WATCH: What’s Wrong Mr Bernanke? (Epic Rick Santelli Rant)

“Where does it say in the Constitution that stock prices have to go up?” – CNBC commentator Rick Santelli on an epic rant in the aftermath of Ben Bernanke’s FOMC comments on tapering and QE and how the Fed has no idea about what they’re doing.

When you add in Bill Gross saying on Bloomberg that the Federal Reserve is “walking around in a fog”, we have to laugh. His PIMCO Total Return fund took a bath yesterday as financial markets took a hit on the back of Bernanke’s comments. When Bill Gross “the king of bonds” basically said “WTF are you doing Mr Chairman!” you know that central banks playing central planner has opened a massive can of worms for the global financial markets.

Maybe Having Your Kiwisaver Account With Your Bank Is Risky

Apparently one of the main reasons why people are switching Kiwisaver providers is because they want to see their Kiwisaver account balance when they log into their online banking. Maybe getting less regular updates about your Kiwisaver performance will increase long-term returns because of the costs of switching Kiwisaver provider.

When you think about Kiwisaver, and its goal as a long-term investment to help you in your retirement, is it really a good idea to be constantly checking the performance of a long-term investment vehicle?

Our brains are wired to be far more risk-averse than we should be. We also prefer avoiding losses at any cost – we sell low and buy high more often than we think we would. In short, we’re terrible investors almost always better off investing in an index fund unless we dedicate a substantial amount of time and effort to investing activities.

Past performance is no guarantee of future performance. In fact, just on a coin-flipping basis, there will always be some Kiwisaver funds that will outperform their competition and see a substantial inflow of funds the year after the stellar performance.

Having your Kiwisaver account with your bank is risky – you’re unlikely to possess the information with which to constantly assess the ups and downs of that account balance and therefore will experience strong reactions to the viscissitudes of that balance that stares at you in the face when you pay your bills or make transfers to your other savings accounts.

It is also a violation of the idea of diversification. Having all of your eggs in one basket is what cost finance company silly buggers so much. One of the things that I haven’t found any discussion of is how Kiwisaver cash funds would be treated in an open bank resolution situation.

As counter-intuitive as it might sound, maybe setting and forgetting about your Kiwisaver is the optimal strategy in the long-run. If you’ve already chosen a provider with low fees then the error costs from choosing a high fee-poor performer will be lower anyway.

You have no direct control over the performance of your Kiwisaver account so getting all worried and worked up about it isn’t the right choice. The United States’ experience with 401(k) retirement accounts has shown that constant changing of providers hurts long-term returns more than simply sticking with the default choice offered in the plan!

Having your Kiwisaver account balance right in your online banking login is just putting more stress and worry on your shoulders. When more than 2.2 million Kiwisaver members are chopping and changing their Kiwisaver provider so frequently, it’s clear that many of them haven’t read enough about finance and economics.

Disclaimer: I am not an Authorised Financial Advisor. You should contact your financial advisor, accountant or solicitor for personalised advice based on the specifics of your situation and objectives before making any investment decisions.

P.S If you don’t do so, the economist in me tells me that you should internalise the costs of your mistakes but sadly that’s not how regulation works these days. Mummy and daddy taxpayer & regulator are here to protect you from sub-optimal decision making.

P.P.S I wrote a post a while back about how to learn more about finance. It is negligent for anyone to fail to educate themselves given the enormous amount of free knowledge available on the internet these days. Try educating yourself instead of watching the rugby or some cooking show.

P.P.P.S If you are using Kiwisaver as a vehicle to get money for your first home, maybe you should think about the opportunity cost of buying a home. What’s an opportunity cost? It’s what you give up to get something. Renting is almost always cheaper than buying. A housing expense is a housing expense. There’s no such thing as “throwing money away” – if you didn’t value a roof over your head you’d live on the street.

Richard Koo Thinks Abenomics Honeymoon Is Over

Nomura economist Richard Yoo, who’s produced a lot of really good analysis of the Japanese economy over the past decade, thinks the Abenomics honeymoon is over.

Check his comments out at ZeroHedge.

Basically, despite the Bank of Japan injecting enormous liquidity into the Japanese financial system through their 20th something iteration of QE, private sector demand for credit has barely budged.

