It’s FOMC day and, as sure as eggs are eggs, rates are headed north.
For all intents and purposes the outcome is not in question although that is like German playing Liechtenstein at football, and saying that Germany would win. What one really wants to know is whether the Liechtensteiners would get on the score sheet without the Germans gifting them an own goal. In FOMC terms, today is not about what is expected but what might not be.
On that front, the risk of black swans sailing onto the scene would appear to be fairly remote. Although risk asset prices are highly inflated by all traditional measures, Madame Yellen and her merry men are clearly aware of just how skittish markets can be and they definitely do not want to read one day “Fed insensitivity causes asset price implosion and subsequent recession”. No sir , the Federal Reserve is as much part of the conspiracy of silence as is everybody else who has done well by maintaining the debt-fuelled mirage of the post-crisis recovery.
CHICAGO HOPE
In that context I was particularly intrigued by a section in Julius Baer Zurich’s Beat Matzinger’s daily observations on Tuesday in which he wrote:
“Keep an eye on the US muni market… While Puerto Rico has been the headline, many states and municipalities are starting to worry us … Friday, Massachusetts was downgraded, but they still have a strong rating … But Illinois could be made into a junk credit in the near future … S&P lowered Illinois to BBB- on June 1 and has said it would lower the rating again if a budget was not approved by July 1 … only two weeks away …
“There are not the only states in trouble as Ct, NJ, and Kentucky all have pension plans funded at less than 50% … Dallas Texas County Schools became the first municipal issuer to default in two years this month.
“Reading through the municipal problems, interesting, there was a report saying that “tax revenues are lower than expected in many states as wage gains have been weaker than forecast” … Hmmm … They have 4.3% unemployment and tax revenues are lower because wage gains stink … Two things … one, the employment report is missing something, and maybe the Fed governors should not be out there talking about multiple increases … Just work on reducing the balance sheet.”
I find the first bit to be truly interesting. I do, however, have to take issue with the final comment. Increasing the Fed’s balance sheet by way of bond purchases was known as quantitative easing. Therefore reducing it, whether by not reinvesting redemptions or by outright bond sales is nothing other than quantitative tightening. Whether the Fed flattens the yield curve by increasing the target rate for Fed funds or whether it steepens it by pushing the responsibility for refinancing matured debt instruments onto the open market is neither here nor there; they are different sides of the same tightening coin.
THE WONDER YEARS
We shall read reams of reports tonight and tomorrow analysing every word and every phrase that Madame Yellen utters in her post-meeting press briefing although these will ultimately add up to little more than occupational therapy exercises for Fed watchers with nothing to say. Yellen follows in a long line of Fed bosses who can talk for a long time, saying nothing we didn’t already know and still somehow exciting the audience.
Meanwhile the after-effects of the engineered takeover by Banco Santander of the troubled – to put it mildly – Banco Popular and the subsequent bailing-in operation continues to exercise the minds of some very smart people. The wiping out of Tier 1 subordinated debtholders would have been sort of expected. The creation of Additional Tier 1 securities was targeted at doing exactly that but it was the ruthless nixing of Tier 2 investors that caught almost everybody by surprise.
There is something in the pricing model for bonds that we have all grown up with and that is that the price of a security is a reflection of the perceived probability of default adjusted by the expected recovery rate. I recall the horrors of the past when the likes of WorldCom and Enron pitched up with zero recovery, a level to which not even Lehman Brothers descended. But now, with Popular’s AT1 having defaulted in its entirety, the full force of bailing-in had been observed and found to be doing, as the bon mot goes, what it says on the tin.
But that is by far not the end of it. The total loss on Popular’s Tier 2 bonds opens an entirely new can of worms, namely how to price middle-ranking sub debt. The thought of these securities also offering a binary outcome of par or zero make a mockery of the multi-layered structure of subordinated bank debt.
I spoke at some length to a portfolio manager who was musing along the lines of if Tier 1 and Tier 2 might be of equal risk in the event of default, why would anyone ever want to buy Tier 2 while being paid a comparative pittance for equal risk? Although acknowledging that there is a lot of ground to be covered before subordinated paper issued by a bank that is unlikely to actually go under – think BNP Paribas or HSBC – can be compared to that of seriously distressed institutions – all eyes on Italy between Sienna and the Veneto – neither of us could pin the tail on the donkey of where one might begin and the other end.
If the risk of total loss now stretches further up the capital structure, does that not strengthen the possibility of pushing weaker institutions into a death spiral of capital inadequacy? Thus emergency capital raising and efforts to shore up the balance sheet will either become impossible or, if it were to be possible, the cost of doing so would beggar the bank one way or the other.
THE REAL WORLD
New fangled trading rules have not helped. Rumour has it that one large investor, possibly one based in California, had been stuck with up to half of Popular’s AT1 issue and although it had spent many months trying to get out of the position, there had never been a bid forthcoming. If there is no bid, there is no market and if there is no market, how can a mark-to-market price be applied to the holdings? Asymetric liquidity risk at its very worst.
I was brought up in this business to believe that there is a bid for everything, it might not be a bid that one likes but there will be a bid. So much for trading platforms, total transparency and level playing fields. Why is it so easy to sit down with the children and to tell them that life isn’t fair but so difficult to apply that to everyday bond trading?
The resilience which the AT1 market showed in the aftermath of Popular’s de facto default has been held up as living proof that the Single Resolution Board system works. It is either that or it is the market whistling in the dark while the cherished quant models find themselves incapable of including a tipping point where perfectly sound pricing flips into binary par/zero valuation territory.
Finally, I’m happy to report that Tuesday went by without a single record index high or record low index being recorded. What a pleasant change that makes…