U.S. Term Premia and U.S. Economy

An economics/financial writer recently expressed surprise that U.S. five year term premia nearly matches U.S. 5 year breakeven inflation.  To me, it seemed obvious, in this low interest, low growth economy, that the above would be true.  In 2015, Bernanke commented on how low term premia appears to be holding down  interest rates.  In the March 2017 New York Federal Reserve Bank Snapshot of the U. S. Economy, on page 14, you can see the term premia of the U.S. Treasury ten year nearly matches the 5-10 year inflation risk premia.  This is what one would expect in a period of low growth, no significantly surprising political instability in the world, and no financial instability.

I find nothing wrong in my disagreement with the writer, because he pointed to data, expressed his opinions, and ended up asking questions.  The fact that I disagreed caused me, as is my habit, to look and see if I was right or wrong.

Here is a good compilation of how the New York Federal Reserve Bank calculates term premia how it has been used and evaluated.

I have, in the past, pointed readers to the New York Federal Reserve Bank U. S. Economy in a Snapshot monthly report.  Put it in your bookmarks to review monthly. 

In New York Federal Reserve's analysis of the last 15 bond market sell offs, it immediately struck me that the last sell off in July 2013 was consistent with the Cyprus "banking" crisis.  As a country which is a member of the EMU and uses the euro as its currency, Cyprus saw its banks closed, deposits seized or taxed to fund a bailout, and monetary capital controls imposed to keep money in the country.  The bailout terms, banks resolution, and capital controls were imposed on Cyprus, a sovereign nation, by the EMU.

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China's Capital Markets, Pettis, and Balding

Here is a 93 page analysis of China's capital markets, from the Asia Securities Industry and Financial Markets Association, with three pages of recommendations with respect to equities, fixed income, FX, laws and regulation, market infrastructure, and market access. It is well worth reading. 

There are many places to look for what is going on in China and what it means for the world.  You are going to get a variety of opinions on debt, property bubbles, corruption, inequality, SMEs, currency controls, and the potential problems of deleveraging.  Bottom line, China is a very government controlled, closed society which has great power to force its will on the rich and poor.  The extent it might impact those who export to it, who have invested in China, and those who have bought its corporate stock and debt should be of concern.  It is large enough to have world-wide effect.

Michael Pettis  and Christopher Balding are good sources to follow for similar and differing views on what is going on in China and what i being done or might be done or should be done.  Both teach in China.  Pettis has a private monthly newsletter to which one can subscribe by e-mailing him at chinfinpettis@yahoo.com asking for a regular subscription as an investor or a complimentary subscription as a journalist, academic, or government official.  His blog posts are usually shorter versions of the monthly newsletter.  Balding also writes for Bloomberg View.

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Are ECB Target2 Balances Ever Risky?

Izabella Kaminska is a very talented and intelligent writer for FTAlphaville and I try to read everything she writes, because she makes you think.  I will continue to read what she writes.  When she wrote yesterday that ECB Target2 balances are a big deal, I was thrown for a loop and wondering what am I missing.  I even reached out to another financial and economic professional for a give and take discussion.

Kaminska cites the March BIS Quarterly which shows that Target2 balances have substantially increased as the result of the Asset Purchase Program but CDS spreads have remained stable.  She then concludes that the capital flight during the 2012 Greek crisis was a big deal which resulted in Target2 balances increasing and creating "financing" by Target2 credit National Central Banks, such as the Bundesbank in Germany.  She also concludes this was a failure of the transmission mechanism and cites a paper on the old Soviet Union's International Investment Bank in an attempt to draw a comparison of flows and a failure of the transmission mechanism.

I have written about Target2 twice in 2015 (here and here) and discussed it with economic and financial professional in the United states and other countries.  Additionally, as I have previously cited, Whelan published an excellent paper on Target2 and how it works in 2012.

I am going to try to keep this simple.

The stable CDS spreads with increasing Target2 balances show the Asset Purchase Program is working.  In fact Footnote 3 in the BIS March Quarterly cites the BIS November 2016 Quarterly which states, "The ensuing upward trend in TARGET balances largely reflects the settlement of these cross-border transactions by central banks and, therefore, does not signal renewed stress in financial markets."

