Posts Tagged ‘Monetization’

Europe Is Japan? Goldman Expects ECB To Become The BOJ, Purchase Private Assets

Monday, July 30th, 2012

 

Goldman’s ex-employee Mario Draghi is in a box: he knows he has to do something, but he also knows his options are very limited politically and financially. Yet he has no choice but to escalate and must surprise markets with a forceful intervention as per his words last week or else. What does that leave him? Well, according to Goldman’s Huw Pill, nothing short of pulling a BOJ and announcing on Thursday that he will proceed with monetization of private assets, an event which so far only the Bank of Japan has publicly engaged in, and one which will confirm the world’s relentless Japanization. From Pill: “Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed.” Why would the ECB do this: “A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations.” In other words, the only thing better than a little global central banker put is a whole lot global central banker put, and when every central planner is now all in, there is no longer any downside to putting in even more taxpayer risk on the table. Or so the thinking goes.

Of course, a rational person may wonder: why would the ECB, which a week ago was arguing for impairing senior debt, suddenly go ahead and monetize not only senior but subordinated debt. And one step further, one may also wonder if this is merely the latest iteration of a Goldman call that should be faded. Because if so, the market is in for a rude awakening. Alternatively, if Draghi does go the full Shirakawa, expect merely a brief LTRO-type response higher, to be followed by yet another major swoon lower as the drug addict demands more, more, more, only that more no longer exists with each succeesive asset dilution iteration.

From Goldman:

We forecast that the ECB will permit NCB purchases of private sector assets

ECB President Draghi’s comments in London last week have raised market expectations that important new measures will be announced by the Governing Council on Thursday (August 2).

Were the Spanish government to request support from the EFSF ahead of Thursday’s meeting and accept the implied conditionality, we would expect the ECB to offer significant support to sovereigns, including through outright ECB purchases of government debt via the SMP. This would mark a significant acceleration and intensification of what we have previously forecast. However, our base case is that events will not move so quickly: the Spanish government is pre-funded through October and, according to the latest reports, an immediate Spanish request to the EFSF is unlikely. We do not expect the ECB to move unilaterally: we view explicit and concrete political support for its actions via EFSF conditionality as a prerequisite for an extension of support to the sovereign markets.

The ECB therefore risks disappointing heightened expectations. Bringing forward measures to ease private-sector financing conditions in the periphery is a likely response. Well-flagged possibilities in this regard include a further easing of collateral eligibility standards and new longer-tenor refinancing operations. But precisely because these measures have been anticipated, they are unlikely to satisfy the market expectations raised by Mr. Draghi’s comments. And we would in any case view the  effectiveness of such measures as questionable, given the segmentation of financial markets and dysfunctionality of financial systems in the periphery.

Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed. Progress in centralising banking supervision at the ECB would facilitate such support for the banking sector.

1.Market tensions continue to mount in the Euro area, in an environment of ongoing macroeconomic weakness.

2.Thursday’s comments by ECB President Draghi in London have raised expectations that the ECB will resume purchases of peripheral sovereign debt via its Securities Markets Programme (SMP). Peripheral markets have rallied as a result.

3.Anything short of an announcement of such a resumption at next week’s ECB Governing Council meeting risks disappointing markets. Indeed, expectations have been raised further on reports that a package of additional measures (interest rate cuts, new liquidity operations) is being prepared in parallel for the August 2 ECB monetary policy meeting.

4.Thus far, we have assumed that the European Financial Stability Facility (EFSF) would be the authorities’ first line of defence in addressing sovereign market tensions. We continue to hold this view. Moreover, we anticipated that the ECB would act in a supportive manner towards sovereign markets should the EFSF take up its responsibility in this regard, for example by offering another longer tenor LTRO operation on a fixed rate / full allotment basis (thereby supporting Euro area banks’ purchase of peripheral sovereign debt). We also continue to hold this view. And recognising the limited capacity of the EFSF / ESM, we have assumed that ultimately the ECB’s balance sheet will need to be mobilised to fund financial support for vulnerable Euro area sovereigns. Our view here is also unchanged.

5.How then to interpret the (to us) surprising boldness of Mr. Draghi’s remarks in London last week? We see them as reflective of an accelerated pace of events, rather than a fundamental change of character. We organise our further analysis around two possible explanations for this acceleration: (a) that Mr. Draghi expects an imminent Spanish request for EFSF support, and therefore foreshadows ECB action as part of a more comprehensive policy response; and (b) that Mr. Draghi’s concerns about contagion and spillovers from sovereign funding tensions in Spain have become more acute.

The Spanish are coming

6.We had been working on the assumption that – with the Spanish sovereign pre-funded for several months yet – we would not see Spanish recourse to the EFSF until the early autumn, as the usual political prevarication prevailed.

7.Mr. Draghi was clearly aware of the market expectations he was creating last week; hence, his comments might suggest he is confident that the Spanish government will turn to the EFSF sooner than that, opening the way for new ECB actions in the coming weeks. Comments from the German and French governments in the aftermath of Mr. Draghi’s remarks, which point to the EFSF as the vehicle for addressing market tensions, would support this view.

8.We continue to doubt the ECB will act ahead of a Spanish request for EFSF support. A unilateral reactivation of SMP purchases of sovereign debt by the ECB in the form seen on past occasions risks being not only ineffective, but even counterproductive – for all the usual reasons:

  • As Friday’s statement from the Bundesbank demonstrates, its resistance to central bank purchases of peripheral sovereign debt remains strong. The Bundesbank is not alone. Reigniting discord within the ECB’s decision-making bodies by restarting the SMP threatens to disrupt once again the ECB’s capacity to act on this and other dimensions of policy. And such discord inevitably implies commitment to such interventions is somewhat ambiguous, thereby undermining their effectiveness;
  • Given how ECB holdings were treated in the Greek debt restructuring, subordination concerns understandably persist among market participants. Declarations of a willingness to take losses on SMP holdings ring hollow: actions speak louder than words in this context. While the ECB may have the opportunity to demonstrate such willingness sooner rather than later in the Greek context, the effectiveness of unilateral SMP purchases is questionable: they need to encourage rather than deter the natural longer-term holders of peripheral sovereign debt from re-entering this market;
  • Above all, were the ECB to restart SMP purchases unilaterally, the incentive for the Spanish government to seek EFSF support – and accept the implied conditionality – would be reduced. An opportunity to hardwire the necessary consolidation, reform and adjustment into the institutional system would be lost. Broadly speaking, we take a positive view of the Spanish government’s policy programme. While we see scope for accelerating and deepening structural reform, if anything we view their envisaged fiscal adjustment as possibly too aggressive. But these measures have not arisen spontaneously: they have come in response to market pressure. For market pressure to be relieved by external financial support, we view the introduction of greater conditionality as crucial to maintain the momentum of adjustment.
  • More generally, it has been a long-held ambition of the ECB to ensure governments have explicit financial involvement with regard to peripheral sovereign debt purchases via the EFSF, rather than leaving the ECB to take sole responsibility. And involving the EFSF introduces the necessary formal conditionality and political accountability to the process, which – as last year’s experience in Italy demonstrates – the ECB acting alone lacks.

