Sunday, 4 September 2011

The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!

"Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time."

The recent volatility experienced in August and the continued sell-off in risky assets, suggest something more radical has happened, and what would some people call a game changer. I certainly think it is the case. In this long post we will review the reason behind and more on the subject of the disappearance of risk-free interest rate and its implications.

Safe havens no longer exist. The game was based on confidence, on risk-free interest rates and fiat-money based on the trust we had in our governments.

I am often asked, what monthly letter do I enjoy reading, one particular letter immediately comes to my mind, namely the credit newsletter written by Dr Jochen Felsenheimer from asset management company "assénagon". It is for me, one of the most insightful and best written letter available dealing with credit and credit dynamics.
It is available at the following link, free of charge and a must read:
assénagon Credit Newsletter

"Once a month Dr. Jochen Felsenheimer comments on his analyses of the market for corporate bonds in the Credit Newsletter. In doing so, he not only succeeds to describe current market developments, but also to present the underlying economic theories in an interesting and understandable way."
Dr Jochen Felsenheimer, prior to set up "assénagon", was previously head of the Credit Strategy and Structured Credit Research team at Unicredit and co-author of the book "Active Credit Portfolio Management".

In his latest letter published in August, Dr Felsenheimer comments in the opening of his monthly letter:

"As if the debt situations in Europe and the US were not already bad enough on their own, the attempts to find a way out - which have been in some cases amateurish (Europe) or dominated by power politics (USA) - have had a long-lasting impact on investors across the globe. It is not just a temporary loss of confidence, but actually more about the recognition that the dire search for a safe haven in the capital markets is something of an oddysey."

And Dr Felsenheimer to add:

"In the end, all investors face the same problem - the whole world is a credit investment. And it is difficult to negotiate this problem with the classical theory of economics. Short selling bans, Eurobonds and ratings agency bashing will not provide a remedy here either."
Confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues.

In recent weeks, I have touched on liquidity issues - "Macro and Markets update - It's the liquidity stupid...and why it matters again...".

The liquidity issue discussed in the previous post are key in understanding the implications of recent weeks market activity and change of perception. No matter how you look at it, risk-free, as designated by the coveted AAA from rating agencies are endangered species as I commented in June 2010:
"AAA, the most endangered rating, regulating the rating agencies and Basel III"
The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg.
I wrote in relation to the disappearance of AAA ratings in June 2010 in the post "AAA, the most endangered rating, regulating the rating agencies and Basel III" :
"The decline in triple-A-rated companies is one of the most obvious -- though hardly the most worrisome -- sign of a widespread decline in credit quality."

So, yes, I have to agree with Dr Felsenheimer comment that the world is indeed a "credit investment".

The damages of the debt ceiling debate in the US and the ongoing jitters in the European space surrounding the sovereign debt crisis were both a game changer, in the sense that, it has lead to a global repricing of risk based on a false assumption, namely the existence of risk-free interest rates which the Modern Portfolio Theory is based on.

Couple of interesting points surrounding repricing in credit risk:
Spread between 10 year German bonds and French 10 year government debt:

Spread between Italian 10 year bonds and German 10 year bonds:
Repriced... In 2005, the spread was around 22 bps and before the introduction of the Euro, in 1999, the spread was around 120-130 bps. And it will keep rising, as Prime Minister Silvio Berlusconi keeps testing the ECB's resolve in backing Italian debt by conceding in the revamping of austerity measures decided on the 12th of August. Tax surcharges on high earners have been dropped, cuts in regional spending reduced and measure to lower pension costs reversed, leading to a 7 billion euros hole in the package aiming to balance the budget in 2013.

The consequences of the change of heart of the Italian government lead to a fall in demand in Spanish and Italian bonds in latest auctions: August 30, Investors bid for 1.27 times the amount of Italian 10-year bonds down from 1.38 times. Demand for Spanish five-year debt dropped to 1.76 times from 2.85 times at the previous auction.

Italy has 46 billion euros of maturing bonds in September, rising yields don't help funding costs and they will have to raise 18 billion euros of bonds in September. So far the ECB has sustained Spanish and Italian bonds by 43 billion euros of purchases, more than half of its purchase of Greek, Portuguese and Irish debt since the start of its buying spree a year ago.

Following up on the disappearance of the notion of risk-free interest rates, in the credit space, everything has been repriced, throughout the rating spectrum.
Arcelor Mittal 4 5/8% 11/17 bond (swap related value)- repriced:

Lafarge SA 7 5/8% 11/16 bond, one of Europe's largest cement makers - repriced:
Lafarge's rating is Ba1 according to Moody's, High Yield.

BMW Finance 5% 08/06/18 bond - Repriced:
A2 Moody's credit rating, upgraded on the 24th of July.

and AAA, GE 4 3/8% 09/21/15 bond - repriced as well:

We live in competing systems, where not only does sovereign countries compete against one another to raise capital, but companies as well, and capital is scarce. Access to capital is depending on growth outlooks, consequences are great on debt dynamics.

