Tuesday, 5 February 2008

Inflation or Deflation ? The Market Speaks

Do the math ...

Readers of the excellent
Bearwatch (now sadly in some kind of semi-limbo) will have enjoyed the debate over whether the next economic cycle will be inflationary or deflationary. I tend to expect the former, and the unhappy Mitchells & Butlers saga gives us an interesting market data-point that reinforces this view.

Recall that M&B put on a huge 30-year derivative position to provide an inflation hedge for a putative but ultimately illusory property deal. The strike was 3.1775%, the 'hedge' became stranded, and was finally liquidated when £391 million out-of-the-money last week. M&B had
bought the fix, so OTM for them means implied RPI is higher than the strike.

So - do the math, as they say. Principal was £ 240 million and it's an interesting question as to what we assume is the relevant risk-free discount rate: but if we say 5%, doing some simple sums,
the implied 30-year RPI is 3.7% ! (it's fairly robust: +/- 50 basis points on the risk-free rate results in only +/- 5 bps on the implied rate)

And 30 years is a long time ! OK Gordon, that's what it costs to hedge out your stable economy these days - where's your economic miracle now ?



CityUnslicker said...

excellent piece Nick. You have the beating of Worstall in the numbers game.

Steven_L said...

Well you've lost me on this one Nick. What are we talking about, kind of like a spread bet on inflation or something?

Nick Drew said...

It ended up being a bet for M&B, but they hadn't meant it that way.

The plan was to buy a load of commercial property, the income from which they considered likely to rise & fall with inflation. But to raise max + cheapest financing, a more predictable income was desirable.

So they entered an RPI swap: they would pay (monthly or qtrly or whatever) a variable amount indexed to RPI (approximating their income from the property) and would receive a fixed amount, rising at the strike-rate (3.1775%). In combination this would have the effect of fixing the income from their properties at that rate - a 'hedge' against variable income.

But without the property, the swap stood alone - a commitment to pay RPI-related variable amounts and receive 3.1775%. Is this a good deal in its own right ? Only if the future RPI is less than 3.1775%. Will this be the case ? Nobody knows. But at any given time the market will put a forward value on it.

M&B might have just wanted to sit this out, to wait and see. But unfortunately for them they are obliged to 'mark to market' a derivative exposure such as this swap, i.e. recognise its current market value in their books, because it's a huge commitment.

We know what that value was - and that it was negative for them - because they paid up in order to get out of the deal, and reported the amount. So we know the market values RPI at more than 3.1775% just now. From the numbers M&B gave (plus an assumption on the risk-free rate of return, which is not completely transparent for a 30-year deal) - *bingo* - we have the market's current value on 30-year RPI, namely 3.7% (courtesy of Mr Gates' fine software)

This isn't any type of forecast, it's a forward price. But it gives no comfort for anyone fantasising that RPI can somehow be expected to be kept below 3% on a sustained average basis. And absolutely no endorsement for Brown's supposed economic genius ...

tory boys never grow up said...

Oh dear oh dear - I'm afraid you are making the old mistake of assuming that markets are perfect and reading too much into what they imply. For a long period the market used to imply that Northern Rock shares were worth over £10 each and that there was only limited risk in providing funding to sub-prime lending.

What you have noticed is a fairly long standing feature - there is only limited liquidity in the market index linked bonds and that and the tendency of banks offering such derivatives to take a nice fat spread in such situations contribute to the figure you have calculated - which is well above what most reputable economists are forecasting for future inflation.

This is a real issue when it comes to valuing pension scheme liabilities where it is necessary to estimate future RPI and salary rises - and most actuaries have insisted on RPI forecasts based on market rates - however I think you will find that a lot of schemes have compnsated for this by assuming a fairly narrow margin for future pay rises over the (inflated RPI figure)

I bet M&B wish they had a Corporate Treasurer who knew about swaptions - surely he should have asked the question what would have happened if the property deal did not go through. Does actually highlight a problem that Corporate Treasury is not very good in the UK outside the financial sector - and now we are in a period of volatility after a long period of quiet, I expect many similar stories in the near future.

Nick Drew said...

making the old mistake of assuming that markets are perfect and reading too much into what they imply

TB - nope, I chose my words very carefully

"that's what it costs to hedge out your stable economy these days"

"Nobody knows. But at any given time the market will put a forward value on it"

"This isn't any type of forecast, it's a forward price"

I accept, of course, that this isn't the most liquid market and that there will be a juicy spread. However,

(a) the premium was clearly not enough to offset the better financing terms they were working for (promised ?)

(b) the premium "above what most reputable economists are forecasting" is there primarily because of the medium-term volatility / unpredictability needing to be catered for, which is what makes the current situation so problematic, and why anyone would be willing to pay to hedge it out.

My main point was - deflation doesn't feature as a high-probability scenario in any of this

Naturally I also agree that most non-financial corp treasuries are weak. Wonder who pressured them to enter this swap ... - overselling derivatives ? Orange County, anyone ?

Anonymous said...

I think the jury is still out on the inflation question.

Right now the central banks are tending to tackle the issue of a possible recession by reducing interest rates but it is not showing any signs of working. Sure, it worked in the past which is why they are trying it now, but will it work this time? I'm pretty sure that it won't.

We have to remember that what underpins the current crisis is fractional reserve lending. Creating debt out of thin air to give to creditors. When interest rates are low then banks need to shift a lot of loans to make the same profit. They can't do this with just deposits alone so they create debt out of thin air and sell it as a loan. As you know, they can't do this willy-nilly because they have to keep some cash reserves. This is where credit derivatives come into play - because banks use these to sell the debt on and therefore get it off their balance sheets, thus circumventing the rules on reserves. By this means the low interest rates have forced an explosion of debt as the banks have repidly expanded the quantity of loans they have released to make a greater profit from a lower interest rate.

