Sunday, 20 October 2013

Credit - The return of the Gibson paradox

"Take away paradox from the thinker and you have a professor." - Soren Kierkegaard 

While looking at the continuation in the rally for risky assets, credit included, thanks to the "Cantillon Effects" coming from the continuous generosity of our "omnipotent" central bankers, and lackluster performance of gold since the threat of the tapering, we reminded ourselves of an economic theory which was put forward in 1923 by British economist Alfred Herbert Gibson about the negative correlation between gold prices and real interest rates and decided to use it as our title. This theory was coined Gibson's paradox by John Maynard Keynes. 

What of course has been of interest is the return of Gibson's paradox. Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact.

As of late, thanks to the "Debt ceiling" stand-off, the Dollar Index fell to around 79 with Gold rising slightly in the process as indicated in the below graph displaying the Dollar Index versus Gold since June 2011:
In our previous conversation "The Rebel Yell" we argued the following:
"This leads us not to believe the Fed will "taper" in 2013. For 2014, we are not too sure either...That's our own "Rebel Yell"."

Therefore in this week's conversation we will again look at the deflationary risks at play which represent significant headwinds for the Fed's willingness in "tapering". Of course this will add more trouble ahead when it comes to the inflationary aspect of the risky assets bubble which continues to feed on loose monetary policy. Flooding the economy with cheap credit like under Alan Greenspan and now Ben Bernanke, in true "Cantillon effect" is fueling asset-price inflation like it did it 1992, and like it did in the 1920s under Fed Chairman Benjamin Strong.

Why our no tapering stance? 

As we argued in our Chart of the Day from the 19th of September:
"No bank Fed tightening", and we agreed with Bank of America Merrill Lynch takes on the subject at the time:
"The Fed may taper once housing sustainably picks up. But in our view it is very unlikely to tighten until banking sectors around the world start lending again."
- source Bank of America Merrill Lynch

.We also agree with their latest take on the subject of the liquidity induced rally from their note from the 16th of October entitled "Red, White & BOOM":
"The Final Melt-up for the “One Percenters”
We believe the opiate of investors for the moment remains central bank liquidity. The degree of stimulus since 2007 has been unprecedented: $13 trillion of FX reserve accumulation and financial asset purchases by central banks and 560 central bank rate cuts. And the “bulls” appear to remain driven by “liquidity”: only 13% of the 235 investors polled in our Fund Manager Survey believe the global economy will grow "above-trend" in 2014 versus 84% who believe it will be "below-trend". We think “Bernanke-care” may have truly cured all known investor concerns." - source Bank of America Merrill Lynch

And when it comes to lending growth, while the US seems to have had a positive impact in improving lending in the United States as displayed by the below graph from Bank of America Merrill Lynch's note:
 - source Bank of America Merrill Lynch

It is definitely not the case in Europe and particularly in peripheral countries as displayed by this graph coming from Bank of America Merrill Lynch's note on European banks entitled "Going round the corner on two wheels" from the 14th of October and displaying loan growth or lack thereof in Europe:
 - source Bank of America Merrill Lynch

We also agree with Bank of America Merrill Lynch that a "VLTRO" is on the card, while it amounted to "Money for Nothing" in the first instance given it did not provide loan growth for economic growth but enabled banks to set up carry trades and soak up most of European government bonds issuance in the process:
"Each time the ECB extends term funding to the banks, it encourages peripheral banks to add more sovereign debt. Since LTRO1 in 2009, Italian and Spanish bank holdings of their own sovereign are up by €360 billion. Each LTRO therefore becomes harder to step back – unless growth recovers and government deficits fall. It is perhaps in the expectation of these that the ECB will be positioning the next wave of term funding."
 - source Bank of America Merrill Lynch

As we have argued the painful deflationary bust in Europe is being merely "delayed", as indicated by the strength of the Euro versus the US dollar. The FED's swap lines and its January 2012 FOMC decision of keeping rate low until at least late 2014 are indeed delaying the occurrence of a painful adjustment in Europe.

We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity": "Given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

Last year, on the 25th of January 2012 we did make the following forecast in relation to the European recession and the EUR/USD following the FOMC decision to maintain US rates in our conversation - The law of unintended consequences:
"Unintended Consequences according to Martin Sibileau:
"With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unaddressed. All these factors only contribute to prolong the recession and a high unemployment rate."Given today's decision of the FOMC to maintain US rates low until late 2014, it seems to us that the European recession can only be prolonged."

The deflationary forces at play in Europe cannot be ignored and can be seen clearly in the euro inflation market where 5 year 0% inflation floor prices are close to their lows as displayed in the below graph from Bank of America Merrill Lynch from their note from the 16th of October 2013 entitled "EUR inflation floors are floored but should be through the roof":
"IMF appreciates the euro zone deflation risk
“Deflation risks remain elevated in Japan, despite the new inflation target, and in the euro area, particularly in the periphery,” according to the IMF World Economic Outlook, October 2013.
"Few things make a strategist happier than a two-line chart where the lines track each other for a long period of time and then diverge sharply in the recent past; it means there’s a story to tell. Today’s Chart of the Day is a classic example – the best we’ve seen in a long time. It shows how the price of 5y EUR deflation floors have fallen close to the lows of recent years while at the same time 5y inflation swap rates have also fallen close to their lows over the same period. In short, implied inflation volatility has collapsed.
We do not want to create the impression that EZ deflation is our central case but there are several roads that could take us there. Nobody expects the US debt ceiling issue to give as another “Lehman moment”, but nobody completely rules out that remote tail risk. More tangible perhaps is the US economic “relapse risk”, under the circumstances. With the EZ experiencing low and falling actual inflation, a large and growing output gap and a strengthening currency, adding a US relapse into the mix would likely push up deflation risk materially.
So the collapse in floor premiums is a puzzle to us. Or maybe it’s a paradox. At low inflation rates, interest in inflation structures (requiring floors) dwindles, while negative real yields can further hamper the economics of building such structures."- source Bank of America Merrill Lynch