As put it simply by Dr Felsenheimer in his August note:

"Competing systems between countries in a world of globalisation and fully integrated capital markets restrict a country's room for manoeuvre in that mobile factors of production seek out the state infrastructure which give them the best possible reward. The state can only counter the migration of workers and relocation of whole production sites with economic measures, for example the creation of an effective infrastructure (e.g. education) or tax incentives. Accordingly, a government's outgoings - and also its income - are not just determined by domestic economic developments, but also by other countries' economic strategies. Countries are in competition with each other - just like companies. And this is particularly true within a currency union, which is fully reflected in the different tax policies of the individual member states."

And the race for capital is truly on, hence the liquidity issues building up, as I discussed in a previous post:
"The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates."

There is a point of major importance, as well pointed out by Dr Felsenheimer in his last note:

 "in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. effecient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth."

Consequences? Dr Felsenheimer sums it up nicely:

 "Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."
A fiat money based system is based on one single item, confidence, and confidence can only be guaranteed by extreme fiscal discipline by governments. The lower the confidence, the higher the rates issuers will have to pay to raise capital. Solvency of the issuer will ultimately determine the allocation of the capital which means that the impact on Modern Portfolio Theory is as follows, given it postulates that risk-free investment exists and that all investors hold the same risky market portfolio to achieve optimum portfolio, it can only mean more demand for government bonds according to Dr Felsenheimer's August letter.

And confidence is gone.
Confidence is gone in the US with the tragic debate surrounding the US debt ceiling this summer. I recently wrote: "The US downgrade was not a downgrade of America's economy but a dowgrade of its leadership.".
Confidence is gone in Europe, because Europeans cannot even agree on a proper solution for a small problem like Greece, in effect putting the entire European system at risk.
Confidence in the Euro is waning fast with a supposedly independent ECB, now used as a political tool, to bail out cash strapped countries, on fiat-money.

The name of the current game is maintaining, at all cost, rates as low as possible, to avoid government bankruptcies. I do expect rates to stay low, even in the US, and the 10 year bond to reach 1.50% in yield.
Should you have invested in PIMCO 25+ zero coupon US ETF in August, you would be sitting on a 32% monthly performance:
I expect it will go higher and the yield will go lower. No suprise there, but back to our analysis of the disturbing disappearance of risk-free interest rate.

The difference between the current situation of the US and Japan, is that Japan started an an isolated event, we are ending up with truly global phenonemon of over-indebtness.

I started the post indicating, no more safe havens, one could posit, no more safe investments.
Dr Felsenheimer commented in is letter:

 "In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely."

But we are not the only ones with Dr Felsenheimer, in reaching this disturbing conclusion. Arnaud Marès, from Morgan Stanley in his publication of the 31st of August - Sovereign Subjects - The Economic Consequences of Greece, arrives to the same conclusion.

"'Private sector involvement' in the restructuring of Greek debt was in our view a major policy error, which has changed in a quasi-irreversible way the perception of sovereign debt in advanced economies as risk-free and therefore as safe haven assets. This has broadened the channels of contagion across Europe.
Does it matter that sovereign debt is risk-free? It very much does. If sovereign debt is no longer a safe haven, then the ability of governments to implement counter-cyclical policies is impaired. Fiscal policy is becoming at best neutral, at worst pro-cyclical. At a time when growth is rapidly slowing, the economic cost may be high.

Weakening the quality of government credit means weakening the fiscal backstop from which banks benefit. This risks resulting in an accelerated de-leveraging of bank balance sheets, with equally costly economic consequences.

Pandora’s Box has been opened. Only fiscal integration accompanied by centralised financing of governments can bring about full stabilisation of the market in Europe, in our view. The alternative could eventually be a resumption of the run on governments and a wave of public and private defaults.
The ECB can provide protection against a run, temporarily. While the ECB has the capacity to act as a lender of last resort, doing so exacerbates political tensions and is not a lasting solution, we think."

This what I had in mind when I wrote "Credit Terminal Velocity?"

So what are the implications of the disappearance of the risk-free interest rate notion?
Arnaud Marès commented:
"Does it matter whether government debt is risk-free? This, in essence, is the question being raised by the downgrade of the US government by S&P and, much more importantly, by the decision of European governments to effect sovereign debt restructuring in Greece in the form of ‘private sector involvement’.
The answer is yes. It matters considerably, we think. The risk-free nature of sovereign debt and its resulting safe haven status are in our view instrumental to the ability of governments to use fiscal policy counter-cyclically as a macroeconomic stabilisation tool. If government debt is deprived of its safe haven status, then this pushes us back towards a ‘pre-Keynesian’ state of the world where fiscal policy is neutral at best (US), and more likely pro-cyclical (Europe). Against a backdrop of slowing growth in advanced economies, the consequences are likely to be serious."

To put nicely, we are indeed facing contagion on a very large scale, given sovereign debt is officially no longer risk-free and we have not yet reached a satisfying European political solution to European debt woes.

