Skip to main content

Gleacher's Head of Rates Russ Certo Discusses Capital Transfer, ZIRP's $400B (or 2% of GDP) Downside, Concern in PRIME Market

Russ Certo is a managing director and head of rates at Gleacher & Co. His market commentary this week discusses a "cryptic zero sum net capital transfer from creditors to common" that he is observing in the current macro climate as inflation expectations embed themselves across asset classes. We had the chance to discuss some of these ideas with Russ on Benzinga Radio as well as the crisis in Europe, dead weight in the PRIME market, and the 2% of additional GDP growth we're choking out through zero-interest rate policy in the United States.

Italy's yields are trading at all-time Euro area highs, while UST yields are also at record lows. Why are bond markets in risk-off mode while across other assets, the trade seems to be risk-on?

Financial markets generally do not respond well to uncertainty. Regime changes, political changes, referendums, resignations, coalition governments--these are not the fare of stability in markets; they tend to discount uncertainty. Many years ago, we used to term this phenomenon country risk. Before you had the common currency union--the euro--a lot of the bond markets in legacy Europe used to trade as a spread not to the U.S. "risk-free rate" Treasury, but to the bund.

The bund was considered the staple of austerity, the risk-free rate, if you will, in Europe--the steward of monetary rigidity and austerity. Peripheral bond markets, then--legacy bonds--used to trade at incremental spreads to the bund market. To some extent, you see that now. Even though you're united by a currency union, you're beginning to see the markets deploy their resources and allocations differently, and they are penalizing Italy for its lack of consistency historically, and for the political confusion right now.

Inflation-linked securities in the U.S. and Germany are locking investors in at negative real rates of return.

It's a common phenomenon across the globe right now. We call this financial repression. Financial markets are penalizing the Italian bond market because of this confusion and the demand by private capital markets for austerity right now. Politicians don't seem to understand. There seems to be two camps: the political and legislative camps that think they can promise austerity in the future and deliver something else in the present, and markets are very quick--based on their own historical and current observations--to discount these notions and understand that it's not coming.

It's not going to be coming because governments have the tendency to repress--which is a supposedly benign term. It's one end of a spectrum, but what governments can typically do if they get into debt challenges or try not to pay back debt is actually aspire to create inflation. You reduce purchasing power when you are creating inflation. It used to be called monetization of debt here in the U.S. in the late seventies and early eighties. It's an elusive concept.

A common phenomenon, which is generally ushered in through government policy: if you can't explicitly default on your debt--which is the other end of the spectrum, and it's a very harsh, explicit phenomenon--you repress by creating inflation. Generally, central banks don't advertise the creation of inflation; this is more of a subtle framework. And yet, we see it showing up in TIPS break-evens, real rates of return, and so on.

What is really happening there is that you are not being compensated for the risk that you are taking in the marketplace, and the value of what you are receiving is going to be lower relative to what you need to purchase. That is normally the first stage of a policy gimmick which is affecting markets. We see it embedded in central bank policies right now, and it's embedded in the pricing of markets.

Your note discusses the value proposition of owning lower-quality assets versus traditionally higher-quality assets as the result of a "cryptic zero sum net capital transfer from creditors to common."

This concept is about what I've often said is "remedy or reality." We have weak economic fundamental realities. Fiscal situations--they are less than optimal; they are not benign. Governments, consumer balance sheets--they're struggling. They are struggling fiscally. There are imbalances; they are out of order. That's the economic fundamental reality: it affects consumption, behavior, purchasing power, retail sales for the holidays, consumer confidence, and the like.

Now, we enter a period where the policy community is aspiring to limit or to minimize the reality through their policy schemes. There is a whole scale of options when you are a policymaker. You can begin to implement soft policies that are subtle, where you can slowly inflate. You are essentially transferring value from a traditionally high-quality asset--like a U.S. Treasury or Bund, or a loan, a contractual obligation with a creditor--to another element in the investment asset-class universe, which would be a lower-quality element.

Most people don't think of common stocks as low-quality, but this is hundreds of years of corporate finance in the making. Financial law--not just property rights, but securities law, restructurings, bankruptcy law. In these restructurings, in the hierarchy of the world of corporate finance, common equity is actually a lower-quality asset.

When central banks are engaging in this "remedy of reality" behavior, the first order of business: they tend to try to generate inflation. Investors witness this and participate; they try to protect themselves from the perception of inflation. Remember, the Fed targets inflation expectations, not just inflation. If the Fed can generate the expectation that you are going to have inflation in the future, that may alter your behavioral patterns.

So, what would you do? Many people would suggest, "Well, I need protection from inflation." How do you get protection? Well, companies sometimes have protection from inflation embedded in their pricing power, in the margins of their businesses. So, an equity market tends to benefit more in an inflationary regime, which is, again, the beginning stages of this policy regime that we are talking about. Companies can raise prices; we are seeing it. They can reduce package sizes. That's really a form of inflation.

Then, there are other pursuits which tend to benefit broad asset classes like real estate or other risk assets that we are talking about, all sorts of risk assets versus fixed streams of contractual payments, which are bonds. Remember, those bonds don't benefit from inflation because when you're getting that coupon--over thirty years, the same coupon--it's not paying for the risks associated with increased prices in the financial marketplace or in the consumer marketplace. You're going to have to buy Huggies diapers, and they're going to cost you $30 in the future if there is inflation. That fixed-coupon payment does not pay for the cost of that future good and service. Therefore, the prices of bonds now are being robbed to pay the common stock element in the capital structure.

