Posts Tagged ‘Central Banks’
Friday, April 5th, 2013
While the crisis in Europe is first in Goerge Soros’ mind because it is the “hottest” risk flare currently, his biggest concern in what he calls the “disarray in global cooperation,” or what we would call ‘dueling central banks’. “The almost universal adaptation of quantitative easing,” worries him and he notes that “Europe is the last bastion of orthodoxy,” in this regard as the aging hedgie warns, “Europe is entering a situation that Japan is desperate to escape from,” as “Japan has just abandoned – after 25 years of stagnation – a process that Germany is just in the process of imposing on Europe.” But perhaps his clearest concern in this brief clip is that no matter what we are told, the central banks’ actions are ‘creating’ increasing financial instability because, “let’s face it, quantitative easing is really and directly competitive devaluation.” But it is his comments on the actions of the BoJ that should be most concerning as he stated to CNBC, “What Japan is doing is actually quite dangerous because they are doing it after 25 years of just simply accumulating deficits and not getting the economy going,” as he fears should they actually get something [inflation] started, “they may not be able to stop it.” If the yen starts to fall, which it has done, and people in Japan realize that it is liable to continue, and want to put their money abroad, then “the fall may become like an avalanche.”
Tuesday, March 12th, 2013
From Dylan Grice of Edelweiss Holdings
Would the real Peter and Paul please stand up?
In a previous life as a London-based ‘global strategist’ (I was never sure what that was) I was known as someone who was worried by QE and more generally, about the willingness of our central bankers to play games with something which I didn’t think they fully understand: money. This may be a strange, even presumptuous thing to say. Surely of all people, one thing central bankers understand is money?
They certainly should understand money. They print it, lend it, borrow it, conjure it. They control the price of it… But so what? What should be true is not necessarily what is true, and in the topsy-turvy world of finance and economics, it rarely is. So file the following under “strange but true”: our best and brightest economists have very little understanding of economics. Take the current malaise as prima facie evidence.
Let me illustrate. Of the many elemental flaws in macroeconomic practice is the true observation that the economic variables in which we might be most interested happen to be those which lend themselves least to measurement. Thus, the statistics which we take for granted and band around freely with each other measuring such ostensibly simple concepts as inflation, wealth, capital and debt, in fact involve all sorts of hidden assumptions, short-cuts and qualifications. So many, indeed, as to render reliance on them without respect for their limitations a very dangerous thing to do. As an example, consider the damage caused by banks to themselves and others by mistaking price volatility (measurable) with risk (unmeasurable). Yet faith in false precision seems to us to be one of the many imperfections our species is cursed with.
One such ‘unmeasurable’ increasingly occupying us here at Edelweiss is that upon which all economic activity is based: trust. Trust between individuals, between strangers, between organisations… trust in what people read, and even people’s trust in themselves. Let’s spend a few moments elaborating on this.
First, we must understand the profound importance of exchange. To do this, simply look around you. You might see a computer monitor, a coffee mug, a telephone, a radio, an iPad, a magazine, whatever it is. Now ask yourself how much of that stuff you’d be able to make for yourself. The answer is almost certainly none. So where did it all come from? Strangers, basically. You don’t know them and they don’t know you. In fact virtually none of us know each other. Nevertheless, strangers somehow pooled their skills, their experience and their expertise so as to conceive, design, manufacture and distribute whatever you are looking at right now so that it could be right there right now. And what makes it possible for you to have it? Exchange. To be able to consume the skills of these strangers, you must sell yours. Everyone enters into the same bargain on some level and in fact, the whole economy is nothing more than an anonymous labor exchange. Beholding the rich tapestry this exchange weaves and its bounty of accumulated capital, prosperity and civilization is a marvelous thing.
But we must also understand that exchange is only possible to the extent that people trust each other: when eating in a restaurant we trust the chef not to put things in our food; when hiring a builder we trust him to build a wall which won’t fall down; when we book a flight we entrust our lives and the lives of our families to complete strangers. Trust is social bonding and societies without it are stalked by social unrest, upheaval or even war. Distrust is a brake on prosperity, because distrust is a brake on exchange.
But now let’s get back to thinking about money, and let’s note also that distrust isn’t the only possible brake on exchange. Money is required for exchange too. Without money we’d be restricted to barter one way or another. So money and trust are intimately connected. Indeed, the English word credit derives from the Latin word credere, which means to trust. Since money facilitates exchange, it facilitates trust and cooperation. So when central banks play the games with money of which they are so fond, we wonder if they realize that they are also playing games with social bonding. Do they realize that by devaluing money they are devaluing society?
To see the how, first understand how monetary policy works. Think about what happens in the very simple example of a central bank’s expanding the monetary base by printing money to buy government bonds.
That by this transaction the government has raised revenue for the government is obvious. The government now has a greater command over the nation’s resources. But it is equally obvious that no one can raise revenue without someone else bearing the cost. To deny it would imply revenues could be raised for free, which would imply that wealth could be created by printing more money. True, some economists, it seems, would have the world believe there to be some validity to such thinking. But for those of us more concerned with correct logical practice, it begs a serious question. Who pays? We know that this monetary policy has redistributed money into the government’s coffers. But from whom has the redistribution been?
The simple answer is that we don’t and can’t know, at least not on an amount per person basis. This is unfortunate and unsatisfactory, but it also happens to be true. Had the extra money come from taxation, everyone would at least know where the burden had fallen and who had decreed it to fall there. True, the upper-rate tax payers might not like having a portion of their wealth redirected towards poorer members of society and they might not agree with it. Some might even feel robbed. But at least they know who the robber is.
When the government raises revenue by selling bonds to the central bank, which has financed its purchases with printed money, no one knows who ultimately pays. In the abstract, we know that current holders of money pay since their cash holdings have been diluted. But the effects are more subtle. To see just how subtle, consider Cantillon’s 18th century analysis of the effects of a sudden increase in gold production:
If the increase of actual money comes from mines of gold or silver… the owner of these mines, the adventurers, the smelters, refiners, and all the other workers will increase their expenditures in proportion to their gains. … All this increase of expenditures in meat, wine, wool, etc. diminishes of necessity the share of the other inhabitants of the state who do not participate at first in the wealth of the mines in question. The altercations of the market, or the demand for meat, wine, wool, etc. being more intense than usual, will not fail to raise their prices. … Those then who will suffer from this dearness… will be first of all the landowners, during the term of their leases, then their domestic servants and all the workmen or fixed wage-earners … All these must diminish their expenditure in proportion to the new consumption.
In Cantillon’s example, the gold mine owners, mine employees, manufacturers of the stuff miners buy and the merchants who trade in it all benefit handsomely. They are closest to the new money and they get to see their real purchasing powers rise.
But as they go out and spend, they bid up the prices of the stuff they purchase to a level which is higher than it would otherwise have been, making that stuff more expensive. For anyone not connected to the mining business (and especially those on fixed incomes: “the landowners, during the term of their leases”), real incomes haven’t risen to keep up with the higher prices. So the increase in the gold supply redistributes money towards those closest to the new money, and away from those furthest away.
