I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.
Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:
“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”
All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB. This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.
There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.
If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).
But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years. Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.
Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.
If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.
The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).
Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.
 This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.
I am beginning to worry about my own complacency. As a person who has been a participant in the fixed-income markets for a long time, I have become quite naturally a very cautious investor. Such caution is a quintessentially fixed-income mindset (although you might not guess that from the way bond people behaved in the run-up to the global financial crisis) – as a bond investor, you are essentially in the position of someone who is short options: taking in small amounts on a regular basis, with an occasional large loss when the credit defaults. A bond investor can greatly improve his performance in the long run relative to an index by merely avoiding the blow-ups. Miss the Enron moment, and you pick up a lot of relative performance. (The same is true of equities, but there is much more upside to being an optimist. The stock market selects for optimists, the bond market for pessimists.)
This is a lesson that many high-yield investors today, chasing near-term carry, seem to have forgotten. But my purpose here isn’t to bash those involved in the global reach for yield. I am merely pointing out that this is how I tend to think. I am always looking for the next disaster that hangs a portfolio with a big negative number. As Prince Humperdinck said in The Princess Bride, “I always think everything could be a trap – which is why I’m still alive.”
And I am starting to worry about my own complacency. I don’t get the feeling that we’re gearing up for Round 2 of the global financial crisis. Something bad, perhaps, but not catastrophic.
To be sure, there are a large number of potential pitfalls facing investors today, and I think market volatilities underestimate their probabilities substantially. We are facing an inflection in policy from the ECB this week, with analysts expecting a substantial additional easing action (and it is overdue, with money growth in Europe down to a feeble 1.9% y/y, near the worst levels of the post-crisis period – see chart, source Bloomberg). Absent a major change in policy, liquidity on the continent is going to become increasingly dear with possible ramifications for the real economy as well as the asset economy.
The Federal Reserve is facing a more-serious policy inflection point, with no agreement amongst FOMC members (as far as I can tell) about how to transition from the end of QE to the eventual tightening. I’ve pointed out before – while many Fed officials were whistling Dixie about how easy it would be to reverse policy – that there is no proven method for raising interest rates with the vast quantity of excess reserves sitting inert on bank balance sheets. Moreover, raising interest rates isn’t the key…restraining money growth is. The key point for markets is simply that there is no plan in place that removes these reserves, which means that interest rates are not likely to respond to Fed desires to see them rise. And, if the Fed uses a brute-force method of raising the interest paid on excess reserves, then rates may rise but we don’t know what will happen to the relative quantities of required and excess reserves (and it is the level of required reserves that actually matter for inflation). It is a thorny problem, and one which the markets aren’t giving enough credit regarding the difficulty thereof.
Valuation levels are high across the board (with the exception of commodity indices). They’re doubly high in stocks, with high multiples on earnings that are themselves high with respect to revenues. And yes, this concerns me. I expect more volatility ahead, and perhaps serious volatility. But the fact that I am just saying “perhaps,” when all of my experience and models say “there is no escape without some bad stuff happening,” means that I am being infected – relative to my usual caution – by the general complacency.
In other words, I am worried that I am not worried enough.
The interesting thing is that equity bulls said during the entire march higher that “it doesn’t matter what the fundamentals are, the Fed is pushing the market higher and spreads tighter.” I still don’t believe that was an inevitable outcome to the Fed’s QE, but the fact is that people believed it and they were correct: that was enough to keep the market going higher. I can’t be comfortable going along with the crowd in that circumstance, but in retrospect it would have been better to abandon the models, throw caution to the wind, and ride along with the fun. And perhaps this regret is one reason for my developing complacency.
But that way lies madness, since the problem is not the ride but the getting out when the ride is over. The Fed is no longer providing QE (or, in any event, QE will shortly end altogether). So what’s the excuse now? It seems to me that everyone is still riding on the fun train, and just watching carefully to see if anyone jumps off. I think the market rally is on very tenuous footing, because if faith in the market’s liquidity goes away, the value anchor is very far from these levels. Yet, part of me is skeptical that a market which hasn’t corrected in more than two years can actually return to those value anchors. I should know better, because the bond-market mindset reminds me that market gains are generally linear while market losses are discontinuous, sloppy, and non-linear. Especially, I ought to be thinking, when market liquidity is so poor thanks to the government’s assault on market makers over the last few years.
I keep wondering if there is one more pulse higher in stocks coming, one more decline in commodities before they begin to catch up with money growth and inflation, one more rally in bonds before they begin to discount a higher inflation path. And this is very possible, because while I worry about my own developing complacency most investors are not concerned about their own.
Complacency or no, insurance is cheap. The low current level of implied volatilities in almost every asset class makes portfolio protection worthwhile, even if it costs a bit of performance to acquire that protection.
