agcapita july 12 2013 – central banking’s scylla and charybdis

7/28/2019 Agcapita July 12 2013 Central Bankings Scylla and Charybdis

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Agcapita Update

July 2013


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CENTRAL BANKINGS SCYLLA AND CHARYBDIS

ROLLOVER AND CONVEXITY

The idea that the developed world, beginning with the US, mightjust be contemplating a reduction to its unprecedented monetary

stimulus has shaken the confdence o investors. Clearly the die-hard Keynesians at the Federal Reserve would like to have theircake and eat it too in the orm o artifcially low interest rates,real economic growth and no asset bubbles, but the marketincreasingly seems to be in the mood to deny them nirvana.

While I believe that eliminating QE is the right thing to do or thelong-term health o the economy, the recent equity and bondmarket declines are but modest harbingers o the unintendedshort-term consequences that the Feds prolonged ZIRP/QEprogram and its termination will wreak rollover and convexity risk.

These are the proverbial pigeons that will come home to roost i

the US Federal Reserve stops its massive bond-buying spree andrates normalize.

Sovereign borrowers have had unlimited privileges over the lasttwo decades. Those privileges are gradually being revoked as theability to repay is being called into doubt. Without the ability toroll over their obligations at current historically depressed interestrates, the truly precarious nature o sovereign fnances will berevealed. Consider that while interest rates or many developednations are at generational lows, sovereign debt loads as apercentage o GDP are at all time highs.

The Scylla o our story today is what happens to westerngovernments when their borrowing costs go rom 2% tosomething approaching the long-term historical average o 5%?

In countries like Japan and the US, the answer is that the majorityo the budget would be dedicated to simply paying interest.Perhaps this sounds alarmist and unlikely. But consider that, aso 2012, US ederal government debt exceeds US$ 15 trillion.In 2011, the US government paid US$ 454 billion in interest (animplied rate o 2.9%). The Congressional Budget Ofce notes

Agcapita Update


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Agcapita Update (continued)

that ederal government debt will rise to US$ 20trillion by 2015. I we assume that it carried a rate o5% instead o 3%, interest payments would total US$1 trillion or 45% o current tax revenues.

According to a report by Incrementum Even morestriking is the over-indebtedness situation in Japan.As a result o the zero interest rate policy being

in orce or 17 years by now, the government has

already refnanced the bulk o its debt burden at

extremely low interest rates. Despite such avorable

fnancing conditions, debt service costs already

amount to 25% o tax revenues. An increase o the

average refnancing costs by three percentage points

(to 4.6%) would consume the entire public revenue.

O course, these debt numbers understate the issue

signifcantly. It is estimated that the present valueo all uture US expenditures (including such itemsas social entitlements and pensions etc.) less allcurrently contemplated uture tax revenues, amountsto more than a US$ 200 trillion defcit. Now imaginethis is unded with debt carrying 5% interest, then theannual interest bills would be US$ 10 trillion or 500%o current US ederal tax revenues. Clearly, maturingsovereign debt must continue to be refnanced at lowrates or as long as possible otherwise state solvencystarts to come into question.

Rollover risk can be defned broadly as the possibilitythat a borrower cannot refnance maturing debt atall or at least at rates sufciently low enough to beserviced. Here is a concrete example o rollover riskthat may be unolding right in ront o us. By 2015,it is estimated that US$ 15 trillion (50%) o the debto the top 10 global debtors will have matured andmust be rolled over. Considering that global GDP isestimated at US$ 70 trillion, the magnitude o this

number begs the questions: how will this maturingdebt be re-fnanced and, perhaps more importantly,at what interest rates?

Although the US bond market appears well bid or

now courtesy o the US Federal Reserve, privatelenders are not so sanguine. They are retreating romperipheral markets at the frst hint o trouble. I thiscontinues, either the monetary authorities will have tocontinue to monetize maturing debt or interest rateswill have to rise considerably rom current historiclows. We have seen this on a relatively modest scalein the southern EU countries what would happen ithis goes global (see the recent spike in yields in theUS and Japan)?