Target2 credit balances are money created by the ECB and not by financing from the credit National Central Banks.  National Central Banks are only liable for losses at the ECB to the extent of their Capital Key ratio, which with Germany is 17.9973%.  With respect to the APP, National Central Banks are only exposed to 20% of any APP losses which would be distributed according to the NCB's Capital Key ratio. 

With respect to the study on the Soviet Union's International Investment Bank, its failure was from pricing, industrial capacity, governmental policy, access to international markets, and a weak Soviet ruble unsuitable for international trade.  It is an interesting study of a failure of the transmission mechanism.  However, the ECB and Target2 during 2012 demonstrates the success of a transmission mechanism.  While the ECB balance sheet shows spikes in 2012 and currently, they are from two different causes and both speak to the maintenance of financial stability. 

The IIB transferable ruble loans to Soviet Block countries creating foreign currency denominated debt for those countries has some similarity to every eurozone country having its debt in a foreign currency (euro), but the eurozone is a monetary union (without a fiscal transfer mechanism) with a central bank (ECB) exercising monetary policy.

When would Target2 levels constitute a risk?  Any risk to Target2 would be a risk to the eurozone itself.  This is why arguments against Target2 have been arguments against the credibility of the euro as a currency and attempts to argue the euro is on its way to a currency crisis.  While I have long maintained the euro is treading towards a currency crisis, the crisis is dependent on growing political risk fed by a defective monetary union without a fiscal transfer mechanism which uses destructive austerity to compensate and only creates negative economic growth, more unsustainable debt, and a growing eruption of political unrest which is swelling to possible political risks in Italy and France. 

People are suffering.  Greece, which is already at depression economic levels, is again facing demands for more destructive austerity from the EMU and has never recovered from the EMU enforced coup in 2012 or the monetary warfare waged by the ECB in 2015.  Spain has had a temporary government for so long it may have forgotten how a real democratic parliament functions.  Spanish and Italian banks need support.  Portugal was allowed to keep its government on condition it did what the EMU wanted.  Cyprus had its citizens bank deposits taken away from them. It is no surprise people are unhappy.  And nobody really wants to ask how strong German banks, not just the large international banks (like Deutsche Bank and Commerzbank) but the national, savings, and landes banks really are, particularly since Germany has resisted including all its banks in ECB stress tests.

How serious would the political risk have to be?  If you look at the CDS spreads of 2003 euro bonds and 2014 (which have CAC provisions) bonds, you can see the increased political risk with the spreads between the two doubling to 40 basis points.  This perceived political risk ignores the possibility of an eurozone country actually exiting the EMU, changing its countries bond laws and abrogating CAC's, and redenominating its debt from the euro to its own fiat currency.  Just using Target2 balances as a base example, it is easy to see that if Greece and Portugal both left the EMU, the EMU could easily survive with its monetary credibility tarnished.  However, if Spain and Italy left and defaulted on Target2 and redenominated euro debt, it would create a significant loss and change in remaining eurozone countries Capital Key ratio.  Even if France left, it would create a significant change in remaining countries Capital Key ratio and create damaged euro credibility.  A currency depends on its credibility to survive.

Could the eurozone survive as a monetary union without Spain and Italy if they defaulted on Target2 and redenominated their euro debt?

The political risks are growing and they are not supportive of democracy. 


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Financial Market History: Reflections on the Past for Investors Today

The CFA Institute Research Foundation and the University of Cambridge Judge Business School just published a long read study "Financial Market History: Reflections on the Past for Investors Today".

The First section "examines what we can learn about the trade-off of risk for return from an extensive analysis of historical returns on equities, bonds, and other assets" and "concludes with an extension to other financial markets."

The Second section "explores the historical evolution of how financial claims are traded."

The Third section "addresses the perception that financial markets are inherently prone to irrational exuberance and bubbles."

The Fourth section "addresses the history of financial innovation."