9.As we have argued in the past, such concerns make us even more sceptical of proposals to cap peripheral sovereign yields or  target spreads through an ECB commitment to potentially unlimited SMP purchases of peripheral government debt. Market participants seek the certainty offered by such an unconditional commitment to stabilise yields. Given the multiplicity of uncertainties they face at present, that desire is understandable. But such an unconditional commitment by the ECB renders public budget constraints very soft. Irrespective of their behaviour, governments are able to borrow at the rates pegged by the ECB, serving to create moral hazard and scope for ‘free-riding’ on others’ disciplined behaviour.

10.For the ECB in the current environment, this tension between satisfying markets and constraining government is inescapable. It lies at the heart of the difficult course the ECB has charted throughout the financial crisis. Managing the trade-off entails offering external financial support to governments in return for their acceptance of conditionality. Hence, involvement of the EFSF to provide political legitimacy to that conditionality appears crucial.

11.All this leaves the initiative for triggering the next steps in the hands of the Spanish government. Should a request for EFSF support be forthcoming ahead of or in parallel with the ECB Governing Council meeting next Thursday, it would open the door for the ECB to announce supportive measures on that occasion.

12.As we have said in the past, in parallel with EFSF purchases of Spanish sovereign debt subject to adherence to the conditionality expressed in the required Memorandum of Understanding (MoU), we would expect the ECB to support sovereign markets through a repeat of the longer-tenor LTROs that served this purpose earlier in the year. These fund banks to buy domestic sovereign debt in the primary market (where the ECB is prohibited by the Treaty from operating directly). The latest data reveal greater reluctance on the part of Spanish banks to increase their holdings of sovereign debt, while Italian banks continue to show a willingness to do so. In the former case, some ‘arm twisting’ may be required to ensure demand at sovereign auctions, but with public ownership of the Spanish banking sector on the increase, this should be possible.

13.Moreover, recognising the inadequate capacity of the EFSF in the face of sovereign tensions in Spain and / or Italy, we have argued that ultimately – and probably sooner rather than later –the ECB will be drawn into funding that vehicle. With  considerations in the German Constitutional Court delaying the introduction of the EFSF’s permanent (and slightly larger) successor (the European Stability Mechanism, ESM) until at least mid-September, this concern will be particularly acute in the coming weeks.

14.We have always argued that the typical characterisation of how this funding would be provided – giving the EFSF / ESM a banking licence – was an unnecessarily clumsy and provocative route in the face of the well-known institutional and political sensitivities. Admittedly, having the ECB make outright government debt purchases via the SMP in parallel with EFSF / ESM interventions (as envisaged above) is not much (if any) better in this regard, but nevertheless has returned to the discussion. A less controversial scheme, perhaps involving the publicly-owned development banks of the larger Euro area countries, could be found. But these institutional and legal niceties should not detract from the underlying economic reality: one way or another, the ECB’s balance sheet has been and will be mobilised to support sovereign funding. As reflected in the preceding discussion, the crucial question concerns the terms on which this funding is provided.

Addressing contagion (1): Cross-country sovereign spillovers

15.All this assumes that Spain will request EFSF support. Yet German Finance Minister Schaeuble is reported on Saturday as saying a Spanish request for EFSF support is not imminent, as Spain does not face immediate funding problems. And in this Mr. Schaeuble is correct. Having taking advantage of the post-LTRO euphoria in the first quarter, the Spanish government has pre-funded itself, probably through early October. On Spain’s part, there is no urgency to seek external financial support.

16.But Spanish tensions have implications elsewhere. One rationale for immediate ECB action is to contain potential contagion across countries. After all, the introduction of the SMP back in May 2010 stemmed from the concerns that disorder in Greek sovereign markets was dragging down ‘innocent bystanders’ with more modest fundamental problems, simply because of adverse market dynamics. In his London remarks, Mr. Draghi appeared to endorse this line by reviving discussion of the need to re-establish an effective transmission of monetary policy throughout the Euro area.

17.Italy is the most pressing case in this regard. With a primary fiscal surplus, even from its initial high level of sovereign debt the Italian fiscal situation is sustainable – provided that outstanding debt can be rolled over at reasonable rates. But this crucial condition is not met in the current challenging environment. Political pressure is therefore building in Italy: despite accepting the pain of fiscal austerity (and suffering a deep and prolonged recession as a result), Italy has not been rewarded by the markets or by their European partners.

18.In his London comments, Mr. Draghi referred to the impact of ‘convertibility risk’ on interest rates, yields and financial conditions. These remarks are consistent with our own interpretation of recent developments: as the risk of Euro exit has mounted through the crisis, a redenomination risk has become embedded in some asset prices. Uncertain as to what a paper Euro-denominated asset originating from the periphery really represents, foreign investors have been unwilling to hold, still less buy, such assets – and peripheral financial conditions have tightened significantly as a result. Viewing the emergence of this redenomination risk as a systemic problem of which Spanish funding tensions are simply a symptom, one can argue that a systemic solution is required. However well Spain and Italy behave, they are victims of a systemic problem over which they have limited influence.

19.The impact of such systemic considerations could justify ECB actions to contain sovereign spreads. But unfortunately for ECB policy makers, spreads do not come with labels. As we have argued in the past with respect to the distinction between liquidity and solvency risks, a grey area exists between spreads arising from systemic risks and those coming from country-specific economic fundamentals. Attempts to cap sovereign spreads run foul of the dangers expressed above: while they can offset the impact of systemic risks beyond the country’s control, they can also induce free-riding and moral hazard.

20.Conditionality is therefore required. And that leads us back to the role of the EFSF/ ESM in providing the political legitimacy for such conditionality. In the end, the elimination of redenomination risk requires fundamental changes that prompt long-term private holders of sovereign debt back into peripheral markets. Introducing incentive problems makes achievement of that goal harder rather than easier.

Addressing contagion (2): Spillovers from public- to private-sector financing

21.Concerns about spillovers from Spanish sovereign funding tensions not only extend to other countries, but also to the Spanish private sector. Mr. Draghi’s remarks about the impairment of the monetary policy transmission mechanism reflect the extremely difficult financing conditions facing Spanish companies and households, and weak pass-through of official ECB rate cuts to the Spanish real economy. Our own recent analysis of the relationships among official interest rates, bank lending rates and sovereign yields support these concerns. And we have demonstrated that these concerns are not unique to Spain: similar issues arise in Italy and the rest of the periphery.

22.One approach to addressing this problem is to reduce the sovereign spreads that are associated with higher bank funding costs and financial market dislocations. SMP purchases of sovereign debt are a natural vehicle for the ECB to use in that context. But such an approach immediately runs into the problems identified above: the effectiveness of such interventions will be greater the less conditional they are, but the risk of free-riding by the fiscal authorities will be greater.

