Category Archives: Monetary Policy

Is the low rate environment sustainable in 2013?

26 Tuesday Feb 2013

Posted by in Debt and Inflation, Monetary Policy

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I think current unconventional policy measures remind us that central banks’ willingness to provide ultra-cheap liquidity is high and should remain so for some time. The market believes this for now. Authorities are aiming at low short-term rates while creating inflation expectations on the long-end. After all this seems to be to only viable strategy to significantly reduce debt/GDP figures. Also central banks today operate under much more transparency than, lets say, 20 years ago. FOMC minutes are announced few days after the meeting and the banks basically operate under specific growth and unemployment targets.

In the US the FED is committed to purchase mortgages at a rate of 80bn per month, which is a key driver to lower rates. It is also the single biggest holder of US treasuries at the moment. At the same time attempts by central banks in Asia, first and foremost Japan, to suppress rates on the one hand and devalue their own currency should not only lower rates but in a feedback loop lead to additional USDs flowing back into Treasury markets further maintaining and stabilizing the lower rate environment.

Therefore I fundamentally see the market pricing the situation correctly as the next few years will see both deflationary forces from attempts of deleveraging in the private and public sectors which are being neutralized by government intervention resulting in a very flat trajectory back to a normal rate environment. However  I do not believe that this necessarily means that the current rate environment will act as unsupportive for other asset classes. On the contrary, the artificially low-rate environment could through other channels lead to stimulating effects especially in the international equity markets.

 2nd order consequences of low rates

Given the global developments described above I could imagine rates to behave differently than expectations by bond vigilantes in the current debt-laden environment. Japans central bank is quite figuratively no longer independent. At current rates of 0.77% for 10Y JGBs roughly ¼ of tax revenues are used for debt service. An increase to only 2%, a current international average will increase this to ¾ and make it mathematically unsustainable to return to a normal path. As such there will be massive pressure to keep rates low.

So as currency wars could potentially unfold in 2013 we could see something similar to the Greenspan conundrum of the early 2000s as new funds from attempts of currency devaluation flow into treasury markets. There have already been reports of CB investments in asset classes such as equities and corporate bonds hence continued devaluation of currencies could prove as a natural stabilizer for these asset classes.  The second round effects can be seen as an international type of QE4 potentially even stronger in combination with the structural flows into the equity markets.

The continuing dichotomy between inflationary stimuli measures from CBs and depressionary deleveraging effects will persist but I tend to believe that CBs will be continue their support for the markets and continue to be the dominant force.

 Irrational investors?

I think the current moment coined as the “great rotation” out of bonds into equities is very interesting. Although investors are aware of uncertainties and the general obliviousness to risk is low they feel compelled to progress with this secular shift.

We are in a very unique point in the cycle right now. Risk aversion is low although risk-awareness is high. This is quite paradoxical and makes for a quite dangerous investment environment. The Fed’s intervention has helped drag Treasury yields to extremely low levels. The present S&P 500 dividend yield of 2.2% commands a 150 bp premium over five-year Treasuries, which has not been seen in 50 years.

As such the market no longer reflects the fundamental economic environment but follows a self-induced risk-on attitude despite prevalence of all the uncertainties. Investors desperately looking for income (see rally in HY bonds and high div equities in 2012) could have sparked a secular rotation from fixed income into equities. The probability of this occurring is linked to sustainability of international debt service. As mentioned above, Japan is currently in a precarious situation so authorities are fully aware and ready to act accordingly.

This is definitely a high priced environment defined by market participants compelled to buy equities that look very cheap to bonds when looking at earnings yields. At the same time institutional clients which need to obtain income to fund liabilities are  compelled to shift funds into higher income asset classes than conservative bonds.

So to sum up, Fed policies could have opened the door to an environment where markets are unwillingly turning investors risk-prone for the coming months.

Money Creation – Revisiting the LTRO

14 Monday Jan 2013

Posted by in Monetary Policy

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In my first post I re-told the story of a fictitious Irish village to show how money, as an abstract concept is hard to define. The point I tried to make was that money is not just the cash/ banknotes in your wallet but a much broader idea, essentially anything that is eligible collateral to borrow against and that can be monetized. In this post I want to very briefly describe the extent of this abstraction, using the LTRO (everything you need to know in here) in December 2011 as a specific example.