Over the past week or two we have seen and heard from the Fed (in the minutes released on Wednesday), the ECB (after their April 3rd meeting), the BOJ (after their April 7th meeting), and the Bank of England (today). Having heard from the “big four,” I think it’s very interesting to compare what they seem to be indicating they will do to what they probably ought to do. (I am actually going to neglect the BOE, since their situation is quite complex at the moment and probably too much for a reasonable-length article).
In the US, the latest surprise – for some people – was the dovish tenor of the FOMC minutes when they were released yesterday. I shake my head in wonder at anyone who has managed to convince themselves that Chairman Yellen is a closet hawk even after years of evidence to the contrary (not least being the fact that she was nominated at all – not since Volcker has any Fed chief with remotely hawkish credentials been nominated to the Chairman’s position). After the FOMC meeting itself, a few weeks ago, TIPS had been clobbered and some (although not me) attributed that to the hawkish tone of the statement and the fact that Yellen had mentioned offhand that a lengthy period of low rates after QE has ended might be something like six months. The Fed is not hawkish at this point in its history; this is not to say that it does not have hawkish members but on the whole it is a dovish institution and I maintain that the Fed will likely tighten too late, and too little. For now, the Fed seems to be trying to make clear that they are concerned about low inflation and not likely to step on the brakes any more than they have.
What ought the Fed to be doing right now? The Fed ought to be tightening. Though growth is not robust, “robust” growth cannot be the standard demanded before starting a tightening of monetary policy, especially when there are tremendous excess reserves. The monetary policy car has no traction with such huge reserves, and the Fed needs to start trying to get control so that when it is time to steer, it can do so. Moreover, with disinflation fears waxing – incredibly – at the FOMC, inflation is in fact heading higher. Median inflation should approach or exceed 3% this year, despite the Fed’s belief that it will be well below 2% for a very long time. In a few months, the fear of disinflation and deflation will seem quaint.
No increase in policy rates is going to be coming any time soon. The Fed will continue to tighten very slowly, by winding down QE and then possibly starting to mop up some of the trillions in extra liquidity. That’s a sine qua non to rates going up, unless the Fed decides to establish a floor with the interest rate on excess reserves and to ship big boxes of money to Wall Street. But the interesting part will be when the Fed starts to mop up that liquidity either by outright bond sales (unlikely) or by some sort of massive reverse repo operation. It will get interesting because this classic tightening maneuver won’t be met with rising short rates – making it clear even to non-Fed-watchers that the Fed has no control over short rates at the moment. Again, I seriously doubt that the Fed will move with alacrity towards a tighter policy, and as it is they are at least a couple of years behind. But even if they do continue to tighten it will take years, not months, for the system to approach a normal state of liquidity.
The ECB talks like it is ready to ease further. ECB President Draghi was perceived as extremely bullish at his post-meeting presser last week, and recently there has been more chatter about negative deposit rates or other ways to increase the money supply.
And they need to do it. Disinflation, and possibly even deflation, actually probably is the threat in Europe, because the ECB has allowed money growth to slow back to the too-slow range that characterized the post-credit-crisis period (see chart, source ECB).
This obvious failure to keep money growth up is one reason for the strength of the Euro since 2012 – while the Fed talks about tightening, but does so in a way that only a dove could love, the ECB talks about easing, but does so in a way that can only appeal to hawks. Currency traders can smell it – European monetary policy may be as poorly managed as US monetary policy is, but holders of a currency prefer when the central bank is printing 2% more every year, rather than 6-8% as in the US. (Which would you prefer, a 2% dilution of your equity ownership, or an 8% dilution?)
The problem for the ECB is that their legal structures have been set up so that, at least officially, they don’t have the same tools for QE that other central banks have. Theoretically, they are prohibited from purchasing government bonds without sterilizing the intervention since that would mean effectively financing member governments. What ought the ECB to do? Well, I suppose it ought to follow its charter, but in a perfect world it is the ECB, and not the BOE or Fed, which would be doing QE. I suppose it will not surprise any reader to discover that I am a cynic, and I suspect that the ECB will at some point conclude that ceasing to sterilize the OMT bond portfolio is somehow allowed, even though practically speaking that would be the same as buying new government bonds without sterilization. We have already found out that in a pinch, the Federal Reserve is willing to be moderately “flexible” when it comes to its legal mandates. It would not surprise me a bit to see the ECB take a similar step. I suspect this will not happen in the next few months, since core European inflation for the year ended February has risen to 1.0% after being as low at 0.7% at year-end, but if that figure doesn’t continue to rise – and there’s no reason I can see that it should – then the ECB may test its flexibility later this year.
In Japan, the Bank of Japan has lifted core inflation to 0.8%, and it will continue to rise. Money supply growth is over 4% y/y, but only just barely. I believe that in Japan, what they profess to want and what they actually will act to secure are one and the same: increased QE, in increasing amounts, until everyone realizes that they are serious, the Yen declines markedly, and deflation is finally banished from the nation.