23.An alternative approach would be to bypass the sovereign spreads and support private-sector financing directly. With its broad and widening definition of collateral eligibility, purchases of bank covered bonds and 3-year LTROs, the ECB has already engaged in variants of this approach, a path now being mimicked by some other central banks. But scope exists to go further.

24.Collateral eligibility could be relaxed again and the haircuts imposed on collateral values reduced. Indeed, the ECB is already engaged in a review of its collateral framework: we anticipate that this will look to remove sovereign credit ratings from the system, in an attempt to eliminate the ‘cliff risk’ inherent in the current system. While the rationale for such a measure may be systemic, it is undoubtedly convenient in the specific circumstances faced by Spain now. And a review of the collateral system offers scope to make more aggressive easing measures elsewhere. Further longer-tenor LTRO operations could be envisaged, out to 5 or 10 years.

25.But, particularly in Spain, the efficacy of such measures is open to question. With the replacement of private unsecured financing with funding from the ECB’s 3-year LTROs against eligible collateral, assets on Spanish bank balance sheets have become encumbered. While bank funding at ECB operations is now cheap and readily available, insufficient free collateral is available to exploit this. Buying covered bonds – as the ECB has done in the past – does not help in this respect (as it also, by nature, involves encumbering bank assets), while changes in collateral eligibility and haircuts have a marginal impact.

26.Outright central bank purchases of unsecured bank debt – something that we have discussed previously – would address this issue. They would support banks’ balance sheet flexibility and facilitate the flow of credit to bank-dependent (and thus credit-starved) small and medium-sized enterprises (SMEs), particularly if marginal incentives were introduced to expand new credit and direct it towards SMEs. Of course, despite the recapitalisation scheme being put in place in Spain, other constraints (notably capital problems) weigh on banks’ ability to lend. And credit demand is weak. So such measures are not a panacea. But in a  bank-dependent economy where the traditional interest rate channel of monetary policy transmission is impaired by market segmentation, they may be the most effective tools available. And the prospect of assuming responsibility for banking supervision across the Euro area may make the ECB more willing to act aggressively through the banks.

27.Extending the chain of logic developed above, this would point to the desirability of bypassing not only the sovereign space, but also the banking system by buying corporate debt. Admittedly corporate debt markets in the periphery are underdeveloped. But were the ECB to initiate purchases, issuance would no doubt quickly follow. And financing the larger corporates that are able to issue would improve their working capital position and thereby indirectly ease financing pressures on their SME suppliers as payment periods normalise.

28.A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations. And, by their nature, credit easing measures involve the assumption of credit risk. The more aggressive the measure, the greater risk assumed. If – as the macro data suggest – Spain and Italy need substantial stimulus, then imparting that via credit easing means that a lot of risk will need to be taken. And given the present segmented state of Euro area financial markets, for a given willingness to accept risk, it may be preferable to make targeted interventions in the countries and sectors where tensions are most acute – even if this means the risks inherent in any single position is greater.

29.The risk assumed can also be distributed across countries in a politically acceptable manner. As with the risk associated with the national schemes for bringing unrated corporate loans as collateral introduced last December, one could envisage the ECB approving a set of voluntary national private asset programmes proposed by NCBs to reflect their particular circumstances, where the credit risk in those operations remained on the NCB balance sheet. Of course, this would not eliminate the risk faced by Germany and the Bundesbank: to the extent that such purchases create TARGET 2 balances (which is likely to be significant), the Bundesbank would still suffer losses in the event of Euro break-up or a peripheral country exit. But the idiosyncratic risks associated with an individual purchase (or indeed any cyclical or sectoral risk that does not lead to exit) would fall on the peripheral country alone, and not on Germany or other Euro area countries. (Of course, in some respects this is a disadvantage: only the ‘catastrophe risk’ is mutualised, but other forms of risk are concentrated at the national level. Thus the risk sharing benefits of a more integrated financial sector are forgone.)

30.Such a scheme allows NCBs to undertake quasi-fiscal action (since credit easing is a form of public subsidy) and monetise the fiscal consequences (by expanding their balance sheets). NCB purchases of private-sector assets (within a framework overseen by the ECB that leaves the credit risk inherent in such operations lying on the NCB balance sheet) offer scope for surgical interventions targeted to address the most impaired elements of monetary policy transmission, while limiting the potential adverse consequences for incentives (especially of governments). Cosmetically, such measures will add to the impression of a renewed Balkanisation of monetary policy in the Euro area. But, with Euro financial markets deeply segmented, such targeted measures offer a way of managing the consequences of that segmentation for the private sector and real economy while maintaining the pressure for governments to act on fundamentals in a manner that reduces and ultimately eliminates the segmentation over time.

Tags: , , , , , , , , , , , , , , , , , , ,
Posted in Markets | Comments Off

Ray Dalio’s Bridgewater On The “Self Re-Inforcing Global Decline”

Thursday, July 19th, 2012

The world’s largest hedge fund is not as sanguine about the hope that remains in the markets today. The firm’s founder, Ray Dalio, who has written extensively on the good, bad, and ugly of deleveragings, sounds a rather concerned note in his latest quarterly letter to investors as the “developed world remains mired in the deleveraging phase of the long-term debt cycle” and has spread to the emerging world “through diminished capital flows which have weakened their growth rates and undermined asset prices”. Between China, Europe, and the US, which he discusses in detail, he sees the lack of global private sector credit creation leaving the world’s economies highly reliant on government support through monetary and fiscal stimulation. The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country’s decline tends to reinforce another’s, making a self-reinforcing global decline more likely and a reversal more difficult to produce. After discounting a relatively imminent return to normalcy in early 2011, markets are now pricing in a meaningful deleveraging for an extended period of time, including negative real earnings growth, negative real yields, high defaults and sustained lower levels of commodity prices. Lastly he believes the common-wisdom – that the Germans and the ECB will save the day – is misplaced.

 

Bridgewater Q2 Letter: Outlook and Markets Discussion

by Ray Dalio, Bridgewater Associates

The developed world remains mired in the deleveraging phase of the long-term debt cycle. The European deleveraging has been badly managed and is escalating, bringing Europe closer to either a debt implosion or a monetization and currency collapse. The impact of the European deleveraging has spread to the emerging world through diminished capital flows which have weakened their growth rates and undermined their asset prices. In the US, the deleveraging is progressing in a more orderly fashion but continues to weigh on the economy’s ability to grow without the monetary support of the Fed. Our studies of deleveragings have proven to be invaluable through this period (let us know if you would like a copy of the expanding library). Because the dynamics of deleveragings are understandable and observable throughout history, one can reasonably assess the nature of their outcomes over time. But because highly-indebted systems that are in deleveragings are also inherently unstable, the timing of discrete events is always highly uncertain (e.g., the shift from austerity to monetization, an exit from the euro, etc.). Through these studies we have continued to refine the indicators we use to measure how the forces of deleveraging are impacting various economies and markets, and we continue to make the relevant adjustments to our investment process that both allow us to anticipate these shifts and to control our risks through the unpredictable twists and turns.

