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“Is the falling exchange rate good news or bad news?”
I was on CBC radio yesterday morning for about 5 minutes, talking about the exchange rate.
From this experience, and from previous similar experiences, this is what reporters want to ask:
“Who gains, and who loses, from the fall in the exchange rate? For Canada as a whole, is the fall in the exchange rate good news or bad news?”
And the answer they expect to hear is:
“Exporters gain; importers lose. On the one hand it reduces unemployment; on the other hand it increases inflation.”
I don’t think reporters are alone in looking at it from that perspective. Most non-economists are probably the same. But economists are uncomfortable answering that question. Let me try to explain why:
The exchange rate didn’t just fall. Something, call it X, caused it to fall. So when we ask “Is the fall in the exchange rate good news or bad news?”, what are we really asking? You can’t give a good answer if you are unclear on the question.
We might be asking:
1. “Is X good news or bad news?”
Or, we might be asking:
2. “Given that X happened, should the Bank of Canada take action to prevent the fall in the exchange rate?”
To my mind, that second question is the useful one to ask. Because, even if we think we know what X is, and whether X is good news or bad news, if we can’t do anything about X, that isn’t very useful.
2a. An economist can say something useful about the benefits of two different monetary policies: would it be better for the Bank of Canada to fix the exchange rate, or should it target inflation and let the exchange rate adjust to wherever it needs to keep inflation on target?
2b. Or, an economist can say something useful about whether the Bank of Canada, in this particular case, needs to prevent the exchange rate falling in order to prevent inflation rising above the 2% target.
I decided to answer that second question, in the form 2a. I said it would be better for the Bank of Canada to target 2% inflation than to fix the exchange rate to the US Dollar.
I didn’t really answer 2b. But I think that, in this particular case, the Bank of Canada is right to let the Loonie depreciate, to help bring inflation back up to the 2% target.
My guess is that X is mostly news about Canadian inflation coming in lower than had previously been expected, and the realisation that the Bank of Canada would therefore not be raising interest rates as quickly as had previously been expected. (Note that when Statistics Canada released the December CPI data, on Friday morning, and inflation was just slightly higher than I had expected, the Loonie gained nearly half a cent in the next hour.) And maybe weaker commodity prices are part of X too. And maybe the US recovery, and the prospect of rising US interest rates, is part of X too.
Sometimes, when a reporter asks you a question, it’s best not to answer it, and to answer a different question. Not because you are weaseling out of answering the reporter’s question, but because you think about it differently, and you think the reporter’s question isn’t the right one to ask. (I now have more sympathy for politicians being interviewed, when they appear to duck an apparently straight question!)
Update: by the way, when reporters want to interview an economist, they (or one of the people they work with) will normally want to have a pre-interview discussion first. This is your chance to suggest they re-frame the question in the way you think it should be framed. You can tell them you wouldn’t be able to give a good answer to that question, but you could give a good answer to a different but related question. Because very few reporters have any economics background, they don’t really know what questions to ask. And, from my experience, they seem to be willing to listen to your suggestions, because they are trying to prepare for the interview, as well as help you prepare.
It would be interesting to hear any reporter’s thoughts on interviewing economists. (It must be tough!)
Posted by Nick Rowe on January 28, 2014
A classicial economist… and Harvard professor… preaching to the world that one’s money is not safe in the US banking system due to Ben Bernanke’s actions? And putting his withdrawal slip where his mouth is and pulling $1 million out of Bank America? Say it isn’t so…
From Terry Burnham, former Harvard economics professor, author of “Mean Genes” and “Mean Markets and Lizard Brains,” provocative poster on this page and long-time critic of the Federal Reserve, argues that the Fed’s efforts to strengthen America’s banks have perversely weakened them. First posted in PBS.
Is your money safe at the bank? An economist says ‘no’ and withdraws his
Last week I had over $1,000,000 in a checking account at Bank of America. Next week, I will have $10,000.
Why am I getting in line to take my money out of Bank of America? Because of Ben Bernanke and Janet Yellen, who officially begins her term as chairwoman on Feb. 1.
Before I explain, let me disclose that I have been a stopped clock of criticism of the Federal Reserve for half a decade. That’s because I believe that when the Fed intervenes in markets, it has two effects — both negative. First, it decreases overall wealth by distorting markets and causing bad investment decisions. Second, the members of the Fed become reverse Robin Hoods as they take from the poor (and unsophisticated) investors and give to the rich (and politically connected). These effects have been noticed; a Gallup poll taken in the last few days reports that only the richest Americans support the Fed. (See the table.)
Why do I risk starting a run on Bank of America by withdrawing my money and presuming that many fellow depositors will read this and rush to withdraw too? Because they pay me zero interest. Thus, even an infinitesimal chance Bank of America will not repay me in full, whenever I ask, switches the cost-benefit conclusion from stay to flee.
Let me explain: Currently, I receive zero dollars in interest on my $1,000,000. The reason I had the money in Bank of America was to keep it safe. However, the potential cost to keeping my money in Bank of America is that the bank may be unwilling or unable to return my money.
They will not be able to return my money if:
- Many other depositors like you get in line before me. Banks today promise everyone that they can have their money back instantaneously, but the bank does not actually have enough money to pay everyone at once because they have lent most of it out to other people — 90 percent or more. Thus, banks are always at risk for runs where the depositors at the front of the line get their money back, but the depositors at the back of the line do not. Consider this image from a fully insured U.S. bank, IndyMac in California, just five years ago.
- Some of the investments of Bank of America go bust. Because Bank of America has loaned out the vast majority of depositors’ money, if even a small percentage of its loans go bust, the firm is at risk for bankruptcy. Leverage, combined with some bad investments, caused the failure of Lehman Brothers in 2008 and would have caused the failure of Bank of America, AIG, Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and many more institutions in 2008 had the government not bailed them out.
In recent days, the chances for trouble at Bank of America have become more salient because of woes in the emerging markets, particularly Argentina, Turkey, Russia and China. The emerging market fears caused the Dow Jones Industrial Average to lose more than 500 points over the last week.
Returning to my money now entrusted to Bank of America, market turmoil reminded me that this particular trustee is simply not safe. Or not safe enough, given the fact that safety is the reason I put the money there at all. The market turmoil could threaten “BofA” with bankruptcy today as it did in 2008, and as banks have experienced again and again over time.
If the chance that Bank of America will not return my money is, say, a mere 1 percent, then the expected cost to me is 1 percent of my million, or $10,000. That far exceeds the interest I receive, which, I hardly need remind depositors out there, is a cool $0. Even a 0.1 percent chance of loss has an expected cost to me of $1,000. Bank of America pays me the zero interest rate because the Federal Reserve has set interest rates to zero. Thus my incentive to leave at the first whiff of instability.
Surely, you say, the federal government is going to keep its promises, at least on insured deposits. Yes, the Federal Government (via the FDIC) insures deposits in most institutions up to $250,000. But there is a problem with this insurance. The FDIC currently has far less money in its fund than it has insured deposits: as of Sept. 1, about $41 billion in reserve against $6 trillion in insured deposits. (There are over $9 trillion on deposit at U.S. banks, by the way, so more than $3 trillion in deposits is completely uninsured.)
