Thursday, August 21, 2014

Jackson Hole
Central bankers like to get together on a regular basis at nice locales. They do so every year in late August at Jackson Hole, Wyoming. This annual conference brings together the top honchos of the major central banks. They tend to focus their discussions on the hot issues of the day. This year’s topic is “Re-Evaluating Labor Market Dynamics.” The program for the August 21-23 meeting will be posted today at 6 p.m., MT. Last year’s topic was “Global Dimensions of Unconventional Monetary Policy.”

On Wednesday, Bloomberg’s Simon Kennedy reported:
Every time then-Federal Reserve Chairman Ben S. Bernanke spoke at the annual monetary policy symposium in the shadow of Wyoming’s Teton mountains since 2007, stocks rallied. With Janet Yellen set to make her first speech to the conference as central bank chief on Aug. 22, investors may be setting themselves up for a fall, according to Steven Englander, global head of G-10 foreign exchange strategy at Citigroup Inc.
Kennedy noted that from 2007 to 2012, Fed Chair Ben Bernanke’s keynote speech was bullish, with the S&P 500 up an average 1.3% that day. Bernanke skipped last year’s meeting. Englander was quoted as saying that Fed Chair Janet Yellen’s speech could be a letdown: “We worry that dovishness is increasingly anticipated and that by the time we get to her talk anything less than ‘full dovishness’ will be a disappointment.”

I’m not worried. As I noted yesterday, I expect that the “Fairy Godmother of the Bull Market” won’t let us down. In a June 30, 2009 speech, Yellen said that the lesson of history, particularly of the Great Depression, is that premature monetary tightening can be disastrous. I’m sure she still thinks so, and might very well say so again on Friday.

Yellen is a Yale PhD macroeconomist with particular interest in the labor market. She is also a liberal and believes that the labor market needs all the help it can get from the Fed. I doubt that she picked the topic for discussion at Jackson Hole, but I’m sure the folks at the Kansas City Fed, which has been hosting the conference since 1978, did so to please the boss.

Yellen’s liberal bias was plain to see in the statement issued after the July 30 meeting of the FOMC. It noted: “Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources.” The previous statement following the June 18 meeting noted: “Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated.” This change in wording clearly reflects Yellen’s focus on the negatives rather than the positives in the labor markets.

I believe that American consumers are in better shape than Yellen believes. However, if she insists on helping them out with more ultra-easy money than they really need, then stock investors will continue to benefit as well. Again: Thank you, Fairy Godmother!

ECB President Mario Draghi will follow Yellen with the keynote luncheon address on Friday. It’s unlikely that he will drop any new “whatever-it-takes” bombshells, as he did on July 26, 2012. It’s unlikely that he will hint at the possibility of a Fed-style quantitative easing given the legal issues surrounding this program. Instead, he will most likely stress that the ECB’s recent easing moves, including TLTRO lending to the banks starting next month, should help to revive growth in the Eurozone. Unlike Yellen, he is likely to say that monetary policy can’t fix all of our problems, including structural ones in the labor market.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, August 19, 2014

'Fairy Godmother' Will Speak on Friday
Investors may be looking forward to Fed Chair Janet Yellen’s speech at Jackson Hole on Friday. I’ve often affectionately called her the “Fairy Godmother of the Bull Market.” Stock prices tend to rise after she speaks about the economy and monetary policy. That happened often when she was a Fed governor, and has continued now that she is Fed chair.

A few Fed watchers are speculating that the upcoming speech would be a good opportunity for Yellen to signal that she is ready to normalize monetary policy, i.e., hike the federal funds rate. So they are expecting a hawkish speech. I disagree. In a June 30, 2009 speech, Yellen said that the lesson of history, particularly of the Great Depression, is that premature monetary tightening can be disastrous:
If anything, I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery. That’s just what happened in 1936 when, following two years of robust recovery, the Fed tightened policy because it was worried about large quantities of excess reserves in the banking system. The result? In 1937, the economy plunged back into a deep recession. Japan too learned that hard lesson in the 1990s, when both monetary and fiscal policies were tightened in the mistaken belief that the economy was rebounding.