The whole point of QE is to keep interest rates low, but if the velocity of money is low then that monetary base is not moving around the economy spreading fairy dust in the form of investment, consumption and job creation.

There is an interesting Bank of Japan paper that explains the low velocity of money since the Japanese economy went into decline over 20 years ago.

In order for Abenomics to be successful three things have to happen:

  1. Overseas investors have to stick around
  2. Private sector credit demand has to increase
  3. All of the supply-side reforms he wants to implement can’t be held up

Because all of these three are unlikely – even though there’s reasonable evidence to suggest the Nikkei 225 at 15,000 wouldn’t be unreasonable, the Abenomics experiment could soon be filed under “Stuff Japan Tried And Failed Dismally At”.

It’s not their economy’s first time at the QE rodeo – and the jitters it is sending through their financial markets are something to be concerned about.

Graeme Wheeler, Currency Intervention And Mean Reversion

Reserve Bank governor Graeme Wheeler is giving a speech to the Institute of Directors in Auckland today. It is interesting to see how our central bank, which pioneered inflation targeting and has maintained a credible monetary policy for some time, rationalises its inability to successfully intervene in the foreign exchange market.

For example, the challenges faced by producers competing against foreign low-cost producers, or multinationals with global supply chains, increase when our exchange rate overshoots.  On the other hand, the high exchange rate makes imports of capital goods cheaper and may encourage the take up of capital intensive technologies.

How successfully have exporters “captured” the mind of the Reserve Bank? Remember, everyone benefits from imports, but the benefits from exports primarily accrue to asset rich farmers and closely held manufacturing firms that export high value products. Yes, they earn the foreign exchange we need, but it’s no different to working people turning up at the office to collect their salary – it’s essential but not where the value in the economy is added.

Among the developed market currencies, the Kiwi has been the third strongest performing currency against the US dollar (after the Mexican peso and Swedish krona) over the past 12 months.

There is a global reach for yield going on. The Reserve Bank can’t do anything about it through playing with the Official Cash Rate. Imposing loan-to-value restrictions in the housing market are unlikely to have much effect on housing demand and will funnily enough make increasing the housing supply more difficult for people wanting to build on greenfield subdivisions on the outskirts of Auckland.

Our past exchange rate cycles have exhibited substantial overshooting followed by a sharp and rapid exchange rate depreciation.  Such rapid exchange rate corrections reflect the drain in market liquidity that can occur when a small market like New Zealand begins to turn down.

This happened in 2008 after the global financial crisis began in earnest after the collapse of Lehman Brothers. Since quantitative easing began, volatility in risky assets like those denominated in NZD has increased alongside their price – there is a global reach for yield that necessitates investors who don’t want to earn 1% buying foreign bonds like those on offer in New Zealand where yields range from 3% to 6% on bonds and equities that pay dividends.

The Federal Reserve is currently buying USD85 billion per month in assets. They are on track to have a balance sheet that is 25% of US GDP by the end of 2014 at this rate. If they taper off, there is the risk that interest rates will rise fast and high losses will be imposed on bondholders and equity holders alike.

In assessing whether to intervene in the exchange market, we apply four criteria. These are whether the exchange rate is at an exceptional level, whether its level is justifiable, whether intervention would be consistent with monetary policy, and whether market conditions are conducive to intervention having an impact. This last factor is especially important given the volume of trading in the Kiwi.  (In the most recent survey – April 2010 – by the Bank for International Settlements, the Kiwi was the tenth most traded currency in the world with daily turnover of spot and forward exchange transactions totalling around USD $27 billion.)

How do you define justifiable? The Reserve Bank’s intervention justifications are ridiculously broad. 4.4 million people against 44,000 farmers. In terms of societal welfare, in the age of the Apple gadget, all that matters is the price of imports. Hardly anything we actually want to spend money on is made here so now that we’ve made our bed (through not supporting NZ manufacturing at the point of sale, revealed preference people) the RBNZ can’t suddenly “fix things” for the tradable sector through selective intervention.

But we are also realistic in respect of potential outcomes given the strength of the foreign demand for the New Zealand dollar relative to the scale of our intervention capacity.  We can only hope to smooth the peaks off the exchange rate and diminish investor perceptions that the New Zealand dollar is a one-way bet, rather than attempt to influence the trend level of the Kiwi.  But we are prepared to scale up our foreign exchange activities if we see opportunities to have greater influence.

