A compromise for Greece and the troika.

• A debt exchange offer.
• New debt at much extended maturities. Face value smaller than existing face value.
• New debt to feature step up coupons to equalize the NPV of cash flows versus the existing debt.
• Effectively a refinancing.

Very quickly after winning the Greek elections, Syriza has approached Independent Greeks as a coalition partner. A coalition of the radical left and nationalistic right make strange bedfellows. Syriza’s 149 seats to Independent Greeks’ 13 mean Syriza will mostly have discretion in policy. With the elections out of the way, the question is, what next? Alexis Tsipras had made conciliatory sounds during the election but victory can change things significantly. Syriza had campaigned on a decidedly anti austerity ticket which was softened slightly during at the eleventh hour. With a stronger mandate than they had expected, Syriza may return to a more intransigent position. Indeed they may be expected to by their supporters.

Tsipras is in an unenviable position. On the one hand he has promised an end to austerity and to renegotiating the national debt with the ECB, EU and IMF, specifically seeking a one third write down of face value. The Germans have signalled that debt forgiveness is out of the question and that a Greek exit from the union is a practical possibility.

The Greeks will want to end austerity, to renegotiate the national debt and to reduce the face value of the national debt, as well as to benefit from the ECB’s bond purchase program. The Germans will want the Greeks to maintain austerity, continue to service their debt, and not write down any debt. A compromise needs to be found. There is no guarantee it will be.

A practical compromise would involve the following. Austerity measures could be partially rolled back so that the government could run a budget deficit. The terms of debt would be restructured to provide the Greeks more time to achieve cash flow solvency and balance sheet stability. Specifically, the coupons on the debt would be reduced but the maturities of the debt would be extended. The debt would include a 10 year moratorium on coupon payments but step up in later years. The average duration of Greece’s liabilities are just over 16 years. The debt could be restructured to push the average out to 30 years. The coupons would start in year 10 and step up. This would satisfy the Germans that there was no bailout but rather a constructive reorganization. New debt could also be issued on a novel basis requiring an explicit senior and secured claim on a proportion of tax and other government revenues. This innovation could be adopted even for non distressed issuers.

Even then, the ECB will not be able to buy primary issue, and of the secondary issue, special arrangements are required since the ECB already owns more than 33% of the Greek national debt, beyond the limit specified in its current QE program. For Greece to benefit from QE. It would have to make some concessions on austerity and it certainly could not seek a debt writedown. What Greece could seek is an exchange offer in which the longer maturity step up coupon debt is exchanged for the existing debt. Theoretically, the face value of the new bonds could be less provided the NPV of the cash flows is equal to the NPV of the old cash flows. This would require a higher average coupon or a much extended maturity. The former is not feasible given Greece’s current cash flow but the second is certainly a possibility. These are details of course but as is so often when politics interferes with economics, a compromise solution is more cosmetic than real.

Yet another FOMC meeting has passed and the market continues to scrutinize the language of the FOMC statement for clues of what the Fed intends to do, heavily assuming that the Fed in fact knows what to do. The details will have been circulated ad nauseum by the financial press so we won’t delve into them here. Instead let us consider possibilities.

The market has been expecting the US Fed to raise interest rates, the timing is fluid but sometime this year seems to be the expectation. The Fed has to raise interest rates eventually if nothing else to reset an important policy tool. The strength of the US economy where employment is finally catching up to headline GDP growth is another factor. The current growth the US is experiencing is reminiscent of the mid 1990s Goldilocks (not too hot, not too cold, just right) economy, helped by depressed oil, energy and commodity prices. The weakness in the global economy is also helping the US grow without a pickup in inflation. China’s growth is decelerating, Japan is in recession and the Eurozone while recovering is barely clinging on to positive growth.

The consensus is therefore that the US has done with monetary accommodation and low rates while the rest of the world, stagflationary economies excepting, are in monetary loosening mode. What if the Fed was to postpone its rate hike? What would be the consequence? What is the likelihood? The USD could weaken. The consensus is for a strong USD and this is a very strong consensus. In the absence of a rate hike, the market could be quite unpleasantly surprised. The 10 year US treasury yield could move towards 1% and the 30 year to 2%. This could happen anyway while we wait for the rate hike. Fixed coupon issuance is likely to slow as tax receipts improve and debt is issued in FRN format. The demand and supply dynamics could flatten the curve.

