Guest post - Is Risk Parity a Scam - Rcube Global Macro Research

"We have a natural right to make use of our pens as of our tongue, at our peril, risk and hazard." - Voltaire 

Courtesy of our friends at Rcube Global Macro, please find enclosed their latest publication where Paul Buigues looks at Risk Parity strategies:

(for PDF please use the following link: http://www.rcube.com/docs/Rcube_Is_Risk_Parity_a_Scam.pdf)

Risk parity strategies experienced large drawdowns between early May and late June due to a combination of rising government yields and falling equities.

Note: The original and largest fund in the sector (Bridgewater All Weather Fund) does not publish daily NAVs.

This rather significant correction raised quite a few eyebrows, particularly because risk parity strategies are often marketed as being able to withstand a wide range of economic environments (and, unlike 2008, today’s environment is rather benign).

Although it would be preposterous to disparage a strategy based on two months of negative returns, this drawback gave us the impetus to express our thoughts on risk parity as an investment strategy, as it emerged from relative obscurity just a few years ago, only recently becoming fairly popular among investors.

Like other passive asset allocation strategies,1 the basic premise of risk parity is that asset returns are unpredictable, at least in the short] and medium]term. Consequently, investors should only attempt to capture risk premia, without wasting their time and energy trying to forecast the behavior of specific asset classes.

According to the Modern Portfolio Theory (which is, itself, based on a dozen theoretical assumptions), the only rational choice for an investor is consequently to own the gmarket portfolioh which contains every asset available in the market, weighed according to its relative size. Because this is difficult to implement in practice, investors often settle for a (generally more granular) version of the 60/40 allocation between equity and fixed income.

Risk parity is a different viewpoint on how not to exert judgment on any asset class. According to risk

parity proponents, investors should try to own all major investable asset classes on an equal risk basis.

Supposedly, this results in portfolios that have better risk/reward characteristics than traditional asset allocations. Moreover, as mentioned above, some argue that risk parity portfolios can generate quasi-absolute performances, even in the face of stormy markets.

Before going any further, it is worth stating that implementing a portfolio that contains all assets on

an equal-risk basis is even more challenging to implement than implementing the "market portfolio".

This explains the existence of many different variants of risk parity.2

Recap: Portfolios that express a neutral view on future asset class returns

After selecting a specific variant of risk parity, many implementation choices need to be made:

‐ What universe of assets should be used, and how should they be regrouped them in asset classes?

‐ Should asset class correlations be taken into account? And if so, how?

- How should we define risk? In our understanding, most risk parity implementations use volatility,

which obviously exists in many different varieties (historical, implied, predicted, GARCH, etc.) and

calculation horizons.

- What leverage should be applied to the portfolio for it to reach an acceptable rate of return? (Risk

parity generally involves leverage.)

- What frequency should be used for portfolio rebalancing and volatility calibration?

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1 Although risk parity strategies have to be managed actively (if only to equalize risk levels on a regular basis), we consider them to be passive, in the sense that they are not based on trying to forecast future asset returns.

2 Here are just a few implementations of risk parity: the “All weather” portfolio, classical risk parity, cluster risk parity, risk factor parity, and equal risk contribution.

To our understanding, the “All weather” strategy is not risk parity in the strict sense. From the way it has been described in various papers, it basically consists in choosing a set of asset classes, and in leveraging each of them to obtain a common expected return (generally the expected return of equities). In that sense, this strategy should be called return parity, rather than risk parity. Unless we expect all asset classes to have the same Sharpe ratio, these two approaches are not equivalent.

Due to this large number of degrees of freedom and parameters, this paper will present risk parity from a generic viewpoint. It will contain case studies and thought experiments rather than backtests (as we will see, backtests are generally biased towards risk parity strategies).

Although the term “risk parity” was only introduced in 2005, we can trace the origins of the concept

to a strategy that Ray Dalio (3) started using in 1996 to manage his family trust. Despite Bridgewater’s success in generating sizeable alpha for their clients, Dalio wanted to create an investment process that would not depend on his own ability to manage funds or to select managers (as he wouldn’t be able to do so after his death).