Careful, here be dragons. The list of central bank failures in currency intervention are legion. We have to realise that there is nothing inherently wrong with currency speculation. It’s a free market in currencies for the most part and the NZD is extremely liquid.

The Reserve Bank is basically saying that spending hundreds of millions of dollars or even billions of dollars to give people the appearance that they are doing something is better and more welfare-enhancing than simply realising they are powerless and letting the market work its way to a “fairly valued” exchange rate.

There is some extremely risky thinking going on here. The Reserve Bank are thinking like Long Term Capital Management, you know, the US hedge fund that employed a trading strategy that used mathematics to prove that the market was wrong and through buying long/selling short they’d profit from the market price of whatever they were speculating in as it reverted to the mean.

This is hilarious stuff – just because a financial asset (the NZD) has an historical mean does not mean one iota that it will revert to it at all! Every day is a new day, and it the age of global central bank intervention driving financial markets, there is a high risk of the RBNZ being on the wrong side of the trade with taxpayer money at risk.

How did Long Term Capital Management work out? Oh, it got bailed out. But the guys behind it still rationalise their trades! To paraphrase Keynes, the market can remain irrational longer than you can remain solvent or take advantage of a central bank bailout to keep carrying a losing trade.

Our society has made a lot of collective decisions over the past 20 years that have led up to this point. We abandoned a compulsory super scheme that could have led to the NZ Super Fund being the size of Temasek, we spent more than we earned while simultaneously wasting money on unproductive housing investments and ignored the risks of betting the farm on the farm.

The Reserve Bank and the exporting community may not like the “high” NZD but that’s the price. That’s the price we pay for having a reasonably non-crazy fiscal response to the global financial crisis, reasonable institutions and tax policy and reasonable levels of regulation relative to other countries.

It’s not because New Zealand is amazing, it is because we suck less on a relative basis to other OECD countries where people could park their hot money capital. We might as well enjoy it while we can with cheap stuff from ASOS. The NZD will not revert to the mean – next week 10 billion barrels of oil might be found off the East Coast – we don’t know, therefore risking taxpayer money on the NZD short trade is bad business for “NZ Inc”.

Perspective On NZX Market Capitalisation

This morning I was listening to Bloomberg Radio.

Pimm Fox and Carol Massar were talking about a US company.

The quote was something like:

This company only has a market cap of like, $1 billion, $1.5 billion, so it’s tiny right?

It was a fascinating perspective on NZX Market Capitalisation – just over $76 billion at yesterday’s close.

It also shows what possibilities there are if NZ companies take advantage of globalisation to scale up and have “not tiny” market capitalisations.

If you have an interest in the US perspective on financial news, I’d recommend downloading the Bloomberg Radio app for your phone.

Of course, as a technology savvy consumer, I’d only run it when I’m at work (wi-fi), at university (wi-fi) or home (wi-fi!).

If you’ve always got access to wi-fi, and rarely travel, why would you need an expensive mobile phone contract with bonus data?

End Irrigation Subsidies For Dairy Farmers

The NBR this morning has an article that doesn’t include any commentary, but tells us that “without local council and government subsidies, irrigation projects couldn’t go ahead”. (PAID)

The dairy farming industry is a business, and as such should bear the costs of capital projects that primarily benefit their business interests. Statistics New Zealand recently released a document that shows that more irrigated land leads to higher agricultural production.

This is a good thing! More agricultural production is wonderful. But how can an industry be profitable or an efficient use of resources if it relies on subsidies to finance irrigation projects that primarily benefit agriculture?

Some ratepayers are more equal than others – farmers pay higher rates but receive disproportionately higher benefits in the form of capital projects they contribute to at a rate far below what they would have to if the irrigation projects were financed by more targeted rates levies.

With a low rate of return on assets, the deification of the agricultural industry as some reality-defying, economic principle-bending, accounting standards-reinterpreting “special case” is insane. It is even more insane when you realise that banks are lowering their agricultural debt exposure (finally!) because they are aware that high commodity prices won’t last forever.