So in the race for weaker currencies, I suspect Japan will eventually win, with the US placing second and Europe having – annoyingly for its central bank, who would like a weaker currency to spur growth – the strongest unit.
The equity melt-up continues, with the S&P 500 now up more than 25% year-to-date in a period of stagnant growth and an environment of declining market liquidity. The catalysts for the latest leg up were the comments and testimony by Fed Chairman-nominee Janet Yellen, whose confirmation hearings began today.
Her comments should alleviate any fear that Yellen will be anything other than the most dovish Fed Chairman in decades. Ordinarily, potential central bankers take advantage of confirmation hearings to burnish their monetarist and hawkish credentials, in much the same way that Presidential candidates always seem to try and campaign as moderates. It makes sense to do so, since the credibility of a central bank has long been considered to be related to its dedication to the philosophy that low and stable prices promote the best long-term growth/inflation tradeoff. Sadly, that no longer appears to be the case, and Janet Yellen should easily be confirmed despite some very scary remarks in both the scripted and the unscripted part of her hearing.
In her prepared remarks, Yellen commented that “A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases.” Given half a chance to repeat the tried-and-true mantra (which Greenspan used repeatedly) about the Fed balancing its growth and inflation responsibilities by focusing on inflation since growth in the long run is maximized then inflation is low and stable…Yellen focused on growth as not only the primary but virtually the only objective of the FOMC. As with Bernanke, the standard which has been set will be maintained: we now use extraordinary monetary tools until we not only get a recovery, but a strong recovery. My, have the goalposts moved quite a lot since Volcker!
That means that QE may indeed last forever, since QE may be one of the reasons that the recovery is not strong (notice that no country which has employed QE so far…or ever, as far as I know…has enjoyed a strong recovery). In a very direct sense, then, Yellen has declared that the beatings will continue until morale improves. And I always thought that was just a saying!
I would call that borderline insanity, but I am no longer sure it is borderline.
Among other points, Yellen noted that the Fed is intent on avoiding deflation. In this, they are likely to be successful just as I am likely to be successful in keeping alligators from roosting on my rooftop. So far, there is no sign of it happening, hooray! I must be doing something right!
Yellen also remarked that the Fed might still consider cutting the interest it pays on banks’ excess reserves, or IOER. The effect of this would be to release, all at once, some large but unknown quantity of sterile reserves into the transactional money supply. If there was any question that she is more dovish than Bernanke, there it is. It was never clear why the Fed was pursuing such a policy – flood the market with liquidity, and then pay the banks to not lend the money – unless the point was merely to reliquify the banks. It is as if the Fed shipped sealed crates of money to banks and then paid them rent for keeping the boxes in their safes, closed. If you’re going to do QE, this is at least a less-damaging way to do it although it raises the question of what you do when you need the boxes back. Yellen, on the other hand, is open to the idea of telling the banks that the Fed won’t pay them any longer to keep those boxes unopened, and instead will ship them crowbars. This only makes sense if you really do believe that money causes growth, but has nothing to do with inflation.
The future Fed Chairman also declared that the Fed has tools to avert emergence of asset bubble. Of course, no one really doubts that they have the tools; the question is whether they know how and when to use the tools. And, to bring this to current events, the question is no longer whether they can avert the emergence of an asset bubble, but whether they can deflate the one they have already re-inflated in stocks, and an emerging one in property! Oh, wait, she’s at the Federal Reserve…which means she won’t realize these are bubbles until after the bubble pops, and then will say that no one could have known.
Now, it may be that the U.S. is merely nominating Dr. Yellen in self-defense, to keep the dollar from becoming too strong or something. Last week’s surprise rate cut from the ECB, and the interesting interview by Peter Praet of the ECB in which he opens the door for asset purchases (which interview is ably summarized and dissected by Ambrose Evans-Pritchard here), keeps the heat on the Fed to remain the most accommodative of the major central banks.
At least the ECB had a reasonable argument that there was room for them to paint the least attractive house on the block. Europe is the only one of the four major economies (I exclude China since quality data is “iffy” at best) where central-tendency measures of inflation are declining (see chart, source Enduring Investments).
And that is, of course, not unrelated to the fact that the ECB is the only one of the four major central banks to be presiding over low and declining money supply gowth (see chart, source Enduring Investments).
There is of course little desire in the establishment to do so. The equity market continues to spiral higher, making the parties louder and longer. It is fun while it lasts, and changing to a bartender with a more-generous pour might extend the good times slightly longer.
It is no fun being the designated driver, but the good news is that I will be the one without the pounding headache tomorrow.
[Hmmm...erratum and thanks to JC for catching it. The S&P is "only" up 25.6% YTD (my Bloomberg terminal decided that it wants to default to the return in Canadian dollars). So originally the first paragraph had "32%" rather than 25%. Corrected!]
