Posts Tagged ‘Monetary Policy’

Japan: Nothing Fails Like Success

Monday, May 13th, 2013

by Marc Chandler, Marc to Market (co-authored with my Tokyo-based colleague Masashi Murata)

Abenomics appears to be off to a fairly successful start, despite the volatility in the JGB market. The yen is sharply lower. Equities are dramatically higher. The Japanese economy itself is likely boast the best performance in the G7 in Q1, when the GDP estimate is released early on Thursday in Tokyo. Abe and his government are running strong in the opinion polls, putting it in a solid position to win 2/3 of the upper house in this summer’s election.

The critics of Abenomics have generally focused on the risks involve. On the fiscal front, the high debt burden limits the government’s ability to maneuver. This leaves the onus on monetary policy. Here the BOJ has been exceptionally aggressive. Consider the US economy is nearly three times bigger than Japan and the BOJ is buying roughly $75 bln a month in securities, while the Federal Reserve is buying $85 bln a month. Structural reform to boost the country’s growth potential also seem limited, thus far.

However, what could be even worse for Japan than the failure of Abenomics is its success. The ultimate goal of Abenomics is revitalize the Japanese economy by freeing up the vast savings Japan has amassed (in the corporate sector).  Savings in the household sector have generally fallen, as one would expect given the unfavorable demographic trends characterized by shrinking and aging population.

Far from a revolution that many observers have hyped, the Abe’s diagnosis and medicine is not new, even if the dosage is.  The problem, as we have argued before, is not too little investment in Japan but really the opposite; too much investment.

Consider that over the past decade, gross fixed investment in the US averaged about 10.5% of GDP.  A comparable figure for Japan is almost 14%.  Yet, US growth surpassed Japan’s.  As we have seen in China, so too with Japan, each new unit of investment generates less economic growth.

Data from Lombard Street Research shows that combined depreciation and retained earnings amount to 29.5% of Japan’s 2011 GDP.  In the US, where corporations also enjoy a financial surplus, it is closer to 16%.  Boosting the wherewithal to invest would seem to compound the problem.

As Martin Wolf of the Financial Times argued in a recent column, corporate savings in Japan are too high relative to the plausible investment opportunities.  This problem of surplus savings is incomprehensible to Japanese policy makers.  They continue to insist on understanding the problem in traditional terms of boosting investment to increase employment and consumption.

In the early 1900s, a US journalist and presidential advisor, Charles Conant, was the first American to conceive of problem of surplus savings and he gave it a deep think.  He argued there finite number of ways to address the issue the surplus.  Wars destroy capital, but Conant argued against such a course. Redistribution was another strategy, but Conant was no socialism.   Conant also realized that internal improvements (public works) or public investment could absorb some the surplus savings but not enough.

Conant concluded that exporting the saving to other countries, building infra-structure, laying the railroads and telegraph lines, the information highway of the day, was the way to alleviate the US savings congestion, which threatened profit-margins at home.

Japan can export some of its surplus savings, but typically, Japanese investors have been reluctant to do so on a sufficient scale.  Japanese companies do invest in plant and production outside of Japan and since the late 1990s, the Ministry of Finance reports that the local sales of Japanese affiliates surpassed exports as the primary way Japanese businesses service foreign demand.   For example, roughly 70% of the Japanese-brand cars in the US were produced in the US.

Portfolio capital flows are even bigger.  Until very recently, Japanese investors have been net sellers of foreign financial assets this year.  Moreover, Japan’s past investments in foreign bonds (and equities) generate a large monthly capital stream that is the main driver of the country’s current account surplus.  The stock of that investment is so great that on a given month, the income it generates may be larger than the new portfolio outflows and that is with record low bond yields in the US, Germany, UK and France.

In the past when the private sector was unable to recycle Japan’s current account surplus, the government would through intervention.  Japan has accumulated more than $1 trillion of reserves.  This route seems to have been effectively blocked by the G7/G20), given the sharp depreciation of the yen seen in past six months.

Japan does need to revolutionize its thinking, but Abenomics is not it.  Japanese officials think their world is characterized by a shortage of investment.  Instead it is plagued by a surplus of savings.  It can boost consumption (what Conant saw as redistribution), but instead the Abe government is still poised to raise the retail sales tax next year and in 2015, as the DPJ legislated, with what appears to be its dying political breath.  Abe said he wants wages to rise, but wanting and doing are not the same thing.

Lower real interest rates, even negative nominal rates, may not absorb the surplus savings as change their location by prompting a reallocation of portfolios to equities and real estate, for example. Instead, Japanese officials may be better served by addressing the corporate savings surplus directly.

There are many forms this could take, such as dramatically reducing the depreciation allowance applied to business investment.  The tax on dividends could be cut,  but  this might not trickle down to households as their equity holdings tend to be a small part of their financial assets, and could end up simply redistributing the corporate surplus among businesses. Of their financial assets, the equity holdings of Japanese households as of March 2012, was about 6.5%, nearly half of what it was in March 2007.  The comparable figures for the US households are 31.9% and 36.3% respectively.

Businesses are opposed to the suggestion that retained earnings should be taxed. Corporate governance reform could also force a reduction in corporate savings if shareholders had more power.   A more politically palatable route seems to be tax based on the size of the business (pro forma basis).

In order to conceive of the solution, Japanese policy makers and investors need to perceive the problem. Yet, ideological blinders are preventing this and keeps Japan pushing on the same string, albeit somewhat harder, as it has for the better part of two decades.

Copyright © Marc to Market

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Modern Monetary Theory is the winner…at least for now

Tuesday, April 16th, 2013

by Martin Sibileau, A View from the Trenches

“…MMT is to me the 21st century re-incarnation, in monetary policy, of
Cardinal Richelieu’s raison d’état concept. If I am correct, it will bring
the same serious consequences it brought in the 17th century…”

 (To read this article in pdf format, click here: April 14 2013)

If I have to summarily describe the events of the past week, I will say that it was the week Modern Monetary Theory won over any other school of thought…(I promise you this: Today’s letter will not be a rant…)

Brief introduction to Modern Monetary Theory

I suggest you do your own research on this topic, because what I will say here is by no means exhaustive. But it is important to be aware of a new reality. I, for one, found a fair summary of it here. Below is a list of some theses held by this school, from L. Randall Wray’s “Modern Monetary Theory: A Primer on Macroeconomics for Sovereign Monetary Systems”(From chapter 18, edited by me):

“Statements that do NOT apply to a currency-issuer:

-Governments have a budget constraint (like households and firms) and have to raise funds through taxing or borrowing

-Government deficits drive interest rates up, crowd out the private sector…and necessarily lead to inflation

-Government deficits leave debt for future generations: government needs to cut spending or tax more today to diminish this burden