Irrigation subsidies for dairy farmers and other agricultural enterprises are inefficient. Industries should rise and fall on their merits, not because they are able to engage in capital gains farming on the back of other ratepayers who will never have the opportunity to benefit from asset-price inflation.

If local councils wanted to more efficiently allocate the cost of these irrigation schemes, they could monitor production and profitability of agricultural enterprises in their district and increase rates proportionally to recover the massive risk of borrowing to finance a capital project at the peak of a commodities boom.

It is unlikely that the hysteria of the farming special interest groups will be muted by reasonable analysis of the facts. Therefore, expect Think Big (Milk Solids Edition) to progress without interference from people with a clear understanding of how special interest groups can shift the risk of large capital projects onto “everyone else” by claiming that the “benefits to the community” offset the cost of the higher rates and opportunity cost of what the local councils could have spent on what the people of their districts may want.

Over at Whaleoil a few months ago, Cameron Slater said my comment on a Hawke’s Bay irrigation scheme was the Comment of The Day. For your reading pleasure I’ll reproduce it here:

If the farming sector is so productive and profitable, or would be made so by this dam, why do they need to get every other ratepayer to chip in?

If they really needed it, and weren’t just looking for a handout they’d write the cheque themselves.

The farming sector’s return on assets is dismal. If it wasn’t for capital gains and the tens of billions of dollars banks can’t afford to write down on agricultural debt the loans would have been called in years ago.

Interest cover ratios are abysmal in agriculture.

As for sports stadiums, the economic literature and real world experience is clear they are a waste of money.

There is no difference between saddling Hawke’s Bay ratepayers with a $600 million “productivity enhancing” boondoggle and Dunedin ratepayers $200 million stadium for a rugby union that traded while insolvent.

Both force higher rates in the long term for something they might not even benefit from.

Just look at the Mangawhai sewerage system stuff up!

This stuff is the depressing side of economics. We know that something is clearly wrong, but there is simply no way short of a meritocratic dictatorship that would lead to sensible policy like making industries internalise the cost of capital projects that primarily benefit their bottom lines while imposing costs on everyone else.

The Search For Yield

The effect of quantitative easing on asset yields is clear. When central banks buy bonds and other private sector assets, they bid up the price and push the yield down.

Last week, junk bonds in the United States dropped below 5% yield. This is because when almost every other asset class has a low yield, anything with a higher yield will be purchased by those who need to own assets with yield.

Pension funds in the United States have substantial unfunded liabilities becaused they are “defined benefit” retirement schemes. These corporations, states and unions made promises to their members. They have suffered investment losses and thus need to earn more than the market is currently offering if they want to have any hope of reaching the level of assets needed to deliver on promises made in the past.

The search for yield in the current low interest rate environment presents a whole new level of risk. Higher yields are traditionally linked to higher credit risk if we are talking about bonds. But if high risk bonds suddenly become low yield as a second-order effect of quantitative easing, then there is effectively a mis-pricing of risk.

What this does is create a dilemma for the bond markets. If lower yields let more bonds into the “lower risk” screen, and pension funds can purchase these bonds because at a lower yield “they’re less risky”, and corporates like Apple can issue bonds to return cash to shareholders, what happens when interest rates rise eventually?

Private sector demand for credit has not recovered from the global financial crisis. We have no way of knowing how dramatic the change in interest rates could be if demand shocks or supply shocks flow through to demand for credit and end up performing what the central banks have failed to do with quantitative easing.

Thus, the search for yield is a double-edged sword that runs the risk of capital writedowns if interest rates rise. If they rise dramatically, or central banks end quantitative easing abruptly, we could find ourselves in another money market liquidity crisis because a lot of borrowing uses bonds as collateral for repo transactions and the like.

Low Interest Rates And Risk

The music is still playing despite global interest rates being very low. Quantitative easing is acting as an interest rate suppressant, bidding up the prices of bonds and therefore lowering yields. When you are earning almost nothing on cash and cash equivalents, anything with higher yield looks like a better bet than a bank account.

The problem with low interest rates is the risk of what will happen when they inevitably change. When we think about debt dynamics, stabilising the debt is a lot more difficult when interest rates rise. The primary surplus required if a government is running a primary deficit will be far higher than it currently is under very low interest rates.