It’s true, of course, that when the FDIC fund risks running dry, as it did in 2009, it can go back to other parts of the federal government for help. I expect those other parts will make the utmost efforts to oblige. But consider the possibility that they may be in crisis at the very same time, for the very same reasons, or that it might take some time to get approval. Remember that Congress voted against the TARP bailout in 2008 before it relented and finally voted for the bailout.
Thus, even insured depositors risk loss and/or delay in recovering their funds. In most time periods, these risks are balanced against the reward of getting interest. Not so long ago, Bank of America would have paid me $1,000 a week in interest on my million dollars. If I were getting $1,000 a week, I might bear the risks of delay and default. However, today I am receiving $0.
So my cash is leaving Bank of America.
But if Bank of America is not safe, you must be wondering, where can you and I put our money? No path is without risk, but here are a few options.
- Keep some cash at home, though admittedly this runs the risk of loss or setting yourself up as a target for criminals.
- Put some cash in a safety box. There is an urban myth that this is illegal; my understanding is that cash in a safety box is legal. However, I can imagine scenarios where capital controls are placed on safety deposit box withdrawals. And suppose the bank is shut down and you can’t get to the box?
- Pay your debts. You don’t need to be Suze Orman to know that you need liquidity, so do not use all your cash to pay debts. However, you can use some surplus, should you have any.
- Prepay your taxes and some other obligations. Subject to the same caveat about liquidity, pay ahead. Make sure you only pay safe entities. Your local government is not going away, even in a depression, so, for example, you can prepay property taxes. (I would check with a tax accountant on the implications, however.)
- Find a safer bank. Some local, smaller banks are much safer than the “too-big-to-fail banks.” After its mistake of letting Lehman fail, the government has learned that it must try to save giant institutions. However, the government may not be able to save all failing institutions immediately and simultaneously in a crisis. Thus, depositors in big banks face delays and defaults in the event of a true crisis. (It is important to find the right small bank; I believe all big banks are fragile, while some small banks are robust.)
Someone should start a bank (or maybe someone has) that charges (rather than pays) interest and does not make loans. Such a bank would be a good example of how Fed actions create unintended outcomes that defeat their goals. The Fed wants to stimulate lending, but an anti-lending bank could be quite successful. I would be a customer.
(Interestingly, there was a famous anti-lending bank and it was also a “BofA” — the Bank of Amsterdam, founded in 1609. The Dutch BofA charged customers for safe-keeping, did not make loans and did not allow depositors to get their money out immediately. Adam Smith discusses this BofA favorably in his “Wealth of Nations,” published in 1776. Unfortunately — and unbeknownst to Smith — the Bank of Amsterdam had starting secretly making risky loans to ventures in the East Indies and other areas, just like any other bank. When these risky ventures failed, so did the BofA.)
My point is that the Federal Reserve’s actions have myriad, unanticipated, negative consequences. Over the last week, we saw the impact on the emerging markets. The Fed had created $3 trillion of new money in the last five-plus years — three times more than in its entire prior history. A big chunk of that $3 trillion found its way, via private investors and institutions, into risky, emerging markets.
Now that the Fed is reducing (“tapering”) its new money creation (now down to $65 billion a month, or $780 billion a year, as of Wednesday’s announcement), investments are flowing out of risky areas. Some of these countries are facing absolute crises, with Argentina’s currency plummeting by more than 20 percent in under one month. That means investments in Argentina are worth 20 percent less in dollar terms than they were a month ago, even if they held their price in Pesos.
The Fed did not plan to impoverish investors by inducing them to buy overpriced Argentinian investments, of course, but that is one of the costly consequences of its actions. If you lost money in emerging markets over the last week, at one level, it is your responsibility. However, it is not crazy for you to blame the Fed for creating volatile prices that made investing more difficult.
Similarly, if you bought gold at the peak of almost $2,000 per ounce, you have lost one-third of your money; you share the blame for your golden losses with Alan Greenspan, Ben Bernanke and Janet Yellen. They removed the opportunities for safe investments and forced those with liquid assets to scramble for what safety they thought they could find. Furthermore, the uncertainty caused by the Fed has caused many assets to swing wildly in value, creating winners and losers.
The Fed played a role in the recent emerging markets turmoil. Next week, they will cause another crisis somewhere else. Eventually, the absurd effort to create wealth through monetary policy will unravel in the U.S. as it has every other time it has been tried from Weimar Germany to Robert Mugabe’s Zimbabwe.
Even after the Fed created the housing problems, we would have been better of with a small 2009 depression rather than the larger depression that lies ahead. See my Making Sen$e posts “The Stockholm Syndrome and Printing Money” and “Ben Bernanke as Easter Bunny: Why the Fed Can’t Prevent the Coming Crash” for the details of my argument.
Ever since Alan Greenspan intervened to save the stock market on Oct. 20, 1987, the Fed has sought to cushion every financial blow by adding liquidity. The trouble with trying to make the world safe for stupidity is that it creates fragility.
Bank of America and other big banks are fragile — and vulnerable to bank runs — because the Fed has set interest rates to zero. If a run gathers momentum, the government will take steps to stem it. But I am convinced they have limited ammunition and unlimited problems.
What is the solution? For you, save yourself and your family. For the system, revamp the Federal Reserve. The simplest first step would be to end the dual mandate of price stability and full employment. Price stability is enough. I favor rules over intervention. We don’t need a maestro conducting monetary policy; we need a system that promotes stability and allows people (not printing presses) to make us richer.
The IMF’s woeful forecasting record, chronicled extensively before, has just taken yet another hit, following the latest flip flop on emerging markets. Try to spot the common theme of these assessments by the IMF.
IMF Chief economist Olivier Blanchard, April 11, 2011 (source):
“In emerging market economies, by contrast, the crisis left no lasting wounds. Their initial fiscal and financial positions were typically stronger, and the adverse effects of the crisis were more muted. High underlying growth and low interest rates are making fiscal adjustment much easier. Exports have recovered, and whatever shortfall in external demand they experienced has typically been made up through increases in domestic demand. Capital outflows have turned into capital inflows, due to both better growth prospects and higher interest rates than in the advanced economies. The challenge for most emerging market economies is thus quite different from that of the advanced economies—namely, how to avoid overheating in the face of closing output gaps and higher capital flows.”
IMF Chief economist Olivier Blanchard, July 9, 2013 (source):
“If you look country by country it seems to be specific . . . so in China it looks like unproductive investment, in Brazil it looks like low investment and in India it looks like policy and administrative uncertainty. But you wonder whether there is not something behind. I think behind this is a slowdown in underlying growth – not the cyclical component but just the average rate. It’s clear that these countries are not going to grow as fast as they did before the crisis.”
IMF Chief economist Olivier Blanchard, January 23, 2014 (source)
“Finally, we forecast that both emerging market and developing economies will sustain strong growth“
A few days later, EMs around the globe crashed, and central banks virtually everywhere had to step in to bail out their crashing currencies, and hit the tape with even more impressive verbal intervention every several hours.
