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The Anglo Disease - Financiers worried about end of great bull run

by Jerome a Paris Mon Jun 18th, 2007 at 12:03:25 PM EST

Two simultaneous articles this morning underline the worries of many senior players in the financial markets these days. One is a full page analysis in the Financial Times (from which the graph below is taken); another is a guest Op-Ed by Steven Rattner in the Wall Street Journal. Both suggest that hard times are ahead, as can be seen in their titles:
A fright in the bond markets may end the cheap funds era
The Coming Credit Meltdown

The above reminds us that we have been in a 20 year bull market for bonds, as inflation threats slowly receded - in fact, it's been more than 25 years, a full generation, as it really started after Paul Volcker pushed Fed rates to 20% to kill inflation in the very early 80s).

Describing the interest rates set by the bond market as the “cornerstone” for valuing equities and other securities, [Albert Edwards, Dresdner Kleinwort’s well-known global equity strategist] cautions that if the bond market has truly entered a new era of steadily rising long-term rates, “all investment portfolios will be shredded to ribbons”.

Increasingly cheap money, underpinned by ever more optimistic prognoses about inflation and, more generally, future returns on financial assets, has fuelled the massive financial boom we've been in for most of our lives and which has so transformed our economic landscape. By making high returns possible, it has generalised the requirement for such returns in all economic activities, and thus the need for constant restructuring of businesses, for cost-cutting, offshoring and, often, for the wholesale dismantlement of whole sectors of activity that could not generate the required profitability.

In fact, I'd like to propose to call that the Anglo disease, as a mirror of the so-called 'Dutch disease' which was first identified in the 60s in the Netherlands as other industrial acitvities suffered from the discovery of natural gas in Groningue, which created a new industry with much higher returns which made investment in other sectors relatively unprofitable and eventually generated economic hardship for the country. Today, economic activity and growth in the UK and the US is similarly dominated to a large extent by the City and Wall Street, to the exclusion of many other sectors of activity, as is demonstrated by the skyrocketing deficit in the trade balance for goods in both countries, by various studies that suggest that 40% of company profits in the US come from financial firms:


This month’s sell-off in the bond markets is already a landmark event. The fall in bond prices, both in the US and Europe, has been as sharp as any seen this decade. The consequent rise in yields has forced investors to re-examine the cosy assumptions that have underpinned the cheap financing available across the world for the past few years.

The article notes that inflation fears may slowly tick upwards again; it flags that Asians are moving away from buying US Treasuries and are trying to buy equity and corporate bonds (i.e. slightly more "real" assets than a general claim on the US economy); it also notes that contrary to what triggered the most recent bond market "scares" in 1994 and 2003, the US Federal Reserve has done nothing to surprise or disappoint markets this time. And thus it comes to a simple conclusion:

The best single explanation may be that the bond market suddenly recognised it had grown too complacent about risk.

The markets have been living off easy financing for many years, and it has generated a self-sustaining boom, as companies found it easy to refinance even when in dire straits, they did not have to default on their obligations, thus improving default rates; with easy money, investment has been strong and has boosted economic activity - starting within the financial sector, via an orgy of juicy mergers & acquisitions and refinancings.

But as investment turns out not to have been very wise, or financial transactions driven by the ego of CEOs and fuelled by greedy bankers turn out not to be such great ideas, the machine is beginning to choke on its own excesses. The subprime mortage market has already been wiped out; it's not clear yet whether that will have an impact on the overall economy, but the process that took place in that particular market might very well take place in other markets as well.

The more fearful view is that the contradictions in the US economy are about to come home to roost, as the housing boom required unsustainably cheap finance. On this reading, yields of 5.15 per cent, though low by historic standards, could provoke an economic crash.

Apart from housing, the biggest worry comes from the high-yield market, as noted by Steven Rattner in his WSJ article.

Just like subprime mortgages are loans to the weakest home buyers, high yield debt is lending to the worst companies - it's riskier but it pays better, and when conditions are mild in the overall economy, the risk becomes lower as these companies can do well enough to pay their debts.

The current market has offered such a favorable environment that defaults are a record low levels, and thus high yield debt prices (as measured by the "spread" between the cost of such debt and the cost of risk-free debt like borrowings by the government) are also at record low levels.