So, this starts as a benign function where we try to reflate, revalue, alter inflation expectations--but it tends to take on more moderate forms, which would be something less than just a simple, benign, financial repression scheme of making the value of your house seem like it is worth a little more with inflation. You begin now to talk about currencies and depreciations, because now you're trying to import inflation, which also benefits risk assets (as long as it's not a dramatic event). The pricing power to be protected in risk asset markets--it's better to be in a risk asset for modest or moderate inflation. You're seeing these policies which started in a very modest framework go now where we are competing against weakening our currencies so we can import inflation to absolve the debts and further repress the instruments that we discussed earlier.

If the Federal Reserve were to raise rates, would it perhaps actually benefit the economy and help get the housing market going again?

There has been some work done--unofficially--from a lot of members of our peer group, and I've even heard some Fed officials acknowledge the concept recently on radio and other news programs. This is the concept of unintended consequences of sustained low rates for a long period of time. There has been some data out of the Federal Reserve--Flow of Funds report, which I'm sure we can get access to--which essentially earmarks roughly $10 trillion in the money market arena. Money market funds, municipal funds, savings and deposit funds--these are what we generally consider to be safe-haven, front end, money market-type assets.

If you just do some envelope analysis on where rates are now--let's just assume they are 2 percent--versus a normal rate structure over the history of modern finance, I think ten-year notes have yielded, on average, 7 percent since the 1970s. That's a pretty big difference. We'll be conservative in our estimates relative to the current rate structure, but let's just say a historical average of 6 percent versus what we have now at 2 percent--that's a 4 percent difference on $10 trillion. So, that is $400 billion that's being sucked out of the economy. That is interest that consumers--moms and pops, widows and orphans--don't have to consume, to pay their bills.

When you extrapolate a consumption pattern off of that, very conservatively--let's assume your average consumer spends 70% of their income, which I don't think is an unreasonable assumption. That's 70 percent times the $400 billion, which is$280 billion. As part of the GDP of our current economy, which is growing at 4%, that's $600 billion from a $15 trillion economy. You're talking almost two percentage points of GDP. It's amazing what you can accomplish with an envelope, off the cuff analysis, but what I'm trying to tell you is that $400 billion of income, give or take, is being sucked out of the economy through extended low interest rates for an extended period of time, and this is a departure from the historical rate structure that we used to live in.

You can make a direct linkage between consumption patterns on that $400 billion and getting the economy going. These are cash flows that could be going back into GDP. I just earmarked that as almost 2 percent of GDP, and when we're talking about GDP numbers that haven't been coming in in a very robust fashion, you have desperately needed cash flow for consumers that are struggling, that can be reinvesting it back into consumption. This creates more jobs, more tax revenues, and ironically, it reduces some of the expenditures that we are trying to prevent. Low rates are penalizing the economy.

There are benefits to lower rates. There are sovereign nations that roll over debt at a lower cost. There are banks that need to roll over debt, there are financial capital markets that need to roll over debt. Rolling over at a lower interest rate reduces your debt service costs in the future. However, on the consumption side, there is a very good argument to be made that higher rates--because we know from the Fed's Federal Flow of Funds report that there is about $10 trillion in discretionary, front-end assets that are being earmarked for security for families and households at higher rates--would likely spur income, and hence, consumption.

Then, there are other unintended psychological impacts. If the Fed were to tell you--remember, we talked about inflation expectations. There are probably some people that have "hidden," given the kind of commentary coming out of the central bank and policy community. When you are telling people to run for the hills--"We're keeping rates low for an extended period of time"--you're actually impacting the psychology of your consumer. If there were a little bit more of a robust, upbeat proclamation coming out of the policy community, it may actually give some people confidence to go out there and do some things. Simply, some people may just be putting their plans on hold given the dire forecasts.

How big a cause for concern is the recent spike in trading activity and asset depreciation in the PRIME market?

PRIME is a wonderful example because this is really scratching the tip of the iceberg. We can look at PRIME as a much broader sign of the complexion of what's going on within the banking community, credit with consumers, and balance sheets. And of course, all of these things are linked to policy, but we've experienced a quarter-end recently where banks try to, as they call it, [engage in] "window dressing." We take a nice financial reporting snapshot of our balance sheets and income statements--classic financial reporting, GAAP principles--and what banks do is try to tidy those up and make sure they look right.

I'm not suggesting anything out of the ordinary here, but what happens as you approach these quarter-ends is financial markets become illiquid because these banks are the same dealers in markets where they have a responsibility to service clients, service the government, underwrite U.S. Treasury debt, underwrite debt for other sovereign governments. So, they are active participants in the marketplace--they are there raising capital for countries, for companies. When they are strained by their own balance sheets and their inability to manage their balance sheets, they provide less financial lubrication to the marketplace.

Then, there are less people raising money in the capital markets to achieve their goals, whether it's the expansion of a factory, or a government that needs the cash flow, or a municipality that needs the cash flow. So, the gridlock starts on the balance sheet of banks--when they are unable to maneuver because they are impaired by assets that are sitting there. It clogs the whole system.

There was a nice article in the WSJ that highlighted how since there is not a lot of traction in financial markets right now--transactional volume in dealers' books right now and stifled, uncertain financial conditions that have been created in Europe and here--other players in the market, including some of the banks themselves, have decided to try to hedge not just typical assets that they would want to hedge, but also extremely high-quality assets. So, there is a whole spectrum of causality here which certain players are accounting for.

find us on Twitter @matthewboesler, @lukelavanway, @BenzingaRadio, @Benzinga


Most Popular

Radio Archive