Another way to think about this might be to think about Milton Friedman’s idea of dropping new money from a helicopter. He used this example to demonstrate how easy it would theoretically be for a government to create inflation. What he didn’t say was that such a drop would redistribute income in the same way more gold from Cantillon’s mines did, towards those standing underneath the helicopter and away from everyone else.
So now we know we have a slightly better understanding of who pays: whoever is furthest away from the newly created money. And we have a better understanding of how they pay: through a reduction in their own spending power. The problem is that while they will be acutely aware of the reduction in their own spending power, they will be less aware of why their spending power has declined. So if they find groceries becoming more expensive they blame the retailers for raising prices; if they find petrol unaffordable, they blame the oil companies; if they find rents too expensive they blame landlords, and so on. So now we see the mechanism by which debasing money debases trust. The unaware victims of this accidental redistribution don’t know who the enemy is, so they create an enemy.
Keynes was well aware of this insidious dynamic and articulated it beautifully in a 1919 essay:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. … Those to whom the system brings windfalls… become “profiteers” who are the object of the hatred…. the process of wealth-getting degenerates into a gamble and a lottery.
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
Deliberately impoverishing one group in society is a bad thing to do. But impoverishing a group in such an opaque, clandestine and underhanded way is worse. It is not only unjust but dangerous and potentially destructive. A clear and transparent fiscal policy which openly redistributes from the rich to the poor can at least be argued on some level to be consistent with ‘social justice.’
Governments can at least claim to be playing Robin Hood. There is no such defense for a monetary driven redistribution towards recipients of the new money and away from everyone else because if the well-off are closest to the money, well, it will have the perverse effect of benefitting them at the expense of the poor.
Take the past few decades. Prior to the 2008 crash, central banks set interest rates according to what their crystal ball told them the future would be like. They were supposed to raise them when they thought the economy was growing too fast and cut them when they thought it was growing too slow.
They were supposed to be clever enough to banish the boom-bust cycle, and this was a nice idea. The problem was that it didn’t work. One reason was because central bankers weren’t as clever as they thought. Another was because they had a bias to lower rates during the bad times but not raise them adequately during the good times. On average therefore, credit tended to be too cheap and so the demand for debt was artificially high. Since that new debt was used to buy assets, the prices of assets rose in a series of asset bubbles around the world. And this unprecedented, secular and largely global credit inflation created an illusion of prosperity which was fun for most people while it lasted.
But beneath the surface, the redistributive mechanism upon which monetary policy relies was at work. Like Cantillon’s gold miners, those closest to the new credit (financial institutions and anyone working in finance industry) were the prime beneficiaries. In 2012 the top 50 names on the Forbes list of richest Americans included the fortunes of eleven investors, financiers or hedge fund managers. In 1982 the list had none.
Tuesday, August 21st, 2012
by Peter Tchir, TF Market Advisors
Is it a New EU?
Of the major players coming into June 2011, almost none are left. Attrition and elections have taken care of most of the major players. In fact, you could make a case that Merkel is really the only major player still in the same position.
I think this is important particularly for the ECB. Draghi has now had time to establish himself in his role, and get comfortable with the people at the ECB, the various central banks, and the politicians. He entered the role with a bang – a rate cut, more symbolic than anything, at this first meeting and then began the LTRO’s.
Since then, his efforts to get Spanish and Italian bond yields down have been thwarted by the markets and a deteriorating economic situation. He wants yields low and looks like he is prepared to stretch his powers to fulfill the mandate of “transmission of economic policies”.
How far is he willing to stretch? How much can he do based on that “transmission” mandate? That is the question and we need to get answers, but more and more, it looks like he is prepared to be aggressive. It may not be a completely new EU, but it has changed a lot in a year, and the ECB does look to be a new ECB.
Nein to Nein!
Germany looks more and more isolated in their refusal to play nice and even there it is becoming clear that not everyone is against the idea of money printing and aggressive actions. On top of that, Germany is “only” 25% of the EU economy. It is the single largest economy, but France, Spain, and Italy combined are much larger. Germany plays an important role, but it cannot make decisions unilaterally. Germany could in theory walk away from the EU, but the German “elites” more than anyone seem committed to trying to hold the Eurozone together. They are stubborn and have a deep seated fear of somehow once again being the ones that cause Europe to splinter.
Their voice, while important, is diminishing, and for many of them, they are looking for ways to save face as they backtrack from 2 years of causing problems. Assuming Nein means Nein is likely to be wrong in this case.
The Immediate Problems that the ECB CAN Address
Currency exit and forced redenomination has to be taken off the front pages of the newspapers. I have not seen a single paper that walks through how redenomination would work in practice. There are 100′s that talk about an event, and then a future where the currency adjustment “restores equilibrium” or some such nonsense, but they gloss over how you get to that stage. The reality is that you don’t. Not easily and possibly never. The uncertainty created will cause business to die. To die quickly and violently as no one will want any part of cross border commerce while currencies and laws are in a state of flux. This isn’t just for the weak countries. Germany will see problems as well as they face political backlash from the rest of Europe and from a strong currency. A lack of energy resources makes this reversion to old currencies and devaluation even more problematic.
While currency redenomination risk remains on the front burner, business will be slow to engage in big new projects and the risk of bank runs remains high.
Any policy that provides funds direct from the ECB to weak countries, such as the plan floated this weekend, would immediately reduce the risk of redenomination. The ECB would become the center of a tangled web, so intricate and complete it would be hard to visualize how to untangle. So the ECB CAN take redenomination risk of the table.
Budget problems in Spain and Italy need to be fixed. The ECB cannot do much to fix the overall budgets of Spain and Italy, but it CAN help. Both countries have seen cost of new money increase dramatically and are paying rates far above the ECB’s target rate for banks. That adds to the annual budget deficit as that higher interest rate cost affects current year payments. It takes time for these higher rates to influence the overall cost, but we are well over a year into the crisis and if Spain and Italy had been able to refinance all that debt 2% cheaper, it would be having an impact. The circular nature of this is vicious as well. The more Spain and Italy have to pay to refinance debt, the bigger their current deficits, and the lower their credit quality, causing rates to go higher. This is the “transmission” element the ECB is focusing on. The ECB wants (in fact needs) Spain and Italy to have low rates, and needs to find a way to get them. It will reduce current deficits and future projected deficits.
An ECB plan to support countries would take away roll risk, so not only would the countries that need money the most, be able to get it at rates in line with overall policy, but they could spend less time on how to raise money in the bond market, and more time on how to fix their economies and budgets. So the ECB program can help the budgets, it will take time, but it is real, and will also allow countries to focus on things other than bond auctions.
Constraints in both Will and Way
Throughout the crisis there have been concerns about whether the EU had the will or the way to fix the problem. Much of the conversation revolves around the “way” they can fix it. Do they have the tools? Do the treaties allow them to do what is necessary? The reality is that the “way” argument was to hide the fact that Europe didn’t have the “will” to fix things.