However, now there is no market for credit derivatives as the risk in holding these has become apparent. The banks cannot take the debt off their balance sheets and in fact in many cases have had to put debt back on their balance sheets. Thus some are already infringing rules on cash reserves, preventing them from making further loans. This in itself should cause a collapse in money supply but also as interest rates rise due to the greater risk involved and the need for greater income the consumer switches from spending to saving. Similarly, industry finds high interest rates increasingly punitive and pulls away from investing and M&A activity and aims for higher liquidity instead. The overall impact of this is a collapse in the money supply leading to deflation, if left to its own devices, as the entire global economy switches from spending based on debt to saving and paying down debt (or failing to pay down the debt and defaulting instead).

Currently central banks are trying to cut interest rates to re-inflate the global economy, but you can see in the above scenario that this won't work. The debt based economy has simply hit the end-stops. Nobody wants debt anymore. We are in the same situation as Japan has been for almost 2 decades - extremely low interest rates but nobody interested in investing, leading to deflation and economic stagnation with persistantly high unemployment and severe social problems.

Inflation is only a likely outcome at the present time if the central banks give up trying (and failing) to re-flate the global economy by cutting interest rates and instead simply print money. This would result in a technical default on the global debt on a large scale. Individuals and nations holding large amounts of Western currency (or assets denominated in Western currency) would find these declining rapidly in value. Western currencies would become pariahs. Global trade might be halted in its tracks as traders question the value of paper currencies. But Ben Bernanke has not yet decided to destroy the dollar as the worlds reserve currency, so currently Japanese-style deflation remains the most likely outcome.

Nick Drew said...

RS - excellent, thank you !

PS good to report that Sackers seems to have returned to the fray (they all do, don't they - give 'em a week and the withdrawal symptoms kick in), so the great IN vs DE debate will doubtless continue there

Anonymous said...

"what most reputable economists are forecasting for future inflation." Oh dear, oh dear, are these the reputable economists who failed to forecast the ongoing credit problems, American housing market bust, and so on?
Chocolate teapots.

Ed said...

My survey of one (me) suggests that many consumers are going to switch from spending to saving quite rapidly and quite strongly. But us Brits are addicted to cheap tat so we won't stop spending altogether, and when people's mortgages stop costing so much some of that money will go straight into the shops. My totally ignorant prediction: more likely to have stagflation than a Japanese style depression.

Anonymous said...

ed: Just to clarify something. As I said before banks create debt out of thin air by means of fractional reserve lending. Since this debt is actually indistinguishable from real money, this process actually results in an increase in the UK money supply. This broad money supply is measured by "M4".

When people switch to saving rather than spending on credit, the debt created by fractional reserve lending is swapped for real money, and the net effect is a decrease in the total amount of money in the system as measured by M4. If the production capacity is the same but there is less money in the system you actually get deflation - prices of produced goods must actually decline to find a market. Since this decline in revenue has a negative impact on corporate profits, companies start cutting costs to compensate. Unemployment rises but people in work have to work harder to keep production up.

Deflation tends to be self-sustaining, which is why it is considered to be a grave danger to an economy. Why buy today if the product you want to buy will be cheaper tomorrow? And even cheaper the day after that? People continue to defer spending decisions, preferring to pay down debt instead (because they have seen unemployment rise and they are worried about the state of their finances). By deferring spending the consumer economy collapses, money supply continues to contract as debt is paid down, companies continue to cut costs, unemployment rises still further and so on for years. Eventually all the debt is paid off (or written off) and confidence starts to return, but this can take decades. This is what happened in Japan and also to some extent in Germany where consumers worried about changes to the pension system started saving a greater proportion of their wealth.

It is important for all of us to realise that there really isn't any such thing as a mysterious "business cycle". There is only a credit cycle, with expansions and contractions of the money supply driven by consumer optimism and pessimism and aided and abetted by corrupt government that sees the short term benefit to its electoral chances of credit expansion. Keep money supply growth in check and you will rid yourself of the "boom and bust" cycle. A government that claims "no more boom and bust" but presides over a trebling in the money supply is telling an outright lie.

Sure, we all feel richer when there is more money in the system, but actually we are just mortgaging our future, competing with our neighbours to get into more cheap debt.

I have wondered for some time just how bad the situation could be. Certainly as bad as during the late 70s. But in the late 70s we had enormous spare production capacity and fewer people with huge mortgages. It was possible to dig ourselves out of the mess we were in. Now the levels of debt are so big, extending into all areas of the economy, they vastly exceed the ability of the economy to pay back the debt.

The whole global system is broken. Massive debt and insufficient cash in the system to service the debt. We are heading for a global cash-flow crisis and technical global insolvency. Unless the governments of the world can get together and agree to write off the debt that should never have been allowed to be created, we are heading for a repeat of 1929 and all that followed for 30 years afterward.

Wolfie said...

RS, excellent comment well written.

I just want to pin some detail on this :

Inflation is only a likely outcome at the present time if the central banks give up trying (and failing) to re-flate the global economy by cutting interest rates and instead simply print money.

This is exactly what they have been doing on the quiet and may will continue for a while until their nerve breaks. Then you have the financial "hysteresis" inherent in economic cycles and you end up with :

Short-term inflation (backed by increasing taxation and energy costs) followed by sharp deflation.

Nick Drew said...

great thread, thanks guys

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