At this point in time Europe is in the most critical stage of the deleveraging process, without a credible plan that will allow a transition from an “ugly” deleveraging, where incomes fall faster than debts decline, to a “beautiful” one, where income grows faster than debts. A transition from an “ugly” to a “beautiful” deleveraging requires an acceptable mix of default, redistribution and monetization. Steps have been taken in this direction, but they remain well short of what is necessary. The range of potential outcomes for Europe and the impacts on the global financial system are wide, so navigating this environment will require flexibility and an understanding of how new policy decisions will affect the path of the deleveraging.

The unresolved European imbalances and the differences in their impacts on each country have produced widening differences in the self-interests of these countries, which have led to political divergences that have magnified the risks. Unlike a year ago, Germany and France no longer stand in solidarity as backstops behind the euro system, but have been divided in their self-interest by divergent financial conditions which are leading to conflicting rather than unified political orientations. France’s deteriorating finances and economy have shifted its self-interest toward alliances with “recipient” (lower credit rated) countries like Italy and Spain and away from “contributor” (higher credit rated) countries like Germany and the Netherlands, leaving Germany more isolated as a guarantor of the risks in the euro system and in its views about how to manage the imbalances. Given these shifts in the alliances between contributor and recipient countries we think that the popular assumption that the Germans and the ECB (which requires agreement of the key factions within it) will come through with money to make all of these debts good should not be taken for granted. Said differently, we think that there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a viable Plan B in place. This fat tail event must be considered a significant possibility.

Given the lack of global private sector credit creation, the world’s economies remain highly reliant on government support through monetary and fiscal stimulation. Now that the most recent round of global monetary stimulation has ended, world economic growth has slowed and central bankers are in the process of stimulating again. We estimate that in the past few months, global growth has slowed from about 3.3% to 1.9% and that 80% of the world’s economies have slowed, including all of the largest. The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country’s decline tends to reinforce another’s, making a self-reinforcing global decline more likely and a reversal more difficult to produce. And at this point, while actions have been taken, none of the world’s largest economies are stimulating aggressively via either monetary or fiscal policy, further reducing the odds of a reversal.

About half of the global slowdown has been due to slower growth in China. In recent years, China has been the locomotive of world growth and its recent sharp slowdown has had knock-on impacts on numerous countries and markets. China itself now makes up 12% of world GDP and its interactions with the rest of the world add to its impact. China is a large export destination for many countries and is the largest marginal consumer of raw materials in the world, so its slowdown has disproportionately hurt the economies which export to China, and its weaker commodity consumption has hurt the commodity producers. In response to this slowdown, China has begun to ease monetary policy and is contemplating more aggressive fiscal stimulation, but the actions have so far been gradual and have not yet been sufficient to produce a notable economic response.

US conditions have slipped with the rest of the world and the Fed has decided to extend its Twist operation; to end it would have been an inappropriate tightening. Last year’s hump in growth has passed as numerous temporary forces have faded, and private sector credit growth remains weak, so growth is converging on the growth of income of around 1.5%. Besides the drag from Europe and the potential for a contagious debt blowup there, numerous US federal programs will expire in the fourth quarter, and given the likely political divisions after the election it will be a challenge for the new Congress to deal with these in a timely manner. Without action, the expiration of these programs represents a fiscal drag on growth of about 2.5%. Given the lack of new aggressive Fed stimulation, the threat from Europe, the simultaneous decline in major country growth rates and the fiscal cliff, the risks to US growth are skewed to the downside.

Over the past 18 months what markets are discounting has changed radically, with a clear bias toward discounting much weaker growth for a longer period of time. This shift is reflected in the rise in credit spreads, fall in bond yields, much lower discounted future earnings growth, flattening of the yield curve, currency moves and shifts in commodity prices. But such price changes simply reflect a transition from the discounting of one set of future economic conditions to the discounting of another set of future economic conditions. After discounting a relatively imminent return to normalcy in early 2011, markets are now pricing in a meaningful deleveraging for an extended period of time, including negative real earnings growth, negative real yields, high defaults and sustained lower levels of commodity prices. This pricing is the midpoint of discounted expectations and each market has an equal probability of outperforming or underperforming. By balancing the portfolio’s exposure to discounted growth and inflation, a disappointment in one asset class will be offset by gains in another, without the necessity of predicting which it will be.

Tags: , , , , , , , , , , , , , , , , , , ,
Posted in Markets | Comments Off

The Stock Is Dead, Long-Live The Flow: Perpetual QE Has Arrived

Thursday, June 14th, 2012

 

Two months ago, as we were carefully reading the latest Goldman explanation of how the firm had completely missed something Zero Hedge predicted back in January, namely the record warm winter’s impact on skewing seasonal adjustments for payroll data (which has since validated our day 1 of 2012 predication that 2012 will be a carbon-copy replica of 2011, and which has made the comedy value of another Goldman masterpiece, that of Jim O’Neill’s idiotic “2012: Not a Repeat of 2010 or 2011″ soar through the roof) we stumbled upon something we knew was about to get much, much more airplay: Goldman’s quiet and out of place admission that what matters for a country’s central bank is the flow of its purchases, not the stock (another massive economic misconception we have been trying to debunk since the beginning). Recall these words: “…we have found some evidence that at the very long end of the yield curve, where Operation Twist is concentrated, it may be not just the stock of securities held by the Fed but also the ongoing flow of purchases that matters for yields…” This is how we summarized this observation two months ago (pardon the all caps): “UNLESS THE FED IS ACTIVELY ENGAGING IN MONETIZATION AT EVERY GIVEN MOMENT, THE IMPACT FROM EASING DIMINISHES PROGRESSIVELY, ULTIMATELY APPROACHING ZERO AND SUBSEQUENTLY BECOMING NEGATIVE!”

All caps aside, what this means is simple: if it is indeed flow that matters (and it is), then Fed intervention can never stop, period. If the stock of a central banks’ assets is irrelevant, the Fed can have $1 on the left side of the balance sheet or $1 quadrillion: it does not matter – if the market expects the Fed to stop buying assets tomorrow, then the crash is as good as here. That has precisely been the biggest flaw with the Fed-accepted stock model, per which Bernanke can buy up a few trillion in MBS and the stock market will be flat as a frozen lake. Alas, this is increasingly becoming obvious is not the case. Hence flow.

Which is why today, two months later, and a week before Bernanke will almost certainly announce the NEW QE, we were not surprised at all to see that Goldman has actually made the case for flow in the form a of a white paper titled “Flow Effects at the Ultra-Long end of the Curve.”

For monetary theory purists this is equivalent to Martin Luther walking up to the front door of the Marriner Eccles building and nailing his 95 theses: we have now entered the era of the monetary reformation, which incidentally as more and more classical economists follow suit, will throw all of Keynesian and neo-classical economics into a tailspin where virtually every core assumption will have to be reevaluated.

