Moral hazard or paranoia – January 21st 2013

The Bank of England has purchased 50% of the gilts issued since 2009 and owns 32% of the whole gilt issuance currently in existence. Do you think this has something to do with yields being down at all time lows? Assuming we had access to a printing press it would be illegal if we tried to pull the same stunt. Compared to the Fed, the BoJ and the ECB the UK is almost a minor league player in this systematic global rigging of sovereign debt markets.

 The definition of moral hazard has changed over time. It used to refer to the bailing out of “lesser” banks and “minor” economies, which just encouraged others to carry on regardless. Now we have the wholesale support of major economies, their governments and banking overlords to the detriment of anyone else. Government securities used to be the home, during periods of market unrest, for flight to safety investors and others of a cautious disposition. They were also the marker for the risk free rate when calculating the value of equity markets and other instruments. As an aside would the LIBOR scandal have happened if we had had a properly functioning bond market? Hmm.

 On the basis that most sovereign debt issues produce a negative real yield to redemption, investors are being “encouraged” to search for income elsewhere. High yielding corporate bonds have been one of the favourites, but didn’t we have an “issue” with this asset class a few years back or has that episode been consigned to the memory vacuum? Yes a very different set of underlying instruments I agree, but as Mark Twain said, “History doesn’t repeat but it rhymes.” Having enjoyed decades of capital growth from bond investments, those with a lower risk appetite have few other options than to increase their equity weightings.

 If you believe that money printing is the answer; that governments can continue to increase debt levels ad infinitum; that austerity in Europe will propel their economies, unfazed, onwards and upwards and that China will eventually get the hang of capitalism; then I would agree that equity markets look like a steal. In P/E terms the FTSE is at half the level it was at 10 years ago.

 But according to “Economics 101”, quantitative easing, on the heroic scale we have witnessed thus far, should already have led to rampant if not hyper inflation. That it hasn’t is down to the continuing decline in the velocity of circulation of money. In simple terms the banks aren’t lending (compared with the amount of money available to them), but instead are punting on financial assets, which is where “inflation” is ending up and benefitting their balance sheets… Charles Hugh-Smith put the Fed’s actions into context very well, if indelicately for some, on his recent Of Two Minds website. BoE, ECB and BoJ please take note.

 “We can view unprecedented Federal deficit spending as a misguided attempt to compensate for the implosion of money velocity. I say “attempt” because the Treasury borrowing and blowing $6 trillion over the past five years and the Federal Reserve printing $2 trillion, backstopping the parasitic financial cartel and buying over $1 trillion each of mortgage securities and Treasury bonds has only kept the economy stumbling along at essentially zero growth while real wages have declined by 7% to 9%.”

 Markets generally front run the economy, but if, as many folk believe, including our commentator above, that quantitative easing has been a failure from the start, then why are equity markets indicating an upturn in economic activity? At the end of the day, if the central banks continue to believe they have no other option than money printing and you can put up with the volatility, it’s all aboard the equity train. Bond yields won’t rise much either; if at all. The gold price should give some indication of whether this strategy is working or not, but that is a market that is far easier to rig than sovereign debt – the Germans seem to think so as they contemplate repatriating some of their bullion held by other central banks.

 Moral hazard or paranoia; your choice.