Now it looks like Europe might have the “will” to fix things. That Europe is finally willing to engage in a wholesale effort to support the periphery. If Europe is willing to do that, they can find ways. EFSF, while lacking in many respects, isn’t insignificant. The ECB, while constrained by its mandate, seems to have some flexibility, especially if they decide they want to push the envelope. A lack of will has been a bigger impediment to success than a lack of way, so this psychological change is important.
It is also useful to point out that so far the term “bailout” has been applied very loosely. Germany, for example has delivered very little cash to any of the countries. It has guaranteed debt that was used for the countries or supported IMF and ECB efforts to funnel money to the countries, but very little German cash has found its way to the countries as part of “bailouts”. On top of that, all nations that have received “bailout” money have continued to pay that money back. There has not been a single default on any money lent as part of the “bailouts” so Germany is actually profiting from this so far (ignoring the cheap rates they are also benefitting from).
The image of German’s dumping money on these nations just isn’t correct. So far, Germany has acted more like Rumpelstiltskin and demanded a high price for their loan, rather than as some sort of charity act that the term “bailout” implies.
Even though I believe the will is now much stronger, and there is a way, they will be careful not to be “reckless” and will embark on programs that are easier to sell internally.
What Trades Should do Well?
I like Spanish and Italian bonds, but only with maturities of less than 5 years. I think that the ECB will focus on the primary market and the short end of the curve. I think they will make money available in the 2 year range. It is long enough to offer real support, but short enough that the political opposition will be lower. I don’t exactly agree with the theory that 2 year risk is so much less than 5 year or 10 year in the case of Spain or Italy, but politicians tend to. Politicians often have a simplistic view and will take comfort in that the next 2 years are “foreseeable” and 5 years and out isn’t. It’s not true, since they can’t seem to anticipate anything 3 months out, but that is what they believe. They can be convinced to lend short term rather than long term.
I would go out as much as 5 years because any such program will be in place for awhile so even if loans are only for 2 years, there will be a window during which they are available. That will support the 5 year point. The 5 year point is also aided by bad CDS shorts and is in the comfort zone of banks.
The threat of subordination will keep the curve extremely steep. Even if the program were to be “senior unsecured” and pari passu with other debt, there would be doubt in the minds of investors. There should be concern that if things don’t work out, that non public holders would once again (like Greece) bear the brunt of the initial restructuring. So the curve should be steep as it prices in risk that any program goes away AND that bonds not part of the program would be subordinated. The ECB needs to ensure that countries have access to cheap money, but they don’t need to support the secondary market, and they don’t need to lend to countries for long term (it would be good if they did, but it isn’t necessary for the ECB’s objectives to get accomplished).
Spanish and Italian stocks, Bank stocks, and bank CDS. The best analogy I can think of is that this is like an earthquake and the “damage” will be greatest around the epicenter. So if the ECB launches on a new program, the epicenter of the earthquakes will be in Italy and Spain. The closer to the center the more benefit. Italian and Spanish banks are sitting right on the fault line and will benefit the most from this action. Companies in these countries should also see a rebound. Banks outside these countries will benefit more than companies. In many ways, the rest of the world has decoupled from the problems (DAX is up 20% YTD), but banks have been held back more than other companies because of how interconnected the global banking system is. This would extend as far as U.S. banks.
Credit Default Swaps. I continue to believe that CDS can go tighter. It will be led by bank CDS, but will be helped along as shorts capitulate. CDS has become the last bastion of “cheap shorts”. Too many investors are short, some whose primary knowledge of CDS came from reading “The Big Short”. I continue to see a lack of interest in bank hedging, and if “real money” ever decides to stop chasing the same silly bonds to the same silly yields and sells CDS instead, the gap will be ferocious. CDS spreads aren’t at the tights of the year yet, and have been stubborn these past few days (tighter, but grudgingly so). High yield bond and leveraged loans should continue to do well, but at this stage, high quality, BB type paper should be traded with a rate hedge.
Short German, French, and EFSF bonds. As the realization that your bunds aren’t about to get converted into Deutschemarks any time soon hits, these will look expensive. As EFSF is called upon to use up its remaining capacity, the supply will add to pressure to this particular entity, above and beyond the pressure on German and French yields. While I would be uncomfortable owning 10 year bonds in Spain and Italy, getting short 10 year bonds in Germany, France, and EFSF seems fine. The subordination argument that makes 10 year scary on the one side doesn’t directly translate to making it appealing on the other.
US stocks are the “dirtiest shirt” and far from the epicenter. The US has largely decoupled. We are about to start facing our own problems, and the campaign format that we will face them in, is particularly troubling. We rally because everyone in China is going to buy a iPhone despite evidence that China is having much bigger trouble than access to iPhone. US stocks will go along with the global rally, but I expect them to lag.
China. Tempting, but I’m not comfortable yet. Japan, maybe? I am working on forming a better opinion here, but suspect they will outperform the U.S. market on European action, but still underperform Europe itself.
Short, nervous, and rebalancing.
I shifted from being long to finally having gotten short on Friday. I don’t like that position right now. I will be shifting back to a more positive position. I think I will be between small short and small long, with longs continuing to focus on Spain, Italy, banks, and the credit positions mentioned above. Shorts will become more common and will be focused on U.S. markets. It is hard to be long Spain here after a 20% run from the lows, but I find that I gag less when looking at that, than other options for being long.
On the option front, I have started buying S&P September puts. I will look at increasing that position once I’m out of more of my short, but will continue to be patient as I think we will see a move higher in index values and see a drop in the cost of vol.
I will definitely be taking this morning’s fade as a chance to take off shorts and get back to a long bias.
Tags: Aggressive Actions, Attrition, Bond Yields, Central Banks, Decisions, Draghi, ECB, Economic Policies, Economic Situation, Economy, Elections, Elites, Eurozone, Fear, First Meeting, Mandate, Merkel, Money Printing, Politicians, Tf
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Sunday, August 19th, 2012
Love Trade Cools as Central Banks’ Gold Demand Heats Up
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
The two largest gold buyers in the world that largely drive the Love Trade, China and India, underwhelmed the metals market with their subdued demand for the yellow metal during the second quarter of this year.
According to the World Gold Council’s (WGC) quarterly Gold Demand Trends report, total demand was 990 tons, which was about 7 percent lower compared to the second quarter of 2011. When you break down demand and look at the jewelry sector, you can see that Chindia remains about 50 percent of the world’s total gold demand. However, this quarter’s jewelry demand of a little more than 400 tons makes it one of the weakest periods in two years.
Total bar and coin demand was also weak in China and India compared with the rest of the world.
As we discussed earlier this year, India has been facing a number of economic challenges, resulting in a dramatic decrease of 30 percent in jewelry demand for the country over the second quarter compared to this time last year. The country’s “unsupportive environment” for gold included a slowing GDP growth, record high gold prices because of its currency, rising domestic inflation, high interest rates, and fears of a poor monsoon season, says the WGC.