Congratulations economists: in their pursuit of another record year of bonuses at any cost, Goldman just sacrificed your precious voodoo. Because where Goldman goes, everyone else promptly follows.

From Goldman Sachs:

Flow Effects at the Ultra-Long End of the Curve (Shan/Stehn)

  • With the scheduled end of the Fed’s twist approaching, market participants are debating the extent to which the end of the Fed’s purchases will affect the yield curve. The “stock view” – which Fed officials and we have generally subscribed to – suggests that markets tend to price in the Fed’s purchases at announcement and then show little responsiveness to the subsequent flow (and end) of purchases. The “flow view,” however, would suggest that yields increase when the twist concludes.
  • Using a simple model of the Treasury yield curve, we revisit this issue in today’s daily. Our estimates suggest that the flow effect is negligible for short and intermediate maturities (of less than 20 years) but statistically significant at the ultra-long end of the curve (with maturities of 20+ years). Although the uncertainty is significant, these estimates suggest that – all else equal – the end of the twist will have negligible effects on the short and intermediate part of the curve, but might push up yields at the ultra-long end of the curve by around 5 basis points.

With the scheduled end of the Fed’s twist approaching, market participants are debating the extent to which the end of the Fed’s purchases will affect the yield curve. Economic theory suggests that we need to distinguish between the effects of the announced stock of Fed purchases and the flow of actual purchases. In forward-looking and liquid markets, bond yields should primarily depend on the announced stock of purchases. Therefore, markets should price in the size of the purchase program at announcement and show little response to the subsequent flow of purchases. This means that when the flow of Fed purchases is discontinued—but the size and duration of the Fed’s balance sheet is unchanged—there should be little effect on yields. Empirical evidence has generally reinforced this prediction. Our own work, for example, has confirmed that stock effects dominate flow effects. (See Sven Jari Stehn, “Stocks vs. Flows Revisited: End of QE2 Unlikely To Have Significant Effect on Bond Yields,” US Daily, April 13, 2011.)

Although the “stock view” appears to be a good description of the effects of Fed purchases at the short and intermediate maturities, flows might be more important at the ultra-long end of the Treasury curve. Intuitively, this would fit with the observation of investment habitat – how purchases of 20-30 year bonds are mostly conducted by more heterogeneous investors that are less sensitive to changes in demand and supply in the Treasury market. Consistent with this view, we found tentative evidence for flow effects at the ultra-long end of the curve in earlier work (see US Daily cited above). However, the number of observations was very small and so the estimates were very imprecise.

With more data on hand and the end of the twist in sight, we revisit the issue of flow effects from Fed asset purchases at the long end of the curve in today’s daily.

Following our previous work, we focus not just on one particular point on the yield curve at a time but also explore how the Fed’s purchase program has affected the entire yield curve. Doing so allows us to better separate the effects of economic factors (which affect the entire yield curve) from the Fed purchases (which differ across the yield curve). Making use of the relative movement of yields at different maturities provides more information and should thus provide better identification. (This disaggregated approach is motivated by Stefania D’Amico and Thomas King, “Flow and Stock Effects of Large-Scale Treasury Purchases,” Finance and Economics Discussion Series, Federal Reserve Board, 2010-52.)

Specifically, we construct our model in a number of steps.

First, we use the New York Fed’s Treasury yield curve estimates, which provide coupon-equivalent par yields for maturities between one year and 30 years.

Second, we construct a dataset of daily flows of Treasury purchases from the New York Fed’s website and allocate these into different “maturity buckets.” For example, we match purchases of bonds that have remaining maturity of between 9.5 and 10.5 years with the 10-year bond yield discussed above. Our sample period – which runs from March 2009 through April 2012 – can be divided into three phases: QE1 (March 2009 through October 2010), QE2 (November 2010 through August 2011), and the twist (since September 2011). The distribution of the purchases is shown in Exhibit 1 below.

Third, we control for the announced stock of Treasury purchases. Given our focus on testing for flow effects and the difficulty of identifying the announcement effect at individual maturities, we use a very flexible approach to capture the effect of the stock of purchases on yields. (Specifically, we use an intercept dummy and a linear trend for each maturity bucket in each QE phase.) The advantage of this approach is that we do not have to make a priori assumptions on the magnitude of the stock effect and doing so should raise the bar for finding flow effects. The drawback, of course, is that our model focuses solely on generating a flow estimate and cannot provide an estimate for the magnitude of the stock effect.

Finally, we combine the data on yields and flows with our stock dummy variables to construct a panel model for these thirty maturity buckets with daily data since March 2009. To take into account variations in duration and/or liquidity factors across maturity buckets, we allow the constant in our model to vary across maturities (that is, we include so-called maturity “fixed effects”). And to disentangle the effect of the Fed’s purchases at the different maturity buckets from economic factors that affect yields across the maturity spectrum, we allow the whole yield curve to shift over time (that is, we include so-called “time fixed effects”). In a nutshell, we estimate the following panel regression:

yield = ?*flow + ?*stock+ fixed effects

where the flow variable captures the purchases, the stock variable is given by the dummies described above and the fixed effects represent maturity and time fixed effects as discussed above. If there is a flow effect, then we should find a negative ? in this regression. To explore whether the flow effect differs at different parts of the curve, we allow ? to vary across different maturity buckets. In our baseline specification, we split the yield curve into seven segments (namely, 1-2 years, 3-4, 5-7, 8-10, 11-14, 15-20, and 21-30 years).

Our results are summarized in Exhibit 2 below. (For the full set of details, see Table 1 in the appendix). Our estimates reveal statistically insignificant ? coefficients at the short and intermediate maturities (up to 20 years), but negative and statistically significant estimates of ? at the ultra-long end of the curve (with 21-30 years maturity). In other words, our estimates confirm previous findings that the flow effect is negligible for short and intermediate maturities but significant at the ultra-long end of the curve. In terms of magnitudes, our results suggest that a $1bn purchase at the ultra-long end of the curve (all other things equal) lowers the yield by 3.3bp at that part of the curve.

We performed a few robustness checks. First, we split the regressions for the 1-10 maturities and 11-30 maturities in two regressions to address the concern that the daily time effects are not appropriate when grouping all 30 maturities together in one regression. The results are qualitatively similar: the flow effect at the very long end of the curve remains significant but the size of the effect drops from 3.3 to 2.3bp per $1bn (see Table 1 in the appendix). Second, we omitted the 1-2 years and 1-3 years maturities since the yields of these maturities have effectively been pinned down by the Fed’s guidance language. Again the results are qualitatively unchanged (not shown).

In a final step, we can look at the implication of our estimates for the yield curve should the twist end in June as currently scheduled. As discussed, our model suggests that – all other things equal – we should not expect to see significant effects on the short and intermediate parts of the yield curve. But – again all other things equal – our model would point to an increase in yields at the ultra-long end of the curve. A simple approach to gauging the implied magnitude of this effect is to look at the average monthly purchases at this part of the curve over the last few months and ask by how much yields would move if this dried up. The Fed has purchased around $13bn per month at the ultra-long end of the curve (21-30 years) since the start of the twist. Taking into account that no purchases were actually made at the 21-23 year maturity (see Exhibit 1 above), this comes to an average of around $1.8bn per month in each of the maturity buckets where purchases actually took place. Applying our estimates of the flow effect – the 2.3bp to 3.3bp range per $1bn of purchases – this would imply that an increase in yields at the ultra-long end of the curve of around 5bp.