-Government deficits take away savings that could be used for investment

-We need savings to finance investment and the government’s deficit

While these statements are consistent with the conventional wisdom, and while they are more-or-less accurate if applied to the case of a government that does not issue its own currency, they do not apply to a currency issuer…”

“…Principles that DO apply to a currency issuer. Let us replace these false statements with propositions that are true of any currency issuing government, even one that operates with a fixed exchange rate regime:

-The government names a unit of account and issues a currency denominated in that unit;

-The government ensures a demand for its currency by imposing a tax liability that can be fulfilled by payment of its currency;

-Government spends by crediting bank reserves and taxes by debiting bank reserves; in this manner, banks act as intermediaries between government and the non government sector, crediting depositor’s accounts as government spends and debiting them when taxes are paid;

-Government deficits mean net credits to banking system reserves and also to non government deposits at banks;

-Central banks set the overnight interest rate target; it adds/drains reserves as needed to hit its target rate;

-The overnight interest rate target is “exogenous”, set by the central bank; the quantity of reserves is “endogenous” determined by the needs and desires of private banks; and the “deposit multiplier” is simply an ex post ratio of reserves to deposits—it is best to think of deposits as expanding endogenously as they “leverage” reserves, but with no predetermined leverage ratio;

-The treasury cooperates with the central bank, providing new bond issues to drain excess reserves, or retiring bonds when banks are short of reserves; for this reason, bond sales are not a borrowing operation used by the sovereign government, instead they are a “reserve maintenance” tool that helps the central bank to hit interest rate targets;

-The treasury can always “afford” anything for sale in its own currency, although government always imposes constraints on its spending; and lending by the central bank is not constrained except through constraints imposed by government (including operational constraints adopted by the central bank itself).

I could discuss at length (and likely shall have to in the future) how I disagree with the statements above, but today it is not relevant. Today, that school of thought won the day and rather than criticism, I believe it merits that we acknowledge its existence and understand its implications.

Historical context of Modern Monetary Theory (MMT)

MMT is to me the 21st century re-incarnation, in monetary policy, of Cardinal Richelieu’s raison d’état concept. If I am correct, it will bring the same serious consequences it brought in the 17th century (In his book “Diplomacy”, Henry Kissinger gives Cardinal Richelieu all the credit for this political concept. It is very unfair. About a century earlier, Niccolò Machiavelli dedicated his book “The Prince” precisely to encourage the Medici family to undertake his dream of national unification in Italy. Yet, Kissinger did not devote one single sentence of his book to Machiavelli).

When Cardinal Richelieu thought of état, he thought along the terms most of us can relate to. When Modern Monetary Theory discusses sovereignty, the borders change: We can no longer speak of states, but of fiat currency jurisdictions; and there are only two: The one corresponding to the global reserve fiat currency and the one corresponding to the rest of fiat currencies, which are benchmarked to the global reserve.

Why Modern Monetary Theory won last week

Perhaps to MMT, its raison d’état is its very same existence. When Richelieu (but not Machiavelli) thought about état, he did not think in état as “the” entity in itself. He thought of France, as a particular case. MMT however is universal; its raison d’etat is the survival of fiat currencies, which forces policy makers to cooperate globally in order to destroy any other alternative currencies. In the case of gold, precisely, I methodically proved it in an earlier letter (here).

On April 4th, we had a strong indication that the raison d’etat was becoming increasingly relevant. During a press conference, Mr. Draghi, answering a question from Zerohedge.com, stated that “… people(…)  vastly underestimate what the Euro means for the Europeans (…); they vastly underestimate the amount of political capital that has been invested in the Euro...”  I thought he was very wrong. I don’t think anyone actually underestimates them, which is why I so fear that this game will end in a war, as unseen unemployment rates are coerced upon millions of innocent families.

Then, last week we saw the evidence of MMT realpolitik at work: First with Bitcoins and then with gold. Both destroyed on no fundamentals. In the case of gold, it even occurred at precisely predicted timing. Because even if Draghi openly did (although in a more subtle way) what Gordon Brown did in May of 1999, the prospect of Cyprus selling its gold had already been made public two days before last Friday (April 12th). Therefore, this was not a new fundamental. Hence, having not been enough, the typical take down on gold first at 4:00am ET, then at 8:20am and 10:30am ensued (see chart below).

April 13 2013

 

Free, open, markets cannot be anticipated in such way. Yet I can remember pointing out to you the precise timing of these moves in earlier letters (i.e.”… I am tired of seeing endless proof of suppression (i.e. the typical take downs in the price at either 8:20am ET or at 10am-11am ET, with impressive predictability) …February 21, 2013”). Nothing else to add here. If a schmuck like me can tell you months in advance that a market price will fall at 8:20am and 10am and you see that price falling at 8:20am and 10am, then….

Why did bitcoin and gold collapse? (And make no mistake, because gold did collapse). Because they are not redeemable. In the first case,  it is easier to accept this. In the second, most will disagree with me. To those, I answer that as long as the US government can refuse (or get away with refusing) to deliver the physical gold to a central bank the sorts of the Bundesbank, one can safely say that regardless of the marginal bullion held by retail in safety boxes or bullion banks in vaults, for all practical purposes, gold shall be negated. I am deeply disappointed with myself, for not having understood this fact earlier, of course.

There are those who still think China will reveal its true holdings of gold. Personally, I think it is very unlikely. They would be acting against their own interest.

What next? Upcoming challenges to Modern Monetary Theory

As at April 2013, I can see three main challenges to MMT. If they are overcome by MMT, freedom as we know it, will be a thing of the past.  They can be temporarily overcome, with coercion,  and the words of Mr. Draghi at his last press conference are more than ominous in this regard. Times like these have taken place in every century of the history of civilization, and I see no reason to deny the probability of them occurring once again in the 21st. In no particular order, these are the challenges:

-Annihilating the last bastion of redeemable, alternative marketable value:

After April 13th, the last bastion of redeemable and alternative market value is in agricultural commodities. Because these are perishable, they cannot be stored away and refused to deliver, like precious metals. Because they cannot be stored away, they cannot be exponentially securitized. And because they cannot be exponentially securitized, their price cannot be sustainably manipulated.

Furthermore, if redeemability was affected, these markets would segment, into one with capped prices (where nobody sells), and an underground one, where inflation expectations inevitably will be shaped. In addition, their production is not the monopoly of any particular country and the rise in its prices, always ends in social conflict (as my uncle Alberto Mario once told me: “Every revolution begins with a baker being hanged by the mob”).