China’s gold demand has been affected by a slowing economy as well as a “lack of clear direction in the gold price,” says the WGC. However, during the WGC’s conference call, Managing Director of Investment Marcus Grubb said it would be wrong to think that China is entering a period of extended weakness. If you look at Chinese demand for gold over the first half of 2012, the level was 410 tons—about the level that it was this time last year over the same period.
As we enter the Love Season for gold, we’ll look for any indications from government policies that might spur the continuation of the long-standing tradition of gold buying for weddings and Diwali in India, along with gold gifts for weddings and births that take place in China during this auspicious Year of the Dragon.
Although the Love Trade is on ice for the period, a relatively new gold buyer has been warming up to gold.
The official sector continued its gold buying spree this quarter. The WGC reported that central bank purchases hit a record high since the official sector became gold buyers three years ago. According to Mr. Grubb, if this trend continues over the remainder of 2012, central banks will be entering a “new territory” of gold buying that has not been seen since the early 1960s and since the end of the Bretton Woods System in 1971.
According to the firm’s quarter-end data, official sector institutions purchased 158 tons of gold in the second quarter—or about 16 percent of the quarter’s total gold demand. During the first half of 2012, central banks have acquired 254 tons of the metal, which is about 25 percent higher than the same period last year, says WGC.
Central banks from developing markets led the buying trend once again. The WGC says Kazakhstan indicated that it is “targeting an allocation to gold of 15 percent of its foreign exchange reserves” and one way it plans to build up its allocation is to purchase “the country’s entire domestic production over the next two to three years.”
Other emerging countries with central banks increasing their allocations to gold include Mexico, the Philippines, Russia, Turkey and Ukraine. According to Mr. Grubb, central banks have been motivated to add gold mainly as a currency hedge. Central banks want to increase their weightings in reserve asset portfolios and diversify away their dependence on U.S. dollars—and possibly the euro. There’s also a belief that sovereign debt is no longer considered to be a “risk-free” asset, says the WGC.
During his quarterly conference call, Mr. Grubb elaborated on this up-and-coming trend that we’ve been watching take place over the past 12 to 18 months. He believes gold is being “reintegrated into the fabric of the financial system” as a use of collateral. Mr. Grubb noted how “many exchanges are making gold eligible, with a haircut somewhere between sovereign debt and equities, as a collateral asset in all kinds of financial transactions.” The CME Group in the U.S. has already accepted gold as collateral, and just today, the European clearing house, the CME Clearing Europe, announced that gold bullion is now considered an “eligible collateral type.”
When it comes to collateral and capital requirements, “gold is being brought back into the fold as an important asset,” says Mr. Grubb.
Strike While Gold’s Not Hot?
There’s been a lot of discussion from market pundits wondering where gold is heading. I say investors should use math to their advantage. Similar to card counting strategies used by blackjack players, count historical trends to discover inflection points.
Gold appears to be at one of those inflection points right now. Using the last 10 years of data, if you plot the 12-month rolling return, you can see that gold has reached an extreme low, registering a -2 sigma.
The last time gold reached this point was in August 2008. You can see below the yellow metal’s significant climb after hitting that standard deviation low.
Just recently, the gold price has moved above its 50-day and 100-day moving averages, which is another indication of potential strength for the metal and an additional reason to believe that gold may be an attractive entry point.
I’ll be talking about gold and natural resources at the Chicago Hard Assets Investment Conference on September 21. If you’d like to learn more about attending the free event and when I’ll be speaking, send me a note at firstname.lastname@example.org.
Tags: Central Banks, Chief Investment Officer, Chinese Demand, Domestic Inflation, Dramatic Decrease, Economic Challenges, Frank Holmes, GDP Growth, Gold Buyers, Gold Demand Trends, Gold Price, Gold Prices, Government Policies, Grubb, High Interest Rates, India, Metals Market, Monsoon Season, Russia, Trade China, U S Global Investors, World Gold Council
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Friday, August 10th, 2012
by Don Vialoux, EquityClock.com
Upcoming US Events for Today:
- Import/Export Prices for July will be released at 8:30am.
- The Treasury Budget for July will be released at 2:00pm. The market expects -$71.0B versus -$129.4B previous.
Upcoming International Events for Today:
- German CPI for July will be released at 2:00am EST. The market expects a year-over-year increase of 1.7%, consistent with the previous report.
- Canadian Net Change in Employment for July will be released at 8:30am EST. The market expects an increase of 8,000 versus an increase of 7,300 previous. The unemployment rate is expected to remain unchanged at 7.2%.
Recap of Yesterday’s Economic Events:
Equity markets ended flat on Thursday despite better than expected reports in the US pertaining to employment and international trade. Volume was once again deadly, amounting to the lowest four-day volume in 5 years. In an article posted by Zerohedge.com, the website notes that “the last 4 days have been the lowest volume for a non-Xmas holiday week since 2007 in futures and NYSE volumes are just remarkably bad compared to even normal cyclical seasonal dips.” Looking at the 4-day simple moving average of the S&P 500 ETF (SPY) volume, the last time the average was this low outside of a Christmas holiday week was October 2007, the last market high prior to the significant decline in the months and years to follow in 2008/2009. Volume confirms conviction, of which very little exists. Conviction to equities remains low as debate grows over the sustainability of the present rally that appears based solely on hope of further monetary stimulus from one of the major central banks around the world.
The divergence between price and volume can also be picked up on the NYSE Cumulative Advance-Decline Volume line, which is derived from the volume of advancing stocks less the volume of declining stocks. The NYSE recently managed to break firmly above the high of early July, yet the NYSE Cumulative Advance-Decline Volume Line has yet to accomplish the same. The pattern of this breadth indicator and price typically match each other, showing similar highs and lows, therefore this divergence just adds to the concern that conviction to equities is lacking, often a precursor to market declines should buyers fail to accumulate.
Sentiment on Thursday, according to the put-call ratio, ended bullish at 0.86. The apparent declining wedge pattern that can be derived from the ratio over the past three months is reaching a peak, which could imply a significant jump higher should the tendencies of this pattern be fulfilled. A significant move higher in the put-call ratio would likely be accompanied by an increase in volatility, a pattern that is seasonally common between now and October.
Chart Courtesy of StockCharts.com
Chart Courtesy of StockCharts.com
- Closing Market Value: $12.37 (down 0.24%)
- Closing NAV/Unit: $12.39 (up 0.18%)
|2012 Year-to-Date||Since Inception (Nov 19, 2009)|
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Tags: Canadian, Canadian Market, Central Banks, Christmas Holiday, Conviction, CPI, Dips, Divergence, Don Vialoux, Economic Events, ETF, ETFs, Export Prices, Import Export, International Trade, Moving Average, Nyse, Stimulus, Trade Volume, Treasury Budget, Unemployment Rate, Volatility, Xmas Holiday
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Thursday, August 9th, 2012
by Don Vialoux, EquityClock.com
Upcoming US Events for Today:
- Weekly Jobless Claims will be released at 8:30am. The market expects Initial Claims to show 375K versus 365K previous. Continuing Claims are expected to reveal 3290K versus 3272K previous.
