Saturday, August 11th, 2012
The Solution…is the Problem, Part II
When we wrote Part I of this paper in June 2009, the total U.S. public debt was just north of $10 trillion. Since then, that figure has increased by more than 50% to almost $16 trillion, thanks largely to unprecedented levels of government intervention.
Once the exclusive domain of central bankers and policy makers, acronyms such as QE, LTRO, SMP, TWIST, TARP, TALF have found their way into the mainstream. With the aim of providing stimulus to the economy, central planners of all stripes have both increased spending and reduced taxes in most rich countries. But do these fiscal and monetary measures really increase economic activity or do they have other perverse effects?
In today’s overleveraged world, greater deficits and government spending, financed by an expansion of public debt and the monetary base (“the printing press”), are not the answer to our economic woes. In fact, these policies have been proven to have a negative impact on growth.
While it hasn’t received much attention in recent years, a wide body of economic theory suggests that government policies and their size relative to the total economy can have a significant detrimental impact on economic growth. A recent paper from the Stockholm Research Institute of Industrial Economics compiles evidence from numerous empirical studies and finds that, for rich countries, there is overwhelming evidence of a negative relationship between a large government (either through taxes and/or spending as a share of GDP) and economic growth.1 All else being equal, countries where government plays a large role in the economy tend to experience lower GDP growth.
Of course, correlation does not imply causation. While the literature is not definitive on causation, it still provides strong evidence that more taxes and government spending as a share of GDP (except for productive investments such as education) is associated with lower growth.
One exception to these findings is the experience of Scandinavian countries. They have both high taxes and high government spending as a share of GDP but have experienced relatively rapid growth over the past 20 years. However, a significant share of their spending goes to education, which has been found to foster growth. They also counterbalance the large role of the state with very liberal, pro-market reforms and low levels of public debt.2
Debt overhang and economic growth
Even if one believes that temporary Keynesian-type fiscal stimulus, in the form of tax breaks and increased government spending, can spur growth in the short-term, these actions inevitably lead to larger deficits and higher government debt (see July 2010 Markets at a Glance, “Fooled By Stimulus”). As Figures 1 and 2 below show, the U.S. Federal Government deficit and debt levels are already at their highest levels since the end of World War II and the scope of future stimulus appears to be rather limited. According to our projections (which assume there will be no fiscal cliff), the U.S. federal debt will increase significantly as the deficit remains sustained and elevated. For many European countries the situation is even worse.
FIGURE 1: U.S. DEFICIT AS A SHARE OF GDP
FIGURE 2: U.S. DEBT-TO-GDP*
Source: The White House: Office of Management and Budget (OMB) and Sprott Calculations
*For reasons discussed in May 2009 Markets at a Glance The Solution … is the Problem, Part 1, we show total federal debt subject to the debt ceiling.
High levels of debt, or debt overhangs, cause more problems. Recent work by Carmen Reinhart and Kenneth Rogoff (Harvard University) demonstrates that banking crises are strongly associated with large increases in government indebtedness, long periods of unemployment and, ultimately, some form of default. They identify a threshold of 90% debt-to-GDP as the trigger to a debt crisis.3 As shown in Figure 2, the U.S. has already passed that threshold.
The historical evidence shows that countries with large governments and high levels of debt have on average, achieved lower economic growth. Given the already high level of debt and deficits in most developed countries, it is doubtful that increased fiscal stimulus will really help the recovery. It’s clear that debt is the problem and the solution does not lie in piling on even more of it. The current debt situation, coupled with the increasing lack of transparency of politically motivated regulations and interventions, leaves little room for a healthy deleveraging of our economies. Here is what central planners have in mind.
Debt overhang resolution and implications for the future
Througout history, high debt-to-GDP ratios have been resolved through five channels:4
- Economic growth
- Sudden bursts of inflation
- Steady financial repression and inflation
Clearly, number one and two are not working right now and, in some European countries, are actually negatively reinforcing each other. The U.S. is facing its homegrown fiscal cliff and political polarization makes its resolution doubtful. Number three seems politically unacceptable for rich, developed nations, which see default as the realm of developing countries. Sudden bursts of inflation are hard to contain and work only so many times as investors, assuming a normal bond market, demand higher interest rates to compensate for inflation risk. Moreover, with interest rates already, at zero it seems that we are left with number five: steady financial repression and inflation. This terminology was first introduced in the early 1970s by Edward Shaw and Ronald McKinnon, both from Stanford University.5
They define financial repression as:
- Explicit or indirect caps or ceilings on interest rates
- The creation and maintenance of a captive domestic audience (i.e.: forced holdings of government debt by financial institutions and pension funds)
- Direct ownership of financial institutions and/or entry restriction in the financial industry (i.e.: China, India)
We are clearly living through a period of financial repression. The symptoms include:
- Artificially low interest rates in most of the G20 countries and commitments to keep them low for long periods of time combined with inflation, which results in negative real interest rates
- Large expansion of central banks’ balance sheets through the purchase of government bonds
- Basel III liquidity rules which force banks to hold more government debt on their balance sheets6,
- Newly nationalized banks in many countries (UK, Ireland, Spain, etc.), which have drastically increased their holdings of government debt
- and it will bet worse…
Figure 3 below shows that financial repression can be observed within the holdings of U.S. financial institutions and pension funds, which have steadily increased their holdings of U.S. Treasuries since 2009.
FIGURE 3: HOLDINGS OF U.S. TREASURY SECURITIES BY DOMESTIC FINANCIAL INSTITUTIONS
Source: Federal Reserve Flow of Funds
It’s clear that governments are preparing for more. A key component to erasing government debt through inflation is extending the duration (maturity) of one’s outstanding bonds. In a normal bond market, negative real interest rates make it difficult to roll over short-term debt at low borrowing rates (although financial repression and captive financial institutions certainly help to keep rates lower than they normally would be). Due to this tendency for short-term rates to rise with inflation, however, it is in the best interests of highly-indebted countries to issue the majority of their bonds at the long end of the yield curve. As Figure 4 shows, the US Treasury is proactively planning to increase the maturity of its outstanding debt (green line) in order to maximize its benefit from inflation erosion. In other words, they are capitalizing on the current flight to safety to set the stage for further financial repression down the road. The same is true for the U.K., which benefits from one of the longest weighted-average maturity of debt in the developed world. For Eurozone countries to do away with their current debt overhang they will either have to default (the least preferred option for political reasons) or use the good old combination of steady inflation and financial repression (feared by the Germans and the ECB central planners).
FIGURE 4: U.S. TREASURY WEIGHTED AVERAGE MATURITY OF MARKETABLE DEBT
Source: U.S. Treasury Office of Debt Management, Fiscal Year 2012 Q1 Report
On both sides of the Atlantic, the largest contributors to the current crisis are excessive debt and spending. We are now at a point where additional government stimulus measures will have negligible, if not detrimental effects on the economy and long-term growth. Debt has to be reduced, not increased by more deficits. Central planners have demonstrated that they don’t have the discipline to implement the Keynesian model of surplus in good times in order to finance deficits in bad times. We have now reached the limit of indebtedness and need to muddle through a painful but necessary deleveraging.
The politically favoured option of financial repression and negative real interest rates has important implications. Negative real interest rates are basically a thinly disguised tax on savers and a subsidy to profligate borrowers. By definition, taxes distort incentives and, as discussed earlier, discourage savings. Also, financial institutions, which are traditionally supposed to funnel savings towards productive investments, are restrained from doing so because a large share of their balance sheets is encumbered by government securities. The same is true for pension funds, which instead of holding corporate paper or shares, now hold an ever growing share of public debt. Pensioners, who are also savers, get hurt in the process.
The current misconception that our economic salvation lies with more stimulus is both treacherous and self-defeating. As long as we continue down this path, the “solution” will continue to be the problem. There is no miracle cure to our current woes and recent proposals by central planners risk worsening the economic outlook for decades to come.
1 Bergh, A., Henrekson, M. (2011): “Government Size and Growth: A Survey and Interpretation of the Evidence”, Research Institute of Industrial Economics, IFN Working Paper No. 858, April 2011.
2 Bergh, A., Karlsson, M., (2010): “Government Size and Growth: Accounting for Economic Freedom and Globalization”, Public Choice 142 (1–2): 195–213.
