Tag Archives: unintended consequences

Hi there LIBOR

According to this article in the FT by Bhanu Baweja of UBS, the rise in the spread between the dollar 3-month LIBOR, now over 2.25% compared to 1.7% at the start of the year, and the overnight indexed swap (OIS) rate, as per the graph below, is a “red herring” and that “supply is at play here, not rising credit risk”. This view reflects the current market consensus, up until recently at least.

click to enlarge

Baweja argues that the spread widening is due to the increased T-bill-OIS spread because of increased yields due to widening fiscal deficits in the US and to the increased commercial paper (CP) to T-bill spread due to US company repatriations as a result of the Trump tax cuts. Although Baweja lists off the current bull arguments to be cheerful, he does acknowledge that an increasing LIBOR will impact US floating borrowers of $2.2 trillion of debt, half of whom are BB- and below, particularly if 3-month US LIBOR breaks past 3%. Baweja points to rises in term premiums as the real red flags to be looking out for.

Analysts such as Matt Smith of Citi and Jonathan Garner of Morgan Stanley are not as nonchalant as the market consensus as articulated by Baweja. The potential for unintended consequences and/or imbalances in this tightening phase, out of the greatest monetary experiment every undertaken, is on many people’s minds, including mine. I cannot but help think of a pressure cooker with every US rate rise ratcheting the heat higher.

Citi worry that LIBOR may be a 3-month leading indicator for dollar strengthening which may send shock-waves across global risk markets, particularly if FX movements are disorderly. Garner believes that “we’re already looking at a significant tightening of monetary policy in the US and in addition China is tightening monetary policy at the same time and this joint tightening is a key reason why we are so cautious on markets”. Given Chairman Powell’s debut yesterday and the more hawkish tone in relation to 2019 and 2020 tightening, I’ll leave this subject on that note.

The intricacies of credit market movements are not my area of expertise, so I’ll take council on this topic from people who know better.

Eh, help Eddie….what do you think?

The bowels of the system and helicopters

The market volatility in 2016 did seem odd in certain respects. Valuations were too high and a correction was needed. No doubt. It’s more the way the selling seemed to be indiscriminate at certain points with oil and equity prices locked in step. Some argue that China selling reserves to support their currency or oil producing countries selling assets to make up for short falls in oil revenue may be behind some of the erratic behaviour. Buttonwood had an interesting piece over the past weeks on how consequences from new bank regulations are impacting market liquidity with unusual activity in derivative pricing such as negative swap rates and relative CDS rates.

Gilian Tett, in a FT article in January, pointed to the example of capital outflows from China. Whether repaying US debt (or as Tett succinctly calls it, a quasi carry trade in reverse) in face of likely further yuan weakness or withdrawals from overzealous M&A (about a quarter of China outbound deals are said to be in trouble) or other reasons behind the veil of the Chinese economy, the outflows are having impacts. Tett said:

“Capital flows, fuelled by politics and policy change, are where the important action is taking place. Deep in the bowels of the system all manner of financial flows are switching course, creating unexpected knock-on effects for many asset prices. Capital flight from China is one example. The energy sector is another.”

The strangle lockstep between oil and the S&P500 can be seen below.

click to enlargeoil and sp500

Energy has only a small impact on the S&P500 makeup, as can be seen below, and on the operating profit profile.

click to enlargeS&P Sector Weightings 1980 to 2015

The OECD interim economic outlook by Catherine Mann on 18th February recommended “maintaining accommodative monetary policy, supportive fiscal policies on investment led spending and more ambition on structural policies which raise global growth and reduce financial risks”. Ah, yes the old structural reform answer to all of our ills. The OECD gave some graphic reminders of where we are, as below.

click to enlargeUS & Euro Household & Nonfinancial Corporate Debt 2015

click to enlargeCentral Bank Balance Sheets 2015

Central Bank policies remain stuck to QE and increasingly exotic forms of monetary policy despite the obvious failure so far for QE to kick-start either inflation or growth. The latest experiment is on negative interest rate which has had funny impacts on banks and the lending rates they need to charge. Japan in particular has shown how their brand of negative rates was countered by a currency whiplash. Mark Carney, the Governor of the Bank of England, offered the view that “for monetary easing to work at a global level if cannot rely on simply moving scarce demand from one country to another.

A recent BIS article on negative interest rates in Switzerland, Europe and Japan stated that “there is great uncertainty about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period. It is unknown whether the transmission mechanisms will continue to operate as in the past and not be subject to tipping points“.

This week Mario Draghi came up with a new twist on negative interest rates, relying on targeted long-term refinancing operations (TLTROs) to give banks effectively free money. The currency impact will be interesting, particularly to see if the Japanese whiplash will repeat. One of the results of all this QE is that central banks are a much larger player in the system and have basically taken over the government bond markets in Europe, Japan, and America. The ECB even buys low-rated bonds, not just the AA and AAA positions taken by the Fed, and makes billions of euros in low-interest-rate loans to banks.