These episodes teach us a valuable lesson that we should heed in the present situation. Let this not be another 1937, but a time when policymakers have the wisdom and patience to nurse the economy back to health. And, when the economy does come back, let it be built on a foundation of sound private investment and sustainable public policies. Only then can we be confident that we can escape destructive boom-and-bust cycles and build a more permanent prosperity. Thank you very much.
Thank you, Fairy Godmother!
(Based on an excerpt from YRI Morning Briefing)

Wednesday, August 13, 2014

Labor Market De-Slacking
Fed Chair Janet Yellen is no slacker. She is a hard worker for sure. You’ll never see a photo of her at the golf course. She would like everyone who wants a job, and wants to work hard, to have the opportunity. She intends to keep interest rates near zero for as long as necessary to do the job. The economy seems to be moving faster toward Yellen’s goal of eliminating slack in the labor market. June’s JOLTS report and July’s NFIB survey of small business owners, which were both released yesterday, certainly confirm this assessment.

Of course, Fed Chair Janet Yellen has said that she won’t be completely satisfied with the progress in the labor market unless wages are rising at a faster pace. That’s not happening so far. During her March 19 press conference, she said:
The final thing I’d mention is wages, and wage growth has really been very low. …. In fact, with the productivity growth we have and 2 percent inflation, one would probably expect to see, on an ongoing basis, something between--perhaps 3 and 4 percent wage inflation would be normal. Wage inflation has been running at 2 percent. So not only is it depressed, signaling weakness in the labor market, but it is certainly not flashing.
Back in July, I suggested that Yellen should read a very interesting 7/21 article posted on Bloomberg titled, “Yellen Wage Gauges Blurred by Boomer-Millennial Shift.” The conclusion is that demographic shifts in the labor markets may keep a lid on wage inflation, which would make it a poor indicator of labor market conditions:
As today’s middle-aged Americans grow older, they are leaving their prime working years behind, trading big salaries for part-time gigs or retirement, just as an even larger group of young people come into the labor force at entry-level salaries. The seismic shift may be one reason behind the sub-par wage growth that Yellen says still shows ‘significant slack’ in the job market.
I concluded then, as I still believe:
If she continues to put too much weight on this demographically flawed indicator, monetary policy may stay too easy for too long (as it has already, in my opinion). What’s wrong with that if wage inflation remains subdued, and so does price inflation? Nothing really, I suppose, unless it all leads to lots more financial bubbles that should have been averted with the more immediate normalization of monetary policy.
(Based on an excerpt from YRI Morning Briefing)

Thursday, July 17, 2014

Yellen: Fashion Statement
Bubbles are in fashion. On Tuesday, when she testified before the Senate Banking Committee, Fed Chair Janet Yellen wore a stylish outfit with a jacket that was grayish looking with lots of white circles. That was a fitting choice since they looked like bubbles, which was a topic covered during her semi-annual congressional testimony on monetary policy. Let’s review the testimony:

(1) Prepared remarks. In her prepared remarks, Yellen said that the FOMC “recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events.” She pinpointed the junk bond market, where “valuations appear stretched and issuance has been brisk.” The Fed is also monitoring the leveraged loan market and working on supervising it effectively. On the other hand, she doesn’t see much irrational exuberance in the prices of real estate, equities, and corporate bonds. While they “have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms.”

(2) The report. The Fed’s latest Monetary Policy Report accompanied Yellen’s testimony. The word “stretched” is in fashion. It appeared twice in the report to describe valuations in some asset markets, “particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

The report also downplayed any irrational exuberance in the rest of the equity market: “However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities.”

What about other asset classes? “Beyond equities, risk spreads for corporate bonds have narrowed and yields have reached all-time lows. Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened.”

(3) Q&A. During the Q&A session, Senator Tom Coburn (R-OK) framed his question as follows: “Rather than preventing asset bubbles from happening, we're now taking the approach that they're going to happen and we're going to deal with them. It just seems to me now that we're kind of locked in this zero interest rate phenomenon, and one of the consequences of that is reaching for yield, and now we're going to try to attenuate the response to the zero interest rate rather than change the policy so we don't have the bubbles in the first place.”