This means that the political costs of achieving a primary surplus are almost impossible if interest rates rise, which they could given higher inflation expectations following the Bank of Japan joining in the QE party in order to keep up with the Federal Reserve and European Central Bank who are injecting enormous amounts of liquidity into the global financial system.

Each additional dollar/yen/euro at the margin is unlikely to be left earning 0% for long. But we don’t know how the QE experiment will wind down. And that means that any sudden increase in interest rates could lead to major problems for global balance sheets. If your solvency is dependent on low interest rates, and you don’t have fixed term debt, and need to constantly issue new debt to rollover old debt, then you will very quickly run into a wall.

Uncertainty about Government Policy and Stock Prices

I was looking at the Journal of Finance today and ran into this paper from last year on uncertainty about government policy and stock prices. It is written by Lubos Pastor and Pietro Veronesi at Chicago. In light of events last week surrounding the Labour/Green electricity policy announcement and subsequent loss of shareholder wealth in the form of share price declines for CEN, TPW and IFT I thought I’d share some findings from academia on the issue.

The paper is available ungated through Stanford if you don’t have access to Wiley Online Library – Uncertainty about Government Policy and Stock Prices.

Some interesting findings:

  • policy changes tend to occur after downturns in the private sector
  • political uncertainty relates to uncertainty about whether government policy will change
  • impact uncertainty has to do with the fact that firms have beliefs about current policy that would apply to changes to policy (I’m interpreting this as firms realise a new policy could lower return on capital outlay but they are unsure as to what extent that will be)
  • “If the government derives an unexpectedly large political benefit from changing its policy, the policy will be replaced even if it worked well in the past.”
  • There are two effects that explain the price fall – policy changes are generally made after a market experiences a downturn in profitability (this is not happening in electricity) but the discount rate increases because the firm needs to learn how to deal with the new policy (pushing stock prices down)
  • negative announcement returns tend to be larger because they occur when the announcement of a policy change contains a bigger element of surprise. The probability distribution of the announcement returns is left-skewed and, most interesting, its mean is below zero—we prove analytically that the expected value of the stock return at the announcement of a policy change is negative. We also find that this expected announcement return is more negative when there is more uncertainty about government policy. When impact uncertainty is larger, so is the risk associated with a new policy, and thus also the discount rate effect that pushes stock prices down when the new policy is announced. When political uncertainty is larger, so isthe element of surprise in the announcement of a policy change

  • If firms think the risk from an announced policy is to high they will shift from high risk investments to low risk investments in order to maintain the firm’s (shareholder’s) wealth
  • 4 of the model’s factors seem to be at play in the NZ electricity market
  • One of the biggest assumptions is a quasi-benevolent government!
  • The authors think their work could help bridge the gap between asset price movements and political economy

While I can follow the math, I would definitely not be able to do something similar. It’s graduate level stuff. Nonetheless, the academic literature in finance has something to offer us in explaining why stock prices experience shifts after policy announcements and how impact uncertainty and political uncertainty affect both government and firm behaviour which of course affects asset prices.

This paper can also help explain to non-economists / finance people why a firm that invests in big capital projects will apply the brakes when they are not able to predict the likelihood of a new policy being introduced that would change the net present value of investment projects by increasing the discount rate through higher risk premia caused by “jump risk” after a policy announcement.

$1 Billion Of Foreign Capital Needed?

The proof that New Zealand has an inefficient banking sector that primarily serves the interests of its shareholders and executives as opposed to the social utility of connecting savers and borrowers in both residential and commercial activity is proven by the call by the Property Council for $1 billion dollars to develop Wynyard Quarter.

There is more than $100 billion on deposit in New Zealand banks earning a low rate of return.

If the banks were entrepreneurial, employed intelligent people or implemented safeguards against wet-behind-the-ears bankers getting taken for a ride by wide boys they could easily syndicate $1 billion in finance domestically.

Their foreign exchange trading desks could move $1 billion in less than an hour, yet apparently we are starved of capital.

Because of asset-price inflation and restrictions on housing development, the banking sector has no incentive to provide finance for anything other than housing.

New Zealand needs to look overseas for business capital because the housing market dominates the lending books of banks.

Everyone forgets that the finance companies collapsed over loans on land that has now in some cases surpassed the value it had when the loans were called in.

Where is the investigate reporting into that arbitrary reallocation of wealth?