By now, you have probably heard that the sun did not set on the British Empire as a result of BrExit. Here is one chart from Tuesday’s Daily Shot letter – and see that letter for others.
This is not at all shocking. While in the long-term it is possible (though I think unlikely) that Germany and other major European trading partners may choose to reduce the business they do with the UK – business which is bilateral, by the way – the immediate short-term impact of a lower pound sterling was much easier to read. In the immediate aftermath of the vote, I made the bold prediction that “Britain Survived the Blitz and Will Survive Brexit,” and then later that week in a post called “Twits and Brits” I made the fairly out-of-consensus prediction that “For what it’s worth, I think that thanks to the weakening of sterling Brexit is likely to be mildly stimulative to the UK economy, as well as somewhat inflationary, and slightly contractionary and disinflationary to the rest of the world.”
Oh, I should also point out that in early July I asked the question whether UK property price declines were rational, or overdone and concluded that “I don’t believe the current drop in listed UK property funds is a rational response to correcting bubble pricing, and it’s probably a good opportunity for cool-headed investors…and, more to the point, cool-headed investors who aren’t expecting to liquidate investments overnight.” What has happened since? See the chart below (Source: Daily Shot).
I only mention these items in back-patting fashion because (a) I am proud that I responded thoughtfully, rather than hysterically like many analysts, to the Brexit surprise, and (b) I want to promote my credibility when I make the following observation:
Good news for the UK is bad news for the Eurozone. Not for growth or inflation in the Eurozone, but for its very survival.
The audacity of Britain in leaving the EU was shocking to the establishment, but everyone carefully predicted disaster for the ancient empire. They did this not because the economics said it would be that way – as I pointed out, the economics pointed the other way – but because it was in the interest of the common-currency project that there be huge costs to breaking the covenant. The “marriage” of the countries in the Eurozone was difficult and painful, and the ongoing relationship has been difficult on some of the members. If “divorce” is easy – and even worse, if it is beneficial, then the marriage will not last. The experience of the UK so far – not only doing okay, but actually doing well – cannot be escaping notice in Athens or Rome (or Madrid or Lisbon…or Paris).
Now, that doesn’t mean the Euro is doomed to fail next week. But it means that in the next crisis, whether that is Greece redux or Italy or some other ground zero, the Eurozone bosses in Brussels will be lacking a major threat to use to force the recalcitrant nation to accept painful austerity. Remember that it was the threat of a generational depression that helped get Greece into line. How is Greece doing? The chart below (source: Bloomberg) shows that nation’s unemployment rate.
Admittedly it is not a statistically-valid sample, although to be sure it is a sample that matches the a priori arguments of those who suggested that Greece should leave the Euro: the country that exited the EU is doing fine, and better-than-expected, while the country that remained in the Eurozone is actually mired in a depression. Hmmm. So tell me again why my poor country needs to accept austerity to remain in the Eurozone?
So much about policy depends on one’s priors. If your prior expectation is that leaving the Eurozone is likely to be a disaster, then both sides in the negotiation are likely to reach agreement on a relatively smaller inducement to stay than if the prior expectation is that leaving the Eurozone might be a positive event for the leaver. The events to date should cause these priors to shift when the next crisis happens.
Speaking of priors, and changing countries: Friday’s employment report did not seem, to me, to be outside of the range of outcomes that would cause policymaker priors to change. That is, if the Fed Chairman was planning to raise rates later this month, prior to seeing the Employment report, then I wouldn’t expect the report was weak enough to change that course of action. Conversely, if the Chairman (as I believe) was not planning to hike rates, then it doesn’t seem to me that the report was strong enough to change that course of action.
Markets have decreased the implied probability of such a rate hike, compared to what it was before the report. That’s just Mr. Market’s bipolar nature. The 6-month moving average of payrolls was 189k last month; it is 175k now. The 12-month average is exactly unchanged at 204k. There’s nothing here that is out of the ordinary. But if your attitude was that rates should rise because they need to be returned to neutral, then a 151k monthly Non-Farm Payrolls shouldn’t affect that decision. And if your attitude was that the economy might be weakening, and can’t sustain a rate hike, the number doesn’t change your attitude either. So, while Mr. Market has changed the implied probability, I seriously doubt Dr. Yellen wavered at all.
The problem is that we don’t know what Dr. Yellen (and let’s be clear, hers is the only vote which matters) was thinking prior to the number. We don’t know her priors. But, unless the data appreciably strengthens or weakens between now and September 21st, we will know her priors after we see the results from the meeting. My guess continues to be that the Chairman’s operating assumption is that low rates do more good than harm, and that therefore a hike in rates is unlikely until inflation (already above the Fed’s target, and rising) gets quite a bit more above the Fed’s target, or market interest rates signal restlessness with the Fed’s course.