Why might the Fed delay a rate hike? Low inflation might be one reason. 5 year 5 year forward breakeven which traded between between 2.4% to 2.6% has fallen steadily to 1.94% in Jan 2015. Deflation risk might stay the hand of the Fed. Slowing international growth is another possibility. The US is currently the main engine of growth. Of course people forget that the 7% growth rate that China puts out is a big number for a big economy, but even that number is shrinking. Latin America is flirting with stagflation. Brazil’s rising rates since March 2013 have not stopped the Real from steadily losing ground against USD. Europe has only just begun its money printing and debt monetization activities. If the European QE takes time to bite and Europe slows further, the US may not be able to raise rates for a while. In these scenarios, however, a weak USD is not likely since other currencies would be debased aggressively. Then there is the little question of the US treasury’s interest expense, currently 416 billion USD a year. A 0.25% hike in rates could, depending on debt maturities, issuance and impact on the term structure, result in interest expense rising some 50 billion USD, a 12% increase. Gently does it Janet.

The ECB, from pawnshop to used car dealer:

If you want to get more money out there into the economy, and get that money circulating instead of sitting in a dusty corner, you can’t just be a pawnshop. Lending cash against investment grade bonds is a pawnshop business, a.k.a. LTRO. Buying bonds in the secondary market is a used car business. You want to get the economy going, buy some new cars. Supplying money is one thing, stepping in where private demand is deficient is another. Buying used cars pushes used cars around at increasing prices making profits for other used car dealers but it does little for car manufacturers, output and employment.

And yet the ECB’s mandate excludes purchasing primary issues since this appears to be interference in fiscal policy. Purchasing secondary market issues apparently is not despite the issuers being clearly the same. Somewhere there is an argument that buying bonds from private holders does not explicitly bail out the issuers. True I guess. Bail out the holders of the debt, not the borrowers. Perverted but true.

Will QE work? The European economy is already recovering, so the timing of the announcement is fortuitous. Because trend growth globally, not just in the Eurozone, is slower than before 2008, policy will continually be miscalibrated. The European economy has slowed, but it has also very likely hit bottom and will recover. And now, the ECB and their QE will get the credit for it. On its own, QE would not have worked. QE depresses cost of debt, debt which nobody wants to incur. QE also depresses yields which are already well below US treasury yields. The analogy of pushing on a string was never more appropriate.

What is needed is more demand for goods and services, not more supply of credit. In the absence of private demand, governments need to target a budget deficit. Yet Europe is obsessed with fiscal restraint and budget discipline. What is ultimately required is a bond purchase program which is free to buy primary issue not only of sovereign debt but also of covered bonds and ABS. A To-Be-Announced mechanism of ABS and covered bond issues should be underwritten by an ECB asset purchase program. By actively encouraging demand instead of passively enabling it, policy makers might be able to awaken the moribund economy.

The current policy lifts asset prices but does little to address underlying demand deficiency and the failure of factor markets clearing. The ECB will simply have to do more later on thus fuelling a protracted asset boom while output and employment languish.

We remain positive on the outlook for China generally across risk assets.

1. Political reform is happening in the open and behind the scenes. At the Fourth Plenum, China elevated the constitution and announced the establishment of circuit courts free from local government influence.
2. Part of the reform is the wide scale anti-corruption effort which has ensnared some high profile officials previously believed off limits.
3. China is embarking on credit market reforms including eschewing blanket bailouts, encouraging more market discipline, regulating local government financing methods, prescribing collateral eligibility in swaps and repos. The recent policing of equity market margin trading is another encouraging measure.
4. Monetary policy has turned loose and is likely to stay that way. The PBOC reacted to US QE by tightening monetary conditions for the past 5 years expecting inflation. Inflation has abated and external economies are at risk of deflation. The PBOC has moved to compensate. Expect further macro prudential as well as traditional loosening.
5. The Chinese economy is slowing which is to be expected. That said, it is still the fasting growing large economy. The slowing economy will encourage the PBOC to be more aggressive.

The outlook is good for China risk assets. The investment strategy should be, A) avoid the obviously non viable, B) diversify among the remaining alternatives.

Draghi; Hi Tom. I’m going shopping next Thursday.

Jordan: How nice Mario. What are you buying?

Draghi: Nothing special. Just some high grade bonds.

Jordan: Really. How interesting. How much are you buying?

Draghi: Well, that’s the thing Tom. It sort of depends.

Jordan: Oh. On what Mario?

Draghi: Well, on how much YOU will be buying.

Jordan: I’m sorry? What was that?

Draghi: The exchange rate cap… Tom. Tom, are you there… Hello?

Could the ECB embark on a large scale bond buying program without consulting the SNB, which has been a large buyer of Euro sovereign investment grade bonds in order to maintain its currency cap? Of course not. The ECB would have to consult the SNB as to its intentions if it was to calibrate its own bond buying program size.

The fact that the SNB has abandoned its cap means that on Jan 22, the ECB will act with high probability and the program size is likely to be large, compensating for the fact the SNB will not be party to the purchase efforts.