Thursday, 16 April 2015

Angels and Demons - Draghi and the ECBERN

I used to like Draghi, he was the force of reason behind the chaos of European politics. The man trying to keep the whole political mess together and, having been given limited powers by his political overlords, has done the best he can and done a pretty good job of it too. But the latest ECB press meeting appeared to betray another side. A darker, harder side, the emergence of which appears to coincide with his aquisition of the QE weapon which, almost Gollum’esque, he will not give up.  He intends to see it through to the end. He sees no bond bubble, he sees no shortage of bonds to buy and he cannot understand why anyone would think otherwise. No wonder that Bunds went flying up again in response.

But is he really that inflexible? Whereas the Fed is, to the chagrin of Fed watchers, presenting a future guidance of ‘well we will see and do what we feel is suitable at the time’ the ECB appears to be laying down an eight lane expectation road of type one hardcore topped with finest asphalt stretching out to sept 2016. Draghi’s deliverance of convicted determination towards future policy has been the past saviour of EU crises (the mythical OMT) but is a message of single minded policy execution, come what may, the right one to now be sending as doing so builds even greater pent up stresses in a spring that has to unwind at some point.

This cold eyed determination in the man, a servant of his political masters, who up until now has been seen as the hand of good guidance has reminded me of a the character in the Dan Brown’s book and film Angels and Demons. The Camerlengo.

'The Camerlengo of the Holy Roman Church is an office of the Papal household. The Camerlengo is the administrator of the property and revenues of the Holy See. Formerly, his responsibilities included the fiscal administration of the Patrimony of St. Peter. After the death of a pope, until a successor can be elected, the Camerlengo serves as the Vatican City's acting head of state'

In Dan Brown’s story the Carmelengo turns rogue and tries to create a new order of hard-line traditionalists. To do so he utilises anti-matter stolen from CERN. Now if we imagine that anti-matter is an analogy for negative interest rates and the ECB is in fact CERN, let’s call it ECBERN, then Draghi as Carmelengo still fits. But I’m not the first to notice a sinister overtone to the ECB. A young lady at the meeting also expressed her concern.

Lets push this one stage further and have a look at Draghi's ECBERN

ECBERN is a massive European experiment where huge amounts of debt are fired at enormous speeds around and around in a massive circle in the hope of finding the answers to the structure of future European economic success. The experiment has been running for 17 years and despite costing trillions has failed to fuse a stable particle of growth and a stable particle of inflation into the God Particle of a stable economy. All components have so far proven highly unstable leading to the Prodi Exclusion Principle stating it is impossible for stable inflation and stable growth to exist in the same EU State.

ECBERN has however seen other successes. The discovery of monetary antimatter (negative interest rates) was hailed by many as a triumph over the laws of financial nature. Though theoreticians had proposed negative interest rates could  be possible no one ever thought they would be proven to physically exist. Negative interest rates have to be contained within the containment of a high QE field in a deflationary bubble otherwise they will react with the normal rules of economics and annihilate the future.

ECBERN has also been attempting to prove String Theory where pushing on a piece of string causes the other end to move. They are determined that this is the case and will make it work through brute force by applying massive nuclear blasts to one end of the string. Unsurprisingly the other end has twitched but the transmission mechanism is now completely broken.

Experiments also seek to prove the existence of the economic dark matter needed in order to explain how the EUniverse is still holding together. First thoughts are that it could be something to do with the black market or local fiscal policy but ECBERN aren’t allowed by their political masters to experiment, or even pass judgement, on fiscal policy.

Inflation theory is used by ECBERN to explain the origin of the large-scale structure of the economic cosmos. Quantum fluctuations in the microscopic inflationary region, magnified to cosmic size, become the seeds for the growth of economies in the EUniverse. The inflationary epoch lasted for 10-32 seconds after original EU creation but has been elusive ever since despite their best efforts to recreate it.

ECBERN definitions-

Bosons - General term applied to all components of economic policy but is more befittingly a description of the policy makers as they are characterised by their spin. “They are all Bosons’. The wavefunction for a collection of bosons is symmetric as they all have the same spin.

Higgs Boson - The God Particle. A stable economy. The carrier of future happiness and economic contentment and the glue that, in theory, holds the EUniverse together.

