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THE CONCEPT OF "REAL RISK-FREE" TOTAL RETURNS
IN AN ERA OF FINANCIAL REPRESSION
Published 01-29-15
HOW FINANCIAL REPRESSION LEADS TO
MISPRICED RISK
CULTURE OF RISK
The financial system is based on debt. US Treasuries, the benchmark for an allegedly “risk free” rate of return, is the asset against which all other assets are priced based on their relative riskiness. This “risk free” rate has been falling steadily for over 25 years.
The Wall Street Journal estimates that a third of traders have never witness a rate hike. However, the real problem is far greater than this. Bonds have been in a bull market for over 30 years. Forget rate hikes… an entire generation of investors and money managers (anyone under the age of 55) has been investing in an era in which risk has generally gotten cheaper and cheaper.
FINANCIALIZATION & RISE IN LEVERAGE
This, in turn, has driven the rise in leverage in the financial system. As the risk-free rate fell, so did all other rates of return. Thus:
investors turned to leverage or using borrowed money to try to gain greater rates of return on their capital.
The ultimate example of this is the derivatives market, which is now over $700 trillion in size. This entire mess is backstopped by about $100 trillion (at most) in bonds posted as collateral.
ASSETS CAN NO LONGER BE ALLOWED TO FALL - Deleveraging is Misinformation
This formula of ever increasing leverage works relatively well when the underlying asset backstopping a trade is rising in value (think of the housing bubble, which worked fine as long as housing prices rose). However, if the asset ever loses value, you very quickly run into trouble because you need to post more as collateral to backstop your trade. If you can’t do this easily, the margin calls start coming and you can find yourself having to unwind a massive position in a hurry. This is how crashes occur. This is what caused 2008.
Despite all of the rhetoric, the world has not deleveraged in any meaningful way. The only industrialized country to deleverage since 2008 is Germany.
This is not unique to sovereign nations either. As McKinsey recently noted, there has been no meaningful deleveraging in any sector of the global economy (the best we’ve got is households and financial firms which have basically flat-lined since 2008).
In the simplest of terms, the 2008 collapse occurred because of too much leverage fueled by cheap debt. This worked fine until the assets backstopping the leveraged trades fell in value, which brought about margin calls and a selling panic.
REHYPOTHECATION
The practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients.
In rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades. While rehypothecation was a common practice until 2007, hedge funds became much more wary about it in the wake of the Lehman Brothers collapse and subsequent credit crunch in 2008-09. That has all changed as has the re-emergence of Cov-Lite, PIK Loans et al.
Since the Financial Crisis everyone has become even MORE leveraged than they were in 2008. And they did this against an ever-smaller pool of quality assets (the Fed and other Central Banks’ QE programs have actually removed high grade collateral from the financial markets).
Thus, we now have a financial system that is even more leveraged than in 2007… backstopped by even less high quality collateral. And this time around, most industrialized sovereign nations themselves are bankrupt, meaning that when the bond bubble pops, the selling panic and liquidations will be even more extreme.
Excerpts above taken from a note from Graham Summers, Phoenix Capital Research
THE CONCEPT OF "RISK FREE"
DEFINITION: Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. One interpretation is that the risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time.[1] Since the risk free rate can be obtained with no risk, any other investment will have additional risk. In practice to work out the risk-free interest rate in a particular situation, a risk-free bond is usually chosen that is issued by a government or agency where the risks of default are so low as to be negligible.
As my MACRO ANALYTICS Co-Host writes in The Surprising Consequences Of The Global Frenzy For Positive Yield
As the dollar soars, so does the real yield on bonds denominated in dollars.
As central banks rush to depreciate their currencies and push yields into negative territory, what's becoming scarce globally is real yield in an appreciating currency. Real yield is yield adjusted for inflation/deflation: if inflation is 3% and bonds yield 2%, the real yield is negative 1%. If inflation is negative 1% (i.e. deflation), and the yield on bonds is .1%, the real yield is 1.1%.
What's the real yield on a bond that earns 1% annually in a currency that loses 10% against the U.S. dollar in a year? Once the foreign-exchange (FX) loss/gain is factored in, the investor lost 9% of his investment.
Needless to say, the real yield must include the foreign-exchange loss/gain. An investor earning 10% in a currency that's losing 20% annually against other currencies is losing 10% annually, despite the apparent healthy nominal yield.
An investor earning 1% in a currency that's appreciating 10% annually against other major trading currencies is earning a yield of 11%.Clearly, the nominal yield is deceptive; the real yield can only be calculated by factoring in both inflation/deflation in the issuing economy and the appreciation/depreciation in the issuing currency against major tradable currencies.
Now we understand why what's scarce globally is real yield in an appreciating currency: the only major trading currency that's appreciating is the U.S. dollar. Any nominal yield on bonds issued in euros or yen turns into a loss when measured in U.S. dollars. Even the Chinese renminbi, which is pegged to the U.S. dollar, has slipped against the dollar as Chinese authorities have responded to the devaluation of the Japanese yen and other Asian-exporter currencies.
One result of the global scarcity for real yield is high demand for U.S. Treasuries, which are denominated in U.S. dollars. High demand pushes bond yields down, effectively replacing the Fed's quantitative easing (QE) bond-buying programs, which the Fed ended last year.
The U.S. gets the benefits of strong demand for its bonds (i.e. low interest rates) without having to issue new money (QE).
Another factor is the reduced issuance of new Treasury bonds as the U.S. fiscal deficit declines. This effectively reduces supply as demand remains strong.
This is a self-reinforcing feedback loop: as the U.S. dollar strengthens and the U.S. fiscal deficit declines, the Fed has no need to buy Treasury bonds (with freshly issued money) to keep interest rates low. Since the U.S. central bank isn't issuing new money while every other major central bank is printing massive amounts of new money to depreciate their currencies, this pushes the U.S. dollar even higher.
And as the dollar soars, so does the real yield on bonds denominated in dollars. That may not surprise everyone, but few can support a claim of predicting this a few years ago.
REAL RISK FREE TOTAL RETURN
This is THE trick of FINANCIAL REPRESSION in financing the US Government Debt
Savers lose but the US Government & International Banks win.
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Gordon T Long
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Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that you are encouraged to confirm the facts on your own before making important investment commitments.
© Copyright 2013 Gordon T Long. The information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities. Please note that Mr. Long may already have invested or may from time to time invest in securities that are recommended or otherwise covered on this website. Mr. Long does not intend to disclose the extent of any current holdings or future transactions with respect to any particular security. You should consider this possibility before investing in any security based upon statements and information contained in any report, post, comment or suggestions you receive from him.
