“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?
It Can't Be A Bubble!
Articles claiming that the current situation in financial markets does not deserve the epithet “bubble” are a dime a dozen – we come across several every week since at least late 2013. Before continuing, we should point out that there is a big difference between recognition of a bubble and forecasting the timing of its actual bursting. For instance, we were well aware that there was a bubble in the late 1990s, but not only did it still take a good while before it hit its peak (a peak that was then retested in terms of the broader market half a year later), it also expanded considerably further before it did so, and only started collapsing in earnest in late 2000.
It is important to realize in this context that this particular bubble – the one in technology stocks that peaked in early 2000 – is not some sort of “standard measure” for what constitutes a bubble. It was certainly the most extreme stock market bubble in all of history in a major developed market (in terms of valuation expansion in this particular sector) – beating even the Nikkei's famous 1989 blow-out by a huge margin. Again, only if one compares the tech sector's then trailing P/E of more than 300 to the Nikkei's trailing P/E of more than 80 in 1989.
In terms of the broader market's valuation, the bubble peak in 2000 was less than half as spectacular as the Nikkei's, but it was still the top of the greatest valuation expansion ever experienced in the US stock market. We merely want to point out here that it would be wrong to claim that “well, the year 2000 was a bubble, and therefore anything that doesn't look quite as extreme as this one outlier isn't”.
We came across another article of this type recently and want to discuss what we believe the flaws in its arguments are. The article in question is “Bubble paranoia on S&P 500 is a storm in a teacup”, which was posted at Saxo's tradingfloor.com by Mr. Peter Garnry. Note here that we don't want to make an argument about the likely timing of the bubble's bursting or its potential for further expansion (that is a different subject) – we only want to discuss whether a bubble actually exists or not.
Legal Tender Renders Planning Impossible
There is much confusion over what the legal tender law does. I have read articles, written by people who are otherwise knowledgeable about economics, claiming that legal tender forces merchants to accept dollars under threat of imprisonment. Recently, I wrote a short article for Forbes clarifying how legal tender law works in the US.
Legal tender law has nothing to do with merchants. If you want to sell steak dinners in your restaurant for silver, you may legally have at it. Unfortunately, the tax code discourages your would-be customers as I wrote in another article.
The legal tender law targets the lender. It grants to debtors a right to repay a debt in dollars. In practice, this means that if you lend gold, the debtor gets a free put option at your expense. If the gold price rises, he can repay in dollars. If it falls, of course he will be happy to repay in gold. It’s a rotten deal for the lender.
The relationship between lender and borrower is mutually beneficial, or else it would not exist. The parties are exchanging wealth and income, creating new wealth and new income in the process. The government is displeased by this happy marriage, and busts it up by sticking a gun in the lender’s face. His right to expect his partner to honor a signed agreement is violated.
Because no lender will lend gold under such circumstances, gold is relegated to hoarding and speculation only. This strikes a blow to savers, because the best way to save is to lend and earn interest. Savers are forced to choose betweenhoarding gold, getting no yield, or holding dollars and getting whatever yield crumbs are dropped by the Fed.
If there’s no lending in gold, what takes its place? The Fed force-feeds credit in ever-larger amounts, and at ever-falling interest rates.
The Fed is supposed to make its credit decisions in order to optimize two variables. First, employment shouldn’t be too high or too low. Second, consumer prices shouldn’t rise too quickly or too slowly. The Fed has little ability to predict employment and prices, and even less control over them.
Equal Opportunity Offender
Let us begin with some criticism from a reader:
“What you said about Janet Yellen is disrespectful to All Women. You said you meant no disrespect, and then you go ahead and say most women her age are baking cookies for their grandchildren and saying she has soft shoulders.
You would not make the same kind of sexist comment about a man holding the position that she does. You should grow up… your comments are so old fashioned and out of touch. If you are going to put someone down because you don’t agree with what they are doing, resorting to sexist commentary as a metaphor only makes you look like the fool.”
Ouch! We thought we headed off this kind of complaint with our frank alert a few weeks ago. Didn’t we warn readers?
Sexist … ageist … religionist … racist … abilityist … intelligencist. We are an equal opportunity offender. We disrespect all groups without favor or distinction. Especially those we like.
Besides, didn’t we advise those with delicate feelings and hypersensitivities to cover their ears and eyes, lest they discover some calumny?
The dear reader says she speaks for “All Women.” We don’t know if she’s polled them all… but wow! We offended half the world’s population in a single paragraph. And without even breaking a sweat.
And we stick by our point: It’s better to bake cookies than to wreck the world’s biggest economy! So, let us divert the conversation, from our personal failings to the coming disaster.
There Could be Some Bubble Risk Somewhere … Maybe …
Ms. Yellen has inter alia shared her insights about financial markets with the Senate Banking Committee – while wearing her bubbly dress, no less! According to her, there may be a “risk of bubbles” in leveraged loans and low grade debt – to which we say, it is way too late to worry about whether there “may” be such a risk. That horse has left the barn long ago. We have the biggest bubble in low grade debt ever, and central banks are 100% responsible for it.
Interestingly, she thinks that stocks at the third highest CAPE in all of history are just fine, valuation-wise (CAPE or Shiller P/E at 25,5 currently, approximately at the 92nd percentile of the 1602 data points in this series according to Doug Short). Note here that there are some measures by which stocks are actually valued at the second highest level since the 2000 mania peak (e.g. price/revenues).
Our guess? She is probably consulting the long-discredited “Fed model” when she is trying to divine whether stocks are overvalued.
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