Anti-matter - negative interest rates

Quark - A component of overall monetary policy. Comes in two varieties, the down quark and the up quark. Modern policy consists mostly of the up version hence the cry from observers 'Jeez it’s another policy quark-up’

Anti-Quark - A particle that opposes quarks. Greece.

Meson - Composing of a quark and an anti-quark. Formed by putting Varoufakis and Schauble in the same room.

Electrons - Not present at ECBERN as none of them are elected by the public.

Atlas Detector - Eurostat. A massive machine that cost billions to build designed to detect stable economy. So far has detected nothing.

Baryon - from the Greek for ‘heavy'. Baryons are just heavy Greek debt.

All good fun and the idea that the EU is modelling its economic policy on a huge experiment is no doubt fitting. But as with all experiments, we have to have trust in the scientists involved as to whether their discoveries are of benefit to humankind and not instead the forebearer of our own destruction.

Current ECB policy is toeing the line.

I should credit George Cooper for a post he guided me to when I first proposed a post this subject. Much better depth than mine.

Thursday, 9 April 2015

Premium Bonds With Negative Yields.

I have always maintained that crossing the zero bound to negative yield results in behaviour that doesn’t cross as easily and instead diverges into a new dimension of imaginary numbers that leads to craziness. But here is a thought to add to the interest rate negative absurdum files. Premium Bonds.

For non-UK readers, Premium Bonds are a UK Government perpetual bond that instead of paying the coupon as a fixed guaranteed payment, pools the interest due and allocates it to the bond holders by a lottery type draw. Bond numbers are drawn each month and prizes paid that equate to the total interest pot. There are multiple small prizes but they scale down in number to a single £1,000,000 prize per month. The bonds are always redeemable for original face value. The average yield on the bonds is currently 1.35%.

The UK National Lottery, by contrast, has a negative yield as about half of the money from the ticket sales is paid back in prize money. As we all know the ticket is not redeemable for face. So the expected yield on a lottery ticket is about -50%. Despite this monstrously negative yield people still buy them for the dream.

With public willingness to buy -50% yield you can see why the regulator has to step in and licence lotteries so that we all can’t cash in and borrow at such negative yields from the pool of dream money. But what if the State were to cross the zero yield line with their Premium Bond issues and move into negative yield territory?

The dullest and probably the most predictable way to do this would be to sell the bonds at a premium to face but as these are perpetuals pricing to maturity is not possible so instead the amount of bonds held could be scaled back depending upon the purchase date and time the Premium Bond is held, letting the holding effectively decline to near zero in a half life function.

But the really fun way of taking Premium Bonds negative yield is to follow the rules they currently abide by where the pool of interest is allocated by lottery. Now imagine if that pool of interest is negative. One (un)lucky owner of the Bond that is drawn now receives a letter

“Dear Mrs Smith, Congratulations! Your Premium Bond has been drawn and you owe the state £1,000,000”

A few thousand others will be receiving a letter saying they owe the state smaller sums.

Would they sell? Of course not because no one would like to own (in personal finance terms) unlimited downside even if the maths says there is huge chance of escaping any negative yield with a ‘miss’. The organiser of a lottery has the advantage of knowing the averaging will work for them as they own the whole market. An individual buying or issuing one ticket does not and will risk the vagaries of probability.

Which then leads me to ask how great does the capital gain of a premium bond have to be before an individual is willing to buy one to compensate the perceived risk of a one off down side hit. If you receive a 20% capital yield on your ticket what maximum down side would you be willing to bear, even at a tiny probability, to buy the ticket.

The balance between capital return and prize coupon is one of complexity that could be part of a behavioural finance study. Perhaps the way to run it is by setting up a real market test and let the market find its own level. The payoff between capital return and coupon is relatively easy in bond maths but how interesting it would be if the government was to issue a form of Premium Bond where the individual could choose the balance between negative coupon they may wear, if they are unfortunate enough to get drawn, against the yield if they don’t get drawn. As an issuer the State can gear it so the pay-off on average is always the national interest rate but it is up to the individual to choose their preference. Or they could let the market find its own level and with the proven bias towards paying over the odds for hope, as expressed by the market for -50% lottery tickets) the State may well find its borrowing cost go pleasantly negative without them even having to try. Bizarre but probable.

Credit risk on the individuals ability to pay an enormous penalty loss is of course a massive consideration, but as an experiment the results would be a benchmark in behavioural finance and risk perception.