The low spreads have been accompanied by less tangible indicia of imprudent lending practices: the easing of loan conditions ("covenants," as they are known in industry parlance), options for borrowers to pay interest in more paper instead of cash, financings to deliver large dividends to shareholders (generally private equity firms) and perhaps most importantly, a general deterioration in the credit quality of borrowers.

In 2006, a record 20.9% of new high-yield lending was to particularly credit-challenged borrowers, those with at least one rating starting with a "C." So far this year, that figure is at 33%. No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.

In other words: today's market conditions are absolutely unprecedented, and nobody has the experience of what might happen next.

Like past bubbles, the current ahistorical performance of high-yield markets has led seers and prognosticators to proclaim yet another new paradigm, one in which (to their thinking) the likelihood of bankruptcy has diminished so much that lenders need not demand the same added yield over the Treasury or "risk-free" rate that they did in the past.

To be sure, the emergence in the past 20 years of more thoughtful policy making may well have sanded the edges off of economic performance -- what some economists call "the Great Moderation" -- thereby reducing the volatility of financial markets and consequently the amount of extra interest that investors need to justify moving away from Treasuries.

But to think that corporate recessions -- and the attendant collateral damage of bankruptcies among overextended companies -- have been outlawed would be as foolhardy as believing that mortgages should be issued to home buyers with no down payments and no verification of financial status.

And just as the unwinding of the subprime market occurred at a time of economic prosperity, the high-yield market could readily unravel before the next recession. With the balance sheets of many leveraged buyouts strung taut, a mild breeze could topple a few, causing the value of many leveraged loans to tumble as shaken lenders reconsider their folly.

Compared to the Dutch disease, the industry that causes activity-substitution (high finance) can appear to be able to grow ad infinitum, without any limitation to actual resources. Just borrow more money to do bigger deals and enjoy the very real income taken along the way. Find another lender to refinance or another buyer to re-purchase, and you're home and dry. Or just do deals where the actual burden to repay is pushed back into the future (and you won't be around anymore if and when they falter). Thus the City and Wall Street can generate more jobs than the industry it kills off destroys (especially when you are also making some of your money off industries in other parts of the world).

And blame it all on "globalisation" and "the freedom of investors to seek out the best returns around".

Bankers provide necessary and useful services. But the runaway juggernaut we have inflicted upon ourselves today has gone far beyond oiling economic activity. It has metastised into something which behaves like a parasite, destroying substance and justifying it by creating an apparently larger, but a lot more fleeting, prosperity increasingly based on our collective belief that it is actually doing so and not on underlying value added. When that illusions shatters, the reckoning will be painful.

Doom and gloomers are often accused of being unduly pessimistic, and making careers out of such announcements that rarely end up being true, but an increasing number of voices seem to see this the same way. As long as the collective delusion is maintained, the system can live on. But when opinion turns, things will move really quickly. As the fall will be smaller the earlier it takes place (although it is already much too late to think we'll avoid any pain), it would be better if it happened sooner rather than later.

Oh, as a final note of irony, it looks like the very top of the bond market was on the day when the USA invaded Iraq. Make of that what you will.

Display:
I think the concept could have some potential and should be developed. I hope you can read this text with a critical eye and point me to bits which (i) you don't understand, or (ii) think are incorrect, or (iii) could be phrased better), or (iv) rely on assumptions that need to be explicited, or anything else you see.

I'll crosspost this late to other sites.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Mon Jun 18th, 2007 at 12:09:20 PM EST
It's a very important concept. Hopefully later in the week I'll be able to post some bits from the latest Larry Elliot book which has some circumstantial evidence that the "City of London" has indeed had this investment substitution effect over many years in the UK.

One thing that of course is not easy to assess is just how many of the financial instruments in use will stop being employment centres if economic conditions trend as you suggest.

by Metatone (metatone [a|t] gmail (dot) com) on Mon Jun 18th, 2007 at 12:32:37 PM EST
[ Parent ]
Incidentally, in the UK case, there is an extra wrinkle in that it's possible to draw a line following the influx of North Sea Oil revenue, through the manipulations of the exchange rate to privilege the City over manufacturing, which sounds even closer to the Dutch disease...
by Metatone (metatone [a|t] gmail (dot) com) on Mon Jun 18th, 2007 at 03:30:19 PM EST
[ Parent ]
On the Larry Eliott book (Guardian excerpt from), see darragh's diary.
by afew (afew(a in a circle)eurotrib_dot_com) on Mon Jun 18th, 2007 at 04:42:26 PM EST
[ Parent ]
This is very good. I'm going to have to come back and read it again.

