How many ways can you say ‘it’s different this time?’ There’s ‘abnormal’, ‘subnormal’, ‘paranormal’ and of course ‘new normal’. Mohamed El-Erian’s awakening phrase of several years past has virtually been adopted into the lexicon these days, but now it has an almost antiquated vapour to it that reflected calmer seas in 2011 as opposed to the possibility of a perfect storm in 2012. The new normal as PIMCO and other economists would describe it was a world of muted western growth, high unemployment and relatively orderly deleveraging. Now we appear to be morphing into a world with much fatter tails, bordering on bimodal. It’s as if the earth now has two moons instead of one and both are growing in size like a cancerous tumor that may threaten the financial tides, oceans and economic life as we have known it for the past half century. Welcome to 2012.
But before ringing in the New Year with a rather grim foreboding, let me at least describe what financial markets came to know as the ‘old normal’. It actually began with early 20th century fractional reserve banking, but came into its adulthood in 1971 when the US and the world departed from gold to a debt-based credit foundation. Some called it a dollar standard but it was really a credit standard based on dollars and unlike gold with its scarcity and hard money character, the new credit-based standard had no anchor – dollar or otherwise. All developed economies from 1971 and beyond learned to use credit and the expansion of debt to drive growth and prosperity. Almost all developed and some emerging economies became hooked on credit as a substitution for investment in tangible real things – plant, equipment and an educated labour force. They made paper, not things, so much of it that it seems they debased it.
Interest rates were lowered and assets securitised to the point where they could go no further and in the aftermath of Lehman 2008, markets substituted sovereign for private credit until it appears that that trend can go no further either. Now we are left with zero-bound yields and creditors that trust no one and very few countries. The financial markets are slowly imploding – deleveraging – because there’s too much paper and too little trust. Goodbye ‘old normal’, standby to redefine ‘new normal’, and welcome to 2012’s ‘paranormal’.
This process of deleveraging has consistently been a part of PIMCO’s secular thesis but implosion and bimodal fat tailed outcomes are New Age and very ‘2012ish’. Perhaps the first observation to be made is that most developed economies have not, in fact, deleveraged since 2008. Certain portions of them – yes: US and eurozone households; southern peripheral eurozone countries. But credit as a whole remains resilient or at least static because of a multitude of quantitative easings in the US, UK, and Japan.
Now it seems a gigantic tidal wave of QE is being generated in the eurozone, thinly disguised as a three-year long term refinancing operation, which in effect can and will be used by banks to support sovereign bond issuance. Amazingly, Italian banks are now issuing state guaranteed paper to obtain funds from the European Central Bank and then reinvesting the proceeds into Italian bonds, which is QE by any definition and near ponzi by another.
So global economies and their credit markets, instead of deleveraging and contracting, continue to mildly expand. Yet there is bimodal fat-tailed risk in early 2012 that was seemingly invisible in 2008. Granted, the fat right tail of economic expansion and potentially higher inflation has existed for the three-year duration. QEs and €500 billion LTROs can do that. At the other tail, however, is the potential for implosion and actual deleveraging. To the extent that most sovereign debt is now viewed as ‘credit’ in addition to ‘interest rate’ risk, then its integration into private markets cannot be assured. If only Italian banks buy Italian bonds, then Italian yields are artificially supported – even at 7 per cent. If so, then private bond markets and non-peripheral banks in particular may refuse to play ball the way ball has been played since 1971– purchasing government debt, repossessing the paper at their respective central banks and using the proceeds to aid and assist private economic expansion. Instead, fearing default from their sovereign holdings, any overnight or term financing begins to accumulate in the safe haven vaults of the ECB, Bank of England and Federal Reserve. Sovereign credit risk reintroduces liquidity trap and pushing on a string fears that seemed to have been long buried and forgotten since the Great Depression in the 1930s.
But deleveraging now has a new spectre to deal with. Not just credit default but zero-bound interest rates may be eating away like invisible termites at our 40-year global credit expansion. Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. Near zero policy rates and a series of quantitative easings have temporarily succeeded in keeping asset markets and real economies afloat in the US, Europe and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health.
