Tail risk zero bound dynamics are driven by credit risk, not interest rates

This is my third post on tail risk now. See the first two here and here. I think the continued and broadening market volatility we have seen across asset classes in the last few months is a sign of increased tail risk and i wanted to put some parameters around how to think about tail risk and where to look for it. This post is going to integrate those last two posts together and tie up some loose ends using a few recent articles that illustrate where this is headed. I want to discuss oil, Russia, emerging markets, the eurozone, the US and Canada here.

When it comes to the investment and economic climate today, the most important factor to consider is the degree to which low nominal rates in developed economies have dominated the discussion and influenced investment strategies. It is safe to say that low or even negative nominal rates are the single most influential policy in the wake of the financial crisis. I believe this will have a meaningful impact as this cycle turns down as well.

In prior economic cycles, economies began to show signs of overheating, precipitating a tightening response from central banks which would raise interest rates. In turn, tightening led to recession and renewed easing via a reduction of interest rates. The result was that debtors throughout the economy saw credit terms tighten as the economy turned down but then felt an easing of credit stress when interest rates fell, irrespective of credit conditions.In contrast, during this economic cycle, there are no clear signs of overheating anywhere, including in the US and the UK where the central banks have turned to a tightening bias. With rates at the zero bound already, it is likely that we will see the credit cycle in many economies turn down without room for interest rate policy to add debt servicing cost relief. The lack of interest rate policy space is going to be the most important factor distinguishing this downturn from prior downturns. And so, tail risk zero bound dynamics are driven by credit risk and term premiums, not interest rates.

Japanese experience is instructive here. When the Japanese lowered rates to the zero lower bound, the business cycle did not end. Instead what we saw was that the full measure of credit tightening came down on debtors in the form of credit spreads and term premia gapping up. And I would argue that this increases pro-cyclicality and tail risk by concentrating more credit stress on the most vulnerable elements of the credit spectrum within developed economies and outside of them as well through private portfolio preference shifts.

Moreover, once rates hit the lower bound and the central bank turns to unconventional policy, we are in a world of financial repression as negative real interest rates dominate the landscape. Nominal real rates mean that borrowers are getting paid to borrow whereas savers are losing money. Thus, quantitative easing and forward guidance work primarily through the portfolio preference channel as investors reach for yield to escape the penalty of financial repression. Quantitative easing is an asset swap of base money for existing financial assets and can only lower yields to the degree private portfolio preferences shift. And this shift is kept in place via forward guidance that assures market participants that low rate policy will remain in place for an extended period despite negative real interest rates. But, of course, the search for yield due to financial repression means excessive levels of risk, misallocation of resources into high risk, and longer duration plays, which get unwound all at once at the slightest hint of policy normalization. Risk-on moving to risk-off as QE stops and forward guidance turns to a tightening bias means a violent selloff in the risk assets that benefitted from easy money in the first place. That’s the reason we saw the taper tantrum in 2013 and why we are witnessing a strong dollar in 2014, with the concomitant fall in oil prices and emerging market volatility. And I should note that in this context, it makes no sense to say that “market neutral” policy rates are below zero, something we often hear from those who want even easier monetary policy than we have at present.

In sum, zero rate monetary policy is pro-cyclical in that it misallocates resources by exacerbating swings in private portfolio preferences. And given the over-reliance on monetary policy to steer the economy cyclically, we have every reason to take tail risk seriously in times of market volatility.

Let’s look at a few of the tail risk areas I mentioned yesterday to see how this is playing out in real time.

The oil market is ground zero for what is occurring. And while the fundamentals point to oversupply as demand growth slumps, the pace of the decline in prices has the hallmarks and unpredictability of power law distribution dynamics that we see in tail risk events. It’s anyone’s guess when the decline in prices will end. Yesterday, we saw prices fall further despite media reports that, on net, players were building long positions to take advantage of oversold conditions:

Speculators added to wagers that the slump in oil futures, the worst since the global recession, is ending. Prices kept falling anyway.

Money managers raised their net-long position in U.S. crude to the highest in two months in the week ended Dec. 9, U.S. government data show. Most of the change came from short holdings contracting to the lowest level since August.