Just one day before the allotment of the LTRO Italian banks issued a series of bonds. The following links from the Borsa Italiana shows the registration of these bonds and the BBG screenshot for the Unicredit bond issue can be seen below. Conspicuously over 40bn of bonds were issued on that specific day during the climax of the Euro-crisis which was the reason for the implementation of this innovative 3 year financing facility in the first place.

Bildschirmfoto 2013-01-14 um 20.40.02

Since these bonds were clearly not issued to specific investors, all this means that banks issued these bonds to themselves! and used them as collateral to obtain central bank funding. These series of events challenges the notion that central banks are the sole provider of bank reserves as put forward in the ECB’s scope of monetary policy:

“The central bank is the sole issuer of banknotes and bank reserves. That means it is the monopoly supplier of the monetary base. By virtue of this monopoly, it can set the conditions at which banks borrow from the central bank. Therefore it can also influence the conditions at which banks trade with each other in the money market.”

While it is true that the central banks issued the reserves they did not do this autonomously as it was the individual bank that ultimately had to power to decide to issue a bond to itself and re-pledge it as central bank collateral.

This acts as yet another example of why the (shadow) banking system is much more crucial to monetary transmission and creation than understood. There are a series of intermediary steps between ultimate borrower and ultimate lender which exist for the purpose of maturity transformation and liquidity creation. The following chart can be found in a new paper on shadow banking which reminds us that much more research on that very topic needs to take place to address precisely these issues.

Bildschirmfoto 2013-01-14 um 20.23.54

The reflection of the market’s shadow

18 Tuesday Dec 2012

Posted by in Monetary Policy, new normal

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Are financial markets a reflection of the economy and its business cycles or vice-versa? The accounts of most mainstream economic textbooks and academics would suggest that financial markets are considered an approximation of real economic activity, and have little significance in models that interpret and predict business fluctuations.

It is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle. The  financial sector is first and foremost perceived as an intermediary that allocates capital efficiently between savers and borrowers. Low rates, should increase the demand for loanable funds for investments and consumption thus leading to future economic growth. An increase in bank lending and monetary aggregates following a recession are thus interpreted as a sign of  recovery.

Bildschirmfoto 2012-12-18 um 19.21.34

An interesting Societe Generale research report1 contradicts this popular notion and shows that although companies are currently cash rich they are issuing debt at record rates and offsetting this with an equal measure of equity buy-backs, thus leveraging their capital structure as seen in the chart below.

Bildschirmfoto 2012-12-12 um 18.45.24The report therefore suggest that the increase in bank lending and monetary aggregates, traditionally a signal of recovery following a recession should be viewed with caution as it implies more risk-taking and not necessarily a solid recovery.

 

The following chart shows a similar picture graphing the average asset age, which in recent years spiked significantly upwards. This spike further exemplifies that instead of spending on CAPEX, companies have been using their cash for other purposes.

Bildschirmfoto 2012-12-17 um 21.06.03

 

 

 

 

 

 

While the explanations above are coherent and plausible, the financial markets themselves offer similar viable interpretation.

Similar to Plato’s allegory of the cave, where we are reminded that we are like prisoners and assume the shadows on the wall in front of us to be to be the real world, each argument has two sides. Contrary to the implications of most textbooks it is difficult to judge whether the shadows we see are reflections of the real economy or whether of the real world activity is influenced by precisely those shadows it is supposed to be creating.

As such, perhaps the answer for buy-backs can be found in the equity market themselves.  This new paradigm of record low interest-rate yields forces investors to look for income elsewhere. Therefore companies which pay-out solid cash via dividends or buy-backs are rewarded by the market. The following two charts show personal interest and dividend income for the US. As mentioned low levels of rates have decreased interest income while income-seeking investors piling in to dividend paying stocks have contributed to a sharp increase in dividend income.