One of the more disturbing meta-trends in markets these days is the direction the evolution of central banking seems to be taking.
I have written before (and pointed to others, including within the Fed, who have written before ) about the disturbing lack of attention being paid in the discussion and execution of monetary policy to anything that remotely resembles money. Whether we have to be concerned about money growth in the short- and medium-terms, ultimately, will depend on what happens to the velocity of money, and on how rapidly the central bank responds to any increase in money velocity. But there are trends that could be much more deleterious in the long run as the fundamental nature of central banking seems to be changing.
Today the Bank of England released its Quarterly Inflation Report, in which it introduced an “Evans Rule” construction to guide its monetary policy looking forward. Specifically, the BoE pledged not to reduce asset purchases until unemployment dropped below 7% (although Mark Carney in the news conference verbally confused reducing asset purchases with raising interest rates), unless:
“in the MPC’s view, CPI inflation 18 to 24 months ahead is more likely than not to be below 2.5 percent; secondly, if medium-term inflation expectations remain sufficiently well anchored; and, thirdly, the Financial Policy Committee has not judged the stance of monetary policy — has not judged — pardon me — the Financial Policy Committee has not judged that the stance of monetary policy poses a significant threat to financial stability, a threat that cannot otherwise be contained through the considerable supervisory and regulatory policy tools of various authorities.”
This is quite considerably parallel to the FOMC’s own rule, and seems to be the “current thinking” among central bankers. But in this particular case, the emperor’s nakedness is revealed: not only is inflation in the UK already above the 2.5% target, at 2.9% and rising from the lows around 2.2% last year, but the inflation swaps market doesn’t contemplate any decline in that inflation rate for the full length of the curve. Not that the swaps market is necessarily correct…but I’ll take a market-based forecast over an economist consensus, any day of the week.
So, for all intents and purposes, while the BOE is saying that inflation remains their primary target, Carney is saying (as my friend Andy the fxpoet put it today) “…the BOE’s inflation mandate was really quite flexible. In other words, he doesn’t really care about it at all.”
Along with this, consider that the candidates which have so far been mooted as possible replacements for Bernanke at the US Fed are all various shades of dovish.
Here, then, we see the possible long-term repercussions of the 2008 crisis and the weak recovery on the whole landscape of monetary policy going forward for many years. In some sense, perhaps it is a natural response to the failure or monetary policy to “get growth going,” although as I never tire of pointing out monetary policy isn’t supposed to have a big impact on growth. So, the institutions are evolving to be even more dovish.
At one time, I thought it would happen the other way. I figured that, since the ultimate outcome of this monetary policy experiment is clearly going to be higher inflation, the reaction would be to put hawkish central bankers in charge for many years. But as it turns out, the economic cycle actually exceeded the institutional cycle in duration. In other words, institutions usually evolve so slowly that they tend not to evolve in ways that truly hurt them, since the implications of their evolution become apparent more quickly than further evolution can kick in and compound the problem. In this case, the monetary response to the crisis, and the aftermath, has taken so long – it’s only half over, since rates have gone down but not returned to normal – that the institutions in question are evolving with only half of the episode complete. That’s pretty unusual!
And it is pretty bad. Not only are central banks evolving to become ever-more-dovish right exactly at the time when they need to be guarding ever-more-diligently against rising inflation as rates and hence money velocity turn higher, but they are also becoming less independent at the same time. A reader sent me a link to an article by Philadelphia Fed President Plosser, who points out that the boundaries between fiscal and monetary policy are becoming dangerously blurred. It is somewhat comforting that some policymakers perceive this and are on guard against it, but so far they seem ineffectual in preventing the disturbing evolution of central banking.
 Consider reading almost anything by Daniel L. Thornton at the St. Louis Fed; his perspective is summed up in the opening sentence of his 2012 paper entitled “Why Money Matters, and Interest Rates Don’t,” which reads “Today ‘monetary policy’ should be more aptly named ‘interest rate policy’ because policymakers pay virtually no attention to money.”
It has been a busy couple of weeks on the business side, which is why I haven’t been writing many articles. However, I wanted to be sure and pen a quick one today.
The main economic data is due out later this week: Existing Home Sales on Wednesday, New Home Sales on Thursday (both of these more interesting for the home price indications than for the volume figures), and Durable Goods on Friday. (Some of us also get excited about the 10-year TIPS re-opening on Thursday, with real yields at a 1-year high after a 35bp selloff over the last three weeks). But Monday and Tuesday have been relatively bereft of news, except for the occasional Fed speaker.
It is that “occasional Fed speaker” that I want to mention today.
St. Louis Fed President James Bullard today gave a speech in Europe, about the need for the ECB to pursue “aggressive” QE in order to prevent a long period of low inflation and deflation such as that experienced by Japan over the last few decades.
What word am I searching for here…would it be “chutzpah?”