Finally, today we get IMF economist Alejandro Werner, January 30, 2014 (source)
“Conditions in global financial markets will stay tighter than they were before the U.S. central bank’s “taper talk” in the first half of 2013, translating into higher international borrowing costs,particularly with the recent volatility in emerging markets…. sustained turbulence in emerging markets could tighten global financial conditions further…. Rebuilding fiscal buffers, and using monetary policy and flexible exchange rates to absorb shocks where possible, remains the order of the day.”
In other words, going from a forecast of “high underlying growth”, to “not going to grow as fast as they did”, to “sustain strong growth”, to violent EM crash, to “turbulence”, “volatility”, and urging EMs to “using monetary policy to absorb shocks”, what is clear is that nobody knows what is going on, nobody has any handle on the future of Emerging Markets, but let’s all just pretend that the MIT central-planners in control, are in control, and all shall be well.
Submitted by Ben Hunt of Epsilon Theory
It Was Barzini All Along
Tattaglia is a pimp. He never could have outfought Santino. But I didn’t know until this day that it was Barzini all along.
— Don Vito Corleone
Like many in the investments business, I am a big fan of the Godfather movies, or at least those that don’t have Sofia Coppola in a supporting role. The strategic crux of the first movie is the realization by Don Corleone at a peace-making meeting of the Five Families that the garden variety gangland war he thought he was fighting with the Tattaglia Family was actually part of an existential war being waged by the nominal head of the Families, Don Barzini. Vito warns his son Michael, who becomes the new head of the Corleone Family, and the two of them plot a strategy of revenge and survival to be put into motion after Vito’s death. The movie concludes with Michael successfully murdering Barzini and his various supporters, a plot arc that depends entirely on Vito’s earlier recognition of the underlying cause of the Tattaglia conflict. Once Vito understood WHY Philip Tattaglia was coming after him, that he was just a stooge for Emilio Barzini, everything changed for the Corleone Family’s strategy.
Now imagine that Don Corleone wasn’t a gangster at all, but was a macro fund portfolio manager or, really, any investor or allocator who views the label of “Emerging Market” as a useful differentiation … maybe not as a separate asset class per se, but as a meaningful way of thinking about one broad set of securities versus another. With the expansion of investment options and liquid securities that reflect this differentiation — from Emerging Market ETF’s to Emerging Market mutual funds — anyone can be a macro investor today, and most of us are to some extent.
You might think that the ease with which anyone can be an Emerging Markets investor today would make the investment behavior around these securities more complex from a game theory perspective as more and more players enter the game, but actually just the opposite is true. The old Emerging Markets investment game had very high informational and institutional barriers to entry, which meant that the players relied heavily on their private information and relatively little on public signals and Common Knowledge. There may be far more players in the new Emerging Markets investment game, but they are essentially one type of player with a very heavy reliance on Common Knowledge and public Narratives. Also, these new players are not (necessarily) retail investors, but are (mostly) institutional investors that see Emerging Markets or sub-classifications of Emerging Markets as an asset class with certain attractive characteristics as part of a broad portfolio. Because these institutional investors have so much money that must be put to work and because their portfolio preference functions are so uniform, there is a very powerful and very predictable game dynamic in play here.
Since the 2008 Crisis the Corleone Family has had a pretty good run with their Emerging Markets investments, and even more importantly Vito believes that he understands WHY those investments have worked. In the words of Olivier Blanchard, Chief Economist for the IMF:
In emerging market countries by contrast, the crisis has not left lasting wounds. Their fiscal and financial positions were typically stronger to start, and adverse effects of the crisis have been more muted. High underlying growth and low interest rates are making fiscal adjustment much easier. Exports have largely recovered, and whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand. Capital outflows have turned into capital inflows, due to both better growth prospects and higher interest rates than in advanced countries. … The challenge for most emerging countries is quite different from that of advanced countries, namely how to avoid overheating in the face of closing output gaps and higher capital flows. — April 11, 2011
As late as January 23rd of this year, Blanchard wrote that “we forecast that both emerging market and developing economies will sustain strong growth“.
Now we all know what actually happened in 2013. Growth has been disappointing around the world, particularly in Emerging Markets, and most of these local stock and bond markets have been hit really hard. But if you’re Vito Corleone, macro investor extraordinaire, that’s not necessarily a terrible thing. Sure, you don’t like to see any of your investments go down, but Emerging Markets are notably volatile and maybe this is a great buying opportunity across the board. In fact, so long as the core growth STORY is intact, it almost certainly is a buying opportunity.
But then you wake up on July 9th to read in the WSJ that Olivier Blanchard has changed his tune. He now says “It’s clear that these countries [China, Russia, India, Brazil, South Africa] are not going to grow at the same rate as they did before the crisis.” Huh? Or rather, WTF? How did the Chief Economist of the IMF go from predicting “strong growth” to declaring that the party is over and the story has fundamentally changed in six months?
It’s important to point out that Blanchard is not some inconsequential opinion leader, but is one of the most influential economists in the world today. His position at the IMF is a temporary gig from his permanent position as the Robert M. Solow Professor of Economics at MIT, where he has taught since 1983. He also received his Ph.D. in economics from MIT (1977), where his fellow graduate students were Ben Bernanke (1979), Mario Draghi (1976), and Paul Krugman (1977), among other modern-day luminaries; Stanley Fischer, current Governor of the Bank of Israel, was the dissertation advisor for both Blanchard and Bernanke; Mervyn King and Larry Summers (and many, many more) were Blanchard’s contemporaries or colleagues at MIT at one point or another. The centrality of MIT to the core orthodoxy of modern economic theory in general and monetary policy in particular has been well documented by Jon Hilsenrath and others and it’s not a stretch to say that MIT provided a personal bond and a formative intellectual experience for a group of people that by and large rule the world today. Suffice it to say that Blanchard is smack in the middle of that orthodoxy and that group. I’m not saying that anything Blanchard says is amazingly influential in and of itself, certainly not to the degree of a Bernanke or a Draghi (or even a Krugman), but I believe it is highly representative of the shared beliefs and opinions that exist among these enormously influential policy makers and policy advisors. Two years ago the global economic intelligentsia believed that Emerging Markets had emerged from the 2008 crisis essentially unscathed, but today they believe that EM growth rates are permanently diminished from pre-crisis levels. That’s a big deal, and anyone who invests or allocates to “Emerging Markets” as a differentiated group of securities had better take notice.
Here’s what I think happened.
First, an error pattern has emerged over the past few years from global growth data and IMF prediction models that forced a re-evaluation of those models and the prevailing Narrative of “unscathed” Emerging Markets. Below is a chart showing actual Emerging Market growth rates for each year listed, as well as the IMF prediction at the mid-year mark within that year and the mid-year mark within the prior year (generating an 18-month forward estimate).