Bildschirmfoto 2012-12-17 um 21.06.22

 

 

 

 

 

 

Bildschirmfoto 2012-12-17 um 20.46.36

 

 

 

 

 

 

Finally, one can draw differing conclusion using precisily the same data from above, namely the increase in monetary aggregates M1 and M2, which are interpreted as a sign of recovery. However only a fraction of the modern monetary system falls within the realm of the regulated system. Viewing the system holistically, the de-leveraging of the shadow banking system (unregulated yet vital in liquidity and maturity transformation) becomes apparent and was the single most deflationary effect of the  broader financial system.  Courtesy of zerohedge the following chart shows that on a blended notional basis, total traditional and shadow liabilities have not significantly moved over the last three years despite the massive injections from the Fed (main increase in M1 quantity)

Bildschirmfoto 2012-12-12 um 20.02.43

 

 

 

 

As such the last graph shows that the premises from the beginning about an improvement in monetary aggregates (M1 and M2) is flawed on its own as the increase in the traditional bank liabilities have merely offset the de-leveraging of the shadow-bank system. It remains vital to view a variety of different data to not be fooled by the shadow the financial markets throws on the real economy.

 

1 https://www.sgresearch.com/

A case for a banking union

12 Friday Oct 2012

Posted by in debt crisis, Monetary Policy

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This could be an ideal opportunity to write about a compelling reason for a European banking union. With the upcoming release of Hans-Werner Sinn’s new book ” Die Target Falle” (Target Trap) the German economist who initially warned about the systemic imbalances of the Target2 payment system is back in the news.

I believe that looking at this accounting figure provides the best overview of imbalances of capital flows within the Eurozone and allows for a much profound analysis than simply monitoring government bond yields as an indicator of risk in monetary transmission channels.

I will comprehensively give an overview of this system and then demonstrate why severe stress will not be mitigated by government bond purchases. Using the schematic monetary system from a previous post I will add on a central bank system and assume that these banks are in different countries but belong to the same currency union (Eurozone). As before a customer of bank A moves 50 of his deposit to a customer at Bank A to do one of two things:

  • Purchase goods from client in country B (process as shown below)
  • Or simply moving his money (deposit) to a bank in Country B  (Capital flight)!

 

 

 

 

As shown in the previous post to make this payment the Bank A will draw on its overdraft facility at its central bank and transfer reserves (central bank currency) to the account at CB B. Obviously in the case of capital flight Customer B and Customer A are the same people. In the current example however bank B does not want to lend to Bank A as it regards this as being too much of a risk, even short-term (one of the main reasons for a banking union). In the previous post’s example, in an ideal system money market lending would have extinguished the overdraft at Central Bank A but these funds are now no longer available.

 

 

 

 

Bank A must now draw on a standing facility with its central bank to fund the withdrawal of deposits. It does so by pledging its assets (previously made loans, bonds etc.) at the central bank and uses these to convert the daily overdraft into a somewhat more permanent overdraft (in case of a Long-Term Refinancing Operation a 3 year overdraft). This is shown below in the semi blue-yellow square. Correspondingly central Bank records a claim vs. central bank B via its payment system Target2. To understand this you could view the entire central bank system holistically and note that central bank B has a liability to its bank but central bank A which was initially responsible for this liability by making the loan still holds the assets as collateral.

 

 

 

 

The next chart is relatively well known and shows these Target2 claims and deficits for the actual countries Germany and Spain. Germany would be Country B and Spain Country A. The data for the following data is from the corresponding central banks. It thus shows a build up of claims in Germany currently at almost EUR 800bn while the Spanish central bank records a EUR 400bn deficit.

 

 

 

 

 

For the final two graphs I have colour coded the lines similar to the first 3 charts. So the purple line corresponds to Target2, yellow to lending and orange to reserves. The following chart specifically shows the Spanish situation where the Target2 deficits almost perfectly offset total lending (LTRO and MRO). This shows that all the liquidity provided from central bank funding is being transferred out of the country.

 

 

 

 

In contrast the situation in Germany shows a different picture. The two yellow lending lines are almost at 0 and reserves are almost at EUR 300 bn through the deposit facility while the central bank as previously mentioned records a record Target2 claim vs. the Eurosystem.

 

 

 

 

 

Two interesting features have to be noted to conclude this post.

In contrast to the US where the FED balance sheet has expanded massively due to outright bond purchases the situation in Europe is somewhat different as outright purchases only account for a fraction of the increase. As shown the lending was conducted to provide a smooth functioning of the payment system and fund deposit outflow from the periphery countries to the core. While in an early phase of the financial crisis these outflows were perhaps to fund imports, undoubtedly the current outflows are predominantly outright deposit withdrawals.