Yellen responded by expressing confidence in the Fed’s macroprudential tools: “They diminish the odds that bubbles will develop.” However, she did concede, “So I think there are some risks in a low interest rate environment. I've indicated that, and we're aware of them. But I think the improvements we've put in place in terms of regulation both diminishes the odds that risk will develop and, if there is an asset bubble and it bursts, it will--it will, and we're not going to be able to catch every asset bubble or everything that develops.” Her comment raises an interesting question: Might there be too many bubbles to catch?

There was no discussion in either the testimony or the report, nor during the Q&A, of what might happen when the Fed finally starts raising rates. Last year’s “taper tantrum” triggered a mini crisis in emerging market currencies, debt, and stocks. When the Fed starts hiking rates, that could happen again. Another worrisome development under this scenario would be massive withdrawals from corporate bond mutual funds, which have become a large “shadow bank.” That would be particularly troublesome since the corporate bond market has become increasingly illiquid since the Great Financial Crisis.

The biggest bubble of them all, of course, is in government debt around the world. All the more reason why the Fed and other central banks might be very hesitant to raise interest rates. They’ve been getting away with their NZIRPs (near-zero interest rate policies) because CPI inflation rates have remained surprisingly low. That might actually be attributable to ultra-easy money, which has financed too much excess capacity, particularly in China. However, there has certainly been lots of asset inflation (a.k.a. bubbles), and probably more to come.

In her prepared remarks, Yellen was a two-handed economist about the outlook for interest rates. If the labor market continues to improve faster than expected, “then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned.” On the other hand, if economic activity is disappointing, “then the future path of interest rates likely would be more accommodative than currently anticipated.”

During the Q&A, she clearly favored erring on the ultra-easy side of the street. “The Federal Reserve does need to be quite cautious with respect to monetary policy.” She warned about the “false dawns” that tricked Fed officials in recent years. Later, Yellen told lawmakers that “accommodative policy” would be necessary until the economic headwinds that have slowed the recovery are “completely gone.” She didn't explain how she will determine that to be the case.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, July 16, 2014

The Fed: Monetary Policy Report
Yesterday, Fed Chair Janet Yellen presented the Fed’s semi-annual Monetary Policy Report to the Senate Banking Committee. While the accompanying testimonies of Fed chairs always make headlines, the report is rarely even read. Not so the latest one, which provided the following investment advice: “Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms.” In other words, sell them.

That unnerved stock investors despite the following reassurance in the report about the overall market: “However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities.”

Yellen was also reassuringly dovish, stating: “Although the economy continues to improve, the recovery is not yet complete.” Despite all the recent strength in lots of labor market indicators, she claimed that “significant slack remains in labor markets.” She said that this is “corroborated by the continued slow pace of growth in most measures of hourly compensation.” In the past, she indicated that she would like to see wage inflation rise from 2% currently to 3%-4%.

The 7/21 issue of The New Yorker includes a lengthy article about Yellen that’s worth reading. It confirms that she is an impassioned liberal: “Yellen is notable not only for being the first female Fed chair but also for being the most liberal since Marriner Eccles, who held the job during the Roosevelt and Truman Administrations. Ordinarily, the Fed’s role is to engender a sense of calm in the eternally jittery financial markets, not to crusade against urban poverty.”

Yellen is from the Fed, and here “to help American families who are struggling in the aftermath of the Great Recession.” She and her husband, who leans far to the left, have published a series of papers on why labor markets don’t automatically work to maintain full employment. The government can do the job better: "I come from an intellectual tradition where public policy is important, it can make a positive contribution, it’s our social obligation to do this. We can help to make the world a better place.”
(Based on an excerpt from YRI Morning Briefing)

Monday, June 23, 2014

The Fairy Godmother of the Bull Market
The Fairy Godmother of the Bull market did it again last week. Whenever Janet Yellen speaks publicly about monetary policy and the economy, stock prices tend to rise. On Wednesday, the S&P 500 climbed 0.8% to yet another new record high in response to her press conference that day. It rose 0.3% on Thursday and Friday to 1962.87. It would have to gain just 2.6% to reach my yearend target of 2014, which I am thinking about raising. However, a melt-up followed by a meltdown back to 2014 by the end of this year remains a distinct possibility.