Pre-crisis the IMF systematically under-estimated growth in Emerging Markets. Post-crisis the IMF has systematically over-estimated growth in Emerging Markets. Now to be sure, this IMF over-estimation of growth exists for Developed Markets, too, but between the EuroZone sovereign debt crisis and the US fiscal cliff drama there’s a “reason” for the unexpected weakness in Developed Markets. There’s no obvious reason for the persistent Emerging Market weakness given the party line that “whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand.” Trust me, IMF economists know full well that their models under-estimated EM growth pre-crisis and have now flipped their bias to over-estimate growth today. Nothing freaks out a statistician more than this sort of flipped sign. It means that a set of historical correlations has “gone perverse” by remaining predictive, but in the opposite manner that it used to be predictive. This should never happen if your underlying theory of how the world works is correct. So now the IMF (and every other mainstream macroeconomic analysis effort in the world) has a big problem. They know that their models are perversely over-estimating growth, which given the current projections means that we’re probably looking at three straight years of sub-5% growth in Emerging Markets (!!) more than three years after the 2008 crisis ended, and — worse — they have no plausible explanation for what’s going on.
Fortunately for all concerned, a Narrative of Central Bank Omnipotence has emerged over the past nine months, where it has become Common Knowledge that US monetary policy is responsible for everything that happens in global markets, for good and for ill (see “How Gold Lost Its Luster”). This Narrative is incredibly useful to the Olivier Blanchard’s of the world, as it provides a STORY for why their prediction models have collapsed. And maybe it really does rescue their models. I have no idea. All I’m saying is that whether the Narrative is “true” or not, it will be adopted and proselytized by those whose interests — bureaucratic, economic, political, etc. — are served by that Narrative. That’s not evil, it’s just human nature.
Nor is the usefulness of the Narrative of Central Bank Omnipotence limited to IMF economists. To listen to Emerging Market central bankers at Jackson Hole two weeks ago or to Emerging Market politicians at the G-20 meeting last week you would think that a great revelation had been delivered from on high. Agustin Carstens, Mexico’s equivalent to Ben Bernanke, gave a speech on the “massive carry trade strategies” caused by ZIRP and pleaded for more Fed sensitivity to their capital flow risks. Interesting how the Fed is to blame now that the cash is flowing out, but it was Mexico’s wonderful growth profile to credit when the cash was flowing in. South Africa’s finance minister, Pravin Gordhan, gave an interview to the FT from Jackson Hole where he bemoaned the “inability to find coherent and cohesive responses across the globe to ensure that we reduce the volatility in currencies in particular, but also in sentiment” now that the Fed is talking about a Taper. Christine Lagarde got into the act, of course, calling on the world to build “further lines of defense” even as she noted that the IMF would (gulp) have to stand in the breach as the Fed left the field. To paraphrase Job: the Fed gave, and the Fed hath taken away; blessed be the name of the Fed.
The problem, though, is that once you embrace the Narrative of Central Bank Omnipotence to “explain” recent events, you can’t compartmentalize it there. If the pattern of post-crisis Emerging Market growth rates is largely explained by US monetary accommodation or lack thereof … well, the same must be true for pre-crisis Emerging Market growth rates. The inexorable conclusion is that Emerging Market growth rates are a function of Developed Market central bank liquidity measures and monetary policy, and that all Emerging Markets are, to one degree or another, Greece-like in their creation of unsustainable growth rates on the back of 20 years of The Great Moderation (as Bernanke referred to the decline in macroeconomic volatility from accommodative monetary policy) and the last 4 years of ZIRP. It was Barzini all along!
This shift in the Narrative around Emerging Markets — that the Fed is the “true” engine of global growth — is a new thing. As evidence of its novelty, I would point you to another bastion of modern economic orthodoxy, the National Bureau of Economic Research (NBER), in particular their repository of working papers. Pretty much every US economist of note in the past 40 years has published an NBER working paper, and I only say “pretty much every” because I want to be careful; my real estimate is that there are zero mainstream US economists who don’t have a working paper here.
If you search the NBER working paper database for “emerging market crises”, you see 16 papers. Again, the author list reads like a who’s who of famous economists: Martin Feldstein, Jeffrey Sachs, Rudi Dornbusch, Fredric Mishkin, Barry Eichengreen, Nouriel Roubini, etc. Of these 16 papers, only 2 — Frankel and Roubini (2001) and Arellano and Mendoza (2002) — even mention the words “Federal Reserve” in the context of an analysis of these crises, and in both cases the primary point is that some Emerging Market crises, like the 1998 Russian default, force the Fed to cut interest rates. They see a causal relationship here, but in the opposite direction of today’s Narrative! Now to be fair, several of the papers point to rising Developed Market interest rates as a “shock” or contributing factor to Emerging Market crises, and Eichengreen and Rose (1998) make this their central claim. But even here the argument is that “a one percent increase in Northern interest rates is associated with an increase in the probability of Southern banking crises of around three percent” … not exactly an earth-shattering causal relationship. More fundamentally, none of these authors ever raise the possibility that low Developed Market interest rates are the core engine of Emerging Market growth rates. It’s just not even contemplated as an explanation.
Today, though, this new Narrative is everywhere. It pervades both the popular media and the academic “media”, such as the prominent Jackson Hole paper by Helene Rey of the London Business School, where the nutshell argument is that global financial cycles are creatures of Fed policy … period, end of story. Not only is every other country just along for the ride, but Emerging Markets are kidding themselves if they think that their plight matters one whit to the US and the Fed.
Market participants today see Barzini/Bernanke everywhere, behind every news announcement and every market tick. They may be right. They may be reading the situation as smartly as Vito Corleone did. I doubt it, but it really doesn’t matter. Whether or not I privately believe that Barzini/Bernanke is behind everything that happens in the world, I am constantly told that this is WHY market events happen the way they do. And because I know that everyone else is seeing the same media explanations of WHY that I am seeing … because I know that everyone else is going through the same tortured decision process that I’m going through … because I know that everyone else is thinking about me in the same way that I am thinking about them … because I know that if everyone else acts as if he or she believes the Narrative then I should act as if I believe the Narrative … then the only rational conclusion is that I should act as if I believe it. That’s the Common Knowledge game in action. This is what people mean when they say that a market behavior of any sort “takes on a life of its own.”
For the short term, at least, the smart play is probably just to go along with the Barzini/Bernanke Narrative, just like the Corleone family went along with the idea that Barzini was running them out of New York (and yes, I understand that at this point I’m probably taking this Godfather analogy too far). By going along I mean thinking of the current market dynamic in terms of risk management, understanding that the overall information structure of this market is remarkably unstable. Risk-On / Risk-Off behavior is likely to increase significantly in the months ahead, and there’s really no predicting when Bernanke will open his mouth or what he’ll say, or who will be appointed to take his place, or what he or she will say. It’s hard to justify any large exposure to public securities in this environment, long or short, because all public securities will be dominated by this Narrative so long as everyone thinks that everyone thinks they will be dominated. This the sort of game can go on for a long time, particularly when the Narrative serves the interests of incredibly powerful institutions around the world.