One thing strikes me though: the description of the "Dutch disease" - one high-yield activity substituting for one or more others - seems on the surface to be analogous to what's supposed to happen within a trading country according to the theory of comparative advantage.

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman

by dvx (dvx.clt ät gmail dotcom) on Mon Jun 18th, 2007 at 05:14:26 PM EST
[ Parent ]
Agreed, but that doesn't stop it being a train wreck if you pick an unsustainable "comparative advantage."

I know that Schumpeter style economists will say untrammeled creative destruction is a good thing, but I think that's more contentious.

by Metatone (metatone [a|t] gmail (dot) com) on Mon Jun 18th, 2007 at 05:42:42 PM EST
[ Parent ]
I'm with you on the sustainability and lack thereof.

But isn't the inevitable effect of comparative advantage that someone goes to the wall in the medium term (albeit everyone will ultimately be better off when used as directed)?

IANAE, but it just seemed to me from the way Jerome described it that the "Dutch disease" triggered the same mechanisms one would expect to see when transitioning to a comparative advantage scenario.

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman

by dvx (dvx.clt ät gmail dotcom) on Mon Jun 18th, 2007 at 05:58:51 PM EST
[ Parent ]
As I understand it, we're never supposed to pick comparative advantages that are as potentially unsustainable as some of the financial instruments Mig has referred us to... it's not something the theory seems to consider, but then, IANAE either...
by Metatone (metatone [a|t] gmail (dot) com) on Tue Jun 19th, 2007 at 12:57:39 AM EST
[ Parent ]
Since, as not-economists (ie dummies), the kind of analogies we are offered by way of explanation of comparative advantage generally concern Bob and Alice who grow tomatoes and lettuces, or some such agricultural object lesson, it's interesting to note that the theory never takes into account that it might be a more sustainable practise to rotate the cultures of tomatoes and lettuces rather than specialise.

This takes on real-world proportions when applied to rain-forest clearance for monocultures. Yet we're still being told, in the name of comparative advantage, that the Doha Round is the way to go.

by afew (afew(a in a circle)eurotrib_dot_com) on Tue Jun 19th, 2007 at 09:34:02 AM EST
[ Parent ]
My own ricardo gardening version has specialisation risk mentionned and then discussed in the comments :)

http://guerby.org/blog/index.php/2006/04/23/65-salades-et-tomates

by Laurent GUERBY on Tue Jun 19th, 2007 at 03:39:16 PM EST
[ Parent ]
I know that Schumpeter style economists will say untrammeled creative destruction is a good thing, but I think that's more contentious.

Not true - at least if you speak about economists the way we (economists) define our profession, not the way people like Klaus think of themselves. Even a simplest Schumpeterian model can generate a lot of waste, when someone else creatively destroys your business because your investment doesn't enter his profit function.

by Sargon on Mon Jun 18th, 2007 at 08:13:59 PM EST
[ Parent ]
For once I didn't actually mean to tar all economists with the same brush, there's a small sub-sect who are really devoted to creative destruction, who see it as the main means of "progress." They are the only ones I was referring to in this case.
by Metatone (metatone [a|t] gmail (dot) com) on Tue Jun 19th, 2007 at 12:55:38 AM EST
[ Parent ]
So I've been thinking of investing in tulip bulbs, they've just been going up,up, and away lately.

And I'll give my consent to any government that does not deny a man a living wage-Billy Bragg
by ManfromMiddletown (manfrommiddletown at lycos dot com) on Mon Jun 18th, 2007 at 10:43:27 PM EST
[ Parent ]
I suppose this is affected by the fact we don't really know how all this new derivatives-based finance will react when faced with a real crisis?