Yellen’s pronouncements have tended to be bullish for stocks since she first took office as vice chair of the Board of Governors in October 2010. Now we can look forward to her quarterly press conferences as Fed chair, the position she assumed in February of this year. Of course, Fed policy has been ultra-easy since the start of the bull market, and stocks have also tended to rise after most FOMC meetings.

The stock market’s bulls were charged up last week by both the FOMC’s statement and Yellen’s spin on monetary policy. Consider the following:

(1) Unanimous. The latest statement was almost identical to the previous one on April 30. (See the WSJs Fed Statement Tracker.) Once again, the FOMC reaffirmed its NZIRP, or near-zero interest-rate policy:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
Remarkably, the vote for the current policy stance was unanimous. No one dissented in favor of language suggesting that interest rates might have to be raised sooner given the ongoing improvement in the economy and the labor markets, as well as the recent rebound in inflation.

(2) Noisy inflation. Even more remarkable, when asked in her press conference about the recent inflation rebound, Yellen blew it off as noise. In her prepared remarks, she didn’t even acknowledge the recent broad-based upturn in inflation:
Inflation has continued to run below the Committee’s 2 percent objective, and the Committee remains mindful that inflation running persistently below its objective could pose risks to economic performance.
Last week, I noted that the core CPI, on an annualized three-month basis, rose from 1.4% during February to 1.8% during March to 2.2% during April to 2.8% during May. I expected some mention of this new inflation risk in the FOMC statement and Yellen’s press conference. Instead, it was like it never happened.

Indeed, Yellen’s response to the first question by CNBC’s Steve Liesman about the possibility that inflation might be on the verge of exceeding the FOMC’s 2016 target was bizarre:
So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it's--the data that we're seeing is noisy. I think it's important to remember that broadly speaking, inflation is evolving in line with the committee's expectations. The committee has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.
(3) Unemployment spin. In her prepared remarks, Yellen acknowledged that the labor market is improving, but accentuated the negatives rather than the positives:
The unemployment rate, at 6.3 percent, is four-tenths lower than at the time of our March meeting, and the broader U-6 measure--which includes marginally attached workers and those working part time but preferring full-time work--has fallen by a similar amount. Even given these declines, however, unemployment remains elevated, and a broader assessment of indicators suggests that underutilization in the labor market remains significant.
During the Q&A, Yellen added:
That said, many of my colleagues and I would see a portion of the decline in the unemployment rate as perhaps not representing a diminution of slack in the labor market. We have seen labor force participation rate decline.
She also noted that wage inflation is running around 2%, which is too low in her opinion. It’s barely keeping up with inflation and should be rising faster to reflect productivity. She is rooting for this to happen, and isn’t inclined to tighten monetary policy if and when it does.

(4) No thresholds. The Fed’s experiment with tying monetary policy to a specific threshold for two key indicators started at the December 11-12, 2012 meeting of the FOMC, when an unemployment rate of 6.5% was specified as the “threshold” for discussing raising interest rates as long as the inflation rate wasn’t still below 2%. The unemployment threshold was dropped at the March 18-19, 2014 meeting, the first one with Yellen as chair.

At her latest press conference, Yellen said that the FOMC has reverted to a fuzzier data-dependent approach:
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This broad assessment will not hinge on any one or two indicators, but will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.
(5) No bubbles yet. Yellen said she sees some signs of speculative excesses, and she is monitoring the low pace of volatility in financial markets, a sign of complacency. However, so far, she doesn’t see a need for monetary policy to respond to these developments, thereby contributing to the markets’ complacency!

