In early 2012 it gradually became apparent that the world was slipping into a synchronized slowdown. At least it became gradually apparent to slower minds like this one. By mid 2012 it became quite clear that the US recovery which started in August or September 2011 was petering out, Europe had never really picked up since the Summer of 2011 when Greece first exposed the vulnerability of the Union, and China’s slide was gaining momentum. In the last month we have seen better numbers from China, continuing weakness in Europe and in the US, a rebound in the real estate market if nowhere else in that economy.

What are governments hoping for and working to? The scale of the debt problems whether in the West or in Asia are too much not to enlist the aid of time. Some call this kicking the can down the road. Its not a good strategy, on its own, but its not a bad strategy if it buys sufficient breathing space to address more fundamental problems. The problem in Western democracies is that the gestation of such policies extends beyond the election cycle.

Lets make a to do list for a garden variety sovereign in a bit of a tight spot.

1. Increase real GDP growth. This is hard to do. Increase nominal GDP growth. This is also not easy without fiscal intervention which is constrained by budgetary issues. Keeping a low but positive real or nominal GDP growth seems to be the easiest best that one can do.
2. Reduce unemployment. This depends on the success of 1 above.
3. Keep inflation high as long as it does not surface in official statistics or lead to social unrest. This should debase debt without damaging officially measured real GDP growth.
4. Keep the banking system functioning. Only Europe has a real problem on this point. The US has recapitalized its banks and Asia looks healthy for now. The opacity and complexity of banks’ financials mean that this problem never ever truly goes away. Vigilance is required at all times.
5. Keep interest rates low. Facilitate the refinancing of the government and other credit strapped institutions. QE suffices for now in achieving this aim. Ideally there will be sufficient demand for government debt that debt monetization can stop. Low interest rates are necessary for an over-indebted world. If interest rates rise the implications for large swathes of the economy are highly negative.
6. Keep a competitively low exchange rate. The world’s economies cannot all simultaneously operate this strategy successfully. Yet attractive terms of trade are necessary to keep the export sector supported. In a sufficiently globalized world excessive success of one country can likely lead to instability for its trading partners making any such success short lived. Low FX volatility is good for all.
7. Balance the budget. This is almost intractable but it needs to be addressed at some point. By addressing refinancing risk in 5 above, central banks have bought time for governments to at least turn the budgets in the right direction. The longer term goal of balancing the budget is of course to reduce the outstanding amount of government debt and improve.

The above is a realistic, practical and feasible strategy to pursue, subject to a few limitations.

1. The time bought by debt monetization might not be well spent. There are many issues to address and the extra time obtained by debt monetization is finite. Many things can go wrong.
2. The scale of the problem might be bigger than everybody thought. This is a serious risk and one that can come from the banking system or sovereigns hiding the scale of their solvency issues.
3. Central banks are unable to reduce the banking system’s balance sheets sufficiently quickly in the face of accelerating inflation or recovery. Point 3 above is a risky strategy as it assumes that a desired level of inflation can be sustained without accelerating beyond targets.
4. Investors’ patience runs out before the root causes of the sovereign crisis are adequately addressed. This can lead to higher interest rates even in the absence of inflation or recovery and can threaten the cash flow solvency of sovereigns. Companies’ cost of debt would likewise rise. Given the current low levels of interest rates, the immediate impact on debt service could be severe. The stock market may also give up which would damage sentiment and cause a recession or depression.
5. Debt monetization and fiscal reflation are redistributive policies. The proposed redistributions may prove unpopular and precipitate a reaction.

The strategy is not entirely without merit and not completely hopeless, but there are serious risks, some of which have been understated above.

The yield on high yield bonds is not very high.

The ability of an insolvent concern to raise debt can stave off insolvency.

• I’m sorry, I can’t pay you in silver or gold, will you take an IOU?
• But that’s what you said last time. Can you pay off the last IOU?
• Will you take paper money? 

