Showing posts with label store of value. Show all posts
Showing posts with label store of value. Show all posts

Tuesday, April 23, 2013

Beyond bond bubbles: Liquidity-adjusted bond valuation

Real t-bill and bond yields have been falling for decades and are incredibly low right now, even negative (see chart below). With an eye to historical real returns of 2%, folks like Martin Feldstein think that bonds are currently mis-priced and warn that a bond bubble is ready to burst.

Investors need to be careful about comparing real interest rates over different time periods. Today's bond is a sleek electronic entry that trades at lightning speed. Your grandfather's bond was a clunky piece of paper transferred by foot. It's very possible that a modern bond doesn't need to provide investors with the same 2% real coupon that it provided in times past because it provides a compensating return in the form of a higher liquidity yield.

[By now, faithful readers of this blog will know that I'm just repeating the same argument I made about equity yields.]

Here's a way to think about a bond's liquidity yield. Bonds are not merely impassive stores-of-value, they also yield a stream of useful services that investors can "consume" over time. In finance, these consumption streams are referred to as an asset's convenience yield. (HT Mike Sproul)

For instance, the convenience yield of a house is made up of the shelter that the house owner can expect to consume. A Porsche's convenience yield amounts to travel services. What about a bond's convenience yield? I'd argue that a large part of a bond's convenience yield is comprised of the liquidity services that investors can expect to consume over the life time of the bond. Let's call this a monetary convenience yield.

In an uncertain world, it pays to hold a portfolio of goods and financial assets that can be reliably mobilized come some unforeseen event. A fire alarm, a cache of canned beans, and a bible all come to mind. Liquid financial instruments, say cash or marketable bonds, are also useful since they can be sold off quickly in order to procure more appropriate items. This ability to easily liquidate bonds and cash is a meaure of their monetary convenience.

Even if the unforeseen event for which someone has stockpiled canned beans or bonds never materializes, their holder nevertheless will enjoy the convenience of knowing that in all scenarios they will be secure. The stream of uncertainty-shielding services provided by both a bond and a can of beans are "consumed" by their holder as they pass through time.

This monetary convenience yield is an important part of pricing bonds. Prior to purchasing a bond, investors will appraise not only the real return the bond provides (the nominal interest rate minus expected inflation) but will also tally up the stream of future consumption claims that they expect the bond to provide, discounting these claims into the present. The more liquid a bond, the greater the stream of consumption claims it will yield, and the higher its monetary convenience yield. The greater the stream of consumption claims, the smaller the real-return the bond need provide to tempt an investor into buying. (HT once again to Mike Sproul on consumption claims)

Which brings us back to the initial hypothesis. If the liquidity of government debt has increased since the early 1980s, then we need to consider the possibility that bonds are providing an ever larger proportion of their return in the form of a monetary convenience yield, or streams of future consumption claims. If so, the observed fall in real rates isn't a bond bubble. Rather, negative real rates on treasuries may reflect technological advances in market microstructure and improvements in bond market governance that together facilitate the increased moneyness of bonds. Put differently, investors aren't buying bonds at negative real interest rates because they're stupid. It's possible that investors are willing to accept negative real interest rates because they are being sufficiently compensated by improving monetary convenience yields on bonds.

I find this story interesting because we usually think that in the long term, real interest rates are determined primarily by nonmonetary factors, including the expected return to capital investments and the time preferences of consumers. The story here is a bit different. In the long term, real interest rates on bonds are determined (in part) by monetary forces. The higher a bond's monetary convenience yield, the lower its real interest rate. Oddly, bonds may be bought not by consumers who are willing to delay gratification, but by impatient consumers who want to immediately begin consuming a bond's convenience yield (ie. using up future consumption claims). The line between consumption and saving is blurred and fuzzy.

In my previous post on equities, I gave some numbers as evidence for the increased liquidity of stocks. Bonds aren't my shtick, so I won't try to prove my hypothesis. All I'll say is that the rise of repo markets would have contributed dramatically to bond market liquidity since repo increases the ability to use immobilized bonds as transactions media. Give Scott Skyrm a read, for instance.

There is a case of missing markets here. If we could properly prices a bond's monetary convenience yield, then we could get a better understanding of the various components driving bond market prices over time.

Imagine a market that allowed bond investors to auction off their bond's monetary convenience yield while keeping the real interest component. Thus a bond investor could buy a bond in the market, sell (or lease) the entire chain of consumption claims related to a bond's liquidity, invest the proceeds, and be left holding an illiquid bond whose sole function is to pay real interest. By stripping out and pricing whatever portion of a bond's value is related to its monetary nature, investors might now precisely appraise the real price of a bond relative to its real interest payments. Excessively high real prices relative to real interest would indicate overvaluation and a bubble, the opposite would indicate undervaluation and a buying opportunity.