3 Reinhart, C., Rogoff, K. (2010): “From Financial Crash to Debt Crisis”, National Bureau of Economic Research, NBER Working Paper #15795, March 2010. Reinhart, C., Rogoff, K. (2011): “A Decade of Debt”, National Bureau of Economic Research, NBER Working Paper #16827, February 2011. Reinhart, C., (2012): “A Series of Unfortunate Events: Common Sequencing Patterns in Financial Crises”, National Bureau of Economic Research ,NBER Working Paper #17941, March 2012.
4 Reinhart, C., Sbrancia, B. (2011): “The Liquidation of Government Debt”, Bank of International Settlements – Monetary and Economic Department, BIS Working Paper #363, November 2011. Reinhart, C., Reinhart, V., Rogoff, K. (2012): “Debt Overhangs: Past and Present”, National Bureau of Economic Research ,NBER Working Paper #18015, April 2012.
5 McKinnon, R., (1973): “Money and Capital in Economic Development”, Washington DC: Brookings Institute. Shaw, E., (1973): “Financial Deepening in Economic Development”, New York: Oxford University Press.
6 Bordeleau, E., Graham, C., (2010): “The Impact of Liquidity on Bank Profitability”, Bank of Canada Working Paper, WP#2010-38, December 2010.
Tags: Central Planners, Detrimental Impact, Economic Theory, Economic Woes, Empirical Studies, Eric Sprott, GDP Growth, Government Intervention, government spending, India, Industrial Economics, Investment Outlook, Monetary Base, Monetary Measures, Negative Relationship, Overwhelming Evidence, Perverse Effects, Productive Investments, Public Debt, Rich Countries, Sprott, Unprecedented Levels
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Wednesday, April 18th, 2012
April 15, 2012
by Chris Clark, Royce Funds
As we highlighted in last month’s Contrarian View, a surprisingly underappreciated risk that we think investors are now confronted with is the potential for losses in their future purchasing power, especially those invested in low-yielding fixed income securities.
The combination of a highly stimulative Fed, artificially low interest rates, and a rapidly expanding monetary base is geared toward insuring both the stability of the global banking system and the upward trajectory of the fragile economic recovery, while also meaningfully shifting the balance of risks.
For some time now, investors have been understandably focused on the risk of deflation and therefore have been investing with a singular focus on the preservation of capital. In a deflationary world, results are measured in nominal terms, not real ones. With so many monetary programs being implemented around the world in response to the legacy effects of the financial crisis, our view now is that the longer-term preponderance of risk is skewed to the inflationary side of the spectrum.
Yet with so much lingering economic and political uncertainty, we understand investors’ reluctance to suddenly embrace risk assets, especially given both the recent uneven performance of those assets and the remarkable record of gains that have been achieved by less risky vehicles such as U.S. Treasuries. We recognize that equities have demonstrated greater price volatility and are generally riskier investments than high-quality fixed income securities. However, it’s also worth noting the variance in their relative risk can shift quite a bit over time.
When stocks have traded significantly above their long-term valuation averages, such as during the Nifty Fifty period in 1973-74 and the Tech bubble of 2001-02, they certainly carried more risk than they have at times when equities have been deeply out of favor due to recessionary economic conditions or other bear markets. By the same token, other factors can influence relative prices, such as investors becoming more enamored with one asset class over another.
“When stocks have traded significantly above their long-term
valuation averages, they carried more risk than they
have at times when equities have been deeply out of favor due
to recessionary economic conditions or other bear markets.”
In any event, we are now in a period where stocks are deeply out of favor. One only has to glance at asset flows over the past several years to recognize that bonds have been the overwhelming asset class of choice and as a result have prices that carry very little margin of safety. In other words, what investors have lost by focusing on preservation of capital on a nominal basis is that those assets currently deemed safe have arguably very little or no margin of safety on a real basis.
In nearly four decades of investment management, Royce has always recognized the need for a margin of safety. Equities can be volatile, but they don’t have to be risky, at least over the long run. In fact, risk management and the avoidance of permanent capital loss are not concepts exclusive to the fixed income world. A focus on risk —both nominal and real—an absolute value approach, and a long-term investment orientation are all hallmarks of our investment discipline.
How do we attempt to build a margin of safety? In three very important ways: The first, and arguably most important step, is a detailed examination of a company’s balance sheet. We want to be sure that a company has sufficient financial flexibility to both survive challenging periods and to invest in strengthening its business when the opportunity arises.
Second, we focus on finding high-quality companies where we can become comfortable with the long-term sustainability of the company’s success. High internal rates of return and the ability to generate free cash flow are key metrics in this analysis.
Finally, we focus on what we pay. We have found that investment returns are primarily a function of entry price. Put simply, we like to buy what is out of favor with the crowd. Paying a discount to our estimate of intrinsic value is an important aspect of our investment approach, especially in an uncertain future.
The world is gradually healing, and with this slow-but-steady improvement has come a shift in the balance of risks. It is our belief that investors need to refocus their attention on investments that have the potential to provide both a margin of safety and the flexibility to navigate the uncertain pricing environment that lies ahead.
Chris Clark is a Portfolio Manager and Principal of Royce & Associates LLC. Mr. Clark’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements.
Tags: Banking System, Bear Markets, Condit, Contrarian View, Deflation, Economic Recovery, Global Banking, Income Securities, Low Interest Rates, Margin Of Safety, Monetary Base, Political Uncertainty, Preponderance, Preservation Of Capital, Price Volatility, Relative Risk, Remarkable Record, Royce Funds, Singular Focus, Uneven Performance, Upward Trajectory
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Sunday, August 7th, 2011
Gold Market Cheat Sheet (August 8, 2011)
According to Erste Research, “QB Asset Management calculates the so-called “Shadow Gold Price” (“SGP”). It divides the US Monetary Base by U.S. official gold holdings, the same formula actually used during the Bretton Woods regime to fix the exchange value of the dollar at USD 35.00/ounce. It would be the theoretical price of gold today, were the Fed to depreciate the USD to a level that would cover systemic bank liabilities. The current Shadow Gold Price would be just under USD 10,000.”
For the week, spot gold closed at $1663.80, up $35.92 per ounce, or 2.2 percent for the week. Gold equities, as measured by the Philadelphia Gold & Silver Index, fell 4.74 percent. The U.S. Trade-Weighted Dollar Index rose 0.78 percent for the week.
- In tumultuous week of price action, as evidenced by the S&P 500 Index falling 7.19 percent, gold faired pretty well with a 2.1 percent gain, but silver fell 4.3 percent.
- Both Royal Gold and Yamana Gold posted positive gains for the week. Royal Gold benefits from its first in line royalty structure of income generation; the company essentially gets paid via the revenue stream from gold sales on mines that other companies operate, while Yamana Gold has begun to regain market confidence in its ability to deliver consistently on company guidance.
- Year-to-date, emerging market central banks have bought nearly 180 tons of gold, more than double the roughly 73 tons purchased by central banks globally in the whole of 2010. This hits the central issue of the public’s recognition that government policy makers in Europe and the U.S. do not have the will to address spending cuts. The budget deal over the prior weekend only allowed for a $10 billion reduction in planned spending increases over the next two years while a couple of trillion dollars in cuts would allegedly take place after the presidential election.
- It was a stark week of underperformance by the junior and mid-tier gold and silver stocks relative to their senior peers as evidenced by a weekly decline of 9.2 percent for the junior space versus the larger capitalization gold stocks which fell 2.6 percent.
- Underperformance in the junior space can largely be attributed to a loss in confidence in overall stock markets around the world to provide capital for what is turning out to be a period of low growth.
- On a risk-preference basis, investors have been more willing to add to their gold bullion exposure versus adding to equity market exposure, even in the realm of gold mining companies.
- Noted market historian Don Coxe believes that the gold rally “is primarily driven by fear-not greed.” He advised “gold is gradually becoming recognized as a necessary investment for those with wealth to conserve who do not assume that the political classes in the US and Europe will display sustained statesmanship.”
- Despite rising prices, precious metals demand in India, the world’s biggest consumer of bullion, continues to soar. Jewelry manufactures note that gold is likely to see further increased demand with the festival and wedding season around the corner.
- Entertainment specialist Jim Cramer recommended that gold should account for 20 percent of any portfolio. Just a small shift in investment portfolios allocations towards this weight would likely create an order of magnitude change in the gold price should investors follow his advice.