The same is occurring in Russia, a major oil exporter. The Russian central bank still has over $300 billion in foreign reserves and it has now hiked interest rates to 17% to stem the quickening pace of currency decline. What’s more is that the decline in the ruble exceeds the decline in oil prices, meaning that Russia is now earning more hard currency with its energy exports. But that won’t keep the currency from declining further still, causing a serious funding problem for Russian corporate debtors. And the market is now dominated by psychology because previous price moves are so significant in the consciousness of investors. No one wants to catch a falling knife. So bids have died up and the action is dominated by sellers. This is where power law distributions dominate.

In Brazil, Petrobras announced that, for the second time, it is delaying quarterly financial results. People are talking about fraud and malfeasance as an issue for the delay. The company says that it has until 15 January to release its financials before it breaches debt covenants and is in technical default. But this can only add to a sense of panic and increase selling pressure in Brazil and emerging markets more generally. Corporate bonds in Latin America are selling off as a result, not just in Brazil but also in Colombia and Peru, according to the International Financing Review.

In the Middle East, Moody’s downgraded Lebanon to B2 from B1, adding a negative outlook to boot. Moody’s said the rise in government debt was the reason for the downgrade. They also cited the effects of the Syrian crisis “on government finances, economic growth and political stability.”

I would call this a crisis at this point – a mini crisis to be sure, but a crisis nonetheless.

In Europe, we have seen a shift from risk on to risk off. And this has caused private portfolio preferences to shift toward safe assets. In my view, Europe provides us with the perfect view into how zero bound tail risk dynamics are all about credit and duration. Look at Greece versus Germany. The increasing spread shows risk off – and it does so in a way in which all of the weight to bear comes down on the risk asset, Greek bonds. German Bunds have rallied as preferences for safe assets have increased. But bunds are stretched here. Why own German Bunds when you could own Treasurys, Canadian government bonds or British Gilts, all of which are backed by central banks with more degrees of freedom than the ECB?

The general market volatility and the problems in Greece make quantitative easing more likely. Austian central bank head Nowotny has indicated he supports QE now whereas previously he had said that he is not against the policy. That’s a shift in stance in my view. What is holding up QE are the four members of the ECB, including the two Germans, who are opposed to the policy. It is not inflation or hyperinflation driving the German policymaker’s consciousness here. It is fear of an exploding debt burden. Take a look at the following chart for example:

Source: Burret, Feld, Köhler, 2012

You can see the shift up in German debt as a percentage of GDP in two waves. The first wave was in the 1970s when inflation was high. So, right after the move into fiat currencies and during the oil embargoes. The second kink up happened just after reunification when the burdens of supporting the integration of the east increased Germany’s debt load. The Germans want to reduce the burden from debtors within the eurozone because they feel uncomfortable with this government debt trajectory and already know what it is like to assume burdens due to a monetary union.

It is not that the Germans are against quantitative easing per se. Recently, Bundesbank President Jens Weidmann told El Pais that it was fine for the Bundesbank to conduct QE in the 1970s because the debt to GDP was below 25% which meant that state finances weren’t in question (link in Spanish). This statement suggests he believes the German state’s debt burden is now questionable. But Weidmann then went on to say the Bundesbank realized this policy was in error and stopped, suggesting that even there quantitative easing has a high hurdle to overcome.

Die Welt had an interesting article on German state debt, showing that even at the municipal level, there is mounting concern about public debt. Here are two charts from that article showing both total deficits and surpluses in various Bundesländer as well as the debt per capita.

The bottom line here is that the Germans are never going to get onboard with QE. Weidmann acknowledged to El Pais that sovereign QE can happen without unanimity. I think it will happen as a result. Draghi is going to have to move without them, consequences be damned.

if ECB does do QE, will private portfolio preferences switch to risk on from risk off? Well, Italian banks now have record levels of Italian government debt. Assuming the risk off sentiment continues, the Italians are third in line on the risk spectrum behind Greece and Portugal to sell off and that would mean a sell off that damages Italian bank balance sheets. The ECB would be forced to do QE and I think it would shift yields in Italy down indeed.

At this point, I believe QE will happen. The question is whether it will be open-ended like QE3 in the US was and whether the purchases will be roughly proportional to eurozone GDP. I don’t have a view on the former but in terms of the latter, the Germans should be against a proportional buy, simply because it creates bubble-like conditions in German credit markets and is ineffective to boot since German Bunds are at record lows. So we are likely to see disproportional QE weighted toward the periphery, something that will allow lawsuits calling this monetary financing of fiscal policy to proceed. “Whatever it takes” will be tested.