I realize that Chairman Bernanke has already been featured on a magazine cover as a Hero. It bears remembering that Greenspan was also called the Maestro at one point, although we are now all aware that his management of the Fed helped to precipitate a massive crisis. History isn’t written in real time by bloggers. It’s written by historians, years later.
But hasn’t the Fed, after all, been really successful? Isn’t a victory lap deserved? Haven’t they earned the right to lecture to other central banks about the proper execution of monetary policy? After all, the Fed brought down the unemployment rate while inflation remains tame. Case closed.
Perhaps that would be a good argument if Earth was hit by a comet tomorrow and all life ceased. But in the event life continues, we will need to wait until the cycle is complete. Celebrating now is like pumping one’s fist in celebration in the middle of a motorcycle jump over 25 buses. Nice trick, but we’ll hold our applause until you stick the landing if you don’t mind.
There seems to be great faith in the Federal Reserve that the tough part is over. All that they need to do now, it seems they believe, is to just start tightening before inflation gets going; they can do it very gradually, supposedly, because of the great credibility the Fed has and because they understand how inflation responds to rates.
But in fact, inflation doesn’t respond to rates but to money. And not to reserves, but to transactional money. Transactional money responds not to total reserves, but to banking activity and the resulting level of required reserves…which the Fed is unable to directly affect. When the Fed begins to taper, and then to somehow drain reserves, I predict it will have almost zero impact on the inflation process until the excess reserves have been drained.
Indeed, if interest rates rise when the Fed begins to do this, it will perversely tend to increase the velocity of money, which tends to vary inversely with the opportunity cost of holding cash balances (that is, velocity goes up when interest rates go up, all else equal). It’s not the only thing that matters, but it’s pretty important, as the chart below suggests (I think I have run something like this chart previously).
Now, ordinarily when the Fed is raising rates, they’re also draining reserves – so the increase in money velocity is balanced by the decline in money to some degree. That won’t happen this time. When rates go up, velocity will go up, but the quantity of (M2) money will not change because it is driven by a multiplier that acts on required reserves. That means inflation may well rise as interest rates increase, at least for a while.
I might be wrong, but I am willing to wait and see how it plays out. If I am wrong, then you don’t have to put me on the cover of a magazine.
To conclude that inflation is fully tamed at this point, anyway, is remarkably optimistic. Home prices are skyrocketing at rates only rarely seen, and it would be incredible if that did not lead to higher rents and higher core inflation…literally within a couple of months from now, judging from the historical lag patterns.
But, again, I should return to my main point: it isn’t that the Fed is wrong, it’s just that they are so completely certain that they are right even though the difficult part of the trick – unwinding the extraordinary policy without any adverse effects – lies ahead.
Sit down, James Bullard. Let the ECB manage its own affairs. I am sure they can mess it up on their own, without your help. And certainly, without your condescending advice!
The sine qua non for a disaster is that no one is worrying about the disaster. Earthquakes are less damaging in Tokyo than the same earthquake would be in New York, because in Tokyo buildings are designed to be earthquake-resistant. This is also true in markets; if investors are guarded about purchasing equities because of all the bad things that can happen, then prices of equities will be very low and it will be difficult to effect a true crash in such a circumstance.
The opposite doesn’t necessarily follow in the physical world (if you don’t prepare for an earthquake, it doesn’t increase…so far as we know…the probability of it happening), but it occasionally does in the financial world. I pointed out in January the work by Arnott and Wu which indicates that a company which enjoys “top dog status” in terms of having the greatest market capitalization in its sector tends to underperform the average company in the market by 5% per year for a decade. This is largely because investors in such companies are not prepared for adverse surprises, so that any such surprises tend to be taken poorly. Similarly, problems in Cyprus had an outsized effect on markets because (remarkably) no one was prepared for there to be problems in Cyprus that the rest of the Eurozone wouldn’t simply write a check to cover.
By this standard, inflation is growing more dangerous by the day, as more and more investors and pundits start talking – incredibly – about deflation. St. Louis Federal Reserve President Bullard today told an audience at the Hyman Minsky Conference in New York that it is “too early” to worry about deflation. That statement must hit most readers of this column as hysterically funny, given how many readers typically complain that the CPI is far lower than their personal experience of inflation. Bullard also noted that he favors an increase in the pace of QE if inflation falls further. Since core inflation is currently at 1.9%, Bullard is essentially putting a floor on inflation near where we once thought the ceiling was.
I read somewhere today that the recent declines in copper and gold are “signs of deflation.” I disagree. At best, they are signs of fears of deflation, right? But even that, I don’t buy. While breakevens in the TIPS market have declined recently, they are still not particularly low by any historical standard (see chart of 10y BEI, source Bloomberg). Moreover, a not-insignificant part of that decline represents a direct response to energy’s retracement and isn’t a reaction to a softer opinion about core inflation.
