Mind the gap! – May 21st 2013

In the 70’s, when I was cutting my teeth in investment management, we were in a bizarre world, which included the Sex Pistols and a phenomenon known as the reverse yield gap. For many years I pondered the use of the word “reverse” because as far as I was concerned the gap between bond (mostly in double figures) and equity yields (significantly lower) was just that; a yield gap. It had not occurred to me that at a much earlier and more rational time equities yielded more than bonds because they were more risky.

But the ‘70s saw the rise and rise of inflation which of course is anathema to bonds so yields went into orbit until Paul Volker, the last Fed Chairman who knew what he was about, put the genie back in the bottle by raising the Fed funds rate to 20% in 1981. 20%!!

Ten year Treasury yields were sub 4% in the early ‘60s and it was 50 years before the rate settled below that level again and the yield gap again became the norm, but for a whole new set of reasons. Volcker was followed by Greenspan who achieved a God like status; his every word was treated as the ultimate truth when it reality he hadn’t got a clue, but before we all worked that out the cult of central bank interference was embedded in the investment psyche.

Here was a man who called a market top in 1996 as irrational exuberance only for the S&P to double over the next four years. He also thought that Y2K was a huge threat and kept downward pressure on rates until mid-1999 when the aforementioned irrationality was gathering pace. His next mistake was not to lower the funds rate until December 2000, well after the top of the tech bubble and then drive it down to 1% by 2004 a move that begat the next bubble in property and the resulting CDS/CDO melt down.

Pushing the rate back over 5% didn’t stem the property surge and in 2006 he handed over to Bernanke who very quickly opined that the housing market was not in a bubble and that the proliferation of mortgage backed securities was never going to be an issue and we trust central bankers to run monetary policy with these sort of insights…BoE, ECB, BoJ are all in it together.

Since the Lehman bust they have struggled to get the economies going again and deliberately kept rates low in the belief that this will encourage borrowing and spur demand. It has failed to do either, but created yet another bubble, this time in the bond markets. The yield gap, should be telling us that bonds are less risky than equities, but with yields at all-time lows, that does not look to be the case.

The assumption to validate such low yields is that the central banks will keep up the money flow, but already the Fed has started to debate just when QE might stop and the latest suggestions are that it will be some time this year. Treasury, Gilt and Bund yields are now off their lows, and equities may just be getting the message that rapidly rising bond yields are not good for stock markets. Where does the risk off money go then??

When yields got down below 4% in 2008 we were saying much the same thing about bond valuations and then the conversation moved on to whether we were becoming Japanese and about to move towards eternal deflation. Now the Japanese want to become good inflationistas. They have got off to a good start with the “J” curve effect upping import costs. It remains to be seen whether increased export competitiveness actually translates into more exports. The yield on 10 year JGBs has gone from 0.3% to 0.9%; still under 1% for now but inflation is back on the menu. If they do manage to stoke it up they might want to revisit Volcker’s methods for getting it back down again. If you want a real shock put his 1981 Fed funds rate in your risk free return calculation and extrapolate just how “cheap” equities are….Mind the gap!


A brief update on gold – April 16th 2013

Gold has suffered an unprecedented fall from grace and in the vernacular it has been “bitcoined”. Bitcoin was an alternative to fiat currency and was gaining some traction after the Cyprus debacle as hot money looked for a “safe” home, even IG Index the spread betting company have started trading it! Alas currencies are the sphere of governments and central banks and any upstarts are not to be tolerated. The same debate can be had about gold, but, to misquote Mervyn King “it is foolish to start a run on gold, but when it has begun it would be madness not to join in” which is exactly what we have seen so far this week.

 Since Friday morning the price has fallen from the opening at $1561 to a low of $1321 this morning, -15%, and is now having its first rally of any note to $1400. The Friday fall was missed by Asian traders and they took up the bit on Monday, with the US following up in the afternoon. There are no doubt still a few bulls left with positions well under water in hedge fund world and are now probably biding their time for a rally of sorts back to the $1500 level which had been close to support levels for the market since 2011. Any progress past there is going to take time.