Importantly, this is not another name for ‘pushing on a string’ or a ‘liquidity trap’. Both of these concepts depend significantly on perception of increasing risk in credit markets which, in turn, reduces the incentive of lenders to expand credit. Rates at the zero bound do something more. Zero-bound money – credit quality aside – creates no incentive to expand it. Will Rogers once fondly said in the Depression that he was more concerned about the return of his money than the return on his money. But from a system-wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may breakdown. We all start to resemble Will Rogers.
A good example would be the reversal of the money market fund business model where operating expenses make it perpetually unprofitable at current yields. As money market assets then decline, system-wide leverage is reduced even if clients transfer holdings to banks, which themselves reinvest proceeds in Fed reserves as opposed to private market commercial paper. Additionally, at the zero bound, banks no longer aggressively pursue deposits because of the difficulty in profiting from their deployment. It is one thing to pursue deposits that can be reinvested risk-free at a term premium spread – two/three/even five-year Treasuries being good examples. But when those front end Treasuries yield only 20 to 90 basis points, a bank’s expensive infrastructure reduces profit potential. It is no coincidence that tens of thousands of layoffs are occurring in the banking industry, and that branch expansion is reversing industry-wide.
In the case of low borrowing rates, this paradox at first blush seems illogical. If a bank can borrow at near 0 per cent then theoretically it should have no problem making a profit. What is important, however, is the flatness of the yield curve and its effect on lending across all credit markets. Capitalism would not work well if Fed funds and 30-year Treasuries perpetually coexisted at the same yield, nor if commercial paper and 30-year corporates did as well. It is not only excessive debt levels, insolvency and liquidity trap considerations that hurt both financial and real economic growth; it is the zero-bound nominal yield, the assumption that it will stay there for an "extended period of time” and the resultant flatness of yield curves which are the culprits. That front ends of yield curves are relatively flat at near zero per cent interest rates is critical as well. If they were flat at 5 per cent as in 2007, then banks and investors could extend maturities with the possibility of capital gains. Now at 1 per cent or lower, they cannot. Leverage is constrained.
Conceptually, when the financial system can no longer find outlets for the credit it creates, then it delevers. The point should be understood from a yield as well as a credit risk point of view. When both yield and credit are at risk the mix can be toxic. The recent example of MF Global emphasises the concept, as does the behaviour of depositors in some struggling European economies. If an investor has money on deposit with an investment bank/broker that not only appears to be at risk but returns nothing, then why maintain the deposit? Perhaps an investor would be more comfortable with a $100 bill at home in a mattress than a $100 bill on deposit with a broker – Securities Investor Protection Corporation notwithstanding. If so, system wide deleveraging takes place as opposed to the credit extension historically necessary for an expanding economy.
This new duality – credit and zero-bound interest rate risk – is what characterises our financial markets of 2012. It offers the fat-left-tailed possibility of unforeseen deleveraging, or the fat-right-tailed possibility of central bank inflationary expansion. I expect the January Fed meeting to mirror in some ways what we have first witnessed from the ECB. It won’t take the form of three-year financing by a central bank – but will give assurances via language that the cost of money will remain constant at 25 basis points for three years or more – until inflation or unemployment reach specific targeted levels. QE by another name I suggest. If, and when, that doesn’t work then a specific QE3 may be announced – probably by mid-year – and the race to reflate will shift into high gear. But the outcome of left-tailed deleveraging or right-tailed inflation is not certain. Both tails are fat.
The critical question of course is whether efforts by the ECB, BOE and the Fed will work. Can they reinvigorate animal spirits in the face of credit and zero bound money risk? We shall see. An investor, however, should hedge his/her bets until the outcome becomes more obvious.
For 2012, in the face of a deleveraging zero-bound interest rate world, investors must lower return expectations. 2–5 per cent for stocks, bonds and commodities are expected long-term returns for global financial markets that have been pushed to the zero bound, a world where substantial real price appreciation is getting close to mathematically improbable. Adjust your expectations, prepare for bimodal outcomes. It is different this time and will continue to be for a number of years. The New Normal is 'Sub', 'Ab', 'Para' and then some. The financial markets and global economies are at great risk.
Bill Gross is managing director of Pimco. © Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.