This is a problem that QE and outright purchases of government bonds cannot fix. A banking union can therfore be understood as the predominant framework required for a functioning curreny union. By providing a uniform deposit insurance scheme backed by all members it wil no longer matter whether a German bank lends to a German bank or a Spanish bank. This cross-european guarantee will imply a transfer or further resources from the core to the periphery, but its implemenation is much more urgent and has the power to alleviate many more of the current imbalances than the continued focus on further liquidity measurements and bail-outs.

Money Multiplier Fallacy

27 Thursday Sep 2012

Posted by in Monetary Policy

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In prior posts I have made an attempt at explaining what money is. A common and popular tool in monetary economics is the money mulitiplier model  which describes the relationship between commercial bank money and central bank money in a fractional-reserve banking system. This basic principle of macroeconomics, found in every standard economics textbook is unfortunately a fallacy, perhaps even the biggest one that the understanding of modern monetary economics entails.

It assumes as shown below that a client of bank A deposits 100 in his account and the bank now lends out 90 and keeps 10 as reserves if 10% is the minimum reserve requirement. The new loan will lead to more deposits and through an iterative process of lending out the new deposits the initial 100 will result in 1000 of commercial bank money.  See more here.

My problem with this theory is that it ignores the process, which banks nowadays undergo to make a loan. It is much more compelling and comprehensive to think of it in the following  way shown below. When a customer of Bank A asks his bank for a loan the bank will approve the loan if he is sufficiently credit-worthy. The bank will thus increase its balance sheet by extending the loan and at the same create the deposit at Bank A in client A’s name. The bank therefore makes a loan and simultaneously creates the liability/ the deposit.   No reserves are needed in the first place to make a loan and neither are deposits. Deposits are nothing more than an accounting entry.  Although this might seem unconventional it is well understood by the experts as Paul Tucker, Deputy Governor for Financial Stability, Bank of England in a spech on Money and Credit, says something identical:

“..Banks extend credit by simply increasing the borrowing customer’s current account … That is, banks extend credit [i.e. make loans] by creating money..”

Every commercial bank itself holds an account with its central bank where it can itself take out a loan. Making use of an overdraft at the central bank is similar to the central bank extending a credit to the bank. It does this by lending against the available collateral that the bank holds on its balance sheet. Using this overdraft facility a bank is able to obtain the required reserves as show in the figure above.

So if credit creation is technically not constrained by deposits and reserves there are considerable factors that a financial institution will take into account. It has to fund the loan on its balance sheet and at the same time make a profit. This is the true constraint for credit creation.

One very basic example should illustrate the mechanics behind this decision. Let us assume Customer A needs 50 of his loan to pay for goods which he purchases from Customer B who banks at Bank B.  How does such a transaction work? Below in what I labelled Scenario A the outcome of that transaction is shown. We can now see that that BANK A on behalf of customer A transfers 50 to Bank B into the account of customer B. Customer B now has deposits of 50 in exchange for having sold goods to Customer A.

The mechanics to achieve this outcome are shown in the next three steps. First its important to note that these payments occur in payment system which the central bank oversees. Transactions are made using central bank money (reserves) and the daily amount far exceeds EUR 2.3trillion! in the euro payment system known as Target2.  Using the aforementioned overdraft facility at its central bank it borrows 50 from the central bank and immediately transfers 50 to Bank B as shown in Step 1.

However these overdrafts have to be cleared by the end of the day so the bank now has to fund the 50 somehow. Ideally this will happen in the money market and the ease of doing so will as mentioned earlier influence its decision to grant a loan in the first place. Bank B which now has 50 in assets as well as the deposit of 50 from Customer B will realize that it actually does not want to hold 50 in low yielding reserves. In the money markets it can now offer these 50. Bank A is looking for these  50 as it needs to clear the central bank overdraft before the close of business. As depicted in Step 2 Bank B now provides a short term loan to Bank A transferring the 50 in reserves back to Bank A and recording this transaction as a short term loan to bank A which itself now has ST liability. The overdraft with the central bank is also cleared and the final balance sheets are as shown below in Final Step.

