Have central bankers lost control?

published 16 April 2007

Another strong March US payroll report has rattled financial markets. Although investors had expected slowing US economic activity to presage the first base rate cut in that country late in the second quarter of 2007 the report proved sufficiently strong to suggest that the US may not now embark on the process of interest rate reductions until early in the third quarter. Looking at the shape of the US Treasury bond yield curve, the extent of the inversion (3 month Treasuries yielding more than 10 year paper) might indicate, as it has done in the past, that investors were increasingly concerned regarding the possibility of a hard economic landing later this year.

However, the global economy is clearly thriving, equity prices continue to surge as investor confidence reasserts itself in the wake of the "risk episode" at the end of February and M&A activity continues to hit record levels around the world as "hot money" surges from one destination to the next in the same bewildering way in which a drunken sailor might reel from one side of the road to the other. Around the world central bankers have been raising short-term interest rates in concerted fashion but to no avail. What is going on and how might it all end?

A very interesting article published in the April edition of the CFA magazine landed on the writer's desk in the week before Easter. The article was written by Mr John Rubino who has established a strong reputation for considered pieces on the state of the global economy and its impact on financial markets. Historically, banks were the traditional source of liquidity, making money by borrowing short and lending long. When a bond yield curve assumes its "normal" upward slope, banks enjoy the positive "carry" between short and long rates and lend enthusiastically. When the yield curve inverts the positive carry dries up, banks pay more for deposits than they earn by lending, activity pulls back and growth slows.

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However, a quick glance at the real world indicates continued boundless prosperity. Credit is being created in multiple forms and in unprecedented amounts all around the world. Could it be, the article asks, that the linkages between global economies have altered so fundamentally over the past decade that the shape of an individual country's bond yield curve is no longer of any real relevance and that the traditional work of the central banker to regulate activity levels is doomed to failure?

The most obvious example of the world as a smaller place lies in the yen carry trade. An inverted bond yield curve may be a problem for a domestic operator but the financial markets operate under no such geographical restrictions. In such circumstances the shape of an individual country's bond yield curve is rendered meaningless. Nothing stops a global investor from borrowing in yen at just 0.5% and investing in higher yielding bonds or property somewhere else. Although the UK and US have benefited from the ensuing tidal surges other higher yielding, often emerging, markets have found themselves the surprised (and not altogether welcome) recipients of global investor "largess".

Whilst hard to assess just how substantial the yen carry trade might be, the Economist magazine estimates that it could be as much as $1trillion. Although clearly of considerable significance at that sort of size it is still dwarfed by global central bank reserve allocation decisions. We have written in the past regarding the increasing likelihood that overseas, particularly Asian, central banks were looking to diversify their reserves away from an over-dependence on US treasuries, but despite ongoing talk of such moves the export-driven economies of China, Japan and elsewhere across Asia continue to have over $3 trillion invested in the US bond market, a function of the apparently simple decision to recycle structural trade surpluses back into US bonds.

In simple terms, when Chinese companies receive dollars in return for exported goods, they exchange the US currency for renminbi at the People's Bank of China (PBoC). The latter could sell those dollars but in so doing would depress the $ / renminbi exchange rate making Chinese exports more expensive. Given that the Chinese currency is pegged to the dollar and that officials continue to show no great appetite to alter the situation any time soon, the dollar effect is "sterilised" by recycling funds back into US treasuries. This "vendor financing" on a vast scale clearly enables the Chinese and Japanese to continue selling very competitively priced goods to US consumers whilst providing the latter with an unlimited credit card with which to buy overseas goods.

The massive structural imbalances between the world's largest trading partners, coupled with a pegged Chinese currency, have created enormous demand for long-dated high grade debt. The US authorities have a problem in meeting this voracious appetite from only limited supply. The US hardly issues sufficient paper to meet the demands of China, let alone Japan or Saudi Arabia or other surplus countries or trading blocs. Enter the financial market alchemists!

The process of securitisation, bundling up high grade and low grade paper attempts to solve the US central banker's conundrum. By packaging up high grade debt, low grade "junk" bonds, together with home loan mortgages and credit card balances financial market engineers create a legal entity known as Special Purpose Vehicles (SPVs). These vehicles bundle up the bonds and then slice them up again into varying tranches, each with varying claims on the underlying debt's cash flows. Tranches with first claim are sold to central bankers with riskier tranches off loaded onto hedge funds and other operators prepared to bet that defaults will stay low enough to make their higher yielding portions profitable.

Rubino's article indicates that the dawn of synthetic securitisation on business has been "nothing less than seismic". In the past a bank writing a mortgage or business loan might have held it to maturity, it can now be sold on immediately and the proceeds used to create more loans. Banks have thus been turned into the suppliers of raw material to the securitisation industry, illustrating their continued willingness to lend despite the inverted nature of the bond yield curve. Private equity firms can instantly monetise their leveraged buy-outs and mezzanine debt, allowing them to jump straight back into more deals!

Whilst young and relatively inexperienced investment bankers yearn for the yields on these securitised packages they have had trouble, in the past, in convincing older and more experienced managers to participate in the frenzy. Such risk-averse individuals have needed persuading that these products are for them and the best way of so doing has been to provide such potential decision makers with insurance as a back-up. Enter the Credit Default Swap (CDS)!

