The Good and the Bad
Bloomberg, which is a major purveyor not only of useful economic and financial data, but also a major proponent of economic central planning as practiced by modern central banks, informs us that Fed chair Janet Yellen has actually found the holy grail. Finally, central planning will work! At last, the promise of the “scientific monetary policy” is about to be fulfilled. Nirvana has practically arrived.
In a once again slightly confusing Bloomberg headline we are told: “Yellen Takes the Good Greenspan, Leaves the Bad”. If that’s so, obviously nothing can go wrong. It does make us wonder though what she’ll do about the ugly Greenspan.
In a way, this is an almost prophetic poster, with its references to risk taking and someone “doing the cutting”…
So what is the promising secret sauce discovered by Ms. Yellen? After a string of abysmal failures over the past century, how is central economic planning by the Fed finally going to lead us to salvation? As the headline already indicates, tweaking Alan Greenspan’s playbook is believed to do the trick:
“Janet Yellen looks to be taking one page out of Alan Greenspan’s playbook while tearing up another as she plots monetary strategy for 2015 and beyond.
The Federal Reserve chair and her colleagues signaled this month they would be willing to push unemployment below its so-called natural rate — a feat Greenspan as chairman managed in the late 1990s without fanning much inflation. Yellen showed less desire to pursue her predecessor’s “measured” approach to raising interest rates in the mid-2000s, suggesting his strategy may have fostered complacency that made a small contribution to the financial crisis.
The late 1990s “was a very good period for the U.S. economy, and Greenspan made the correct call on monetary policy,” said Michael Gapen, a former Fed official who is now senior U.S. economist for Barclays Capital Inc. in New York. On the other hand, “there is a general consensus the way they did policy wasn’t right” in the run-up to the housing bust that preceded the 2007-2009 recession.”
H.W. Sinn Chides Ms. Merkel
A friend pointed a recent editorial by German economist Hans-Werner Sinn in the FT out to us, in which Mr. Sinn – one of the staunchest opponents of stealth bailouts via central bank policy in Europe – takes Germany’s chancellor Angela Merkel to task for not doing anything to stop the latest schemes instituted by the ECB.
Specifically, Sinn points to the many ways in which the ECB has already skirted its statutory limitations, and how this trend continues and is actually getting worse with the most recent monetary policy announcements. An excerpt:
“Despite the Bundesbank’s protests, the European Central Bank is giving Europe’s banks a leg-up. To make them fit enough for the proposed banking union, the ECB proposes to relieve them of some of the potentially toxic loans they have extended to the private sector, which will be bundled into asset-backed securities and taken on to the central bank’s balance sheet. The ECB’s preference is to purchase the better tranches of these securities and leave the junk for the European Investment Bank. But since politicians are not playing along, the ECB will have to hold its nose – and complete its conversion into a bailout agency.
The ECB began as a central bank that carried out monetary policy, providing liquidity for domestic uses. But when the financial crisis hit in 2008, banks in Ireland and southern Europe faced a dearth of foreign loans, on which they had come to depend. The ECB allowed national central banks in these countries to end the drought by lending even more money against ever-weaker collateral. This exercise in money creation went beyond what was needed to ensure domestic liquidity; €1tn in central bank credit was created out of thin air to settle foreign bills. The citizens of the six countries that were indulged in this way used the money to pay off their foreign debts and to purchase foreign goods.
The ECB went on to instruct national central banks to grant crisis-afflicted states credit totaling €223bn under the so-called Securities Markets Program. Mario Draghi, the ECB president, moreover offered unlimited protection for their government bonds, formalizing his vow to do “whatever it takes” to save the euro under the rubric of “outright monetary transactions”. This lowered the interest rates at which overstretched euro zone members could obtain credit and reversed the losses of their foreign creditors, triggering another borrowing binge.”
Sinn then goes on to explain that what is being considered now, is going well beyond even these past interventions. He then chides Ms. Merkel for failing to look after the interests of German citizens as instructed by the rulings of Germany’s constitutional court over recent years, which tended to be of the “yes, but” kind: they allowed all sorts of bailout schemes to go forward, but with certain strings attached.
