Tuesday, June 14, 2016

Pictet: "The Pricing And Valuation Of Bonds No Longer Reflects Fundamentals" - Why This Matters

From ZeroHedge, June 11:
Another day, another confirmation of what fringe, tinfoil blogs have been saying all along: there are no more "markets"; there are merely policy tools created and manipulated by central banks to create the impression of stability, and keep asset prices artificially high. This week this was confirmed by yet another "non-fringe" voice, that of Christophe Donay, Head of Asset Allocation and Macroeconomic Research at Pictet, one of the largest Swiss private banks, who however posits his observation of broken markets into a philosophical question: in the hundred year-old debate between Wicksellians and Fisherians, who will end up being proven right.
Wicksellians believe that in today’s climate, where markets are being swamped with money pumped in by central banks via QE, long-term sovereign bond yields need to rise steeply to revert to their ‘natural’ rate of interest. An unexpected spike in inflation might be the trigger for this upward movement. According to proponents of this scenario, bonds would then be sent crashing, as they were in 1994. Conversely, the Fisherian camp believes that low government bond yields essentially reflect the anaemic state of the economy and that, as a result, central banks will do their utmost to ensure interest rates stay low to ward off any relapse into recession. Wicksellians are duly offloading their positions in government bonds, whereas Fisherians are building up theirs.
Aside from bond prices what else will determine which of these two core economists is right? According to Donay, "In the near term, a hike of 25 basis points in the Fed’s official rates over the summer, coupled with accelerating US growth, could lead to an increase in US long-bond yields. As such, 10- year Treasuries present an asymmetrical risk for investors. If this risk were to turn to reality, we might be able to conclude that the Wicksellians were right after all." However, "if a recession were to occur in the US as interest rates moved back towards their ‘natural’ levels and if the Fed were to expend less effort trying to prevent it, we could declare that the Fisherians were right."

In either case, one of these two dominant theoretical economic schools of thought will soon be cast away on the trash heap of failed economic through. We can only hope that in doing so, the economic consequences won't be too devastating for the non-theoretical, real world.

From his full note:
Wicksell or Fisher: a century on, who is going to be right?
Central banks have been intervening wholesale on financial markets since 2008. Where is all this interventionism leading? Two economists from the last century could provide some pointers, however disconcerting. The extension by the European Central Bank (ECB) of its quantitate easing (QE) programme from sovereign bond purchases to corporate bonds in June offers the most recent evidence of the interventionism of central banks, following on from the QE programmes implemented by the US Federal Reserve between 2008 and 2013 and by the Bank of Japan (BoJ) since 2013.

These large-scale interventions have resulted in disruption of financial-market mechanisms. The prices of assets is meant to be ‘manufactured’ through the trade-off between supply and demand, but the pricing and valuation of some assets, particularly bonds, no longer reflects values warranted by economic fundamentals because as buyers of bonds the aims of central banks differ from those of investors. Through QE, central banks are seeking simultaneously to avoid a spike in long-bond yields and to enable governments and private-sector companies to raise financing more cheaply. By no stretch of the imagination are central banks basing their bond-purchase programmes on the fundamental valuation of bonds. As a result, a gap has developed between market rates and their equilibrium price.

In 1898, Swedish economist Knut Wicksell put forward the idea that going rates of interest on financial markets could differ from the ‘natural’ rates of interest (deemed to be rates consistent with a stable price level) that were justified by fundamentals. He pointed out that, when market rates were below natural levels, economic growth was stimulated. From this standpoint, it is fair to say that the policies being  pursued by central banks in the last few years have been Wicksellian. By way of comparison, with nominal growth of around 3.5% (2% growth and 1.5% inflation), the ‘natural’ rate of interest for 10-year US Treasury bonds should be in the region of 3.5% instead of the current rate of about 1.8%....