In fact, the core inflation implied by the 1-year inflation swap, once energy is extracted, is above the current level of core inflation and near the highs that have been seen since early 2011 (see chart, source Enduring Investments).
So I suspect, rather, that the causality runs the other way: the decline in copper and gold has caused an increase in chatter and vocal concern about deflation. But the people who are investing directly on whether deflation will happen aren’t seeing it. This is somewhat comforting, as it’s the people with actual money (rather than pundits and economists) who determine whether their institutions are ready.
Now, to the extent that the increased chatter actually leads to renewed relaxation in inflation expectations (ex-energy), it sets the stage for worse damage when it inevitably happens. Inflation, like earthquakes, is more injurious when societal institutions have not prepared for it. Median inflation in the U.S. over the last decade is about 2.5%. But in South Africa, it is 5.7%. In the U.S., a 5.7% inflation rate would cause major havoc, but South Africans would be amused at that since they deal every day with that pace of price change (as did Americans, in the 1980s). In Turkey, median inflation has been about 9.5%, but there again the society has adapted to it. To the extent that there is any fear in the U.S. about inflation rising to 5% or to 10%, institutions will prepare for it, and they will eventually learn to deal with it. It’s the shift to that new reality that can be especially painful.
The rest of the week has only minor economic data releases, with the Philly Fed report on Thursday (Consensus: 3.0 vs 2.0 last) the most important of them. A few Fed speakers will be on the tape. But the real market concern is concern in the market: the VIX has risen to 16.5 after having receded slightly on Tuesday; the dollar today retraced all of Tuesday’s decline and then some. Gold and commodities have not fallen further after the washout on Monday, but neither have they rejected the lower levels and rallied back. The S&P has support at 1540 or so but below that level there could be a substantial further fall. All of these markets have potential for important moves, and in the meantime there is the potential for renewed headlines out of Cyprus where there is consternation over the new demands from the EU. The trader in me would guess (stress: guess) at further weakness in equities, an attempt made by energy markets to hold near these levels, a halting rally into resting sell orders in precious metals markets, steady nominal bond markets but with some rebound higher in long breakevens. But here are the problems: (1) these are all connected – so I could easily miss on every one of these guesses; (2) any big move will affect sentiment on the others, so that there are copious feedback loops; (3) much of what happens will depend on the next quantum of news to hit the screens, and (4) Wall Street is less and less in a position to take risk and maintain orderly markets, as it has in the past. We might even simply tread water into the weekend and take our volatility on Monday. But I’m fairly convinced that more volatility is coming before markets calm down again.
But that’s not a problem, if you’re prepared for it!
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Markets have been surprisingly quiet over the last few days. Some of that, no doubt, is due to the NCAA basketball tournament, to the Good Friday/Easter Monday holiday in the U.S. and in Europe, and to baseball’s Opening Day.
We also had Japanese year-end and the end of Q1 in the U.S., and to the extent that the last week has brought any market moves of interest at least a portion of that can be put on the account of the calendar. On Thursday, the S&P set a record month-end close, although a higher intraday print was established in October of 2007. But while news accounts attributed the almost-record to an “easing of Cyprus fears,” it is much more likely that it was due to the normal (and well-known) quarter-end “mark ‘em up” machinations of less-scrupulous fund managers in illiquid market conditions.
In a similar vein, the quirk of having the quarter end on a Thursday three days before the calendar turns helped exaggerate a massive move in grains, especially corn, on a mildly bearish crop report. Those who are invested in commodities for tactical reasons are being flushed because they’re tired of waiting, as an article in today’s Wall Street Journal made clear. The investors who are leaving do not have comfort in the asset class because they don’t understand the drivers of the asset class; the result is that they become performance chasers. So, when crop reports suggest that the real price of corn should fall a little bit, investors slash nominal prices 10% in ‘get me out’ orders.
But as I said, these investors don’t understand the fundamental drivers of the asset class. The article cited above regarded the breakdown of the correlation between commodity indices and equity indices as something sinister, saying that the correlation is at its lowest level since 2008 and suggesting that this means that one of the two markets is wrong. As it turns out, though, the correlation of stocks and commodities is a relatively new phenomenon. Over the last 5 years, the correlation of monthly changes in the DJ-UBS index and the S&P is 0.61. However, for the 17 years prior to that, the correlation was 0.04 (see chart, source Bloomberg).
For the GSCI commodity index, the last-5-years correlation is 0.65, but for the 38 years prior to that (the GSCI has a longer history) the correlation was -0.02. In short, there is no reason to read a whole lot into the recent decoupling of stocks and commodities, except that it may suggest the hot money is finally leaving commodities. The correlation breakdown is also a good thing for anyone who believes – as I do – that stocks are overvalued. And, since a good portion of commodities’ long-run return comes from a rebalancing effect that is larger when the inter-commodity correlations are lower, this is more good news.
