Bank gossip. Thank you BIS.-
When the going gets tough, it’s always revitalizing to read somebody else (with a prominent reputation), that comes to back your views. I will be for a lifetime morally indebted to the BIS for playing that role ever so frequently. This is what they had to say about the October market swings that motivated my November post “CB’s win another round in financial markets”. Read Claudio Borio, head of the Economic Department, on the December quarterly review of events. Emphasis is mine.
“… what is going on? It is too early to say what exactly triggered these sharp, if brief, price swings.
…To my mind, these events underline the fragility – dare I say growing fragility? – hidden beneath the markets’ buoyancy. Small pieces of news can generate outsize effects. This, in turn, can amplify mood swings. And it would be imprudent to ignore that markets did not fully stabilise by themselves. Once again, on the heels of the turbulence, major central banks made soothing statements, suggesting that they might delay normalisation in light of evolving macroeconomic conditions. Recent events, if anything, have highlighted once more the degree to which markets are relying on central banks: the markets’ buoyancy hinges on central banks’ every word and deed.
The highly abnormal is becoming uncomfortably normal.”
In fact, what Borio is saying, is consistent with his thoughts expressed many times before. “The Economist” has labeled him as one of the world’s most provocative and interesting monetary economists. Financial cycles keep on being used and abused, once and again, to induce spurious short term reactions in the real economy. See what he was saying back in december 2012.
“Economists are now trying hard to incorporate financial factors into standard macroeconomic models… (but) the approach is firmly anchored in the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) paradigm… In the environment that has prevailed for at least three decades now, just as in the one that prevailed in the pre-WW2 years, it is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle. This calls for a rethink of modelling strategies. And it calls for significant adjustments to macroeconomic policies.”
Needless to say, the BISs last wording is fully applicable to the December swings -coetaneous to the recent, but nearly forgotten, crude oil black swan. A fresh victory on this last episode of financial instability is a done deal. Central Banks did a lot better than last time. It is undeniable that we didn’t get the 257 point S&P 500 rally Jason Haver was suggesting, but they got a better bang for their buck (word). Amazingly, they didn’t even have to mention the verb “print” in any of its forms. Verbal manipulation was nothing short of exquisite. No nervous breakdowns like back in October. This is an excerpt of what the FOMC actually skillfully said.
“Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, …”
So, they dropped the term “considerable time”, …. and simultaneously they said that in fact they didn’t. Not even the “maestro” can beat that. Fedspeak at its very best. Janet Yellen then teased the reporters at the FOMC press conference when characterizing “patience” as … “a couple” of meetings. Further questioned on the issue, she reluctantly detailed “a couple” as meaning two or more meetings. Undoubtedly a tiring depuration process for new words incorporated to Fedspeak. I find it easier to call a spade, a spade. But then, nobody would follow me at my press conferences.
The result is that, from now on, we have a new iconic word in fedspeak –patience. Wow! isn’t it great not to have to talk about “zero”, “taper”, or “guidance” for a change? And now that I mention zero once again, I think it is imperative to underline that a rate rise in the US has never been a menace for the “statu quo”. As I have reiterated in previous posts, I am sure the US can handle higher rates. Consequentially, I think the debate on patience, or haste, entirely misses the point. I really don’t care much about their patience hiking rates. History suggests that rate rises, unless they are the 1994 type, are not life threatening for bulls.
Printing, spending, and pretending (debt sustainability) are key words. Interest rates, to a reasonable extent, are not. A 100 bps hike will not derail markets. And I doubt we can get much more, because the debt overhang will ensure that Aggregate Demand does not gravely tension the supply side. Nothing (including moderate rate rises), will stop this orgy from going on further for longer, provided we keep on printing, and everybody believes global debt is not a spurious asset. POMOs are efficient and can easily handle volatility using market technicals to confound market players. They just need an environment of printing and debt building to go on.
Latin gossip. Infrastructure spending in Japan and Spain.-
After the last Abe plan (24 billion euros) on the spending arrow of this troika of policies (print/buy bonds, spend, and devalue/reflate), more is coming on infrastructure spending. And no, it’s not the Chinese this time around.
It’s been a warm fall in Spain. Ski resorts are unhappy. Social climate is also quite hot. The Spanish version of the no money-all credit Juncker spending plan is will be unveiled today. A massive (no money, Summers style free lunch) investment plan is being launched by the central government. The target is creating 5.000+ extra jail beds for corrupt politicians, bankers, IBEX corporations board of directors members, and a couple of high level judges. They will be luxury prisons. No pickpockets or minor lawbreakers will be allowed in.