Here is what she had to say about volatility:
The FOMC has no target for what the right level of volatility should be. But to the extent that low levels of volatility may induce risk-taking behavior that for example entails excessive buildup in leverage or maturity extension, things that can pose risks to financial stability later on, that is a concern to me and to the committee.
More specifically, she believes that the level of risk-taking remains “moderate”:
Trends in leverage lending in the underwriting standards there, diminished risk spreads in lower-grade corporate bonds, high-yield bonds have certainly caught our attention. There is some evidence of reach for yield behavior. That's one of the reasons I mentioned that this environment of low volatility is very much on my radar screen and would be a concern to me if it prompted an increase in leverage or other kinds of risk-taking behavior that could unwind in a sharp way and provoke a sharp, for example, jump in interest rates. …But broadly speaking, if the question is: To what extent is monetary policy at this time being driven by financial stability concerns? I would say that--well, I would never take off the table that monetary policy should--could in some circumstances respond. I don't see them shaping monetary policy in an important way right now. I don't see a broad-based increase in leverage, rapid increase in credit growth or maturity transformation, the kinds of broad trends that would suggest to me that the level of financial stability risks has risen above a moderate level.
(6) Complacent valuations. With regards to stock market valuations, she remains relatively complacent:
So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly.
(7) Uber dove. Fed policy remains data dependent. However, Yellen is likely to describe the data as “noisy,” and therefore irrelevant if the numbers don’t support her ultra-liberal assessment of the disappointing performance of the economy and her preference for maintaining ultra-easy monetary policy until all ex-cons are gainfully employed. I wish I was kidding.

In her 3/31 speech in Chicago, she briefly described the struggle of three workers in the Windy City--Dorine Poole, Jermaine Brownlee, and Vicki Lira--in the labor market. On April Fools’ Day, Jon Hilsenrath reported in the WSJ:
One person cited as an example of the hurdles faced by the long-term unemployed had a two-decade-old theft conviction. Another mentioned as an example of someone whose wages have dropped since the recession had a past drug conviction.
Hilsenrath also noted that a Fed spokeswoman said Yellen knew of the people's criminal backgrounds and that they were “very forthright” about it in conversations with the chairwoman before the speech!

During last week’s Q&A, Yellen confirmed that she remains one of the FOMC’s most dovish members when she said, “inflation continues to run well below our objective, and we're still some ways away from maximum employment and for the moment, I don't see any tradeoff whatsoever in achieving our two objectives. They both call for the same policy, namely a highly accommodative monetary policy.”

Thank you, Madam Fairy Godmother! Fairy tales can come true, especially for us bulls.
(Based on an excerpt from YRI Morning Briefing)


Wednesday, April 16, 2014

The Fed & Inflation
Janet Yellen, “The Fairy Godmother of the Bull Market,” may soon have to deal with an age-old adage: “Beware of what you wish for, because you just might get it.” She might have to explain why the Fed’s goal is to inflate the inflation rate back to 2%. She obviously wants to avoid deflation. Consider the following:

(1) CPI inflation rate upticking. March data released yesterday showed an increase in the CPI inflation rate to 1.5% y/y from 1.1% the month before. It was led by food prices and rents. The former rose 0.4% m/m, and 1.7% y/y.

(2) Rent inflation rising.The CPI rent of shelter component rose 0.3% m/m, and 2.7% y/y, the highest reading since March 2008. This is a very odd measure indeed. It accounts for 32% of the total CPI. It has two major subcomponents, namely tenant rent and owners’ equivalent rent (OER). The former, which reflects actual rent paid by actual renters and accounts for 7% of the CPI, rose 2.9%, and has been hovering around this rate for the past 10 months. The latter, accounting for 24% of the CPI, has increased from 2.2% six months ago to 2.6% during March.

OER is an imputed measure of the rent homeowners would have to be charged to rent the homes they own. I kid you not, though I’m sure you knew that already. Presumably, it is based on actual tenant rent. Nevertheless, the recent leap in the OER inflation rate obviously can’t be explained by a similar jump in tenant rent inflation.

This oddity is one reason why the Fed prefers to use the personal consumption expenditures deflator (PCED) as a better measure of consumer price inflation. Both rent components are in the PCED too. However, the overall weight of rent of shelter is only 15% of the PCED, with tenant rent at 4% and OER at 11%.

(3) Inflation mandate needs explaining.It’s not obvious to me why the Fed’s commitment to boost inflation is a good thing, especially if inflation is led by higher food prices and rents. We doubt that will stimulate economic activity by causing consumers to buy food and rent apartments before their prices go higher. On the contrary, the rising costs of these essentials reduce the purchasing power of consumers.