• Who is going to lend us money?
• Well, we are.
• What? We are going to lend us money? Why? How?
• Its simple really. You ask for a loan and we will give you one.
• With what money?
• With the money you borrowed from us.
• I see. Quite elegant if I may say so. How will we repay it?
• You’re going to have to balance the budget.
• That’s problematic. We can’t raise taxes.
• We don’t want you to. Can you spend less?
• We could but if we did I’m afraid that apart from healthcare being completely underfunded, unemployment benefits and other social welfare costs are not likely to abate.
• In that case you’ll need to raise taxes.
• We can’t. If we did the drag on the economy would put us back in recession. And tax receipts might fall. As it is we have cash flow problems. That’s why we need to borrow some money. The problem is no one will lend us any.
• Don’t worry, we will. But you will have to balance the budget.
• That’s problematic…

The better game show host won.

Since the great transfers following the great crisis of 2008 and the realization that debt levels had surged out of control, inflation has seemed like a tantalizingly viable and easy solution to the debasement of debt.

It is clear that central banks and governments would be encouraged to create as much inflation as possible as long as this inflation is not picked up in official data. So far their efforts have led to an asset bubble in bonds and emerging market assets and currencies. It seems as though the results of quantitative easing are invariant to the perpertrators of QE, that is, you can print but you cannot direct. The liquidity will flow to where the liquidity will flow. For emerging markets this has been a painful side effect of Western government’s efforts to save their own skin. For Western governments this has been frustratingly like blowing up a punctured balloon.

Those who support these inflation policies should understand that economics is not physics or chemistry and that inflation targeting and debt erosion tactics are a bit like running a nuclear reactor. A controlled chain reaction in a nuclear reactor provides heat energy which is harvested. The key word here is “controlled”.

Given their explanatory and forecasting track record of economists and central bankers, would anyone like to entrust an economic nuclear reactor to them?

The past decade has seen the emergence of the yield junkie. You recognize them from their propensity to pay and subsequently overpay for anything with the tiniest shred of yield from investment grade corporate bonds to sovereign bonds to AAA rated junk. In the past couple of years, the yield junkie has trampled on spreads and thinned out yields across investment grade and high yield bonds. The more hardened ones even buy equities for an at risk dividend payout.

There are various sources of yield. There is duration risk, which tends to be isolated in the sovereign debt of a handful of countries who remain solvent enough to repay their debts or have a sufficiently strong following that they can continually issue their payment-in-kinds until, well, until they cannot. There is credit risk, which is the element of risk over and above the risk free asset of similar duration or tenure, although the concept of a risk free asset is a bit threadbare at the moment, but let’s suspend disbelief for a moment. And why not, the central banks have suspended theirs indefinitely. Another source of yield, and now we are in the realm of Class A drugs, is option premium. Side effects include a healthy dose of negative gamma and often an even healthier dose of built in leverage. Dealers of course would suggest the application of light leverage, only because the application of heavy leverage looks too much like a lit fuse. A mercury switch is much more marketable.

As so often happens, dealers become users when they sample their own wares. Its when management samples the inventory that the wheels really threaten to come off. The largest buyers of US treasuries are private commercial banks and the Fed. The continued debt monetization operations of the central banks flatten yield curves and compress yields leading to mark to market profits for current investors. But what can investors today expect in future returns? The same question is relevant not only of treasuries but also of investment grade and even high yield corporates.

Lets try to find the new drug of choice for the yield junkie before they really get deep in it. What are the prospects for high yield? Average high yield spreads in the last 20 years have been around 590 bps. In the financial crisis, they spiked to over 1800 bps. Today, high yield has recovered to a fairly tight 615 spread to worst. How about leveraged loans? Leveraged Loans have typically traded 140 bps tight of high yield. In the financial crisis, leveraged loans traded in line with high yield, a significant underperformance. Since then they have recovered with equal abandon. However, since the financial crisis, leveraged loans now trade within 50 bps of high yield. Why is this?