The rumor is that prominent economists close to Paul Krugman, have blasted the plan as not being ambitious enough. They think the average cost of every additional bed in jail is too low, and, in order to generate substantial economic growth, we should either build at least 50.000 new beds behind bars, or else increase the cost per bed substantially.
Different alternatives are being discussed, the actual front-runner being the proposal to build a jacuzzi and a swimming pool for every thirty five interns. That would increase capex and generate more maintenance jobs. And we would have to hire new politicians and directors to fill in the vacancies brought about by the indicted future clients of the prison resorts. That would sure help with unemployment figures.
The best of this warm social climate is that, wherever you go, everybody is seemingly upset! Anybody you talk to will look at you with saddened eyes, and express remorse for not having been able to see the corruption infrastructure before. Undoubtedly a black swan social event. Nobody was aware of it over here. More than 50% of the previous government by the Partido Popular (chaired by Aznar and his charming “cup of café con leche” spouse) have been indicted. I’ve been told it is a worldwide Guiness record. ¡Viva España!
Lounge bar gossip. I sense that the Fed continues to take away the punch bowl discreetly.-
When I was young, my dad always insisted that I try to gauge people out of facts, rather than words. Words are easily pronounced, and facile to forget. Ask Bullard. Facts are a lot more reliable. In between his “taper moments”, Bernanke was a workaholic: he just kept printing all the time -with the short exceptions of the interim periods between QE1 QE2 and Qeternity.
With Janet it is the other way around. Constantly trying to soothe market fears in the open, while at work she is quietly trying to get herself out of the corner she and Ben painted themselves in. With Stanley Fisher’s full support.
The way I read these charts, and all the fedspeak by Fisher (increasingly the hand that rocks the cradle), is that either money is being gobbled up by the real economy, or they are thoughtfully tightening liquidity, as much as they can, before raising rates. Most plausibly a combination of both factors (bank loans are up). And, for once, doing what they are doing makes a lot of sense. If credit is flowing into the real economy, it is time to be increasingly vigilant on money velocity. If not, they are simply trying to undo some of the distance traveled in the sequential QEs. In any case, it makes sense to try to avoid tightening before mopping up at least some liquidity.
With excess liquidity of this magnitude, interest rate hikes can, and will, generate some inflation. It is not the other way around as most economists think. It is not conventional thinking, and it is counterintuitive, but higher rates will increase money velocity and induce some inflation. It turns out that reducing the money base is good to fight against the ogre of deflation, and a lot more stabilizing for market exuberance, than increasing rates.
I think some CBs are beginning to understand (about time!) that their enemy is not inflation or overheating, but either market instability, or wild increases in money velocity. They know chronic aggregate demand apathy will take care of excessive economic growth. They are not primarily worried about overheating, and that’s why they think they can afford to be patient.
I am of the view that they now feel that they have little to gain, and lots to lose, from a financial stability standpoint, if they do not reduce liquidity in the financial system. With the exception of ECB thinking, of an entirely different breed, more on that another day. The FOMC now, wants to tighten, but they are also apprehensive of excessive dollar TWI induced tightening.
And, above all, they are terrified of black swans. In my view, they will try to do what Dudley suggested (quoted in my last post). Adapt to financial market conditions. When there is excessive froth, try to temper it verbally, and when the market goes south, prop it up with Bullards inconsistent but timely talk. All in all, I think from now on they will lean against bullish financial markets, while tempering downdrafts and volatility spikes. As I have said before, a tightrope walker balancing act. I wish them good luck. If I was wearing their shoes, that is exactly what i would be doing. Only I would’t have messed it all up to this point in the first place.
On a practical note, I think that points to selling out of the money calls against your underlying equity portfolio, as a sensible strategy for the next couple of months ( and, sorry Janet, a couple means three or four to me). Janet and Stanley will use market strength to unwind excess reserves as much as they can -without making any noises that could disturb the crowd of brainless investors. That doesn’t mean the market can’t go up, but it does foretell they will be leaning against strength in a subtle and secretive manner.
The best way to tighten a touch, is to reduce liquidity, not raise rates. And they know it. They just can’t say so without upsetting equity, and currency markets (BRIC currencies for example).
See below, the irrelevance of yields for equities, in a QE context. Virtually no correlation for the last couple of years. Liquidity draining is dangerous for the ecosystem, both from a game theory perspective and a flow of funds dynamic, but interest rate hike expectations will not rock the boat.
No gossip. The Wicksellian natural rate is below market rates.-
We are all surprised to see what’s going on with interest rates for “safe” long term bonds. Flight to quality, POMO desk work, or recessionary expectations, have all been blamed for actual market prices. Non Princeton economists are all surprised to see the CHF, JPY ten year government bond rates below 0.5%, with Germany not far behind at 70 bps. If I wasn’t this old, I would inevitably apply for a retraining as an economist with Krugman. You have to do that if you want to get the hang of the levers of the actual economic system.