- Trade Balance for June will be released at 8:30am. The market expects -$47.5B versus -$48.7B previous.
- Wholesale Inventories for June will be released at 10:00am. The market expects an increase of 0.3%, consistent with the increase reported previous.
Upcoming International Events for Today:
- The ECB Publishes the August Monthly Report at 4:00am EST.
- Great Britain Merchandise Trade for June will be released at 4:30am EST. The market expects –9.0B versus –8.4B previous.
- Canadian Housing Starts for July will be released at 8:15am EST. The market expects 210K versus 222.7K previous
- Canadian Trade Balance for June will be released at 8:30am EST. The market expects -$0.9B versus -$0.79B previous.
Equity markets traded flat on Wednesday with little to move the tape one way or the other. Volume was once again light as conviction appeared lacking. The two consumer sectors bookended the days activity with Consumer Staples showing the best sector performance with a gain of seven-tenths of a percent, while Consumer Discretionary showed the worst performance, succumbing to a loss of half a percent.
Investors continue to remain hopeful for further monetary stimulus from any one of the major central banks, a fact which is clearly showing up in inflation expectations. The ratio of the Treasury Inflation Protected ETF (TIP) over the 7-10 Year Treasury ETF (IEF) continues to trend higher following an almost five month decline. Even the 5 Year Breakeven Rate has pushed higher since ECB President Mario Draghi hinted of further central bank intervention. Increased inflation expectations are bullish for stocks and commodities, both of which are at multi-month highs.
Inflation is particularly conducive to strength in the price of Gold, which has shown moderate improvement over recent weeks. Seasonal investors are well aware that we are within the period of seasonal strength for the yellow metal, but thus far the price action of bullion has been rather subdued, at least compared to years past. The metal is hinting of a breakout above a descending triangle pattern, a pattern that has bearish implications should the price of Gold fall below $1525. Further evidence is required to confirm the breakout. Hesitation from investors to believe in the stimulus hype is suspected to be culprit for the shallow returns.
The framework for a strong move higher in Gold has become established. In addition to increased inflation expectations, the US Dollar index has also come under pressure over the course of the past month and a minor head-and-shoulders top can be spotted on the charts. The target of this topping pattern points down to 81, also the point at which the price action would intersect with the rising intermediate trendline. The long-term trend for the US Dollar continues to look positive as the upside target derived from a head-and-shoulder bottoming pattern is fulfilled. The US Dollar Index seasonally declines, on average, between now and September, supporting commodity prices, such as Gold.
Another positive for the Gold trade is the fact that the miners have recently shown outperformance compared to bullion, a typical precursor to a positive move in the commodity. The relative performance chart for Gold Miners versus Gold bullion has shown a declining trend for over a year and a half, just recently charting the lowest level since the 2008 low. However, a double bottom has become apparent on the chart, hinting of positive things to come as investors become content with equity valuations at current gold prices. A positive trend still needs to be established, which may not be able to be confirmed until the ratio breaks above the 200-day moving average (0.29 on the chart below). The seasonal trade in gold currently looks appealing given the positive backdrop, but keep in mind that the trade could easily break if stimulus expectations are not confirmed.
Sentiment on Wednesday, as gauged by the put-call ratio, ended bullish at 0.80. The ratio continues to hold within a declining range as bullish expectations flourish.
Chart Courtesy of StockCharts.com
Chart Courtesy of StockCharts.com
- Closing Market Value: $12.40 (up 0.40%)
- Closing NAV/Unit: $12.36 (down 0.02%)
Click Here to learn more about the proprietary, seasonal rotation investment strategy developed by research analysts Don Vialoux, Brooke Thackray, and Jon Vialoux.
Tags: 10 Year Treasury, 9b, Bullion, Central Bank Intervention, Central Banks, Consumer Sectors, Consumer Staples, Don Vialoux, Ecb President, ETF, ETFs, Half A Percent, Inflation Expectations, Initial Claims, Merchandise Trade, Seasonality, Sector Performance, Seven Tenths, Stocks And Commodities, Trade Balance, Weekly Jobless Claims, Wholesale Inventories
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Wednesday, August 8th, 2012
“An improvement in the global economic outlook is the key fundamental reason to take on more risk in an investment portfolio,” said BCA Research in a recent commentary. “The U.S. payroll report was positive relative to expectations, but rather weak in absolute terms. Moreover, last week’s Fed and ECB meetings did little to lift our optimism. Several indicators continue to suggest it is too early to add to pro-cyclical currency trades.
- For example, the global leading economic indicator is still pointing down. More importantly, with no new stimulus measures announced this week, it is difficult to see the global LEIs inflect upwards.
- In addition, gold is a real-time monetary indicator and the peak in March 2008 correctly warned that deflation risks were escalating. Gold’s recovery in early 2009 (ahead of the bottom in equities) then accurately indicated that reflationary policies were finally gaining traction. Gold prices slipped back below $1,600/oz following this week’s Fed and ECB meetings. This suggests that major central banks are still behind the curve. As in early 2009, a sustained rally in gold will signal that the forces of reflation are starting to win out.
- Finally, an uptrend in Chinese stocks and an acceleration in Chinese money supply growth will be bullish signs for Chinese growth and the commodity complex.”
BCA concludes that “it will take further proof that the global economy is stabilizing before augmenting a pro-cyclical currency investment stance.”
Source: BCA Research, August 7, 2012.
Tags: Absolute Terms, Central Banks, Chinese Growth, Chinese Money, Chinese Stocks, Currency Investment, Currency Trades, ECB, Fundamental Reason, Global Economic Outlook, Global Economy, Gold Prices, Investment Portfolio, Investment Risk, Leading Economic Indicator, Monetary Indicator, Money Supply Growth, Payroll Report, Reflation, Uptrend
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Sunday, August 5th, 2012
The Race for Resources
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
The world watched in awe as American swimmer Michael Phelps became the most decorated Olympian of all time. I’ve read he’s been training in the pool for an average of 6 hours a day, 6 days per week, which equates to about 30,000 hours since age 13 and about 10,000 calories burned during a training day. It’s inspiring to see the incredible results of his tremendous sacrifice and commitment.
Investing in global markets requires the same sort of stamina, especially at times like this week, when the month’s reading on the manufacturing industry was not encouraging. The J.P. Morgan Global Manufacturing PMI of 48.4 for July was the lowest since June 2009.
However, I believe there are encouraging pockets of strength to energize and inspire investors.
For example, we’re coming up on the anniversary of the first stimulus move that kicked off the global easing cycle. On August 31, 2011, Brazil unexpectedly cut rates by 50 basis points, and since then, ISI says 228 stimulative monetary and fiscal policy moves have been initiated across several countries, including the Philippines, China, France, and Colombia.
In June and July alone, there were nearly 70 moves—the most since the world began this massive easing.
Generally, by the time central banks make a fiscal or monetary easing move, economic deterioration has already occurred. Even with these moves, it still takes several months for the stimulative measures to take effect and work their way through.
But while the world wades in the shallow end of the pool waiting for the economy to warm up, Asia has taken a deep dive into the energy space as they’ve recently announced acquisitions of Canadian resources companies.
