Sunday, 2 June 2013

Credit - Goodhart's law

 "When a measure becomes a target, it ceases to be a good measure." - Charles Goodhart

"The original formulation by Goodhart, a former advisor to the Bank of England and Emeritus Professor at the London School of Economics, is this: "As soon as the government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends." This is because investors try to anticipate what the effect of the regulation will be, and invest so as to benefit from it. Goodhart first used it in a 1975 paper, and it later became used popularly to criticize the United Kingdom government of Margaret Thatcher for trying to conduct monetary policy on the basis of targets for broad and narrow money" - source Wikipedia.

In anticipation of next week's nonfarm payroll number and the US unemployment rate, we thought this week, following the suggestion of another good credit friend, we would make a reference to Goodhart's law. Conducing monetary policy based on an unemployment target is, no doubt, an application of the aforementioned Goodhart law. Therefore, when unemployment becomes a target for the Fed, we could argue that it ceases to be a good measure.

After a quick market overview where we will be looking at the implications of surging volatilities in the bond space spilling onto other asset classes (a point we touched recently), we would like to focus our attention on the broken credit transmission mechanism. Some punters have been putting the blame on QE recently, we think it has much more to do with global ZIRP. We will also discuss the issues we have with the Keynesian multiplier.

This week, we have continued to watch the moves in the MOVE index, which are going to spill no doubt to the CVIX index and most likely in the equity volatility indices space - source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Like we posited last week, the spike in volatility in Japan has been preceding the widening move in CDS Spreads of the Itraxx Japan, a move we saw coming. Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Itraxx Japan 5 year CDS since January 2010 until today - source Bloomberg:
As per 2011, the spike in volatility in Japan has been preceding the widening move in CDS spreads for the Itraxx Japan.

The volatility jitters in the bond space, have led to a surge in European Government Bonds yields in the process as indicated in the below graph with German 10 year yields rising towards the 1.50% level - source Bloomberg:

As we argued in the last few conversations, Investment Grade is a more volatility sensitive asset to interest rate changes meaning a surge in the MOVE index is leading to increasing volatility in the investment grade bond space where record lows yields on long bonds can lead to some vicious losses on highly interest sensitive long bonds (Apple 30 year bond being a good example of the repricing risk), whereas High Yield is a more default sensitive asset. The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened significantly recently. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:
With Treasury 10-year note yields, the benchmark for investment grade US bonds rising to 2.23% on May
29, the highest on an intraday basis in 13 months, before falling towards 2.128% on Friday, has led to the biggest losses in the global bond market in 18 months. This month losses on corporate bonds worldwide pare gains for 2013 on the Bank of America Merrill Lynch Global Corporate and High Yield index to 1.3% following a 12% return in 2012. The monthly performance is the worst since a 1.98% loss in November 2011 according to Bloomberg. No wonder investors are piling into shorter duration bonds at a record pace.

Of course in true Goodhart's law fashion so far equity volatility indices have ceased to be a good measure, since the massive liquidity injections courtesy of Central Banks around the world, have led to the volatility measure to be completely anesthetized for now. 

The divergence between VIX and its European equivalent V2X - Source Bloomberg:
The highest point reached by VIX in 2011 was 48 whereas V2X was 51. VIX is around 14.53,  and V2X at 19.14. We haven't seen a similar surge in equity volatility yet, but, rest assured that if the bond repricing continues, we will no doubt have some spillover of risk in the equities space.

Moving on to the subject of the Keynesian multiplier, in 1991, looking across 100 countries, Robert Barro of Harvard presented historical evidence that high government spending actually hurts economies in the long run by crowding out private spending and shifting resources to the uses preferred by politicians rather than consumers. There has also been a study by Valerie Ramey on the same subject.
Robert Barro’s work and research by Valerie Ramey, an economist at the University of California–San Diego, on how military spending influences GDP. Both studies found that government spending crowds out the private sector, at least a little. And both found multipliers close to one: Barro’s estimate is 0.8, while Ramey’s estimate is 1.2. Indicating that every dollar of government spending produces either less than a dollar of economic growth or just a little over a dollar.

Let's agree on one thing, governmnent spending comes from three sources, debt, new money, or taxes.

The Keynesian multiplier is normally supposed to be above 1 in order to justify an increase in government spending, if the multiplier is below 1, there is destruction of value, not creation of value.

Many seasoned economists, such as IMF Olivier Blanchard, have tackled the Keynesian multiplier and they have all come up with different results!

The link to a study of their calculations and different outcomes can be find here unfortunately it is in French but the results are on page 9 of the pdf:

So you can do all the calculations you want, because if your model is flawed from inception due to wrong hypothesis to start with, so will be the results.

What Keynesian economists tend to forget is that government spending is coming from three sources, you either have to tax more, or to increase debt more, or create new money.