Contrary to Sinn’s interpretation of these rulings, we do not believe that they constrained the ECB much – rather, by making parliamentary consultations and votes on bailout proposals such as the ESM rescue fund a sine qua non, they increased the propensity of Germany’s government to leave the heavy bailout lifting to the formally independent ECB, as no parliament exercises control over it. In fact, Sinn himself suspects as much when he says:
Slow Uptake of TLTRO Funding
It seems European banks are not all that eager to take up more central bank credit. The ECB has begun to offer its dirigiste “targeted long term refinancing operations” at a spread of 10 basis points above the repo reference rate. Since the repo rate was lowered from 0.15% to 0.05% at the last ECB council meeting in early September, this type of funding has become even cheaper. However, when banks obtain funding by posting collateral with the ECB, this automatically creates additional bank reserves – and those bear a penalty rate of 20 basis points these days. We continue to be mystified by the introduction of the penalty interest rate on bank reserves. We have no idea what it is supposed to achieve and in fact we suspect that it actually achieves the opposite of what the ECB ostensibly wants.
One of the goals is to weaken the euro, which is quite a hare-brained idea, as a weaker euro will affect consumer purchasing power across the euro zone negatively. Note that the euro area just posted another strong increase in its trade surplus. So even those who believe that a positive balance of trade is in any way indicative of an economy’s health (which is nonsense to begin with), will have to admit that the euro zone’s export sector hardly appears to be in need of an extra boost.
As to the TLTRO funding, this is extra-cheap long term bank refinancing tied to certain conditions – banks must use these funds to extend private sector credit (exclusive of mortgages). In the event they use the funds for other purposes like e.g. more carry trades in government debt, they merely need to repay the TLTRO funds two years earlier, in 2016 instead of 2018. Since there is very little private sector credit demand, it should perhaps not be too surprising that the first round elicited very little demand. Reuters reports:
“The European Central Bank saw far less demand than expected on Thursday for its new four-year loans to banks, raising doubts about a stimulus package it hopes will stave off deflation and revive the euro zone economy.
The launch of the scheme, a central plank of the ECB’s efforts to coax reluctant banks to lend, saw the euro zone’s central bank hand out 82.6 billion euros of 400 billion euros ($515.16 billion) on offer to 255 banks. That was well below the 133 billion euros forecast by a Reuters poll of 20 money market traders. Banks will get a second chance on Dec. 11 to apply for the cash, granted at ultra-low interest rates on condition they lend it on to businesses, when the poll predicted take-up of 200 billion euros.
Berenberg Bank chief economist Holger Schmieding called the low demand “a disappointing result for the ECB” that cast doubt on the bank’s hopes of injecting 400 billion euros into the economy through this scheme. “Simply offering more liquidity at more generous terms to banks awash in cash will not make a huge difference to the outlook for growth and inflation,” he said.
But ECB Executive Board member Peter Praet warned against reading too much into the first result, stressing that it was part of a broader policy package that “will have a sizeable impact” on the ECB’s balance sheet. He added that expectations for the first round had always been lower than for the second offering in December.
“Markets have understood that the June and September measures should be seen as a combination aiming at addressing credit impairment,” Praet told Reuters in an interview, adding the measures could only be assessed once fully implemented. Praet also reiterated the ECB’s readiness to do more should it become necessary.
No Surprises in Carbon Copy Statement
If anything, the FOMC statement was probably interpreted by Kremlinologists as less hawkish than expected (although the Fed already leaked that fact via the WSJ’s John Hilsenrath on Tuesday, spurring yet another surge in risk assets). The reduction in QE by a further $10 bn. to a mere $15 bn. per month was widely expected, but the feared “change in language” was conspicuous by its absence – in short, there were no hints as to a change in the envisaged time table for eventual rate hikes.
This provoked two hawkish dissents (actually, to call them “hawkish” is a bit of an exaggeration), by regional presidents Richard Fisher & Charles Plosser, i.e., the usual suspects who were never really on board with the Fed’s unconventional policies anyway. Their beef was precisely with the unchanged guidance on the timing of rate hikes. Readers can compare the changes relative to the July statement with the help of the WSJ’s trusty statement tracker.