In my presentations, I’ve discussed how resources companies have significantly underperformed their underlying commodities. During 2009 and most of 2010, the performance between oil and the S&P 500 Oil & Gas Exploration and Production Index was closely correlated. By the middle of 2011, oil and oil stocks started to separate, with crude continuing to rise while stocks deteriorated. Even with the recent drop in oil prices, oil stocks have continued to lag.
I’ve also discussed the strikingly similar trend occurring between gold and gold stocks. There’s been a spectacular pop in gold stocks recently, but it hasn’t been enough to catch up to gold’s performance.
The disparities mean that the cheapest resources are not found in the ground—they’re listed, and it’s been confirmed by recent energy company acquisitions.
Chinese oil company CNOOC put in a bid of $15 billion to purchase Canada’s Nexen. This was at a 61 percent premium to Nexen’s share price on July 20, according to Bloomberg. As you can see below, not only did the takeout announcement close the gap, now the company is outperforming the price of oil.
If CNOOC’s deal is approved, the state-run oil giant gets even bigger, gaining access to significant energy stores in several areas of the world, including Canada, the Gulf of Mexico, Colombia and West Africa, as shown below.
With a rapidly growing middle class and rising urbanization, Chinese leaders know they need to fill their country’s tremendous energy demands and are continually finding innovative ways to keep their country powered. CNOOC’s acquisition is one way China continues to acquire not only the resources needed to power the country, but also the technological innovations that come from countries with free markets and lower barriers to entry. According to The New York Times, China “has been garnering advanced production technologies to better draw oil and gas from nontraditional areas like deepwater fields and hardened rock formations.”
The other announcement came from Malaysia’s state-owned and natural-gas giant Petronas, which will purchase Canada’s Progress Energy Resources Corp. Petronas is one of the largest producers and shippers of supercooled LNG fuel in the world. According to the Vancouver Sun, the company is “anxious to increase its market share in Asia, where analysts expect demand to surge 75 percent by the end of the decade.”
After Petronas’ original bid was announced, Progress increased 74 percent—a record gain for the company, says Bloomberg. As shown below, Progress now dramatically outperforms the underlying commodity.
Ready to be a Buyer like Asia?
If you’re contrarian investor, there may be an additional reason to jump into the market today. According to research from J.P. Morgan, institutional investors have become extremely negative, as hedge funds “essentially short the market,” meaning that their expectation is that stocks will fall.
J.P. Morgan looked at the rolling 21-day beta of macro fund returns compared to the S&P 500 Index returns and found that the ratio is at an extreme level of -0.26. Research shows that the last two times the ratio fell this low—in September 2010 and February 2012—stocks rallied. In 2010, the S&P 500 climbed 26 percent in five months; in 2012, stocks rose 8 percent in two months.
These signs the market is sending out make it an especially attractive time to “mine” for investment opportunity. In July, we began to see energy stocks and oil get recharged, as the energy sector in the S&P 500 was the second best performer, increasing 4.17 percent and crude oil rose 3.68 percent. Unlike the start of an Olympic race, in investing, there isn’t a signal sounded to let you know when to dive off the starting block into the markets. Just make sure your portfolio is poised to participate in the race for resources.
Tags: American Swimmer, Basis Points, Canadian, Canadian Market, Canadian Resources, Central Banks, Chief Investment Officer, Deep Dive, Economic Deterioration, Frank Holmes, Global Markets, J P Morgan, Manufacturing Industry, Michael Phelps, Monetary And Fiscal Policy, Pmi, Policy Moves, Stamina, Stimulus, Training Day, U S Global Investors, Wades
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Sunday, August 5th, 2012
Gold Market Radar (August 6, 2012)
For the week, spot gold closed at $1,603.48 down $19.42 per ounce, or 1.20 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 1.04 percent. The U.S. Trade-Weighted Dollar Index slid 0.48 percent for the week.
- Central bank buying of gold continues to be a strong theme. This week the Bank of Korea, which has the world’s seventh biggest foreign exchange reserves, announced it had purchased 16 metric tons of gold last month, increasing reserves to 70.4 tons. Central banks and the International Monetary Fund (IMF) are the largest bullion owners with 29,500 tons at the end of last year, or 17 percent of all mined metal, World Gold Council data shows. Central banks have been net buyers for two straight years, the Council said. Purchases this year will probably exceed the 456 tons added in 2011, the Council estimates.
- Although gold was down for the week we think the price action was positive. Gold was down somewhat when the strong ADP jobs number came out on Wednesday morning, and then gold initially declined further after Federal Reserve Chairman Ben Bernanke held off on announcing new stimulus measures. The selloff did not last long before buyers came back in and scooped up the metal. The simplistic trade of shorting gold on no new Bernanke announcement for another round of quantitative easing has become quite crowded.
- Although global gold mine production has fallen -2.9 percent year-to-date and has registered year-over-year declines for eight months running may sound like bad news, and it has been for certain gold producers, this is certainly a positive for those companies that have maintained or grown their production. Despite the 11 years of consecutively higher gold prices, gold production has been flat and this should bode well for higher prices in the future.
- Kinross Gold replaced CEO Tye Burt this week. This is the second senior gold company CEO to have been removed by their boards in the past month. The replacement CEO is J. Paul Rollinson, a long-time associate of Mr. Burt. Mr. Rollinson is also a former investment banker, with a geology and engineering background. In general, analysts lamented that they would have preferred a high profile manager with a proven track record of operating and/or building mines and/or turning companies around.
- Standard & Poor’s has downgraded Barrick Gold from “A-” to “BBB+” with a negative outlook. The rating agency’s negative outlook on Barrick “reflects our view that the execution risks surrounding Pascua-Lama could potentially stretch the company’s credit measures and free operation cash flow generation beyond the levels we have assumed within our base case scenario.”
- The Indian market is still seeing no relief as the rupee remains weak, the arrival of the monsoon season has been disappointing and the multi-state electric grid collapse last week caused widespread blackouts across the region, obviously curtailing near-term economic activity.
- Nick Holland, CEO of Goldfields Ltd., recently addressed the Melbourne Mining Club and covered a 35-page presentation surveying all the things that gold miners have been getting wrong over the last decade and offering a few ways to solve some of them. Nick Holland pointed out that one theme has run through the presentations of large gold producers at investor conferences over the last 15 years is that production is going to increase and this will result in the company increasing its earnings. Nick notes that if the gold industry had actually met all its production promises over the last five years, then it would not have dropped output on a compound annual basis by 2 percent between 2006 and 2011. Unfortunately gold miners have not met their production promises and investors have become skeptical.
- Nick also highlighted that gold miners need to think differently about costs. “Who are we trying to kid? We don’t kid the investors because they know how much cash we really generate after everything is accounted for. The sell-side also understands this. The only people we’re kidding are governments and communities, who, not surprisingly, say, okay, you’re making super profits, please pay up. And before we know it we have windfall taxes, higher royalties and so on. We’ve got to change the lens through which we and the world view this industry, and start talking about what it really costs to produce an ounce of gold. I don’t care if we call it NCE or something else, but to talk about cash costs only is not telling the full story.” We view this type of examination of the industry as a strong positive for management to take full notice of and start delivering on what the investor is expecting from gold mining companies.