But until we have these sorts of markets, we simply can't say if bond prices are in a bubble. Sure, real rates could be unjustly low because bonds prices have been irrationally bid up. But they could also be justly low if bonds are simply providing alternative returns in the form of monetary convenience. Without a moneyness market, or a convenience yield market, we simply lack the requisite information to be sure.

Friday, January 25, 2013

Bitcoin is an amoeba, central banks are blowfish

When my mother asked me yesterday if I was still buying the bit points, I took it as a sign that it was time for another bitcoin post.

One of the most popular reasons for owning bit points—sorry, bitcoin—is that the supply of coin is fixed whereas the supply of central bank money can be increased ad infinitum. Like an amoeba colony nearing population saturation, the bitcoin supply is growing at a decreasing rate as it approaches the magic 21 million number, the ceiling specified by designer Satoshi Nakamoto. Bitcoin advocates believe that this controlled supply effectively grounds the price of bitcoin while leaving the value of central bank money to flap in the wind.

But this ignores the mirror image of this argument. Yes, a central bank can rapidly increase the supply of notes and reserves. But blowfish-like, a central bank can just as quickly suck this supply back in—indeed, a central bank can go to the extreme of extinguishing every last liability it has ever issued. Bitcoin, on the other hand, can never be destroyed by its issuer—it has no issuer. The implications of this for the values of bitcoin and central bank money are important. I'm going to use someone else's model to show why.

Mencius Moldbug has a recent post called How Bitcoin Dies. If I'm not mistaken, he's making reference to Adam Ferguson's book When Money Dies (pdf), an account of the Weimar inflation. In any case, I agree with much of what Moldbug (his real name?) writes. Bitcoin's value is highly tenuous, and it wouldn't take much of a shock to send it to 0. I'm going to borrow Moldbug's model of a bitcoin economy and use it to explain a central-bank economy. This will help us to see the core difference between the stabilities of these two exchange media.

Moldbug starts out by imagining that there are 2 types of bitcoin users. First, there are "speculators" who hold bitcoin over time, hoping to earn a return. The second type of user, the "exchangers," only hold bitcoin for brief moments to engage in daily transactions, selling all coins to speculators at the market close. Only speculators, therefore, hold bitcoin overnight, presumably selling it back to exchangers the next morning.

If we abstract a bit from this, what Moldbug is really talking about is the two famous "functions" of money, that of serving as a store-of-value and a medium-of-exchange.

Now if speculators all flee the market at once, then desperate exchangers have no one to sell to come evening time. Bitcoin's overnight price falls to 0. Since bitcoin no longer has any purchasing power, the next day exchangers will find their bitcoin useless as an exchange media. Bitcoin becomes just bits. What might lead to this result? Moldbug hypothesizes that a government closure of the various bitcoin exchanges would spook speculators, causing them to all exit and drive the price down to 0.

I want to show why the same thing can't happen to central bank money. During the day, banks in an economy need large quantities of central bank balances for clearing and payments purposes. A central bank provides these balances to banks in return for collateral. At the end of the day, what do the banks do with these unwanted balances? Well, let's say that they sell them onwards to speculators to hold overnight. Speculators accept the trade because they think they can make a return. The next day the banks repurchase these balances in order to use them for their daily payments. This is very much like the stable bitcoin economy described above.

What happens when the speculators suddenly exit the market? Banks now have no one to sell their clearing balances to at the end of the day. As in our bitcoin case, won't the value of balances fall to 0? No. The issuing central bank will offer to buy all of the balances back.* With what? With the collateral that was originally used to buy them. Unwanted clearing balances will therefore be slurped right back up by the central bank. So long as the central bank holds adequate collateral, it will be able to suck every single clearing liability it has issued, contracting its balance sheet to 0.

This, in short, is why the bitcoin price is highly unstable whereas the price of central bank liabilities is highly stable. All that underpins the value of bitcoin is the presence of a few speculators in the market—whatever random event causes these speculators to depart will be the end of bitcoin. In the case of central bank money, the original issuer is committed to repurchase whatever is unwanted, even if speculators scramble to leave.

In real life, speculators typically don't hold central bank clearing balances overnight. Central banks usually repurchase all clearing balances back at the end of the day, returning the collateral to the banks so they can use it for the next market day. Central banks are like blowfish.** They blow themselves huge during the day in order to accommodate the needs of banks for clearing balances, then suck themselves tight at night when they aren't needed. Bitcoin is like a slowly growing amoeba. It can't contract itself when it needs to.

PS: What about gold? If speculators all leave the gold market, demand will still be anchored overnight by those who desire gold for ornamentation, dental, and manufacturing purposes. Thus, when the market reopens next day, exchangers will find their gold still has a positive value, although probably far less than the night before.

