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Posts Tagged ‘QE’

If Liquidity is Your Sword, Keep Swinging

April 28, 2015 9 comments

I am not one of those people who believe that if the Fed is dramatically easing, you simply must own equities. I must admit, charts like the one below (source: Bloomberg), showing the S&P versus the monetary base, seem awfully persuasive.

monbaseequalsstocks

But there are plenty of counter-examples. The easiest one is the 1970s, shown below (source: FRED, Bloomberg). Not only did stocks not rise on the geyser of liquidity – M2 growth averaged 9.6% per annum for the entire decade – but the real value of stocks was utterly crushed as the nominal price barely moved and inflation eroded the value of the currency.

m2notequalstocks

If you do believe that the Fed’s loose reins are the main reason for equities’ great run over the last few years, then you might be concerned that the end of the Fed’s QE could spell trouble for stocks. For the monetary base is flattening out, as it has each of the prior times QE has been stopped (or, as it turns out, paused).

But for you bulls, I have happy news. The monetary base is not the right metric to be watching in this case. Indeed, it isn’t the right metric to be watching in virtually any case. The Fed’s balance sheet and the monetary base both consist significantly of sterile reserves. These reserves affect nothing, except (perhaps) the future money supply. But they affect nothing currently. The vast majority of this monetary base is as inert as if it was actually money sitting in an unopened crate in a bank vault.

What does matter liquidity-wise is transactional balances, such as M2. And as I have long pointed out, the end of QE does nothing to slow the growth of M2. There are plenty of reserves to support continued rapid growth of M2, which is still growing at 6% – roughly where it has been for the last 2.5 years. And those haven’t been a particularly bad couple of years for stocks.

So, if liquidity is the only story that matters, then the picture below of M2 versus stocks (source: Bloomberg) is more soothing to bulls.

m2andstocksnow

Again, I think this is too simplistic. If ample liquidity is good today, why wasn’t it good back in the 1970s? You will say “it isn’t that simple.” And that’s exactly my point. It can’t be as easy as buying stocks because the Fed is adding liquidity. I believe one big difference is the presence of financial media transmitted to the mass affluent, and the fact that there is tremendous confidence in the Fed to arrest downward momentum in securities markets.

What central bankers have done to the general economy has not been successful. But, if you are one of the mass affluent, you may have a view of monetary policy as nearly omnipotent in terms of its effect on securities and on certain real assets such as residential real estate. What is different this time? The cult.

I am no equity bull. But if you are, because of the following wind the Fed has been providing, then the good news is: nothing important has changed.

Money, Commodities, Balls, and How Much Deflation is Enough?

January 22, 2015 2 comments

Money: How Much Deflation is Enough?

Once again, we see that the cure for all of the world’s ills is quantitative easing. Since there is apparently no downside to QE, it is a shame that we didn’t figure this out earlier. The S&P could have been at 200,000, rather than just 2,000, if only governments and central banks had figured out a century ago that running large deficits, combined with having a central bank purchase large amounts of that debt in the open market, was the key to rallying assets without limit.

That paragraph is obviously tongue-in-cheek, but on a narrow time-scale it really looks like it is true. The Fed pursued quantitative easing with no yet-obvious downside, and stocks blasted off to heights rarely seen before; the Bank of Japan’s QE has added 94% to the Nikkei in the slightly more than two years since Abe was elected; and today’s announcement by the ECB of a full-scale QE program boosted share values by 1-2% from Europe to the United States.

The ECB’s program, to be sure, was above expectations. Rather than the €50bln per month that had been mooted over the last couple of days with little currency-market reaction, the ECB pledged €60bln. And they promised to continue until September 2016, making the total value of QE around €1.1 trillion. (That’s about $1.3 trillion at today’s exchange rate, but of course if it works then it will be much less than $1.3 trillion at the September 2016 exchange rate). To be sure, a central bank always has the prerogative to change its mind, but on the risks of a sudden change in policy please see “Swiss National Bank”. It really is remarkable that Draghi was able to drag the Bundesbank kicking and screaming into this policy choice, and it is certain to end the threat of primary deflation in Europe just as it did in the U.S. and in Japan. It will likely also have similar effects on growth, which is to say “next to nothing.” But in Europe, deflation risks stemming from slow money growth had been a risk (see chart, source Bloomberg).

EUM2

Interestingly, y/y money growth had already been accelerating as of late last year – the ECB releases M2 with a very long lag – but this puts the dot on the exclamation point. The ECB has said “enough!” There will be no core deflation in Europe.

Commodities: How Much Deflation is Enough?

Last week, in “Commodities Re-Thunk” and “Little Update on Commodities Re-Thunk”, I presented the results of using a generalization of the Erb & Harvey approach to forecast expected long-term real returns for commodities. It occurred to me that, since I have previously played with long-term real equity returns, and we have the real yield on 10-year TIPS as well, that it would be interesting to see if using these figures might produce a useful strategy for switching between assets (which doesn’t change the fact that I am a long-term investor; this is still based on long-term values. We merely want to put our assets in whatever offers the best long term value at the moment so as to maximize our expected long-term return).

