As a Portugal-based business, we at Sol Capital are happy to see the great and the good of the central banking community descending on the former royal residential city of Sintra, just west of Lisbon, to attend the ECB forum and to declare that all is well in the garden and that nobody has anything to fear.
In most respects they are right in as much as the European economy is in a pretty robust state relative to where it has come from but, alas, it is still looking fairly poorly compared to where it should be heading for.
ECB president Mario Draghi is on the defensive. The extremely loose monetary policy that the ECB is pursuing is beginning to look a bit out of step with the slow but consistent growth within the eurozone. Still, Draghi is showing no signs of wanting to show consideration for the voices that are calling for an end to the zero interest rate policy that has now prevailed for a year and a quarter. In a speech yesterday to students in Lisbon Draghi argued that without strong support from the monetary policy side none of them would find jobs at the point of graduation.
He has a point, He also sees monetary policy as executed by the ECB as a stimulant to earnings equality in that it helps the weakest more than it helps the strongest members of the community and he perceives the stability of the eurozone and the EU to depend on a closing of the wealth gap. All this is true but it is also pretty strong ideological stuff coming from the head of the central bank who really has no right to be fiddling around in the social engineering space - and if he does, he certainly shouldn’t to be talking about it.
While parts of the markets were dancing in the aisles yesterday after the successful bail-out of Veneto and Vicenza, others were asking themselves what has happened to the rules. Should the ECB, always such a stickler for pan-eurozone thinking, not have been screaming blue murder on the back of the Italian government’s flagrant disregard of the book? Or could it be that St Mario is not quite as blue and gold as we had all thought and that there is a stronger-than-expected residual streak of red, white and green hidden behind his calm exterior?
More pensive observers of the banking sector seem to be universally horrified by the structuring of the rescue and, myself included, wondered what the format of the rescue is telling us about what we are not being told. Is the ECB’s habit of remaining so resolutely schtumm just a matter of political expediency or a tacit acknowledgement that there are too many cases where one-size-fits-all policies end up not fitting anybody?
Based on Draghi’s utterances, we know pretty much for certain that we need not expect, in the near future at least, a tightening of monetary conditions within the eurozone. The ECB will be out there playing QE and ZIRP for some time to come. The response in the euro-dollar rate - or the lack thereof – would have one believe that the ECB boss was preaching to the converted. The Germans within the ECB, especially Jens Weidmann and Sabine Lautenschläger, might not necessarily agree but they both know when they are beaten and they will barely offer more than a notional protest.
John Williams, the San Francisco Fed chief whom I quoted yesterday in the context of his Sydney speech, also gave us a new mantra which is “Boring is the new exciting”. Is the Fed going to be taking lessons from the ECB?
Yield!
Meanwhile, risk asset markets had another snooze day; up a bit, down a bit and closing within fractions of where they had opened. Credit spreads also tightened slightly.
Risk? What’s risk? A year ago today the iTraxx Crossover closed at 417.51. As at last night it was trading at 233.21, just two points above its 12-month low of 231.14, which it clocked on Monday of last week. Has the default probability within the crossover cohort really diminished by that much in just one year? More to the point, we are now clipping the coupons on speculative-grade bonds at levels below blue-chip dividends.
By and large high yield is treated by most asset allocation groups as a bond proxy for equities. The strategic risk profile might prescribe a certain amount of fixed income but most of us know that this can be circumvented and equity risk exposure can be exceeded by buying high-yield bonds, the performance characteristics of which resemble those of equities more than they do those of bonds. That’s fine; we all know it and we all accept it. But when the point comes when the yields on HY fall behind those of equities, they ought to be dumped for the liquidity risk-adjusted return on bonds needs to be higher than on equities.
Pre-crisis it was easy to trade supra and sovereign bonds in clips of US$50m on both sides of the price. I once quoted and traded €1bn Bunds outright – not with the basis hedge - and on the price. That might not have been right but nor is trying to find a bid in the self same supra and sovereign bonds for US$5m, only to be told “Sorry, I’m not axed to bid”. The purpose of a two-way price is to show where one is prepared to trade assuming one is axed neither way. I digress. The fact is that in the event of a crisis in risk assets, one would surely be better positioned to liquidate in stocks than in high-yield bonds.
At the end of the 2008/2009 meltdown, it was agreed that markets had failed to price liquidity risk. To me it looks as though we’re sailing into the same old liquidity cul-de-sac, eyes wide shut. I refer back to June 1 on which I imparted Hume’s first law which goes “Markets will never learn and will therefore repeat even their most stupid of excesses”. Maybe time for a little think. Hume, an Australian-born actuary, was one of the co-creators of the modern money markets as we know and trade them but who packed his bags and took his money in the late 1980s, walked away from the City and who dedicated the rest of his working life to breeding prize sheep. Trust me, he knows a thing or two, not least about timing.