A Credit Default Swap is a bi-lateral, privately negotiated, insurance contract through which an underwriter agrees to cover any losses arising on securitised instrument default. Whilst banks used CDS's to limit default risk on a loan, a huge market has been created in structured finance (providing insurance against default in asset-backed securities). As these insurance-type products have gained widespread acceptance so a market for them has inevitably evolved. Extraordinary as it may seem there is, at present, no regulatory restriction on the number of CDS's written on any one company's debt, hence US automotive parts supplier Delphi had, at one stage in 2005, c$25bn insurance on just $2bn debt!

When default rates are as low as they are such instruments gain huge popularity with hedge fund managers looking for new and alternative ways to make money for investors. Finding buyers for such instruments can be a problem but not if accompanied by cheap financing deals to any non-bankrupt company interested in acquiring them. Armed with cheap credit companies and private equity businesses have taken full advantage. According to Rubino S&P 500 companies bought back $431bn of stock over 2006, three times the levels of 2003. It hardly needs us to point out that share buy-backs are popular amongst large companies apparently lacking internal growth opportunities and for small companies eager to pre-empt possible private equity intrusion. As in the 1980s companies seeing themselves as possible bid targets are leveraging up to boost short-term investor returns and head off possible predatory interest but it still didn't stop global M&A increasing by 38% to $3.79 trillion in 2006!

The growth of securitisation has made bank reserve requirements much less relevant today than they were in the past but combine this new age credit explosion with massive structural trade imbalances and central bankers are seemingly powerless to act. Rubino's article poses an interesting problem. Imagine you are Ben Bernanke. Your economy is piling up a massive trade deficit and your country's bonds are filling the coffers of Asian central banks. You have engineered an inverted bond yield curve in an attempt to slow things down and show no great desire to moderate its shape in the light of generally upbeat data releases and yet the system is showing signs of getting out of hand. Banks are still lending where once they would have eased off and credit is still cheap. The appreciable easing in financial conditions in your country over the past few years has born fruit in a prolonged period of economic expansion but your trade deficit is still on an unsustainable path. Instead of cutting base rates you are sending indications to the market that you are actually still thinking about raising rates irrespective of the damage that yet higher short-term rates might have on an economy with so much leverage. Furthermore, as dollars pile up in the coffers of regimes not historically regarded as particularly friendly to US overseas interests do you in fact have any control over the exchange rate or credit conditions in your own country any more?

Those countries boasting a massive trade surplus have a problem too. China, Japan and others in surplus are frantically printing money to soak up the dollars generated by their exporters and ploughing those dollars back into US assets. Inflationary forces are being unleashed but China has its currency peg and is raising short term interest rates all the time. Japan keeps base rates artificially low (for this stage in its economic cycle) as a nod in the direction of its beleaguered ruling political party, thus encouraging the yen carry trade. Whilst few believe that such conditions can possibly last for ever (no country can absorb an infinite number of dollars for ever) current conditions have produced an uneasy confluence of divergent views. Given increasing protectionist calls in the US it is not inconceivable that, at some stage, politics may yet intervene to send the whirligig flying off the spindle.

So much for larger, more diversified and established economies, but what about those smaller emerging economies which have benefited thus far from the prolonged period of global economic prosperity but which are now being forced to confront seemingly endless waves of cash crashing down on their shores. A huge inflow of global capital drives up emerging market currencies making life difficult for local exporters. Cutting base rates to drive currencies down would risk stoking inflationary pressure and would probably have only added to hedge fund carry trade zeal. So, confronted with a unique and potentially catastrophic external force, many smaller economies have sought to impose capital controls in an attempt to limit the effect. Result, the "hot" money so necessary to fund internal investment heads quickly for the exit. Of such scenarios are the contagion fears of the future nurtured.

Inevitably, troubling thoughts such as these lead to uncomfortable conclusions for those who favour the old order and a desire to return to the comforting ways of the past. What will the future hold? Supporters of free markets will insist, taking their argument to its inevitable conclusion, that capital should always flow to where it is used best and where risk is understood and managed most effectively. Charles Stanley is strongly supportive of free market conditions, favouring the continuation of growth with plentiful jobs and subdued inflation, however, it cannot be denied that deep below the surface imbalances keep piling up. A falling oil price may take the US trade deficit away from earlier record levels but 2007 is bound to reveal another massive deficit following the $700bn built up over 2006. Total US debt now stands at a walloping 360% of GDP (compared with 280% in 1929) and that still fails to take account of what US Comptroller General Mr David Walker sees as the soaring levels of unfunded liabilities on government trust funds such as social security and Medicare as baby boomers start to retire. Apparently, unfunded liabilities increased from an already significant $20 trillion (read it and weep) in 2000 to $50 trillion last year. This potentially devastating build up leads even those not normally given to hyperbole to conclude that the current course is completely unsustainable.

The problem is that whereas in the past such a situation would inevitably have triggered a dollar driven balance of payments crisis nowadays there are so many vested interests in attempting to retain the status quo that an uneasy equilibrium on global foreign exchanges has evolved. Instead new risks are bulging out in unfamiliar places. The new debt created is, inevitably, of much lower quality than that of the past and relies entirely on the continuing willingness on the part of financial institutions to keep playing the game. In an environment in which Western bond yield curves are inverted, banks continue lending but only by taking on ever greater risks. For now the appetite for synthetic products is clearly apparent, but for how long? Markets in such derivative instruments as those discussed above are largely unregulated and are absolutely enormous. It is estimated that the amount of outstanding credit insurance alone is about the same size as global GDPand is still growing! Ultimately, a system cannot live with infinite debt. At some point a correction must take place, the fall-out from which would be substantial.

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