This will be a challenge, although not new. In the past, it has always been addressed with price controls, from the times of the grain trade between Egypt and Rome, to the 1930s with the creation of grain/meat Boards, which were monopolies that failed miserably at containing inflation. Canada and Argentina, for instance, are an example of the latter.  I have to give the intellectual credit to Albert Friedberg, founder of the Friedberg Mercantile Group, for bringing this challenge to light and remembering the Russian wheat deal of July-August 1972 (Mr. Friedberg’s quarterly conference calls are invaluable. This topic was discussed on January 31st here, after the 38th minute)

There is no doubt in my mind that MMT will address with this challenge with repression too. In the process, food prices will rise but as I wrote before (here), this will not mean that Jim Rogers will be proved right. Farmers will not drive Lamborghinis. Prices will rise precisely because the opposite will occur and scarcity of production will be the norm.

-Overcoming the lack of a price system to allocate resources:

When prices are suppressed, markets cannot efficiently allocate resources. When this happens, defaults eventually follow. And as they take place and production falls, the difference between the former and actual output is seen as something negative. Of course, in a world with fiat currency and leverage, this gap is brutal. In a world without leverage, this would be mere evidence of creative destruction.

One of the most (if not the most) flawed concepts in non-Austrian economics is that of the existence of an output gap, which has to be closed by economic policy. The concept is so deeply embedded and so little challenged that it is assumed right away without further ado. It was in Martin Feldstein’s article (“When interest rates rise”) two weeks ago and it is in the famous Taylor’s policy rule.

The idea of an output gap denies the role played by the price system in allocating resources. In other words, it would be very wrong to think that because I could work until 10pm but leave my work regularly at 6pm, my output gap is 4 hours worth of my productivity. Why? Because I consciously decide to leave at 6pm, since I am not paid enough to stay at the office until 10pm. Vice versa, my employer does not see any marginal value that would be compelling enough to pay me for those additional hours. Therefore, even though the capacity/ infrastructure is there for me to stay at the office until 10pm, it is simply mistaken to infer that there is an output gap. It is even more idiotic to believe that by lowering interest rates, my employer would be willing to invest more, to fill that hypothetical gap.

There is one more angle to this. If there is a gap, it is understood that at some point in the past, I used to work until 10pm and now that I no longer do, it would be desirable that I go back to work until 10pm everyday. Why? Nobody wonders why I decided not to work until 10pm. Nobody asks why resources are no longer allocated to work from 6pm to 10pm. The reallocation of resources (of my time) is completely ignored. In the same fashion, when governments seek to close that gap manipulating the inter-temporal rate of exchange (i.e. interest rates), rather than facilitate a natural reallocation of resources, they insist with sustaining the old state of affairs, which was not desired, in the first place.

The idea of an output gap is Aristotelian in nature, and had Galileo been an economist in 2013, he would have invited Mr. Feldstein, Krugman or Bernanke to see for themselves that there has never been high inflation with full employment of resources; that high inflation is never triggered by an increase in demand, but by a lack of supply, when production collapses destroyed by fiscal and financial repression.  The scene of high inflation is a scene of empty shelves at supermarkets while goods are transacted at higher prices in underground markets; enforced high minimum wages under which nobody gets employed; banks that post negative lending interest rates but lend to no one (except their governments); entrepreneurs who borrow outside the system or vendor financing replacing working capital lines from banks.

With the steadily increasing level of financial repression, how will this challenge present itself to MMT? Via defaults. Until last week, I was convinced that these defaults would come first from the European Union. Now, I am inclined to accept the possibility that they originate in Japan. How will MMT deal with them? By creating more liquidity, of course. By further suppressing any possible signal.

-Suppressing a spiraling of inflation expectations in Japan:

The recent change in regime at the Bank of Japan merits a lot more than this final comment. When I have a moment, I will address it. Meanwhile, it is becoming clear to me that Japan is close to entering a Latin American-style spiraling cycle, where inflation expectations take the lead and the central bank can only follow.

As the Yen is devalued, capital in Yen-denominated fixed income and credit flees and is reallocated in the same, but USD denominated, asset classes. This simple movement increases interest rates in Yen, which is counterproductive to the initial efforts by the Bank of Japan. The Bank has to therefore purchase even more Yen-denominated debt, which triggers a further devaluation. As the devaluation makes imported commodities/food more expensive, the rate of devaluation channeled through to consumer prices can shape inflation expectations and the market may incorporate the expected rate of devaluation to Yen nominal yields.

Indexation is MMT’s worst nightmare. They were able to postpone it destroying the gold market, but this may prove a more formidable challenge. The unintended consequence of the Yen intervention is that the Bank of Japan ends up indirectly effecting quantitative easing on USD debt; both sovereign and private. This was in my view another bearish driver for gold, as the need for direct Fed intervention in the US Treasury market, on the margin, decreases.

As capital out of Japan floods the USD corporate debt market, credit spreads compress even further, weakening correlations among asset classes and making eventual defaults, of global consequence, more likely and dangerous. In summary, MMT is faced here with perhaps its biggest challenge, because the spiraling process just described sets the stage for an uncooperative Japanese central bank, which will be terribly busy trying to fix the unfixable. In Latin America, MMT often crystallizes in a controlled and segmented foreign exchange market. But this is unconceivable in a G-7 country like Japan and if any hint of it was even suggested, chaos of an unseen scale would fall upon the Asia Pacific region, dragging the rest of the world with it.

Conclusion

Last week, without any doubt, Modern Monetary Theory had a great victory. We are not in Kansas any more. From now on, without any price signals left, we will only be guided by volume, particularly in the labour market. This situation will persist until finally a new signal emerges. Whether it will come from the agricultural commodity market, the European Union or the Japanese fixed income market, remains to be seen.

Martin Sibileau

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BOJ QEases: Kuroda’s “Shock And Awe” Post-Mortem From Goldman And SocGen

Thursday, April 4th, 2013

First, from Goldman’s Themistoklis Fiotakis

Bank of Japan Delivers; Dollar is Bid Across the Board in Response

Earlier this morning the BoJ introduced a comprehensive change to its monetary policy framework. The asset purchasing program will be merged with the outright JGB purchase program (rinban), and JGB purchases will be expanded to include all maturities, including 40-year bonds. The pace of JGB purchases by the BoJ will be accelerated to ¥7trn per month from just under ¥4trn currently (on a gross basis), and purchases of ETFs and J-REITs will also be increased. The main operating target for money market operations was changed to a monetary base control (a quantitative index) from the uncollateralized overnight call rate.

The size and speed of these measures were a dovish surprise to markets. The Yen has weakened against a number of currencies; indicatively $/JPY moved from 92.9 to 95.4. The JPY is returning to levels prevailing in the weeks before the market started to reflect concerns about a potential BoJ disappointment. Given the dovish surprise vis a vis initial expectations, the risks are for a $/JPY move higher in the near term. Interestingly, the move in the Yen has also benefited the Dollar more broadly, with DXY moving up 0.7% this morning. The Dollar move combined with market expectations of a dovish ECB led the EUR down to 1.2792 this morning (from 1.2850).

