Friday, January 30, 2015

How the World Works
Why hasn’t ultra-easy monetary policy revived global economic growth? Why is the global economy increasingly mired in secular stagnation despite record-low interest rates and the flood of central bank liquidity? Last year, the supply of global liquidity, measured as the sum of non-gold international reserves held by all central banks plus the Fed’s holdings of US Treasuries and Agencies, rose to a record $16.6 trillion during August. That’s up $8.7 trillion, or 116%, since the start of 2009.

Central banks responded to the financial crisis of 2008 by pumping lots of liquidity into the global economy since then. They also lowered their official interest rates close to zero, with some of them now below zero. Bond yields are at historical lows in most of the major advanced economies. Rather than deleveraging, borrowers around the world were enabled by the central banks to borrow more.

The problem is that easy money has been around for a long time, and seems to be losing its effectiveness in stimulating economic growth. During the previous two decades, many of the borrowers were consumers of commodities, goods, and services. Their debt-financed spending boosted economic growth. That encouraged producers to expand their capacity by borrowing as well. In recent years, easy money seems to have lost its ability to boost consumption, while enabling producers to stay in business.

The result has been mounting deflationary pressures. The major central bankers have responded by lowering their interest rates to zero and providing more liquidity through various QE programs. They’ve been doing so since the financial crisis. That’s more than six years, yet secular stagnation seems to be spreading along with deflationary forces around the world.

In addition, populist politicians are gaining power, especially in the Eurozone and particularly in Greece. They want to end their governments’ austerity measures. In other words, they want to reduce the burden of the debts that their countries and countrymen accumulated during the so-called “debt super-cycle” of the past couple of decades. That means restructuring their debts by forcing lenders to extend maturities, to lower borrowing rates, to take haircuts, or to accept defaults. Of course, the last option is the one that would put a stake in the heart of the debt super-cycle and destroy the credibility of the central banks.

Is there a solution to this mess? Beats me. Central banks have been going down this road for a long time. They are likely to continue doing what they have been doing without recognizing how they might have inadvertently created the mess. Their mess has spread to the foreign exchange market, triggering an undeclared currency war. The central bankers have declared that their ultra-easy monetary policies aren’t aimed at driving down their currencies, but that’s what they are doing.

The Bank of Japan’s contribution to Abenomics was to devalue the yen with its QQE program. The currency plunged 34% from September 13, 2012 through yesterday. ECB President Mario Draghi started talking the euro down late last summer, and pushed it lower with the QE program announced last week. The euro is down 19% from last year’s high on May 6. Commodity currencies are plunging around the world because the commodity super-cycle wasn’t as super as many producers had anticipated when they expanded their capacity.

Instead of fretting over where this is all leading, let’s take a brief stroll down Memory Lane to recall how we got here:

(1) Fed. The Fed provided lots of easy money since the late 1980s. Under Fed Chair Alan Greenspan, the result was a bubble in high-tech stock prices during the late 1990s and a housing bubble during the previous decade. Under Fed Chair Ben Bernanke and now Janet Yellen, bond and stock prices have soared. Home prices have recovered.

The economy finally seems strong enough that Fed officials are aiming to start raising interest rates at mid-year. The problem is that the soaring dollar is pushing inflation further below the Fed’s 2% target. In addition, it is depressing corporate profits, causing companies to reduce their labor costs, which may continue to keep wage inflation around 2%, below the Fed’s 3%-4% preference.

This increases the likelihood of either one-and-done or none-and-done for rate-hiking this year. Yesterday’s FOMC statement reiterated: “Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.” The word “patient” is ambiguous enough that the FOMC dropped the “considerable time” phrase without upsetting the markets yesterday.

(2) ECB. The introduction of the euro at the start of 1999 caused bond yields to converge in the Eurozone as investors no longer distinguished between the credit risk of the different members of the monetary union.

The spread between both Spanish and Italian government bond yields versus the comparable German yield narrowed to zero during the previous decade. Spreads widened again at the beginning of the current decade, but narrowed significantly after Mario Draghi pledged to do whatever it takes to defend the euro on July 26, 2012.

ECB data show that loans to the Eurozone private sector soared by €4.0 trillion to a record €11.1 trillion from the start of 2004 through the end of 2011. As of November 2014, this debt measure was down to €10.4 trillion. In other words, the ECB’s various attempts to revive lending since the financial crisis have failed. That might be because borrowers are already maxed out on their ability to service more debt.

(3) PBOC. The Chinese responded quickly to the financial crisis of 2008 with a large fiscal stimulus program and lots of easy money. Banks were encouraged to lend freely, which they did. Bank loans soared by $8.9 trillion from the end 2008 to a record high of $13.3 trillion at the end of last year. Yet China’s economic growth continues to slow as the economy gets less bang-per-yuan of borrowing.

(4) BOJ. Last Wednesday, the BOJ monetary policy committee cut its core inflation forecast to 1.0% for the fiscal year starting in April from 1.7%. Despite the latest QE (introduced on April 4, 2013) and then QQE (October 31, 2014) under Abenomics, Japan’s monetary policymakers can’t seem to get core inflation up to 2%.