But what ultimately saved the Corleone family wasn’t just the observation of Barzini’s underlying causal influence, it was the strategy that adjusted to the new reality of WHY. What’s necessary here is not just a gnashing of teeth or tsk-tsk’ing about how awful it is that monetary policy has achieved such behavioral dominance over markets, but a recognition that it IS, that there are investment opportunities created by its existence, and that the greatest danger is to continue on as if nothing has changed.
I believe that there are two important investment implications that stem from this sea change in the Narrative around Emerging Markets, which I’ll introduce today and develop at length in subsequent notes.
First, I think it’s necessary for active investors to recalibrate their analysis towards individual securities that happen to be found in Emerging Markets, not aggregations of securities with an “Emerging Markets” label. I say this because in the aggregate, Emerging Market securities (ETF’s, broad-based funds, etc.) are now the equivalent of a growth stock with a broken story, and that’s a very difficult row to hoe. Take note, though, the language you will have to speak in this analytic recalibration of Emerging Market securities is Value, not Growth, and the critical attribute of a successful investment will have little to do with the security’s inherent qualities (particularly growth qualities) but a great deal to do with whether a critical mass of Value-speaking investors take an interest in the security.
Second, there’s a Big Trade here related to the predictable behaviors and preference functions of the giant institutional investors or advisors that — by size and by strategy — are locked into a perception of Emerging Market meaning that can only be expressed through aggregations of securities or related fungible asset classes (foreign exchange and commodities). These mega-allocators do not “see” Emerging Markets as an opportunity set of individual securities, but as an asset class with useful diversification qualities within an overall portfolio. So long as market behaviors around Emerging Markets in the aggregate are driven by the Barzini/Bernanke Narrative, that diversification quality will decline, as the same Fed-speak engine is driving behaviors in both Emerging Markets and Developed Markets. Mega-allocators care more about diversification and correlations than they do about price, which means that the selling pressure will continue/increase so long as the old models aren’t working and the Barzini/Bernanke Narrative diminishes what made Emerging Markets as an asset class useful to these institutions in the first place. But when that selling pressure dissipates — either because the Barzini/Bernanke Narrative wanes or the mega-portfolios are balanced for the new correlation models that take the Barzini/Bernanke market effect into account — that’s when Emerging Market securities in the aggregate will work again. You will never identify that turning point in Emerging Market security prices by staring at a price chart. To use a poker analogy you must play the player — in this case the mega-allocators who care a lot about correlation and little about price — not the cards in order to know when to place a big bet.
In future weeks I’ll be expanding on each of these investment themes, as well as taking them into the realm of foreign exchange and commodities. Also, there’s a lot still to be said about Fed communication policy and the Frankenstein’s Monster it has become. I hope you will join me for the journey, and if you’d like to be on the direct distribution list for these free weekly notes please sign up at Follow Epsilon Theory.
Shock And Awe From Turkey Which Hikes Overnight Rate By 4.25% To 12%, Blows Away Expectations | Zero Hedge
The much anticipated Turkey Central Bank Decision is out and it is a stunner:
- TURKEY’S CENTRAL BANK RAISES OVERNIGHT LENDING RATE TO 12.00% – this is the key rate, and it was at 7.75% until now, so an epic 4.25% increase, far greater than the 2.50% expected.
- TURKEY’S CENTRAL BANK RAISES BENCHMARK REPO RATE TO 10.00% – from 4.50%
- TURKEY’S CENTRAL BANK RAISES OVERNIGHT BORROWING RATE TO 8.00% from 3.50%
- TURKEY CENTRAL BANK SETS PRIMARY DEALER RATE AT 11.5% VS 6.75%
- TURKEY CENTRAL BANK RAISES LATE LIQUIDITY WINDOW RATE TO 15%
The full release from the TCMB:
The Monetary Policy Committee (the Committee) has decided to adjust the short term interest rates as follows:
a) Overnight Interest Rates: Marginal Funding Rate is increased from 7.75 percent to 12 percent, borrowing rate from 3.5 percent to 8 percent, and the interest rate on borrowing facilities provided for primary dealers via repo transactions from 6.75 to 11.5 percent.
b) One-week repo rate is increased from 4.5 percent to 10 percent.
c) Late Liquidity Window Interest Rates (between 4:00 p.m. – 5:00 p.m.): Borrowing rate is kept at 0 percent, lending rate is increased from 10.25 percent to 15 percent.
Recent domestic and external developments are having an adverse impact on risk perceptions, leading to a significant depreciation in the Turkish lira and a pronounced increase in the risk premium. The Central Bank will implement necessary measures at its disposal to contain the negative impact of these developments on inflation and macroeconomic stability. In this respect, the Committee decided to implement a strong monetary tightening and to simplify the operational framework. Accordingly, (i) one-week repo rate is increased from 4.5 percent to 10 percent; (ii) the Central Bank liquidity will be provided primarily from one-week repo rate instead of the marginal funding rate in the forthcoming period.
Tight monetary policy stance will be sustained until there is a significant improvement in the inflation outlook. Under this policy stance, inflation is expected to reach the 5 percent target by mid-2015.
It should be emphasized that any new data or information may lead the Committee to revise its stance.
The summary of the Monetary Policy Committee Meeting will be released within five working days.
This is what a shock and awe move is. And it better work. This is how the revised Turkish “corridor” looks as of this moment:
For now the TRY (as well as the USDJPY and thus, equity futures) is loving the move, plunging 500 pips against the dollar.
Here is the bottom line: a $10 billion taper (out of $85 billion) just caused Turkey to hike its rate by 4.25%. This is just the beginning.
In the meantime, we hope our Turkish readers don’t suddenly need to take out a loan tomorrow morning. It may just be a tad more expensive.
In what is sure to be met with cries of derision across the European Union, in line with what the IMF had previously recommended (and we had previously warned as inevitable), the Bundesbank said on Monday that countries about to go bankrupt should draw on the private wealth of their citizens through a one-off capital levy before asking other states for help. As Reuters reports, the Bundesbank states, “(A capital levy) corresponds to the principle of national responsibility, according to which tax payers are responsible for their government’s obligations before solidarity of other states is required.” However, they note that they will not support an implementation of a recurrent wealth tax in Germany, saying it would harm growth. We await the refutation (or Draghi’s jawbone solution to this line in the sand.)
Germany’s Bundesbank said on Monday that countries about to go bankrupt should draw on the private wealth of their citizens through a one-off capital levy before asking other states for help.
The Bundesbank’s tough stance comes after years of euro zone crisis that saw five government bailouts. There have also bond market interventions by the European Central Bank in, for example, Italy where households’ average net wealth is higher than in Germany.
“(A capital levy) corresponds to the principle of national responsibility, according to which tax payers are responsible for their government’s obligations before solidarity of other states is required,” the Bundesbank said in its monthly report.
It warned that such a levy carried significant risks and its implementation would not be easy, adding it should only be considered in absolute exceptional cases, for example to avert a looming sovereign insolvency.
