Debelle embraces the unknown

It was obvious in the recent SoMP that the 2012 RBA is more circumspect than the 2011 version. And we have more evidence of a useful acceptance of doubt (or should I say “risk”) in today’s speech by the Assistant Governor Guy Debelle on the local effects of recent shifts in European capital markets. Debelle offers a useful assessment of the paralysed European banking system before turning to the effects Downunder. He then describes the rise in the bank’s funding costs via both spreads and higher swap costs. His description is fair enough but does include the following chart about which Debelle says:

While the cost of the first wave of covered bond issuance by the Australian banks has been high, it is broadly comparable to that of recent covered issuance by banks in other jurisdictions where there has been a similar step up in cost:

That seems a little misleading to me. Canadian banks have seen a rise in costs but the absolute levels are much lower. And then there’s the small but rather important point that the other countries are all in Europe.

Letting that pass, Debelle then looks at the flipside phenomenon, the rally in Australian government bonds driven by offshore money and consequent narrowing of spreads to fifty year lows.

You can read all of this yourself if you want the technicals. But what I found most interesting was Debelle’s conclusion:

So these are some of the channels of influence of the situation in Europe on Australian financial markets. So far this year, that has been a more positive story than it was at the end of the last year. The major instigator of this change, in my opinion, was the ECB’s 3-year liquidity operation. Whether this happier state of affairs persists is difficult to tell. There have been outbreaks of optimism over the past couple of years which were dashed.

I think the only thing which is certain, is that uncertainty is likely to persist for some time to come. In that regard I’d like to finish with a variation on the famous Rumfeldian take on uncertainty, recently articulated by David Murphy on his Deus Ex Macchiato blog: There are known unknowns and unknown unknowns, which complicate the pricing of risk, but over the past decade, there has also been a fair few examples of ‘too-lazy-to-be-knowns’. European sovereign debt before 2007 might conceivably fall into that category. While mispricing due to Knightian uncertainty is excusable, mispricing due to laziness is not. As I said last November, you’ve got to Know Your Product, otherwise, it can quickly turn into a case of No, Your Product.

One could just as easily cite Australian private debt and the current rally in government bonds – which is increasingly being viewed through a bubble lens oversees – as a too-lazy-to-be-known risk. From City Wire recently:

Consensus is frequently a dangerous thing in the world of investment and few recent areas have united investors as much as the implied benefits of holding plenty of Australian sovereign debt.

Some of the sector’s biggest names, such as the Citywire-A rated Fidelity Strategic Bond manager Ian Spreadbury, Jupiter Strategic Bond managerAriel Bezalel and Pimco have done handsomely by their investors in the past 12 months by maintaining large exposure.

Its combination of solid returns and apparent gilt-edged AAA defensiveness has not just appealed to fixed income stars: leading multi-asset managers such as Hugh Hendry of Eclectica and Iain Stewart of Newton Real Return have also filled their boots.

…An emerging chorus of naysayers, though, is warning that not only is Australian paper fundamentally weaker than its cheerleaders believe, but that the continent’s risk assets are overpriced to several standard deviations outside their historical norm: essentially, close to bubble territory.

M&G is the biggest of the major UK bond managers to strongly make the negative case. The company’s investment director Anthony Doyle points out the wall of money heading south has resulted in a record 80.4% of outstanding debt being held in foreign hands.

Careful what you wish for, Assistant Governor.