The strategy (named the “All Weather portfolio”) also had to deliver returns, regardless of economic

conditions. Dalio therefore concluded that the portfolio should maintain 25% of the portfolio’s risk in

each of the four following quadrants:

This is clearly an excessively simplified portrayal of a strategy that now has $70Bn under management and that has generated an annualized performance of around 8.5% with a volatility of around 10% since 1996, inspiring many fund managers and institutional investors to run the same type of strategies in-house.

However, despite its commercial and financial success, many observers consider risk parity to be an

investment scam. Finding a strategy that might dominate the classical 60/40 portfolio is one thing. Pretending that this strategy is able to produce stable returns (without attempting to predict those returns) sounds a lot like a "get rich steadily and without effort" scheme.

Even though wefre not into passive asset allocation strategies (otherwise, we would look for another

line of work), we will try to contribute to the debate. We will organize our thoughts by looking at

three intertwined dimensions of risk parity: diversification, returns, and risk. In each section, we will

express our opinion on the conceptual merits of risk parity, as well as its prospects in the current

environment.

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(3) Ray Dalio is Bridgewater’s founder and one of risk parity’s pioneers. Despite the criticism against risk parity expressed in this paper, Dalio is at the very top of our pantheon of financial thinkers.

1. Diversification

From a passive asset allocation standpoint, it is hard to argue against diversification, which

constitutes the core of risk parityfs philosophy.

The idea of spreading risk among different asset classes obviously precedes risk parity by a few millennia, as we can find references to it in the Talmud ("One's assets should be divided into thirds: 1/3rd in land, 1/3rd in business, 1/3rd in gold") or in the Ecclesiast ("Divide your investments among many places, for you do not know what risks might lie ahead").

In the early 1980s, Harry Browne introduced the gpermanent portfolioh, an investment strategy whose aim was to withstand all sorts of economic environments, and which was originally composed of an equally weighted portfolio of four asset classes: 25% US stocks, 25% long-term bonds, 25% cash, and 25% precious metals.

However, it is worth noting that these simple equal]weight approaches only aim at minimizing the risk of ruin from a personal wealth standpoint, which is not the modern view of how portfolios should be managed (i.e., maximizing investment returns for a given level of risk).

In terms of diversification, the major innovation of risk parity over these early approaches resides in

equally weighting risks, instead of allocations.

In that respect, risk parity proponents are indisputably right when they state that traditional 60/40 asset allocations are not truly diversified, as they have had a correlation of 0.90 with equities over the last 40 years.

That being said, we believe that placing diversification above everything else can lead to unpleasant consequences. The main advantage of a passive gmarket portfolioh approach is that, by definition, it does not disturb the market's equilibrium, as every asset class is weighted according to its relative importance in the market. On the opposite side, once it becomes popular, any other passive investment process that significantly deviates from market weights can wreak havoc in market valuations, precisely because passive investment processes entail not caring about valuations.

For example, letfs take a small exotic asset class (public Timber REITS, for instance), which would display nice diversification properties in the eyes of many different diversification]minded managers. Although each individual manager might decide not to own more than 1% of the total float, their combined buying power could very well provoke a bubble in the asset class.

A real-life example of the damage that can be caused by a blind quest for diversification can be found

in the way in which CDOs used to be managed before the credit crisis. In order to increase their contractual Moody's "diversity score", CDO managers were forced to diversify their exposures in terms of industries. As a consequence, some industries that had little outstanding debt became heavily sought after and, therefore, completely mispriced. In the end, a supposedly superior diversification did not help CDO managers, as correlations converged towards 1.00 during the 2008 credit crunch.

To a certain extent, the appeal of diversification might also explain investorsf willingness to buy TIPS

at negative yields (down to around -1% for the 10 years recently). While being a relatively small part of government debt (around 10%), TIPS' characteristics make them very attractive in the eyes of

investors who value diversification far above everything else, including valuation (in this particular

case, however, the jury is still out in determining whether we’re all “turning Japanese”).