No less that Adair Turner, Martin Wolf and Ray Dalio have all made favourable comments about another evolution in QE, so called helicopter money (named after Milton Friedman).  Wolf argues that central banks should enter the arena of public investment in the face of inaction by fiscal authorities (by which I assume he means elected politicians). He passionately says “policymakers must prepare for a new “new normal” in which policy becomes more uncomfortable, more unconventional, or both.” Turner believes that targeted stimulus of nominal demand poses “less risk to future financial stability than the unconventional monetary policies currently being deployed“.

The recent anxiety by electorates across the developed world in expressing a desire for the certainty of the past, whether it be the popularity of Donald Trump, anti-immigrant rhetoric in Europe or the arguments in the UK to leave the EC, show that ordinary people are worried about the future and no end of short term monetary stimulus is likely to change that. Helicopter money sounds like a medicated solution to the symptoms of low growth rather than any real answer to the problem of slowing growth, Chinese and Japanese unsustainable debt loads and global productivity challenges due to aging populations.

Maybe it’s just me, and I do respect the views of Wolf, Turner and Dalio, but it looks to me a measure that is open to so much moral hazard as bordering on the surreal. It gives Central Banks more power in the markets and that could be dangerous without more thought on the unintended consequences. If we are moving piecemeal towards a Chicago Plan or some other alternate economic model, then somebody should get the public on board. I think they are desperately looking for new answers to the way we run our economies.

Inhibiting Derivatives

The array and complexity of new financial regulation in response to the financial crisis can have unforeseen impacts. A reduction in the liquidity of the bond markets today compared to before the crisis is commonly explained as a result of increased regulation of the banking sector.

A report by International Organization of Securities Commissions (IOSCO) in 2013 highlighted the impact of the regulatory push, following a G20 direction in 2009, for the OTC derivatives markets to be cleared through central counterparties (CCPs), thereby creating a potential for systemic counterparty risk (as per this post). The idea was to provide a centralised clearing point per asset class with the goal of increasing transparency and providing regulators with consistent data across borders to monitor.

The reality today is somewhat different that the theory. Many competing repositories have sprung up with the commercial intend of leveraging the valuable data. David Wright, the Secretary General of IOSCO, recently stated “we’ve got 25 of these beasts today and they don’t talk to each other, so a basic fundamental trawl of transparency is actually missing”. Regulators are stressing the need for further reform so that data can be aggregated to improve monitoring and, in February, issued requirements on CCPs to disclose information on topics such as the size of their credit risk, liquidity risk, collateral, margins, business risk, custody, and investment risks

Benoît Cœuré, a member of the Executive Board of the ECB, said in a speech this month that “the gross notional outstanding amount of centrally cleared positions was estimated at $169 trillion for OTC interest rate derivatives, and at $14 trillion for credit derivatives. The sheer magnitude of these figures (around ten times the GDP of the United States or European Union) gives us an idea of the severity of the potential consequences from a stress event at a major global CCP”.

Cœuré outlined a number of options for strengthening the financial resilience of CCPs including increased regulatory capital, initial margin haircutting, setting up cross-CCP resolution funds or a central resolution fund. Any such measures would have to be consistently applied across jurisdictions to ensure fairness and designed so as not to provide a disincentive to using CCPs.

In March, the Bank of International Settlements (BIS) and IOSCO announced a delay until September 2016 for the introduction of margin requirements for non-centrally cleared derivatives (above certain thresholds and subject to exemptions). The proposed margin requirements are split between initial and variable, with the initial margin phased in from September 2016 to September 2020 and the variation margin phased in from September 2016 to March 2017.

The amount of initial margin reflects the size of the potential future exposure calculated “to reflect an extreme but plausible estimate of an increase in the value of the instrument that is consistent with a one-tailed 99 per cent confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant financial stress”. The required amount of initial margin is calculated by reference to either a quantitative portfolio margin model or a standardised margin schedule (as per the schedule below). The requirements also prohibit the re-hypothecation of initial margin required to be collected and posted under the rules.

click to enlargeInitial Margin for Derivatives

The amount of variation margin reflects the size of this current exposure dependent on the mark-to-market value of the derivatives at any point in time. As such, the volatility of this requirement may be significant in stressed cases, particularly for illiquid derivatives.

The proposals, as set out by the BIS and IOSCO, are ambitious and it will be interesting to see how they are enforced across jurisdictions and the impact they will have on market behaviour, both within and outside CCPs. I suspect there will be a few twists in this tale yet, particularly in relation to unintended consequences of trying to tame the derivative monster.