Twisting into a knot

Another week goes by and with it was another iteration of Central Bank intervention. Last week it was the US Federal Reserve (Fed) that once again tried to influence the outcome of the US economy through their extension of Operation Twist (OT) to the end of December 2012. The term OT is a reference to the first time this measure was used back in the 1950s. This incarnation stated a year ago and was due to expire at the end of June. The programme involves the US Fed selling its holdings of short-term treasury bonds and buying long-term treasury bonds with the proceeds. Central banks around the world have anchored their short-term rates and many are currently operating on what is effectively a zero interest rate policy (ZIRP). T&T is no different in this regard, with our repo rate at a historic low of three per cent in an economy where headline inflation is at 11.8 per cent.   

The objective of OT is to flatten out the yield curve.

 

 

Since shorter rates are anchored the market will have no issue with purchasing these bonds from the Fed since rates are unlikely to rise during the tenor of the bond, thus eliminating any price risk. By purchasing the longer-dated bonds, the Fed is increasing demand, which will, all other things being equal, increase the price of those bonds. There is an inverse relationship between price and yield, so as the price goes up, the yields fall. With the short end of the curve already anchored by a ZIRP, lower yields at the long end results in a flattening of the curve. This is in part why the ten-year yield on US treasuries is below two per cent. Mortgage interest rates in the US are based on the ten-year treasury bond yield, so the Fed action would have the effect of among other things bringing down mortgage rates. The extension to OT by another six months gives the Fed the opportunity to sell an additional US$267 billion of shorter-term bonds and allocate its purchases to the tune of 32 per cent in the eight-ten-year bond maturity, four per cent in the ten- to 20-year and 29 per cent in the 30-year sector. 

 

 

T&T impact

All of this may seem far removed from T&T, but as I have said many times before, we take our interest rate cue from the United States. Our local currency is matched against the US dollar and the US interest rate environment has an impact on the way the US dollar trades against other international currencies. The only way that rates in T&T could be at such record low levels is because US rates are also similarly positioned. If that were not the case and US rates were higher than what obtains in TT dollars, then the rational investor would choose to place their funds in US dollars, causing the demand for US dollars to increase and the value of the TT dollar to fall. The troubles in other parts of the world also provide a “benefit” for T&T from a currency perspective. As the European crisis unfolds and investors flee the uncertainty of European assets and the Euro, there is a money flow into US assets which requires the purchase of US dollars. This makes the dollar stronger, which, in turn, makes the TT dollar stronger against other world currencies. Once the action by the US Fed is completed in December 2012 it should have over US$2 trillion or 75 per cent of its total US Treasury bond holding with a maturity greater than six years.

 

 

At some point, the Fed has to exit this position. This is where challenges can pop up. All of the actions that we have discussed so far are distortions to the financial system. By influencing interest rates in a manner they consider to be best for the economy, central banks around the world are not allowing the markets to do their job. The fear is the market, if left on its own, would produce a result akin to a global financial meltdown, so the intervention is considered necessary. However, when the Fed intervenes to buy longer dated bonds, it should be clear this is an artificial demand, so the true price of those bonds is not reflected in the market. There tends to be a rough spread of around three per cent (300 basis points) between US and TT rates all other things being equal. So if a ten-year bond in the US is at around 1.6 per cent, then a ten-year TT bond should be in the region of 4.6 per cent. Other fixed income assets are in some way all priced relative to these benchmark rates. As a result, the action by the Fed influences the price and the yield that local investors will pay and receive for fixed income investments. If these rates are “distorted” in some way by policy action, then investors are buying into these distortions. 

 

 

Distorting risk

Mind you, we are far from the end of this cycle of intervention. By the time you read this, Spain should have requested a bailout, with the European Central Bank having a key role to play. In addition, since last year, I suggested that another round of quantitative easing (QE3) would be required and many analysts in the US now also subscribe to this view and see OT as a stepping stone towards that end. The longer this process continues the more these price distortions are ingrained into the economy. There are two risks to consider with this scenario. First, there is the altering of market behaviour during the period of intervention. Then there is the challenge of unwinding the central bank’s balance sheet to a more “normal” construct. The impact on market behaviour is the more immediate concern and the most obvious alteration is the search for yield. It was back in 2001 when the Fed had interest rates at one per cent that the search for yield gave rise to the sub-prime crisis a few years later. Low interest rates in the US at that time allowed our Central Bank to also cut rates. This move contributed to the run up in the local stock market from 2003 to 2005—a move which then resulted in subsequent years of anemic returns. Just as the search for yield in a low interest rate environment in the US gave us the sub-prime crisis, the same environment in T&T, coupled with high inflation, contributed to the attractiveness of the Clico executive flexible premium annuity (EFPA) product in T&T.

 

 

 In fact, it can also be argued that similar dynamics were at play in making the Stanford Bank an attractive investment vehicle as I was at the time privy to their investment terms, which were very similar to the rates offered on a Clico EFPA. Here we are a decade later and we are another four years into an artificial and historically abnormal low-interest-rate environment. The US Fed is suggesting this will be the case for another couple years at least. Locally, we have seen stocks rally, even though volumes have been thin. A number of companies that pay consistent dividends has seen their price rise significantly over the past couple years as investors seek some from of return on their funds. T&T has a peculiar scenario of low rates and high liquidity, so the yields on all classes of fixed income investments are being pushed down, this is so even in the face of high inflation. In addition, we have had around $5 billion of bonds to cover the Clico EFPA settlement coming into the market. This by itself is a distortion in that it is an unusual amount of issuance within a short period of time and these bonds carry no coupon. There is the risk that pension plans would not be able to achieve the returns required to meet their obligations. There is the risk an overweight position in longer-term low yielding bonds can result in losses charged against capital if interest rates rise. This risk is heightened in rates rise earlier than expected or at a faster rate than expected. The local capital markets are very underdeveloped and it is very difficult to unwind losing positions and worse still to raise capital to support a challenged balance sheet. It should be clear that prolonged periods of low rates carry the risk off distortions which only become apparent down the road. At that time, we could then be in a very tight knot. 

 

 

Ian Narine is a broker registered with the Securities and Exchange Commission