The co opting of banks in debt monetization, the fear of investors, the shackles of Basel 3, place significant constraints on the banking industry. 

Fractional reserve banking has always carried liquidity mismatches, but has managed to mitigate this by relying on some degree of inertia and asymmetrical information. Bank’s historically high ROEs were a function of leverage and the carry trade.

Today, government bond yields are low on a historical basis (even in Italy and Spain), and term structures are still flattening.

For the investor, the actions of central banks and regulators have created an acutely high liquidity risk premium. Normally, this would imply a steep term structure. Today it manifests in a flat term structure. How can this be? The liquidity in sovereign bond markets is responsible for their flat structures and low yields. Because the longer maturity bonds are tradable, they are liquid; and because they are liquid, they are sought after, hence their yield compression. Mark to market volatility remains a risk, however.

Investors seeking liquidity are now forced to take much higher risk than before since liquid assets either produce a low yield, or exhibit high volatility, or both.

Dogged demand for both liquidity and yield will drive some investors to seek equity dividends (discounting capital gains or losses), high yield bonds (discounting mark to market volatility and default), selling options (sometimes unknowingly in structured products), and whatever new products the financial industry will almost surely invent to meet this demand.

Spread between 2 and 10 year US treasuries:

What’s all this talk of QE3? The private commercial banks have been big buyers of US treasuries to the extent that they are operating QE3 on behalf of the Fed. Buying has accelerated from 63 billion usd in 2011 to 136 billion usd YTD 2012. The Fed is already the largest lender to the US treasury, ahead of the PBOC.

The BoE and BoJ are explicitly monetizing sovereign debt hand over fist. The only mega scale central bank to not engage in direct debt monetization is the only central bank without a country, the ECB. Constitutional issues impede the ECB from direct debt monetization, however, Mario Draghi has already found proxies in the private commercial banks using the LRTO. The current negotiations will likely lead to capitulation and a direct flow of capital from the ECB to sovereigns.

So every single central bank will be in easing mode with most of them monetizing local domestic debt.

The question of local or external funding of sovereign debt is only relevant at the micro level. At the global level, all debt is internally funded. Economists who point out that Japan need not worry since its debt is internally funded should not worry any further.

One question that arises is whether with excess liquidity at an extreme, inflation might become a problem. Debt monetization increases the money in circulation per unit output potentially leading to inflation. Depending on sentiment and confidence, inflation can occur even before the economy achieves full potential.

You can’t have your cake and eat it. The economy is a complex system and like most systems it has a number of variables or parameters. Some of these you can control. Others are the consequence of what you control. It isn’t always possible to choose all the controls and consequences. Choosing a bunch of controls automatically render other variables as consequences. Some variables are mutually exclusive controls. Attempting to arbitrarily define sets of controls and states, either by design or accident often leads to unintended consequences.

Hedge funds have been some of the most successful money makers since hedge fund records have been available. Since 2008, even the best managers with long track records have stumbled. Things just don’t work the same way as they used to anymore.

The approach to solving the problems that continue to ripple from the 2008 financial crisis is an example of trying to have your cake and eat it. The Euro is a specific example. You cannot have a single currency and expect to have convergence in factor prices. Not unless you have a convergence in factor productivity, economic policy and political and social ideology. You might be able to get convergence in interest rates or other factor prices but you will need multi currencies since exchange rates will automatically become system determined variables. (An interest rate peg, how interesting. I wonder how many crazy ideas we can conjure up.)

So far no one has been able to profit from the Euro crisis. Why? In a recession when credit default rates rise, distressed debt funds are able to step in to assume risks that other investors cannot or will not. The rule of law, chapter 7 or chapter 11 in the US for example, guides the process and assigns the rights and obligations of the different claims. There is no equivalent law or regulation governing countries who default. Neither is the balance sheet of a country sufficiently defined that one can value a country let alone one of its claims. Investing in distressed sovereign debt is thus risky and highly uncertain business.