The Nikkei closed up over 2% despite falling around 1% earlier in the session. Long-term Japanese rates declined, with the 10-year rate falling by around 10bp. The largest impact, however, was at the long end of the curve, with the 30-year yield down 22bp. The flattening of the curve is in line with our fixed income views and has benefited our trade recommendation for a 10s20s JGB flattener; we initiated our recommendation last Thursday at a level of 92bp and it is currently at 77bp, 12bp away from the target of 65.

Events today include the ECB and BoE meetings. For the ECB, we do not expect any change to interest rates, and any easing is more likely to come in the form of credit easing measures that target the impaired transmission mechanism within the Euro area. We expect the BoE to keep policy unchanged as it prepares to extend the FLS and explore other non-QE easing options.

* * *

And next, from SocGen’s Kiyoko Katahira

BoJ announces bold policy change

The BoJ meeting concluded with an introduction of a new “quantitative and qualitative monetary easing,” aiming to achieve the inflation target of 2% within a time horizon of about 2 years. Overall, the decision made by the BoJ was indeed “bold”, and the market reacted positively – the yen dropped (USD/JPY jumped from 93 to close to mid-95) and the Nikkei stock surged. The yield on JGBs from 5 years to 30 years broadly declined, with the 10y yield reaching the lowest since June 2003.

The BoJ’s decision – abolished policy rate, APP and bank note rule

The BoJ has decided the following:

  1. Intoduction of the “monetary base control”: The bank will shift the main operation target from the current policy rate (uncollateralized overnight call rate ) to the monetary base. The BoJ will conduct money market operations so that the monetary base will increase at an annual pace of 60-70 trillion yen. The monetary base which was 138 trillion yen as of end of 2012 will be increased to 200 trillion yen (+45% yoy) by the end of 2013 and to 270 trillion yen (+35% yoy) by the end of 2014.
  2. The bank will also terminate the Asset Purchase Program (APP) and combine with the regular JGB purchases known as Rinban operations. Purchases of JGBs will be increased substantially, and the JGBs held will increase at an annual pace of about 50 trillion yen. As of end of 2013, the bank’s holding of JGBs will increase to 140 trillion yen as compared to 89 as of end of 2012. The bank will further increase the JGBs held to 190 trillion yen by the end of 2014. It has also decided to purchase JGBs with longer maturity – the average remaining maturity of the JGB purchases will be extended from 3 years to about 7 years.. This will allow the bank to purchase JGBs with all maturities including 40-year bonds. It has also decided to increase the purchases of ETFs by 1 trillion yen in 2013 and another 1 trillion yen in 2014. As for J-Reits, the amount is small, but will increase by 300 billion yen in both 2013 and 2014.
  3. The bank has also decided to suspend the so-called “Bank note rule” which limits the amount of JGBs it can hold on its balance sheet to the amount of outstanding bank notes. However, in our view, this rule has already been violated in practice and we see little impact.

Overall, the decision by the BoJ was indeed bold. It will increase the JGB purchases substantially from the current pace (about 4 trillion yen per month) to about 7 trillion yen per month. It has combined the two separate asset purchase programmes which will help increase transparency of policy and make communications with the market more straight-forward. The Rinban operations tended to be overlooked by a market that had been focused on the APP. It has extended the average remaining maturities of the JGBs to be bought, allowing it to buy even super-long JGBs, which will certainly reduce yields along the yield curve, just as Mr Kuroda has stressed during his speech over the last few weeks. The BoJ has also announced to set forums for enhanced dialogue with market participants – aiming to exchange views on money market operations in general.

As we had expected, the new BoJ has broken with the cautious policies of the past and has started a monetary policy that can be called “bold”, just as the PM Abe has demanded. We wait to see for further implications ahead.

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Yet Another Unintended Central Planning Consequence: Running To Stand Still

Monday, February 25th, 2013

Via Louis-Vincent Gave of GK Research (A Gavekal Company),

Lemmings And The Quandary of Negative Real Rates

For most portfolio managers, investable assets can be thought of as sitting somewhere on the risk-return curve shown below. Of course, depending on valuations at a particular point in time, positioning in the economic cycle, or overall geopolitical risks, some of the relative positions may change. But over long periods, investable assets have tended to display the risk-reward characteristics highlighted by the efficient frontier below.

Now in recent decades, investors could assume that across the length of an economic cycle, almost all investments would provide a positive real return. Diversification across the curve made ample sense, and this is precisely what happened: looking at the stock of global assets, one sees that out of an estimated $209trn in global financial assets (excluding real estate), $52trn sits in equity with $45trn in government debt, $65trn in loans (possibly a good chunk of which finances real estate), and $46trn in corporate debt. In other words, roughly one quarter of the world’s financial assets are in equity (on the top-right hand of the risk-return curve) with three quarters in debt (at the bottom left of the curve). This asset mix brings us to the policies followed today by most Western central banks of guaranteeing negative real rates for as long as the eye can see. This policy of negative real rates has an obvious goal: push out investors from the bottom left of the curve to the top right, thereby boosting animal spirits, creating jobs, and returning Western economies to a more solid growth environment. But could these policies suffer from the law of unintended consequences?

If we look at the risk-return curve today it is obvious that 75% of global financial assets are now locking in real losses, unless of course, inflation collapses and deflation takes hold in the major economies. Consider a 2 year treasury bond yielding 0.25% as an example. With inflation running at around 1.7%, anyone buying such an instrument is locking in a -1.5% real capital loss for the next two years. The same argument can be made for Germany where yields are even lower than in the US, even if inflation is running at the same pace (and likely to accelerate further), or indeed Japan, France or the UK… In short, in today’s world, it is almost impossible to gather any kind of real returns on fixed income instruments without either taking significant duration risk and/or quality risk, i.e.: moving up to the right of the curve.

 

Now let us assume for a second that the world will be spared a massive deflationary wave and that, consequently, the assets at the bottom left of the curve will lose 1.5% real per year every year for the next five years. This means that, for global assets to stay roughly in the same place, equities will need to provide a real return of 4.5% per annum every year for five years. This is broadly in line with the long term return of equity markets and, given that global equities are not blatantly overvalued, such returns may well be achieved. However, it is important to note that such returns will only serve to compensate for the capital destruction taking place in the fixed income market. Real returns on equities of 4.5% will not leave us any richer compared to our starting level. This means that investors will have effectively spent five years on a treadmill running to stand still. When you consider that no asset growth was registered in the previous five years, we are facing a whole decade devoid of capital accumulation. Given the world’s ageing population, isn’t this bound to be problematic?