The answer is yes. Now, I did a more-elegant version of what I am about to show, but the chart below shows the results of switching 100% of your assets between stocks, commodities, and TIPS based on which asset class had the highest expected real yield at a given month-end. Each line is an asset class, except for the blue line which shows the strategy result.

realswitch

The labels at the top show the asset class that dominated for a long period of time. In 2005 there were a couple of quick crossovers that had little impact, but by and large there were three main periods: from 1999-2005, commodities offered excellent expected real returns; from mid-2005 through early-2008 the strategy would have been primarily in TIPS, and subsequent to that the strategy would have been primarily in equities. Fascinating to me is that the overall strategy does so well even though it would have been invested in equities throughout the crash in 2008. The crash in commodities was worse.

Now what is really interesting is that there is a vertical line at the far right-hand side of the chart. That is because at the end of December, the expected real return to commodities finally exceeded that of equities for the first time in a very long time. For this “selling out” strategy, that means you should be entirely out of stocks and TIPS and entirely in commodities.

As I said, that is the coarse version of this approach. My more-elegant version optimized the portfolio to have a constant expected risk in real terms. It was much less risky as a result (10.5% annualized monthly standard deviation compared to 15.5% for the strategy shown above), had lower turnover, but still sported returns over this period of 9.5% compounded compared to 11.2% for the strategy above. I am not, in other words, suggesting that investors put 100% of their assets in commodities. But this method (along with lots of other signals) is now suggesting that it is time to put more into commodities.

Balls: How Much Deflation is Enough?

Being a football fan, I can’t keep from weighing in on one mystery about deflate-gate (incidentally, why do we need to put ‘gate’ on the end of every scandal? It wasn’t Water-gate, it was the Watergate Hotel that proved Nixon’s undoing. “Gate” is not a modifier). Really, this part isn’t such a mystery but I have seen much commentary on this point: “How did the balls get deflated during the game since they were approved before the game?”

The answer is really simple in the real world: the official picked up one of the balls, said “fine”, and put them back in the bag. He has a million things to do before the championship game and in years of refereeing he has probably never found even one ball out of spec. This sort of error happens everywhere there are low reject rates, and it’s why good quality control is very difficult. (Now, if you fired the ref every time a bad ball got through, you damn betcha those balls would be measured with NASA-like precision – which is perhaps a bad metaphor, since similar issues contributed to the Challenger disaster). The real mystery to me is: if the Patriots truly think they are the better team, why would they cheat, even a little? As with the CHF/EUR cross that we discussed yesterday, the downside is far worse than the gain on the upside.

Or, is it? The NFL will have a chance to establish the cost of recidivism in cheating. Maybe the Patriots were simply betting that the downside “tail” to their risky behavior was fairly short. If the NFL wants to put a stop to nickel-and-dime cheats, it can do that by dropping the hammer here.

Worried About Not Being Worried

June 2, 2014 4 comments

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.

EUM2

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.

Madness or Wisdom?

December 3, 2013 2 comments

Trading, and to some extent investing, is all about knowing when markets are moving with the wisdom of the crowds and when they’re moving with the madness of the crowds. In recent years, there has seemed to be much more madness than wisdom (a statement which can probably be generalized beyond the financial markets themselves, come to think of it). Where do we stand now?

I think a recent letter by John Hussman of Hussman Strategic Advisors, entitled “An Open Letter to the FOMC: Recognizing the Valuation Bubble In Equities,” is worth reading. Hussman is far from the only person, nor even the most august or influential investor, questioning the valuation of equities at the moment. Our own valuation models have had the projected 10-year compounded real return of equities below 3% for several years, and below 2% since late April. For a time, that may have been sustainable because of the overall low level of real rates, but since the summertime rates selloff the expected equity premium has been below 1.5% per annum, compounded – and is now below 1% (see Chart, source Enduring Investments).

realequitypremHussman shows a number of other ways of looking at the data, all of which suggest that equity prices are unsustainable in the long run. But what really caught my eye was the section “Textbook speculative features”, where he cites none other than Didier Sornette. Sornette wrote a terrific book called Why Stock Markets Crash: Critical Events in Complex Financial Systems, in which he argues that markets at increased risk of failure demonstrate certain regular characteristics. There is now a considerable literature on non-linear dynamics in complex systems, including Ubiquity: Why Catastrophes Happen by Mark Buchanan and Paul Ormerod’s Why Most Things Fail: Evolution, Extinction and Economics . But Sornette’s book is one of the better balances between accessibility to the non-mathematician and utility to the financial practitioner. But Hussman is the first investor I’ve seen to publicly apply Sornette’s method to imply a point of singularity to markets in real time. While the time of ‘breakage’ of the markets cannot be assessed with any more, and probably less, confidence than one can predict a precise time that a certain material will break under load – and Hussman, it should be noted, “emphatically” does not lay out an explicit time path for prices – his assessment puts Sornette dates between mid-December and January.