- Investor confidence going forward after the recent near panic in selling will be a headwind in the near term.
- Liabilities on quasi-government-backed debt relating to the housing bust on corporate balance sheets were bought back by the government over the last couple of years via the bailout package. Company balance sheets are relatively healthy, but this fact has been overshadowed by the central debt issue not being dealt with effectively and the continuing threat of tax increases to solve the spending problem of governments.
- While gold has performed very well as of late, investors must be cognizant that some leveraged market participants may get liquidated and be forced to sell their holdings in gold too.
Tags: Budget Deal, Central Banks, Company Guidance, Dollar Index, Exchange Value, Gold Equities, Gold Holdings, Gold Market, Gold Price, Gold Sales, Government Policy Makers, India, Market Confidence, Monetary Base, Philadelphia Gold, Price Of Gold, Royal Gold, Royalty Structure, Silver Index, Spot Gold, Theoretical Price
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Monday, April 25th, 2011
Monetary Policy in 3-D
by John P. Hussman, Ph.D., Hussman Funds
One of the most important factors likely to influence the financial markets over the coming year is the extreme stance of U.S. monetary policy and the instability that could result from either normalizing that stance, or failing to normalize it. It is not evident that quantitative easing, even at its present extremes, has altered real GDP by more than a fraction of 1% (keep in mind that commonly reported GDP growth rates are quarterly changes multiplied by 4 to annualize them). Moreover, it’s well established – on the basis of both U.S. and international data – that the “wealth effect” from stock market changes is on the order of 0.03-0.05% in GDP for every 1% change in stock market value, and the impact tends to be transitory at that.
Still, by replacing an enormous quantity of interest-bearing assets with non-interest bearing money, quantitative easing has created profound distortions in asset prices, where Treasury bills now yield less than 5 basis points annually, while “risk assets” such as stocks and commodities have been driven to prices high enough that their likely future returns now compete perfectly (on a time-horizon and risk-adjusted basis) with the zero expected returns on cash.
Taken together, despite the limited and transitory real effects of QE on output and employment, the Federal Reserve has created an unprecedented monetary position that creates an extremely unstable equilibrium for the financial markets. There are several ways that this might be resolved. Based on the very robust relationship between short-term interest rates and the monetary base, it is clear that a normalization of short-term interest rates, even to 0.25-0.50%, would require the Federal Reserve to fully reverse the $600 billion of asset purchases it conducted under QE2. Alternatively, with the monetary base now exceeding 16 cents for every dollar of nominal GDP, any external upward pressure on interest rates (that is, not produced by a Fed-initiated reduction in the monetary base) would quickly provoke inflationary pressures.
Last week, my friend John Mauldin reprinted our April 11 market comment Charles Plosser and the 50% Contraction in the Fed’s Balance Sheet . John told me that he had received several nearly identical questions, along the lines of “Wait, now I’m confused – I thought that the Fed reduces inflation pressures by raising interest rates. Why would higher interest rates trigger inflation?”
So, this is where that phrase “external upward pressure” comes in. We have to distinguish between what economists would call an “endogenous” increase in interest rates – one that the Fed itself provokes by reducing the monetary base – and an “exogenous” increase in interest rates – one that is produced by changes in the behavior of investors and the economy, independent of actions by the Fed.
See, when the Fed decides to raise interest rates, it does so by reducing (or slowing the growth) of the monetary base, which can reasonably be viewed as an “anti-inflationary” policy. However, if interest rates rise independent of any change in the monetary base, then cash – which doesn’t bear interest – becomes a “hot potato” that is suddenly less desirable. In that case, you get one of two outcomes: people holding cash may bid up Treasury bills, lowering short-term interest rates to the point where people are again indifferent between cash and non-cash alternatives, or failing that, the attempt to get rid of cash holdings in other ways provokes inflation and a depreciation in the foreign exchange value of the dollar (which was the outcome in the 1970′s).
As I’ve argued elsewhere, one of the primary sources of exogenous inflationary pressure is growth in unproductive forms of government spending (spending that creates demand but does not expand capacity or incentive to produce), but I’ll leave that feature of the argument for another time.
Monetary Policy in 3-D
The extreme stance of monetary policy is such a critical factor in the financial markets here that it is worth spending a bit more time on the relationship between interest rates, inflation, and the monetary base.
Tags: Adjusted Basis, Asset Prices, Asset Purchases, Enormous Quantity, Extreme Stance, Future Returns, Gdp Growth Rates, Gold, Hussman Funds, Monetary Base, Nominal Gdp, Qe2, Quarterly Changes, Real Gdp, Stock Market Changes, Stock Market Value, Stocks And Commodities, Time Horizon, Treasury Bills, Unstable Equilibrium, Wealth Effect
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Sunday, April 10th, 2011
by John Hussman, Hussman Funds
Last week, an unusual event happened in the money markets that should not escape the attention of investors. The yield on 3-month Treasury bills plunged to less than 5 basis points. As I noted this past January in Sixteen Cents: Pushing the Unstable Limits of Monetary Policy , a collapse in short-term yields to nearly zero is a predictable outcome of QE2, based on the very robust historical relationship between short-term interest rates and the amount of cash and bank reserves (monetary base) that people are willing to hold per dollar of nominal GDP:
“Barring external upward pressures on interest rates, a further non-inflationary expansion of the Fed’s balance sheet of $400 billion, to $2.4 trillion (as contemplated under QE2), would imply the need for 3-month Treasury yields to fall to just 0.05%. Higher rates would be inflationary, because monetary velocity would not be sufficiently restrained. In effect, a further expansion in the monetary base requires that short-term interest rates decline enough to ensure a significant drop in velocity.
“In terms of liquidity preference, a completion of QE2 requires liquidity preference to increase to 16 cents per dollar of nominal GDP – easily the highest level in history. We hit 15 cents at the peak of the credit crisis. To get past that, short-term interest rates will have to decline to the point where there is no competition from interest rates at all, but where the slightest amount of interest rate pressure would either drive inflation higher or force a massive contraction in the Fed’s balance sheet to avoid that outcome. Then what?”
On further review, that “16 cents” figure actually underestimates how extreme the situation will be within a few weeks. The monetary base has already surpassed $2.4 trillion. Indeed, as of Wednesday, the U.S. monetary base stood at $2.49 trillion. QE2, as presently contemplated, will actually bring the U.S. monetary base to over $2.6 trillion. As the Fed notes in its report Domestic Open Market Operations during 2010 ,
” With progress towards its statutory objectives of maximum employment and price stability disappointingly slow in the fall of 2010, most Committee members judged it appropriate to provide additional monetary accommodation. Accordingly, the FOMC announced at its November meeting that it intended to increase the total face value of domestic securities in the SOMA portfolio to approximately $2.6 trillion by the end of June 2011 by purchasing a further $600 billion of longer term Treasury securities in addition to any amounts associated with the reinvestment of principal payments on agency debt and MBS.”
With nominal GDP at about $15 trillion, the U.S. economy will then have to hold well over 17 cents of base money per dollar of GDP. This would be by far the largest figure in history. In order to prevent inflationary impact from this level of monetary base (that is, to prevent base money from becoming a “hot potato” that nobody is willing to hold), we estimate that 3-month Treasury bill yields will have to be sustained no higher than a few basis points until the Fed reverses course.
[Geeks Note: The interest rate estimates are based on the inverse of the liquidity preference function, which explains 96% of the historical variation in money holdings as a fraction of nominal GDP. The dynamic equation is i = exp(4.25 - 129.87*M/PY + 84.42*M/PY_lagged_6_mos). This has the steady-state of i = exp(4.27 – 45.5*M/PY). See the original "Sixteen Cents" piece for further details].
Market participants widely assume that they are relatively “safe” to take speculative risk through mid-year, on the belief that the Fed’s policy of quantitative easing will be sustained through the end of June. But looking at the monetary data, it is not clear that the Fed’s statement “by the end of the second quarter” means “precisely until the end of the second quarter.”
We can evaluate the pace of QE2 in two ways. One is by looking directly at the monetary base. QE2 transactions expand the Fed’s balance sheet, increasing its assets (Treasury debt) and simultaneously increasing its liabilities (currency and bank reserves). So we can measure the progress of QE2 by calculating the change in the monetary base since QE2 was initiated.