- Bank of America Merrill Lynch noted that while the Federal Open Market Committee (FOMC) did not take any easing action at its current meeting, under its forecast, the economic data should weaken enough by the September 13 FOMC meeting to convince most Fed officials to support more QE and extend the forward guidance then. But the call on further Fed easing remains very dependent on the path of incoming data. We think only a small portion of recent gold buyers entered with the expectation of a Fed move this week but it is more likely a greater number are looking toward the Jackson Hole meeting at the end of August, and then the September FOMC meeting as key entry points into the gold market.
- While most governments are outright buyers of gold, Vietnam’s government has a different view on gold. The problem is nobody wants to use their local currency, the dong but instead more and more rely on gold to settle transactions. The Vietnamese people have a huge affinity with gold, but the country’s government is taking major steps to restrict the gold market and the practice of replacing the dong with gold in transactions. These restrictions included banning gold as a medium of exchange and issuing seven directives which are designed to reduce “goldization” the practice of replacing the dong with gold in transactions.
- David Rosenberg, of Gluskin Shelf, pointed out that U.S. investors withdrew a net $11.5 billion out of equity funds in the prior week according to the Lipper data that includes ETFs, the sharpest outflow in two years. Taxable bond funds attracted over $3 billion and that brings the year-to-date tally to $151 billion as the secular shift in investor behavior towards income-generation continues apace.
- Baby boomer investors looking forward to retirement have been burned by the tech bubble, the housing boom and ensuing credit crisis. Much of the shift in money flows has been to extreme risk aversion and government bonds have been the choice for the safety. Unfortunately, the market has the uncanny ability to move in a direction that will disappoint the most investors. It is unlikely, given the rising debt burden of governments, that the masses will be rewarded for seeking safety in bonds for the next five years. Under owned assets which are out of favor, such as gold, deserve some consideration for portfolio diversification.
Tags: Central Banks, Company Ceo, Dollar Index, Federal Reserve Chairman, Foreign Exchange Reserves, Gold Company, Gold Market, Gold Mine, Gold Miners, Gold Prices, Gold Producers, Gold Production, gold stocks, International Monetary Fund, International Monetary Fund Imf, Market Radar, Nyse Arca, Selloff, Spot Gold, World Gold Council
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Tuesday, July 31st, 2012
by Tony Crescenzi, PIMCO
- As the global slowdown progresses, we can expect central banks to deploy more policy tools – without limits – to stem the pace of deleveraging.
- In Europe, quantitative easing using ESM bonds could prove to be another bridge that buys politicians more time, but does not solve the root problem.
- We expect real economic growth in China to be muted. While some stabilization is possible later this year, it is hard to foresee a sustained recovery.
Saddled with debt and mindful of recalcitrant investors, nations in the developed world have lost their ability to solve their economic woes by adding more debt, leading them more than ever to rely upon central bank action. It is fantasy, however, to think that central banks can keep the game going for long. No central bank ever created anything tangible – you won’t find any stories about a Fed chairman discovering electricity or creating the light bulb. What central banks are best at creating is fiat currencies, and these are only as valuable as what they are backed by, whether it be gold, silver or the productive capability of a nation. Create or print too many of these and they will have no value to anyone, save for nerdy numismatists.
All that a central banker can do to add value to society is help foster financial conditions that facilitate the efficient use of capital, but even here central bankers can get it wrong and produce exactly the opposite result. The housing bubbles that preceded the onset of the recent financial crisis are proof; they were in fact at the heart of the crisis.
Central bankers today are striving valiantly to help smooth the deleveraging process by promoting conditions aimed at reflating the value of financial and real assets that would otherwise almost certainly fall in price. This isn’t easy to do because the world is striving just as valiantly to reduce its debt, taking actions that result in persistent downward pressure on asset values.
Central bank liquidity can’t turn the lights on in Italy
The orderly liquidation of debt requires economic growth. By boosting asset prices, central bankers have sought to promote economic growth and buy time for the fiscal authorities of the developed world to formulate and implement growth-oriented policies. Global investors have been patient, but the repeated failure of policymakers has their patience running thin.
No amount of central bank liquidity by the Federal Reserve, the European Central Bank (ECB) or any other central bank can possibly fix what ails the developed economies. The ECB, for example, can’t fix the fact that Italy ranks 109th out of 183 countries in providing electricity. Nor can it fix the fact that Spain ranks 133rd in the ease of opening a business. How about Greece?
Can the ECB reduce the size of government, improve tax collection or reduce the number of occupations Greece considers so hazardous that hairdressers, pastry chefs and clarinet players can retire in their early 50s? In the U.S., can the Fed reduce the outsized growth rate of the entitlement system? Central bankers can do nothing about these competitiveness issues, but the restoration of growth and competitiveness is essential to improving the ability to repay debt.
To use football vernacular – and here I mean American-style football – central bankers have taken the ball about as far down the gridiron as they can. To be sure, they can still do more; the Fed could implement another round of asset purchases, cap Treasury rates, cut the interest rate it pays banks on excess reserves, extend further its conditional promise to keep rates low, or perhaps consider some form of credit easing. If the Fed did any of these it would mark another courageous effort by The Decider, Fed Chairman Ben Bernanke, but it will never get the ball into the end zone.
To cross the goal line, to restore growth and competitiveness, the fiscal authority – not the monetary authority – must move the ball. This isn’t easy because the citizens of the world are voicing their objection to the changes necessary to do so. Try all you might, central banker, but at the 99th yard you will find the longest yard!
Unlimited global monetary policy – Ben Emons
In recent media debates, some commentators have pointed out that quantitative easing (QE) programs may have seen their effectiveness diminish. However, monetary policymakers in both developed and emerging markets continue to pursue easing measures. Different kinds of policies emerged, such as the Bank of England’s direct lending scheme, known as “credit easing.” The European Central Bank and the Danish central bank went another direction, cutting their deposit rates to zero or even negative. The lower zero bound is often viewed as a constraint, a limit in using conventional tools. The ECB and Danish central bank decisions to cut deposit rates showed how conventional policy is not necessarily limited. In fact, all central banks could cut deposit rates or rates on excess reserves in order to “force” out large cash balances held at the central bank to stimulate lending.
There could be “practical limits,” where QE or deposit rate cuts cause nominal and real interest rates to turn negative, affecting future income streams on savings accounts, pension funds and money market portfolios. The central banks’ growing market share in longer-term Treasury bonds and their low yields has added to the challenge. These practical limits are not necessarily seen as a barrier, evident by the recent string of actions by emerging and developed market central banks. Milton Friedman argued in his 1968 paper, “The Role of Monetary Policy,” how monetary policy should be based on limits. His view was that policy should not “peg” interest rates for a prolonged period of time or it may lead to structural inflation. Friedman pointed out that rapid monetary base growth was generally associated with high nominal rates, a sign in his view of easy policy, e.g., Brazil in the 1960s. Low interest rates were related to slow money growth, like the U.S. during the 1930s, which Friedman viewed as tighter monetary policy. Friedman saw the setting of rates connected to the amount of money growth the central bank would conduct to influence price expectations. When interest rates are pegged in an environment of seemingly stable inflation expectations, Friedman noted a risk of disconnect where the monetary base could become uncontrollable and lead to higher inflation.