Interestingly, a number of markets reacted as though the guidance had been changed – gold was down $12, the dollar index jumped to a new high for the move, treasuries weakened. The stock market is usually the last market to get the memo, and at first rallied with some verve, but gave back much of its gain as the initial euphoria faded – however, it still managed to close in positive territory (after all, nothing bad can possibly happen).
“Conjuring Profits From Sub-Zero Yields”
The above is the title of the recent Bloomberg article that discusses the ECB’s penalty rate on bank excess reserves (which as one analyst recently remarked have become the proverbial “hot potato” now that a 20 bp fine is charged for their possession) and its effects on bond markets. In euro-land, government bond yields have already completely collapsed, partly to almost Japan-like levels – and yet, more capital gains can still be achieved, even with paper sporting negative yields. According to the article:
“David Tan got to help oversee $1.5 trillion at JPMorgan Asset Management by picking winning trades. Now he’s studying how to make money from investments that look sure to lose.
Across much of Europe in the past year, the yield on two-year government debt tumbled from little, to none, and then below zero. That means buyers would walk away with less cash when the securities matured — if they waited that long.
Money managers like Tan are navigating a market where positive returns are still possible on debt with negative yields provided others will pay a higher price before the notes come due. Those opportunities were enhanced last week when the European Central Bank increased the cost for financial institutions to park their money with it. After that, depositors were tempted to take their cash from the ECB and funnel it intogovernment bonds, because the negative yields hurt less than the central bank’s more punitive charge.
“If yields continue deeper and deeper into negative territory, the opportunities for capital gains remain,” Tan, who is head of rates in London for the fund-management unit of the U.S.’s biggest bank. “If your central hypothesis is that yields are going to converge” with the ECB’s charge on deposits then you still see “some potential price appreciation,” he said.
The list of institutions that may choose to lose includes asset managers so large they’re willing to pay for their cash to be held safely as well as banks that want to avoid the higher ECB charges. And it includes many large financial groups like insurers whose rules are too inflexible to give many alternatives. At the top of the heap probably are other central banks.
Central bankers “are a fairly value-insensitive bunch,” Michael Riddell, a London-based fund manager at M&G Group Plc, which oversees the equivalent of about $415 billion, said on Sept. 5. “They have to invest their FX reserves somewhere if they want to buy euro-area assets that have the top credit ratings, then they have no choice.”
ECB Cuts Rates From Nada to Zilch (and Less), Announces QE
In his Jackson Hole speech, Mario Draghi already hinted at further ECB interventions, pointing out that 5 year forward inflation breakevens indicated that long term inflation expectations had fallen below 2% (i.e., 2% CPI rate of change). Consumers would of course see this as a reason to rejoice, but not our vaunted planners. It was already widely expected than an ABS purchase program would eventually be announced, as preparations for this have been underway for several months.
Frankly, we thought that given that the TLTROs are beginning in September, the ECB would likely wait for their impact before announcing additional interventionist steps. As it turned out, they announced so many things at once on Thursday, they actually managed to surprise not only us, but apparently the great majority of market participants.
The announcement included: further rate cuts; with the repo rate now at 5 basis points, which we might as well call zero, this avenue is now rapidly closing. Since all rates were cut, they also increased the bizarre penalty rate on excess reserves to minus 20 basis points. All this measure achieves is that it costs the banks money. It's not going to make them more eager to lend, but it will lead to them cutting the paltry interest they pay to savers even further. So the war on savers is continuing at full blast.
Waiting Until 2158
All over the world stocks are rising. In the US, the S&P 500 rose over the 2,000 mark for the first time in history. The Dow is over 17,000. And if you want to buy a share of online TV network Netflix, Inc. (NASDAQ:NFLX), you will pay $144 for every dollar the company earned over the last 12 months.
The Current Path of ECB Policy
While the ECB keeps talking about what it might possibly do, its actual policy choice is a rather odd mixture, as Sharmila Whelan of Asianomics recently pointed out. On the one hand, it is evident that a policy of internal deflation has been embarked upon in the euro area.
However, on the other hand, this is combined with a policy of “pain avoidance”, which we can see by the frequent reactive ECB decisions to temporarily inject liquidity again with instruments such as its LTROs (and their new bastard child TLTRO) and keeping administered rates at ridiculously low levels, as well as by the continued increase in government debt. As we have previously noted in these pages, to the extent that credit expansion has taken place in the euro area in recent years, it has been focused almost exclusively on the funding of more government spending.