Disclaimer: I am long bitcoin. Why? I'm curious about bitcoin and the best way to learn is by doing. Secondly, I'm speculating that before it hits $0, it could hit $50. There are a lot of people out there who don't yet realize that they'll be buying over the next months. Keynes's beauty contest and all.

*Central banks are required to ensure that the value of clearing balances stay moored to basket of consumer goods, or a CPI target. They typically do this by setting the overnight bank rate. If no one wants to contract to hold reserves overnight, the interest rate will collapse. The central bank will have to conduct open market sales - basically repurchasing clearing balances with collateral - in order to reduce the supply of clearing balances until the overnight interest rate has returned to its prior level. In any case, that's why a central bank needs to "suck" the money supply back in.

** I'm borrowing the imagery from Alex Tabarrok's 2008 post, although he uses a bullfrog.

Saturday, August 11, 2012

Decoding Glasner on reflux, inside and outside money, and reflux

I had a few comments on a recent David Glasner post. Basically, I was trying to understand the way he reconciles various aspects of the monetary system, namely, inside and outside money, the arbitrage mechanism that links these two assets, and the price level.

David responded to me-
Inside money cannot trade at a discount relative to outside money because inside money is issued on the condition of its being convertible into outside money, so they always are exchangeable at par. If too much inside money is created (i.e., more than the public desires to hold given the relative attractiveness of holding inside money relative to alternatives including outside money) it refluxes back to the issuing banks. 
David says that excess inside money (say convertible bank notes) will reflux back to an issuing bank. But the only way this can happen, as far as I can see, is if somehow that bank's inside money trades at a slight discount to outside money (gold). David in his first sentence above says that inside money cannot trade at a discount. But how else can a reflux process emerge if one can't fall to a discount with the other?

So a temporary price discrepancy is necessary to enforce reflux and keep the quantity of outside money equal to demand. But what happens if inside money - say convertible bank notes - and outside money - fiat notes - are considered perfect substitutes by their users? After all, they can both be used to pay taxes, buy stuff, and "store value" over time.

David, for instance, points out that-
Because inside money and outside money are fairly close substitutes, the value of outside money is determined simultaneously in the markets for inside and outside money, just as the value of butter is determined simultaneously in the markets for butter and margarine. 
The problem here is... if inside and outside money are perfect substitutes, then given an excess issuance of convertible bank notes by a bank, why would the price discrepancy between inside and outside money that is necessary to drive reflux ever arise to begin with?

Rather, in an effort on the part of individuals and firms to rid themselves of their extra balances (either inside or outside money, they are indifferent) they will spend away both willy nilly. In spending away outside money, they will cause the price level to increase (the value of outside money to fall). David points this out:
If, however, the quantity of inside money increases because the public wants to hold the additional balances and are induced to hold inside money instead of outside money, then the value of outside money will tend to fall (causing the value of inside money to fall as well) unless the value of outside money is maintained by some form of convertibility or a price rule.
But doesn't this mean that issuing banks might cause infinite inflation by issuing inside money no one wants, thereby confirming Milton Friedman's wariness of free banking?

It would if currency users did in fact treat inside and outside money as equal.

But we live in a competitive banking system in which multiple banks issue inside money and receive other bank's inside money via cheque deposits and money transfers. Furthermore, currency users do not have uniform views about the quality of various money-like assets. Unlike individuals, competitive banks are picky and prefer to hold outside money rather than another bank's inside money. Put differently, banks are very sensitive to the store-of-value nature of inside money... they tend to view it as a financial asset characterized by risk and return, and not as a medium of exchange, and therefore view inside money as inferior to outside money due to its riskiness. Furthermore, holding another bank's inside money because they value its liquidity would be silly, since the bank already has its own liquidity factory. Thus the moment they receive another bank's inside money, a bank returns it to that issuer as fast as they can, settling with outside money. A reflux mechanism is thereby enforced by interbank settlement.

In sum, excess issuance of inside money by banks will not cause the price level to rise - it will cause the inside money to return to issuer.

Wednesday, April 11, 2012

The evolving nature of central bank liabilities - from gold convertibility to bond convertibility

In his tradition of imagining alternative monetary systems, Nick Rowe asks if there is any fundamental theoretical difference between how monetary policy worked under the gold standard and how monetary policy works today for a modern inflation-targeting central bank. Nick uses a progression-style of reasoning in which he incrementally adds/subtracts elements to the original gold standard system to arrive at a modern inflation-targeting regime, or what he calls the CPI standard.

His point, and I agree with it, is that the two standards are not fundamentally different - rather, the same core mechanism underlies each system, with only a few modifications here and there. This runs counter to most people's intuition that the gold standard is a totally different beast from our modern system.