While we have reasonable confidence in the qualitative conclusion of our analysis – that flows tend to perturb yields only at the ultra-long end of the curve – it is important to keep in mind a number of caveats when interpreting the quantitative implications of our model. First, disentangling the influence of stocks, flows and other variables on the yield curve is a very difficult exercise and the uncertainty is therefore considerable. Second, our estimated magnitudes are only about as large as the average daily volatility of yields over the last three years (around 6bp at the 30-year maturity). Finally, it is important to note that our model’s estimate only refers to the effect of the end of the flow of purchases on yields and does not take into account other factors that might influence yields at the same time. For example, the end of the twist could have a significant effect on the yield curve beyond the analysis presented here if Fed officials deliver something different from what the market is expecting for the June meeting.

Tags: , , , , , , , , , , , , , , , , , , ,
Posted in Markets | Comments Off

David Rosenberg’s Take on Europe

Monday, May 7th, 2012

From David Rosenberg of Gluskin Sheff

MY TAKE ON EUROPE

Europe is a mess, politically, economically, and fiscally. LTRO gave a short lifeline and at the same time bound the ties even more tightly between bank balance sheets and government bond performance. For all the backslapping, LTRO was a failure, pure and simple. Just as QE — for if QE had been a success, nobody would be looking for a third round (more like the fourth).

I fail to see how any country is going to be able to “grow” their way out of their deficits, barring ECB debt monetization or via German acceptance of a common fiscal policy, which would then allow profligate sovereigns to ride off of Germany’s strong balance sheet. The problem is that the German economy is starting to soften, and along with that I expect polls to start showing lesser support for providing backstops to the periphery. And from a geopolitical standpoint, an ever-isolated Germany spells even more instability. Gold and the gold mining stocks should be a beneficiary.

In less than two years, we are now up to a total of seven European leaders or ruling parties that have been forced out of office, courtesy of the spreading government debt crisis — tack on France now to Ireland, Portugal, Greece, Italy, Spain and the Netherlands. Even Germany’s coalition is looking shaky in the aftermath of the faltering state election results for the CDU’s (Christian Democratic Union) Free Democrat coalition partner.

This is quite a potent brew — financial insolvency, economic fragility and political instability.

Now we have governments, led by Mr. Hollande, who want to adopt “growth agendas” at a time when eroding credit quality is increasingly impeding fiscal borrowing capacity. The French vote comes quickly on the heels of the Dutch government collapse and is joined by a fractious election result in Greece. Germany and other pro-austerity/structural reform entities are the big losers. Then again, how cash-strapped sovereigns who need Germany’s comparatively strong financial position embark on this new anti-fiscal-probity drive is an interesting question.
More uncertainty, more volatility, more risk-aversion likely lies ahead — and along with it, a further deterioration in government financial strength.
As it stands, globally, since the time the Great Recession took hold in 2008, we have seen the total value of government debt backed with AAA-ratings decline from over a 50% share of total outstanding sovereign credit to less than 10%. Quality is scarce, and as such should be owned.

In sum, this is not the backdrop for sustained risk-on investment behaviour. Both Bob Farrell and Walter Murphy see the current corrective phase in the market being extended over the near and intermediate term. I’m not sure I’d want to bet against them, even if Mike Santoli in Barron’s and Paul Lim in the Sunday NYT are advocating a “buy the dips” strategy.

In terms of scouring the globe for countries that are currently being rated AAA by all three agencies, here they are:

- Australia
- Canada
- Denmark
- Finland
- Germany
- Luxembourg
- Netherlands
- Norway
- Singapore
- Sweden
- Switzerland
- U.K.

If we did a further overlay with respect to the most attractive “real yield” characteristics — low inflation and attractive coupons along with strong national balance sheets — we would find Norway, Australia and Switzerland leading the pack.

Tags: , , , , , , , , , , , , , , , , , , ,
Posted in Markets | Comments Off

Albert Edwards: “The Eurozone Crisis Will Get Much, Much Worse” And “The ECB Will Print”

Thursday, October 27th, 2011

Anyone expecting that the events over the last 24 hours will have changed the persistently negative outlook of one of the original skeptics, will be disappointed. The SocGen strategist falls back to that old time-tested principle in complicated situations: math and logic. His summary of events released this morning: “The increasingly frenzied attempts of eurozone governments to persuade financial markets that they can draw a line under this crisis will ultimately fail – even if this week’s measures bring some short-term relief. I have minimal confidence that governments can turn this around within the confines of the eurozone project. You might be surprised though that I feel more bullish! Why? Both Dylan and I have come to the view that the ECB will be forced, by events, to monetise debt in the GIIPS and beyond. And if investors believe the governments in Spain and Italy are bust, then Germany, France, and not forgetting the UK and US, are far, far worse.” To be sure, we may see a brief respite as we get the traditional post-TARP knee jerk reaction, only for markets to digest the sad reality of the situation in the proceeding 48 hours. And what will that imply? To Edwards, it will be nothing short of the realization, that even with €1 trillion (or more), the ECB will have no choice but to commence outright monetization as well. And the real question will be whether or not “Germany, will leave the eurozone after being over-ruled on the ECB (again!) and in the face of such monetary debauchery?”

Looking at the macr Edwards, first points out the unsustainable fiscal picture at the “other” countries, assuming one applies the same logic to them as to Italy:

Italy never “enjoyed” a boom to suffer any bust. And on many measures, including reputable attempts to take account of off-balance sheet liabilities, Italian public sector debt fares well on cross-country comparisons (see chart below). These off-balance-sheet liabilities will now increasingly become visible to all. Who then will be really bust?

The complexity of Europe is only exacerbated by the feedback loop with a recessionary America:

Regular readers will know we like to use leading indicators. These have been weakening for some months in the US and elsewhere. We have not highlighted the Economic Cycle Research Institute’s (ECRI) weekly leading indicator for some time, although it is as weak now as it was last year. But, unlike last year, this time around the ECRI have put out a rare recession call – link.

Lakshman Achuthan, the ECRI’s COO notes that they made the recession call only after an array of economic indicators showed a “pronounced, pervasive and persistent” downturn consistent with a recession. “By contrast, in the summer of 2010, when some market bears interpreted the decline in one of the institute’s indexes as a signal that a recession was in the offing, the institute said the pattern pointed not to recession, but only to weakness.” (Does he mean me? Surely not!) The last time we entered a recession with unemployment this high was back in 1937 (see right-hand chart above). This is indeed a crisis.