The private sector by contrast continues to slowly deleverage (see our previous article “Euro Area Credit and Money Supply”, which contains a recent update of the most important data points in this context).
Naturally, this combination of policies makes little sense, as it simply serves to prolong the pain of the adjustment. If the ECB and other policymakers in Europe were to let market forces make short shrift of the remaining bubble activities in the euro area, there would be a sharp, but short recession. This would indeed be quite painful, but it would also lay the foundation for a sustainable upswing. However, one would have to be politically prepared to endure the considerable short term pain associated with this approach, and a great many impediments to price and wage adjustments would have to be removed beforehand.
The current period of relative calm is likely to soon give way to a more “interesting” time period again, in the Chinese curse sense. This is so, because money supply growth in the euro area is recently decelerating significantly.
No “Inflation Worries”
Ahead of the Jackson Hole pow-wow, where a bunch of central bankers and establishment-approved intellectuals advising them will soon meet, it may be worth taking a look at what motivates the policies of the new Fed chair. On August 12, Bloomberg reported – employing its inimitable style of headlines construction – that “Yellen resolved to avoid raising rates too soon, fearing downturn”. Bloomberg elaborates:
“Approaching a historic turn in U.S. monetary policy, Janet Yellen has staked her tenure as chair of the Federal Reserve on a simple principle: she'd rather fight inflation than another economic downturn.
Interviews with current and former Fed officials indicate that Yellen and core decision-makers at the U.S. central bank are determined not to raise interest rates too early and risk hurting the fragile U.S. economy.
It's a commitment that will be vigorously tested in coming months as pressure builds inside the Fed, among Republicans on Capitol Hill, and perhaps even in financial markets, for the Fed to acknowledge a strengthening U.S. economy with its first interest-rate increase in more than eight years. A global central bankers' conference in Jackson Hole, Wyoming next week will give Yellen a major stage on which to press her case.”
To this it must be kept in mind that the definition of “inflation” has been twisted over time to represent one of its possible effects rather than the thing itself. Prices obviously cannot be “inflated” – they can either rise or fall. What can be inflated is the money supply, and until large parts of the science of economics began to retrogress from the late 1930s onward, this was precisely what economists held to be the meaning of the term. In short, “inflation” once designated the increase in the money supply. However, Bloomberg, Ms. Yellen and her fellow Fed members use the term “inflation” to refer to the mythical “general price level”, specifically the rate of change of consumer prices.
Why is there no such thing as the “general price level”? Even our largely disembodied digital money is essentially a good with its own supply-demand characteristics. If one compares the array of price ratios it forms with other goods against which it is exchanged, there are two problems:
Firstly, since both money and the goods one exchanges it for are subject to the laws of supply and demand, there exists no fixed yardstick – if one e.g. looks at the money price of oil, it is simply not possible to know to what extent its height is influenced by the supply of and demand for money, or the supply of and demand for oil.
The second problem is that by adding up an entire array of money prices of disparate goods, one arrives at a number that is devoid of logic.
To see why consider the following sentence: “1/25,000 of a car, plus one movie ticket, plus two pounds of potatoes, plus one fifth of a massage, plus ½ of a haircut, plus 1/500 of a personal computer, equals….” – when it is put in this way, it should be immediately obvious what the problem is. An “average” of cars, potatoes, haircuts, etc. is inherently meaningless.
When One Central Bank Slows its Destructive Policies, Another Must Step Into the Breach …
We could call this the summary of Lorenzo Bini Smaghi's views, who frets in a recent FT editorial about the effects the Fed's decision to 'taper' its 'QE' operations may have on the moribund euro area economy.
In about two thirds of the editorial, Bini Smaghi lists the ways in which a slowdown in monetary largesse across the pond might impact financial markets in Europe. There is nothing wrong with this analysis, in fact, a similar impact will likely also be felt in the US and elsewhere. After burdening the economy with the biggest money printing and deficit spending orgy in post WW2 history, we must expect all the economic errors these policies have induced to become visible as soon as the inflationary policy is actually slowed down sufficiently.