Arnaud Marès in his note also added:
"Government solvency is a blurred concept. For governments with high levels of debt, the concept of solvency is very sensitive to the government’s cost of funding, and therefore to swings in market confidence. What makes a government solvent is its ability to stabilise its debt (as opposed to the level of debt in itself). This, in turn, depends on the ability of the government to generate a sufficient primary balance, which can be expressed as follows:
Where i is the average interest rate paid on the debt and g is the nominal rate of growth of the economy.
What this relationship emphasises is the importance of the interest rate paid on the debt. All other things being equal, a higher cost of funding raises the ‘fiscal hurdle’, i.e., the required primary balance, in proportion to the initial level of debt. The higher the interest rate, the higher the likelihood that the fiscal hurdle becomes politically insurmountable, which in turns justifies a higher risk premium in what becomes a vicious spiral. Conversely, a government with even a very large level of debt can appear entirely solvent if funded cheaply enough,"

And Mr Marès to comment:
"It is possible to be solvent yet illiquid. The second issue with the heads of states’ position is that to guarantee that sovereign debt outside Greece remains risk-free, governments have to have unconstrained access to liquidity. Following the precedents set by Greece, Ireland and Portugal, this can no longer be taken for granted in the absence of sufficient contingency liquidity support by core governments and/or the ECB. The size of Europe’s main inter-government liquidity support scheme (EFSF) has been calibrated in line with the requirements of Greece, Ireland and Portugal. It could be sufficient to absorb in addition the funding needs of Cyprus but not those of Spain and Italy in the event of a ‘run’ on governments, such as that which was effectively starting to unfold until the ECB intervened. In its current state, therefore, it does not constitute an entirely credible liquidity backstop, especially given political opposition in several countries to an increase of its capacity. Meanwhile, the ECB provides indirect liquidity support to Spain and Italy through its bond purchases, but it appeared to take on this role reluctantly and under the assumption that it would only be temporary (until such point at which EFSF may take over). This does not provide much reassurance that solvent government will always be kept liquid."

and contagion we have:
This Bloomberg Chart of the day indicates that the net amount of CDS on France surged to 25.7 billion USD from 12 billion USD in the past year when Italy remained constant according to the DTCC (Depository Trust and Clearing Corp.).

Arnaud Marès added the following in his note on the important of risk-free and its implications:
"This leads us to the central question we raised earlier: why does it matter? What matters is not so much that government debt is risk-free as that it is seen as a safe haven. In our view, this is a precondition for governments to be able to use fiscal policy as a macroeconomic stabilisation tool. Indeed, what allows governments to deploy their balance sheet defensively at a time of recession is two properties of public debt, both of which derive from this safe haven status:
The first is practically unlimited access to finance. This is the property that allowed, for instance, governments to support their banking systems in the winter of 2008/09 by guaranteeing bank deposits and bank debt. In essence, what governments were doing in that instance was to lend their superior access to funding to the banks.
The second property, perhaps even more important, is that in a recession or crisis, flight-to-quality flows towards the safe haven lower the relative cost of funding of the governments. As long as this holds true, governments can cost-effectively deploy their balance sheet, borrowing more to supplement a fall in private sector consumption and investment.

The consequences of disabling fiscal policy. Should public credit start behaving like private credit, then the ability of governments to run counter-cyclical fiscal policies (even merely by letting automatic stabilisers run their course) would in our view be impaired. At best, fiscal policy would become neutral. At worst, it would become pro-cyclical in a slowdown. It is in that sense that we see one of the consequences of the Greek precedent to be to push us towards a ‘pre-Keynesian’ state, where fiscal policy is largely disabled."

So yes, liquidity, matters, because the major implication of the disappearance of risk-free interest rates is that it weakens in the process the quality of the "fiscal backstop" enjoyed by banks which explains the significant rise in bank credit spreads during the summer and particularly in August:
Itraxx Financial Senior 5 year CDS index:

Itraxx Financial Subordinate 5 year CDS index:

The iTraxx SovX Western Europe Index of credit-default swaps insuring the debt of 15 governments rose 12 basis points to 311 at 3 p.m. in London, surpassing an all-time high closing price of 308 on August 26.

And Arnaud Marès from Morgan Stanley to add on the very subject of banks, sovereign and liquidity in his note:
"There is a direct relationship between the credit quality of the government and the cost and availability of bank funding, as illustrated by the correlation between their CDS prices, or by the relationship of causality from sovereign credit rating to bank credit rating. We therefore regard the renewed tensions in the bank funding market in Europe as at least in part the consequence of the decision to use private sector involvement in the restructuring of Greece’s sovereign debt.

The risk, if funding tensions continue, is that banks de-lever their balance sheets more rapidly from the bottom end of the balance sheet (debt reduction and therefore credit contraction) as opposed to more slowly from the top end of the balance sheet (recapitalisation over time through retained earnings). Tougher term funding markets is another of the factors identified by Elga Bartsch as responsible for a deterioration of the European growth outlook."

The detioration of credit as reflected by the diminishing universe pond of AAA securities and the current situation can only lead to the following:
An age of financial repression, so, yields will go down further in core countries, which mean nominal prices will go up, at least that's what the zero coupon 30 year US ETF is showing.

German 10 year Bond, intraday yield movement:

Itraxx Crossover (High Yield) 5 yeard CDS index going wider again:

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!"

Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern.

Stay tuned!

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