Monetary Base 11/03/10: $1985.1 billion
Monetary Base 04/06/11: $2490.3 billion
QE2 completed based on change in Monetary Base: $505.2 billion
A second way to evaluate the pace of QE2 is to go directly to the information on “permanent open market operations” (POMO) conducted by the Federal Reserve Bank of New York. However, the POMO figures also include reinvestment of principal repayments from mortgage-backed securities. So a portion of these transactions do not change the monetary base – they simply exchange mortgage-backed assets with Treasury securities. The cumulative par amount accepted by NY FRB from 11/04/10 through 04/07/11 is $523.2 billion
A $600 billion addition to the monetary base from QE2 would leave the Fed with only about $94.8 billion of QE2 transactions remaining. Alternatively, the targeted size of the Fed’s SOMA (System Open Market Account) portfolio is $2600 billion at the end of QE2 (this is the primary repository of assets backing the monetary base, the remainder representing the Maiden Lane portfolios and about $11 billion in gold). As of April 6, the SOMA portfolio was already at $2421 billion. This would leave a larger $179 billion remaining to QE2, putting the program about 70% complete. The average pace of Fed purchases since February has been about $5.5 billion per business day, with about $4.7 billion adding to the monetary base, on average (the rest representing mortgage principal reinvestments). That leaves QE2 somewhere between 20 to 38 business days from completion.
The next FOMC meeting is on April 26-27. While there has been some debate on whether the Fed might decide at that meeting to terminate the policy of QE2 early, that debate is actually moot. By the time the Fed meets later this month, QE2 will already be at least 85% complete.
As a side note, I’ve seen a comment from a number of analysts lately, along the lines of “there’s been an 80% correlation between the size of the monetary base and the level of the S&P 500 since early 2009.” This is just poor statistics. There’s little doubt that the two have been related, but the seemingly impressive strength of the correlation is completely an artifact of the shared upward slope. If you take any two series with generally diagonal trends and little cyclical fluctuation, you’ll always get a “strong” correlation. That’s not to say that the market has not been substantially driven by Fed policy, but rather to warn against careless statistical reasoning more generally. I guarantee that there’s also a 80%+ correlation between the height of a baby kangaroo in Melbourne and the cumulative number of eggs laid by a hen in Oklahoma since early 2009.
Charles Plosser and the 50% contraction of the Fed’s balance sheet
A week ago, Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should increase short-term interest rates to 2.5% “starting in the not-too-distant-future,” preferably during the coming year. Given the robust historical relationship between short-term yields and the amount base money per dollar of nominal GDP, we can make a fairly tight estimate of how much the Fed would have to contract the monetary base in order to achieve a 2.5% yield without provoking inflationary pressures. While the monetary base will be over $2.5 trillion by the end of this month, a 2.5% interest rate would require a contraction of about $1.3 trillion in the Fed’s balance sheet, to a smaller monetary base of just under $1.2 trillion.
In his comments, Plosser discussed a plan to sell about $125 billion in Fed holdings for every 0.25% increase in the Fed Funds rate. That overall estimate is just about right (ten increments of 0.25 each, with an overall contraction approaching $1.3 trillion in the Fed’s balance sheet). So Plosser’s estimates correctly imply that a 2.5% non-inflationary interest rate target would require the Fed’s balance sheet to contract by more than 50%.
The problem, however, is that the required shift in the monetary base is not linear. It’s heavily front-loaded. Based on the historical liquidity preference relationship (which explains about 96% of the variation in historical data), and assuming nominal GDP of $15 trillion, the following are levels of the monetary base consistent with a non-inflationary increase in short-term interest rates up to 2.5%. The non-inflationary provision is important. You can’t just allow interest rates to rise without contracting the monetary base. Otherwise, as noted earlier, non-interest bearing money would quickly become a hot potato and inflation would predictably follow:
Treasury bill yields and monetary base consistent with price stability
0.04%: $2.56 trillion
0.25%: $1.92 trillion
0.50%: $1.68 trillion
0.75%: $1.54 trillion
1.00%: $1.44 trillion
1.25%: $1.36 trillion
1.50%: $1.30 trillion
1.75%: $1.24 trillion
2.00%: $1.20 trillion
2.25%: $1.16 trillion
2.50%: $1.12 trillion
The upshot is that Plosser’s estimate of about $125 billion in asset sales for every 0.25% increase in yields is an accurate overall average, but the profile of required asset sales is enormously front-loaded. The first hike will be, by far, the most difficult. In order to achieve a non-inflationary increase in yields even to 0.25%, the Fed will have to reverse the entire amount of asset purchases it has engaged in under QE2. Indeed, the last time we observed Treasury bill yields at 0.25%, the monetary base was well under $2 trillion.
In my view, this is a major problem for the Fed, but is the inevitable result of pushing monetary policy to what I’ve called its “unstable limits.” High levels of monetary base, per dollar of nominal GDP, require extremely low interest rates in order to avoid inflation. Conversely, raising interest rates anywhere above zero requires a massive contraction in the monetary base in order to avoid inflation. Ben Bernanke has left the Fed with no graceful way to exit the situation.
As a side note, it’s probably worth noting that the Federal Reserve has already pushed its balance sheet to a point where it is leveraged 50-to-1 against its capital ($2.65 trillion / $52.6 billion in capital as reported the Fed’s consolidated balance sheet ). This is a greater leverage ratio than Bear Stearns or Fannie Mae, with similar interest rate risk but less default risk. The Fed holds roughly $1.3 trillion in Treasury debt, $937 billion in mortgage securities by Fannie and Freddie, $132 billion of direct obligations of Fannie, Freddie and the FHLB, and nearly $80 billion in TIPS and T-bills. The maturity distribution of these assets works out to an average duration of about 6 years, which implies that the Fed would lose roughly 6% in value for every 100 basis points higher in long-term interest rates. Given that the Fed only holds 2% in capital against these assets, a 35-basis point increase in long-term yields would effectively wipe out the Fed’s capital.
Still, the Fed also earns an interest spread between its assets and its liabilities, providing about 3% annually (as a percentage of assets) in excess interest to eat through, which would allow a further 50 basis point rise in interest rates over a 12-month period without wiping out that additional cushion. Even so, it is clear that if the Federal Reserve was an ordinary bank, regulators would quickly shut it down. To avoid the potentially untidy embarrassment of being insolvent on paper, the Fed quietly made an accounting change several weeks ago that will allow any losses to be reported as a new line item – a “negative liability” to the Treasury – rather than being deducted from its capital.
Assets compete. If you create a huge volume of non-interest bearing money, somebody somewhere has to hold it. So long as close substitutes such as Treasury bills offer any competition at all, investors try to shift out of the non-interest bearing stuff into the interest-bearing stuff. Of course, in equilibrium, that sort of shift is impossible in aggregate since somebody still has to hold the money. So the result of the Fed’s quantitative easing is that short-term interest rates have dropped to about zero. As long as that happens, people are OK holding the money, and you don’t need to have inflationary consequences, but the sensitivity to small errors becomes magnified. Meanwhile, QE has also caused investors to seek out riskier assets, and the result has been an increase in stock prices, commodity prices and a variety of speculative securities. As prices rise, prospective future returns fall. The process stops at the point where all assets, on a maturity- and risk-adjusted basis, are priced to achieve probable returns near zero.
And so here we are.
There are a few possible outcomes as we move forward. One is that the economy weakens, and the Fed decides to leave interest rates unchanged, or even to initiate an additional round of quantitative easing. In this event, it’s quite possible that we still would not observe much inflation, provided that interest rates are held down far enough. Unfortunately, the larger the monetary base, the lower the interest rate required for a non-inflationary outcome. T-bills are already at less than 4 basis points. In the event of even another $200 billion in quantitative easing, the liquidity preference curve suggests that Treasury bill yields would have to be held at literally a single basis point in order to avoid inflationary pressures.
A second possibility is that we observe any sort of external pressure on short-term interest rates, independent of Fed policy. In that event, the Fed would have to rapidly contract its balance sheet in order to avoid an inflationary outcome. As noted above, even a quarter-percent increase in short-term interest rates would require a full-scale reversal of QE2. Alternatively, the Fed could leave the monetary base alone, and allow prices to restore the balance between base money and nominal GDP. In order to accommodate short-term interest rates of just 0.25% in steady-state, leaving the monetary base unchanged at present levels, a 40% increase in the CPI would be required. I doubt that we’ll observe this outcome, but it provides some sense of what I mean when I talk about the Fed pushing monetary policy to its “unstable limits.”