 

Analyst optimism on profits has also slipped sharply recently (see left-hand chart above, optimism defined as EPS upgrades as % of all estimate changes). We find the change in optimism (dotted lines in both charts above) is a good leading indicator for the official leading indicators (see right-hand chart above). This signals continued weakness ahead.

But enough about the rest of the world. The ticking time bomb in Europe is and has always been Italy, and specifically its horrific governance structure.

With Italian 10 year bond yields once again pressing towards 6% in recent weeks, they are definitely still in the eye of the storm. The trigger for this  was back in early July, when Italian Prime Minster Berlusconi turned on his well-regarded Economy Minister. Reuters reported on 8 July that “Speculation is growing that Italy’s Economy Minister Giulio Tremonti – credited with shielding the country from the eurozone debt crisis – will soon be forced out of government, which would further raise the heat on Italian bonds… Tremonti overcame cabinet resistance to push through a tough austerity programme last week, but now looks increasingly isolated and appears to no longer have the full support of Prime Minister Silvio Berlusconi.

“He thinks he’s a genius and everyone else is stupid,” Berlusconi said in an interview with Repubblica daily on Friday.”He is the only minister who is not a team player,” Until this untimely outburst, Italian bonds yields had consistently traded below Spanish yields by about 75bp (see chart below). Now they trade at a clear 50bp premium, with yields once again pushing up close to 6%. Belgium, without a government to speak of (an advantage?), but also suffering from a very high government debt/GDP ratio, has by contrast managed to keep below the market’s crisis radar. Italy has been ill-served by its politicians for dragging the country to its knees unnecessarily. It could/should have escaped this debacle.

Albert concludes that “the real issue is Italy’s incredibly low productivity growth (see top right-hand chart above). Hence, having been in excess of 2% yoy in the late 1990s, Italy’s trend GDP growth rate is now barely positive on Vladimir’s estimates (see left-hand chart below) and investment in people is poor (see right-hand chart below). The near-zero trend rate of growth means that Italy simply cannot grow its way out of its debt and will remain highly vulnerable to market shocks.”

Furthermore, when looking at the present, one must not ignore the future, and the future hinges on a demographic crunch: “As populations age and unfunded liabilities increasingly appear on the balance sheet, all governments are effectively bust. Reinhart and Rogoff in their book This Time is Different: A Panoramic View of Eight Centuries of Financial Crises – (link) show that there is no magic public sector debt threshold that determines when a crisis hits. It happens when the markets decides it is time to happen.”

And going back full circle to the most recent events, Edwards redirects to a new and interesting question: not whether this bailout attempt will succeed: it won’t; not whether the ECB will be forced to step up to the plate and monetize: it will, but whether or not Germany, after being once again overruled by Europe will say enough, and leave the eurozone.

Dylan and I feel more optimistic about the medium term. The current eurozone talks will not solve this crisis and it will get worse – much worse. But we would agree with the well known eurozone commentator, Paul de Grauwe of the Leuven University, who wrote “Everyone needs the ECB to step up to the plate. The ECB has no excuse not to act. In trying to keep its monetary virginity intact, the bank threatens to destroy the eurozone.

The ECB will have to choose between its two most cherished ideals: the euro or its hard money principles. Notwithstanding some legal issues to get around and Germany being outvoted, we think the impending threat of a euro break-up will force the ECB to begin printing money, very reluctantly joining in the global QE party. Let’s be clear – neither Dylan nor I view ECB monetisation as a “solution”. Indeed its actions will mirror those of Rudolf Von Havenstein, president of the Reichsbank in the early 1920s. He kept printing because he was scared of the mass unemployment that would ensue if he stopped – link. The question for me is not if the ECB will print, but rather will Germany leave the eurozone after being over-ruled on the ECB (again!) and in the face of such monetary debauchery?

In other words, as we have been saying for over two years, the fundamental question boils down to whether the opportunity cost of being part of the eurozone and funding the entire continent is greater than the loss of returning to the Deutsche Mark and abandoning the implicit peg which has kept the country’s “currency” about 50% lower than its fair value since 1999. Last night’s decision will bring the answer that much closer.

Tags: , , , , , , , , , , , , , , , , , , , , ,
Posted in Bonds, Brazil, Markets, Outlook | Comments Off

Insights from Q&A with Bernanke

Thursday, February 10th, 2011

This post is a guest contribution by Asha Bangalore, vice president and economist of The Northern Trust  Company.

Chairman Bernanke’s testimony today was a repetition of the February 3, 2011 speech at the National Press Club.  He stressed that the unemployment rate was unacceptably high and inflation was low.  In Q&A session, Representative Ryan questioned Chairman Bernanke about whether the Fed is monetizing debt.  Bernanke explained that “debt monetization” stands for a permanent change in money supply to finance the debt.  He went on to add that the Fed plans to reverse course, thus it is not debt monetization.  Money supply grew 4.2% from a year ago during the week ended January 24 (see Chart 1), which is hardly indicative of impending inflationary pressures.

Another noteworthy question pertained to how the Fed would determine if QE3 will be necessary.  Bernanke noted that if the recovery is on a sustainable path and inflation is low and stable, it will not be necessary.  He was also asked under what circumstances the Fed would reverse QE2, which is currently underway.  Bernanke indicated that rapid economic growth and rising risk of inflation would be necessary to reverse the current plan to purchase $600 billion of Treasury securities by June 2011.

Bernanke reiterated that inflation in the U.S is “very very low” (Inflation measures are in Chart 2).  This comment was in response to Representative Ryan citing a Wall Street Journal story “Inflation Worries Spread,” published today.  The Chairman implied that inflation in emerging markets requires responses from their respective central bankers.  It is important to bear in mind that the dual speed world economy (slow growth in advanced economies vs. strong growth in emerging markets) will entail different monetary policy responses such that it is suitable to the economic status of each economy.

Bernanke’s opinion about the recent upward trend of bond yields was also sought.  The Chairman replied that it reflects “increasing optimism about the U.S. economy.”  The 2-year and 10-year Treasury note yields were trading at 0.80% and 3.65%, respectively, as of this writing.  The recent lows were 0.54% and 3.36%, respectively, for 2-year and 10-year Treasury note yield as of January 28 (see Chart 3).

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, February 9, 2011.

