Moral Hazard Meets Bail-in
By John R. Taylor, Jr.
It is hard to remember when I first heard the term “moral hazard,” but it was possibly sometime early in 1988, after Greenspan had rescued the equity market from itself in the hours surrounding the collapse on October 19, 1987. I don’t think that I paid much attention, as it seemed so obvious that Greenspan had done the right thing. My sense of history had told me that the stock market crash would be transferred into the death of ‘animal spirits’ and a decline in economic performance, but I was totally wrong as Greenspan’s actions had short-circuited the history of the Depression. Moral hazard jumped into widespread discussion for the first time after the Mexican rescue, driven by Bob Rubin and Clinton’s team, at the start of 1995 and moved toward the center of economic and financial debate (at least that of the more critical analysts) after the Asian crisis, the Russian collapse and the LTCM debacle in 1997 and 1998. After the turn of the century, the Greenspan ‘put’ became one of the most common financial aphorisms and then slipped onto Bernanke’s shoulder, as “helicopter Ben”. After the Lehman collapse, moral hazard has changed our way of thinking; it has run amuck. The Fed has been there to save everything: the stock market, the bond market, and the economy. Bernanke has even taken the interest rate down to zero, which in fact, is nothing but another rescue tactic to save investors and debtors. Now it is over. Once rates are at zero, they can’t go lower and there is only one way to go from there – up. The rise of moral hazard has matched our movement into the most dangerous part of Hyman Minsky’s cycle of financial market fragility. We call this the Ponzi phase, where companies and the government are unable to discharge their debts and, in fact, need to borrow more money just to cover the interest payments. Debt just keeps rising. Our governments have been in that situation for some time, but now most companies and individuals are there too. This is true even with interest rates anchored at zero percent in the front end of the curve. In this situation, a debt crisis must eventually occur as it is now impossible for debtors to cut the cost of carrying their increasing debt loads. As the debts can’t be repaid, the only logical alternatives are default or forgiveness.
Enter the bail-in. This concept first made the front page – and jolted the financial world – during the Cyprus crisis in late March. The EU and its associates decided that the taxpayers – really the yet-to-be-born taxpayers (because todays’ won’t pay) – should not take on the burden of repaying the debts of profligate borrowers. Rather, those who had lent to the borrowers should pay, by not getting repaid. Sounds good – if you make a loan to a bank and it goes bankrupt, you should lose. Unfortunately, bank deposits are ‘loans’ too, at least if they are above the guaranteed amount, and large deposits are way more than 50% of bank liabilities. If bail-ins are applied, there will be no moral hazard in European banks. They must stand on their own, but to protect themselves they should not even lend to their sovereigns if they look weak! And will the EU and ECB stand aside if equity markets crash? In the US, the Congress, or parts of it, finds bail-ins a good way to put more individual responsibility into investment decisions. Risk was socialized by Greenspan and Bernanke, this frees it and returns it to individuals. Will I take as many risks now? No way! With animal spirits subdued, the long-term economic outlook will darken. The rise in moral hazard stimulated growth, its death will kill it.
Weak to Mid-July, then Strong for Months
By Jonathan Clark
Monetary policy has a very powerful influence on exchange rates, particularly in the current environment. The Federal Reserve shocked the financial markets on May 22 and again on June 19 by hinting that asset purchases would be scaled back sooner than previously expected. Goldman Sachs CEO Lloyd Blankfein made a prescient comment prior to the last FOMC meeting: “Even if the Fed wants to change its rate slowly, at the first sign of change, the markets will change it quickly.” Meanwhile, the ECB is making it clear that monetary policy will remain accommodative. The short-term interest rate differential moved strongly in favor of the US versus the Eurozone and the single currency declined. We expect this weakness to persist into the middle of July and this should drive the euro lower. The rate on a 30-year fixed rate mortgage in the US rose from 3.40% in early May to 4.58% currently, threatening to slow the housing recovery and, as a result, consumer spending. This is last thing the Fed wants and it will take steps to ensure that mortgage rates fall to keep the economic recovery on track. On a 3-month basis, the rise in mortgage rates is the fastest in three decades and, typically, spikes higher are quickly reversed. For them to remain high the US economy must grow at a robust pace and this appears unlikely to us. Much of current US consumer spending is based on borrowing and perceptions of wealth through rising house prices rather than higher wages – this isn’t sustainable. If US interest rates retreat as we expect, then so will the US dollar. By the second half of July, we expect the European currencies to bottom and begin an uptrend lasting a minimum of several months.
EUR/USD formed a medium-term peak on June 19, the day Mr. Bernanke had his post FOMC comments regarding future monetary policy. We are expecting the single currency to decline for another two weeks before forming a medium-term low. Our target for this decline is the 1.2850 area and provided this area holds it will then attempt to begin a sustained rally. A close above 1.3275 will signal the euro has begun an uptrend that should last into October and probably the end of the year. It will then rally to the 1.4000 area and possibly further before peaking. A close below 1.2850 is needed to turn the outlook negative into the middle of August and it will then fall to the 1.2500 area before bottoming, but this more negative outlook is less likely.