The BOJ has succeeded in devaluing the yen and boosting stock prices. But it is distorting the bond market. Thanks to QQE purchases by the BOJ, the Japanese 10-year government bond yield was down to only 0.28% yesterday. The 30-year yield was 1.29%. The flattening of the yield curve near zero is bad news for financial companies, especially insurance companies and banks.

Already some forex watchers are watching out for a Swiss-style jump in the yen if the BOJ finds that it’s getting harder to buy JGBs because no one wants to sell them.
(Based on an excerpt from YRI Morning Briefing)

Monday, January 26, 2015

Q€ for Geeks & Greeks
The ECB’s decision last Thursday to implement Q€ wasn’t a surprise. Nevertheless, the details of the plan as presented by ECB President Mario Draghi in his follow-up press conference provided some shock-and-awe to global financial markets. Let’s review the key elements of the program:

(1) Bigger size. Before the meeting of the ECB’s Governing Council on Thursday, the financial press was full of stories reporting that unnamed sources said that bond purchases would be €50 billion per month. Draghi said the purchases would be €60 billion per month starting in March through the end of September 2016. That would add €1.1 trillion to the ECB’s balance sheet over that period. Draghi said that this purchase program includes the existing one for asset-backed securities and covered bonds, which is around €10 billion per month.

(2) Open-ended. The big surprise was that the program might continue beyond September 2016. Draghi said that the purchases “will in any case be conducted until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term.”

(3) Long bonds. As noted above, Draghi said that the maturities of the bonds purchased by the ECB would be between two years and 30 years. That certainly exposes the central bank to some risk if it succeeds in boosting inflation back to 2%, since yields would rise in that scenario. No one asked Draghi about that at the press conference.

(4) Risk sharing. The bulk of the bond purchases will be by the national central banks (NCBs) under the direction of the ECB. The NCBs and ECB will share any losses attributable to the securities of European institutions, which will account for 12% of Q€ assets. The same goes for an additional 8% of additional assets that will be held by the ECB. According to the press release: “This implies that 20% of the additional asset purchases will be subject to a regime of risk sharing.” In other words, the NCBs will be at risk on their own for 80% of the assets purchased under the program. That shows the contortions that were necessary to get the deal done.

(5) Immaculate conception. Incredibly, notwithstanding the historic significance of the ECB’s Q€ and the ongoing controversy about it, particularly in Germany, the Governing Council adopted it without a formal vote. Draghi said that “there was a large majority on the need to trigger it now, and so large that we didn’t need to take a vote.” In other words, none of the members wanted to be on the record as having voted for it! Indeed, there was “a good discussion” on whether it needed to be implemented right away.

(6) Greasing Greece. Draghi was asked whether or not the ECB will purchase Greek debt. He responded as follows: “We don't have any special rule for Greece. We have basically rules that apply to everybody. There are obviously some conditions before we can buy Greek bonds. As you know, there is a waiver that has to remain in place, has to be a program. And then there is this 33% issuer limit, which means that, if all the other conditions are in place, we could buy bonds in, I believe, July, because by then there will be some large redemptions of SMP bonds and therefore we would be within the limit.”

In Sunday’s election, Alexis Tsipras’s Coalition of the Radical Left, known by its Greek acronym of “Syriza,” took 36.5% of the vote compared with 27.7% for Prime Minister Antonis Samaras’s New Democracy, according to official projections. Campaigning on an anti-austerity program, Tsipras pledged to negotiate a write-down of Greek debt and to abandon budget constraints that were imposed in return for aid. Samaras warned that would risk Greece’s exit from the Eurozone.

The return of Grexit fears could increase financial stress in the region again, and offset whatever stimulative impact Q€ might have. On the other hand, it could send the euro down faster to parity with the dollar.

The big question, of course, is will Q€ work, barring a Grexit? It’s possible, though not very likely, in my view. The Eurozone’s economy has been stagnating since 2011. Interest rates had already fallen sharply since Draghi’s whatever-it-takes sermon on July 26, 2012. It’s not obvious how Q€ will boost bank lending, which is a much more important source of funds for borrowers than the capital markets in the Eurozone. However, the sharp drop in the euro only started last summer, and it might lift Eurozone exports.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, January 14, 2015

Two More Patient FOMC Officials
On Monday, Bloomberg reported that both FRB-San Francisco President John Williams and FRB-Atlanta President Dennis Lockhart expect to vote on the FOMC to start raising interest rates around mid-year. The minutes of the December 16-17 FOMC meeting suggested that lift-off could start at the April 28-29 meeting. More likely now is that the statement released immediately after that meeting might prepare the financial markets for such a decision at the June 16-17 meeting, which will be followed by a press conference with Fed Chair Janet Yellen.