The investment landscape has become doubly difficult. Pre 2008, fundamentals were fairly straightforward, and once they were estimated, investor behavior was fairly straightforward as well. Markets have always been moved by investor psychology and how it interprets fundamentals. But now fundamentals have become dependent on more than just commercial realities and cold rationality. As the economic pie has shrunk so strategic concerns have increase in importance. The world has become more protectionist and mercantilist as peoples and their leaders seek to avoid loss and disadvantage. Hedge fund managers who have found their fundamental approach to investing confounded point to increased macro risks. This can arise from strategic policy impacting macro variables in unexpected ways which in turn impact industry conditions. As the world adjusts to this new reality, so too has the psychology of investors changed. The same information finds different interpretations. The problem for traders is that the prevailing interpretations are just not what they used to be. Investors are reacting differently to how they used to react to the same pieces of information.

The minor question is, how do we invest and profit from this new reality? We have seen relative value strategies in infinite duration assets fail miserably while arbitrage strategies within capital structures in finite duration assets have obtained encouraging results. Arbitrage it seems is the only safe play, and as we all know, arbitrage is rare, difficult to identify, difficult to implement, and often requires pre-defined gestation periods.

The bigger question is, as policy attempts the impossible, what are the consequences? Can a debt bubble induced depression be solved by the creation of more debt? Can fundamentally insolvent organizations continue to fund themselves ad infinitum? What is the final solution to the problem of excess debt?

Even more fundamentally, is today’s capitalism capitalism? Will the rolling legacy of moral hazard ever be addressed?

PS

Government Policy Put.

Governments the world over, in an effort to avert recession and disaster have written government policy puts (QEs, LTROs, Optwists) in such vast notional size that their negative gamma must be killing them.

Equities continue to rise or at the very least are resilient in the face of good and bad news., Sovereign bond yields head for zero. Meanwhile economic data seem to indicate a synchronized global slowdown. What gives?

1. Economic growth has fully recovered. The current tepid growth is a function of the necessary debt repayment and deleveraging which the world is undergoing. It is a mistake to anticipate a stronger recovery.

1. If you accept the above, then because the market doesn’t read current growth as having fully recovered, it is misinterpreting the impact of the short term business cycle. Current growth is inclusive of a peak in the short term business cycle. Hence, earnings expectations are too high and equities will be vulnerable over the next couple of reporting periods.

 I am wary of equities and other risk assets.

The world’s major central banks need to buy the debt issued by their governments. This is not just to boost the economy by increasing money supply. It is mostly because no one else will buy their junk bonds.

Most countries are able to do this, except the Eurozone. In the Eurozone, there are a number of countries who need to have their junk bonds bought by their central bank and there are also a few countries who don’t. These countries, understandably, don’t want the central bank to go about buying any junk bonds, even, or especially those issued by their fellow members. The ECB is not allowed to buy government bonds. So in December last year, the ECB came up with a clever plan. It lent money to private commercial banks in such a way that they had no choice but to buy the junk bonds issued by their respective national treasuries. This was the LTRO. The countries that are not so broke and don’t issue junk were not too happy about this. In the meantime, the countries that are broke have, under austerity measures, seen their economies get a bit worse, which is no good for tax revenues, and no good for debt service, and therefore no good for their creditors. So they need to refinance themselves and roll over their junk bonds. Once again, no one will buy this PIKable junk. So they look to their central bank to buy them. But the ECB cannot.

So here is the cunning plan. The ESM is established with a banking licence so it can borrow from the ECB. The ESM is basically the proposed successor to the EFSF and the EFSM. Don’t ask me what those are, I’m not sure I know. The ESM will basically be a hedge fund domiciled in Luxembourg, (one wonders if they will make it a UCITS and offer it to retail investors,) whose equity capital will be funded by the Eurozone member states, including (and one wonders quite how this works) the broke member states, and which will additionally be levered by the ECB. Technically, the ESM is a hedge fund and the ECB its prime broker.

It will be interesting to see if the Germans will invest in this hedge fund. They are being asked to seed it and be the largest investor with 27% of the equity capital. Not only that, Germany is a significant owner (19%) of the prime broker as well.

It is hard enough to get the Germans to invest in a for profit hedge fund but one has the feeling the ESM will be a not-for-profit hedge fund, the only one if its kind.

And what of the prime broker agreements? What leverage is being offered? At what cost? What are the margin requirements? Its going to be a long night.