I believe politicians have fnally started to sense the

rollover end game is underway; hence the concernaround keeping interest rates low by having centralbanks intervene in the bond market. But by keepingrates low over extended periods o time to allowfnancially constrained governments to roll debtat manageable rates central banks are orcing theworlds fxed income investors to accumulate everygreater portolios o low yielding bonds which leadsdirectly to the Charybdis.

The worlds monetary authorities have been engagingin ZIRP or almost 5 years now. The longer this takesplace the greater amounts o maturing, higher yieldingdebt that are replaced, by necessity, with newsovereign debt at historically low yields according toIncrementum once again in July 2012, 10-year yields

in the US thus reached with 1.39% the lowest level

since the beginning o records in the year 1790. In

the Netherlands which provide the longest available

time series or bond prices interest rates ell to a

496 year low. In the UK, base rates are currently


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Agcapita Update (continued)

at the lowest level since the ounding o the Bank o

England in 1694. In numerous countries (Germany,

Switzerland), short term interest rates even ell into

negative territory.

In addition, with yields on shorter-term sovereigndebt virtually non-existent, bond investors (primarilypension plans struggling to meet growing beneftobligations) have been orced to increase the durationo their portolios chasing the marginally betteryield, regardless o how minimal, o longer datedinstruments.

It is important to note that the bond market dwarsthe public equity markets sovereign debt is thelargest asset class in the world. So why the recentpanic over an approximate 70 bps move in US

interest rates, surely such a large asset class with itspool o sophisticated investors is prepared to dealwith such changes? Through the process o replacinghigher yielding maturing debt with new debt at ZIRPdistorted rates and at longer maturities in an attemptto generate any yield at all, traditional bond investorsare creating portolios o lower yield, higher convexityand higher duration.

The issue o convexity is central to the crisis thatnormalizing rates will bring to the pension industry.In very simple terms, convexity is a straightorwardconcept to understand all things being equal, amove rom 1% yield to 1.5% yield causes a greaterdrop in the price o the underlying bond than a moverom 7% to 7.5%. For the more mathematicallyinclined delta is the frst derivative with respect toyield (oten reerred to as the dollar value o a basispoint and this is usually based on a $1MM notionalamount o a particular bond) and convexity is therate o change o delta with respect to yield. This

complexity is not relevant to this discussion, simplythe concept that the current global bond universeis likely to have ar higher convexity than the bonduniverse o the pre-ZIRP world.

In a nutshell this extra sensitivity to rate increaseswith its higher loss potential is the risk that the worldsmonetary authorities have created with their extendedZIRP programs by orcing bond investors into a loweryield, higher duration, higher convexity universearguably the most risky confguration possible. Whenrates normalize these investors in aggregate will suerthe perect storm o losses on underlying portolios.

I you are still skeptical that pension unds could beat risk, a recent report by consulting frm Mercer onthe solvency ratio o Canadian pension plans should

provide some perspective. The solvency ratio othe average Canadian plan ell by 7% in May and asa consequence that most plans now had negativesolvency ratios. The solvency ratio is the amount o

money available to pay or earned benefts known

as liabilities under a plan compared with the cost o

buying annuities to cover those benefts in the event

o an immediate plan windup.

Recent yields moves were modest, imagine thelosses that will stem rom a return to historicalaverage yields arguably 300-500bps higher.

These losses cannot be avoided through fnancialengineering someone has to suer them. It will beinteresting watch to the worlds monetary authoritiesgrapple with this conundrum they can 1) continueQE and hope that the equity and bond marketbubbles do not come to a violent end or 2) stop QEcausing pension unds to suer signifcant losses asyields normalize which in turn will most likely trigger agovernment bailout and more QE.


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agcapita july 12 2013 – central banking’s scylla and charybdis

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