In case the foregoing comment seems preposterous, it’s helpful to remember that the U.S. economy has never held even 10 cents of monetary base per dollar of nominal GDP except when short-term interest rates have been below 2%. We are presently approaching 17 cents. So you can think of the situation this way. Short-term interest rates of 2% are consistent with money demand of about 10 cents of base money per dollar of GDP. To get there, with the monetary base unchanged, you would have to increase nominal GDP (mostly through price increases) by 70%. Again, because the relationship is non-linear, this impact would be front-loaded. Significant inflation pressure would emerge in response to an increase of even 0.25% – 0.50% in short-term interest rates. Historically, it has taken about 6-8 months for such pressures to translate into observed inflation.
A third possibility is that the Fed intentionally reduces the monetary base, gradually moving interest rates higher as Plosser suggests. This is undoubtedly the best course, in my view, but it’s important to recognize that there are already substantial risks baked in the cake as a result of the Fed’s recklessness up to this point. The first 25 basis points will require an enormous contraction of the Fed’s balance sheet. Risky assets have already been pushed to price levels that now provide very weak prospective returns. Our 10-year annual total return projection for the S&P 500 remains in the 3.4% area. Expected returns for shorter horizons are near zero or negative, but are associated with greater potential variability. Commodity prices have been predictably driven higher by the hoarding that results from negative short-term interest rates (if you expect inflation, but interest rates don’t compensate, you have an incentive to buy storable goods now, and this process stops when commodity prices are so high that they are actually expected to depreciate relative to a broad basket of goods and services, to the same extent that money is expected to depreciate).
In short, the outcome of the present situation need not be rapid inflation, and need not be steep market losses. Rather, the predictable outcome is instability. If you put a brick on a flagpole, and keep raising the flagpole and adding more bricks, you don’t have the luxury of predicting when the bricks will fall, or in what direction. What you do know, however, is that the situation is not stable. People may briefly be rewarded for standing directly below, cheering, while branding anyone who keeps their distance as fools or worse. But if you look closely, those cheerleaders are typically hiding enormous welts, scars and gashes from being repeatedly smacked over the head – if you look even closer, you’ll find that they have typically thrived no better for it over the long-term. While it’s possible to continue without unpleasant events, the Fed has already placed the course of the economy, inflation, and the financial markets beyond a comfortable scope of control should surprises emerge.
As of last week, the Market Climate for stocks was characterized by a syndrome of overvaluation, overbought conditions, overbullish sentiment, and rising yield pressures that has historically been hostile to stocks on average. Every component of this syndrome worsened last week. Our estimate of 10-year projected total returns for the S&P 500 is presently just 3.4% annually, the major indices remain overbought on an intermediate-term basis, and Investors Intelligence reports that bullish sentiment has surged to 57.3% bulls and only 15.7% bears, which is close to the spread we observed at the 2007 market peak. Investors Intelligence observes “extreme readings, as we are experiencing right now, historically have major significance.” Meanwhile, upward interest rate pressures reasserted themselves last week. Both Strategic Growth Fund and Strategic International Equity remain well hedged here.
Importantly, our defensive stance is not driven by the expected completion of QE2, nor our considerable doubts about the potential for a successful economic “handoff” to the private sector in the face of tightening federal and state budgets and a fiscal cliff as stimulus funding to the states rolls off about mid-year. All of those considerations make us aware of potential risks, but in practice, we are defensive based on testable and observable market conditions that have historically been associated with a negative return/risk profile, on average.
Though the market has not recovered to its February highs here, the measures that define the “overvalued, overbought, overbullish, rising yields” syndrome are actually worse now, on balance. While there remains a possibility that we can clear some component of this syndrome without also observing a strong deterioration in broader market internals (including breadth across individual stocks, industries, and sectors, leadership measures, price-volume action across a wide range of industries and security types, and other factors), conditions are so extended here that there is now only a narrow “window” between a market decline that would be sufficient to clear the overbought or overbullish components of the present hostile syndrome, and a market decline that would signal a larger and more robust shift toward investor risk aversion. Put simply, a market decline that clears this syndrome could be a whopper. That said, we’ll respond to the evidence as it emerges, and will continue to look for opportunities to accept exposure to market fluctuations as the overall return/risk profile improves.
In bonds, the Market Climate deteriorated last week. On Tuesday, in response to evidence of accelerating yield pressures, as well the recognition that QE2 was much further along than investors widely seem to believe, we substantially cut our bond duration to about 1.5 years in Strategic Total Return.
In gold, the further advance in prices on shallow corrections brings us back to the concern I expressed a few weeks ago about bubble-type action. Silver prices are displaying even more exaggerated “log-periodic” behavior, as are some agricultural commodities. We don’t know exactly when this will end, but we would prefer to scale back early rather than late. A Sornette-type analysis (see Anatomy of a Bubble ) suggests a “finite-time singularity” within days or weeks. Any additional upward leaps in price, with very shallow corrections and increasing volatility at 10-minute intervals would strengthen that impression further. I’ve been generally bullish on gold since September of 2000, when it was below $300 an ounce and we observed a clearly favorable shift in the set of conditions I noted in Going for the Gold . Our actual gold models are more elaborate in practice, but as I noted back then, precious metals shares tend to perform far better in the face of falling Treasury yields, particularly when the ISM indices are weak. Those conditions are absent at present, and the recent extreme price behavior is of some concern. The rally in gold stock prices late in the week gave us an opportunity to clip our exposure back to about 6% of assets in Strategic Total Return. The risks in precious metals are clearly increasing.
Copyright © Hussman Funds
Tags: Balance Sheet, Bank Reserves, Basis Points, BRIC, BRICs, Charles Plosser, Collapse, Commodities, Contraction, Credit Crisis, Gold, Hussman Funds, Inflationary Expansion, John Hussman, Liquidity Preference, Monetary Base, Money Markets, Nominal Gdp, Predictable Outcome, Qe2, Term Interest, Term Yields, Treasury Bills, Treasury Yields
Posted in Commodities, Credit Markets, Emerging Markets, Gold, Markets, Silver | Comments Off
Monday, February 28th, 2011
by John P. Hussman, Ph.D., Hussman Funds
Last week, the S&P 500 pulled back by less than 2% – certainly not sufficient to clear the overvalued, overbought, overbullish, rising-yields syndrome that we observe in the market, but enough to bring our estimate of S&P 500 10-year total returns from an expected 3.06% to an expected 3.25%.
From the standpoint of prospective investment returns, it is important to recognize that the main effect of quantitative easing has been to suppress the expected return on virtually all classes of investment to unusually weak levels. It’s widely believed that somehow, QE2 has created all sorts of liquidity that is “sloshing” around the economy and “trying to find a home” in stocks, commodities, and other investments. But this is not how equilibrium works.
Here’s how equilibrium does work. Every security that is issued has to be held by someone, in precisely the form in which it was created, until that security is retired. Period. That means that if the Fed creates $2.4 trillion in currency and bank reserves, somebody has to hold that money, in that form, until those liabilities are retired. The money ultimately can’t go anywhere. If someone tries to get rid of their cash in order to buy stock, somebody else has to give up the stock and hold the cash. In the end, every share of stock that has been issued has to be held by somebody. Every money market security that has been issued has to be held by somebody. Every dollar bill that has been created has to be held by somebody. None of these instruments somehow “find a home” by going somewhere else or becoming something else. They are home.
Let me be clear – the additional monetary base created by the Fed certainly is “liquidity” from the standpoint of the banking system, and does amount to funding the U.S. deficit by printing money, until and unless the transactions are reversed. As I’ve noted previously, at what is approaching 16 cents of base money per dollar of GDP, there will also be significant inflationary risk in the event of even modest upward pressure on short term interest rates. The point, however, is that it is incoherent to say that this “cash on the sidelines” will somehow find a home in some other financial market, or anywhere else in a manner that makes it vanish from “the sidelines” – until it is explicitly retired by the Fed.