Indeed, at a time when most pension funds are already far under water, does a policy that locks in real losses for plan managers really make sense? In short, can the world today afford the real capital destruction central banks are engineering through negative real rates (perhaps we can if that capital destruction mostly occurs on the central banks’ own balance sheets?). This quandary brings us back to the law of unintended consequences: just like the pensioner who, sitting on a fixed amount of capital, will simply buy more and more bonds as interest rates are pushed down (for he needs a fixed level of income—witness Japan over the past twenty years), won’t the world’s pension funds, sitting on real losses because of their existing large fixed income holdings, prove ever more resistant to moving to the far right of the curve? Could the negative real interest rate policies, by destroying capital, guarantee the world a period of sub-par investment growth, sub-par productivity growth, and sub-par economic growth instead? This is what occurred in Japan for a decade, once the bank of Japan moved to a zero rate policy. Basically, ZIRP meant the banks could not make much money, nor were they interested in taking much risk or making loans. And without bank credit, the economy just puttered along, while equities continuously de-rated.

 

Copyright © GK Research (A Gavekal Company)

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After Trial Balloon, Fed Quickly Mobilizes Media to Let Everyone Know They will Remain Easy For a Long Time

Monday, February 25th, 2013

by Mark Hanna, Market Montage

As expected, the Fed saw that even the most minor of divisions in the minutes would cause heartache in the investing community and above all else the central bank is now about not disappointing markets.  As has often been said in these pages the ONLY people who matter on the Fed are Bernanke, Yellen (VP) and Dudley (NY Fed).  These are among the ultra doves, especially Yellen.  Some of the regional Presidents, especially of the Dallas or Kansas City variety are hawks, but they are marginalized.  Hood ornaments of sorts.  Hence when “some members” raise concerns about asset bubbles and Fed policy, it really does matter which members they are since not all members are created equal.

Anyhow there is a FLURRY of stories in the media this morning walking back the minutes (AS EXPECTED).   See here, here, and here for a sampling.  Don’t you worry everyone – the Fed has now stated it is targeting the stock market as a transmission mechanism of policy and the heroin shall remain available for “a long time” as Mr. Bullard told us this morning.  Investors the country over who had the shakes for the two days now are getting their fix.   

Bullard added, “Fed policy is very easy and it’s going stay easy for a long time.“

Stocks are of course gapping up in glee and trying to close the gap down from yesterday.  As noted yesterday the nature of the buying after this short but intense selloff will be something to note.  If that ascending channel is quickly recaptured it will be very similar to what happened in March 2012 when the market fell out of a similar channel for a few days before resuming a trend for another few weeks.   If this buying is quickly sold off and the channel breaks anew (or stocks don’t get back into the channel) in the coming week or two – then a different story.  But 3 month rallies don’t roll over immediately…. even if this is the intermediate top.

•   “It is not an even discussion in the sense that these two sides on the committee do not have equal weight,” said Dean Maki, chief economist at Barclay’s Capital in New York. “Bernanke and Yellen are strong advocates of QE.”
•   Federal Reserve Chairman Ben S. Bernanke minimized concerns that the central bank’s easy monetary policy has spawned economically-risky asset bubbles in comments at a meeting with dealers and investors this month, according to three people with knowledge of the discussions.
•   The Fed chairman brushed off the risks of asset bubbles in response to a presentation on the subject from the group, one person said. Among the concerns raised, according to this person, were rising farmland prices and the growth of mortgage real estate investment trusts. Falling yields on speculative- grade bonds also were mentioned as a potential concern, two people said.

 


 

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Confidence and Enthusiasm (Hussman)

Monday, August 20th, 2012

by John Hussman, Hussman Funds

The present confidence and enthusiasm of investors about the ability of monetary policy to avoid all negative outcomes mirrors the confidence and enthusiasm that investors had in 2000 about the permanence of technology-driven productivity, and in 2007 about the durability of housing gains and leverage-driven prosperity. Market history is littered with unfounded faith in new economic eras, and hopes that “this time is different.” Those periods can be difficult, at least for a while, for investors who are less willing to abandon evidence and lessons of history, not to mention basic principles of economics and valuation. We endured similar discomfort in periods like 2000 and 2007, before hard reality set in.

Investment notes

The recent market cycle has required two changes to our hedging approach. One was in 2009, when our existing approach was dramatically ahead of the S&P 500, but I insisted on making our methods robust to the worst of Depression era data. The other was earlier this year, when we imposed criteria to restrict the frequency of defensive “staggered strike” option positions in Strategic Growth Fund, requiring not only strongly negative expected returns, but also either unfavorable trend-following measures or the presence of unusually hostile indicator syndromes. There’s little doubt that massive central bank interventions have pushed off economic and market difficulties that might have occurred more quickly. The tighter criteria help adapt to that reality, without foregoing the benefit that defensive option positions would have historically had over the course of the market cycle.

These hedging changes would clearly have altered many of our investment positions during the most recent cycle, particularly during the 2009-early 2010 period, but would not alter the strongly defensive position we’ve maintained since early March (see Warning: A New Who’s Who of Awful Times to Invest). Based on a blend of investment horizons from 2 weeks to 18 months, we presently estimate the prospective return/risk profile of the market as being among the most negative 0.5% of historical instances. On the technical front, the S&P 500 is either at or just short of its upper Bollinger band on nearly every resolution (daily, weekly, monthly), while numerous divergences are already in place, including the failure of many sectors and indices to confirm the recent high.

Valuations remain unusually rich on our measures, and only seem benign to Wall Street because profit margins are nearly 70% above their historical norms as a result of depressed savings rates and unsustainable government deficits (see Too Little to Lock In). On that note, it should be of some concern (though it is clearly not) that the price/revenue multiple of the S&P 500 is now above any level seen prior to the late-1990’s market bubble. Prior to that time, the highest post-war peaks were in 1965 (which was not followed by a deep or immediate decline, but marked the onset of what would ultimately become a 17-year secular bear market), and 1972, just before the S&P 500 lost nearly half of its value. Stocks are emphatically not a claim on next year’s projected earnings. They are a claim on a very long-term stream of cash flows that will be delivered to investors over time, and however speculative hopes or fears might move prices in the short-term, the factors that drive long-term prospective returns have remained durable for a century.

We presently estimate that the S&P 500 is likely to achieve a 10-year total return (nominal) of about 4.5% annually, but that alone is not what concerns us. We generally target an exposure to market risk that is proportional to the expected return/risk profile of the market on a blended horizon of 2 weeks to 18 months. Valuations exert a significant effect on those estimates, but numerous other considerations such as broad market action, trend-following measures, and a variety of indicator syndromes (e.g. overvalued, overbought, overbullish) also have significant effect. It is the full combination of evidence that concerns us.