Inflation-adjusted average hourly earnings in private industry (using the overall CPI to deflate this measure of wages) fell 0.2% m/m during March. It is still up 0.5% y/y. Tenant rent inflation has been outpacing wage gains since September 2011.

Despite March’s uptick in the CPI inflation rate, we believe that there are powerful deflationary forces offsetting all the monetary stimulus provided by the major central banks of the world. Since the start of 2009, the assets on their balance sheets have increased 78% by $6.2 trillion--at the Fed ($2.3 trillion), ECB ($0.4 trillion), BOE ($0.3 trillion), BOJ ($0.9 trillion), and PBOC ($2.3 trillion).

If anyone had predicted five years ago that this would happen and that the major central banks would be worrying about the possibility of deflation rather than hyperinflation, few would have believed such a ludicrous prediction. Yet here we are, with all the models used by macroeconomists at the central banks to predict inflation clearly not working.

Microeconomic models seem to be more useful in explaining why this is happening. Globalization has made markets more competitive and reduced the pricing power of firms. Technological innovations are inherently deflationary as they boost the productivity of both labor and capital. Instead of "hypering" inflation, ultra-easy monetary policy has funded the development and implementation of deflationary technologies. Easy money has also funded the fiscal excesses of governments that often expanded capacity to provide jobs even if the demand fundamentals didn’t justify such expansion.
(Based on an excerpt from YRI Morning Briefing)
The ECB & Deflation
Over in the Eurozone, ECB President Mario Draghi has been the Fairy Godfather of the bull market, not only in stocks but even more impressively in bonds, especially in the region’s peripheral countries. This past Saturday, at an IMF conference, he sought to reassure investors in these markets that the ECB will do whatever it takes to avert deflation.

Of course, he first made that pledge in the context of defending the euro in a speech on July 26, 2012. Now he is worried that the euro is too strong: “The strengthening of the exchange rate would require further monetary policy accommodation. If you want policy to remain as accommodative as now, a further strengthening of the exchange rate would require further stimulus."

On a year-over-year basis, the euro is up by 8% against the dollar and by 9% against the yen. In recent weeks, it has reached levels against the dollar not seen since late 2011. The strong euro is contributing to deflationary pressures by depressing import prices, which boosts the CPI, and by raising export prices, which could slow the Eurozone’s export engine.

"I have always said that the exchange rate is not a policy target, but it is important for price stability and growth," Draghi said. "What has happened over the last few months is that it has become more and more important for price stability."

On Sunday, at the same IMF conference, ECB executive board member Benoît Cœuré, in prepared remarks, reiterated that the bank’s Governing Council “is unanimous in its commitment to use also unconventional instruments within its mandate,” including asset purchases if additional easing is required to avert deflation.

Some observers claim that this is easier said than done since the ECB's charter forbids it from financing governments. However, buying government bonds in the secondary market isn’t explicitly prohibited. Since assuming the ECB presidency in November 2011, Draghi introduced two major unconventional policies to ease funding pressure in the Eurozone's banking sector:

(1) More than €1 trillion was pumped into the bloc's financial system between December 2011 and February 2012 through the provision of cheap three-year loans to banks. The banks used the funds to buy government bonds. Some observers called it "backdoor Quantitative Easing."

(2) In September 2011, Draghi launched his Outright Monetary Transactions (OMT) program to buy bonds in the secondary market. This ship never left port because of opposition from the Bundesbank. In addition, Germany's constitutional court in a preliminary ruling in February claimed, "there are important reasons to assume [OMT] exceeds the [ECB's] mandate.” However, final judgment was deferred pending a ruling by the European Court of Justice.

In any event, Draghi’s pledge to do whatever it takes to defend the euro worked like magic to ease financial conditions in the Eurozone. It’s not obvious how actually implementing a QE program now will work much better to boost inflation given that government bond yields are already so low. It would have to channel more of the monetary stimulus to the private sector through purchases of asset-backed securities, which are in short supply currently.