On the US, two weeks ago I wrote that “the oil price decline is one disinflationary sign that I find troubling. We know that there is weakness in China and Europe. And to the degree that these economies were beyond stall speed, the decline in oil prices would be stabilizing. But Europe is not beyond stall speed and perhaps China is not either. But oil is a global disinflationary symbol. The US equivalent, falling long-term yields, has come roaring back, with the 10-year now at levels below 2.20%. I pegged 2.25% as an outlier move  because of economic weakness in my ten surprises in February. And we are now below that level. I would love to hear alternate views on what the yield decline is signal – move into safe assets due to high yield volatility, lower inflation expectations that mean lower future Fed Funds expectations, etc. To me, the signal is of disinflation that spells weakness.”

Some further thoughts on that. First, British inflation came in at 1% this morning, putting the Bank of England on the cusp of having to write a formal letter to the Chancellor of the Exchequer explaining why the BoE is failing to meet its target. This is further proof that inflation targeting is hard. I would say it is impossible. But, regarding the US here, it reminds me of the two alternative views I posited two weeks ago as to why we have seen the sharp decline in US sovereign debt yields. Both seem plausible if not likely now. If you look at what is happening in Europe with Bunds, the same thing is occurring in the U.S. with Treasuries. A bid for safe assets is suppressing yield as volatility in high risk sectors increases. Moreover, as inflation expectations decline with oil, for real yields not to rise, bond yields have to come down. So, I would now say that the decline in US long duration yields has three explanations, two of which I like. There’s the weakness in the US economy. That is my original explanation and it not pleasing. But there is also the desire for safe assets and an understanding that inflation expectations have declined.

On Canada, I have been reading for some time now that the rise in house prices is all about Calgary, Vancouver and Toronto now. Canadian heavy oil is now selling for prices below $40 a barrel. Oil is going to really dent Calgary. Estate agents there expect transaction volume to slow considerably, according to the Canadian press. And the rest of Canada has already lost momentum. So that leaves just Toronto and Vancouver to prop up housing. The finance minister Joe Oliver claims the government is sticking to its pledge to balance the budget despite these headwinds. I believe him and so that means monetary policy is left to do the heavy lifting. This is bearish for the Canadian dollar, which I expect to weaken further.

So that concludes my country and sector thoughts. Let me finish off with a few market comments.

Again, I think low nominal yields matter. I don’t believe for a second that the so-called natural rate for yields is negative. 2014 has been the biggest year for investment-grade bond issuance ever. Companies are trying to load up while nominal yields are low and investors starved for yield are eating up bond issuance. We have seen just over $1.1 trillion in investment grade bond volume this year. And flows into bond funds this year are high. On the flip side, now that we have moved to risk off, flows out of high yield or emerging markets have started to become problematic. Here’s the International Financing Review:

“The high-yield bond market is shut,” said one senior leveraged finance banker.

“We might see some big outflows over the next three weeks, but we’re telling clients to move quickly in January. Things can always get worse.”

Lipper reported a US$1.885bn outflow from high-yield funds for the week ended December 10.

This all goes back to my comments about debt stress a contagion agent. Inflows into bond funds since 2009 have outstripped the inflows into tech funds that we saw in the 1990s tech bubble and have outstripped flows into equities by an order of magnitude of nearly 10 to 1, according to Goldman Sachs. Is it a surprise that yields are low? Isn’t this what the Fed was trying to achieve? The problem, of course, is this is getting unwound now – and violently. The riskiest debtors will feel the pain without any interest payment relief. They will default and their stress will be passed on as contagion throughout the financial system. As oil prices fall, more and more projects will be lost. We are now looking at $1 trillion in potential lost capex. And so the real economy is going to feel the transmission from financial markets in these two distinct ways – through contagion of financial stress and through lost capital investment.

From an investing standpoint, that means to move out of risk. In equities, even though the decline in oil prices might favour consumer cyclicals, I would say overweight consumer staples. Utilities have a low beta, benefit from oil decline and have high dividend yields. The sector P/E is relatively high by historical standards though. It is a defensive sector. And so this is a sector to consider overweighting as well.

I am going to leave it there. There is much more volatility to come and I will be reporting on it.

Best,

Edward

P.S. – I have been a little under the weather, so I apologize to those of you who gave me such positive feedback for the first two tail risk posts. Hopefully, I will be back to full strength later in the week.