The German Institute for Economic Research calculated in 2012 that in Germany a 10-percent levy on a tax base derived from a personal allowance of 250,000 euros would add up to around 230 billion euros. It did not give a figure for crisis countries due to lack of sufficient data.
Greece has been granted bailout funds of 240 billion euros from the euro area, its national central banks and IMF to protect it from a chaotic default and possible exit from the euro zone. Not all funds have been paid out yet.
In Germany, however, the Bundesbank said it would not support an implementation of a recurrent wealth tax, saying it would harm growth.
“It is not the purpose of European monetary policy to ensure solvency of national banking systems or governments and it cannot replace necessary economic adjustments or bank balance sheet clean ups,” the Bundesbank said.
In considering some of the potential measures likely to be required, the reader may be struck by the essential problem facing politicians: there may be only painful ways out of the crisis.
There is one thing we would like to bring to our readers’ attention because we are confident, that one way or another, sooner or later, it will be implemented. Namely a one-time wealth tax: in other words, instead of stealth inflation, the government will be forced to proceed with over transfer of wealth. According to BCG, the amount of developed world debt between household, corporate and government that needs to be eliminated is just over $21 trillion. Which unfortunately means that there is an equity shortfall that will have to be funded with incremental cash which will have to come from somewhere. That somewhere is tax of the middle and upper classes, which are in possession of $74 trillion in financial assets, which in turn will have to be taxed at a blended rate of 28.7%.
The programs BCG (and the Bundesbank) described would be drastic. They would not be popular, and they would require broad political coordinate and leadership – something that politicians have replaced up til now with playing for time, in spite of a deteriorating outlook. Acknowledgment of the facts may be the biggest hurdle. Politicians and central bankers still do not agree on the full scale of the crisis and are therefore placing too much hope on easy solutions. We need to understand that balance sheet recessions are very different from normal recessions. The longer the politicians and bankers wait, the more necessary will be the response outlined in this paper. Unfortunately, reaching consensus on such tough action might requiring an environment last seen in the 1930s
While last night’s almost unprecedented reverse repo liquidty injection into the Chinese banking system stopped the bleeding of short-dated money-market rates briefly, the likelihood remains that a shadow-banking system default will occur: As CASS’s Zhang noted:
- *CHINA TRUSTS AND SHADOW BANKING TO SEE DEFAULTS IN 2014: ZHANG
- *CHINA SHADOW-BANKING DEFAULTS WOULD BE GOOD THING: CASS’S ZHANG
Perhaps that explains why China’s CDS spread remains at its highest since the summer credit crunch, barely budging on last night’s cash drop. At double the default risk of Japan, China appears far from out of the contagion fire.
China’s risk makes the US debt ceiling debacle look miniscule and while liquidity does not reign supreme in these markets, the last few months have seen considerably more activity in Asian sovereign CDS…
China’s Academy of Social Sciences Zhang Ming had a few other things to say…
- *CHINA EXPORTS MAY NOT BE AS GOOD AS MARKET EXPECTS: ZHANG
- *CHINA MONETARY POLICY TO REMAIN RELATIVELY TIGHT IN 2014: ZHANG
- *YUAN APPRECIATION COMING TO AN END, CASS’S ZHANG MING SAYS
- *YUAN MAY WEAKEN AFTER REACHING 6 PER DOLLAR: RESEARCHER ZHANG
and typically is seen as yet another mouthpiece for the administration… so that won’t please Schumer and his crowd…
Last week we were the first to raise the very real and imminent threat of a default for a Chinese wealth management product (WMP) default – specifically China Credit Trust’s Credit Equals Gold #1 (CEQ1) – and its potential contagion concerns. It seems BofAML is now beginning to get concerned, noting that over 60% of market participants expects repo rates to rise if a trust product defaults and based on the analysis below, they think there is a high probability for CEQ1 to default on 31 January, i.e. no full redemption of principal and back-coupon on the day. Crucially, with the stratospheric leverage ratios now engaged in such products, BofAML warns trust companies must answer some serious questions: will they stand back behind every trust investment or will they have to default on some or potentially many of them? BofAML believes the question needs an answer because investors and Trusts can’t have their cake and eat it too. The potential first default, even if it’s not CEQ1 on 1/31, would be important based on the experience of what happened to the US and Europe; the market has tended to underestimate the initial event.
For those who have forgotten, below is a quick schematic of what a WMP looks like:
And as we previously noted,
…borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).
Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.
Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.
So the PBOC’s efforts are merely exacerbating the situation for the worst companies… and as BofAML notes below, this is a major problem…
The 3bn CNY Beast Knocking
via BofAML’s Bin Gao
CNY stands for the currency, and also a beast
CNY represents China’s official currency. It also stands for Chinese New Year, the biggest holiday for the country and the occasion for family reunions and celebration. But less familiar for many, however, the Year (?) itself actually stood for a beast which comes out every 365 days and eats everything along the way from bugs to humans. The holiday tradition started as a way for people to fend off the beast by getting together and lighting up the firecrackers.
At the same time, custom dictated that people also to paid their due to avoid becoming the beast’s target. In particular, it has been a tradition to settle all debt before the New Year. From the perspective of such folk culture, the trust product Credit Equals Gold #1, referred as CEQ1 hereafter, by China Credit Trust planned poorly for having the maturing date on the New Year, leaving a 3bn CNY beast running wild.
High probability for the trust product to default
Though the term default is used quite frequently, there are actually confusions on what constitutes a default in this case when talking to investors and especially onshore investment professionals. To simplify the issue, we define a default as failing to pay the promised contractual amount on time.
The product, CEQ1, is straightforward. It is CNY3.03bn financing with senior tranches of CNY3bn and junior tranche of CNY30mn. In principle, the senior tranches are also equity investment, but the junior tranche holder pledged assets for repurchasing senior investment at a premium. The promised rate was indexed to PBoC’s deposit rate with a floor for three classes of senior tranches at 9.5%, 10% and 11%, paid annually (detailed structure is illustrated below).
In a sense, the product is in technical default already. The last coupon payment in December, with nearly all the money (CNY80mn) left in the trust account, came in at only 2.7%, falling far short of the promised yield. The bigger trouble is the CNY3bn principal payment, along with the delinquent coupon, on 31 January.
We see high probability of default on 31 January
Political or economic consideration: ultimately, given the government’s strong grip on financial institutions, default may be a political decision as much as an economic decision. From that perspective, CEQ1 would be a good candidate for default. The minimum investment in CEQ1 is CNY3mn, much more than the typical amount required for other trust investment and 75 times of per capita GDP in China. If defaults were to be used to send a warning signal to shadow banking investors, this group of rich investors may have been a good target because the government does not need to worry too much of them demonstrating in front of government offices.
Timing: there is never a good timing for deleverage because of risks involved. But the current job market situation provides a solid buffer should defaults and subsequent credit contraction slow down the economy growth. The government planned 9mn jobs last year; instead it has created more than 12mn by November. So the system could withstand a potential shock.