For us it is simply the manifestation of the Gibson paradox, because, while the manifestation of "Cantillon effects" in asset prices come from negative interest rates, the suppression of the rate of interest under ZIRP, intensifies gold hoarding as clearly explained by Antal Fekete in his 2006 article "When Atlas Shrugged...Part Two: Gibson's Paradox and the Gold Price":
"The validity of Gibson's Paradox clearly extends to the regime of the irredeemable dollar with a variable gold price. It varies directly with the price level. In particular, as the irredeemable dollar loses purchasing power, the price of gold will rise for the stronger reason. In terms of Gibson's Paradox, the price level rises less if the rate of interest is suppressed; otherwise it rises more.

Properly interpreted, there has never been an episode in history when Gibson's paradox failed to operate. It is the empirical description of the apodictic truth that suppression of the rate of interest brings about increased gold hoarding, subject to leads or lags. Every ounce of hoarded gold is a testimony to the fact that somebody, somewhere, has found the quality of savings instruments, and their yield, inadequate. By making the regime of irredeemable dollar non-negotiable, the U.S. government has foolishly deprived itself of the possibility to channel people's savings into "socially more useful" applications. Therefore it is the government, not the people, that is to be blamed for the present negative savings rate in the United States."

Furthermore, we already touched on put-call parity and what it entails, namely going long US Treasuries and long gold:
"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up." - David Goldman's article about Gold and Treasuries and bonds in general written in August 2011 (the former global head of fixed income research for Bank of America)

So far we have bought the put leg of the put-call parity strategy and we are indeed thinking of adding the call leg shortly."

Professor Antal Fekete also added in his 2006 note:
"In encouraging bull speculation in bonds the government prompts more gold hoarding, making gold scarcer and the gold price more buoyant still. On the other hand in encouraging bear speculation in gold, in so far as it is effective, gold hoarding is reduced pushing interest rates higher. Rather than canceling out, the two effects could ratchet up both the gold price and the rate of interest simultaneously."

By not tapering in September, the Fed has lost more than credibility, it has put at risk the faith and credibility of the US dollar. Dollar weakness and rising real rates in OECD countries with an increase in gold prices are tantamount to a return of the Gibson paradox we think.

We always point out shipping as indicative of the deflationary forces at play, and we keep tracking shipping rates to that effect. The latest rates figures from the Drewry container prices point to slack demand which was evident in the earnings figures coming out from corporate giant such as IBM where Emerging Markets' demand had been impacting the bottom line. The Drewry Hong-Kong-Los Angeles container rate - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 2.8% to $1,736 in the week ended Oct. 16, the lowest level since December 2011 ($1,436). This marks the 14th week this year that rates are below $2,000. Rates are about 31% lower than the July 2012 high of $2,519. Even with six increases in 2013, rates are 34.5% lower yoy and down 21.6% ytd, as slack capacity continues to pressure pricing." - source Bloomberg.

The weakness in Emerging Markets exports to Europe can be seen in the latest Asia-to-Europe Container Shipping rates - table source Bloomberg:
"Shipping rates for 40-foot containers (FEU) fell 6% sequentially to $1,476 for the week ending Oct. 17, the sixth straight decline and the largest drop in three weeks, according to World Container Index data. The Shanghai-to-Rotterdam trade lane continues to be weak, with rates falling for the sixth straight week (down 13%), yet Shanghai to Genoa declined the most (15% lower). New York-to-Rotterdam rates rose the most (3.5%), reversing last week's decline."  - source Bloomberg.

As far as "Cantillon effects" are concerned, we expect the huge cash balances sitting idle on major corporate balances sheet to be put at play in M&A in 2014, following the raft of buy-backs we have seen as of late. It is the next evident step that will be taken in this survival of the fittest deflationary contest as displayed in Bloomberg's Chart of the Day:
"Mergers and acquisitions have failed to keep up with a record-setting share rally in the U.S. because many companies are repurchasing stock instead of making deals, according to Erin Lyons, a Citigroup Inc. strategist.
The CHART OF THE DAY compares the 12-month average dollar value of proposed takeovers, as compiled by Bloomberg, with the performance of the Standard & Poor’s 500 Index. Lyons presented
a similar chart in a report two days ago.
Dealmaking in the 12 months ended in September averaged $89.7 billion, up 12 percent from two years earlier. Between September 2011 and last month, the S&P 500 climbed 49 percent and surpassed 1,700 for the first time. “As share prices increase, usually deals follow,” Lyons wrote. This time around, there appears to be too much concern about the pace of economic growth and other issues for chief executives to pursue takeovers, the New York-based credit strategist wrote. 
“Buying back shares is the least risky” way to lift stock prices and has grown in popularity, the report said. The dollar amount of shares that U.S. companies agreed to repurchase jumped 68 percent this year from the same period of 2012, according to data compiled by Birinyi Associates Inc. through last week.
There are four other explanations for why dealmaking has lagged behind stock prices, Lyons wrote: potential increases in the cost of financing, higher valuations for potential targets, reluctance to spend cash on hand for takeovers, and caution about taking on debt as the economic outlook gets cloudier." - source Bloomberg.

For the time being the "Cantillon effects" rule the game, meaning additional spread tightening and additional rise in risky asset prices.

About Gibson's paradox:
“no problem in economics has been more hotly debated”. - Irving Fisher, 1930

Stay tuned!

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