As a side-note, our exposures are generally not directly proportional to the prospective 10-year return that we estimate on the basis of valuations alone. The difficulty with setting an exposure proportional to the 10-year prospective return is that there is little to stop a 10% prospective return from turning into a 15% or even 20% prospective return as a result of much steeper market losses (which we saw in the 1930’s, 1950’s, 1970’s and early 1980’s). Indeed, in 1931, the stock market’s dividend yield exceeded 6%, the Shiller P/E was well below prior and subsequent historical norms, and the market’s prospective 10-year return was above 10% annually, by our methodology. Yet this did not stop the stock market from losing two-thirds of its value over the following year, for an overall Depression-era loss of about -85%, taking the stock market – on a total return basis – to one-seventh of its 1929 level. That said, we certainly don’t require clear undervaluation in order to reduce hedges and establish a constructive position. Absence of severe overvaluation coupled with a shift to favorable market action on our measures is typically sufficient, as was the case in 2003, and might have been possible in 2009 had we not faced the “two data sets” uncertainty.

It may seem overly cautious that I demanded that our hedging models should perform well in cross-validation (“holdout”) data from both post-war data and more extreme Depression-era periods. My view is that the arithmetic of deep losses is devastating to long-term returns, and the behavior of the market and the economy in 2008 and early 2009 was simply out-of-sample from a post-war perspective. I don’t share the confidence and enthusiasm of investors about the ability of central banks to make recessions, debt crises, and major market losses a thing of the past. Again, while the resulting changes in our methods (ensemble models, more restrictive criteria on staggered-strike positions) would have produced substantially different investment positions over the most recent cycle than we took in practice – particularly during the 2009-early 2010 period – the fact is that our defensive stance here is fully intentional, and the “heat” that we experience during points of investor enthusiasm is something that this same discipline would have occasionally experienced in numerous prior cycles.

In Strategic Growth Fund, part of the setback in recent months has been due to hedging costs, and part has been due to a modest lag in our stock holdings, relative to the indices we use to hedge. Neither outcome is extremely rare, or even particularly deep relative to the volatility regularly experienced by a passive buy-and-hold approach, but it’s uncomfortable to experience erosion in both aspects of our approach at the same time. That said, I doubt that this fairly run-of-the mill setback – especially since March – would feel nearly as uncomfortable if it did not blend in with our “miss” of 2009 through early-2010 (which I would not expect to be repeated in future cycles even under identical conditions).

In any event, I believe that the challenges we experienced during the recent, extraordinary cycle have been addressed. We’ll always work to learn new things and to bring new knowledge into practice, but unless we go back to the South Sea Bubble or the Dutch Tulip Mania, there isn’t a great deal of historical context available to augment what we’ve already incorporated into our methods. On the question of whether I believe our present methods require additional stress-testing or remediation, the answer is no, because I am satisfied that these methods would have strongly navigated not only the most recent cycle, but also post-war data, and also Depression-era data (without the exposure to significant periodic losses that our pre-2010 methods would have experienced during the Depression). On the question of whether I believe it was necessary to make our methods so robust to extreme outcomes and economic risks, my answer unfortunately remains an emphatic yes. I believe that investors should be prepared for far greater turbulence than present valuations and complacent sentiment seem to envision.

In my view, this time is not different. It may be more drawn out, but it bears repeating that the 2008-2009 market decline, when it arrived, wiped out the entire total return that the S&P 500 had achieved, in excess of Treasury bill returns, all the way back to June 1995. Regardless of any immediate relief from the Federal Reserve or the European Central Bank (both which I suspect are largely priced into the markets, and leave investors vulnerable to disappointments), I expect that stocks will achieve weak overall returns over the next few market cycles, and I am confident that we are well-prepared to navigate the full course of those cycles, if not always shorter segments (particularly the richly valued portion of mature bull advances, which is where I believe we are today).

What Merkel actually said

What’s fascinating about the present confidence and enthusiasm about central bank intervention is that investors have stopped actually listening for fact, and are increasingly hearing only what they want to hear. A good example of this is the notion last week that German Chancellor Angela Merkel now supports a major round of distressed debt purchases by the European Central Bank. As background, recall that ECB head Mario Draghi indicated a few weeks ago that the central bank was prepared to do “everything” to support the Euro, “and believe me, it will be enough.” Yet immediately after these words, the ECB had a meeting in which it initiated – nothing.

Germany’s position on ECB purchases of distressed country debt (Greece, Spain, Italy) has always been that this support must be conditional on the imposition of centralized control over the fiscal policies of those countries. This is what Germany calls “political” action, and that is why when Germany talks about its willingness to do everything necessary to save the euro, it typically uses the phrase “everything politically necessary.” Merkel’s most concise summary of this position – “Liability and control belong together.”

Fast-forward to last week, when Merkel was in Canada discussing trade issues. There, she gave a statement that was widely reported as suggesting that ECB action is “completely in line with what we’ve said all along.” That phrase was then reported as if Merkel was endorsing a massive and unconditional ECB intervention, which is what Wall Street now seems to be anticipating.

The problem is that here is what Merkel actually said: “The European Central Bank, although it is of course independent, is completely in line with what we’ve said all along. And the results of the meeting of the central bank and their decisions, actually shows that the European Central Bank is counting on political action in the form of conditionality as the precondition for a positive development of the Euro.”

So look at the “results of the meeting of the central bank, and their decisions” that Merkel mentions. The ECB decided to do nothing. No unconditional bailout. No liability without control. That result was indeed completely in line with what Germany has said all along. It just wasn’t what investors wanted to hear, so they heard something else entirely.

Meanwhile, nonperforming loans in Spanish banks surged from 8.96% in May to a record 9.42% in June. There remains an urgent but fully-denied need for broad receivership and restructuring of undercapitalized Spanish banks. It is important to recognize that bailing out the debt of insolvent entities is not a loan, because it is money that can’t be paid back. It is either a direct fiscal expenditure or it is permanent money creation – which is effectively indirect fiscal expenditure since the proceeds of money creation could otherwise be used to finance new government spending. The simple way to understand the Euro crisis is to understand that countries like Germany and Finland expect to be paid back, and failing that expectation, they are unwilling to transfer more fiscal resources than they already have. As the German finance minister said over the weekend, “It is not responsible to throw money into a bottomless pit.” That’s hardly a tone that indicates a willingness to accept unconditional ECB bailouts. All of this will remain very interesting, and most likely very turbulent. In any event, my impression is that the confidence and enthusiasm about easy central bank fixes is sorely misplaced.

Market Climate

As of last week, our estimates of prospective stock market return/risk on a blended horizon from 2 weeks to 18 months remains in the most negative 0.5% of historical instances. It’s easy to blur our present defensiveness in response to extreme conditions we’ve observed since early March into a much longer period of defensiveness : our strategic and intentional defensiveness in anticipation of the 2008-2009 credit crisis, our stress-testing period in 2009-early 2010 which was “non-strategic” in that we would expect to be similarly defensive in future cycles even under identical conditions, and our strategic and intentional defensiveness since April 2010 (though tighter criteria on staggered strike index option positions would have avoided some amount of hedging costs during much of this period). Still, the fact is that present conditions correspond to less than half of one percent of historical observations going back nearly a century.