However, the problem is that Bini Smaghi thinks that therefore, we need more of the same, only this time, the ECB is supposed to take upon itself the role of chief money printer. Naturally, there is not a single word about the causes of the last crisis, which was caused by a boom triggered by the very same loose monetary policies Smaghi once again supports. Smaghi not only thinks the ECB should print money in reaction to the turbulence the Fed's tapering may cause, but it should do so “preemptively”.
“The only way to avoid such a scenario is for the ECB to counteract the restrictive effects produced by the combination of a US monetary tightening and renewed market turbulence. The measures announced so far do not seem to be sufficient, as their effectiveness largely relies on the prevailing demand for bank financing coming from European companies, which currently seem to have little incentive to invest and still need to deleverage. The ECB’s balance sheet might thus continue to shrink, while the economic recovery slows down. Forward guidance, which aims primarily at short-term policy rates, may lose credibility as it is unable to prevent the rise in long-term rates.”
Loans to the Private Sector Keep Declining, Money Supply Growth Slows
We want to briefly update the most important credit and monetary data of the euro area, which we last briefly discussed in March (see: “Overview of Recent Monetary Trends”, which focused however more on the US than on Europe).
In spite of the ECB cutting interest rates to the bone and offering new “targeted long term refinancing operations” to banks (see “European Credit Dirigisme” for background information), neither lending to the private sector nor money supply growth have so far picked up in the euro area as a whole (there are of course differences between the individual member nations).
Generally we would regard this as a positive development, insofar as it should help to minimize capital malinvestment. Unfortunately, we can infer from the fact that money supply growth remains in positive territory, that lending to the private sector has been replaced with lending to governments, so the economy continues to be exposed to the burden of deficit spending by governments. This is probably not particularly surprising, but we would be remiss not to mention it.
Below we show three charts, consumer credit, loans to non-financial corporations and the euro area's true money supply (currency plus demand deposits). The red lines show the absolute numbers in millions of euro, the blue lines show the annual rate of change in percent.
Consumer credit has taken a dive, and the slump has recently slightly accelerated again – click to enlarge.
Everybody is under pressure here. Elizabeth has planned a big party at our place in western France to welcome daughter Sophia and her husband, Ryan, into the local community. Two hundred people are scheduled to gather on the lawn.
(Image via depositphotos.com)
But what’s this? We just checked the weather forecast; it’s supposed to rain! Too late to get a tent. Too late to call it off. Oh là là!
“Everything is so nice here,” says our mother, clearly not paying attention. “It’s perfect …”
The family is gathering. This is where the younger children grew up. It is the place they regard as home. Which is a bit strange to their father, who never expected to stay for more than a few years and has never really felt at home here.
But we’ve now been here, off and on, for nearly two decades. And it looks like more will follow. That’s both the trouble and the charm of life – you never know exactly where it will lead you.
The Fed's Mortgage Bond Purchase Announcements
Fed/QE followers know the Fed has been publishing its weekly, on Thursdays. This is a detailed summary of everything the Fed has purchased for the week, broken down by type, while netting out sales.
The link will also connect the reader to archived transactions dating back to the origins of QE3. Recently, the Fed started pre-announcing what it would be doing for the week with the Tentative Outright Agency Mortgage-Backed Securities Operation Schedule.
In addition, at every FOMC meeting, they have already told the world how much they are tapering by. It is not as if the transaction amounts could be a surprise to anyone.
Then what is the purpose of this transparency?
I think the Feds are either stupid, or they think the market is stupid. Having given them too much benefit of the doubt hitherto, I have concluded that it is the former.
This transparency is Ms. Yellen's version of Fed jawboning, hoping that with the help of pre-announcements, she can somehow micro manipulate interest rates.
A Case of Jitters
What was that sound? Did you feel a little bump? Nah… don’t worry about it. Go back to your cabin and have a good sleep.
Just when things were going so well! With all that GDP growth! All those new jobs! We were all set to believe that the US economy really had recovered from the shock of 2008.
(Photo taken by the Chief Stewad of the Prinz Adalbert)
What does the stock market know that these happy numbers aren’t telling us? On Thursday, the Dow dropped more than 300 points. Gold fell $14 an ounce. There may be nothing more to this than a case of the jitters.
Or could it be something more?
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