Pimco Investor Consider This Before Bailing_5

Post on: 30 Июнь, 2015 No Comment

Navigating Europe’s Distorted Cash Markets

Two groups of market participants — speculators and European financial institutions — seem comfortable holding an elevated level of cash while forfeiting their principal by buying instruments with zero or even negative yields.
These entities have created distortions in the European money markets and historic anomalies fueled by non-profit maximising behaviour.
As the European Central Bank is forced to look for increasingly creative ways to transmit liquidity, investors may consider moving further along the liquidity spectrum where distortions are not nearly as severe.

Article Main Body

Despite organisations’ need for a certain amount of true cash to facilitate transactions and meet other immediate liquidity commitments, the rationale for minimising cash holdings has never before been stronger. Near-zero, and in many cases negative yields on cash instruments have ensured an erosion of purchasing power, certainly on an inflation-adjusted basis if not on a nominal basis. For example, 3-month German treasury bills currently yield

-0.02% in nominal terms. Given these low yields, it’s not surprising that stable net asset value (NAV) money market funds across Europe are closing on a regular basis and/or devising clever ways to pass on penalty rates to investors.

Not surprisingly, investors have reacted by concentrating their cash holdings in bank deposits. But recent events in Cyprus, specifically the haircuts on uninsured depositors, sends a clear message to large institutional and high-net-worth individual depositors across the eurozone: counterparty risk must rank ahead of all other risks when deciding how much true cash to hold and where to hold it.

Market distortions and the liquidity cascade

There are two groups of market participants that seem comfortable holding an elevated level of cash while forfeiting their principal by buying instruments with zero or even negative yields.

First, there are the speculators who believe that Europe’s monetary union will fracture into a number of independent currencies. Considering that a hypothetical new German mark could appreciate by 30-50% against a new Spanish peseta, this group considers the penalty of principal erosion a fair price to pay for the optionality of capturing such large upside potential.

Second, and far more important, is the group of ‘building bloc’ entities integral to the European financial system that prioritise objectives other than profit-maximisation. These include:

Private banks — these institutions have prioritised risk minimisation, focusing on survival through balance sheet reduction and liquidity hoarding, paying down liabilities and deleveraging their balance sheets instead of identifying profitable lending opportunities to viable businesses and households. Against this backdrop, negative nominal yields on true cash holdings are an acceptable price to pay to insure against a potentially fatal liquidity shock.

The European Central Bank (ECB) — the ECB is the biggest non-profit maximiser of all. Restricted by politics from engaging in the type of asset purchases further along the maturity spectrum common to the other major central banks, it has instead focused on channeling a glut of liquidity through the banking system, fulfilling banks’ demand for liquidity via lending operations. In combination with lowering its deposit rate to 0%, banks have been forced to find alternatives in the money markets to warehouse this ECB-created and bank-demanded glut of liquidity.

The Swiss National Bank (SNB) — this is another example of an official sector non-profit maximiser. In fact, the SNB is one of the biggest purchasers of German government bonds and other money market instruments, even at negative nominal yields. The SNB has engaged in a policy of creating money without limit, exchanging newly printed francs for euros, and (bound by guidelines and internal policies) investing those euros in only the highest quality European assets regardless of how low those yields may be. The SNB has effectively abandoned interest rates as its policy instrument, adopting instead the exchange rate with the euro. The loss of AAA ratings in the UK and France only magnified the supply shortage of such high quality collateral.

These entities, the backbone of the European financial system, have created distortions in the European money markets and historic anomalies fueled by non-profit maximising behavior.

In response, investors looking to maximise profit can no longer treat cash allocations as an afterthought. Rather, cash is now an investment equally worthy of optimisation, achieved via tiering liquidity (excess of immediate cash needs) further along the liquidity spectrum where distortions are not nearly as severe.

This is how PIMCO optimises cash holdings in our investment vehicles. We make upward or downward adjustments of our cash targets based on scenario analysis and stress test these to ensure sufficient liquidity against all market conditions. We then sweep excess liquidity into second- and third-tier cash instruments just beyond the point where cash markets are most distorted and into an area of the money markets less subject to financial repression.

Not only does this minimise the effects of financial repression but it stands to gain from ongoing ECB liquidity support. It is safe to assume that politicians are unlikely to shepherd the euro area towards a durable monetary, fiscal and political union anytime soon. This will then leave the ECB as the sole barrier between order and disorder during Europe’s deleveraging and rebalancing process. Monetary policy, however, is a blunt instrument. The ECB can only raise the penalty until the marginal investor is forced out along the safety and liquidity spectrum into the next incremental tier. This was most apparent in July 2012 (as illustrated in Figures 1 & 2) when the ECB lowered its deposit rate to 0% and capital cascaded down the safety and liquidity spectrum as follows:

3-month German treasury bills into 6-month treasury bills,

German treasury bills into French treasury bills,

government bonds into government-related bonds, and

government-related bonds into corporate bonds, and so on down the spectrum.

Such a “liquidity cascade” has been ongoing for the past few years and we expect this to continue for quite some time. As the ECB is forced to look for increasingly creative ways to transmit liquidity through a fragile and fragmented financial system, we expect that investors who dynamically stay one step ahead by avoiding the zone of maximum financial repression will be in a far better position.