Un roi sans divertissement est un homme plein de misères
by linca (antonin POINT lucas AROBASE gmail.com) on Mon Jun 18th, 2007 at 04:11:10 PM EST
As Rattner says:


Assessing the likely consequences of a correction is more daunting than merely predicting its inevitability. The array of lenders with wounds to lick is likely to be far broader than we might imagine, a result of how widely our increasingly efficient capital markets have spread these loans. No one should be surprised to find his wallet lightened, whether out of retirement savings, an investment pool or even the earnings on their insurance policy.

The bigger -- and harder -- question is whether the correction will trigger the economic equivalent of a multi-car crash, in which the initial losses incur large enough damages to sufficiently slow spending enough to bring on recession, much like what happened during the telecom meltdown a half-dozen years ago.

The thing with derivatives today is that nobody knows where the risk is now, on a macro basis. So we don't know who will be left holding the bag. Maybe it will be nicely spread around so that the financial world absorbs a lot of the pain itself (funds lose out, banks eat their reserves, investors see their portfolio lose value) and there is no need for a bailout. Or there will be more localised breakdowns in places of unexpected concentration of risk, which may threaten to spread and require public intervention. We just don't know.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Mon Jun 18th, 2007 at 04:34:18 PM EST
[ Parent ]
The problem is not derivatives, it's the over-the-counter market in custom-designed financial products.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 04:46:12 PM EST
[ Parent ]
Could you elaborate on that?

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman
by dvx (dvx.clt ät gmail dotcom) on Mon Jun 18th, 2007 at 05:05:44 PM EST
[ Parent ]
There are two kind of financial products: exchange-traded and over-the counter.

Exchange-traded products are standarised and to some extent trackable (at least in terms of volume outstanding and traded, etc) because of regulatory requirements and those of the exchange itself. Banks provide bespoke financial products to their customers "over the counter", with very limited regulatory oversight or reporting requirements. Financial derivatives and "swaps" can be (and are) used to circumvent regulatory limits, hide transactions and holdings, reduce one's tax base, etc.

I'm suggesting that, if there were no OTC market it would be less difficult (in principle) to have an idea of where the risk is.

On the other hand, it's in the OTC market where "financial innovation" takes place.

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 05:14:04 PM EST
[ Parent ]
You don't need complex derivatives to blow yourself up.

Some hedge funds are taking huge positions on listed derivative markets. It's just that when they fail through listed markets the boom is spread a bit to the clearing exchange members and it happens earlier through margin calls.

Whereas in the OTC market you have only one counterparty that takes the boom (or a chain of counterparties).

AFAIK, there is no more regulatory reporting requirement in OTC than in listed.

Banks are supposed to monitor their risk and regulators supposed to monitor banks risk monitoring. If a bank blows up, the boom goes to in order:

  1. shareholders
  2. bondholders
  3. deposits of clients in the bank

Part 3 is you and me money. Did you get a dividend for the risk you're taking? :)
by Laurent GUERBY on Mon Jun 18th, 2007 at 05:35:55 PM EST
[ Parent ]
AFAIK, there is no more regulatory reporting requirement in OTC than in listed.

Do you mean no less regulatory requirement?

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 05:39:00 PM EST
[ Parent ]
I mean it's the same reporting requirement.

OTC requirement = listed requirement.

by Laurent GUERBY on Mon Jun 18th, 2007 at 05:44:08 PM EST
[ Parent ]
I don't agree: some mortage CDO's, corporate index CDS, tranches thereof, and all sort of other MBS are all listed stuff with delirial risks. And they will be among the first hit by the subprime meltdown. And the amounts at stakes are openly known, and they are already frightening.

I dont' mean the OTC are not another (possibly bigger) time bomb, I mean it is possible to blow up the planet by taking risk on listed stuff alone, and it has already been done, that listed bomb is cocked ready to set off.

I've seen some CDS on baskets of corporate lenders in europe which, according to some basic industry-standad default event models (thoroughly untested outside of the highly benevolent period of low refinancing rates), have their price go from zero to full pay for changes of just 1 bp at a certain threshold value of the borrower's spread. These threshold values are just a percentage point away from the present rates.

If the corresponding (listed) CDO really fares like the model suggest (symmetric of its default swap), this is going to be ugly, and it will happen, not overnight, but in just weeks as bankruptcies pile up.