However, Williams, who was the director of research when Yellen ran the FRB-SF until he succeeded his boss when she left during March 2011, hedged his bet, saying in the phone interview with Bloomberg:
I would expect by June that the argument pro and con for lifting off rates will be probably a close call. … If inflation data come in significantly softer than expected and we’re not seeing some kind of better growth in wages, those are clearly factors that I’d be taking into consideration in the timing of liftoff.
In a speech in Atlanta on Monday, Lockhart said:
At the recent meeting of the FOMC in December, the Committee made an adjustment of its forward guidance by introducing the theme of patience in beginning to normalize the stance of policy. I supported and expect to continue to support a patient approach, one that is relatively cautious and conservative as regards the pace of normalization of rates.
(Based on an excerpt from YRI Morning Briefing)

Monday, January 12, 2015

Fairy Godfather
For quite a while, I’ve described Fed Chair Janet Yellen as the “Fairy Godmother of the Bull Market.” Apparently, FRB-Chicago President Charles Evans aspires to be the “Fairy Godfather of the Bull Market.” He certainly was last Thursday when the S&P 500 soared 1.8% on news reports that he said, “I don’t think we should be in a hurry to increase interest rates.” Evans said so during a discussion at the University of Chicago. Later in the presentation, he said such a move to tighten too soon would be a “catastrophe.” He appeared Friday morning on CNBC to give us all the opportunity to hear the same basic message directly from him.

He was interviewed right after the release of December’s employment report, which showed that the jobless rate fell to 5.6% from 5.8% the month before. That’s the lowest since June 2008. The short-term unemployment rate fell to 3.8%, the lowest since November 2007. However, Evans focused on average hourly earnings, which fell 0.2% m/m during December and was up only 1.7% y/y, the lowest since October 2012. He reiterated that he prefers to be “patient” before raising interest rates until wage inflation moves higher and price inflation rises back up to 2%.

On a few occasions late last year, I wrote that Evans is an important FOMC member. He is a voter this year on the FOMC. He is among the most dovish members of the committee. His views very often coincide with those of fellow doves Fed Chair Janet Yellen and FRB-NY President Bill Dudley. Evans first publicly counselled a “patient” approach to monetary normalization in a CNBC interview on 9/29 last year. Lo and behold, that word appeared for the first time in the 12/17 FOMC statement last year: “Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.” The phrase also appeared three times in the minutes of that meeting, which was released last Wednesday. Let’s review some of its highlights:

(1) Interestingly, the dollar continued to soar on Thursday despite Evan’s suggestion that the Fed’s lift-off of interest rates should be postponed. That might be because the minutes reported:
With lower energy prices and the stronger dollar likely to keep inflation below target for some time, it was noted that the Committee might begin normalization at a time when core inflation was near current levels, although in that circumstance participants would want to be reasonably confident that inflation will move back toward 2 percent over time.
In other words, the Fed might be less patient than Evans would like. I am betting on Evans, which is why I think "one-and-done," or even "none-and-done," is more likely than normalization, i.e., a series of rate hikes later this year.

(2) The minutes defined the FOMC’s patience as follows:
Most participants thought the reference to patience indicated that the Committee was unlikely to begin the normalization process for at least the next couple of meetings.
That confirmed Yellen’s view on this subject, which she expressed at her 12/17 press conference. The next two meetings are on January 27-28 and March 17-18. So normalization might begin at the April 28-29 meeting, though I doubt it.

(3) I think that the strong dollar and weak overseas economic growth may increase the Fed’s patience. The minutes noted:
Many participants regarded the international situation as an important source of downside risks to domestic real activity and employment, particularly if declines in oil prices and the persistence of weak economic growth abroad had a substantial negative effect on global financial markets or if foreign policy responses were insufficient.
Exports of goods now account for 9.3% of current dollar GDP, up from 6.8% ten years ago. Real merchandise exports remained on an upward trend during November, rising 2.6% y/y. Some of the recent strength was attributable to exports of petroleum products, which are likely to decline as US production falls along with oil prices. If the dollar continues to strengthen and global economic growth remains lackluster, other exports might start to weaken too.

The Fed’s patience is also likely to persist as long as wage inflation remains around 2% rather than rising to 3%-4% as Yellen previously said she would like to see happen. As noted above, Evans is concerned that it actually declined to 1.7% y/y during December. So it’s heading in the wrong direction.

A 1/9 Bloomberg article on this subject titled “The Wage Weakness May Not Be as Bad as It Seems” reports: “Stores and online merchants hired a larger-than-usual army of seasonal workers to help keep up with the demand for holiday gift-giving. Inc. prepared for the crush this year by adding 80,000 seasonal workers, up from 70,000 last year.”

FRB-Atlanta Fed President Dennis Lockhart in an interview with Bloomberg news on Friday said, “I am prepared to look at the earnings numbers as potentially noise or month-to-month fluctuations that are not really telling of any condition in the economy that we have to worry about.” Yet he too is willing to be patient: “I don’t see a reason yet to accelerate my assumption of when a policy move might be appropriate.” He also gets to vote on the FOMC this year.
(Based on an excerpt from YRI Morning Briefing)