The choppy melt-up in stocks on Thursday was partially reversed by the new-quarter blues today, but all of this is mere detail. Over the last week, while authorities in Europe have encouraged investors to put the Cyprus issue to bed additional details have emerged that deserve mentioning. For example, it turns out that the larger depositors (over €100,000) investors in one of the Cypriot banks will not get a 10% haircut, or a 20% haircut, but something close to a 100% haircut – 37.5% of the deposit balance in excess of 100k will be converted to equity in the bankrupt bank. There are some reports that certain deposits belonging to “EU funds” will be exempt from the haircut. There are of course the stories that capital controls implemented in Cyprus were ignored in non-Cyprus branches of Cypriot banks, and one Cypriot newspaper is claiming that relatives of the president withdrew substantial funds from Laiki bank just before the bank was shut down.
While the worst of the immediate crisis has surely passed, it seems madness to me to pretend that it never happened or that it will have no knock-on effects. For that matter, it seems madness to conclude that since the knock-on effects were not immediate, that no such effects exist. On the other hand, when events are no longer going bang-bang-bang in rapid succession, it is reasonable to ask “whose move is it?” Will bank deposits begin to flee from periphery countries, or wait to see what assurances European officials give? Are central bankers already injecting liquidity into shaky banks, or are they waiting for the invitation from the banks in-country? Are investors reducing risk and diversifying away from European assets, or are they waiting to see if other investors do so first? All of these actions entail costs, and so there is a natural desire of every party to delay action…but to not delay action so long as to cause those costs to rise substantially.
As a trader, my inclination is to hit a bid and get out, and not worry about the bid/offer spread or those other costs. But I am not dealing with billions of Euros when I do that. Still, the insight is that when bad things might happen, the here-and-now transactions costs are usually a poor reason not to seek protection. This is why T-Bills over the last couple of years have occasionally had negative nominal yields (see the chart of 3-month T-bill yields below, source Bloomberg). Yes, it’s clearly dumb to pay $1.01 now to receive $1 in the future. But is it dumber than the alternatives?
Cyprus, for now, has seen disaster averted. In a flurry of weekend maneuvers, Cypriot and troika officials decided on a plan to merge the top two banks, fully protecting the insured depositors while socking the uninsured depositors of those two banks and the non-government financial stakeholders. In short: depositors at the largest bank will lose ~40% of their deposits above the guaranteed threshold, depositors at the second-largest bank will lose ~100% of their deposits above the threshold, bondholders (both senior and subordinated) at the second-largest bank will be wiped out and bondholders (including senior bondholders) at the largest bank will be wiped out. Equity holders in both banks will be fully wiped out.
That’s not completely accurate, because there are various classes of government (Cyprus) and supranational stakeholders (e.g. the ECB) who it appears will be spared, but the rest will be fully “bailed in.”
Yes, let’s take a minute to examine this addition to the lexicon. “Bailed in” is the opposite of “bailed out.” We already had a term for that; we used to say that these people were “wiped out.” But now, the idiocracy has decided that “bailed in” is a kinder and gentler way of saying that you’ve lost everything, but thanks for your contribution to the bailout.” It’s based on the law of conservation of bailing, I think, which states that for every bailout there is an equal and opposite bail-in.
Personally, I don’t think it’s a word and Microsoft Word doesn’t think so either.
However, we should get used to the word because the head of the Eurogroup of Eurozone finance ministers said that the Cyprus solution is the “new template” for resolving future Eurozone banking problems. I would hope that somewhere here it would occur to these people that the “template” they arrived at after almost losing Cyprus was something like what a financial-sector analyst (say, three years out of school) would have come up with as the “first-pass after thinking about the problem for five minutes” solution. Unfortunately, the “after thinking about it for five more minutes” solution recognizes that this solution pushes assets into the too-big-to-fail banks, since no person (or corporation) in his right mind will hold more than the deposit insurance maximum at any given bank (even if that person believes that the idiocracy learned a lesson and won’t grab insured deposits in the future), unless it’s very unlikely that the bank would ever be allowed to fail in the first place.
To be sure, the Powers That Be are aware that this solution isn’t perfect, since banks in Cyprus are to remain closed “until further notice.” This is because the obvious side-effect to the implemented Plan B is that every uninsured deposit will flee the country’s third, fourth, fifth, and sixth-largest banks the moment the wires open. This is the classic problem with bank runs. If you ring-fence a group of banks, the weakest bank outside of that circle immediately becomes the weakest overall bank and the run commences there. Thus, unless you protect all of the banks, the run will continue until there are no more uninsured but vulnerable deposits.
