Accentuate the positive…up to a point
On the third Friday of every month the US Bureau of Labor Statistics releases its preliminary data on non-farm payrolls, which are seen widely as a barometer of the broader economic picture in the US. Markets move significantly on the basis of these figures, so there is always a keen sense of anticipation on trading floors about what “the number” will be. The children of the bull-market (like me) working on trading floors of investment banks through the mid-2000s typically only ever saw a positive read out for the payrolls number – month on month the US economy was adding jobs, as the economy grew. This was taken to the point where the perception appeared to be that the number could only ever be positive – we had blocked out the notion of a negative figure.
As was typical of the trading floors I worked on there was always at least one trader “making a market” on what the payroll number would be, looking to make a few quid out of would be punters. The youngsters of the trading floor with this “only can be positive” perspective were often the target of such markets. The trader/ bookmaker of the payrolls number at Lehman Brothers, for example, aimed to capture the market in such a way as that he had no downside in the event that the number was positive, but had huge upside if shock-horror the number came out negative. In the bull-market his strategy never worked, but he was convinced rightly that this was a good strategy.
Bill Gross, the head of PIMCO, writing in his monthly “Investment Outlook” reminded me of these monthly payroll gambles. In a world where interest rates are near zero, and where deposit rates are truly awful (again almost zero), there is a desperation mindset in the investment community that Gross calls “Anything but 0.01%”. To clarify – while the world seems to know that there are good reasons not to invest in riskier assets than deposits, it will always take that gamble because it cannot stomach such a paltry return as the 0.01%.
As Gross points out it would take close to 7000 years to double your money at that 0.01% rate – not exactly compelling even if you are saving for your great great grand children’s school fees. The problem, as with the mentality of the young punters on the non-farm payrolls, is that in the “new normal” world that we are supposed to be living in 0.01% could be seen as a reasonable rate of return. The last twelve months of great returns in risk assets, however, are serving to delude us into thinking otherwise. Very quickly we have resumed the notion that “the number” is bound to be positive.
One of the great concerns about the rally in asset prices over the past year is that virtually every asset you can think of has gone up in value – from gold (the ultimate inflation hedge), to equities, through to government bonds. Old inverse relationships seem to have broken-down, which suggests that the “reflation” in asset prices is not caused by underlying economic improvement, but by an excess of liquidity in the system – in effect there is more money than sense.
Recently, as Gross points out, approximately $20bn a week has been flowing out of deposit accounts in search of higher yields. The rewards for having made this transition have been stellar in the past year – Gold at $1130 an ounce, global equity markets up 60-70% from their lows this year, oil at $80, mortgage rates at 4% thanks to a $1 trillion credit card from the Federal Reserve, commodities up across the board. The legitimate question of the day, as posed by Bill Gross: “Is a 0% interest rate creating the next financial bubble, and if so, will the Fed and other central banks raise rates proactively – even in the face of double-digit unemployment.” The answer is that they won’t, and the implications of that policy will start to tell.
Nationwide, the UK building society, on Friday accused government-backed companies of seriously distorting the UK retail savings market with “uneconomic pricing” of products. The building society, which had weathered the economic storm relatively well, saw retail savings outflows of £5.6bn in the half year ending September, which it ascribed to both lower market rates and tougher competition.
“We have elected not to chase market share in a retail savings market, which is subject to serious competitive distortion and uneconomic pricing, often by institutions which benefit from government guarantees”, it said. Naming Northern Rock, Lloyds and the NS&I, Nationwide rightly commented that these institutions were paying way over the odds to attract market share in a way in which Nationwide could not compete. NS&I had been offering a 3.95% return on a fixed one year bond, while the market was offering 95 basis points. That’s 300 basis points over Libor” said Chris Rhodes, the Nationwide marketing director. In layman’s terms, a private sector company (Nationwide) can’t compete against a UK government backed institution paying the standard interbank lending rate with an additional 3% kicker on top. And that 3% kicker is almost entirely subsidised by the taxpayer.
You then have to ask the question, if NS&I or any other government backed entity is borrowing at such high rates surely they must be taking way too much risk on the loans they are then offering out.
We have reached a point where the efforts to save the system, while initially critical, are now actually creating distortions such that markets are no longer allocating capital in an efficient or sensible way. The reality should be that the 0.01% paid on deposit accounts might actually represent a “reasonable rate of return” given the underlying real economic context. Those who have chased returns in risky assets, have been successful in the past year, but it doesn’t necessarily make them smart or sensible. The fact that governments and central banks continue to flood the system with liquidity certainly doesn’t make them smart or sensible either.