On 30 September, 2008, the US National Debt clock installed at New York’s Times Square ran out of numbers as it ticked over $US10 trillion.
In the midst of the worst financial crisis of a generation, that moment came to symbolise the alarming lack of control over public finances that would lead the Western world to doom.
“Today when I go back to New York and ask investors if the clock is still there, nobody knows, and nobody cares,” says Danny Yong, the co-founder of $7 billion Singapore-based hedge fund Dymon Asia Capital.
In fact, few noticed that a month ago – moments after the electronic clock recorded $US20 trillion – it was taken down.
That in itself was symbolic. This is the post-financial crisis world of quantitative easing where debt doesn’t matter.
And we may have to accept it may not matter for a long time. With no sign of inflation and the market imposing no discipline on governments that have the ability to print money, it’s a fiscal free-for-all.
“In the past whenever a country didn’t manage its fiscal spending and budget, debt sustainability was in question, you would be massively punished by the market,” says Yong, who will speak at the Sohn Hearts and Mind charity conference next month.
“Bond curves would steepen, credit spreads would widen and the currency would weaken. Today, nobody seems to care. That is the new paradigm.”
Australia is a prime example of this new world order.
The Reserve Bank didn’t have to resort to quantitative easing, but as other central banks expanded their balance sheets, the full force of its impact was felt Down Under. The flood of money chasing positive returns swamped the bond market and forced the currency higher, pressuring the RBA to lower the cash rate, propelling a real estate boom.
As a small, open economy, Australian federal and state governments have become accustomed to the discipline imposed on them by the markets, and in particular the credit rating agencies.
And for those who remember the “banana republic” days, a downgrade of the AAA credit rating was an unthinkable relapse. Fear and loathing accompanied Standard & Poor’s decision to put the rating on review last year. And since around two-thirds of Australian bonds are held by foreigners, one would think the AAA stakes were higher than they’ve ever been.
“I spoke to a couple of sovereign wealth funds and asked – if Australia does get downgraded, do you sell?” Yong told The Australian Financial Review.
“They said ‘maybe we’ll wait for a 30 basis point increase, but once the market stabilises, we’ll buy more’.”
The federal government, and the bond traders that deal in its debt, are among the winners from QE.
But quantitative easing has had its victims. Large global banks, life insurers and pension funds have been suffocated by low interest rates. Macro hedge funds too have collectively failed to prosper in a prolonged period where volatility has been suppressed by central banks.
But rather than waving his fists in the air, Yong is embracing this new era.
“I love investing in macro at this time where there is really no precedent. Even the smartest minds in the US, Nobel Prize winners are scratching their heads as to what is going on.”
This is no longer a “global macro” world, Yong says, but a “local macro” world – and the fund’s proximity to Asia and teams of local experts helps give them an edge.
Yong says Dymon has never had a year where they have lost money trading the yen or the renminbi. Right now they’re growing more bullish on China, which bodes well for Australia.
“Whenever I go to the US, they are persistently bearish on China –they tell me ‘it’s a Ponzi scheme that’s going to blow up.’ But they have been saying that for the last 15 years.
“They come to China, they look at a few empty cities and say ‘oh look, there are all these ghost cities’. I am sure if you went to Arizona or Detroit you could find some empty buildings. It’s not symptomatic of the entire country.”
In a world where central banks are setting the price of bonds and equities, either by buying them or forcing down risk premia, foreign exchange is the one market they cannot control.
“We see the opportunities in dislocations, which are mostly in foreign exchange. There are big moves that happen every year.”
Just in time
In its relatively short life, Dymon Asia has carved out a reputation as the top Asia-focused macro hedge fund. But the fund prides itself on humility and famously gave back its performance fees after its Swiss franc trade soured.
Yong says he’s extremely self aware – and appreciates his success has a lot to do with luck. He got his first break as a JP Morgan derivative trader as their top picks among thousands of candidates dropped out, leaving him to take the role.
And Dymon got off the ground just in time. Legendary trader Paul Tudor Jones tipped in $100 million of seed funding in August 2008, a month before the Lehman collapse that Dymon bet against. The fund probably wouldn’t exist if he’d delayed any longer.
Yong says crisis led to a change in risk management including a “4 per cent monthly circuit-breaker” to protect them from their own self-confidence.
“The thing that trips up good investors is that after a while you drink your own Kool Aid.
“You believe you the master of the universe and the markets are wrong. We have seen it multiple times – traders have fantastic careers and latch onto one high-conviction trade and refuse to cut. They could lose almost everything.”
An ego can be particularly perilous – especially in this age where “the limits of the fiat currency systems are being tested”.
The post-2008 period where “quantitative easing gates have been opened” is analogous to the 1970s with the end of the gold standard. Yong points out that this monetary system that we accept as normal is less than 50 years old.
Central banks will embark on QE until they can’t, Yong believes.
Previous efforts by Japan to voluntarily remove QE were unsuccessful and even though the Federal Reserve and European Central Bank are preparing for ‘normalisation’, “when the next crisis hits, they’ll print again”.
“I am not convinced that we can have the extended period of stability that allows the central banks to gradually whittle down their balance sheets.”
And even without a crisis, QE is still the path of last resistance for governments that can’t get things done “in a world of social media”.
One of the more severe side-effects of QE has been an increase in pension liabilities as low bond rates dramatically lowered the financial returns that can be generated without taking risk. But QE may ultimately be the prescribed treatment.
“I believe that the pension under-funding will ultimately end up on the balance sheets of the central banks at some point. That’s just the easiest way to solve it.”
So will QE go on forever? There are limits. What could reverse it is a meaningful rise in inflation that forces central banks to tighten. Yong isn’t convinced it’s inevitable for a few reasons.
One is that QE is actually deflationary as the cheap money created leads to over-production.
Another is demographics. The Japan experience has shown that the reduction in spending by retirees is more deflationary than the inflationary impact of a smaller workforce. Japan has less than 2 per cent unemployment, and little inflation even after quadrupling its QE program.
Quantitative easing could also be undone by the political process. While traditional measures of inflation are stubbornly low asset prices have levitated, widening inequality. Even if its true that the actions of central banks saved Western economies from ruin and restored millions of jobs, not every voter will accept that the only way to achieve this was to make the rich way richer.
Finally, central banks could simply run out of things to buy – an issue that the central banks of Japan and Europe are already encountering. While their shopping list could be expanded to include equities, land and property, practical limits could be reached.
“It’s either a form of financial repression or nationalisation – they [governments] are buying back assets that were given to citizens earlier. But it could last for a long time and it may not be that bad. It has led to a period of stability.
“The day of reckoning can only happen when there’s a catalyst that stops QE.”
By Jonathan Shapiro
Source: Australia Financial Review