In the short term, if we take France as a base case example of Keynesian policies at play, with the short term increase in taxes, the French government is expecting a boost in growth (financed by taxes) and a boost in growth in the long term (financed by debt). It is working just fine at the moment...

France unemployment rate versus Germany - source Bloomberg:

If a country has 100% debt to GDP, it means that this country has roughly bought growth at a 2% rate for 50 years. Last time France's budget was balanced was in 1974 and debt to GDP was around 20% in 1981.
That's why we think Europe is moving towards "japonification", and locked in a vicious deflationary spiral. 

But let's be constructive and talk about debt and credit:
Credit is like cholesterol, there is bad cholesterol that can’t dissolve in the blood (Low-density lipoprotein) and good cholesterol (High-density lipoprotein).
When too much LDL (bad cholesterol) circulates in the blood, it can slowly build up in the inner walls of the arteries that feed the heart and brain. This condition is known as atherosclerosis, and heart attack or stroke can result.

In 2008, we came very close to a global heart failure. The world had a stroke.

But what led to the bad cholesterol in the first place? Bad credit. So betting on a government making the right choice of allocation with "fiscal stimulus" is wishful thinking, we think.

Government policies favoring housing bubbles have led to mis-allocation of credit (bad cholesterol), like in the US, the UK, Hungary, Ireland and Spain.  Bad cholesterol (the "credit stroke) has led to "Balance Sheet Recession".

Government policies favoring infrastructure investment is good cholesterol:
One can posit that President Eisenhower when he signed the 1956 bill that authorized the Interstate Highway System in 1956 was of great benefit to the US. In his parting speech of the White House on the 17th of January 1961, he warned about the risk of bad cholesterol (military complex) but that's another story...

As we have argued in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is.

The velocity of money is the only real sign that your real economy is alive and well. US Velocity M2 index and US labor participation rate over the years - source Bloomberg:

M2 and the US labor participation rate are indicative of the failure for both theories. Both theories failed in essence because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows".

In similar fashion to the current Japanese plight, the Fed will eventually discover soon that company debt sales will counter its bond buying plan because corporate debt should act to absorb the cash generated by the Fed’s quantitative easing. As more companies take advantage of the relatively cheap funding (thank you ZIRP), they are overwhelming any growth in bond demand that stems from the Fed’s buying and related bond investments.

As we posited at the beginning of the conversation, we have argued that when unemployment becomes a target for the Fed, it ceases to be a good measure.  Don't blame it Goodhart's law but on Okun's law, as reported by Simon Kennedy on the 24th of May in his Bloomberg article - Fed History Shows Punch Bowl Goes as Job Rise:
"U.S. employment is 1 percent weaker than the level suggested by a popular economics’ rule of thumb, meaning about 1.2 million people can’t blame their lack of work on the weak recovery.
That’s the conclusion of a paper published this week by the National Bureau of Economic Research, which looked at Okun’s Law. Created by the late Yale University professor Arthur Okun, it maps a statistical relationship between gross domestic product growth and changes in the jobless rate.
The findings suggest more than 1 million of the jobs lost since the end of the 2008-2009 recession can’t be attributed to cyclical factors. That challenges the view of some Fed officials, including Bernanke, who question the assertion that the economy is suffering from structural shifts that permanently lift unemployment.
“Eliminating this shortfall will depend upon the implementation of measures that improve the workings of the labor market, as well as other government policies that raise the natural rate of unemployment,” said Menzie D. Chinn of the University of Wisconsin, Laurent Ferrara of the Bank of France and the University of Paris Ouest’s Valerie Mignon." - source Bloomberg.

The issue is not the efficiency or inefficiency of QE but, we think the troubling consequences of ZIRP when one looks at Japan as a proxy of the deflationary forces at play, unleashed by the damages caused by a zero interest rate policy for too long.

On that subject we agree with William Pesek views in his Bloomberg column from the 25th of April entitled "Zero Rates Are Harder to Escape Than IMF Thinks":
"Japan’s two lost decades are worth considering. The nation of 127 million people has been living with zero rates for so long that they seem, well, normal. Under the surface, credit spreads mean little, not when the underlying assets on which they are based are drugged up on monetary stimulants. Bank balance sheets get muddied. So do the government’s books, as it becomes hard to discern where a central bank’s holdings begin and end. Corporate shenanigans are easier to disguise.
Oddly, free money has done more to hold Japan back than to revive it. Monetary largesse relieves the pressure on politicians to make industries, from electronics to steel, more competitive and innovative. It concentrates capital in nonproductive sectors such as construction, telecommunications and power, and it starves others -- like startup companies --that could fuel job growth.
Zero rates also sapped the urgency from Japan Inc. at the very worst moment, just as it needed to keep up with a cast of growth stars in Asia, China included. Even when Japan has churned out growth of, say, 3 percent, it has been more artificial than organic. All that liquidity was meant to support so-called zombie companies and industries that employ millions. It has led to a “zombification” of the broader economy, complicating Prime Minister Shinzo Abe’s revival efforts.