So what is the effect of creating an extra $600 billion dollars of monetary base by having the Fed purchase $600 billion dollars of Treasury debt? The same thing that happens anytime any security is issued. Somebody has to hold it, and the returns on all other assets have to shift by just enough to make everyone in the economy happy, at the margin, to hold the outstanding quantity of all of the securities that have been issued. In practice, the only way you can get people to willingly hold $2.4 trillion in non-interest bearing cash is to depress the return on all close substitutes to next to zero. So short-term Treasury bill yields have been pressed to nearly nothing.
Of course, people also look at risky assets and ask whether they might be able to get higher risk-adjusted returns by holding those instead. In order to make people happy to hold the outstanding quantity of zero return cash, the prospective returns on other risky securities have also collapsed (securities are a claim to future cash flows – as investors pay a higher price, they implicitly agree to accept a lower long-term return). In my view, this has gone on to an extent far beyond what is likely to be sustained, but thanks to eager speculation, the S&P 500 is now priced, by our estimates, to achieve annual returns of just 3.25% over the coming decade.
Likewise, all of those securities yielding zero or nearly zero returns have to compete with commodities. Here, the markets have responded to the massive deficits of world governments by increasing their expectations regarding inflation. Now, if you’re looking at a zero nominal return on money-market instruments, as well as expected inflation over time, it’s natural to start hoarding commodities. See, if you expect your dollars to buy fewer goods and services in the future, and you’re not earning interest to make up for it, you’d prefer to stockpile goods right now. This, of course, has created terrible problems for people in less-developed countries, who are experiencing soaring prices for food and fuel, but commodity hoarding was a predictable outcome of QE2.
The real question is how high commodity prices have to rise until people are indifferent between holding non-interest bearing cash, and commodities that are elevated in price. The basic answer is that commodity prices have had to “overshoot” the expected future level of broad consumer prices by enough that both cash and commodities can now be expected to suffer a negative real return as measured against a broad basket of consumer goods. This sort of overshoot is necessary to make people indifferent between holding one versus another, and it restores equilibrium in the face of the negative real return available on money market securities. As with stock prices, I believe that this has already gone too far, but the civil unrest in the Middle East has certainly worsened the situation over the short-term.
This is a critical point – commodity prices tend to swing by a much greater amount than consumer prices. You can easily get periods where general consumer prices are advancing, yet commodities prices are advancing slower or even falling. In my view, QE2 has provoked an “overshooting” advance in commodities prices, which has been necessary because the Fed is holding real interest rates at negative levels. In the face of moderately higher consumer price inflation, coupled with short-term interest rates at zero, the only way to get people to be comfortable holding that much cash is to make the prospective returns on every possible alternative just as bad.
If investors don’t understand that this is how QE2 is “working,” they are likely to be as blindsided by the coming decade of weak investment returns as they’ve been over the past decade. It’s notable that the weak returns achieved by the S&P 500 over the past decade were predictable, and our estimates of projected total returns have remained quite accurate in recent years. It bears repeating that our difficulty in 2009 was not that we viewed stocks as overvalued, but that we were forced to contemplate data from periods other than the post-war period, which had generally required much more stringent criteria for accepting market risk. At the 2009 lows, stocks were priced to achieve 10-year total returns in excess of 10% annually by our estimates. The problem is that similar expected returns were not sufficient to end prior declines during much lesser crises even in post-war data.
As for the Depression, stocks were priced to achieve negative 10-year returns, by our estimates, at the 1929 peak. After losing half their value, stocks were priced to achieve 10-year returns in excess of 10%. From there, stock prices dropped by an additional two-thirds before bottoming.
Whatever value was available at the 2009 lows is long gone. Our miss in 2009 was emphatically not the result of inaccurate valuation estimates – it was the result of having to contemplate data outside of the post-war period. I’ve extensively discussed the adjustments we’ve made (see recent commentaries as well as our semi-annual report). Still, there is nothing in recent data, nor long-term historical data, that creates meaningful doubt for us that stocks are priced to achieve bitterly small returns over the coming decade.
As it happened, much of the 10-year prospective returns that were priced into stocks at the 2009 low have been compressed into the advance since then. For long-term investors, there is now a great deal of risk with not much prospective return to compensate them at current prices. There will still be periods warranting at least a moderate exposure to market fluctuations based on shorter-term considerations, but with the market still characterized by an overvalued, overbought, overbullish, rising-yields syndrome, now is not one of them.
Savings, Investment and Credit Market Debt
Having discussed QE2, let’s move on to the broader subject of “credit.” Here also, there is a lot of confusion about how credit creation is related to real economic activity. My hope is that the following discussion will clarify some of these relationships. As usual, the best way to evaluate the merit of somebody’s analysis is if they show you the data, so I’ll also show you the data.
Let’s start by considering an economy that produces 100 units of output. 80 are consumed, and 20 are saved as “investment goods” to increase the ability of the economy to produce more output in the future. On the “income” side, those 20 units would be considered to be “savings.” On the “output” side, those 20 units would be classified as “investment.”
Tags: All Sorts, Bank Reserves, Banking System, Base Money, Commodities, Credit Implications, Dollar Bill, Equilibrium, Financial Markets, Hussman Funds, Investment Returns, Liabilities, liquidity, Monetary Base, Money Market, Printing Money, Quantitative Easing, Standpoint, Trillion, Trying To Find A Home
Posted in Commodities, Credit Markets, Markets | Comments Off
Thursday, November 18th, 2010
Submitted by David Galland of The Casey Report
What Could Trip Gold Up?
Can you visualize a possible scenario that could put a sudden end to the secular rise now underway in gold and silver?
In a recent conference call with the research team of The Casey Report, we once again collectively tried to imagine what situation… what scheme… what government manipulation… might finally put a stake through the heart of gold.
Setting the stage, I think it’s safe to assume that in order for the gold bull to decisively reverse direction, the following general conditions would have to be precedent in the economy:
1. The financial crisis will have to have ended. Which is to say that…
1. Unemployment would have to begin falling by significant numbers – with 300,000 jobs or more being added month after month, instead of being lost.
2. The housing markets will be stabilizing. Foreclosure rates would have to fall to more normal levels (and not because banks are forced to postpone the process for legal reasons, which is the case now), and sales would have to accelerate in the right direction.
3. Government deficits would have to be sharply curtailed and heading lower.
4. All quantitative easing will have ended.
5. GDP will have to be on sound footing and rise based on sustainable, private-sector growth – not based on the activities of government, which loom so large today in the calculation.
2. Real interest rates – the yields you earn over the actual rate of inflation (not the fabricated numbers ginned up by the government) – will have to be solidly positive. Which, of course, is a big problem given the sheer magnitude of the outstanding debt. Rising rates will only beget more debt.
3. The monetary base of the country will have to be contracting, not soaring as it has been in recent years. The following chart from The Casey Report a few months ago tells the story of runaway printing, and of why gold is so strong by comparison.
Inherent in the list just above are other conditions that will have to be precedent for gold’s run to end.
For example, politicians around the world will have to find the uncharacteristic courage to act in ways that are deeply unpopular with the very voters that brought them to office. Namely by slashing the scale and cost of government, with all the many cutbacks in subsidies and services that such a Great Downsizing must entail. And this rare new breed of politician would have to retain their jobs long enough to see through the reduction in government that must occur if stability is to be regained.
Tags: BRIC, BRICs, Casey, Conference Call, Financial Crisis, Foreclosure Rates, Galland, GDP, Gold And Silver, Government Deficits, Heart Of Gold, interest rates, Manipulation, Monetary Base, Private Sector Growth, Rate Of Inflation, Right Direction, Russia, Sheer Magnitude, Significant Numbers, Silver, Sound Footing, Stake, Unemployment
Posted in Emerging Markets, Energy & Natural Resources, Gold, Markets, Oil and Gas, Silver | Comments Off
Sunday, October 24th, 2010
by John Hussman, Ph.D., Hussman Funds
“There is the possibility… that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control.”
John Maynard Keynes, The General Theory
One of the many controversies regarding Keynesian economic theory centers around the idea of a “liquidity trap.” Apart from suggesting the potential risk, Keynes himself did not focus much of his analysis on the idea, so much of what passes for debate is based on the ideas of economists other than Keynes, particularly Keynes’ contemporary John Hicks. In the Hicksian interpretation of the liquidity trap, monetary policy transmits its effect on the real economy by way of interest rates. In that view, the loss of monetary control occurs because at some point, a further reduction of interest rates fails to stimulate additional demand for capital investment.
