Thursday, November 21, 2013

Bond Markets and the Ever Elusive Taper

Bond market watchers have, in recent weeks, become mindful of what is widely perceived to be an possible game changer: If the Federal Reserve, as expected, announces an exit strategy from its $85 billion per month bond-purchasing program, known as QE3, investors can expect a rise in yields and a fall on bond prices, effectively ending the secular bull market in fixed-income securities that has prevailed since the inception of the Fed's zero-interest rate policy in December of 2008.

A concurrent and highly relevant development is notably absent from the recent discussion of the trajectory of the bond market: the imminent (it now seems) appointment of Janet Yellen as the new Federal Reserve chairmanwoman. Yellen's academic career as well as her previous contributions to the direction of monetary policy (she is the current Vice Chair at the Fed) indicate one thing for certain: her moral suasion as formal leader of of the Federal Open Market Committee will favor continued monetary expansion. As far as inflation "hawks" and "doves" are concerned, she is firmly the later. 

Continued expansion in the short-term is just what bond markets ought to expect regardless of changes in leadership. At the inception of QE3 in December of last year, Chairman Bernanke stated that the bond purchases would continue until inflation exceeded 2.5% or unemployment fell to 6.5%. Neither metric is near these parameters. The Federal Reserve, always wary of losing institutional credibility, is even more so in the last five years since its primary policy tool, adjusting the Federal funds rate, has failed to return the economy to full employment. Reneging on an explicit policy pronouncement is unlikely to be on the Fed's agenda.

On a longer time spectrum, and with the assumption that Yellen's tenure will result in a continued expansionary stance for monetary policy, longer-term bond yields are actually as likely to rise as to fall. If unemployment remains high and the economy continues to operate below potential, the "liquidity effect" caused by swapping monetary base for interest-bearing Treasury bonds will hold rates down all along the yield curve. If, on the other hand, a consistently expansionary stance of policy actually succeeds in boosting demand, creating jobs, and moving the economy toward full employment, inflation expectations will rise. At this stage the "Fisher Effect" will dominate, and nominal interest rates will rise as investors demand a premium to protect their real yield from erosion by inflation. In short, bond investors won't feel the heat unless it's generated by the labor market.

Wednesday, November 20, 2013

Calibrating the Volcker Rule: Better Get It Right

The Frank-Dodd Wall Street Reform and Consumer Protection Act celebrated its third birthday in July. Yet regulators are just now attempting to hash out the specs of one of the most potent weapons in the new arsenal appropriated to regulators: the Volcker Rule.

Put simply, the Volcker Rule prevents bank deposits that are insured by the FDIC from being used in "proprietary trading," essentially buying and selling securities with depositor's money for profit. The logic behind the rule is as follows: since the deposits are insured by the FDIC, banks have less incentive to invest them carefully, since any losses will be covered by insurance premiums they've already paid. Thus moral hazard induces banks to take more risk onto their balance sheets than they otherwise would ceterus paribus. Heads, the banks win; tails, the FDIC loses.

The treatment for this ailment plaguing the financial system seems straight-forward: ban speculation with depositor's money. As with any complicated medical procedure, however, complications have arisen. Regulators at the SEC and the CFTC are having difficulty formulating a coherent distinction between proprietary trading and its close cousin, "market making." Market making occurs when a bank buys a security with the intention of selling it in the near future and pocketing the spread between the bid and offer. If these two transactions sound eerily similar it's because they are. Market making, however, is done with the intention of being able to offer clients a variety of financial instruments as well as being able to sell instruments on their behalf. In proprietary trading, the bank earns income from solely from successful speculation; market making generates income through commissions paid by clients.

Another banking practice liable to fall as collateral damage should the gauge of the Volcker Rule be set too low is the practice of "hedging". Hedging allows banks to protect the total value of their assets relative to deposit liabilities and hence protect their capital position. Even if a bank were to hold only risk-free Treasury securities, an increase in interest rates would cause a decline in the market value those bonds. Loan default has the same effect. To protect against these types of risks, banks may purchase securities such as forward rate agreements that are expected to reverse correlate with changes in price of the original asset.

Regulators need to properly and clearly define the "Volcker Rule" as expediently as possible, and in doing so take care not to preclude banks from performing functions essential to their stability. Buying and selling securities on behalf of clients is not a clandestine or risky business practice; hedging against risk does not destabilize the financial system.

The fact that the Volcker Rule was included in the Frank-Dodd bill yet is only being defined three years later suggests that regulators expect to wield large discretionary power in deciding what sorts of banking transactions pass muster. This is a mistake.