Financial capability: China Credit Trust has a bit over CNY10bn net assets, which some analysts cite as evidence of the trust company’s capability to fully redeem the product first and recover from the collateral asset later. However, the assets might not be liquid enough, so the net asset is not the best measure. Based on its 2012 annual report, the company has liquid asset of CNY3bn and short-term liability of CNY1.35bn, leaving liquid accessible fund of CNY1.65bn at most. ICBC for certain has much deeper pocket, but it has declared that it won’t be taking major responsibility.
Career concern: To certain extent, the timing was unfavorable for another reason, the ongoing anti-corruption campaign. It is reported that there are around 700 investors involved. On CNY3bn senior tranche investment, it averages CNY4.3mn per investor. We do not know the exact identity but with CNY3mn entry point, we know no one is a small-scale investor. Legally unjustified, if either China Credit Trust or ICBC decided to pay 100% with their capital, the decision maker would have to ensure that he does not have any business deals with any of the 700. Because if he does, his career or even his freedom could be in jeopardy in the current environment of ongoing anti-corruption campaign and strict scrutiny of shady deals/personal favors.
Questionable asset quality and uncertain contingent claim: There are cases in the past of near default, but most of them involved collateral of real estate assets, which have at least appreciated over the years. The appreciation of collateral assets makes it easier for the third party to step in by paying back investors and taking over the collateral assets. This particular product involves coal-mining assets whose value has been decreasing over the last couple of years. Moreover, there have been multiple claimants on these assets, as exemplified by the sale of Yangjiagu coal mine. Although the mine was 51% pledged through two levels of ownership structure, only 20% of the sales proceed accrued to trust investors (Exhibit 1 above). Such a low percentage would be a deterrence and concern to whoever contemplating a takeover of the collateral assets.
Other cases less relevant: In the past, one way to deal with the issue was for banks to lend to shareholders of the existing collateral asset owners for them to payback investors, with explicit or implicit local government guarantees. Shangdong Hailong’s potential default on bond was avoided this way last year. However, in the current case, the owner has been arrested for illegal fund raising, making the past precedence less applicable.
Putting all the above reasons together, we think there is a high probability for CEQ1 to default on 31 January, i.e. no full redemption of principal and backcoupon on the day.
Immediate impact would be for China rates curve to flatten
The case has been widely covered in the media. However, many still believe one way or the other the involved parties will find a last minute solution to fully redeem the maturing debt. So if the trust is not paid, we believe it will be a big shock to the market.
China rates market reaction, however, might not be straightforward. On the one hand, default would likely lead to risk-averse behavior, arguing for lower rates. On the other hand, market players would likely hoard cash in such an event, leading to tighter liquidity condition and pushing money rates higher.
We think that both movements are likely to ensue initially, meaning higher repo/SHIBOR rates and lower CGB yield if default were to realize. We suggest positioning likewise by paying 1y IRS and long 5y CGB. On the swap curve itself, we think the immediate reflection will be a bear flattening move.
Interestingly, an informal survey conducted on WeChat among finance professionals suggests the same kind of repo rate reaction (Chart 1). We think this survey is important because we believe these investment professionals will likely behave accordingly because the default event is not priced in and hard to hedge a priori.
Trust company can’t have their cake and eat it too
Of course, we can’t rule out that the involved parties do find a solution to avoid default. However, with a case as clear cut to us as this one favoring default, we believe such outcome would send a strong signal to investors that the best investment is to buy the worst credit.
Thus, we believe the near term market reaction with no default would be for the AA credit to shine brightly since this segment has been under pressure for quite some time. Trust investment would be met with enthusiasm and trust assets would likely expand further.
However, we see a fundamental problem in the industry; the leverage ratio has gone to a level which requires investors and trust companies to answer some serious questions: will trust company stand back behind every trust investment or will trust company have to default on some or potentially many of them? We believe the question needs an answer because the trust companies can’t have their cake and eat it too.
For the industry, the AUM/equity ratio has nearly doubled from 23 to 43 in less than three years during the period of 4Q2010 to 3Q2013 (Chart 2). Some in the industry has argued that one should only count the collective trusts since other trusts are originated by non-trust players like banks. Thus, trust companies have no responsibility for paying investors other than collective trusts.
We see two problems.
Even if we accept the trust companies’ argument, it is still questionable whether trust companies would be able to pay even a reasonable amount of default. The growth of leverage on collective trusts was much more aggressive. Collective trust AUM/equity ratio was 2.7 in 1Q2010 and 4.7 in 4Q2010 (Chart 2). It rose to 10 by 3Q2013, more than doubled in less than three years and more than tripled in less than four years. Along the way, the average provision has dropped from 84bp to 34bp when measured against collective AUM.
As the case of CEQ1 illustrates, as long as full redemption is on the table, no involved party could walk away totally clean. CEQ1 is a case of collective trust, but the ICBC still faces the pressure to pay. If the bank is being pressured to pay in the case of collective trust default, trust companies will likely be pressured to pay as well should some non-collective trusts get into trouble. If trust companies are on the line for the total AUM, their financial condition is even shakier, with average provision covering barely 7bp of total AUM as of 3Q2013.
On longer term market trend
Based on the analysis in the above section, we see a possibility for trust companies to have to let some trust products default with such high leverage and so few provisions. This is especially likely the case given that there will be more and more trust redemption this year and next year as a result of the fast expansion of this industry over the last couple of years and short duration of such products.
The heaviest redemption in collective trusts this year will arrive in the 2Q (Chart 3). Given that the financial system is stretched thin and there were more cases of near defaults on smaller amount of redemption last year (three cases in December alone), we believe some form of default is almost inevitable in the near term.
The potential first default, even if it’s not CEQ1 on 31 JANUARY, would be important based on the experience of what happened to the US and Europe; the market has tended to underestimate the initial event. Over the last year, China appeared to be mirroring what happened in the US during 2007, the spike of money rate (much higher repo/SHIBOR), the steepening of money curve (14d money much more expensive than overnight and 7d), and small accidents here and there (junior tranches of a few wealth management products offered by Haitong Securities losing more than 60%, a few small trusts and now CEQ1’s redemption difficulty).
Theoretically, China’s risk is best expressed using a China related instrument, but we also think the more liquid expression of China goes through the south pacific. The following points list our longer views on China and Australia rates.
- We have liked using Australia rates lower as a way to express our China concern and we continue recommending doing so as a theme.
- We recommend long CGB and underweight credit product. The risk for such positioning in the near term is no CEQ1 default. But we believe any pain suffered due to overt market manipulation to avoid default will be short lived since it has become much harder to keep the debt-heavy system in balance and the credit spread is bound to widen.
- After a brief flattening on CEQ1 default, we see swap curve steepening as being more likely on more default threatening growth leading to easy monetary policy and more issuance going to the bond market.
- We look for higher CCS rates due to the fact that the currency forward will more likely start expressing the risk.
“There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.”
The “eerie resemblances” – as Soros previously noted – to the US in 2008 have profound consequences for China and the world – nowhere is that more dangerously exposed (just as in the US) than in the Chinese shadow banking sector.