Alternatively, monetary policy might transmit its effect on the real economy by directly altering the quantity of funds available to lend. In that view, a liquidity trap would be characterized by the failure of real investment and output to expand in response to increases in the monetary base (currency and reserves).
In either case, the hallmark of a liquidity trap is that holdings of money become “infinitely elastic.” As the monetary base is increased, banks, corporations and individuals simply choose to hold onto those additional money balances, with no effect on the real economy. The typical Econ 101 chart of this is drawn in terms of “liquidity preference,” that is, desired cash holdings, plotted against interest rates. When interest rates are high, people choose to hold less cash because cash doesn’t earn interest. As interest rates decline toward zero (and especially if the Fed chooses to pay banks interest on cash reserves, which is presently the case), there is no effective difference between holding riskless debt securities (say, Treasury bills) and riskless cash balances, so additional cash balances are simply kept idle.
A related way to think about a liquidity trap is in terms of monetary velocity: nominal GDP divided by the monetary base. (The identity, which is true by definition, is M * V = P * Y. The monetary base times velocity is equal to the price level times real output). Rising velocity implies that a given stock of money is “turning over” rapidly, so that nominal GDP is increasing faster than the stock of money. This is associated with either growth in real output or inflation. Falling velocity implies that a given stock of money is being hoarded, so that nominal GDP is growing slower than the stock of money. This is associated with either unresponsive real output or deflation.
How to spot a liquidity trap
The chart below plots the velocity of the U.S. monetary base against interest rates since 1947. Since high money holdings correspond to low velocity, the graph is simply the mirror image of the theoretical chart above.
Tags: Base Currency, Capital Investment, Cash Reserves, Commodities, Controversies, Effective Control, Hussman Funds, John Hicks, John Hussman, John Maynard Keynes, Keynesian Economic Theory, Leaps, Liquidity Preference, Liquidity Trap, Monetary Authority, Monetary Base, Monetary Control, Monetary Policy, Money Balances, Rate Of Interest, Theory Centers
Posted in Gold, Infrastructure, Markets | Comments Off
Monday, August 23rd, 2010
This article is a guest contribution by John P. Hussman, Ph.D., Hussman Funds.
A week ago, the Federal Reserve initiated a new program of “quantitative easing” (QE), with the Fed purchasing U.S. Treasury securities and paying for those securities by creating billions of dollars in new monetary base. Treasury bond prices surged on the action. With the U.S. economy predictably weakening, this second round of quantitative easing appears likely to continue. Unfortunately, the unintended side effect of this policy shift is likely to be an abrupt collapse in the foreign exchange value of the U.S. dollar.
How exchange rates are determined – a primer
To understand how currencies fluctuate, it’s helpful to understand two forms of “parity” that operate in the foreign exchange markets.
1) Purchasing Power Parity (PPP): This describes the tendency for long-term exchange rate movements to reflect long-term changes in relative price levels between countries. Suppose for simplicity that a given basket of goods costs $10 in the U.S., and costs FC40 in some other country (where FC is simply a unit of foreign currency). If the goods are identical and can be transported costlessly without any barriers, one would expect that $10 = FC40, or that $1 = FC4. So the exchange rate would satisfy purchasing power parity if one dollar traded for 4 units of foreign currency.
Suppose the foreign country is highly inflationary, so that the price of that basket of goods increases to FC60, while the U.S. experiences no corresponding inflation. PPP suggests that the exchange rate should track the relative price levels between the two countries, resulting in a new exchange rate of $1 = FC6. This would be a “strengthening” or “appreciation” in the dollar, since each dollar would command a greater amount of foreign currency. Conversely, this would be a “weakening” or “depreciation” in the foreign currency, since each unit of FC would command fewer dollars.
More generally, goods and services are not identical across countries and cannot be moved costlessly, so PPP is only a long-term tendency, and is not enforced at every point in time. Still, there is a strong tendency for exchange rate movements, in the long run, to reflect relative inflation rates of inflation between countries. Countries with high rates of inflation tend to depreciate over time, relative to countries with lower rates of inflation, and this depreciation is in nearly direct proportion to the relative changes in price levels (particularly when one uses price indices of tradeable goods).
2) Interest Rate Parity: This describes the tendency for exchange rates to move in a way that offsets expected differences in interest rate returns. Suppose that interest rates in the U.S. are 2%, and interest rates in the foreign country are 5%. If the exchange rate was expected to remain perfectly constant, and there were no barriers to capital movements, investors would have a strong tendency to buy the foreign currency in order to earn the higher interest rate. Of course, the exchange rate would not remain constant, as investors would tend to bid up the foreign currency. In fact, there would be a tendency to bid up the foreign currency until it was sufficiently elevated today that a 3% annual depreciation would be expected in the future. At that point investors would be indifferent, since the 2% interest rate available in the U.S. would be equivalent to the 5% interest – 3% depreciation expected in the foreign currency. From a foreigners perspective, the 5% interest rate available in that country would be equivalent to the 2% interest + 3% appreciation expected in the U.S. dollar.
Tags: Collapse, Commodities, Exchange Rate Movements, Exchange Value, Fc4, Fc6, Foreign Currency, Foreign Exchange Markets, Gold, Hussman Funds, Monetary Base, New Exchange, Policy Shift, Purchasing Power Parity, Purchasing Power Parity Ppp, Qe, Relative Price Levels, Term Changes, Term Exchange, Treasury Bond Prices, Treasury Securities, U S Treasury
Posted in Gold, Markets | 1 Comment »
Monday, May 17th, 2010
This article is a guest contribution by John Hussman, Hussman Funds.
Last week, the European Central Bank pledged to spend as much as 750 billion euros (about a trillion US dollars) in an attempt to discourage market concerns about European debt, particularly that of Greece, Portugal and Spain. The intended message was to show the markets – particularly bond market “vigilantes” speculating against European debt – that the ECB has deep enough pockets to thwart the mounting pressure on European debt and the euro itself.
ECB President Jean-Claude Trichet has been quick to deny concerns that the move by the ECB will be inflationary, emphasizing that the intervention will be “sterilized” in order to prevent a major increase in the amount of euros outstanding. This is “totally different,” he argued last week, from the massive increase in monetary base that has occurred as the U.S. Federal Reserve has bought up over $1.25 trillion in debt obligations of Fannie Mae and Freddie Mac. A “sterilized intervention” is one where the euros created through the purchase of distressed Euro-area debt will also be absorbed by selling other assets from the ECB’s balance sheet, in order to take those euros back in.
In order to evaluate the arguments being made, it’s helpful to understand the balance sheet of a typical central bank. Whether in the U.S., Europe, or elsewhere, the basic structure is the same. On the asset side, the central bank has government debt that it has purchased over time. A small proportion of total assets might be held in “hard” assets such as gold, but primarily, the assets of each central bank has traditionally represented government debt – mostly of its own nation (or in the case of the ECB, euro-area governments). As a central bank purchases these securities, it creates an equal amount of liabilities, in the form of “monetary base” (currency and bank reserves).
Notice, for example, that the pieces of paper in your wallet have the words “Federal Reserve Note” inscribed at the top. Currency is a liability of the Federal Reserve, against which it has traditionally held assets such as Treasury securities, and prior to 1971, at least fractional backing in gold.
In this context, consider the ECB’s proposed 750 billion euro line of defense. Essentially the ECB is saying “We stand ready to buy as much as 750 billion euros of distressed Euro-area debt in order to defend the euro.” Simultaneously, despite the fact that Euro area countries are running large fiscal deficits, the worst being in Greece, Portugal and Spain, the ECB is saying “However, we intend to sterilize this intervention, which will ultimately require that we sell Euro-area debt into the market in order to absorb the euros we create.” The only way that both statements can be true is for the ECB to admit “Therefore, we are fundamentally promising to debase the quality of our balance sheet, by exchanging higher quality Euro-area debt with lower-quality debt of countries that are ultimately likely to default.”
Far from being “totally different” from what the U.S. Federal Reserve has done, the ECB is essentially promising exactly the same thing – to corrupt its balance sheet and debase its currency in order to protect the worst stewards of capital from the consequences of bad lending and poor investment.