A QE program would have to dramatically lower the foreign exchange value of the euro. Over in Japan, the essence of Abenomics over the past year was to use massive monetary easing to depreciate the yen and boost inflation. But the shock-and-awe may be wearing off already. Central bankers may soon have to consider the possibility that they aren’t as powerful as they believe themselves to be against the forces of deflation.
(Based on an excerpt from YRI Morning Briefing)

Monday, April 7, 2014

Draghi Has To Start Walking the Talk
While the yen and the Nikkei are marking time waiting for more stimulus from the BOJ, Eurozone bond yields are plunging, especially in the peripheral countries, on expectations that the ECB soon will counter mounting deflationary forces by providing another round of monetary stimulus. The Italian and Spanish 10-year government bond yields are down by about 100bps since late last year to 3.2%. The French yield is down to 2.0%, while the German yield is at 1.5%. Even the Greek bond yield is down to 6.1%. (See our Global Interest Rates.)

In his 4/3 press conference, ECB President Mario Draghi raised those easing expectations when he said:
The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation.” During the Q&A session, he explained: “So this statement says that all instruments that fall within the mandate, including QE, are intended to be part of this statement. During the discussion we had today, there was indeed a discussion of QE. It was not neglected in the course of what was actually a very rich and ample discussion.
On Friday, Reuters reported that according to The Frankfurter Allgemeine Zeitung, the ECB “has modelled the economic effects of buying 1 trillion euros” as part of a QE program, estimating that it would add 0.2-0.8 percentage points to inflation. Frankly, that seems like very little bang for some much additional liquidity. Furthermore, it was also reported that “an unnamed senior central banker was extremely concerned about possible market distortions that could result from such an intervention, and feared such purchases could create a bubble in the corporate bond market.” There certainly seems to be a bubble in peripheral bonds already.
(Based on an excerpt from YRI Morning Briefing)
Bank of Japan Deserves Some Credit
The Bank of Japan deserves lots of credit for devising “unconventional” monetary policy tools during the previous two decades that other central banks have subsequently adopted to respond to the most recent financial crisis. During the 1990s, after Japan's stock market and real estate bubbles burst, the BOJ lowered its official interest rate from over 8% at the start of the decade to zero by the end of the decade. ZIRP (or NZIRP) is now the fashion among the other major central banks (the Fed, ECB, and BOE).

During the first half of the previous decade, the BOJ was the first to implement QE. Another round of QE was implemented during 2011 and 2012. Then a year ago, the BOJ implemented QQE (quantitative and qualitative easing) as the first of the three “arrows” of Abenomics. The aim is to boost inflation to 2% by 2015 by doubling the monetary base. In addition to purchasing Japanese government bonds (JGBs), the BOJ has also been buying exchange traded-funds (ETFs) and Japan real estate investment trusts. The BOJ is unique among its peers in the major developed economies in its high-profile purchases of ETFs, which it began in December 2010 as part of aggressive easing measures.

The BOJ’s policy committee met on Monday and Tuesday. This past Sunday, Bloomberg reported the results of a survey of 36 analysts, who predicted no change in the central bank’s target for the yearly expansion of the monetary base. However, the consensus is that more monetary easing is likely in coming months and could be implemented by a doubling of ETF purchases and more buying of JGBs.

Japan’s CPI inflation rate rose to 1.5% y/y during February, up from -0.6% a year ago. However, the core CPI inflation rate (excluding food and energy) was up only 0.8% during February. That’s certainly an improvement over -0.9% a year ago, but still awfully close to zero despite all the liquidity provided by QQE.

Contributing most to boosting inflation has been the 24% drop in the yen since September 6, 2012. However, most of the decline occurred during late 2012 and early 2013, suggesting that QQE is losing its effectiveness. That’s why there are widespread expectations that more monetary easing is coming. Maybe so, but this time, the yen isn’t falling and stock prices aren’t rising on those expectations. The Nikkei is currently just about where it was a year ago.

I met with a few of our hedge fund accounts in Connecticut yesterday. The head of one of them was profitably positioned for the big jump in Japan’s stock prices during late 2012 and early 2013. He remained bullish earlier this year, but has turned more cautious recently. We both agreed that Prime Minister Shinzo Abe probably isn’t Japan’s Ronald Reagan.
(Based on an excerpt from YRI Morning Briefing)