Rediscovering the price of money
When things can't get worse
For some time now, I've been starting start my speeches by saying: "I am the most optimistic I have been in almost thirty years in the market, if not only because things can't get any worse."
Is that true, and more importantly how do we get a fundamental change away from this extend-and-pretend which prevails not only in Europe but also the world?
History will tell us that we only get real changes as a result of war, famine, social riots or collapsing stock markets. None of these is an issue for most of the world – at least not yet – but on the other hand we have never had less growth, worse demographics, or higher unemployment since WW II. This is a true paradox that somehow needs to be resolved, and quickly if we are to avoid wasting an entire generation of European youths.
Policy makers try to pretend we have achieved significant progress and stability as the result of their actions, but from a fundamental point of view that's a mere illusion. Italian banks today own more government debt than before the banking crisis, leaving them systematically more exposed to their own government, not less. The spread on government bonds between Germany and Club Med is down to below historic averages, but the price has been a total suspension of the "price discovery" of money.
The price discovery of money is the cruel capitalistic part of any system. An economics textbook would call it the modus operandi by which capital is allocated where it can find the highest marginal utility. In practice, this should mean that the market dictates the price of money beyond one year – while at durations of less than one year, the central banks determine the price of money. The beauty of the system is that money is allocated in an auction where the highest bidder for "money" or "credit" gets filled on the price he or she deems to match his expected price of money.
Contrast the market driven model with the present "success story" of relatively low sovereign spreads in Europe, which are driven by ECB President Draghi's promise to do whatever it takes to keep the Euro out of trouble. He has threatened to activate the EFSF and the ESM plus the full arsenal of policy tools to ensure stability.
By doing so, he has effectively suspended price discovery for sovereign debt and for money, as the ECB and local central banks will provide infinite liquidity to local banks and hence indirectly to their government in any market conditions. This one-sided offer from the ECB and the market means there is the market has no power to discipline the government with higher rates or to allocate credit more generally. We have simply disconnected the market and the price of money.
This comes after Draghi's LTRO, a cheap funding for banks with little or no collateral, or the closest thing to QE you can have without calling it QE.
This is a problem because corporations that need to finance long-term projects, like building a power stations over six to eight years, need a price for the credit they require throughout the building period. Right now they have an almost flat yield curve from zero to 30 years, which would be fine if it was realistic, but the problem is that one day in the "distant future" when the market normalizes, interest rates should revert to their normal price, which is roughly inflation plus a risk premium.
In the case of an industrial company, an appropriate loan rate calculation could be something like inflation + Libor + a risk spread, which might work out to about 7%. Compare this with the rates available for highly credit-worthy companies Recently, Nestle was able to issue a four-year corporate bond at 0.75% - the lowest ever. Yes, it's nice for Nestle but remember the situation is created by the central banks presence in the market, not just due to the financial strength of Nestle.
A move from less than one percent to seven percent would administer an ugly shock to companies. We have created a negative vicious circle in which not only investors, but also companies are depending on low interest rates forever. They have priced their future earnings and costs on government support prices rather than on realistic market prices.
The worst thing about the situation, however, is that the reason a blue chip company like Nestle can borrow at less than one percent in the capital market is the lack of alternatives for banks and investors. Less credit worthy SME's, which make up as much as 80% of many countries' economies are not allowed to borrow. They are deemed too risky to lend to at the current "market rates" even though they hold the key to improving the employment and productivity picture. They are willing to work cheaper, longer, harder and with higher risk tolerance in order to survive. So the remaining 20% of the economy occupied by large and publicly listed companies and banks get 95% of all credit and 99% of all political capital. In other words, blue chips receive artificially low interest rates only because the SME's don't get any credit. Herein lies my continued belief in the my traditional opening statement: things must get better soon because they can hardly get any worse.
We have never been in a more dysfunctional state at the corporate, political and individual level in history. It's time to realize that the reason capitalism won the war against communism in the 1980s was its strong market based economy – based on price discovery. Now the policy makers in their "wisdom" are copying everything a planned economy entails: central planning and control, no price discovery, one supplier of credit, money and the corollary effect of suppressing SME's and even individuals.
Finally, history offers a compelling lesson: the last time the Federal Reserve engaged in a sizeable QE was in the 1940s. The low growth and falling inflation only reversed when Federal Reserve stopped intervening due to a severe recession brought on by the policy mistakes of keeping QE in place too long.
In 2014, a bout of near or real recession in Germany and the US could kick start the price discovery mechanism again, which will help us to start healing the deep wounds left by years of policymakers compounding their errors with round after round of extend-and-pretend. Getting to the bottom is good in one sense: the only way is up.
Med venlig hilsen | Best regards
Steen Jakobsen | Chief Investment Officer
Saxo Bank A/S | Philip Heymans Allé 15 | DK-2900 Hellerup
Phone: +45 39 77 40 00 | Direct: +45 39 77 62 23 | Mobile: +45 51 54 50 00
Please visit our website at www.saxobank.com
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