The Study " concludes with a contribution from Barry Eichengreen, who argues that the research frontier in financial history will be driven by current concerns motivated by the 2008–09 financial crisis. He points to a number of studies that reexamine the historical record on the basis of what we now understand about the role of banks and systemic risk. This research is now possible through low-cost and easily accessible historical data. There is the danger that access to these data may inappropriately frame research questions being asked. He concludes that looking to the past may not of itself allow us to predict what might happen in the future; however, it does allow us to understand the broader historical context and our ability to appreciate what is different about our current circumstances. This important observation helps establish why the study of financial history has such important practical significance in the current economic environment."

Understanding the market is not just for professional advisors and analysts; it is important for the investor.  It is information and factual information drives proper investing.


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Investing Requires Reliable Governmental Economic Information

As a fiduciary investment advisor, I do daily macroeconomic and financial research which is very lengthy and time consuming.  If I could not rely on unbiased (ethically professional), independent (without political interference) U.S. governmental economic statistical data, all efforts at economic and financial research would be meaningless.  Whether any current fears and concerns regarding the future of U.S government economic and scientific data are legitimate does not remove the absolute need for reliable statistically unbiased economic data which must be vigorously protected in order to have a free, democratic society.  While no statistical model is perfect, the professional ongoing debate on the construct of statistical models which are data based rather than result oriented based is fundamental to ethical professional conduct.

A lot of misunderstanding of BLS data has been repeatedly manifested, to the point where is almost a meme, by politicians who do not care if they are ignorant or lie and "financial" talking heads or wanna be talking heads who make money taking advantage of people. 

There are always professional concerns about statistical models and how they might be better, but the data has to be independent of political bias.  Brent Moulton at Political Arithmetick has written an excellent professional critic and concern for the need of independent U.S. government economic data, particularly with respect to the BLS.

Mark Thoma of  Economist's View has written at CBSmoneywatch on the political economic concerns which result if economic data is not factual data based (documentable as independent)  without political bias.  To skew the data reporting to promote a belief rather than a factual data set analytical result would make it impossible for economists to know what is going on in the economy and impossible for investors to make investment decisions within a factually known economic environment and trend.



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Is the Gig Economy the New Feudalism?

 Isabella Kaminska at FTAlphaville has demonstrated the gig economy is rigged against the workers in a series of articles, while nakedcapitalism has run a series of articles by Hubert Horan on Uber's destructive business model which is dependent on having enough money to run an unprofitable business until the competition is forced to disappear.

The Gig Economy is reliant upon a defenseless workforce which signs up for opportunity and become dispensable units is a business model which does not acknowledge its workers much less value them.


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Are Soda taxes a Tax Regressive Health Failure?

From the Jayson Lusk, a food and agricultural economist, is a new post of his in which he points to new research by Emily Wang et al and in which he points out as he has again and again:

"First, even if we believe people suffer from various behavioral biases, higher prices almost certainly make people worse off.  Second, when we raise the price of one unhealthy thing, people might substitute to consume other unhealthy things.  Third, if the tax is just added at the checkout counter and not on the shelf display, it may not have nearly the effect on purchase behavior as assumed.  Forth, if people know the reason for the tax, some may "protest" and buy more instead.  Fifth, the projected weight loss from such taxes often relies on unreasonable rules of thumb like 3500kcal=1lb. Six, even when taxes have an effect, the causal impact may arise more from an "information effect" rather than a "price effect."  Seventh, such taxes may induce unanticipated effects because of how sellers respond to the policy.  Finally, soda taxes are regressive - having a proportionally larger effect on on lower income households (see also my co-authored paper on effects of "unhealthy" food taxes more generally)."

Cook County passed a soda tax in 2016 and the idea is being floated in the Illinois General Assembly.  I do not drink soda pop, because it contains high fructose corn syrup and I prefer brown sugar, although I have never been a fan of too much sugar in food and often cut sugar amounts in recipes.  Taxing "sugar", more likely high fructose corn syrup, will in crease tax revenue but it is unlikely to make people more healthy and the argument the tax will decrease obesity should be discarded as a political excuse to impose a regressive tax on lower income citizens.


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