Pierre

by Pierre on Tue Jun 19th, 2007 at 10:26:44 AM EST
[ Parent ]
http://europa.eu/eur-lex/en/treaties/dat/EU_treaty.html


CHAPTER II

OBJECTIVES AND TASKS OF THE ESCB

Article 2

Objectives

In accordance with Article 105(1) of this Treaty, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 of this Treaty. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 3a of this Treaty.

Article 3

Tasks

3.1. In accordance with Article 105(2) of this Treaty, the basic tasks to be carried out through the ESCB shall be:

  •  to define and implement the monetary policy of the Community;

  •  to conduct foreign exchange operations consistent with the provisions of Article 109 of this Treaty;

  •  to hold and manage the official foreign reserves of the Member States;

  • to promote the smooth operation of payment systems.

[...]

Article 19

Minimum reserves

19.1. Subject to Article 2, the ECB may require credit institutions established in Member States to hold minimum reserves on accounts with the ECB and national central banks in pursuance of monetary policy objectives. Regulations concerning the calculation and determination of the required minimum reserves may be established by the Governing Council. In cases of non-compliance the ECB shall be entitled to levy penalty interest and to impose other sanctions with comparable effect.

[...]
Article 34

Legal acts

34.1. In accordance with Article 108a of this Treaty, the ECB shall:

-  make regulations to the extent necessary to implement the tasks defined in Article 3.1, first indent, Articles 19.1, 22 or 25.2 and in cases which shall be laid down in the acts of the Council referred to in Article 42;

ECB governors are fully and the only ones responsible for what's going on in the credit and financial world.

If they prefer to spend their time and public credit on <i<work market deregulation</i> which is not in their mission instead of their real mission that's really bad, but nobody seems to notice up to know so we'll have to wait for the boom.

And I know who I'll blame then.

by Laurent GUERBY on Mon Jun 18th, 2007 at 05:15:33 PM EST
[ Parent ]
By making high returns possible, it has generalised the requirement for such requirements in all economic activities

returns

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Mon Jun 18th, 2007 at 05:27:14 PM EST


In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Mon Jun 18th, 2007 at 05:31:20 PM EST
[ Parent ]
I don't know if this helps you, but I started going over the comparison in my mind between the financial sector and certain gold producing towns in Western Australia I'm familiar with:

  1. One obvious point in the analogy that needs careful explanation is that when the price of gold is high, life in the town is good, whilst most of the conditions that make life in financial London good are connected to "lows" (e.g. low Treasury yields, low inflation, low interest rates, etc.)

  2. What is a "gold town?" Basically it's an accumulation of physical assets and human capital around the mining of a particular ore. When gold prices are high, it is a more profitable business than anything else. The town becomes composed of a central economic core (gold mining) and ancillary services (machine repair, basic human needs and entertainment/culture for the workers.)

  3. What happens when the gold price goes down?

Money stops coming in. There is a crisis because most of the physical and human assets are invested in the gold production process. It's like watching the decline of any heavy industry. Large human dislocations occur.

4) But the financial industry doesn't have lots of heavy machinery? True, but the skills of the workers are arguably much more specialised than those of gold miners. Gold miners can convert to construction, other ore extraction or even farming (which are all locally prominent industries.) Just what can you quickly turn a derivatives specialist into?

(And yes, the answer might be a management consultant, but it's not at all clear that there's any shortage of those, particularly if the financial sector takes a downturn.)

  1. What's the paranoid nightmare of the gold miner? Well, suppose someone really worked out that "gold from seawater process." It's hard to see the gold production industry staying where it is, instead it will move to be closer to the industrial customers for gold.

  2. What's my paranoid nightmare about financial services? In the long run, absent the boom conditions, the customers for financial services are other industries, notably manufacturing. (Whether service industries need as much financial wizardry is a debate for another diary.) That being so, then the long term expectation would be that eventually financial services will move to be near the manufacturing?

  3. But that's long term paranoia, what about "Anglo disease"? Right now, London is a boom town, living off the mining of "financial ore." With changes in conditions this ore will stop being worth so much and the industry will have to contract. Problem is, government policy (regulation and exchange rates) has been oriented around the financial ore industry for 20 years. Other industries have largely withered. That has the potential to leave a lot of people unemployed and waiting for the next boom in the "financial ore" market.
by Metatone (metatone [a|t] gmail (dot) com) on Tue Jun 19th, 2007 at 02:17:35 AM EST
I presume you used the French word? In English (and Dutch) it is known as Groningen (province and city).