Over the shorter term, the Federal Reserve has promised to abet the ECB by entering currency swaps, essentially accepting euros from the ECB and providing U.S. dollars that the ECB can in turn use to buy up euros and European debt. The promise, of course, is that the ECB will reverse these swaps at a later date, at the same exchange rate at which they entered into the transaction. The problem here is that this is a very dangerous game for the ECB (not to mention the Fed). If the euro depreciates materially, the ECB will later be forced to sell euros into an already weak market (effectively creating new currency to cover the loss) in order to buy back enough dollars to reverse the swaps and make the Federal Reserve whole (assuming the Fed will ultimately be made whole).
Presumably, the ECB hoped that the 750 billion euro figure would inspire shock and awe, but after a quick rally on Monday, the markets were neither shocked, nor durably awed, as investors began figuring out that the ECB was essentially promising to buy Euro-debt with Euro-debt, and to defend euros with euros.
In the end, as I’ve argued repeatedly over the years, monetary policy is only as good as fiscal policy. A central bank does not have wealth of its own. It is a zero-sum entity that can only enrich those from whom it purchases debt by debasing the relative wealth of people who hold the existing stock of currency. If a government insists on running deficits, engaging in wasteful spending, and dissipating public resources to bail out private bondholders, it has to find somebody willing to buy its debt. If it does not, the central bank buys it, and dilutes the currency by doing so. The situation is particularly insidious when the central bank buys low-quality debt, because there is no taxing authority behind it to provide a basis for confidence in the currency.
The Euro-area has a special problem in this regard, because the bailouts represent clear country-to-country transfers of wealth, and risk creating inflation for all the members of the European Community in order to defend the deficit spending of countries that simply do not have enough flexibility to cut those deficits. Greece in particular is likely to experience so much loss of output that it will most likely lose on the revenue side much of what it cuts on the spending side. For that reason, the deficits are likely to come down much slower than expected. Germany, with its particularly strong aversion to inflation, is unlikely to accept the costs for long.
It is difficult to project the timing and events by which all of this will be resolved, but I increasingly suspect that the (relatively) stronger Euro-area countries will reject the prospect of providing continuing subsidies and accepting growing inflation risk as the cost of keeping deficit-prone member countries under the euro umbrella. In short, I don’t expect that Greece or Portugal (Spain is more uncertain) will ultimately remain part of the euro.
At the point that Greek and Portugese debt has to be restructured (which seems inevitable given the negative revenue effects of austerity measures), departure from the euro will give these countries a better ability to depreciate their currencies to a level that re-aligns internal wages and prices with competitive levels. This will be a less disruptive solution than having to force – as austerity measures do – a massive internal deflation through wage reductions and spending cuts. The unpleasant alternative is to hold the line on wages and prices within Greece, Portugal and other high-deficit countries, and suffer inflation throughout the entire Euro-area as those debts are monetized. The only other alternative, which does not seem at all likely, is that other Euro-area countries will accept ongoing country-to-country transfers in order to finance the deficits of their neighbors.
Without a central taxing authority, the goal of a common European currency can only survive if the participating countries obey a rule that strictly controls the deficits of individual countries. Without that, the whole system is compromised. It should not be difficult to recognize that the confidence in any currency is tied to the confidence in the assets which stand behind it, and associated confidence in the restraint of fiscal and monetary authorities. The bureaucrats in both the U.S. and European central banks have chosen to betray that trust. It’s fascinating that they seem genuinely surprised when their generosity with other people’s wealth (and their assurance of greater betrayal) is met with contempt. While I expect that the euro will survive by the coordination of its stronger members, it risks being debased by the unwillingness to accept debt restructuring sooner rather than later.
On Monday of last week, the Market Climate re-established its overvalued, overbought, overbullish, rising-yields syndrome. Given the easing of interest rates in the preceding week, I had expected more latitude for upside before that syndrome reasserted itself, but yields shot back up on Monday, and investor sentiment did not ease nearly as much as anticipated. Not surprisingly, much of the gains from Monday evaporated as the week continued. The Strategic Growth Fund is effectively fully hedged here.
My impression is that the market remains in a tenuous state in that we have not meaningfully cleared the overextended syndrome that has been with us in recent months. Even so, we’ll respond fractionally to any clearing that we do observe (with a growing responsiveness as we move through the year). We’re certainly not inclined to “buy the dip” to a material extent, and I continue to anticipate a second wave of credit difficulties in the months immediately ahead. But I also believe that if we can move through 2010 without a second “crisis-level” wave of credit strains, we’ll be more able to rely on post-1940 criteria in setting our investment positions, with less concern about the more hostile “post-crash” dataset.
Suffice it to say that we’re not about to lift a significant portion of our hedges early in a selloff provoked by fresh credit strains, but that I also don’t intend to specifically factor in concerns about a second-wave for an extended period if we don’t observe them.
In bonds, the Market Climate was characterized last week by relatively neutral yields and neutral yield pressures. The Strategic Total Return Fund continues to hold a duration of just under 4 years, mostly in medium term Treasuries. In response to the move by the ECB, we also scratched on our sell a few weeks ago of precious metals shares, re-establishing those positions early this week at about the same level that we sold them. The Fund currently has about 3% of assets in that group, which is not much, but we’re inclined to add exposure on weakness or retracement from last week’s spike. We liquidated our small 1% holding the euro early in the week (same reason), shifting to the Swiss franc, which ominously continues to gain ground against the European currency. A spike in the euro/Swiss franc exchange ratio would be a sign of speculative pressure that one would observe in an escalating crisis, as would a spike in eurocurrency rates denominated in euros, versus other inter-bank deposit rates.
On the inflation question, we continue to observe a debate between those anticipating inflation and those anticipating deflation. From my perspective, this is a false dichotomy. Certainly, we can expect a continued relative deflation in real wages – elevated unemployment has a remarkably inconsistent relationship with overall price levels, but the true “Phillips Curve” relation is between unemployment and real wages. High unemployment is predictably associated with wage growth that falls short of growth in the general price level. Whatever happens with the general price level, we can expect wage growth to be uncomfortably tepid in the next several years.
With regard to the general price level, observers frequently make the mistake of equating inflation with demand growth, which effectively assumes that the quantity of money (or at least its marginal utility) is constant. This is a poor assumption in the present state of the world.
Think of it this way. If you were in an elementary school lunchroom, and the kid that always has the Chips Ahoy cookies suddenly starts bringing in three times as many, you could predict fairly accurately that the value of a cookie relative to just about everything else would fall (that is, the price of everything, in terms of cookies, would go up). Moreover, this would occur even if nobody else was a bit hungrier. When you substantially increase the quantity of something, you reduce its marginal value relative to everything else. You don’t need strong demand for the price of goods and services to rise in terms of dollar bills. All you need to do is to debase the marginal value of dollar bills by creating too many.
Over the past year, Ben Bernanke has pushed a monstrous sack of Chips Ahoys into the cafeteria. In terms of general price inflation, the question is how eager people are for those Chips Ahoys. If there is a crisis that makes people fear that everything else they might eat will give them food poisoning, the kid’s Chips Ahoys will hold their value even if he brings in three times as many. But over time, well after the food poisoning scare is past, those cookies will be worth much less.
The bottom line is that we can expect real wages to stagnate for several years, as a predictable reflection of slack capacity in the labor market. While credit concerns will be helpful in augmenting the demand for U.S. government liabilities as a default-(food poisoning)-free alternative to other assets, there is a continued prospect for significant price inflation beginning in the second half of this decade. With the ECB surrendering monetary discipline for the sake of short-term expedience, that prospect has become even more hostile.
I want to be clear that my concern about inflation is not very strong at present. This is important, because investors seem to be chasing precious metals a bit too avidly here. Commodities can experience extremely high levels of volatility. Corrections can be both abrupt and deep, which allow for multiple entry points. But it is important to recognize that this volatility can be quite painful, so very deliberate risk-management is important. We’ve generally found that chasing advances in commodities is unrewarding. Again, our own holdings are fairly restricted here. Reversing our recent sale simply maintains the very small exposure we’ve held for several months.
Longer term, in the name of defending the holders of bad debt, the world’s major economies appear willing debase their currencies. Most likely, we’ve got several years (not weeks or months) before we observe a striking return of inflation, and there will be probably plenty of time in between where investors give up the concern entirely for a while. As always, we try to look ahead at the major risks facing the economy, even if those risks take a while to fully emerge. At present, I believe our monetary authorities are moving down an unfortunate path. This will create opportunities as well, but we’ll move very deliberately.
Copyright (c) 2010 Hussman Funds
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