A couple of weeks after Brexit, and the world has not ended. Indeed, in the UK the fallout seems relatively tame. Sterling has weakened substantially, which will increase UK inflation relative to global inflation; but it will also help UK growth relative to global growth. That’s not a bad tradeoff, compared to predictions of the end-of-days. Although I am not so sure I like the tradeoff from Europe’s perspective…
There are a number of UK property funds that have been gated – but this appears to be not so much a Reserve Fund moment, and certainly not a Lehman moment, but just a natural reaction when a fund gives broader liquidity terms than the market for the underlying securities offers.
I think the property panic is probably overdone. It is partly triggered by fears that the financial center is going to leave London. This strikes me as absurd, having worked for several of the institutions that have offices in Canary Wharf. I checked my gut reaction with a friend who actually headed up a large banking institution for a time. His answer was “you are right to be very skeptical: English, availability of workforce, taxation, labor laws, contract law and legal framework. There will be some shifting at the margin but that’s it.” Brittania is not about to sink beneath the waves, folks.
Were UK property values overinflated? At least UK home prices don’t appear much more out-of-whack than US home prices do. The chart below (source: Bloomberg) shows the UK national average home price from the Nationwide Building Society (in white) versus the US median existing home sales price.
The picture looks more concerning if, instead of median home sales, you use the Case-Shiller Home Price Index as a comparison (see chart, source: Bloomberg). But while the CS20 is a superior measure of home prices, I’m always a bit wary of comparing two series that are constructed methodologically very differently. Still, this comparison would suggest UK prices have risen more than their US counterparts.
These comparisons are all on residential property, and I am comparing two markets which are likely both a bit overheated. But the scale of decline in the UK property funds seems to me to be too large relative to the overpricing that may exist, and I suspect it is more due (as I noted above) to the structure of the funds holding the property – which would suggest, in turn, that halting redemptions is the right thing to do to protect existing investors who would be disadvantaged if the portfolio was liquidated into a market that is not designed to have daily liquidity. Of course, the right answer is to not offer those liquidity terms in the first place…
One little niggling detail, however, deserves mention. I noted that UK home prices do not appear terribly out-of-whack relative to US home prices. The problem is that US home prices themselves appear out-of-whack by roughly 15-20%. The chart below (source: Bloomberg; Enduring Investments calculations and estimates) shows median home prices as a multiple of median incomes. What is apparent is that for many years these two series moved in lock-step, until the bubble; the popping of the bubble sent everything back to “normal” but we’re back to looking bubbly.
That said, I don’t believe the current drop in listed UK property funds is a rational response to correcting bubble pricing, and it’s probably a good opportunity for cool-headed investors…and, more to the point, cool-headed investors who aren’t expecting to liquidate investments overnight.
I want to talk today about some of the really important pieces of information that circulated this weekend. First, I am certain that everyone is familiar with the following chart, which made the rounds after the Brexit vote. It shows an enormous surge in the search term “What is the EU” after the Brexit vote was completed:
This chart, or something very much like it, was all over the place. Oh, wait! I just realized that I forgot to put the axes on the chart! Here it is with a few more relevant pieces of information – incidentally the same information that was left off the original chart. It turns out that it wasn’t the chart I thought it was. Sorry about that…they looked the same.
(For the record, after an extended period of indolence, on Thursday I went for a run; on Friday I went for a run before putting on any other shoes first; on Saturday I went for a run and then later put on different shoes to go to a cocktail party.)
Is it too much to ask that people seeking to insult the British voters at least put some effort into their attempt? Ignore for a moment the simple fact that we don’t know who was searching this – it might well have been the people who voted to Remain, after all – and so the story line that the people who voted Leave were just morons gets no support from this chart. It also turns out that this was the second-most-searched term only for one small time segment: early in the morning after the vote. By 5am it was eclipsed by questions about the weather. Oh my – it seems the Britons also don’t know what weather is! Also, as the Telegraph’s skeptical story (linked above) points out, the raw number of people asking the question was only on the order of 1,000 – it was just a massive increase since it hadn’t been previously asked very much. This is where not having axes matters…it turns out this is a non-story, and nonsense.
Another piece of nonsense I want to point out is more general. I have seen several Twitter polls and other polls in something like this form:
Q: What effect do you think that Brexit will have on the global economy?
a) Deeply contractionary
b) Moderately contractionary
c) Somewhat contractionary
Now this is nonsense because the actual result not only has nothing to do with opinion, it’s not even clear why we would care about people’s opinion in this case (unless we are trying to show how pervasive the negative news stories are, or something). Polls work comparatively well when there is not a lot of information inequality – for example, when each person is asked about his or her own vote. But the poll above is analogous to this poll:
I submit that only me, and my valet, have the information sought by this poll; all other respondents have zero information. Therefore…what’s the value of the poll? Unless I or my valet are respondents, precisely zero; if we are, then the value is inverse to the number of other respondents diluting the response of the people who know.