 

 

 

 

In summary, it’s important to realize that reserves are not a constraint on lending/credit creation as the money multiplier model would suggest.  A much more realistic representation is the process shown above. When making a loan or buying an asset financial institutions ultimately have to conceive the true cost of making the loan which is tied to their ability to fund that specific asset while making a profit. The simple transaction above showed how many important factors are relevant to accomplish this.

Also while technically its correct to say loans create deposits its not quite that simple. Ultimately the quality of the asset is far more important in credit creation. Therefore emphasis should be placed on the quality of the asset which needs to be funded. This was written about here and here, and consequently demonstrates that money is collateral in our financial system.

A Parallel Currency?

30 Thursday Aug 2012

Posted by in Monetary Policy

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It is now commonplace to regard the problems of the Greek economy as a debt crisis stemming from systemic current-account imbalances. The problems are only amplified as Greece is bound to a “fixed-exchange” rate regime and cannot devalue its currency thereby lacking a key measure to stimulate the economy. The plight of debtor in such a currency union is to internally devalue by gradually decreasing factor costs, first and foremost wages.  The implications of ensuing austerity and social unrest and its implications are still not fully understood and so it’s satisfying to see that there are more conceivable options than the binary exit/no-exit option which is discussed in the press.

One out-of-the box solution would be for Greece to issue a parallel currency which was proposed by Deutsche Bank chief economist Thomas Mayer:

“…the Troika could decide on “a partial stop in financial assistance, with continuing support for debt service needs and the Greek banking sector but no further support for the financing of the government’s primary expenses….”

The financing of the primary government would work as below:

“..assuming that the Greek government is unable to quickly balance its primary budget, a plausible response of the government to the shortage of euro cash as a result of the end of financial transfers would be to issue debtor notes (IoUs) to its creditors, promising payment as soon as fresh euro cash would become available. As creditors lacking euro cash would have to use the IoUs to settle their own bills, these instruments would assume the role of a parallel currency (let’s call it Geuro)…..”

This innovative and radical solution is also interesting because it offers a lot of insights especially on the topic of what constitutes a modern currency.
Some of the key take-aways are:

1.      A currency is nothing but an IOU backed by the full credit of the government

2.      The government first needs to spend money into existence for money to circulate in the economy.

The government financing its primary deficits with IOUs is the proposal brought forward by Mr. Mayer. It is noteworthy that without a government deficit a currency cannot come into existence. It cannot tax its citizens or issue bonds because the currency does not exist yet. As a consequence a government deficit is imperative for a currency to exist.

3.      Government bond issuance is a tool to regulate the monetary transmission channel

As Mr. Mayer suggests, Greece could fully return to the Euro by buying back Geuros using Euros. While he does not mention a concrete framework of doing so a similar option would be to issue treasuries and redeem the holders in Euros. In any case, an attempt by the government to buy-back the currency, tax citizens, or issue bonds is not a way of financing itself, as this is something it can do by issuing IOUs (the Geuro) but a way to control the value of its currency.

While the proposal of the Geuro is insightful and offers a new look at the debt situation in Greece I also think that the implications of such a thought-experiment reveal the true nature of the role of the government in controlling its deficits to maintain the value of the currency.

Money is collateral

05 Thursday Jul 2012

Posted by in Monetary Policy

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Anyone describing the monetary system starts with the history of money which starts with early bartering system where farmers traded apples in exchange for meat subsequently developing a more refined and efficient means of exchange. “The Ascent of Money: A Financial History of the World” by Niall Ferguson provides a very good and interesting read. I will do things slightly more different and jump straight in and start with my first entry with a satirical story of the bailout package for Ireland that I read about 1 year ago and I recently came across again.

At that time I didn’t think too much of it but considering the current financial developments and many misconceptions I decided to revisit it and now believe that these few lines can help explain how the modern monetary system,  based on credit works. The story probably helps explain the complexities of our monetary and credit system far better than anything I have come across using such few words. I will explain why but first bear with me and re-read the satirical depiction of the Irish bail-out:

How the Bailout works for Ireland

It is a slow day in a damp little Irish town. The rain is beating down and the streets are deserted. Times are tough, everybody is in debt, and everybody lives on credit.

On this particular day a rich German tourist is driving through the town, stops at the local hotel and lays a €100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night.

The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the €100 note and runs next door to pay his debt to the butcher.