Although I criticized some of his points in the comments section, these disagreements stemmed from the fact that what interests me is not so much the evolution of monetary policy, but the evolution of the nature of a central bank liabilities. But this is really just the flip side of Nick's argument, since monetary policy is carried out via central bank liabilities, and updates to central bank monetary policy occur by tinkering with the structure of the liabilities issued by central banks. In essence, mine is the store of value approach to money, in which money is analyzed as a security. That's also why Nick didn't quite understand what I was saying, even though our final meeting place was the same.

Invoking Nick's method, the evolution of central bank liabilities goes something like this. Under a gold standard, the convertibility feature provided by central bank money - when it was exercised - was to be settled in gold by the central bank. The convertibility rate was some fixed quantity of gold. Everyone could directly go to the central bank and enjoy money's gold convertibility feature. Convertibility meant that in the secondary market, the public market for already-issued money, central bank money could purchase the same amount of gold for which it could be converted at the central bank.

Nowadays, the convertibility feature is still there, but it's been updated. Upon exercising central bank money's convertibility feature, the redemption medium is bonds, not gold. You can redeem notes for bonds via open market operations. The redemption rate is no longer fixed. Rather, it is adjusted to ensure that, in the secondary market for central bank money, that money's value relative to goods-in-general falls by 1-3% a year. Only a select few institutions can enjoy this redemption feature, but their participation is enough to ensure that central bank money falls at a 1-3% rate. The exclusivity of the modern redemption option is not entirely unique to our modern system, since even in the waning days of the gold standard central banks began to limit gold conversion to a few select institutions, usually other central banks.

Saturday, March 17, 2012

Money as a liability

Nick Rowe has posts here and here that explain why money is not a liability. This is related to his point that  money is not a store-of-value.

I have several comments on each thread.

In short, I disagree with him. If you do the security analysis, central bank issued notes and deposits are unsecured senior perpetual liabilities with a limited floating conversion feature attached to them. Most people don't perceive them as such because in the normal course of life they only experience these liabilities as pure means-of-exchange. Only those individual's with a banker or investor's mentality treat central bank issued notes and deposits. Either way works - what is interesting is how these two mentalities weave together to create an integrated store-of-value and medium-of-exchange approach to understanding money.

Nick also tries to re-conceptualize central bank issued money as put options. This money can be "putted" for CPI. I like this idea. Because I see central bank issued notes and deposits as liabilities, I prefer the analogy to convertible bonds. Convertibility is really just an option feature added on to a liability like a bond, deposit, or note. How does this convertibility work?  The Bank of Canada, for instance, will conduct sale and repurchase operations (SRAs) - selling bonds for cash - should the overnight fall below its target. Banks have the option in this case to convert their deposits into the underlying. This is a floating rate because over time the Bank will change the note-to-bond conversion price.

Friday, February 24, 2012

Money as a store of wealth

Nick Rowe has a post that decries the idea of money as a store of value. He asks:

How much would I have been willing to pay for my house if the seller had imposed a condition that I could use it as long as I wanted but could never sell it again, or rent it out to someone else? Less than I paid for it, but still a positive amount. It yields a flow of services even if I can't sell that right.
How much would I have been willing to pay for the S20 note in my pocket if the seller had imposed a condition that I could use it as long as I wanted but could never sell it again, or rent it out to someone else? Nothing.
My response:

That's the same question a value investor asks before buying a stock.
The answer usually comes to something like, if I can pay $50 for a stock that is worth $100, then even though I can't resell it in the market I'll still buy it. Because the stock can't be resold, that $50 in value has to be realized through dividends. But if the stock is prohibited from ever paying a dividend, this value can still be realized by the firm repurchasing and canceling shares at higher prices.
I'd say roughly the same applies to central bank notes. If I can buy a note for far less than it's worth and hold it till the central bank begins to mop up the supply notes and cancel them, then I'll go ahead with the transaction. Since central banks are less opportunistic than firms and therefore less likely to announce buy backs, I'd only buy at a huge discount. A huge discount to what? The value of its bonds, bills, gold, buildings, and forex. In sum, the price I'd be willing to pay for non-transferable bank notes is not "nothing" but some number >0.
The store of value vs. medium of exchange argument is one of the oldest arguments in monetary economics. I don't think the answer is is binary, as in either/or. Rather, there is some sort of way to properly configure the two concepts into a logical whole. The answer would be a lot easier if the twin concepts medium of exchange and store of value were to be defined first in a microeconomic sense. In a sense, this sort of integration of monetary economics with microeconomics goes against the grain, since this would be making microeconomics more like monetary economics, and not vice versa, which has been the general approach taken by the whole microfoundations of money enterprise.