In today’s environment of low interest rates, monetary base growth and stable inflation expectations, such disconnect is not seen as a risk, as debt deleveraging has been overwhelming. Since most major central banks see deflation as a bigger risk at this point, practical limits or those limits that Friedman spoke of do not seem to be tempering the willingness of global central banks to go further. In fact, as the global slowdown materializes further, we can expect more policy tools will be deployed to stem the pace of deleveraging, and without any limits.
The ECB can only provide a bridge – Andrew Bosomworth
The ECB can only provide a bridge for the European monetary union’s problems, not a solution. Its decision to cut all policy rates by 25 basis points (bps) earlier this month signaled the bank’s ongoing willingness to provide that bridge by creating time for political and fiscal agents to implement durable solutions. Judging by the gyrations in yields on southern European bonds since the ECB’s meeting, however, markets were evidently disappointed the ECB did not announce further unconventional measures to shore up Europe’s dysfunctional bond markets. Even after ECB president Mario Draghi’s “whatever it takes” statement on 26 July, we still have not seen yields on outer peripherals drop to sustainable levels.
Market expectations for unconventional measures derive from at least two sources. First, since the ECB crossed the Rubicon in 2010 by buying Greek government bonds, markets now believe the bank will do whatever it possibly can to prevent the Economic and Monetary Union (EMU) from breaking up; the costs of not doing so would be too great. Indeed, the ECB currently holds €211 billion in securities from previous forays into the bond market. Second, some market participants, policymakers and influential figures, like Italy’s prime minister and the head of the IMF, are lobbying the ECB to buy even more in order to drive southern European bond yields lower.
Such proposals are shortsighted and address the symptoms rather than cause of the EMU’s problem. Buying bonds without fixing the design faults in the EMU’s governance structure is a near-term fix whose beneficial effects, like painkillers, will soon wear off. Were the ECB to follow lobbyists’ calls and resume the Securities Market Program (under which it bought government debt in 2010 and 2011), it will not solve the governance structure problem. However, buying bonds to ward off deflation once conventional monetary policy has reached the zero lower bound is likely warranted.
The ECB usually refers to Article 123 of the Treaty on the Functioning of the European Union, which prohibits it from financing governments’ budget deficits. The ECB’s reasoning is not entirely clear, given the same European law (part of the Lisbon Treaty) governs both the ECB and Bank of England (BoE) yet the latter buys government bonds as part of its quantitative easing. We think the explanation lies in differences between the ECB and BoE’s perceived risk of deflation, the degree of trust between the monetary and fiscal authorities and the fragmentation of the EMU government bond market relative to the singularity of the United Kingdom’s government bond market owing to its centralized fiscal policy.
As credit to the EMU’s private sector declines – the natural consequence of deleveraging after a credit boom – the risk of deflation in Europe is likely to rise. We think deflationary forces will intensify, making a further reduction in the main refinancing rate to 0.5% likely and perhaps necessitating quantitative easing. Which government bonds might the ECB buy in those circumstances?
The ECB’s capital key (which reflects each member country’s proportional contribution to total capital) suggests about one-quarter and the largest allocation of purchases would be in German Bunds. But capital flight to Bunds has already driven their yields abnormally low, suggesting quantitative easing would achieve little. And the ECB would send mixed signals if it concentrated purchases in Italian and Spanish government bonds. Would the ECB do this to offset eurozone-wide deflation risks or to compensate for member states’ reluctance to centralize fiscal policy?
Purchasing the bonds of the European Stability Mechanism (ESM) could circumvent this dilemma. Unlike the ECB, the ESM is designed to provide member states with financial assistance subject to conditionality. While it lacks the same degree of democratic legitimacy as Europe’s parliaments, at least the ESM is a child born of the democracy. However, like its predecessor, the European Financial Stability Facility (EFSF), the ESM’s main weakness is that it is unfunded. We think the ESM will find it equally difficult to raise sufficient funds from the capital market at low enough yields to perform the job it is designed for. And even if it finds buyers, the ESM will likely crowd out demand for other government bonds from Italy, Belgium, France and Austria, thereby raising their borrowing costs. Quantitative easing using ESM bonds could thus prove to be yet another bridge that buys politicians more time but does not solve the root problem. When it comes to Europe there is only one thing we can say with certainty: This crisis is not yet over.
People’s Bank of China moves to counter weakening growth – Isaac Meng
Policymakers in China face different limitations today than those in the U.S. and Europe, but they too have had to respond to the strain in the global economy, especially as slowing global demand exerts downward pressure on China’s export-investment-driven growth model. In a surprise move, the People’s Bank of China (PBOC) cut its benchmark rate by 25 bps twice within a month. The PBOC also deregulated deposit rates, allowing a 10% float above the benchmark, which largely offsets the cut’s effect on deposit and lending rates.
Though one to two months earlier than the market expected, the latest rate cut is not surprising in light of weakening growth and a slowing inflation outlook. Second quarter growth at 7.6% is barely above target, and inflation risk is easing fast with CPI likely stay below 2.5% over the next two to three quarters versus the PBOC’s target of 4%. Even though rates were cut by 50 bps, China’s real rates are still rising because CPI is heading down toward 2%. If the PBOC targets positive real deposit rates as a floor in the medium term, then there is still room to cut another 25 bps to 50 bps. The 8% to 9% average lending rates remain too high for borrowers struggling to deleverage amid a deepening industrial slowdown.
With the Chinese yuan’s outlook and foreign flows turning to a more balanced stance, the PBOC needs to further unwind past foreign exchange sterilizations, most likely by cutting the Reserve Requirement Ratio by 50 bps per quarter to maintain money market rates in the range of 2.5%–3.0%.
Despite room for monetary easing, the PBOC still seems behind the curve in easing financial conditions. Chinese banks remain tight in credit and slow to cut their lending rates. Domestic Chinese borrowers have excess capacity to deleverage, and the yuan’s nominal effective exchange rate is rising amid a rigid foreign exchange rate regime. Thus, we expect real economic growth in China to be muted and slow, and while some stabilization is possible in late 2012, it is hard to see a sustained recovery.
Past performance is not a guarantee or a reliable indicator of future results. This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
Copyright © 2012, PIMCO.
Tags: Asset Values, Central Banks, Downward Pressure, Economic Growth In China, Economic Woes, Efficient Use, Fed Chairman, Fiat Currencies, Financial Crisis, Global Slowdown, Gold Silver, Light Bulb, Longest Yard, Numismatists, PIMCO, Policy Tools, Productive Capability, Real Assets, Root Problem, Tony Crescenzi
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