Wednesday, September 10, 2014

Central Bank Induced Market Distortion Goes Bananas

by Pater Tenebrarum

“Conjuring Profits From Sub-Zero Yields”

The above is the title of the recent Bloomberg article that discusses the ECB’s penalty rate on bank excess reserves (which as one analyst recently remarked have become the proverbial “hot potato” now that a 20 bp fine is charged for their possession) and its effects on bond markets. In euro-land, government bond yields have already completely collapsed, partly to almost Japan-like levels – and yet, more capital gains can still be achieved, even with paper sporting negative yields. According to the article:

“David Tan got to help oversee $1.5 trillion at JPMorgan Asset Management by picking winning trades. Now he’s studying how to make money from investments that look sure to lose.

Across much of Europe in the past year, the yield on two-year government debt tumbled from little, to none, and then below zero. That means buyers would walk away with less cash when the securities matured — if they waited that long.

Money managers like Tan are navigating a market where positive returns are still possible on debt with negative yields provided others will pay a higher price before the notes come due. Those opportunities were enhanced last week when the European Central Bank increased the cost for financial institutions to park their money with it. After that, depositors were tempted to take their cash from the ECB and funnel it intogovernment bonds, because the negative yields hurt less than the central bank’s more punitive charge.

“If yields continue deeper and deeper into negative territory, the opportunities for capital gains remain,” Tan, who is head of rates in London for the fund-management unit of the U.S.’s biggest bank. “If your central hypothesis is that yields are going to converge” with the ECB’s charge on deposits then you still see “some potential price appreciation,” he said.

The list of institutions that may choose to lose includes asset managers so large they’re willing to pay for their cash to be held safely as well as banks that want to avoid the higher ECB charges. And it includes many large financial groups like insurers whose rules are too inflexible to give many alternatives. At the top of the heap probably are other central banks.

Central bankers “are a fairly value-insensitive bunch,” Michael Riddell, a London-based fund manager at M&G Group Plc, which oversees the equivalent of about $415 billion, said on Sept. 5. “They have to invest their FX reserves somewhere if they want to buy euro-area assets that have the top credit ratings, then they have no choice.”

(emphasis added)

We have previously remarked that some of the buyers of short term government debt with a negative yield are those who don’t trust the banking system with their cash. This actually makes at least some sense. All the rest only shows how utterly crazy the market distortions caused by central bank policies have become. Why the geniuses running the central banks believe that this time, this is somehow going to end well, is utterly beyond us.

1-Germany, 2yr yield

Germany’s 2 year note yield – deeper into negative territory, at minus 0.055% – click to enlarge.

Such negative yields can only exist in the policy-distorted world – the natural rate of interest can never turn negative, as that would imply that future goods can be worth more than present goods. This is a logical impossibility. Note here that the natural interest rate is nothing but the price ratio between future and present goods. It is actually a non-monetary phenomenon, expressing time preferences, which can be low, but are always positive. If they were at zero or negative, people would stop consuming altogether and would soon starve to death.

An inference from this is that current central bank policies are once again leading to capital malinvestment and capital consumption on a large scale. This is also demonstrated by the asset bubbles currently in train. E.g. stocks are titles to capital and thus reflect the mispricing of capital and partly illusory profits that stem from misguided economic calculation.

Covered Bonds in the Grip of ECB Madness

Since the ECB has announced it will engage in outright purchases of covered bonds, i.e., it will buy these assets with money conjured from thin air, the covered bond market has been infected with crazy behavior as well. The ECB is not the only central bank in the market – others from that “value-insensitive bunch” are apparently active as well. Here is a summary of the salient points from a report on new covered bond issues in France in recent days – for more details see here (note though that this site requires registration):

“CFF priced EUR 1bn obligations foncieres at 5 bps through mid swaps this morning. The EUR 1 b. offer generated bids for EUR 4.8 bn. from 150 accounts, with heavy central bank participation. Comment of a syndicate official:

“The plus 1 bp area and even the minus 2 bp area guidance turned out to be quite conservative”  Further: “It’s quite a jump, I have to admit. Syndicates and issuers are getting used to this post-ECB world, with the market bid only and so technical. It’s crazy”

Caffil’s 1.25 bn. issue from Monday (which generated 4.9 bn. in bids) had already tightened from its reoffer of 1 bp through to -5 bp to -8 bp by Tuesday morning.

“Everyone’s piling in”, said the syndicate official, although he noted that accounts that were finding pricing too tight were biased towards bank treasuries. “It’s difficult for it to make sense for them”.

A syndicate banker away from the leads said that CFF’s results were “astounding”.

“That’s a trade! It just goes to show how crazy things are. People expect spreads just to ramp in on the back of this purchase program (referring to the ECB here). But there’s got to come a point where you have to ask if investors know what they are buying and what they are doing.”

“Things are so tight, I get a headache just thinking about it” said a banker away from the deal. He noted that a EUR 500 m. UniCredit Bank Austria benchmark issued on April at 23 bps above mid swaps now trades at around 7 bp over.”

(emphasis added)

We can only agree: it is crazy. It “works” only as long faith in the omnipotence of central banks remains intact. This faith will eventually be tested. Note here that the underlying assumption is always that the monetization of assets is just a temporary policy instituted to “help the economy”. The latter is absurd, the former remains to be seen. So far all these “temporary” interventions undertaken since 2008 seem to just continue, with more piled on every year (whereby major central banks seem to be alternating in the printing duties).

In other words, it is by no means guaranteed that the beliefs currently held by market participants are immutable. Let us for argument’s sake say though that these central bank interventions will not only cease, but will be significantly reversed at some point. What then about all those assets that have been bought at paltry or even negative yields? What about the mountain of interest rate derivatives that have been written and are supposed to hedge these positions?

It seems to us that central banks have embarked on a one-way street. Unless they are prepared to preside over a monumental bursting of the asset bubble, they are in a box. Hence the widespread faith in the temporary nature of central bank money printing is likely misplaced. It won’t stop until the markets revolt.

One market that needs to be closely watched in this context is the JGB market (or what is left of it), as Japan is the nation where extremely low bond yields, massive debt monetization and huge public debt growth all have a considerable head start. It seems quite possible that faith will crumble there first. Should that happen, it will crumble everywhere. Once again, the chart of JGB yields actually reminds us of how gold looked when it bottomed in 1999-2000. The similarity is in fact eerie.

2-JGB yield

JGB yields – finally bottoming out? – click to enlarge.

For comparison, below is a line chart of gold from mid 1997 to mid 2001. We will see whether the JGB market will continue to track it. There is of course no reason for this to happen apart from the fact that chart patterns of different markets often tend to look similar at key junctures.

3-Gold, 1997-2001

Gold from 1997 to 2001 – a pattern eerily similar to that in JGB yields – click to enlarge.


Central bank interventions always “seem” to work up to a point. As long as enough real wealth is created that it is possible to divert some of it toward bubble activities, everything appears to be fine. However, major structural economic distortions and asset bubbles are invariably the result. The question is usually only whether the interventions are discontinued voluntarily or not. In either case an economic and market backlash is unavoidable. If an inflationary policy is not abandoned, it will eventually end up destroying the underlying monetary system. If it is abandoned in time, all the malinvestments are unmasked and a major bust becomes unavoidable. Apparently central bankers like to be between a rock and a hard place. That wouldn’t be a problem if not for the fact that everybody else is affected by their actions as well.

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