Tags: , , , , , , , , , , , , , , , , , , , ,
Posted in Markets, Outlook | Comments Off

John Taylor’s Controversial Outlook on Inflation: “Not Here, Not Now”

Friday, January 21st, 2011

This article is a guest contribution via ZeroHedge.com

John Taylor, traditionally one of the most insightful strategists, has released a controversial note looking at the prospect of surging inflation, which he says is not much of an issue, “because the global economy is suffering from excess manufacturing capacity and a deficit of consumption, history tells us there is little chance that inflation will be a problem.” We wholeheartedly agree with him on this point… to an extent. All the African countries experiencing food riots also have record high unemployment: read massive excess capacity, manufaturing and otherwise. Thus, at least in the developing world, the two are no longer related. Is that the case in the developed world? With enough money thrown at it, the answer is a resounding yes. Should the Chairvillain continue his money printing “third mandate” duty, we are confident we will be proven correct soon. And after all, as many have speculated, the Fed has no other choice to deal with the massive debt load. Additionally, if as the WEF is correct, and world debt stock has to double to over $200 trillion in a decade, the bulk of that debt will have to be acquired by assorted central banks: read – monetization…whose one certain side effect is a surge in excess reserves, and thus, inflationary expectations. Should the ill-defined concept of velocity pick up even a smidge, it is game over for the monetary system, and not just regionally, but globally. Which is why we are in full agreement with Taylor on phase 1 of the reflationary experiment, he is short on the second phase, namely the one in which Bernanke continues to print, print, print, drowning out all incremental deflationary threats from “excess capacity” which always has just one monetary outcome…

Inflation, Not Here, Not Now

January 20, 2011
By John Taylor
Chief Investment Officer, FX Concepts

Commodity prices are flying higher, interest rates are near zero, base money growth is staggeringly high and inflation expectations are going to the moon. It looks like inflation is back, but it isn’t the kind of inflation the Germans worry about or the kind that leads to high interest rates followed by a deep recession. If this is not the inflation of post-WWI or the 1970′s, then what is it? Although the current bout of food shortages and price increases have helped topple the government in Tunisia and led to food riots in Algeria, these commodity price increases and the excess money being spread around should not have any impact in the G-10 countries, unless some central bank makes a big mistake and hikes interest rates. Why is it so different this time around?

Because the global economy is suffering from excess manufacturing capacity and a deficit of consumption, history tells us there is little chance that inflation will be a problem. If we just look at the second half of the 1930′s, the prime example of a consumption shortfall, when interest rates were exceedingly low and base money was growing sharply (because Roosevelt had changed the price of gold), many were worried about inflation but it never arrived. Fed Chairman Bernanke’s QE efforts are only a pale shadow of Roosevelt’s powerful inflationary stroke, but prices stayed subdued back then and they will now. With still climbing excess manufacturing capacity, and so much of it located in low- wage China, there is little or no wage pressure in the developed world. The situation was exactly the opposite in the 1970′s when there was not only a shortage of skilled workers but many contracts were inflation adjusted as well. Now these inflationary adjustments are history except in some public pension plans (which are on their way to insolvency). Labor’s pricing power has been declining since the 1970′s. In the US the number of hours necessary to buy a car bottomed in 1972 and it now takes about twice as long for the average worker to buy the average car. Although monetary growth is a necessary condition for inflation, without tight labor markets it just cannot find the traction necessary. When the price of oil or food goes up, the weakened worker will drive less or eat less, he/she cannot drive wages up. Final demand stays the same but it is just spread around differently.

If commodity prices climb higher and higher, the American and European worker will tend to spend more for food and fuel, cutting down his purchases of manufactured items and locally produced services. Units of food and fuel purchased will drop as well, as each one is more expensive, cutting final demand and lessening the upward pressure on commodity prices. The raw material producers, generally the emerging markets, should prosper in relation to the manufacturing countries, shifting the balance of global power. This change in relative economic dominance matches the concept of the Kondratieff cycle and fits very well with MIT’s capital investment cycle. The current period seems to fit nicely with 1937, and if we use that as a base date, the commodity producers will prosper for another 13 to 15 years as they did back then. Although the western countries will have a growth problem, not an inflation problem, the commodity producers will have plenty of growth and plenty of inflation. Although Australia, a perfect example in the early 1950′s, with high growth and high inflation, controlled its overheating problems fairly well, this time around there will be many countries that have not tasted “capitalist” freedom before. As many of these newly wealthy countries have managed currencies with exploding reserves and money supplies, the next decade or so should see dramatic inflationary booms and busts, plus plenty of political turmoil. With the G-10 consumers facing a difficult 2011, global commodity prices should peak soon and inflation fears will melt away in the US and Europe.

Copyright (c) ZeroHedge.com

Tags: , , , , , , , , , , , , , , , , , , , , ,
Posted in Energy & Natural Resources, Gold, Markets, Oil and Gas, Outlook | Comments Off

“Being shocked by the implications of QE2 re ‘printing money’ and ‘debt monetization’ hypocritical,” says Kasriel

Tuesday, November 16th, 2010

This post is a guest contribution by Paul Kasriel, Chief Economist of The Northern Trust  Company.

Every student who took Econ 101 and stayed awake during the lectures learned that the Federal Reserve has the power to create credit figuratively “out of thin air”. The A-students also learned that the commercial banking system, not individual banks, under the fractional-reserve system that we and every other developed economy have, also has the power to figuratively create credit out of thin air if the Federal Reserve first provides the “seed” money to do so. This is not unique to the Federal Reserve and the U.S. commercial banking system. This holds wherever there are central banks and fractional-reserve commercial banking systems. So, when there is an increase in the sum of Federal Reserve credit and commercial banking system credit, credit is created out of thin air, which is akin to “printing money.” When there is an increase in the sum of Federal Reserve credit and commercial banking system credit, some entity’s debt is being “monetized.”

Until the first round of quantitative easing was initiated by the Fed at the end of November 2008, the Fed had mostly restricted its debt monetization to Federal debt. Then, in the first round of quantitative easing, the Fed began monetizing large amounts of private debt in the form of mortgage-backed securities. Because Treasury securities comprise a small proportion of commercial banking system credit, the bulk of debt monetized by the commercial banking system is private debt.

Chart 1 shows the history of “money printing“/“debt monetization” from 1953 through 2009 in the U.S. The median annual percentage change in money printing/debt monetization during this period was 7.5%. In 2009, for the first time during this period, money printing/debt monetization contracted. In the 12 months ended October 2010, the fastest three-month annualized growth in money printing/debt monetization was a paltry 1.1% (see Chart 2). The Fed has said that it plans to purchase $600 billion of Treasury securities by the end of June 2011. If Federal Reserve credit were to increase by $600 billion and commercial banking system credit were to remain unchanged between the end of October 2010 and the end of June 2011, then the sum of Federal Reserve credit and commercial banking system credit would have increased by 5.2%, at an annualized rate over this eight-month period of 7.9% and 5.6% over the June 2010 level.

So, here are the important take-aways (see, I’m hip to corporate lingo) from this commentary. Whenever the sum of Federal Reserve credit and commercial banking system credit increases, credit is being created out of thin air and some kind of debt is being monetized. Assuming that the commercial banking system does not create any net new credit between now and the end of June 2011, the magnitude of the credit creation being contemplated by the Fed is not extraordinary in an historical context. And, it is not an extraordinary increase in credit creation given the current amount of resource underutilization in the U.S. economy. So, being shocked by the implications of QE2 with respect to “printing money” and the “monetization of debt” would appear to be either naïve or hypocritical.

Source: Paul Kasriel, Northern Trust, Daily Global Commentary, November 15, 2010.

Tags: , , , , , , , , , , , , , , , , , , ,
Posted in Markets, Outlook | Comments Off