Bill Gross is out with his monthly commentary. Because his points are central to the discussion of policy and markets right now, I am going to write this weekly newsletter commentary outside the paywall.
Below are the key points as summarized at the outset of Gross’ column:
- How do we deliver in this New Normal world that levers much more slowly in total and can delever sharply in select sectors and countries?
- When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
- In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
- We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.
What Gross is referring to here is what I call "risk seeking return". It is a direct consequence of the Fed moving out the curve and attempting to artificially suppress interest rates in order to reflate the economy through asset price inflation. Gross puts it this way:
The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.
What he goes on to describe is the great secular leveraging. Gross remarks that, depending on your ideological world view, you could date this leveraging:
from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, this combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth.
I tend to date it from the end of Bretton Woods and the beginning of the nonconvertible, floating exchange rate fiat currency system. See "The Age of the Fiat Currency: A 38-year experiment in inflation" from April 2009.
The key to recognize here is that we are in a credit-based economic system and not a reserve-based system. There is no direct link between reserves and credit. It’s not as if the central bank adds reserves to the system and these are transmuted into credit via fractional reserve banking. The amount of credit in the system is determined by the risk-reward calculations of banks in granting loans and the demand for those loans. Banks are not reserve constrained. They are capital constrained. Financial institutions grant credit based on the capital they have to deal with losses associated with that activity.
As for reserves, they function largely to help the Fed hit its rate target. The US government, as monopoly issuer of its own sovereign currency, has given the Fed monopoly power in the market for base money. The Fed then exercises this monopoly power by targeting the overnight rate for money, the fed funds rate. That is to say, the Fed targets a rate or a price, not a quantity. Almost all modern central banks of today operate with explicit interest rate targets, allowing the overnight rate to fluctuate within a range. Any monopolist can only control either price or quantity, not both. Central banks want to target rates i.e. price. Central banks can’t target rates unless they supply banks with all the reserves the banks desire to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target.
Thus, in our credit-based fiat currency system, it is bank credit creation which is king. Normally, with rates not at the so-called zero bound, there is a fairly consistent relationship between reserves and credit. After all, loans create deposits, which end up increasing reserve balances as the Fed adds all the reserves banks need to continue to hit the fed’s specified policy rate. Again, failure to do so would mean failure to hit the rate and would require raising that rate. So financial institutions make risk/reward calculation based on the creditworthiness and demand for loans of borrowers and the capital they have to deal with potential losses. This creates deposits which are then backed by reserves when the Fed provides them to hit the Fed Funds rate it has set in the marketplace.
There is no natural check on the amount of credit that can be created under this arrangement. Even if income and GDP growth diminish, if financial institutions find a way to immunize themselves against credit quality deterioration and still grant credit to borrowers, they will do so. And that is the exactly what we witnessed with credit default swaps, mortgage-backed securities and a host of other derivative products sold on Wall Street and in the City. And this is why we had a monstrous credit bubble.
The question then is two fold:
- How do you stop this kind of system from inflating as it seems to tend toward credit inflation?
- If it does inflate excessively, how do you work it down and what are the consequences of that policy choice?
Over the past twenty-odd years, the way most economies have chosen to deflate credit growth is by raising the interest rate for overnight money. If you follow what I said above, this means that the central bank is setting a higher bar for the reserves over which it has a monopoly. The response by financial institutions is to want fewer reserves and thus to slow credit growth. Of course, if financial institutions feel immunized from their credit decisions by CDS or by having sold off their loan books as asset-backed securities, a central bank will need to be quite aggressive to bring credit growth to heel as we saw during the Greenspan conundrum days. In any case, boom bust is endemic to this system.
When the bust happens, the question then is how we deflate. In the past, again its been all about the interest rate policy lever – lowering the interest rate for overnight money and letting that feed through the system. But during this crisis we reached zero and credit deflation was so aggressive that the system bordered on collapse. So policy makers frantically started pulling other levers: quantitative easing, suspension of mark to market, fiscal stimulus,lower tax rates, payroll tax holidays, etc. Remember, none of these policy levers would have been utilised if rates were not at zero.
And so, things have stabilised somewhat. But rates are still zero while inflation is above zero. And this is likely to continue to be the case as financial repression is the order of the day.
What do you do then if you look at your monthly bank account statement and the interest income you once relied on as a retiree is negligible? Gross had the answer at the outset:
In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
And that’s exactly what the Fed wants you to do. They want you to shift your investment portfolio preferences to higher return/higher risk assets. And they have told you that rates will be at zero through 2013 to entice you to do so. This always means relevering. Gross has it right when he writes:
Actually global financial markets are only selectively delevering. What delevering there is, is most visible with household balance sheets in the U.S. and Euroland peripheral sovereigns like Greece. The delevering is also relatively hidden in the recapitalization of banks and their lookalikes. Increasing capital, in addition to haircutting and defaults are a form of deleveraging that is long term healthy, if short term growth restrictive. On the whole, however, because of massive QEs and LTROS in the trillions of dollars, our credit based, leverage dependent financial system is actually leverage expanding, although only mildly and systemically less threatening than before, at least from the standpoint of a growth rate.
He then asks the right question: "How do we deliver in this New Normal world that levers much more slowly in total, and can delever sharply in selective sectors and countries?"
- Commodities and real assets become ascendant, certainly in relative terms, as we by necessity delever or lever less. As well, financial assets cannot be elevated by zero based interest rate or other tried but now tired policy maneuvers that bring future wealth forward. Current prices in other words have squeezed all of the risk and interest rate premiums from future cash flows, and now financial markets are left with real growth, which itself experiences a slower new normal because of less financial leverage.
- PIMCO’s potential alpha generation and the stability of bonds remain critical components of an investment portfolio. For bond markets: favor higher quality, shorter duration and inflation protected assets. For stocks: favor developing vs. developed. Favor shorter durations here too, which means consistent dividend paying as opposed to growth stocks. For commodities: favor inflation sensitive, supply constrained products. And for all asset categories, be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.
Gross calls his investment paradigm "safe carry". I have to remind you that higher risk means potential for greater losses as well as greater gains. In risk seeking return, it is going to all be about alpha, particularly during the coming period of profit margin mean reversion.
I think that’s about all I intend to say here. I suggest you read the full post linked below. But let me make a few final comments. I am seeing some releveraging too. See Daniel Alpert’s piece at Naked Capitalism on this. It speaks volumes. Question: Why would you deleverage unless you have to? I know a lot of people talk about the balance sheet recession and so on but the only answer I can come up with is the debt distress and bankruptcy that lead to credit writedowns. And since no one has repealed the business cycle, you have to see some releveraging outside of these credit writedowns. That’s what business cycles are all about – credit creation. Bottom line: balance sheet recessions aren’t an unmitigated orgy of painful deleveraging. The business cycle necessarily means that the majority of the deleveraging is done around and during recessions.
At this point in the business cycle I don’t expect mass deleveraging. I expect some mild – or even robust – releveraging. Moreover, in the US, the federal government deficit is still high and households are releveraging. That is supportive of profit margins. And this should continue through the election in November 2012. What I see in the meantime is mounting negative earnings surprises. We need to watch the policy response for pointers on where asset markets are headed. If we get a muted response, that would be negative for shares and other risk assets. But, at the end of the day, it’s really about the financial sector balances. US Consumers are not increasing savings. That game is done. Meanwhile weakness outside of the US means that trade will not support profits. Therefore, when budget cutting starts after the election, absent significant consumer releveraging, that’s when you would expect profit margins to decline – and stocks with them.
Source: The Great Escape: Delivering in a Delevering World – Bill Gross, PIMCO
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