By John R. Taylor, Jr.
It is hard to remember when I first heard the term “moral hazard,” but it was possibly sometime early in 1988, after Greenspan had rescued the equity market from itself in the hours surrounding the collapse on October 19, 1987. I don’t think that I paid much attention, as it seemed so obvious that Greenspan had done the right thing. My sense of history had told me that the stock market crash would be transferred into the death of ‘animal spirits’ and a decline in economic performance, but I was totally wrong as Greenspan’s actions had short-circuited the history of the Depression. Moral hazard jumped into widespread discussion for the first time after the Mexican rescue, driven by Bob Rubin and Clinton’s team, at the start of 1995 and moved toward the center of economic and financial debate (at least that of the more critical analysts) after the Asian crisis, the Russian collapse and the LTCM debacle in 1997 and 1998. After the turn of the century, the Greenspan ‘put’ became one of the most common financial aphorisms and then slipped onto Bernanke’s shoulder, as “helicopter Ben”. After the Lehman collapse, moral hazard has changed our way of thinking; it has run amuck. The Fed has been there to save everything: the stock market, the bond market, and the economy. Bernanke has even taken the interest rate down to zero, which in fact, is nothing but another rescue tactic to save investors and debtors. Now it is over. Once rates are at zero, they can’t go lower and there is only one way to go from there – up. The rise of moral hazard has matched our movement into the most dangerous part of Hyman Minsky’s cycle of financial market fragility. We call this the Ponzi phase, where companies and the government are unable to discharge their debts and, in fact, need to borrow more money just to cover the interest payments. Debt just keeps rising. Our governments have been in that situation for some time, but now most companies and individuals are there too. This is true even with interest rates anchored at zero percent in the front end of the curve. In this situation, a debt crisis must eventually occur as it is now impossible for debtors to cut the cost of carrying their increasing debt loads. As the debts can’t be repaid, the only logical alternatives are default or forgiveness.
Enter the bail-in. This concept first made the front page – and jolted the financial world – during the Cyprus crisis in late March. The EU and its associates decided that the taxpayers – really the yet-to-be-born taxpayers (because todays’ won’t pay) – should not take on the burden of repaying the debts of profligate borrowers. Rather, those who had lent to the borrowers should pay, by not getting repaid. Sounds good – if you make a loan to a bank and it goes bankrupt, you should lose. Unfortunately, bank deposits are ‘loans’ too, at least if they are above the guaranteed amount, and large deposits are way more than 50% of bank liabilities. If bail-ins are applied, there will be no moral hazard in European banks. They must stand on their own, but to protect themselves they should not even lend to their sovereigns if they look weak! And will the EU and ECB stand aside if equity markets crash? In the US, the Congress, or parts of it, finds bail-ins a good way to put more individual responsibility into investment decisions. Risk was socialized by Greenspan and Bernanke, this frees it and returns it to individuals. Will I take as many risks now? No way! With animal spirits subdued, the long-term economic outlook will darken. The rise in moral hazard stimulated growth, its death will kill it.
Weak to Mid-July, then Strong for Months
By Jonathan Clark
Monetary policy has a very powerful influence on exchange rates, particularly in the current environment. The Federal Reserve shocked the financial markets on May 22 and again on June 19 by hinting that asset purchases would be scaled back sooner than previously expected. Goldman Sachs CEO Lloyd Blankfein made a prescient comment prior to the last FOMC meeting: “Even if the Fed wants to change its rate slowly, at the first sign of change, the markets will change it quickly.” Meanwhile, the ECB is making it clear that monetary policy will remain accommodative. The short-term interest rate differential moved strongly in favor of the US versus the Eurozone and the single currency declined. We expect this weakness to persist into the middle of July and this should drive the euro lower. The rate on a 30-year fixed rate mortgage in the US rose from 3.40% in early May to 4.58% currently, threatening to slow the housing recovery and, as a result, consumer spending. This is last thing the Fed wants and it will take steps to ensure that mortgage rates fall to keep the economic recovery on track. On a 3-month basis, the rise in mortgage rates is the fastest in three decades and, typically, spikes higher are quickly reversed. For them to remain high the US economy must grow at a robust pace and this appears unlikely to us. Much of current US consumer spending is based on borrowing and perceptions of wealth through rising house prices rather than higher wages – this isn’t sustainable. If US interest rates retreat as we expect, then so will the US dollar. By the second half of July, we expect the European currencies to bottom and begin an uptrend lasting a minimum of several months.
EUR/USD formed a medium-term peak on June 19, the day Mr. Bernanke had his post FOMC comments regarding future monetary policy. We are expecting the single currency to decline for another two weeks before forming a medium-term low. Our target for this decline is the 1.2850 area and provided this area holds it will then attempt to begin a sustained rally. A close above 1.3275 will signal the euro has begun an uptrend that should last into October and probably the end of the year. It will then rally to the 1.4000 area and possibly further before peaking. A close below 1.2850 is needed to turn the outlook negative into the middle of August and it will then fall to the 1.2500 area before bottoming, but this more negative outlook is less likely.
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