The Eventual Impact of Rising Bond Yields. Further Cracks Appearing in the ‘Global Consensus’ of Bank Supervision.
Global Bond Market Yields are Rising
The ECB’s recently announced 6 month extension of its QE programme reminds us that the speed at which the programme will eventually be tapered, indeed its eventual elimination, depends substantially on the observed and expected pick up in Eurozone inflation. The annualised 0.6% modest rise in consumer price inflation, reported in November, is seen by policymakers as a step in the right direction.
Despite there being no end in sight to QE, the ECB is pleased with itself. So much so that it has described itself as a “pillar of stability” against the backdrop of major governing coalitions struggling to fend off the rise of non-centrist (we dislike the term ‘populist’) parties. And that was before Renzi’s defeat. Privately, the ECB is surely aware that its persistent demands for the implementation of structural reforms by national governments look about as far away as the end of its QE programme.
So, is the ECB’s self-confidence justified? We think not. Latest estimates of November investor losses in the global bond market exceed $1.7 trillion. This has been accounted for, according to mainstream media, by expectations that the Federal Reserve will increase interest rates in December, coupled with the ‘Trump effect’. The incoming Trump administration is expected to implement a fiscal stimulus (tax cutting) plan, which markets think will probably balloon the budget deficit.
However, as John Butler points out in a technical essay published elsewhere, there is much more to this story. He makes three points:
i) The trend reversal in global bond yields has been underway for some time. Even though bond prices have been rising for years, the rally had palpably fizzled out earlier in 2016. Central bank interest rates had bottomed out at around zero, and consumer price inflation was observable in most economies. For example, yields on US ten year treasuries increased during November from 1.8% to 2.4%; a large move invoking memories of the 2013 sharp swings when the US announced the start of QE tapering.
ii) The market fall was much greater than that implied by the modest levels by which policymakers are expected to raise interest rates. The sell-off reflected jumps in the so-called “term premia”. This term quantifies the compensation that investors demand for taking exposure to more uncertain future long-term interest rates, as this uncertainty risk increases. These greater “term premia” must then be added to the increase in the expected level of actual future rates in order to determine the new market yield of bonds and, consequently, their prices.
iii) The very low levels of interest rates which underpinned the bond bull market have exacerbated the extent of the sell-off. An investor owning a bond yielding 5% which lost 10% of its value would sacrifice two years of expected return. But if the same price drop was suffered by the holder of a 1% yielding bond, that would represent the loss of ten years of returns.
The effect of this is that the relatively tiny increases in policy interest rates mulled by the Federal Reserve and others in order to demonstrate the ‘normalization’ of policy, have triggered much bigger increases in term yields. Sadly, this higher cost of borrowing for all economic actors (including governments) in economies experiencing low growth could prove unwelcome. As borrowing costs rise, so growth tends to fall, and this ‘fear factor’ will likely spur further rises in term premia and thus a recurring cycle could commence. Moreover, these November bond yield increases have occurred after almost a full year of inflation rising. Admittedly this is from a very low base, and by modest increments, but inflation’s years long downwards trend has firmly reversed. Global commodities prices look set to continue their recent rises, underscored by the OPEC agreement to limit oil production.
These factors all point to steady and accelerating inflation. Naturally, when consumer price inflation in Europe reaches the magic 2 per cent number we expect the ECB to pop the champagne corks. We will not be joining them.
The Global Consensus on Banking Supervision is Breaking Down
The decision by the US authorities in 2014 to require foreign (mainly European) banks to post reserves at the US central bank proportionate to the size of their US banking businesses was a significant, if underreported development. European banks’ complaints of discrimination were ignored. At the time Michel Barnier, Europe’s Commissioner responsible for the planned Banking Union, warned that this could fracture the concept of global banking supervision, but this warning was ignored.
Almost two years later, this November, the European Commission (EC) announced its reciprocal move. The EC even imitated the US rule by requiring banks to establish “intermediate holding companies” on European soil whose soundness will be assessed by European supervisors in accordance with CRD rules:
“Article 21b of the CRD introduces a new requirement for establishing an intermediate EU parent undertaking where two or more institutions established in the EU have the same ultimate parent undertaking in a third country. The intermediate EU parent undertaking can be either a holding company subject to the requirements of the CRR and the CRD, or an EU institution.”
The document authorises the relevant supervisor to require the bank to demonstrate additional capital requirements and post “own funds add-ons” in a range of circumstances, essentially where the calculations of the European supervisor as to the businesses’ exposures so warrant. It applies only to non-EU systemically important banks with assets of at least €30 billion in the EU.
Naturally, in the light of Brexit, banks with significant deposit bases in the UK must show that these are ringfenced.
These measures are unpopular with banks who worry about where this trend will end. US banks, mainly London based, are particularly unhappy. In addition to the increased regulatory burden there is the liquidity burden of posting pools of reserves (always misreported in the media as “holding capital”) in potentially multiple jurisdictions. These reserve requirements can be large. Credit Suisse has been compelled to maintain reserves with the US equal to 61% of its CET1 (core equity tier 1) capital.
With Europe’s banking system reportedly much weaker than the US’, why would the EC now risk provoking the US? Is this in part a petulant reaction to the US Department of Justice’s imposition of a $14 billion misconduct fine on Deutsche Bank? Or is it a wise response to the Financial Stability Board’s specification of Citibank and JP Morgan as the two joint leaders of their “Systemically Important” bank list? The term “important” is carefully chosen, it justifies mainstream media fawning on the importance of the banks whilst its true meaning is “threat” as demonstrated by the FSB’s addition of a 2.5% buffer to the minimum capital hurdles for each bank.
It is perfectly possible that this FSB news helped European authorities realise the weaknesses in the concept of global supervision, and the EC’s response should in that context be seen as sympathetic to the US’ rather than hostile.
All regulators know that banks are very highly leveraged, and efforts to strengthen the rules get beaten back by policymakers. That is why in 2014 US authorities wanted to ringfence foreign activities on their turf, so that they could make first claim on any tangible reserves within easy reach. Further reasons probably included the following:
1. the US tests, known as CCAR, are stricter than European tests in many respects, notably the Liquidity Ratio soon to be applied at the 6% level, not 3% as it is in Europe.
2. the actual admission that certain European stress tests have been ‘fixed’ against a backdrop of steady reports of failures of European banks and severe concerns about Deutsche Bank;
3. fears of 2) above destabilising the euro itself.
If the US was the first mover, the EC’s announcement shows that the veneer of a global supervision is now fundamentally cracked. This news reinforces our consistent message: both official measurement tools of bank solvency, the Liquidity Ratio and the Risk Weighted Assets metric, are of no use in demonstrating solvency. They can expose a manifestly insolvent bank, such as Italy’s BP Bari, but the measures are then easily gamed by ‘optimisation’ techniques as we demonstrated last month.
The irony of the EC’s decision is that it was framed as part of the process of harmonizing Europe’s Banking Union. The announcement did at least concede that:
“further steps are needed to complete the Banking Union, including the creation of a single deposit guarantee scheme.”
Germany’s Bundesbank is believed to be dead set against this. Its representative is going into the forthcoming Basel (bank rule) negotiations with two “red line” demands. One of these, we assume, will be the end to zero risk weighting for all OECD sovereign debt. If provoked again on the common deposit guarantee scheme the EC may find that global banking regulation fractures further, possibly along national lines.