From Russ Certo, head of rates at Brean Capital
Two Roads Diverged
As we know, it has been a suspect week with a variety of earnings misses. Although I have been constructive on risk asset markets generally, equities anecdotally, as figured year end push for alpha desires could let it run into year end. New year and ball game can change quickly. Just wondering if a larger rotation is in order.
There is an overall considerable theme of what you may find when a liquidity tide recedes as most major crises or risk pullbacks have been precipitated by either combination of tighter monetary or fiscal policy. Some with a considerable lag like a year after Greenspan departed from Fed helm, or many other examples. I’m not suggesting NOW is a time for a compression in risk but am aware of the possibility, especially when Fed Chairs take victory laps, Bernanke this week. Symbolic if nothing more. Cover of TIME magazine?
I happen to think that 2014 is a VERY different year than 2013 from a variety of viewpoints. First, there appears to be a dispersion of opinion about markets, valuations, policy frameworks and more. This is a healthy departure from YEARS of artificiality. Artificiality in valuations, artificiality in market and policy mechanics and essentially artificiality in EVERY financial, and real, relationship on the planet based on central bank(s) balance sheet expansion and other measures intended to be a stop-gap resolution to tightening financial conditions, adverse expectations of economic activity, and the great rollover….of both financial and non-financial debt financing. Boy, what a week in the IG issuance space with over $100 billion month to date, maybe $35 billion on the week. Debt rollover on steroids.
Beneath the veneer of market aesthetics, I already see fundamental (and technical) relevance. This could be construed as an optimist pursuit or reality that markets are incrementally transcending reliance and/or dependence on the wings of central bank policy prerogatives. The market bird is trying to fly on its own with inklings of a return to FUNDAMENTAL analysis. A good thing, conceptually, and gradualist development of passing the valuation baton back to market runners. A likely major pillar objective of policy despite more than a few critics worried about seemingly dormant lurking imbalances created by immeasurable policy and monetary and fundamentally skewed risk asset relationships globally.
This exercise of summarization of ebb and flow and comings and goings of markets and policy naturally funnels a discussion to what stature of central bank policy currently or accurately exists? Current events. What is the accurate stage of policy?
I actually think this is a more delicate nuance than I perceive viewed in overall market sentiment. Granted, we have taken a major step for mankind, which is the topical engagement of some level of scope or reduction of liquidity provisioning,” not tightening.” Tip of the iceberg communique with markets to INTRODUCE the concept of stepping off the gas but not hitting the break. Reeks of fragility to me but narrative headed in right direction to stop medicating the patient, the global economy.
Some markets have logically responded in kind. The highest beta markets as either beneficiaries or vulnerable to monetary policy changes, the emerging markets, have reflected at least the optics of change with policy. More auditory than optics in hearing a PROSPECTIVE change in garbled Fedspeak. The high flyer currencies which capture the nominal flighty hot money flows globally affirmed the Fed message.
In literally the simplest of terms, the G7 industrialized, not peripheral; interest rate complex has simply moved the needle in form of +110 basis point higher moves in nominal sovereign interest rates. And there are a bevy of other expressions which played nicely and rightly conformed to the messages coming out of the central bank sandbox. But there are ALSO notable dichotomies, which send a different or even the opposite message.
I perceive a deviation in perception of message as some markets or market participants appear to be betting on taper or a return to normalcy in global growth or U.S. growth outcomes??? OR no taper, or conversely QE4 or whatever. Sovereign spreads have moved materially tighter vs. industrial and supposed risk free rates (Tsys, Gilts, Bunds) both last year and in the first three weeks of 2014. Something a new leg of QE would represent, not a taper. A different year!!!
There have been VERY reliable risk asset market beta correlations over the last 5 years and sovereign or peripheral spreads have been AS volatile and correlated as any asset class. These things trade like dancing with a rattle-snake. Greece, Spain, France etc. They can bite you with fangs. They have been meaningfully more correlated to high yield spreads and yields and to central bank balance sheet expansion as nearly any asset class. So, the infusion of central bank liquidity into markets has seen “relief” rallies in peripherals and one would think the converse would be true as well. The valuations have represented the flavor and direction of risk on/risk off or liquidity on/liquidity off reliably for many months/years.
But I THOUGHT markets were deliberating tapering views and expressions as validated by some good soldier markets BUT that is not necessarily what the rally in riskiest of sovereign “credits” is suggesting. The complex seems to be decoupling with Fed balance sheet correlation and message. Some are OVER 100 standard deviations from the mean! They are rich and could/should be sold. Especially if one was to follow the obvious correlation with the direction of central bank as stated.
But look to other arena’s like TIPS breakevens which also have been correlated with liquidity and risk on/off and central bank balance sheet expansion. Correlated to NASDAQ, HY, peripherals and the like. BUT this complex COUNTERS what peripherals are doing. They haven’t shown up to the punch bowl party yet. Not invited. This is a departure of markets that have largely and generally been in synch from a liquidity and performance correlation view.
Like gold and silver which got tattooed vis a vis down 35%+ performance last year MOSTLY, but not exclusively, due to perceptions of winds of central bank change. BUT even within a contrary, the fact that rallies in Spain, France, Greece, and Italy reflect more of central bank easing notions, the opposite of taper. In essence, the complex has gone batty uber-appreciation this year. Sure, many eyeball the Launchpad physical metals marginal stabilization no longer falling on a knife but the miner bonds and the mining stocks are string like bull with significant appreciation. This decidedly isn’t the stuff of taper which had the bond daddy’s romancing notions of 3% 10yr breaks, 40 basis point Green Eurodollar sell-offs, emerging market rinse, and upticks in volatility amongst other things.
Equity bourses appear to be changing hands between investors with oscillating rotations which mark the first prospective 3 week consecutive sell-off in a while. New year. This is taper light. Somewhere in between and further blurs the correlation metrics.
So, which is it? Are we tapering or not and why are merely a few global asset classed pointed out here, why are they deviating or arguably pricing in different central bank prospects or scenarios or outcomes?
I’m not afraid but I am intrigued as to the fact that there may some strong opinions within markets and I perceive a widely received comfortability with taper or tightening notions, negative leanings on interest rate forecasts, a complacency of Fed call if you will. And all of these hingings occur without intimate knowledge of the most critical variable of all, what Janet Yellen thinks? She has been awfully quiet as of late and there are many foregone conclusions or assumptions in market psyche without having heard a peep from the new MAESTRO.
Moreover, looking in the REAR view mirror within a week where multiple (two) Fed Governor proclamations, communicated and implicated notions which arguably would be considered radical in ANY other policy period of a hundred years. How to conduct “monetary policy at a ZERO lower bound (Williams) ” and “doing something as surprising and drastic as cutting interest on excess reserves BELOW zero (Kocherlakota).”
This doesn’t sound like no stinking taper? A tale of two markets. To be or not to be. To taper or not to taper. Two roads diverged and I took the one less traveled by, and that has made all the difference. Robert Frost.
Which is it? Different markets pricing different things. Right or wrong, the market always has a message; listen critically.