 This does however give some lumpy buyers (central banks) the opportunity to buy gold at distressed prices. It would seem that this is not the time to sell gold but to start accumulating again on setbacks which there will be as overleveraged traders are squeezed out. As one blogger put it, “at last someone has done something for the first time gold buyer”…

Massive currency debasement by all the major central banks means that there is still a very strong case to hold gold.


Send in the economists – March 3rd 2013

Back in August 2011 I quoted these lines from Sondheim’s “A Little Night Music” apropos the then raising of the debt ceiling in the US which we thought was the height of farce at the time.

 Don’t you love farce?

My fault I fear

I thought that you’d want what I want,

Sorry my dear

But where are the clowns

There ought to be clowns

Quick send in the clowns, don’t bother they’re here…

 It turned out to be a “little light music” compared to the sequestration dance we are going through now. I find castration a lot easier to say and would have no problems applying the procedure to the members of the political circus that poses as democracy on both sides of the pond. The real problem is that a good number of the electorate require the same treatment for voting the muppets in in the first place.

 The gravy train that poses as the Electoral College in the States is rigged to make it near impossible for anyone other than the Democrat or GOP nominee to get into the White House. Ron Paul was on the ballot paper but he knew that third place was as good as it gets. Eventually the US electorate will wake up to the fact that their political system only works for their politicians. Democracy US style means that the rich get richer and the poor get food stamps…

 In Europe it is very different. We can vote for the Monster Raving Looney Party – yes there truly is such a thing – the Beer party and one day soon the Blessed Nigel of Farage. To get on the list of candidates over here you have to stump up £500, be a UK, Commonwealth or Republic of Ireland (how did that happen?) citizen, be seconded by 10 voters in the constituency and not be a police officer, in the military or a member of the House of Lords or bankrupt or bonkers. UKIP may well have won the Eastleigh by-election had Farage stood as a candidate – along with 13 others – but as it was Diane James took votes off the Tories and Liberal Democrats in equal measure. This may have been spun as an inconsequential protest vote, but the happenings in Italy earlier in the week are beginning to cause the establishment some angst.

 A whole raft of vested interests German newspapers and politicos have been venting spleens; here’s a selection.

 Italy’s Childlike Refusal to Acknowledge Reality – Der Speigel

Silvio Berlusconi ruined Italy and brought it almost as close to bankruptcy as Greece. It is worrying that voters didn’t punish this jester by ignoring him. In the campaign he promised the abolition of the IMU real estate tax and even the repayment of the taxes already paid under it. The failure to punish such nonsense casts a bad light on a country that requires a fundamental political renewal. If you count the results of the Five Star Movement of the rabid Beppe Grillo, who has been preaching wild hatred of the ‘freeloaders up there,’ then more than half of Italians voted for some form of populist. This amounts to an almost childlike refusal to acknowledge reality. – Die Welt

 “More than half of Italians voted for some form of populist”. Well I wonder why that was. Could it be that they have had enough of the “freeloaders up there”? And then there is The Economist that bastion of the establishment with a remonstrating front page headline, “Send in the Clowns. How Italy’s disastrous election threatens the future of the euro”. The democratic process; more than half the electorate voted for Grillo and Berlusconi; has been sidelined as a childish tantrum. Is there any chance that the powers that be have some real skin in this game as in can they get more power and more money? When Grillo was making his name as a proper comedian the then premier of Italy, the head of the Italian Socialist party Bettino Craxi was visiting China. The apocryphal joke runs as follows. “If the Chinese are all socialists who do they steal from?” Craxi spent the latter years of his life in Tunisia to avoid the rather short arm of the Italian law on charges of corruption.

 The euro is a political construct that has been flawed in design and execution from day one of its sorry existence. The Greeks know that; they have just been downgraded by Russell to emerging market status. In Spain with youth unemployment at 55% Catalonia has taken the first steps towards succession and ominously General Juan Antonio Chicharro, until 2010 commander of the Marine Corps, has opined that “What do the Armed Forces do now?” he gave no answer but the inference is quite clear. In Italy the populace has had enough of the German insistence on austerity. Their choice of politicians is, after all, their choice and if they want to live as Italians in a sub optimally run country then good for them.

 Leaving the eurozone is an option unless your pig headedness misguided politico/economic beliefs prevents you from understanding that fact. The populist vote suggests that they want to get back to being what they are very good at – being Italian…..not German. Euro R.I.P.


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.