The butcher takes the €100 note and runs down the street to repay his debt to the pig farmer.

The pig farmer takes the €100 note and heads off to pay his bill at the supplier of feed and fuel.

The guy at the Farmers’ Co-op takes the €100 note and runs to pay his drinks bill at the pub.

The pub-owner slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him “services” on credit.

The prostitute then rushes to the hotel and pays off her room bill to the hotel owner with the €100 note.

The hotel proprietor then places the €100 note back on the counter so the rich traveller will not suspect anything. At that moment the traveller comes down the stairs, picks up the €100 note, states that the rooms are not satisfactory, pockets the money, and leaves town.

No one produced anything. No one earned anything. However, the whole town is now out of debt and looking to the future with a lot more optimism. And that, Ladies and Gentlemen, is how the bailout package works.

 And that ladies and gentlemen is a very good start to explain the modern monetary system. Why?

Although it sounds very simplistic there are many hidden truths that I would like to touch on. One of the first:

“Times are tough, everybody is in debt, and everybody lives on credit”.

In the financial system everybody is in debt and everybody lives on credit but times are normal.

6 people live in this town and each owes €100 to someone else. If the hotel owner owes €100 to the butcher than obviously the butcher treats this same €100 as a future receivable, an asset. The butcher can now go the pig farmer to purchase the pigs promising him to pay €100 upon receiving the €100 which are owed to him from the hotel owner. It should become clear that this new €100 was created out of thin air based on a promise and trust. No physical note €100 note was necessary to buy pigs. This is an important point. The butcher was able to purchase physical goods (pigs) with a promise to pay in the future (debt). Credit was created but on a more abstract level so was money. Money is credit and credit is debt.

The pig farmer who now has a claim on the butcher can go and do the same until the circle of claims described in the story is completed. One person’s debt is someone else asset meaning that on aggregate the town ignoring all other assets is worth €600. The total value of the town is determined by participants in the chain and interestingly all the value/debt can be cleared with one €100 note. It sounds strange, unconvincing and utopian yet it is a quite accurate description of modern finance. The amount of physical money (central bank reserves) does not influence the amount of credit in the economy. This is clearly one of the greatest financial misunderstandings!

Admittingly there are many simplifications and assumptions which make the story work the way it does. One of main assumptions is that all participants are of the identical credit worthiness. The butcher is willing to accept the same promise (€100) coming from the hotel-owner as the hotel owner is willing to accept from the prostitute. This is not just a simplification but rather a caveat. The hotel owner as implied by the name has a hotel backing his claim making him probably the most creditworthy participant in that town, but even he is faced with some distrust.

More realistic would be for the butcher to say the following: “Hotel-owner, I’ll sell you meat for €90 and you can pay me in the future but I require €100 as collateral (an insurance that this debt will actually be honoured). The pig farmer would say to the butcher, who now not has €100 but only €90: “Listen butcher, I’ll sell you pigs but you are no hotel owner so you’ll get pigs worth €70 which you can pay in the future but I require that €90 as collateral as you only have your butcher store as an insurance and therefore are not as credit worthy. Every member in the chain applies a “haircut on members with lower credit worthiness”.

Following this new chain of events we can see that this chain of claims does not go on indefinitely. Adding more town members to the chain does not create more debt and wealth indefinitely. There is a limiting factor, a very important one, but again its not the amount of physical money in the town. Its not how many physical euro notes are available but its the amount of trust members have in each other. The overall wealth breaks down to the credit worthiness. The higher the credit worthiness the smaller will be the haircut applied to collateral and the more can be borrowed from the next person in line. Borrowing is debt and debt is money and in finance money is collateral.

Now re-read the story and instead of hotel-owner and pig farmer insert Citgroup, Barclays etc.   Decide for yourself who takes the role of the town prostitute. That is not up to me to decide. This shows that in a world based on credit and debt trust, confidence and high-quality collateral far more important than physical money (reserves). Unfortunately 4 years into the current crisis we have not yet been able to restore trust and credit-worthiness and quite frankly are starting to run out of high-quality collateral.

Although simplistic this first post should give an introduction on how the modern monetary system functions and I hope that in the following posts I will be able to explain some of the more common misconceptions and provide some more clarity.