Similarly, there is likely some information asymmetry among respondents to the poll about the effect of Brexit on the global economy. I would respectfully suggest that most people who are responding are saying what they have heard, or what they fear, or what they hope, while some people – macroeconomists, for example – might have actual models. To be sure, those models are probably only slightly better than the fearful and hopeful assumptions put into them, but the point is that this poll is nonsense in the same way that polling people about what they expect inflation next year to be is nonsense. The vast majority of respondents have no way to evaluate the question in a structured way, so what you are capturing is no more and no less than what people are worried about, which is itself just a reflection of what they’re seeing and hearing…for example, on Twitter.
(For what it’s worth, I think that thanks to the weakening of sterling Brexit is likely to be mildly stimulative to the UK economy, as well as somewhat inflationary, and slightly contractionary and disinflationary to the rest of the world. But the question about global effects is a trick question. Obviously, global production and consumption are unlikely to change much in real terms just due to the arrangement of trade flows. More friction in the system to the extent that Europe puts up significant trade barriers against the UK – something I don’t view as terribly likely – will lower global output slightly and raise global prices.)
These flash polls and Google trends data are part and parcel of the Twitterization of discourse. They have in common the fact that they can be snapshot and draw eyeballs and clicks, whether or not there is any content to the observations. In these cases, and in many others, there isn’t.
Here’s a thought: why don’t we wait a few months, or better yet a few years, before we judge the impact of Brexit? Sometimes, having actual data is even better than a Twitter poll.
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.”
A quick summary of where we are in the “global currency war:”
For several years now, global central banks have been engaging quietly in this war. Each central bank has been implicitly playing “beggar-thy-neighbor” by making its currency relatively plentiful, and therefore relatively cheaper, than its neighbors. In one case, that of Switzerland, the currency issue became explicit rather than implicit, though not to weaken its currency but rather to stop it from strengthening without bound (see Chart, source Bloomberg). It is instructive that, in order to accomplish this end, the SNB had to pledge to print unlimited quantities of Swiss Francs to sell – essentially saying that if it can’t beat ‘em, it would have to join ‘em.
Now, in January some well-known asset managers muttered the ‘currency war’ phrase, and Japan’s Economic Minister Akira Amari suggested that the Yen could fall 10% (and Japanese officials have implied that they are looking for such a move to help end deflation). Since then, both the G20 and the G7 have discussed whether countries ought to be engaging in currency adjustment as a means of confronting macroeconomic challenges. Searches for the term “currency war” on Google (see chart, source Google) have risen appreciably. But again, this isn’t really new; what’s new is that people are actually talking about it.
Earlier this month Adair Turner, chairman of the Financial Services Authority talked about “permanent monetary easing” and said that central bankers “may need to be a little bit more relaxed about the creation” of money. By permanent, he means that the central bank would print money with the express intention that the printing would never be reversed. Ignoring history, Lord Turner said “the potential benefits of paper money creation [to stimulate the economy] should not be ignored.” Today, the Bank of England released its quarterly forecasts, showing policymaker expectations that inflation will stay higher than the Bank’s target for longer than expected, and growth will be weaker than expected. Even less surprising, given talk about “permanent” easing, is that 10-year UK inflation swaps are now back above 3.40% (see chart, source Bloomberg). The first 30bps of this jump was due to the decision by the ONS to maintain the current definition of RPI for existing contracts (I mentioned this here), but some amount of it is probably due to the currency wars talk.
It bears noting too that the 10-year US inflation swap is within a handful of basis points of its post-Lehman highs.
The UK inflation market has been around longer than other inflation markets. Index-linked Gilts date back to the early 1980s. So I wonder whether we shouldn’t be a bit more curious about how much of the rise in UK inflation expectations actually reflect a rise in global inflation expectations due to the currency wars that are (and have been) underway.
Because to some extent, the question of “who will win” the currency war is difficult to discern, and to some extent the question is moot. Like in the movie “WarGames,” the only thing that has been certain since the currency war started a couple of years ago is that there will be a lot of scorched earth. The only real “winners” are debtors, relative to lenders.
Who will win? To change the analogy: if you’re in a bay surrounded by people in boats who are pumping water in so that they can see who can sink his boat the fastest, the winner is the one who is wearing a life vest. All the others are just some varying grade of loser. Don’t be the last one to grab a life vest.