 Long-term Risks
Ultralow rates, for example, have exacerbated Japan’s fiscal woes because the costs of adding to the world’s largest public debt appear negligible. Someday, bond traders will decide that a debt more than twice the size of a $5.9 trillion economy is too great for a rapidly aging population. For now, 10-year yields of 0.58 percent warp politicians’ sense of long-term risks.
China looks certain to fall into this stimulus trap, too. The yen’s 20 percent drop in the past six months, at a time when the Chinese economy’s prospects are already looking gloomy, has infuriated officials in Beijing. Cutting rates will do little good, as China grapples with its longest streak of sub-8 percent growth rates in at least 20 years. That could mean a yuan devaluation." - source Bloomberg.

We think that QE is not the core issue but ZIRP, which is in effect preventing creative destruction in a Schumpeter fashion and delaying much needed adjustments such as the ones needed from the European banking sector.

On a final note, since the beginning of the year we have not bought into the story of the "Great Rotation" from bonds to equities. One of the reason being on one hand demography with the growing numbers of baby boomers retiring, the other one being pension asset allocation trends. 

The bias towards greater equity allocation versus lower debt allocation is often associated with higher assumption regarding returns. But, as far as allocation data is concerned, there has been a consistent trend since the tightening of pension regulation  and the changes in accounting treatment of defined benefit plans set up in 2006 for lower allocation to equities. In 2006 the Financial Accounting Standards Board (FASB) required that the year-over-year change in the funded status of the plan to be recorded in the company financial statements as part of the Other Comprehensive Income line. 

The "unintended consequences" of such a change as indeed brought volatility in corporate earnings given that the swing in the pension funding level now directly has an impact, pushing companies to increasingly try to reduce the risk and aforementioned volatility as indicated by Bloomberg:
"Companies offering pension plans in the U.S. are increasingly seeking to reduce the risk of failing
to meet their obligations, according to Erin Lyons, a Citigroup Inc. strategist.
As the CHART OF THE DAY illustrates, swings in pension-fund returns may give them an incentive to act. The chart tracks the iBoxx U.S. Pension Index, designed to mirror the performance of a typical plan with defined benefits.
The index had a 6.1 percent loss for the year as of two days ago, when Lyons wrote her report. The decline followed a 0.2 percent gain for all of last year -- and a 31 percent surge the year before.
Volatility in funds’ asset value and relatively low interest rates “have made managing pensions increasingly difficult,” the New York-based strategist wrote. “Corporate managers are evaluating whether or not they want to be in the asset-management business.”
One possibility is switching to defined-contribution programs, especially 401(k) plans, the report said. Another is shifting into bonds and away from stocks. Ford Motor Co. will “walk toward” raising fixed-income investments to 80 percent of pension assets from 55 percent at the end of last year, Treasurer Neil Schloss said in March.
Ford and General Motors Co. offered pension buyouts to retirees last year, and Lyons cited the lump-sum payments as a third option for “de-risking.” GM also used a fourth approach, transferring obligations to an insurance company through the purchase of a group annuity." - source Bloomberg

As indicated by CreditSights in their 29th of May 2013 Asset Allocation Trends - 2012 Pension Review:
"Key among the prevailing market realities in the post-financial crisis environment has been the extended period Quantitative Easing and the continuation of the Fed's prevailing zero interest rate policy and in the latest year's plan asset allocation data there was evidence of the effect this was having. As noted above, historically low interest rates have not only inflated the calculated liabilities of pension plans via the downward pressure on interest rates, they have also deflated assumed plan asset return rates as fixed income has increased as a percentage of plan assets." - source CreditSights.

So much for the great rotation, given, as indicated in the same report from CreditSights:
"One of the notable observations from our data analysis was that there was very little change in the allocation across the plans vs. the prior year. The median allocation to equity fell only marginally (from 50.8% to 50.0%) and the allocation to fixed income, rather than increasing, fell from 37.0% to 36.4%. This suggests that the trend towards Liability Driven Investment has slowed. While this, at least in part, likely reflects that the shifts made over the last seven years have better aligned many plans with their desired allocations, it also is undoubtedly influenced by the interest rate environment. Historically low interest rates across the full maturity spectrum make it an inopportune time to be increasing the allocation to fixed income assets (or to be increasing the duration of those assets in the portfolio!) " - source CreditSights.

Hence the reason, we care more about the distortion created by ZIRP, because if the increasing duration risk which has to be taken by players such as pension funds...

"It is the set of the sails, not the direction of the wind that determines which way we will go." - Jim Rohn 

Stay tuned!

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