requires a change in private sector
incentives.
Here is the bottom line - by lowering the term structure
of risk free real rates, Ben is INCREASING the term structure of risky real
rates. And these higher real rates (the ones that really matter) get us to a
world with higher equity valuations, a higher DXY, lower Gold and weaker EM. So
in essence - by lowering risk free real rates and forcing risk taking we are
moving down the path to a REAL recovery. Incentivizing risk taking solves a
traditional post crisis market failure where no one wants to take any risk. The
rise in the risky real rate basically represents the portfolio balance channel
at work.
There is of course always a risk that long term inflation
expectations come unglued in the future, and that real returns to these risky
investments turn sour. We should always keep in mind that these aggressive
balance sheet expansion policies are highly experimental - and therefore they
create material future risks to price stability. But markets show no sign of
such worries now.
And it will be a long ways down the road before we have
to think about the potential for a stagflationary outcome. Today we can
celebrate a US market that has crossed the rubicon into strong and POSTIVE
risky real rate expectations.