The reason lies not in the properties of the asset but the nature of their buyers. The main buyers of high yield are mutual funds. (If ever there was a proxy yield junkie, the long only, index hugging mutual fund is it.) Insurance companies, bank prop desks and hedge funds used to also participate but with increased regulation (read Basel 3 and Solvency 2 which are basically trying to wean the junkie off the poison by allowing them only controlled doses supported by…. Capital), demand is a lot less frantic than before. And besides, hedge funds tend to be long and short the stuff, equally imbibing and dealing at the same time. Leveraged loans, however, were the preserve of the structured credit animal called the CLO, a specific flavour of CDO. CLO issuance has ebbed since 2008, globally, but especially acutely in Europe. As a result leverage loans are relatively unloved. Also, because of the unfortunate nomenclature of credit markets, these senior secured debt instruments have been unloved by the garden variety investor (this includes institutional investors, it’s a big garden.)

Since central banks have fiddled with sovereign balance sheets, banking system balance sheets and real economy relative prices, they have created a situation where interest rates are expected to remain low for the foreseeable and indeed unforeseeable future. Until inflation perks up, or a recovery takes hold, or someone describes the Emperor’s new clothes.

Corporate bonds, investment grade:

• Fixed rate.
• Tight as a drum.
• Implying low default rates.
• Senior unsecured.

Corporate bonds, high yield:

• Non investment grade issuers
• Senior unsecured
• Elements of equity risk
• Fixed rate
• Average spread of 615 bps 

Loans:

• Non investment grade issuers
• Senior secured – senior in claim to second lien and to senior unsecured (bonds)
• Floating rate.
• Average spread of 580 bps.

Loans are no panacea in an over QE’d world, but hopefully, given that garden variety investors will take some time to react to this asset class, yields should not collapse. Also, there is a relative value argument that is pretty compelling. With average recovery rates of 40% for high yield and 80% for loans, and average spreads of 6.1% for high yield and 5.8% for senior loans, conceptually at least, one could buy a dollar of loans and 60 cents of credit protection netting a yield of 2.14% with a loss given default of 16 cents. It is highly highly highly unlikely that you will be able to perform this little trick within the same issuer, that would be too easy. However, the arithmetic highlights the relative value opportunity between high yield and senior loans.

The above analysis is a stretch for the yield junkie but here is something they might understand. When a government is as indebted as the Western governments are, interest rates cannot remain low for long. Fixed rate bad, floating rate good. Unsecured bad, secured good. Subordinated bad, senior good.

PS

What are the chances that strategies like this will be offered in a regulated, risk managed, transparent, fund format to investors? Professional gatekeepers and experts stand in the way, and unfortunately the industry contains professionals who may lack the intellectual faculties or experience to understand strategies or matters in general outside a very tightly defined remit. Fear of the unknown, superstition, insularity, and reckless extrapolation plague certain parts of the industry. These elements limit the scope of investment opportunities to the general public to the detriment of all.

The need for political correctness is the tolerated, celebrated suppression of honesty. It conflicts with the goal of transparency. Yet today’s world seems to drift toward more political correctness, rhetoric and oratorical populism.

It is as if people have lost faith in their past heroes in the boom years and cry out for new direction only to find a gaggle of game show hosts, used car salesmen and worse, politicians, chasing their dollars, votes and adoration. This is dangerous because humans are generally weak minded and seek to be led. This encourages those who wish to lead, including those who are driven by greed, glory and ambition which may be independent of the causes of the people they seek to lead.

It is in this sweltering climate of famine, inequality and oppression that this species has elected some of our worst madmen to replace our erstwhile oppressors. Those fed us lies of prosperity through the application of credit, rising housing prices, ever falling interest rates and a persistent sense of entitlement. What will the new generation sell us? It almost seems that we cannot survive without some form of oppression.

What could Washington sell Americans still drunk on the inevitability of the success of the American Way? More QE? More credit? Rising house prices? More useful jobs certainly wouldn’t hurt.

What might Beijing sell a billion witnesses to the failure of Western Capitalism, the apparent triumph of the Chinese model, unbridled greed in the coastal cities and an inequality of wealth unmatched in the Western Democracies? Affordable housing? Lower food inflation? Greater equality? Within? Without?

And what could European leaders sell their collection of people’s shoehorned into union by a broken currency union? Closer union? Fracture? Fission?