Good new(?) concept, J. Please build on this further!! It is higher-up economics for me, so I can only follow half of this diary. The graph are worrying by themselves, though.

Question: How are the bond markets connected to the stock markets? Can its be said that the cheap money made available from the bond markets were (partly) poured into fueling the stock markets?

by Nomad on Tue Jun 19th, 2007 at 05:30:36 AM EST
There's a good narrative here, especially linked (see Metatone's comment and darragh's diary) to Larry Eliott's book Fantasy Island (at least what we've seen of it...)

Echoing Nomad, I'd say that, if you are aiming at being understood by the non-initiated, you might give an explanation of the counter-intuitive declining trend line in the first graph compared to "a 20-year bull market for bonds". Ie, explain the mechanics of bond markets a bit.

I really like the Dutch Disease parallel (and think it's accurate). The strong point is the generalisation of the requirement for high returns, that ravages other activities through cost-cutting, downsizing, outsourcing, offshoring, or just plain neglect. Add to this the free movement of capital in a world of rising population therefore cheap labour, and you can see why globalisation is (Anglo-Saxon above all) financial capitalism's swimming pool.

Just a suggested edit : for

In other words: today's market conditions are absolutely unprecedented, and nobody has the experience of what might happen next.

read: "...unprecedented, and no past experience can throw light on what might happen next".

by afew (afew(a in a circle)eurotrib_dot_com) on Tue Jun 19th, 2007 at 09:59:37 AM EST
Echoing Nomad, I'd say that, if you are aiming at being understood by the non-initiated, you might give an explanation of the counter-intuitive declining trend line in the first graph compared to "a 20-year bull market for bonds". Ie, explain the mechanics of bond markets a bit.

Does it help to say that as the price of a bond goes up its yield goes down? Is that what's counter-intuitive about it?

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Tue Jun 19th, 2007 at 10:04:24 AM EST
[ Parent ]
Explain first to the non-initiated what a bond is, how it is different than, say, a stock/share and perhaps how they are tied together (I still don't know whether they are!!).

I did some basic reading during J's diary to get a sense about what he was talking.

I haphazardly compared to it currency: when the South African Rand is weakening compared to the Euro, it means that it will take me longer to pay off my study loan in Euro because my yield (in Euro) goes down. Whether that analogy is correct of course begs the question...

by Nomad on Tue Jun 19th, 2007 at 10:33:01 AM EST
[ Parent ]
A simple bond is a promise to pay a given principal amount at a given maturity time. If you buy the bond for a price that is less than the principal you will realise a profit. The (compound) rate of interest that will make the price grow to the principal between now and maturity is the yield to maturity. The lower the price, the higher the yield and conversely. There are more complicated bonds that pay interest regularly (called a coupon) in addition to the principal at maturity, but they still have inversely correlated price and yield. And a fixed-interest mortgage is like a bond with monthly coupons and no principal.

It should be plain that bonds are completely different from stock shares, which are shares in the capital of a company.

Let's not get into exchange rate risk at this point ;-)

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Tue Jun 19th, 2007 at 10:54:59 AM EST
[ Parent ]
What appears counter-intuitive is a downward trend on the graph = a bull market.

And what many people don't know about is the relation of the bond market to credit, and its relation to stocks.

I don't propose to try to write anything myself because I'd probably screw up :)

by afew (afew(a in a circle)eurotrib_dot_com) on Tue Jun 19th, 2007 at 11:27:25 AM EST
[ Parent ]
I'll let myself being used as an economic student / guinea pig... But only for this post, because I'm poised to leave.

Bloody linguistic terms. It's still rather opaque to me - One buys to realise a profit? I do see how the principle works, yet when does the actual return set in? When do you "sell" bonds to realise the profit in actual numbers on your bank account? Or is the buying the selling? *confused *

And (once again): (how) does the bond market affect the stock market?

by Nomad on Tue Jun 19th, 2007 at 11:39:23 AM EST
[ Parent ]
If you buy a 10-year €1,000 bond for €600 when the bond is issued, you invest €600 now and are guaranteed €1,000 10 years from now. If you lend €600 at 5.24% annual yield and only require one repayment 10 years from now, the borrower will have to pay you €1,000 when the loan expires. So buying a bond is like lending money, and if the yield is positive (or larger than inflation, or larger than the profit you can make elsewhere, or larger than whatever your benchmark is) you'll make a profit.