One last word about diversification: as we will see in our next section, we’re not convinced that financial markets offer a sufficient number of uncorrelated risk premia in order to be able to reach a “true” diversification.

2. Returns

2.1. Risk premia

Like any other passive asset allocation strategies, risk parity relies on the assumption that some asset

classes should structurally outperform the risk‐free rate. Although there are theoretical justifications and ample empirical evidence for some of these risk premia, their number and their magnitude is ‐ and will always be ‐ subject to intense debate.

To us, the most convincing and economically meaningful risk premium resides in equities. Because of

the high covariance of corporate asset values with the state of the economy, equities have to compensate investors for the risk they take (no one wants to lose his job and experience portfolio losses at the same time). We can obviously only make rough estimates of the forward equity risk premium (letfs settle for 5% on a global basis), but we do have little doubt about its existence.

Even if they might offer some diversification benefits from a marked]to]market perspective, we believe that many asset classes (e.g., high yield bonds, REITS, or private equity) have a risk premium that originates from the same covariance with the state of the economy. Whether they should be considered as completely separate assets classes is, therefore, debatable. In fact, this question is specifically addressed by newer risk parity implementations, such as cluster risk parity and equal risk contribution.

For some asset classes, the very existence of a positive risk premium can be questioned. In the case

of commodities, for instance, the classical justification for a risk premium (i.e., Keynesf "normal backwardation") is nowadays dubious, as an increasing number of investors have been willing to take hedgersf opposite side. Roll yields, which had been the sole source of excess returns for commodities, have been centered on zero for the last 10 years.

For other asset classes, risk premium prospects currently look rather grim, the most obvious example

being Treasuries. If we look at 10]year Treasuries, their historical long-term return over short-term

rates has been around 1.6% since 1920. Since the early 1980s however, 10-year Treasuries have produced far higher excess returns (around 5%), as 10]year yields went from 15.8% to the current 2.5%.

Although there are only a few things about which we can be certain in finance, we can safely proclaim the mathematical impossibility of getting 5% excess returns by rolling 10-year treasuries over the next 10 years.

Therefore, because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a gbig rotationh that would bring 10-year yields back to a theoretical long]term equilibrium value.

There are obviously many other sources of risk premia. However, most of them (liquidity‐based ones,

for instance) are the “bread and butter” of specialized hedge funds. Therefore, they are outside of the scope of risk parity, which is not a bad thing, as many of these arcane risk premia tend to display a very negative skewness.

Our main point is that, even if we consider a large universe of asset classes, it’s not as if there were dozens of investable and economically meaningful risk premia waiting to be harvested by passive investors. In the end, when we take into account the fact that many risk premia actually originate from the same basic sources, we might end up with just a few investable risk premia. Additionally, as more people reach for diversification, those few risk premia tend to become more correlated over time.

2.2. Leverage

One important point regarding returns resides in the fact that risk parity strategies generally involve

leverage—that is, unless the investor is satisfied with long‐term returns of 2 to 2.5% over the risk-free rate.

Risk parity practitioners generally characterize leverage as a mere “implementation tool”, and they

believe that their superior diversification outweighs the disadvantages of running a levered strategy.

Although a reasonable use of leverage might not be fatal to a portfolio, it can irremediably hurt its

returns. Indeed, as we will see in our section about risk, leverage introduces a path dependency issue.

We can very well imagine a “black swan” situation, in which a supposedly safe asset class experiences a price trajectory that forces a deleveraging of the portfolio and, therefore, wipes out a large chunk of it.

3. Risk

We believe that the subject of risk is the one wherein risk parity is the most open to criticism.

Indeed, to reach the gparityh in risk parity, one has to reduce the risk of an asset to a single number

one way or another (generally a specific variant of the assetfs volatility). Although it is not a very original point of view, we believe that the risk of an asset cannot be quantified in this simplistic way.

Despite the fact that there is a certain level of stickiness in an assetfs risk (or volatility), every now

and then, assets - even supposedly gsafeh ones - have the nasty habit of breaking the parameters of

the equations that are supposed to describe their behavior (especially if these equations do not take

into account skewness).