Now, if the original Plan A hadn’t called for the “bailing in” of depositors even at more-stable banks, then the bank run may not have happened since “vulnerable” then would be taken to mean “deposits at a weak institution.” But now, depositors in Cyprus are on notice that “vulnerable” means “deposits in a country that has weak banks, whether or not that includes this one.” Indeed, I would expect many “insured” deposits to leave the banking system for mattresses and other alternative savings vehicles, now that we know that an “insured” deposit in Cyprus is just exactly as secure as the politicians’ spines allow it to be. This time, the spines held (and three cheers for the Cypriot legislature who declared they’d secede before allowing their insured citizens to be mugged), but what about next time? In their place, I’d be taking out enough to live on for a few months, at least.
Incredibly, despite the fact that the stock market got exactly what it wanted, market gains evaporated within minutes of the opening bell as smart money sold to the folks who did what CNBC told them to do (it’s okay…it’s just that they’re trying to bail you in. You want to help the institutions, right?). Commodities and bonds were flat, but there’s always tomorrow. Ironically, today’s weak market performance came on the heels of a couple of strong regional Fed reports from Dallas and Chicago, and ahead of what is likely to be decent Durable Goods (Consensus: +3.9%, +0.6% ex-transportation), New Home Sales (Consensus: 420k from 437k, but that would still be the 2nd highest non-tax-break number since 2008), and Consumer Confidence (Consensus: 67.5 from 69.6, but still closer to the highs than the lows of the last few years) data. Also out is the S&P Case Shiller index for January, which is expected to have risen 7.85% from year-ago levels.
All of which, and much more, is already in the price. Stocks only look good if your alternative is a bank account in Cyprus.
It really is a marvel of a market these days. It doesn’t strike me as completely odd that stocks have recovered almost all of the losses they experienced on the first Cyprus news, but what is amazing to me is that the VIX index has retraced about half of its jump and that “fear index” sits just about a point and a half above six-year lows.
Yes, Cyprus is a small country, which is a point that seems endlessly repeated as a sort of incantation, a warding against bad stuff happening. As my friend Andy F pointed out, subprime-mortgage-backed paper was also pretty small (roughly 1.3T in size compared with a worldwide bond market around 80T), and somehow still managed to leave a mark. Cyprus is very small, relative to the Eurozone. But if it was as small in significance as it is in relative GDP, do you think the EU finance ministers would be wasting this much time on them? It’s a bit like saying “I don’t care about my grade in Calculus,” and then staying up all night studying. There’s a clue that perhaps someone cares more than they’re letting on.
If Cyprus was insignificant, as opposed to small, then the other Eurozone countries would simply pony up the dough, or wave goodbye and let Cyprus exit the Eurozone.
But they can’t just pony up the dough, as that would continue a bad precedent.
And they can’t just wave goodbye. Why? Because Cyprus’s significance far outweighs its size. If Greece had left the Euro, there would be no precedent value to Cyprus’s doing so and this crisis would have been but a blip. But it doesn’t matter how big the first domino here is: the EU has sworn that the Euro is inviolate, that it’s impossible to undo, that there’s no provision from anyone leaving the union, etc. If any country leaves the Euro, the statement of absolutes is exposed to be false. And worse, from the standpoint of the elites…what if a country leaves the Euro and survives?
So, while everyone tries to persuade investors (and they’re largely succeeding, it seems) not to be concerned about Cyprus because it’s so small, the country declared that its banks will remain closed through next Tuesday. Russians are lecturing Europeans on how the seizure of private property reminds them of Soviets. And, after declaring that the Cypriot government had to enforce the levy or lose the bailout funds – and then watching the legislature vote 36-0 to reject the levy – European officials are trying to find some way to look like they are sticking to their principles while compromising them. The ECB has delayed a decision on whether to keep supporting Cypriot banks as the discussions between Cyprus and Eurozone finance ministers continue. Looks like someone really does want to pass that unimportant Calculus exam! Perhaps we should not take the protestations of insignificance at face value.
All of which is to say that within a week or two, unless the Eurozone capitulates, Cyprus is still going to go through bank failures and sovereign default and possibly exit or be ejected from the Eurozone. The market is pricing a near-100% chance that these finance ministers capitulate, scuttling their own political futures for the sake of the Euro and returning the Euro crisis to a slow simmer from a rolling boil – not solving anything, but delaying the inevitable. So far, this has been a good bet. But 100-1 odds are probably worth taking, especially when it involves a politician sacrificing his/her future for an idea.
The FOMC also met today, and as expected the pedal remains pressed to the metal. If there had been any question about that one week ago (and I don’t think there really was), the Cypriot events eliminated any chance that the FOMC would even hint at an eventual walking-back of liquidity. It’s not going to happen any time soon.
On Thursday, we’ll get a look at Existing Home Sales for February. While most focus will be applied to the headline number, which is expected to touch 5.0mm sales for the first time (absent government programs) since 2007, I am much more attentive to the year-on-year rise in the median home sales price. That figure was last at an astounding 12.61%, and surely can’t go much higher than that?