Of course, if you can turn around a year later and sell the bond for €660 then you've made a 10% in a year, the yield of thebond has gone down to 4.72% and the price went up higher than expected.

The bond market affects the stock market in that bonds involve guaranteed payments so, neglecting default risk (and if the bond is a US treasury bond you pretty much can) the bond yield is a measure of risk-free return. When valuing stocks, return is measured relative to the risk-free rate of return. So, if bond yields go down, stock returns above the risk-free rate go up and so investing in the stock market becomes more attractive. Also, investments that used to be less profitable than bonds and so wouldn't be undertaken suddenly become profitable.

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Tue Jun 19th, 2007 at 11:57:33 AM EST
[ Parent ]
Migeru:
If you buy a 10-year €1,000 bond for €600 when the bond is issued, you invest €600 now and are guaranteed €1,000 10 years from now. If you lend €600 at 5.24% annual yield and only require one repayment 10 years from now, the borrower will have to pay you €1,000 when the loan expires. So buying a bond is like lending money, and if the yield is positive (or larger than inflation, or larger than the profit you can make elsewhere, or larger than whatever your benchmark is) you'll make a profit.

That makes it crystal clear what a bond is for the ignoramus.

Similarly:

the bond yield is a measure of risk-free return. When valuing stocks, return is measured relative to the risk-free rate of return. So, if bond yields go down, stock returns above the risk-free rate go up and so investing in the stock market becomes more attractive. Also, investments that used to be less profitable than bonds and so wouldn't be undertaken suddenly become profitable.

This explains to me the relation between the bond and stock market. And I haven't been looking up information since I logged off yesterday.

If J could blend this into his diary as an introduction to the bond market, I think it would be able to reach a larger audience unfamiliar with financials.

by Nomad on Wed Jun 20th, 2007 at 03:30:02 AM EST
[ Parent ]
I think the concept of the Anglo Diseasa is important enough to warrant writing some concise explanation of these underlying concepts. I'll do that in the very near future.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jun 20th, 2007 at 04:30:19 AM EST
[ Parent ]
The relation between stocks returns and yields is incomprehensibly "explained" in the wikipedia article on the Sharpe Ratio.

Maybe the article on Modern Portfolio Theory will be more instructive, but I think it's overkill - more than you need to know about any of this. However, this diagram from the article hopefully makes it clear what "excess return above risk-free" means.

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jun 20th, 2007 at 05:52:04 AM EST
[ Parent ]
This quotation from the diary
Describing the interest rates set by the bond market as the "cornerstone" for valuing equities and other securities, [Albert Edwards, Dresdner Kleinwort's well-known global equity strategist] cautions that if the bond market has truly entered a new era of steadily rising long-term rates, "all investment portfolios will be shredded to ribbons".
might be clarified by this other quotation from the beginning of the FT piece:
US Treasury bond yields in effect set the "risk-free" rate used when pricing securities - from corporate credit through derivative contracts to equities - across the world. They form the financial world's clearest expression of risk.
Does this answer "how the bond market affects the stock market"?

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Tue Jun 19th, 2007 at 12:15:54 PM EST
[ Parent ]
It's a wonder that the human race has not yet starved itself to death on the theory that the financial return on other endeavors was much better than that in food production.

Hey, Grandma Moses started late!
by LEP on Tue Jun 19th, 2007 at 10:34:33 AM EST
It's not theory but a practical consequence of improvements in the productivity of agricultural labour. Or a consequence of agriculture itself.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Tue Jun 19th, 2007 at 11:04:47 AM EST
[ Parent ]
Excellent question.

As a matter of fact, returns on food become higher than on financial assets in times of famines, thus ensuring investment in food production (or hoarding via pillaging). of course, there is the small matter that these investments take time to be brought to market...

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Tue Jun 19th, 2007 at 05:22:07 PM EST
[ Parent ]
And are very likely to be unsecured property in times of trouble :).
by Laurent GUERBY on Tue Jun 19th, 2007 at 06:21:19 PM EST
[ Parent ]


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