Financial regulations must be concrete and communicated with clarity, with a minimum of discretion left to the individual regulators. The reason is simple: Regulators at agencies such as the SEC or CFTC or the newly created CFPA are overseen by the House Financial Services Committee and the Senate Banking Committee. These committees are comprised of Congressmen and Senators who rely on the largess of campaign donations to finance their political careers. If broad discretion is left to individual regulators, the whole operation is reduced to something akin to a magic show: impressive sounding regulatory legislation serves as misdirection to distract the public into thinking lawmakers have "reigned in the big banks;" Congress serves as a false wall between the regulators and the firms swapping campaign cash for influence. In the end, no one is held accountable when there's no rabbit in the hat.

Tuesday, November 19, 2013

Genesis at Geneva: Let's Begin the De-fissilization of Iran

The latest fracas to widen the gulf between competing factions in the Federal government has arrived, a mere month after partisan gridlock nearly laid the global financial system low. Its origins lie not with Federal debt or deficits, nor even with the recent road-bumps in the implementation of President Obama's signature achievement, the Affordable Care Act. In fact, its origins aren't even in North America. The newest casus belli springs from some 4,078.1 miles away in Geneva, Switzerland, where the P5+1 (Britain, France, Russia, China, the U.S., + Germany) are convening to discuss the latest specter to haunt the security community of the advanced world: the nuclear ambitions of the Islamic Republic of Iran.

In 2006, the International Atomic Energy Agency was "unable to verify" whether Iran was pursuing nuclear technology capabilities for purely civilian purposes as claimed, or whether it was in violation of the Nuclear Non-Proliferation Treaty. Iran was given a one-month deadline to "suspend all enrichment-related and reprocessing activities, including research and development" or face increased economic sanctions from the U.N. Security Council. The deadline was not met.

Since then, sanctions placed by the U.N. have resulted in the halving of potential oil revenues, the prime source of income for the Iranian government and broader economy. Despite possessing some 15% of the world's natural gas reserves, Iran has been largely unable to develop this resource. Export markets in Europe remain closed, as does sources of foreign investment funds and industry expertise. In addition, tens of billions of dollars in financial assets held abroad have been frozen due to the banking portion of the sanctions. Under intense fiscal pressure, the government of Iran has turned to fill the gap from lost revenues with inflationary finance, which has resulted in inflation running at 40% for the last two years. Faced with supply constraints on imports and a soaring cost of living, the Iranian economy has entered a full-fledged inflationary recession (the same phenomena dubbed "stagflation" when it occurred in the US in the 1970s).

These pressures have sufficed to bring Iran to the negotiating table in Geneva, and President Obama now has an opportunity to initiate the diffusion of Iran's fissile ambitions. The specific terms of the negotiation are being constructed as I write this, but they seem to hedge around two premises: Iran will agree to curtail enrichment of uranium, which it has been producing at an accelerating rate thus far, and limit it nuclear reactor capacity. In return, the West will agree to a limited reduction in sanctions, possibly allowing for limited foreign investment and technology to develop the liquified natural gas sector and unfreeze around $10 billion in frozen assets.

Not everyone is convinced. Benjamin Netanyahu, the Israeli Prime Minster, has called for demands that Iran immediately cease enrichment of uranium and the halting of a plutonium reactor in the eastern city of Arak. Failure to meet these demands, according to Netanyahu, should be met with increased sanctions and advised the P5+1 to "keep the pressure up." Economic sanctions were enough to bring Iran to the table. By extrapolation, it follows that increased and prolonged sanctions should suffice to bring Iran to its knees. But this is logic defied by historical experience. Fifty-one years of embargo on Cuba have not resulted in any concessions from our island neighbor to the south. Nor has the economic isolation of North Korea proved efficacious in limiting it's nuclear program. It turns out a nation can remain obstinately committed to a nuclear program on a GDP per capita of $1,800.

This hardline stance is also inconsistent with recent developments in the international geopolitical landscape. The United States no longer enjoys the near monopoly on soft-power it once did. The market for power-projection is becoming increasingly competitive, with a resurgent Russia and a newly- potent China offering nations that evoke ire of Washington an alternative to isolation. Vladimir Putin demonstrated his nation's ability to punch above its weight when he (at least appeared to) single-handedly remove the impetus of the planned American strike on Damascus by orchestrating the removal of Assad's chemical weapons arsenal. Now Syrian government forces are making headway against rebels who only recently thought their victory was at hand, courtesy of Uncle Sam.

The proposed lightening of sanctions on Iran will have a palpable effect on the material standard of living for Iranians. By lessening some (not all) of the pressure that is squeezing their incomes, in return for concrete reductions in their nuclear program, Obama will signal to the Iranian people that there truly is a tradeoff between the nuclear ambitions of their despotic government and the purchasing power of their take-home pay. Let's give them a taste of what compromise can bring. With any luck, they'll be back for seconds.