The issue now is what we should do going forward. In my view, we’ve wholly addressed the “two data sets” problem that we had to address in 2009, and as a result, I am convinced that our approach is well-suited to navigate both run-of-the-mill and very extreme market behavior over the course of future market cycles. I am also convinced that investors should not easily dismiss conditions that are more negative than more than 99% of market history, particularly when they are accompanied with evidence of emerging global recession, overbought conditions at the upper band of daily, weekly and monthly Bollinger channels, and a variety of historically hostile indicator syndromes (Aunt Minnies such as “overvalued, overbought, overbullish” conditions, and evidence of technical divergence and exhaustion).

There is no reason to expect that the Fed will refrain from periodic interventions aimed at encouraging speculation for some period of time. But the effect of previous rounds of quantitative easing have typically been restricted to little more than a recovery of decline in stock prices over the preceding 6-month period, and I am doubtful that we will see much effect when the market is already near the top of its Bollinger channels (2 standard deviations above 20-period moving averages at daily, weekly and monthly resolutions). I am even more doubtful that Fed purchases of Treasury securities to create an even deeper ocean of zero-interest currency and reserves – when banks hold trillions of idle currency and reserves already – will have any material effect on a global recession that we view as already quietly in progress. In any case, our approach is always focused on the average outcomes associated with a given set of market conditions, and individual instances may deviate from the average. Suffice it to say that we continue to adhere to our investment discipline here.

We are presently in an environment that has historically been associated with the overvalued segment of late-stage bull markets. This segment of the market cycle has been frustrating for us before, and that frustration may not be over. Yet in each instance, our defensiveness was overwhelmingly vindicated. The drum-beat of investors is that “this time is different.” Simply put, I doubt that this time is different.

Strategic Growth Fund remains fully hedged, with a staggered-strike position representing about 1.6% in additional option premium cost (versus a standard matched-strike long-put/short-call hedge), looking out to year-end. Strategic International remains fully hedged. Strategic Dividend Value fund remains hedged at close to 50% of the value of its stock holdings (its most defensive stance), and Strategic Total Return carries a fairly conservative duration of about 1.8 years in Treasury securities, with about 10% of assets in precious metals shares, and a few percent of assets in utility shares and foreign currencies.

—

Copyright © Hussman Funds

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Behold The Fed’s Takeover Of The Bond Market

Friday, August 17th, 2012

The must see time lapse video below courtesy of Stone McCarthy shows the distribution across the entire curve of the US marketable debt, as it was held by either the Fed, or the private sector over the past three unconventional monetary policy programs: starting in 2003 and concluding yesterday. In one short minute, this clip demonstrates very vividly how the Fed effectively took over the US bond market.

Some things to note:

  • The reason why the Fed no longer holds any debt with a maturity under ~3 years is because of the “ZIRP through late-2014″ language which means there is no point for the Fed to hold that debt. For all intents and purposes it is the equivalent of cash. Debt maturing between now and 2014 amounts to just under $5 trillion.  Which means the Fed only has about $5.5 trillion in marketable debt with a maturity over 3 years to work with, and already owns about a third of it. It also means that as all the Fed’s holdings in the under 3 year category are sold, Twist will have to be extended, and with it the ZIRP language to beyond 3 years – most likely 5 or so.
  • What is very visible is how the Fed had no choice but to expand its SOMA limit holdings per CUSIP from 35% to 70%. Soon, once the Fed owns 70% of every longer-dated Cusip, it will have no choice but to again extend the maximum permitted holdings, this time to 100% as it gradually become theentire market.

If after watching this clip anyone still believes that the biggest bond market in the world resembles anything even close to fair and efficient or which would have clearing prices anywhere near to where they transact now, they may want to double down on the FaceBook IPO allocation now.

Initial marketable debt distribution by holders starting back in2003 when the first Fed monetary policy started:

And most recent.

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The Economy and Bond Market Radar (July 30, 2012)

Sunday, July 29th, 2012

 

The Economy and Bond Market Radar (July 30, 2012)

After hitting a new low on Tuesday, Treasury yields bounced back sharply on Friday as ECB president Mario Draghi vowed to do whatever it takes to save the euro. This news sparked a “risk on” rally driving risky assets higher and bond prices lower. Yields on Spanish 10-year government bonds reversed course and dropped sharply on the news as it appears the likelihood of a sovereign default has diminished.

Spanish 10-Tear Bond Yields

Strengths

  • In addition to the ECB news discussed above, there was a front page story in the Wall Street Journal earlier this week that was widely believed to be leaked from the Fed to prep the market for potential Fed policy actions as soon as next week. Monetary policy-makers are taking action around the globe.
  • Second quarter GDP grew 1.5 percent. While this is a slow level of absolute growth, it modestly beat expectations.
  • Several homebuilding companies reported earnings this week which indicated orders in the second quarter were very robust.

Weaknesses

  • June durable goods orders ex-transportation fell 1.1 percent, indicating broad-based weakness.
  • The U.K. economy contracted by 0.7 percent in the second quarter, while Mexico’s economy shrank by 0.36 percent in May.
  • Markit’s July eurozone manufacturing Purchasing Managers Index (PMI) fell to the lowest level since June 2009. The more traditional PMI reports will be released next week, but the indications obviously look weak.

Opportunity

  • The Fed and ECB are both talking about additional monetary stimulus. Interest rates are likely to remain very low for the foreseeable future.

Threat

  • Europe remains a wildcard with the markets shifting focus on a weekly basis.

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Is a U.S. Recession Looming?

Wednesday, July 11th, 2012

 

by Scott Colyer, Advisors Asset Management

In the third quarter of 2011 the Economic Cycle Research Institute (ECRI) called for a 100% chance of a U.S. recession. They have a stellar track record of calling U.S. economic cycles. We noted this in our communication to clients at the end of 2011 and again in the first quarter of 2012. We gave the call credence because of who was making the call. What we also noted is that the ECRI estimated the severity of any slowdown to be shallow and fairly short-lived. Most recessions in the U.S. are over even before they are positively identified. Other very reliable indicators did not flash a U.S. recession and did not support the ECRI assertion which included a very positively sloped U.S. yield curve (still 100-110 basis points between the 30’s and 10’s).

The ECRI is very well thought of as Morgan Stanley reversed their bullish call on the U.S. equity markets back in August of 2011 based on the same data. Months and months have gone by since these calls were made. It now appears that we have a slowing economy based on the trajectory change in job creation and other monitors. Europe woes are the blame of the day. Is this the 2011 recession coming in 2012? I am not sure but I doubt it makes much difference to us.