I know we have gotten used to this. But please spare a sec to think about Japan. With debt at nearly 230% of GDP, and a yearly fiscal deficit of nearly 10%, they exhibit a ten year yield of … 35 bps! (see daily shot charts for Japanese fiscal deficit topping all the rest, and their ludicrous JGB yield).
There is always an explanation for everything, however bizarre, regardless of whether you like or dislike the reasoning. It is just, more frequently than not, not easy to find. Wicksell’s most influential contribution to economics, was his theory of interest. Published in his 1898 work, “Interest and Prices”, he then made a key distinction between the natural rate of interest and the money rate of interest. Krugman acolytes hate him.
The distinction works in a similar way to the discernment between real and apparent wind when sailing. Counterintuitive as it may be, in truth only the apparent wind is real. The real wind is only an abstract physical concept. To Wicksell, the money rate of interest was merely the interest rate seen in the capital market. Something like the “real wind”; it may be the real imposed rate, but it is not the functional equilibrium ensuring rate for the system. Instead, the natural rate of interest is the interest rate at which supply and demand in the real market are in equilibrium – as though there were no need for capital markets. Only serious printing, and Central Bank intervention, can make them differ substantially for a prolonged period of time.
Central Bank manipulation has endorsed extended periods in which the natural rate of interest was higher than the market rate. That enabled the credit booms that sustained the expansionary periods we have seen in the post-Volcker time. This contribution was a “cumulative process”. If the natural rate of interest was not equal to the market rate, demand for investment and quantity of savings would not be equal. If the market rate is beneath the natural rate, an economic expansion occurs, and prices, “ceteris-paribus”, and in normal conditions, will rise. Endogenous money –money created by the internal workings of the economy, rather than external factors, fuels a credit expansion induced economic boom.
We are now living the opposite situation. The natural rate of interest is now well below zero, and CBs favorite game, pushing the real, imposed, rate below the natural market rate, is now impossible for them. So they have a bittersweet result. Rates in the long end of the curve continue to go down almost everywhere. Good enough, they thought at the beginning of this process.
As I always say, too much of a good thing is a relevant concept in life. Not even an excess of a delicacy, such as caviar, for Christmas, comes without consequences. Ask Buddists about the notion of equilibrium. It is now obvious that we have too much of a good thing in bond yields (and in crude prices, in risk premiums, equity prices, social expenditure -in europe, and so on and …).
So now, krugmanite, but not dumb, CBs, would like to mitigate that process. Even the BOJ and government officials concede that the rate on the 10 year bond may be “slightly” off balance. Trying to prevent this trend to continue may be a tough nut to crack though. The natural glide path for “risk free” long term rates continues to be down almost everywhere. And I feel certain that the US 10y bond will join the trend as soon as the US economy cools down on the joint forces of an energy sector hard landing, a stronger TWI for the USD, and a global stagnation contagion.
The only way to crack this is, what they are most scared of, a meltdown. After we clean the global balance sheet weeding out debt (in a more or less disorderly way), rates will rocket up in just a couple of months, because real available capital is scarce. Money has been spent buying back equity in listed companies (increasing leverage), or adding more and more to phony debt in the global balance sheet (and yes Ben, I know the consolidated balance sheet does not grow on that). Fresh capital will come expensive, with a rich risk premium, after the global disorderly, debt jubilee.
As a corollary to what I said, I firmly believe the trend for interest rates will continue to be down (Wicksellian rates will remain below zero) unless, or until, the meltdown occurs. You want to be long bonds, but beware of fat tails and catastrophic outcomes. Yes, I know, a tough play. Anybody know of an easy trade nowadays?
A personal note for Christmas. After discussing the most recent events in our global village, I would like to share something special, something personal. This interview with a really charming, and unique, woman, is nice, very nice. If you have the time. Not very consistent talk, and her French is nothing to write back home about, but interesting nevertheless. The “diva” was human after all.
I don’t think we shall be viewing Dragui’s or Bernanke’s interviews fifty years from now. Callas had the talent, whereas they only control the levers. I do not think we need any Gods, but if we do, we have the wrong Gods living in Mount Olympus.
On the left, a “selfie”, doing what I used to do best (hopefully not any more): work. Thank you all, for your time -the most limited human resource. I hit the two thousand readers a day mark, at various times last month, and it was entirely unexpected when I began this seven months ago. I am aware of the fact that I certainly do not write for the populace, and my posts are on the long side. Je vour remercie beaucoup pour votre gentillesse.
¡¡¡¡ Happy 2015 !!!!