Hussman, like me, is clearly of the belief that we are well beyond the wisdom of crowds, into the madness thereof.

One might reasonably ask “what could cause such a crash to happen?” My pat response is that I don’t know what will trigger such a crash, but the cause would be the extremely high valuations. The trigger and the cause are separate discussions. I can imagine a number of possibilities, including something as innocuous as a bad “catch-up” CPI print or two that produces a resurgence of taper talk or an ill-considered remark from Janet Yellen. But speculating on a specific trigger event is madness in itself. Again, the cause is valuations that imply poor equity returns over the long term; of the many paths that lead to poor long-term returns, some include really bad short-term returns and then moderate or even good returns thereafter.

I find this thought process of Hussman’s interesting because it seems consonant with another notion: that the effectiveness of QE might be approaching zero asymptotically as well. That is, if each increment of QE is producing smaller and smaller improvements in the variables of interest (depending who you are, that might mean equity prices, long-term interest rates, bank lending, unemployment, etc), then at some point the ability of QE to sustain highly speculative valuations goes away and we’re left with the coyote-running-over-the-cliff scenario. Some Fed officials have been expressing opinions about the declining efficacy of QE, and Janet Yellen comes to office on February 2nd. I suspect the market is likely to test her very early.

None of this means that stocks cannot go straight up from here for much longer. There’s absolutely nothing to keep stock prices from doubling or tripling from here, except the rationality of investors. And as Mackay said, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” Guessing at the date on which the crowd will toggle back from “madness” to “wisdom” is inherently difficult. What is interesting about the Sornette work, via Hussman, is that it circles a high-risk period on the calendar.

For two days in a row now, I’ve discussed other people’s views. On Wednesday or Thursday, I’ll share my own thoughts – about the possible effects of Obamacare on measured Medical Care inflation.

Moving Goalposts

November 14, 2013 9 comments

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).

globalinfAnd 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).

globalmsStill, the Bundesbank holdovers must be apoplectic at these developments. I wonder if it’s too late to nominate one of them to be our next Fed Chairman?

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!]

Time is Running Out

October 25, 2013 16 comments

All the expectations for resurgent growth are running into a time problem. While the Federal Reserve continues to pump the system, hoping for that burst of energy coming out of the slump, there is really little reason to expect anything more than we have already gotten. I’ve written recently about that in the context of payroll growth and the rate of improvement in the unemployment rate. But there is also, as I say, a time problem.

The current expansion, believe it or not, is getting long in the tooth. While there have been longer expansions – the one from 1991 to 2001, fueled by a continuous decline in interest rates, a budget that was near balance or in surplus, and an asset bubble engendered by the promise of the Internet and some remarkable Wall Street pitchmen – the average postwar expansion has only been 68 months, peak to peak, or 58 months, trough to peak. According to the NBER, on which we rely to jog our memories since this was so long ago, the prior business cycle peak occurred in December 2007 and the prior trough in June 2009. So, using those average business cycle lengths, the expected date of the subsequent peak would be between August 2013 and May 2014. This latter date is especially interesting because it is approximately the current consensus on when the QE taper is expected to begin (again).

I think it’s not unreasonable to suggest that getting more than an “average” expansion in the current circumstance would be a pleasant surprise indeed. With the size of government deficits, the uncertainty engendered by the morass in Congress and the rapid proliferation of regulatory overhead (both ACA-related and other), real interest rates much closer to the likely bottom than to the likely top, and continued threat of volatility in the international political economy… it is remarkable to me that we’ve even been able to squeeze out one of “average” duration.

And all it took was a few trillions!

It is well past time when it was appropriate for the Federal Reserve to stop trying to push the economy faster. Blowing into the sail simply doesn’t work very well to make the boat go faster. It will only lead to hyperventilation.

So now we are in a situation in which the expansion is likely to begin to wind down, and very likely to do so at least partly provoked by the Fed’s tightening of policy (for lessening QE is, as we have seen from the interest rate response, clearly a tightening of policy). It may become very tempting for the Yellen Fed to continue QE as weakness manifests, but the problem is going to be that inflation is going to be heading higher, not lower, into the slowdown as the housing price inflation continues to percolate into rental prices and a weakening dollar helps other prices to firm as well.

We really are in a very dangerous situation equity market-wise, as a result of this timing issue. Over the next year inflation is going to rise, growth is (probably) going to slow, and equity earnings ex-finance are looking decidedly punk as a recent article by Sheraz Mian from Zacks Investment Research pointed out. Which is not to say, of course, that the stock market can’t or won’t continue to ramp higher…just that it is increasingly subject to sudden-breakage risk as the shelf it sits on gets higher and higher.

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