Normally, a slowing U.S. economy would prompt Central Banks to ease monetary policy. However, right now, not only the U.S. Federal Reserve (Fed) has the monetary policy pedal already to the metal. Likewise, the global economies are easing at record pace. The point here is the Fed, if faced with a recession, will certainly move to implement QE3. We believe this would be supportive of higher U.S. equity prices and lower bond yields. The bottom-line here is that whether we are seeing a recession or just a soft patch in the economy, our investment thesis remains the same. With monetary policy GLOBALLY being the easiest in history, we would expect future returns in the equity markets to be greater than high grade debt. Additional QE measures should goose hard asset prices and tend to weaken the dollar. Income assets will be what investors will seek as traditional assets have little yield. This situation will be supportive of the prices of income producing assets.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.

Copyright © Advisors Asset Management

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No Country for Old Bulls

Sunday, July 8th, 2012

  
With global PMI rolling over again, dimming unemployment growth, and slowing EM Asia impacting global production, it is no wonder than BofAML’s economics team sees a dearth of ‘feelgood’ factors in the market. In fact, as they note, further rate cuts in the euro area and China along with around $500bn of NEW QE in this quarter are priced into the market with any hope for risk assets to rally more consistently, investors will need to see not just willing-and-able central bankers but an abatement of the sovereign crisis in Europe and improvement in global data – neither of which they expect anytime soon. Easier monetary policy can only cushion the blow from higher uncertainty in the US and Europe. Effective policy breakthroughs would thus have to come from compromises in the European Council or in US cross-party politics. Investors have yet to zero in on the real impacts of rising economic uncertainty in the US. As Ethan Harris and Michael Hanson have argued, it is unlikely that the cliff is fully priced into the markets and US political dysfunction will share the spotlight with the European crisis over the next few months. And as last time, the joint act will likely undercut investor confidence.

and the prize for best research title also goes to BAML…

BofAML: No Country For Old Bulls

Review: policy to the rescue

Global central banks continued to ease monetary policy in response to a deteriorating global backdrop. Both the ECB and China’s PBoC cut interest rates this week, while the Bank of England kicked off another round of its quantitative easing program. As we expected, the ECB lowered interest rates by 25bp and brought deposit rates down to zero. In the UK, the BoE announced it aims to add £50bn to its balance sheet over the next four months. Meanwhile in Asia, the Chinese central bank surprisingly cut interest rates less than one month after it last lowered borrowing costs.

Most importantly, policymakers’ continued focus on downside risks backs expectations of further policy support. The ECB sounded more concerned about area-wide demand conditions and, although ECB President Mario Draghi discouraged hopes of further non-standard measures such as new LTROs, we think the Governing Council will lower interest rates once again before the end of the quarter. Likewise in China, we look for follow-ups to this week’s rate cut. Reserve requirement ratios will probably be lowered within the next few days, and we expect the PBoC to cut interest rates twice more before the end of the year. This week’s policy action was accompanied by mostly downbeat economic data.

 

Global confidence stumbled again, with the global PMI dropping to 49.6 in June from 50.1 in the previous month (Chart 1). In the US, nonfarm payrolls expanded by a below-consensus 80k in June, while the unemployment rate remained at 8.2%. This brings the 2Q average to 75k, well below the 226k per month seen during the first quarter. The unemployment outflow rate – a statistic tracked by Federal Reserve staff – remained close to historically low levels (Chart 2).

 

Hot topic: a dearth of ‘feelgood’ factors

Besides further interest rate cuts in the euro area and China, we also expect the Federal Reserve to underwrite $500bn worth of QE this quarter. If we are right, systemic central banks will have largely fulfilled recent market expectations of significant policy rescue. But for risk assets to rally more consistently, investors need to see more than willing-and-able central banks, in our view. On top of expanding liquidity, a meaningful market rally needs: (i) an abating sovereign crisis in Europe; and (ii) improvement in the global data. Are these conditions likely to materialize?

 

We think the crisis in the euro area will remain an open sore. The outcome of last week’s summit indeed revealed steps in the right direction. But it was no game changer. As German officials have been keen to highlight, the principle of no mutualization of national liabilities without sovereignty transfers looks intact. Moreover, the painstaking debate on what both shared banking supervision and ESM direct help to banks entail is only beginning. As Laurence Boone explains, the effectiveness of a banking union lies in the details.

 

The Eurogroup will meet next week, when we hope to learn more about the conditions underpinning the Spanish banking bailout. By the end of the month the Troika should unveil the magnitude of funding gaps in Greece. With policymakers still balking at prospects of another debt relief round (that is, official sector involvement), pressure on the new Greek government is likely to mount. We have seen this before: if the Troika pushes for significant adjustment over a short period of time the weakest link of Greek political stability will likely break. The well-known Greek dilemmas should resurface soon.

Better EM data to be cold comfort

As recessions in euro area countries deepen and doubts about both the crisis fighting strategy and the future institutional contours of the monetary union linger, we see no meaningful respite from the sovereign crisis. But could market perceptions brighten up once global activity data start to improve? In other words, could rebounding EM economies lighten up the mood in the marketplace and help investors tolerate foot-dragging in Europe?

 

Our real-time global activity gauge does suggest business conditions became less negative in June. Although activity appears to have softened further in the US, conditions seem to have improved in GEMs. This pushed the global aggregate higher. That said, the GLOBALcycle still indicates that global GDP growth likely dropped to 2.1% qoq (saar) in 2Q from 3.1% in the previous quarter. Looking ahead, wobbling global business confidence argues against a meaningful follow-up from June’s improvement. But mounting policy support in countries such as China and Brazil plus substantial recent drops in EM industrial production (Chart 3) point to a 3Q rebound in local activity. Its global reach, however, will likely be limited. As the US economy weakens ahead of the oncoming fiscal cliff and the euro area remains in recession, we expect global GDP growth to remain close to the 3% level. That is down from the average 4% seen between 2010 and 2011.

The looming fiscal fog

All in all, therefore, market respite opportunities are likely to be few and far between. On the plus side, global monetary conditions should continue to ease. Next week, whereas we now expect the BoJ to stay put, we look for the Brazilian central bank to cut interest rates by 50bp. Likewise, India’s RBI will probably reduce rates by the end of the month. However, as we illustrated last week, easier monetary policy can only cushion the blow from higher uncertainty in the US and Europe. Effective policy breakthroughs would thus have to come from compromises in the European Council or in US cross-party politics.

Investors have yet to zero in on the real impacts of rising economic uncertainty in the US. As Ethan Harris and Michael Hanson have argued, it is unlikely that the cliff is fully priced into the markets. The issue may only start to visibly influence the consensus once lumpy economic decisions – such as business investment and durable goods consumption – start being postponed in the run-up to the cliff. In all likelihood – and much like last summer – US political dysfunction will share the spotlight with the European crisis over the next few months. And as last time, the joint act will likely undercut investor confidence.

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