To illustrate this point with a little story, letfs imagine a situation that could very well have happened

during the last decade:

In the aftermath of the 2000s tech crash, John becomes yet another young unemployed electrical

engineer (as Taleb, the inventor of the Black Swan theory, likes to characterize most quants). He decides to start a new career by getting a masterfs degree in finance. Armed with his solid math skills, John quickly digests modern portfolio theory, basic statistics, and all varieties of volatility calculations. He finds a job at an institutional investor and quickly moves up the corporate ladder.

In 2006, John convinces his board to apply a risk parity strategy to manage the firm's portfolio. Because he has a fresh and open mind about finance, he decides to spice up the asset mix by adding an exposure to mortgage]backed securities in the form of newly-minted ABX indices.

Who could blame him, based on the information available in 2006?

- The total size of the US mortgage debt is huge ($13 trillion in 2006), comparable to US equities, and larger than government debt.

- ABX indices are highly diversified, as each index is based on 20 distinct RMBS transactions. Each RMBS containing a minimum of $500 million worth of homes, an ABX investor is exposed to more than 50,000 homeowners throughout the US. What can possibly go wrong with such a diversified pool of debtors?

- ABX products are rated by respectable institutions, such as Standard & Poorfs (1860) and Moody's (1909), and they offer a wide variety of risk levels (from AAA to BBB).

- The volatility of the underlying financial products that compose the index is minuscule (they always trade around par).

Even if John had opted to buy the safest AAA ABX tranches (with, consequently, a high allocation due to their glowh risk), he would have experienced heavy losses during the 2007-2008 crisis. Additionally, he would have been forced to drastically reduce his allocation to the asset class as the gtrueh risk (or volatility) of ABXs revealed itself, preventing it from benefiting from any subsequent recovery.

Consequently, given that he was running a leveraged portfolio, John would have been forced to crystallize his losses.

This story might sound far]fetched, but we could have invented a similar story about Georgios implementing a risk parity strategy for a Greek institutional investor by leveraging on domestic government debt.

Some might argue that both of these examples involve blatantly asymmetric assets, which could have

easily been filtered out (especially in retrospect) by an experienced risk parity practitioner.

However, we can also imagine a forward‐looking scenario that would involve one of the most respectable assets on earth ‐ US Treasuries ‐ as the main culprit of a risk parity carnage:

Let’s imagine that, a few years down the road, Bernanke’s successor has to manage another “great

recession”. This time, the Fed decides to go beyond QE by pegging long‐term rates at a very low level (let’s say 0.5% for the 10year).4

As the Treasury remains stuck at 0.5%, there is no more volatility on Treasuries.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…

From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself.

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 4 This solution was discussed by the Fed in late 2010, and it has already been experimented with
between 1942 and 1951.

 Conclusion

Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance]based arguments that are often put forward by the proponents of risk parity.

From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:

1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategyfs performance under different scenarios.

2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.

3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.

4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.

5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly 

asymmetric returns, which can happen to any asset class given the right set of circumstances.

If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.

For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).

There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's

numerous flaws. However, we have little doubt that when the next gblack swanh terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage onefs life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.

That being said, the idea of a passive investment strategy that would be able to withstand any kind of financial weather is not unrealistic. However, its goal should be the long]term preservation of capital and not its theoretical maximization under a theoretical risk constraint. Additionally, the strategy should make very little use of leverage, and it should not make too many assumptions on the risk of a given asset (as risk becomes an unpredictable beast every now and then). In the end, we would probably end up with something quite similar to the Talmudic portfolio (N equally-weighted assets).

We realize that, without adhering completely to risk parityfs principles, many institutional investors

are implementing it as a part of their portfolio alongside other "absolute return" strategies. This approach is clearly less dangerous than an all]in commitment to risk parity. At a portfolio level, it simply results in overweighting low]volatility assets, which is obviously far-removed from the original purpose of risk parity.that is, true diversification at a portfolio level.

"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury 

Stay tuned!

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.

Consequences:
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!